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Chapter 13. The Next Big Bang: A Road Map for Financial Reform in China

Anoop Singh, Malhar Nabar, and Papa N'Diaye
Published Date:
November 2013
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Nigel Chalk and Murtaza Syed 

Managed well, financial reform will generate significant benefits—in growth, employment, and standards of living—that will help sustain China’s spectacular development and accelerate the rebalancing of its growth model. Done right, it could be as significant as the state-owned enterprise reform of the 1990s. Conversely, a prolonged delay in financial liberalization or implementing it in a poorly sequenced or badly executed manner would pose substantial risks for China and spill over onto an already fragile global economy. This chapter presents the rationale for financial reform in China and outlines a road map that could be implemented over the next three to five years.


Liquidity control has traditionally been a hallmark of prudent macroeconomic management in China, contributing significantly to the country’s sustained and stable economic development. Since the mid-1990s, the authorities have relied on a wide-ranging system of controls to lock up the large amounts of structural liquidity generated by China’s economic model. The financial system is flush with liquidity, both because of a high stock of savings (Figure 13.1) held domestically by China’s closed capital account, and because of large external inflows associated with the country’s balance of payments surpluses, as well as the corresponding foreign currency intervention historically necessary to resist appreciation of the exchange rate (Figure 13.2).

Figure 13.1Decomposition of Saving, 1994–2010

Sources: CEIC Data Company Ltd.; and IMF staff estimates.

Figure 13.2People’s Bank of China’s Sterilization of Foreign Exchange

Sources: CEIC Data Company Ltd.; and IMF staff estimates.

To prevent this liquidity from fueling dangerous lending booms and asset bubbles, the People’s Bank of China (PBC) has historically relied on control—predominantly direct tools like quantitative limits on bank credit, regulation of deposit and loan rates, and relatively high reserve requirements.

These tools have proven effective for conducting macroeconomic management during most of China’s past, given the historically bank-based nature of China’s financial system. Nevertheless, a by-product of these policies has been artificially low loan and deposit rates, which have created incentives for banks to allocate much of their lending to very large, capital-intensive enterprises, and has lowered the costs of sterilizing China’s foreign currency intervention.

However, China’s financial landscape has changed dramatically in the wake of the massive credit stimulus that was used to counter the effects of the 2008–09 global financial crisis. Credit was first unleashed through banks, placing pressure on their balance sheets and contributing to a rapid run-up in property prices. Since the crisis, more and more credit has been intermediated outside the banking system, through channels that are harder to control and regulate under existing frameworks. In the absence of reforms, the attendant risks for macroeconomic and financial stability will continue to grow.

So what does this all mean? Because it is the world’s second largest economy, a safe, stable, well-regulated, and efficient system of financial intermediation in China is in everyone’s best interests. Since the onset of the global crisis, we have learned all too well of the enormous global social costs that financial instability in systemic economies can create.

Moreover, sustaining China’s spectacular growth record will be impossible without a modern financial system that efficiently intermediates savings and allocates capital. Financial reform will be necessary to achieve many of the key themes identified in the 12th Five-Year Plan, including (1) boosting household income, by increasing the returns to savings; (2) increasing consumption, through prudently managed household credit as well as instruments that smooth consumption and hedge risk; (3) reducing income disparities, through better access to financial services, including in rural areas; (4) increasing employment, through a more appropriate pricing of capital and a move toward a more labor-intensive means of production (Figure 13.3); and (5) supporting the development of new industries, by reallocating resources on market terms and making more financing available to small and medium enterprises and start-ups, including in the services sector.

Figure 13.3Average Employment Growth, 2004–10, Industrial Countries and Emerging Markets

Sources: IMF (2011).

It is also worth bearing in mind that China is, in any case, outgrowing its current system of direct government influence over the allocation and pricing of credit. Certainly, this managed approach allowed for strong growth following the start of China’s reform efforts, in part because sectors with high growth potential were easier to identify. However, the system was not perfect, and generated significant downsides in the form of overcapacity, a capital-intensive means of production (Figure 13.4), a tendency for asset bubbles (Figure 13.5), and a periodic need for public-funded bank recapitalizations. With the Chinese economy growing in size and complexity, the ability to productively steer credit directly is diminishing and the costs of misallocating resources are growing.

Figure 13.4Imputed Subsidy to Capital

Source: IMF (2011).

Note: Non-China Asia = Indonesia, the Republic of Korea, Singapore, and Taiwan Province of China. Other S5 = Euro area, Japan, UK, U.S.

Figure 13.5China: Residential Housing Prices, 2002–09

Sources: IMF (2010).

