Today I’d like to share a firsthand account from someone who lived through China’s financial system reform. The author, Cao Yuanzheng, is currently Chairman of BOC International Research. In the 1980s he joined the State Commission for Restructuring the Economic System (SCRES 国家体改委)—the central body that steered nationwide economic reform—where he served successively as Director of the Research Office at the Institute of Economic System Reform, Director of the Comparative Economic Systems Division within the Bureau of Foreign Economic Systems, and ultimately First Deputy Director (director-general rank) of the Institute of Economic System Reform. For more than a decade, he helped design China’s economic reform and took part in drafting the State Council’s 1993 Decision on Reform of the Financial System. He then moved to the Bank of China, shifting from a designer of reform to an executor of it, and personally witnessed a series of financial reforms—the rise of investment banking, the commercialization of state-owned banks, and the internationalization of the renminbi.
I believe this piece is invaluable for understanding China’s reforms of its state-owned banks in the 1990s, as well as how China gradually integrated itself into global financial markets.
The author recalls the failure of CNOOC's first overseas IPO, which he led in 1999. The core reason for that failure was a difference in how China and the outside world perceived exclusive franchise rights. In China’s eyes, the monopoly that came with an exclusive franchise was a positive; but international markets saw it as a risk, reasoning that there was no legal guarantee the company would hold that monopoly forever. In a sense, this difference in perception (I’d rather not call it a “gap”) remains widespread even today.
Cao also looks back on how, two decades ago, he helped design the prototype of Hong Kong’s renminbi-reflux mechanism—the “clearing bank + offshore market” model—and how that model was later taken global in the wake of the 2008 financial crisis. He uses this experience to reflect on how to break through the traditional “impossible trinity” of currency policy, which holds that free capital flows, an independent national monetary policy, and a stable exchange rate cannot all be achieved at once. In his view, China’s approach to RMB internationalization was to first let the renminbi circulate offshore and then gradually loosen convertibility—in other words, rather than forcing a choice at one corner, it left room on all three fronts to find a middle-ground solution.
Below is the full English ver of the article I made with the help of AI; it hasn’t been reviewed by Cao Yuanzheng
Cao Yuanzheng: The Two Decades of China’s Financial System Reform That I Experienced
Cao Yuanzheng, Visiting Professor of Management Practice, School of Economics and Management, Tsinghua University
This year marks the twentieth anniversary of the founding of the China Finance 50 Forum. Twenty years ago, at the same time as I became a member of the 50 Forum, I left the State Commission for Restructuring the Economic System, where I had worked for more than a decade, due to the restructuring of Chinese government institutions, and was reassigned to the Bank of China. I was transformed from a researcher and formulator of economic reform policies into an implementer of them. Over these twenty years, I participated in the reform of China’s financial system, witnessed the opening up of Chinese finance to the outside world, and experienced the process by which Chinese finance grew from weak to strong, continuously deepening its capacity to serve China’s economic development and increasingly moving onto the world stage.
I. The Development of a National Investment Bank and the Reform of State-Owned Enterprises
Unlike commercial banks, which are dominated by asset-and-liability business and characterized by deposits and loans, investment banks do not have massive balance sheets; rather, they are non-bank financial institutions primarily engaged in underwriting stocks and bonds. Although investment banking has a long history, its true rise came only after World War II, and especially in the era of floating exchange rates, marked by the decoupling of the U.S. dollar from gold in 1973. To hedge against interest rate and exchange rate risks, capital markets—including financial derivatives—developed rapidly. The endless stream of financial instruments and their corresponding financial engineering theories and operational innovations gave birth to a large number of new financial institutions engaged in investment banking.
China began to understand investment banking after reform and opening-up, particularly after the 1990s. As the market economy developed, both township enterprises and enterprises owned by the whole people came to recognize the importance of establishing corporate governance mechanisms. Restructuring into joint-stock companies became a natural choice, and combined with the preliminary development of China’s capital markets, capital market business became a new hotspot in Chinese finance, and securities firms emerged accordingly. However, compared with the developed international capital markets, China’s capital market—despite its rapid development—remained small in capacity and insufficient in scale. Compared with the increasingly mature international investment banks, the investment banking business of China’s securities firms lagged enormously, both technically and managerially, and was still taking its first tottering steps. Under these circumstances, the pressing needs of institutional reform and financing forced enterprises to turn their eyes overseas. In 1993, with the successful H-share listing and issuance of Tsingtao Brewery, international investment banks began to become involved in the joint-stock restructuring and listing financing of Chinese enterprises. Capital market business became a focus of competition among domestic financial institutions, and, by comparison, strengthening the competitiveness of national investment banking business was put on the agenda.
