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Liberalizing China's Financial Sector

by James A. Dorn

August 13, 2002

James A. Dorn is a China specialist at the Cato Institute in Washington, D.C., and co-editor of "China's Future: Constructive Partner or Emerging Threat?" (Cato Institute, 2000).

In June the Chinese government provided a dose of financial morphine for the struggling stock market by announcing a halt in the placement of a large number of new shares in state-owned enterprises. That announcement came as a relief to anxious investors hoping to gain from official support. China's gambit to appease investors in the short run, by trying to support stock prices, may come back to haunt them.

What Chinese investors need is not more intervention but less. The dominance of SOEs (State-Owned Enterprises) on the stock exchanges means that there are no real capital markets in China. Government support of the market only compounds the difficulty of trying to evaluate socialist firms. Without real owners with fully transferable shares, there can be no way to know the capitalized values of the listed companies and no way to discipline socialist managers.

A bleak profit picture will reduce the prices of those limited number of shares that can be traded on the exchanges, but most investors in China's casino-like stock market have no idea of the future profitability of the listed SOEs. Government attempts to prop up the market will ultimately mean a sharper fall in prices when the bubble bursts. A better strategy for protecting investors is to create real value by getting the government out of the capital markets and by privatizing SOEs.

If SOEs were transformed into private companies in which individuals held saleable shares, the stock market would reflect more accurately the present values of the listed companies, and price-earnings ratios would return to normal levels. Chen Mingxing, senior researcher with the State Information Centre, recognizes that fact and has recommended more rapid ownership reform. According to the China Daily's Business Weekly, "Chen said that the government should leave the adjustment of share prices to market forces, but put more effort into establishing a marketplace that is 'just, fair and transparent,' and reforming the ownership systems at the listed companies."

By failing to create real capital markets, China is missing the opportunity to take advantage of the gains to be had from specializing in ownership and risk bearing. The socialization of risk under the current system of state ownership reduces incentives to innovate and create wealth. The value of Chinese firms is below what it could be if capital were free to flow to its highest-valued uses - and there is no way to discover those uses without competitive markets, which depend on private property rights.

Privatizing state-owned banks and allowing interest rates to be set in private capital markets would depoliticize the allocation of bank credit and increase investment returns to the private sector. Allowing both Chinese and foreign investors access to China's capital markets would put China's vast pool of private savings to better use than they are under the current discriminatory system.

The benefits to China and to foreigners from liberalizing the financial sector are great: China would achieve a more efficient use of its capital and attract new investment; the Chinese people would have an important part of their human rights - the right to own property - protected by law; and foreigners would be able to deal with private firms and offer more options to China's savers.

Improving capital freedom in China by securing property rights and liberalizing capital markets and capital flows will increase wealth in China and increase the demand for foreign goods, services, and investment. As China's internal markets expand (because of privatization and liberalization), so will China's external trade. Increasing economic freedom is a win-win strategy - both China and her trading partners will gain.

Free trade and privatiztion can help normalize China and transform it into a modern economy and a civil society under the rule of law. China's accession to the World Trade Organization will help move China in the right direction. The United States, as the world's dominant power, must be patient and not lose sight of the long-run benefits of a firm commitment to the principles of market liberalism and capital freedom.

This article originally appeared in The Korea Herald on August 13, 2002.