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Changes in financial sector accompany ‘new normal’

(Chinese Social Sciences Today)

At the fifth National Financial Work Conference in Beijing from July 14 to 15, Chinese President Xi Jinping emphasized three major financial tasks: making the financial sector better serve the real economy, preventing risks and deepening reforms.

At the fifth National Financial Work Conference in Beijing from July 14 to 15, Chinese President Xi Jinping emphasized three major financial tasks: making the financial sector better serve the real economy, preventing risks and deepening reforms.

The National Financial Work Conference has been held every five years since 1997. Relative to past conferences, this year there was a greater focus on exploring the basic laws of the operation and development of finance.

Serving real economy
Finance is the lifeblood of the real economy. History has shown that if finance becomes disconnected from the real economy for a long time and to a large extent, financial development will not be sustainable. This usually results in an accumulation of risks that ultimately culminates in crisis.

In the past two years, the capital in China’s economy has shown a tendency to flow from the real to the virtual economy, remain idle or cycle internally within the financial system. As a result, high growth in financial sectors coexists with a decline in manufacturing while capital fails to flow into the real economy.

This activity lengthens the chain of credit through which finance serves the real economy, increases the financing costs of the real economy and reduces access to financial services.
For the financial sector to serve the real economy, two questions must be answered correctly: Which sectors of the real economy should finance focus on serving? And how can finance serve the real economy more efficiently?

In the context of China’s economic “new normal,” the way in which finance serves the real economy should uphold new ideas about development, including “innovation, coordination, greenness, openness and sharing” and push forward supply-side structural reform. Financial services should focus on economic activities that promote innovation and entrepreneurship as well as upgrading the industrial structure and fostering new points for economic growth.

Making finance serve the real economy more efficiently depends on the nature of related economic activities. The conference clarified how finance should function as well as the means of macroeconomic adjustment and control, and the ways in which financial services should be provided.

On the one hand, the world economy is still slow to recover from the crisis. Against this backdrop, macroeconomic adjustment and control must uphold the general principle of “making progress while ensuring stability.” When implementing a prudent monetary policy, the precision of policies should be improved, ensuring moderate credit growth and basically stable liquidity to provide a suitable monetary environment for economic development.
On the other hand, direct financing should be prioritized over indirect financing while indirect financing should focus more on structural adjustment. Developing direct financing, particularly equity financing, will facilitate supply-side structural reform.

This includes improving the equity-exchange and quotation system for small and medium-sized enterprises as well as pilot programs for equity-based crowdfunding. The strategy of innovation-driven development and the revitalization of real economy can be advanced through such means as establishing a market for strategic emerging industries.

The key to adjusting the structure of indirect financing is to develop small and medium-sized banks and private financial institutions, diversifying the providers of financial services. At the same time, the ideas of inclusive and green development should be practiced among the large banks, expanding services to more small and micro enterprises, to the impoverished populations and to remote areas.

In addition, various financial activities should return to their original functions. For example, as a means for risk management, the insurance industry should fulfill its function of managing and securing risks.

Preventing risks
Risk is an essential aspect of finance. At the macro level, the operation of the economy is an aggregate of thousands of economic and financial activities. The interrelationship and rapid spread of a large number of risks accumulate into systemic risk. Therefore, an eternal theme of financial work is to guard against the enormously destructive potential of systemic risk.

Individual risks are symptoms of systemic risks. Therefore, preventing systemic risks requires attention to the sources as well as overall planning and coordination of supervision.

The establishing of the Financial Stability and Development Committee under the State Council was announced at the conference. The purpose of the committee is to strengthen coordination and connectivity among the organizations responsible for regulating the financial sector and provide institutional safeguards for preventing systemic financial risks.

With the ongoing reform of the financial sector—particularly the marketization of the interest rate—a number of financial innovations are emerging. Many of these activities could simultaneously fall under the jurisdictions of multiple supervisory authorities and connect different financial markets, which complicates efforts to implement comprehensive supervision.

Defining the jurisdictions and responsibilities of each financial regulator as well as the joint operation of these authorities is crucial. Coordination includes cooperation among the four supervisory authorities at the central government level: the People’s Bank of China (PBOC) and the regulatory commissions on banking, securities and insurance. In addition, supervisions at both the central and local levels should also be coordinated.

At the local level, supervision should be coordinated among the local supervisory agencies, and the local governments who are both contributors and managers. Financial management is primarily an affair of the central government. The establishment of the committee will properly address this problem at the institutional level.

Whether a mechanism is able to achieve its goal depends mostly on the ideas and actions in practice. In terms of ideas, the conference pointed out that financial regulation will strengthen comprehensive supervision with an emphasis on functional supervision and behavioral supervision.

 Functional supervision proposes similar sets of regulations on businesses that have similar functions but are conducted by different financial institutions. The idea of behavioral supervision stresses prudent goals, including the healthy operation of financial institutions, as well as the stability of the entire financial system and the goals of promoting efficiency—including market transparency and consumer protection.

In terms of practice, the conference called for regulators to have a consciousness of duty, responsibility, technology and accountability when supervising financial activities.

Deepening reforms
Economic growth cannot be separated from the continued deepening of financial reform. The imperfect financial system and institutions are the source of all kinds of problems and risks in financial operation in recent years, which can only be resolved through reforms.

Financial reform at the microeconomic level targets various financial institutions. Financial reform aims to introduce and improve the modern financial enterprise system and corporate governance structure in China’s financial industry.

The clear ownership of property is at the core of the modern enterprise system. Therefore, optimizing the equity structure of financial institutions is a basic task of financial reform. A typical corporate governance structure requires properly tackling the relationships among the board of shareholders, the board of directors, supervisory committees, the managers and stakeholders. Effective mechanisms for incentive and restraint, internal control, risk management and external supervision should also be established.

In terms of state-owned financial institutions, where party organizations play a significant role, the relationship between the party organizations and other corporate subjects in these institutions should also be properly tackled, combining the leadership of party with corporate governance. The role of party leadership is crucial in discipline inspection and supervision, and auditing the operation of these financial institutions. The principle that the party designates positions of state-owned financial institutions should be combined with the principle that the board of directors selects the managers.

The key to financial reform at the macroeconomic level is to further improve various mechanisms—including the marketization of interest rate and formation of RMB exchange rate—to define the goal and proper order for financial opening-up. Although the liberalization of the deposit interest rate of RMB marks the nominal marketization of interest rate, the marketization of interest rate in the real sense still requires the establishment of the mechanism for benchmark interest rate formation as well as interest rate transmission and adjustment. In this way, the market will eventually play a decisive role in determining the price of money and allocating resources.

The formation mechanism of the RMB exchange rate, capital account convertibility of the RMB and the internationalization of the RMB are three goals of China’s financial opening-up. The relationship among these three goals and the proper order of pursuing each of these goals are entirely new challenges for a developing giant as China.

China has no examples from any nation in history to guide it when confronting these challenges. What China can do is only to steadily push forward its reform according to the changing circumstance of its economic development. However, the fundamental principles are that the financial reform should always contribute to protecting the interests of the financial consumers, strengthening orderly financial competition and preventing financial risks.

He Dexu is the president of the National Academy of Economic Strategy (NAES) under the Chinese Academy of Social Sciences and Wang Chaoyang is an associate research fellow from the NAES.