The rest of this chapter is organized as follows: The next two sections lay out the case for financial reform in China by highlighting the potential benefits of action and the growing risks from inaction, respectively. The subsequent section analyzes the experience of a number of China’s G20 peers, with a focus on indentifying lessons for the composition and sequencing of reforms that would help ensure that the full benefits of financial liberalization are realized and costs minimized. Applying these lessons to China’s specific context, the penultimate section develops a broad road map for financial reform in China that could be implemented in the medium term.

The Benefits of Reform

What could China gain from financial reform? First, a well-executed financial reform program will allow the Chinese economy to adapt steadily to the ongoing, worldwide evolution in financial intermediation and to maximize the benefits from an increasingly diverse set of financial markets and instruments. Developing credible competition for the banks—in the form of corporate bond markets, deeper and more liquid equity markets, mutual funds, exchange-traded funds, derivatives, and other financial products—will create incentives for the whole financial system to operate in a more effective and productive manner. Capital will be allocated more efficiently, and companies—particularly smaller enterprises—that are currently denied access to bank loans will have new options for financing their operations.1

Second, well-designed reform, accompanied by a robust regulatory infrastructure that spans all forms of financial intermediation and guarantees seamless coordination across regulators, will help ensure that the financial system continues to develop in a robust way without excessive risk taking, lowering the possibility of future financial volatility and disruption.

Third, making a broader range of alternative investment instruments available to households will increase the return on their savings,2 allow households and corporate savers to hold more diversified portfolios of assets, and reduce the tensions that are currently evident from having housing viewed as a preferred store of value (Figure 13.6).

Figure 13.6Distribution of Returns to Bank-Intermediated Capital

Source: Chapter 3 of this volume.

And finally, financial reform will facilitate China’s move toward a more modern means of macroeconomic control, one that deploys market-clearing prices to determine the availability and cost of credit rather than having both the price and quantity of loans regulated by the government. This move will strengthen the monetary transmission mechanism and give the central bank greater ability to fine-tune policy in response to changing economic conditions (Feyzioglu, Porter, and Takats, 2009).

These benefits are well known to China’s policymakers and were highlighted in the 12th Five-Year Plan, which included a clear commitment to moving ahead with the reform of China’s financial system, as well as recent policy intentions announced by the incoming leadership.

The Risks of Inaction

If China does not implement reforms, what could go wrong? China has long been characterized by a very deep financial system but one that has relied predominantly on banks to intermediate enormous levels of household and corporate savings. However, this bank-dominated structure is now changing. Since the global financial crisis, China has experienced an acceleration in the pace of financial innovation; an expansion of new ways to intermediate savings; and a migration of resources out of the banks and into other forms of financial intermediation, such as trusts, wealth management products, and corporate bonds (Figure 13.7).

Figure 13.7Social Financing

(broad measure of credit in China)

Source: CEIC Data Company Ltd.; and IMF staff estimates.

The diversification and development of financial markets and instruments is generally good (Figure 13.8), facilitating a more efficient means of allocating China’s capital, opening up financing opportunities for companies that previously were unable to get bank loans, and increasing the level of remuneration that households receive on their savings.

Figure 13.8Credit Intermediation, 2010

Source: CEIC Data Company Ltd; and IMF staff estimates.

However, these changes also pose risks to financial and macroeconomic stability. Regulation of the nonbank system of intermediation is weaker and less well developed than that for banks. Care is also needed to ensure that banks are healthy enough to withstand a steady loss of resources implied by a growing nonbank system. Evidence is already appearing of growing liquidity pressures on smaller banks in China. In addition, the underlying system of macroeconomic control needs to evolve with the times. In particular, the current regulation of interest rates distorts the pricing of deposits and creates huge incentives for resources to migrate out of the banks to institutions that are not subject to such controls on the rates of return they offer. Why put your money in a bank deposit that earns less than inflation when you can choose from a convenient array of more lucrative wealth management products instead? Furthermore, international experience demonstrates that the use of administrative limits on the quantity of bank lending as a means to exercise macroeconomic control is likely to become less and less effective as financial innovation takes hold and more and more intermediation takes place outside of the banks.

Therefore, financial reform is essential to sustaining the ability of China’s policymakers to effectively guide the macroeconomy, ensure that the expansion of nonbank channels proceeds safely and soundly, and prevent the banking system from being undermined by a loss of deposits and funding.

