Source: SCMP    Published: 2024-11-27

By Li Shanshan

In 2017, at its highest-level financial work conference, China stressed the need for the country’s financial affairs to be under centralised and unified party leadership. This was reaffirmed at the five-yearly conference last year, which spoke of strengthening party leadership over the financial sector.

Since last year, China’s evolving financial regulatory reform has sparked widespread debate in the international media. Critics warn that heightened centralisation and political oversight could, through interventions in capital and credit allocation, exacerbate financial instability.

But these critiques often fall short of fully capturing the complexity and broader context of China’s regulatory approach.

China’s approach of “centralised and unified leadership” is deeply rooted in its governance structure, which blends political centralisation with partial fiscal decentralisation. This arrangement, often described as a “quasi-fiscal federalism”, grants local governments much autonomy in economic decision-making, but without formal bankruptcy mechanisms. Many local financial institutions maintain close ties with local governments, adding complexity to the financial landscape.

Beijing has worked to recalibrate the balance of power between central and local governments and to mitigate implicit guarantees that distort market behaviour. Yet, given China’s size and the growing complexity of domestic and international environments, these reforms necessarily proceed gradually.

At the heart of this governance model is the asymmetry in risk-sharing. In a sound corporate governance system, shareholders bear the primary risks and receive matching returns. In China, however, the central government is the de facto guarantor of financial stability.

The asymmetry leaves local governments and financial institutions with insufficient incentives to prudently manage financial risks. This is the political distinctiveness of China’s financial system.

The past two decades of financial reforms have largely been modelled on Western economies but adapted to domestic realities. While China tried to balance marketisation with regulatory oversight, the regulatory framework has still revealed critical governance and regulatory gaps, especially in small and medium-sized institutions, compounded by regulatory blind spots and the failure of local governments to enforce fiscal discipline.

The corruption cases, escalation in local debt and risk exposure from small financial institutions underscore the need for a more centralised regulatory framework. The emphasis on centralised and unified leadership is thus a response to these systemic challenges, and a reflection of China’s efforts to strengthen financial oversight and risk management.

Despite inefficiency concerns, China’s emphasis on centralised leadership reflects a pragmatic strategy to maintain financial stability in a volatile environment. The country’s uneven regional development and complex ethnic and diplomatic relations, particularly along its extensive borders, make central coordination critical.

As China grapples with rising domestic economic pressures and escalating international risks in recent years, financial stability has become paramount. While fiscal decentralisation has fuelled local-level economic dynamism in past decades, it has also contributed to moral hazard and risk mismanagement, pressing threats to China’s financial stability.

The absence of a formal bankruptcy mechanism, combined with the entanglement of local governments and financial institutions, has created a precarious system, making centralised and unified leadership necessary to staunch the bleeding.

Crucially, there is no significant evidence the central government has intensified direct intervention in the operational decisions of financial institutions. Even though it may amplify procyclical risk and reduce operational efficiency, its primary effect is to mitigate moral hazard at the regulatory and managerial levels, while managing systemic risks.

In this regard, the central leadership has proved effective in addressing the most pressing challenges facing China’s financial system. Regulatory data shows a marked reduction in high-risk institutions last year, a notable decline in shadow banking risks since 2017, and progress in local government debt resolution – all signs of a more controlled risk landscape.

The ultimate goal is not to centralise power but to establish a more cohesive framework to accommodate further orderly decentralisation. On this basis, financial regulators have been advancing the decentralisation reform through enhancing central-local collaboration. The reforms also involve optimising and streamlining the organisational framework at both levels.As China navigates an increasingly complex global landscape, its financial reforms are expected to evolve in a manner that aligns with its unique political and economic context.