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China's attack on bloated financial sector

China's attack on bloated financial sector

Anti-corruption fight vital for Beijing reforms 

by Stewart Fleming

Tue 7 Jan 2014

The slowdown in annual Chinese growth from around 10% in recent decades to nearer 7% at present will curb wasteful investment – and could also help the fight against the rampant corruption that has characterised China’s economic modernisation.

One senior official even told me in Beijing that the stimulus programme of 2009-10 was an economic policy blunder because it was a factor supporting corruption.

A succession of background discussions in Beijing and Nanjing has revealed the full extent of anxiety felt by China's new leaders about graft and economic crime. The briefings included a conversation with top officials of the Central Commission for Discipline Inspection, the Communist Party’s secretive and powerful 400,000 strong anti-corruption agency.

Corruption is seen as inflicting massive waste and inefficiency on the economy. Moreover, it is viewed as a threat to the legitimacy of the Communist party itself, and so to the stability of the one-party state.

Failure to expose and curb corruption among the 62m members of the Communist Party will, officials fear, undermine its dominant role in society. But attacking corruption aggressively could also weaken the party. Many of its members have been profiting from it, especially in the financial sector and related fields such as property development.

The bloated financial sector is a particular concern. The International Monetary Fund bluntly warned Beijing last year, following an Article IV review of its economy, that its ramshackle informal or shadow-banking system could pose ‘a systemic threat to financial stability'.

It’s no wonder the reform agenda which emerged in November from the epochal Third Plenum placed great emphasis on the financial sector and tackling corruption.

Historically, when looking at the financial sector, western analysts have tended to focus on China's highly visible big four banks, not least because of the bail out the banking sector needed at the turn of the millennium.

In recent years, however, restrictions on the interest rates banks can pay on deposits and charge on loans – financial repression – have spurred the growth of alternative financing vehicles.

In this highly decentralised state, some are linked to powerful local authorities and others to the formal banking system, including so-called wealth or asset management trusts which are not constrained by official restrictions on deposit or lending rates. As a result this informal or shadow banking sector has, according to an IMF report, frequently been charging small and medium sized businesses ‘usurious’ rates of interest.

In the past three years, however, just as rapid credit growth triggered shivers of apprehension in some quarters in the years before the trans-Atlantic financial crisis hit in 2007, so in China the sheer pace of the credit expansion in China has become a source of growing concern. George Magnus of UBS estimated last year that China's aggregate debt, including non-financial corporate debt, had reached a worrying 250% of gross domestic product.

An official report from China's National Audit office in December suggested that local authority debt had soared by some 70% to $3tn between 2010 and 2013, close to one third of China's gross domestic product, intensifying fears that some local authorities may default.

The Third Plenum's endorsement of the idea of allowing selected local authorities to turn to bond markets to raise money, confirmed in the first week of January, is hardly surprising when seen in this context. Neither is its emphasis on financial sector reform. Behind the scenes, however, an intense debate is underway.

Some officials, especially in the People's Bank of China, the central bank, reportedly see the rapid internationalisation of the renminbi and the liberalisation of the capital account of the balance of payments as a way to sidestep powerful vested interests and put intense reformist pressure on the domestic financial systems. Others, including some IMF officials, worry that one of the lessons of international economic history is that liberalising the capital account before ensuring that the domestic financial system is robust and well regulated has been a recipe for disaster.

Stewart Fleming is a Senior Member at St Antony's College, Oxford and a member of the OMFIF Advisory Board. 

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