Chinas Financial System: Past, Present, and Future Franklin Allen Jun Qian Meijun Qian Finance Department Finance Department Finance Department he Wharton School Carroll School of Management Carroll School of Management University of Pennsylvania Boston College Boston College Philadelphia, PA 19104 Chestnut Hill. MA 02467 Chestnut Hill. MA 02467 allen@wharton. upenn. edu ianjuabc edu gianme(abc.edu First draft: October 2004 Last Revised: July 21, 2005 To appear in the book titled"The Transition that Worked Origins, Mechanism, and Consequences of China s long boom, edited by loren brandt, Univ of Toronto, and Thomas Rawski, Univ of Pittsburgh) e We examine and compare the role of China's financial system in supporting the growth of firms and omy with that in other countries, and explore directions of future development. First, we find that the current financial system is dominated by a large but inefficient banking sector, and reducing the amount of non-performing loans among the major banks to normal levels is the most important objective for reforming the financial system in the short run. Second, despite the fast growth of the stock market, its role of resource allocation in the economy has been both limited and ineffective. Further development of Chinas financial markets is the most important long-term objective. Third, we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, coalitions, and institutions. This sector should co-exist with banking and markets in the future in order to continue to support the growth of the Hybrid Sector(non-state, non-listed firms). Finally, in order to sustain stable economic growth, China should aim to prevent and halt damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a"twin crisis" in the currency market and banking sector JEL Classifications: O5.KO. G2 Keywords: banks, non-performing loans, markets, corporate governance, hybrid sector, financial crisis We appreciate detailed comments from Loren Brandt and Tom Rawski(editors of the book "Chinas Economic Transition: Origins, Mechanism, and Consequences")that significantly improved the paper. We wish to thank Dong Chen, Ed Kane, Nick Lardy, Anthony Neoh, Phil Strahan, and other participants of the"China,'s Economic Transition project for their comments, Qiao Yu and wuxiang Zhu for assisting us in conducting the firm survey, Y ing Xia and Jason Mao for research assistance, and Michael Chui, Richard Herring, and State Street Private Edge Group for roviding data on financial intermediaries, bond markets, and venture capital private equity. Financial support from Boston College, the Smith Richardson Foundation, and Wharton Financial Institutions Center is gratefully knowledged. All remaining errors bility Phone: 215-898-3629, fax: 215-573-2207, E-mail: allenf(@wharton. upenn. ed ennsylvania, Philadelphia, PA 19104 Corresponding author: Finance Depar artment, Wharton School, University of Pe
China’s Financial System: Past, Present, and Future * Franklin Allen† Jun Qian Meijun Qian Finance Department Finance Department Finance Department The Wharton School Carroll School of Management Carroll School of Management University of Pennsylvania Boston College Boston College Philadelphia, PA 19104 Chestnut Hill, MA 02467 Chestnut Hill, MA 02467 allenf@wharton.upenn.edu qianju@bc.edu qianme@bc.edu First Draft: October 2004 Last Revised: July 21, 2005 (To appear in the book titled “The Transition that Worked: Origins, Mechanism, and Consequences of China’s Long Boom,” edited by Loren Brandt, Univ. of Toronto, and Thomas Rawski, Univ. of Pittsburgh) Abstract We examine and compare the role of China’s financial system in supporting the growth of firms and the economy with that in other countries, and explore directions of future development. First, we find that the current financial system is dominated by a large but inefficient banking sector, and reducing the amount of non-performing loans among the major banks to normal levels is the most important objective for reforming the financial system in the short run. Second, despite the fast growth of the stock market, its role of resource allocation in the economy has been both limited and ineffective. Further development of China’s financial markets is the most important long-term objective. Third, we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, coalitions, and institutions. This sector should co-exist with banking and markets in the future in order to continue to support the growth of the Hybrid Sector (non-state, non-listed firms). Finally, in order to sustain stable economic growth, China should aim to prevent and halt damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a “twin crisis” in the currency market and banking sector. JEL Classifications: O5, K0, G2. Keywords: banks, non-performing loans, markets, corporate governance, hybrid sector, financial crisis. * We appreciate detailed comments from Loren Brandt and Tom Rawski (editors of the book “China's Economic Transition: Origins, Mechanism, and Consequences”) that significantly improved the paper. We wish to thank Dong Chen, Ed Kane, Nick Lardy, Anthony Neoh, Phil Strahan, and other participants of the “China's Economic Transition” project for their comments, Qiao Yu and Wuxiang Zhu for assisting us in conducting the firm survey, Ying Xia and Jason Mao for research assistance, and Michael Chui, Richard Herring, and State Street PrivateEdge Group for providing data on financial intermediaries, bond markets, and venture capital & private equity. Financial support from Boston College, the Smith Richardson Foundation, and Wharton Financial Institutions Center is gratefully acknowledged. All remaining errors are our own responsibility. † Corresponding author: Finance Department, Wharton School, University of Pennsylvania, Philadelphia, PA 19104. Phone: 215-898-3629, fax: 215-573-2207, E-mail: allenf@wharton.upenn.edu
L Introduction We examine the role of China's financial system in supporting the growth of its economy and explore the directions of its future development. Almost every functioning financial system includes financial markets and intermediaries(e.g, a banking sector), but how these two sectors contribute to the entire financial system and economy differs significantly across different countries Although there is no consensus regarding the prospects of China's future economic growth, a prevailing view on China's financial system speculates that it is one of the weakest links in the economy and it will hamper future economic growth A comprehensive examination of all aspects of China's financial system, and extensive comparisons with other countries where data is available are provided below. We also discuss wha has worked and what remains to be done within the financial system, and examine how further development can better serve the entire economy. Finally, we provide guidelines for future research and policy making on several important unresolved issues, including how China's financial system should integrate into the world's markets and economy We draw four main conclusions about China's financial system and its future development First, when we examine and compare China's banking system and financial markets with those of both developed and emerging countries, we