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 BROOKINGSThe 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 like￾ly stock price movements in the short run. Many Chinese also attribute speculation to a nation￾al 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 inves￾tors, 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 Pub￾lic Offerings. Western nations generally allow a new issuance as long as appropriate documen￾tation 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 wid￾er range of considerations. Regulators apparently maintain informal quotas that hold down issu￾ance volumes. Other parts of the regulated financial system re￾main 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 sys￾tem, 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 devel￾oping 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, State￾Owned 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 be￾havior and excessive risk-taking by institutions and individuals that are less regulated. How effec￾tively 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 not￾ing 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 lend￾ing that came out of China’s massive stimulus program in response to the global financial crisis, which primarily consisted of bank-financed activ￾ities. 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 al￾most certainly comes with less careful underwrit￾ing, 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 lo￾calities 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