Finance is at the core of a country’s competitiveness. The Central Committee of the Communist Party of China (CPC) attaches great importance to preventing and controlling financial risks and safeguarding financial security. Since the 18th CPC National Congress, under the leadership of the CPC Central Committee with Comrade Xi Jinping at the core, the financial sector has responded to the grave challenges of the lingering impact of the global financial crisis and the synchronized domestic developments of growth rate moderation, difficult structural adjustments, and absorption of the impacts of the previous stimulus policy, vigorously promoting reform and innovation, and enhancing macro-economic management and financial regulation. As a result, financial institution have gained in strength, further diversified financial products, and promoted access to financial services. The multi-layered financial market and financial infrastructure have been improved and the financial system has built stronger risk prevention and control capability. The 19th CPC National Congress has put forward requirements: “We will deepen institutional reform in the financial sector, better serve the real economy, increase the share of direct financing, and promote the healthy development of a multilayered capital market. We will improve the two-pillar framework of monetary and macro-prudential policies, and deepen market-based interest rates and exchange rate regime reform. We will improve the financial regulatory system to hold the bottom line of no systemic financial risks.” These are the fundamental requirement for the financial sector from the Xi Jinping’s Thought on Socialism with Chinese Characteristics for a New Era, representing a scientific decision that combines the general law of financial development and Chinese practice of financial reforms, an action guide for the stable development of financial reform, and the fundamental rules for the financial sector to follow in the new era.
I. The prevention of systemic financial risks hinges on speeding up financial sector reform and opening-up
At the 5th National Financial Work Conference in July 2017, General Secretary Xi Jinping made a series of major judgments, decisions and explicit requirements, “Since the 18th CPC National Congress, significant achievements have been made in China’s financial sector reform and development. Looking back on the financial industry development since the reform and opening-up, we have learned that we must deepen reform to address the tough problems affecting and constraining further development in the financial sector.” “We will open the financial industry wider to the outside world and seek optimization and prosperity through competition.” “Preventing systemic financial risks is the fundamental task and eternal theme in the financial work. A proactive approach in preventing and resolving systemic financial risks shall be given higher priority.” In coping with systemic risks, the theme is prevention and the key is initiative. Reform and opening-up offers both historical experience and future choices in this process.
1. Reform and opening-up has improved the soundness of the entire financial system
First, the basic institutional arrangements of the financial system are in place. Since the reform and opening-up, especially since the 18th CPC National Congress, the monetary policy and financial regulatory system have been based on national conditions and moved closer to international standards. Explorations were made to establish a macro-prudential policy framework and a deposit insurance regime, and to build stronger resilience against the shocks of systemic risks. Major pillars including the stock market, the bond market, derivatives and all kinds of financial market infrastructure have been established, and the financial markets have become one of the world’s largest.
Second, the internationalization of RMB and the two-way opening-up of the financial industry have led to continuous improvement of the financial system. With the RMB included in the currency basket of special drawing rights (SDR) of International Monetary Fund (IMF), China becomes a more important participant in the governance of global financial system. Internationally active financial institutions have promoted competition in China’s financial market through their commercial presence here and improved management and resilience of Chinese institutions. Chinese financial institutions have made progress in “going global.” The four big banks, i.e. Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), Bank of China (BOC) and China Construction Bank (CCB), are G-SIFIs(Globally Systemically Important Financial Institutions). In terms of NPL ratio, capital adequacy ratio and profit making capacity, the Chinese banking industry has a high ranking in the world.
2. Reform and opening-up has promoted the structural improvement of financial institutions and markets
To pursue the vision of innovative, coordinated, green, and open development that is for everyone in the financial system, measures have been taken to deepen the market-based interest rate and exchange rate regime reforms, improve the corporate governance of financial institutions, promote innovations in the organizational system of financial institutions, financial products and services and the development of multi-layered capital market, facilitate the establishment and development of diversified market entities, notably improving the financial sector’s efficiency in serving the real economy and resilience. The stock of aggregate financing to the real economy increased from RMB 76.7 trillion in 2011 to RMB 156 trillion in 2016, and the share of direct financing rose from 15.9 percent to 23.8 percent over the same time period. Traditional businesses including deposits, lending, remittance services and bond trading are now developing soundly in compliance with industry standards, a far cry from the situation at the initial stage of reform and opening-up where the off-balance-sheet business, misappropriation of clients’ funds and rule-violating fundraising were rampant. The financial market has raised its bar and extended its participation in international and domestic financial markets.
