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Why China Needs to Accelerate Financial Reform

J.P. Morgan’s Ulrich sees liberalization as crucial for the small enterprises that drive China’s economy.

Future of Finance

Few people know China’s markets as well as Jing Ulrich. The Beijing native studied at Harvard and Stanford universities, was one of the earliest fund managers to focus on Greater China in the mid-’90s, then built a reputation as a star equity analyst at CLSA, Deutsche Bank and J.P. Morgan, where she now works as chairman of Global Markets, China. Ulrich believes that the financial reforms China is implementing are critical to the country’s future and its rise as a global financial power. She spoke recently with Institutional Investor’s Asia Bureau Chief, Allen T. Cheng, and explained why China must accelerate those reforms.

What financial reforms are necessary for China to free up its hidden financial energies?

One of the most important objectives of reform in China’s financial system is to reduce the prominent role played by bank intermediation in growth, considering that bank credit accounts for 80 to 90 percent of funds raised by the corporate sector. Small and medium-sized enterprises generate about 65 percent of GDP and 80 percent of the country’s jobs, but have received only about one-fifth of bank loans. This bank-centric model of finance was effective in mobilizing savings to satisfy investment needs during China’s earlier stages of development, but it has placed the private sector and smaller firms at a disadvantage.

One of the chief aims of the current round of financial reforms is to increase the proportion of direct financing as a share of total social financing. According to data from the People’s Bank of China, bond and equity fundraising by non-financial companies accounted for only 14.1 percent of total social financing in 2011. Interest rate reform is also needed to deter lending to lower-return projects and promote more efficient allocation of capital.

Why are Chinese financial institutions so cautious about going global since the financial crisis broke in 2008? Might they move more aggressively into global markets?

Chinese banks are now massive in terms of market capitalization and assets, but their business reach is still limited in terms of functional and geographical diversification. Although the potential for domestic growth is very strong, Chinese banks will naturally expand into global markets, both organically and through acquisitions, to accelerate their development and to cater to many of their major corporate customers, which are increasingly making investments abroad or extending their operations overseas.

In late-2007, we witnessed an early wave of overseas investments by Chinese banks that were bolstered by their IPO proceeds and rising profits at the time. Naturally, Chinese financial institutions took a more prudent approach following the onset of the global financial crisis.

Which markets do you think Chinese financial institutions will target?

It seems reasonable to expect that the geographical pattern of expansion by Chinese institutions will move in line with the expansion of their major customers. They may do this by establishing local branches, acquiring local banks or establishing strategic partnership with their foreign counterparts.

We have recently seen Industrial and Commercial Bank of China, China Investment Corp. and Central Huijin receive approval from the Federal Reserve to become bank holding companies in the U.S., while Bank of China and the Agricultural Bank of China have been approved to establish new branches in Chicago and New York.

Like their international counterparts, China’s leading investment banks and asset management firms have global aspirations and have a growing presence in the world’s major financial centers.

By 2030, how significant will Chinese players become globally, and what kinds of products and services might they offer that they currently aren’t offering?

China’s largest financial institutions will have expanded substantially into new markets, both geographical and in terms of their product offering. It’s reasonable to expect that Chinese banks will have become more market-oriented entities and will have narrowed the remaining gaps relative to international practice. The further opening of the capital account will result in higher inbound and outbound portfolio flows, which represents a tremendous business opportunity for both Chinese and international asset management and securities firms.

How important will Hong Kong be as an offshore financial center in 2020?

Hong Kong has already emerged as an important center for offshore RMB business, as evidenced by the expanding suite of products in the CNH market (the Hong Kong market for yuan products). As of late-May, the total value of outstanding dim-sum products, including dim-sum bonds and CDs, accounted for roughly 53 percent of Hong Kong’s total RMB deposit base. In the first five months of the year, a total of 84 dim-sum bonds with a value of 44.2 billion yuan ($7 billion) were issued, an increase of 54.5 percent over the same period last year.

Over time, the dim-sum product suite should continue to diversify to include more equity products, ETFs, structured products and even derivatives.

Might the RMB be more or less convertible by 2020, and how will this benefit Shanghai’s rising importance?

The renminbi’s prominence as a currency for global trading and investment has risen dramatically since the Chinese government stepped up its internationalization campaign at the height of the global financial crisis.

Even so, China will carry out financial sector reforms at a prudent pace, so as to set the stage for capital account liberalization and further the process of interest rate liberalization. Shanghai’s aspirations of becoming an international financial center would certainly benefit from progress in this direction.

Might other offshore centers dominated by ethnic Chinese, such as Singapore, benefit from the rise of the RMB?

Interestingly, London was the first offshore market aside from Hong Kong to launch an RMB bond. London has the advantages of being the largest foreign exchange market worldwide and being situated in a European time zone. That said, other potential offshore RMB centers such as Singapore and Taipei have the potential to compete, since they are geographically more proximate and have a higher degree of cultural affinity with China.  Notably, Singapore is the key trading hub between China and the ASEAN region.

Might there be increased competition between Chinese financial institutions and U.S. and EU financial institutions?

Competition between Chinese and foreign banks will certainly increase, especially as traditionally government-owned institutions continue to evolve into market-driven, customer-oriented commercial banks. There is also, however, much room for cooperation, especially in combining the local market knowledge and distribution advantage of domestic banks with the global financial resources and product innovation capabilities of their foreign counterparts.