《中国金融市场 Chinese Financial Markets》补充阅读文献：chinese-financial-system-elliott-yan

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Introduction he financial system plays a critical role in of the differences between China and the US will fueling the expansion of China, which has disappear over time as Chinas economy becomes grown to be the second largest economy in bigger and more sophisticated, and as the finan the world and is likely to eventually surpass th cial system adapts to a level of development more US. Yet there is much less understanding of Chi similar to the us. other differences will remain na's financial system than there is of America's or because of policy or societal choices or inherent Europe's. Many analysts believe that the finan- differences between the two nations cial system represents a major vulnerability for Chinas economic development, whereas others, Despite the variations across countries, all finan equally respected, think that the financial system cial systems need to perform a few key functions is adapting effectively to Chinas more developed effectively. Ideally, they optimize the allocation of status and will continue to provide the necessary scarce funds to the most worthy projects, allow fuel for the rest of the economy. savers and investors to maximize their return for a given level of risk, allow risks to be diversified This paper provides an overview of Chinas finan- across a wide pool of families and businesses(to cial system and details what we know and what we reduce the danger from catastrophic losses), and do not know about its workings. We begin with an help transform shorter-term assets into funds that overview and then structure the remainder of the can support longer-term projects paper around a series of questions and answers Chinas financial system has managed for sever- Financial systems can be organized in multiple al decades to perform well enough to support the ways that differ in terms of the role of the govern- very rapid economic growth of that nation. One ment,the relative importance of banks and other can argue about whether alternative approaches financial intermediaries compared to stock and would have worked better, but, at a minimum, it bond markets, the degree of financial leverage in represents a real accomplishment to have avoid the economy, and other differences. The optimal ed acting as an anchor preventing the impressive financial system for a given nation depends on its growth that China has achieved stage of development, its particular social values its political system, and various idiosyncratic fac- However, China is once again entering a new tors. This paper will frequently compare China phase of its economic development, and doing so to the US, not because China should necessarily at a time of major political change, with the com copy the US approaches, but principally to help ing to power of a new leadership team at the helm our American readers put China in context. Some of the Chinese Communist Party and the central The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS

The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 1 T he financial system plays a critical role in fueling the expansion of China, which has grown to be the second largest economy in the world and is likely to eventually surpass the US. Yet there is much less understanding of China’s financial system than there is of America’s or Europe’s. Many analysts believe that the financial system represents a major vulnerability for China’s economic development, whereas others, equally respected, think that the financial system is adapting effectively to China’s more developed status and will continue to provide the necessary fuel for the rest of the economy. This paper provides an overview of China’s financial system and details what we know and what we do not know about its workings. We begin with an overview and then structure the remainder of the paper around a series of questions and answers. Financial systems can be organized in multiple ways that differ in terms of the role of the government, the relative importance of banks and other financial intermediaries compared to stock and bond markets, the degree of financial leverage in the economy, and other differences. The optimal financial system for a given nation depends on its stage of development, its particular social values, its political system, and various idiosyncratic factors. This paper will frequently compare China to the US, not because China should necessarily copy the US approaches, but principally to help our American readers put China in context. Some of the differences between China and the US will disappear over time as China’s economy becomes bigger and more sophisticated, and as the financial system adapts to a level of development more similar to the US. Other differences will remain because of policy or societal choices or inherent differences between the two nations. Despite the variations across countries, all financial systems need to perform a few key functions effectively. Ideally, they optimize the allocation of scarce funds to the most worthy projects, allow savers and investors to maximize their return for a given level of risk, allow risks to be diversified across a wide pool of families and businesses (to reduce the danger from catastrophic losses), and help transform shorter-term assets into funds that can support longer-term projects. China’s financial system has managed for several decades to perform well enough to support the very rapid economic growth of that nation. One can argue about whether alternative approaches would have worked better, but, at a minimum, it represents a real accomplishment to have avoided acting as an anchor preventing the impressive growth that China has achieved. However, China is once again entering a new phase of its economic development, and doing so at a time of major political change, with the coming to power of a new leadership team at the helm of the Chinese Communist Party and the central I. Introduction