Reaping the Benefits and Avoiding the Pitfalls: Lessons from International Experience

A number of China’s G20 peers have reformed their financial sectors, and their experiences provide important lessons. As in China, their pre-reform financial sector landscapes were often characterized by a heavy bias toward bank intermediation, rigid segmentation across financial institutions by function, low levels of competition, regulated interest rates, a large public sector role (including directed lending and state guarantees of financial institutions), the conduct of monetary policy mainly through direct instruments, and capital controls. In addition, countries embarking on financial liberalization have encountered several challenges, and their reform efforts have often led to periods of financial volatility and crisis (see Annex 13A for a summary of the major steps and mistakes made by other G20 economies as they moved toward a more modern and market-based financial system). From international experience, a few broad lessons stand out:

  1. Financial sector weaknesses should be sought out and addressed before liberalization begins, including ensuring institutions have the ability to adequately price and manage risks; recapitalizing or restructuring systemically important institutions; and enhancing corporate governance. Unaddressed weaknesses create the potential for financial institutions to take greater risks to boost returns and cover up their underlying vulnerabilities. These vulnerabilities will then grow as financial reform proceeds, potentially culminating in weaknesses in systemically important institutions.
  2. The macroeconomic policy framework should move toward market-based monetary policy at an early stage, and should be based on indirect instruments and include increased exchange rate flexibility. Before financial reform proceeds, the monetary authority needs to have at its disposal sufficient macroeconomic control tools to prevent an unintended surge in lending or creation of the conditions for large capital inflows.
  3. Implicit public guarantees of financial institutions should be explicitly withdrawn during the early stages of liberalization. Blanket backing should be replaced with an explicit scheme for deposit insurance. Ensuring that banks face hard budget constraints would be an important prerequisite for a more commercially oriented banking system that adequately prices risk and efficiently allocates credit. Hard constraints also help mitigate moral hazard risks and prevent banks from taking undue risks as restrictions on bank activities are eased and new markets are opened.
  4. The financial, legal, and accounting framework should be revised before embarking on major reforms, in particular with regard to regulatory and supervisory frameworks. The major prerequisites include (1) clear objectives and mandates for the responsible agencies; (2) regulatory independence, with appropriate accountability; (3) adequate resources (staff and funding); and (4) effective enforcement and resolution powers.
  5. The regulatory and supervisory perimeter needs to be sufficiently wide and well coordinated to prevent regulatory arbitrage and identify emerging vulnerabilities. Virtually all postliberalization crises can be traced to inadequate supervision or to regulations not keeping up with changing financial landscapes. All potentially systemically important financial institutions, including nonbank financial institutions, need to be within the perimeter before restrictions on financial activities are significantly relaxed and new markets developed. The regulatory and supervisory framework should be empowered to limit concentration in bank ownership and require clear identification of beneficial owners (to mitigate the risks of connected lending). Activities in nonbank financial institutions in particular should be monitored closely; these institutions should be prohibited from taking deposits.
  6. Measures to deepen financial and capital markets should move in parallel with reform of the banking system. Financial market development is important to improving the allocation of capital and to creating competition. However, lopsided sequencing can have significant effects on bank balance sheets by undermining banks’ deposit base or by eroding their pool of corporate clients. Loss of deposits and clients, in turn, can lead banks to increase risk exposures.
  7. Many of the important objectives of financial sector reform—including greater competition and efficiency, and enhanced risk management—depend on having market-determined deposit and loan rates. Interest rate liberalization facilitates the development of a market-based monetary policy framework that is based on indirect instruments and has an effective transmission mechanism. Interest rate liberalization provides increased scope for macroeconomic control to mitigate the risks of instability as reforms proceed. Other goals, such as enhanced competition, allocative efficiency, and stronger risk management, all rely on allowing prices (interest rates) to provide the right market-based signals.
  8. But successful liberalization of interest rates has several preconditions. These preconditions include a stable macroeconomic environment, an absorption of excess liquidity, an interest rate structure that is not in serious disequilibrium before liberalization, an active and well-functioning money market, and a sound payments system. Strong supervision policies and instruments and a flexible and effective monetary policy framework are also required. In particular, monetary policy needs to guard against the development of an excess supply of credit as interest rate constraints are removed. In successful cases of liberalization (such as Australia, Belgium, and Canada), credit expansion was reined in by a deliberate containment of liquidity and increases in real interest rates (Figures 13.9 and 13.10). Conversely, other countries—such as Argentina, Chile, and Mexico—lost control of monetary aggregates as they liberalized, injecting enormous amounts of credit and monetary stimulus into their economies that culminated in asset bubbles and banking crises.
  9. Opening to international portfolio flows should occur only after the bulk of financial sector reform has been achieved. The current scale of global capital flows and the increasing sophistication and interconnectedness of the world’s financial markets create large risks for those economies that open themselves up to international capital flows before the distortions and misalignments in their domestic financial systems are resolved. The early stages of capital account liberalization can open up to stable long-term sources of financing, such as direct investment inflows. However, full liberalization—including for short-term portfolio flows—should be put in place only after the bulk of financial sector reform has taken hold.

Figure 13.9Real Interest Rates Following Interest Rate Liberalization

(three-year average)

Source: CEIC Data Company Ltd.; and IMF staff estimates.

