China's Financial Markets: What They Need

While China's manufacturing sector booms and people sock away money in savings accounts, the country's financial markets remain in their infancy, according to international finance experts who gathered at the recent 2008 Wharton China Business Conference.

That partly reflects the realities of economic development -- the so-called "real economy" tends to develop in advance of capital markets . Once an economy takes off, as China's has over the last several years, creative financiers start to figure out ways to fund investments, distribute gains and share risks. Yet the relative underdevelopment of China's capital markets also reflects the biases of its powerful central government.

"Chinese regulators are comfortable with the real economy," said Vincent Duhamel, managing director at Goldman Sachs Asia GS. "They are less experienced with financial markets." Ideally the regulators should act only as referees, and allow the market to innovate, "but they are not comfortable letting the market do its own work." Duhamel doesn't see the "financial markets in China developing quickly. For now, there are too many regulatory restrictions, and liberalization is off the table because of what is happening in financial markets in the rest of the world. The subprime crisis has been a cold shower for them."

Even a widely perceived Chinese strength -- the country's massive foreign currency reserves -- reflects the underlying weakness of the financial markets, said Jennifer Amyx, a University of Pennsylvania political science professor. China lacks the financial infrastructure to internally deploy the huge sums of money that its exports are generating.

The Chinese government has therefore begun to invest part of these reserves abroad via the China Investment Corp., a sovereign wealth fund. While some U.S. commentators view the fund as a way for China to flex its new economic muscle and undercut the U.S., Amyx suggested that such notions ignore China's economic realities and historic boom and bust cycles.

China isn't the only country that has recently built up a trove of foreign exchange reserves, and it isn't the only one that has created a sovereign wealth fund to handle them, she noted. A number of Middle Eastern oil exporters have them, too. "At $1.4 trillion, China's foreign currency reserve is huge," Amyx conceded, "but for many years, it was Japan that was buying U.S. Treasury bonds with its foreign exchange reserves." At the time, some U.S. commentators fretted that Japan was, in effect, becoming the financial master of the United States. But those sorts of doomsday predictions never came to pass. Instead, in the 1990s, Japan's economy entered a long slump.

Holding Investors Back

Another reason why fears of China's fund may be exaggerated is that Chinese officials have not, so far, shown themselves to be the world's most sophisticated or aggressive investors. They keep most of their country's foreign exchange reserves stashed in stodgy, safe U.S. Treasuries. And while the China Investment Corp. has recently made riskier forays into the U.S. stock market, some of them haven't fared well. The fund, for example, invested $3 billion last year in the initial public stock offering of the Blackstone Group BX, a U.S. private equity firm. Blackstone's stock price has fallen by nearly half since then -- a development that has made the fund even more cautious, Amyx said.