Financial Reform Has Only Begun

The Chinese economy’s rapid growth over the past thirty years has fundamentally changed global economic structures. But our achievements have come at a price: We have run up against hard limits in many areas, including factor investment costs and resource allocation efficiency. It is both understandable and reasonable that our domestic economy has slowed since the beginning of the year.

Thus, we cannot put off transforming our mode of development. In fact, that is at the core of the Twelfth Five-Year Plan. Through this process, we face the historic task of deep reforms for the financial system. The fate of everything hinges on whether we succeed.

Severe Imbalances

According to the National Bureau of Statistics, the Chinese GDP in 2011 was 47 trillion yuan, of which 22.5 trillion came from consumers, 22.9 trillion from capital formation and 1.2 trillion from net exports. This shows that the Chinese savings rate is as high as 52 percent.

Some economists abroad think our accounting methods are different from those in general use. But even if we calculate based on a 45 percent savings rate, total savings in China in a single year exceed 21.5 trillion yuan, equivalent to US$3.4 trillion. That is the highest savings rate in the world. So we Chinese can no longer talk about our capital shortages.

Our savings are primarily placed in industrial investments, which account for 40 percent of total Chinese fixed-asset investments. But as early as 2009, there were overcapacity problems in twenty-one of twenty-four major industries. Almost no manufacturing industry with mature technology has suffered from insufficient capacity.

So-called high-tech industries such as crystalline silicon, solar-powered batteries, and wind power, which have benefited from large-scale investments in recent years, are facing or will soon face heavy losses.

Second, we have been sinking huge investments into building infrastructure. The energy, transportation and communications industries alone account for about 12 percent of total Chinese fixed-asset investments. This used to be the “bottleneck” for development, but now excessive construction has become apparent in some local regions.

Third, urban construction accounts for a high proportion of our investments, with real estate alone accounting for about 25 percent. Yet all over the country we continue to tear down and rebuild buildings, over and over.

Fourth, rural investments make up a small proportion of total investments—only 3 trillion-plus yuan annually—but the waste is not at all lower than urban consumption. For structures built by farmers, the problem of repeatedly razing and rebuilding is even more severe.

Lastly, we should turn an eye toward other service industries, which account for less than 20 percent of total fixed-asset investments. Among service industries, wholesale and retail account for 2.4 percent; scientific research and technical service for 0.5 percent; education for 1.3 percent; health and public welfare for 0.8 percent; citizen services for 0.4 percent; and culture and entertainment for 1 percent. We must take special note of the fact that water conservation, forestry and environmental protection altogether account for only 1.9 percent.

Human capital formation is perhaps more important than physical capital formation. In 2008, the average education expenditures totaled 5.4 percent of GDP in high-income nations and 4.5 percent in middle-income nations. The global average in 2008 was 4 percent, yet this year China may for the first time reach the 4 percent mandated under our law. Global average expenditures on health care and sanitation are 9.7 percent of GDP, 5.4 percent in middle-income countries, and 11.2 percent in high-income countries. In China, it is 4.3 percent.

The savings structure in China is also markedly different from those in the rest of the world. The Chinese population is much older than the American population, with 13.7 percent of our population sixty or older. But we have accumulated very little money in our old-age pension funds, only about 3 trillion yuan altogether, less than 7 percent of GDP, or 2,300 yuan per capita. According to statistics from the Organisation for Economic Co-operation and Development, the social security fund in the United States amounts to 73 percent of GDP, or US$35,000 per capita. The ratio is 87 percent in the United Kingdom, 61 percent in Canada, and 67 percent in Chile.

The divergent nature of the structures of savings, investments, and consumption in China can very handily explain the structural imbalances in our economy. Among the domestic economy’s main sectors, there has been insufficient growth in the tertiary sector, which includes finance. In 2011, tertiary industries accounted for only 43 percent of total GDP. That is a significant divergence from the near 73 percent in developed nations and near 53 percent in middle-income nations. It is even lower than in many developing nations. The world average in 2008 was 69 percent.

There are deep social, cultural, and economic legacies at the root of our structural imbalance problems. A major reason for imbalance is that factor markets have been unable to effectively allocate our resources. To resolve this problem, we will need to continue deepening our reforms and to eliminate long-term systemic obstacles in factor markets, such as labor, land, and capital markets. And we will need to greatly increase the efficiency of resource allocation.

