RDP 2014-10: Financial Reform in Australia and China 1. Introduction

The financial architecture currently in place in China shares some characteristics with Australia's financial system prior to deregulation in the late 1970s and early 1980s. In the late 1970s, Australia maintained a managed exchange rate regime, capital account transactions were subject to restrictions and the banking system was tightly regulated. Taken at face value, this is similar to China today, where portfolio capital flows are largely prohibited, the renminbi exchange rate continues to be managed, and banking sector interest rates are only partially liberalised.

Naturally, there are important differences as well. Australia's weight in the global economy was smaller, and its financial reforms occurred in the context of a much smaller and less integrated global financial system. While its capital account in the 1970s and early 1980s was more tightly restricted than other similar economies, Australia was somewhat more open to foreign portfolio investment than China is currently. China receives larger direct investment flows today than Australia did prior to capital account liberalisation, both in absolute terms and relative to GDP. In addition, parts of the Chinese financial system are now more developed than the Australian financial system was prior to financial deregulation.

Notwithstanding these differences, the Australian example serves to underscore both the potential importance of sequencing and the powerful catalytic effects of a decision to liberalise. The floating exchange rate is now widely recognised as having played a crucial role in helping to steer the economy through challenging periods (Beaumont and Cui 2007; Stevens 2013). Nevertheless, the full benefits of financial deregulation, the float and capital account liberalisation were not fully realised until economic agents had adapted, markets had developed and the credibility of Australia's economic policy framework and institutions had been established.

Although there had been efforts to deregulate the banking system in the 1970s, this process was not completed until after the float of the exchange rate and the liberalisation of the capital account. The combination of a newly liberalised financial sector and capital account exposed Australia's underdeveloped prudential regulatory framework and banks' relative inexperience in the pricing of risk. This, in turn, led to an unsustainable boom in credit and asset prices in the 1980s, followed by a sharp correction and significant effects on the real economy. Similarly, while foreign exchange markets had started to develop prior to the float, it was only after agents were subjected to greater exchange rate volatility and the discipline of a free market – underpinned by credible institutions and economic policies – that Australia's hedging and foreign exchange markets could fully develop.

China's own process of economic reform and opening began in the late 1970s. Its transition from a centrally planned economy began with the reform of agricultural and industrial product markets, and proceeded to the opening of external trade, the domestic corporate sector, and later the urban labour and property markets. Financial reform has occurred more slowly. In the late 1990s, the authorities began a process of gradually liberalising interest rates on loans that culminated in the removal of nearly all such restrictions in 2013. Deposit rates, however, have yet to be fully liberalised. Since 2005, China's renminbi-US dollar exchange rate has gradually become more flexible, although it continues to be managed closely by the authorities.

In recent years, the optimal sequencing of China's financial reform has been a subject of much discussion. The liberalisation of domestic interest rates, the exchange rate and the capital account have all been on the formal agenda of regulators since the early 2000s (PBC 2003; Zhou 2005), and were listed as national priorities in the Eleventh and Twelfth Five-Year Plans (Govt of the PRC 2005, 2011) and the Third Plenum of the Chinese Communist Party in 2013 (CCP 2013). But within Chinese policy circles, the debate over China's future financial reforms has been polarised.

Some observers have advised China against prioritising the removal of capital controls on the basis that the domestic financial infrastructure and regulatory framework are insufficiently developed to open the economy to short-term capital flows (Yu 2013). The deterioration in the quality of banking sector assets since China's policy stimulus during the global financial crisis, rising corporate and local government debt and the expansion of off-balance sheet activities by banks are cited as reasons for delaying capital account convertibility. It is argued that domestic financial deregulation and increased exchange rate flexibility should happen first if the liberalisation of short-term capital flows is to occur in a manner that does not lead to instability (He 2013).

Others have called for the Chinese capital account to be liberalised within 5–10 years, on the grounds that China's large foreign exchange reserves, low foreign debt and the current absence of currency mismatches on the balance sheets of banks greatly lower the risk that speculative flows will create financial instability (PBC Department of Surveys and Statistics Task Force 2012a, 2012b). According to this argument, capital account liberalisation should proceed in conjunction with efforts to complete domestic interest rate deregulation and free floating of the exchange rate. Prioritising interest rate deregulation over capital account convertibility and currency flexibility is viewed as unnecessary: reform can be focused on one area until a certain stage of maturity is reached, and then be redirected towards another. The PBC Department of Surveys and Statistics Task Force (2012b) contends that the historical experiences of Germany, Japan, South Korea, the United Kingdom and the United States do not support an interpretation that domestic financial deregulation must precede liberalisation of the capital account.

In general, the literature on the sequencing of financial reform tends to prioritise domestic financial reform and exchange rate flexibility ahead of capital account liberalisation. Based on numerous case studies, McKinnon (1982, 1991) argues that the development of domestic financial institutions, markets and instruments are prerequisites for successfully liberalising the capital account, and that therefore capital account liberalisation should occur at a relatively late stage in the reform process. While stressing that a sound system of domestic financial regulation should be prioritised, Johnston (1998, p19) notes that early capital account liberalisation can have ‘an important catalytic role in broader economic reforms, and can help overcome entrenched vested interests that otherwise postpone necessary reforms’. Ishii and Habermeier (2002) propose that, to avoid instability, longer-term capital flows – particularly foreign direct investment (FDI) flows – should be liberalised before short-term flows. Fry (1997) emphasises that the successful removal of interest rate ceilings requires certain preconditions to be met, including adequate prudential regulation and supervision of commercial banks.

This paper contributes to discussions of financial liberalisation in comparative financial systems. It follows a substantial literature studying Australian financial deregulation (Battellino and McMillan 1989; Grenville 1991; Debelle and Plumb 2006; Battellino and Plumb 2011) and financial reform in China (McKinnon 1994; Lardy 1998; Prasad and Wei 2005; Prasad, Rumbaugh and Wang 2005; Allen et al 2012; Huang et al 2013; Eichengreen, Walsh and Weir 2014). It should be emphasised, however, that this paper does not interpret Australia's experience as a prescription for China. Indeed, it emphasises the differences in initial conditions and aspects of Australia's financial arrangements which, prior to reform, the ‘sequencing’ literature would consider sub-optimal. The paper also stresses the interdependence between financial reform and financial deepening.

The paper proceeds as follows. The next section discusses Australia's historical experience with financial deregulation. We then consider China's financial reforms to date and itemise the restrictions that currently affect interest rates, the exchange rate and capital flows. Following that, we outline differences and similarities in the Australian and Chinese experiences, before offering some concluding remarks.