The Path Forward for China’s Markets
By Leo Melamed
Hangzhou July 6, 2013
It is well know that the ancient Chinese philosopher Lao-tzu said that “A journey of a thousand miles begins with a single step.” It represents one of the great human wisdoms.
It is also well known that the Chinese people have been on a very long journey and have taken many, many single steps in the course of their history. Some of these steps included innovations that defined human civilization. For instance, back in the Shang dynasty a writing system, a 12-month calendar, and a currency system were first invented. During the twists and turns of the millennia that followed, the steps taken are far, far too numerous to enumerate. Some advanced Chinese civilization, some did not. Allow me therefore to jump over the centuries and bring this story to the most-recent dramatic step in China’s history. That would be with the leadership during the 1980s of Li Xiannian and Deng Xiaoping. Together they launched the economic structure of today’s China.
I had the honor and privilege of inviting President Li Xiannian to visit the Chicago Mercantile Exchange back in 1985. He thus became the first President of China to come to the United States. His visit to Chicago, the capital of risk management, was much more than a tourist’s curiosity. It was a clear signal to the world that China was preparing to shed the economic impediments of the past---barriers which prevented its people from using their natural and inherited talents---and to set the nation on a new path, one that would lead toward a successful and modern economy.
Mr. Den Xiaoping followed Mr. Li Xiannian’s lead and is considered as the primary architect and driving force behind China's radical transformation in the late twentieth century. He encouraged a “black cat, white cat” philosophy to pursue a pragmatic path towards a market-driven economy. The results have been nothing short of astounding. Deng’s vision of common sense economics opened trade relations with the West, which among many things, lifted hundreds of millions of his countrymen out of poverty--- more than the efforts of any other world leader, anytime, anywhere.
Thus, for the past thirty years China's story has been one of rapid economic steps, driven by export-focused manufacturing. During this time-frame, China became an industrial giant, moving up the ladder from production of clothing and footwear to the high level production of computers, pharmaceuticals, and machinery---even to the ambitious path of conquering the mysteries of space. The foregoing is but a thumbnail description of some of the salient steps taken by China to reach the present status of the second largest economy in the world.
Where does China go from here? Part of the answer can be found in the 12th Five-Year Plan. It represents another turning point. From past emphasis on growth, the plan concentrates on strategies to ensure long-term prosperity. It is directed at efforts to rebalance the economy, shifting emphasis from investment, towards consumption. The three main priorities are: sustainable growth, industrial upgrading, and the promotion of domestic consumption. Those are ambitious and laudatory goals. They come at the right moment in the progression of China’s economic growth. Some of these imperatives fall within my sphere of experience.
My expertise of course pertains to the market arena---specifically to futures and derivatives markets. My history in this respect is well known. It began with the launch of the International Monetary Market (IMM) in 1971 which introduced financial instruments to futures markets. According to Merton Miller, the 1990 Nobel Prize economist, it represented “the most significant financial innovation of the last twenty years.” That innovation has been copied by every center of finance in the world. A decade later, I expanded the scope of this idea by introducing the concept of electronic trade in place of the traditional transaction architecture of “open outcry.” Today the CME’s Globex electronic transaction system is the most widely used international platform for futures and options---available in 150 countries around the globe.
Obviously, my efforts did not stop at the American shores. I lectured and advised financial centers in Brazil, France, Germany, Great Britain, India, Israel, Japan, Kuala Lumpur, Mexico, Russia, Singapore, South Korea, and Ukraine. Most important, ever since my personal meeting with Li Xiannian in Chicago, I also kept another mission in the back of my mind: To advance the capital markets in China. I knew that the greatest benefit from futures and derivatives markets will flow to the people of China. Like Deng Xiaoping’s white cats and black cats they will catch “market mice” in order to allocate capital efficiently. They will act like a gigantic insurance mechanism that allows inherent market business risks---in agriculture, foreign exchange, interest rates, and equities---to be adjusted quickly, more precisely, and at lower cost.
During the last decade, pursuant to my advice, the CME Group has invested considerable intellectual and monetary capital in efforts to educate and assist the financial community and government regulators here in China. We have executed Memoranda of Understanding with the Shanghai Futures Exchange, the Zhengzhou Commodity Exchange, the Dalian Commodity Exchange, and the China Financial Futures Exchange. We have maintained an ongoing dialog, provided workshops and symposia. Separately, I counseled the Chinese government that it was imperative for its financial markets to become more liquid and efficient. In 2005, I suggested to Vice Premier Wang Qishan and noted economist Cheng Siwei, that one step toward this goal would be the creation of a futures exchange for financial instruments.
