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STRATEGY
China and the world's other major emerging market, India, have achieved great gains through the through the transformation of their economic institutions and integration with the global economy, contributing to the remarkable growth in the Asian giants. Their further growth depends on how they manage the next steps of their reform. Hung Q. Tran, deputy director of international capital markets at the International Monetary Fund, discussed the progress of financial sector reforms in China and India at the Kellogg School of Management at Northwestern University in August. "Together [China and India] represent about 40% of the world's population, 19% of world GDP in purchasing power-parity terms, and 32% of global GDP growth," Tran said. "Together, they also account for about 25% of the annual graduation of scientists and engineers in the world today. "Impressive as these growth stories are, their future remains even more promising if they can successfully navigate the reform challenges ahead." In his Kellogg speech, Tran focused on reforms of banks and capital markets in China and India. Both countries have moved ahead by reducing the role of the government in their economies, but have followed different approaches. "China has managed to accommodate several aspects of a market-based system, while still retaining its communist underpinnings. India, on the other hand, has mainly relied on removing the restrictions of a 'license raj,'" Tran said. "China has a more deliberate policy of manufacturing and export-driven growth, but with a heavy reliance on foreign direct investment. . . . India's growth story, on the other hand, owes in large part to a spontaneous exploitation of opportunities offered by the IT sector, with little or no emphasis on overseas capital." Progress in banking China and India are also pursuing similar projects to reform their banking systems, again reaching somewhat different results, Tran said. China's financial system is more bank-dominated and has greater financial depth- as measured by domestic credit to GDP-than India. However, that does not put China's financial sector on more solid ground. "On the contrary, the financial sector might be the weakest link and its progress has not matched that of the rest of the economy," he said. State-owned enterprises still account for most bank lending, causing inefficient capital allocation, the consequences of which fall on depositors. "The dominance of state ownership in banking as well as in the corporate sector has been the Achilles' heel," Tran said. "The legacy of policy lending has manifested in high NLPs [non-performing loans] in China, and while the stock problems are being addressed, current lending practices continue to be largely based on a non-commercial basis." India's banking system is smaller than China's, but better developed. However, lending there is still heavily influenced by the government. "While the large public sector ownership … is actually quite similar to China's, Indian banks are more commercialized and on a more solid footing as far as capitalization, NPLs, risk assessments, and banking supervision are concerned," Tran said. Despite remaining vulnerabilities, progress has been made in interest liberalization, bank autonomy, capitalization and restructuring. Both countries have made promises to open their banking sectors to foreign competition, though actual foreign competition remains low. China's WTO membership commits it to liberalize banks by the end of this year. "While in early 2005, the Reserve Bank of India announced that foreign banks would be allowed to establish wholly-owned subsidiaries . . . restrictions would broadly remain in place until 2009. In China, foreign financial institutions were permitted to provide services in foreign currency without restrictions since the WTO accession in 2001, and they were also allowed to provide local currency services to Chinese companies since the end of 2003," Tran said. Chinese and Indian banks should also expand their offerings at the household level, where they lag behind other Asian emerging markets, according to Tran. "Greater access to a varied range of household credit products improves the consumption and investment opportunities for households and smaller businesses and enables a better risk diversification of the banking sector portfolio," he said. Further progress in the banking sector would come with more private sector ownership and privatization. Evolving capital markets "In China, the equity market is more of a recent phenomenon," compared to India's 130-year-old stock market. China is taking some important steps, though. It has eased restrictions on the sale of government-owned shares, created a program to convert state-owned shares to tradable shares, and streamlined requirements for listings on the stock exchange. It has also created the China Securities Investor Protection Fund Company. The problems remaining in China and India are typical for emerging markets: poor market liquidity, trading concentrated in a handful of large companies, and weak corporate governance. "These problems compromise minority shareholder rights," Tran said. "Although the institutional investor base is rapidly growing, both [countries] lack shareholder activism that can take up corporate governance-related issues." The bond markets in China and India have also been historically dominated by the public sector, according to Tran. China has a small institutional investor base, and a complicated regulatory system has hampered the corporate bond market. In India, problems include under-developed insurance, pension funds and bond funds; high issuance cost due to a lengthy approval process; and corporate retail deposit issuance and private placements that do not have to comply with public issuance requirements. However, both countries have taken steps toward reform of the bond market, Tran said. China has:
India has improved its market infrastructure by establishing standards and benchmark yield curves for the bond market. Tran said that continued evolution of capital markets would be supported by development of institutional investors such as pension funds, insurance companies, mutual funds and corporations. This goes hand-in-hand with improving both public retirement systems and fostering more participation by institutional and foreign investment. "All in all, financial sector reforms in India and China will be better served by further enabling market forces to dictate the allocation of financial resources and thereby facilitate the price discovery process," Tran said. "In this regard, further deregulation and liberalization will provide the right incentives for financial institutions to compete across products and markets. "Financial sector reforms also have to be more holistic, encompassing not just banking supervision by central banks and banking regulators but a wider environment in which all financial intermediaries function and have the operational freedom to make commercial decisions." Increased risk Though openness to foreign capital and deregulated ownership of the financial sector is necessary, increased globalization also brings increased risk from volatile capital flows and economic crises, Tran said. "The first line of defense against crises must be a sound macroeconomic framework, including appropriate exchange rate, monetary and fiscal policies," he said. "While China faces greater challenges in the exchange rate and monetary policy arena, India faces a daunting challenge on the fiscal front." As the countries move ahead, they will have to weigh reforms on the choice between controlling volatility and creating new investment opportunities. Tran believes "going forward, China and India's financial sector reforms would have to be placed in the context of the globalization of capital markets as financial linkages with the global economy intensifies. Both countries are indeed taking steps to address this issue." Regardless of the reforms both countries have already adopted, "in a fast-moving global marketplace, reform is by necessity a continuous process," according to Tran. "Nevertheless," he concludes, "the high growth potential of these two economies will likely provide ample opportunities for potentially higher return on capital. If you talk to the investment management industry people and ask them as to where they see major opportunities over the next five to 10 years, there is a high probability that they will mention the China and India story." Copyright © ChinaForum 2006 |
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