KEY QUESTIONS Stock Market What is the structure of the Chinese stock Overvie market? What is the overall structure of China's finan-. Why is the Chinese stock market so specula cial system? Who regulates the financial system? What is the regulatory framework for IPOs? How does political influence on personnel ap What financial innovations have occurred in ointments affect the large state-owned finan the Chinese stock markets? What are the ownership structures of the list What are the accounting standards in China? ed State-Owned Enterprises? How prevalent are accounting frauds in China? Banking sector Other financial Institutions What is the structure of the banking sector? ow developed is Chinas asset management How profitable is the banking sector in China? Inqu How are lending and deposit interest rates de What is the situation of the trust industry in termined China? How did the government reduce Non-Per- What is the situation of the insurance industry forming Loans? How did efficiency at the state-owned banks What is the situation of the Venture Capital improve over the years? and Private Equity industry in China How do foreign exchange interventions affect How open is China's financial system to for Chinas banks? eign participation Bond market Informal Secto What is the state of development of the Chi- .Why does China have an informal financial nese bond market sector? What is the structure of local government What is the situation of the informal financial debt? sector in China? How did the local governments raise money? What is the situation of rating agencies in The Intersection of the Financial System and the Real eco What is the financial markets role in Chinas real estate market? Conclusions The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS
The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 7 Key Questions Overview • What is the overall structure of China’s financial system? • Who regulates the financial system? • How does political influence on personnel appointments affect the large state-owned financial institutions? • What are the accounting standards in China? How prevalent are accounting frauds in China? Banking Sector • What is the structure of the banking sector? • How profitable is the banking sector in China? • How are lending and deposit interest rates determined? • How did the government reduce Non-Performing Loans? • How did efficiency at the state-owned banks improve over the years? • How do foreign exchange interventions affect China’s banks? Bond Market • What is the state of development of the Chinese bond market? • What is the structure of local government debt? • How did the local governments raise money? • What is the situation of rating agencies in China? Stock Market • What is the structure of the Chinese stock market? • Why is the Chinese stock market so speculative? • What is the regulatory framework for IPOs? • What financial innovations have occurred in the Chinese stock markets? • What are the ownership structures of the listed State-Owned Enterprises? Other Financial Institutions • How developed is China’s asset management industry? • What is the situation of the trust industry in China? • What is the situation of the insurance industry in China? • What is the situation of the Venture Capital and Private Equity industry in China? • How open is China’s financial system to foreign participation? Informal Sector • Why does China have an informal financial sector? • What is the situation of the informal financial sector in China? The Intersection of the Financial System and the Real Economy • What is the financial market’s role in China’s real estate market? Conclusions
I Key Questions OVERVIEWS 341%, and in recent years the annual rate has been as high as 666%. The market for initial public of What is the overall structure of China's financial ferings(IPOs)is particularly prone to speculative system? excess,with participants bidding for many mu tiples of their desired allocation, and putting up Banks dominate the Chinese financial system, pro- the required deposits for that full amount, just in viding the private sector with credit amounting to hopes of gaining at least a modest allocation. about 128%of Gross Domestic Product (GDP) in 2012, compared to 48% for the US.6 The bond Insurance companies are another under-devel market,however, is under-developed, providing oped part of the Chinese financial system, holding credit equivalent to approximately 41% of Chinas $1.2 trillion in assets, or just over 14% of GDP.12 GDP,7 compared to 243%in the US. Chinese stock The scale of the insurance industry is thus relative- capitalization of about 44% of domestic GDP in oped financial systems. For example, US insurers 12. This contrasts with Western economies, have over $4.8 trillion in total assets, amounting to where the stock market is typically smaller than over 30%of GDP13 the bond market Chinas asset management industry is even less Unfortunately, Chinese stock markets are of developed compared to the West, particularly ten aptly compared to casinos, driven heavily by compared to the prominent role played by mutual speculation rather than end-investment. For ex funds in America. Assets under management in ample, the average annual turnover rate in the China are equivalent to only about 5. 