Chinese Financial System: Past, Present and Future

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Queries • China's biggest state-run banks 623.61 billion yuan ($99 billion) in

annual profits, Chinese financial system is better than the U.S ?• Whether external shock will influence China’s financial reform

process against background of international crisis ?

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Figure 1 Annual Net Profit for Big 4 State –run banks

Contents

• A. The role of “finance” in economy• B. The process of Chinese financial system

transformation since late 1970s• C. The problems of current Chinese financial

system • D. Financial System Reform and Economic

Imbalance• Conclusions

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A. Role Of “Finance” In Economy

• A1: definition of Finance: “brain” of modern economy…

• A2: Concepts of “money” and “finance" in a planned economy in China

• A3. Concepts of “money” and “finance“ in a market economy

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A2: Concepts Of “Money” And “Finance" In A Planned Economy In China

1. Money is the only financial asset2. Money is “passive” , only used as a tool for pricing and

accounting.3. Bank is cashier for the state fiscal system; assumes

roles of both central bank and commercial banks,” mono-bank system”.

4. Bank’s financing to enterprises is limited only credit financing for “non-budgeted” working capital (i.e. ,the part of working capital that is not employed perennially)

5. Households and individuals are not allowed to participate in any financial activities other than opening deposit accounts in the bank.

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Financial Repression In Planned Economy

• Fund scarcity

• Prioritizing heavy industry development

• Distorted productive factor price

• Lowered the interest rate under the market level

• State directly controlled the banks, no financial market

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A3. Concepts Of “Money” And “Finance“ In A Market Economy

• A tool of resource allocation

• Financial system= various financial institutions + financial markets

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Financial Deepening And Financial Broadening In Market Economy

• Financial deepening: Increase in the ratio of financial assets to national income , or GDP

• Financial broadening: an increase in the variety of financial institutions and instruments.

----Source: Barry Naughton,The Chinese Economy: Transition and Growth, pp450

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How Did China Reconstruct the Financial System to Adapt to A

Market Economy?

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Contents

• A. Role of “finance” in economy

• B. The process of Chinese financial system transformation since late 1970s

• C. The problems of current Chinese financial system

• D. Financial System Reform and Economic Imbalance

• Conclusions

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B. The Process Of Chinese Financial System Transformation Since Late

1970s

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B1 Changes In China’s Financial System In The 1980s: Drives

• Two Drives: 1. The financial deepening challenged the

financial repression policy2. great changes in Chinese economy:

– People’s communes were replaced by households as units of agricultural production, which greatly expanded the scope of monetary activities

– Non-state industrial and commercial enterprises, which operated independently and were somewhat market-oriented, began to emerge

– SOEs were given more decision-making power in financing.

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B1 Changes In China’s Financial System In

The 1980s: Enterprise Financing *SOEs• Major source: fiscal appropriations

– Perennially employed fixed asset investment and working capital (“budgeted working capital”) came from state budget

• short-term loans from the PBoC – Temporary funds for daily operations (non- budgeted working capital)

depended on short-term loans from the PBoC.• replacing fiscal appropriation with banks loans for investment in capital

construction (since 1985), encourage “paid use”. • some enterprises began to raise funds through the securities market

*Non-state sectors had to support their operations through self-financing

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B1 Changes In China’s Financial System In The 1980s: Introduction Of New Financial Instruments

And The Start Of Capital Markets

• Pre-reform: Cash and bank deposits in planned economy

• After reform– Offer Commercial paper discount service – Offer Rediscount service – Restore bond issues– Establish corporate bonds and treasury bonds

secondary markets– Establish Shanghai Stock Exchange and Shenzhen

Exchange(1991,1992)

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B1: Changes In China’s Financial System In The 1980s: Organizational Structure Of

Financial Institutions

Commercial banks

State-owned commercial banks

Joint stock commercial banks

Industrial and commercial bank of ChinaAgricultural Bank of China

Bank of China

People’s Construction Banks of China

Central Bank(PBoC)

