Status Report on China's Financial Sector reforms

1. WORKING DOCUMENT
REPORT ON THE ROUND TABLE OF NOVEMBER 20, 2012 ORGANISED BY
ITALY-CHINA FOUNDATION JOINTLY WITH THE BANK OF ITALY
on
Economic Trends and Evolution of Chinese Financial Sector Reforms:
Scenarios and Opportunities for International Investors
Milan, January 14, 2013
The working paper was prepared by Franco Fornasari with the support of Thomas Rosenthal,
and the Staff of the Italy-China Foundation. Any error in quotation or interpretation of the
contributions by the participants to the Round Table is solely attributable to the author. The
views expressed in this document cannot be attributed to the Sponsors of the Round Table.
Comments are welcome to F.Fornasari@valuetreepartners.com / info@italychina.org.

2. On November 20TH, the Italy-China Foundation - in collaboration with the Bank of Italy - organized
a Round Table entitled Economic Trends and Financial Sector Reforms in China: Scenarios and
Opportunities for Cross-Border Investment. The meeting was also the occasion to present the
Number 148-149 of the Chinese World Magazine entitled "The Red Knight of finance." The
roundtable was held at the Hotel Rome Cavalieri Waldorf Astoria, starting at 4:30 PM, and was
followed by a Luncheon in honor of the Governor of the Bank of Italy, Ignazio Visco, with the
sponsorship of the Industrial and Commercial Bank of China, the Bank of China, the Intesa
Sanpaolo Group and Mandarin Capital Partners. The event addressed technical issues and was
attended by leading representatives of institutions, academia, business and finance, both Italian,
Chinese, and international. The meeting focused on prospects for the Chinese economy in the
present domestic and international context; the role of financial sector reforms - including the
internationalization of the Chinese currency; and on the opportunities and risks that arise for
International investors.
The Presentation of the Round Table and Agenda of the Meeting are enclosed in ANNEX 1 and 2
2

3. TABLE OF CONTENTS
INTRODUCTION
I. THE CHINESE ECONOMY IN THE SHORT, MEDIUM AND LONG-TERM
* An economy in “soft landing” for cyclical factors, but structural constraints are looming;
* Traditional manufacturing and private sectors are suffering the most at this point in time;
* The difficulties of Chinese Small and Medium Enterprises have local and global impact;
* A new era of "less-growing expectations" and "slower locomotives" is setting in;
* The real economy is at a "turning point" and the financial sector is in "continuous rapid
transformation";
* A saturation of investment opportunities in the "tradable sectors"?
* Growth is still "investment-led" and "external risks" are still present;
* The development of highly capital intensive sectors changes the supply chains of the Region
* The demographic wave is at the peak and the labor market is changing rapidly
* The "Lewis turning point" is still far ... but the challenge of innovation is closer
* Household savings are poised to drop to more "normal" levels, but it takes time and good policies;
* The growth in social spending will lead to a drop of Households savings, but also of bank deposits;
* Dependence on imported energy and raw materials is an ongoing challenge for economic policy;
* The race for natural resources is not the only way ... but it is the most widely practiced;
* China’s future depends on innovation and technologies for sustainable growth
II. THE FINANCIAL SECTOR REFORMS OF THE CHINESE ECONOMY
* Moving toward a financial sector that helps the country’s real economy realize its potential
* From "shield" against the crisis "constraint" for the balanced development of the real economy
* An expanded financial sector that remain shallow and dependent on banks
* From a "deposit-credit" bank to one that delivers a range of competitive financial services
* The reforms of the financial system have accelerated in 2011;
a. Banks have more flexibility in setting interest rates and margins
b. The "wholesale banking" market is growing and opens new opportunities to foreign investors
c. Chinese banks accelerate their international expansion - "going global"
d. “Going global” is a necessity, but also an opportunity to enter markets affected by crises
e. Capital markets expand in the "high yield" segment and feed new credit to the economy
f. Growing role of the "shadow banking sector" – the Wenzhou Case
* Internationalization of the RMB as a "necessity" and part of financial sector reform
* Internationalization as a "functional process" to eliminate obstacles to the use of the RMB
* Capital Account liberalization and RMB Internationalization: in sequence or in parallel?
* New reforms push for the Internationalization of the RMB;
a. Cross-border settlement in RMB: from experiment to operating system;
b. New "currency swaps" arrangements with the global trading partners;
c. Less stringent rules of access for particular types of operators and capital transactions;
d. Further development of offshore channels to access the chinese financial market;
e. "Hong Kong SAR, China" as the major offshore RMB market;
f. The "dim sum" bond market of Hong Kong
g. New rules for fixing the exchange rate RMB/US$
3

4. * The 2012 exchange rates and speculative capital movements
* The impossible triangle of independent monetary policy, stable exchange rate and open capital
account
III. CHINESE INVESTMENT FLOWS AND THE ROLE OF EUROPE
* Chinese investment flows into the European manufacturing sectors are on the rise
* The risk of Barriers to Chinese investment in Europe should not be underestimated
* Europe is the Leading Destination of Chinese ODI excluding the Natural Resource Sectors
* Co-operation strategies for competitiveness and the role of financial intermediaries
* Non-bank Intermediaries are bound to play a larger role to promote cross-border investment
* Diversification of Chinese foreign investment (ODI) and acquisitions on private markets are
growing
IV. OPEN QUESTIONS AND CONCLUSIONS
A) Where is the Chinese economy going in the short, medium and long-term?
B) What is the role of China in the international economy?
C) What is the direction of reform of the financial system?
D) What role for the RMB - renminbi - and for Chinese banks at the international level?
E) What are the business prospects for international investors?
BIBLIOGRAPHY
CHARTS
1-6: Gross Domestic Product (GDP), inflation in the long run; Contributions to GDP growth;
Dynamics of Exports, Investment and Current Account; Turnover and fixed investment by
components;
7-11: Composition of Imports; integration with international production; production capacity,
wages, labor costs per unit of product and industrial profits; active population, Incremental Capital-
Output ratio;
12-16: Employment by sector and Urbanization; Demogreafy and labor market, saving and
investment by sector; household disposable income and wage gaps in some Chinese provinces;
17-19: Social expenditure, real rate on deposits; deposits at the banking system; imports of
commodities; weight of China in world trade; international comparisons of per-capita consumption;
20-21: “Terms of Trade” of China and International Comparisons of fuel and water prices;
22: Engines of Chinese Growth, International Comparisons of Growth Paths , the” Middle Income
Trap";
23-24: Architecture of Financial System; Calendar of Financial System Reform at the end of 2010;
4

5. 25-27: Bank rates, inflation, profit margins and total assets of banks - international comparisons;
28-29: Credit flows to Economy 2007-2012; Interest Rates and minumum margins for banks; the
2012 bank interest rates reform;
30-32: The Chinese Wholesale Banking market, Foreign Investment in Chinese Financial System;
financial indicators of the Chinese banking system;
33-35: Non-Financial companies debt and growth of credit to the economy; Credit from Trusts and
the shadow banking system of China;
36-37: Functions of an international currency; Current account transactions settled in RMB;
exchange rate RMB/US$, Onshore (CNY), Offshore (CNH);
38-40: Settlement of Chinese imports payments via Hong Kong; exchange rate of RMB/US$,
Onshore (CNY), Offshore (CNH); Expectations of RMB appreciation measured on the Onshore and
Offshore (Non-Deliverable Forward - NDF) markets;
41-44: Offshore Securities Market in RMB (CNH) and Yield Curve of Chinese public debt onshore
(CNY) and offshore (CNH); widening of the "Flotation band” of the RMB/US$ exchange rate in the
period April -June 2012; Exchange Rates RMB/US$ and Nominal Effective Exchenge Rate of RMB
against other currencies (NEER);
45-46: Interest rate differential and short-term capital movements; Chinese central bank
interventions in the foreign exchange market; dynamics of the RMB/US$ exchage rate in 2012;
capital account opening and the "Impossible triangle";
47-52 China Investment Corporation – 2011 Data Highlights; Dragon Investment Index of China;
composition of outward direct foreign investment of China (ODI); foreign investment opportunities
in RMB for Non-Residents in the Chinese market;
TABLES
1. GROWTH OF GROSS DOMESTIC PRODUCT BY TYPE OF EXPENDITURE (2009-13)
2. IMF MEDIUM-TERM SCENARIO
3. DEVELOPMENT INDICATORS OF THE FINANCIAL SECTOR - 2005-2010
4. FINANCIAL INDICATORS - 2005-2010
ANNEX 1: Round Table Introduction
ANNEX 2: Agenda of the Event of November 20th
5

