1. WORKING DOCUMENTREPORT ON THE ROUND TABLE OF NOVEMBER 20, 2012 ORGANISED BY ITALY-CHINA FOUNDATION JOINTLY WITH THE BANK OF ITALY onEconomic Trends and Evolution of Chinese Financial Sector Reforms:Scenarios and Opportunities for International Investors Milan, January 14, 2013The working paper was prepared by Franco Fornasari with the support of Thomas Rosenthal,and the Staff of the Italy-China Foundation. Any error in quotation or interpretation of thecontributions by the participants to the Round Table is solely attributable to the author. Theviews expressed in this document cannot be attributed to the Sponsors of the Round Table.Comments are welcome to F.Fornasari@valuetreepartners.com / info@italychina.org.

2. On November 20TH, the Italy-China Foundation - in collaboration with the Bank of Italy - organizeda Round Table entitled Economic Trends and Financial Sector Reforms in China: Scenarios andOpportunities for Cross-Border Investment. The meeting was also the occasion to present theNumber 148-149 of the Chinese World Magazine entitled "The Red Knight of finance." Theroundtable was held at the Hotel Rome Cavalieri Waldorf Astoria, starting at 4:30 PM, and wasfollowed by a Luncheon in honor of the Governor of the Bank of Italy, Ignazio Visco, with thesponsorship of the Industrial and Commercial Bank of China, the Bank of China, the IntesaSanpaolo Group and Mandarin Capital Partners. The event addressed technical issues and wasattended by leading representatives of institutions, academia, business and finance, both Italian,Chinese, and international. The meeting focused on prospects for the Chinese economy in thepresent domestic and international context; the role of financial sector reforms - including theinternationalization of the Chinese currency; and on the opportunities and risks that arise forInternational investors.The Presentation of the Round Table and Agenda of the Meeting are enclosed in ANNEX 1 and 22 3. TABLE OF CONTENTS INTRODUCTIONI. THE CHINESE ECONOMY IN THE SHORT, MEDIUM AND LONG-TERM* An economy in soft landing for cyclical factors, but structural constraints are looming;* Traditional manufacturing and private sectors are suffering the most at this point in time;* The difficulties of Chinese Small and Medium Enterprises have local and global impact;* A new era of "less-growing expectations" and "slower locomotives" is setting in;* The real economy is at a "turning point" and the financial sector is in "continuous rapidtransformation";* A saturation of investment opportunities in the "tradable sectors"?* Growth is still "investment-led" and "external risks" are still present;* The development of highly capital intensive sectors changes the supply chains of the Region* The demographic wave is at the peak and the labor market is changing rapidly* The "Lewis turning point" is still far ... but the challenge of innovation is closer* Household savings are poised to drop to more "normal" levels, but it takes time and good policies;* The growth in social spending will lead to a drop of Households savings, but also of bank deposits;* Dependence on imported energy and raw materials is an ongoing challenge for economic policy;* The race for natural resources is not the only way ... but it is the most widely practiced;* Chinas future depends on innovation and technologies for sustainable growthII. THE FINANCIAL SECTOR REFORMS OF THE CHINESE ECONOMY* Moving toward a financial sector that helps the countrys real economy realize its potential* From "shield" against the crisis "constraint" for the balanced development of the real economy* An expanded financial sector that remain shallow and dependent on banks* From a "deposit-credit" bank to one that delivers a range of competitive financial services* The reforms of the financial system have accelerated in 2011;a. Banks have more flexibility in setting interest rates and marginsb. The "wholesale banking" market is growing and opens new opportunities to foreign investorsc. Chinese banks accelerate their international expansion - "going global"d. Going global is a necessity, but also an opportunity to enter markets affected by crisese. Capital markets expand in the "high yield" segment and feed new credit to the economy f. Growing role of the "shadow banking sector" the Wenzhou Case* Internationalization of the RMB as a "necessity" and part of financial sector reform* Internationalization as a "functional process" to eliminate obstacles to the use of the RMB* Capital Account liberalization and RMB Internationalization: in sequence or in parallel?* New reforms push for the Internationalization of the RMB; a. Cross-border settlement in RMB: from experiment to operating system; b. New "currency swaps" arrangements with the global trading partners;c. Less stringent rules of access for particular types of operators and capital transactions;d. Further development of offshore channels to access the chinese financial market;e. "Hong Kong SAR, China" as the major offshore RMB market;f. The "dim sum" bond market of Hong Kongg. New rules for fixing the exchange rate RMB/US$ 3 4. * The 2012 exchange rates and speculative capital movements* The impossible triangle of independent monetary policy, stable exchange rate and open capitalaccountIII. CHINESE INVESTMENT FLOWS AND THE ROLE OF EUROPE* Chinese investment flows into the European manufacturing sectors are on the rise* The risk of Barriers to Chinese investment in Europe should not be underestimated* Europe is the Leading Destination of Chinese ODI excluding the Natural Resource Sectors* Co-operation strategies for competitiveness and the role of financial intermediaries* Non-bank Intermediaries are bound to play a larger role to promote cross-border investment* Diversification of Chinese foreign investment (ODI) and acquisitions on private markets aregrowingIV. OPEN QUESTIONS AND CONCLUSIONSA) Where is the Chinese economy going in the short, medium and long-term?B) What is the role of China in the international economy?C) What is the direction of reform of the financial system?D) What role for the RMB - renminbi - and for Chinese banks at the international level?E) What are the business prospects for international investors?BIBLIOGRAPHYCHARTS1-6:Gross Domestic Product (GDP), inflation in the long run; Contributions to GDP growth;Dynamics of Exports, Investment and Current Account; Turnover and fixed investment bycomponents;7-11: Composition of Imports; integration with international production; production capacity,wages, labor costs per unit of product and industrial profits; active population, Incremental Capital-Output ratio;12-16: Employment by sector and Urbanization; Demogreafy and labor market, saving andinvestment by sector; household disposable income and wage gaps in some Chinese provinces;17-19: Social expenditure, real rate on deposits; deposits at the banking system; imports ofcommodities; weight of China in world trade; international comparisons of per-capita consumption;20-21: Terms of Trade of China and International Comparisons of fuel and water prices;22: Engines of Chinese Growth, International Comparisons of Growth Paths , the Middle IncomeTrap";23-24: Architecture of Financial System; Calendar of Financial System Reform at the end of 2010; 4 5. 25-27: Bank rates, inflation, profit margins and total assets of banks - international comparisons;28-29: Credit flows to Economy 2007-2012; Interest Rates and minumum margins for banks; the2012 bank interest rates reform;30-32: The Chinese Wholesale Banking market, Foreign Investment in Chinese Financial System;financial indicators of the Chinese banking system;33-35: Non-Financial companies debt and growth of credit to the economy; Credit from Trusts andthe shadow banking system of China;36-37: Functions of an international currency; Current account transactions settled in RMB;exchange rate RMB/US$, Onshore (CNY), Offshore (CNH);38-40: Settlement of Chinese imports payments via Hong Kong; exchange rate of RMB/US$,Onshore (CNY), Offshore (CNH); Expectations of RMB appreciation measured on the Onshore andOffshore (Non-Deliverable Forward - NDF) markets;41-44: Offshore Securities Market in RMB (CNH) and Yield Curve of Chinese public debt onshore(CNY) and offshore (CNH); widening of the "Flotation band of the RMB/US$ exchange rate in theperiod April -June 2012; Exchange Rates RMB/US$ and Nominal Effective Exchenge Rate of RMBagainst other currencies (NEER);45-46: Interest rate differential and short-term capital movements; Chinese central bankinterventions in the foreign exchange market; dynamics of the RMB/US$ exchage rate in 2012;capital account opening and the "Impossible triangle";47-52 China Investment Corporation 2011 Data Highlights; Dragon Investment Index of China;composition of outward direct foreign investment of China (ODI); foreign investment opportunitiesin RMB for Non-Residents in the Chinese market;TABLES1. GROWTH OF GROSS DOMESTIC PRODUCT BY TYPE OF EXPENDITURE (2009-13)2. IMF MEDIUM-TERM SCENARIO3. DEVELOPMENT INDICATORS OF THE FINANCIAL SECTOR - 2005-20104. FINANCIAL INDICATORS - 2005-2010ANNEX 1: Round Table IntroductionANNEX 2: Agenda of the Event of November 20th5 6. INTRODUCTIONThis report presents an overview - albeit partial - of the points raised during the Round Table ofNovember 20th with additional context, data and comments on the main topics and scenarios brought upby the discussion. The working document is intended to stimulate comments and provide elements toframe the issues and provide specific references for further deepening and follow up on the issues inquestion.The focus is on the general framework of the Chinese economy and on salient points of policy and issuesthat international investors should take into account for their future decisions. The enclosed commentstake into account the economic policies of the XII Five-Year Plan, 2011-15 which were also evoked by thenew leadership at the close of the XVIII Congress of the CPC in November 2012.Following the break down of the issues and questions proposed in the introduction to the Round Table(see Annexes), the report is divided into four chapters:- the first touches on cyclical and structural issues with reference to the general economic policies toaddress them;- the second addresses the role of the most recent financial sector reforms, including theinternationalization of the Renminbi (RMB) within the framework of the reform process that began inearly 2000 i.e., after the entry of China into the WTO - and led the sector to rapid expansion andincreased complexity, as pointed out in his introductory remarks by Dott. Fabrizio Saccomanni;- the third chapter deals with the flow of investment and the role of Europe in the process ofinternationalization of the Chinese economy and its opening up from the stand point of the capitalaccount of the balance of payments.