1% of GDP, Chinese stock markets over the past 5 years was compared to 240% in the US.However, China 205%, reaching a recent high of 293%, compared asset management industry has been growing to the US rate of 188% 10 This high turnover rate rapidly since emerging in the late 1990's,with the is particularly striking given that large po number of funds increasing markedly, and the to of Chinese shares are non-tradable, generally be tal assets under management projected to rise to cause they are owned by government entities. (The approximately 6.8 trillion RMB by 2015(which government has self-imposed restrictions on share would constitute over 10% of projected GDP) sales in order to alleviate fears that their shares will (The "renminbi, or"peoples currency, is abbre- I the ng viated"RMB and is sometimes also referred to a gotiable shares are taken into account, the average the Yuan. It currently trades between 6. 1 and 6.2 turnover rate over the past five years increases to RMB to the uS dollar.) The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS
The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 8 II. Key Questions Overviews What is the overall structure of China’s financial system? Banks dominate the Chinese financial system, providing the private sector with credit amounting to about 128% of Gross Domestic Product (GDP) in 2012,5 compared to 48% for the US.6 The bond market, however, is under-developed, providing credit equivalent to approximately 41% of China’s GDP,7 compared to 243% in the US.8 Chinese stock markets, for their part, had an aggregate market capitalization of about 44% of domestic GDP in 2012.9 This contrasts with Western economies, where the stock market is typically smaller than the bond market. Unfortunately, Chinese stock markets are often aptly compared to casinos, driven heavily by speculation rather than end-investment. For example, the average annual turnover rate in the Chinese stock markets over the past 5 years was 205%, reaching a recent high of 293%, compared to the US rate of 188%.10 This high turnover rate is particularly striking given that large portions of Chinese shares are non-tradable, generally because they are owned by government entities. (The government has self-imposed restrictions on share sales in order to alleviate fears that their shares will flood the market, reducing prices.) When only negotiable shares are taken into account, the average turnover rate over the past five years increases to 341%, and in recent years the annual rate has been as high as 666%.11 The market for initial public offerings (IPOs) is particularly prone to speculative excess, with participants bidding for many multiples of their desired allocation, and putting up the required deposits for that full amount, just in hopes of gaining at least a modest allocation. Insurance companies are another under-developed part of the Chinese financial system, holding $1.2 trillion in assets, or just over 14% of GDP.12 The scale of the insurance industry is thus relatively small compared to countries with more developed financial systems. For example, US insurers have over $4.8 trillion in total assets, amounting to over 30% of GDP.13 China’s asset management industry is even less developed compared to the West, particularly compared to the prominent role played by mutual funds in America. Assets under management in China are equivalent to only about 5.1% of GDP, compared to 240% in the US.14 However, China’s asset management industry has been growing rapidly since emerging in the late 1990’s, with the number of funds increasing markedly, and the total assets under management projected to rise to approximately 6.8 trillion RMB by 2015 (which would constitute over 10% of projected GDP).15 (The “renminbi”, or “people’s currency”, is abbreviated “RMB” and is sometimes also referred to as the “Yuan”. It currently trades between 6.1 and 6.2 RMB to the US dollar.)