6. INTRODUCTION
This report presents an overview - albeit partial - of the points raised during the Round Table of
November 20th with additional context, data and comments on the main topics and scenarios brought up
by the discussion. The working document is intended to stimulate comments and provide elements to
frame the issues and provide specific references for further deepening and follow up on the issues in
question.
The focus is on the general framework of the Chinese economy and on salient points of policy and issues
that international investors should take into account for their future decisions. The enclosed comments
take into account the economic policies of the XII Five-Year Plan, 2011-15 which were also evoked by the
new leadership at the close of the XVIII Congress of the CPC in November 2012.
Following the break down of the issues and questions proposed in the introduction to the Round Table
(see Annexes), the report is divided into four chapters:
- the first touches on cyclical and structural issues with reference to the general economic policies to
address them;
- the second addresses the role of the most recent financial sector reforms, including the
internationalization of the Renminbi (RMB) within the framework of the reform process that began in
early 2000 – i.e., after the entry of China into the WTO - and led the sector to rapid expansion and
increased complexity, as pointed out in his introductory remarks by Dott. Fabrizio Saccomanni;
- the third chapter deals with the flow of investment and the role of Europe in the process of
internationalization of the Chinese economy and its opening up from the stand point of the capital
account of the balance of payments.
- the concluding section recalls the questions that the Round Table brought to the attention of the
participants and highlights some implications on the emerging scenarios – obviously leaving the
conclusions for each and everyone to draw.
For sake of brevity, the report includes only summary references to the contributions of the participants
that were already circulated as "Readings" and are available upon request.
I would like to acknowledge various sources of the data and references included in the report, and
particularly the ICBC, BOC, Mandarin Fund, A-Capital, Goldman Sachs, JP Morgan, Citigroup, CICC, Credit
Suisse, Euromoney, fDi / Financial Times, The Wall Street Journal, IMF, World Bank, UNCTAD and others
authors quoted in the reading list and charts.
Milan, January 14, 2013
6

7. I. THE CHINESE ECONOMY IN THE SHORT, MEDIUM AND LONG-TERM
An economy in soft landing for cyclical factors, but structural constraints are looming
I.1 The diagnosis of the slowdown of the Chinese economy has emphasized known economic factors
related to the deteriorating performance of the Euro Zone - which accounts for about 16.3% of Chinese
exports and, to a lesser extent, the United States [chart 1]. Other factors include the effects of economic
policies, with reference to bank lending which had reached growth rates of around 60% per year during
2009-10 and which was significantly slowed down in the recent period in order to avoid inflationary and
asset bubble effects. This is particularly true in relation to construction / housing sectors which received
massive investments flows in the post-financial crisis period. Many speakers stressed that the current
downturn is due to other structural factors and internal imbalances (see below) that weigh on the
performance of the Chinese economy. The combined impact of these factors is an increased level of
imports - and greatly reduced size of the current account surplus which had reached its maximum
contribution to the China’s growth in 2007 [Charts 3-4]. A further set of factors is related to the special
circumstances of the political transition and the XVIII Congress of the CCP - in conjunction with the
presidential elections in the U.S. - which may have slowed down the economic policy responses to the
decelerating growth rates experienced since the end of 2011 – i.e., from over 10% to 7%. Overall, the
evaluation of Li Yuefen (UNCTAD) is that 70% of the slowdown in economic growth is due to the
international developments in Europe and the U.S., and 30% is due to factors concerning economic policies
and structural, long-term, phenomena.
Traditional manufacturing and private sectors are suffering the most at this point in time
I.2 The sectors that are now suffering the most are manufacturing and heavy industries. The causes
are the fall in demand for exports and the slowdown in construction and infrastructure programs -
especially those promoted by local authorities (SNG - Sub National Governments) that today are in a fragile
financial position due to the deceleration the Chinese economy. Fan Zhigang (ICBC) pointed out that heavy
industry and private enterprises, particularly SMEs (small and medium enterprises) - and not the state-
owned enterprises (SOEs - state owned enterprises) – are suffering the most and are dealing with the most
difficult choices to overcome the crisis. The financial constraint faced by Chinese SMEs was deemed
particularly severe, as indicated by the distribution of bank credit: Banks loans represent around 80% of
the external financing of SOEs compared to 20% in the case of SMEs – although they represents 65% of
national product and 80% of total employment. The local government expenditure is another potential
cause of imbalance - as highlighted by Amb. Vincenzo Petrone (SIMEST) - in view of the size of their
accumulated debt (about 20% of GDP).
7

8. The difficulties of Chinese Small and Medium Enterprises have local and global impact
I.3 The attention to the situation of SMEs is justified on many grounds as it is clear that the economic
policies of China have significant effects both internally and across borders. This is particularly relevant in
areas where global competition is more intense, as in the case of the steel industry. The Chinese steel
sector benefited from the long investment boom in construction and local government expenditure which
allowed many small size plants and companies to thrive leading to a highly fragmented industry structure.
The international economic crisis and the reduction of domestic financing could lead to industry
consolidation as both sources of growth – i.e., exports and investment in infrastructure – are faltering to
some extent. One should consider that in the steel sector - which presents a worldwide excess capacity of
about 300 million tons and an estimated total capacity of 1,800 million tons - China holds between 600 and
800 foundries and a capacity equal to 46% of the global market. The effects of Chinese economic policies
will be felt globally also in consideration of the pipeline of investment coming into production: industry
sources indicate that there are at least 100 plants under construction in the most disparate locations
(Vietnam, Colombia, Argentina, Ecuador, Peru and Bolivia) that will bring additional capacity for 350 million
tons. Thus, Chinese industrial and credit policies weigh on the shape of the sector in the coming years. Less
concern has emerged on the status of the housing / real estate sector. Prof. Laixiang Sun stressed that the
development of the sector depends on a high rate of self-financing and low dependence on bank loans.
Thus, there is less concern about the effects on the banking system of the current imbalance in the market.
8

9. A new era of "less-growing expectations" and "slower locomotives" is setting in
I.4 On the general economic policy front, Dott. Fabrizio Saccomanni stressed the prudent and skillful
approach shown by China’s policymakers during this period in order to balance the need to stimulate
growth and to contain the spill-over effects of the aggressive lending policies implemented to stimulate the
economy after the 2008 crisis. Such a caution was reflected in a reduced growth target of 7% per annum,
which was indicated for the decade 2012-2022 – i.e., this would "only" double the size of the Chinese
economy, compared to the growth rate of the past decade during which the Chinese economy did more
than quadruple in size and became the second-largest in the world, although in absolute size and certainly
not yet in terms of per capita income [chart 2]. Such growth would lead China to exceed the size of the U.S.
economy at the end of 2020, but hopefully with a better balance and less spill-over effects into the global
economy. On this subject, Prof. Fu Jun pointed out that the global economy will have to adjust in the
future, and live with a "Chinese locomotive" traveling at slower speed than in the past. On the other hand,
it will be the reform of the Chinese economy that will have to accelerate its pace compared to recent years.
The real economy is at a "turning point" and the financial sector is in "continuous rapid transformation"
I.5 The diagnosis of the structural problems of the Chinese economy has been the focus of comments
by Cao Yuanzheng (BOC) and Fan Zhigang (ICBC). They drew a picture of a real economy "reaching a
turning point," as well as a financial sector in "fast and constantly changing mode". There is no doubt that
the financial sector reforms are advancing as a continuous process, pragmatic and incremental - rather than
a sequence of decisions that are consistent with a clearly defined model. So we are faced with a "silent
policy revolution" in a country still looking for a "Beijing Consensus" which differs from the "Washington
Consensus", but yet is able to meet the challenges faced by China at this stage of its development.
A saturation of investment opportunities in the "tradable sectors"?
I.6 The Chinese production system has reached a turning point for various “change factors” and first of
all its over-dependence on manufacturing/export markets. The growth of China in the pre-financial crisis
was in fact linked to the dynamics of exports, but in earnest it was supported by massive investment (at
levels close to 42% of GDP) concentrated in manufacturing capacity for products destined to international
markets. The state of the world economy “post-crisis” makes this model unsustainable, leading to the
slowdown in Chinese exports – falling from 30% to 7% over the last 3 years. This calls into question the past
growth model based on full integration of the Chinese economy in global supply chains that depend on the
rapidly changing world demand patterns (as in the case of photovoltaic panels sector which was driven by
government incentives that now appear clearly unsustainable). Diversifying the production structure
towards domestic demand is a priority for the Chinese economy, given the outlook for the G7.
9

10. Growth is still "investment-led" and "external risks" are still present
I.7 It is interesting to note that this diagnosis is fully endorsed by the twelfth Five-Year Plan 2011-15 -
which aims to promote the growth of consumption and domestic demand, and also promote growth of the
service sector: Yet these new trends are not reflected in the dynamics of fixed investment in manufacturing
which shows sustained growth rates for the whole 2010-12 period [Charts 5-6]. Only investment in
residential construction has slowed (Table 1 - 2). The strong demand for private fixed investment is
associated with sustained import growth of machinery and minerals in particular – i.e., this indicates that
sectors such as mechanical, engineering, steel have reached a prominent position as a share of global
production chains [Charts 7-8]. Considering the investment dynamics of non-manufacturing sectors – i.e.,
infrastructure such as social housing which grows along with the urbanization process now close to 50% of
the population – as well as investment in services, one reaches levels of aggregate investment for the post-
crisis period that went as high as 48% of GDP (as in 2010). This helped fill the void created by the decline in
net exports and sustained GDP growth. The downside is that the Chinese economy seems still exposed to
the risks of the international economy and the risk of obsolescence of its vast investments base.
10