China Huaxia BankBank of CommunicationsCITIC Industrail BankChina Everbright BankGuangdong Development BankShenzhen Development BankShanghai Pudong Development BankChina Merchants BankFujian Induatrial Bank

Non-bank Financial Institutions

Trust Investment CompaniesFinance CompaniesFinancial Leasing CompaniesRural Credit Cooperatives Urban Credit Cooperatives 15

B1: Changes In China’s Financial System In The 1980s: Central Bank’s Approaches To

Macroeconomic Control

1979: centralized planning, managing at different levels, linking Deposits with loans, and controlling the balance

1981: centralized planning, managing at different levels, linking Deposits with loans, and balance responsibility

1985: centralized planning, partition of funds, actual loans linked to actual deposits, and mutual financing

Pre-1979: Unified control over deposits and loans

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B2:The Banking Reform in 1990s and Its Future Direction

1. Major Problems in China’s banking system before 1994 reform

2. The Progress of the banking reform since 1994

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1. Major Problems In China’s Banking System Before 1994 Reform

a) PBoC: could not effectively perform its fundamental role in maintaining the stability of currency.

b) Commercial business were not separated from policy related businesses in specialized banks.

c) The market was in disorder and developed in a distorted way.

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2. The Progress Of The Banking Reform Since 1994

• 1) Establishment of a separate central bank system

• 2) Establishment of Commercial Banks independent from the mono bank

• 3) Reform of Foreign Exchange Control System

• 4) Establishment and improvement of the financial supervision system

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1) The Establishment Of The Central Bank System

• Switching the monetary policy from multi-level adjustment to single-level adjustment.– Replaced its 31 main branches in the provinces by 9 regional offices to

further eliminate interference of local governments in the central bank ‘s monetary policy and financial supervisions

• Making indirect adjustment the core of the macro adjustment system.– Objectives of the PBC( Law of the People’s Bank of China,1995):

maintain the stability of currency and thereby promote economic growth;

– Intermediate objective: change from regulating credit quotas to regulating money supply

• Policy tools: rediscount business, open market operation and reform of credit control system, improvement on interest rate mechanism

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2) Establishment Of Commercial Banks Independent From The Mono bank

• The four preexisting specialized state banks( the “big four”) were transformed to wholly state-owned commercial banks. separation operation established.

• non-wholly state-owned, joint-stock banks were established to foster competition within banking sector.

• Three policy banks were simultaneously created to fiance the infrastructure development to support China’s agricultural sector and export industries– - China Development Bank, – Agricultural Development Bank (ADB) – Export-import Bank of China.

• This decision freed the Big Four to become more focused on commercial Business

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3) Reform Of Foreign Exchange Control System In 1994

• Pre-reform and opening up: – Unified control over revenues and expenditures in FX– Dual-track of foreign exchange rate– FX retention

• Reform in 1994– Sale and purchase of FX under current account– Establishment of inter-bank FX market – Merger of dual rate – Formally accepted Article 8 of the International

Monetary Fund Agreement, undertaking obligations of IMF members.

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Financial Institution

Bank System

CommercialBank

Policy-relatedBank

The Central Bank(The People’s Bank

of China)

State-owned banks

Joint-stock banks

Urban and Rural United Commercial bank

The State Development BankThe Agricultural

Development BankThe Import and

Export Bank

Non-bank Financial System

Security Companies Credit Housing & Cooperatives

Trust & investmentcompanies

Insurance Companies

Leasing Companies

Funds Companies

Asset Management Company

Foreign banks

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Monetary Market

Interbank Offer Market

Repurchase AgreementMarket

Commercial ExchangesMarket

Treasury Billsmarket

Capital Market

Stock market

Bond Market

Foreign Exchange Market

A share

B share

H share and N share

Treasury bonds

Corporate bonds

Financial Market

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The People’s Bank of China

The China Banks Regulatory Commission

The China Securities Regulatory Commission

The China Insurance Regulatory Commission

Establishment And Improvement Of The Financial Supervision System

The State Administration of Foreign Exchange25

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Contents

• A. Role of “finance” in economy

• B. The process of Chinese financial system transformation since late 1970s

• C. The problems of current Chinese financial system

• D. Financial System Reform and Economic Imbalance

• Conclusions

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C. The Problems Of Current Chinese Financial System

• C1. the financial system is unbalanced and underdeveloped.