In the mid-1990s, China Construction Bank and the Bank of China took the lead in this area. China Construction Bank established the China International Capital Corporation (CICC) as a joint venture with the internationally renowned investment bank Morgan Stanley, each holding a fifty percent stake, with its registered office in Beijing. The Bank of China took a different path, leveraging its advantage of long-term overseas operations to register BOC International Holdings (BOCI) in London, wholly owned by the Bank of China. One was a joint venture established domestically, and the other was wholly owned yet steeped in the international capital markets. Different paths, but the same purpose: to learn advanced international investment banking techniques and set a benchmark for the development of China’s capital markets. Zhou Xiaochuan, a member of the 50 Forum and then Vice President of the Bank of China, had advocated for the establishment of BOCI. Later, when he became President of China Construction Bank, he also personally served concurrently as Chairman of CICC.
In 1998, the State Commission for Restructuring the Economic System（国家经济体制改革委员会） was abolished, and I was reassigned to the Bank of China, tasked with participating in the restructuring of BOCI. At that time, Hong Kong had just returned; Chinese-funded institutions in Hong Kong no longer needed to adopt a strategy of decentralized operations, and the stability and prosperity of Hong Kong also became a duty-bound responsibility for Chinese-funded institutions. BOC International Holdings relocated its registration back to Hong Kong, and on the basis of the non-bank financial institutions affiliated with the Bank of China in Hong Kong, it was restructured and established as BOC International Holdings Limited, becoming an internationalized investment bank spanning the capital markets of London, Singapore, and Hong Kong.
When BOCI Holdings was established, the Asian financial crisis was raging. In Hong Kong, international speculative capital repeatedly moved back and forth, suppressing the stock and foreign exchange markets; the financial markets were filled with an air of desolation, and the linked exchange rate system hung in the balance. On the mainland, hit by the Asian financial crisis, enterprises found their operations even more difficult. A large number of state-owned enterprises became insolvent and went bankrupt, and layoffs and unemployment became a widespread phenomenon. Newly born, BOCI immediately faced a grim economic and financial situation. While being entrusted by the Hong Kong SAR government to help counter the speculative activities of international speculators, BOCI also shouldered the responsibility of assisting in the joint-stock restructuring and listing of state-owned enterprises.
In 1999, BOCI was appointed as one of the lead underwriters for the overseas listing of China National Offshore Oil, a project which I chaired. China National Offshore Oil had originally been an offshore oilfield development unit subordinate to the Ministry of Petroleum Industry石油工业部. In 1998, with the restructuring of the Chinese government, the Ministry of Petroleum Industry was abolished and split into three: apart from the north (China National Petroleum Corporation, CNPC) and the south (Sinopec), offshore oilfield development became a separate wholly state-owned enterprise. However, under the planned economy system, all profits were handed over to the fiscal authorities and all expenditures were allocated by the fiscal authorities. The three oil companies split off from the Ministry of Petroleum Industry all fell into the embarrassing situation of insufficient capital, high debt ratios, backward governance structures, outdated modes of operation, and inadequate momentum for development. Strengthening capital and improving governance structures through listing financing became an inevitable choice. An overseas listing would not only strengthen market discipline but also facilitate international cooperation.
After National Day in 1999, China National Offshore Oil formally launched its overseas listing roadshow. This was the first overseas listing of a large central state-owned Chinese enterprise. The roadshow route ran from Asia to Europe, with final pricing in New York. The Asian leg of the roadshow was highly successful, with enthusiastic subscription, but in Europe and America the atmosphere was cold and indifferent—especially as global oil prices declined, sales became increasingly difficult and the price kept sliding. In the end, the issuance had to be terminated, and we returned disappointed.
The failure of China National Offshore Oil’s first overseas listing and issuance was a bucket of cold water poured over BOCI, which had aspired to set a benchmark for national investment banking. For the first time, we felt to the bone the harsh mercilessness of the market; for the first time, we experienced with searing pain the powerlessness and helplessness of a small, weak Chinese investment bank in the international market. The Asian market understood China but not oil; the European and American markets understood oil but not China—leaving us caught in a dilemma.
But the market does not believe in tears. While we continuously wrote self-criticisms, we also seriously reflected on the gaps we faced. Beyond certain technical and capability issues, the biggest gap was our understanding of market mechanisms, especially in specialized markets. For example, China National Offshore Oil Corporation was the only company authorized by the state to conduct offshore oil extraction, and the parent company had injected this exclusive franchise right into the listed company. When we valued it, we assumed that being the only shop in town—an exclusive monopoly operation—was a favorable factor. But the international market did not interpret it that way; it regarded this as a risk, an unfavorable factor. The reasoning was: what law guaranteed that the Chinese government would forever grant this listed company the exclusive right to extract offshore oil? If there was none, a risk discount was needed. Frankly speaking, I had worked at the State Commission for Restructuring the Economic System and the Institute of Economic System Reform of China for fourteen years, and I thought I understood the market economy. But reality coldly handed me a failing grade.
