FINANCIAL EXPRESS

China may be about to tick another box on its lengthy to-do list for financial reform. In late May media reports claimed that the People’s Bank of China plans to allow banks to issue certificates of deposit to ordinary bank customers this year， another encouraging stride toward interest rate liberalization and a baby step in overall financial reform.

A list of the tasks that China needs to undertake to remake its financial system is readily available. In fact， there are several versions. Each related ministry and regulator has its own index for the next step in opening up. The securities commission， for example， is trying to wipe the domestic stock market clean of fraud and false reporting while also creating investment opportunities for foreigners. The State Administration of Foreign Exchange is ever so slowly allowing the yuan to trade more freely. The central bank itself may have the longest list. PBOC is the trailblazer of financial reform， if not announcing changes to the system then pushing others to do so. It’s often hard to keep up.

In mid-March People’s Bank chairman Zhou Xiaochuan set a new pace for change. In perhaps the biggest announcement on financial reform in years， Zhou said China could fully liberalize interest rates by 2016.

Ending state control over the interest rate paid on bank deposits is the final step China must take in interest rate liberalization. The cap on the rate， currently set at 3%， has kept the cost of lending artificially low during the last two decades of relentless development. That ceiling， along with a floor on borrowing costs that was scrapped nearly a year ago， gave state banks ample room to lend the deposits of the masses to state-owned firms and local governments at below market prices. Without reform， China faces the risk of an increasingly high debt to GDP ratio while the return on its investments grows smaller and smaller.

Allowing certificates of deposit for the public， which give qualified bank customers a slightly higher return on deposits， would show the central bank’s determination to meet Zhou’s tight two-year deadline on interest rate reform.

But this 2016 date is a single point on a timeline that stretches far beyond the horizon. Which reforms happen before or after that date are debatable， even contested. That’s because a change in one area of China’s fragile financial structure could， at least in the short term， undermine another reform somewhere else in the system. Freeing interest rates is just one of four major financial reform initiatives. The other three are liberalizing exchange rates， reforming capital markets and opening China’s capital account. None of these takes priority over another. As the People’s Bank pushes forward， not only must it consider the pace at which other financial players are crossing items off their lists， it must be sure the entire economy， down to the level of property developers and regional governments， is on board. However， in local authorities far from Beijing， some cadre may not have received the checklist for reform yet.

How to stall forex reform

Two years is a blink of an eye in China’s overall reform， and the new timeline has found critics. Just a month after Zhou’s announcement on uncapping deposit rates， another top financial regulator put forward his own version of how reform would sweep the financial sector.

Yi Gang， the chairman of the State Administration for Foreign Exchange and one of five PBOC deputy governors， said the exchange rate should be liberalized before interest rates can be fully freed. This has caused some commotion among analysts， most of whom have long viewed foreign exchange reform as a far more distant goal than interest rate liberalization.

“Yi Gang’s concern is perhaps that interest rate liberalization is likely to result in higher interest rates and attract more speculative inflows， making it harder for foreign exchange reform，” said Wang Qinwei， an economist at research firm Capital Economics in London.

Nixing the cap on deposit rates would shake China’s growth model to its core. The cost of borrowing would rise as banks start to compete for deposits by paying higher interest. That in turn could give rise to a new wave of arbitrage on the yuan.

With a currency seeming set only on an upward trajectory， those with the means have borrowed dollars offshore， exchanged them for renminbi on the mainland and invested in places such as money market funds. The primary culprits in this “carry trade”are traders. As the cost of borrowing rises， so do the yields on money market funds， making them an increasingly attractive investment option. It could also stall foreign exchange reform.

Carry trade has wreaked havoc on reformers and customs officials alike. For years， it has warped China’s export data. In an attempt to halt the practice， PBOC began pushing the value of the yuan lower in February. In response traders halted the arbitrage and exports fell by 15% year-onyear in March. The practice also artificially drives up demand for the yuan and could make the currency appreciate further than the Chinese government would like. Yi’s worry is that hot inflows of cash attracted by interest rate liberalization would make exchange reform unruly and potentially destabilizing.