find China's financial system is dominated by a large but under-developed banking system, which is mainly controlled by the four largest state-owned banks with a large amount of non-performing loans (NPLs). The continuing effort of improving the banking system, in particular, reducing the amount of NPLs of the major banks to normal levels, is the most important aspect of reforming Chinas financial system in the short run We consider three channels through which the NPls can be reduced and efficiency of the banking sector improved. The main obstacle in evaluating these solutions is the lack of accurate bank-level data. First, the entrance and growth of non-state banks and intermediaries should be encouraged. With more domestic and foreign banks and intermediaries, the banking sector becomes more competitive, and competition improves the incentives and efficiency of state-owned banks Second, the ongoing privatization of state-owned banks will not be completed until the majority of these banks' assets are owned by non-government organizations and investors. With(majority) state ownership, banks will have perverse incentives in selecting borrowers and borrowers(in particular, state-owned companies) have perverse incentives in selecting investment projects. As a result, a large amount of new NPLs may surface within the network of state-owned banks as the government rids old NPLs from the banks' books. Third. the Chinese government and central bank
2 I. Introduction We examine the role of China’s financial system in supporting the growth of its economy and explore the directions of its future development. Almost every functioning financial system includes financial markets and intermediaries (e.g., a banking sector), but how these two sectors contribute to the entire financial system and economy differs significantly across different countries. Although there is no consensus regarding the prospects of China’s future economic growth, a prevailing view on China’s financial system speculates that it is one of the weakest links in the economy and it will hamper future economic growth. A comprehensive examination of all aspects of China’s financial system, and extensive comparisons with other countries where data is available are provided below. We also discuss what has worked and what remains to be done within the financial system, and examine how further development can better serve the entire economy. Finally, we provide guidelines for future research and policy making on several important unresolved issues, including how China’s financial system should integrate into the world’s markets and economy. We draw four main conclusions about China’s financial system and its future development. First, when we examine and compare China’s banking system and financial markets with those of both developed and emerging countries, we find China’s financial system is dominated by a large but under-developed banking system, which is mainly controlled by the four largest state-owned banks with a large amount of non-performing loans (NPLs). The continuing effort of improving the banking system, in particular, reducing the amount of NPLs of the major banks to normal levels, is the most important aspect of reforming China’s financial system in the short run. We consider three channels through which the NPLs can be reduced and efficiency of the banking sector improved. The main obstacle in evaluating these solutions is the lack of accurate bank-level data. First, the entrance and growth of non-state banks and intermediaries should be encouraged. With more domestic and foreign banks and intermediaries, the banking sector becomes more competitive, and competition improves the incentives and efficiency of state-owned banks. Second, the ongoing privatization of state-owned banks will not be completed until the majority of these banks’ assets are owned by non-government organizations and investors. With (majority) state ownership, banks will have perverse incentives in selecting borrowers and borrowers (in particular, state-owned companies) have perverse incentives in selecting investment projects. As a result, a large amount of new NPLs may surface within the network of state-owned banks as the government rids old NPLs from the banks’ books. Third, the Chinese government and central bank
have been injecting foreign reserves into the largest state-owned banks in order to boost their capital reserves and balance sheets so that they can become publicly listed companies. USing official data on NPLs, we conclude that it is feasible for the government to assume a large fraction of the existing NPLS, provided that current economic growth rates(and hence the governments tax receipts)can be sustained. However, since the official data may significantly underestimate the amount of NPLs, we view the reform of state-owned banks and the improvement of the banking sector as the ultimate solution to npls Our second conclusion concerns China's financial markets. Two domestic stock exchanges the Shanghai Stock Exchange(ShSE hereafter)and Shenzhen Stock Exchange (SZSE hereafter) were established in 1990, and have been growing very fast since then. However, their scale and importance are not comparable to the banking sector for the entire economy. Moreover, the financial markets have not been effective in allocating resources in the economy, in that they are highly speculative and driven by insider trading. Going forward, financial markets are likely to play an increasingly important role in the economy, and the further development of the financial markets is the most important long-term objective for China's financial system. We propose several measures that can increase the size and scope and help to improve the efficiency of the markets More specifically, the regulatory environment should be improved; in particular, corporate and trading laws and legal protection of investors, as well as institutions governing the enforcement of contracts should be further developed. Second, the large blocks of shares held by various government entities in listed companies (including state-owned banks) should be reduced by announcing and carrying out a plan to sell them off slowly over time. Third, more professionals such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth, domestic financial intermediaries that act as institutional investors should be encouraged, as they will play a critical role in improving the efficiency of the markets and strengthening the corporate governance of listed firms. Finally, new financial products and markets should be developed Third, in a companion paper(Allen, Qian, and Qian, 2005), we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is not the banking sector or stock market, but rather a sector of alternative financing channels, such as internal financing and trade credits, and coalitions of various forms among firms, investors, and local overnments. Many of these financing channels rely on alternative governance mechanisms, such competition in product and input markets, and trust, reputation, and relationships. Together these methods of financing and governance have supported the growth of a"Hybrid Sector"of non-state
