Get ready for a revolution in the Chinese financial system, says Qu Hongbin, HSBC’s chief economist for Greater China. Qu’s anticipating that the new leadership is about to oversee pretty fundamental change, seemingly at odds with some of the recent commentary casting the new elite as lacking in reforming instincts.
“We think this misses the point,” Qu countered in a research piece last week. “Five out of the seven new members built their careers in the 1980s and 1990s in the coastal regions, the frontline of China’s reforms and economic development. More importantly, we believe they no longer have the luxury of choice. The new leaders are under great pressure to address China’s structural problems and the only way to do this is to push forward with reforms.”
In fact, most of HSBC’s predictions for the reform agenda this month came before the new Politburo Standing Committee was formally announced. China’s Big Bang – a substantial report authored by Qu and two colleagues – focuses on a series of steps intended to remodel the financial landscape.
The key forecasts: liberalised interest rates, a doubling in the size of the domestic bond market, and the renminbi to become convertible. And all within five years.
Behind much of the analysis is a changing role for China’s banks, as the bond markets take on more of the task of financing economic growth. The switch is an essential one because of the current over-reliance on the banks for lending, as well as the glaring mismatch in funding long-term loans with short-term deposits. Additionally, local governments are struggling to service loan repayments, especially on infrastructure projects that will take more time to generate returns.
Fortunately, HSBC thinks there is a fairly immediate solution for resolving the imbalance: long-term construction bonds issued by the central government on behalf of local borrowers, who then finance future projects with the money raised, or repay current bank loans for earlier spending. Demand for the new bonds shouldn’t be a major problem either, Qu thinks, with Rmb38 trillion ($6.1 trillion) sitting in savings accounts, and local insurers and mutual funds now more interested in investing in this kind of debt.
Another positive: as the bond market matures, banks will shift some of their attention away from large, state-owned corporate customers to small and medium-sized enterprises, which contribute a disproportionate share of jobs and growth.
HSBC also has high hopes for further interest rate reform, following steps in June and July this year to loosen central control of how banks set their lending and deposit rates (see WiC158). The next round of reform is likely to see rates for long-term deposits addressed first, while demand deposits (which account for about half of bank liabilities) will be last in the queue to be fully liberalised.
Of course, the banks will be less willing participants in this particular process, as so much of their income comes from the favourable net interest cushion. Without it, margins will be squeezed and they will have to generate alternative income. But HSBC still expects to see China’s interest rates set by the market within three years.
The third major area for the reform agenda is the renminbi, which Qu says is already “making giant strides” towards global currency status. The expectation is that at least 12% of China’s cross-border trade will be paid for in renminbi this year, and that the total will pass 30% in three years time. This pick up in volume is triggering a reaction in the capital markets as the renminbi gains traction as an investment option too. Here the reform agenda is evident once more, as Beijing opens up more channels for capital to flow in and out of China.
There are words of caution in Qu’s final analysis: that the dismantling of China’s current capital controls will have to be carefully sequenced. But again, the reform message is a clear one – and HSBC expects the renminbi to reach full convertibility within five years.
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