China takes stock in crisis
By Wu Zhong, China Editor

HONG KONG - China's financial system, even after three decades of reforms, remains pretty much closed by standards of a free economy. In consequence, it has been less savaged than many other countries as the financial crisis has rippled out from the United States to Europe and more or less the rest of the world.

That crisis lapping at its borders and the sight of the "systemic risk" in the financial system in the free economic world, with the US in the van, will inevitably encourage China to slow down on the reform path that was leading to further deregulation and opening up its financial markets.

So far, the direct impact of the US financial tsunami on the Middle Kingdom has remained limited, even though the Chinese government, its sovereign wealth fund - the China Investment Corporation - and state-controlled commercial banks have had to write off or make provisions for their more than US$300-billion worth holdings of shares or bonds of American companies, including troubled financial institutions such as Lehman Brothers, American International Group (AIG), and the two major mortgage finance firms, Fannie Mae and Freddie Mac.

The total amount, though large, is relatively insignificant in view of the financial strengths of these Chinese investment entities.

Growth in China's exports to US in the first seven months of the year slowed to 9.9% from the same period in 2007, reaching $140.39 billion, 8.1 percentage points slower than the rate of 12 months earlier, according to Chinese Customs. It is the first time since 2002 that the growth rate in China's exports to the US has dropped to single digits.

US consumption will definitely shrink dramatically next year and Chinese exporters will suffer a "very cold winter", according to Jack Ma Yun, chairman of Hong Kong-listed Alibaba Group, which runs, a leading China-based business to business marketplace Internet site.

Beijing, anticipating a slowdown in exports, has begun to ease its monetary policy to boost domestic consumption. The country's financial system is, however, relatively unexposed directly to the US financial crisis.

"Our financial industries are not so much internationalized and thus not attacked severely," a commentary on the official website of the state-run Xinhua News Agency said. "Although the nine listed banks ... hold some Lehman Brothers-related assets, the amount is relatively small, which will not have a big impact [on the financial industry]. [1]

"In the past, China has been blamed for the low-degree of internationalization of its financial industries. Now it seems we are profiting from this 'fault'," the commentary said.

Many Chinese economists share this view. "Our not-fully-open financial system and not-fully-convertible currency saved China from being rattled during the 1997 Asian Financial Crisis. And now again this seems to be a strong dam to protect us against the current financial tsunami," an economics researcher with the Chinese Academy of Social Sciences (CASS) said.

What is happening in the free economic world is reinforcing Beijing's belief in its gradualist approach toward liberalization of the Chinese currency and opening up its financial markets.

"China doesn't have a timetable for yuan liberalization, though it has progressed gradually toward this goal. But under the current circumstances, it is inevitable for China to slow down the pace in this regard so as not to import systemic risks into our financial industries," the CASS researcher said.

Before it gains a full understanding of such systemic risks in the US, the Chinese government will have to slow down its market-oriented financial reforms.

"It is evident that the financial industries cannot become entirely market oriented. The semi-market, semi-government-control system may prove a better [system]. The problem in China is that the part of government control is too big and thus reforms are needed to deregulate."

In early September, Steven N S Cheung, a Hong Kong-born Chinese-American economist living in exile in China, being wanted by the US government for alleged tax evasion, claimed that China "has formed the best system in the history of human kind".

Beijing is expected now to shift its aim of financial reforms to seek a balance between market and government control, rather than simply emphasizing market-oriented reforms. As Hao Bin, director of the China Securities Regulatory Commission's research center, wrote, "We must seriously study the Wall Street crisis to draw a lesson. We must also be fully aware of our own national circumstances ... and prudently make financial [changes] to strengthen risk management. From an early stage, market development has been pushed forward jointly by the government and market forces. There is no absolute freedom and no absolute regulation; a balance between the two is needed for the healthy development of financial market."

The current "national circumstances" seem to put China at the exact opposite of the US. At the center of the current financial crisis in the US is a lack of liquidity, while China suffers excess liquidity, or too much cash in circulation. "The Americans like to borrow and spend, but Chinese prefer saving to spending. It seems we both have our own problems," Premier Wen Jiabao said during his visit to the United Nations last month.

Apparently in consideration of the current situation at home and abroad, China has shelved several financial-reform plans. For instance, the government announced at the start of this year that it would launch a Nasdaq-like board and index futures this year. Now, in early October, no one talks about such things any more.

In the absence of a fully convertible yuan, China has said it will expand the qualified foreign institutional investor (QFII) scheme that allows overseas investors to trade in A shares, and the qualified domestic institutional investor (QDII) scheme, which allows Chinese investors to trade in overseas securities.