II. Prevention of systemic financial risks is the eternal theme of financial work
1. An Overview of the current financial risks profile
General Secretary Xi Jinping has repeatedly emphasized that, “Financial security is an important part of national security and the basis of safeguarding financial security is to identify the hidden risks.” In general, China’s financial situation is favorable. However, our financial industry is at a high-risk stage and will remain so for some time in the future. With pressure from multiple domestic and global factors, the financial sector has a wide range of potential financial risks that are hidden, complex, sudden, contagious and hazardous. Structural imbalance is pronounced; violation of laws and regulations is pervasive; hidden risks and dangers are accumulating, and the industry is becoming increasingly fragile. It is necessary to prevent the dangers of both “black swan” and the “gray rhino”.
First, high financial leverage and liquidity risks at a macro level. High leverage is the ultimate origin of the macro financial fragility, which is reflected as excessive debt in sectors of the real economy and as credit that has been expanding too quickly in the financial sector. At the end of 2016, the overall leverage ratio was 247%. Of that, the corporate leverage ratio reached 165%, higher than the international warning line. Some state-owned enterprises have outstanding debt risks and the elimination of “zombie enterprises” has been slow. Local governments are also adding leverage, in some cases disguising debt as equity, or borrowing in the name of spending on services. The abnormal volatility of the stock market in mid-2015 and real-estate price bubbles in some cities were directly related to leveraging such as margin financing, opaque forms of leveraging up bonds and excessive growth of real estate credit. Some highly risky operations, in the disguise of “financial innovation,” have built up bubbles in several markets. The sluggish international economic recovery and policy spillover of major economies have also exposed China to external shocks such as cross-border capital flows and exchange rate fluctuations.
Second, credit risks of financial institutions at a micro level. In recent years, the non-performing loans have risen, eroding bank capitals and risk resilience. Credit default in the bond market increased sharply and bond issuance declined. Credit risks have a considerable impact on the society and even overseas confidence in China’s financial system.
Third, risks of cross-market, cross-industry and cross-regional shadow banking and criminal activities. Some financial institutions and enterprises have used regulatory gaps and defects to engage in regulatory arbitrage, resulting in multilayered investments of the wealth management products, the mismatch of the asset-liability maturity, implicit repayment guarantees, and distorted responsibilities, rights and interests. Various types of financial holding companies have developed rapidly, and some industrial companies are keen to invest in the financial industry to make fast money through insider trading and connected transaction. Some Internet enterprises are actually Ponzi schemes in the name of inclusive finance. Online and offline illegal fund-raising are common, and trading floors approved and established at random without restraint are likely to give rise to cross-regional mass disturbances. A few financial “magnates” conspire with “inside men” that have regulatory and licensing authority to conduct tunneling. A very small number of officials serving on regulatory positions have been compromised by people that they are supposed to regulate, and the rights and interests of financial investors and consumers are still at risk.
2. An analysis of the causes of financial risks
General Secretary Xi Jinping has pointed out that, “We should see through the appearance to perceive the essence. The current financial risks are the inevitable consequences of intertwined cyclical, structural and systematic factors in the real economy and financial sector.” Specifically, the current hidden financial risks are the mirror images of the structural imbalances in the real economy, inadequate counter-cyclical regulatory capabilities, poor governance of financial institutions, inadequate opening-up of the financial industry as well as defects of regulatory systems and mechanisms.
The first issue is the problems in macro management and financial regulation regime that account for the systemic nature of financial risks. In macro management, effective control of the monetary aggregate is disturbed. While risks were building up, industries and regional governments were keen to promote economic growth and wanted to ease monetary policy. As a result, financing activities boomed. The rapid growth of money and aggregate financing to the real economy often give market players false expectations and give rise to asset bubbles. When risks are accumulated to a certain degree, the bearing capacity of financial institutions and markets will approach the critical point and then all parties would call for increased money supply to provide assistance, leaving hardly any window of time for regulation to reverse the risks. The imperfection in regulatory coordination mechanisms becomes more prominent against the backdrop of rapid development of new business models, organizations and products and more frequent cross-market, cross-industry, cross-regional and cross-border transmission of financial risks. The regulation focus is not precise; there is an emphasis on development of industries rather than risk prevention and control. The fragmented supervision of “each railway policeman managing a section of the rail” has resulted in the inconsistency of regulatory rules for similar financial businesses and encouraged regulatory arbitrage. There is a lack of coordinated regulation for systemically important financial institutions and a regulatory vacuum over financial holding companies. Statistical data and infrastructure have not yet been centralized and unified, making it harder to assess and identify systemic risks. Financial regulation functions are not clear at central and local governments, leaving some financial activities out of the regulatory radar.
