Prospects for Financial Reform Huang Yiping Peking University January 7, 2013 New York Stock Exchange

“New normal” of Chinese growth Three conditions that supported Chinese growth in the past – unlimited labor supply, low production costs and rapid export expansion – are all diminishing The economy is transitioning toward slower growth, higher inflation, improving income distribution, rebalancing of economic structure and accelerating industrial upgrading But the key challenge remains: can China avoid the middle- income trap? Financial reform should be a necessary step Various estimates of Chinese growth potential

Experiences of financial reform China has been implementing financial reforms since And by some measure it’s probably been half-way through the process Financial reform in China has been strong in building institutions and growing volumes but weak in liberalizing markets and improving governance The impact of financial repression on economic growth turned from positive in the 1980s and 1990s to negative in the 2000s Financial repression index for China,

Growing Shadow banking Non-loan financing exceeded 50% of total social financing recently. Shadow banking could be CNY25trn and wealth management product is about CNY6-8trn While this is consistent with the government’s objective of diversifying away from the banks, it is also a step of back-door liberalization of the interest rate But growing shadow banking businesses point to significant (financial and debt) risks ahead and also forces the government to accelerate paces of liberalization Changing composition of total social financing

Interest rate liberalization Growth of both government and corporate bond markets, in depth, liquidity and product Increasing open market operation to regulate interbank interest rate Will net interest margin narrow or widen? It may widen in absolute terms but may narrow on comparative basis Deposit insurance system may be introduced in 2013 Can banks survive the change – shrinking books and increasing competition? Comparison of net interest margin (% points)

Exchange rate flexibility Renminbi exchange rate may be close to the equilibrium rate now, judging from the current account position The central bank has reduced intervention in the foreign exchange markets, hoping to introduce two-way movement Accumulation of foreign exchange reserves and demand for US Treasury bonds should slow The exchange rate may become more volatile in the short term but should continue to appreciate in the medium term “Hot money” flows and PBoC’s fx purchase

Internationalization of renminbi? Basic convertibility within 3 years? reserving rights to restrict volatile flows, control money laundering and resume temporary restrictions Outward direct investment may surge in resources, finance, infrastructure and high/low end manufacturing International use of renminbi increased significantly, due to growing demand (US dollar + Chinese economy) But renminbi will unlikely rule the world any time soon given its emerging market economy, financial system and politics Use of renminbi in cross-border transactions

Key takeaways Implications for rest of the world: Slowing reserve accumulation may pressure treasury yield (and the Fed’s QE policy?) Opening financial markets should provide new opportunities for foreign funds and institutions Outward investment may rise rapidly, including direct investment into the US resource, finance, infrastructure and manufacturing Accelerated industrial upgrading should redefine international division of labor Financial reform is accelerating and the new leaders may work on a blueprint before Autumn Regulations for shadow banking could tighten in the near term though interest rate liberalization should continue It is possible to see greater exchange rate flexibility and basic convertibility of the capital account within 2-3 years Renminbi will be increasingly used in international transactions but won’t become a major global currency