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 PeChina’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