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‘Hierarchical’ system spells trouble in Chinese reform year

Shangahi: In this make-or-break reform year, close attention will be paid to China’s willingness to expose its financial system to the vagaries of the market. And there are several contradictions which China must manage if it wants to maintain a growth rate of 7.7 per cent, of the previous two years, avoid the pitfalls of an overheated economy and also develop financial products that are comparable to advanced markets.

China’s leadership unveiled a comprehensive reform plan to transform its growth models after a crucial Communist Party of China plenary session in November last year. This helped boost investors’ confidence, both inside China as well as globally, since one of the goals of the reform blueprint was to build a large, versatile financial system.

But as the new year rolls out, it is becoming increasingly clear that financial planners are more keen to guard the hardcore real economy with a multi-layered, hierarchical financial system, rather than take any real risks.

Roughly, this informal hierarchy translates into a top tier in which a handful of institutions control the country’s most important financial resources on behalf of the government. This is very much in evidence with a tiny sliver of state-owned banks holding the reins of the economy and steering the financial markets by manipulating liquidity flow.

The preponderance of state-owned banks may not be able to neutralise the demon of ‘shadow banking’ that has engulfed local governments in billions of yuan worth of debts. To achieve that, the central government is expected to redirect local governments’ fundraising channels from shadow banking to a more open and better-regulated bond market.

This year, provinces will be allowed to issue bonds to pay back their debt and bring in more transparency. The question that bothers market watchers is, who will help float these provincial bonds, and who will hold them.

The good news is that the bond market may develop slightly better this year, despite the hurdles, as the government is keen to lift the scourge of shadow banking.

The second tier that has evolved, comprises of institutions, not necessarily all State-owned, competing in the marketplace. This segment does not have the luxury of government bailout packages and is unlikely to be rescued if things go badly. China’s gargantuan property sector falls in this intermediate category, dominated as they are, by a large number of private enterprises — straddling the two risky worlds of market demands and government diktat.

What does the relative freedom for real estate sector mean for stock market operations? This is where the link between the property market and stock market situation begins to get complicated.

Like many other asset classes, such as equities and fixed income securities, the value of real estate is primarily determined by its fundamental value, or the rent generated from leasing.

Rental yields from Chinese real estate are appallingly low, when compared to international average. So although housing prices have increased substantially over the past five years, rents, or the dividends from owning real estate as investment assets, have not increased in tandem.

The question being debated for this year is – will real estate prove to be more attractive than equities in terms of investment returns in China or vice versa? The jury’s still out on this one.

A third distinct layer that is now emerging is the greater entry of private capital into certain sectors of the real economy. Since these sectors can’t do any major harm to the main body of the national financial system, they are being exposed to private capital and will be left alone to ‘sink or swim’ with the market tide.

Entry of private capital, especially foreign capital, into banking or insurance will remain severely limited. But sectors which can expect to get a free rein are logistics and e-commerce. The two fastest growing industries will remain totally open to private capital.

There are several pitfalls to this hierarchical financial system, that puts large state-owned banks and corporations smugly at the top. The desired changes to the growth model will not occur in a hurry. The real economy will continue to depend on the informal shadow banking circuit for credit, as big banks shun small businesses.

Newer financial products will not be put into the market and diverse institutions and services for all players in the economy will be prevented from flourishing. It’s one step forward, and two steps back for Chinese reforms.