Chinas Financial System: Past, Present, and Future Franklin Allen Jun Qian Meijun Qian Finance Department Finance Department Finance Department he Wharton School Carroll School of Management Carroll School of Management University of Pennsylvania Boston College Boston College Philadelphia, PA 19104 Chestnut Hill. MA 02467 Chestnut Hill. MA 02467 allen@wharton. upenn. edu ianjuabc edu gianme(abc.edu First draft: October 2004 Last Revised: July 21, 2005 To appear in the book titled"The Transition that Worked Origins, Mechanism, and Consequences of China s long boom, edited by loren brandt, Univ of Toronto, and Thomas Rawski, Univ of Pittsburgh) e We examine and compare the role of China's financial system in supporting the growth of firms and omy with that in other countries, and explore directions of future development. First, we find that the current financial system is dominated by a large but inefficient banking sector, and reducing the amount of non-performing loans among the major banks to normal levels is the most important objective for reforming the financial system in the short run. Second, despite the fast growth of the stock market, its role of resource allocation in the economy has been both limited and ineffective. Further development of Chinas financial markets is the most important long-term objective. Third, we find that 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, coalitions, and institutions. This sector should co-exist with banking 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 JEL Classifications: O5.KO. G2 Keywords: banks, non-performing loans, markets, corporate governance, hybrid sector, financial crisis We appreciate detailed comments from Loren Brandt and Tom Rawski(editors of the book "Chinas Economic Transition: Origins, Mechanism, and Consequences")that significantly improved the paper. We wish to thank Dong Chen, Ed Kane, Nick Lardy, Anthony Neoh, Phil Strahan, and other participants of the"China,'s Economic Transition project for their comments, Qiao Yu and wuxiang Zhu for assisting us in conducting the firm survey, Y ing Xia and Jason Mao for research assistance, and Michael Chui, Richard Herring, and State Street Private Edge Group for roviding data on financial intermediaries, bond markets, and venture capital private equity. Financial support from Boston College, the Smith Richardson Foundation, and Wharton Financial Institutions Center is gratefully knowledged. All remaining errors bility Phone: 215-898-3629, fax: 215-573-2207, E-mail: allenf(@wharton. upenn. ed ennsylvania, Philadelphia, PA 19104 Corresponding author: Finance Depar artment, Wharton School, University of Pe
China’s Financial System: Past, Present, and Future * Franklin Allen† Jun Qian Meijun Qian Finance Department Finance Department Finance Department The Wharton School Carroll School of Management Carroll School of Management University of Pennsylvania Boston College Boston College Philadelphia, PA 19104 Chestnut Hill, MA 02467 Chestnut Hill, MA 02467 allenf@wharton.upenn.edu qianju@bc.edu qianme@bc.edu First Draft: October 2004 Last Revised: July 21, 2005 (To appear in the book titled “The Transition that Worked: Origins, Mechanism, and Consequences of China’s Long Boom,” edited by Loren Brandt, Univ. of Toronto, and Thomas Rawski, Univ. of Pittsburgh) Abstract We examine and compare the role of China’s financial system in supporting the growth of firms and the economy with that in other countries, and explore directions of future development. First, we find that the current financial system is dominated by a large but inefficient banking sector, and reducing the amount of non-performing loans among the major banks to normal levels is the most important objective for reforming the financial system in the short run. Second, despite the fast growth of the stock market, its role of resource allocation in the economy has been both limited and ineffective. Further development of China’s financial markets is the most important long-term objective. Third, we find that 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, coalitions, and institutions. This sector should co-exist with banking 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. JEL Classifications: O5, K0, G2. Keywords: banks, non-performing loans, markets, corporate governance, hybrid sector, financial crisis. * We appreciate detailed comments from Loren Brandt and Tom Rawski (editors of the book “China's Economic Transition: Origins, Mechanism, and Consequences”) that significantly improved the paper. We wish to thank Dong Chen, Ed Kane, Nick Lardy, Anthony Neoh, Phil Strahan, and other participants of the “China's Economic Transition” project for their comments, Qiao Yu and Wuxiang Zhu for assisting us in conducting the firm survey, Ying Xia and Jason Mao for research assistance, and Michael Chui, Richard Herring, and State Street PrivateEdge Group for providing data on financial intermediaries, bond markets, and venture capital & private equity. Financial support from Boston College, the Smith Richardson Foundation, and Wharton Financial Institutions Center is gratefully acknowledged. All remaining errors are our own responsibility. † Corresponding author: Finance Department, Wharton School, University of Pennsylvania, Philadelphia, PA 19104. Phone: 215-898-3629, fax: 215-573-2207, E-mail: allenf@wharton.upenn.edu
