What’s Next for Financial Opening Up?
In the early 1990s, China’s financial system covering commercial banks, insurance companies and capital markets began to take shape after reconstruction across a decade since 1978, when the financial sector was in ruins.
Following the rapid development of the financial market, China launched two major measures on financial opening up: First, it adopted a policy to welcome foreign direct investment in 1993, which ultimately made China the biggest benefactor of foreign direct investment over the subsequent two decades. Second, the combination of the dual exchange rate in 1994 marked the launching of a system of managed floating exchange rates.
During the second half of 1996, Dai Xianglong, then governor of the People’s Bank of China, wrote to the International Monetary Fund (IMF) that China had realized RMB convertibility on its current account and planned to realize convertibility on capital account in next five to ten years.
The financial crisis in East Asia in 1997 postponed China’s plans to open up the capital account, but the opening up of China’s financial sector did not stop. At the end of 2001, China joined the World Trade Organization and clearly pledged to open up its financial service sector. China’s economy has enjoyed robust growth since then. Although the country’s exports increased and foreign exchange reserves accumulated fast, China’s financial sector endured fierce global competition.
On January 1, 2004, Central Huijin Investment Ltd. was established to execute the power and fulfill the obligation of an investor on behalf of the government for major state-owned financial enterprises, which evidenced that reform had influenced all types of financial institutions. This reform continued all the way to 2012, when China Everbright Bank went public in China. This round of reforms has led Chinese financial institutions operating at their own risk and shouldering responsibility for their own profits or losses. They have improved significantly in business philosophy, operation modes, capital adequacy ratio, and risk management.
The financial crisis of 2008 accelerated China’s progress on interest rate liberalization and RMB globalization. As the RMB’s proportion steadily increased in global payment and reserve, it was included in the new Special Drawing Right (SDR) basket of the IMF, manifesting the RMB’s arrival as one of the major reserve currencies in the world. RMB globalization has made new contributions to the reform of the international monetary system and will lead the integration of China’s financial sector with that of the world.
China has been progressing in reform and opening up for four decades. Its financial opening up has made remarkable achievements based on macro indicators. The huge inflow of foreign direct investment has made significant contribution to China’s exports and economic growth. Additionally, China’s relatively stable financial system and sound international balance of payments have boosted the confidence of investors. The opening up of China’s financial sector has taken place alongside the dramatic changes in the country over the four decades of reform and opening up. It offers valuable experience and lessons for implementing financial policies in the next phase. Meanwhile, it may also serve as references for other emerging economies that are opening up.
First of all, China needs to make the right choice on the sequence of reform policies. It is universally agreed that the sequence of measures is important for financial reform. Without sound reform policies, opening up can generate risks. Therefore, China should combine measures to promote reform through opening up and those facilitating opening up through reform. Cross-border capital flows should not be further unleashed until the liberalization of interest rates is finished and the flexibility of exchange rates significantly improves.
Second, the trial opening up of the financial service sector can be launched. The opening up of financial services doesn’t involve major flow of capital and is still regulated domestically, so it has low risk. At the same time, participation of foreign-funded financial institutions will create more competitions and improve the quality of the industry. Those institutions shall bring new operational techniques and management. These are conducive to economic growth.
Moreover, it is crucial to set a pragmatic target for the opening up of capital accounts. There has been a consensus in the international policy circles after the American subprime mortgage crisis that major capital flows in a short term can cause major risks. Therefore, the IMF has also changed its policies, allowing regional and temporary limits by countries on cross-border capital flow for the purpose of maintaining financial stability or the independence of a currency. In the case of China, as it cannot withstand the aftermath of fully opened capital.
The author is deputy dean of the National School of Development at Peking University.