By Hong Liang (China Daily)
Updated: 2008-04-01 07:37

China is making rapid progress in the development of new markets for a variety of financial instruments. The gold futures market began operations in January and the China Financial Futures Exchange is in the final stage of preparation for the launch of the long-awaited stock index futures market. Talks are reportedly underway for the introduction of stock options and other financial derivative products.

The financial community and the investment public have placed high hopes on these developments which promise to open up the opportunity for financial innovation to achieve greater flexibility and efficiency in the use of capital. By bringing down the cost of funds through risk transfers, financial innovation can help enhance economic growth potential, maximize investment returns and improve risk management.

Despite the huge potential benefits it could bring, financial innovation, as a concept, has been brought into question by the fall out of the subprime mortgage troubles that are threatening to drag the US economy into a recession.

To try to stave off the recession, the US Federal Reserve lowered interest rates several times in the past few months. The fall in bank interest rates has further depressed the already weak US dollar, which, in turn, has pushed up the prices of a wide range of commodities, including oil, to record highs.

Growing worries about a US-led global economic recession has put many stock markets around the world in a tailspin. Although the Chinese economy is still growing at a brisk pace, the high-flying stock market has taken a severe beating with the leading index sinking more than 30 percent since its peak in October 2007.

It is still too early to access the full impact of the US subprime mortgage problems. But the debacle has clearly demonstrated, once again, that the major market players and regulators have been left way behind in the progress of financial innovation. It would not have been unreasonable for some less developed markets to consider retarding or even rolling back the progress they have made in market liberalization and globalization, as some had done in the wake of the Asian financial crisis in 1997.

But we should keep in mind that financial innovation can help promote market stability by facilitating the transfer and dispersion of risks. For example, institutional investors who are concerned about market uncertainties can sell stock index futures to lock in their gains without having to disrupt the market by rapidly unloading their large holdings. In so doing, these investors have transferred their perceived risks to other investors and speculators who take a different view of the market.

Financial innovation, almost always, creates new and often hidden risks. As Hong Kong monetary chief Joseph Yam noted, the biggest risk occurs when "the incentives surrounding financial innovation greatly encourage indulgence and leverage, to the extent of turning hidden risks, to which individual players are exposed, into a hidden vulnerability of the whole financial system to shocks".

When those shocks erupt, "systemic financial instability ensures," Yam said.

To address these problems, it is necessary to devote "greater effort to understanding and managing the associated risks" of financial innovation, Yam said. There is no quick fix, but tighter regulations and more government oversight would certainly help.

What is important is to avoid hasty actions that could stifle and choke financial innovation.

E-mail: jamesleung@chinadaily.com.cn

(China Daily 04/01/2008 page8)