government. How the leaders of the party, gov- mental policy. For example, direct controls on the ernment, and business sector manage the transi- total amount of lending by banks can be circum tion over the next few years will have important vented to some extent by shifting loans onto the amifications not only for Chinas future, but that books of trust companies and their asset manage- of the world. The financial system will play a ma- ment customers, with an implicit guarantee by the or role in the future successes and failures of that bank. This creates incentives for Chinese banks to economic transition obscure the continuing financial risks associated with those loans, comparable to the reliance in the financial system is particularly hard to West on Structured Investment Vehicles(SIVs) because it is highly opaque and evolving whose blow-up contributed to the financial crisis rapidly. Every decade sees major changes in the regulation, structure, and operation of finance inIn addition, there are a wide variety of implic China, consistent with the rapid changes in the it guarantees embedded in the financial system nations overall economic and political develop- These represent assumed support by the central ment. Only a few decades ago the private financial government for the borrowings of state-owned sector virtually did not exist and all banking was enterprises, support for state-owned banks, im done through branches of the state-owned Peo- plicit deposit guarantees(since there is currently ples Bank of China. no formal protection of deposits), the assumption by many investors that banks or trusts will cover In consequence of this opacity and continuing losses on wealth management products, etc. Im evolution, there are questions about the strength plicit support is more opaque, easier to misun of the financial system, its effectiveness at allocat- derstand, and riskier, than more formal arrange ing capital to maximize Chinas growth, and the ments pact of capital allocation on the shape of the economy(including the relative size of the gov- The leading role of the Chinese Communist Par ernment and private sectors). Moreover, the likely ty is enshrined in the Constitution and is ver overall effects of future economic reforms, such as much evident across all sectors of the economy, loosened capital controls and freer exchange rates, especially banking. Party leaders at the national, remain unclear provincial, and local levels have many channels through which they exert influence on finance, A factor encouraging opacity is that China's na- including the ability to determine the career paths tional, regional, and local governments play a of leading executives at financial institutions. As a much bigger role in directing the activities of result, one of the areas of major debate among an banks and other financial intermediaries than in alysts is the extent to which the major banks make America or Europe. To some extent, the banks "commercial"decisions, as opposed to respond make loans as a substitute for fiscal actions that ing to political influence would otherwise need to be taken, as was clearly shown in the use of the banking system to provide As in many developing countries, problems with he bulk of the economic stimulus after the glob- the structure of the formal financial sector have al financial crisis struck in 2008. The use of the encouraged many informal channels for lend. banking system for government purposes increas- ing. There is a strong tendency of the formal es opacity in at least two ways. Government lead- sector to lend to large state-owned corporations ers often wish to obscure their interventions into and to others with political connections, leav the financial system, making that system harder to ing smaller and less favored businesses strug understand. The interventions also lead non-gov- gling to fund their growth. This situation results ernment participants to seek ways around govern- in high demand for otherwise riskier and more The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS

The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 2 government. How the leaders of the party, government, and business sector manage the transition over the next few years will have important ramifications not only for China’s future, but that of the world. The financial system will play a major role in the future successes and failures of that economic transition. China’s financial system is particularly hard to analyze because it is highly opaque and evolving rapidly. Every decade sees major changes in the regulation, structure, and operation of finance in China, consistent with the rapid changes in the nation’s overall economic and political development. Only a few decades ago the private financial sector virtually did not exist and all banking was done through branches of the state-owned People’s Bank of China. In consequence of this opacity and continuing evolution, there are questions about the strength of the financial system, its effectiveness at allocating capital to maximize China’s growth, and the impact of capital allocation on the shape of the economy (including the relative size of the government and private sectors). Moreover, the likely overall effects of future economic reforms, such as loosened capital controls and freer exchange rates, remain unclear. A factor encouraging opacity is that China’s national, regional, and local governments play a much bigger role in