The core technique of investment banking is enterprise valuation, and the departments and processes of an investment bank are almost entirely designed and built around valuation. It is a three-dimensional reproduction of the market economy mechanism at the micro level. Inside an investment bank there is a “Chinese Wall,” with different departments set up on either side of the wall—one end connected to the issuer, that is, the company intending to list, and the other end connected to the investors, that is, the market. The departments at the two ends are strictly forbidden from crossing the wall: not only must document information be kept confidential and not cross the wall, but there must also be physical separation, and personnel are not allowed to interact. In an economic sense, these two ends are in fact reproductions of the supply and demand curves, and the “Chinese Wall” is the point at which supply and demand intersect. The department at the end of the wall connected to the issuer, driven by interest, will work to prove how excellent the quality of the company intending to list is; while the department at the other end of the wall connected to investors, equally driven by interest, will repeatedly emphasize how picky the market is. When the company intending to list approaches the Chinese Wall from both ends through a series of processes, the significance of the market is expressed to the fullest. Under the repeated fault-finding of the department at the end of the wall representing the interests of market investors, the department at the end of the wall representing the interests of the issuer must continuously dig out the investable highlights of the company intending to list; the value of the enterprise is thereby discovered, and valuation is thus formed. But this is not the end of the process. A simulated market, after all, is not the real market. An investment bank’s valuation of an enterprise is only a price range; the final pricing must still be determined through the roadshow. The roadshow involves one-on-one negotiations with investors, especially institutional investors represented by mutual funds, collecting the bids—including quantity and price—of different investors for the same target enterprise. By continuously narrowing the price range, the accumulated final result is the public offering quantity and the offering price.
Under the investment banking organizational structure that simulates the market, the most important responsibility of the end of the wall connected to the issuer—aside from marketing to clients—is to research the enterprise in order to value it. In theory, to do valuation well, one must understand the client even better than the client understands itself. Apart from finance, law, and other requisite financial capabilities, one must also have the ability to understand the physical production processes of the enterprise. In a sense, only by understanding the physical production processes of the enterprise can one grasp its financial processes. Therefore, investment banks all have industry groups, whose members mostly have backgrounds in that industry or are professionals in that field. The number of industry groups depends on the business direction and scale of the investment bank. At the same time, an investment bank also needs professional economic and market research teams, including in macroeconomics, to provide support.
In an economic sense, the market economy selects the superior and eliminates the inferior. In the capital market, the enterprise with the highest market valuation in its industry is also the enterprise with the best business model—the benchmark enterprise. In investment bank valuation, apart from the general construction of valuation models, the customary method is the comparable company method. One searches the international capital markets for comparable benchmark enterprises to serve as reference points, uses the benchmark enterprise as a model to adjust the business model—including the corporate governance structure—that is, to restructure, and thereby obtains the optimal market pricing.
From the above, an optimized organizational structure, excellent industry research capability, and skilled valuation techniques together constitute the core competitiveness of an investment bank. After the failure of the CNOOC issuance, BOCI, on the basis of reflection, began to build its own capabilities in this way. On the one hand, it relied on its own efforts to build a talent pipeline, conducting large-scale, one-time recruitment of graduate students from key domestic universities to form industry groups, and sending them to overseas institutions for training. On this basis, it made campus recruitment an ongoing effort, replenishing fresh blood year after year, and thereby maintaining internal competitive pressure that selected the superior and eliminated the inferior. On the other hand, in accordance with the needs of China’s economic reform and development, it sought breakthroughs in key industries to build competitiveness. In 2000, the Shenzhen municipal government decided to carry out reform in the field of public utilities, and BOCI was entrusted to serve as an advisor. Seizing this opportunity, BOCI organized young rising talents, divided them into several groups, and extensively researched domestic and international restructuring cases in public utility fields such as water supply, gas, and public transportation, repeatedly pondering their physical characteristics and related financial arrangements. On the basis of a thorough understanding of asset specificity, they formed practical and effective restructuring plans, successfully introduced overseas strategic investors, and won widespread acclaim.
It was precisely by virtue of its unique understanding of “whole-process, whole-network” and “whole-process, not whole-network” that BOCI established a competitive advantage in this field, extending its business to infrastructure fields including public utilities in various localities, successively serving as financing advisor for the Beijing-Shanghai High-Speed Railway, the West-to-East Gas Transmission project, the State Grid, the Beijing Subway, the Beijing Olympic venues, and more. More importantly, a single flower does not make spring. As a national investment bank, we had a responsibility to elevate our experience into theory to be shared by society. While summarizing the Shenzhen experience and publishing a monograph, I discussed with 50 Forum members Zhang Shuguang, Sheng Hong, and Mao Yushi and together established the Unirule Public Utilities Research Center. The Center brought together the various industry associations of China’s public utilities, established a board of directors, and I served as chairman. The Center’s mission was to provide decision-making references for the government, solutions for enterprises, and high-quality academic resources for society in the field of public utilities. The Center successively released the Green Paper on China’s Public Utilities, published a variety of monographs and translated works, organized theoretical and case discussion seminars, promoted the exchange of experience among peers, and powerfully advanced the application of PPP techniques and institutional arrangements in China’s infrastructure field.