Capital Market (in trillion USDS) Fixed Bank credit Stock Income Insurance Asset Management Companies Size( China) 3.7 Size(US) 7.6 18.7 36 %GDP(China) 8% 44% 41% 14% % GDP (US) 118% 240% 32% 230% Note: All values above computed for end of year 2012, except for the values for Chinese Bank Credit, which are up to date through Q1 2013. The relative size of the different financial sectors and their respective ratio to GDP is summarized The Concept of Total Social Financing as follows: 16 The Chinese authorities generally report figures for As in most countries. there are also a number of the overall size and composition of their financial other types of financial intermediaries in the Chi system in terms of a concept that they devised and which is unique to China. They report"Total So nese formal sector, such as trust companies, rural cial Financing, which includes the following cat credit cooperatives, urban credit cooperatives, and egories: bank loans, foreign currency loans, trust several others. Most of them are regulated by the and entrusted loans, bank acceptance bills, corpo- China Banking Regulatory Commission(CBRC), rate bond financing, nonfinancial enterprise equity but under different rules than for banks it is diffi cult to locate comprehensive data on the size of nd other funding sources such as insurance, mi cro lending, and industry funds these other financial intermediaries, but they ap pear to have grown fairly quickly in recent years The concept is a broad measure of the nations year For example, the assets owned by cooperative fi ly flow of liquidity, described by officials as"indi nancial institutions grew from 5 trillion in 2007 to ating total funds the real economy obtained from about 7.8 trillion RMB in 2010, amounting to 12% the financial system over a certain period of time. of all household deposits. Total Social Financing aggregates the prima ry sources of credit with a number of non-credit In addition to formal financial institutions, Chi- items, such as equity and foreign direct investment. na has a large and diverse informal lending sector At the same time, it is not fully inclusive of all fi- that helps fill the gaps left by a formal sector ex nancing sources. As a result, it is not comparable cessively focused on funding state-owned enter- to figures reported by other countries either fo es and politically favored businesses. Lender credit origination or for overall financing. This pa in this sector include loan sharks, pawn brokers, per therefore generally does not report figures for Total Social Financing, but attempts to calculate formal or informal cooperatives of locals lending figures that match the concepts that are used in to each other, State-Owned Enterprises(SOes)re- other nations. For example, in order to determine lending out excess cash, and many other privately the ratio of credit provided from bank loans, one and sometimes secretly, raised funds that invest in must exclude financing equity and other sources start-ups. The informal sector has that are not identifiable as credit from the Total So- lationship with the Chinese state and regulators asy re- cial Financing figure. "Bank acceptances, " are also excluded in the adjusted calculation, as these rep Since 2002, the Ministry of Finance and the State resent bank credit, but are generally collateralized Administration of Foreign Exchange has cracked at least in part by an equivalent deposit at the same down on over 500 underground banks, whose bank. Collateralization of this nature reduces the sets totaled more than 100 billion rmb 8 true credit risk taken by the bank. The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS
The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 9 The relative size of the different financial sectors and their respective ratio to GDP is summarized as follows:16 As in most countries, there are also a number of other types of financial intermediaries in the Chinese formal sector, such as trust companies, rural credit cooperatives, urban credit cooperatives, and several others. Most of them are regulated by the China Banking Regulatory Commission (CBRC), but under different rules than for banks. It is difficult to locate comprehensive data on the size of these other financial intermediaries, but they appear to have grown fairly quickly in recent years. For example, the assets owned by cooperative financial institutions grew from 5 trillion in 2007 to about 7.8 trillion RMB in 2010, amounting to 12% of all household deposits.17 In addition to formal financial institutions, China has a large and diverse informal lending sector that helps fill the gaps left by a formal sector excessively focused on funding state-owned enterprises and politically favored businesses. Lenders in this sector include loan sharks, pawn brokers, formal or informal cooperatives of locals lending to each other, State-Owned Enterprises (SOEs) relending out excess cash, and many other privately, and sometimes secretly, raised funds that invest in start-ups. The informal sector has an uneasy relationship with the Chinese state and regulators. Since 2002, the Ministry of Finance and the State Administration of Foreign Exchange has cracked down on over 500 underground banks, whose assets totaled more than 100 billion RMB.18 The Concept of “Total Social Financing” The Chinese authorities generally report figures for the overall size and composition of their financial system in terms of a concept that they devised and which is unique to China. They report “Total Social Financing”, which includes the following categories: bank loans, foreign currency loans, trust and entrusted loans, bank acceptance bills, corporate bond financing, nonfinancial enterprise equity financing, foreign direct