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David McCormick, U.S. Treasury Undersecretary, "Global Financial Turmoil and its Implications for China," May 9, 2008

McCormick, speaking in Shanghai, on the impact of the liquidity/credit problems in the United States on China and the world and what measures are being taken to alleviate the crisis.
May 9, 2008
David McCormick is Undersecretary for International Affairs at the U.S. Department of the Treasury.

Shanghai –Thank you, Vice Chairman Zhu, for your kind introduction.  I would like to thank the co-chairmen of the forum, Governor Zhou and Mayor Han, as well as the co-hosts of the forum at the CBRC, the CSRC, and the CIRC for inviting me to deliver remarks today.  It is my distinct honor to participate in this inaugural session of the Lujiazui Financial Forum.  I anticipate this year's event will be the first of many lively and informative sessions.

Today I'd like to talk about the recent financial turmoil in the United States – why it happened, how we have responded, and what lessons we have drawn for financial regulation and policy for the longer term.  I will also suggest some of the lessons that I hope China will draw from this episode and why recent events should be seen as all the more reason for China to push ahead with financial sector reform. 

I will make the case that continued financial sector reform and development is critical to China's own future growth and prosperity.  Foreign participation – and the critical technology and knowhow that foreign investors bring – will help accelerate China's financial sector development.

Responses to the Financial Market Turmoil

In the United States

Why did this financial turmoil occur?  A long period of benign credit conditions – relatively stable asset markets, low interest rates, and low inflation – encouraged many investors to seek higher returns.  Responding to this demand, the financial services sector created a variety of complicated new products that diversified risk and lowered borrowing costs.  Financial innovation brought enormous benefits, helping many people to move into homes, others to start or expand businesses, and investors to diversify their risk and enhance returns.  Complacency about risk, however, encouraged a loosening of credit standards and an erosion of market discipline among investors, regulators, and credit rating agencies alike. 

Last summer, these new vulnerabilities in our financial system became clear.  Looser credit standards in the housing market, combined with an end to rapid home-price appreciation, led to a significant rise in delinquent mortgages.  This in turn contributed to immediate and unexpected losses for investors and a reconsideration of the risk-reward relationship – first in housing, and soon after, across all asset classes.  The shaken investor confidence in housing assets had a domino effect throughout world markets, ratcheting up demand for cash and liquidity, and curtailing the pace of the new lending and investment necessary for strong growth to continue.

In short, those in the United States and around the world were reminded of an age-old lesson:  financial innovation, for all its advantages, sometimes produces unexpected consequences to which policymakers must quickly and creatively react. 

Policy Responses:  Domestic and International

Policymakers in the United States have responded quickly and aggressively to stabilize markets, reduce the impact of the turmoil on the real economy, and address underlying regulatory and policy weaknesses.  At the same time, we have sought to avoid overreacting with regulations or policy responses that would stifle innovation or distort the natural self-correcting forces of markets.

Treasury Secretary Henry Paulson has led the U.S. government effort to ensure a comprehensive, timely and appropriate response to the turmoil.  He and other authorities have urged banks to promptly recognize and report losses, and raise additional capital.  Many global financial institutions have done just that – reporting subprime-related losses of over $300 billion and raising additional capital of more than $200 billion.

The U.S. government has acted decisively to help soften the negative impact of these events on the real economy, through fiscal policy and a series of initiatives to help families stay in their homes.  The $150 billion economic stimulus package will support consumer and business spending as we weather the current economic slowdown, and will lead to the creation of over 500,000 new jobs that would not have been created otherwise. 

The U.S. Federal Reserve and other central banks have taken focused, and sometimes coordinated, actions to protect the financial system from severe disruption by ensuring that markets have access to financing. 

There are already some early indicators that this combination of actions is beginning to have the desired effect, as markets appear to be gaining confidence and the availability of credit has improved modestly.

As the immediate remedies take effect, we have also begun to focus on the weaknesses in business practices of financial institutions that this experience has revealed, and on fragmented U.S. and European regulatory structures that had difficulties guarding against or responding to modern challenges.

The President's Working Group on Financial Markets recently recommended changes to mitigate systemic risk and restore investor confidence to facilitate stable economic growth.  The President and Secretary Paulson have welcomed these recommendations, and we are now implementing them. 

