October 18, 2005
JS-2975

Remarks by Secretary Snow to the Securities Industry Association

Good morning and thank you for having me here today.  As you know I've just spent the last week traveling through China and in meetings here in Beijing with economic officials from the Group of Twenty leading economies and with my counterparts in China's economic leadership.  I'd like to thank my good friend, Ambassador Sandy Randt and his excellent staff here in Beijing, and also in Shanghai and Chengdu.  We always receive first-class treatment when we visit, and it is greatly appreciated.  I would also like to thank our Chinese hosts, especially Minister Jin at the Ministry of Finance.

Finally, I would very much like to thank Marc Lackritz and the Security Industry Association for inviting me to speak at your meeting today.  The themes of financial services modernization and capital market development are ones I have focused on during this visit to China, so the timing of this meeting is perfect.

Traveling through China one cannot but be impressed with the rapid rate of economic growth that this nation has been able to achieve.  China's drive toward a fully market-oriented economy is showing results even in some of the further reaches of the country.  We have long held that allowing the private sector to thrive is the best way to raise living standards.  Perhaps nowhere in history has that notion been proven more dramatically than here in China where in the span of a handful of years, hundreds of millions of people have seen their living standards rise above the poverty line as Chinese authorities have been unleashing restraints on private initiative so that the Chinese people can meet their great potential. 

Before arriving in Beijing I visited Shanghai, the financial capital of China on the coast, the city of Chengdu, located in the western province of Sichuan, and a small town, Mulan, about an hour outside of Chengdu in Sichuan. 

In Shanghai I had the opportunity to meet with businesspeople who have established firms here and leaders of financial institutions.  I had excellent discussions with officials from China's Foreign Exchange Trading System and at the Shanghai Stock Exchange.

In Chengdu, we were able to get a sense of the penetration of economic reforms in China.  I suspect that if one had visited Chengdu ten years ago, it would have taken a leap of faith to predict seeing five-star hotels, western brands like Cadillac and Nike, and Starbucks….well, OK, maybe Starbucks!

But it's clear that the economic reforms are quickly transforming the landscape of this great nation.  The town of Mulan, a small rural village in Sichuan, has not yet seen the full power of the market economy in its daily life, but I think that is only a matter of time.  The people of Mulan are clearly anxious for the good things that greater growth and prosperity make possible. 

Certainly it is Mulan, and thousands of towns like it, that occupy the thoughts of China's economic leaders today.  They recognize that China's great challenge is to make the country's economic growth more balanced and sustainable.  The failure to do so will have wide-ranging implications for the Chinese people – and also, in this interconnected world, for the global economy as well.

Most of the attention involving the U.S. economic relationship with China has focused on the narrow issue of exchange rates.  China's foreign exchange regime certainly is important, and it's an issue that we have devoted a great deal of attention to with our Chinese counterparts.  Our views on this by now are well known: China and the global economy will both benefit from greater currency flexibility.  Greater currency flexibility would increase – not decrease -- stability in output prices and will assist in the adjustment of imbalances in Asia and the global economy.  But China's foreign exchange regime is just one of many economic and financial issues that would contribute to this goal.  As I have said, greater currency flexibility is a necessary element of reform, but insufficient alone to bring global trade and financial flows into appropriate alignment.

This morning, I would like to spend some time discussing how greater access to financial services and robust capital markets can help China achieve the balanced, sustained growth it desires and why this is important for the global economy.

* * *

China's leaders have committed to pursue financial market reforms as part of their transformation to a market-driven economy.  Chairman Greenspan and I discussed these issues in great depth with our Chinese counterparts this week in our annual Joint Economic Committee meetings.  It was significant that, in addition to the Fed and Treasury, Chairman Chris Cox of the SEC and Rueben Jeffrey, Chairman of the CFTC, and other U.S. agencies also participated in these meetings.  China's most senior economic leaders also participated.  In addition today, senior technical level U.S. regulators and supervisors for the first time will be having a full day of discussions with their counterparts.  I think that this level of senior official engagement underscores the importance we place on the need for the establishment of a modern, world-class financial system in China and the breadth of our economic and financial relationship.

One goal on which both nations agree is the need for China to transform from a primarily export-driven economy to one that is more balanced and led by domestic demand with a far greater role for the consumer.  Recent Chinese economic growth has depended on continued sharp increases in investment and net exports.  This pattern of growth has contributed to regional and sectoral imbalances in the Chinese economy and does not provide a basis for sustained long-term growth.