Figure 13.10Private Credit Growth Following Interest Rate Liberalization

Source: CEIC Data Company Ltd.; and IMF staff estimates.

Designing a Road Map for China

There is certainly no “one size fits all” approach to sequencing financial sector liberalization, especially in an economy as sophisticated and complex as China’s. In many cases, the appropriate pace and sequencing of reforms will involve multiple trade-offs, and judgment must be exercised in a dynamic manner as the financial system evolves in potentially unpredictable ways when reforms are implemented. As the situation for many comparator countries demonstrates, the agenda for financial reform is a complex, multiyear undertaking. However, starting now will ensure that this process can be largely completed within a three-to-five-year horizon. A broad road map for reform should include adopting a new monetary policy framework; raising real interest rates; strengthening and expanding regulatory coverage of the financial system, including putting in place a broad set of tools for crisis management; developing financial markets and alternative means of intermediation; deregulating interest rates; and, eventually, opening up the capital account (Table 13.1).

Table 13.1China: A Roadmap for Financial Reforms
Deepening commercialization and market orientation of financial system
Absorb liquidityTo move to a "true" market clearing for capital and prevent excess liquidity from leading to rapid credit growth during reform process.
Conduct open market operations, placing PBC bills at market-determined prices.
Steadily increase entire structure of deposit and loan rates.
Reform monetary control instrumentsTo increase scope for macroeconomic control to mitigate risks of instability during reform process and pave way for greater role for markets in setting interest rates and determining pace of credit growth.
Greater exchange rate flexibility.
Greater reliance on indirect instruments, focused on market rate, while narrowing corridor on interbank rates.
Introduce reserve averaging to decrease interest rate volatility.
Remunerate reserves at market-determined rate.
Ensure open market operations are conducted in market-based way, with quantities determined by market-clearing equilibrium associated with given target for interest rates.
Phase out direct government influence on pace of growth, allocation, and pricing of credit.
Move monetary framework away from targets for monetary aggregate growth and toward well-specified policy objective (e.g., inflation and activity).Need to build technical capacity for design and implementation of framework.
Liberalize interest rates (for parallel construction with other recommendations)To increase efficiency of credit allocation, while paving the way for improved competition and risk management in the banking sector and providing a benchmark for pricing other financial products and services.
Raise (and eventually eliminate) ceiling on deposit rates.Could commence with deposit rate deregulation to minimize risk of excessive competition for market share and damaging undercutting of interest margins. Begin with longer-term deposits and then expand to demand deposits.

Strengthen risk management of banks.

Strengthen supervision to ensure banks do not compress margins excessively and thereby erode their profitability and capital base.

Ensure monetary policy is sufficiently flexible (through liquidity absorption and application of macroprudential restraints) to prevent risk of burst in credit growth.
Developing a modern financial infrastructure
Create an environment for promoting the commercial orientation of banks and other financial firmsTo improve credit allocation and strengthen transmission of monetary policy.
Strengthen smaller banks and commercialize large state-owned banks.
Change governance structure at state-owned banks to delink local banks from local governments.
Ensure free entry and level playing field in banking system, including for foreigners.
Promote the development of financial marketsTo build out alternatives to bank-based intermediation.
Preconditions: Strengthen consumer protection and improve availability and reliability of market and financial institution data
Corporate bond marketMain issues: Removing segmentation, streamlining issuance rates, rates being more market-determined.
Equity marketMain issues: Increasing liquidity, making all shares tradable, allowing more domestic and foreign companies to list on Chinese and international markets, broadening shareholder base.
Currency market and derivativesMain issues: Providing nonbanks access to interbank derivatives market to increase competition in retail hedging market.
Mutual funds and broader institutional investor base
Expand range of commercially available insurance products, including life, health, and annuities and private pension plans.
Expand use and availability of financial products, including lending and deposit products.Precondition: Priced off benchmark RMB yield curve set by market.
Consider securitization and other “trust” products.Precondition: Subject to strict regulation and transparency.
Strengthen supervisory, regulatory, and crisis management frameworksTo ensure risks are contained as reforms advance.
Integrating with the global financial system.
Liberalize external account
Ease restrictions on capital outflows.To provide broader range of international assets to Chinese investors.
Move existing controls from quantity- to price-based regulations.
Expand Qualified Domestic Institutional Investor program, followed by more broad-based removal of restrictions.
Take further steps to internationalize RMB.Respond to market demands.
Liberalize inflows.
Gradual expansion of Qualified Foreign Institutional Investor program until quotas no longer binding.Open first to foreign direct investment, then longer-term fixed income products.
Open up to inflows into most-liquid primary markets before secondary markets.
Allow inflows of RMB before foreign exchange inflows.
At final stage, expand to secondary markets for equities and short-term debt.
Promote foreign and cross-border competition
Remove tax and regulatory barriers for foreign financial institutions to participate in domestic markets, and for domestic institutions to go out.Precondition: Subject to appropriate supervision and risk management.
Source: IMF staff estimates.
Source: IMF staff estimates.