11. The development of higly capital intensive sectors changes the supply chains of the Region
I.8 The combined effect of abundant labor supply and strong accumulation of fixed capital is to
significantly increase the available production capacity of China [Chart 9]. Even taking into account the
effects of structural changes that are taking place in the world economy, it is clear that China holds a strong
reserve of capacity for non-inflationary growth that can spur its rapid expansion in the case of global
economic recovery or - otherwise – presents a serious potential problem of productive restructuring and
consolidation in its industrial base. The observation of William Lee (Citibank) is that the massive
investment in activities with a high content of knowledge, technology and capital puts China in a position of
direct competition with traditional partners in regional production chain (i.e., South Korea and Taiwan) with
potential fall outs and consolidation effects on the whole supply chain, in a scenario of low global demand.
So the success of China in the transformation of its production system is not a "win-win" proposition for the
region unless the countries in China’s “supply chain” adapt their production to China’s new growth model
by providing the consumption goods and services (especially consumer electronics and tourism) that will be
in high demand. Thus, in line with “neo-structuralist” hypotheses, China is becoming a competitor in
products and markets led by countries in the Region that escaped the middle income trap (Chart 22-C).
11

12. The demographic wave is at the peak and the labor market is changing rapidly
I.9 A second set of "change factors" concerns the dynamics of the labor market and the weakening of
China’s traditional "comparative advantage" in terms of abundant, low-cost stream of young workers
willing to take up manufacturing jobs. On the one hand, there are demographic factors leading to a long-
term decline in labor supply approximately by the year 2020 – this marks the beginning of a rapid fall in the
ratio of population aged between 15 and 30 years and the total population aged between 15 and 59 years
[Chart 10]. United Nations estimates indicate that, following a period of increases in the labor force by
some 103 million units between 2000 and 2015, one can foresee a reduction of 69 million units from 2015
to 2030. On the other hand, there are factors related to the increasing diversification of the production
structure, the urbanization - which went from 20% to about 50% in just over a decade – the changes in
lifestyles and in the participation rates of Chinese population, especially female who tend to prefer
employment in services compared to manufacturing. Looking ahead, both the reduction of migration flows
to the cities and the changes in the workforce create a situation in which it is increasingly difficult to meet
the demand of low cost labor, particularly in the top high-tech sectors such as electronics. The immediate
effect of the changes under way is a sustained increase in wages in industry - with peak increases of over
20% [Charts 11-12] - leading to a convergence in labor costs compared to international standards and
shifting the terms of Chinese competitiveness toward other factors such as productivity and innovation.
12

13. The "Lewis turning point" is still far ... but the challenge of innovation is closer
I.10 It is worth stressing that all of the above trends are not expected to result in a severe tightening of
the labor supply curve – i.e., leading to the Lewis Turning Point - at least for another 10 years [Chart 13],
depending on economic and social policies implemented in the coming years. In addition, the sustained
wage increases only affect the coastal areas that are more heavily industrialized, and not so much the
interior of the Country where profound differences exist between by sector and area [Chart 14]. Although
the growing income inequality is in many ways a disturbing factor, the fact remains that China has
enormous growth potential for non-inflationary growth in its own internal Western frontier - as pointed out
by Li Yuefen (UNCTAD). Similar points were made by Silvia Ardagna (Goldman Sachs) who stressed that
the challenges of growing social expenditure and non-tradable sectors can be met as China holds ample
margins to improve efficiency in the production system. China is also making rapid progress in building
innovation capabilities, starting from key sectors in which patents have grown exponentially (Chart 22-D).
Household savings are poised to drop to more "normal" levels, but it takes time and good policies
I.11 A third set of "change factors" is the reduction in the saving rate of Households due to aging of the
population which results in exits from the labor market and changing patterns of consumption - also due to
economic reforms that provide additional incentives to increase Households consumption. After two
decades of steady increase, Chinese national saving has reached 54% thanks to the decisive contribution by
the Households sector. This is the pillar supporting sustained growth rates exceeding 10% per year in
conjunction with a large accumulation of international reserves (with current account surplus reaching up
to 10% of GDP) and an investment boom that set the stage for the creation of a large production base in
steel, mechanical and chemical industries, engineering, and more recently, a residential construction boom.
The growth of Households savings in the latter period is noticeable [Charts 15-16] as it is obtained despite a
flat disposable income - in which only the wages of those employed in the modern sectors recorded strong
increases. Looking ahead, both the increase in the dependency ratio (i.e., the ratio of non-active to active
population) and the increase in consumption are expected to lead to savings levels in line with those of
non-oil exporting countries.
13

14. The growth in social spending will lead to a drop of Households savings, but also of bank deposits
I.12 The aging population highlights the problem of how to meet the growing demand of retirement
benefits and social security which China only provides in limited quantity to urban areas workers. This is a
priority issue in the XII Five-Year Plan, which aims to raise the ratio of private consumption to GDP above
historical levels of 35% by a systematic increase in social spending for education and for "social safety nets"
[Chart 17]. In addition to social public spending and pensions, the Plan also aims at developing an efficient
health services sector able to create jobs for that part of the population that has not yet benefited from the
explosive growth of the Chinese economy. This is why the Plan provides for an increase of the contribution
of the service sector from 43% to 47% of GDP through programs of liberalization of public services and
improved management of utility companies in energy, water, etc. The commentary added by Cao
Yuanzheng (BOC) is that all these policies have a downside as they lower the level of deposits made freely
available to the banking system to meet the needs of low-cost credit for the economy. In the future, banks
will have to act as intermediaries relying less on deposits - which today are the main financial assets in
which Households keep their large stock of precautionary money [Chart 18] – and more on financial
markets that should also provide suitable instruments to mobilize long-term savings and meet the social
security needs of the country.
14

15. Dependence upon imported energy and raw materials is an ongoing challenge for economic policy
I.13 A fourth-order of "change factors" is the China’s dependence upon imported energy and raw
materials for the functioning of the whole economy and of the heavy industry in particular. The high
dependence on oil imports – i.e., about 66% of domestic oil consumption is imported – is a cause of
concern due to the volatility of international markets on which China is a relatively small importer
compared to the overall size of the global market. Not so in the case of metals and agro-industrial products
in which China has a greater impact and did contribute to the sharp price increase and volatility
experienced by these commodities in the past decade – i.e., the so-called "commodities super cycle" – also
leading to a fall in its terms of trade that have weighed on the Chinese economy [Charts 19-20]. It is clear
that the road to reduce the China’s reliance on imports is long, but it certainly involves reforms in the
structure of factor prices to encourage greater energy efficiency, expanded reliance on renewable energy
and technological innovation to put China on a more sustainable growth path.
15

16. The race for natural resources is not the only way ... but it is the most widely practiced
I.14 China has long been aware of its “import dependence fragility”, and has set in motion a wide range
of programs aimed at developing countries in order to gain privileged access to their natural resources.
Between 2001 and 2010 the rating agency Fitch estimated that the development arms of the Chinese
government - Eximbank of China and China Development Bank - have committed credit lines of US$ 67.2
billion to countries in Sub-Saharan Africa – and this is more than the US$ 57 billion committed by the World
Bank during the same period. In the past few days there is news (Financial Times, November 9, 2012) of a
credit line of US$ 3 billion to Ukraine for a "loans for crop" program concerning food products. Considering
the critical role that China plays in the development of commodity-producing countries and in setting the
equilibrium of international commodity markets, it seems that the rush to natural resources is far from an
optimal strategy and it presents risks of spill-over for the global economy. In perspective, the reform of the
internal factor price system towards more market-based mechanisms - particularly for energy [Chart 21] –
could contribute to further increase energy efficiency and encourage a more sustainable use of natural
resources.
China’s future depends on innovation and technologies for sustainable growth
I.15 The call for reforms to steer China on a more sustainable growth path came from Prof. Fu Jun who
stressed that the urbanization and industrialization processes require a market basis for prices of all factors
- land, labor and capital - and a set of financial sector policies to support a transformation of production
system and encourage innovation and technological development. Some economic policy lines have been
articulated in the recommendations of the World Bank report on "China 2030", but it is the New Leadership
emerged from the XVIII Congress PCC that will determine the course of action for the country. The remarks
of Dott. Fabrizio Saccomanni and Fan Zhigang (ICBC) emphasized the complexities involved in overcoming
the middle-income trap [Chart 22 A / B / C] and the critical role of financial sector reforms to maintain a
balanced growth process – not only in terms of external accounts, but also internally – i.e., to avoid
bubbles, favor the development of SMEs and overcome the effects of rising wage inequality in the modern
sector of the Chinese economy. The long-term outlook indicated by Prof. Fu Jun and Fan Zhigang (ICBC) is
one of a country determined not only to achieve the stated goal of doubling its per-capita income over the
next nine years, but also to reach the growth potential that pertains to a country with one fifth of the world
population. Enrico Tommaso Cucchiari (Intesa Sanpaolo) pointed out that the Chinese economy in 2030
would reach US$ 60 trillion – which is close to 20% of the projected world GDP. In perspective, the market
capitalization of the Shanghai and Shenzhen exchanges might grow over 20 times compared to 2011 levels
of US$ 3.3 trillion. This is a historic opportunity and the international community has a vested interest in
the success of economic reforms.
16

