Enhance the Capacity for Independent Financial Innovation; Accelerate Shanghai towards Becoming a Global Financial Center [I]

 

The core of international economic competition is manifested, to some extent, by financial competition. Finance has now become a tool in global political and economic competition; and financial competition, to a large extent, lies in competition amongst international financial centers. Building a global financial center, therefore, has become an important path and development strategy to enhance competitiveness in the world. To build a global financial hub, a key aspect is to strengthen the capacity for independent financial innovation. Experience shows that a stronger capacity for independent financial innovation can promote the construction of an international financial center. On the other hand, building a global financial hub may precipitate the enhancement of financial innovation. These two sides form a supplementary and causal relationship. 14 years after the CPC Central Committee set the goal of building Shanghai into a global financial center as a national strategy, the significance of financial innovation upon the building of the international financial center has become increasingly evident. We are now striving to improve the capability of the financial institution, product and technology innovation, so as to fulfill the country's strategic goals by making breakthroughs in building Shanghai into a global financial center.

 

Financial innovation is a necessary choice to raise China's strategic role in global resource allocation

At the China Science and Technology Conference held in January this year, President Hu Jintao pointed out that China should stick to the path of independent innovation with Chinese characteristics, so as to turn China into an innovation-oriented country within 15 years. A path of independent innovation with Chinese characteristics has become a major strategic policy in building a modern socialist China. Why can independent innovation capability never be over emphasized? It's because innovation is the soul of a people's advancement. In current global economic development and competition, only an advantage in independent innovation can realize a nation's dream to become powerful. The capability of independent innovation is now a decisive factor in international competitiveness. With finance being the core of the national economy, it is of greater significance to actively promote financial innovation. From the micro perspective, financial innovation is necessary to enlarge and strengthen China's financial industry as well as to raise the profitability of microeconomic entities. Financial innovation can help business innovation and diversification of financial institutions, thus contributing to expand their profitable activities and meanwhile create more options for investors and borrowers. At present, financial innovation is being understood to be an effective approach for the financial sector to develop, raise profits and enhance competitiveness.

 

At the macro level, financial innovation is a matter of national economic security. Finance is a necessary product of economic development, and allocating resources by using financial capital serves as an advanced and effective form of resource allocation. The influence of financial capital on the real economy is increasingly important in the world. Virtual finance created by derivatives is now the most magnificent economic phenomenon after the world economy entered the new economic age. Economic globalization, along with financial e-trading, has further contributed to the wide application of financial derivatives, hence the increasing multiplier effect of virtual finance in financial markets. For instance, daily trading in global FX market reached US$ 2 trillion in 2005, that is, ten days' turnover equaled the grand total of world trade in one year. Financial capital, increasing by thousands of fold through derivatives innovation and integration, is exerting a mighty effect on the real economy. To a large extent, whoever controls this power can possess pricing rights on resources and commodities in global markets.

 

After more than two decades of reform and opening-up, China's increasing participation in the world economy has made the country an important link in global economy. However, a series of recent affairs related to "China Factors" in the international markets of major raw materials have given light to China's shortcomings in obtaining the power of global resources allocation. Currently, China has become a major buyer or seller in international energy and raw material markets such as oil, metal ores and agricultural products markets. For example, China is the second biggest importer of oil, the top importer of iron ore, and the No. 1 exporter of rare earth. According to the traditional theory of oligopolistic competition, China, as the biggest buyer, should have a rather great influence on prices in the oil and iron ore markets; and in the rare-earth market, China is the industry oligarchic supplier and should have great ability to influence the setting of global market prices. However, the fact is that China has little say in pricing these major strategic commodities, and can only passively accept the given price. In 2005, China imported 127 million tons of crude oil, up 3.3% year-on-year; while the value of the imports climbed year-on-year by 40.7% to US$47.723 billion. For iron ore, the imports in 2005 rose by 31% to 275 million tons, accounting for over one third of global iron ore trade by ocean shipping; while the 71.5% soar in the ore price cost China's iron and steel enterprises an extra of US$10 billion on the material. China's exports of rare earth was 53,000 tons in 2004, or 85% of global supply, and the figure reached 55,300 tons in 2005; however, the export price of rare earth fell by 46.2% in 2004 and recovered slightly in 2005 when it was listed among forbidden commodities of processing and trade.

