Chinese authorities should move faster in reforming their financial markets and opening the industry to foreign firms, U.S. Treasury Secretary, Henry Paulson Jr. said in a speech to the Shanghai Futures Exchange.

“I believe increasing the pace of reform in your financial services markets is in the best interest of China’s future — to spread prosperity to all the people of your nation, to promote greater stability here and abroad, and to demonstrate leadership in accordance with your global economic presence,” Paulson said.

He indicated that efficient financial sectors are essential to modern economies, and he called well-developed financial markets “a necessary precondition” for China’s development as well. “Efficient, developed capital markets will allocate resources more effectively and efficiently, allowing China to continue growing at a healthy pace, while spreading prosperity throughout the economy and giving Chinese citizens a better return on their savings and investments,” he added.

China’s growth is increasingly imbalanced — among regions, households, and sectors, he stressed. “Over-reliance on a single part of your economy has the potential to cause problems in the future. Your long-term economic strength requires a diverse economy, with high-value-added manufacturing and world-class services, including financial services,” he said.

Paulson said that China’s financial markets face four important structural challenges: its capital markets remain underdeveloped; China has no real institutional market; the banking system is also underdeveloped; and, it lacks a predictable, transparent regulatory structure that fosters innovation.

“Strong capital markets require strong property rights; robust supervision; sound accounting standards and corporate governance; strong financial institutions; objective financial analysis; a meaningful disclosure regime; and independent credit rating agencies,” he noted.

To develop stronger capital markets, China needs a larger and more accessible government bond market, a more liquid and transparent corporate bond market, and a legal construct in which private equity can flourish, Paulson counseled. He said that China would also benefit by moving to a “disclosure-based” regulatory system; eliminating interest rate controls and requirements that long-term bonds receive guarantees from state-owned banks; and, a legal construct that allows for limited liability companies will help cultivate private equity and venture capital.

He also noted that, without a meaningful institutional investor base, the market relies too much on retail investors. “The development of a broad-based institutional investing market is being inhibited by a number of policies, including the fact that some important institutional investors, such as insurance companies, are highly restricted in the types of investments they can own. Big investors, such as insurance companies and pension plans, with large pools of capital, should drive the development of an institutional market when an appropriate tax and regulatory regime is in place,” he said. “Permitting professionals to enter the asset management business would strengthen the fiduciary role, protect investors, and develop trust in the industry. A switch to risk-based capitalization requirements in the asset management industry from a fixed minimum capital requirement would also be beneficial.”

Paulson said that there is widespread recognition of what needs to be done to reform China’s banking sector – better risk management; a more developed and accessible credit bureau; more consumer finance products; greater scope to set interest rates to reward depositors and price risk; consolidated supervision and reporting; greater competition, including of electronic payment systems; and opportunities for new banks to expand branch networks far more quickly. The insurance sector would also benefit from greater opportunities to expand branches in China.

Finally, he stressed that as China transitions from a centrally administered economy to a market-based economy, its regulatory regime must adapt. “Today, central authorities continue to be too involved in investment decisions that are more efficiently made by the market,” he said. “The appropriate role for government is to set the rules for the market as a whole and enforce them – rather than to make individual investment decisions.”

He also called for more foreign access to its markets. “China can make progress toward financial sector reform simply by making these domestic changes. But allowing much more foreign participation in China’s financial markets would speed reform, as well as the stability and prosperity it will bring,” Paulson said. “Opening your capital markets to global competition and participation would bring many benefits: world-class financial institutions can introduce new technology and products to China, enhance training and the transfer of skills, improve market practices and infrastructure, and enhance financial stability.”

@page_break@“Time is of the essence,” Paulson concluded. “The risks for China are greater in moving too slowly than in moving too quickly toward transparent, liquid, stable capital markets. The longer China waits, the more difficult it will be to create robust capital markets and reach your goal of more balanced, harmonious, and innovation-based growth. Some industries that may seek protection from competition will grow more politically powerful as they grow more economically powerful. That will make it more difficult to withdraw protection, to the detriment of a nation and its citizens who are deprived of world-class performance.”

“Historically speaking, existing financial services companies tend to oppose liberalization and reform that brings new competition, even if it brings new opportunities and produces benefits for society overall,” he added. “This has certainly been true of major financial sector reform in the United States and the United Kingdom, where market participants have almost always resisted change which increased competition in their sectors – change which ultimately proved to be beneficial to society as a whole and to the financial sector, which continued to grow and flourish with greater competition, efficiencies, and increases in employment.”

“Rebalancing your economy and welcoming international competition in the financial services sector is a win-win proposition. China and its major trading partners will benefit from increased prosperity that will strengthen other parts of your economy,” he noted.

In response to the speech, the Securities Industry and Financial Markets Association issued a statement lauding the remarks. “Removing the roadblocks that prevent innovation, reform and modernization is essential to the success of the global financial marketplace,” said Marc Lackritz, SIFMA co-CEO. ”Such barriers hurt not only the international community being barred from entry, but also stunt the growth and development of the ‘protected’ economy by blockading expertise and innovation at the border.”