Balancing financial risk and progress

Developing a successful finance sector will depend on innovation backed by sensible regulation

China has achieved phenomenal economic growth over the past 30 years and during that time it has learnt many valuable lessons from both developed economies and other developing nations.

At the same time, the country has a long, rich history and has learnt considerably from its own successes and failures.

Chinese leaders understand the importance of financial markets and cleverly started designing, creating and regulating financial markets many years ago. Now that China has accomplished its first phase of economic growth, it seems to be turning to finance to catapult itself to the next stage.

But there is no doubt China has to, and probably will, keep learning from the rest of world, too, when it comes to financial markets. Its people are smart enough to know that instead of simply copying existing institutions or products, it has to learn about the fundamental principles and mechanisms of its own financial system, and not just rely on short-term market fixes.

Behavioral finance and economics are particularly important to the current Chinese financial markets, which have achieved unprecedented growth in the past couple of decades.

But such learning can be difficult, and involves both individual learning and cultural differences.

Individual learning is not only about how investors learn about products, but also about ability.

Cultural learning, perhaps even more important, is about how society and markets learn from their history.

Only if a society learns from its own mistakes can it ensure it does not repeat them.

For example, many state governments in the United States defaulted on their bonds during the 1840s, causing many to pay closer attention to the fiscal soundness of local government, especially state-level administrations.

That set a precedent and to this day many government constitutions in the US require that state government be careful with its borrowings.

Frequently in the past, the problems and crashes have set important lessons for society and proved beneficial to long-term growth.

After the creation of the People's Republic of China in 1949, China severed its ties to capitalism and capital markets for about 30 years and effectively whatever had been learnt in history was lost, as was much of its recent cultural learning.

As a result, all of its early financial investors, participants and regulators had to learn from scratch.

The Chinese economy and financial markets have to be prepared to go through cycles or even bubbles and busts, and accept them as inevitable stages from which to learn.

To make things even more interesting, the entire global monetary and economic system is now undergoing a period of fundamental shift.

Stalled by each of their own sets of fiscal problems, developed economies such as the US, the European Union and Japan have all been busy solving their own problems.

At the same time, these domestic policies have considerable repercussions on the rest of the world, most notably emerging economies that rely heavily on exports and foreign capital investment.

There have been some concerns in China, and some other emerging economies to a lesser extent, that developed economies are trying to suppress the rise of the emerging economies.

In particular, there is a growing feeling in China that the US is waging a "financial war" on China.

China has many reasons to be seriously concerned with US monetary and fiscal policy, given that China holds a large amount of US treasuries and government agency debts.

Of course, we can ask all kinds of questions about why people do certain things.

Sadly we cannot see inside the mind of the chair of the Federal Reserve, Janet Yellen, to get the answer to the above.

But clearly a game is being played between the countries, using politics, economics and finances.

However, we do have to realize that the US Federal Reserve is responsible to the US Congress, which has set out some very clear policy mandates.

The Fed's mandate is independent from the US government, and promoting the country's international political and economical status is not among the Fed's remit, at least not to my knowledge.

Of course, it is perfectly feasible that the Fed's governors think about such things when making their decisions.

However, it is hard to see how they could personally benefit from such "conspiracies".

China has every reason to feel concerned with US policy, but consider this: $2 trillion (1.46 trillion euros) would represent just one to two months of US GDP - so I really question whether it would be worthwhile for the US to engage in such a conspiracy.

Instead of blaming the US for its irresponsible monetary policy, China would be better to modernize its own financial system through financial innovation and come up with policies that the US would have to respect when making its own foreign and monetary policies.

Unlike many innovations in technology - such as those made by Apple, for instance, or Tesla, which produces electric cars - people do not get particularly excited about financial innovation.

Culturally, people like innovations that have a "wow" factor, and unfortunately financial innovation rarely creates such excitement.

Add in, too, that people often do not really understand financial innovation, and as a result have become hostile and suspicious about it.

People like innovation that can bring them instant, tangible benefits, and here again financial innovation can fall short. The benefits of many financial innovations can simply be too hard to quantify.

Many are long term, such as those aimed at retirement, and people find them hard to connect with - after all, hedging and a reduction in a portfolio risk is never going to be as exciting as a Tesla roadster.

As a result, few are genuinely interested in financial innovation, even though it can bring fundamental changes for the better, to society, an economy, or a financial system.

Be it shadow banking or Internet financing, both very popular in China, an important motivation for financial innovation is to circumvent regulation.

Financial regulation is still strict in China, and a lot of reform is needed, and this may explain why financial innovation is a massive growth area that could transform the regulatory landscape.

On the other hand, one has to bear in mind that financial innovation is particularly prone to risk because it can sometimes fall outside traditional regulatory boundaries.

I hear that some shadow banking products in China are already experiencing rising default levels.

This is exactly what happened during the 2007-08 housing crisis in the US.

The key is whether investors themselves are aware of investment risk, and whether they are protected properly.

Some risks may seem distant, but that does not mean they do not exist. So called long tail risk events can be the riskiest of them all.

Pushing forward financial innovation, without incurring substantial and systematic financial risk, may well be critical to Chinese economic reform, and its development in the decades to come.

The author is a faculty fellow at the International Center for Finance, Yale University, and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. The article is based on his conversation with Professor Robert Shiller of Yale University, the 2013 Nobel Laureate in Economics. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 07/04/2014 page10)