RDP 2014-10: Financial Reform in Australia and China 4. Comparing Financial Reform in Australia and China

In some respects, China is now facing a similar set of policy challenges on its path towards financial liberalisation to those faced by Australia in the late 1970s and early 1980s. These include challenges currently posed by China's domestic financial system, including the rapid growth of financing channels outside of a tightly regulated banking sector, and concerns about firms' ability to insure against increased exchange rate volatility. These challenges have led some observers (such as Yu (2013)) to emphasise the risks of a rapid reduction in China's capital controls. However, the reforms currently underway in China are taking place in a very different domestic and global context to those which took place in Australia and, to an extent, these differences have been reflected in the contrasting approaches to reform taken in the two countries.

4.1 The Context of Reform

The global economy and financial system are much more interconnected today than they were in the 1970s and 1980s. Australia's capital account and financial reform process began in the context of a breakdown in the Bretton Woods system and the very early stages of global financial integration. The combination of a fixed exchange rate regime, rising cross-border capital flows and the expansion of the NBFI sector made it increasingly challenging for the Australian authorities to control domestic monetary conditions.

Both China up to the late 1990s and Australia up to the float imposed asymmetric capital controls, with tighter restrictions on residents' investment abroad than on foreign investment in their domestic economies, and relatively relaxed policies towards FDI inflows in particular. However, Australia's capital account prior to 1983 was probably more open with respect to non-FDI inflows than China's is today (Figure 13).^[30] The greater integration of the modern global financial system, larger global capital markets and a relatively low starting point in terms of non-FDI inflows all suggest that, in the event of capital account liberalisation, China will be exposed to a more substantial increase in capital flows than Australia faced in the early 1980s.

The size and volatility of these flows may be amplified by China's already significant role in the global financial system – something that Australian policymakers did not have to contend with in the early 1980s. At the time of the float, Australia was a relatively minor participant in global financial markets. Thus, there was little ‘feedback’ between financial developments in Australia and the global system. In contrast, the Chinese economy and financial sector are much larger than Australia's were at the time of liberalisation. In 1983, total assets of the Australian financial sector were 1.3 times the value of GDP whereas in 2013, total assets of the Chinese banking sector alone amounted to 2.7 times GDP. Scaled by the size of the Chinese economy, this implies that the liberalisation of China's capital account and financial sector is likely to be accompanied by a substantial increase in the size of inward and outward cross-border capital flows, and so will have significant spillover effects on global capital markets.

The size of China's economy and financial sector could provide some ballast against these flows, by providing China with more capacity to absorb speculative capital inflows. In addition, China's large foreign exchange reserves, which were around 40 per cent of GDP in 2013, could provide a buffer against the impact of global capital flows (Australia's foreign exchange reserves were less than 5 per cent of GDP in 1983).

Notwithstanding these considerations, a more open capital account could still be a source of instability if the process is not carefully managed. For example, similar to Australia, the recent rapid growth in China's non-bank financial sector has posed challenges for the authorities in their control of aggregate financing flows. Such challenges are likely to be compounded by any surge in cross-border capital inflows and outflows.

4.2 The Approach to Liberalisation

The different starting points are partly reflected in the different roads to liberalisation taken by Australia and China. Australia's capital account and financial liberalisation was ultimately prompted by sizeable external pressures that were placed on the economy by the increasing integration of world financial flows, coupled with Australia's relatively open capital account and small (economic) size. The sequencing of reform in Australia prior to the float featured a series of currency regimes (a peg to the UK pound, a peg to the US dollar, a peg to a TWI and a crawling peg to a TWI), the removal of deposit rate ceilings prior to those for lending rates, and a gradual easing of financial sector and capital controls (albeit with the reimposition of some controls when the effects became severe). Contrary to the advice of the academic literature on ‘sequencing’, at the time of the float the work on banking sector deregulation was only partly complete, and Australia lacked credible frameworks for macroeconomic policy and prudential regulation.^[31]

Nonetheless, Australia's approach to reform was not entirely ‘reactive’. The Australian authorities had in most cases given advance thought to the need for reform and the manner of its implementation. Documents from the era, and the commissioning of the Campbell Committee inquiry on financial sector deregulation in the late 1970s, indicate that a considerable amount of planning went into reforming Australia's capital account and financial system (Cornish 2010, Chapter 7). But a characteristic of the Australian approach was that the actual decisions to implement reform were often taken relatively quickly, and in response to external changes that exposed weaknesses in the existing system.

The approach to financial reform taken by the People's Republic of China has, since the early 2000s (and implicitly since the mid 1990s), been characterised by a stated objective of eventual interest rate, exchange rate and capital account liberalisation. China's reform path has involved implementing partial reforms via pilot programs first, before expanding their scope and/or scale. The Australian authorities also used this approach to an extent – for example, removing interest rate ceilings for CDs prior to the removal of all deposit rate ceilings. By comparison, the Chinese approach to interest rate reform has emphasised tightly controlled pilot programs to increase the flexibility of various types of interest rates offered by different financial institutions, in some cases to specific classes of enterprises.

