China is liberalising its banks, and that’s good news for Australia

A freer flow of money in and out of China presents opportunities for Australia. SimonQ/Flickr

China has signalled its intention, reiterated in the recent Third Plenum, to open up its financial markets. This would be an important reform which carries significant risks and opportunities both for China, and many opportunities for Australia.

There are two main elements to the reforms. The first is to remove many of the regulated prices in the domestic financial system and to allow markets more scope to set them. The second is to float the Renminbi and allow freer international flows of capital. Both carry substantial risks.

Until recently bank lending and deposit rates, and hence bank net interest margins, were heavily regulated. The effect was to guarantee bank margins and protect the (mainly government owned) banks from much of the low quality lending they had engaged in during the 1990s.

With the deposit rate set artificially low, funds were cheap. Over time however less-regulated financial institutions found ways to offer higher returns to depositors. Many of these wealth management products were effectively deposits in that they could be readily turned back into cash. China has thus seen a rapid growth in its shadow banking system as a result.

The deregulation of lending rates squeezed the banks. Since they were forced to pay a below-market price for deposits but had to compete in lending, their margins have been under pressure.

Deregulating deposit rates is the next big step. But regulators are worried about whether the banks will cope with competition for deposits. The risk of bank failure increases significantly.

Chinese banks have been limited in the products they can offer, spurring on a large shadow banking sector. gaobo/Flickr

China currently limits its banks to only lend out a fixed proportion of their deposits, that is the volume of their deposits always exceeds the value of loans they make – unless they make very poor lending decisions. The deregulation of deposit rates puts this at risk. It is now far more likely that banks will fail, and depositors lose money. Since China does not have a deposit insurance system, this is a significant risk.

Protecting depositors

China is currently working on developing the required deposit insurance scheme. We are unlikely to see the deregulation of deposits until that is in place. Even that though does not end the problems.

The transition of banks from only having to worry about the quality of their assets (loans extended) to also having to worry about their liabilities (deposits and other forms of funding) is problematic.

Australia almost lost one of our major banks (Westpac) in the process of adjusting to a liberalised financial system, although there is little doubt that the economy functions better now than it did in the 1980s.

The implicit trade-off between the additional growth generated by a better allocation of resources valued against the risk of more frequent crises has generally come down in favour of liberalisation (see for example Ranciere, Tornelland and Westerman’ paper “Systemic Crises and Growth” in the Quarterly Journal of Economics, February 2008).

Those with longer memories will also remember many Australians losing money when they took out loans in foreign currencies just before a big fall in the Australian dollar. Some elements of the Asian crisis were also worsened by foreign currency borrowing as countries (partially) liberalised their capital accounts.

Both the internal reforms and the floating of the currency provide opportunities. While Australian banks, wealth managers and insurers have struggled to get a strong foothold in China in the face of strict regulation, that should change with the next phase of reform.

The biggest opportunities for Australia however will derive from the opening up of the Chinese capital market to the freer flow of money in and out of the country. Recent work by the IMF suggests while it’s hard to see whether China will finish up importing or exporting capital, the size of the flows both inward and outward will increase significantly. Chinese will seek to diversify their portfolios away from China, and foreigners will try to increase their exposure to China.

The IMF paper actually suggests that Chinese will increase their current foreign asset holdings by a factor of five, and that foreign holdings of Chinese assets will increase by a factor of three. That is, China will be a net foreign investor.

Australia will have to get used to the idea of Chinese companies and individuals continuing to buy local assets. This should bid up the price of assets, which is good for their owners, but is likely to raise community concern. There will obviously be sizeable business opportunities involved in servicing this outflow.

The other flow is also important. Australian wealth managers, and Australian companies, will have very significant business opportunities servicing the outward flow.