By: Udaibir Das
This article originally appeared in the OMFIF on August 13, 2024.
From foundational reforms to progressive milestones
Since the pivotal economic reforms in 1978, China has strived to mould its financial sector to meet macroeconomic, social welfare and stability objectives. However, the outcomes have been mixed, leaving the country to experiment with various approaches.
Marked by results often falling short of expectations, China remains wary of fully embracing market reforms, fearing potential failures. Communist Party leaders have consistently favoured a strong regulatory presence over an open market approach typical of advanced economies. This caution is why recent financial sector directions at the Third Plenum focus on optimising governmental roles and ensuring effective regulation to preempt and mitigate market failures.
Under the firm guidance of the state and the specific political context of the Communist Party’s priorities, design and implementation of financial reforms will need to be shaped. Rebalancing the financial system from state dominance to a market-oriented ethos is ongoing, aiming to align growth and financial interactions with China’s global aspirations. Success in these endeavors hinges on fostering a conducive environment for sustainable growth.
Meanwhile, the country’s financial reform process has begun to carry significant implications for the global economy, influencing trade, capital flow channels, market sentiment and the management of systemic risks. Efforts to promote the renminbi and develop the Cross-Border Interbank Payment System intertwine with geopolitical and geoeconomic strategies, reflecting China’s broader ambition to enhance its global influence and economic sovereignty.
The 20th National Congress of the Chinese Communist Party in 2022 marked another milestone in rebalancing the financial sector with market-oriented reforms. Building on previous phases, it introduced new reforms to refine regulatory frameworks and enhance efficiency and trust in capital markets. A significant institutional transformation was the dissolution of the China Banking and Insurance Regulatory Commission, replaced by a more tightly managed financial supervision authority to address structural and legacy challenges in financial sector oversight.
The Third Plenum, convened in July 2024, advanced these efforts by liberalising capital markets, bolstering financial oversight and extending additional support to small and medium enterprises. Though not yet fully detailed as ‘reforms,’ these initiatives were complemented by measures to attract foreign investment and advance green finance. The decisions from the 20th National Congress and the Third Plenum collectively represent significant strides in reinforcing the financial sector’s role as China recalibrates its growth model.
Promoting a private economy
The Third Plenum’s focus on market liberalisation manifested in initiatives such as simplifying the Qualified Foreign Institutional Investor programme and expanding the use of the Digital Yuan (e-CNY) for international transactions. These measures aim to draw global capital and integrate China into the global financial landscape. However, the introduction of the e-CNY raises questions about its impact on monetary policy and economic stability, particularly regarding inflation, interest rates and overall economic dynamics during times of stress.
Green finance
The promotion of green finance emerged as a central theme of the Third Plenum, with initiatives such as issuing green bonds, providing tax incentives for companies adopting sustainable practices and accelerating reforms in power and emission trading systems. These efforts highlight China’s strategy to leverage finance for building climate resilience and pursuing environmentally sustainable development. However, issues including substantial investment and changes in business practices must be addressed to ensure these initiatives yield tangible environmental benefits without hindering economic growth.
Bridging the financial inclusion gap with SMEs
Supporting SMEs emerged as a priority during the Plenum. The government established dedicated funds and credit support mechanisms to enhance SMEs’ access to financing. This focus on financial inclusion is pivotal for enabling smaller businesses to contribute to economic stability and growth. Nonetheless, local government debt and vulnerabilities within small and medium-sized banks persist, necessitating comprehensive solutions for long-term financial stability.
External and financial sector interactions
China’s external sector management, including its exchange rate policy and strategy to enhance renminbi usage, remains deeply intertwined with its financial sector. The extensive documentation from the Third Plenum does not clarify how these interactions will be managed. Current approaches often necessitate capital controls and foreign exchange interventions, which distort market signals and create inefficiencies within the financial system, thus blunting the impact of financial sector reforms.
Managing China’s vast FX reserves require substantial financial resources and strategic planning to avoid exacerbating domestic liquidity or causing asset bubbles. The central bank’s external actions in managing these reserves also signal back to domestic markets, influencing their behaviour. The interaction between external sector policies and financial market liberalisation poses challenges, particularly as increased foreign participation leads to volatile capital flows. This necessitates a fundamental rethink of policy approaches to maintain China’s financial stability.
China’s financial future
As China embarks on its financial journey, it faces numerous challenges. Implementing and enforcing new regulatory frameworks, managing volatility and risks associated with increasing foreign investment, and addressing enduring issues are paramount. The audacious move to expand the Digital Yuan and further liberalise capital markets raises pertinent questions about the system’s adaptability to transformative changes. Mitigating risks related to local government debt and the real estate sector should especially be prioritised.
While focusing on green finance and including SMEs is commendable, practical challenges remain significant. These initiatives underscore the complexity of the reform process and the delicate balance required to achieve financial stability and sustainable growth.
China’s recent policy changes, as outlined in the Third Plenum and supported by the International Monetary Fund’s Article IV report, demonstrate a concerted effort to reduce systemic risks, promote sustainable growth, and strengthen financial stability. The success of these reforms hinges on their effective implementation, global co-operation and vigilant monitoring of emerging risks.
The international community must carefully assess these developments and closely observe how China actualises the intent of the 20th National Congress and the Third Plenum. While the ball is firmly in China’s court, the world may need to adjust accordingly, recognising the increasing importance of macro-financial interactions in China and their potential global implications.
Udaibir Das is a Visiting Professor at the National Council of Applied Economic Research, a Senior Non-Resident Adviser at the Bank of England, a Senior Adviser of the International Forum for Sovereign Wealth Funds, and a Distinguished Fellow at the Observer Research Foundation America.