directing the activities of banks and other financial intermediaries than in America or Europe. To some extent, the banks make loans as a substitute for fiscal actions that would otherwise need to be taken, as was clearly shown in the use of the banking system to provide the bulk of the economic stimulus after the global financial crisis struck in 2008. The use of the banking system for government purposes increases opacity in at least two ways. Government leaders often wish to obscure their interventions into the financial system, making that system harder to understand. The interventions also lead non-government participants to seek ways around governmental policy. For example, direct controls on the total amount of lending by banks can be circumvented to some extent by shifting loans onto the books of trust companies and their asset management customers, with an implicit guarantee by the bank. This creates incentives for Chinese banks to obscure the continuing financial risks associated with those loans, comparable to the reliance in the West on Structured Investment Vehicles (SIVs), whose blow-up contributed to the financial crisis. In addition, there are a wide variety of implicit guarantees embedded in the financial system. These represent assumed support by the central government for the borrowings of state-owned enterprises, support for state-owned banks, implicit deposit guarantees (since there is currently no formal protection of deposits), the assumption by many investors that banks or trusts will cover losses on wealth management products, etc. Implicit support is more opaque, easier to misunderstand, and riskier, than more formal arrangements. The leading role of the Chinese Communist Party is enshrined in the Constitution and is very much evident across all sectors of the economy, especially banking. Party leaders at the national, provincial, and local levels have many channels through which they exert influence on finance, including the ability to determine the career paths of leading executives at financial institutions. As a result, one of the areas of major debate among analysts is the extent to which the major banks make “commercial” decisions, as opposed to responding to political influence. As in many developing countries, problems with the structure of the formal financial sector have encouraged many informal channels for lending. There is a strong tendency of the formal sector to lend to large state-owned corporations and to others with political connections, leaving smaller and less favored businesses struggling to fund their growth. This situation results in high demand for otherwise riskier and more

illegal, so information on this important sector is ture. There are at least five broad reasons for this much less readily available lending bias, some of which also apply in Western markets SUMMARY Strong business positions. Some of the majo Banks dominate the Chinese financial system, borrowers are simply very good credit risks be providing about three fifths of total credit to the cause of their strong business positions, resulting private sector. This is not too different from Eu- from monopolistic or oligopolistic power, supe- ropean levels, but contrasts with the US system, rior business models, or other factors. (In rece where financial markets and non-bank lenders years, firms with majority state ownership re provide significantly more credit than banks. The portedly represented 35% of business activity in Chinese banking system is fairly concentrated, China, but earned 43% of the profits )Firms may with five banks splitting almost half the total loan also have grown large because of their strengths market, which is somewhat less concentrated Further, size can bring a degree of diversification than many national markets in Europe but more that in its own right reduces credit risk and make concentrated than in the us hem more attractive borrowers. In all of these cases, there is no particular mystery as to why A major difference with more developed financial these SOE's would be favored customers systems, however, is the high level of state owner ship and control. The five largest Chinese banks Implicit government guarantees. There is a wide are majority-owned by the central government ly held perception that the government would not nd there are significant government stakes let a large state-owned enterprise formally default many of the other banks. Further, the government on their loans. This implicit guarantee is poten intervenes far more actively in banking decisions tially of great value, although it does not preclude than in the West. Most important, the central bank the lender suffering economic losses by being explicitly sets maximum interest rates for deposits forced to accept modifications to the loan terms nd minimum interest rates for loans, and often that fall short of default. There are also degree sets target levels for loan volumes in the strength of these implicit guarantees. For example, SOE's that are owned, or controlled in Government and party leaders can exert consid- practice, by powerful central ministries have a erable influence behind the scenes, often pushing greater certainty of support than entities owned loans to particular firms, sectors, or regions to by less powerful government bodies further their political agendas. The close linkag between the government and banking, as well Career safety. The large state-owned banks are as the pervasive power of the Communist Party, now sufficiently commercial in their outlooks that make this possible. Unlike in the West, the careers loan officers do risk their jobs if their borrowers of the most important bankers are determined by default. However, there is a clear perception that the Party and many of them move in and out of lending to a large Soe will never be a career-end the banking along the course of their ca- ing decision, whereas lending to private borrow- reers ers co The big banks lend principally to large, state- Personal relationships. Senior officials at large owned enterprises(SOE's), although the propor- SOEs are in a position to favor bank officers,in tion has declined substantially in recent year cluding through their Party influence, and there The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS

The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 3 expensive informal lending channels. The informal sector is less regulated, and sometimes illegal, so information on this important sector is much less readily available. Summary Banks dominate the Chinese financial system, providing about three fifths of total credit to the private sector.1 This is not too different from European levels, but contrasts with the US system, where financial markets and non-bank lenders provide significantly more credit than banks. The Chinese banking system is fairly concentrated, with five banks splitting almost half the total loan market,2 which is somewhat less concentrated than many national markets in Europe but more concentrated than in the US. A major difference with more developed financial systems, however, is the high level of state ownership and control. The five largest Chinese banks are majority-owned by the central government and there are significant government stakes in many of the other banks. Further, the government intervenes far more actively in banking decisions than in the West. Most important, the central bank explicitly sets maximum interest rates for deposits and minimum interest rates for loans, and often sets target levels for loan volumes. Government and party leaders can exert considerable influence behind the scenes, often pushing loans to particular firms, sectors, or regions to further their political agendas. The close linkages between the government and banking, as well as the pervasive power of the Communist Party, make this possible. Unlike in the West, the careers of the most important bankers are determined by the Party and many of them move in and out of the banking sector along the course of their careers. The big banks lend principally to large, stateowned enterprises (SOE’s), although the proportion has declined substantially in recent years. One of the great outstanding questions is why this occurs and how it might change in the future. There are at least five broad reasons for this lending bias, some of which also apply in Western markets. Strong business positions. Some of the major borrowers are simply very good credit risks because of their strong business positions, resulting from monopolistic or oligopolistic power, superior business models, or other factors. (In recent years, firms with majority state ownership reportedly represented 35% of business activity in China, but earned 43% of the profits.3 ) Firms may also have grown large because of their strengths. Further, size can bring a degree of diversification that in its own right reduces credit risk and makes them more attractive borrowers. In all of these cases, there is no particular mystery as to why these SOE’s would be favored customers. Implicit government guarantees. There is a widely held perception that the government would not let a large state-owned enterprise formally default on their loans. This implicit guarantee is potentially of great value, although it does not preclude the lender suffering economic losses by being forced to accept modifications to the loan terms that fall short of default. There are also degrees in the strength of these implicit guarantees. For example, SOE’s that are owned, or controlled in practice, by powerful central ministries have a greater certainty of support than entities owned by less powerful government bodies. Career safety. The large state-owned banks are now sufficiently commercial in their outlooks that loan officers do risk their jobs if their borrowers default. However, there is a clear perception that lending to a large SOE will never be a career-ending decision, whereas lending to private borrowers could be. Personal relationships. Senior officials at large SOE’s are in a position to favor bank officers, including through their Party influence, and there

will often be social relationships as well, such as higher rates. If the pessimists are right, banks school connections could have serious problems as their net interest margins become squeezed. This could lead them, Direct government or Party influence. Some- like some Savings Loans in the US in the 1970s times an influential official will strongly urge a and 1980s, to take unreasonable risks to restore an loan to be made, essentially circumventing nor- acceptable level of profitability. It could also lead mal credit procedures. This is apparently less com- to a slowdown in loan growth, as banks'inter mon than in the past, and there is more likelihood nal capital generation slows and external capital of resistance, but it certainly still occurs today to sources find the banking industry less attractive. an extent that is hard to quantify. One reason it is hard to measure is because there are legal lim- Optimists believe the large banks will be consid on how strongly one can push a loan officer to erably more flexible and intelligent in their re make a specific loan, intended precisely to reduce sponses, and that the government and Party will the extent to which such pressure is exerted sensibly manage the process of change with an eye towards avoiding these potential problems Government and party leaders have recognized that it is too easy for large SOE's to acquire