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Reforming China's Banks Is Key to Boosting Consumer Buying Power

Randall Kroszner served as a U.S. Federal Reserve member of the Board of Governors from 2006 to 2009, where he chaired the committee on Supervision and Regulation of Banking Institutions and the committee on Consumer and Community Affairs. In those positions he played a key role in formulating responses to the financial crisis, and working to strengthen consumer protection, related to home mortgages and credit cards. Earlier, he was a member of the President’s Council of Economic Advisers (CEA) from 2001 to 2003.

Kroszner now serves as a professor of economics at the University of Chicago’s Booth School of Business. He recently visited Shanghai, where he gave a speech on Oct. 17 as part of Booth’s Global Leadership Series, entitled “Unlocking the Spending Power of China’s Middle Class.” Bloomberg Businessweek spoke with Kroszner on Oct. 18. The following are edited excerpts of that conversation.

Can you talk about how China’s financial system today is built to favor government-led investment and companies over consumers?

In China you have relatively large banks primarily focused on funding large enterprises. And the fact that there are limits on the rate of interest that can be paid on deposits limits how much competition is entering the banking sector. The system works to take the deposits of savers, who are not getting a very high real rate of return, with inflation around 3 percent. And then the banks turn around and lend that money to the larger [often government-owned or -controlled] enterprises.

In some ways the situation in China is similar to what we used to have in the U.S. with Regulation Q [the Federal Reserve Board regulation from 1933]. Regulation Q limited the deposit rates banks could offer in the U.S. until the 1970s. As a result, people were searching for higher rates of return and turning to nonbank markets.

There are parallels with what has happened in China, with the rapid development of shadow banking, focused on trust investments. In both cases you had frustrated savers looking for higher rates of return. So reforming the financial sector can be good for the stability of the overall financial system and good for consumers.

What kinds of changes have to happen to the Chinese banking system if China is to successfully rebalance toward a more consumption-based economy?

There are a number of things to be done. Relaxing the restrictions on deposit interest rates is the first one. And they need to make it much easier for new entrants to compete in China’s financial market. Chinese leaders have already said they will allow more kinds of consumer finance—they know it is crucial if they want to unlock the power of the middle class to consume, so they have the power to buy a house, a car, and a refrigerator. They need to introduce things like installment payments on consumer loans and credit cards.

Today consumption is nearly 70 percent in the U.S., and it is half that here in China. In the U.S., having a system of consumer finance was crucial to building postwar economic growth. As many of the soldiers started coming back from war, they were not starting with a lot of wealth or income. But they wanted to build households and families. So it was extremely important that they had access to mortgages and consumer loans.

Are there risks for China as it moves to open its financial system?

Actually, these kinds of micro reforms would be very valuable to make the overall financial system more robust, before they start to open the capital market. With a more diversified banking and finance system, regulators get experience with a larger set of products and dealing with more enterprises and individuals. Of course, there are always risks involved. But to make the macro transition smoother, first unlocking the spending power of the middle class will be very important.

Here is an example of risk, from the early 1960s in Chicago. At that point, people didn’t really know about credit cards. The credit card companies were trying to get people to use them, so they would do mass mailings. Postal workers started to understand that there were bags of credit cards sitting around the post office, and sometimes they would take them out and use them themselves. There are always risks. But you can take steps to minimize them.

Most countries have some form of deposit insurance. So China needs to think about developing a framework for deposit insurance, considering under what circumstances it would be used, and what kind of deposits would get guarantees. China wants to introduce competition, but they don’t want to introduce instability.

One other important reform is credit scoring. This was extremely important in the U.S., in allowing people that were not wealthy to get access to credit. It is a bit like standardized test scores for entry into college. That was an important democratization. Before, universities were familiar with people from elite schools, but if you couldn’t afford to go to them, then it was difficult for you to get into a top university. That changed with the introduction of standardized testing.

It is the same kind of thing with credit scoring. In the U.S. it has allowed banks to develop information on the reliability of middle-income borrowers, and so expand access to credit. And it has allowed the financial system to develop in a stable way.

There are a lot of different pieces that have to come together to make sure the system works well. Allowing the private sector to enter into the financial system through participation in banks, other financial institutions, and credit scoring agencies is very important to introduce competition. That allows China to use its financial system more efficiently.

China’s official press had a commentary earlier this week calling for a “de-Americanization” of the world and advocating for the development of a new global currency to rival the U.S. dollar. What are your thoughts on that?

First, on the role of the dollar as an international reserve currency: I believe it is valuable to have competition because it puts discipline on U.S. policymakers. So I was heartened by the creation of the euro. Obviously the problems in Europe have made it difficult for the euro to challenge the dollar, however.

While Japan was rising in ’70s and ’80s, the yen never really challenged the dollar. And today I don’t think the yen is developing in that way either. In Japan they are still fighting deflation, and the fact that they have close to a 250 percent debt-to-GDP ratio doesn’t give people confidence either.

China is far from seeing the RMB become a reserve currency mainly because of uncertainty about the development of the capital markets here. Without a clear framework for capital market opening it becomes very, very difficult for the RMB to globalize and internationalize.

I think the Chinese leadership understands this, and that is why they are thinking about reform of the financial sector. But I don’t see much competition for the dollar from the RMB anytime soon despite some of the fiscal follies we have seen in the U.S. over the last couple of years.

As for diversification of portfolios, it is interesting to look at what others are doing. Norway has a very large sovereign wealth fund, for example. They are diversifying both in terms of instruments and currencies. But once again, because the dollar-based market is the largest and deepest in the world, it is very difficult to not keep holding a lot of dollars.

How exposed is China to an eventual Fed tapering? There seems to be a debate here as to how much it affects them, with their closed capital account.

The People’s Bank and the leadership in China exercise a lot of control over the foreign exchange market, so the impact is limited. But it does have an indirect effect. It affects the amount of resources needed by the People’s Bank to maintain a particular band for the currency. And China is also very aware of how its trading partners are affected by the Fed’s actions.

It has been interesting to see how countries like India and Brazil, who had high current-account deficits, high inflation, and slowing growth, were hit much harder than, for example, Colombia, which had a good financial situation. In some sense this is a warning shot for those countries to try to get their acts together.

What are you expecting for reforms at the upcoming Third Plenum?

The Chinese leadership understands the importance of macroeconomic rebalancing. That is their large-picture goal. Now they have to decide what are their priorities as they try to achieve that goal. Financial sector reform should be a very large priority. And I would argue that consumer financial sector reform is just as important as capital-account reforms if they want to succeed in rebalancing.

Roberts is Bloomberg Businessweek's Asia News Editor and China bureau chief. Follow him on Twitter @dtiffroberts.

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