3 have been injecting foreign reserves into the largest state-owned banks in order to boost their capital reserves and balance sheets so that they can become publicly listed companies. Using official data on NPLs, we conclude that it is feasible for the government to assume a large fraction of the existing NPLs, provided that current economic growth rates (and hence the government’s tax receipts) can be sustained. However, since the official data may significantly underestimate the amount of NPLs, we view the reform of state-owned banks and the improvement of the banking sector as the ultimate solution to NPLs. Our second conclusion concerns China’s financial markets. Two domestic stock exchanges, the Shanghai Stock Exchange (SHSE hereafter) and Shenzhen Stock Exchange (SZSE hereafter), were established in 1990, and have been growing very fast since then. However, their scale and importance are not comparable to the banking sector for the entire economy. Moreover, the financial markets have not been effective in allocating resources in the economy, in that they are highly speculative and driven by insider trading. Going forward, financial markets are likely to play an increasingly important role in the economy, and the further development of the financial markets is the most important long-term objective for China’s financial system. We propose several measures that can increase the size and scope and help to improve the efficiency of the markets. More specifically, the regulatory environment should be improved; in particular, corporate and trading laws and legal protection of investors, as well as institutions governing the enforcement of contracts should be further developed. Second, the large blocks of shares held by various government entities in listed companies (including state-owned banks) should be reduced by announcing and carrying out a plan to sell them off slowly over time. Third, more professionals such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth, domestic financial intermediaries that act as institutional investors should be encouraged, as they will play a critical role in improving the efficiency of the markets and strengthening the corporate governance of listed firms. Finally, new financial products and markets should be developed. Third, in a companion paper (Allen, Qian, and Qian, 2005), we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is not the banking sector or stock market, but rather a sector of alternative financing channels, such as internal financing and trade credits, and coalitions of various forms among firms, investors, and local governments. Many of these financing channels rely on alternative governance mechanisms, such as competition in product and input markets, and trust, reputation, and relationships. Together these methods of financing and governance have supported the growth of a “Hybrid Sector” of non-state
non-listed firms with various types of ownership structures. It is important to point out at the or that our definition of the Hybrid Sector is broader than privately or individually owned firms,w are part of this sector. In particular, firms that are partially owned by local governments(e.g Township Village Enterprises or TVEs)are also included in the Hybrid Sector, because: first, despite the ownership stake of local governments and the sometimes ambiguous ownership structure and property rights, the operation of these firms resembles more closely that of a for- profit, privately-owned firm than that of a state-owned firm; and second, the ownership stake of local governments in many of these firms has been privatized. The growth of the Hybrid Sector has been much higher than that of the State Sector(state-owned enterprises or SOEs, and all firn here the central government has ultimate control) and the listed Sector(publicly listed and traded firms with most of them converted from the State Sector ), and contributes to most of the economic growth. We believe these alternative channels and mechanisms should be encouraged going forward. They can co-exist with the banks and markets while continuing to fuel the growth of the Hybrid Sector Finally, in our view a significant challenge for Chinas financial system is to avoid damaging financial crises that can severely disrupt the economy and social stability. China needs to guard against traditional financial crises, including a banking sector crisis stemming from continuing accumulation of NPLs and a sudden drop in banks' profits; or a crisis/crash resulting from speculative asset bubbles in the real estate market. China also needs to guard against new types of financial crises, such as a"twin crisis"(simultaneous foreign exchange and banking/stock market crises)that was prevalent in many Asian economies in the late 1990s. The entrance of China into the World Trade Organization(WTO) introduces cheap foreign capital and technology but large scale and sudden capital flows and foreign speculation significantly increase the likelihood of a twin crisis. At the moment, the rapid increase in China's foreign exchange reserves suggests that there is a large amount of speculative money in China in anticipation of an appreciation of the hina's currency, relative to all other major currencies. Depending on how the government and the central bank handle the process of revaluation, there could be a classic currency crisis as the The Hybrid Sector comprises all the firms that are not state-owned or publicly listed, and more specifically, it includes the following types of firms(see Appendix A. 5 for details): 1)privately owned companies(but not publicly listed and investors(or companies); 2)collective\ g iontly-owned companies, where joint ownership among locr r foreign traded) controlling owners can be Chinese citizens, investors(or companies)from Taiwan or Hong Kong government, communities, employees, and institutions is forged. See Li(1996)and Che and Qian(1998)for arguments on why an ambiguous ownership structure with local governments is more efficient than well defined private property rights or state ownership in an environment with underdeveloped markets and institutions
4 non-listed firms with various types of ownership structures. It is important to point out at the outset that our definition of the Hybrid Sector is broader than privately or individually owned firms, which are part of this sector. In particular, firms that are partially owned by local governments (e.g., Township Village Enterprises or TVEs) are also included in the Hybrid Sector, because: first, despite the ownership stake of local governments and the sometimes ambiguous ownership structure and property rights, the operation of these firms resembles more closely that of a forprofit, privately-owned firm than that of a state-owned firm; and second, the ownership stake of local governments in many of these firms has been privatized.1 The growth of the Hybrid Sector has been much higher than that of the State Sector (state-owned enterprises or SOEs, and all firms where the central government has ultimate control) and the Listed Sector (publicly listed and traded firms with most of them converted from the State Sector), and contributes to most of the economic growth. We believe these alternative channels and mechanisms should be encouraged going forward. They can