Capital is the lifeblood of the economy. It fuels investment, research and risk-taking. It powers competition, innovation, productivity and prosperity. But that lifeblood must flow effectively and efficiently through a circulatory system. Rather than veins and arteries, the financial circulatory system is comprised of institutions and technological infrastructure that support the mobilization and allocation of investment capital.

Given the unique and critical role the financial system plays in a healthy economy, reform of China’s financial sector is a prerequisite to China achieving its own economic goals of:

1. Maintaining high rates of growth and job creation
2. Encouraging a structural shift from industry to services
3. Promoting the development of domestic consumer demand
4. Reducing poverty
5. Ensuring a more equitable distribution of opportunity and prosperity.

Financial sector reform is also a prerequisite to a more balanced and mutually beneficial relationship between the United States and China, the most important bilateral economic relationship in today’s global economy. Greater currency flexibility and reduced trade imbalances are two critical reforms to ensure continued healthy growth.

Reform Benefits China

In maintaining high rates of growth and job creation, China requires an effective system for mobilizing investment capital. China’s banking system intermediates nearly 75 percent of the economy’s total capital. In other developed economies, 80 percent is obtained through the capital markets. Despite recent improvements, credit analysis, loan pricing, risk management, internal controls and corporate governance practices in China’s banks remain inadequate to meet the demand for growth.

The equity and bond markets in China are among the smallest and least developed in the world. More fully developed capital markets would provide healthy competition to China’s banks and support the development of alternative retail savings products, such as mutual funds, pensions and life insurance products. Broadening the range of funding alternatives for emerging companies would greatly enhance the flexibility and, therefore, the stability of the Chinese economy.

In shifting from a manufacturing-for-export to a services-based economy, China requires competitively priced capital and credit be channeled to the most promising emerging service businesses. These start-up businesses require a broader array of financial products and services than are available in China today, including loans, letters of credit, accounts management services, asset management and insurance products.

In activating consumer demand to ensure a more equitable distribution of opportunity and prosperity, China requires the availability of financial products and services – personal loans, credit cards, mortgages, pensions, insurance products and insurance intermediary services. Chinese households historically save as much as a third of their income since most must depend on their families and private savings to pay for retirement, healthcare and the economic consequences of accidents or disasters.

In improving the effective and efficient flow of capital, China could benefit from the expertise offered by U.S. and foreign financial institutions with regard to products and services, technology, credit analysis, risk management, internal controls and corporate governance. The competition would accelerate the adoption of such techniques and methodologies by domestic institutions. [1]

Reform benefits the U.S.

A more effective and efficient financial sector in China is also a prerequisite to address issues that have complicated the economic and trade relationship with the United States.

Greater currency flexibility through a market-determined exchange rate is possible with the expertise provided by U.S. and foreign financial services firms. A rapid shift to a market-determined yuan is not possible given the underdeveloped state of China’s capital markets. China’s banks, securities firms and other businesses lack the expertise to develop and trade derivatives and other structured instruments used to hedge the risk associated with greater currency volatility. Sophisticated derivative products and hedging techniques provided by foreign institutions would diminish such concerns.

Reduced trade imbalances benefit both nations. Transforming China’s economy from industry to service-based and activating Chinese consumer demand requires a more open, competitive and effective financial sector. Reorienting the financial habits of China’s population to a better balance between savings and consumption, while progressively bringing more than a billion Chinese into the global economy, is the most powerful remedy to the U.S.-China trade imbalance.

[1] Former U.S. Treasury Secretary Paulson spoke directly to this critical point in announcing the Dialogue on September 21, 2006: “I am a very strong advocate of [China] opening up its capital markets to foreign investment.  I believe that when they open up and let foreign competition in, the biggest beneficiary will be China, and it will mean more jobs in the financial services industry for the Chinese people.  It will mean better training.  It will mean more competitive capital markets that will have all sorts of other benefits for the economy…I can’t think of a single example anywhere of a situation where a country has a strong capital market system and they haven’t opened themselves up to competition.”