17. 17

18. 18

19. II. THE FINANCIAL SECTOR REFORMS OF THE CHINESE ECONOMY
Moving toward a financial sector that helps the country’s real economy realize its potential
II.1 The issue of financial sector reforms was introduced by Prof. Fu Jun, Li Yuefen (UNCTAD) and
others, starting from a diagnosis of issues related to various components of the complex architecture of the
Chinese financial sector [Chart 23]. The dominant theme was deepening the system and balancing the role
of banks, non-bank intermediaries and capital markets. The goal is to ensure that the system can perform
the basic functions of a modern financial system and support transition towards a Chinese economy more
focused on domestic demand – both private consumption, "social safety nets" and pension systems that
today are underdeveloped (Table 4). Prof. Fu Jun emphasized the critical role plaid by the financial system
to support the complex processes of industrialization, urbanization, and efficient allocation of resources -
land labor, capital - to promote the realization of the enormous growth potential of the country. Other
efforts have touched on the most urgent and the latest reforms of the banking sector (i.e., adding flexible
mechanisms to set interest rates on deposits and loans), capital markets, the exchange rate and
internationalization of the renminbi (RMB) – following up on a twenty year reform process [Chart 24].
19

20. 20

21. From "shield" against the crisis to "constraint" for the balanced development of the real economy
II.2 Li Yuefen (UNCTAD) framed the issue of financial sector reforms by stressing the good performance
of the Chinese system during the financial crisis of 2008. She indicated that the financial system emerged
from the long process of reform of the last two decades – i.e., the complete restructuring and
recapitalization of banks which included the "cleaning up" of balance sheets from bad loans (NPL - non-
performing loans) – had left the public sector in a dominant position throughout the banking system. For
this reason the system could play a dual role – i.e., one of financial intermediation and another of
instrument for industrial policies. Thus, it could implement stimulus policies based on targeted credit
expansion. However, the recent economic developments show how this "shield" against financial crises has
become more of a "bottleneck” to achieve the goals and growth strategies set by the policymakers. In
effect, the system is becoming “a problem” for the distortions it causes in the functioning of the Chinese
economy. Basically, the Chinese financial system presents four critical issues: (i) the level of “administered
interest rates” is kept low to facilitate the restructuring of the NPLs of the system - despite the costs
imposed on Households in terms of negative real interest rates [Chart 25]; (ii) the structure of interest rates
guarantees wide margins between the cost of funds / deposit rates and lending rates [Chart 26] and ensure
the profitability of the banks - without considering the distorting effects on credit allocation; (ii) financial
markets are underdeveloped to prevent rapid decline in the very large savings deposited in the banking
system, and of course, (iv) the State is directly involved in the allocation of credit.
21

22. An expanded financial sector that remain shallow and dependent on banks
II.3 The observation of the current state of the Chinese financial system shows a very complex reality
and it highlights the considerable progress made in the past years, but it also shows its fragility. At present,
China occupies the second place in world rankings by size of the stock market, and the fifth by size of the
bond market, as pointed out by Bert Gochet (JPMorgan Chase). However, these markets are relatively
immature. Both the controls on interest rates and exchange rates, the weak corporate governance, and the
controls on capital movements are major factors that distort financial markets and slow progress towards
the internationalization of the currency (RMB). Bank have made limited contribution to the growth and
internationalization of SMEs - as pointed out by Lorenzo Stanca (Mandarin Fund); this is stark contrast with
their disproportionate weight within the financial system - which mirrors the small weight of non-bank
intermediaries and capital markets as source of credit to the businesses sector - as pointed out by Prof. Fu
Jun. International comparisons show that the weight of banks as a percentage of total financial assets is
more than 63% in China, compared to South Korea (25%) and the USA (11%) [Chart 27]. In addition, it is
worth noticing that the boom of banking assets and profits is mainly due to the massive increase in loans
during the 2009-10 period, as part of post-2008 stimulus policies [Chart 28].
22

23. From a "deposit-credit" bank to one that delivers a range of competitive financial services
II.4 Overall, the business model of the past - in which banks were primarily focused on supporting the
SOE sector and serve as an instrument of industrial policy - is now considered unsustainable. Cao
Yuanzheng (BOC) stressed that both the economic slowdown and the set of economic policies chosen by
the Government require a change in the bank business model: They should evolve from entities that
administer the abundant mass of deposits and provide credit to priority areas identified by the government
– i.e., a model of "deposit-credit" - to institutions that respond to market mechanisms, according to
"Western models of banking intermediaries." Hence, he stressed that Chinese banks need to accept more
competition in the internal market and to need to accelerate growth in international markets.
The reforms of the financial system have accelerated in 2011
II.5 The China's financial sector reforms are integral to the XII Five-Year Plan 2011-15 and, since
December 2011, they led to the adoption of various liberalization measures and achievements that were
discussed in various interventions.
Banks have more flexibility in setting interest rates and margins
(a) The first area of intervention is bank interest rates and competition within the sector. From July 2012,
the benchmark rates have been reduced; in parallel, banks have been given increased flexibility in
setting interest rates both on deposits (i.e., they can increase them above the 3% benchmark rate) and
on loans (i.e., they can align the current rate of 6% to values that better reflect the credit risk of the
borrower). All this is meant to increase competition for deposits and allow banks to allocate credit by
pricing mechanisms – as opposed to administrative mechanisms prevailing in the past [Chart 29; Box 1].
23

24. The "wholesale banking market” is growing and opens new opportunities for foreign investors
(b) The second area is the opening up of the financial sector by increasing the investment ceiling and other
rules for foreign acquisition of interests in "securities firms" (from US$ 30 to 80 billion). This opens up a
segment of the Chinese financial service market which is more sophisticated and is rapidly growing -
even though the business models for foreign investors are evolving, in line with the changing market
[Chart 30 A-B]. The entry of foreign financial institutions in China [Chart 31] dates back to early 2000s -
in the post-accession to the WTO - and is in a phase of transition toward modes that can be suitable for
the profitable development of "wholesale" services. So far, foreign investors have entered the market
in various forms, including Chinese-foreign joint venture, the opening of "subsidiaries" and the minority
stake in Chinese institutions (i.e., the maximum of 20-25% is being increased). The "retail" market
remains firmly in the hands of Chinese institutions (Chart 31 Bis).
24

25. 25

26. Chinese banks accelerate their international expansion - "going global"
(c) The third line of action is the international expansion of Chinese banks. This is a decisive step in the
internationalization of the Chinese economy, which - as pointed out by Dott. Fabrizio Saccomanni - will
benefit Chinese SMEs, by reducing the fixed costs of a presence in foreign markets as well as the
barriers to acquiring the knowledge required to succeed in new markets; this should also help increase
the depth of the Chinese financial market by transferring best technologies and business practices
across borders. For Chinese banks "going global" is an integral part of the process of opening up that
was indicated by government policies to deepen and modernize the financial system of the country –
i.e., a country that has now become the world's largest exporter of goods. The four major banks under
the direct control of the State (Industrial and Commercial Bank of China, Bank of China, China
Construction Bank, and Agricultural Bank of China) have stated ambitious plans for opening branches in
key markets (e.g., ICBC indicated that it will reach a presence in 37 countries at the end of 2012,
according to press releases (The Wall Street Journal 28-Nov-12).
“Going global” is a necessity, but also an opportunity to enter countries touched by financial crises
(d) The reasons for Chinese banks to grow outside their domestic market can be summarized as follows: (i)
supporting the internationalization of Chinese enterprises that are already integrated into the global
trading system (i.e., those companies already part of "global manufacturing supply chains” or those
that can aspire to expand globally; among them, the engineering and construction companies operating
in infrastructure sectors can greatly enhance their competitiveness by leveraging long-term funding
from their home banking system), (ii) developing a sophisticated financial services sector that can
advance the diversification of the Chinese economy and help Chinese companies expand their cross
border payment system in international markets – i.e., by providing services such as "forex", "cross-
border trade settlement", "cash management", "trade and project finance", brokerage etc. that are
now performed by large international banks; and also (iii) stabilizing profits and diversifying credit risks
from excessive concentration on domestic markets with declining profitability – due to the ongoing
reforms (see Chart 32-Bis). To these reasons, Li Yuefen (UNCTAD) added the opportunity offered to
well-capitalized Chinese banks [see Capital Asset Ratios (CAR) of Chart 32 and Table 4] to enter the
banking systems of countries affected by financial crises – i.e., to fill market gaps in those business
segments with the highest capital requirements];
26

27. 27

28. Capital markets expand in the "high yield" segment and feed new credit to the economy
(e) The fourth area of intervention is capital markets. In June 2012 – following up on the program launched
in 2011 to allow sub-national entities to issue "municipal bonds" - the CSEC (China Securities Regulatory
Commission) initiated a program to allow SME to issue bonds through private placements (high -yield
corporate bonds). This step lays the foundation for rapid growth of a key market segment for non-
financial companies which reached 853 billion RMB (US$ 134 billion) at the end of June 2012, compared
to a value of 530 billion RMB in the same period of 2011. To understand the importance of the private
bond market, one should consider that, in the past 2 years, this aggregate has shown the highest
growth rate – i.e., about 40% - among the components of the credit to the economy [Chart 33]. The
CSEC continues to strengthen the structure of stock markets to facilitate capital raising in the 3
operating Boards (see CSEC, 2011 Annual Report ) – i.e., the Main Board, the SME Board and the
Growth Enterprise Board (GEB). On this point Prof. Fu Jun stressed the importance of opening a fourth
market dedicated to knowledge-based companies, to promote innovation in sectors with a high
content of research, development, and innovation. In 2011 there were 502 issues (Initial Public
Offerings and Follow up Offerings) of A-shares for over 500 billion RMB.
28