Urgent Problem

There is a paradox inherent to the financial industry that we all know which I like to call “two too manys and two difficulties.” When there are too many companies, financing is difficult, but when there is too much capital, investing is difficult.

This paradox is closely related to the theme of this year’s forum. The crux to solving it is to reform the financial system and build the capital market. However, there are many other structural problems within our country’s financial market.

There are structural imbalances in the financial industry. The most prominent of these imbalances is over-reliance on indirect financing and under-reliance on direct fund-raising. Since the beginning of this year, loans and notes accounted for 80 percent of all Chinese financing. Less than 20 percent of financing was handled by issuing stocks and bonds.

Bank loans accounted for 54 percent of social financing at the end of 2011, and company stocks and bonds accounted for only 26 percent. This ratio is not only lower than the direct-financing predominant in nations such as the United States (73 percent) and the United Kingdom (62 percent), but it is also lower than indirect financing-predominant nations such as Germany (39 percent) and Japan (44 percent).

Bank deposits account for 64 percent of personal financial investments, with stocks, bonds, funds, etc., amounting to less than 14 percent of that total. In the United States stocks, funds, and pensions invested in capital markets altogether account for nearly 70 percent of personal financial assets.

There are structural imbalances within capital markets. The first imbalance is the severe lag in growth in the bond markets. At the end of 2011, stock market values were nearly 4.5 times total company debt, and in most mature markets company debt was much greater than the market value of its stock.

The second is our insufficient layering of equity financing markets. In the United States, they have the NYSE, Nasdaq, and OTC markets, the gray market and several other layers to choose from. Their system is roughly in the shape of a pyramid. In markets in our country, we have the Main Board, the SME board, the Growth Enterprise Market (GEM) Board, and the Agency Share Transfer System, which roughly form an upside-down pyramid.

The third is insufficient growth for futures and derivatives markets. Futures, options, swaps, and other derivative products on mature markets are well developed in terms of variety, with large transaction amounts and a high level of connection to the growth of the economy. But our derivatives markets have not grown enough.

The fourth is an irrational investor structure. Professional investment institutions hold 15.6 percent of the A-share market, but in developed markets that ratio is closer to 70 percent. Even more irrational is the transaction structure. Individual investors on the A-share market hold 26 percent of total market value but are responsible for 85 percent of transactions.

There are structural imbalances affecting the real economy within the financial services industry. In the financial system, which is led by commercial banks, large enterprises and enterprises connected to government have a clear advantage in access to financial resources. Small, mid-size, and micro enterprises and innovative enterprises receive very limited service.

In 2011, there were over 10 million SMEs in China, which contributed 50 percent to total tax revenue, accounted for 60 percent of our domestic GDP, were responsible for 70 percent of innovation, and provided 80 percent of urban employment. In the Zhongguancun Science and Technology Park (in Beijing) alone, there were over 1,000 companies that met the conditions to list on the GEM Board, but their access to capital markets is still very limited.

Direct Financing

The most pressing problem facing the Chinese economy at present is the difficulty in obtaining financing for small and micro enterprises. We absolutely need to root up all latent capacity in the banking industry and actively promote the expansion of private credit. But small and micro enterprises often require principal or debt financing over a slightly longer term, and this kind of service can only be provided through basic direct financing.

To develop the industries of scientific and technological innovation and cultural creativity, and to upgrade industry in general, we must make better use of the capital market. We should make better use of the mergers market as we integrate many of our industries.

In developed nations, the annual transaction amount of mergers is often 5 percent or more of GDP, sometimes even more than 10 percent. In emerging market nations the amount is 3 percent or more. But in our country, it is only about 1 percent. As we discover and promote new strategic industries, we must likewise use the capital market to the utmost.

True, emerging industries are often born from small and micro enterprises. Uncertainties and few assets tend to limit their access to bank capital. The capital market, including stocks, bonds, venture capital, private equity funds, etc., has provided a system in which financiers and investors mutually shoulder risk and share profits. This can become the basic platform for promoting the growth of innovative enterprises.

To develop the capital market, we need to strengthen the social safety net. I estimate that by 2020, 12 percent of our population will be seniors sixty-five and older, but our social security and pension systems are seriously insufficient. It is difficult to invest social security capital, enterprise annuities, and other long-term capital on the capital market due to narrow investment channels and an outdated system. We must scientifically and rationally allow such capital to be invested by developing professional investment institutions.