L Introduction We examine the role of China's financial system in supporting the growth of its economy and explore the directions of its future development. Almost every functioning financial system includes financial markets and intermediaries(e.g, a banking sector), but how these two sectors contribute to the entire financial system and economy differs significantly across different countries Although there is no consensus regarding the prospects of China's future economic growth, a prevailing view on China's financial system speculates that it is one of the weakest links in the economy and it will hamper future economic growth A comprehensive examination of all aspects of China's financial system, and extensive comparisons with other countries where data is available are provided below. We also discuss wha has worked and what remains to be done within the financial system, and examine how further development can better serve the entire economy. Finally, we provide guidelines for future research and policy making on several important unresolved issues, including how China's financial system should integrate into the world's markets and economy We draw four main conclusions about China's financial system and its future development First, when we examine and compare China's banking system and financial markets with those of both developed and emerging countries, we find China's financial system is dominated by a large but under-developed banking system, which is mainly controlled by the four largest state-owned banks with a large amount of non-performing loans (NPLs). The continuing effort of improving the banking system, in particular, reducing the amount of NPLs of the major banks to normal levels, is the most important aspect of reforming Chinas financial system in the short run We consider three channels through which the NPls can be reduced and efficiency of the banking sector improved. The main obstacle in evaluating these solutions is the lack of accurate bank-level data. First, the entrance and growth of non-state banks and intermediaries should be encouraged. With more domestic and foreign banks and intermediaries, the banking sector becomes more competitive, and competition improves the incentives and efficiency of state-owned banks Second, 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. Third. the Chinese government and central bank
2 I. Introduction We examine the role of China’s financial system in supporting the growth of its economy and explore the directions of its future development. Almost every functioning financial system includes financial markets and intermediaries (e.g., a banking sector), but how these two sectors contribute to the entire financial system and economy differs significantly across different countries. Although there is no consensus regarding the prospects of China’s future economic growth, a prevailing view on China’s financial system speculates that it is one of the weakest links in the economy and it will hamper future economic growth. A comprehensive examination of all aspects of China’s financial system, and extensive comparisons with other countries where data is available are provided below. We also discuss what has worked and what remains to be done within the financial system, and examine how further development can better serve the entire economy. Finally, we provide guidelines for future research and policy making on several important unresolved issues, including how China’s financial system should integrate into the world’s markets and economy. We draw four main conclusions about China’s financial system and its future development. First, when we examine and compare China’s banking system and financial markets with those of both developed and emerging countries, we find China’s financial system is dominated by a large but under-developed banking system, which is mainly controlled by the four largest state-owned banks with a large amount of non-performing loans (NPLs). The continuing effort of improving the banking system, in particular, reducing the amount of NPLs of the major banks to normal levels, is the most important aspect of reforming China’s financial system in the short run. We consider three channels through which the NPLs can be reduced and efficiency of the banking sector improved. The main obstacle in evaluating these solutions is the lack of accurate bank-level data. First, the entrance and growth of non-state banks and intermediaries should be encouraged. With more domestic and foreign banks and intermediaries, the banking sector becomes more competitive, and competition improves the incentives and efficiency of state-owned banks. Second, 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. Third, the Chinese government and central bank
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 governments tax receipts)can be sustained. However, since the official data may significantly underestimate the amount of NPLs, we view the reform of state-owned banks and the improvement of the banking sector as the ultimate solution to npls Our second conclusion concerns China's financial markets. Two domestic stock exchanges the Shanghai Stock Exchange(ShSE hereafter)and Shenzhen Stock Exchange (SZSE hereafter) were established in 1990, and have been growing very fast since then. However, their scale and importance are not comparable to the banking sector for the entire economy. Moreover, the financial markets have not been effective in allocating resources in the economy, in that they are highly speculative and driven by insider trading. Going forward, financial markets are likely to play an increasingly important role in the economy, and the further development of the financial markets is the most important long-term objective for China's financial system. We propose several measures that can increase the size and scope and help to improve the efficiency of the markets More specifically, the regulatory environment should be improved; in particular, corporate and trading laws and legal protection of investors, as well as institutions governing the enforcement of contracts should be further developed. Second, the large blocks of shares held by various government entities in listed companies (including state-owned banks) should be reduced by announcing and carrying out a plan to sell them off slowly over time. Third, more professionals such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth, domestic financial intermediaries that act as institutional investors should be encouraged, as they will play a critical role in improving the efficiency of the markets and strengthening the corporate governance of listed firms. Finally, new financial products and markets should be developed Third, in a companion paper(Allen, Qian, and Qian, 2005), we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is not the banking sector or stock market, but rather a sector of alternative financing channels, such as internal financing and trade credits, and coalitions of various forms among firms, investors, and local overnments. Many of these financing channels rely on alternative governance mechanisms, such competition in product and input markets, and trust, reputation, and relationships. Together these methods of financing and governance have supported the growth of a"Hybrid Sector"of non-state