- the concluding section recalls the questions that the Round Table brought to the attention of theparticipants and highlights some implications on the emerging scenarios obviously leaving theconclusions for each and everyone to draw.For sake of brevity, the report includes only summary references to the contributions of the participantsthat were already circulated as "Readings" and are available upon request.I would like to acknowledge various sources of the data and references included in the report, andparticularly the ICBC, BOC, Mandarin Fund, A-Capital, Goldman Sachs, JP Morgan, Citigroup, CICC, CreditSuisse, Euromoney, fDi / Financial Times, The Wall Street Journal, IMF, World Bank, UNCTAD and othersauthors quoted in the reading list and charts.Milan, January 14, 2013 6 7. I. THE CHINESE ECONOMY IN THE SHORT, MEDIUM AND LONG-TERMAn economy in soft landing for cyclical factors, but structural constraints are loomingI.1The diagnosis of the slowdown of the Chinese economy has emphasized known economic factorsrelated to the deteriorating performance of the Euro Zone - which accounts for about 16.3% of Chineseexports and, to a lesser extent, the United States [chart 1]. Other factors include the effects of economicpolicies, with reference to bank lending which had reached growth rates of around 60% per year during2009-10 and which was significantly slowed down in the recent period in order to avoid inflationary andasset bubble effects. This is particularly true in relation to construction / housing sectors which receivedmassive investments flows in the post-financial crisis period. Many speakers stressed that the currentdownturn is due to other structural factors and internal imbalances (see below) that weigh on theperformance of the Chinese economy. The combined impact of these factors is an increased level ofimports - and greatly reduced size of the current account surplus which had reached its maximumcontribution to the Chinas growth in 2007 [Charts 3-4]. A further set of factors is related to the specialcircumstances of the political transition and the XVIII Congress of the CCP - in conjunction with thepresidential elections in the U.S. - which may have slowed down the economic policy responses to thedecelerating growth rates experienced since the end of 2011 i.e., from over 10% to 7%. Overall, theevaluation of Li Yuefen (UNCTAD) is that 70% of the slowdown in economic growth is due to theinternational developments in Europe and the U.S., and 30% is due to factors concerning economic policiesand structural, long-term, phenomena.Traditional manufacturing and private sectors are suffering the most at this point in timeI.2The sectors that are now suffering the most are manufacturing and heavy industries. The causesare the fall in demand for exports and the slowdown in construction and infrastructure programs -especially those promoted by local authorities (SNG - Sub National Governments) that today are in a fragilefinancial position due to the deceleration the Chinese economy. Fan Zhigang (ICBC) pointed out that heavyindustry and private enterprises, particularly SMEs (small and medium enterprises) - and not the state-owned enterprises (SOEs - state owned enterprises) are suffering the most and are dealing with the mostdifficult choices to overcome the crisis. The financial constraint faced by Chinese SMEs was deemedparticularly severe, as indicated by the distribution of bank credit: Banks loans represent around 80% ofthe external financing of SOEs compared to 20% in the case of SMEs although they represents 65% ofnational product and 80% of total employment. The local government expenditure is another potentialcause of imbalance - as highlighted by Amb. Vincenzo Petrone (SIMEST) - in view of the size of theiraccumulated debt (about 20% of GDP).7 8. The difficulties of Chinese Small and Medium Enterprises have local and global impactI.3 The attention to the situation of SMEs is justified on many grounds as it is clear that the economicpolicies of China have significant effects both internally and across borders. This is particularly relevant inareas where global competition is more intense, as in the case of the steel industry. The Chinese steelsector benefited from the long investment boom in construction and local government expenditure whichallowed many small size plants and companies to thrive leading to a highly fragmented industry structure.The international economic crisis and the reduction of domestic financing could lead to industryconsolidation as both sources of growth i.e., exports and investment in infrastructure are faltering tosome extent. One should consider that in the steel sector - which presents a worldwide excess capacity ofabout 300 million tons and an estimated total capacity of 1,800 million tons - China holds between 600 and800 foundries and a capacity equal to 46% of the global market. The effects of Chinese economic policieswill be felt globally also in consideration of the pipeline of investment coming into production: industrysources indicate that there are at least 100 plants under construction in the most disparate locations(Vietnam, Colombia, Argentina, Ecuador, Peru and Bolivia) that will bring additional capacity for 350 milliontons. Thus, Chinese industrial and credit policies weigh on the shape of the sector in the coming years. Lessconcern has emerged on the status of the housing / real estate sector. Prof. Laixiang Sun stressed that thedevelopment of the sector depends on a high rate of self-financing and low dependence on bank loans.Thus, there is less concern about the effects on the banking system of the current imbalance in the market. 8 9. A new era of "less-growing expectations" and "slower locomotives" is setting inI.4On the general economic policy front, Dott. Fabrizio Saccomanni stressed the prudent and skillfulapproach shown by Chinas policymakers during this period in order to balance the need to stimulategrowth and to contain the spill-over effects of the aggressive lending policies implemented to stimulate theeconomy after the 2008 crisis. Such a caution was reflected in a reduced growth target of 7% per annum,which was indicated for the decade 2012-2022 i.e., this would "only" double the size of the Chineseeconomy, compared to the growth rate of the past decade during which the Chinese economy did morethan quadruple in size and became the second-largest in the world, although in absolute size and certainlynot yet in terms of per capita income [chart 2]. Such growth would lead China to exceed the size of the U.S.economy at the end of 2020, but hopefully with a better balance and less spill-over effects into the globaleconomy. On this subject, Prof. Fu Jun pointed out that the global economy will have to adjust in thefuture, and live with a "Chinese locomotive" traveling at slower speed than in the past. On the other hand,it will be the reform of the Chinese economy that will have to accelerate its pace compared to recent years.The real economy is at a "turning point" and the financial sector is in "continuous rapid transformation"I.5The diagnosis of the structural problems of the Chinese economy has been the focus of commentsby Cao Yuanzheng (BOC) and Fan Zhigang (ICBC). They drew a picture of a real economy "reaching aturning point," as well as a financial sector in "fast and constantly changing mode". There is no doubt thatthe financial sector reforms are advancing as a continuous process, pragmatic and incremental - rather thana sequence of decisions that are consistent with a clearly defined model. So we are faced with a "silentpolicy revolution" in a country still looking for a "Beijing Consensus" which differs from the "WashingtonConsensus", but yet is able to meet the challenges faced by China at this stage of its development.A saturation of investment opportunities in the "tradable sectors"?I.6The Chinese production system has reached a turning point for various change factors and first ofall its over-dependence on manufacturing/export markets. The growth of China in the pre-financial crisiswas in fact linked to the dynamics of exports, but in earnest it was supported by massive investment (atlevels close to 42% of GDP) concentrated in manufacturing capacity for products destined to internationalmarkets. The state of the world economy post-crisis makes this model unsustainable, leading to theslowdown in Chinese exports falling from 30% to 7% over the last 3 years. This calls into question the pastgrowth model based on full integration of the Chinese economy in global supply chains that depend on therapidly changing world demand patterns (as in the case of photovoltaic panels sector which was driven bygovernment incentives that now appear clearly unsustainable). Diversifying the production structuretowards domestic demand is a priority for the Chinese economy, given the outlook for the G7.9 10. Growth is still "investment-led" and "external risks" are still presentI.7 It is interesting to note that this diagnosis is fully endorsed by the twelfth Five-Year Plan 2011-15 -which aims to promote the growth of consumption and domestic demand, and also promote growth of theservice sector: Yet these new trends are not reflected in the dynamics of fixed investment in manufacturingwhich shows sustained growth rates for the whole 2010-12 period [Charts 5-6]. Only investment inresidential construction has slowed (Table 1 - 2). The strong demand for private fixed investment isassociated with sustained import growth of machinery and minerals in particular i.e., this indicates thatsectors such as mechanical, engineering, steel have reached a prominent position as a share of globalproduction chains [Charts 7-8]. Considering the investment dynamics of non-manufacturing sectors i.e.,infrastructure such as social housing which grows along with the urbanization process now close to 50% ofthe population as well as investment in services, one reaches levels of aggregate investment for the post-crisis period that went as high as 48% of GDP (as in 2010). This helped fill the void created by the decline innet exports and sustained GDP growth. The downside is that the Chinese economy seems still exposed tothe risks of the international economy and the risk of obsolescence of its vast investments base.10 11. The development of higly capital intensive sectors changes the supply chains of the RegionI.8 The combined effect of abundant labor supply and strong accumulation of fixed capital is tosignificantly increase the available production capacity of China [Chart 9]. Even taking into account theeffects of structural changes that are taking place in the world economy, it is clear that China holds a strongreserve of capacity for non-inflationary growth that can spur its rapid expansion in the case of globaleconomic recovery or - otherwise presents a serious potential problem of productive restructuring andconsolidation in its industrial base. The observation of William Lee (Citibank) is that the massiveinvestment in activities with a high content of knowledge, technology and capital puts China in a position ofdirect competition with traditional partners in regional production chain (i.e., South Korea and Taiwan) withpotential fall outs and consolidation effects on the whole supply chain, in a scenario of low global demand.So the success of China in the transformation of its production system is not a "win-win" proposition for theregion unless the countries in Chinas supply chain adapt