At Treasury, we have also worked closely with counterparts in major economies around the world, including China, to address market instability.  The Financial Stability Forum (FSF), which brings together the supervisors, central banks, and finance ministries of major financial centers, has been critical to this effort.  The FSF has produced a series of recommendations that echo and complement efforts underway in the United States.  These proposals include:

  • Strengthening prudential oversight of capital adequacy, liquidity and risk management;
  • Enhancing transparency and improved valuation, particularly for structured products;
  • Revising and clarifying the role and use of credit ratings;
  • Improving the responsiveness of authorities to risks; and,
  • Creating robust arrangements for dealing with stress in the financial system.

There is no silver bullet to place financial markets on a sound footing or prevent past excesses from recurring, but each of these specific proposals represents an important step toward addressing the challenges we face.  Taken together, they constitute a clear and significant response to the underlying weaknesses that contributed to the turmoil in global financial markets.

A Look Ahead

While our first priority is working through the current turmoil in the capital markets and the housing downturn, we are also considering longer term changes to our financial regulatory system to maintain efficient, safe, and sound U.S. capital markets.  This dynamic process requires balancing appropriate regulation with the need for an environment that fosters innovation. 

Specifically, Treasury has considered how to modernize our financial regulatory structure, which resembles a patchwork of overlapping agencies and responsibilities cobbled together over the past 75 years.  Secretary Paulson's recently released Blueprint for a Modernized Financial Regulatory Structure proposes an optimal financial regulatory model that ensures market stability, safety and soundness for federal guarantees, and consumer and investor protection.  It calls for a market stability regulator, a prudential financial regulator, and a business conduct regulator.  We believe that this approach will foster innovation, mitigate risk, and enhance the competitiveness of America's capital markets.

Effects on the US and Global Economies

Although we have taken major policy steps to cushion the consequences of current market events on the real economy, they are undoubtedly having an impact.  Growth has already slowed significantly to 0.6 percent in the last quarter of 2007 and the first quarter of this year.  The combination of stress in financial markets, the housing correction, and high energy prices will weigh on growth through 2008, though fiscal stimulus will support the economy while corrections take place in the housing and financial markets.  Despite these near-term challenges, our longer-term growth prospects remain sound because of the underlying strength of our institutions, the flexibility of our markets, and our capacity to absorb technological change. 

Recent events have also made clear that emerging markets are not decoupled from events in the United States.  As U.S. growth has slowed, so too has our demand for imports, affecting exporters in a variety of nations, including China.  At the same time, emerging market growth has shown resilience in the face of a U.S. showdown.  Most emerging market countries have followed prudent macroeconomic policies, giving them room to respond to slowing external demand.  Stronger domestic demand growth in emerging markets like China is playing an important role in cushioning the impact of the U.S. slowdown.    

Financial Market Turmoil and China

China has weathered the recent turmoil relatively well.  Stronger growth in domestic consumption has offset much of the weakness in external demand.  Moreover, a slowing of overall Chinese economic growth from last year's pace may in fact be welcome in addressing concerns about excessive growth in investment and rising domestic inflation.  The sharp fall in Chinese equity prices since last October appears more due to domestic factors than to linkages with global stock markets.

Financial Reform and Future Growth

Despite its relatively benign effects thus far, I fear the recent bout of turbulence in global financial markets is being viewed by some in China as a reason to slow or pause financial sector reform.  I hope Chinese policymakers will ask the more pertinent question:  What lessons should China's leaders draw from recent events as they consider the pace and potential benefits of financial sector reform? 

This morning's presentations highlighted the giant leaps China has made in financial sector reform in the past decade, from the banking sector to the stock, foreign exchange, and bond markets.  These reforms have been important for laying the foundation to address the key challenges ahead in China's financial sector development.  These challenges include:

  • Increasing access to direct financing through the equity and bond markets;
  • Developing a yield curve for government bonds that can be used as the baseline for pricing other financial products;
  • Introducing a variety of financial products to hedge risk; and,
  • Fostering the growth of institutional investors.

