Knock-on effects

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Regulators pull down one reform lever in their great command center in Beijing and five other levers spring up down the corridor. With several different policy-writing departments manning the controls of China’s rebalancing and opening， progress in one office can result in problems in another.

When the People’s Bank of China（PBoC） tightened the spigot of cash to interbank market in June， it was signaling to banks that had grown accustomed to easy cash that times are changing. The clampdown drove up the rates at which banks lend to each other to record highs and pushed a few ill-prepared lenders close to the wall.

Normally emotionless officials at the central bank probably allowed themselves a pat on the back for sending a clear message on their newfound distaste for shadow lending， which bodes well for the creation of a stronger domestic banking sector. Meanwhile， the suits at another top decision-maker， the China Securities Regulatory Commission （CSRC）， must have been pulling their hair out.

The securities regulator is trying to stabilize and clean up a securities market beset by irregularities and fraud. It has suspended new IPOs for nearly a year while it mulls over how best develop the sector it oversees. The liquidity squeeze wasn’t exactly helpful. Investors got spooked and the Shanghai Stock Exchange experienced major volatility on June 25， eliciting editorials in Chinese financial rags saying the country’s securities markets were still not ready for new listings.

The incident illustrated the potential knock on effect of reforms in one department on those in another. That’s why the order in which government agencies enact reform – not just the policy itself – has garnered increased attention in recent months. Is it inward-looking changes followed by more global integration？ The other way around？ Or everything at once？

First， split China’s ongoing reform efforts down the middle. On one side there is domestic rebalancing， such as breaking down direct state involvement in the economy. On the other side there is opening financial markets to the world， of which the final goal is full convertibility of the renminbi.

Regulators are pursuing both tracks simultaneously， albeit with a slow gait. On July 22， the PBoC scrapped the floor on lending rates. While not as far reaching as analysts say is required， the move hinted that more substantial changes are in the works for domestic rebalancing. The State Council also announced that month that it would allow for the establishment of fully private banks.

At the same time， the CSRC is opening the flood gate on foreign investment. In early July， the regulator nearly doubled the quota for foreign investors in mainland assets. The same day， the regulator expanded a program that lets foreign investors recirculate yuan into China to invest in stocks and bonds to London， Singapore and Taiwan.

Analysts are generally supportive of this brand of concurrent reform – the kind that allows more foreign investors into China’s capital markets while the nature of those markets are themselves shifting.

That’s not to say there isn’t a high level of risk associated with the effect that one could have on the other， namely the pressure that opening to the outside world could apply to reform on the domestic front. But exposure to the global market could very well be a driving force for pushing through changes at home that help sustain the momentum behind economic growth.

“I think， in some sense， this is exactly the purpose of opening up the capital account： To introduce some external competition and put pressure on domestic institutions， to change their behavior，” said Ding Shuang， senior China economist at Citi Investment Research. There are already examples of this happening. Ding notes that China’s accession to the WTO in 2001 put pressure on financial regulators to speed up reform.

In many ways， the problems that China is facing in the domestic financial sector are a result of a closed capital account.

Chinese businesses and investors lack access to capital and decent investment opportunities at home. Heavy restrictions on investment abroad have pushed cash into risky domestic investments in coal and the housing market. This in turn has led to bubbles and bad debt. Small and medium businesses struggle to get loans from banks and have little access to capital markets abroad. That has sent businesspeople into shady lending houses， fueling a huge shadow banking market.

Regulators need to weigh the risk of international exposure with the benefits. China’s debt market is in dire need for reform. Giving global investors access to this market is essential in effectively pricing credit risk and would fast-track change， HSBC argued in a report this week.

That said， if foreign capital pours into the debt market without allaround financial stability， the country could experience a quick outflow in the event of global market turmoil.

It is these dilemmas that can make Beijing appear to chase its tail as it deepens reform. HSBC says full liberalization of the yuan could happen within three to five years from now. The timeframe sounds about right. But the question for regulators isn’t when to arrive at the final destination； it is which direction to walk in to get there.