their production to Chinas new growth modelby providing the consumption goods and services (especially consumer electronics and tourism) that will bein high demand. Thus, in line with neo-structuralist hypotheses, China is becoming a competitor inproducts and markets led by countries in the Region that escaped the middle income trap (Chart 22-C).11 12. The demographic wave is at the peak and the labor market is changing rapidlyI.9 A second set of "change factors" concerns the dynamics of the labor market and the weakening ofChinas traditional "comparative advantage" in terms of abundant, low-cost stream of young workerswilling to take up manufacturing jobs. On the one hand, there are demographic factors leading to a long-term decline in labor supply approximately by the year 2020 this marks the beginning of a rapid fall in theratio of population aged between 15 and 30 years and the total population aged between 15 and 59 years[Chart 10]. United Nations estimates indicate that, following a period of increases in the labor force bysome 103 million units between 2000 and 2015, one can foresee a reduction of 69 million units from 2015to 2030. On the other hand, there are factors related to the increasing diversification of the productionstructure, the urbanization - which went from 20% to about 50% in just over a decade the changes inlifestyles and in the participation rates of Chinese population, especially female who tend to preferemployment in services compared to manufacturing. Looking ahead, both the reduction of migration flowsto the cities and the changes in the workforce create a situation in which it is increasingly difficult to meetthe demand of low cost labor, particularly in the top high-tech sectors such as electronics. The immediateeffect of the changes under way is a sustained increase in wages in industry - with peak increases of over20% [Charts 11-12] - leading to a convergence in labor costs compared to international standards andshifting the terms of Chinese competitiveness toward other factors such as productivity and innovation.12 13. The "Lewis turning point" is still far ... but the challenge of innovation is closerI.10It is worth stressing that all of the above trends are not expected to result in a severe tightening ofthe labor supply curve i.e., leading to the Lewis Turning Point - at least for another 10 years [Chart 13],depending on economic and social policies implemented in the coming years. In addition, the sustainedwage increases only affect the coastal areas that are more heavily industrialized, and not so much theinterior of the Country where profound differences exist between by sector and area [Chart 14]. Althoughthe growing income inequality is in many ways a disturbing factor, the fact remains that China hasenormous growth potential for non-inflationary growth in its own internal Western frontier - as pointed outby Li Yuefen (UNCTAD). Similar points were made by Silvia Ardagna (Goldman Sachs) who stressed thatthe challenges of growing social expenditure and non-tradable sectors can be met as China holds amplemargins to improve efficiency in the production system. China is also making rapid progress in buildinginnovation capabilities, starting from key sectors in which patents have grown exponentially (Chart 22-D).Household savings are poised to drop to more "normal" levels, but it takes time and good policiesI.11A third set of "change factors" is the reduction in the saving rate of Households due to aging of thepopulation which results in exits from the labor market and changing patterns of consumption - also due toeconomic reforms that provide additional incentives to increase Households consumption. After twodecades of steady increase, Chinese national saving has reached 54% thanks to the decisive contribution bythe Households sector. This is the pillar supporting sustained growth rates exceeding 10% per year inconjunction with a large accumulation of international reserves (with current account surplus reaching upto 10% of GDP) and an investment boom that set the stage for the creation of a large production base insteel, mechanical and chemical industries, engineering, and more recently, a residential construction boom.The growth of Households savings in the latter period is noticeable [Charts 15-16] as it is obtained despite aflat disposable income - in which only the wages of those employed in the modern sectors recorded strongincreases. Looking ahead, both the increase in the dependency ratio (i.e., the ratio of non-active to activepopulation) and the increase in consumption are expected to lead to savings levels in line with those ofnon-oil exporting countries.13 14. The growth in social spending will lead to a drop of Households savings, but also of bank depositsI.12The aging population highlights the problem of how to meet the growing demand of retirementbenefits and social security which China only provides in limited quantity to urban areas workers. This is apriority issue in the XII Five-Year Plan, which aims to raise the ratio of private consumption to GDP abovehistorical levels of 35% by a systematic increase in social spending for education and for "social safety nets"[Chart 17]. In addition to social public spending and pensions, the Plan also aims at developing an efficienthealth services sector able to create jobs for that part of the population that has not yet benefited from theexplosive growth of the Chinese economy. This is why the Plan provides for an increase of the contributionof the service sector from 43% to 47% of GDP through programs of liberalization of public services andimproved management of utility companies in energy, water, etc. The commentary added by CaoYuanzheng (BOC) is that all these policies have a downside as they lower the level of deposits made freelyavailable to the banking system to meet the needs of low-cost credit for the economy. In the future, bankswill have to act as intermediaries relying less on deposits - which today are the main financial assets inwhich Households keep their large stock of precautionary money [Chart 18] and more on financialmarkets that should also provide suitable instruments to mobilize long-term savings and meet the socialsecurity needs of the country.14 15. Dependence upon imported energy and raw materials is an ongoing challenge for economic policyI.13 A fourth-order of "change factors" is the Chinas dependence upon imported energy and rawmaterials for the functioning of the whole economy and of the heavy industry in particular. The highdependence on oil imports i.e., about 66% of domestic oil consumption is imported is a cause ofconcern due to the volatility of international markets on which China is a relatively small importercompared to the overall size of the global market. Not so in the case of metals and agro-industrial productsin which China has a greater impact and did contribute to the sharp price increase and volatilityexperienced by these commodities in the past decade i.e., the so-called "commodities super cycle" alsoleading to a fall in its terms of trade that have weighed on the Chinese economy [Charts 19-20]. It is clearthat the road to reduce the Chinas reliance on imports is long, but it certainly involves reforms in thestructure of factor prices to encourage greater energy efficiency, expanded reliance on renewable energyand technological innovation to put China on a more sustainable growth path. 15 16. The race for natural resources is not the only way ... but it is the most widely practicedI.14China has long been aware of its import dependence fragility, and has set in motion a wide rangeof programs aimed at developing countries in order to gain privileged access to their natural resources.Between 2001 and 2010 the rating agency Fitch estimated that the development arms of the Chinesegovernment - Eximbank of China and China Development Bank - have committed credit lines of US$ 67.2billion to countries in Sub-Saharan Africa and this is more than the US$ 57 billion committed by the WorldBank during the same period. In the past few days there is news (Financial Times, November 9, 2012) of acredit line of US$ 3 billion to Ukraine for a "loans for crop" program concerning food products. Consideringthe critical role that China plays in the development of commodity-producing countries and in setting theequilibrium of international commodity markets, it seems that the rush to natural resources is far from anoptimal strategy and it presents risks of spill-over for the global economy. In perspective, the reform of theinternal factor price system towards more market-based mechanisms - particularly for energy [Chart 21] could contribute to further increase energy efficiency and encourage a more sustainable use of naturalresources.Chinas future depends on innovation and technologies for sustainable growthI.15The call for reforms to steer China on a more sustainable growth path came from Prof. Fu Jun whostressed that the urbanization and industrialization processes require a market basis for prices of all factors- land, labor and capital - and a set of financial sector policies to support a transformation of productionsystem and encourage innovation and technological development. Some economic policy lines have beenarticulated in the recommendations of the World Bank report on "China 2030", but it is the New Leadershipemerged from the XVIII Congress PCC that will determine the course of action for the country. The remarksof Dott. Fabrizio Saccomanni and Fan Zhigang (ICBC) emphasized the complexities involved in overcomingthe middle-income trap [Chart 22 A / B / C] and the critical role of financial sector reforms to maintain abalanced growth process not only in terms of external accounts, but also internally i.e., to avoidbubbles, favor the development of SMEs and overcome the effects of rising wage inequality in the modernsector of the Chinese economy. The long-term outlook indicated by Prof. Fu Jun and Fan Zhigang (ICBC) isone of a country determined not only to achieve the stated goal of doubling its per-capita income over thenext nine years, but also to reach the growth potential that pertains to a country with one fifth of the worldpopulation. Enrico Tommaso Cucchiari (Intesa Sanpaolo) pointed out that the Chinese economy in 2030would reach US$ 60 trillion which is close to 20% of the projected world GDP. In perspective, the marketcapitalization of the Shanghai and Shenzhen exchanges might grow over 20 times compared to 2011 levelsof US$ 3.3 trillion. This is a historic opportunity and the international community has a vested interest inthe success of economic reforms.16 17. 17 18. 