These are the basic building blocks of financial sector development, not exotic products on the cutting edge of financial innovation.  There are risks, to be sure, in carrying out these reforms.  Financial regulation and supervision must be developed in tandem.  But policymakers in China must also recognize that there will be significant costs if China slows the development and reform of its financial sector.  Important gains for China and its people would be left unrealized.  An ambitious reform agenda will advance China's economic goals in four important ways by:

  • Rebalancing the sources of China's growth to ensure that it is more harmonious, more energy and environmentally efficient, and provides greater welfare for Chinese households;
  • Creating effective macroeconomic policy tools to ensure stable, non-inflationary growth; 
  • Supporting China's transition to a market-driven and innovation-based economy; and,
  • Assisting in dealing with demographic challenges. 

First, as China's economy becomes more sophisticated, an efficient, well-developed financial sector is essential to channeling capital to the new ideas, businesses, and entrepreneurs that will power future growth.  As China's economy becomes more complex, so too will its need for financial services.  A more developed financial sector is necessary to fund the industries of tomorrow.

A more developed financial sector is also essential in shifting to a growth model that can be sustained in the future, one less dependent on industrial activity and exports, and one more oriented towards services and household demand.  Key to this is reducing the need for very high saving rates.  A greater diversity of financial instruments for saving, risk diversification, and consumer borrowing would relieve some of the need for precautionary saving.

A higher risk adjusted return from a broader array of financial assets would allow Chinese households to achieve their financial goals – such as buying a house, educating their children, or achieving a secure retirement – without having to set aside large portions of their current income.  A more developed financial sector will also provide Chinese enterprises with options beyond reinvesting earnings primarily in expanding their own capacity.  This will enhance the efficiency of capital allocation and dampen the volatility of investment cycles.

Third, more developed financial markets will help bring greater stability to China's economy by giving the authorities the macroeconomic tools – flexible and more powerful monetary policy in particular – to assure stable growth and prices.  Deeper, interconnected bond markets would give the central bank greater ability to guide market interest rates and credit throughout the economy to ensure continued strong, stable, and non-inflationary growth.

Finally, a robust financial sector will help to enable China to deal with the demographic challenges that lie ahead, including population aging and the provision of healthcare.  A deep and sophisticated financial sector will be critical to strengthening the social safety net and providing tools such as health care insurance and retirement investment vehicles necessary to cope with growing demographic pressures.

The Role of Foreign Participation

Greater foreign participation will contribute substantially to financial sector reform, and for that reason, it has been a top priority for the Strategic Economic Dialogue (SED) launched by Presidents Hu and Bush. 

We recognize the concerns of some in China who believe that opening the doors to foreign financial firms could jeopardize the position of domestic firms.  On the contrary, we believe that increased foreign participation expands the breadth and depth of opportunities for all firms in the market, including domestic Chinese firms.  This is not a zero-sum game.  Clearly, foreign firms stand to benefit from expanded opportunities in China.  But they will also enhance the diversity of financial products in China, improve allocation of capital, and spur innovation, all of which will benefit China's economy and its people.

Foreign investment in Chinese financial institutions has, in fact, turned institutions that were a drain on fiscal resources into engines of growth – creating jobs and strengthening financial sector soundness.  Take for example, Shenzhen (shun-jun) Development Bank, which was one of the first banks to be controlled by a foreign investor.  Over the past several years, profitability and capital adequacy at the bank have increased significantly, while non-performing loans have declined sharply.  The bank is lending more to finance households and medium-sized enterprises.

We have heard from financial institutions across China that meeting the strong demand for experienced personnel is a challenge in this period of rapid expansion.  Increased foreign participation in the financial sector will expedite the development of world class financial sector talent within China, benefiting Chinese workers, businesses, and financial centers like Shanghai.

Looking forward, the current approach of offering limited scope for foreign investment in Chinese financial firms hinders the growth opportunities of China's entire financial sector.  It leads to unwieldy managerial and ownership arrangements that reduce operational flexibility and the transfer of financial technology.  We believe that higher ownership thresholds for foreign firms would benefit the financial sector overall and the Chinese businesses that depend on it to grow their companies and create jobs.  China achieved great success by opening its manufacturing sector to foreign investment.  This has fostered – not inhibited – growth of Chinese manufacturers.  Greater opening in financial services will do the same.