co-exist with the banks and markets while continuing to fuel the growth of the Hybrid Sector. Finally, in our view a significant challenge for China’s financial system is to avoid damaging financial crises that can severely disrupt the economy and social stability. China needs to guard against traditional financial crises, including a banking sector crisis stemming from continuing accumulation of NPLs and a sudden drop in banks’ profits; or a crisis/crash resulting from speculative asset bubbles in the real estate market. China also needs to guard against new types of financial crises, such as a “twin crisis” (simultaneous foreign exchange and banking/stock market crises) that was prevalent in many Asian economies in the late 1990s. The entrance of China into the World Trade Organization (WTO) introduces cheap foreign capital and technology, but large scale and sudden capital flows and foreign speculation significantly increase the likelihood of a twin crisis. At the moment, the rapid increase in China’s foreign exchange reserves suggests that there is a large amount of speculative money in China in anticipation of an appreciation of the RMB, China’s currency, relative to all other major currencies. Depending on how the government and the central bank handle the process of revaluation, there could be a classic currency crisis as the 1 The Hybrid Sector comprises all the firms that are not state-owned or publicly listed, and more specifically, it includes the following types of firms (see Appendix A.5 for details): 1) privately owned companies (but not publicly listed and traded): controlling owners can be Chinese citizens, investors (or companies) from Taiwan or Hong Kong, or foreign investors (or companies); 2) collectively- and jointly-owned companies, where joint ownership among local government, communities, employees, and institutions is forged. See Li (1996) and Che and Qian (1998) for arguments on why an ambiguous ownership structure with local governments is more efficient than well defined private property rights or state ownership in an environment with underdeveloped markets and institutions
government and central bank try to defend the currency peg, which in turn may trigger a banking crisis if there are large withdrawals from banks. In order to prevent such a crisis, policies improving the financial system should be implemented in conjunction with supportive fiscal and trade policie ganized as follows. In Section Il, the history of Chinas financial system development, present aggregate evidence on China's financial system, and compare them to those of developed and other developing countries. In Section Ill, we examine Chinas banking system and the problem of NPLs and reforms. In Section IV, we examine the rowth and irregularities of financial markets and listed firms. In Section V, we examine the non standard financial sector, including alternative financial channels and governance mechanisms. We then examine different types of financial crises and how China's financial system can be better prepared for these crises in Section VI. Finally, Section VIl concludes the paper and is followed by the Appendix that contains definitions and sources of all key terms and phrases used IL. Overview of Chinas Financial System In this section we examine China's financial system, focusing on both the banking system and financial markets, as well as firms' financing channels at the aggregate level, including non- bank and non-market channels. Appendixes A I through A 3 contain definitions and sources of variables used in Table I and Figures I and 2, while Appendix A 4 contains definitions of different types of financial intermediaries Il.1 A Brief Review of the history of Chinas Financial System Chinas financial system was well developed prior to 1949.- The earliest form of capitalism can be traced back to the late Ming Dynasty(17 century), with commerce initiated in the Zhejiang Jiangsu area and further developed during the Qing Dynasty (17 century to early 20century ). The Opium War(1840s) between China and Great Britain ruined China's sovereignty, but it brought Western-style legal and capital systems into Chinas coastal areas(until 1949). In 1904, the newly created Ministry of Commerce( Shangbu) of the waning Qing government issued China's first Company Law(Gongsili), aimed at promoting China's industrial development. Interestingly, foreign systems and the Chinese system co-existed and commerce boomed. Despite the entrance and development of Western-style courts in Shanghai and other major coastal cities(see Lee( 1993) For more details on the description of pre-1949 history of Chinas financial system and the rise of Shanghai as Chinas financial center, see, for example, Chow(2004), Kirby(1995), and Lee (1993)
5 government and central bank try to defend the currency peg, which in turn may trigger a banking crisis if there are large withdrawals from banks. In order to prevent such a crisis, policies improving the financial system should be implemented in conjunction with supportive fiscal and trade policies. The remaining sections are organized as follows. In Section II, we review the history of China’s financial system development, present aggregate evidence on China’s financial system, and compare them to those of developed and other developing countries. In Section III, we examine China’s banking system and the problem of NPLs and reforms. In Section IV, we examine the growth and irregularities of financial markets and listed firms. In Section V, we examine the nonstandard financial sector, including alternative financial channels and governance mechanisms. We then examine different types of financial crises and how China’s financial system can be better prepared for these crises in Section VI. Finally, Section VII concludes the paper and is followed by the Appendix that contains definitions and sources of all key terms and phrases used. II. Overview of China’s Financial System In this section we examine China’s financial system, focusing on both the banking system and financial markets, as well as firms’ financing channels at the aggregate level, including nonbank and non-market channels. Appendixes A.1 through A.3 contain definitions and sources of variables used in Table 1 and Figures 1 and 2, while Appendix A.4 contains definitions of different types of financial intermediaries. II.1 A Brief Review of the History of China’s Financial System China’s financial system was well developed prior to 1949.2 The earliest form of capitalism can be traced back to the late Ming Dynasty (17th century), with commerce initiated in the ZhejiangJiangsu area and further developed during the Qing Dynasty (17th century to early 20th century). The Opium War (1840s) between China and Great Britain ruined China’s sovereignty, but it brought Western-style legal and capital systems into China’s coastal areas (until 1949). In 1904, the newly created Ministry of Commerce (Shangbu) of the waning Qing government issued China’s first Company Law (Gongsilü), aimed at promoting China’s industrial development. Interestingly, foreign systems and the Chinese system co-existed and commerce boomed. Despite the entrance and development of Western-style courts in Shanghai and other major coastal cities (see Lee (1993) 2 For more details on the description of pre-1949 history of China’s financial system and the rise of Shanghai as China’s financial center, see, for example, Chow (2004), Kirby (1995), and Lee (1993)