18 19. II. THE FINANCIAL SECTOR REFORMS OF THE CHINESE ECONOMYMoving toward a financial sector that helps the countrys real economy realize its potentialII.1 The issue of financial sector reforms was introduced by Prof. Fu Jun, Li Yuefen (UNCTAD) andothers, starting from a diagnosis of issues related to various components of the complex architecture of theChinese financial sector [Chart 23]. The dominant theme was deepening the system and balancing the roleof banks, non-bank intermediaries and capital markets. The goal is to ensure that the system can performthe basic functions of a modern financial system and support transition towards a Chinese economy morefocused on domestic demand both private consumption, "social safety nets" and pension systems thattoday are underdeveloped (Table 4). Prof. Fu Jun emphasized the critical role plaid by the financial systemto support the complex processes of industrialization, urbanization, and efficient allocation of resources -land labor, capital - to promote the realization of the enormous growth potential of the country. Otherefforts have touched on the most urgent and the latest reforms of the banking sector (i.e., adding flexiblemechanisms to set interest rates on deposits and loans), capital markets, the exchange rate andinternationalization of the renminbi (RMB) following up on a twenty year reform process [Chart 24]. 19 20. 20 21. From "shield" against the crisis to "constraint" for the balanced development of the real economyII.2Li Yuefen (UNCTAD) framed the issue of financial sector reforms by stressing the good performanceof the Chinese system during the financial crisis of 2008. She indicated that the financial system emergedfrom the long process of reform of the last two decades i.e., the complete restructuring andrecapitalization of banks which included the "cleaning up" of balance sheets from bad loans (NPL - non-performing loans) had left the public sector in a dominant position throughout the banking system. Forthis reason the system could play a dual role i.e., one of financial intermediation and another ofinstrument for industrial policies. Thus, it could implement stimulus policies based on targeted creditexpansion. However, the recent economic developments show how this "shield" against financial crises hasbecome more of a "bottleneck to achieve the goals and growth strategies set by the policymakers. Ineffect, the system is becoming a problem for the distortions it causes in the functioning of the Chineseeconomy. Basically, the Chinese financial system presents four critical issues: (i) the level of administeredinterest rates is kept low to facilitate the restructuring of the NPLs of the system - despite the costsimposed on Households in terms of negative real interest rates [Chart 25]; (ii) the structure of interest ratesguarantees wide margins between the cost of funds / deposit rates and lending rates [Chart 26] and ensurethe profitability of the banks - without considering the distorting effects on credit allocation; (ii) financialmarkets are underdeveloped to prevent rapid decline in the very large savings deposited in the bankingsystem, and of course, (iv) the State is directly involved in the allocation of credit. 21 22. An expanded financial sector that remain shallow and dependent on banksII.3The observation of the current state of the Chinese financial system shows a very complex realityand it highlights the considerable progress made in the past years, but it also shows its fragility. At present,China occupies the second place in world rankings by size of the stock market, and the fifth by size of thebond market, as pointed out by Bert Gochet (JPMorgan Chase). However, these markets are relativelyimmature. Both the controls on interest rates and exchange rates, the weak corporate governance, and thecontrols on capital movements are major factors that distort financial markets and slow progress towardsthe internationalization of the currency (RMB). Bank have made limited contribution to the growth andinternationalization of SMEs - as pointed out by Lorenzo Stanca (Mandarin Fund); this is stark contrast withtheir disproportionate weight within the financial system - which mirrors the small weight of non-bankintermediaries and capital markets as source of credit to the businesses sector - as pointed out by Prof. FuJun. International comparisons show that the weight of banks as a percentage of total financial assets ismore than 63% in China, compared to South Korea (25%) and the USA (11%) [Chart 27]. In addition, it isworth noticing that the boom of banking assets and profits is mainly due to the massive increase in loansduring the 2009-10 period, as part of post-2008 stimulus policies [Chart 28]. 22 23. From a "deposit-credit" bank to one that delivers a range of competitive financial servicesII.4Overall, the business model of the past - in which banks were primarily focused on supporting theSOE sector and serve as an instrument of industrial policy - is now considered unsustainable. CaoYuanzheng (BOC) stressed that both the economic slowdown and the set of economic policies chosen bythe Government require a change in the bank business model: They should evolve from entities thatadminister the abundant mass of deposits and provide credit to priority areas identified by the government i.e., a model of "deposit-credit" - to institutions that respond to market mechanisms, according to"Western models of banking intermediaries." Hence, he stressed that Chinese banks need to accept morecompetition in the internal market and to need to accelerate growth in international markets.The reforms of the financial system have accelerated in 2011II.5The Chinas financial sector reforms are integral to the XII Five-Year Plan 2011-15 and, sinceDecember 2011, they led to the adoption of various liberalization measures and achievements that werediscussed in various interventions.Banks have more flexibility in setting interest rates and margins(a) The first area of intervention is bank interest rates and competition within the sector. From July 2012, the benchmark rates have been reduced; in parallel, banks have been given increased flexibility in setting interest rates both on deposits (i.e., they can increase them above the 3% benchmark rate) and on loans (i.e., they can align the current rate of 6% to values that better reflect the credit risk of the borrower). All this is meant to increase competition for deposits and allow banks to allocate credit by pricing mechanisms as opposed to administrative mechanisms prevailing in the past [Chart 29; Box 1].23 24. The "wholesale banking market is growing and opens new opportunities for foreign investors(b) The second area is the opening up of the financial sector by increasing the investment ceiling and otherrules for foreign acquisition of interests in "securities firms" (from US$ 30 to 80 billion). This opens up asegment of the Chinese financial service market which is more sophisticated and is rapidly growing -even though the business models for foreign investors are evolving, in line with the changing market[Chart 30 A-B]. The entry of foreign financial institutions in China [Chart 31] dates back to early 2000s -in the post-accession to the WTO - and is in a phase of transition toward modes that can be suitable forthe profitable development of "wholesale" services. So far, foreign investors have entered the marketin various forms, including Chinese-foreign joint venture, the opening of "subsidiaries" and the minoritystake in Chinese institutions (i.e., the maximum of 20-25% is being increased). The "retail" marketremains firmly in the hands of Chinese institutions (Chart 31 Bis).24 25. 25 26. Chinese banks accelerate their international expansion - "going global"(c) The third line of action is the international expansion of Chinese banks. This is a decisive step in theinternationalization of the Chinese economy, which - as pointed out by Dott. Fabrizio Saccomanni - willbenefit Chinese SMEs, by reducing the fixed costs of a presence in foreign markets as well as thebarriers to acquiring the knowledge required to succeed in new markets; this should also help increasethe depth of the Chinese financial market by transferring best technologies and business practicesacross borders. For Chinese banks "going global" is an integral part of the process of opening up thatwas indicated by government policies to deepen and modernize the financial system of the country i.e., a country that has now become the worlds largest exporter of goods. The four major banks underthe direct control of the State (Industrial and Commercial Bank of China, Bank of China, ChinaConstruction Bank, and Agricultural Bank of China) have stated ambitious plans for opening branches inkey markets (e.g., ICBC indicated that it will reach a presence in 37 countries at the end of 2012,according to press releases (The Wall Street Journal 28-Nov-12).Going global is a necessity, but also an opportunity to enter countries touched by financial crises(d) The reasons for Chinese banks to grow outside their domestic market can be summarized as follows: (i)supporting the internationalization of Chinese enterprises that are already integrated into the globaltrading system (i.e., those companies already part of "global manufacturing supply chains or thosethat can aspire to expand globally; among them, the engineering and construction companies operatingin infrastructure sectors can greatly enhance their competitiveness by leveraging long-term fundingfrom their home banking system), (ii) developing a sophisticated financial services sector that canadvance the diversification of the Chinese economy and help Chinese companies expand their crossborder payment system in international markets i.e., by providing services such as "forex", "cross-border trade settlement", "cash management", "trade and project finance", brokerage etc. that arenow performed by large international banks; and also (iii) stabilizing profits and diversifying credit risksfrom excessive concentration on domestic markets with declining profitability due to the ongoingreforms (see Chart 32-Bis). To these reasons, Li Yuefen (UNCTAD) added the opportunity offered towell-capitalized Chinese banks [see Capital Asset Ratios (CAR) of Chart 32 and Table 4] to enter thebanking systems of countries affected by financial crises i.e., to fill market gaps in those businesssegments with the highest capital requirements]; 26 27. 