 

The reason for China's lack of global pricing power for bulk strategic commodities, to a large extent, lies in the fact that China, without effective measures to control financial capital, fails to form powerful financial capital synergy to compete for global resources at high end. Take oil for example. According to statistics from the Ministry of Commerce, China's oil enterprises have participated in 65 projects of oil and gas prospecting and exploration in more than 30 countries, with an accumulative investment of US$7 billion and a procurement of 60 million tons of share oil. Nevertheless, each investment project averaged at merely US$107.7 million with 923,100 tons of share oil. In the meantime, international oil mergers often involve billions or even tens of billions of US dollar. For instance, the New York based Access and Chatterjee purchased Basell for 4.4 billion. A comparison shows that the meager investment of Chinese enterprises lacks a competitive edge.

 

It is worth noting that the competition on world resources allocation is now extending from commodities to the financial field. According to a limited survey, since May 7,2001 when the Hong Kong Exchange officially launched the MSCI China Free Index Futures, foreign institutions, ahead of domestic ones, have launched four China stock index derivatives and are to introduce another three stock index derivatives.

 

Offshore institutions' preemptive introduction of China's financial futures will, first of all, decrease the competitiveness of domestic exchanges and lead to the loss of financial resources and trading tax. It may also segregate China's stock and stock index futures market and its overseas parts, thus causing an imbalance in China's capital market structure. This would put domestic exchanges at a disadvantage in future global competition and result in the loss of the right to use financial resources as well as large amounts of trading tax and fee. Secondly, the power of China's stock market to set the price for domestic assets may be restricted. For instance, Taiwan's Morgan futures index first launched by Singapore used to exceed Taiwan's own futures index dramatically in such aspects as price discovery, information reflection speed, liquidity, and trading vitality, thus enjoying a marked advantage in asset pricing rights. Thirdly, the preemptive launch of China's financial futures by foreign institutions will channel the incremental funds out of China's capital market and attract part of the existing funds from the domestic stock market. Fourthly, it would give birth to unfair competition among investors in the A-share market, and even lead to speculative arbitrage and illegal activities, to different degrees, between markets at home and broad. QFIIs can shuttle freely between offshore and A-share markets; active civil funds may also invest in offshore markets by various means; while most investors in the A-share market have no access to offshore financial markets. Therefore, unfair competition may come into being among different investors. Besides, by using China's offshore financial futures, global speculative funds may even maliciously manipulate the domestic A-share market and cause large fluctuations in the market. Such a potential risk may increase with the opening of the A-share market, and would become more striking when currency or economic crisis breaks out.

 

On the other hand, China's large state-owned enterprises' offshore IPOs one after another are undoubtedly related to the backward state of the domestic capital market. It also shows that constant innovation in financial field is an objective necessity, as China's growing economy is increasingly integrated into the world economy. The problem is whether we can effectively guide and utilize the spontaneous forces of the market. Do we select actively or accept passively?

 

Financial innovation and global financial center construction can support and promote each other

First, the shaping and development of a global financial center is the result of financial innovation. Financial innovation is an activity to re-assort and integrate financial resources and elements, and every successful innovation may create new trade and new markets. It is the forming of financial centers that often goes along with the emergence of new markets. For instance, the birth of the Eurodollar after World War II helped London to resume the title of one of the most influential global financial centers in the 1980s. The emergence of financial futures trading makes Chicago the vane of the world's financial futures market and one of the most significant financial hubs in the world.

 

The important effect of financial innovation can also be discovered in the development of the financial sector in Shanghai. Nearly one century ago, Shanghai was the birthplace of China's national financial industry. May 1897 started the history of China's own banks with the birth of the first Chinese-run bank in Shanghai. In July 1920 Shanghai Exchange was officially launched. Banks in Shanghai started the businesses of commercial acceptance bills, bank acceptance bills and discounting. This not only took the initiative of the banking industry's acceptance and discounting business, but also formed a paper market of considerable scale. Shanghai also set up a forex trading market. Innovations in Shanghai's financial industry had constantly promoted the reforms of China's modern financial system as well as the development of China's financial industry. It is for this reason that in the 1930's, Shanghai became the financial center of the country and even of Asia.

