Globalization: the Role of Institution Building in the Financial Sector _ The Case Study of China

Globalization: the Role of Institution Building in the Financial Sector ---The Case Study of China August, 2003 I. Introduction Financial globalization could be described as a process in which global financial activities get increasingly integrated with the risk creation mechanism. This description emphasizes three points. First, financial globalization is not only a process in which financial activities transcend national borders, but also a process in which risks spread across the markets. Second, financial globalization is initiated by many micro-economic entities to seek profits and is driven by the integration of global financial markets. Third, it is a gradually deepening process with distinct phases. In general, financial globalization covers five areas: capital flow, monetary system, financial markets, financial institution, and financial coordination and supervision. In China, institution building in the financial sector takes place against the backdrop of financial globalization. It not only shares common features with other countries’ experience but also has its own characteristics. Therefore, it is useful to review the process of institution building in China, to analyze its effect on the economy and prospects under the framework of financial globalization. II. Review of Institution Building in the Financial Sector A. Main driving forces of institution building A review of the developments of China’s financial sector over the past 20 years reveals that reform and opening up have been two major forces driving institution building in the financial sector. Generally speaking, the fundamental reason for financial system reform is to increase the efficiency of allocating and utilizing financial resources. The micro economic entities in the financial system initiate financial innovation through seeking for financial resources, resulting in improved efficiency of the whole financial market. The reform is market-oriented and aimed to establish advanced financial system and sound financial order commensurate with the socialist market economy. Endogenous institutional reform mainly depends on participation of micro entities. It covers financial incentive, innovation and discipline mechanism, which drive financial development as a lasting and inherent force. Opening up of the financial industry is an important part of the whole opening strategy of China. Facing financial globalization, it is the rational choice for China to further open up its economy and benefit from the strategy called ‘improvement through contact’. Full-scale contact with the international markets means that China may gain access to global economic resources in a broader scope and at the same time expose the domestic financial market to the impact of the global financial markets, whether positive or negative. 1 B. The role of FDI in institution building Over the past 20 years, foreign financial institutions, mainly foreign banks have played an important role in the opening up of Chinese financial industry. In the early days of their operation in China, foreign banks’ deposits were generally larger than their loan portfolios, and most of the excess funds were either deposited in their overseas headquarters or correspondence banks. In recent years, the growth of lending has accelerated. The ratios of loan balance to total capital, total assets and deposit balance have also increased. At the end of June 2003, total assets of foreign banks amounted to USD41.25 billion and total loan balance amounted to USD19.86 billion. 54 percent of foreign bank loans were granted to support manufacturing industry and has promoted the development of light industry, chemical industry, and electronic industry and machinery industry. Foreign banks also bring more overseas customers to the Chinese market, which has further promoted the overall increase of foreign direct investment. In particular, foreign banks have provided intermediate services such as business consultation and information service in the negotiation of international loans, and such services constitute an important part in the process of attracting foreign capital. In addition, foreign banks also play a unique role in institution building in the financial sector. They help to mitigate financial repression in China, to establish sound financial system, to enlarge contribution of the financial sector to economic development and to realize a virtual cycle of financial deepening and economic development. The role of foreign banks covers the following areas: 1. Competition effect. After the entry of foreign banks into the domestic market, the monopoly of state banks has been broken. Competition forces Chinese banks to reestablish their business strategy and operation. 2. Demonstration effect. Foreign banks have demonstrated their advanced technology, equipments, organization and management to domestic banks. Their higher profitability has stimulated Chinese banks to upgrade technology and equipment while improving management. 3. Training effect. Foreign banks provide training programs for their Chinese employees so as to improve their professional skills. At the same time, foreign banks also transfer technology and management skills to their Chinese counterparts. All these have helped to improve the efficiency of Chinese banks. More importantly, foreign banks not only provide an external financing channel for Chinese enterprises, but also facilitate the development of the domestic capital market while they are engaged in investment and securities business. Also, entry of foreign banks urges the Chinese regulatory authorities to comply with international standards and to reduce government intervention. In addition, foreign banks have set a good example for Chinese banks on how to do business in the international financial markets. For China, the role played by foreign banks is like a double-edged sword. While promoting financial deepening in China, expansion of foreign banks’ market share might have negative effects on Chinese economy, especially on the financial industry. 2 These negative impact include potential shocks to Chinese banks, strengthened transmission of international financial crisis, and reducing capability of the central bank to exercise macro-economic management using traditional monetary policy instruments. C. Sequencing of institution building in the financial sector The sequencing of institution building in the financial sector may differ from country to country. However, there are some experiences worth mentioning for a developing country like China. First, the government should base the contents and speed of reform on macroeconomic stability. Second, the adjustment in financial sector should be consistent with adjustment of the real economy. Third, internal adjustment should not lag far behind the process of opening up. Fourth, a gradual approach should be adopted. The government should take into account possible economic and social consequences, as well as the time frame required for the domestic markets to adapt to the new system and the management of enterprises to improve their professional skills. In view of its overall economy, it is an inevitable choice for China to adopt a model of ‘limited opening and gradualism’. Most developing countries and a few developed countries have adopted the model of ‘limited liberalization’. When these countries opened their domestic financial markets to foreign competition, the authorities tend to set various restrictive measures in the areas of market entry and business licensing. Therefore, foreign financial institutions, compared with their domestic counterparts, face more strict barriers in entering the