29. Growing role of the "shadow banking sector" – the Wenzhou Case
(f) The fifth line of action concerns the lending activities of the non-banking sector and the experiments of
financial deregulation in particular areas of the country, as in the case of Wenzhou. This is a coastal city
with strong private sector, entrepreneurial culture and a dense network of institutions dedicated to the
collection of savings and lending outside the banking system. Although the Whenzhou case was not
discussed – i.e., it is a measure of the State Council of March 28, 2012, which gives the city the status of
the Comprehensive Reform Pilot Financial Zone – this case puts the spotlight on “shadow” banking”.
The Financial Stability Board (FSB) – which monitors these activities across countries - identifies
“shadow banking” as "credit intermediation carried out by entities outside the regular banking system,
and in particular by" Other Financial Intermediaries", including finance companies, trust companies
that have taken an increasing role in recent years [Chart 33]. They collect private savings providing a
return of 8-10% and invest the proceeds in risky activities, both in the private and municipal sectors –
i.e., nearly US$ 50 billion went to fund infrastructure projects recently [Chart 34]. While these activities
play an important role in supporting investment activities, they may pose a risk from the standpoint of
investor protection or even a potential risk for the financial system. The FSB data show that the assets
of the non-banking sector in China are a small percentage of GDP, and the net exposure of banks is
likely to be small in their balance sheets. However, “shadow banking” is important in terms of credit
flows, which showed exponential growth before 2008 and are continuing to grow, although at a slower
pace after the crisis [Chart 35]. The Banking regulatory commission (CBRC) is monitoring the role of
banks as agents in the placement of wealth management products (WMPs) similar to USA “structured
notes that invest in loans, bonds, equity of those sectors that the Government is trying to rain in. The
volume of shadow banking loans is estimated at about 20% of total loans outstanding at the end of
September 20011 (12 trillion RMB compared to 52 trillion RMB respectively).
Internationalization of the RMB as a "necessity" and part of financial sector reform
II.6 The internationalization of the RMB has been addressed by Cao Yuanzheng (BOC) who stressed
that this course of policy action arose in response to liquidity problems emerged in the dollar market during
the 2008-2009 financial crisis. The dollar shortage and the difficulties encountered in the ordinary conduct
of international trade during this period highlighted the risk of a system based on a single currency for
international payments. This laid the foundation for a thorough reflection on the potential benefits of using
other currencies, including those of emerging markets, especially for transactions between them – i.e., for
"South-South" trade. It follows that China sees the internationalization of the RMB as an issue of reform of
the Chinese financial sector and part of the Agenda of internal economic reforms – i.e., leaving open any
other consideration on making further progress in reaching a better system of reserve currencies for the
International Financial System.
29

30. Internationalization as a "functional process" to eliminate obstacles to the use of the RMB
II.7 Li Yuefen (UNCTAD) made reference to the analysis of Yu Yongding (ADBI, Revisiting the
Internationalization of the Yuan, Working Paper 366, 2012) pointing out that the internationalization of the
RMB does not follow a well defined "road map", but rather is a "functional process" aimed at eliminating
the operating restrictions that hinder the use of the RMB in international transactions. In this perspective,
since 2009, the Chinese authorities have launched reforms to dismantle barriers to the use of RMB for all
transactions related to the current account of the balance of payments – i.e., the regulation of trade in
goods and services - and started to expand the range of transactions on the capital account. This is meant
to facilitate the use of RMB as a unit of account and in the denomination of financial assets that would
bring the RMB to assume the role of reserve currency in all respects [Chart 36]. It seems clear that the main
reason for the rapid progress made towards the internationalization of the RMB is the growing size and
strong diversification of the Chinese trade relations. At present, China accounts for about 12.6% of world
trade, but only 0.26% of payments is settled in RMB - so there is room for strong growth, also considering
that in 2030 China could account for 19% of global GDP compared to 16% in the U.S. - according to the
report of the World Bank, which was mentioned by Prof. Fu Jun.
30

31. Capital Account liberalization and RMB Internationalization: in sequence or in parallel?
II.8 The basic requirements for the internationalization of the RMB have been illustrated by Bert
Gochet (JPMorgan Chase) who stressed that a reserve currency cannot function without the opening of the
capital account. In addition, there is need for deep and liquid foreign exchange and capital markets to allow
economic agents to manage all risks – i.e., foreign exchange, interest rate and credit risks connected to the
assets / liabilities denominated in RMB. In this regard, it may be noted that for a country like China – which
is in structural current account surplus (i.e., it accumulates foreign currency in exchange for goods and
services), capital account transactions are key to supply RMB liquidity in international markets and allow
the creation of RMB-denominated assets/liabilities for non-residents. So internationalization is closely
linked to the liberalization of the capital account and the creation of transparent and efficient mechanisms
for trading RMB-denominated assets/liabilities. It is also worth emphasizing that the Chinese authorities do
not seem to consider the liberalization of the capital account as a pre-requisite for the internationalization
of the RMB, but they see it as a parallel process that reinforces the internationalization of the Chinese
currency - and thus, must be started in a "pro-active, gradual and controllable fashion” (Zhou Xiaochuan,
"Special Interview-everything about the renminbi", Century Weekly, January 2, published by Caixin Media).
31

32. New reforms push for the Internationalization of the RMB
II.9 Various interventions have covered the highlights of the reforms implemented so far in terms of
RMB internationalization, starting with Fan Zhigang (ICBC).
Cross-border settlement in RMB: from experiment to operating system
(a) A first set of reforms concerns the mechanisms for the RMB settlement of international payments of
goods and services. The introduction of such a mechanism goes back to July 2009 with a pilot program of
"cross-border settlement" in which a group of 365 companies in 5 cities was allowed to proceed to pay
imports in RMB, making it possible for non-residents in Hong Kong, Macau and ASEAN countries to receive
RMB payments from Chinese importers through banks authorized to hold RMB balances at corresponding
Chinese banks. This program was quickly extended to 20 provinces and more than 60,000 companies in
2010 and then, in June 2012, to all Chinese companies and for all current account transactions. The growth
in the use of RMB for transactions related to the current account has been exponential and now reaches
about 10% of the total Chinese trade of goods and services [Chart 37]. The RMB use is heavily biased
toward the payment of Chinese imports because of entrenched expectations of RMB appreciation
(exporters to China are willing to accept a currency that appreciates in perspective, but appear to be more
reluctant to denominate and pay for their imports from China in the same currency).
32

33. New "currency swaps" arrangements with the global trading partners
(b) Special attention deserves the rapid expansion of the network of currency swap lines built by the
Chinese central bank (PBOC) against those of many other trading partners to promote the expansion of
transactions settled in RMB, which have reached a level of about 600 billion RMB per quarter [Chart 37].
Among them are the major trading partners of China, such as Japan, South Korea, Hong Kong, Argentina,
Belarus, Iceland, Indonesia, Malaysia, Singapore, Russia, Kazakhstan, Kyrgyzstan, Tajikistan, Uzbekistan and
others. In January 2012, China has signed the first agreement with the United Arab Emirates (UAE) for 35
billion RMB. The PBOC has special arrangements with the Monetary Authority of Hong Kong – i.e., the
currency swap agreement covers three years for a total of 200 billion RMB – which has became the most
important center of settlement of RMB payments for non-residents [Chart 38]. At the end of June 2012,
there are 18 agreements for a total of 1.6 trillion RMB, but progress is continuing with China’s main trading
partners, including the latest agreements with Brazil (with an currency swap of 30 billion US$). In countries
such as South Africa the direct exchange RMB-Rand is cheaper than the triangulation on the dollar and it
adds a competitive advantage especially to importers of textiles and artifacts that Chinese exporters offer
at a discount in the case of payments in RMB (The Wall Street Journal, November 30, 2012).
33

34. Less stringent rules of access for particular types of operators and capital transactions
(c) A second set of reforms concerns the timid opening of the capital account to allow non-residents to
use their RMB balances to make portfolio investments in Chinese assets. The first permits (August 2010)
went to international banks involved in "cross-border settlement" allowing them to investment their RMB
funds in the domestic interbank securities market. In 2011 the RMB was allowed in transactions involving
foreign investments by Chinese companies and also investments into China by non residents. Special
concessions apply to the group of Foreign Institutional Investors in Renminbi (R-QFII). These are
intermediaries based in Hong Kong that can offer to non-residents a range of investment products
denominated in RMB, both offshore funds and onshore (i.e., investment representing equity and debt
securities listed in Chinese markets), although all of this is subject to an aggregate limit set by the PBOC.
During the 2012 the limits and procedures for the use of the RMB were loosened. This follows the trend of
recent years, as in the case of limits for qualified institutional investors (QFII) to acquire financial assets in
the Chinese market which increased from 30 billion to 80 billion US$). Based on 2011 data, foreign
investors have used RMB for 10.8% of their total direct investment in China. On the other hand, Chinese
investors have used RMB for 4.1% of their investment outside China (ODI).
Further development of offshore channels to access the chinese financial markets
(d) A key element in the internationalization of the RMB is the development of offshore channels to access
China's financial markets: Hong Kong has emerged as the main center that allows China to build on the
progress made so far in the liberalization of its capital movements and payments and to advance the RMB
internationalization. This point was reiterated by Cao Yuanzheng (BOC) who pointed out that very few of
the over 40 liberalization measures identified by the IMF for a full opening of the capital account have not
been implemented so far [Chart 48]. They deal with existing restrictions in three areas: (i) the full opening
of foreign direct investment into China (although the limits for investors and financial institutions have
been further enlarged); (ii) the possibility for Chinese companies to borrow abroad, and (iii ) the opening of
the Chinese capital market to non-residents. In any event, the first condition is perfectly avoidable through
the Hong Kong market where non-resident investors can borrow in RMB and make direct investments in
RMB assets (see below).
34

