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Mitchell, Arthur "The Significance of China for US and Japanese Financial Markets" [2004] ADBLPRes 5 (22 October 2004)

The Significance of China for US and Japanese Financial Markets

Arthur M. Mitchell
General Counsel
Asian Development Bank

Harvard Symposium on Building the Financial System of the 21st Century: An Agenda for Japan and the United States

October 22 – 24, 2004

In the past the interests of the United States and Japan have been aligned or in conflict but, at no time in recent history have US-Japanese interests been as aligned as they are today. These shared interests extend from the political realm to the economic sphere. And I think that this will continue to be true regardless of whether a Democrat or Republican heads the next US administration because the relationship between our two nations has moved from one dominated by the economic rivalry to one driven by economic cooperation and interdependence. I think we can all conclude that, particularly with respect to our financial markets, the US-Japan bilateral relationship is predicted on the shared goals of promoting liberal and democratic economic and political institutions.

For the first time since the beginning of this Symposium, the organizers have decided to incorporate another dimension to the discussions: the significance of the People’s Republic of China for US and Japanese financial markets. This is an intriguing topic and one that merits discussion.

There is no doubt about China’s ascending influence in the global sphere. This ascendancy is no less real for those countries outside of the Asia-Pacific region as it for China’s neighbors. While the US and certain European countries remain Japan’s largest trade and investment partners, Japan’s share of trade with and investment in China is beginning to surpass that with ASEAN. China’s trade share with the US is also increasing. Quite significantly, China has now replaced the U.S. as the largest recipient of Foreign Direct Investment (“FDI”).

There are numerous issues that could be addressed concerning China’s role in US/Japan financial markets and numerous approaches to take in our discussions. In earlier sessions, the economic issues of trade, capital flows and currency valuations were discussed. I would like to focus on the impact that FDI has had on China, particularly in relation to liberalization of the PRC economy and the further development of the “rule of law”.

A. Liberalization of the PRC Economy

The presence of multinational corporations in China, through FDI and otherwise, has has made a major contribution to growth and development in China, through the introduction of technology, management expertise and training of the local workforce. China’s recent accession into the World Trade Organization (“WTO”) required reforms in many sectors, including the redrafting of many laws and their corresponding implementing regulations.

By far, the most extensive area of market liberalization is taking place in the service sector. The PRC is, through its WTO obligations, committed to relaxing foreign ownership and geographical restrictions on foreign investment in the banking, securities, telecommunications, and construction sectors, among others.

The banking sector in China is, at least for the time being, a heavily protected industry through government ownership and a regulatory regime that underpins a directed economy. Foreign participation in this sector is permitted in a number of limited forms, although each such form carries significant restrictions in terms of both geographic operation and scope of business activities. Under China’s WTO commitments, the restrictions on foreign participation in the banking sector are scheduled to be relaxed in incremental stages culminating in almost unrestricted access by December 2006. However, even after 2006, the road to building an effective foreign bank presence in China will continue to be very difficult. Rules aimed at “managing” the influx of foreign investors after 2006 may very well delay the creation of a truly level playing field in the banking sector.

One of the greatest challenges facing China is the large number of non-performing loans (“NPLs”). While the exact magnitude of NPLs in the banking system has been the subject of much debate, there is evidence that some progress has been made in recent years in reducing the overhang of NPLs and strengthening the balance sheets of the major banks. Supervision and regulation of the banking system have also visibly improved. But all of these improvements will need to be underpinned by more fundamental changes before China will have a full-blown market economy, albeit one with Chinese characteristics. The examples of both Japan and the U.S. demonstrate that financial systems in all market economies do not look exactly alike but they do share certain elements: an independent central bank, credit-risk- based allocations of capital and strong regulatory agencies.

The problems encountered in both Japan and the U.S. demonstrate that improvements in those financial systems need to be made. Accordingly, we should not expect spectacular results in China overnight. Under China’s WTO commitments, China will progressively eliminate geographical restrictions on the issuance of licenses in the insurance industry within three years. In the telecoms sector, China’s Ministry of Information Industry has agreed to allow more foreign ownership and less geographical restriction of licenses. This will limit the ability of dominant local carriers to keep rates high and depress demand for telecommunication services and electronic commerce.

B. Rule of Law

Typically, investors want a normative set of rules that are consistently applied and are readily enforceable. An interesting debate has emerged in the context of doing business in emerging markets: what comes first, economic development or legal certainty? This is an important debate that has practical implications on the US and Japanese (as well as global) financial markets.

Common wisdom has supported the idea that a well-functioning rule of law is required in order to attract foreign direct investment. However, this premise is being reconsidered. While investors are clearly more comfortable operating in an environment where there is legal clarity, experience in the PRC (and elsewhere) has shown that, while optimal, a well developed rule of law is not enough to override the economic impetus behind an attractive investment. Aside from the desire of investors to capitalize on good business opportunities, some additional justifications for investors jumping into countries where legal systems are not yet fully mature should be considered. First, we have to recognize that legislation and institutional reform in post-communist societies is an organic process that is “long and torturous”. Second, foreign investors are an integral part of the legislative and institutional reform process, often being the impetus behind changes to existing regulations.1

This second point is intriguing, particularly in light of our discussions today. As active investors in the PRC marketplace, US and Japanese investors can have a profound influence in the legal investment environment in the PRC. Recognizing the potential inadequacies of legal standards, but driven by the desire to seize upon a sound business opportunity, these investors can help shape reform by highlighting specific areas of concern for them. This approach recognizes that foreign investors are not willing to sit on the sidelines until the legal system of China has been reformed to their satisfaction. Rather, reform and liberalization are dynamic processes that offer the foreign investor opportunities for participation.

In the recent past, ADB has assisted the PRC with the drafting of its company law, securities regulations and investment trust law. We have also had inputs into the drafting of the bankruptcy law that is currently being considered. Currently we are engaged in a policy dialogue with the government on proposals for an anti-monopoly law. Foreign investors, as individual entities, face a tremendous collective action problem. ADB and other multilateral institution are ideally placed to bring the real issues facing foreign investors to the attention of the most relevant government officials, so that the reform taking place will lead to a legal and regulatory environment that supports private-sector-led growth. I encourage all of you to bring your concerns to us so that this input can be incorporated into our policy dialogue.


1Working papers, Foreign Direct Investment. Does the Rule of Law matter?

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