A New Framework for Monetary Policy

Financial reform should involve a reinvention of the current framework to move away from the current system’s reliance on controls on deposit rates, the exchange rate, and the quantity of credit to one in which the central bank has clear objectives for growth, inflation, and financial stability. In addition, the PBC should be given flexibility and control over the macroprudential and monetary tools that will be needed to achieve these goals.

As a first step, the high levels of liquidity currently residing in the financial system would need to be absorbed. Judging the extent of this liquidity absorption, however, will be complicated by the lack of reliable price signals and the fact that the “true” level of liquidity in the system is masked by the lack of fully market-determined interest rates, the presence of direct controls on credit, and administrative determination of both the price and quantity of central bank paper issued. Nevertheless, as a first step, open market operations should be deployed to absorb the liquidity overhang by placing central bank paper at market-determined rates and moving the structure of deposit and loan rates closer to the neutral real interest rate.

At the same time, the ongoing liquidity injection that is created by large-scale foreign currency intervention will need to be decreased by appreciating the exchange rate to the point at which the currency market is more balanced and there are genuine two-way flows in the balance of payments and two-way movements in the exchange rate (Figure 13.11). This would lessen the need for monetary tools—including reserve requirements and open market operations—to be so geared toward sterilizing foreign currency inflows and managing the currency. Instead, policies could be reoriented toward a more market-based and countercyclical approach focused on the domestic economy.

Figure 13.11China: Exchange Rate and Foreign Reserves

Source: CEIC Data Company Ltd.; and IMF staff estimates.

With liquidity absorbed and interest rates clearing the capital market, the central bank can then shift toward the use of more indirect monetary instruments to exercise macroeconomic control. The central bank can begin using short-term rates—perhaps the seven-day repo rate—as its effective operational target for monetary policy and phase out direct influence on the growth, allocation, and pricing of credit. The PBC would be able to effectively influence short-term rates through open market operations and could conduct daily open market operations using quantities determined by achieving market-clearing at a given target level for the policy interest rate. Reserve averaging could be introduced to decrease interest rate volatility, and reserve requirements could be remunerated at a market-determined rate.

Because financial innovation and development makes money demand unstable, targeting M2 would no longer be a feasible proposition and a new framework for the conduct of monetary policy would be needed. In particular, the PBC could move toward a monetary policy regime that has objectives for growth, inflation, and financial stability that are achieved through a combination of interest rates and macroprudential tools.

Improving Regulation and Supervision

As the system evolves, the government will need to be nimble in adapting to the changing environment by increasing the commercial orientation of the banking system, bolstering its crisis management capabilities, and strengthening supervisory efforts to identify and manage macrofinancial vulnerabilities.

Further advances in the regulatory and supervisory regime will be needed to ensure it is sufficiently adaptable and dynamic to react in a new environment of tighter liquidity, indirect monetary control, and, eventually, liberalized interest rates. In a more liberalized environment, strict supervision will be needed to prevent banks or nonbank institutions from engaging in unsafe practices to boost profitability or gain market share. Particular attention will be needed to address the supervisory and regulatory gaps that will inevitably emerge in a more dynamic and liberalized setting. To this end, investments should be made to improve stress-testing capabilities; increase oversight for the largest financial institutions; overhaul the crisis management and resolution framework; build a process for the orderly exit of weak or failing financial institutions; develop clear rules on central bank emergency liquidity support; put in place a formal deposit insurance scheme; and pursue better data quality and collection. Interagency regulatory and supervisory coordination will also need to become more ongoing and systematic, identifying and resolving regulatory gaps. A key step will be to establish a permanent, high-level, interagency financial stability committee that would monitor and identify macrofinancial vulnerabilities and implement a macroprudential framework geared toward preventing the buildup of systemic risks.

Developing Broader Channels for Intermediation

Strengthening nonbank financial intermediation will be an important objective of financial reform. Nonbank institutions will compete with the banking system, offer companies alternate avenues for project financing, and provide households with a broader range of financing and investment possibilities. Expansion of nonbank areas of intermediation will, however, need to move largely in tandem with reform of bank-based intermediation. Failure of these developments to occur on parallel tracks could create incentives for a faster migration of resources out of the banks (into bonds, equities, trusts, leasing, and wealth management products), creating accompanying supervisory and regulatory challenges and the potential for destabilizing the banking system.

The focus should be on dismantling impediments to the development of alternate markets and instruments but with corresponding clarity about the regulations and responsibilities of those new institutions. Priorities include reducing segmentation, increasing liquidity, and simplifying regulatory requirements in equity and bond markets. In addition, efforts should be made to encourage a broad institutional investor base—including pension, insurance, and mutual fund companies.