Secondly, defects in governance and institutional arrangements of opening-up contribute to the frequency of risks. In terms of corporate governance, the regulation and governance of state-owned capital has not been sorted out. Thus, capital cannot fully cover risk, and the corporate governance of financial institutions is not sufficient, reflected in phenomena such as shareholders acting in excess of authority, shareholders exercising no authority, insider control, and distortion in development strategies, risk culture and incentive mechanism. Looking at the progress of opening-up, protectionism is still prevalent in some industries. Financial regulations lag behind compared with international standards. Financial institutions are not sufficiently competitive and risk pricing capabilities are weak. The financial market cannot effectively control the herding effect, asset bubbles and financial risks. Onshore and offshore markets are not connected, and the spreads between onshore and offshore markets could result in arbitrage opportunities that turn some institutions towards cross-border investment for speculation purposes rather than down-to-earth businesses.
III. The key to financial risks control and prevention is to address both symptoms and root causes with both preemptive and proactive measures.
There are four basic principles in preventing and controlling risks and properly managing the relationship between curing symptoms and addressing root causes. First, return to the basics of financial sector serving the real economy and promoting social development. It is necessary to prevent the financial sector from moving fund around within the financial system instead of into the real economy and to prevent the building up and transmission of risks. Second, optimize the structure of the financial system, including financial institutions, financial markets and financial products, strengthen the ability to prevent and control risks at the micro level. Third, strengthen the regulation and enhance the ability to prevent and resolve financial risks, and minimize the impact of financial risks to economy and society. Fourth, keep the market-oriented basis, let the market play a decisive role in allocating financial resources, and reduce the distortion caused by intervention on market mechanisms.
1. Focus on solving problems and promote the reform and opening-up of financial institutions and financial markets.
First, improve the ability of financial sector to serve the real economy. The financial industry and the real economy should coexist and seek common prosperity. Serving the real economy is the basis for the financial industry and the fundamental measure to prevent financial risks. It is important to create a favorable monetary and financial environment for the development of the real economy. We should focus on strengthening and improving financial regulation, prioritize the supply-side structural reform, to ease financing difficulty and reduce financing cost for the corporate sector, strengthen coordination between monetary policy and other relevant polices. Meanwhile, we should balance the goals of stabilizing growth, promoting reform, structural adjustment, improving living standards and preventing risks while implementing regulation and management measures. The financial industry should return to its original purpose of serving the real economy. The financial industry should focus on the core businesses, emphasize the development of inclusive finance, fin-tech and green finance, guide more financial resources to the key areas and weak links in the economic and social development. We should strengthen financial institutions’ responsibilities in risk prevention. It is necessary to keep their balance sheet healthy and to promote the sound development of corporate governance, internal control system and clearing of complex financial product transactions. There will be rigorous enforcement of requirements of market access and qualification control of financial institutions' shareholders to prevent behaviors such as tunneling, insider trading and interference with the operation of financial institutions. We will establish the sound regulation and supervision on financial holding companies, strictly limit and regulate investment by non-financial companies in financial institutions, separate the real economy sector from the financial sector in the system. We will promote the reform of corporate governance in financial institutions so that they effectively assume primary responsibilities to manage risks and contain financial crimes.
Second, deepen the reform of financial market and optimize the social financing structure. Measures will be taken to develop equity financing in an active and orderly way and steadily raise the proportion of direct financing, to expand multilevel, diversified and complementary equity financing channels, to reform the stock issuance system, to reduce intervention in market prices (indexes), and to eliminate tunneling and corruption from the root causes. Protection of small and medium sized investors’ rights and interests will be strengthened and the market-based M&A and restructuring mechanism will be improved. Measures will be taken to facilitate market-oriented and law-based debt-to-equity swaps, develop diversified investment entities, such as private equity fund, and help enterprises to reduce their leverage ratios and facilitate the market clearing of “zombie enterprises.” We will actively develop the bond market, expand the scale of bond financing, diversify the bond markets products, unify the regulation standards and better meet the bond financing needs of different enterprises. There will also be measures to further develop market connectivity, improve financial infrastructure, expand the risk protection function of insurance market, and promote the sound development of the futures market.
Third, we will continue to open-up the financial industry to competition, and seek improvement and prosperity through competition. The significance of opening-up shall be understood from a higher perspective to keep the direction of further opening-up and to further reforms in order to better achieve the opening-up of troika: a) open up trade and investment; b) deepen the reform of RMB exchange rate regime in an pro-active and steady way and in prompt response to market demand; and c) reduce the capital control, steadily promote the internationalization of RMB, facilitate economic activities with other countries and make the capital account convertible in a prudent and orderly manner. At the same time, on the basis of safeguarding financial security, we will ease the restrictions on market access for oversea financial institutions; further improve financial market regulation to be in line with international standards on the basis of national conditions.