Twenty years have passed, and China’s national investment banks have completely changed their former appearance of being “poor and blank.” Not only are institutions numerous, but their competitiveness is also improving. The scale of China’s capital markets now ranks among the world’s foremost. At the same time, Chinese enterprises, whether state-owned or private, all believe that restructuring and listing is an important method for strengthening capital and accelerating development, as well as an important avenue for improving governance and raising competitiveness. The two reinforce each other. At present, in the restructuring of Chinese enterprises and in listings both at home and abroad, one can see the figure of Chinese-funded investment banks competing on the same stage as foreign banks. Although we still have a considerable distance to go compared with the international majors, the facts of the past twenty years demonstrate that only by opening up to the outside world and “swimming in the open sea” can one develop the ability to weather storms. We believe that China’s national enterprises and national investment banking industry will grow increasingly in the course of opening up.
II. The Commercialization Reform of China’s Banking Industry and the Development of Chinese Finance
In January 1984, marked by the separation of the Industrial and Commercial Bank of China from the People’s Bank of China, China for the first time began to possess a financial architecture with a central bank and commercial banks independent of the fiscal authorities. But at this time, not only was the financial market still in its infancy, but the banks were still government-led specialized banks, still linked to and even dependent on the fiscal authorities by countless ties. Entering the 1990s, although the financial market had developed considerably and various types of non-bank financial institutions had sprung up, as far as the specialized banks were concerned, they still bore the responsibility of helping to reform state-owned enterprises and fully supporting economic development. There was neither the condition nor the will to build the systems and mechanisms for their own autonomous operation, self-assumption of risk, responsibility for their own profits and losses, and self-restraint—that was still a work in progress.
In December 1993, the State Council promulgated the “Decision on the Reform of the Financial System.” In this decision, the reform goal of “turning the state specialized banks into genuine commercial banks” was clearly put forward for the first time. This opened the process of the commercialization reform of state-owned banks. Because of my work at the State Commission for Restructuring the Economic System, I participated in the relevant work of drafting this decision. Thereafter, I became involved in the actual process of pushing forward this reform, which also constituted one of the reasons why I was reassigned to the Bank of China after the Commission for Restructuring was abolished.
The first task I undertook upon joining the Bank of China in 1998 was to draft a restructuring plan for the Bank of China’s Hong Kong business.
The Bank of China is China’s earliest national bank, and its predecessor can be traced back to the Da-Qing Board of Revenue Bank in 1905. After the founding of New China, with the establishment of the planned economy system, the market foundation for financial development disappeared, all domestic financial institutions were merged into the People’s Bank of China, and the Bank of China, which had existed for decades, thus became the Foreign Business Bureau of the People’s Bank of China. However, overseas, and especially in Hong Kong, New China’s international financial activities were still conducted in the name of the Bank of China. Hong Kong at that time was still a British colony, and constrained by objective conditions, the Bank of China implemented a policy of decentralized operations. In addition to the Bank of China itself, there were thirteen banks including Po Sang, Nanyang Commercial, Chiyu, Yien Yieh, Sin Hua, and the Kwangtung Provincial Bank, four of which were registered domestically and the rest registered in Hong Kong. Together they constituted the Bank of China Group in Hong Kong. In 1997, with Hong Kong’s return to the motherland, the necessity for decentralized operations disappeared, and the drawbacks of overly small capital, complex structure, and low efficiency began to be exposed; restructuring was truly important. The basic idea of the restructuring was to use Po Sang Bank as the main body, inject the businesses of the other banks into Po Sang, and—except for retaining the Bank of China Hong Kong Branch, Nanyang Commercial Bank, and Chiyu Bank—successively deregister the other banks. On this basis, Po Sang Bank would list and be renamed Bank of China (Hong Kong). In December 1999, this restructuring and listing plan was approved by the State Council and began to be implemented. In 2002, Bank of China (Hong Kong) listed overseas in a red-chip form; the restructuring and listing ultimately achieved great success, accumulating useful experience for the commercialization reform of China’s banking industry.
Since the beginning of this century, following China’s accession to the WTO and its commitment to open up the financial services industry, the commercialization reform of state-owned banks was urgently placed on the agenda. This urgency can be glimpsed from the asset-and-liability situation of China’s banking industry at the time. In 2002, the capital adequacy ratio of China’s state-owned banks averaged only about four percent, while the level of bad debts was as high as about twenty percent—the level of bad debts was almost five times that of capital. Judged by the Basel Accord’s eight percent capital adequacy standard for the banking industry, they had already gone bankrupt five times over. China’s banking industry had almost entirely fallen into a state of technical bankruptcy of insolvency.