investment, foreign debt, and other funding sources such as insurance, micro lending, and industry funds. The concept is a broad measure of the nation’s yearly flow of liquidity, described by officials as “indicating total funds the real economy obtained from the financial system over a certain period of time.” Total Social Financing aggregates the primary sources of credit with a number of non-credit items, such as equity and foreign direct investment. At the same time, it is not fully inclusive of all financing sources. As a result, it is not comparable to figures reported by other countries either for credit origination or for overall financing. This paper therefore generally does not report figures for Total Social Financing, but attempts to calculate figures that match the concepts that are used in other nations. For example, in order to determine the ratio of credit provided from bank loans, one must exclude financing equity and other sources that are not identifiable as credit from the Total Social Financing figure. “Bank acceptances,” are also excluded in the adjusted calculation, as these represent bank credit, but are generally collateralized at least in part by an equivalent deposit at the same bank. Collateralization of this nature reduces the true credit risk taken by the bank. Capital Market (in trillion USD$) Sector Bank Credit Stock Fixed Income Insurance Asset Management Companies Size (China): 10.7 3.7 3.4 1.2 0.4 Size (US): 7.6 18.7 38 4.8 36 % GDP (China): 128% 44% 41% 14% 5% % GDP (US): 48% 118% 240% 32% 230% Note: All values above computed for end of year 2012, except for the values for Chinese Bank Credit, which are up to date through Q1 2013
Who regulates the financial system resort during a financial crisis. The Pboc also sets limits on deposit interest rates and lending interest Chinas regulators are divided primarily by the rates. Further, it controls the State Administration broad types of activity they oversee, although, of Foreign Exchange, which manages the exchange there are some overlaps and oddities, as is the case rate. However, both the exchange rate an n most countries. Banks are regulated primarily terest rate limits are largely decided at a higher by the China Banking Regulatory Commission level, ultimately by the State Council, the highest (CBRC), securities and financial markets by the government body China Securities Regulatory Commission( CSrC) and insurance by the China Insurance Regulatory The Ministry of Finance(MOF)also touches on fi Commission(CIRC). The Chinese central bank, nancial regulation through both its share holdings the Peoples Bank of China(PBOC), also has im- in the major commercial banks and its control over portant regulatory responsibilities, in addition to the Central Huijin Company, through which it indi managing monetary policy. It is in charge of draft- rectly owns substantial stakes in commercial banks ing regulatory bills, regulating systemic risks, and anaging financial stability. As is true for virtual- Beyond this fairly traditional division of regulato ly all central banks, it can serve as a lender of last ry responsibilities, the high level of state control National People's Congress State Council People's Bank China Banking China securities China Insurance Ministry of Human Resource atory Commission ry Commission Regulatory Commiss Central Hu State Adm. of oreign Exchange Insurance Asset Firms Manage Firms Agency/Bre Commercial Banks all and Medium si Financial Institutions Financial Institutions State Policy Banks Financial Institutions township banks Development Bank Corporation AMC Finance companies commercial bank Corporation AMC Turst companies City commercial Rural cooperative Rural mutual of china Corporation AMC Rural commercial China cinda Corporation AMC Auto finance Foreign bank Money brokerage Consumer finance Notes: The thickest connecting lines correspond to the highest levels of authority in financial policy making. The NPC promulgates financial sector laws and the State Council executes financial regulation and issues mandatory policy directives to all the financial regulatory and supervisory agencies. The dotted connecting lines indicate the three primary functions of PBC-formulating monetary financial stability, and providing financial servi role of the mof as tax ad d owner of several commercial banks The thinne ecting lines emerging from CBRC, CSRC, CIRC, and MHRSS reflect that these entities are mostly responsible for regulating and conducting supervision and oversight of their respective financial Additiond otes: The SAFE is responsible for foreign exchange operations of securities and insurance companies. The China Development Bank nd the Postal Savings Bank are in the process of reforming into commercial banks. Central Huijin exercise rights and obligations as n investor in major state-owned financial enterprises on behalf of the State. The National Social Security Fun has also a dual role as an institutional investor and a stakeholder in some of the largest commercial banks. The Chinese Financial System: An Introduction and Over JOHN L. THORNTON CHINA CENTER AT BROOKINGS 10
