Law and Financial Sector Development in China

A few days back, over at Naked Capitalism, Yves had a guest blogger discussing why China is different. Readers of Rogoff and Reinhart will cringe, as Yves notes in the comments section, but the post's extended discussion of the unique features of China's economic development is certainly thought provoking. However, for now I just want to focus on a few points made on financial sector development:

What everyone should be watching is what China is doing in its finance system, and it is moving very fast (and the shadow banking system is moving even faster). It has reformed the four key banks, allowed foreign banks to come in a limited way, managed its SOEs, started to develop a securities industry, started to develop a corporate bond market. But it is quite a balancing act. It still lacks the micro-infrastructure, such as accounting law, securities law, governance structures and so on that are necessary to having a fully functioning cost of capital – that is, capitalism (of a twentieth century type, as opposed to the much sicker, twenty first century type appearing in the West). The aim needs to be to stop the heavy dependence on various forms of lending, by instigating a shift to a better balance between shares, bonds and bank deposits as the capital structure (in developed economies they are roughy in balance). Big equity and bond markets are much safer than a system that depends mostly on bank lending because equity markets and bond markets can reprice without the system breaking, whereas banks break. So it is an issue of national security for the Chinese leadership.

Main takeaways: 1) China has reformed the big four banks, 2) allowed some foreign access to financial markets, 3) started to develop non-equity capital markets, 4) lacks the legal and regulatory framework necessary for these capital markets to full develop and 5) should do all this with the aim of creating financing options outside of the banking sector.

I don't think anyone would contest points 2), 3) or 5), so we can leave them for now and focus on 1) and 4). Has China really reformed its big banks in a meaningful way? Are the legal obstacles just due to a lack of proper laws or institutions? I find it difficult to agree on these points.

With regards to 1), yes, its true that the Big Four banks no longer have massive non-preforming loan (NPL) ratios, but that is hardly due to any substantial reform. Government financed Asset Management Companies (AMCs) bought the NPLs at face value, despite the fact that they are bad loans. While this certainly helped remove the problematic loans from Chinese banks' balance sheets, it did nothing to reform their lending standards. In fact, by creating such a serious moral hazard problem, it may have made them harder to reform. Sure, the introduction of western banks as minority shareholders might help improve lending practices, but the most recent stimulus package has restarted the cycle of reckless lending. Perhaps, as this round's bad loans begin to surface the Chinese government will handle them differently, but its starting to look like a regular cycle.

This, of course, leads us to point 4) regarding the legal and institutional framework for deeper capital markets. It is true that the government is playing catch up, developing new laws and regulatory structures where none exist. However, the problem is not simply a lack of laws: there is an active effort to manipulate the laws they do have. Take, for example, the July 2009 Chinese Supreme Court ruling against UBS (PwC has a great summary in their 2009 NPL Asia Newsletter). In March 2009 the Supreme Court issued a guidance clarifying when courts can rule on investors' claims on NPLs purchased from the AMCs (the answer: when the claims are not on state owned enterprises). While the original guidance was not great, it did clarify when investors could make claims on NPLs and when they couldn't. However, just four months later, in the UBS case, the Supreme Court changed its position indicating that all NPL claims require consent to be transferred to foreign investors, citing older laws and regulations, which the 2009 guidance had appeared to supersede. Why did the Supreme Court change its position? The PwC newsletter speculates it was a political message to foreign investors. Regardless, the result was predictable: most major players left what was a promising and growing market in the financial sector because of an unpredictable legal framework. The point is that while China may still be lacking in the laws and regulations needed for deepening capital markets, it is not making a serious effort at using what laws it does have.

This is important because the post goes on to explain that the top-notch leadership in China is working on filling in the holes:

It would be a fool who thinks the Chinese don’t understand the challenge; they do. Having your life on the line if you get it wrong does rather tend to concentrate politicians’ minds. To get to the top in China on your merits when there is a billion people ensures some serious quality; we can safely assume that some of the Chinese leadership has significant intellectual grunt. It would be worthwhile to listen very closely to what the Chinese say about their understanding of capitalism and what it is doing at the micro, institutional level with its financial system, not so much what it does with the macro-economic levers.

This position seeks to mitigate criticism of Chinese leadership. In essence it says "The problem is a lack of good laws, but very smart and responsible people are working on fixing that." Yet when they make new laws to address these problems they have no problem casting them to the wind for arbitrary political purposes. That this arbitrary change in law closed a potential venue for the government to recover something on its existing NPLs only shows how self-defeating these efforts can be.

China claims to be serious about developing deeper capital markets, and I am confident that many in the government are serious. However, China will be confronting some major structural problems if it cannot properly address financial sector reform. This can't happen until leadership stops using the legal system for political ends.