Abstract
We provide a comprehensive review of China’s financial system and explore directions of future development. First, the current financial system is dominated by a large banking sector. In recent years, banks have made considerable progress in reducing the amount of non-performing loans and improving their efficiency. It is important that these efforts are continued. Second, the role of the stock market in allocating resources in the economy has been limited and ineffective. Further development of China’s stock market and other financial markets is the most important task in the long term. Third, 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, and institutions. This sector should co-exist with banks 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.
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Notes
- 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: (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.
- 2.
For more descriptions of the pre-1949 history of China’s financial system, see a companion paper of this chapter, AQQ (2005b); for more anecdotal evidence on the development of China’s financial system in the same period, see, for example, Kirby (1995) and Lee (1993).
- 3.
BOC, among the oldest banks currently in operation, was originally established in 1912 as a private bank and specialized in foreign currency-related transactions.
- 4.
At the end of 2007, the total market capitalization of the two domestic exchanges (SHSE and SZSE) is around $4.5 trillion, whereas total investment in the real estate market is around $2.53 trillion.
- 5.
While there is a nationwide, government-run pension system (financed mainly through taxes on employers and employees), the coverage ratio of the pension system varies significantly across regions and is particularly low in rural areas. Moreover, there is a very limited amount of capital in individual accounts, and most of the capital has been invested in banks and government projects with low returns. See, for example, Feldstein (1999, 2003) and Feldstein and Liebman (2006), for more details on China’s pension system.
- 6.
If we look at total bank credit, including loans to state sectors, the ratio of China’s bank credit to GDP rises to 1.10, higher than even the German-origin countries (with a weighted average of 1.06). The difference between total bank credit and private credit suggests that most of the bank credit is issued to companies that are ultimately owned by the state.
- 7.
La Porta, Lopez-de-Silanes and Shleifer (2002) show that the government owned 99.45% of the assets of the 10 largest commercial banks in China in 1995, one of the highest in their sample of 92 countries. Moreover, their result on the negative relationship between government ownership of banks and the growth of a country’s economy seems to apply to China’s State Sector and the banking sector. However, we show that the high government ownership of banks has not slowed down the growth of the Hybrid Sector.
- 8.
Consistent with this view, Lardy (1998) argues that, if using international standards on bad loans, the existing NPLs within China’s state-owned banks as of the mid-1990s would make these banks’ total net worth negative, so that the entire network of state banks would be insolvent.
- 9.
See, for example, Perkins and Rawski (2008) for a review and projections on the prospects of long-running economic growth and statistics in China.
- 10.
The sale of tranches of securitized NPLs to foreign investors first occurred in 2002. The deal was struck between Huarong, one of the four AMCs, and a consortium of US investment banks led by Morgan Stanley (and including Lehman Brothers and Salomon Smith Barney) and was approved by the Chinese government in early 2003 (Financial Times, 05/2003).
- 11.
A few foreign lenders (e.g., GM and Ford) were approved to enter China’s auto loan market by forming joint ventures with Chinese automakers (Financial Times, 05/27/2005).
- 12.
For example, Park et al. (2003) find that competition among banks and intermediaries leads to better effort of the banks (especially state-owned banks) and better loan decisions in China’s rural areas.
- 13.
Postal savings (deposit-taking institutions affiliated with local post offices) is another form of non-bank intermediation that is not reported in Table 4B due to lack of time series data. However, at the end of 1999, total deposits within the postal savings system exceeded RMB 380 billion, or 6.4% of all deposits in China.
- 14.
An example is Guangxia Industry Co., Ltd., dubbed as “China’s Enron.” Located in Ningxia Province, one of the poorest areas of China, Guangxia was listed on the SZSE in 1994 as a manufacturer of floppy disks. After experiencing poor performance for the first five years, the company reported unprecedented high EPS (earnings per share) at the end of 1999 and claimed that they had mastered the techniques of CO2 fluid extraction. The company’s stock price shot up from RMB 14 to 76 in one year. A CSRC investigation later revealed that the reported earnings and sales records were fabricated, and the company continued losing money in their original line of businesses. The company’s top executives were criminally charged, and its auditors lost their licenses, while shareholders’ lawsuits were eventually processed by courts for the first time in China. For more details on this case and other cases, see, for example, AQQ (2005b).
- 15.
For example, Du et al. (2008) find that many private, non-listed firms use acquisition of blocks of shares of listed firms as a means to gain access to financial markets (without improving operating performance), as indicated by the frequent fundraising activities such as SEO followed acquisition.
- 16.
During most of the period 1988–2003, Moody’s rated China’s government bonds (foreign currency) A2 or A3 (lower than Aa3 and A1 but higher than Baa1; highest rating is Aaa) with a “positive” or “stable” outlook, while the rating on bank deposits (foreign currency ceilings) was Baa, at or above the “investment” grade. These ratings are better or comparable than Moody’s ratings on government bonds from most emerging economies.
- 17.
Explanations of the B share discount include (1) Foreign investors face higher information asymmetry than domestic investors, (2) lower B share prices compensation for the lack of liquidity (due to low trading volume), and (3) the A share premium reflects a speculative bubble component among domestic investors. See Chan et al. (2007) and Mei et al. (2003) for more details.
- 18.
If we include the cross-border M&As and transactions between parent companies and subsidiaries, the total amount increases to US$47 billion in 2000, $14 billion in 2001, $29 billion in 2002, and $24 billion in the first three quarters of 2003. Sixty-eight percent of all M&A deals (66% in terms of dollar deal amount) are initiated by Hybrid Sector firms, while former SOEs and foreign firms initiate 29 and 3% of the rest, respectively (27 and 7% in deal amount). M&As are most active in coastal regions, and in industries such as machinery, information technology, retail, and gas and oil.