“What factors could slow the foreign exchange reforms？” asks Alex Fuste Mozo， chief economist at Andorra-based Andbank. “Crystal clear： Their own Chinese companies engaging again in speculative activity.”

Fuste Mozo has pointed out that the biggest risks lie in the slow pace of foreign exchange reform. As more and more trade is conducted in renminbi， the demand for convertibility increases. Slower changes to the forex scheme could spell out overall delays in the grand prize of financial reform： The opening of the capital account.

All arrows point out

Hot inflows of cash are one thing； a massive outflow of capital is anotherC perhaps a far greater threat of destabilization to the Chinese economy. That prospect has bound policymak-ers such as SAFE and the China Securities Regulatory Commission in a struggle to safely open markets to the outside world.

China’s capital account is still largely closed， preventing any sudden surge of cash in or out of the country but also keeping much-needed foreign capital at the doorstep. In 2003， the CSRC and the central bank began slowly opening the domestic equity market with programs that allot quotas to foreign institutional investors. A similar outbound program opened in 2006 allows domestic institutional investors to invest in capital markets abroad. A system for investing offshore yuan back onto the mainland also exists.

These experiments for opening the capital account have grown rapidly since 2011 and quotas for the inbound program， the Qualified Foreign Institutional Investor scheme， or QFII， have quintupled from US$30 billion then to US$150 billion today. A major breakthrough came this March when the CSRC and Hong Kong’s securities regulator announced that qualified investors in Shanghai would soon be given a quota of US$40 billion to invest in the Hong Kong stock market. A similar cohort in Hong Kong would be allowed to invest up US$48 billion in the Shang- hai stock market.

This most recent step in capital account reform， called the ShanghaiHong Kong Connect， was applauded by analysts but it reveals， yet again， another serious problem in the sequencing in overall financial reform， namely a lag in reinventing China’s domestic capital market. The mainland equities market is stricken with problems such as insider trading and false reporting on earnings. China’s major stock indices have been among the worst performing in the world for several years and the losers have generally been retail investors. Trust in the market has been all but depleted.

At the same time， the CSRC maintains an overbearing role in the approval process for companies coming to market. The regulator closed the IPO pipeline between November 2012 and January 2014. Nearly 1，000 firms queued for approval； some reportedly went bust in the desperate search for capital. The CSRC has promised to move away from its rigorous approval process for new listing by enacting an IPO registry， where all companies that meet a set list of regulations can sell shares on the market. However， it’s stumbling in that effort. In 2014， the regulator has signaled that it will continue to tightly con-trol the number of IPOs， allowing just 100 firms to list in the second half of the year.

The laggard pace of capital markets reform at home will stall any major openings in China’s capital account. Chinese investors tired of losing money on domestic bourses will jump at the first opportunity to put their money into better-performing capital markets overseas； meanwhile international investors aren’t exactly eager to access China’s exchanges. The QFII quota proves this point： Of the US$150 billion available to foreign investors， nearly US$100 billion hasn’t been used.

“If the capital account is fully open there would be huge outflow，” says Dariusz Kowalczyk， senior analyst at investment bank Credit Agricole in Hong Kong. “It would reduce banks’deposit bases and the ability to fund growth in China and lead to a collapse of the exchange rate.”

International foreign investors already have diversified stock portfolios whereas Chinese do not， Kowalczyk pointed out， another reason why more capital would pour out than in.

When reform is not enough

For the People’s Bank， perhaps the most difficult aspect of coordinating financial reform will be trying to get state-owned companies and local governments to follow their lead.