The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 10 Who regulates the financial system? China’s regulators are divided primarily by the broad types of activity they oversee, although, there are some overlaps and oddities, as is the case in most countries. Banks are regulated primarily by the China Banking Regulatory Commission (CBRC), securities and financial markets by the China Securities Regulatory Commission (CSRC), and insurance by the China Insurance Regulatory Commission (CIRC). The Chinese central bank, the People’s Bank of China (PBOC), also has important regulatory responsibilities, in addition to managing monetary policy. It is in charge of drafting regulatory bills, regulating systemic risks, and managing financial stability. As is true for virtually all central banks, it can serve as a lender of last resort during a financial crisis. The PBOC also sets limits on deposit interest rates and lending interest rates. Further, it controls the State Administration of Foreign Exchange, which manages the exchange rate. However, both the exchange rate and the interest rate limits are largely decided at a higher level, ultimately by the State Council, the highest government body. The Ministry of Finance (MOF) also touches on financial regulation through both its share holdings in the major commercial banks and its control over the Central Huijin Company, through which it indirectly owns substantial stakes in commercial banks. Beyond this fairly traditional division of regulatory responsibilities, the high level of state control Ministry of Finance Securities Firms Future Firms QDIIs/ QFIIs Stock Exchanges Futures Exchanges Investment Funds/Banks Insurance Holding Firms Personal Insurance Firms National Social Security Fund Enterprise Annuities Insurance Agency/Broker Insurance Holding Firms Insurance Asset Manage. Firms Reinsurance Firms China Banking Regulatory Commission Commercial Banks • Large commercial banks • Joint-stock commercial banks • City commercial banks • Rural commercial banks • Foreign banks • China Development Bank • Export-import Bank of China • Agricultural Development Bank of China • China Huarong Corporation AMC • China Great Wall Corporation AMC • China Orient Corporation AMC • China Cinda Corporation AMC • Postal savings bank • Finance companies of enterprise groups • Turst companies • Financial leasing companies • Auto finance companies • Money brokerage firms • Consumer finance companies • Village or township banks • Lending companies • Rural mutual cooperatives • Urban credit cooperatives • Rural credit cooperatives • Rural cooperative banks State Policy Banks Small and Medium Size Financial Institutions New-type Rural Financial Institutions Other Financial Institutions Financial Asset Management Companies China Securities Regulatory Commission China Insurance Regulatory Commission Ministry of Human Resource and Social Security Central Huijin Investment State Adm. of Foreign Exchange People’s Bank of China National People’s Congress State Council Notes: The thickest connecting lines correspond to the highest levels of authority in financial policy making. The NPC promulgates all financial sector laws and the State Council executes financial regulation and issues mandatory policy directives to all the financial regulatory and supervisory agencies. The dotted connecting lines indicate the three primary functions of PBC—formulating monetary policy, maintaining financial stability, and providing financial services—and the triple role of the MOF as tax administrator, treasurer, and owner of several commercial banks. The thinner connecting lines emerging from CBRC, CSRC, CIRC, and MHRSS reflect that these entities are mostly responsible for regulating and conducting supervision and oversight of their respective financial sectors Additional notes: The SAFE is responsible for foreign exchange operations of securities and insurance companies. The China Development Bank and the Postal Savings Bank are in the process of reforming into commercial banks. Central Huijin exercise rights and obligations as an investor in major state-owned financial enterprises on behalf of the State. The National Social Security Fun has also a dual role as an institutional investor and a stakeholder in some of the largest commercial banks
of the economy means that other important bod- more susceptible to this form of political pressure ies have quasi-regulatory duties. Most importan from above the leading role of the Chinese Communist Party means that various party bodies and important Second, the highest executives in the banks are all party members have considerable influence over appointed by the Organization Department of the ersonnel decisions at the financial institutions party, comparable to the manner by which all the and over detailed decisions about financial activi- high-level local government officials and central ty, including at times decisions about specific large government officials are appointed. Political in loans. The Organization Department of the party, tegrity is one of the most important factors under which is mainly in charge of personnel appoint- consideration for their appointment. C ments of government officials, is also in charge of hierarchical nature of the party structure, this im naming key executives in the state-owned banks plies a requirement to take very seriously the views and the other state-owned financial institutions. of higher ranking party officials Usually the executives are members of the party, and they, like local or central government officials, Third, many bank executives ultimately aspire to tend to transfer to different assignments every 5 top government jobs. The government divisions years or so. they move to include the regulators of the finance industry, such as the PBOC or the Ministry of Fi- The complete regulatory framework is shown on nance, but also include local government positions, the previous page in a graphic from the IMF: 9 such as provincial leader, and central government appointments, such as vice prime minister. For How does political influence on personnel mer Prime Minister Zhu Rongji, for example, once appointments affect the large state-owned was the ceo of China Construction Bank. Some financial institutions? scholars believe that this appointment system dis torts the incentives of the executives(see Allen Executives