China’s Emerging Financial Markets

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.

Throughout the past three decades of fast growth, China has undergone tremendous structural changes in its economy and financial system. This chapter examines China's evolving financial landscape so as to assess whether it can catch up with or even drive economic growth. China has achieved remarkable growth over the past quarter of a century despite a relatively inefficient financial system. Just as the public sector around the world has not proved to be an efficient manager of enterprises, it also has not been an efficient manager of banks. A solution that would seem to work in theory would be to grow the private sector’s role in the banking system, using banks that operate on market principles as a way to continually starve inefficient enterprises of credit, while supplying credit to the productive enterprises. Finding a way to make this work in practice will require both finesse and good fortune on a scale commensurate with China’s growing importance in the world economy.

China has a two-part financial system with a competitive market-based component and a public, government-directed component. Both have reformed rapidly since China's reforms began in 1978. The market-based component is immature and subject to numerous systemic weaknesses, while the government-directed component, which also suffers shortcomings, performs essential funding for infrastructure and other underpinnings of China's sustained rapid growth. Critics claim that China's financial system is inefficient, with banks considered technically insolvent. But a realistic evaluation of the system's resources and accomplishments, including investment rates of return and efficiency in generating sustained growth, can only conclude that China's financial system is performing well and is likely to continue to do so. China's newly articulated strategy for financial reforms going forward clearly intends to pursue gradual commercialization of the whole system—a process that can be expected to last 20 or 30 years. In the meantime, ongoing improvements in government-directed credit will continue to ensure adequate investments in the necessary substructures for competitive for-profit economic expansion.

While much has already been achieved, monetary policy implementation in China is still in transition. The effectiveness of the current framework, which still relies intensively on rules-based measures, is likely to diminish over time as the sophistication of the economy increases. The authorities are faced with the following challenges: (i) the choice of a nominal anchor; (ii) the choice of an operating target; (iii) the choice of operating instruments; and (iv) the right timing to introduce greater flexibility of the exchange rate. This chapter reviews the framework for monetary policy implementation in China by summarizing the practice of monetary policy over the past 30 years and by discussing the way forward.

The monetary policy plays a critical role in the Chinese economy. This report takes a detailed and fundamental look at each of the following questions: (i) How does policy work? (ii) Which variables does the People’s Bank of China (PBC) target? (iii) Does it have market-based tools? (iv) Does it have effective control of interest rates and liquidity? (v) Can it really influence growth and inflation? Or is the economy “beyond control,”chronically lurching into overheating, asset bubbles, and eventual sharp downturn. It also summarizes in part much of the work we have done on monetary and financial markets over the past few years.

Section 2 explores a number of aspects of the debate about China’s exchange rate policy. The focus is not to recommend specific policies but to expose a number of false arguments that have been made in the debate in order to separate out the serious considerations on which discussions should be based. While we argue that the adoption of a floating rate is not a panacea, we suggest that exchange rate adjustments can play a productive role as part of a coordinated policy strategy.

Section 3 deals with the effects of the large payments surpluses and international capital flows on China. We find that the People’s Bank of China (PBOC) has been able to successfully sterilize most of the effects of the payments surpluses on the domestic money supply so that these have not been a major cause of inflation. Speculation on currency appreciation has not been as disruptive as some expected, and international capital flows have not been a major cause of the rise and fall of China’s stock market. Thus, while China has become a major force in the global economy, it has managed to maintain considerable domestic monetary and financial autonomy.

China-bashing has become a popular media and political sport. This is largely due to the US trade imbalance and the belief, by some, that China is responsible for it because it manipulates its currency to hold down the dollar prices of its goods, unfairly creating a trade advantage that has contributed to the loss of US businesses and jobs. This chapter reviews the problem of the large trade imbalance that the United States has with China and its relationship to Chinese exchange rate policy. It examines the link between a Chinese renminbi appreciation and the trade balance and also whether a generalized dollar decline could solve the global or Chinese–US trade imbalance. The consensus view explained here is that a renminbi appreciation is not likely to fix either the trade imbalance with China or overall. If these perceived benefits of a managed float are small or nonexistent, then perhaps they should be pursued anyway because of small costs or even benefits for China. Section 4 looks at the costs of a managed float in terms of the benefits of the earlier peg. Opponents of a fixed dollar/yuan exchange rate ignore the costs of a managed float for China, especially with limits on currency convertibility. These costs are outlined here in order to provide an economic basis for the earlier fixed rate and China’s reluctance to appreciate. Finally it is suggested that the necessary convertibility on capital account, toward which China is moving, could easily result in yuan depreciation under a floating rate regime. This is hardly the end that China critics have in mind, and it is not one that would improve US or other trade imbalances with China.

China has three major imbalances: a trade surplus, a capital account surplus and a large annual build up, and a very high level of international reserves. Capital flows, especially flows of US government securities, are also important in assessing the bilateral and overall imbalances in transactions. China has a capital account surplus reinforcing its current account surplus and the accumulation of foreign exchange reserves, mainly US dollar denominated assets. This is unusual because a sustainable fixed or floating requires that countries with large current account surpluses run capital account deficits.