3 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. However, since the official data may significantly underestimate the amount of NPLs, we view the reform of state-owned banks and the improvement of the banking sector as the ultimate solution to NPLs. Our second conclusion concerns China’s financial markets. Two domestic stock exchanges, the Shanghai Stock Exchange (SHSE hereafter) and Shenzhen Stock Exchange (SZSE hereafter), were established in 1990, and have been growing very fast since then. However, their scale and importance are not comparable to the banking sector for the entire economy. Moreover, the financial markets have not been effective in allocating resources in the economy, in that they are highly speculative and driven by insider trading. Going forward, financial markets are likely to play an increasingly important role in the economy, and the further development of the financial markets is the most important long-term objective for China’s financial system. We propose several measures that can increase the size and scope and help to improve the efficiency of the markets. More specifically, the regulatory environment should be improved; in particular, corporate and trading laws and legal protection of investors, as well as institutions governing the enforcement of contracts should be further developed. Second, the large blocks of shares held by various government entities in listed companies (including state-owned banks) should be reduced by announcing and carrying out a plan to sell them off slowly over time. Third, more professionals such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth, domestic financial intermediaries that act as institutional investors should be encouraged, as they will play a critical role in improving the efficiency of the markets and strengthening the corporate governance of listed firms. Finally, new financial products and markets should be developed. Third, in a companion paper (Allen, Qian, and Qian, 2005), we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is not the banking sector or stock market, but rather a sector of alternative financing channels, such as internal financing and trade credits, and coalitions of various forms among firms, investors, and local governments. Many of these financing channels rely on alternative governance mechanisms, such as competition in product and input markets, and trust, reputation, and relationships. Together these methods of financing and governance have supported the growth of a “Hybrid Sector” of non-state
non-listed firms with various types of ownership structures. It is important to point out at the or that our definition of the Hybrid Sector is broader than privately or individually owned firms,w are part of this sector. In particular, firms that are partially owned by local governments(e.g Township Village Enterprises or TVEs)are also included in the Hybrid Sector, because: first, despite the ownership stake of local governments and the sometimes ambiguous ownership structure and property rights, the operation of these firms resembles more closely that of a for- profit, privately-owned firm than that of a state-owned firm; and second, the ownership stake of local governments in many of these firms has been privatized. The growth of the Hybrid Sector has been much higher than that of the State Sector(state-owned enterprises or SOEs, and all firn here the central government has ultimate control) and the listed Sector(publicly listed and traded firms with most of them converted from the State Sector ), and contributes to most of the economic growth. We believe these alternative channels and mechanisms should be encouraged going forward. They can co-exist with the banks and markets while continuing to fuel the growth of the Hybrid Sector Finally, in our view a significant challenge for Chinas financial system is to avoid damaging financial crises that can severely disrupt the economy and social stability. 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 hina'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 as the 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(see Appendix A. 5 for details): 1)privately owned companies(but not publicly listed and investors(or companies); 2)collective\ g iontly-owned companies, where joint ownership among locr r foreign traded) controlling owners can be Chinese citizens, investors(or companies)from Taiwan or Hong Kong government, communities, employees, and institutions is forged. See Li(1996)and Che and Qian(1998)for arguments on why an ambiguous ownership structure with local governments is more efficient than well defined private property rights or state ownership in an environment with underdeveloped markets and institutions
4 non-listed firms with various types of ownership structures. It is important to point out at the outset that our definition of the Hybrid Sector is broader than privately or individually owned firms, which are part of this sector. In particular, firms that are partially owned by local governments (e.g., Township Village Enterprises or TVEs) are also included in the Hybrid Sector, because: first, despite the ownership stake of local governments and the sometimes ambiguous ownership structure and property rights, the operation of these firms resembles more closely that of a forprofit, privately-owned firm than that of a state-owned firm; and second, the ownership stake of local governments in many of these firms has been privatized.1 The growth of the Hybrid Sector has been much higher than that of the State Sector (state-owned enterprises or SOEs, and all firms where the central government has ultimate control) and the Listed Sector (publicly listed and traded firms with most of them converted from the State Sector), and contributes to most of the economic growth. We believe these alternative channels and mechanisms should be encouraged going forward. They can co-exist with the banks and markets while continuing to fuel the growth of the Hybrid Sector. Finally, in our view a significant challenge for China’s financial system is to avoid damaging financial crises that can severely disrupt the economy and social stability. 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 as the 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 (see Appendix A.5 for details): 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. See Li (1996) and Che and Qian (1998) for arguments on why an ambiguous ownership structure with local governments is more efficient than well defined private property rights or state ownership in an environment with underdeveloped markets and institutions