for a description on how these courts functioned), most business-related disputes were resolved outside courts. Late Qing China had a highly commercialized society, and dispute resolution by guilds(merchant coalitions), families, and local notables based on the detailed regulations of guild family traditions, and customs was commonplace(see, e.g., Kirby 1995). In Section V 4 beloy argue that modern equivalents of these mechanisms were behind the success of Hybrid Sector in the same areas in the 1980s and 1990s The development of China's financial system from the late nineteenth century to the early twentieth century was highlighted by the emergence of Shanghai as the financial center of China and Asia(see, e.g., Lee(1993) for more details). During this period, Shanghai transformed from an agricultural-based trading hub for surrounding areas into an industrialized center linked to international goods and financial markets. With thriving entrepreneurial and trading activities, financial institutions proliferated and financial innovations surged For example, the number of Chinese lending institutions(qianzhuang)exceeded 105 in 1875; five of China's first modern banks were founded between 1897 and 1908 and by 1936, there were 28 major foreign banks that had set up branches in Shanghai. Merchants used up to eleven currencies in their transactions, some of which were printed by local bankS; the exchange rate of local currency saw wide fluctuations,many unregistered local banks( diaotang)engaged in high-leverage credit transactions with little capital reserves and defaulted frequently. At the same time, merchants fear of risk spawned an active insurance industry, which was first introduced by the British Insurance on real estate, ships, and goods became routine, with collateral and personal guarantors accompanying large transactions to reduce the risk of non-payments to alleviate the problems of asymmetric information, foreign merchants hired Chinese middlemen(and guarantors)to select Chinese merchants. Chinese and foreign merchants also devised the commission indent system, an early form of trade credit llowing firms and institutions to operate with minimum financial resources. Finally, the stock exchange in Shanghai was the largest in Asia for most of the 1920s and 1930s After the foundation of the People's Republic of China in 1949, all of the pre-1949 capitalist companies and institutions were nationalized by 1950. Between 1950 and 1978, Chinas financial system consisted of a single bank--the People's Bank of China(PBOC), a central government owned and controlled bank under the Ministry of Finance, which served as both the central bank and a commercial bank, controlling about 93% of the total financial assets of the country and handling almost all financial transactions. With its main role to finance the physical production plans, PBOC used both a"cash-plan" and a"credit-plan"to control the cash flows in consumer
6 for a description on how these courts functioned), most business-related disputes were resolved outside courts. Late Qing China had a highly commercialized society, and dispute resolution by guilds (merchant coalitions), families, and local notables based on the detailed regulations of guilds, family traditions, and customs was commonplace (see, e.g., Kirby 1995). In Section V.4 below, we argue that modern equivalents of these mechanisms were behind the success of Hybrid Sector firms in the same areas in the 1980s and 1990s. The development of China’s financial system from the late nineteenth century to the early twentieth century was highlighted by the emergence of Shanghai as the financial center of China and Asia (see, e.g., Lee (1993) for more details). During this period, Shanghai transformed from an agricultural-based trading hub for surrounding areas into an industrialized center linked to international goods and financial markets. With thriving entrepreneurial and trading activities, financial institutions proliferated and financial innovations surged. For example, the number of Chinese lending institutions (qianzhuang) exceeded 105 in 1875; five of China’s first modern banks were founded between 1897 and 1908; and by 1936, there were 28 major foreign banks that had set up branches in Shanghai. Merchants used up to eleven currencies in their transactions, some of which were printed by local banks; the exchange rate of local currency saw wide fluctuations; many unregistered local banks (diaotang) engaged in high-leverage credit transactions with little capital reserves and defaulted frequently. At the same time, merchants’ fear of risk spawned an active insurance industry, which was first introduced by the British. Insurance on real estate, ships, and goods became routine, with collateral and personal guarantors accompanying large transactions to reduce the risk of non-payments; to alleviate the problems of asymmetric information, foreign merchants hired Chinese middlemen (and guarantors) to select Chinese merchants. Chinese and foreign merchants also devised the “commission indent system,” an early form of trade credit allowing firms and institutions to operate with minimum financial resources. Finally, the stock exchange in Shanghai was the largest in Asia for most of the 1920s and 1930s. After the foundation of the People’s Republic of China in 1949, all of the pre-1949 capitalist companies and institutions were nationalized by 1950. Between 1950 and 1978, China’s financial system consisted of a single bank -- the People’s Bank of China (PBOC), a central government owned and controlled bank under the Ministry of Finance, which served as both the central bank and a commercial bank, controlling about 93% of the total financial assets of the country and handling almost all financial transactions. With its main role to finance the physical production plans, PBOC used both a “cash-plan” and a “credit-plan” to control the cash flows in consumer
markets and transfer flows from branches of the bank The first main structural change began in 1978 and ended in 1984. By the end of 1979, the PBOC departed the ministry and became a separate entity, while three state-owned banks took over some of its commercial banking businesses: The Bank of China(BOC)was given the mandate to specialize in transactions related to foreign trade and investment; the Peoples Construction Bank of China(PCBC), originally formed in 1954, was set up to handle transactions related to fixed investment (in manufacturing); the Agriculture Bank of China(ABC)was set up(in 1979)to deal with all banking business in rural areas; and the pboc was formally established as China s central bank and a two-tier banking system was formed. Finally, the fourth state-owned commercial bank, the Industrial and Commercial Bank of China(ICBc)was formed in 1984, and took over the rest of the commercial transactions of the pboc For most of the 1980s, the development of the financial system can be characterized by the fast growth of financial intermediaries outside of the" Big Four"state-owned