- 19.
Cross-country information on the efficiency of bankruptcy procedures, based on surveys of lawyers and bankruptcy judges around the world, is available from World Bank (http://rru.worldbank.org/Doingbusiness). Among 108 countries, China’s “goals of insolvency” index is equal to the median of the sample.
- 20.
With a large sample of syndicated loans around the globe, Qian and Strahan (2007) show that strong creditor protection (in borrower countries) enhances loan availability as lenders are more willing to provide credit on favorable terms (e.g., longer maturities and lower interest rates).
- 21.
Gordon and Li (2003) show that the ownership structure (with large state ownership stakes) can be attributed to government collecting monopoly rents from investors and subsidizing listed firms that were formerly SOEs. However, they argue that this behavior is not as efficient as explicit taxes on investors.
- 22.
Huang et al. (2008) document that share reform increases turnovers, especially for firms with low liquidity prior to the reform, and reduces speculative trading. Although share prices drop significantly on the day share supply increases, shareholder wealth increases by 15% overall. Beltratti and Bortolotti (2006) document 8% abnormal return around the date of share reform announcement. Liao and Liu (2008) show that market reactions to share reforms are positively associated with the quality of the listed firms (as measured by firm disclosure), providing evidence of improved market efficiency.
- 23.
All firms, including Hybrid Sector firms, must disclose accounting and financial information to the local Bureau of Commerce and Industry, and most of the reports are audited. However, these data are then aggregated into the Statistical Yearbook without any firm-level publications.
- 24.
Due to data limitations, our calculations underestimate the output of the State and Listed Sectors. We use the output produced by SOEs and listed firms in which the state has at least a 50% ownership stake as the total output for these sectors, but this calculation excludes output from listed firms that are not majority-owned by the state; the output for the Hybrid Sector is the difference between the total output and the total for the other two sectors. However, as mentioned above, only around 20% of all listed firms do not have the state as the largest owner, hence the total output of these firms is not likely to change our overall conclusion on the dominance of the Hybrid Sector over the other two sectors.
- 25.
There is an ongoing process of privatizing SOEs. Potentially this may bias the growth rate of the Hybrid Sector higher, as there are firms shifting from the State Sector to the Hybrid Sector. However, the overwhelming majority of SOEs are transformed into the Listed Sector (the main channel through which SOEs were partially privatized prior to 2004); thus this process is unlikely to change the validity of the results above.
- 26.
Our calculations of the total number of workers employed by the Hybrid Sector actually underestimate the actual work force in the sector, because the Statistics Yearbooks do not provide employment data for all types of firms (by ownership structure) in the Hybrid Sector.
- 27.
Interestingly, the same survey, used in LLSV (1997b), finds that Chinese citizens have a low tendency to participate in civil activities. However, our evidence shows that, with effective alternative mechanisms in place citizens in the developed regions of China have a strong incentive to participate in business/economic activities.
- 28.
Another effective solution for corruption is the common goal of sharing high prospective profits, which aligns interests of government officials with those of entrepreneurs and investors. Under this common goal in a multi-period setting, implicit contractual agreements and reputation can act as enforcement mechanisms to ensure that all parties, including government officials, fulfill their roles to make the firm successful.
- 29.
A frequently talked about and controversial topic is intellectual property rights, including patents and copyrights. The practice of enforcing intellectual property rights by courts is much more vigilant and prevalent in developed countries than in developing countries such as China. An extensive literature in economics has found mixed evidence on the relationship between patent/copyright protection and the pace of innovations. While exclusive property rights provide strong incentives for innovations and do lead to more innovations in a few industries such as chemicals and pharmaceuticals, excessive protection deters competition, which is another important factor in spurring innovations.
- 30.
A good example is the US payment system. At the beginning of the twenty-first century the US had a nineteenth-century system: Checks had to be physically transported from where they were deposited to a central operations center, then to the clearer and then back to the banks they were drawn on. Despite repeated calls for changes from the banks and businesses, the US Congress did not act on this simple yet costly problem, until September 11, 2001. After the terrorist attack all commercial flights in the were grounded for several days, completely halting the check-clearing process. The check clearing for the 21st Century Act was signed in October 2003, allowing electronic images to be a substitute for the original checks, and thus the clearing process is no longer dependent on the mail and transportation system.
- 31.
Chang and Velasco (2001) develop a model of twin crisis based on the Diamond and Dybvig (1983) model of bank runs. Money enters agents’ utility function, and the central bank controls the ratio of currency to consumption. In some regimes, there exists both a “good” equilibrium in which early (late) consumers receive the proceeds from short-term (long-term) assets and a “bad” equilibrium in which everybody believes a crisis will occur, and these beliefs are self-fulfilling. If the bad equilibrium occurs, there is a twin crisis.
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Acknowledgments
We wish to thank Bibo Liu and Zhenrui Tang for their excellent research assistance, Yingxue Cao for sharing data and information on China’s real estate markets, and Boston College and the Wharton Financial Institutions Center for financial support. The authors are responsible for the remaining errors.
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Allen, F., Qian, J.“., Qian, M., Zhao, M. (2009). A Review of China’s Financial System and Initiatives for the Future. In: Barth, J., Tatom, J., Yago, G. (eds) China’s Emerging Financial Markets. The Milken Institute Series on Financial Innovation and Economic Growth, vol 8. Springer, Boston, MA. https://doi.org/10.1007/978-0-387-93769-4_1
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