The difference in approach is especially noticeable in efforts to increase the flexibility of the exchange rate and open the capital account – for example, the staged widening of the renminbi's daily trading band against the US dollar since 2005, and staggered increases in quotas controlling the size of the QFII and RQFII programs. Domestic financial reforms have occurred in tandem with incremental efforts to improve currency flexibility but, to avoid destabilising outcomes, reforms to controls on portfolio flows have been particularly gradual.

Where risks have been encountered in China, as in the cases of the early efforts to increase the flexibility of deposit rates, the banking sector stress of the late 1990s, and the threat posed to exchange rate stability by the Asian financial crisis, the Chinese authorities have usually responded by slowing the pace of deregulation. To some extent this has been facilitated by China's controls on portfolio capital flows, which have provided a buffer against external pressures. In contrast, via the experiences of the 1970s and early 1980s, Australian authorities were ultimately persuaded by the size of short-term speculative flows – and the resulting constraints on domestic monetary policy – to float the exchange rate. While the Australian authorities could have instead opted to reimpose capital controls, the economy's status as a net importer of foreign capital is likely to have made this a less attractive option.^[32]

4.3 Post-reform Challenges

A feature of Australia's financial reform process was the interaction between financial sector development and capital account liberalisation. In particular, the Australian experience suggests that there is the potential for positive feedback loops to develop once the process has begun (Lowe 2014). Two concrete examples of this are prudential regulation and foreign exchange hedging markets, neither of which fully developed in Australia until some time after liberalisation had taken place.

The post-float boom and bust in credit and commercial property prices in Australia revealed the relative inexperience of financial institutions and regulators in forming risk assessments about borrowers. These skills were learned as a result of painful adjustments to the realities of the newly deregulated environment. The episode supports the arguments of Fry (1997), Johnston (1998) and Mishkin (2001) that ideally a good prudential supervision framework should be established before the financial sector and capital account are liberalised to mitigate risks to financial stability. But it also highlights the fact that it can be difficult to develop such a framework in the context of a highly regulated system that is not exposed to risk-taking behaviour (Lowe 2013).

In some respects, China's prudential framework could be considered more advanced than Australia's was before the float of the dollar. The late 1990s NPL crisis and subsequent recapitalisation of the banking system helped focus official attention on prudential regulation in the early 2000s. Significant progress has been made in introducing modern commercial banking practices to Chinese banks and the banking regulator has been active in strengthening banks' provisioning and capital buffers (Turner, Tan and Sadeghian 2012; Huang et al 2013, p 132). However, the widespread perception that loans to SOEs have an implicit state guarantee – notwithstanding concerns about the quality of some of these assets – and the incomplete nature of interest rate deregulation may still hinder the accurate pricing of risk by financial institutions. It may be hard for Chinese banks and regulators to develop risk management capabilities fully prior to the transition to a system which lacks these guarantees and in which interest rates can move more freely.

A similar example can be found in the development of hedging markets. For Australia, a deep and liquid foreign exchange derivatives market has, over time, proven crucial for allowing residents to access overseas funds, while effectively managing their currency and interest rate exposures. Despite the development of an unofficial onshore foreign currency hedging market by the private sector prior to the float of the Australian dollar, the decision to reform the currency regime was the primary catalyst for the emergence of modern hedging markets and practices.

In China, the authorities have to date played a more direct role in fostering the development of hedging practices than Australian authorities did prior to the float. Reforms in the mid 2000s introduced foreign exchange derivatives and over-the-counter trading of the renminbi. More recently, the authorities' efforts to create offshore markets for the renminbi have accelerated the development of foreign exchange products, and helped lay the groundwork for an eventual loosening of capital controls. These offshore markets have the potential to increase the future pool of market participants by creating non-resident counterparties with renminbi exposures they may wish to hedge.

Recent moves by the PBC to bolster two-way volatility in the exchange rate could also lead participants to make greater use of onshore hedging markets. Naturally, the depth and liquidity of these markets continues to be constrained by the managed exchange rate regime and capital controls, which restrict the interaction of onshore and offshore market participants – even more so than was the case for Australia prior to the float (Figure 14). However, the foundations that are already in place – including global and domestic market expertise and infrastructure, and the availability of a relatively broad range of potential hedging instruments – suggest that China's hedging markets could develop quickly once the current restrictions are removed, as they did in Australia.

Footnotes

To some extent, the initial openness of Australia's capital account with respect to portfolio flows reflected the smaller role such flows had played in the global and Australian economies prior to the 1970s. [30]

For example, while the RBA had powers to act if it appeared that deposits were in jeopardy, it was not given formal prudential supervisory powers until 1989 (Thompson 1991). [31]

While differences in political and administrative arrangements in the two countries are no doubt also important in explaining the differences in approach, such considerations are beyond the scope of this paper. [32]