In fact, as early as the mid-to-late 1990s, people had already noticed the problem of making bank balance sheets healthy. To this end, in 1998, four major asset management companies (AMCs) were simultaneously established, each corresponding to one of the four major state-owned banks to separate out bad debts. At the turn of the century, Zhou Xiaochuan, a member of the 50 Forum and then President of China Construction Bank, wrote a special article proposing the use of a “good bank, bad bank” mechanism to accelerate the reform of state-owned banks, which caused a great stir. With the development of China’s economy, and especially the improvement in the operating conditions of state-owned enterprises, the conditions for the reform of state-owned banks also began to be in place. As the conditions for reform grew increasingly ripe and the urgency of reform grew increasingly prominent, the two reinforced each other. On January 1, 2004, the curtain finally lifted on the Bank of China’s commercialization reform through the joint-stock system.
Compared with previous reforms, this reform started from adjusting the property rights structure of financial institutions, reshaping their governance mechanisms, transforming their internal processes, and establishing a commercialized foundation for sustainable operations, so that financial institutions could truly become market entities. This series of reform projects consisted of three relatively independent yet interrelated parts:
First, taking the cleanup of the balance sheet as an opportunity, reshape the relationship between the state and financial institutions. Its core was to establish a limited-liability mechanism. The state exercised the rights of the contributor of capital through Central Huijin Investment Ltd. (hereinafter “Central Huijin”) and assumed limited liability up to the amount of its contribution, thereby severing the “father-son relationship” between the state and enterprises. Financial institutions would assume their own risks, operate autonomously, and be responsible for their own profits and losses.
Second, taking joint-stock restructuring as the breakthrough point, establish a sound corporate governance structure. Through strategic investors introduced under the guidance of the banking regulatory authority, establish a shareholders’ meeting and a board of directors, with the board hiring the management and the management hiring the employees, forming a modern enterprise system. In order to make this mechanism stable and sustainable over the long term, the measure of public listing of commercial banks in overseas capital markets was adopted, so as to strengthen the constraints of market discipline.
Third, taking the establishment of the China Banking Regulatory Commission as the lever, establish a third regulatory system independent of the government, implement the separation of administrative power from regulation, and strengthen professional regulation.
Based on the experience of the successful restructuring and listing of BOC Hong Kong two years earlier, the Bank of China was selected as one of the first two pilot banks. And since I had participated from beginning to end in the restructuring and listing of BOC (Hong Kong), it was only natural that I also participated in the design and operation of the overall listing plan for the Bank of China. The Bank of China was a century-old establishment with numerous legacy problems, and it operated globally. Subject to the supervision of the regulatory authorities of different countries, with varying regulatory standards, just for the restructuring alone there were several tons of various documents and materials, and the personnel directly participating in the restructuring business numbered in the thousands. One can imagine the difficulty and the enormous workload involved. From this one can also imagine what a vast and arduous reform project the joint-stock reform, restructuring, and listing of all the state-owned banks was.
This reform project was also an innovation project. In this process, the theorists and practitioners of Chinese economics and finance, grounded in China’s actual conditions, creatively used various financial instruments and successfully completed the reform tasks. One important innovation was the creation of Central Huijin Investment Ltd. Central Huijin was initially a company of the central bank; it borrowed the central bank’s balance sheet, used foreign exchange as capital to inject into the banks, shored up the banks’ capital adequacy ratios, and rescued the banks from the brink of technical bankruptcy. On this basis, through the four major asset management companies stripping out bad debts, the fiscal authorities reducing profits, writing off bad debts, and other comprehensive measures, the banks’ balance sheets were made healthy, laying a financial foundation for sustainable operations. It should be explained that such a process of making the balance sheet healthy was also a process of corporatization reform amounting to a complete rebirth. The original state-owned banks had, in the balance-sheet sense, already ceased to exist; in their place, newly established companies took over the licenses, trade names, and clients of the original banks and reopened for business—this bank was no longer that bank. For example, the current Bank of China is a limited liability company first wholly established by Huijin, which then underwent joint-stock reform to form a joint-stock limited company; it took over the license and clients of the original Bank of China and began its new operations. It also meant that although the original Bank of China Limited remained under absolute state controlling ownership, the state now assumed limited liability up to the amount of its capital contribution, thereby severing the traditional father-son relationship of soft budget constraints between the government and state-owned enterprises.