35. "Hong Kong SAR, China” as the major offshore RMB market
(e) Both the deepening of Sino-Hong Kong economic and trade relations and the emerging of “Hong Kong
SAR, China” as the major RMB offshore center are two important developments of this period. From 2004
onwards the expansion of banking services on the market in Hong Kong has been relentless - from deposits,
securities, loans, interbank markets and foreign exchange services in RMB for non-residents. Since 2010,
Hong Kong is the key market to determine the offshore exchange rate – spot and forward – of the RMB
against the dollar – i.e., the CNH market, to distinguish it from CNY, the exchange rate determined in the
domestic market [Chart 39]. In addition, there is the RMB derivative market – i.e., the Non-Deliverable
Forwards (NDF) – which operates as a link between the onshore and offshore banking systems (which are
not free to interact directly) and which reflects market expectations on the evolution of the foreign
exchange market [Chart 40]. Equally important is the bond market in RMB which sees the participation of
the Chinese Ministry of Finance and of companies, without restriction (resident or non resident). The
interest rates curves in this market move in parallel with the Chinese domestic market (with a spread) and
it allows operators in RMB outside of China to manage the country risk (i.e., to operate in the Chinese
jurisdiction) while taking the financial risk inherent to RMB assets and liabilities.
35

36. The "dim sum" bond market of Hong Kong
(f) The case of the Hong Kong bond market in RMB - the "dim sum bonds" - is indicative of the potential of
this offshore mechanism to raise RMB funds for direct investments in China at competitive prices. Although
expectations of RMB appreciation have been a limiting factor on the emissions by non-residents – due to
the risk of incurring debt in a currency which has been steadily appreciating - the market has expanded
rapidly thanks to low interest rates due to the high demand for RMB investment instruments in alternative
to deposits [Chart 41]. According to the Bank for International Settlements, at the end of 2011, RMB
deposits at off-shore banks in Hong Kong were in 588 billion RMB, about 10% of total deposits in Hong
Kong, while the "dim sum bonds" reached 322 billion RMB. So this market can only benefit from a
deepening of the financial sector and the strengthening of foreign exchange and interest rates markets, and
make an important contribution to foreign investment and to overcoming the current imbalances in the
Chinese economy.
New rules for fixing the exchange rate RMB/US$
(g) A third block of reforms concerns the mechanisms for fixing the exchange rate. After the period of
anchoring the RMB to the US$ during the financial crisis, in June 2010 the central bank (PBOC) announced
the return to a regime of managed float with a fluctuation band of 0.5% daily around the central parity set
by the PBOC against the US$. Such a fluctuation band has been widened to 1%, effective April 2012 [Chart
42]; in any case, the band does not apply to other currencies whose fluctuations have ranged from 3 to 5%
[Chart 43]. The comments of Prof. Fu Jun and Cao Yuanzheng (BOC) have pointed out that the flexibility in
setting the exchange rate of the RMB has moved the exchange rate close to "equilibrium values" (6.3 RMB
per US$), and that the maneuver of widening of the fluctuation band ensures the alignment of the
exchange rate with market dynamics. It is worth noting that the exchange rate of the RMB appreciated
more against the US$ than against the euro (30% vis-à-vis the US$ versus 25% vis-à-vis the Euro for March
2005 to June 2012) and that the difference in volatility is significant [Chart 44].
36

37. The 2012 exchange rates and speculative capital movements
II.10 The evolution of the RMB exchange rate was briefly addressed in the roundtable. The trend
towards the devaluation of the RMB in the first part of 2012 and its reversal - with the RMB appreciation
starting in September - was indicated by Cao Yuanzheng (BOC) as a market reaction to USA developments
more than to China’s policies. This suggests that the weight of other factors, such as the slowing of the
Chinese economy (or the risk of a "hard landing") and the differential in interest rates [Chart 45], was not
deemed to be as important. It should be noted that during the reference period the PBOC reduced its
massive market interventions/purchases of foreign currencies in exchange for RMB [Chart 46] – i.e., the
PBOC did not contrast the appreciation of the RMB - and left banks, businesses and individuals free to
decide whether to hold or convert their Forex balances in RMB. It remains to be seen whether this is a
turning point in the way Chinese authorities manage the RMB floating exchange rate. On the one hand, the
depreciation of the RMB until September [Chart 47] had the effect of partly rebalancing market
expectations – i.e., for a long time expectations were only focused on the appreciation of the RMB. On the
other hand, the increasing role of market forces in fixing the exchange rates makes it even more urgent to
deepen financial markets and address monetary policy issues related to opening up capital movements.
Various interventions stressed the need to coordinate interest rates and monetary policy to preserve
exchange rate stability for a country aspiring to give to its currency a leading international role. This
coordination becomes more difficult in presence of large surpluses of the current account as well as
speculative capital movements leading to the creation of large volumes of monetary base that the PBOC
needs to sterilize to avoid undesired side effects on inflation and asset bubbles.
37

38. 38

39. The impossible triangle of independent monetary policy, stable exchange rate and open capital account
II.11 The intervention of Bert Gochet (JPMorgan-Chase) highlighted the difficulties and risks of
accelerating the opening of the capital account in the absence of parallel progress in financial sector
reforms - as China would face a situation of "impossible triangle" which was described by Robert Mundell
and others (i.e., the inability to maintain an effective and independent monetary policy - and then to set
the desired level of interest rates and money supply – while pursuing the goals of exchange rate stability
and free movement of capital) [Chart 48]. Prof. Paolo Savona added that the premature opening of the
capital account could expose China to speculative attacks and even financial crises with unpredictable spill-
over effects on the International Financial System. Further acceleration towards the internationalization of
the RMB (e.g., full liberalization by 2015, as indicated in press declarations by some Chinese leaders) does
not seem likely unless further decisive progress is made in the reform of the financial system – i.e., to
provide transparency and credibility to the institutions and mechanisms that govern financial markets and
RMB exchange rates.
39

40. III. CHINESE INVESTMENT FLOWS AND THE ROLE OF EUROPE
Chinese investment flows into the European manufacturing sectors are on the rise
III. 1 The issue of Chinese foreign investment flows and the role of Europe were introduced by Prof.
Alberto Quadrio Curzio who stressed the strategic approach of the Chinese sovereign wealth fund and
observed the revealed preference of China Investment Corporation (CIC) for a strong sectoral
diversification. He also emphasized the importance plaid by the codes and voluntary standards of behavior
- "Santiago Principles" – endorsed by the Chinese Government to address concerns of the international
Community about the governance of companies participated by the Chinese State. In this regard, one can
see [Chart 49] that Europe is in third place among recipients of Chinese direct investment flows in
productive sectors, with 20%, of the total flows, compared to 43% for the U.S. and 30% for the APEC region.
The observation was complemented by Prof. Sun Laixiang with reference to the 2011 data on Chinese
Outward Foreign Direct Investment - ODI) which indicate a more positive picture. The Merger & Acquisition
portion of the ODI investment - which is 37% of the total ODI or about 60 billion US$ according to the
Ministry of Commerce of China - has been directed towards Europe in almost 50% of the cases (i.e., 10.4
billion US$ out of total flows of 22.2 billion US$) which marks an increase of 154% compared to 2010.
40

41. The risk of Barriers to Chinese investment in Europe should not be underestimated
III.2 Despite the encouraging signs, the remarks of Prof. Alberto Quadrio Curzio and Laixiang Sun
stressed the risk of resistance or barriers to the entry of Chinese capital into Europe. This is an important
issue to be considered along with the barriers to a "fair and equal access" to the Chinese market for
European foreign investors in China, which is being investigated by the European Chamber of Commerce in
China – i.e., the "European Business in China - Position Paper 2012/2013” was presented at the Italy-China
Foundation in Milan on October 5th. Andre Loesekrug-Pietri (A-Capital) pointed out that the European
Union has by construction less barriers than the U.S., where you need the scrutiny of an ad hoc committee
of the Treasury Ministry - The Committee on Foreign Investment in the United States (CFIUS). The point is
that, in the case of the USA, the mistrust is often rooted in Congress (i.e., the U.S.-China Economic and
Security Review Commission) and it is particularly focused on SOEs that are in a position of monopoly in the
internal Chinese market and do not allow equal access of foreign investors into their domestic market
(Chart 49-Bis). Also in the case of Europe there is some mistrust vis-à-vis Chinese investors – that are
assumed to be public or para-public by definition and not mainly driven by shareholders’ interest; in part,
barriers are due to the complexity and diversity of European markets or other national factors that hinder
investment flows and prevent them from reaching their potential.
Europe is the Leading Destination of Chinese ODI excluding the Natural Resource Sectors
III.3 In this regard, Andre Loesekrug-Pietri (A-Capital) emphasized the growing strategic interest of
Chinese companies for European technology and brands due to structural transformation of the Chinese
economy. This can be a great opportunity for Europe as these investments could allow European
companies to accelerate their development in the Chinese market – as evidenced by the creation of his
fund (A-Capital) between the Belgian holdings SFPI and the Chinese sovereign wealth fund CIC. Globally,
Chinese investments in manufacturing industries and high-tech mainly go to Europe (up to 95% in Q2 2012
as an illustration), a trend which is currently masked by those investments that go to natural resource
development, which distorts the picture with their large size compared to the size of other acquisitions
[Charts 50 - 51]. The latest data on 2012 Chinese investments in Europe show a growing number of
acquisitions in service sectors with focus on the UK versus a decline in Continental Europe - Germany in
particular. It remains to be seen if this is a shift away from manufacturing or simply a move driven by the
lack of confidence in the Euro during the sovereign debt crisis of countries in the Euro Zone [Chart 50-Bis].
41