27 28. Capital markets expand in the "high yield" segment and feed new credit to the economy(e) The fourth area of intervention is capital markets. In June 2012 following up on the program launched in 2011 to allow sub-national entities to issue "municipal bonds" - the CSEC (China Securities Regulatory Commission) initiated a program to allow SME to issue bonds through private placements (high -yield corporate bonds). This step lays the foundation for rapid growth of a key market segment for non- financial companies which reached 853 billion RMB (US$ 134 billion) at the end of June 2012, compared to a value of 530 billion RMB in the same period of 2011. To understand the importance of the private bond market, one should consider that, in the past 2 years, this aggregate has shown the highest growth rate i.e., about 40% - among the components of the credit to the economy [Chart 33]. The CSEC continues to strengthen the structure of stock markets to facilitate capital raising in the 3 operating Boards (see CSEC, 2011 Annual Report ) i.e., the Main Board, the SME Board and the Growth Enterprise Board (GEB). On this point Prof. Fu Jun stressed the importance of opening a fourth market dedicated to knowledge-based companies, to promote innovation in sectors with a high content of research, development, and innovation. In 2011 there were 502 issues (Initial Public Offerings and Follow up Offerings) of A-shares for over 500 billion RMB. 28 29. Growing role of the "shadow banking sector" the Wenzhou Case(f) The fifth line of action concerns the lending activities of the non-banking sector and the experiments of financial deregulation in particular areas of the country, as in the case of Wenzhou. This is a coastal city with strong private sector, entrepreneurial culture and a dense network of institutions dedicated to the collection of savings and lending outside the banking system. Although the Whenzhou case was not discussed i.e., it is a measure of the State Council of March 28, 2012, which gives the city the status of the Comprehensive Reform Pilot Financial Zone this case puts the spotlight on shadow banking. The Financial Stability Board (FSB) which monitors these activities across countries - identifies shadow banking as "credit intermediation carried out by entities outside the regular banking system, and in particular by" Other Financial Intermediaries", including finance companies, trust companies that have taken an increasing role in recent years [Chart 33]. They collect private savings providing a return of 8-10% and invest the proceeds in risky activities, both in the private and municipal sectors i.e., nearly US$ 50 billion went to fund infrastructure projects recently [Chart 34]. While these activities play an important role in supporting investment activities, they may pose a risk from the standpoint of investor protection or even a potential risk for the financial system. The FSB data show that the assets of the non-banking sector in China are a small percentage of GDP, and the net exposure of banks is likely to be small in their balance sheets. However, shadow banking is important in terms of credit flows, which showed exponential growth before 2008 and are continuing to grow, although at a slower pace after the crisis [Chart 35]. The Banking regulatory commission (CBRC) is monitoring the role of banks as agents in the placement of wealth management products (WMPs) similar to USA structured notes that invest in loans, bonds, equity of those sectors that the Government is trying to rain in. The volume of shadow banking loans is estimated at about 20% of total loans outstanding at the end of September 20011 (12 trillion RMB compared to 52 trillion RMB respectively).Internationalization of the RMB as a "necessity" and part of financial sector reformII.6 The internationalization of the RMB has been addressed by Cao Yuanzheng (BOC) who stressedthat this course of policy action arose in response to liquidity problems emerged in the dollar market duringthe 2008-2009 financial crisis. The dollar shortage and the difficulties encountered in the ordinary conductof international trade during this period highlighted the risk of a system based on a single currency forinternational payments. This laid the foundation for a thorough reflection on the potential benefits of usingother currencies, including those of emerging markets, especially for transactions between them i.e., for"South-South" trade. It follows that China sees the internationalization of the RMB as an issue of reform ofthe Chinese financial sector and part of the Agenda of internal economic reforms i.e., leaving open anyother consideration on making further progress in reaching a better system of reserve currencies for theInternational Financial System.29 30. Internationalization as a "functional process" to eliminate obstacles to the use of the RMBII.7 Li Yuefen (UNCTAD) made reference to the analysis of Yu Yongding (ADBI, Revisiting theInternationalization of the Yuan, Working Paper 366, 2012) pointing out that the internationalization of theRMB does not follow a well defined "road map", but rather is a "functional process" aimed at eliminatingthe operating restrictions that hinder the use of the RMB in international transactions. In this perspective,since 2009, the Chinese authorities have launched reforms to dismantle barriers to the use of RMB for alltransactions related to the current account of the balance of payments i.e., the regulation of trade ingoods and services - and started to expand the range of transactions on the capital account. This is meantto facilitate the use of RMB as a unit of account and in the denomination of financial assets that wouldbring the RMB to assume the role of reserve currency in all respects [Chart 36]. It seems clear that the mainreason for the rapid progress made towards the internationalization of the RMB is the growing size andstrong diversification of the Chinese trade relations. At present, China accounts for about 12.6% of worldtrade, but only 0.26% of payments is settled in RMB - so there is room for strong growth, also consideringthat in 2030 China could account for 19% of global GDP compared to 16% in the U.S. - according to thereport of the World Bank, which was mentioned by Prof. Fu Jun.30 31. Capital Account liberalization and RMB Internationalization: in sequence or in parallel?II.8The basic requirements for the internationalization of the RMB have been illustrated by BertGochet (JPMorgan Chase) who stressed that a reserve currency cannot function without the opening of thecapital account. In addition, there is need for deep and liquid foreign exchange and capital markets to alloweconomic agents to manage all risks i.e., foreign exchange, interest rate and credit risks connected to theassets / liabilities denominated in RMB. In this regard, it may be noted that for a country like China whichis in structural current account surplus (i.e., it accumulates foreign currency in exchange for goods andservices), capital account transactions are key to supply RMB liquidity in international markets and allowthe creation of RMB-denominated assets/liabilities for non-residents. So internationalization is closelylinked to the liberalization of the capital account and the creation of transparent and efficient mechanismsfor trading RMB-denominated assets/liabilities. It is also worth emphasizing that the Chinese authorities donot seem to consider the liberalization of the capital account as a pre-requisite for the internationalizationof the RMB, but they see it as a parallel process that reinforces the internationalization of the Chinesecurrency - and thus, must be started in a "pro-active, gradual and controllable fashion (Zhou Xiaochuan,"Special Interview-everything about the renminbi", Century Weekly, January 2, published by Caixin Media). 31 32. New reforms push for the Internationalization of the RMBII.9 Various interventions have covered the highlights of the reforms implemented so far in terms ofRMB internationalization, starting with Fan Zhigang (ICBC).Cross-border settlement in RMB: from experiment to operating system(a) A first set of reforms concerns the mechanisms for the RMB settlement of international payments ofgoods and services. The introduction of such a mechanism goes back to July 2009 with a pilot program of"cross-border settlement" in which a group of 365 companies in 5 cities was allowed to proceed to payimports in RMB, making it possible for non-residents in Hong Kong, Macau and ASEAN countries to receiveRMB payments from Chinese importers through banks authorized to hold RMB balances at correspondingChinese banks. This program was quickly extended to 20 provinces and more than 60,000 companies in2010 and then, in June 2012, to all Chinese companies and for all current account transactions. The growthin the use of RMB for transactions related to the current account has been exponential and now reachesabout 10% of the total Chinese trade of goods and services [Chart 37]. The RMB use is heavily biasedtoward the payment of Chinese imports because of entrenched expectations of RMB appreciation(exporters to China are willing to accept a currency that appreciates in perspective, but appear to be morereluctant to denominate and pay for their imports from China in the same currency).32 33. New "currency swaps" arrangements with the global trading partners(b) Special attention deserves the rapid expansion of the network of currency swap lines built by theChinese central bank (PBOC) against those of many other trading partners to promote the expansion oftransactions settled in RMB, which have reached a level of about 600 billion RMB per quarter [Chart 37].Among them are the major trading partners of China, such as Japan, South Korea, Hong Kong, Argentina,Belarus, Iceland, Indonesia, Malaysia, Singapore, Russia, Kazakhstan, Kyrgyzstan, Tajikistan, Uzbekistan andothers. In January 2012, China has signed the first agreement with the United Arab Emirates (UAE) for 35billion RMB. The PBOC has special arrangements with the Monetary Authority of Hong Kong i.e., thecurrency swap agreement covers three years for a total of 200 billion RMB which has became the mostimportant center of settlement of RMB payments for non-residents [Chart 38]. At the end of June 2012,there are 18 agreements for a total of 1.6 trillion RMB, but progress is continuing with Chinas main tradingpartners, including the latest agreements with Brazil (with an currency swap of 30 billion US$). In countriessuch as South Africa the direct exchange RMB-Rand is cheaper than the triangulation on the dollar and itadds a competitive advantage especially to importers of textiles and artifacts that Chinese exporters offerat a discount in the case of payments in RMB (The Wall Street Journal, November 30, 2012).33 34. Less stringent rules of access for particular types of operators and capital transactions(c) A second set of reforms concerns the timid opening of the capital account to allow non-residents touse their RMB balances to make portfolio investments in Chinese assets. The first permits (August 2010)went to international banks involved in "cross-border settlement" allowing them to investment their RMBfunds in the domestic interbank securities market. In 2011 the RMB was allowed in transactions involvingforeign investments by Chinese companies and also investments into China by non residents. Specialconcessions apply to the group of Foreign Institutional Investors in Renminbi (R-QFII). These areintermediaries based in Hong Kong that can offer to non-residents a range of investment productsdenominated in RMB, both offshore funds and onshore (i.e., investment representing equity and debtsecurities listed in Chinese markets), although all of this is subject to an aggregate limit set by the PBOC.During the 2012 the limits and procedures for the use of the RMB were loosened. This follows the trend ofrecent years, as in the case of limits for qualified institutional investors (QFII) to acquire financial assets inthe Chinese market which increased from 30 billion to 80 billion US$). Based on 2011 data, foreigninvestors have used RMB for 10.8% of their total direct investment in China. On the other hand, Chineseinvestors have used RMB for 4.1% of their investment outside China (ODI).Further development of offshore channels to access the chinese financial markets(d) A key element in the internationalization of the RMB is the development of offshore channels to accessChinas financial markets: Hong Kong has emerged as the main center that allows China to build on theprogress made so far in the liberalization of its capital movements and payments and to advance the RMBinternationalization. This point was reiterated by Cao Yuanzheng (BOC) who pointed out that very few ofthe over 40 liberalization measures identified by the IMF for a full opening of the capital account have notbeen implemented so far [Chart 48]. They deal with existing restrictions in three areas: (i) the full openingof foreign direct investment into China (although the limits for investors and financial institutions havebeen further enlarged); (ii) the possibility for Chinese companies to borrow abroad, and (iii ) the opening ofthe Chinese capital market to non-residents. In any event, the first condition is perfectly avoidable throughthe Hong Kong market where non-resident investors can borrow in RMB and make direct investments inRMB assets (see below). 