By JuergenFitschen^①

I. Risks in the deregulation process

In the past few years, China has made significant progress towards financial sector deregulation via liberalizing bank lending rates, expanding the QFII quota, increasing the flexibility of the exchange rate, and developing innovative financial products. The key prices in the financial markets, including bank lending rates and exchange rates, are now closer market equilibriums, and market mechanisms are now playing a bigger role in allocating financial resources.

However, China's financial liberalization is only half-completed. To improve the efficiency of financial resource allocation and mitigate structural imbalances due to over regulations, China needs to: 1) remove controls on deposit rates; 2) further increase the RMB's exchange rate flexibility; 3) further open up its capital account; and 4) liberalize market access to the financial industry by removing excessive restrictions on private and foreign ownership of financial institutions. While these objectives of financial deregulation are largely agreed upon and have been written into the third plenum's "Decision", the most challenging question is how to design the specific reform programs to achieve these goals while avoiding systemic risks during the transition.

We believe that the most important risks that Chinese policy makers need to be on high alert include the following, many of which reflect legacy issues of the old system:

1.Refinancing risk of local government debt.

According to the latest National Audit Report, China's local government debt has risen quickly in recent years to about 32% of GDP. The most important risk, however, is the maturity mismatch between local government liabilities (mostly in the form of loans and trust loans) and their project cash flows. For example, the maturity of a typical bank loan or trust loan is 2-3 years, while the project cash flows will only be able to cover repayment of principals and interests within 10-20 years. This refinancing risk can lead to major defaults in case of macro policy tightening, change in prudential regulations on banks and trust companies, as well as deterioration in investor sentiment for wealth management products (WMPs). In Western countries, the average maturity of local government debt is 7-10 years, which is much closer to that of the repayment capacity of local government capital projects.

2.Mispricing of credit risks.

In the past many years, there were no failures of banks and trust companies, and there were very few defaults of highly risky (with risks similar to junk bonds in western countries) WMPs.It is not because the fundamentals of all banks, trust companies and WMPs are exceptionally strong, but because most of these problem institutions and WMPs were bailed out by local governments or SOEs. This perverse incentive for providing implicit guarantees comes from the political system that penalizes senior officials of the local governments in which credit events occur. This incentive and the resulting market perception of government guarantees of all banks, trust companies and WMPs lead to incorrect pricing of credit products issued by some very risky borrowers, i.e., they are able to borrow at lower interest rates than otherwise. Therefore, they borrow too much and magnify the systemic risk. The recent partial default of a WMP originated by China Credit Trust is a right step towards correcting the mispricing, but a single default is not enough.

3.Excessive volatility of interest rates.

Since mid-2013, China's interbank rates became very volatile with major spikes occurred in June and December 2013 and January 2014. The volatility of interbank rates and the resulting volatility of the bond yields had a negative impact on market expectation. In particular, a high volatility of interest rates tends to confuse financial market participants and companies as to what the monetary policy intention is, and creates uncertainty on future outlook of credit availability. Such uncertainty tends to discourage investment and thus is negative to economic growth. As for impact on financial firms, a sudden spike in interbank rates could exacerbate the duration risk faced by some banks and trust companies and could even lead to major defaults. The causes of the interest rate volatility are quite complex: they have do to with the lack of capacity in forecasting liquidity, lack of inter-governmental collaboration, the loan-to-deposit ratio, imprudent liquidity management by banks, shadow banking activities, as well as the over-emphasis on targeting monetary aggregates in monetary operation. A thorough analysis of the reasons for interbank volatility is needed.

4.Excessive capital flows due to lack of exchange rate flexibility. Currently, cross-border capital flows remain manageable as formal controls on QFII and QDII quotas remain, and the RMB has not yet achieved full convertibility. However, as soon as the capital account is open (e.g., the QFII and QDII systems are abolished), large-scale capital inflows and/or outflows could lead to excessive volatility of the exchange rate, destabilize the financial systems, and damage the real economy if foreign investors find it easy to engage in interest rate arbitrage. A key reason for the likely surge in interest rate arbitrage is the lack of exchange rate flexibility. After nearly nine years since China declared its "managed floating exchange rate regime", the volatility of the RMB/USD remains one of the lowest in the world. Its annualized daily volatility is only 1/7 that of Malaysian Ringgit, 1/13 that of Korean won, and 1/11 that of the Australian dollar. As global investors view the RMB as virtually fixed to the USD, massive inflows could result if China's bond market is opened to global investors given the 2-3% interest rate differential between China's risk free bonds and USD treasuries.

II. Reforms to Be Considered

In light of the 1) need to move towards a more liberalization financial system so that to improve efficiency, and 2) the need to contain and defuse the above mentioned financial risks, China's strategy for financial deregulation should be carefully designed. We believe that this strategy should involve at least the following elements, along with the planed reforms such as deposit rate deregulation and capital account liberalization:

1.Developing a local government bond market.

As discussed above, we believe that a key risk facing the financial system is the excessive reliance of local government capex on loans and trust loans with relatively short maturities. This problem should be addressed by developing a local government bond market, which will gradually replace loans and trust loans as the more transparent source of financing with a much lower duration risk. In an ideal situation, local government bonds with longer maturities should account for more than 50% of the financing sources for local government capex(it is only 10% in China). To start the reform program, China should modify its budget law to allow independent issuance of local government bonds, establish a credible credit rating system for local government bonds, require local governments to publish their balance sheets and medium-term financial projections, and establish a legal framework to regulate the approval procedure by local people's congresses and the usage of bond proceeds.

2.Correcting mispricing of credit risk by permitting "managed defaults".

In an economy as big as China, a few failures of small banks and a few dozen defaults by junk bonds (or WMPs) per year should be normal and, indeed, necessary for the financial market to correctly price credit risks. Following the recent credit event associated with China Credit Trust, we believe that regulators should permit a few more defaults of non-standard WMPs in the remainder of this year, with some modest increases in the haircut (from the 7% haircut for the CCT product) to, e.g., 10-20%. These events of "managed defaults" may potentially push up the funding costs by 100-200bps for highly risky borrowers, but they are necessary for containing the excessive borrowing via the trust sector – by pricing out some worst borrowers -- and reducing systemic risks.

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① Co-Chief Executive Officer, Deutsche Bank

The article was published in China Development Review, No. 2, 2014.

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