• C2. the financial system in under-supported

• C3. the banking system is inefficient

• C4. the Banking system is potentially fragile.

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C1. The Financial System Is Unbalanced And Underdeveloped

• Banking system dominates the financial system, Non-bank financial institutions still have a smaller impact; In banking system, The 4 state-owned banks monopolizes banking operations, Non-state commercial banks were restricted.

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The Stock Market Dominates Capital Market

Chinese Corporate Bond Issuance

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Treasury Bond Issuance Corporate Bond Issuance

The Treasury Bonds Market Is Dominates The Bonds Market

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Financial Service Still Lags Far Behind Financial Institutions In Developed Countries

• Banking system– The big four bank system is still managed as state banks in an

inefficient way • Capital market

– The right to list was rationed through local governments and central ministries.

– Existing company and securities laws lacked effective civil remedies for investors

– The bifurcated share structure negatively impacted the markets

• The price control – The government sets all interest rates .– The government controlled the pace and price of new share

listings

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C2. The Financial System In Under-supported

• Rating agencies, accounting and audit bodies, credit ad collateral registries, in formation systems and associated information technology, and the legal system are in their infancy.

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C3. The Banking System Is Inefficient

• High operating costs: over-staffed, overly extensive branch networks

• Their portfolio owe little to market-based assessment of the credit-worthiness of their borrowers, policy-based lending is very high-levels of nonperforming loans (NPLs)

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C4. The Banking System Is Potentially Fragile

• As a legacy of central planning, the state-owned commercial banks (SCBs) are burdened with massive NPLs, – SCBs are technically bankrupt? though that concept

might have little meaning in a system in which the banks and most of their clients are state owned.

• How to improve SCB’s performance and competitive position, especially after China’s WTO entry?

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Asian Financial Crisis of 1997-98, a wake-up call

• Most bank did not report NPLs systematically until the Bank of China applied for listing of its consolidated Hong Kong subsidiaries on Hong Kong Stock Exchange(early 2001), which started a new chapter in Banking reform.

• The pace of financial sector reform quickened markedly. In 1999, four newly created state-owned asset management companies (AMCs) absorbed renminbi 1.4 trillion worth of nominal NPLs from 5 SCBs.

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China’s Commitment To Open The Banking Sector Upon Entry Into The WTO

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What Efforts Have Been Made ?

• From 2001 to now: Opening of financial system speeds up formation of competitive financial market

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Reform SCBs into Share-holding System

• 1. Attract strategic investors both domestically and internationally

• 2. Financial restructuring--corporate governance reform--go public in stock market

• 3. Move risk based on lending. – Introduced international risk standard– introducing AMCs to transfer NPLs– Injected capital into the Big Four Banks

• 4. Making innovative financial products that will better meet household’s saving goals. – Loans of autos and houses(privatization of urban housing in

1998) – Individual financing business – Credit Card Business – E-banking services 39

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Making Further Perfect On The Capital Market System

1. Gradually relax segregated business regulation -Changed from quotas to the approval system in share listing -Set high auditing standards for the disclosure of information for financial institutions

applying for listing rights -Expand the number and size of investment management firms and let them play an

important role in corporate governance.

