This paper will discuss the characteristics of the financial system that exists in China. The role of China’s financial system in aiding the growth of firms will also be examined, as well as exploring the possible directions of future development. The primary motivation here is to have an in-depth understanding of the functioning of China’s financial system, and also the regulatory environment in which it functions or operates and in particular, the relationship that exists between the financial and corporate sectors of the economy. With respect to the banking sector this may include the way the banking system operates, different types of banks, the main users (savers and borrowers), again if there are any constraints whatsoever on ownership and as well as the role played by the country’s central bank.
The financial markets and banking system in China is indeed a vast topic and will be quiet different from developed, developing, transitional and emerging countries. The focus will be on the role of financial institutions as intermediaries for their users, which includes investors, firms and government - and not to try to construct a detailed description of the contracts and operations in which they engage and the legislation in place.
China’s current financial system is dominated by a big banking sector that is quite inefficient. In order to reform the Chinese financial system sooner, there has to be a drastic reduction in the number of non-performing loans amongst the major banks to a normal level. This is a vital objective for the success of any reformation. Although the growth of the stock market in China has been rapid, its role of allocation of resources has been ineffective and limited in the country’s economy. Further development of China’s financial markets happens to be the most important long-term object. For sustainable stable economic growth, China should strive to halt or prevent any damaging financial crises, as well as a banking sector crisis, a “twin crisis” in the currency market and banking sector and a stock market or real estate crash.
In the financial market sector, speculation and insider information has characterized the Chinese Financial markets and has not been very successful in the effective allocation of resources as the banking sector. The Shanghai Stock Exchange (SHSE hereafter) and Shenzhen Stock Exchange (SZSE hereafter) all established in 1990, are China’s two main financial markets, and have been growing at a tremendous rate. But they have not been working a rate that can bring in some improvements in the Chinese financial market sector. Is all due to encumbrances and poor regulation that characterizes the regulatory environment particularly in the corporate and trading laws, the legal protection of investors, and as well as institutions that are responsible for the governing of enforcement of contracts have all been poorly developed.
The poor and ineffective functioning of these markets is also linked to the fact that a reasonable amount of large blocks of shares are held by various government entities in listed companies (including state-owned banks). To greatly improve the functioning of the financial market, there should be a planned reduction of these government owned entities, and that is achievable by selling them off slowly over time. Lack of trained professionals has plagued market such as investment bankers, (business) lawyers and accountants. There is lack of incentive to effectively motivate financial intermediaries who should act as institutional investors for the smooth and efficient running of the market. They are just totally unavailable especially when one considers the role they play in improving the efficiency of the markets and strengthening the corporate governance of listed firms. All these factors have led to the market trading in almost old and same kind of assets. As a result, all of these forces are needed to develop new financial products and markets.
It has been suggested that a sector of alternative financing channels like internal financing, trade credits, and coalitions of various forms among firms, local governments and investors, is the most successful part of the financial system, in terms of supporting the growth of the overall economy rather than the banking sector or stock market. “Many of these financing channels rely on alternative governance mechanisms, such as competition in product and input markets, and trust, reputation, and relationships.” (Allen & Qian, 2005) The growth of a “Hybrid Sector” of non-state, non-listed firms with various types of ownership structures, have been supported by these methods of governance and financing. It should be noted that this definition of the Hybrid Sector is from a broader perspective than that of individual or privately owned firms that are also a part of this sector. Particularly, firms which are owned partly by Township Village Enterprises (TVEs) or local governments are part of the Hybrid Sector due to the fact that these firms tend to operate like privately-owned firms, despite the ownership stake of local governments. The Hybrid Sector includes various firms that are not publicly listed or owned by the state, and this sector has grown much faster than the State Sector, including SOEs, (state-owned enterprises), the central government controlled firms, and the Listed Sector, which constitutes the publicly listed and traded firms. Most of these firms in the listed sector are converted from the State Sector, and they contribute greatly to the country’s economic growth. These alternative channels and mechanisms can co-exist alongside the banks and the financial market, so they should be encouraged because they also enhance the development of the Hybrid Sector.
More specifically, it includes 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), and collectively- and jointly-owned companies, where joint ownership among local government, communities, employees, and institutions is forged (Che and Qian 1998)
In a country like China where the markets and institutions are somewhat under-developed, an ambivalent structure of ownership with local governments would probably be more effective than well defined state ownership or private property rights.