banks mentioned above. For example, regional banks(partially owned by local governments) were formed in the Special economic Zones in the coastal areas; in rural sectors a network of rural Credit Cooperatives(RCCs; similar to credit unions in the U.S. )was setup under the supervision of the ABC, while Urban Credit Cooperatives(UCCs), counterparts of the RCCs in the urban areas, were also set up. Non-bank financial intermediaries, such as the Trust and Investment Corporations (TICs; operating in selected banking services and non-banking services with restrictions on both the sources of deposits and loans made), emerged and proliferated in this period. All of the new financial intermediaries began to take deposits and make loans, which increased the competition but also contributed to higher levels of inflation. As a result, savings deposits surged after the structural change, while the main investment channel for firms(from the government to SOEs) shifted from budget appropriation(70% in 1978)to loans from state-owned banks(80% in 1982). However, the four state-owned banks had almost no discretion in making loan -related decisions as these were based on quotas allocated by the PBOC. While foreign banks were allowed to set up representative offices beginning in 1979(Bank of Tokyo set up the first such office in Beijing), it was not until the later period of 1982 to 1985 that a small number of foreign banks was permitted to set up branch offices(for currency exchange operations) in Chinas Special Economy Zones. In 1985, the government legalized the status of foreign banks' branches and their operations in the Zones. The BOC, the oldest bank that is currently operating, was originally established by Sun, Zhongshan in 1912 as a private bank, and specialized in foreign currency related transactions
7 markets and transfer flows from branches of the bank. The first main structural change began in 1978 and ended in 1984. By the end of 1979, the PBOC departed the Ministry and became a separate entity, while three state-owned banks took over some of its commercial banking businesses: The Bank of China3 (BOC) was given the mandate to specialize in transactions related to foreign trade and investment; the People’s Construction Bank of China (PCBC), originally formed in 1954, was set up to handle transactions related to fixed investment (in manufacturing); the Agriculture Bank of China (ABC) was set up (in 1979) to deal with all banking business in rural areas; and, the PBOC was formally established as China’s central bank and a two-tier banking system was formed. Finally, the fourth state-owned commercial bank, the Industrial and Commercial Bank of China (ICBC) was formed in 1984, and took over the rest of the commercial transactions of the PBOC. For most of the 1980s, the development of the financial system can be characterized by the fast growth of financial intermediaries outside of the “Big Four” state-owned banks mentioned above. For example, regional banks (partially owned by local governments) were formed in the Special Economic Zones in the coastal areas; in rural sectors, a network of Rural Credit Cooperatives (RCCs; similar to credit unions in the U.S.) was setup under the supervision of the ABC, while Urban Credit Cooperatives (UCCs), counterparts of the RCCs in the urban areas, were also set up. Non-bank financial intermediaries, such as the Trust and Investment Corporations (TICs; operating in selected banking services and non-banking services with restrictions on both the sources of deposits and loans made), emerged and proliferated in this period. All of the new financial intermediaries began to take deposits and make loans, which increased the competition but also contributed to higher levels of inflation. As a result, savings deposits surged after the structural change, while the main investment channel for firms (from the government to SOEs) shifted from budget appropriation (70% in 1978) to loans from state-owned banks (80% in 1982). However, the four state-owned banks had almost no discretion in making loan-related decisions as these were based on quotas allocated by the PBOC. While foreign banks were allowed to set up representative offices beginning in 1979 (Bank of Tokyo set up the first such office in Beijing), it was not until the later period of 1982 to 1985 that a small number of foreign banks was permitted to set up branch offices (for currency exchange operations) in China’s Special Economy Zones. In 1985, the government legalized the status of foreign banks’ branches and their operations in the Zones. The 3 BOC, the oldest bank that is currently operating, was originally established by Sun, Zhongshan in 1912 as a private bank, and specialized in foreign currency related transactions
financial reforms slowed down during 1988-1991 to control inflation, during which considerable (government-run) consolidation took place. For example, many TiCs were merged and were increasingly regulated by the PbOc In 1992, the famous"Southern Tour"by then Chinese leader Deng Xiaoping marked the beginning of another economic boom. In the financial system, this period witnessed a sharp increase in foreign direct investment(FDI), a deregulation of the banking sector characterized by the emergence of many new state/local government owned commercial bankS, and the re-emergence of Shanghai as the financial center of China Reform in the insurance industry kicked off the process within the financial system, with the entrance of four foreign insurance companies(branches)in Shanghai in 1992, in 1995, the first joint venture investment bank was formed between Morgan Stanley and PCBC; in 1997, nine foreign banks were allowed to enter the RMB markets and operations in the Pudong Special Zone in Shanghai. In 1994, three policy banks" were established to take over"policy"related lending in underdeveloped areas, export and import, and rural areas, while the four largest state-owned banks further developed into regular commercial banks, with profit maximization becoming an increasingly more important goal. Along with the growth of banks and financial intermediaries, interbank lending(1994 )and bond(1997)markets were established and the bank debit/credit cards market expanded rapidly. During the same period, the central bank (PBOC) increasingly used interest rates and reserves to manage the liquidity of the banking sector For example, the PbOC sets lower and upper bounds on deposits and loans, while commercial banks can decide the actual rates within the bounds The interbank lending rates were converted toward a uniform system in 1996 The most significant event for China' s financial system in the 1990s was the inception and growth of Chinas stock market. Two domestic stock exchanges, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZsE), were established in 1990, and have experienced remarkable growth since then. However, the legal framework and institutions that support the stock market lag the growth of the exchanges. On a trial basis, Chinas first bankruptcy law was passed in 1986(governing SOEs), but the formal Company Law was not effective until the end of 1999 This version of the Company Law governs all corporations with limited liabilities, publicly listed and traded companies, and branches or divisions of foreign companies, as well as their organization structure, securities issuance and trading, accounting, bankruptcy, mergers and acquisitions(for China Pacific Insurance Company is the oldest insurance company in China that is currently operating. Formerly known by its current name in 1943, its insurance business was revived in 1986
