SERVE THE REAL ECONOMY AND PREVENT FINANCIAL RISKS

SERVE THE REAL ECONOMY AND PREVENT FINANCIAL RISKS*

July 14, 2017

Efficient and High-Quality Financial Services for the Real Economy

Finance and the real economy have a symbiotic relationship. The real economy serves as the foundation of finance, while finance acts as the lifeblood of the real economy. Serving the real economy is the duty and mission of finance, and an essential means of preventing financial risks. As Sima Qian said, “When farmers, craftsmen and merchants engage in smooth trade, all forms of currency, including shells, gold and coins, will thrive.”

The interaction of supply and demand in the real economy plays a crucial role in preventing serious problems from emerging in economic flows. China’s economic development is currently facing a significant challenge — the supply structure is falling short of the upgraded demand structure. This structural imbalance between supply and demand has led to poor flows in the real economy. This is precisely what supply-side structural reform aims to solve, and it is also the primary task of finance in serving the real economy at present and for some time to come.

Serving the real economy is the purpose of the financial industry. In the current landscape, it is crucial for the financial industry to meet the requirements of supply-side structural reform and focus on addressing the challenges of limited and expensive financing. This will enable the financial industry to play a more effective role in correcting the imbalance in China’s economy, bridging the gap between supply and demand, and organizing resources. It is a complex issue that needs to be resolved.

During periods of rapid economic growth when the conditions are favorable, the financial industry is motivated to serve the real economy. However, during times of transition to slower growth, the return on many real industries drops sharply, and the risk increases, leading to a lack of incentive for the financial industry. Conversely, if supply and demand in the real economy are imbalanced, the financial industry will face many difficulties. Some of these issues require in-depth research and targeted measures, such as how to accelerate the exit of “zombie enterprises” and restructure existing assets in industries with excess capacity, how to create financial products that mitigate uncertainties, disperse risks across different time periods, industries and groups, and expand effective investment, how to provide financial support for emerging industries and promote reasonable asset pricing and equity protection, and how to establish institutional arrangements for medium- and long-term funding to accommodate the long payback periods typical of green investments. Solving these problems is a shared responsibility of both industry and the financial sector, and it is also a key focus of macroeconomic policy adjustment.

To implement the new development philosophy, we need to consider the laws of development and characteristics of the financial industry. When the economy grows rapidly, the financial industry can expand extensively alongside the real economy. However, this approach has reached its limits. In the future, we should prioritize quality and efficiency and focus on internal improvements. Particularly in the context of excess capacity, we need to shift our focus towards restructuring existing assets, optimizing new assets, and transforming drivers of growth on the supply side. The financial industry used to benefit from wide interest margins as a result of interest rate controls and was strongly driven by the idea of earning profits without effort. Now, it is essential to prioritize customer needs, create value through services, and rely on competitiveness to succeed.

We should optimize the financing structure and construct a financial chain that is aligned with developments in the real economy. The capital market represents a major weakness in China’s financial system and hinders the deleveraging process. Therefore, we must prioritize direct financing, particularly equity financing, and expedite capital market reform to establish a multilevel market system which has complete financing functions, robust basic systems, effective market regulation, and full protection of investors’ legitimate rights and interests. We should prioritize the quality of listed companies, steadily reform the registration-based IPO system, and improve the delisting system to ensure that unfit companies are removed from the market. Furthermore, we should encourage venture investment such as angel investment and startup investment. We need to improve the structure of indirect financing by accelerating the strategic transformation of large state-owned banks and developing small and medium-sized banks and private financial institutions. We must also improve the system of medium- and long-term financing to meet the needs of developing quasi-public goods and infrastructure. We should encourage commercial insurance to play its role in promoting long-term and stable investment, acting as an economic shock absorber and social stabilizer. In order to achieve the unity of economic value and social value, it is imperative that we strengthen the service awareness of the financial industry. Multiple measures must be taken to reduce costs, address shortcomings effectively, and create value and profits while serving economic and social development. All types of financial institution should accelerate the transformation of their business models, optimize their core businesses, and specialize in their fields. Small and medium-sized financial institutions should focus on localized businesses and services, and avoid diversification and cross-regional operations.