2. Transfers of Non-tradable Shares of Listed Companies Rules 3. Gradually relax capital flow control to foreign investor　　 FDI, QFII and QDII 4. Revisions were made to the Company Law and Securities Law

focused on protecting investors -Non-tradable shares in SOEs listed were required to be converted into

tradable shares -Issued new accounting practices that will bring Chinese accounting practices in

line with International Financial Reporting Standards - Ａ new Enterprise Bankruptcy Law was approved 　

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Close Cooperation with International Agencies

• China became a member of the BIS in 1996.took full advantage of training and other development opportunities offered by this and other international financial institutions, such as IMF, The World Bank, IFC, and ADB.

• In parallel PBC developed close cooperation with the monetary authorities of Hong Kong, Singapore, and several other countries for staff training and system development.

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Establishment of an independent banking regulatory /supervisor

• China Banking Regulatory Commission (CBRC) established in March 2003 was a watershed institutional development.

• It separated critical banking supervisory and regulatory functions from central bank and allowed PBC to concentrate on increasingly complex monetary policy changes.

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Removal of Cap on lending rates and floor deposit rates

• The partial liberalization of interest rates, combined with the development of new financial instruments and long –term contractual savings(insurance and mortgage) also contributed to development and commercialization of capital markets.

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Remained Problems

1. Heavy dependence on the banking system is a significant weakness——financial risks are concentrated in the banks

2. The amount of NPLs has declined but not in proportion to the increase in total loans

3. lack credit culture 4. The segregated management control and supervision

institutions facing new challenge. 5. The entry approval issues ---firms primarily sponsored

by private investors are either not approved or approved with crippling business restrictions

6. The Banking system is relatively closed.

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D. How does Financial System Reform influence

Economic Imbalance?

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Domestic Dimensions

• China’s economic and social imbalances– Over-reliance for GDP growth on investment and net-exports– Growing social inequality– Environmental degradation

• One of the reasons for over-investment, particularly in manufacturing, is low ceiling on deposit rates that renders them negative with respect current CPI inflation

• Low deposit rates have tended to increase excess liquidity in the corporate sector and depress the entire interest rate structure.

• Negative rates drive financial intermediation from regulated into unregulated----sometimes “underground” ----financial markets.

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International Dimensions: China’s Dilemma

• “Hot money” inflows in response to higher domestic deposit rate.

• To reduce that risk, domestic interest rate liberalization should be combined with“flexiblization” of exchange rate management and greater capital account opening

• Dilemma: join the international system fully and play by its rule, or maintain at least some capital controls and influence over the exchange rate. – The first choice risks importing instability;

– the second risks contributing to instability.

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The Result of Unfinished Financial Reform

• National credit crunch• Businesspeople borrowed money from private credit circles

or invested in real estate collectively • Crushing lack of liquidity • private lending crisis • entrepreneurs fled the city. The fleeing business owners

were unable to repay loans they had contracted in the city’s underground banking system, according to police.

• State Council decided to make the city of Wenzhou a pilot region for comprehensive financial reform in 2012

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Pilot Financial Reform Zone in Wenzhou12 tasks

1. The orderly development of fundraising for private enterprises.

2. Accelerating the development of new types of financial organizations, including joint-stock village and township banks, loan companies and rural financial co-operatives. Qualified micro-credit companies can be developed into village and township banks.

3. The development of special assets management to guide private capital into venture capital and private capital funds.

4. Allowing private direct investments to be made overseas.

5. Deepening reforms of regional financial institutions; encouraging State-owned banks and joint-stock banks to set up special micro-credit programs for small and medium-sized enterprises; encouraging non-banking financial institutions to expand their businesses; and encouraging rural joint-stock financial institutions.

6. Developing financial services designed for small enterprises and companies involved in farm production.

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Pilot financial reform zone in Wenzhou12 tasks

7. Developing local capital markets and encouraging exchanges of property rights - of technologies and copyrights, among other things - among privately held companies.

