Better rules, more institutions help China redirect local governments' fund-raising channels

A government document to regulate shadow banking, reported by the Chinese business press earlier this month, has highlighted more than ever before the dilemma in China's financial system and the daunting task in its financial reform.

Some say this year will be a time of make-or-break for the country. One thing to watch will be Beijing's success or failure in reining in the risk in the country's financial system while allowing it to grow, diversify services, and to expand to many countries - to follow the footsteps of Chinese investors in the world.

How can new restrictions be reconciled with greater development? There seems to be an inherent contradiction in that.

But this is exactly what China has to do - if it wants to continue to grow relatively fast and avoid a full-blown financial crisis. According to the resolution adopted by the national leadership's Third Plenum last year, one of the goals of the next round of reform is precisely to build a large, versatile financial system able to guard its hardcore from indiscreet or unethical practices.

This is where a multi-layer financial system fits into the picture, as many Chinese economists have pointed out.

This system would consist of a layer in which a few institutions hold the country's most important financial resources on behalf of the government, a second layer in which many institutions, not necessarily all state-owned, compete in the market place - allowed to conduct their own innovations but not expecting a government bailout if things go badly - and a third layer that is left for small services left alone to sink or swim and that therefore cannot do major harm to the main body of the national financial system.

There will be some shadow banking, but it should not be allowed to grow so large and to fund so many local government projects.

With better rules and more institutions, China should be able to redirect local governments' fund-raising channels from shadow banking to a more open and better regulated bond market.

Beijing recently said it would allow local governments to issue bonds to pay back their debt. The question now is who will hold their bonds, and who will help float them. This year it would not be too difficult for China to make a few more good moves in this direction.

But erecting the framework for a multi-layer financial system will require a much larger effort, entailing a tug-of-war between interest groups.

In the process, the performance of many listed companies, and indeed all companies in the financial service industry, along with a huge amount of wealth in China, will be affected.

If the financial services industry continues to be dominated by a few very large state-owned banking corporations, the change desired would not materialize, and the real economy would probably continue to depend on shadow banking for a great portion of its credit. That would pose a permanent risk for the country's growth.

If there is to be a real change, there will have to be diverse institutions and services for all players in the economy. The result would inevitably be more financial service companies in the stock market, which would presumably be smaller than the state-owned banking giants, and be good at generating growth from their expertise in specialized services.

The state-owned banking corporations can spin off some of their better-managed, more competitive departments. They may also sell or outsource some of their not so profitable services to local banks.

All financial services, including those built by private investors, would be forced, not by the government but by market competition, to build a strong management and define a market niche.

Until a change of this kind takes root, China cannot hope it will walk out easily from the long shadow of shadow banking and the risk it inevitably entails.

A danger is that if China waits for too long in defining the game rules and playground for smaller financial institutions, which would be tantamount to protecting the monopolistic status of the state-owned banking giants, shadow banking would grow even more out of control.

If the government cannot build a multi-layer financial system quickly, shadow banking will grow into a multi-layer system in itself, and may grow a new offshoot outside the areas more or less regulated by the government.

So tackling shadow banking is not the economy's priority. The priority is, as always, reform.