market, conducting business and complying with regulatory rules. Gradualism means that a country opens its financial markets on a gradual basis after certain conditions have been met. The restrictions on market entry and business scope of foreign banks are gradually loosened and foreign banks will be granted national treatment step by step. This model often involves three periods, which starts with strict restriction, then loosening restriction and ends with full liberalization. As Professor Ronald McKinnon pointed out, China should adopt the gradual liberalization approach, rather than the big bang approach used by the former Soviet Union and some East European countries. According to Professor Tobin, China should gradually integrate with the international financial market, though it should actively participate in the economic and trade globalization. This is due to the basic economic situation and the development stage of Chinese financial market. It has been proved that global financial stability requires effective surveillance and needs support from the international financial institutions. However, sound macro economic policy and structural reforms in each country constitute the basis for meeting such a challenge. Global financial stability is based on stability of individual country’s financial markets. Also, the stability of individual country depends not only on the surveillance, guidance and support of the international financial institutions such as the IMF and World Bank, but also more fundamentally on the soundness of its monetary and fiscal policy as well as the banking system. Apart from the attack of the speculators, the Asian Financial Crisis was to a larger extent caused by weaknesses in macro economic policy and the banking system in related countries. 3 D. Major Issues in the institution building process of the financial sector 1. The relationship between financial opening and financial security China’s decision to join the WTO signifies a step forward in the opening of financial sector to the outside world. In the mean time, the era of rigid financial control will come to an end. Coupled with the advancement of e-economy, financial opening and liberalization will bring great impact on the existing financial system, and especially on financial regulatory framework. This trend also indicates the importance of financial security. As far as China is concerned, financial security consists of, inter alias, the soundness of domestic financial sector and stability of the liberalized financial market. 2. The disadvantage of domestic banks in competition with foreign banks Compared with large international banks, domestic banks are generally in an apparently disadvantaged competitive position. The restructuring of state-owned banks is yet to gain speed despite the significant improvement that has been achieved. After China’s accession to the WTO, increasing number of foreign enterprises choose to do business with foreign banks as they swarm in. Meanwhile, premier domestic enterprises are also shifting to the securities market for financing, which results in the erosion of and more fierce competition in the traditional banking market. The problems of inadequate innovation, weak competitiveness and the loss of premier customers and professional staff will be more salient for state-owned banks. In addition, high NPL ratio poses a long-lasting difficulty for the state-owned commercial banks, which hinders the process of their ownership restructuring. 3. Moral hazard Since 1996, a set of measures has been taken by the government to prevent and dissolve financial risks. However, these measures had yet succeeded in addressing the problem of incomplete contracts, but brought about moral hazard. The merging and acquisition are not completely the result of market selection and the government itself took a leading role. The “too big to fail” argument has been under debate in theory all the times. The operation mechanism of those merged and acquired financial institutions have not changed fundamentally, however they have increased the number of branches and staff. In China’s case, it is a fact that the bigger the financial institutions are, the less possible for them to be closed. The government guided M&As reduces probability to fail, but it does not necessarily mean improvement of management and assets quality. 4. Weak financial infrastructure Business growth of Chinese banks is constrained by the weak infrastructure in respect of practice in loan classification, accounting, auditing and payment and settlement. For instance, The NPLs of domestic banks have long been defined following traditional criteria as overdue loans, default loans and bad loans. This static classification method is quite different from the international accepted methods and unable to reflect the true quality of loans. In recent years, the application of the five-category classification method has been advanced thanks to the strong push of the central bank and the efforts of commercial banks. 4 5. Slow progress in market-based interest rate reform Since interest rates are not adequately determined on market basis, their roles as signals to the supply of and demand for fund are not fully effective, and sometimes have negative influence on pricing and risk management of commercial banks. E. Policy measures to promote institutional building Institution building in financial sector in China has been mainly achieved through a series of institutional reforms. China’s financial institutional reform process could be divided into the following three stages: (1) preparation and strategy exploration, (2) framework construction, and (3) adjustment and advancement. During the first stage from 1979 to 1984, the financial sector in China began to undergo institutional reform. The prominent features of the financial system at this stage could be summarized as follows: (1) separation of central banking from commercial banking by establishing a two-tier banking system, (2) establishment of specialized commercial banks serving different industries; and, (3) Introduction of deposit based bank growth model. During the second stage from 1985 to 1996, a series of new arrangements and a primary framework for market-based financial operations were introduced. The main features are as follows: (1) The legal status of the central bank was established with the promulgation of the Central Bank Law and the Regulations on Monetary Policy Committee. (2) The institutional structure diversified, including the development of non-banking financial institutions, the establishment of several insurance companies, the fast growth of securities industry, the start-up of Shenzhen and Shanghai Stock Exchanges and the grant of market access to foreign financial institutions. (3) Significant progress was made in financial deregulation, including the separation of commercial banking from policy banking by establishing three policy banks in 1994 and the promulgation of Commercial Banking Law in 1995, encouraging competition among banks, introducing concept of risk, profitability and cost in bank management, improving capital management system, introducing assets/liability ratio regulatory framework, and strengthening internal control. (4) Macro financial management relied more on indirect adjustment than on direct control, with extensive application of monetary policy instruments such as interest rate, reserve requirement and open market operations, while focus of supervision of commercial banks shifted from credit ceiling to a comprehensive set of prudential ratios. (5) Remarkable progress was achieved in institutional innovation of the financial market. Stock exchanges, inter-bank market and bills market began to operate. 5 ... - tailieumienphi.vn