In order to consolidate the fruits of this reform and enable the banks to operate sustainably on a commercialized track, the banks’ corporate governance structures needed to be reshaped and their business and management processes needed to be re-engineered. On the one hand, each bank established a shareholders’ meeting and a board of directors, with the board hiring the management; at the same time, in order to strengthen the constraints of market discipline, the banks went public, and since international market discipline is stronger than domestic, the banks listed not only domestically but also overseas. On the other hand, each bank repositioned itself in accordance with its own business characteristics and re-engineered its various processes in a market-oriented manner, with the market-oriented re-engineering of human resources processes being the focal point. For example, I myself had been a bureau-director-level cadre of the State Commission for Restructuring the Economic System, but in the re-engineering of human resources processes, I not only lost my cadre status but also had to sign a labor contract with the Bank of China—if my performance was poor, the Bank of China could terminate the labor contract. Clearly, such a constraint is a strong constraint, and the process re-engineering thereby bid farewell to the traditional mode of operation.
This round of reform aimed at becoming genuine commercial banks took the establishment of Central Huijin on December 31, 2003, as its starting point. It was first launched by the Bank of China and China Construction Bank, then spread to various types of state-owned financial institutions—including both commercial banks and non-bank financial institutions—and came to a close with the public listing of China Everbright Bank in 2012, lasting eight years. This round of reform gave Chinese financial institutions a new look, and their operating philosophies, modes of operation, capital adequacy ratios, risk management capabilities, and technological levels all rose to a new level. In hindsight, this round of reform came at exactly the right time and was accurately implemented, thereby constituting the foundation for the Chinese financial system’s successful defense against the global financial crisis of 2008.
In this round of reform, the 50 Forum devoted great effort, and many of its members contributed greatly. They were: Zhou Xiaochuan, then Governor of the People’s Bank of China; Lou Jiwei, then Vice Minister of Finance and later Chairman of China Investment Corporation; Guo Shuqing, then Director of the State Administration of Foreign Exchange and later Chairman of Huijin; Xie Ping, then Director-General of the Financial Stability Bureau of the central bank and later General Manager of Huijin; and Li Bo, then Deputy Director-General of the Legal Affairs Department of the central bank. The achievements of China’s banking industry today embody their sweat.
III. The Internationalization of the Renminbi and Chinese Finance Moving onto the World Stage
In 2015, the International Monetary Fund announced that the renminbi would be included in the SDR, formally taking effect on October 1, 2016. This was the fifth reserve currency after the U.S. dollar, the euro, the pound sterling, and the Japanese yen, marking the entry of renminbi internationalization into a new stage.
Because of my work at the Bank of China’s Hong Kong institution, I was among the earliest to become involved in the arrangements for the cross-border use of the renminbi. As early as twenty years ago, hit by the Asian financial crisis, Hong Kong’s financial markets were in turmoil and all trades were depressed. Hong Kong’s stability and prosperity concerned not only the welfare of Hong Kong residents but also the success or failure of “one country, two systems.” After the Asian financial crisis, a series of policies favorable to Hong Kong’s stability and prosperity began to be implemented, the most important of which was CEPA, that is, the Closer Economic Partnership Arrangement between the mainland and Hong Kong under the WTO framework. One important measure of this was implementing zero tariffs on products originating in Hong Kong exported to the mainland. By that time, however, since most of Hong Kong’s manufacturing had already relocated, there were few products originating in Hong Kong. Although the CEPA arrangement was beneficial, it was a drop in the bucket. Hong Kong’s recovery from the Asian financial shock was to a large extent thanks to the free travel of mainland residents to Hong Kong. Large numbers of mainland residents traveled to Hong Kong for tourism—eating, staying, traveling, and shopping—which drove Hong Kong’s consumer industry and supported the income growth of Hong Kong’s grassroots classes. But a problem also became prominent: because the renminbi was still a non-convertible currency, although mainland residents had purchasing power, they had no means of expressing that purchasing power. How to give mainland residents a means of expressing their purchasing power became key. Under the circumstances that the renminbi was still not convertible, one feasible arrangement was for Hong Kong to allow the direct use of the renminbi locally. The cross-border use of the renminbi was thereby placed on the agenda.
However, once the use of the renminbi in Hong Kong was raised, a series of policy and technical difficulties came rushing in, the core of which was the opening of the capital account of China’s balance of international payments. From Hong Kong’s perspective, under the circumstances that the renminbi was non-convertible, the renminbi used in Hong Kong needed to be fully recovered by the mainland—that is, the renminbi needed to flow back. From the mainland’s perspective, if the renminbi could not flow back through the current account (imports), then it would need to be arranged to flow back through the capital account, and this would not only bring pressure on the mainland, which at the time was extremely thirsty for foreign exchange to balance its international payments, but also—with the Asian financial crisis as a cautionary precedent—it was still hard to predict what opening the capital account would mean. Thus, the focal point of the contradiction became whether a closed renminbi reflux loop could be formed so as to effectively control the risks of opening the capital account.