34 35. "Hong Kong SAR, China as the major offshore RMB market(e) Both the deepening of Sino-Hong Kong economic and trade relations and the emerging of Hong KongSAR, China as the major RMB offshore center are two important developments of this period. From 2004onwards the expansion of banking services on the market in Hong Kong has been relentless - from deposits,securities, loans, interbank markets and foreign exchange services in RMB for non-residents. Since 2010,Hong Kong is the key market to determine the offshore exchange rate spot and forward of the RMBagainst the dollar i.e., the CNH market, to distinguish it from CNY, the exchange rate determined in thedomestic market [Chart 39]. In addition, there is the RMB derivative market i.e., the Non-DeliverableForwards (NDF) which operates as a link between the onshore and offshore banking systems (which arenot free to interact directly) and which reflects market expectations on the evolution of the foreignexchange market [Chart 40]. Equally important is the bond market in RMB which sees the participation ofthe Chinese Ministry of Finance and of companies, without restriction (resident or non resident). Theinterest rates curves in this market move in parallel with the Chinese domestic market (with a spread) andit allows operators in RMB outside of China to manage the country risk (i.e., to operate in the Chinesejurisdiction) while taking the financial risk inherent to RMB assets and liabilities. 35 36. The "dim sum" bond market of Hong Kong(f) The case of the Hong Kong bond market in RMB - the "dim sum bonds" - is indicative of the potential ofthis offshore mechanism to raise RMB funds for direct investments in China at competitive prices. Althoughexpectations of RMB appreciation have been a limiting factor on the emissions by non-residents due tothe risk of incurring debt in a currency which has been steadily appreciating - the market has expandedrapidly thanks to low interest rates due to the high demand for RMB investment instruments in alternativeto deposits [Chart 41]. According to the Bank for International Settlements, at the end of 2011, RMBdeposits at off-shore banks in Hong Kong were in 588 billion RMB, about 10% of total deposits in HongKong, while the "dim sum bonds" reached 322 billion RMB. So this market can only benefit from adeepening of the financial sector and the strengthening of foreign exchange and interest rates markets, andmake an important contribution to foreign investment and to overcoming the current imbalances in theChinese economy.New rules for fixing the exchange rate RMB/US$(g) A third block of reforms concerns the mechanisms for fixing the exchange rate. After the period ofanchoring the RMB to the US$ during the financial crisis, in June 2010 the central bank (PBOC) announcedthe return to a regime of managed float with a fluctuation band of 0.5% daily around the central parity setby the PBOC against the US$. Such a fluctuation band has been widened to 1%, effective April 2012 [Chart42]; in any case, the band does not apply to other currencies whose fluctuations have ranged from 3 to 5%[Chart 43]. The comments of Prof. Fu Jun and Cao Yuanzheng (BOC) have pointed out that the flexibility insetting the exchange rate of the RMB has moved the exchange rate close to "equilibrium values" (6.3 RMBper US$), and that the maneuver of widening of the fluctuation band ensures the alignment of theexchange rate with market dynamics. It is worth noting that the exchange rate of the RMB appreciatedmore against the US$ than against the euro (30% vis--vis the US$ versus 25% vis--vis the Euro for March2005 to June 2012) and that the difference in volatility is significant [Chart 44].36 37. The 2012 exchange rates and speculative capital movementsII.10 The evolution of the RMB exchange rate was briefly addressed in the roundtable. The trendtowards the devaluation of the RMB in the first part of 2012 and its reversal - with the RMB appreciationstarting in September - was indicated by Cao Yuanzheng (BOC) as a market reaction to USA developmentsmore than to Chinas policies. This suggests that the weight of other factors, such as the slowing of theChinese economy (or the risk of a "hard landing") and the differential in interest rates [Chart 45], was notdeemed to be as important. It should be noted that during the reference period the PBOC reduced itsmassive market interventions/purchases of foreign currencies in exchange for RMB [Chart 46] i.e., thePBOC did not contrast the appreciation of the RMB - and left banks, businesses and individuals free todecide whether to hold or convert their Forex balances in RMB. It remains to be seen whether this is aturning point in the way Chinese authorities manage the RMB floating exchange rate. On the one hand, thedepreciation of the RMB until September [Chart 47] had the effect of partly rebalancing marketexpectations i.e., for a long time expectations were only focused on the appreciation of the RMB. On theother hand, the increasing role of market forces in fixing the exchange rates makes it even more urgent todeepen financial markets and address monetary policy issues related to opening up capital movements.Various interventions stressed the need to coordinate interest rates and monetary policy to preserveexchange rate stability for a country aspiring to give to its currency a leading international role. Thiscoordination becomes more difficult in presence of large surpluses of the current account as well asspeculative capital movements leading to the creation of large volumes of monetary base that the PBOCneeds to sterilize to avoid undesired side effects on inflation and asset bubbles. 37 38. 38 39. The impossible triangle of independent monetary policy, stable exchange rate and open capital accountII.11 The intervention of Bert Gochet (JPMorgan-Chase) highlighted the difficulties and risks ofaccelerating the opening of the capital account in the absence of parallel progress in financial sectorreforms - as China would face a situation of "impossible triangle" which was described by Robert Mundelland others (i.e., the inability to maintain an effective and independent monetary policy - and then to setthe desired level of interest rates and money supply while pursuing the goals of exchange rate stabilityand free movement of capital) [Chart 48]. Prof. Paolo Savona added that the premature opening of thecapital account could expose China to speculative attacks and even financial crises with unpredictable spill-over effects on the International Financial System. Further acceleration towards the internationalization ofthe RMB (e.g., full liberalization by 2015, as indicated in press declarations by some Chinese leaders) doesnot seem likely unless further decisive progress is made in the reform of the financial system i.e., toprovide transparency and credibility to the institutions and mechanisms that govern financial markets andRMB exchange rates.39 40. III. CHINESE INVESTMENT FLOWS AND THE ROLE OF EUROPEChinese investment flows into the European manufacturing sectors are on the riseIII. 1 The issue of Chinese foreign investment flows and the role of Europe were introduced by Prof.Alberto Quadrio Curzio who stressed the strategic approach of the Chinese sovereign wealth fund andobserved the revealed preference of China Investment Corporation (CIC) for a strong sectoraldiversification. He also emphasized the importance plaid by the codes and voluntary standards of behavior- "Santiago Principles" endorsed by the Chinese Government to address concerns of the internationalCommunity about the governance of companies participated by the Chinese State. In this regard, one cansee [Chart 49] that Europe is in third place among recipients of Chinese direct investment flows inproductive sectors, with 20%, of the total flows, compared to 43% for the U.S. and 30% for the APEC region.The observation was complemented by Prof. Sun Laixiang with reference to the 2011 data on ChineseOutward Foreign Direct Investment - ODI) which indicate a more positive picture. The Merger & Acquisitionportion of the ODI investment - which is 37% of the total ODI or about 60 billion US$ according to theMinistry of Commerce of China - has been directed towards Europe in almost 50% of the cases (i.e., 10.4billion US$ out of total flows of 22.2 billion US$) which marks an increase of 154% compared to 2010.40 41. The risk of Barriers to Chinese investment in Europe should not be underestimatedIII.2 Despite the encouraging signs, the remarks of Prof. Alberto Quadrio Curzio and Laixiang Sunstressed the risk of resistance or barriers to the entry of Chinese capital into Europe. This is an importantissue to be considered along with the barriers to a "fair and equal access" to the Chinese market forEuropean foreign investors in China, which is being investigated by the European Chamber of Commerce inChina i.e., the "European Business in China - Position Paper 2012/2013 was presented at the Italy-ChinaFoundation in Milan on October 5th. Andre Loesekrug-Pietri (A-Capital) pointed out that the EuropeanUnion has by construction less barriers than the U.S., where you need the scrutiny of an ad hoc committeeof the Treasury Ministry - The Committee on Foreign Investment in the United States (CFIUS). The point isthat, in the case of the USA, the mistrust is often rooted in Congress (i.e., the U.S.