 

In the age of China's planned economy, financial market was cancelled and financial resources were distributed according to pre-set plans, not to mention financial innovation. Under such circumstances, Shanghai's role of financial center vanished. After the reform and opening-up, Shanghai, under the leadership from the CPC Central Committee and the State Council, resumed its role as a base of financial innovation. In 1984 Shanghai witnessed the issuance of the PRC's first stock; in March 1987, the Bank of Communication, China's first joint stock bank, was founded after restructuring; in 1990, the Shanghai Stock Exchange made its debut; in 1994, the China Foreign Exchange Trade System was launched; in 1996, a national unified interbank lending market went into operation; in 1999, Shanghai Futures Exchange was set up; in 2002, Shanghai Gold Exchange was founded; on August 10, 2005, Shanghai Head Office of the People's Bank of China was established. Recently, the Shanghai Financial Derivatives Futures Exchange is said to have obtained the green light from the State Council, which, if set up, would be mainly devoted to derivatives trading including stocks index futures, warrants, and options. It is in the process of constant financial innovations that Shanghai is able to define its status of domestic financial center and to make steps toward an international financial center.

 

Second, building a global financial center is by itself a significant financial system innovation. After the Third Plenary Session of 11th CPC Central Committee, China clarified the reform direction "to establish a system of socialist market economy". As the economic system reform unfolded gradually, China's economic construction had achieved splendid success by the early 1990s. At the same time, the constraints from economic scale and institutions became increasingly apparent, and the lagging state of market growth and trade regulations has restrained the further development of China's economy. This calls for the core function of finance in allocating resources and promoting the marketization process of economic buildup. Under such circumstances, China kicked off the financial system reform on deeper levels. It is Deng Xiaoping who first set the strategic idea of building Shanghai into an international financial center. "Shanghai used to be a financial center and a place where currencies could be exchanged freely. We should do the same in the future." "China must rely on the development of Shanghai to raise its international status in financial affairs." Deng Xiaoping's profound remarks established the fundamentals in thought and theory for Shanghai's future as a global financial center. In 1992, the report of the 14th CPC National Congress pointed out that accelerated efforts should be made to build Shanghai into an international economic, financial and trade center to promote the economic development of the Yangtze River Delta and the whole Yangtze River valley. This indicates that building Shanghai into a financial center officially became a national strategy. In the Party's 16th National Congress, Jiang Zemin further pointed out that we should abide by international practices and speed up building Shanghai into a global financial center, which has pushed the financial center construction into a new historical stage.

 

China's financial industry has entered a fresh stage of development after two decades of reform and growth. We are now faced with the problems of how to further reform and respond to a much opener financial industry in the post-WTO-entry era; how to improve operational efficiency of the financial industry to face up to the challenges from financial globalization; how to strengthen the industry's capacity to ward off international financial risks. Facing these problems, the CPC Central Committee and the State Council, with a profound and far-reaching insight, insisted on the strategic aim to build Shanghai into a global financial center. In a visit to Shanghai in July 2004, President Hu Jintao called for continued efforts to develop Shanghai into an international economic, financial, trade and shipping center. In his speech to the  Shanghai delegation of the National People's Congress in March 2006, President Hu stated that, Shanghai, as the pioneering area in China's reform and opening-up, has the responsibility and capacity to continue to act as the pioneer in the country's reform and opening-up, and to keep playing its due role. This statement has put forward clear demands for Shanghai to speed up its global financial center construction.

 

Therefore, the enactment and implementation of this strategic aim for Shanghai is an important strategic measure and financial system innovation to enhance China's international competitiveness and cement the country's real economy and the fruit of reform and opening-up.

 

Third, building a global financial center is of great significance to promote financial innovation. International experience shows that global financial centers always boast the most financial innovations of the country or area. The motivation for financial innovation lies in the pursuit of excess profits, pressure of competition, changes in market environment, and progress in information technology. With large numbers of financial institutions, financial centers see full competition of financial business. To survive in the sharp competition, financial institutions must strive to introduce new tools and trading patterns to meet market needs, and to create new financial organizational forms, thus driving the development of financial innovation within the financial center. Meanwhile, in financial centers, information technology is utilized more widely, resources and facilities are better allocated, financial information is exchanged more sufficiently, and cooperation among people thus goes smoother. All these have created sound conditions for financial innovation. Besides, global financial centers often adopt a comparatively loose supervision policy, offering a favorable environment for financial innovation. In particular, investment and financing in offshore financial centers is subject to neither local laws nor rules of the currency issuing country, and offshore financial centers are therefore a real free heaven. Innovation capacity enables financial centers to obtain the capability of constantly creating excess profits and further forms a centralizing effect to attract more financial institutions. This turns into an internal power for global financial centers' self-sustaining development. And financial centers' influencing ability helps financial innovation to spread and upgrade, thus driving the constant upgrading and progress of global financial activities.   (To be continued)

 

 

Source：CHINAMONEY Journal