November 2014 will be marked in the history books of the Australia-China economic relationship by two events: The signing of the Australia-China free trade agreement, and the opening for trade of the new Shanghai-Hong Kong Stock Connect.
Though ChAFTA has received pages of coverage, relatively little attention has been accorded to the Shanghai-Hong Kong exchange. Yet, both events are significant milestones in further economic and financial deepening, and both will require new modes and mechanisms for interacting with each other in the future. Both hold answers to a key question: How will the China-Australia relationship continue to deepen and build a future of prosperity in both nations?
What ChAFTA and the Shanghai-Hong Kong Stock Connect have in common is the potential to add exponential growth to Australia’s banking and finance connection with China, in addition to the already massive connection in trade. As was extensively quoted in the media frenzy around ChAFTA, two way trade between China and Australia is $150bn, or nearly 30% of the total value of all trade from Australia. Australia is China’s largest single source of iron ore, and its second largest destination for Chinese students studying abroad.
While the expansion in trade has added tremendous growth and income to the Australian economy over the past decade at the macro level, let us recall a few key facts. First, at least 70% of the Australia’s gross domestic product is generated by services and not by the production (or export) of goods. Second, the banking and financial sectors accounts for just under 9% of the gross value add of the economy, making financial services the largest industry in Australia. Third, banking and finance are a very significant employer in the economy, outpacing employment in both agriculture and mining.
On the Chinese side, there is a clear priority to rebalance the economy away from low value add and heavy manufacturing (and polluting) industries, and toward increased consumption including of services. The rebalancing is starting to take hold, but further reform from the opening of trade in services can help to accelerate the change – just as was the case with the huge swathe of domestic reform that accompanied China’s entry into the WTO more than a decade ago.
By the time China hosts the G20 in 2016, it would be great to be able to report that China accounts for far more than the 3.4% of the stock and more than 10% of the flow of foreign investment into Australia, as is currently the case. And that Australian firms – banks, fund managers and insurance providers – can likewise grow through increased access to and investment in the Chinese economy.
But the reasons why two-way investment between Australia and China lags trade is not only due to bilateral factors. Regional and institutional blockages abound, and these must be taken into account by both China and Australia, as well as our other economic partners in the region. As the “top and tail” in the Asia Pacific region – and the only Asia Pacific based countries to be two-time hosts of the G20 so far this century – Australia and China have a special role to play in considering banking and financial policies across the region in the leadup to China’s hosting of the G20 in 2016.
For thought, I offer three observations on the ability of our nations to invest in each other, and in the growth of the Asia Pacific region overall.
Observation 1: The overall availability of credit in Asia Pacific is robust, and is not hindering growth in our region. Unlike in the US and Europe, the post-crisis economic recovery in much of the Asia Pacific region has been credit-intensive, to the point where total outstanding domestic credit as a share of GDP across Asia has recovered back to pre-GFC levels, and remains on a strong upward trajectory.
China has led the region in this regard, with total outstanding domestic credit rising by more than 200% since 2008 to stand at just over CNY100 trillion, or 169% of GDP. This puts China now on par with Australia (160% of GDP), Korea (158% of GDP), Malaysia (149% of GDP) and others.
Note that this means that China now has the largest domestic credit market in Asia, holding 42% of the region’s outstanding domestic credit as against 32% for Japan, 6% for Australia and 5% for Korea.
Observation 2: Although there seems to have been growth in credit in the major economies of Asia, relatively little of it is available for investment or risk management purposes outside of the banking system because of a persistent lack of financial depth in the Asia Pacific.
The excellent database on global capital markets compiled by the McKinsey Global Institute continues to show that Asia’s financial stock is only 25% to 50% of the stock that is available in the US or Europe – well underweight relative to Asia’s share of global GDP or its share of global trade.
To be clear, it is not in the equity markets where have an issue – the size of equity markets in Asia are on par with Europe as a share of GDP. Rather, the deficit is due to a lack of securitized and tradeable debt – government debt, financial bonds, corporate bonds and securitised loans.
What this means is that the vast majority of credit in Asia is held on the balance sheet of banks – leaving banks with the huge role of intermediating virtually all credit across our region. It also means that households don’t have a lot of choice of investment outside of equities, with little access to fixed income as an asset class. And it means that it can be difficult for firms in Asia to use fixed income type instruments for risk management – for example, for the purposes of hedging their own liability exposures.
So although the amount of credit available for productive economic investment in the Asia Pacific is now at 170% of GDP, the tools are not available to buy, sell, trade, swap or hedge these liabilities in a liquid market. Imagine if the supply chain for auto parts was similarly ring-fenced at national boundaries! Aging populations also have very little access to debt products, which are so important in a pension or annuity portfolio.
