CHINESE FINANCIAL
MARKETS: INTRODUCTION
AND OVERVIEW
THE CHINESE FINANCIAL MARKETS, SPRING 2014
PV VISWANATH
LUBIN SCHOOL OF BUSINESS
P.V. Viswanath
THE CHINESE ECONOMY: A BRIEF HISTORY
• Prior to 1978, China was a command economy; resources were allocated on the basis of a
state plan, rather than the use of a price and market system.
• At this stage, the financial system essentially consisted of a monobank, the People’s Bank
of China, PBOC, which acted as a central bank, a commercial bank and government
treasury all rolled into one.
• After 1978, there was a Dual Track system: Co-existence of a traditional plan and a market
channel for the allocation of a good. By the mid-1980s, most state-owned firms were still
being assigned a compulsory plan for some output but had additional capacity available
for production of above-plan market goods.
Presentation to Confucius Institute Seminar, P.V. Viswanath
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EARLY DEVELOPMENTS
• Rural communities were allowed to run township and village enterprises outside the plan in
order to contribute to local investment and economic growth.
• Foreign businesses were allowed to operate freely in special economic zones in order to
increase FDI and facilitate technology transfer. Private economic activity was tolerated.
• Agricultural collectives were given more autonomy to meet procurement targets, which
were also reduced. Collectives contracted individual pieces of land to farm households,
which managed the plot of land, subject to a contractual agreement that they turn over a
certain amount of procurement and tax grain after the harvest.
• All of this required a more responsive financial system that would help in the allocation of
resources to growth sectors. In 1979, under the reform policy introduced by Deng Xiaoping,
the PBOC was given the function of a supervisory body and of a central bank; by the end of
1979, it was no longer under the Ministry of Finance.
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THE ESTABLISHMENT OF THE SOCBs
• From 1978 to 1984, the banking system moved from a mono-bank system, centered on the
PBOC to a two-tier system. The PBOC became the central bank, i.e. in charge of monetary
policy and four state owned commercial banks (SOCBs) were established to fund economic
development.
• The Bank of China (BOC) specialized in transactions related to foreign trade and investment.
• The China Construction Bank (PCBC) handled transactions related to fixed investment,
especially in manufacturing.
• The Agricultural Bank of China was set up to deal with all banking business in rual reas.
• The Industrial and Commercial Bank of China (ICBC) was established in 1984 and took over
the commercial transactions of the PBOC.
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THE FINANCIAL SYSTEM DEVELOPS FURTHER
• In the 1980s, financial intermediaries outside the Big Four sprouted.
• Regional banks (partially owned by regional governments) were formed in the Special
Economic Zones in the coastal areas.
• In rural areas, a network of Rural Credit Cooperatives was set up under the supervision of the
ABC
• Urban Credit Cooperatives, counterparts of the RCCs were set up in the urban areas.
• Non-bank financial intermediaries, such as the Trust and Investment Corporations provided
selected banking and non-banking services with restrictions on both deposits and loans.
• In the 1990s, stock markets grew. The Shanghai Stock Exchange and the Shenzhen
Stock Exchange were set up in 1990.
• The real estate market also grew almost as fast as the stock markets in terms of value.
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REGULATORY SYSTEM
• In 1986, the first bankruptcy law was passed, governing SOEs, but it was not effective until
the end of 1999. In August 2006, a new bankruptcy law was enacted and became effective in
June 2007.
• In the beginning, the PBOC held regulatory control of the entire financial system, but over
time, by the mid 2000s, it ceded control over parts of the system to the China Securities
Regulatory Commission (CRTC) and the China Insurance Regulatory Commission (CIRC).
• In 2003, the Central Government established the China Banking Regulatory Commission,
which supervises financial institutions under the leadership of the State Council.
• The State Administration of Foreign Exchange (SAFE) manages currency reserves and the
exchange rate, under the umbrella of the PBOC.
• The Ministry of Finance is responsible for promulgating accounting and tax rules and the
National Development and Reform Commission (NDRC) is responsible for enterprise finance
issues and industry policies. These two have an important role in defining future policies.
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STAGE TWO OF ECONOMIC DEVELOPMENT
• Gradually, by the mid-1990s, production under state plans, outside the market, dropped to zero
and the entire product sector of the economy had transitioned to a market system.
• Instead of a big-bang approach, Chinese reformers used the planned economy institutions to ease
into a market system.
• Emphasis on the capital-intensive sector was replaced by a move towards more sustainable laborintensive sectors. This allowed the utilization of large numbers of workers who would, otherwise,
have suddenly become redundant in a big-bang switch.
• Resources were gradually shifted to the household sector by reducing procurement and allowing
production for market. This allowed the rural population to generate savings, which they then
ploughed into investment in new enterprises, which were tolerated in the first years. This savings
was enabled by the gradualist reforms that maintained stability and led to trust in economic
growth.
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THE ROLE OF FINANCE IN DEVELOPMENT
• The government’s share of the economy and of newly generated resources was low, since
government monopolies in every sector were removed or at least reduced. Taxation was
also low, partly because of the existence of a large informal sector plus a government
that did not have a taxation system in place.