In conjunction with developing a wider range of investment products, enhanced regulation and supervision will help ensure that risks to financial stability are well managed. In addition, a comprehensive framework for disclosure and consumer protection will be needed to ensure investors are fully aware of the risks they undertake when diversifying their assets away from bank deposits. For prudential reasons, precedence should be given to gaining experience with straightforward instruments before allowing more sophisticated ones, such as securitized and trust products.

Liberalizing Loan and Deposit Rates

With a robust monetary framework in place, and with interest rates rising to clear the capital market, the next step will be for the central bank to move away from the regulation of loan and deposit rates (Figure 13.12). The preferred strategy would be to gradually lift the ceiling on deposit rates, allowing them to be determined by banks on a competitive basis. Competitive determination would facilitate an increase in the cost of funding and a move toward a corresponding increase in loan rates. The ceiling could be lifted in stages based on the term of the deposits, to allow banks time to adjust.

Figure 13.12China: Short-Term Interest Rates, 2007–12

Source: IMF staff estimates.

Note: PBC = People’s Bank of China.

With interest rates liberalized, financial institutions should be held accountable for managing their risks. In particular, regulated firms that are deemed by their supervisor to be well capitalized and well managed could be granted more discretion and held accountable for conducting their operations prudently and in compliance with the regulatory framework. Similarly, customers of financial products could assume greater responsibility for their own financial decisions, complemented by adequate consumer protection, disclosure, and improved financial literacy.

It will be essential to ensure, as this transition proceeds, that it does not translate into an unintended loosening of monetary and credit conditions. Knowing when to rein in monetary and credit conditions will be complicated by the increased difficulty, resulting from the ongoing financial reform and liberalization, of predicting the appropriate pace of monetary growth. Nevertheless, monetary policy would need to be attentive and used actively to counter the potentially unpredictable impact of interest rate liberalization on liquidity, credit growth, and monetary conditions.

The process will need to be carefully managed—through both the use of monetary policy tools to adapt liquidity conditions and the application of macroprudential restraints—to counter any surge in credit growth as interest rates become more market determined. Particular attention will need to be paid to ensuring credit does not expand at a precipitous rate either in the aggregate or to particular sectors (for example, to real estate or consumer credit). As interest rates are deregulated, regulatory and supervisory tools must be used to their fullest to ensure that the banks do not engage in overly aggressive competition or unsafe practices to attract deposits, expand lending, or compress margins to gain market share.

Greater freedom to set loan and deposit rates will create incentives for the banks to manage and price risk better and will make money market interest rates more representative of true financial conditions. At the same time, a more market-determined system of interest rates will provide valuable price signals for macroeconomic policymaking and will strengthen the transmission mechanism for monetary policy.

Opening Up the Capital Account

As the domestic financial system becomes more market based with fewer distortions in the determination of market-clearing levels of credit and interest rates, China can then proceed to dismantle its extensive system of controls on capital flows.

The early stages of capital account liberalization should focus on removing restrictions on more stable, long-term sources of financing such as direct investment flows (as is already being done). As the reform process advances—with market-determined interest rates, a robust monetary policy and regulatory framework in place, a flexible currency, banks operating prudently, and the domestic financial system liberalized—the stage would be set to ease restrictions on short-term inflows. As restrictions are eased, the current qualified foreign institutional investor and qualified domestic institutional investor system could be effectively used to open up the account in stages and at a different pace for different forms of investments.


The motivation for financial reform in China is clear. Before the global crisis, China was on a firm trajectory toward a more modern financial system capable of addressing the challenges of a more mature and complex economy. However, when financial systems across the globe suffered severe setbacks, Chinese policymakers naturally paused. But in the medium term, China needs to regain and maintain the pace of change.

Thus, it is encouraging to note the prominent role assigned to financial reforms in the 12th Five-Year Plan and by the new Chinese leadership. Indeed, the road map laid out above can be completed over a three-to-five-year horizon. Well-executed financial liberalization is the next big wave of reform that China needs. It could be as significant as the state-owned enterprise reform of the 1990s, laying the foundations for continued strong growth in China in the coming decades.

This chapter outlines a broad road map that encompasses both the key elements and the sequencing of the required financial reform effort. Continuing to defer progress in this area heightens the risk that the financial system will evolve in an uncoordinated and disorderly fashion, outpacing supervisory capabilities and revealing regulatory gaps.

The likelihood is high that developments may already be proceeding on a timetable that is being driven not by careful, preemptive, and concerted policy planning but rather in an ad hoc way, propelled by the accelerating pace of market disintermediation and innovation. Such a trajectory is in the interests of neither China nor the rest of the world.