In 2003, I began to participate in the design of this reflux loop. After repeated deliberation and continuous argumentation, a special arrangement was formed that leveraged the specific advantages of Bank of China (Hong Kong): at the consumption venues frequently visited by mainland residents traveling to Hong Kong, designated merchants could accept the renminbi, and the renminbi revenue of these designated merchants would be promptly converted into Hong Kong dollars by Bank of China (Hong Kong); Bank of China (Hong Kong) signed an agreement with the Shenzhen Branch of the People’s Bank of China to transport the renminbi positions (mainly cash) it obtained from the designated merchants back to the mainland. Thus, the renminbi flowed out of the mainland through the current account via multiple channels (carried by individuals), but flowed back into the mainland through the capital account via a single, special, closed conduit (the special arrangement between BOC Hong Kong and the Shenzhen Branch of the People’s Bank of China).
It should be pointed out that under such a special arrangement, Bank of China (Hong Kong) was in effect performing the function of central bank clearing. Its essential significance was: under the circumstances that the renminbi was non-convertible—that is, under the circumstances that there was no foreign exchange market settlement—the clearing of the market could only rely on the central bank’s clearing. And since the central bank, by virtue of its sovereign nature, found it difficult to conduct cross-border clearing, it entrusted a financial institution that it could trust and that was within its jurisdiction to seek agency clearing business.
With the implementation of the above special arrangement, mainland residents could pay directly with renminbi when consuming in Hong Kong. Not only was consumption convenient, but the scale of renminbi use also greatly increased. While promoting the stability and prosperity of Hong Kong’s economy, it also made the original cash-based clearing conduit between BOC Hong Kong and the Shenzhen People’s Bank appear too narrow, unable to fully meet the need for renminbi reflux. So, outside the conduit, a “pump” was set up—that is, through special arrangements, certain mainland institutions were designated to issue renminbi bonds in Hong Kong to channel renminbi funds back to the mainland. At first these were the major banks, and later this was extended to the Ministry of Finance as well. This measure both eased the congestion of the original clearing conduit and, by opening a new channel for reflux through bonds, expanded the reflux of the domestic currency through the capital account, laying the foundation for Hong Kong’s offshore renminbi financial market. At this point, the basic framework of renminbi internationalization—the genetic makeup of “clearing bank + offshore market”—began to be laid.
The international financial crisis of 2008, which originated in the United States, brought a severe shortage of international dollar liquidity; the “dollar shortage” caused normal international economic and trade exchanges to grind to a halt for lack of means of payment. Employing a new international currency for international payments, so as to ease the severe shortage of international liquidity, became a pressing task. And since China’s GDP already ranked among the world’s foremost, and even more because China had become one of the largest international trading entities, the renminbi became the first choice for a newly emerging international currency, and the renminbi was thereby internationalized, no longer merely confined to Hong Kong outside the mainland’s borders. Clearly, the international demand for the renminbi presented the challenge of opening the capital account and achieving convertibility for a developing country even more acutely before China.
With the support of the Boyuan Foundation, Wu Xiaoling, a member of the Academic Committee of the 50 Forum, took the lead in organizing large-scale research activities on renminbi internationalization. One of the difficulties of the research was the question of the relationship between the international use of the renminbi and the opening of the capital account. In this regard, Hong Kong’s experience needed to be seriously explored and summarized, so as to elevate it from a passive, temporary, expedient arrangement into an active, long-term, stable strategy of internationalization. I undertook this research and produced the special research report “The Position and Role of Hong Kong in the Internationalization of the Renminbi.” The conclusion of the research was: on the basis of the financial authorities of both sides reaching a consensus and cooperating closely, a mechanism could be formed for the renminbi to flow back to China and operate in a closed manner under the condition that the capital account was non-convertible. The best arrangement was to designate an international bank that the Chinese financial authorities could manage to act as the clearing bank. This would not only not harm the objectives of China’s foreign exchange controls, but would on the contrary be conducive to the accumulation overseas of renminbi flowing out through the current account. Once the overseas financial authorities gave permission, the renminbi accumulated overseas could form an offshore renminbi financial market, and flow back to China through already-formed or newly created domestic-currency capital-account reflux channels—for example, renminbi raised in the offshore market entering in the form of direct investment. It is worth noting that this research supported by the Boyuan Foundation was not content merely with writing a research report, but aimed to form an operable policy system and implementation measures. The research team continuously communicated with the financial authorities of both Hong Kong and the mainland, and while providing intellectual support, also solicited the opinions of financial institutions in both places and provided advisory opinions, making the operation more meticulous. The most obvious result was jointly promoting the formation of the Hong Kong Monetary Authority’s Circular No. 2 of 2010. The circular determined that: first, the flow of renminbi into and out of Hong Kong was the right of the People’s Bank of China, and Hong Kong would not interfere; and on this basis, the renminbi would be treated the same as other freely convertible currencies and could be used for transactions in Hong Kong’s financial markets. At this point, the model of “clearing bank + Hong Kong offshore market” was formalized and standardized. Using Hong Kong as a blueprint, offshore renminbi markets in Taiwan, London, Frankfurt, Paris, Singapore, Bangkok, Seoul, and North America were successively opened, and the internationalization of the renminbi made its formal entry onto the global stage.