8 financial reforms slowed down during 1988-1991 to control inflation, during which considerable (government-run) consolidation took place. For example, many TICs were merged and were increasingly regulated by the PBOC. In 1992, the famous “Southern Tour” by then Chinese leader Deng Xiaoping marked the beginning of another economic boom. In the financial system, this period witnessed a sharp increase in foreign direct investment (FDI), a deregulation of the banking sector characterized by the emergence of many new state/local government owned commercial banks, and the re-emergence of Shanghai as the financial center of China. Reform in the insurance industry kicked off the process within the financial system, with the entrance of four foreign insurance companies (branches) in Shanghai in 1992;4 in 1995, the first joint venture investment bank was formed between Morgan Stanley and PCBC; in 1997, nine foreign banks were allowed to enter the RMB markets and operations in the Pudong Special Zone in Shanghai. In 1994, three “policy banks” were established to take over “policy” related lending in underdeveloped areas, export and import, and rural areas, while the four largest state-owned banks further developed into regular commercial banks, with profit maximization becoming an increasingly more important goal. Along with the growth of banks and financial intermediaries, interbank lending (1994) and bond (1997) markets were established, and the bank debit/credit cards market expanded rapidly. During the same period, the central bank (PBOC) increasingly used interest rates and reserves to manage the liquidity of the banking sector. For example, the PBOC sets lower and upper bounds on deposits and loans, while commercial banks can decide the actual rates within the bounds. The interbank lending rates were converted toward a uniform system in 1996. The most significant event for China’s financial system in the 1990s was the inception and growth of China’s stock market. Two domestic stock exchanges, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE), were established in 1990, and have experienced remarkable growth since then. However, the legal framework and institutions that support the stock market lag the growth of the exchanges. On a trial basis, China’s first bankruptcy law was passed in 1986 (governing SOEs), but the formal Company Law was not effective until the end of 1999. This version of the Company Law governs all corporations with limited liabilities, publicly listed and traded companies, and branches or divisions of foreign companies, as well as their organization structure, securities issuance and trading, accounting, bankruptcy, mergers and acquisitions (for 4 China Pacific Insurance Company is the oldest insurance company in China that is currently operating. Formerly known by its current name in 1943, its insurance business was revived in 1986
details see the website of China Securities Regulatory Commission, or CSrC http://www.csrc.gov.cn/).Weprovideadetailedanalysisofthestatusandproblemsofthestock market in Section Iv below The exchange rate policies regarding the Rmb have gone through three regimes since 1949 First, during the period 1949-1978, all demand and supply(for firms, individuals, and government agencies)of foreign currency were collected and distributed through the central government and PBOC under official rates. Second, between 1978 and 1994, a retention system among SOEs was introduced at the provincial level so that provincial authorities and enterprises receiving and requesting foreign currencies(via import/export)were entitled to retain a certain proportion of the foreign currencies conditional on their fulfillment of export quotas assigned by the central government. a dual" exchange system was introduced so that official exchange rate and market exchange rates coexisted, although the latter was not freely floatable; a special currency, the" RMB Exchange"was issued and circulated mostly among foreigners(who brought foreign currencies to China). The retention and central planning regime was replaced by a more market-based system in 1994, which is still operating at present. The exchange rate has been exclusively pegged to the US Dollar and can fluctuate in a small range(around US$1= RMB 8.28 )under state regulation and monitoring. Interbank foreign exchange trading is also allowed, while the rmB Exchange currency stopped circulation. Individuals and enterprises have much more freedom in terms of holding short term), although the(legal) currency flows must go through the BOC. At the same time, e o foreign currencies for various purposes(so that the current account can fluctuate significantly in the capital account is still not freely convertible Following the Asian Financial Crisis in 1997, financial sector reform has focused on state owned banks and especially the problem of NPls (the China Banking Regulation Committee was lso established to oversee the banking industry ). We will further discuss this issue in Section Ill Finally, China's entry into the WTO in December 2001 marked the beginning of a new era. Since the eventual opening of the capital account and adopting a floating exchange rate are required by the WTO, we should expect to see increasing competition from foreign financial institutions and frequent and large scale capital flows. Perhaps we can even some witness dramatic changes and intriguing events within China's financial system shortly after December 2006 (the end of the five- year transition period after joining the WTO). Finally, institutional investors began to emerge in the late 1990s although their scale and importance in the financial system was and still is limited. The first two mutual funds( Guo Tai and Nan Fang)were established in 1998. There are 46 fund
9 details see the website of China Securities Regulatory Commission, or CSRC, http://www.csrc.gov.cn/). We provide a detailed analysis of the status and problems of the stock market in Section IV below. The exchange rate policies regarding the RMB have gone through three regimes since 1949. First, during the period 1949 – 1978, all demand and supply (for firms, individuals, and government agencies) of foreign currency were collected and distributed through the central government and PBOC under official rates. Second, between 1978 and 1994, a retention system among SOEs was introduced at the provincial level so that provincial authorities and enterprises receiving and requesting foreign currencies (via import/export) were entitled to retain a certain proportion of the foreign currencies conditional on their fulfillment of export quotas assigned by the central government. A “dual” exchange system was introduced so that official exchange rate and market exchange rates coexisted, although the latter was not freely floatable; a special currency, the “RMB Exchange” was issued and circulated mostly among