Liberalising the Chinese banking system: necessary but dangerous

I recently gave a presentation to the Cambridge China Business Network, a student club. The title is “Like dismantling a nuclear bomb: liberalising the Chinese financial system”. The slides are shown below.

Summary

Liberalisation of a market means removing most or all regulatory and legal restrictions on market forces. Most countries that have liberalised their financial systems, including the flow of funds into and out of the country, have had a financial crisis a few years later. It’s impossible to prove causation but there are good reasons for believing that liberalisation is dangerous, even when it is done for solid reasons: better allocation of finance, less corruption and lower transactions costs.

China’s financial system is dominated by banks so we can refer just to the banking system. The banks are nearly all owned and controlled by the government, even though they have outside private shareholders. For decades the government has set interest rates at low levels, to extract resources from depositors (ordinary households for the most part) to provide cheap loans to favoured borrowers – mainly state owned enterprises and local government. Small and medium sized enterprises and other private sector companies have been starved of credit and depositors have received a low return on their cash.

The government now intends to let market forces set interest rates. It also intends, probably later, to allow full movement of funds into and out of China. That would bring the benefit of access to cheap foreign funding and of a higher exchange rate but also the risk of a sudden move of funds out of the over-invested Chinese real estate market into offshore assets. That risks a sudden fall in property prices and a banking collapse. The scale of the problem is much larger than when other countries liberalised, because China is such a big economy. But the government has, one hopes, learned a lot from other countries and has a good record of pragmatism when it comes to reform (in contrast to the “big bang” approach used in the US and UK – the UK deregulated credit control in 1971 and had a major property and banking crisis only two years later). So there are good reasons to be optimistic that the worst will not happen. But the risks are there.