Observation 3: Informal, non-traditional and unregulated financing channels are opening for firms in China, and Australia – and across the whole region
As was underlined at the Asia Microfinance Forum in Shanghai earlier this year, small and medium sized businesses in China do not have the level of access to the formal banking market that they need to grow, and to support China’s economic rebalancing. Total assets in the formal banking system are CNY76 trillion, as against CNY30 trillion of assets in the shadow banking system and CNY8 trillion in the informal lending market – meaning that half of all credit creation in China is happening outside the formal banking system.
And much of that credit creation is happening in the digital space.
When we speak about the shadow banking system in China, it is often with reference to off balance sheet vehicles and trust companies that invest in the property market. In fact, shadow banking by definition is the creation of credit by individuals or firms that are not subject to regulatory oversight.
In China – and across Asia – this includes the massive growth of peer to peer lending platforms and other forms of digital finance. We have to ask ourselves how long it will be before the digital payment systems that we see springing up – whether Alibaba (AliPay), Paypal, Bitcoin and etc – become global credit providers as well as global payment systems. How do we accommodate the growing role – and borderless nature – of digital finance in our economies?
As an aside, here in Australia we are also seeing a huge divergence in bank-generated business credit to small and medium sized versus large businesses. According to APRA data, since 2006 there has been a doubling in the volume of loans in size of A$500,000 or more – the size of loan that would likely only be supported by a relatively large business. On the flip side, there has been very low growth in the volume of loans under the A$500,000 mark.
Of course, small and medium sized firms are critical to the health of both of our economies. Our SMEs are known to be the key drivers in terms of generating employment, bringing innovation and the creating household and inter-generational wealth. In Australia, SMEs account for at least 70% of all employment across the economy, but surveys of the sector have indicated many entrepreneurs fund themselves through personal savings, credit card debt or home mortgages. This is a development worthy of further investigation and study.
As we look to the future, opportunity abounds.
The Australian business community will no doubt welcome the FTA, including in the banking and finance sector. The potential for partnership in growth presented by China’s rising services sector and its ongoing financial deepening and capital account opening are immense.
Interestingly, the “size of the prize” estimate of how much this may be worth to the Australian economy does not yet seem to have been fully scoped – a worthwhile exercise for Australian economists, who should provide as much rigour, energy and advocacy to the opening of trade in finance and financial services as they have done with trade in primary, intermediate and final goods over the past 30 years.
Opportunities for collaboration exist not just in the banking sector, but also in the areas of wealth management and insurance. The health sector is often nominated as a favoured area for increased investment in China to kick-start its next phase of growth – contributing to growth, jobs, improved access to quality care and longer life expectancy. Australia’s experience with funding a public-private model of health care – including its mix of public benefit and private insurance – is informative. So is our experience in risk management for asset and disaster insurance.
In the financial markets, our firms have much to gain from greater sharing of knowledge, platforms, systems, capital and risk. As an example, Australia has expressed interest in hosting an RMB trading hub, but this is only the tip of the iceberg in terms of the areas for development that we can work on together. Creating the mechanisms that will allow debt to be tradeable and investable between our two countries and across the region are critical, both for risk management and for investment as our populations age.
On a wider scale, I would like to make the rather audacious suggestion of an initiative to develop an Asia-based banking and finance secretariat or organising body where the agenda for both regulation and reform is developed and lead by policymakers in our region.
Within the G20, Australian policymakers and regulators have supported the implementation of Basel III and the expanding role of the Financial Stability Board, which serves under the auspices of the G20. Mike Callaghan has recommended an evolution of the FSB toward a proper and permanent secretariat, an appropriate step forward that should continue as a topic within the G20.
Nonetheless, the regulation coming out of Europe still will not and should not mean much for the majority of Asia’s economies or its banking and financial ecosystem. Our very able-bodied and highly competent regulatory community in the Asia Pacific already collaborates well across the region, and with global counterparts. The issue for us is the nascent state of many elements of our cross-border financial and capital markets, and the wildly divergent level of economic development amongst the countries in the Asian time zone.
An Asia-based banking and finance secretariat or regional body could play an important role in interpreting global regulation in the Asian context, and leading initiatives and reforms that speak to Asia’s unique needs. Such a body could be attached to APEC or to the ASEAN+ community, or it could be a standalone initiative.
Either way, we need a vision. And we need an informed approach and fact-based policy dialogue on the issues of credit creation and allocation across our region, of financial market integration and efficiency, of the challenges of the digital age and on evolving markets such as the pricing of commodities or even carbon in the Asian region…
Perhaps something to think about – and prepare for – for China 2016.
By Amy Auster, Principal Consultant, FDC
Based on presentation notes prepared for the Chinese Academy of Social Sciences and the University of Queensland’s Asia Pacific Forum – Economic growth in the Asia Pacific, November, 2014.