In the banking sector, China’s financial system is basically dominated by a large but under-developed banking system, with the four largest state-owned banks controlling the system due to a large amount of NPLs (non-performing loans). These state-owned banks will a lot of power by using the money injected into their business from the large foreign currency reserves to give out loans to selective borrowers in particular, state-owned banks and to selective investment projects. There have been a lot of privatization activity in the Chinese banking sector, and this can enable more foreign and domestic banks to enter into the sector. This is vital to the growth of the economy, because it will bring about more competitiveness, and remove the non-performing loans, thereby stimulating the banking sector.
In comparison to the size of the Chinese equity markets and gross domestic product (GDP), the country’s stock market is smaller than most other countries, in terms of total value traded as gross domestic product fraction, and in terms of market capitalization. The total value traded would be a better measure of the market’s actual size than market capitalization, because market capitalization includes non-tradable shares whereas the total value traded measures the floating supply of the market or the fraction of the total market capitalization that is traded in the markets. By contrast, China’s banking system is much more relevant in terms of size in relation to its stock markets, with its ratio of total bank credit to a gross domestic product higher than even the German-origin countries. However, when bank credit issued (or loans made) only to the Hybrid Sector are considered, China’s ratio drops sharply to 0.24, suggesting that most of the bank credit is issued to companies in the State and Listed Sectors. Moreover, China’s banking system is not efficient: its overhead cost to total assets (0.12) is much higher than the average of French-origin countries (0.05), the next highest group of countries.
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. 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. 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. (http://www.abfn.org/uploads/cms/documents/allen-qian-wjp-051108.doc)
A notable event in the Chinese financial system during the 1990s was the inception and subsequent growth of China’s stock market. In 1990, the Shenzhen Stock Exchange (SZSE) and the Shanghai Stock Exchange (SHSE) were established, and there has been remarkable growth in both institutions ever since.
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. (http://www.abfn.org/uploads/cms/documents/allen-qian-wjp-051108.doc)
The development of the Chinese financial system between the late nineteenth century and the early twentieth century was highlighted by Shanghai’s emergence as Asia’s financial center.
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. (Lee 1993 retrieved from http://www.abfn.org/uploads/cms/documents/allen-qian-wjp-051108.doc)
In China, merchants used as many as eleven currencies in their transactions. Some of these currencies were printed by local banks and thus there was a lot of fluctuation in the exchange rate of local currency as many unregistered local banks were involved in credit transactions of high-leverage, with little capital reserves which were frequently defaulted.
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. (http://www.abfn.org/uploads/cms/documents/allen-qian-wjp-051108.doc)
Although there is no general consensus about the prospects of China’s future economic growth, a close look at the financial system in China suggests that this sector is a weak link in the Chinese economy, which might impede the country’s future economic growth. On comparison with the financial markets of emerging and developed countries, China’s banking and financial system seems to be dominated by a large but under-developed banking system that is mainly controlled by 4 of the state’s largest banks, with a big amount of NPLs (non-performing loans).
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.
New financial markets and products should also be developed. Although the Chinese central bank and the Chinese government 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. Also, domestic financial intermediaries who may act as institutional investors should be encouraged, because they play a vital role in the improvement of market efficiency and also help to strengthen the corporate governance of the listed firms.
Another important challenge for China’s financial system is avoiding any financial crises that might damage or disrupt social stability and the country’s economy. 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
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According to the Beijing-based China Securities Journal, there have 25 independent directors of 22 listed firms resigned their posts so far this year. Of the resigned, over 60 percent are popular academics, professors and social activists; three are experts of the industries in which their firms do business. Only six of the 25 are of CPA and/or law service background. Of the 26 independent directors engaged, or intended to be engaged, by 21 of the aforementioned 22 listed firms, 18 have ever been CPAs and lawyers. Only two persons can be categorized as known economists or celebrities, the remaining six being experts of relevant industries, according to the newspaper.
Moreover, these newly picked or candidates are younger, with an average age of 44.6, and a peak age of 62 instead of their predecessors' 52 and 74. (http://english.people.com.cn/200208/27/eng20020827_102181.shtml)
Major Banks in China
Listed below is an index of the Major Banks in China:
(Retrieved from www.gov.cn)
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