2. Adhere to the bottom line of preventing systemic risks and improve the institutional arrangements of the financial system
First, we will strengthen and improve the central bank’s macro management functions and develop and improve the dual-pillar policy framework of monetary policy and macro-prudential policy. As the leverage ratio, interconnectivity and complexity of the financial system continue to rise, we should better maintain currency stability and financial stability. Monetary policies mainly deal with the issues of the overall economy at an aggregate level to achieve stable economic growth and price stability. Macro-prudential policies work directly on the financial system to reduce systemic financial risks caused by pro-cyclical fluctuations in the financial system and cross-market risk contagion.
Second, we will improve the financial regulation system and enhance policy coordination. The regulatory authorities at the central level should strengthen coordination. The State Council Financial Stability Development Committee will be established to strengthen PBC's mandate on macro-prudential management and systemic risk prevention, to make sure that each regulatory authority take their responsibilities. The PBC's institutional capacity will be tapped to coordinate systemic risk prevention and regulation of important financial institutions. As for the financial holding companies whose business covers many sectors and markets and those cross-market, cross-industry and cross-region financial products, we should identify the respective regulatory authorities and enforce the regulatory responsibility. We will coordinate the regulation of important financial infrastructure and the comprehensive statistics of the financial industry, establish a framework that integrates functional regulation and behavioral regulation, and strengthen comprehensive regulation. Measures will be taken to coordinate the pace and intensity of policy measures to prevent amplified market shock, and to coordinate the financial management at the central and local levels. Authorities on both levels should be proactive and all the regulatory activities should be coordinated like pieces in a chess game to realize the full-coverage of regulation, leaving no financial institution and no financial activity untouched. Central regulatory authority shall provide unified regulatory guidance, make unified rules for financial markets and financial business regulation, and effectively supervise local financial regulation to correct any deviation from the rules that might arise and make local authorities accountable. Local authorities are responsible for risk prevention, control and resolution of local financial institutions, maintain local financial stability, and shall not interfere with the independent operation of financial institutions. Coordinated efforts should be made in strictly regulating licensed institutions and banning illegal financial activities. Financial regulatory authorities and local governments should strengthen risks management and control at their root, and keep in mind that all financial services should be licensed, unlicensed and beyond-the-scope operations are not allowed. On the one hand, measures will be taken to address unregulated interbank business, off-balance sheet business, illegally taking regulatory arbitrage and over-leverage by financial institutions. On the other hand, actions will be taken to clamp down on the illegal financial activities that severely disrupt the financial market such as illegal fund-raising and establishing unlicensed exchanges. We will steadily and orderly continue the Special Project of Internet Finance Risks Prevention and Resolution. There will be better coordination of regulatory power and responsibility, and business supervision and accountability arrangements will be established at each level.
3. Strengthen Party leadership and steer financial reform in the right direction
The 19th CPC National Congress has rolled out top-level design in financial sector reform and opening up, and systemic risk prevention. We will adhere to the principle of following the CPC’s unified and centralized leadership in the financial work, raise the awareness of maintaining political integrity, thinking in terms of the big picture, following the leadership core, and keeping in alignment with the CPC leadership, implementing the requirements of ensuring full and strict governance over the Party, and safeguard financial security of the country.
First, we will implement all work plans according to the Party Central Committee’s decisions. Thinking in terms of the big picture and with a sense of mutual coordination and support, we will earnestly implement major policies and guidelines, strategies of reform and opening-up in financial sector, and carefully organize the implementation of financial regulatory reform, financial institution reform and financial market reform, as well as all measures to prevent and control financial risks.
Second, we will strengthen the Party’s leadership and Party building in the financial system. Party leadership must be integrated with the corporate governance of financial institutions and exercised in the entire process of corporate governance. The G20 Antalya Summit has adopted the G20/OECD Principles of Corporate Governance. We are capable of promoting reform and innovation to build the governance mechanism for financial institutions in line with national conditions.
Third, we will adhere to the principle of Party’s cadre management and fully tap the advantage of Party’s talents. The financial industry is talent-intensive and knowledge-intensive. The efficiency of financial resource allocation and risk management can be improved with talented management team. Financial security will be guaranteed with talented regulatory team. We will build capable management teams in financial industry, with support of professional teams that meet high political standards and maintain excellent conduct.
At the new starting point in history, we must firmly implement the plans and strategies regarding the financial system stated at the 19th CPC National Congress, and rally more closely around the Party Central Committee with President Xi Jinping at the core. We should fully implement the Party Central Committee’s strategic deployment, follow the rules of financial development, deepen financial reform, enhance the financial sector’s capacity to serve the real economy, build a virtuous circle for the sound development of real economy and financial sector, and focus on preventing systemic financial risks.
(Governor Zhou Xiaochuan contributed this article to Ancillary Reading for the Report Delivered at the 19th CPC National Congress)