The worst consequences of imbalances have been the build-up of large, low-return foreign exchange. These reserves have led to rapid growth in money and credit and, in turn, to a sharp acceleration in inflation, something that China had assiduously avoided since 1994 and that has raised serious doubts about the credibility of the monetary authorities and damaged its inflation-fighting reputation. Moreover, efforts to offset money growth and inflation have deepened existing inefficiencies in the financial system, which China had hoped to begin remedying by its efforts to recapitalize and list its banks’ equities on stock exchanges. China could eliminate these imbalances by policies that would reduce growth. An alternative solution is to lift restrictions on capital outflows, allowing households and business to diversify their wealth holdings and realize higher returns and/or less volatility in their own income and wealth. This would transform future asset growth from massive central bank holdings of US securities to holdings of higher return and lower risk assets abroad. Such a step also would eliminate pressures on the People’s Bank of China (PBOC), allowing for more rapid deregulation of banks, slower money, and credit growth and lower inflation.

This chapter answers some interesting questions on China’s foreign reserve holdings: Are they excessive? Why so much? How to invest them? We first use the popular reserve adequacy measures to examine if China’s foreign reserve holdings are excessive. All the exercises suggest that China is holding too much reserves. We then analyze the motive of reserve holdings from a new aspect: foreign reserve holdings could be self-augmented. We also investigate the problem of how to set up a better portfolio for foreign reserve investment. The simulation in our model suggests that if foreign reserves are used to hedge against potential macroeconomic risks, it may raise the social utility by 56%.

This chapter traces the structural changes in the Chinese banking industry since the 1990s and explores the role of governance in influencing the banking strategies and performance of local financial institutions. Specifically, the chapter focuses on the increasing openness to foreign ownership in local banks, the asset–liability and geographical diversification strategies undertaken by the financial institutions during these deregulatory and changing environments, and the institutional developments in the economy. Finally, the chapter links these changes with bank performance. The evidence suggests that banks with minority foreign ownership are associated with better performance, all types of diversification – captured in four dimensions: loans, deposits, assets, and geography – are associated with reduced profits and higher costs, while banks with minority foreign ownership are associated with fewer diseconomies of diversification, suggesting that foreign ownership plays an important mitigating role. We also observe a significant impact from institutional developments; gradual dominance of the market economy, growth of the private sector, and establishment of secure property rights and rule of law are important factors associated with higher bank performance.

China’s banking industry has grown rapidly over the past three decades. As the major source of funding for Chinese enterprises (especially state-owned enterprises), the banking sector has helped finance the nation’s transformation from a centrally planned economy to a market-oriented economy. In the meantime, large amounts of nonperforming loans have accumulated on the balance sheets of Chinese banks, partly due to the cost of reform, partly due to poor management and inadequate regulation. In 1999, four asset management corporations were established to resolve the nonperforming loan problem. As stated by the State Council, these asset management corporations would cease operation by the end of 2009. It is therefore of interest to examine the progress they have made in disposing of nonperforming loans. In this paper, the author attempts to draw a picture of how the nonperforming loan problem has developed since the mid-1990s, provide an estimate of the total nonperforming loans held by Chinese financial institutions, and assess to what extent these bad assets might pose a threat to the country’s financial stability.

Disaggregated province-by-province analysis appears to confirm the importance of ongoing redistributive lending by the big four Chinese banks together with lending to state-owned enterprises that is especially pronounced amongst the poorer provinces. Agricultural Bank of China’s own allocation of loans to the weaker provinces surges after 2000. This may well reflect its greater presence in the poorer areas of the country and the potential damage exerted if its lending there were cut back. On the other hand, such lending patterns also make it unsurprising that Agricultural Bank of China has not yet followed the other big banks into public ownership.

This chapter investigates location choice of foreign banks within China based on a panel data of 40 cities. Our empirical results show that the market opportunity is the most crucial factor to affect foreign bank decision to enter China cities. The labor cost is also important and the high labor cost of a city attracts more foreign banks. But the restriction on the locations of Renminbi business operation is very limited. Furthermore, we find that the city infrastructures like hardware and software environments strongly enhance the relation between market opportunity and foreign bank penetration.

The rapid increase of China’s property prices in recent years, especially in major municipalities, has drawn much attention and provoked intense debates on the existence of “inflationary property values.” Many believe that over-investment in the real estate sector should be blamed for the skyrocketing property prices in many municipalities. This study takes a slightly different angle by focusing on efficiency of capital allocation rather than total volume of investment. This chapter attempts to address the following question: Will efficiently allocated regional capital help hold off a potential housing price bubble? Our analysis finds a negative relationship between our proxy for loan efficiency and local property price. The finding, however, implies that when loan efficiency improves, local property price tends to be lower. Hence, effective lending policies and practices can reduce the level of “inflationary property value.”