Since cross-border trade settlement in renminbi began on July 2, 2009, only nine years have passed. Over these nine years, the internationalization of the renminbi—though its urgency was within expectations—unfolded beyond expectations. Its speed was so rapid and its scale so enormous that those of us who participated in its design in those days had never anticipated it. On July 2, 2009, the pilot for cross-border renminbi settlement of goods trade began with only 365 enterprises in the five cities of Shanghai, Shenzhen, Guangzhou, Zhuhai, and Dongguan. By 2010 it had expanded to twenty provinces, and by 2011 all enterprises in all provinces nationwide could use the renminbi for trade settlement—not only for goods trade but also for services trade. More importantly, it could be used for cross-border direct investment. At present, the renminbi has become the world’s seventh-largest international payment currency and second-largest trade financing currency; its scope of use extends across the globe, and it has thereby entered the SDR to become one of the reserve currencies of various countries.
More importantly, the internationalization of the renminbi created fresh experience for resolving the contradiction between the opening of the capital account and convertibility for developing economies. Due to the needs of my work, over the past nine years, I have visited the central banks and major financial institutions of almost all of Eurasia and half of the Americas to explain renminbi internationalization. To put it accurately, this was not merely proactive promotion, but more often exchanging views and discussions with foreign counterparts at their invitation, from which I deeply appreciated the uniqueness of this fresh experience—which at the same time strictly conformed to the general logic of economics.
The traditional view holds that if the capital account is opened, it necessarily means the convertibility of the domestic currency with foreign currencies, and once convertibility exists, the inflows and outflows of international capital—especially short-term capital—will disturb macroeconomic stability. The Asian financial crisis of twenty years ago and today’s financial turmoil in Argentina and Turkey are the examples commonly cited by the traditional view. The necessity of opening the capital account and the risks of opening it present a difficult choice. But the successful practice of renminbi internationalization shows that the domestic-currency side of the capital account can be opened first, and then the convertibility of domestic and foreign currencies on the capital account can be achieved—that is, first realize the flow of renminbi through the capital account, and then create the conditions to realize the convertibility of domestic and foreign currencies. This step-by-step approach helps reduce difficulty, ease contradictions, and gradually approach the goal.
Theoretically speaking, the core of this fresh experience is that it created a non-corner solution to Mundell’s impossible trinity. Traditional theory holds that among the three—monetary policy independence, a fixed exchange rate, and free capital flow—only two can hold at a time, that is, the corner solution of 1+1+0=2. But the experience of renminbi internationalization shows that, under the condition of satisfying an aggregate solution of 2, non-corner solutions such as 1+1/2+1/2 and 2/3+2/3+2/3 can also hold. In other words, relax monetary policy independence a little, let the exchange rate float in a managed way a little, and open the capital account a little—all can satisfy the basic condition of an aggregate solution of 2. The emergence of non-corner solutions means that the corner solution of Mundell’s impossible trinity is not the only solution; it has multiple solutions, thereby opening up in practice multiple paths and related arrangements for opening the capital account. This both enriches, in theory, the connotation of Mundell’s impossible trinity, while at the same time, through its diversity, tenaciously proving the theoretical soundness of the Mundell trinity, thereby foreshadowing the direction of convergence for opening the capital account and its related arrangements.
The practice of renminbi internationalization enriches economic theory and also propels the deepening of China’s financial reform and opening-up. With the development of renminbi internationalization, the marketization of exchange rates, and further the marketization of interest rates, has become a new key area and important link of reform, and behind this in turn is the opening of the financial markets and the financial services industry. This in turn demands the reform and innovation of the financial regulatory system. With such a ratchet effect—interlocking, rolling forward—Chinese finance presents a pattern of a great power with great finance. The development of Chinese finance has entered a new stage, and it finally needs to face the problems of the world.
In the process of renminbi internationalization, the 50 Forum also made major contributions. Not only did it, during the international financial crisis of 2008, repeatedly organize discussions on related issues and form a series of ideas and results, but more importantly, many of its members personally participated in advancing this process. They were Zhou Xiaochuan, Wu Xiaoling, Yi Gang, Li Yang, Yu Yongding, Li Bo, Guan Tao, Huang Yiping, and others. I thank them and the teams they led—especially the central bank team—who, when the tsunami of the international financial crisis struck, not only faced the danger without fear but on the contrary seized it as an opportunity, opening up a new chapter in the internationalization of the renminbi at the opportune moment.