A year later, on September 8, 2006, with approval of the State Council and authorization of the China Securities Regulatory Commission (CSRC), the China Financial Futures Exchange (CFFEX) was born and began trading the Shanghai Stock Index, the CSI 300. It was an instant success and is today the most successful futures exchange ever launched.
My past advice is even more valid today. China’s growth during the past three decades---during its period of infrastructure development and rural-to-urban migration---was fostered in part by protection of its domestic economy and currency stabilization policies. It was the prudent thing to do. However, as emerging economies achieve success, develop large-scale corporations, and build a middle class, their economic agenda should materially evolve. In my opinion, China’s corporations and its consumers have reached stages of economic size, growth, and wealth, where global risk management tools are essential as they seek to reach for higher growth on a world scale. It is thus imperative that China continue to create greater liquidity in its underlying cash markets.
Increasing liquidity is about improving the functioning of markets so that participants can easily buy and sell debt or securities, or borrow and lend, without causing large price movements. However, long-term objectives of increasing liquidity in money markets must not conflict with the Bank of China’s desire for price stability and avoidance of undue expansion of credit. The Central Bank is correct in its demand that credit expansion occurs at an appropriate scale. Indeed, proper risk management tools will assist banks in evaluating credit risk and avoiding excessive credit expansion while at the same time improving the efficiency of the markets.
For example, recent Chinese moves to create a futures crude oil, a bond, and options market, will work to improve liquidity in the cash market as well. More tools for risk management, such as futures and options, integrate with the cash markets to allow every segment of the marketplace to function together and more efficiently. Indeed, the Chinese economy needs more financial tools and measures not only to strengthen the development of its capital markets, but to act as buffers should any emergency arise like the credit squeeze encountered by world markets in recent years. Remember, futures were among the few markets that operated flawlessly during that crisis. While vibrant derivatives markets are not a panacea, nor will they alone serve as a solution for all issues arising from the rapid growth of the Chinese economy, or problems stemming from international quarters, they will be significantly helpful in this regard. It is however to be remembered that there is a need for education in the use of derivatives. They represent sophisticated financial instruments that require expertise before utilization.
To be clear: The pendulum has now swung to the other side. Keeping protections in place too long will lead to a lack of innovation, low productivity, and poor service and can hurt the development of the country. China’s rapid modernization has taken the country’s economy to a new level where a lack of global integration now hinders the international expansion of its world-class companies and prevents its middle class from the benefits of international portfolio diversification. Global integration that might have caused domestic challenges in the past now offers the path to more rapid economic growth.
Former Secretary of Treasury, Henry Paulson, recently wrote in the Wall Street Journal, “If China is to achieve its new economic model it must introduce competition into its economy.” I emphatically support this view. Nor is this view new or unique. Noted economists, Francois, J. and L. Schuknecht, in their definitive study on Trade in Financial Services, found that competition-enhancing of international openness stimulates economic growth. Echoing this opinion, The World Trade Organization (WTO) at the outset of the 21st Century Report began with this statement: “A well-developed and stable financial sector and an open international trading system are two key components of prosperous economies.” The WTO Report points out that internationally-open financial markets enhance economic welfare and growth through more efficient intermediation between savers and investors. Precisely among the objectives of the current Five Year Plan.
In addition, there are geo-political advantages for China shifting gears toward more rapid global integration of its financial markets. A strong and open currency market is a critical characteristic of major industrial powers. Moving toward a normalized currency would make a decisive and significant statement that China is ready to take on the mantle of world economic leadership. I am fully aware of the important strides already made in recent years but urge that the pace of capital account liberalization continue to quicken. Full convertibility would vastly improve the international standing of the RMB, and promote the internationalization of the Chinese currency. I feel certain that Chinese authorities are approaching the final stage of preparation toward this eventuality. Indeed, the CME has assisted this movement by recently launching a deliverable RMB for futures trade.
Finally, and most important, allow me to move closer to home. Everything I have stated pertaining to internationalization is especially true in the realm of financial services like futures markets. As the WTO underscores, financial services are the backbone of modern economies. It is difficult to point to any economic activity that does not depend in a significant way upon services provided by the financial sector. Chinese futures exchanges as I previously indicated, have done exceedingly well. They are liquid and well-managed. However, they are nearly completely domestic. They are isolated and insulated from world participation or international competition. Until they become subject to cross-border interaction, their full value to the Chinese economy is limited. Nor can their true competitive strength be measured. Allowing foreign firms and foreign hedgers and traders to participate and compete will strengthen the exchanges, result in more open and efficient capital markets, and help transition China to a nation of investors and not just savers. I am very certain that Chinese leadership and the CSRC are fully aware of this truth.
I urge that movement toward exchange-internationalization become the highest priority.
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