in the large state-owned financial insti- Qian, Zhang and Zhao, 2012 for references). This tutions are also effectively high-level government is because taking their future career path into ac officials, in practice if not in theory. This is evident count, executives decisions about bank operations in the following three aspects may not be completely based on their institution al interests. Financial institutions are thus utilize First, they all have political ranks similar to local as tools to acquire political capital for their future and central government officials. For example, the promotions olitical rank of the ceo of bank of china is the same level as that of a vice president of the PBoC, What are the accounting standards in China? or a vice governor of a province. One of the rea- How prevalent are accounting frauds in China? that political ranks matter is that they provide banks with bargaining power with local govern- The Ministry of Finance sets accounting standards ment officials who are often of lower ranks. Pro- in China and the csrc determines what specific viding bank executives with political rank grants disclosures companies with publicly traded secu them implicit political capital that they can use to rities must make. The most recent disclosure stan bargain with local governments on terms of loans, dards were set in 2007 ncluding resisting pressure to make uneconomic Po re- Unfortunately, there have been a number of prom vent a local official from using connections with a inent accounting frauds in China. The lack of suffi higher-ranking patron to create sufficient pressure cient regulatory resources and the principal-agent to get their way, and interestingly may make them problem between listed firms and accounting The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGS
The Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 11 of the economy means that other important bodies have quasi-regulatory duties. Most important, the leading role of the Chinese Communist Party means that various party bodies and important party members have considerable influence over personnel decisions at the financial institutions and over detailed decisions about financial activity, including at times decisions about specific large loans. The Organization Department of the party, which is mainly in charge of personnel appointments of government officials, is also in charge of naming key executives in the state-owned banks and the other state-owned financial institutions. Usually the executives are members of the party, and they, like local or central government officials, tend to transfer to different assignments every 5 years or so. The complete regulatory framework is shown on the previous page in a graphic from the IMF:19 How does political influence on personnel appointments affect the large state-owned financial institutions? Executives in the large state-owned financial institutions are also effectively high-level government officials, in practice if not in theory. This is evident in the following three aspects: First, they all have political ranks similar to local and central government officials. For example, the political rank of the CEO of Bank of China is the same level as that of a vice president of the PBOC, or a vice governor of a province. One of the reasons that political ranks matter is that they provide banks with bargaining power with local government officials who are often of lower ranks. Providing bank executives with political rank grants them implicit political capital that they can use to bargain with local governments on terms of loans, including resisting pressure to make uneconomic loans for political reasons. But, this does not prevent a local official from using connections with a higher-ranking patron to create sufficient pressure to get their way, and interestingly may make them more susceptible to this form of political pressure from above. Second, the highest executives in the banks are all appointed by the Organization Department of the party, comparable to the manner by which all the high-level local government officials and central government officials are appointed. Political integrity is one of the most important factors under consideration for their appointment. Given the hierarchical nature of the party structure, this implies a requirement to take very seriously the views of higher ranking party officials. Third, many bank executives ultimately aspire to top government jobs. The government divisions they move to include the regulators of the finance industry, such as the PBOC or the Ministry of Finance, but also include local government positions, such as provincial leader, and central government appointments, such as vice prime minister. Former Prime Minister Zhu Rongji, for example, once was the CEO of China Construction Bank. Some scholars believe that this appointment system distorts the incentives of the executives (See Allen, Qian, Zhang and Zhao, 2012 for references). This is because taking their future career path into account, executives’ decisions about bank operations may not be completely based on their institutional interests. Financial institutions are thus utilized as tools to acquire political capital for their future promotions. What are the accounting standards in China? How prevalent are accounting frauds in China? The Ministry of Finance sets accounting standards in China and the CSRC determines what specific disclosures companies with publicly traded securities must make. The most recent disclosure standards were set in 2007. Unfortunately, there have been a number of prominent accounting frauds in China. The lack of sufficient regulatory resources and the principal-agent problem between listed firms and accounting