• The banking sector, at this time, played an important part in channeling household
saving to the enterprise sector.
• The emergence of new private firms coupled with the adoption of market prices by stateowned enterprises (SOEs) (partially, at first) led to enhanced competition and began to
get state-sector managers accustomed to responding to market pressures.
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BENEFITS OF THE GRADUALIST APPROACH
• Rural residents gained from the dissolution of collectives, improved agricultural prices
and the rapid growth of nonagricultural production in the countryside.
• Urban residents gained either because they were able to exploit new niches in the
economy, or because their economic position was protected by continuing government
support for state enterprises.
• However, rising inflation that eroded real incomes, anger at corruption and arbitrary
privilege and rising expectations about political and economic change led to the
Tiananmen Square uprising. The inflation was because of extreme decentralization in
the monetary sector.
• In spite of the strict and violent way in which the protesters were treated, conservative
attempts to turn the clock back failed.
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THE POST-1992 STAGE
• Deng Xiaoping (邓小平), the leader of the country (and the general secretary of the Communist Party),
took a Southern Tour in 1992 to endorse the concept and reality of the SEZs that had been authorized a
decade earlier and to reaffirm a non-ideological, pragmatic approach to development. In October 1992,
the Communist Party Congress endorsed a socialist market economy.
• By the end of 1993, the orthodox planning system was abolished. Non-market contracts with individual
enterprises were allowed to lapse. However, although the state’s direct role in producti0n planning was
ended, there was a renewed move towards centralization of state authority.
• Whereas in the pre-1992 period, local governments had a lot of autonomy, post-1992, the center took
renewed hold of resources.
• At this stage, the economy could have moved in two directions. It could have become a private
enterprise-dominated economy, as in Estonia, for example. However, this would have entailed a ceding
of power and control over resources by the Communist Party and its elites to outsiders. Hence the party
chose an alternative route, where product markets were more-or-less free, yet control over resources
was maintained by the party. This meant control over the financial sector.
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TAX REFORM
• Due to the decentralization of the economy, the government’s budgetary revenue share of
GDP dropped from 33.8% in 1978 to only 10.8% in 1995.
• In the old system, state monopoly enterprises raised revenues through use of their market
power. In the new competitive environment, this was no longer true.
• The solution was to build up a modern tax system. The fiscal reform had three crucial
elements: new taxes, a tax assignment and sharing system, and a new central government
taxation agency.
• VAT was levied on most manufactured goods at the uniform rate of 17%; very small private
enterprises without regular bookkeeping systems were to pay a tax of 6% of gross sales in lieu
of VAT. In addition, a 33% profit tax was introduced with uniform rates for state, collective
and private enterprises. The system of personal income taxes was unified and made more
rigorous; a consumption tax was introduced for cigarettes, alcohol, and a few other luxuries.
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FISCAL REFORM
• The tax reform succeeded in treating all tax payers similarly (SOEs, collectives, and
private firms). Multiple taxes with different tax bases and tax rates were merged into the
VAT. Finally, the VAT was moved to the central government.
• This resulted in less geographic distortion of incentives for development. Local
governments are no longer able to provide tax relief to favored enterprises. This made
the tax system more transparent, less costly to administer, and easier for the public to
understand. This helped in the government’s efforts to establish an effective tax
collection agency.
• Since 1993, the central government has transferred resources to local governments,
based on its planning goals, in contrast to the pre-1985 period, when there was net localto-center redistribution of revenues.
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BUDGETARY PROBLEMS
• It is still the case, however, that the Chinese government is not able to raise as much in
revenues as it would like, through taxes.
• China has tried to keep deficit spending at moderate levels, at around 1% of GDP in most
years of the 1980s and 1990s.
• However, the Asian financial crisis during the last years of the last millennium, coupled with
the change in development strategies in the 1990s led to a greater need for public spending.
This led to an increase in the deficit to well over 2% of GDP from 2000 to 2002. As the
economy recovered, the deficit dropped, as well.
• Nevertheless, the need for increased spending both for social support and for state-driven
capital investment has led to demands for financial resources that cannot be satisfied by
normal budgetary revenues.
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THE DEBT PROBLEM
• The government has tried several tacks to deal with this problem.
• The main strategy is borrowing. In spite of this reliance on borrowing, the public debt in
China at the end of 2005 was only 17.9% of GDP.
• However, many types of public obligations are not included in this number, e.g. special
bonds issued to recapitalize the banking system. Another computation which took a
broader perspective came up with a figure of 55% of GDP in 2000. A WSJ computation
(September 2013) which included local government borrowing, came up with a figure of
167% of GDP for 2011 and 182% for 2012.
• Furthermore, SOEs also have high levels of borrowings, and in many cases, SOEs can be
considered an extension of the Chinese government.
