Research on Financial Deepening in Developing Countries and the Development of China's Financial Market

Author: Cheng Kun / Country: Mainland China
Publisher:
Publish Date: 2005-12-01
Features: Before the 1970s, financial regulation was a common phenomenon in countries worldwide. After the 1970s, many nations launched fervent financial liberalization reforms, aiming to drive economic growth through financial development. However, financial liberalization yielded different outcomes in developed and developing countries. On one hand, developed countries witnessed thriving modern financial innovation, with efficient financial markets fostering high-tech industries. On the other hand, over the past two decades, developing countries from Latin America to East Asia experienced consecutive financial turbulence and crises, leaving their economies in turmoil. So, where did the financial liberalization reforms of developed and developing countries go wrong? What are the objectives of financial liberalization? To address these questions, this book, based on existing theories and national practices, employs modern financial and economic research methods and tools to propose and argue the theory of gradual financial market development. The research aims to achieve three objectives: (1) To explain the relationship between financial development, financial deepening, and modern financial innovation in terms of understanding; (2) To demonstrate the correctness of McKinnon’s "sequence of economic marketization" (i.e., primarily gradual financial deepening) in the context of developing countries through their practices; This paper preliminarily proves theoretically that gradual financial deepening is determined by the intrinsic requirements of gradual financial market development, thereby refining the theory of financial deepening and highlighting that the primary goal of financial liberalization reforms in developing countries (gradual) is to establish, develop, and improve financial markets, otherwise financial instability and crises are inevitable; (3) To apply the theory of gradual financial market development to propose strategic recommendations for China’s financial reforms. Financial development theory is the study of the interrelationship between financial development and economic development, as well as the promotion of economic growth through financial development. This paper analyzes theories on financial development and economic growth from classical economics to modern financial innovation in chronological order, revealing that: (1) Financial development is a comprehensive concept encompassing financial deepening and modern financial innovation. (2) There is a common pattern in financial development worldwide, with different stages of economic development characterized by distinct financial development content and features. While financial liberalization reforms in developed countries led to modern financial innovation due to mature traditional financial markets, developing countries, with underdeveloped and fragmented financial systems, primarily experienced financial deepening. In 1973, McKinnon and Shaw independently proposed the theory of financial deepening, which argued that government financial repression in developing countries created a vicious cycle of finance and the economy, and these countries should undergo financial liberalization reforms to allow financial markets to freely allocate resources, thereby promoting economic growth. At the time, both McKinnon and Shaw advocated for radical financial liberalization. Rapid financial liberalization reforms in Latin American countries during the 1970s demonstrated the failure of the financial deepening theory. Later, after persistent efforts, McKinnon finally proposed the concept of gradual financial deepening in the early 1990s. Gradual financial liberalization reforms in East Asian developing countries during the 1980s achieved certain successes, but they accelerated financial reforms in the 1990s, leading to financial crises. The theory of gradual financial deepening could not adequately explain the East Asian financial crises, and its policy recommendations lacked sufficient persuasiveness, revealing theoretical flaws. Logical reasoning shows that if a developing country’s financial market is imperfect, financial liberalization cannot effectively allocate resources, and may even lead to misguided resource allocation. Therefore, the primary goals of financial liberalization and financial deepening are to establish, develop, and improve financial markets. A review of developing countries’ financial markets reveals their rapid growth but imperfections or severe imperfections. Using the 1990s’ new theory—the "financial risk zone" theory—this paper demonstrates that both credit and securities markets in developing countries objectively exist financial risk zones, with their size determined by the degree of market imperfection. Under such conditions, unrestricted capital account convertibility will inevitably lead to financial instability and crises. Research on the 300-year history of financial market development in Western countries shows that their markets underwent a long, gradual process of liberalization—legalization and standardization—reliberalization. In contrast, developing countries’ financial markets were strictly regulated from the outset, lacking sufficient development through free competition. After liberalization, even if markets and regulations were established in a mimicry-like manner, market participants were unfamiliar with market rules and legal frameworks, resulting in low transparency, inefficiency, and imperfection. Market development must proceed gradually, during which corresponding rules are established, and market participants and regulators adapt through repeated bargaining and full coordination, ultimately developing into a mature financial market. The gradual nature of financial markets determines the gradual nature of financial deepening. During financial liberalization, it is essential to relax controls while strengthening legislation, judicial oversight, regulation, and market supervision mechanisms to accelerate market development. With the implementation of economic reforms that decentralize power and benefits, China’s financial market emerged, centered around the theme of financing for state-owned enterprises and the government. The Chinese government demonstrated strong control over financial market development, leading to a gradual development path. China’s financial market has supported its economic reforms and rapid growth. However, due to China’s approach of tackling easier issues first and avoiding difficult ones, the current financial market remains incomplete under government control, making it difficult for the non-state sector, which contributes most to the GDP, to access this formal market. Meanwhile, state-owned enterprises lack the basic credit conditions for repaying principal and interest. Thus, China’s financial market is not truly a market yet. Further market development must address (or gradually resolve) more substantive issues, such as granting state-owned enterprises independent legal property rights, diversifying the equity of state-owned financial institutions, allowing non-state economies to freely enter the formal financial market, facilitating equity liquidity in state-owned holding companies, and improving the government’s revenue levels, all aimed at developing a complete, fully competitive financial market. Interest liberalization can be phased in over five stages to gradually relax controls. Capital account convertibility should be controlled until domestic financial markets are sufficiently developed. An effective financial regulatory system and market supervision mechanism should be gradually established, and financial regulatory authorities must strictly oversee the market, removing insolvent institutions in a timely manner to ensure the healthy development of financial markets.