The past 10 years have witnessed great achievements made by the Chinese government in enhancing disadvantaged people’s access to financial services. Without fundamental regulatory arrangements, however, no sustainable improvement would be achieved in combating financial inclusion in China. A banking regulatory structure being granted operational independence and accountability is helpful to establish an appropriate, facilitative, and incentive-compatible regulatory and legal environment for developing microfinance. In addition to the objectives of banking system stability and depositor protection, promoting financial inclusion should be incorporated into the regulatory objectives of a banking regulator, the result of which is that the banking regulator would more proactively take mandatory measures to fulfill the responsibility in this regard. Although there is debate as regards whether corporate social responsibility of banks is a statutory obligation, the imposition of the duty of increasing financial inclusion on banks in the form of law would contribute greatly to facilitating more access of disadvantaged people to financial services. Bearing in mind the differences between microfinance providers and general commercial banks, the authors argue that prudential regulation aiming at preventing systemic risks and protecting depositors should not be applied to microfinance providers. A tiered, cost-effective regulatory framework taking into account the special features and risk profile of microfinance should be put in place for microfinance providers to balance promotional and prudential objectives.

This chapter reviews historical lessons, depicts present challenges, and discusses future perspectives of Chinese bond market. Historical lessons on sovereign right concession and market tumult lead to a quite cautious approach toward the bond market. The legal background and political considerations also played an important role in shaping bond market during the past two decades. Given the increasing demand for financing in China these days, the bond market is expected to enjoy some rapid growth in the coming decade and we discuss some areas with particular potentials and the challenges facing the development.

Despite all the ups and downs, China’s capital markets have developed at a very rapid pace over the past 20 years. The market size is growing and systems are gradually being updated. Investors are becoming more mature, and a legal system, regulatory framework, and trading rules have basically been established. Although there is a great deal of room for improvement in China’s capital markets, they are playing an increasingly important role in the overall economy. Nevertheless, we should bear in mind that China is still an emerging entity and some issues in the market need to be addressed to achieve greater efficiency. Those issues include an unbalanced financing structure, a lagging fixed income market, an insignificant role played by institutional investors, and the need to improve the quality of information disclosure and drive market innovation. As a key component of China’s economy, China’s capital markets currently are not functioning efficient enough as a vehicle of capital allocation, with the major reasons being market operational inefficiencies.

This chapter provides a descriptive analysis of China’s privatization, by far the largest one in human history. Unlike the mass privatization in other transitional economies, China has adopted multiple approaches to privatizing its state-owned enterprises (SOEs). These approaches included share issue privatization (SIP), joint ventures with foreign firms, management buy-outs (MBO), and sales to outsiders. I examine how these different approaches may affect the incentive and ability of the new owners to restructure the firms and thus influence the outcomes of privatization programs.

This chapter seeks to provide an understanding of how legal protection for shareholders gradually emerged in China. Specifically, we trace the underlying forces driving the emergence of legal protection to shareholders to the vested interests of the central government. We show that the evolution of the legal developments is consistent with the government’s changing interests in the stock market, with the provision of shareholder protection becoming an increasingly important instrument for the government to serve its interests. To a certain extent, the legal developments in China's stock market show that the country's legal systems still maintain the ancient tradition whereby “[t]he state promulgated laws to make sure its interests were advanced. As this was done, the interests of private individuals or groups of such persons were often protected as indirect results” (Jones 2003, pp. 15–56).

The non-tradable shares reform has changed the market segmentation problem that has puzzled the Chinese stock market for more than 15 years, because of which large shareholders of listed companies changed their past behaviors, which led to a dramatic improvement in firms’ performance. This chapter will appraise such impacts through theoretical and empirical models, indirectly evaluate the effectiveness of the non-tradable shares reform, and provide a guideline for further improvement in the functions of market mechanisms.

Extrapolations of China’s growth suggest that China will soon surpass in size and prosperity the leading developed economies, even the United States. China has several advantages that suggest such convergence possibilities, including its land mass, large population, and rapid transformation over nearly three decades. However, there are serious disadvantages that will lessen the pace of convergence in future. This chapter provides several scenarios for the relative size of China’s GDP and for convergence of her income per capita. Under plausible assumptions, China will not reach the US standard of living until late in this century, at the earliest. Nonetheless, due to the size of its economy and markets, it will have a relatively large share of production and consumption of most goods and services in a few decades. Experience elsewhere, especially among China’s richest neighbors, indicates that convergence is unlikely even by then. China faces four trends that make even this possibility unlikely: urbanization, the transition from state ownership to private sector control of capital, slowing population growth, and rising political risks. The first two forces have been important to China’s success but are transitory and will work to reduce growth in the future. The financial sector’s development could extend the period of rapid productivity growth in China and could even allow the country to become the financial center of Asia. This would not alter the basic conclusions for the relative size of the economy or its convergence, however.