An inclusive financial system must be established, with strengthened financial services for micro and small enterprises, agriculture, rural areas, rural people, and remote areas. Financial support should be reinforced to advance targeted poverty alleviation. Financing channels for social programs must be expanded and new financing models be created to benefit the public, and more financial products developed to meet the needs of the public in areas such as health care, elderly care, education, and training.

The financial industry should actively support the implementation of major national strategies and prioritize the funding needs of key national construction projects. Sci-tech finance should be developed and improved, and green finance encouraged. Internal management of financial institutions must be strengthened, and operating costs and service charges reduced. The phenomenon of charging without providing services must be resolutely dealt with.

Intermediate processes must be regulated, and capital chains shortened. We should avoid malpractices that increase the financing costs of the real economy, such as substandard financing corridors that bypass regulation and debt financing disguised as equity financing. The focus must shift from blindly pursuing high returns to seeking reasonable returns under controllable risks, and from meeting large and massive demands to satisfying personalized, differentiated and customized demands. Differentiated service capabilities must be improved to respond to different demands, including heavy and light assets, micro, small, medium-sized and large enterprises, state-owned and private enterprises, innovative and traditional industries, and infrastructure and eco-environmental conservation that take long to pay back.

Financial innovation must prioritize the real economy and the needs of consumers and investors. Innovation should not be reckless and should not deviate from the needs of the real economy or be designed to bypass regulation. Financial institutions should avoid blind expansion, excessive internal capital circulation, the shift from the real economy to the virtual economy, and Ponzi schemes. Risk assessment of financial innovation should be strengthened, and harmful innovations should be called off.

Financial products should be developed that are adaptable to innovative industries and micro, small and medium-sized enterprises. With high savings rates and limited investment channels among the general public, financial products such as certificates of deposit and fixed-income bonds should be developed. To address high corporate debt ratios, limited sources of funding, and impeded financing channels for local governments, a wider range of bonds should be provided.

As internet finance is characterized by scale, broad coverage, strong flexibility and liquidity, and high risk, it is essential to clean up and rectify the market, optimize the systems for market access and fund monitoring, and improve industry norms.

It is crucial to ensure that financial institutions and the financial system as a whole are sound. The global financial crisis has taught us an important lesson — it is necessary to restore and maintain the health of financial institutions. Financial institutions need to stay healthy not only in terms of their balance sheets but also in corporate governance, internal control systems, trading and settlement of complex financial products, and critical financial infrastructure. If financial institutions are in poor health, it is difficult for them to serve the real economy effectively.

Overall, China’s financial institutions and the financial system are healthy. However, there are still many problems regarding internal controls, asset quality, service level, and competitiveness, which are not aligned with the development of the real economy. Effective measures must be taken promptly to tackle these problems.

Here, I would like to highlight an important issue concerning China’s basic economic system based on the predominance of public ownership and the development of diverse forms of ownership. We have always emphasized the principle of consolidating and developing the public sector and at the same time encouraging, supporting and guiding development of the non-public sector. However, in reality, some state-owned enterprises use low-cost financing to invest in financial products and the stock market, and make financial investments rather than their core businesses the primary source of profit. On the other hand, private enterprises still face restrictions in terms of credit policies and direct financing. The financial sector needs to establish sound values and norms to better serve the improvement of our basic economic system.

Measures for Protecting Against and Defusing Financial Risks

Protecting against and defusing financial risks, particularly systemic financial risks, is a fundamental task and a perpetual concern of financial work. Proactive measures for fulfilling this task should top our agenda, as it would be too late to act once an incident occurs. 

We should adopt a well-conceived approach to protecting against financial risks, with early detection, warning, identification and disposal. Our focus should be on protecting against and defusing risks in key areas, addressing various financial irregularities, strengthening risk control at the source, and reinforcing financial security defenses and emergency response mechanisms. We must actively and prudently protect against and manage significant risks, and closely monitor and defuse risks related to liquidity, credit, shadow banking, abnormal capital market fluctuations, the insurance market, and real estate bubbles. We should effectively protect against technology and information security risks in financial networks and forestall cross-border capital flow risks. We cannot overlook any threat or hidden danger. We must take preventive measures to ensure the security, efficiency and stability of financial operations. Currently, we must focus on three key measures.