42. 42

43. Co-operation strategies for competitiveness and the role of financial intermediaries
III.4 Concerning prospects for China-Europe investment relations, Prof. Fu Jun pointed out that it is in
the interest of Chinese companies to cooperate with European companies in order to compete in global
markets and provide a solid microeconomic foundation to the home development strategies implemented
so far. Both real and financial sector can gain by cooperating across borders, for instance to promote the
absorption / transfer of advanced technologies – as suggested by Prof. Giovanni Ferri. The point is that
both Chinese and European companies can increase productivity and spur innovation to reach a higher
growth path, but they should follow market-based approaches and strategies and not rely so much on
geopolitical considerations. The need to overcome the vision of economic development as a "bubble" was
called by Matthias Klein (Credit Suisse) who stressed the key role of banks and the risk of disruption caused
by moving too rapidly toward market-based interest rates - while not having fully dealt with the legacy
issues caused by the recent credit boom to local and regional government entities. He added that the most
likely way for China to deal with this trade-off between short-run economic and financial stability and
longer-term growth potential - at least if the past is any guide - was to emphasize stability, which in turn,
however, would limit the scope for aggressive financial liberalization in the short-run.
Non-bank Intermediaries are bound to play a larger role to promote cross-border investment
III.5 Prof. Ignazio Musu pointed out that the particular features of the Chinese financial system play a very
important role in the current transition of the Chinese economy - as in the case of the “shadow” banking
sector which is instrumental in accelerating the growth of private sector and SME that are neglected by
large banks. These intermediaries play also an important role in mobilizing increasing portions of savings
that provides “absolute return” to Households - as mentioned by Gloria Bartoli – and are likely to play a
key role in balancing the Chinese economy in the future. The point is that financial sector reform can speed
up cross-border cooperation between Chinese and European companies as both banks and non-bank
financial intermediaries can support investment flows in new technologies and ventures with European
companies. In case of delays in liberalizing bank interest rates (i.e., preserving "financial repression")
Chinese Households would have additional incentives to prefer Wealth Management Products supplied by
non-bank financial intermediaries – i.e., to “dis-intermediate” the banking system. This would make the
shadow banking system even more important in promoting Chinese companies’ cooperation strategies for
competitiveness.
43

44. 44

45. Diversification of Chinese foreign investment (ODI) and acquisitions on private markets are growing
III.6 The investment opportunities that China presents for Europe at this stage of its development are
manifold, in both directions, as noted by Bert Gochet (JPMorgan Chase) [Chart 52] and Li Yuefen
(UNCTAD). An interesting element for a country like Italy is the growing diversification of Chinese
investments outside the natural resource domain and the increasing activity of acquisitions of listed and
non-listed companies through private equity investment – a sector in which Italy has been operating for
some time, as in the case of the Mandarin Fund. The joint action of Chinese financial institutions and
companies to grow internationally is an element that can give new impetus to cross-border investment and
promote the development of Chinese ventures at the global level – both in infrastructure and other sectors.
In this regard, the President of the Italy-China Foundation - Dott. Cesare Romiti - stressed that European
and Italian SMEs - in particular - offer great opportunities for Chinese companies to acquire knowledge,
brand names, and advanced technologies to excel in global markets - not only in the mechanical and
manufacturing sector: the common goal for Italian and Chinese companies is to cooperate internationally
by leveraging the rapidly expanding internal market of China and by enhancing the competitiveness of
domestic production to meet the demand for goods and services of a population in rapid demographic and
socio-economic change.
45

46. IV. OPEN QUESTIONS AND CONCLUSIONS
IV.1 The concluding section intends to recall the questions that the Round Table brought to the
attention of the participants – obviously leaving the conclusions for each and everyone to draw. The
following comments are a personal interpretation in the light of the discussion of November 20th.
A) Where is the Chinese economy going in the short, medium and long-term?
• The Chinese economy is slowing down. Is the deceleration structural or cyclical? How significant
is the impact of the economic crisis? Does it depend on endogenous factors? What can we expect
in the short, medium-long-term? What consequences for Italy and for the global economy?
(A.i) In the short term the Chinese economy does not seem to present critical issues to achieve levels
of growth of about 7-8%. Less clear is the long-term outlook. The insistence of many commentators on the
fact that the economy is at a "turning point" - for reasons that were extensively discussed – brings two
themes into the spotlight: (a) the interdependence of China with the global economy and the strength of
the recovery in the G7 economies - which remains high and fragile, respectively; (b) the success and timing
of the China's transition policies to shift its economic system towards domestic demand - which remain
uncertain to some extent. The most interesting aspect is the increasing role of private consumption in the
dynamics of demand, which is otherwise dominated by the very strong growth of fixed investment in
sectors with high capital intensity – all of which indicates that the main trends of the post-crisis period
remain in place. One could argue that there are components of the Chinese economy that continue to
expand capacity, despite the slowdown in bank credit aggregates as well as in the global economy during
the latest period.
(A.ii) In the long term, the economy seems likely to continue to generate large volumes of savings and
still depend significantly on external demand and / or demand for domestic investment in infrastructure
to remain on its growth path. The unknown factor is the effect of large investment aiming at global
markets in the presence of a weak global recovery and strong, direct competition with other economies of
the region. The risk of a slowdown in the tradable sector of the Chinese economy – which carries a risk of
rapid obsolescence in the capital base of those sectors that dependent mostly on exports - cannot be
underestimated. Thus, the scenario of a persistent weakness in the G7 economies carries some risk of
industrial crises with potential fall out effects on the financial system which cannot be underestimated.
Other point of crisis can arise as a result of runaway investment by local governments. Continuing financial
sector reforms is a key factor to minimizing these risks.
(A.iii) The reasons for optimism about the long-term dynamics of the Chinese economy are linked to
the ample space for policy actions that can be put in place to manage the above long-term risks. Firstly,
there are large margins of productivity gain, both in the "tradable" and "non-tradable "sectors that can be
promptly mobilized as result of market oriented reforms. Secondly, but most importantly, there are wide
margins for fiscal policy intervention in a country with public accounts and balance sheets that remain
relatively robust compared to G7. It is up to the New Leadership emerged from the XVIII Congress of the
CCP to decide about the pace and direction of reforms to stay on the target growth path – i.e., to double
the GDP in less than ten years – and build a more balanced economy – not just a larger one. The main
impact of the new Chinese growth path on Europe and Italy seem to be positive, but subject to much
greater selectivity and discrimination of larger Chinese investors. Potentially there are negative effects as
Chinese trade flows could slow-down and revert to more normal growth rates.
46

47. B) What is the role of China in the international economy?
• China’s global economic and trade share combined with a rising role of the Chinese currency in
international settlements suggests a greater relevance of China in the global and regional arenas.
What about Europe and the Euro?
(B.i) The idea that China is on the way to reach 20% of global output and align its economic weight to
its demographic importance seems tacitly accepted, but the challenge to "overcome the trap of middle-
income countries" is unprecedented. Even more so for an economic system which remains unique in terms
of public sector role and for the mix of market rules and direct government intervention in all echelons of
the economy and society. The transition to a system governed to a greater extent by market mechanisms is
based on the ability to reform key sectors of the economy - such as the financial sector and social services
that are the backbone of most evolved societies both economically and socially.
(B.ii) The increasing complexity and size of the economy is in itself a challenge for the current public
mechanisms to manage and control the economy – the reference to the issue of corruption during the
XVIII Congress of the CCP and the emerging of large unregulated segments of the financial system or
“shadow” banking system highlight some of the issues faced by the new Chinese leadership. At this
development stage, there is mounting evidence that China needs to make a qualitative leap in its
development strategies and build more solid microeconomic foundations for expanding its industry and
service sectors - as pointed out by various interventions. This also includes assessing the global impact of
continued expansion of domestic and global production capacity. The race to control natural resources is a
form of Chinese leadership at the regional level (Africa in particular) which presents a variety of critical
issues which China itself should consider – beginning with the negative impact of its policies on the terms of
trade of the country and on the sustainable development of its regional partners. The integration of China
into the global trading system requires progress in the adoption and application of a system of rules and
standards to which China has acceded by entering the WTO and the Bretton Woods international bodies -
and this is a key step to take an increasing role in the global economy.
(B.iii) Europe is in a very favorable position to accompany the growth of the Chinese economy. The
diversification of official reserves and the opening up and internationalization of the financial system create
opportunities for Chinese investments in Europe and for further internationalization of the Euro. Of course,
the crisis in the Eurozone has cast a long shadow in the past months, but many concrete steps have been
taken to fully restore the Chinese confidence. However, it appears that Chinese investors are increasingly
driven by industrial strategies and sound, traditional project development, more than by geopolitical
portfolio diversification. The fact remains that the purchase of European government bonds (which are
estimated at 800 billion US$) is well present in the strategies of both the State Administration of Foreign
Exchange and the CIC and the financial institutions participated by the Chinese government.
47