Annex 13A.Financial Reforms: Lessons From Country Experiences
Initial ConditionsSequencingOutcomesPath to Crisis
Financial sector reforms were part of a broad effort to diversify the economy and expand the role of the private sector.Phase I (1982-86): Indirect monetary policy instruments were introduced, interest rates were liberalized, and credit ceilings were phased out.During the early stages of reform, real interest rates moved higher to market-clearing levels, and the more efficient private banks began to build market share.As the capital account became more open, domestic imbalances in the financial system combined with a tightly managed exchange rate gave rise to a surge in speculative capital inflows. Domestic banks borrowed heavily offshore in foreign currency to fund rapid growth in local currency loans. Regulatory efforts to dissuade such carry trades were largely too little and too late.
Financial sector was dominated by five large state-owned banks, government-directed lending was prevalent, interest rates were regulated (and typically negative in real terms), and the growth in bank credit was subject to administrative ceilings.Phase II (1987-92): Restrictions on the activities of banks were loosened, directed lending was reduced, and there was greater latitude in the operations of foreign banks. Reserve requirements were equalized across the banking industry, removing a source of preferential treatment for the state banks. Prudential regulation and supervision were enhanced. Capital account liberalization began in 1989, with controls on portfolio and bank capital inflows steadily eased.Macroeconomic policies were kept restrictive, particularly with fiscal policy steadily tightening. However, vulnerabilities began to build up in the second phase of reforms during 1987-92, but these risks were left largely undiagnosed. In large part these were due to weak corporate governance, inadequate regulation and supervision, and a macroeconomic policy mix that encouraged large speculative capital inflows.As the Asian financial crisis unfolded in 1997, the weaknesses in the Indonesian financial sector—including currency and maturity mismatches—were exposed, putting strains on corporate and bank balance sheets and, eventually, ending in a fullblown systemic banking crisis.
On the capital account, outflows had been mostly liberalized, but inflows were subject to strict controls.Despite increasing competition, bank ownership remained highly concentrated and large private banks, which were subsidiaries of politically powerful business conglomerates, were able to use their influence to circumvent regulatory limits related to connected lending. Large parts of the financial sector (and their largest corporate borrowers) were perceived to be covered by implicit public guarantees, a perception that had been strengthened by a succession of opaque bailouts. There was an absence of a clear framework to resolve failing institutions and banks had few incentives to manage downside risks. Overcapacity in the financial sector grew over a number of years, spurring excessive lending to relatively unproductive sectors, including real estate.
JAPAN (1975-90)
Pre-reform financial sector landscape was dominated by banks with limited options for savers, low regulated interest rates, and strict limits on bond issuance. The financial sector was also characterized by rigid segmentation of financial institutions by function.The capital account was liberalized early in the process. In the 1980 Foreign Exchange Control Act, corporate borrowers were given greatly expanded opportunities to raise funds overseas.The lopsided pace of liberalization caused the banks to quickly lose many of their best borrowers, while savers had few choices but to remain in bank deposits. As a result, many large and medium enterprises reduced their dependence on bank financing and increased their funding from bond and equity markets, where nonbank financial institutions were large investors.In the early 1990s, Japan’s real estate bubble burst, and the resulting decline in property prices, equity prices, and economic growth exposed the underlying vulnerabilities on bank balance sheets.
Discretionary administrative guidance was the principal method of financial regulation, with “convoy regulation” aimed at ensuring financial institutions evolved at the same pace, implicitly inhibiting competition. As financial liberalization began, Japan did, however, have a largely open capital account.Liberalization was asymmetric. Corporate borrowers were provided access to a broader range of funding alternatives before savers were given choices in investment instruments. A number of new markets grew, including a commercial paper and corporate bond market, but retail investors were given only limited access.During 1980-90, the ratio of bank debt to total assets for large, publicly listed manufacturing firms dropped by almost 20 percentage points (to less than 15 percent). However, household deposits continued to rise because barriers to entry into the investment trust business remained high and banks were not permitted to market investment management services. The loss of corporate clients and banks’ efforts to continue to build market share led them to expand their exposure to the property market and to smaller firms.The deceleration of economic growth impaired the capacity of small businesses to repay, nonperforming real estate loans skyrocketed as collateral values plummeted, and the fall in equity prices shrank bank capital. The banking system became mired in a collapse from which it has yet to fully recover.
Deposit rate liberalization proceeded slowly and at a slower pace than lending rates. Indeed, it took until 1994 for deposit rates to be fully market determined.Lending decisions became heavily influenced by collateral values (rather than a notion of capacity to repay), credit standards weakened, and between 1980 and 1990, loans to the real estate industry doubled. Much of the remainder of the banks’ loan book was devoted to small firms, with correspondingly higher credit risks.
KOREA (1980-96)
Financial sector was largely state owned, highly regulated, and used as an allocation tool by the government to advance its economic development agenda. Monetary policy was conducted using interest rate and credit ceilings as well as reserve requirements.