First, we should promote deleveraging in the economy. In a sense, high leverage is a source of financial risk. Leverage refers to the ratio of borrowed funds to equity, and the macro leverage ratio usually measures a country’s total debt to its GDP. At the end of 2016, China’s macro leverage ratio reached 247 percent, an increase of 104 percentage points compared to 2008. This high ratio is partly due to high savings rates and our development stage. However, high and imbalanced leverage can easily lead to macroeconomic instability and vulnerability, fuel speculation, increase insolvency levels and risks, disrupt social expectations, and make policy-based regulation and market self-adjustment more difficult. Therefore, when emphasizing supply-side structural reform, I clearly identified deleveraging as one of the key tasks. This is crucial in preventing systemic financial risks.

Deleveraging measures will be ineffective if they cannot control the money supply. In the past, we have used a combination of GDP growth rate, inflation rate, and some other factors to define a reasonable range for monetary supply growth. Based on these criteria, the current overall supply of money and credit is quite abundant. To prevent the macro leverage ratio from further soaring, it is essential to firmly implement a prudent monetary policy, maintain neutrality, and exert strict control over the supply of money and credit. The implementation of monetary policy should strike a balance between the need for steady growth, structural adjustment, and overall monetary supply control. This will ensure stable economic performance and improve development quality and efficiency, while preventing excessive monetary supply from increasing systemic financial risks.

China’s corporate sector has the highest debt to GDP ratio among major economies in the world, standing at 165 percent, with “zombie enterprises” as the primary culprit. To tackle this issue, we need to focus on the main challenges and their main factors. We should prioritize the deleveraging of state-owned enterprises and decisively eliminate zombie enterprises. It is unacceptable for local authorities to protect these zombie enterprises. Sometimes conservative therapy is not enough, and we need to intervene to remove lesions that will have serious consequences if left untreated. I have emphasized this point on several occasions, and we must be resolute in our efforts. We should ensure the implementation of national plans for market-oriented, law-based debt-to-equity swaps. Deleveraging must be combined with the mixed-ownership reform of state-owned enterprises, putting existing assets to good use and optimizing new assets. The role of the capital market and various financial institutions must be leveraged in corporate mergers and reorganizations to create new value. The central government must increase its responsibility for expenditures related to pensions and social security for workers laid off due to overcapacity cuts, while local governments must also play their part in maintaining social stability.

We must strictly control increases in local government debt. Local governments should accelerate the transformation of their development approach and avoid relying on high debt to drive growth. We should put an end to the tendency of disorderly borrowing for construction and prevent financing platform companies from indirectly raising funds for local governments. Moreover, we should closely monitor the emergence of hidden debt and ensure that public-private partnerships (PPP) are not converted into new financing platforms. Government investment funds and government purchases of services must not be used as a “second treasury”. We should strengthen audit and accountability, implement a lifelong liability mechanism, and resolutely investigate all violations of laws and regulations. Local finance departments should borrow lawfully through government bonds, reasonably determine the issue sizes, build open channels and block hidden corridors, and ensure fiscal sustainability. We must accelerate the preparation and publication of local government balance sheets, strengthening market-based constraints on local government debt. Available information shows that the issue of local government debt is complex, particularly for hidden debt beyond the limit, and we must provide differentiated guidance and address the issue prudently. To tackle the issue at its root, we should accelerate reform of the fiscal and tax systems, establish a balanced fiscal relationship between central and local governments, and improve the local tax systems.

Reducing the leverage ratio is a lengthy process, and we must take stock of the situation, clarify responsibility, and adopt practical and effective measures. Through sustained efforts, we can achieve a steady decline in the leverage ratio. 

Second, we should address financial irregularities. As an ancient Chinese statesman observed, “The market reveals order or disorder in a country, as well as the abundance or scarcity of goods.” The proliferation of such irregularities poses a significant risk to systemic stability. This year, I have emphasized on many occasions the need to rectify financial irregularities and consolidate financial order. Relevant departments have already taken action and achieved preliminary results. Investigations into major cases have revealed that various financial irregularities, especially activities in breach of laws and regulations, involve significant economic interests and numerous connections. Rectifying financial irregularities is not an easy task, as it often leads to market volatility and negative public reaction. Nonetheless, we must have the courage and determination to take stringent measures and stay committed to our goals, and we must not be swayed by market sentiment or unbalanced opinions.