8. Opening the local bond market to small enterprises. 9. Broadening the insurance sector. 10. Strengthening the credit system to include small enterprises and

rural entities and strengthening credit market regulation. 11. Building up a comprehensive local financial regulatory system. 12. Developing a risk management system for financial reforms and

duly defining and dividing the local government's responsibilities for maintaining financial stability.

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Summary of 12 tasks

1. Financial access: allow private fund to access to financial system

2. Development of fundraising for private enterprises

3. Capital account liberalization, Allowing private direct investments to be made overseas.

4. Financial system reform, to establish local financial management system

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Whether Wenzhou Approach Will Work?

• Roots of fund misalignment – High saving rate lead to fund surplus – Monopoly in real economy, and – Financial system is heavily dependent on

banking

• Wenzhou approach is difficult to change the fund misalignment

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Sequence of Reform

• As China seeks to further refine its economic model, there will be greater challenges ahead, particularly in terms of balancing environmental and social development with the need for continued economic growth.

• Priorities in reform– Destroy monopoly in real economy – Finance should serve real economy– Better overall governance– More effective regulation and supervision– More reliance on market forces– A more supportive legal system

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Conclusion 1. The beginning of transformation of China’s banking system largely

coincides with the reform process instigated by Deng Xiaoping.

2. China’s state banks----after they had been created----were long used as quasi-fiscal agents to facilitate reform and development of the real economy in according with plan priorities.

3. The Chinese financial system is heavily dependent on banking system, it is a legacy of unfinished economic reform, especially the state-owned enterprise reform.

4. There exists monopoly in banking system, it is determined by the monopoly in real economy. The most active private sectors cannot get fund from official banking system, but the SOEs are eligible to get cheap loans, even they are making loss.

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Con’t5. Wen Zhou pilot program may not work as expected, if the

monopoly in real economy cannot be destroyed.

6. The financial system contributed to China’s economic and social imbalance

7. Overall, Chinese financial system is inefficient ,weak and closed.

8. The current international financial crisis did not influence the Chinese financial market directly, but Chinese financial system has more flaws.

9. In post-crisis period, China will take a forced reform in real economy, and financial system. Because the international division to be changes, China is losing its comparative advantage. To maintain long stability, reform is needed.

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Questions?

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Glossary of AbbreviationsABC Agricultural Bank of China

ADB Asian Development Bank

ADBC Agricultural Development Bank of China

AMCs Asset management companies

BOC Bank of China

BoCom Bank of Communications

CBRC China Banking Regulatory Commission

CCB China Construction Bank

CDB China Development Bank

CDC China Government Securities Depository Trust and Clearing Co.Ltd.

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CSDCC China Securities Depository and Clearing Company

CSRC China Securities Regulatory Commission

HSBC Honkong and Shanghai Banking Corporation

ICBC Industrial and Commercial Bank of China

IPO Initial Public Offering

JSCBs Joint-stock commercial Banks

MBNA MBNA Corporation or its main part, MBNA American Bank

MOF Ministry of Finance

NPLs Non-performing loans

NSSF National Social Security Fund63

PBC People’s Bank of China

RCCs Rural Credit Cooperatives

RMB Renminbi

SAEC State Administration of Exchange Control

SAFE State Administration of Foreign Exchange Control

SASAC State-owned Asset Supervision and Administration

SCBs State-Owned Commercial Banks

SDB Shenzhen Development Bank

SEZ Special economic Zone

UCCs Urban credit cooperatives 64

Reference1. 吴敬琏著，《当代中国经济改革教程》，上海远

东出版社， 2010 年2. 张建华主编，《中国金融体系， China Financial

System 》，中国金融出版社， 2010 年 (Bilingual)3. Zhu Min, China’s Emerging Financial Markets:

Challenges and Global Impact, John Wiley &Sons(Asia),2009

4. Wu Jinglian, Understanding and Interpreting Chinese Economic Reform

5. (Thomson/South-Western, 2005).6. Barry Naughton, The Chinese Economy:

transitions and growth, (MIT Press, 2007).

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