In a surprise announcement, the Chinese Ministry of Finance declared on Friday that it will henceforth allow foreigners to own Chinese banks outright and gain majority stakes in insurance and securities firms. While dramatic, this isn’t China’s first effort to open up its economy to outside expertise and competition. If they want this one to succeed, officials will need to do more than hang out a “for sale” sign.

Ever since joining the World Trade Organization in 2000, China has continued to promote gentle but sustained measures to liberalize its economy. Early on, the government welcomed investment in garment factories and electronics assembly -- light-industry sectors which didn’t infringe upon the state’s main interests.

Eventually, though, foreign investors sought to buy into industries that the government and managers at big state-owned enterprises considered sacrosanct. Resistance stiffened in sectors such as autos, heavy-industry manufacturing, technology and banking. Where the government did allow foreign investment, it typically required buyers to form joint ventures and share technology with local partners, and to make majority capital investments in exchange for minority stakes.

Foreign firms understand that even if they provide the key technology and capital, they still won’t be allowed to control those joint ventures. They also complain of an opaque market in which the government continually rewrites regulations to suit its purposes. As at least one trading firm has noted, officials carefully promote “reforms” that can be adjusted easily whenever regulators desire. After a spring agreement between China and the US to allow Visa and Mastercard into the Chinese market, for example, it came out this week that the two companies are being blocked from operating wholly foreign-owned entities.

President Xi Jinping has moved strongly to reassert state control over the economy. The government has installed Communist Party committees above management and directors even in foreign firms. When foreign companies do invest in China, they often suffer unfair attacks -- such as the annual state TV programs that highlight their supposed misdeeds. Such practices have dampened the ardor of many. Since 2008, foreign direct investment into China has been growing at a paltry 2.4 percent annualized.

China certainly has much to gain from opening up its financial sector. An influx of foreign money and talent could ease the bad-loan burden at smaller banks, increase efficiency and improve the allocation of capital. But officials need to understand that foreign investors are no longer enamored of China. Years of nationalistic business policies, combined with slowing growth and rapidly rising costs, have eroded China’s primary competitive advantages. Wages are now high relative to productivity. Office space and real estate are expensive even by global standards. For many investors, India and other frontier markets offer lower prices and friendlier business environments.

To entice them into its financial sector, China needs to evolve its legal and regulatory structures. Right now, virtually all banks are owned by the state and run as piggy banks for state-owned enterprises and local governments. Despite talk of reform, the vast majority of capital is channeled into politically preferred firms and industries.

If foreign banks are going to acquire Chinese banks, insurance or securities firms, they will want a clear understanding that they can limit their lending to financially viable projects; they’re unlikely to invest simply to bail out state-owned companies. They will also want to see that the politicization of China’s legal system is slowed and eventually reversed, so they can be assured that their investments are properly protected.

Finally, years of lax financial controls will haunt China unless swiftly remedied. There have been widely acknowledged problems with financial reports in both the private and state sectors; investors will naturally be suspicious of any data they’re given on potential acquisition targets.

In the past, China has bristled at Western short sellers targeting Chinese firms and has blocked investigations into accounting irregularities or sued to stop negative reports. Yet these basics form the foundation of any modern capital market. China should instead be seeking to nurture high-quality accounting and auditing industries that can win the trust of outside investors.

There’s no doubt this is a bold move -- and a welcome one. But research has found that market reforms work best when accompanied by other, supporting measures to increase transparency, predictability and efficiency. If Chinese banks and other financial companies remain politicized and plagued by accounting irregularities and arbitrary regulations, it won’t matter where their new owners come from.


By Christopher Balding

Christopher Balding is an associate professor of business and economics at the HSBC Business School in Shenzhen. -- Ed.


(Bloomberg)