48. C) What is the direction of reform of the financial system?
• The reform, as announced by Chinese authorities, is aimed at allocating resources in a more
efficient manner, encouraging commercialization, increasing lending toward SMEs, formalizing
the Chinese “shadow” banks. Banking sector risk arising from non-performing loans is actually
the result of a close triangular relationship between State and local government finances, State-
owned enterprises and State-owned banks. How will the reform address these problems?
• Will the next generation of leaders support or hinder the reform?
(C.i) The attitude of the New Leadership towards financial reform needs to be fully assessed in the next
months, beyond declarations of continuity and irreversibility of the reform process. The key
appointments of policy makers in the coming months will give a better sense of the speed and direction of
reform. It is clear that the recent reforms are changing the working of the Chinese economy in ways that
are not easily reversible.
(C.ii) The reforms undertaken so far – as indicated by the round table discussion - are far reaching and
will certainly have a positive effect on resource allocation - if they continue at a steady pace. The key
point is to focus the attention of the formal financial system on the needs of the private sector and the
SMEs which - until now - have remained at the margin of the system or virtually excluded.
(C.iii) The pragmatic attitude and openness to experimentation characterizing the reforms
implemented in recent years bodes well for what Chinese policymakers are doing to bring the “shadow
banking system” under some form of public scrutiny and regulation. The challenge is to adopt regulatory
and supervisory frameworks that do not hinder the growth on non-bank financial intermediaries capable of
intermediating savings for funding high-risk investment. In general, the issue of developing competitive
financial services (i.e., to deepen the financial system) is clearly identified by the authorities as a litmus test
for continuing the expansion of a financial system that has already grown significantly compared to other
countries and to the level of development of the real economy. The further opening of the domestic
market to foreign banks and their penetration in the "wholesale" markets are crucial steps to expand a
sector in line with the needs of the economy.
D) What role for the renminbi - RMB - and for Chinese banks at the international level?
• The internationalization of the Chinese currency, the renminbi, is accelerating. However, the
currency is not fully convertible as to capital account transactions: there is an inherent
contradiction between an increasing international role of the renminbi and the restrictions to its
use. Possible scenarios and opportunities for banks, enterprises and investors;
• Chinese banks are in the process of going global. Competition or cooperation with Italian and
foreign banks?
(D.i) Progress made in promoting the international use of the Chinese currency in recent months has
been quite extraordinary and points to further rapid spreading of RMB transactions for current account
transactions - in line with the weight of China in world trade (which is 12 times bigger than the share of
trade settled in RMB at this point in time). Part of the success is due to generalized expectations of
currency appreciation - in the presence of structural current account surplus – which may have increased
the acceptance of RMB to settle the payment of exports to China, but this factor should not be overly
48

49. emphasized as it may also have limited the development of offshore markets - given the reluctance of the
international corporate to borrow in RMB. It is conceivable that advances in the management of the
exchange rates and the approach of the RMB/US$ exchange rate to equilibrium values - as indicated by
various Round Table participants - will lead to a further expansion of transactions in the Hong Kong markets
or in financial centers that are gearing up to handle "cash management in RMB" for partners and local
business of Chinese enterprises.
(D.ii) Concerning the liberalization of capital movements, there has been progress, but the road seems
much longer and more complex. Among the critical factors are the role of speculative capital movements
and the difficulties of dealing with them in the absence of a deep financial systems – i.e., they are needed
for an effective management of monetary policies by government authorities and risk management by
economic and financial agents. An accelerated transition toward full liberalization has side effects on the
conduct of monetary policy, making it less effective while pursuing the objectives of exchange rate stability
– as emphasized in the discussion. So the picture seems to evolve gradually, giving banks and investors only
limited investment opportunities that emerge in the offshore centers such as Hong Kong in the first place.
(D.iii) The internationalization of Chinese banks had a strong acceleration in recent times and for
European banks it is a new factor to be reckoned with in the future. The fields on which to develop
cooperation-competition are manifold - also due to the delicate phase of the European economies and the
major changes in the regulatory framework for international banking. The space left open by European
banks could be occupied by Chinese banks that have a mandate, the capital and are now able to
accompany the Chinese corporations in the process of internationalization. While this makes Chinese banks
potentially formidable competitors, on the other hand, the challenge to grow in international markets
involves entry into business areas in which they serve sophistication and expertise that today China's banks
have not yet fully acquired and then you can open up space for collaboration.
E) What are the business prospects for international investors?
• China has been witnessing a transition from a production, procurement and exportation platform
to a market for goods and services. Today it is gaining relevance as a source of foreign direct
investments, and as a market to attract capitals via listings and bond issuances. How can we raise
awareness on these opportunities?
(E.i) Progress in reforms is changing the competitive framework of public and private Chinese
companies, favoring a widening of agents who look to Europe with renewed interest. Hence the need to
pay greater attention on the part of foreign investors to the multiplicity of Chinese entities that are
currently looking at international markets in search of technologies, "brand names", skills and alliances to
strengthen their market position, especially in domestic, but also International markets. The possibility for
European companies to access the Chinese capital markets to raise capital is certainly interesting, but it
seems a topic for the long-term, if not for those already present in the Chinese market. Improving the
communication business-to-business is a strategic objective for those companies that see look at new
markets and opportunities with Chinese partners.
Milan, January 14th, 2013
49

50. Tavola 1: CRESCITA DEL PRODOTTO INTERNO LORDO PER TIPO DI SPESA (2009-13)
GROWTH OF GROSS DOMESTIC PRODUCT BY TYPE OF EXPENDITURE (2009-13)
Fonte / Source: Goldman Sachs, Economics Research, Asia Economic Analyst, “China shifting
to a lower gear”, September 20, 2012;
50

51. Tavola 3: INDICATORI DI SVILUPPO DEL SETTORE FINANZIARIO – 2005 – 2010
DEVELOPMENT INDICATORS OF THE FINANCIAL SECTOR - 2005 - 2010
Fonte / Source: IMF-World Bank, Financial Sector Assessment 2011
51

52. Tavola 4: INDICATORI FINANZIARI – 2005 – 2010 / FINANCIAL INDICATORS - 2005-2010
Fonte / Source: IMF-World Bank, Financial Sector Assessment 2011
52

53. BIBLIOGRAPHY
A-CAPITAL, Andre Loesekrug-Pietri, The Dragon Index, November 2012;
ADBI, Asian Development Bank Institute, Yu Yongding, Revisiting the Internationalization of the Yuan,
Working Paper 366, 2012;
Bloomberg News, China Picks Wenzhou for Small-Business Funding Experiment, March 28th, 2012;
Caixin Media, Zhou, Xiaochuan, “Special Interview—everything about the renminbi”, Century Weekly,
January 2, 2012;
CIC, China Investment Corporation, Annual Report 2011;
CICC, China International Capital Corporation Ltd., “China Economy Research”, November 6, 2012;
CSEC (China Securities Regulatory Commission), Annual Report 2011;
Euromoney – Bank of China, “The 2012 Euromoney Guide to China Cash Management”, June 2012;
Euromeney – RBS, Renminbi convergence, is it inevitable and what are the risks? May 2012;
Financial Times, Kathrin Hille and Rahul Jacob, “Beyond the conveyor belt”, October 15, 2012;
Financial Times, Neil Buckley, “Beijing Targets European Shift”, November 9, 2012;
Financial Times, China Special Report, December 12, 2012;
FSB, Financial Stability Board: Global Shadow Banking Monitoring Report, 2012;
Global Finance, Laurence Neville, China in Europe, May 2012;
Goldman Sachs, Economics Research, Asia Economics Flash, “China: Cooling off: The drivers and
implications of CNY hot money outflows”; October 8, 2012;
Goldman Sachs, Economics Research, Asia Economic Analyst, “China shifting to a lower gear”, N.12/16,
September 20, 2012;
Garcia-Herrero Alicia, D.Santabarbara, “Is China’s Banking Sector Promoting its Economic Development:
An Assessment of an Unorthodox Banking Reform”, Paper presented at the Workshop on China Financial
Market and Internationalization of the RMB, Helsinki, September 17-18, 2012;
HKIMR (HONG KONG INSTITUTE FOR MONETARY RESEARCH), Dong He, Renminbi Internationalization: A
Primer; July, 31st, 2012;
ICBC, Urban Finance Research Center, Fan Zhigang, Conference Presentation, Rome, November 20th, 2012;
IMF, Country Report No. 12/ 195 – People Republic of China – 2012 Article IV Consultation, July 2012;
IMF - World Bank, Financial Sector Assessment Report, 2011;
IMF, Global Financial Stability Report, October 2012;
IMF- G20, People’s Republic of China, Sustainability Report 2011;
53