government and central bank try to defend the currency peg, which in turn may trigger a banking crisis if there are large withdrawals from banks. In order to prevent such a crisis, policies improving the financial system should be implemented in conjunction with supportive fiscal and trade policie ganized as follows. In Section Il, the history of Chinas financial system development, present aggregate evidence on China's financial system, and compare them to those of developed and other developing countries. In Section Ill, we examine Chinas banking system and the problem of NPLs and reforms. In Section IV, we examine the rowth and irregularities of financial markets and listed firms. In Section V, we examine the non standard financial sector, including alternative financial channels and governance mechanisms. We then examine different types of financial crises and how China's financial system can be better prepared for these crises in Section VI. Finally, Section VIl concludes the paper and is followed by the Appendix that contains definitions and sources of all key terms and phrases used IL. Overview of Chinas Financial System In this section we examine China's financial system, focusing on both the banking system and financial markets, as well as firms' financing channels at the aggregate level, including non- bank and non-market channels. Appendixes A I through A 3 contain definitions and sources of variables used in Table I and Figures I and 2, while Appendix A 4 contains definitions of different types of financial intermediaries Il.1 A Brief Review of the history of Chinas Financial System Chinas financial system was well developed prior to 1949.- The earliest form of capitalism can be traced back to the late Ming Dynasty(17 century), with commerce initiated in the Zhejiang Jiangsu area and further developed during the Qing Dynasty (17 century to early 20century ). The Opium War(1840s) between China and Great Britain ruined China's sovereignty, but it brought Western-style legal and capital systems into Chinas coastal areas(until 1949). In 1904, the newly created Ministry of Commerce( Shangbu) of the waning Qing government issued China's first Company Law(Gongsili), aimed at promoting China's industrial development. Interestingly, foreign systems and the Chinese system co-existed and commerce boomed. Despite the entrance and development of Western-style courts in Shanghai and other major coastal cities(see Lee( 1993) For more details on the description of pre-1949 history of Chinas financial system and the rise of Shanghai as Chinas financial center, see, for example, Chow(2004), Kirby(1995), and Lee (1993)
5 government and central bank try to defend the currency peg, which in turn may trigger a banking crisis if there are large withdrawals from banks. In order to prevent such a crisis, policies improving the financial system should be implemented in conjunction with supportive fiscal and trade policies. The remaining sections are organized as follows. In Section II, we review the history of China’s financial system development, present aggregate evidence on China’s financial system, and compare them to those of developed and other developing countries. In Section III, we examine China’s banking system and the problem of NPLs and reforms. In Section IV, we examine the growth and irregularities of financial markets and listed firms. In Section V, we examine the nonstandard financial sector, including alternative financial channels and governance mechanisms. We then examine different types of financial crises and how China’s financial system can be better prepared for these crises in Section VI. Finally, Section VII concludes the paper and is followed by the Appendix that contains definitions and sources of all key terms and phrases used. II. Overview of China’s Financial System In this section we examine China’s financial system, focusing on both the banking system and financial markets, as well as firms’ financing channels at the aggregate level, including nonbank and non-market channels. Appendixes A.1 through A.3 contain definitions and sources of variables used in Table 1 and Figures 1 and 2, while Appendix A.4 contains definitions of different types of financial intermediaries. II.1 A Brief Review of the History of China’s Financial System China’s financial system was well developed prior to 1949.2 The earliest form of capitalism can be traced back to the late Ming Dynasty (17th century), with commerce initiated in the ZhejiangJiangsu area and further developed during the Qing Dynasty (17th century to early 20th century). The Opium War (1840s) between China and Great Britain ruined China’s sovereignty, but it brought Western-style legal and capital systems into China’s coastal areas (until 1949). In 1904, the newly created Ministry of Commerce (Shangbu) of the waning Qing government issued China’s first Company Law (Gongsilü), aimed at promoting China’s industrial development. Interestingly, foreign systems and the Chinese system co-existed and commerce boomed. Despite the entrance and development of Western-style courts in Shanghai and other major coastal cities (see Lee (1993) 2 For more details on the description of pre-1949 history of China’s financial system and the rise of Shanghai as China’s financial center, see, for example, Chow (2004), Kirby (1995), and Lee (1993)