China's Financial Reform and Macroeconomic Regulation have Entered A New Phase
The 20th National Congress of the Communist Party of China (CPC) marked the commencement of a new phase in China's financial reform and development. Addressing the future trajectory of China's financial reform, the report to the 20th CPC National Congress underscored three key aspects. Firstly, modernizing the central bank system. Secondly, strengthening and refining modern financial regulation and reinforcing the systems that safeguard financial stability. Lastly, improving the capital market’s functions and increasing the proportion of direct financing. On the macroeconomic regulation front, the report underscored the institutional necessity of conducting future macroeconomic regulation within the framework of coordinated fiscal and monetary policies. In October 2023, the Central Financial Work Conference took a notable step by setting the ambitious goal of building China into a financial powerhouse for the first time.
How should we approach the significant concerns mentioned above that affect us all? In an exclusive interview to China Forex, LI Yang, Chairman of the National Institution for Finance & Development and an academic member of the Chinese Academy of Social Sciences (CASS) shared his views with GAO Zhanjun, the Executive Editor-in-Chief of China Forex and once a visiting scholar at Harvard University, on China’s financial reform, and macroeconomic regulation.
Professor LI Yang, formerly Vice President of the CASS and a member of the 3rd Monetary Policy Committee of the People's Bank of China (PBOC), boasts an impressive track record. He has been honored with the SUN Yefang Economic Science Award five times. In 2015, he received the China Soft Science Award and was also recognized with the 1st SUN Yefang Financial Innovation Award. In 2016, he was bestowed with the ZHANG Peigang Development Economics Award. In 2022, he earned the esteemed Lifetime Achievement Award in Finance for 2022-2023.
Discussion 1
modernization of the central bank system
Dr. Gao: The commencement of a new phase in China's financial reform and development was marked by the 20th CPC National Congress. Addressing the future trajectory of China's financial reform, the report to the Congress highlighted three key aspects, one of which focuses on the modernization of the central bank system. How do you perceive this aspect?
Professor Li: Naturally, the fundamental role of a central bank is to regulate the overall money supply and interest rates, ensuring an appropriate monetary and financial climate for the real economy. However, since the 1990s, there has been a notable shift in the primary function of central banks towards liquidity management, a crucial element in coordinating fiscal and monetary policies.
From the standpoint of policy objective, liquidity management takes center stage in various functions of central banks to maintain reasonably abundant liquidity. From the standpoint of policy tools, open market operations have emerged as a pivotal tool for liquidity management. In the 21st century, the financial systems of developed economies increasingly rely on the government bond market to provide liquidity. Consequently, the role of central banks has evolved from being the ultimate lenders to becoming ultimate market makers. In essence, whether targeting "quantities" or "prices", central banks now primarily achieve their monetary policies by buying or selling government debts or highly liquid government agency bonds on the financial market. This shift has led to a closer integration of fiscal policy with monetary policy. Notably, the continuous rise in the global debt aggregate since the late 20th century has further reinforced the trend of central banks shifting their policy objective towards prioritizing liquidity management.
Given the evolving functions of central banks worldwide and the developing landscape of liquidity management, China, with its goal of "modernizing the central bank system", should align with the trend by establishing a robust liquidity management system. Notably, recent statements by China's central bank regarding the objectives of its monetary policies consistently emphasize the necessity "to ensure reasonably abundant liquidity", showcasing a keen awareness of international developments. Naturally, given the unique nature of China's central bank system and financial mechanism, the transition should be undertaken gradually. Firstly, to achieve this goal, Chinese government should prioritize enhancing the liquidity hedging mechanism, particularly focusing on the medium-term lending facility (MLF). This approach aims to alleviate the seasonal and phased disruptions caused by fluctuations in government receipts and payments on the liquidity of the banking system. This is crucial because any changes in government receipts and payments, regardless of their magnitude, inevitably affect the operations of various financial institutions and financial markets. Secondly, China should undertake reforms to its statutory reserve ratio system. China’s existing high statutory reserve ratios are a historical legacy. Presently, the circumstances that initially warranted such ratios no longer apply. In response to new circumstances and tasks, China will likely need to further reduce its statutory reserve ratios over the next two years to enhance liquidity. However, once a certain level is reached, these ratios are expected to stabilize. When the statutory reserve ratios cease to experience frequent and substantial changes, the reliance on open market operations becomes imperative to execute monetary policies and concurrently modernize the monetary policy framework. Thirdly, liquidity hedging and management mechanisms should be established, with risk-free assets (treasury bonds) at their core. Through coordinating fiscal and monetary policies, the country needs to gradually develop a new liquidity management mechanism based on government bonds. Fourthly, its treasury cash management system need to be comprehensively enhanced to maximize returns on treasury funds.