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CONTRASTING STYLES OF ECONOMIC REFORM
1980s Reform
1990s Reform
Zhao Ziyang (premier from 1980 to 1987):
Cautious, consensual decision-making
Zhu Rongji (vice-premier from 1993, premier
1998-2003): Rapid, personalized decision-making
Introduce markets where feasible; focus on
agriculture and industry
Strengthen institutions of market economy; focus
on finance and regulation
Dual-track strategy
Market unification, unite dual tracks
Particularistic contracts with powerful incentives
Uniform rules: Level playing field
Competition created by entry; no privatization
State-sector downsizing; beginnings of
privatization
Decentralize authority and resources
Recentralize resources, macroeconomic control
Inflationary economy with shortages
Price stability, goods in surplus
Reform without losers
Reform with losers
Table 4.1 from Naughton, The Chinese Economy
What will 习近平 Xi Jinping’s style be? This is yet to be seen.
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FINANCIAL REPRESSION
• One way that the Chinese government has tried to retain access to resources is by financial
repression. Although there exist bond and stock exchanges, it is not easy for firms to list on the
stock exchange. Permission to issue bonds is also not easy to obtain. As a result, the stock and
bond markets are not really avenues for public investment.
• Individuals are still very limited in the avenues available to them to save. The main outlet is
banks, which do not pay very high rates of interest. Furthermore, SOEs are favored by banks in
terms of lending. Private enterprises cannot get bank loans that easily.
• One proof of this financial repression is the attempt by many Chinese investors to invest large
amounts of money in stock markets and in real estate markets. As a result of a lot of money
chasing small amounts of available supply, stock markets and real estate markets are often way
overvalued. Furthermore, because of the lack of transparency, there is a lot of volatility in these
markets, as well.
• The market inefficiency of the Chinese stock markets is well documented.
• Furthermore, any other way of channeling resources to private investment is illegal, which has
given rise to a large informal financial system, sometimes called shadow banking.
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FUNDAMENTAL PROBLEMS?
• There was a banking crisis following the Asian financial crisis towards the end of the 1990s which involved a very
high proportion of nonperforming loans (NPLs); this was resolved by the creation of asset management companies
(AMCs), which were essentially bad banks that took over the NPLs of the state-owned banks. These AMCs then
tried to collect on these bad loans. Loans that were uncollectible were ultimately written off. The government
underwrote this writing off plus the recapitalization of the state-owned banks by the infusion of capital through the
issuance of special bonds.
• The continuing need for financial resources was partially resolved by the sale of shares in SOEs and SOCBs to
foreigners and foreign financial institutions. For example, Bank of Communications in 2005 was the first Chinese
lender to list abroad. This issue was heavily oversubscribed. However, there is evidence that these IPOs were
stage-managed through “management of earnings,” i.e. earnings manipulation. Furthermore, most of the shares in
these state owned enterprises were held by the government; hence the price of these shares reflected, in a certain
sense, a scarcity value.
• The growth in the Chinese economy during the late 1990s may also have been fuelled by the aggressive purchase at
cheap prices of agricultural land and dispossession of farmers. Obviously, this process could not continue forever.
• In other words, there are grounds for considering whether the Chinese financial and economic system is basically
unstable. This is a dialogue that is taking place both abroad and in China. Students should have some background
to be able to evaluate this discussion.
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OTHER ISSUES
• A lot of the saving is done in the rural areas; however, the ratio of loans made to deposits is very low. This reflects a
conscious strategy to benefit urban areas over rural areas for political reasons. This impetus towards urbanization
has been renewed under Xi Jinping: the Central Economic Conference, which took place in early 2013 stated that “a
new model of urbanization will provide the largest potential for promoting domestic spending and calls for an
orderly urbanization of migrants from rural areas.” Hence in order to understand the financial system, it is
necessary to study the rural-urban divide.
• NPLs are also a problem -- a state-owned asset-management firm, China Orient Asset Management Corp., said in a
report in September 2013, that Chinese commercial banks are facing a resurgence in nonperforming loans. It said in
a report this week that the bad-loan ratio at commercial banks is expected to reach 1% to 2% this year, while the
volume of new bad loans will climb more than 5% from a year earlier.
• However there is general disbelief that this number is correct. Even if the true number is 5% as claimed by some
sources, this is still much less than the 20% that may have reigned in 2005. The current ratio for the US is 3.9% and
10.1% in Cyprus according to World Bank data.
• Still it is not just the current number that is problematic, but rather the fact that there have not been fundamental
changes in the way banks hand out loans.
http://www.ibtimes.com/china-banks-bad-debt-cause-concern-not-if-history-any-guide-1387487
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LOOKING FORWARD
• What is the role of financial securities markets in China? Will they become more important in terms of
being a conduit for resource mobilization and resource allocation?
• Will the banking sector become more privatized? Will it become more commercialized and more
competitive?
• Why are credit cards still not as popular as might be imagined in the second largest economy in the
world? How will this be affected by the growth of online shopping?
• Although more than 50% of Chinese GDP is from the private sector, much of the corporate sector is still
partly or fully owned and controlled by the government. Is the corporate sector likely to be privatized in
the future? How will this affect corporate governance? What will be the role of the M&A market?
• Will the informal sector wrest effective control of the economy from the government or will the
government be successful in imposing control?
• These are some of the questions that we will we dealing with in the rest of the course.
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