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 BROOKINGSThe 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 Chi￾na’s financial system than there is of America’s or Europe’s. Many analysts believe that the finan￾cial 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 finan￾cial 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 govern￾ment, 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 fac￾tors. 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 finan￾cial 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 finan￾cial 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 sever￾al 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 avoid￾ed 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 com￾ing to power of a new leadership team at the helm of the Chinese Communist Party and the central I. Introduction