Currently, we should focus on rectifying behaviors that seriously disrupt the financial market order. These include illegal financial services and fundraising, unregulated interbank transactions and off-balance sheet businesses, abuse of leverage, and illicit arbitrage. To correct such problems, we need to strengthen regulation of internet finance, financial market transactions, and comprehensive financial services, and the integration of financial and industrial capital. We must also reinforce financial risk control at the source, enforce strict market access regulation, strengthen the accountability of financial institutions in fulfilling the main responsibility for risk management, and improve the social credit system.

To achieve our goals, we must resolutely ban illegal financial institutions and activities, continue to take resolute action against illegal fundraising activities, and prohibit non-financial enterprises from engaging openly or clandestinely in statutory financial businesses. We must be particularly vigilant against Ponzi schemes that use noble rhetoric and various tricks. We must be aggressive in combating illegal financial activities and increase punishments for insiders suspected of pay-to-play wrongdoing and abuse of public office for private gain, financial magnates who manipulate the market and engage in backroom deals, and reckless offenders engaged in illegal fundraising and underground banking, so as to form a powerful deterrent. Certainly, rectifying financial irregularities also requires a differentiated approach based on their nature and root causes. For issues that arise from inadequate financial regulatory rules and standards, and weak internal control and compliance management in financial institutions, as long as there is no violation of discipline or law, we should follow the principle of learning from mistakes to prevent recurrence and treating the illness to save the patient. This can be achieved step by step through regulating market behavior, improving corporate governance, and strengthening internal control and compliance management systems.

The frequent occurrence of financial irregularities highlights our shortcomings in the rule of law. As we strive to fully advance the rule of law, financial irregularities must be addressed in accordance with laws and regulations. In the process of rectifying irregularities and defusing risks, we should pay close attention to the lessons learned. As the saying goes, “A fall in the pit, a gain in the wit.” We cannot afford to pay the price for no gain. Departments involved should improve law-based financial governance that best suits China’s national conditions. The Criminal Law should also be revised accordingly to address various financial irregularities and crimes.

In order to reinforce financial regulation, it is important to control the pace and intensity of our efforts and adopt sound methods. Financial risks do not emerge suddenly, and resolving disorder cannot be achieved overnight. We need to have a thorough understanding of the underlying laws of the financial market, control spillovers and contagion, and prevent policy overlaps and inappropriate behaviors from disrupting capital chains. Relevant departments should set phased goals, proceed steadily, make incremental progress, and achieve tangible results.

Third, we should promote the stable and healthy development of the real estate market. Internationally, financial risks are often closely associated with an overreliance on the real estate sector for economic growth. A number of factors such as income, population, land supply and taxation have been behind the recent surge in housing prices. However, the macroeconomic reason behind this was a loose monetary policy, with the real estate market acting as a reservoir for excess liquidity. The links between real estate enterprises and financial institutions have resulted in a high dependence on the real estate sector for economic growth, fiscal revenues, and bank assets and profits. The steady rise in housing prices has caused growing distortions in resource allocation.

Addressing real estate bubbles is a global challenge. I have consistently emphasized the importance of establishing a long-term mechanism for the healthy development of the real estate market. We must ensure that housing is for living in, not for speculation, take a holistic approach to developing the real estate market, and move faster to implement comprehensive and effective policies. In the short term, we need to better manage demand, guide expectations, and improve the land supply system, and adopt well-designed land supply methods to prevent sharp fluctuations in housing prices. In the medium term, we should follow the approach of supply-side structural reform to improve the housing supply system and adjust the supply structure. We can use multiple channels to increase the supply of rental housing in large cities where conditions permit, optimize the spatial configuration of cities of different sizes, and strengthen connectivity between megacities and small and medium-sized cities. We should also promote equitable access to basic public services in small and medium-sized cities — particularly in education and health care — and make small and medium-sized cities more attractive to people. These issues can be fully worked out in the course of further development. The reform of real estate taxes will help real estate regulation out of the current predicament. Relevant departments should accelerate their work in accordance with the requirements of the Party Central Committee.

* Part of the speech at the National Finance Conference.

(Not to be republished for any commercial or other purposes.)