-China Economic andSecurity Review Commission) and it is particularly focused on SOEs that are in a position of monopoly in theinternal Chinese market and do not allow equal access of foreign investors into their domestic market(Chart 49-Bis). Also in the case of Europe there is some mistrust vis--vis Chinese investors that areassumed to be public or para-public by definition and not mainly driven by shareholders interest; in part,barriers are due to the complexity and diversity of European markets or other national factors that hinderinvestment flows and prevent them from reaching their potential.Europe is the Leading Destination of Chinese ODI excluding the Natural Resource SectorsIII.3 In this regard, Andre Loesekrug-Pietri (A-Capital) emphasized the growing strategic interest ofChinese companies for European technology and brands due to structural transformation of the Chineseeconomy. This can be a great opportunity for Europe as these investments could allow Europeancompanies to accelerate their development in the Chinese market as evidenced by the creation of hisfund (A-Capital) between the Belgian holdings SFPI and the Chinese sovereign wealth fund CIC. Globally,Chinese investments in manufacturing industries and high-tech mainly go to Europe (up to 95% in Q2 2012as an illustration), a trend which is currently masked by those investments that go to natural resourcedevelopment, which distorts the picture with their large size compared to the size of other acquisitions[Charts 50 - 51]. The latest data on 2012 Chinese investments in Europe show a growing number ofacquisitions in service sectors with focus on the UK versus a decline in Continental Europe - Germany inparticular. It remains to be seen if this is a shift away from manufacturing or simply a move driven by thelack of confidence in the Euro during the sovereign debt crisis of countries in the Euro Zone [Chart 50-Bis].41 42. 42 43. Co-operation strategies for competitiveness and the role of financial intermediariesIII.4 Concerning prospects for China-Europe investment relations, Prof. Fu Jun pointed out that it is inthe interest of Chinese companies to cooperate with European companies in order to compete in globalmarkets and provide a solid microeconomic foundation to the home development strategies implementedso far. Both real and financial sector can gain by cooperating across borders, for instance to promote theabsorption / transfer of advanced technologies as suggested by Prof. Giovanni Ferri. The point is thatboth Chinese and European companies can increase productivity and spur innovation to reach a highergrowth path, but they should follow market-based approaches and strategies and not rely so much ongeopolitical considerations. The need to overcome the vision of economic development as a "bubble" wascalled by Matthias Klein (Credit Suisse) who stressed the key role of banks and the risk of disruption causedby moving too rapidly toward market-based interest rates - while not having fully dealt with the legacyissues caused by the recent credit boom to local and regional government entities. He added that the mostlikely way for China to deal with this trade-off between short-run economic and financial stability andlonger-term growth potential - at least if the past is any guide - was to emphasize stability, which in turn,however, would limit the scope for aggressive financial liberalization in the short-run.Non-bank Intermediaries are bound to play a larger role to promote cross-border investmentIII.5 Prof. Ignazio Musu pointed out that the particular features of the Chinese financial system play a veryimportant role in the current transition of the Chinese economy - as in the case of the shadow bankingsector which is instrumental in accelerating the growth of private sector and SME that are neglected bylarge banks. These intermediaries play also an important role in mobilizing increasing portions of savingsthat provides absolute return to Households - as mentioned by Gloria Bartoli and are likely to play akey role in balancing the Chinese economy in the future. The point is that financial sector reform can speedup cross-border cooperation between Chinese and European companies as both banks and non-bankfinancial intermediaries can support investment flows in new technologies and ventures with Europeancompanies. In case of delays in liberalizing bank interest rates (i.e., preserving "financial repression")Chinese Households would have additional incentives to prefer Wealth Management Products supplied bynon-bank financial intermediaries i.e., to dis-intermediate the banking system. This would make theshadow banking system even more important in promoting Chinese companies cooperation strategies forcompetitiveness.43 44. 44 45. Diversification of Chinese foreign investment (ODI) and acquisitions on private markets are growingIII.6 The investment opportunities that China presents for Europe at this stage of its development aremanifold, in both directions, as noted by Bert Gochet (JPMorgan Chase) [Chart 52] and Li Yuefen(UNCTAD). An interesting element for a country like Italy is the growing diversification of Chineseinvestments outside the natural resource domain and the increasing activity of acquisitions of listed andnon-listed companies through private equity investment a sector in which Italy has been operating forsome time, as in the case of the Mandarin Fund. The joint action of Chinese financial institutions andcompanies to grow internationally is an element that can give new impetus to cross-border investment andpromote the development of Chinese ventures at the global level both in infrastructure and other sectors.In this regard, the President of the Italy-China Foundation - Dott. Cesare Romiti - stressed that Europeanand Italian SMEs - in particular - offer great opportunities for Chinese companies to acquire knowledge,brand names, and advanced technologies to excel in global markets - not only in the mechanical andmanufacturing sector: the common goal for Italian and Chinese companies is to cooperate internationallyby leveraging the rapidly expanding internal market of China and by enhancing the competitiveness ofdomestic production to meet the demand for goods and services of a population in rapid demographic andsocio-economic change.45 46. IV. OPEN QUESTIONS AND CONCLUSIONSIV.1The concluding section intends to recall the questions that the Round Table brought to theattention of the participants obviously leaving the conclusions for each and everyone to draw. Thefollowing comments are a personal interpretation in the light of the discussion of November 20th.A)Where is the Chinese economy going in the short, medium and long-term? The Chinese economy is slowing down. Is the deceleration structural or cyclical? How significantis the impact of the economic crisis? Does it depend on endogenous factors? What can we expectin the short, medium-long-term? What consequences for Italy and for the global economy?(A.i) In the short term the Chinese economy does not seem to present critical issues to achieve levelsof growth of about 7-8%. Less clear is the long-term outlook. The insistence of many commentators on thefact that the economy is at a "turning point" - for reasons that were extensively discussed brings twothemes into the spotlight: (a) the interdependence of China with the global economy and the strength ofthe recovery in the G7 economies - which remains high and fragile, respectively; (b) the success and timingof the Chinas transition policies to shift its economic system towards domestic demand - which remainuncertain to some extent. The most interesting aspect is the increasing role of private consumption in thedynamics of demand, which is otherwise dominated by the very strong growth of fixed investment insectors with high capital intensity all of which indicates that the main trends of the post-crisis periodremain in place. One could argue that there are components of the Chinese economy that continue toexpand capacity, despite the slowdown in bank credit aggregates as well as in the global economy duringthe latest period.(A.ii) In the long term, the economy seems likely to continue to generate large volumes of savings andstill depend significantly on external demand and / or demand for domestic investment in infrastructureto remain on its growth path. The unknown factor is the effect of large investment aiming at globalmarkets in the presence of a weak global recovery and strong, direct competition with other economies ofthe region. The risk of a slowdown in the tradable sector of the Chinese economy which carries a risk ofrapid obsolescence in the capital base of those sectors that dependent mostly on exports - cannot beunderestimated. Thus, the scenario of a persistent weakness in the G7 economies carries some risk ofindustrial crises with potential fall out effects on the financial system which cannot be underestimated.Other point of crisis can arise as a result of runaway investment by local governments. Continuing financialsector reforms is a key factor to minimizing these risks.(A.iii) The reasons for optimism about the long-term dynamics of the Chinese economy are linked tothe ample space for policy actions that can be put in place to manage the above long-term risks. Firstly,there are large margins of productivity gain, both in the "tradable" and "non-tradable "sectors that can bepromptly mobilized as result of market oriented reforms. Secondly, but most importantly, there are widemargins for fiscal policy intervention in a country with public accounts and balance sheets that remainrelatively robust compared to G7. It is up to the New Leadership emerged from the XVIII Congress of theCCP to decide about the pace and direction of reforms to stay on the target growth path i.e., to doublethe GDP in less than ten years and build a more balanced economy not just a larger one. The mainimpact of the new Chinese growth path on Europe and Italy seem to be positive, but subject to muchgreater selectivity and discrimination of larger Chinese investors. Potentially there are negative effects asChinese trade flows could slow-down and revert to more normal growth rates.46 47. B) What is the role of China in the international economy? Chinas global economic and trade share combined with a rising role of the Chinese currency in international settlements suggests a greater relevance of China in the global and regional arenas. What about Europe and the Euro?(B.i) The idea that China is on the way to reach 20% of global output and align its economic weight toits demographic importance seems tacitly accepted, but the challenge to "overcome the trap of middle-income countries" is unprecedented. Even more so for an economic system which remains unique in termsof public sector role and for the mix of market rules and direct government intervention in all echelons ofthe economy and society. The transition to a system governed to a greater extent by market mechanisms isbased on the ability to reform key sectors of the economy - such as the financial sector and social servicesthat are the backbone of most evolved societies both economically and socially.