When viewed in the context of external imbalances, China and the United States are mirror images.  China's extremely high savings rate – approaching 50% -- contributes to global imbalances, just as does the United States' very low national savings rate of about 13.4%.  In the United States we are looking for ways to increase national saving by encouraging greater household savings and reducing our fiscal deficits.  The challenge for the Chinese is to lower the propensity to save and to encourage greater domestic consumption.

Such a shift towards domestic demand-led growth -- with more efficient investment and more rapid growth in household consumption – would raise the welfare of the Chinese population, help address regional and income imbalances, and provide the foundation for sustained future growth.

For China, the development of financial services and capital markets will be vital to this transformation.  What is noteworthy today is that the development of these sectors need not be delayed, waiting for "homegrown" solutions. 

We live in a world today where the acquisition of knowledge, skills, and capital can be immediate, and this should have positive implications for all emerging market countries -- especially here in China. 

I was reminded of this fact as I traveled through China and had the opportunity to use some of the excellent hotels available to visitors to Shanghai, Chengdu, and here in Beijing.  These world-class hotels are not indigenous to China; they're not "homegrown".  In fact, they are imports from other nations – some Western, some Asian.  They are expertly run by managers from around the world.  The beneficiaries of these hotels, in addition to the visiting tourists, businessmen and government officials who receive the excellent service, are the Chinese themselves.  Rather than waiting the years that might be required for a domestic hotel industry to develop, along with the necessary expertise in administration, logistics and staff management, marketing, client knowledge, taste differentiation, it can be acquired – as it has been here in China – essentially overnight.  Moreover, the technological and managerial know-how foreign firms bring is absorbed in the domestic economy as Chinese managers who learn best practices go on to run their own hotels.

The same rapid acquisition and transfer of knowledge and skills is available today in economics and finance. 

Throughout the world, the "overnight" acquisition of knowledge has already had a dramatic impact, for example, in the field of monetary policy with respect to the understanding of the nature of inflation and the proper application of monetary instruments to combat it.  There is near universal understanding among central bankers today that inflation is a monetary phenomenon and that price stability should be a central goal.  And so what we have witnessed in recent years is a dramatic reduction in inflation and inflation expectations and the near-absence of cases of hyperinflation, despite the recent sharp rise in energy prices.  The conquering of inflation should be viewed as one of greatest contributions in the economic life of people everywhere. 

Nowhere was this knowledge indigenous.  Rather, it was achieved as the result of very painful trial-and-error, in the United States and elsewhere, and significant development of theory and economic analysis.  A great deal of credit for understanding inflation goes to people like Milton Friedman, and certainly to Chairman Greenspan and his predecessor, Paul Volcker.  The contribution of John Taylor, my former Under Secretary for International Affairs at the Treasury Department, should also be noted for his now-famous "Taylor Rule" -- a rules-based method of inflation targeting used by countless central banks.  So it's not necessary for central banks to go through the upheaval of dealing with an inflation crisis to know that they can use market instruments like short-term interest rates to either inject or reduce liquidity in the money supply.  Moreover, many countries, including emerging markets, have found that operationally independent central banks with clear objectives can anchor inflationary expectations with flexible exchange rates.

Likewise, this same rapid acquisition and application of knowledge and skills is available to develop robust financial services and capital markets in emerging market economies.  The pace of change in financial products around the globe is breathtaking.  Things like asset backed securities, securitization, credit and currency derivatives, options, sophisticated hedging devices, and on and on.  These financial instruments allow economic assets to transfer risk to those best able to assess and manage them. 

By reducing the uncertainty associated with economic undertakings, these instruments facilitate economic activity – trade in its many forms, investing in the variety of ways it occurs, China can quickly take advantage of these important advances and thereby "leapfrog" in the development of its financial sector.

Undoubtedly, there is a threshold level of proficiency needed on the part of government in order to develop these sectors.  Governments must provide clear and transparent regulation and supervision, ensure that the rule of law is enforced, protect private property rights, and ensure that investment decisions are free from political interference.  I'm pleased to see China devoting so much effort to putting these key building blocks in place.  Governments should also be cautious about attempting to distinguish between good and bad financial instruments or investors.  The same tools used to hedge risk can be used to speculate.  Risk-takers provide important liquidity to markets.

Achieving these standards go hand-in-hand with broader economic development, and sometimes are not easy to achieve.  Certainly, even more mature economies still have challenges in these areas.  For example, in the United States and Europe we continue to develop and work to implement new rules in areas like corporate governance, accounting standards, oversight of financial markets and banking supervision. 

But if these conditions meet this threshold, the delivery of financial services to consumers can be acquired very quickly, and with immediate benefits.