Expansion of the two schemes could be seen as a speedometer of China's opening up its financial markets, but a proposed expansion has apparently been held back.

Between 2002, when the QFII scheme started, and 2007, China granted 49 foreign institutions QFII status, with a total investment quota of nearly $10 billion. At the end of last year, China said it would expand the QFII investment quota to $30 billion. This year QFII licenses have been granted to a further four foreign institutions, including KBC Asset Management NV and Samsung Investment, but so far only a small proportion of the new investment quota has been granted.

On the other hand, in apparent concern over possible trouble arising from an influx of international speculative "hot money", China has tightened checks on the inflow of foreign funds.

When announcing the increase in the QFII investment quota, the State Administration of Foreign Exchange (SAFE) said it would further raise the quota for the QDII scheme.

By end of 2007, 23 domestic and foreign banks in China had been given a QDII license, with 16 marketing 262 QDII products worth more than 40 billion yuan (US$5.84 billion). By the end of last year, Chinese investors could trade in securities in Hong Kong, the UK, Singapore and Japan, provided relevant QDII products were available. As agreed during the Sino-US Strategic Economic Dialogue, China in March announced it would extend the QDII scheme to the US stock market.

However, according to Shanghai Benefit Wealth Management Consultation, only 10 of the 231 operating QDII products issued by banks were profitable by September 4 this year. All the rest, 95.67% of all products, recorded losses of up to 50% due to the sluggish overseas securities markets.

Chinese investors have developed a wary view of QDII products. Eighty-eight percent of respondents to a recent survey said QDII products were hopeless in the short term, and 71% said they would not consider buying QDII products, regardless of their performance.

As a result, the number of QDII products marketed this year has dropped each month, from 70 in January to 11 in June. There is no more talk about expanding the QDII quota.

The QDII scheme was one of the measures Beijing introduced to combat excess liquidity, caused largely by the sharp increase in the country's foreign exchange reserves. Under Beijing's foreign exchange regime, the government has to buy any foreign currency flowing into the country. With more and more foreign money coming in, the government has to spend increasing amounts of yuan to buy it, resulting in too much money supply.

Beijing has hoped that by encouraging outbound investment people would convert their yuan into foreign currencies so as to reduce liquidity in the domestic economy. The poor response to the QDII scheme (and the failure of other outbound investment projects) has proven this is not a way out, at least not at the present time when the overseas markets are in very bad shape.

Even so, some experts have urged China to take the current opportunity to make outbound investments. In an international forum in Tianjin at the end of last month, former Hong Kong financial secretary Antony Leung Kam Chung and present chairman of Blackstone Group's Asian office in Hong Kong, said the US financial crisis provides "an opportunity in a hundred years" for cash-rich China to take over foreign businesses. China famously took a $3 billion stake in US investment company Blackstone in May 2007, just after Leung was appointed chairman in Asia. Shares in the company, which subsequently went public, have declined from about $35 in July 2007 to below $14.

Institutions that have large amounts of foreign currency at their disposal are also state-owned or state-controlled enterprises. "Top management of these enterprises are government officials, who are not willing to take the political risk in making outbound investment decisions, seeing the failure of many such projects," the CASS economist said.

Hence the Chinese government will have to continue managing the country's $2 trillion and growing, foreign reserve. That means China will have to continue buying US Treasury bonds.

According to the US Department of Treasury and Federal Reserve, China by the end of July this year was the second-largest holder of US Treasuries, at $518.7 billion, next only to Japan's $593.4 billion. China accounted for 19.38 % of the total $2.676 trillion foreign holding of US Treasuries.

The People's Bank of China (PBoC) welcomed the recent US Congress approval of a $850 billion financial sector bailout package, saying: "China and the United States have common interest in stabilizing financial markets."

The US is expected to issue more Treasuries to raise the funds, and China is expected to be a big buyer. Hong Kong's Chinese-language Ming Pao Daily reported at the weekend that the Chinese government plans to buy at least $200 billion worth of new US Treasuries. A PBoC spokesman declined to confirm this.

"We must help the US to help ourselves,'' a Chinese government official said. "We do not want to see the collapse of the US financial system, which would be disastrous for us too." Premier Wen, on the sideline of a visit to the United Nations, has pledged all coordination and assistance to help the US out of its current predicament.

Right now, buying government-backed treasury bonds may be the safest way for China to make outbound investments. "We believe the United States is a country with good credit," Wen said in an interview with CNN last month.

1. The listed banks referred to are Industrial and Commercial Bank of China, Bank of China, China Construction Bank, Bank of Communications, China Merchants Bank, Minsheng Bank, China Citic Bank, the Industrial Bank and Huaxia Bank.

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