Reforming financial market

Authorities will push for greater access for private and foreign capital while keeping proper capital account regulations

The history of the global economy shows that emerging countries need sound and comprehensive financial markets if they are to escape the "middle income trap" and realize their economic transformation from a factors-driven to an efficiency-driven growth model.

As an emerging nation with a per capita GDP that exceeds $5,000, China has been working to build such a financial market over the past two decades and has made remarkable progress in this endeavor.

China has made noticeable steps toward marketizing the exchange rate of the yuan, which has risen considerably in value against the US dollar, and in its real effective exchange rate since the reform of its exchange rate formation mechanism was launched in July 2005. Yet judging from the ratio of China's current account balance to its GDP, the yuan is close to its equilibrium exchange rate. The plus or minus 1 percent margin the yuan is allowed to fluctuate is expected to further widen in the future.

Since September, China's central bank has reduced its interventions into the yuan's central parity interest rate, which has led to its exchange rate against the dollar continually touching its daily upper ceiling. This has to some extent changed market expectations for China's central bank interventions into the yuan's exchange rate. It is expected that the yuan will face wider exchange rate fluctuations in the future, but the pace of its average yearly appreciation against the dollar will slow.

However, compared with its exchange rate, the marketization of the yuan's interest rate regime has encountered obstructions from interest groups. The Chinese government has adopted a gradual approach to this, maintaining the yuan's benchmark interest rates intact while trying to pursue a marketized interest rate policy for its currency, inter-bank lending and bond markets. At the same time, the government has given a green light to experimental financial reforms in Wenzhou, Zhejiang province, in a move to include the city's grey financial sector into a legal framework. The move is also aimed at monitoring and guiding non-governmental borrowing and lending rates in the financially booming region and pushing for indirect interest rate marketization.

So far, China has adopted a market-based interest rate policy for all financial transactions except for banks' benchmark interest rates. This, together with the float margin allowed for domestic banks' benchmark interest rates adopted earlier this year, is a forcible example of China's remarkable progress in financial marketization. It is expected that the country's monetary authorities will further widen the float margin for banks' benchmark interest rates in the future and finally suspend such control. Open operations are likely to be used in the monetary market as a replacement to indirectly influence the financing costs of the domestic banking system.