Financial reform cannot wait

Nevertheless, some financial institutions may need to be wound down as the process unfolds and must be allowed to exit in an orderly way by improving the resolution framework. In all of the above, transparency will be paramount, with the objective being to create a predictable and rules-based system that allows proper pricing of risks and handling of shocks.

Third, a key lesson from the global crisis is that as the financial system is liberalized, regulation and supervision must be continuously upgraded to monitor and identify macrofinancial vulnerabilities. Within this, it will be important to ensure that investors fully bear the losses on assets backing non-deposit instruments in order to promote risk-awareness and counter the perception that investments are implicitly guaranteed.

Fourth, interest rates should be liberalized, beginning in the near-term by increasing the upward flexibility of deposit rates. This will help reduce regulatory arbitrage that currently favors wealth management products over bank deposits. Full liberalization of deposit and lending rates could be completed over time based on prevailing conditions.

Fully liberalizing interest rates too early in the process - particularly before a more nimble monetary policy and better regulation and supervision are in place - would risk "over-competition" by banks that erodes margins or precipitates a dangerous lending spree. Liberalization should lead to higher interest rates, in large part to reflect the true risk premium, which to date has been implicitly subsidized by the government.

Fifth, capital markets need to be further developed to help improve the pricing and allocation of capital, while also providing households and investors with a broader range of potential saving instruments. It would call for further efforts to encourage the development of mutual funds, corporate bonds, equities, annuities and insurance, as well as building a stronger institutional investor base. However, financial market development should be coordinated and not advanced too far ahead of banking reform, lest deposits start to flow out of banks in a disruptive manner.

And finally, as a more robust system of monetary control, market-determined interest rates, a strong prudential regulatory system and a more flexible exchange rate are put in place, China will be well-positioned to gradually free up controls on capital flows. Such steps also will permit China to internationalize the renminbi at an appropriate pace, thus making its currency more freely usable for international trade and finance.

Fittingly, many of the above reforms figure prominently in the 12th Five Year-Plan (2011-15) as well as the new leadership's announcements of policy priorities. Surely, important progress has been made along this path in recent years, including through greater flexibility on both deposit and lending rates, macroprudential measures to contain risks in the non-bank sector, and the steps taken to gradually open up the capital account. Looking ahead, China needs to accelerate the pace of these changes.

Done right, financial liberalization would be the next big wave of reform that China needs. It could be as significant as the State-owned enterprise reform of the 1990s. Through financial liberalization, China would be able to make enormous gains in productivity and lay the foundation for continued strong growth in coming decades.

The author is the IMF's deputy resident representative in China.

(China Daily 06/24/2013 page9)