Discussion 2
enhance coordination between fiscal and monetary policies
Dr. Gao: The report to the 20th CPC National Congress is notably succinct in addressing economic and financial matters. Chapter V under Accelerating the Creation of a New Development Pattern and Pursuing High-Quality Development discusses important issues in around 600 Chinese characters. One of the priorities highlighted in the statement is to "enhance coordination between fiscal and monetary policies". In your opinion, does this relate to the goal of modernizing the central bank system?
Professor Li: The report to the 20th CPC National Congress requires "enhanced coordination between fiscal and monetary policies". From an institutional standpoint, this underscores the necessity of conducting macroeconomic regulation within the framework of coordinated fiscal and monetary policies in the future.
As mentioned earlier, if monetary policy emphasizes liquidity management and open market operations, the treasury bond market must undergo substantial development and corresponding reforms. Given the anticipated economic slowdown, there is a high likelihood that government debt will rise consistently. Presently, government debt is steadily increasing, posing a challenge to management through fiscal authorities alone. This is because government debt inherently serves both fiscal and financial functions. The size and nature of government debt may be influenced by fiscal policies. However once it enters the market, it transforms into highly liquid financial assets and becomes part of the balance sheets of various financial and non-financial institutions. At this stage, it operates under financial principles. Consequently, it is both necessary and sensible for central banks to play a crucial role in the central government bond market, utilizing operations in the treasury market as a means to implement monetary policies.
On December 12, 2022, the Ministry of Finance conducted a private placement of RMB 750 billion in special treasury bonds to specific banks, with an interest rate of 2.48%. On the same day, the PBOC acquired an equivalent amount of treasury bonds from primary dealers in the open market. This action effectively underscores two critical elements of the operating mechanism: firstly, the central bank should play a role in supporting the government's fundraising endeavors by engaging in the treasury bond market; secondly, the central bank is prohibited from directly transacting with the Ministry of Finance as a robust firewall must be maintained between these two entities. Notably, this operating mechanism has long been outlined in the Law of the People's Republic of China on the People's Bank of China, enacted in the 20th century.
In the future, the central bank and the Ministry of Finance need to establish stable cooperation mechanisms for the lawful joint management of the central government's debt. Additionally, there is a necessity to integrate the bond market, with particular emphasis on linking the banking and credit markets, to achieve "interconnectivity" among various markets. Building upon this foundation, it is crucial to establish robust monetary market systems, market-oriented benchmark interest rate formation mechanisms, and effective interest rate systems. These measures set the stage for enhanced debt management practices.
Discussion 3
improving the functions of the capital market
Dr. Gao: Lately, government documents related to financial reform have made few direct references to the reform areas. Nevertheless, the improvement of the functions of the capital markets has consistently appears in the reform tasks listed. The report to the 20th CPC National Congress follows this trend, underscoring the significance and complexity of this reform objective. What is your perspective on this matter?
Professor Li: In my view, improving the functions of the capital market primarily entails improving its capacity to list thebest performing companies — those that exhibit the best performance and represent the highest standards and direction of economic development. At the same time, it involves a continuous process of phasing out companies that have fallen behind. This dynamic process significantly influences a country’s economic restructuring. In theory, the capital market serves as a venue and mechanism for capital allocation, particularly in terms of equity capital. A tangible expression of this improvement is to continuously list outstanding companies, and through the survival of the fittest, provide stable returns for the vast investors, enabling them to enjoy the benefits of economic development. Public companies are generally considered the cream of the crop in any country. Consequently, the composition of public companies serves as an accurate reflection of a country's economic structure. Moreover, the entire process within the capital market—from the listing to the delisting of companies—acts as a guiding force, propelling economic structural adjustments in a specific country. Hence, the operating mechanism of the capital market must effectively embody the principle of survival of the fittest.