loans Bond markets are another source of credit fo and too hard for many smaller, purely private companies, particularly larger firms. However, firms to compete. As a result, leaders are encor the Chinese corporate bond market is smaller aging the banking sector to lend more to smaller and less sophisticated than in the US and Europe, firms and have also become more open to other and at present the banks are the largest holders avenues of credit provision, such as the informal of these corporate bonds. But, the corporate bond sector. One of the analytical debates about China market is growing rapidly. Net issuance of corpo is the extent to which the large banks will be able rate bonds increased by 65% in 2012, according to to change their behavior toward smaller firms. On the PBOC's figures on the size of various compo the one hand, Chinas leaders have proven adept nents of finance, and now represents about 16% of over the years at generating the changes that they net new credit. In addition to serving as compe wish to see. On the other hand, it is not clear that tion to the banks, and an alternative way for them the key incentives described above will change. to invest, the development of the corporate bond Some analysts also believe that the big banks sim- market may also take some pressure off the banks ply do not have the culture and systems necessary to act as a quasi-fiscal arm of the government. to lend successfully to small, private firms Chinese stock markets provide another source of There is also much analytical debate about the funding for businesses. However, there are sev sources of bank profit. Pessimists contend that the eral problems that hold these markets back from large banks are fat and happy, benefitting from a reaching their full potential. First, the markets combination of a ceiling on interest rates for de- are dominated by speculators to a far greater ex- posits, (their main source of funding), and credit tent than in Western nations. There are multiple quotas set by the Chinese central bank, which al- reasons for this, the most fundamental of which low banks to charge higher lending rates for those is that Chinese law, regulation and governance loans they do make. These government interest patterns considerably constrain the control that rates and credit quotas are becoming increasingly shareholders can exercise over management. and may even disappear, over time. Even These problems are now,they can be circumvented in various ways, publicly traded firms where the government owns such as through the use of certain"wealth man- a majority stake. Lacking the ability to influence gement"products that are deposit-like, but pay business choices and dividend levels, or to sell the The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS

The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 4 will often be social relationships as well, such as school connections. Direct government or Party influence. Sometimes an influential official will strongly urge a loan to be made, essentially circumventing normal credit procedures. This is apparently less common than in the past, and there is more likelihood of resistance, but it certainly still occurs today to an extent that is hard to quantify. One reason it is hard to measure is because there are legal limits on how strongly one can push a loan officer to make a specific loan, intended precisely to reduce the extent to which such pressure is exerted. Government and party leaders have recognized that it is too easy for large SOE’s to acquire loans and too hard for many smaller, purely private firms to compete. As a result, leaders are encouraging the banking sector to lend more to smaller firms and have also become more open to other avenues of credit provision, such as the informal sector. One of the analytical debates about China is the extent to which the large banks will be able to change their behavior toward smaller firms. On the one hand, China’s leaders have proven adept over the years at generating the changes that they wish to see. On the other hand, it is not clear that the key incentives described above will change. Some analysts also believe that the big banks simply do not have the culture and systems necessary to lend successfully to small, private firms. There is also much analytical debate about the sources of bank profit. Pessimists contend that the large banks are fat and happy, benefitting from a combination of a ceiling on interest rates for deposits, (their main source of funding), and credit quotas set by the Chinese central bank, which allow banks to charge higher lending rates for those loans they do make. These government interest rates and credit quotas are becoming increasingly flexible, and may even disappear, over time. Even now, they can be circumvented in various ways, such as through the use of certain “wealth management” products that are deposit-like, but pay higher rates. If the pessimists are right, banks could have serious problems as their net interest margins become squeezed. This could lead them, like some Savings & Loans in the US in the 1970s and 1980s, to take unreasonable risks to restore an acceptable level of profitability. It could also lead to a slowdown in loan growth, as banks’ internal capital generation slows and external capital sources find the banking industry less attractive. Optimists believe the large banks will be considerably more flexible and intelligent in their responses, and that the government and Party will sensibly manage the process of change with an eye towards avoiding these potential problems. Bond markets are another source of credit for companies, particularly larger firms. However, the Chinese corporate bond market is smaller and less sophisticated