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Online finance: China's reform battleground

Yu'E Bao, with its attractive interest rates, drew more than 81 million users by March.

Chinese President Xi Jinping took office more than a year ago amid high hopes for economic reform. State banks seemed to be a priority, raising expectations among domestic and international observers that new regulations would increase returns for savers and encourage consumer demand. However, there has been little action on this front, raising doubts about the administration's sincerity, and its ability to overcome vested interests.

     With the emergence of new online financial markets, however, China's reformers have found private companies able to shake up the country's mighty financial institutions. In an apparent rebuttal of calls from state banks to ban or tightly regulate rapidly growing online investment markets, they ruled out a ban and praised Internet finance as a force for reform. Established state banks are trying to stop these new services.

     In presenting the annual government work report to the National People's Congress, Premier Li Keqiang on March 5 promised to "promote the healthy development of Internet finance" as a means of reforming the Chinese economy. A day earlier, in an interview with China's Economic Daily, People's Bank of China Gov. Zhou Xiaochuan -- a long-time proponent of financial reform -- ruled out banning the as-yet largely unregulated sector.

     Commenting on calls from state banks to ban Yu'E Bao, the money market fund offered by Internet giant Alibaba, Zhou stood his ground. "Regarding Yu'E Bao and similar investment products, they will certainly not be banned," he said. "Generally speaking, finance is an area in which technical innovation is to be encouraged; oversight must catch up with the times and follow the pace of technical innovation."

     At a March 11 press conference, Chinese Banking Regulatory Commission Chairman Shang Fulin announced plans to issue licenses for five private banks by the end of March. Each bank is to be established as a joint venture between two private companies. The list included banks backed by Chinese Internet giants Alibaba and Tencent, formally inviting Internet companies into the financial system. Alibaba has announced that its bank, which will be jointly established with auto parts maker Wanxiang, will be online-only.

Starting with local interests

Any effective economic reform plan in China is likely to start with the state banks. They are the linchpin of a system known to economists as "financial repression," which funnels money from ordinary savers to the investment projects of state-owned enterprises and local government bodies -- a major reason for the Chinese economy's outsized reliance on investment.

     Reformers have long hoped to unwind this anachronistic system, moving wealth from the state to consumers and private entrepreneurs. Li, who has emerged as a key figure in bank reform, focused earlier reform efforts on creating a new generation of free-trade zones, starting with the Shanghai pilot project that opened last September. While the Shanghai project featured looser regulations on commercial banking, it attracted little foreign investment interest, and Li appears to have written it off as a defeat.

     While reformers in Beijing were stymied by established interests, online finance was producing new ways to sidestep the iron grip of state banks. In relation to banking reform, the most significant is Yu'E Bao, which offers a floating rate around 6% -- far higher than the legal maximum 0.385% for demand deposits or 3.3% for one-year savings. After entering the market last June, Yu'E Bao attracted 250 billion yuan ($40.6 billion) in seven months.

     After a broad marketing campaign, the figure rose to 400 billion yuan among more than 81 million users by March. More Chinese people now invest money in Yu'E Bao than in the stock market. For the time being, however, banks remain dominant, with combined individual deposits of over 46 trillion yuan and corporate deposits of 52 trillion yuan at the end of 2013.

     Despite Yu'E Bao's relatively small size, its rapid growth did what Beijing's reformers could not: It put state banks on alert. Earlier this year, all four major banks raised deposit rates to the legal maximum in a bid to retain deposits -- a small change that failed to stem the exodus of capital.

     Unable to compete, banks have turned to regulators, hoping to cripple their upstart rivals. While they did not succeed in getting them shut down, the banks have evidently scored a victory against Yu'E Bao. On March 13, Chinese media reported that many state banks had imposed daily limits on transfers to Yu'E Bao of 5,000 yuan, a move that would severely limit the speed of the fund's growth. Rumors in financial media suggest that this limit was imposed by the central bank, suggesting that arguments that warn of financial instability might have convinced regulators to slow things down.

     With his comments at the NPC, Premier Li appears to have identified the Internet as the "Shenzhen" of today's China -- a segregated space in which markets can operate outside state control. If the present trajectory continues, online funds will equal 8% of total bank deposits within three years, according to one Chinese brokerage. However, with the recent limits, this growth may be significantly slowed, or diverted into the new private banks.

     If assets continue to move to online funds or private banks, state banks will no longer profit from regulatory limits on interest rates. That is a powerful reason to drop their opposition and enable changes to China's basic model of investment-led growth.

     Online financial marketplaces have emerged as a key battleground for reform in China. Whether they continue to grow or are hamstrung by existing banks will play a large role in determining whether the state will change its role in the marketplace over the next 10 years.

David Cohen is editor of the Jamestown Foundation's China Brief newsletter; Jia Minhui is a Master's candidate at New York University researching Internet finance and clean tech in China.

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