China isn’t just waist deep in reworking its financial system. The country is also carrying out muchneeded overhauls in nearly every corner of the economy. That includes shaking the way in which local governments fund their public works， how rural migrants move to cities and how state-owned enterprises operate. All of these overlap with financial reform， especially with the liberalization of interest rates. China’s budget law prevents local governments from taking on debt. To circumvent this rule， towns， cities and provinces have set up companies， called local government financ- ing vehicles， to borrow in their place. These companies go on to hire other firms， often state-owned， to build roads or erect apartment buildings and the funds stay off the government balance sheets. A national audit publicized on the last day of 2013 showed that local governments had racked up nearly US$3 trillion in debt； some county-level authorities had debt-toGDP ratios of more than 70%.

This model of growth at the local level is inherently flawed. Local governments base their public works on centrally set economic development targets. Officials， who are flown in for temporary leadership posts， must hit the targets to be promoted to another position somewhere else， leaving a pile of debt behind. Generating growth has relied on the rapid building of infrastructure often without consideration for demand or how projects will produce a profit capable of paying off the loans used to fund them.

The cheap cost of borrowing has played a major role in this process. For decades， banks have channeled depositors’ money to local governments and state firms at a very low price. The recipients have few budget constraints because governments aren’t sensitive to changes in interest rates as long as the money keeps coming. After all， officials in Beijing have mandated local officials to grow this way.

Interest rate liberalization is set to give the model a painful death. Once the cap on deposits is scrapped and interest rates rise， banks will no longer be able to funnel cheap money to local governments. The question is： Can local governments stomach this kind of financial reform？

“I recently realized that financial liberalization is not enough，” said Shen Jianguang， chief China economist at Japanese investment bank Mizuho in Hong Kong. “Actually， what I think is wrong now is that financial liberalization has progressed very fast but fiscal reform as well as SOE reform are lagging behind.”

Progress is being made on the local level C albeit slowly. Since 2011， China has experimented with municipal bond markets in which cities will be able to issue their own debt.

In order to value the bonds， these governments must first straighten up their balance sheets， a long， tedious process. As regional governments build infrastructure， the value of those projects are usually assessed upon completion. But appreciation or deterioration of these assets has not been recorded in most places. Experts who spoke with China Economic Review said this process is still far from complete and local bond issuance will not happen anytime soon. That means that a change to interest rates could limit local government access to capital long before they have found an alternate means of funding. Local officials may soon find their economies running on an empty tank. The 2016 timeline announced by PBOC governor Zhou in March was likely meant to grab the attention of these governments and other parties set to be shaken by reform.

“I would think that announcing in advance a liberalization of deposit rates is designed to give banks， governments and SOEs time to adjust their policies， capital structures and approach to a more market-based financial system，” said Michael Spence， a professor at New York University and winner of the Noble Prize in economics.

Black swan

The entire economy will need to prepare.

China’s growth is slowing yet the cost of borrowing is rising， putting mounting pressure on the property sector， one of China’s most important sectors for growth and employment. Residential real estate prices are slowing while developers are left with great amounts of housing supply on hand. Most of these businesses are highly leveraged and rely on advanced sales of new homes to pay off debts.

Financial reform is not helping developers. If property sales continue to fall， developers will be increasingly reliant on a steady channel of credit to roll over loans and avoid default. Interest rate liberalization will drive up the cost of this borrowing and reduce the banks’ abilities to funnel cash to distressed companies.

A black swan event could be hidden somewhere in this confluence where economic slowdown meets financial reform.

Real estate loans account for 20% of total outstanding loans at China’s commercial banks， according to the Peterson Institute for International Economics. At the same time， up to a third of the country’s GDP is directly connected to property development with the residential sector accounting for about 70% of that growth.

“If [real estate] suffers a slowdown then the whole growth of the economy is under pressure，” says Kowalczyk. “One of the reasons we have delays in interest rate liberalization is precisely because of economic weakness， in particular in the real estate market.”

As PBOC continues to check items off of its to-do list and push harder for advances in financial reform， it will need to make sure that it doesn’t nudge the property sector off a cliff.