(B.ii) The increasing complexity and size of the economy is in itself a challenge for the current publicmechanisms to manage and control the economy the reference to the issue of corruption during theXVIII Congress of the CCP and the emerging of large unregulated segments of the financial system orshadow banking system highlight some of the issues faced by the new Chinese leadership. At thisdevelopment stage, there is mounting evidence that China needs to make a qualitative leap in itsdevelopment strategies and build more solid microeconomic foundations for expanding its industry andservice sectors - as pointed out by various interventions. This also includes assessing the global impact ofcontinued expansion of domestic and global production capacity. The race to control natural resources is aform of Chinese leadership at the regional level (Africa in particular) which presents a variety of criticalissues which China itself should consider beginning with the negative impact of its policies on the terms oftrade of the country and on the sustainable development of its regional partners. The integration of Chinainto the global trading system requires progress in the adoption and application of a system of rules andstandards to which China has acceded by entering the WTO and the Bretton Woods international bodies -and this is a key step to take an increasing role in the global economy.(B.iii) Europe is in a very favorable position to accompany the growth of the Chinese economy. Thediversification of official reserves and the opening up and internationalization of the financial system createopportunities for Chinese investments in Europe and for further internationalization of the Euro. Of course,the crisis in the Eurozone has cast a long shadow in the past months, but many concrete steps have beentaken to fully restore the Chinese confidence. However, it appears that Chinese investors are increasinglydriven by industrial strategies and sound, traditional project development, more than by geopoliticalportfolio diversification. The fact remains that the purchase of European government bonds (which areestimated at 800 billion US$) is well present in the strategies of both the State Administration of ForeignExchange and the CIC and the financial institutions participated by the Chinese government.47 48. C) What is the direction of reform of the financial system? The reform, as announced by Chinese authorities, is aimed at allocating resources in a more efficient manner, encouraging commercialization, increasing lending toward SMEs, formalizing the Chinese shadow banks. Banking sector risk arising from non-performing loans is actually the result of a close triangular relationship between State and local government finances, State- owned enterprises and State-owned banks. How will the reform address these problems? Will the next generation of leaders support or hinder the reform?(C.i) The attitude of the New Leadership towards financial reform needs to be fully assessed in the nextmonths, beyond declarations of continuity and irreversibility of the reform process. The keyappointments of policy makers in the coming months will give a better sense of the speed and direction ofreform. It is clear that the recent reforms are changing the working of the Chinese economy in ways thatare not easily reversible.(C.ii) The reforms undertaken so far as indicated by the round table discussion - are far reaching andwill certainly have a positive effect on resource allocation - if they continue at a steady pace. The keypoint is to focus the attention of the formal financial system on the needs of the private sector and theSMEs which - until now - have remained at the margin of the system or virtually excluded.(C.iii) The pragmatic attitude and openness to experimentation characterizing the reformsimplemented in recent years bodes well for what Chinese policymakers are doing to bring the shadowbanking system under some form of public scrutiny and regulation. The challenge is to adopt regulatoryand supervisory frameworks that do not hinder the growth on non-bank financial intermediaries capable ofintermediating savings for funding high-risk investment. In general, the issue of developing competitivefinancial services (i.e., to deepen the financial system) is clearly identified by the authorities as a litmus testfor continuing the expansion of a financial system that has already grown significantly compared to othercountries and to the level of development of the real economy. The further opening of the domesticmarket to foreign banks and their penetration in the "wholesale" markets are crucial steps to expand asector in line with the needs of the economy.D) What role for the renminbi - RMB - and for Chinese banks at the international level? The internationalization of the Chinese currency, the renminbi, is accelerating. However, the currency is not fully convertible as to capital account transactions: there is an inherent contradiction between an increasing international role of the renminbi and the restrictions to its use. Possible scenarios and opportunities for banks, enterprises and investors; Chinese banks are in the process of going global. Competition or cooperation with Italian and foreign banks?(D.i) Progress made in promoting the international use of the Chinese currency in recent months hasbeen quite extraordinary and points to further rapid spreading of RMB transactions for current accounttransactions - in line with the weight of China in world trade (which is 12 times bigger than the share oftrade settled in RMB at this point in time). Part of the success is due to generalized expectations ofcurrency appreciation - in the presence of structural current account surplus which may have increasedthe acceptance of RMB to settle the payment of exports to China, but this factor should not be overly48 49. emphasized as it may also have limited the development of offshore markets - given the reluctance of theinternational corporate to borrow in RMB. It is conceivable that advances in the management of theexchange rates and the approach of the RMB/US$ exchange rate to equilibrium values - as indicated byvarious Round Table participants - will lead to a further expansion of transactions in the Hong Kong marketsor in financial centers that are gearing up to handle "cash management in RMB" for partners and localbusiness of Chinese enterprises.(D.ii) Concerning the liberalization of capital movements, there has been progress, but the road seemsmuch longer and more complex. Among the critical factors are the role of speculative capital movementsand the difficulties of dealing with them in the absence of a deep financial systems i.e., they are neededfor an effective management of monetary policies by government authorities and risk management byeconomic and financial agents. An accelerated transition toward full liberalization has side effects on theconduct of monetary policy, making it less effective while pursuing the objectives of exchange rate stability as emphasized in the discussion. So the picture seems to evolve gradually, giving banks and investors onlylimited investment opportunities that emerge in the offshore centers such as Hong Kong in the first place.(D.iii) The internationalization of Chinese banks had a strong acceleration in recent times and forEuropean banks it is a new factor to be reckoned with in the future. The fields on which to developcooperation-competition are manifold - also due to the delicate phase of the European economies and themajor changes in the regulatory framework for international banking. The space left open by Europeanbanks could be occupied by Chinese banks that have a mandate, the capital and are now able toaccompany the Chinese corporations in the process of internationalization. While this makes Chinese bankspotentially formidable competitors, on the other hand, the challenge to grow in international marketsinvolves entry into business areas in which they serve sophistication and expertise that today Chinas bankshave not yet fully acquired and then you can open up space for collaboration.E) What are the business prospects for international investors? China has been witnessing a transition from a production, procurement and exportation platform to a market for goods and services. Today it is gaining relevance as a source of foreign direct investments, and as a market to attract capitals via listings and bond issuances. How can we raise awareness on these opportunities?(E.i) Progress in reforms is changing the competitive framework of public and private Chinesecompanies, favoring a widening of agents who look to Europe with renewed interest. Hence the need topay greater attention on the part of foreign investors to the multiplicity of Chinese entities that arecurrently looking at international markets in search of technologies, "brand names", skills and alliances tostrengthen their market position, especially in domestic, but also International markets. The possibility forEuropean companies to access the Chinese capital markets to raise capital is certainly interesting, but itseems a topic for the long-term, if not for those already present in the Chinese market. Improving thecommunication business-to-business is a strategic objective for those companies that see look at newmarkets and opportunities with Chinese partners.Milan, January 14th, 201349 50. Tavola 1: CRESCITA DEL PRODOTTO INTERNO LORDO PER TIPO DI SPESA (2009-13)GROWTH OF GROSS DOMESTIC PRODUCT BY TYPE OF EXPENDITURE (2009-13)Fonte / Source: Goldman Sachs, Economics Research, Asia Economic Analyst, China shiftingto a lower gear, September 20, 2012;50 51. Tavola 3: INDICATORI DI SVILUPPO DEL SETTORE FINANZIARIO 2005 2010DEVELOPMENT INDICATORS OF THE FINANCIAL SECTOR - 2005 - 2010Fonte / Source: IMF-World Bank, Financial Sector Assessment 2011 51 52. Tavola 4: INDICATORI FINANZIARI 2005 2010 / FINANCIAL INDICATORS - 2005-2010Fonte / Source: IMF-World Bank, Financial Sector Assessment 2011 52 53. BIBLIOGRAPHYA-CAPITAL, Andre Loesekrug-Pietri, The Dragon Index, November 2012;ADBI, Asian Development Bank Institute, Yu Yongding, Revisiting the Internationalization of the Yuan,Working Paper 366, 2012;Bloomberg News, China Picks Wenzhou for Small-Business Funding Experiment, March 28th, 2012;Caixin Media, Zhou, Xiaochuan, Special Intervieweverything about the renminbi, Century Weekly,January 2, 2012;CIC, China Investment Corporation, Annual Report 2011;CICC, China International Capital Corporation Ltd., China Economy Research, November 6, 2012;CSEC (China Securities Regulatory Commission), Annual Report 2011;Euromoney Bank of China, The 2012 Euromoney Guide to China Cash Management, June 2012;Euromeney RBS, Renminbi convergence, is it inevitable and what are the risks? May 2012;Financial Times, Kathrin Hille and Rahul Jacob, Beyond the conveyor belt, October 15, 2012;Financial Times, Neil Buckley, Beijing Targets European Shift, November 9, 2012;Financial Times, China Special Report, December 12, 2012;FSB, Financial Stability Board: Global Shadow Banking Monitoring Report, 2012;Global Finance, Laurence Neville, China in Europe, May 2012;Goldman Sachs, Economics Research, Asia Economics Flash, China: Cooling off: The drivers andimplications of CNY hot money outflows; October 8, 2012;Goldman Sachs, Economics Research, Asia Economic Analyst, China shifting to a lower gear, N.12/16,September 20, 2012;Garcia-Herrero Alicia, D.Santabarbara, Is Chinas Banking Sector Promoting its Economic Development:An Assessment of an Unorthodox Banking Reform, Paper presented at the Workshop on China FinancialMarket and Internationalization of the RMB, Helsinki, September 17-18, 2012;HKIMR (HONG KONG INSTITUTE FOR MONETARY RESEARCH), Dong He, Renminbi Internationalization: APrimer; July, 31st, 2012;ICBC, Urban Finance Research Center, Fan Zh