foreigners (who brought foreign currencies to China). The retention and central planning regime was replaced by a more market-based system in 1994, which is still operating at present. The exchange rate has been exclusively pegged to the US Dollar and can fluctuate in a small range (around US$1 = RMB 8.28) under state regulation and monitoring. Interbank foreign exchange trading is also allowed, while the RMB Exchange currency stopped circulation. Individuals and enterprises have much more freedom in terms of holding foreign currencies for various purposes (so that the current account can fluctuate significantly in the short term), although the (legal) currency flows must go through the BOC. At the same time, the capital account is still not freely convertible. Following the Asian Financial Crisis in 1997, financial sector reform has focused on stateowned banks and especially the problem of NPLs (the China Banking Regulation Committee was also established to oversee the banking industry). We will further discuss this issue in Section III. Finally, China’s entry into the WTO in December 2001 marked the beginning of a new era. Since the eventual opening of the capital account and adopting a floating exchange rate are required by the WTO, we should expect to see increasing competition from foreign financial institutions and frequent and large scale capital flows. Perhaps we can even some witness dramatic changes and intriguing events within China’s financial system shortly after December 2006 (the end of the fiveyear transition period after joining the WTO). Finally, institutional investors began to emerge in the late 1990s although their scale and importance in the financial system was and still is limited. The first two mutual funds (Guo Tai and Nan Fang) were established in 1998. There are 46 fund
companies at present, 33 of which are domestic fund companies, and the rest are Qualified Foreign Institutional Investors(QFIl)or joint ventures, which were allowed to enter the asset management industry in 2003. There are no pension funds or government pension system in place. Under the old central planning regime, pensions and other social welfare plans were provided and implemented by individual SOEs. With many SOEs privatized or bankrupt in recent years, these services are no longer available for an increasing number of senior employees and workers Establishing a feasible pension system in the near future is also one of the burning issues for China Presently there are no hedge funds that implement long-short " strategies as short selling is prohibited in China Insert Figure l here. Figure 1 depicts the current structure of the entire financial system. In what follows we will describe and examine each of the four sectors of the system. In addition to the standard sectors of banking and intermediation and financial markets, we will document the importance of the non- standard financial sector and growth of this"other sector" as China s economy becomes more integrated into the world economy 1.2 The size and efficiency of the financial system: Banking and markets For a comparison of countries, we follow the law and finance literature and in particular the sample of countries studied in La Porta, Lopez-de-Silanes, Shleifer, and Vishny(hereafter LLSV, 1997, 1998, 2000). Their sample includes 49 countries, but China is excluded. In Table 1, we compare China's financial system to those of lLSv sample countries, with some measures for financial systems taken from Levine(2002)and Demirguc-Kunt and Levine(2001) Insert Table 1-A here We first compare the size of a country's equity markets and banks relative to that country 's gross domestic product(GDP)in the first panel of Table 1-A. Chinas stock markets are smaller than most of the other countries, both in terms of market capitalization and the total value traded as fractions of gdP In order to measure the actual size of the market. "total value traded" is a better measure than"market capitalization, because the latter includes non-tradable shares while the former measures the fraction of total market capitalization traded in the markets, or the"floating supply of the market (we further discuss this issue in Section IV below ). By contrast, Chinas banking system is much more important in terms of size relative to its stock markets, with its ratio of total bank credit to GDP (1. 11) higher than even the german-origin countries( with a weighted average of0.99). However, when we consider bank credit issued (or loans made )to the Hybrid
10 companies at present, 33 of which are domestic fund companies, and the rest are Qualified Foreign Institutional Investors (QFII) or joint ventures, which were allowed to enter the asset management industry in 2003. There are no pension funds or government pension system in place. Under the old central planning regime, pensions and other social welfare plans were provided and implemented by individual SOEs. With many SOEs privatized or bankrupt in recent years, these services are no longer available for an increasing number of senior employees and workers. Establishing a feasible pension system in the near future is also one of the burning issues for China. Presently there are no hedge funds that implement “long-short” strategies as short selling is prohibited in China. Insert Figure 1 here. Figure 1 depicts the current structure of the entire financial system. In what follows we will describe and examine each of the four sectors of the system. In addition to the standard sectors of banking and intermediation and financial markets, we will document the importance of the nonstandard financial sector and growth of this “other sector” as China’s economy becomes more integrated into the world economy. II.2 The size and efficiency of the financial system: Banking and markets For a comparison of countries, we follow the law and finance literature and in particular the sample of countries studied in La Porta, Lopez-de-Silanes, Shleifer, and Vishny (hereafter LLSV, 1997, 1998, 2000). Their sample includes 49 countries, but China is excluded. In Table 1, we compare China’s financial system to those of LLSV sample countries, with some measures for financial systems taken from Levine (2002) and Demirgüç-Kunt and Levine (2001). Insert Table 1-A here. We first compare the size of a country’s equity markets and banks relative to that country’s gross domestic product (GDP) in the first panel of Table 1-A. China’s stock markets are smaller than most of the other countries, both in terms of market capitalization and the total value traded as fractions of GDP. In order to measure the actual size of the market, “total value traded” is a better measure than “market capitalization,” because the latter includes non-tradable shares while the former measures the fraction of total market capitalization traded in the markets, or the “floating supply” of the market (we further discuss this issue in Section IV below). By contrast, China’s banking system is much more important in terms of size relative to its stock markets, with its ratio of total bank credit to GDP (1.11) higher than even the German-origin countries (with a weighted average of 0.99). However, when we consider bank credit issued (or loans made) to the Hybrid