than in the US and Europe, and at present the banks are the largest holders of these corporate bonds. But, the corporate bond market is growing rapidly. Net issuance of corporate bonds increased by 65% in 2012, according to the PBOC’s figures on the size of various components of finance, and now represents about 16% of net new credit.4 In addition to serving as competition to the banks, and an alternative way for them to invest, the development of the corporate bond market may also take some pressure off the banks to act as a quasi-fiscal arm of the government. Chinese stock markets provide another source of funding for businesses. However, there are several problems that hold these markets back from reaching their full potential. First, the markets are dominated by speculators to a far greater extent than in Western nations. There are multiple reasons for this, the most fundamental of which is that Chinese law, regulation and governance patterns considerably constrain the control that shareholders can exercise over management. These problems are exacerbated for the many publicly traded firms where the government owns a majority stake. Lacking the ability to influence business choices and dividend levels, or to sell the

firm as a whole, shareowners place less reliance loan sharks, pawn brokers, formal and informal on underlying firm value and focus more on like- cooperatives of locals lending to each other,State ly stock price movements in the short run. Many Owned Enterprises(SOEs)re-lending out exce Chinese also attribute speculation to a nation- cash, and many other privately,and sometimes al love of gambling, but it is very hard to know secretly), raised funds that invest in start-ups. The whether this stereotype applies and the extent to informal sector has an uneasy relationship with which it affects investment decisions the chinese state and regulat Another factor contributing to the speculatic Chinese officials are currently wrestling with how and holding back the stock markets in its own to harness the potential of this informal sector to right, is the relative dearth of institutional inves- provide funds to worthy borrowers neglected by tors,who may make more informed and reasoned the formal sector, while avoiding predatory be decisions than individuals. Even if they were no havior and excessive risk-taking by institutions more rational in their behavior, their absence and individuals that are less regulated. How effec reduces the potential size of the stock markets tively the government manages this balancing act and therefore the ability to generate new capital will have a major impact on the financial system through sales of stock by firms and wider economy in the years ahead Chinese regulators also limit the size of the stock There are two other debates about the financial lic Offerings. Western nations generally la ub- sector that are significant enough to warrant not- markets through very close control of Initial ow a ing here. First, many analysts are concerned that new issuance as long as appropriate documen Chinese banks have large undeclared pools of bad tation is provided to investors to allow them to loans, which may deteriorate further. The prime make informed decisions, whereas China only cause of the concern is the huge growth of lend allows an IPO to proceed with specific approval ing that came out of China's massive stimulus that takes into account, on an ad hoc basis, a wid program in response to the global financial crisis, er range of considerations. Regulators apparently which primarily consisted of bank-financed acti maintain informal quotas that hold down issu- ities. It is true in any financial system that a large ance volumes spurt in lending, for whatever reason it occurs, raises a real potential for the creation of bad loans. Other parts of the regulated financial system re- The better loans were presumably already being main fairly undeveloped in China, although they funded, so one would expect a decrease in average are generally growing strongly from low levels. loan quality. In addition, a big jump in volume al The insurance industry is about two-fifths of most certainly comes with less careful underwrit- the size of the US market, relative to the size of ing, especially in a case such as the stimulus where its economy. The asset management industry there was strong pressure from the top to make even smaller in relative terms at a mere fraction loans if at all possible of American or European levels. Trust companies are an increasingly large part of the overall sys- The sector of borrowers that is most concerning tem, but the sector remains relatively smaller than comprises local governments and parties related the non-bank lending sector in the US to them. the national government pushed lo calities to fund the substantial majority of new In response to the gaps and rigidities in the formal stimulus spending in their areas, which forced financial system, China, in line with many devel- them to borrow large sums of money. It is clear oping countries, has a large and diverse informal that many of them overcommitted or invested in financial sector. Lenders in this sector include bad projects and will end up defaulting The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS

The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 5 firm as a whole, shareowners place less reliance on underlying firm value and focus more on likely stock price movements in the short run. Many Chinese also attribute speculation to a national love of gambling, but it is very hard to know whether this stereotype applies and the extent to which it affects investment decisions. Another factor contributing to the speculation, and holding back the stock markets in its own right, is the relative dearth of institutional investors, who may make more informed and reasoned decisions than individuals. Even if they were no more rational in their behavior, their absence reduces the potential size of the stock markets and therefore the ability to generate new capital through sales of stock by firms. Chinese regulators also limit the size of the stock markets through very close control of Initial Public Offerings. Western nations generally allow a new issuance as long as appropriate documentation is provided to investors to allow them to make informed decisions, whereas China only allows an IPO to proceed with specific approval that takes into account, on an ad hoc basis, a wider range of considerations. Regulators apparently maintain informal quotas that hold down issuance volumes. Other parts of the regulated financial system remain fairly undeveloped in China, although they are generally growing strongly from low levels. The insurance industry is about two-fifths of the size of the US market, relative to the size of its economy. The asset management industry is even smaller in relative terms at a mere fraction of American or European levels. Trust companies are an increasingly large part of the overall system, but the sector remains relatively smaller than the non-bank lending sector in the US. In response to the gaps and rigidities in the formal financial system, China, in line with many developing countries, has a large and diverse informal financial sector. Lenders in this sector include loan sharks, pawn brokers, formal and informal cooperatives of locals lending to each other, StateOwned Enterprises (SOEs) re-lending out excess cash, and many other privately, (and sometimes secretly), raised funds that invest in start-ups. The informal sector has an uneasy relationship with the Chinese state and regulators. Chinese officials are currently wrestling with how to harness the potential of this informal sector to provide funds to worthy borrowers neglected by the formal sector, while avoiding predatory behavior and excessive risk-taking by institutions and individuals that are less regulated. How effectively the government manages this balancing act will have a major impact on the financial system and wider economy in the years ahead. There are two other debates about the financial sector that are significant enough to warrant noting here. First, many analysts are concerned that Chinese banks have large undeclared pools of bad loans, which may deteriorate further. The prime cause of the concern is the huge growth of lending that came out of China’s massive stimulus program in response to the global financial crisis, which primarily consisted of bank-financed activities. It is true in any financial system that a large spurt in lending, for whatever reason it occurs, raises a real potential for the creation of bad loans. The better loans were presumably already being funded, so one would expect a decrease in average loan quality. In addition, a big jump in volume almost certainly comes with less careful underwriting, especially in a case such as the stimulus where there was strong pressure from the top to make loans if at all possible. The sector of borrowers that is most concerning comprises local governments and parties related to them. The national government pushed localities to fund the substantial majority of new stimulus spending in their areas, which forced them to borrow large sums of money. It is clear that many of them overcommitted or invested in bad projects and will end up defaulting on their

loans unless they receive help from the national ernment financing vehicles that fund much of the government or forbearance by lenders. This is a nations infrastructure investment. Many observ large-scale problem, with some analysts seeing it ers believe that banks and trusts implicitly back as substantially higher than the government and the loans they make that are packaged into wealth the banks currently admit. But even the more pes- management products. Even deposits operate simistic estimates remain in a range where a res- with an implicit guarantee and not an explicit one cue by the national government would be feasible without seriously compromising the strength of The widespread use of implicit support represents Chinas sovereign debt. a serious risk to the Chinese financial system, because of the large volume of these contingent There are also concerns about loans to industries obligations and because their informal nature with over-capacity, such as shipbuilding and solar can easily lead to misunderstandings. Should a energy, and to small and medium-size enterprises financial crisis begin somewhere in the nations that are squeezed by the weaker export environ- complex financial system, contagion could spread ment through a sudden loss of confidence in these im plicit guarantees Another key debate is the degree to which China will experience a real estate crisis and the resul- Overall, we tend towards guarded optimism or tant effects that would have on the banking sys- the points in debate, while conceding that the tem. The central government has concluded that level of uncertainty about the current and future real estate bubbles have built up in at least some workings of the financial system make it impos sectors and geographic areas, and is taking explic- sible to be sure that the problems that inevitably it action to restrain real estate speculation. Pessi- arise will be worked through effectively. However, mists fear that the problems are more extensive China has earned the right to a presumption that than admitted and that it will be impossible to it will continue to find the way through its growth successfully balance the twin goals of restraining