The average Chinese citizen has 23,000 yuan deposited in banks. Why do most of them save so much money? A great proportion of that money is being saved for retirement, which in itself is a good thing. The only problem is that it is hard to guarantee that these deposits will maintain or increase value. Without access to capital markets, that will be impossible.

The growth of the capital market is beneficial to dispersing risk within the financial system. It may also decrease the frequency of systemic risk and mitigate its harmful effects. In 2008, at the onset of the global financial crisis, the United States was right in the eye of the financial storm, with Europe feeling only the edges. But three years after the onset, the American economy is recovering much faster than the European economy.

At present, U.S. GDP has grown for 12 consecutive quarters, and U.S. production capacity has recovered to pre-crisis levels, but the eurozone remains in a period of negative growth. The difference between the two financial systems explains why the two regions are recovering differently. Economies that predominantly make use of direct financing display stronger elasticity and see faster recoveries. That is mostly because of widespread participation in the capital market and the fact that citizens can better dissipate the negative effects of the crisis by spreading out the risk.

Hard Work

The Chinese capital market could become one of the world’s foremost. However, we can’t reach this goal sitting down. In the short term, we face formidable tasks.

We should resolutely deepen reforms to both the listing and delisting systems. Other necessary steps include: regulate and punish illegal behavior during the course of an IPO; strengthen awareness of responsibility and laws within institutions; quickly implement reforms to the delisting procedure on the Main Board and SME Board, strengthening regulations throughout the implementation; identify risk promptly, while providing countermeasures to ensure stable transitions.

We should also: accelerate the development of a multi-layer, multi-product capital market system; work hard to develop the bond market; actively promote an OTC market with unified regulations; develop standard regional equity markets; steadily develop futures and derivatives market and integrate them into the multi-layer capital market system; introduce more innovative, new products; seriously create pilot programs for SME privately placed bonds; introduce petroleum futures and treasury bond futures; expand financial management channels for citizens.

Also we must: urgently improve governance of listed companies; heed closely to whether companies’ governance is sound throughout the listing process; pay closer attention to regulating the operations of the boards of directors and boards of supervisors of listed companies; and ensure that governance regulations are effective.

The only way to ensure a solid foundation for the stock market is to guarantee the quality of listed companies.

Financial Center

Shanghai is a city with financing in its DNA. Since establishing the Shanghai Stock Exchange in 1990, the city has evolved into the most important financial center in China for trading stocks, bonds, commercial futures, financial futures, foreign exchange, gold, and currency.

On June 1, direct exchange between the yuan and the yen began in Shanghai and Tokyo. This has tremendous significance for the internationalization of the yuan and building Shanghai into an international financial center. In the big picture, a great deal of empirical research indicates that the reality of increasing exchangeability of the yuan for capital feeds is progressing much faster than the theory. We are looking forward to the day that Shanghai becomes a true international financial center.

Shanghai possesses tremendous natural strengths. It is an extremely open and international city, and is home to a great amount of foreign businesses and joint ventures. The labor market and infrastructure of Shanghai are approaching levels of advanced cities around the world. The economy of the surrounding Yangtze River Delta Region is well developed, which means vigorous demand for financial services from nearby businesses and society.

Even more important, Shanghai’s financial environment is very good, and its level of integrity is high. Integrity is of utmost importance to the development of a financial market. In the 200 years since Shanghai’s founding, the city has accumulated an excellent commercial culture and tradition, which may be the city’s most important strength.

Building Shanghai into an international financial center is inseparable from the development of the capital market. The China Securities Regulatory Commission will, as always, do its utmost to support and service the construction of Shanghai into an international financial center.

We also look forward to the day when Shanghai will be able to make use of its international and domestic advantages in resources and human resources to attract institutional investors; develop a modern wealth management industry; foster outstanding financial analysts; and nurture both investors who believe in us for the long term and companies that operate on the value investing concept, etc. As we deepen financial reforms and accelerate structural reorganization, Shanghai will play an even larger, even more innovative role.

Guo Shuqing is chairman of the China Securities Regulatory Commission. This article was adapted from his speech at the 2012 Lujiazui Forum.