The government guided resources to its preferred sectors by a combination of directed credit and preferential lending rates. The capital account was largely closed.
Early reforms included bank privatization and measures to increase financial competition, although the banking sector emerged from the privatization process with ownership concentrated among large industrial conglomerates. Nonbank institutions developed, albeit increasingly owned and controlled by these industry groups.

Progress was also made in developing money and interbank markets, an important precursor for a move to a more indirect monetary policy, and the government somewhat scaled back its efforts to direct credit.

Regulatory standards for loan classification, provisioning, accounting, and large exposures saw little improvement, while supervision remained fragmented.

Restrictions on capital inflows began to be weakened in 1989, largely by allowing financial institutions to borrow offshore.
In 1994, the ceiling on foreign currency lending by domestic banks was eliminated but limits on banks’ medium- and long-term borrowing from international markets were retained.

As a result, Korean banks began to finance their domestic long-term foreign currency lending with short-term foreign currency loans.

At the same time, there were large gaps in the prudential regulations relating to foreign exchange exposures in overseas branches and offshore funds, which accounted for a significant buildup in short-term external liabilities.
Between 1994 and 1997, banks rapidly built up huge maturity mismatches on their balance sheets, and the financial sector became exposed to economically unviable projects through a complex network of cross-holdings within industrial groups and connected lending.

By 1997, banks and nonbank institutions found it increasingly difficult to roll over their external short-term funding, leading to an exhaustion of official reserves and an all-out balance of payments crisis.
MEXICO (1988-93)
In the late 1980s, to combat high inflation and low growth, Mexico undertook a broad set of reforms to increase the role of markets in various aspects of the economy.Mexico pursued a rapid pace of financial reform that was contemporaneous with a broad effort at macroeconomic stabilization and capital account liberalization.Bank balance sheets grew rapidly both before and after privatization, as banks tried to capture market share in a newly liberalized market. In response, the authorities began to tighten prudential regulations between 1991 and 1993 by increasing minimum capital adequacy ratios to 8 percent from 6 percent; strengthening loan classification and provisioning rules; and imposing stricter limits on foreign exchange positions.In the wake of liberalization, the newly privatized Mexican financial institutions began to increasingly fund their operations through over-the-counter structured notes that were linked to exchange rate developments.
The banking system was largely publicly held and segmented across sectors, interest rates were regulated, and supervision was generally weak.1989-90: A big-bang program of sweeping reforms was introduced, including eliminating interest rate controls; replacing very high reserve requirements with liquidity ratios; removing restrictions on private sector lending; ending mandatory lending to the public sector; and removing sector segmentation (which allowed for the emergence of universal banks).However, the new regulatory and supervisory framework was seriously deficient and concealed a range of increasing vulnerabilities, not least weaknesses in the Mexican accounting system. Banks were required to classify as nonperforming only that portion of the loan (or the interest payment) that was due but had not yet been repaid. Banks were also permitted to exercise significant discretion in the risk classification of their loans, which allowed them to inflate capital ratios.Accounting rules allowed the banks to book these positions as claims that were not counted toward their net open foreign exchange position. The increasing bank exposures triggered a balance of payments and financial crisis in 1994, which was amplified by the balance sheet weaknesses that were hidden within the system.
1991-92: Eighteen domestic banks were privatized. Before the banks were sold, the government provided unlimited state-backed deposit insurance.In addition, there was no consolidated accounting for universal banks, making it hard to judge risks at a group level. Domestic banks were able to circumvent prudential regulations designed to prevent currency mismatches while large interest rate differentials and the exchange rate peg provided strong incentives for carry trades.
Source: IMF (1999); and IMF staff research.
Source: IMF (1999); and IMF staff research.

    Feyzioglu, T.,2009, “Does Good Financial Performance Mean Good Financial Intermediation in China?” IMF Working Paper 09/170 (Washington: International Monetary Fund).

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    Feyzioglu, T., NathanPorter, and ElodTakats,2009, “Interest Rate Liberalization in China,” IMF Working Paper 09/171 (Washington: International Monetary Fund).

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    International Monetary Fund, 1999, Sequencing Financial Sector Reforms: Country Experiences and Issues” ed. by B.Johnston and V.Sundararajan (Washington: International Monetary Fund).

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    International Monetary Fund, 2010, “People’s Republic of China: 2010 Article IV Consultation—Staff Report” IMF Country Report 10/238 (Washington).

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    International Monetary Fund, 2011, “People’s Republic of China: 2011 Article IV Consultation—Staff Report” IMF Country Report 11/192 (Washington).

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See Chapter 3 in this volume and Feyzioglu (2009).

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