To assess the condition of China's capital market, it is insightful to analyze the structure of public companies. Let's compare the composition of the top 20 public companies globally with that of the top 20 in China. This comparison can provide valuable insights into appropriate strategies for enhancing the functions of China's capital market.
An analysis of the composition of the top 20 global public companies at the close of 2022 provides many valuable insights. Firstly, in terms of industry, high-technology companies consistently dominate the list. Among them are Microsoft, Facebook, Amazon, Google, Apple, Visa, Tesla, Tencent, Nvidia, and TSMC. Secondly, in terms of country/region, the US holds a significant advantage, securing 15 positions. Following are Saudi Arabia, China, France, Switzerland, and China's Taiwan, each claiming one position. Thirdly, within the top 20 global companies, there are also emerging mass-consumption companies such as United Health, Johnson & Johnson, LVMH, Walmart, P&G, and Nestle, indicating a new trend in economic restructuring focused on widespread enhancements in people's lives through technology. Fourthly, notable is the absence of various resource-based companies and traditional financial institutions from the list, indicating the end of traditional industrialization. In summary, the decisive factor shaping the composition of global public companies is the application of high technology in the economic domain. The application of high technology in various fields not only leads to the creation of new industries but more frequently transforms traditional ones. This evolving trend is indeed noteworthy.
Now, let's examine the top 20 public companies in China's capital market at the end of 2022. Several noteworthy observations include: Firstly, Maotai Group claims the top position and two other liquor producers also feature prominently. Secondly, traditional financial institutions hold eight positions, showcasing their dominance. Thirdly, four resource-based companies maintain a significant presence. Fourthly, there are only three high-technology companies — CATL, BYD, and Mindray. Fifthly, China Duty-Free Group, the exclusive operator of duty-free trade in China, secures a position on the list.
The composition of China's public companies appears somewhat traditional, suggesting that the Chinese economy is predominantly in the conventional stage of industrialization rather than the stages of modernization, informationization, and digitalization. The comparison places significant pressure on China to step up efforts to restructure its public sector and to include more technologically advanced companies. It underscores the urgency to align with the objectives outlined at the 20th CPC National Congress, hastening the digitalization process and facilitating the listing of more digital companies on the stock market. Concurrently, there is a call to nurture companies utilizing modern means to enhance people's livelihoods and health.
Discussion 4
build China into a financial powerhouse
Dr. Gao: The Central Financial Work Conference, convened at the end of October 2023, set an ambitious goal for the first time: to build China into a financial powerhouse. Now, what attributes should define the financial powerhouse we aspire to build, and what strategies can we employ to achieve that goal?
Professor Li: The envisioned financial powerhouse we aim to build possesses not only universal features observed globally, but also distinctive Chinese characteristics that set it apart.
In terms of financial systems, the universal features of financial powerhouses worldwide manifest across eight dimensions: the scale and composition of financial institutions, the size and composition of financial markets, the overall volume and composition of wealth, the level of financial development, the status of international investment, the global standing of the currency, the state of financial infrastructure, and the influence on the global financial system.
We have conducted a comprehensive comparison between China and the US across these eight dimensions. The general conclusion is that the US holds a considerable advantage in all these aspects. However, considering China's rapid growth in the financial sector from its early stages, it has already surpassed the US in certain areas, such as government aggregate wealth. I am optimistic that with another decade of concerted efforts, the disparity between China and the US will continue to diminish, and by the middle of this century, it may well be eliminated.
A particularly noteworthy aspect is the emphasis placed on Chinese characteristics during the Central Financial Work Conference. These characteristics entail upholding and reinforcing the overall leadership of the CPC in conducting financial work, with a distinct political orientation and a focus on being people-centered.
It is necessary to enhance the systems and mechanisms facilitating Party leadership in financial work. This involves maximizing the role of the Central Financial Work Committee and reinforcing Party-building efforts throughout the financial system. Simultaneously, it is essential to empower financial committees under local Party committees and financial work committees to fulfill their roles, establishing clear territorial responsibilities. By robust political, professional, and ethical norms, it is imperative to cultivate a cadre team of highly skilled financial professionals characterized by loyalty, integrity, and a profound sense of responsibility. Additionally, the