challenges, although both the Chinese leadership estate prices, with attendant huge damage to the things actually develop and not become comp bubble behavior while avoiding a crash of real and outside observers need to watch carefully how lenders and the economy. Optimists see the prob- cent as a result of past successes lems as both smaller and more capable of being managed by the leadership. In order to assist the reader in navigating the complexities of China's opaque financial system, The real estate debate ties into a parallel debate on the remainder of this paper is organized as a se bad loans, since many of the loans to local govern- ries of questions and answers. This is intended to ments and their affiliated parties are based either provide a coherent conceptual framework while on real estate as collateral or on the ability of the allowing the reader to easily jump from topic to governments to sell land in order to maintain an topic, depending on interest. Please note that we adequate flow of revenues attempt to show what is not known, as well as to lay out the facts and circumstances as we knor There is an analytical debate in China on the level them. Given the degree of opacity and uncertain of implicit support given to various financial ob- ty pervading this complex subject, it is important ligations by governments or financial institutions. not to be lulled by a false sense of certainty, but Implicit government support of state-owned en- instead to remain aware of what is unknown terprises is a major factor allowing them to bor- w so much at such a low cost. A similar logic, The questions that will be addressed are listed be with somewhat more risk, applies to the local gov-low The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS

The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 6 loans unless they receive help from the national government or forbearance by lenders. This is a large-scale problem, with some analysts seeing it as substantially higher than the government and the banks currently admit. But even the more pessimistic estimates remain in a range where a rescue by the national government would be feasible without seriously compromising the strength of China’s sovereign debt. There are also concerns about loans to industries with over-capacity, such as shipbuilding and solar energy, and to small and medium-size enterprises that are squeezed by the weaker export environment. Another key debate is the degree to which China will experience a real estate crisis and the resultant effects that would have on the banking system. The central government has concluded that real estate bubbles have built up in at least some sectors and geographic areas, and is taking explicit action to restrain real estate speculation. Pessimists fear that the problems are more extensive than admitted and that it will be impossible to successfully balance the twin goals of restraining bubble behavior while avoiding a crash of real estate prices, with attendant huge damage to the lenders and the economy. Optimists see the problems as both smaller and more capable of being managed by the leadership. The real estate debate ties into a parallel debate on bad loans, since many of the loans to local governments and their affiliated parties are based either on real estate as collateral or on the ability of the governments to sell land in order to maintain an adequate flow of revenues. There is an analytical debate in China on the level of implicit support given to various financial obligations by governments or financial institutions. Implicit government support of state-owned enterprises is a major factor allowing them to borrow so much at such a low cost. A similar logic, with somewhat more risk, applies to the local government financing vehicles that fund much of the nation’s infrastructure investment. Many observers believe that banks and trusts implicitly back the loans they make that are packaged into wealth management products. Even deposits operate with an implicit guarantee and not an explicit one. The widespread use of implicit support represents a serious risk to the Chinese financial system, because of the large volume of these contingent obligations and because their informal nature can easily lead to misunderstandings. Should a financial crisis begin somewhere in the nation’s complex financial system, contagion could spread through a sudden loss of confidence in these implicit guarantees. Overall, we tend towards guarded optimism on the points in debate, while conceding that the level of uncertainty about the current and future workings of the financial system make it impossible to be sure that the problems that inevitably arise will be worked through effectively. However, China has earned the right to a presumption that it will continue to find the way through its growth challenges, although both the Chinese leadership and outside observers need to watch carefully how things actually develop and not become complacent as a result of past successes. In order to assist the reader in navigating the complexities of China’s opaque financial system, the remainder of this paper is organized as a series of questions and answers. This is intended to provide a coherent conceptual framework while allowing the reader to easily jump from topic to topic, depending on interest. Please note that we attempt to show what is not known, as well as to lay out the facts and circumstances as we know them. Given the degree of opacity and uncertainty pervading this complex subject, it is important not to be lulled by a false sense of certainty, but instead to remain aware of what is unknown. The questions that will be addressed are listed below:

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