China can quickly move forward with further liberalization of its financial services sector by allowing foreign securities firms to establish or acquire wholly-owned subsidiaries, and by expanding the scope of products securities firms can offer, such as trading in A-shares derivatives.  This would add liquidity and transparency to the China's capital markets, increase the flow of capital to the most productive Chinese firms, inject management expertise, encourage regulatory reforms, and introduce best-practices for technology, risk management, and control systems.  In addition, foreign investment would improve and encourage corporate governance, and increase the efficiency of financial intermediation.

Liberalization must also be accompanied by a shift to risk-based lending.  Last year China deregulated lending rates in order to give banks greater scope to differentiate borrowers based on risk.  But more reforms - such as introducing rigorous credit analysis procedures, improving accounting and financial reporting standards and adopting a strong board and corporate management structure -- are needed to better assess risk, improve asset quality and take advantage of higher interest rates to slow excessively aggressive asset growth.

Capital market development is particularly necessary in China to achieve balanced growth which translates into real prosperity.  For economies to reach their maximum growth potential, capital must be allowed to find those opportunities where it can generate the maximum return.  In a global economy, finding those places is a complex process.  A small investor in the United States or a pensioner in France – even relatively large businesses and governments around the world – lack the expertise or time to find those places for their savings.  This is where the role of financial services and capital markets enters – allowing the "invisible hand" to play its role in organizing economic activity in ways that best advance societies' material well-being.

Financial services and capital markets exist in order to marry the accumulated resources of billions of savers and investors around the world with the myriad of investment opportunities available.  This system involves everything from the small Chinese rural credit cooperative I visited in Sichuan province last week, to the large and sophisticated bond and equity traders in New York, London, Tokyo, Hong Kong, and elsewhere.  The saver in Tokyo cannot be expected to know that the best investment – the one that provides the security and expected return desired at that precise moment in time -- happens to be an equity offering in Kuala Lumpur.  For this you need intermediation, and you need markets.

As I have said, this system has the immediate and obvious benefit of providing maximum return on investment – but only when allowed to operate efficiently, and not impeded by national rules that limit flows of capital, inefficient tax or regulatory structures, corruption or lack of transparency, lack of property rights, or misaligned prices signals due to interference with foreign exchange or interest rates. 

This system has the added benefit of creating the flexibility necessary to adjust to constantly changing economic conditions – benefits that accrue to the saver or investor, financial services firms, and national economies, and the global economic system.  It also has the great advantage of facilitating a continuous series of benign adjustments which help to avoid disruptions and crises and to minimize their consequences.

In the United States, our bond and equity markets are vital to both investors and firms.  U.S. investors – from large companies to small savers – use the bond and equity markets to meet their goals, which can range from making a strategic acquisition to saving for individual retirement.  Our firms also benefit from having the ability to tap outside capital – either equity or debt – to fund their growth.

More developed capital markets are also good for financial stability, as firms have more ways to raise funds rather than simply through the banking system.  Development of bond and equity markets help corporations source funds when banks experience problems, preventing destabilizing cash crunches.  For example, the savings and loan crisis in the United States would have been far more serious, with a deeper impact on our economy, if firms had not had ways to raise funds outside the banking system.  Beyond the United States, in Asia and elsewhere we have seen where the excessive reliance on bank financing has contributed to financial crisis.  Here in China, it's important to keep in mind that the overwhelming volume of domestic firm financing comes from the banking system.  China is at the point where capital markets are increasingly necessary to meet the needs of its people and firms, where such markets could play a helpful role in disciplining economic agents and reducing the cost of capital. 

Fully developed capital markets can help China's economy shift from savings to consumption without sacrificing growth, thus improving living standards for the Chinese people.  Capital markets can produce higher returns on investment for corporations and more efficient utilization of resources for the country.  This would enable China to maintain economic growth with lower savings and higher consumption rates.  Not only would this improve living standards, but it would also work to reduce China's external imbalances.

* * *

Fortunately, the reforms I have outlined today are generally supported by China's economic leadership.  They understand that development of a real market economy requires progress across a broad horizon of sectors and issues.  They agree that increased domestic consumption, the development of modern financial services and capital markets, market interest rates and flexible exchange rates, are all in China's interests and in the interests of the global economy.  I also believe that well-developed financial system is essential to buttress the Chinese economy in the face of the inevitable disruptions in the global economy.  Where we find our differences, they are largely on the questions of the sequence and pace of reforms, not the direction.

Our economic relationship with China is far-reaching and complex.  I am encouraged that we are reaching a level of maturity in our relationship characterized by the understanding that we are not involved in a zero-sum game, but rather a "positive" sum game.  Both nations stand to gain from our increased interaction.