Xu Bin, professor of economics and finance at the China Europe International Business School, says China would risk becoming a magnet for "hot" money because it has some of the highest interest rates in the world. Mao Yanzheng / China Daily

Country should carry out domestic banking reform before it opens up capital markets, says academic

China could face a Latin American-style financial crisis if it fails to carry out domestic banking reform before it opens up its capital markets, says a leading academic.

Xu Bin, professor of economics and finance at Shanghai-based China Europe International Business School, says China would risk becoming a magnet for "hot" money because it has some of the highest interest rates in the world. Deposit account rates are above 3 percent in China compared to less than 1 percent in much of the West.

"The danger would be of having all this liquidity flowing in. There is already a property bubble and China's money supply-to-GDP ratio is already probably the highest in the world.

"You could create a situation where if this bubble burst, all the hot money would then flow out again as asset prices fall, collapsing the entire banking system."

Xu, speaking after delivering a presentation at the 8th Annual China Bankers Forum at CEIBS's Beijing campus in the northern outskirts of the city, says there are big risks of opening China's financial system without solid banking reform being in place.

There has been recent speculation that China might remove many of the current tight restrictions on money moving in and out of the country and allow the Chinese yuan to float freely by as early as 2020.

"I think a lot of us were anxious last year when it was rumored that this might happen within about five years. The argument for it was that it was difficult to do domestic banking reform since it meant taking on the vested interests, particularly state-owned enterprises that benefit from cheap finance. It was felt that opening up the financial system would force the pace," he says.

The academic, who returned from the United States in 2004 to his native Shanghai to join CEIBS, insists China needs to heed the lesson of the Latin American debt crisis of the 1980s.

At that time, private banks in fast growing countries like Brazil, Argentina and Mexico attracted funds from oil-rich countries, which led to the countries taking on huge external debt, ultimately leading to major financial turbulence.

"I think the risk has increased (of a similar scenario as Latin America). I can't say it definitely will happen. The central government still has a very sound balance sheet, but if China opens up to the outside that is a different story."

Xu, who has a priestly air, says China needs to follow a "sequencing" model of financial reform so it does its domestic banking reform first before opening up to the outside world. He believes this could take up to 15 years.

It would involve gradually privatizing the main state-owned banks, allowing the development of private banks and full interest rate liberalization, making the banks compete for deposits.

"I think the government needs to resist outside pressure to open up before then. We should have our own agenda on domestic financial reform and then gradually open up cross-border capital transactions and RMB internationalization. We should not get anxious but take the long approach."

Xu, 49, who is now a US citizen, studied economics at Fudan University in his home city before going to Columbia University in New York, where he received a doctorate.

He stayed on in the US for more than a decade, becoming a professor at Warrington College of Business at the University of Florida and also teaching at the Darden School of Business at the University of Virginia.

Xu, who has also acted as a consultant for the International Monetary Fund and the World Bank, was persuaded to return to Shanghai when CEIBS was in the process of establishing itself as a leading international business school.

"I actually wasn't sure at the time about coming back to China because I had a prominent position in research in the US, so I took leave of one year to join the school. It was very much the early days since there were only 10 faculty members. I eventually decided to join full time and it was a very good decision," he recalls.

From his Shanghai vantage point, Xu says the Chinese government has made solid steps toward achieving banking reform, particularly in relation to liberalizing interest rates, which allows banks to price risk and compete more effectively. Only one key interest rate - the deposit rate for savings under 10 million yuan ($1.6 million, 1.26 million euros) - remains fixed.

"I think that it is fair to say that China has achieved quite a lot, particularly after the new government took office.

"I think the deposit rate will be liberalized quite soon and that is really key to the process since it applies to a lot of money held in Chinese banks."

He believes the government's approach to banking reform should be similar to that adopted for the industrial economy in the 1980s, when it began a program of privatization and fostered the development of a private sector.

"I personally think we should follow the old approach for reform in the industrial sector of gradually allowing private companies to grow until you get to the stage after 20 or 30 years that the private sector dominates the state sector in terms of market.

"It is more difficult in the financial sector because there are higher barriers to entry and more resistance to reform. I think we are reaching a point with the development of Internet banking where these barriers might become lower over time."

He does not underestimate the difficulties of introducing competition in China's banking sector. Foreign banks such as HSBC and Standard Chartered gained entry after China joined the World Trade Organization in 2001 but still only have a 2 percent market share.

"The problem for them has been that they don't have enough branches to take deposits. They are essentially Western banks with their own systems of risk management criteria that don't easily fit in with Chinese ways of doing business.

"If they impose them on some Chinese business owner, he will just say, 'Just forget it', and go to the Chinese bank instead, where he probably knows the local manager anyway."

He, however, welcomes the pilot announced in March to establish five banks owned by private companies such as Suning and Tencent.

"I think it is a very good move. It is perhaps too little but I think it is a good idea to get companies from the so-called new economy into the financial sector."

Xu concedes that if the government is to adopt a sequencing approach and complete domestic banking reform over the next 10 to 15 years before opening up its capital markets, it will have to resist a lot of external pressure.

"The essential difference between us and the Latin American economies of Mexico, Brazil and Argentina is that they weren't major economies, just major regional ones, perhaps.

"Because people want more flexibility with the RMB, China is constantly under pressure to open up its financial system. It needs to be able to resist this outside pressure rather than be too soft on that. China needs to work to its own agenda of having domestic financial reform and then gradually opening up cross-border capital transactions."

Xu would like to see more discipline imposed on Chinese banks, particularly in relation to their shadow banking activities.

A case in point is the recent bailout of the 3 billion yuan wealth management product China Credit Equals Gold #1, which was sold by state-owned Industrial and Commercial Bank of China and offered a 10 percent return to investors.

"I think that was a pity. The Chinese need financial education and they have to understand to get such a return there is always a risk. This may have been an exceptional situation but in future these products should be allowed to go bankrupt."

The academic believes, however, that there is too much pressure on the banks in China since they have to play a larger role than in many other economies.

This is because China's private equity and venture capital industry is of an insufficient scale to provide a direct financing alterative.

"In China all the burden of the risks in the system is on the banks and if there was to be any sort of crisis they would bear the brunt of it."

Contact the writers at andrewmoody@chinadaily.com.cn and huhaiyan@chinadaily.com.cn

(China Daily European Weekly 11/07/2014 page8)