Just as openness to foreign investment is important for strong growth in China, openness to foreign investment is fundamental to the United States.  The United States is committed to ensuring a stable and open international financial system.  In his Statement on Open Economies last May, President Bush reaffirmed the United States' long-standing policy of welcoming international investment. 

Foreign investment creates good jobs, spurs innovation, improves productivity, and results in lower prices and greater variety for consumers in the United States.  Foreign direct investment flows into the United States were $204 billion in 2007, which is nearly double the level of a decade earlier.  Research shows that foreign-owned firms in the United States directly employ over 5 million Americans – 4.5 percent of all private sector employment.  These are good jobs, paying more than 25 percent higher compensation on average than other private sector jobs.  Foreign firms also indirectly employ about the same number of Americans.  Foreign-owned firms contribute almost six percent of U.S. output, 14 percent of U.S. R&D spending, and 19 percent of U.S. exports. 

Despite the benefits of foreign investment, there is rising protectionist sentiment around the world that poses a dangerous threat to the global economy.  We unfortunately see some of these same protectionist forces in our own country.  A number of countries are considering new or revised investment review mechanisms, some of which have the potential to impose broad barriers.  We are engaging our counterparts bilaterally, and through multilateral institutions to emphasize the importance of crafting policies that are predictable for investors and ensure proportional responses to genuine national security concerns.  Investment reviews must not be used to promote protectionist policies.

I know some of you may have concerns about the investment review process in the United States, known as CFIUS, or the Committee on Foreign Investment in the United States, a committee that is chaired by the U.S. Treasury.   However, I want to make clear that the legal authority of CFIUS is narrowly targeted to address only acquisitions that raise genuine national security concerns, not broader economic interests or industrial policy factors. 

Moreover, we are committed to living up to both the letter and the spirit of the new law and the President's open investment statement.  Last month, Treasury issued proposed CFIUS regulations to implement our new Foreign Investment law which passed our Congress and was signed by the President last year.  The new regulations clarify and improve our existing process, reinforce strong open investment principles and procedural protections for foreign investors, and ensure a more timely and efficient review process.  Our focus in this area reflects Secretary Paulson's strong commitment to maintaining an open investment climate in the United States.

Sustaining China's Growth

For all the reasons I have described, financial market development is key to assuring that strong Chinese growth is sustained in the future.  This is vital to China and the global economy.  But financial market development alone is not enough.  China also needs to rebalance the sources of its growth away from heavy industry and exports towards products and services for Chinese households.  This is essential if China is to reduce inequality, assure environmentally harmonious growth, and trim its huge and growing current account surplus.  Achieving these goals will require China to take structural measures to build a strong social safety net and channel the growing profits of Chinese enterprises to their owners.

Also critical to sustained growth for China is greater exchange rate flexibility.  A more flexible RMB would give China's policy makers greater scope to adjust monetary policy as needed to maintain price stability and to address the risks of excessive investment and credit growth.  Just as it was important for the Federal Reserve to have a monetary policy framework that allowed it to move quickly to maintain financial stability, the People's Bank needs to be able to move rapidly to contain inflation today and safeguard financial stability.

Exchange rate flexibility is also needed to provide the price signals that will ensure a more market-driven allocation of resources and investment.  RMB appreciation would provide greater incentives for domestic firms to direct investment towards the domestic market and produce goods and services for Chinese consumers.  In this regard, the increased pace of RMB appreciation since last October is welcome.  We urge China's leaders to maintain this accelerated pace. 


There are many reasons to believe that the appetite for economic reform in China may be waning, after years of demanding reforms.  Each successful reform brings calls from around the world for yet more.  Global volatility in financial markets may give China's leaders pause as they chart the course ahead.  However, I urge our friends in China to use the lessons of the current turmoil to sharpen their focus and strengthen their commitment to the bold path of financial sector reform on which they have embarked.  It is a critical component of China's future, economic growth, and stability.

As I reflect on recent events, I am confident that the United States will pass through this current phase of turmoil and return to the path of sustained growth.  I am also convinced that China will successfully overcome the challenges that it faces in achieving sustained long term growth and stability in an increasing complex economy.  We must not forget that our economies are more interconnected and more dependent on each other than ever before.  Together, we can bring prosperity to our own countries and the world economy.

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