for a description on how these courts functioned), most business-related disputes were resolved outside courts. Late Qing China had a highly commercialized society, and dispute resolution by guilds(merchant coalitions), families, and local notables based on the detailed regulations of guild family traditions, and customs was commonplace(see, e.g., Kirby 1995). In Section V 4 beloy argue that modern equivalents of these mechanisms were behind the success of Hybrid Sector in the same areas in the 1980s and 1990s The development of China's financial system from the late nineteenth century to the early twentieth century was highlighted by the emergence of Shanghai as the financial center of China and Asia(see, e.g., Lee(1993) for more details). During this period, Shanghai transformed from an agricultural-based trading hub for surrounding areas into an industrialized center linked to international goods and financial markets. With thriving entrepreneurial and trading activities, financial institutions proliferated and financial innovations surged For example, the number of Chinese lending institutions(qianzhuang)exceeded 105 in 1875; five of China's first modern banks were founded between 1897 and 1908 and by 1936, there were 28 major foreign banks that had set up branches in Shanghai. Merchants used up to eleven currencies in their transactions, some of which were printed by local bankS; the exchange rate of local currency saw wide fluctuations,many unregistered local banks( diaotang)engaged in high-leverage credit transactions with little capital reserves and defaulted frequently. At the same time, merchants fear of risk spawned an active insurance industry, which was first introduced by the British Insurance on real estate, ships, and goods became routine, with collateral and personal guarantors accompanying large transactions to reduce the risk of non-payments to alleviate the problems of asymmetric information, foreign merchants hired Chinese middlemen(and guarantors)to select Chinese merchants. Chinese and foreign merchants also devised the commission indent system, an early form of trade credit llowing firms and institutions to operate with minimum financial resources. Finally, the stock exchange in Shanghai was the largest in Asia for most of the 1920s and 1930s After the foundation of the People's Republic of China in 1949, all of the pre-1949 capitalist companies and institutions were nationalized by 1950. Between 1950 and 1978, Chinas financial system consisted of a single bank--the People's Bank of China(PBOC), a central government owned and controlled bank under the Ministry of Finance, which served as both the central bank and a commercial bank, controlling about 93% of the total financial assets of the country and handling almost all financial transactions. With its main role to finance the physical production plans, PBOC used both a"cash-plan" and a"credit-plan"to control the cash flows in consumer
6 for a description on how these courts functioned), most business-related disputes were resolved outside courts. Late Qing China had a highly commercialized society, and dispute resolution by guilds (merchant coalitions), families, and local notables based on the detailed regulations of guilds, family traditions, and customs was commonplace (see, e.g., Kirby 1995). In Section V.4 below, we argue that modern equivalents of these mechanisms were behind the success of Hybrid Sector firms in the same areas in the 1980s and 1990s. The development of China’s financial system from the late nineteenth century to the early twentieth century was highlighted by the emergence of Shanghai as the financial center of China and Asia (see, e.g., Lee (1993) for more details). During this period, Shanghai transformed from an agricultural-based trading hub for surrounding areas into an industrialized center linked to international goods and financial markets. With thriving entrepreneurial and trading activities, financial institutions proliferated and financial innovations surged. For example, the number of Chinese lending institutions (qianzhuang) exceeded 105 in 1875; five of China’s first modern banks were founded between 1897 and 1908; and by 1936, there were 28 major foreign banks that had set up branches in Shanghai. Merchants used up to eleven currencies in their transactions, some of which were printed by local banks; the exchange rate of local currency saw wide fluctuations; many unregistered local banks (diaotang) engaged in high-leverage credit transactions with little capital reserves and defaulted frequently. At the same time, merchants’ fear of risk spawned an active insurance industry, which was first introduced by the British. Insurance on real estate, ships, and goods became routine, with collateral and personal guarantors accompanying large transactions to reduce the risk of non-payments; to alleviate the problems of asymmetric information, foreign merchants hired Chinese middlemen (and guarantors) to select Chinese merchants. Chinese and foreign merchants also devised the “commission indent system,” an early form of trade credit allowing firms and institutions to operate with minimum financial resources. Finally, the stock exchange in Shanghai was the largest in Asia for most of the 1920s and 1930s. After the foundation of the People’s Republic of China in 1949, all of the pre-1949 capitalist companies and institutions were nationalized by 1950. Between 1950 and 1978, China’s financial system consisted of a single bank -- the People’s Bank of China (PBOC), a central government owned and controlled bank under the Ministry of Finance, which served as both the central bank and a commercial bank, controlling about 93% of the total financial assets of the country and handling almost all financial transactions. With its main role to finance the physical production plans, PBOC used both a “cash-plan” and a “credit-plan” to control the cash flows in consumer
markets and transfer flows from branches of the bank The first main structural change began in 1978 and ended in 1984. By the end of 1979, the PBOC departed the ministry and became a separate entity, while three state-owned banks took over some of its commercial banking businesses: The Bank of China(BOC)was given the mandate to specialize in transactions related to foreign trade and investment; the Peoples Construction Bank of China(PCBC), originally formed in 1954, was set up to handle transactions related to fixed investment (in manufacturing); the Agriculture Bank of China(ABC)was set up(in 1979)to deal with all banking business in rural areas; and the pboc was formally established as China s central bank and a two-tier banking system was formed. Finally, the fourth state-owned commercial bank, the Industrial and Commercial Bank of China(ICBc)was formed in 1984, and took over the rest of the commercial transactions of the pboc For most of the 1980s, the development of the financial system can be characterized by the fast growth of financial intermediaries outside of the" Big Four"state-owned banks mentioned above. For example, regional banks(partially owned by local governments) were formed in the Special economic Zones in the coastal areas; in rural sectors a network of rural Credit Cooperatives(RCCs; similar to credit unions in the U.S. )was setup under the supervision of the ABC, while Urban Credit Cooperatives(UCCs), counterparts of the RCCs in the urban areas, were also set up. Non-bank financial intermediaries, such as the Trust and Investment Corporations (TICs; operating in selected banking services and non-banking services with restrictions on both the sources of deposits and loans made), emerged and proliferated in this period. All of the new financial intermediaries began to take deposits and make loans, which increased the competition but also contributed to higher levels of inflation. As a result, savings deposits surged after the structural change, while the main investment channel for firms(from the government to SOEs) shifted from budget appropriation(70% in 1978)to loans from state-owned banks(80% in 1982). However, the four state-owned banks had almost no discretion in making loan -related decisions as these were based on quotas allocated by the PBOC. While foreign banks were allowed to set up representative offices beginning in 1979(Bank of Tokyo set up the first such office in Beijing), it was not until the later period of 1982 to 1985 that a small number of foreign banks was permitted to set up branch offices(for currency exchange operations) in Chinas Special Economy Zones. In 1985, the government legalized the status of foreign banks' branches and their operations in the Zones. The BOC, the oldest bank that is currently operating, was originally established by Sun, Zhongshan in 1912 as a private bank, and specialized in foreign currency related transactions
7 markets and transfer flows from branches of the bank. The first main structural change began in 1978 and ended in 1984. By the end of 1979, the PBOC departed the Ministry and became a separate entity, while three state-owned banks took over some of its commercial banking businesses: The Bank of China3 (BOC) was given the mandate to specialize in transactions related to foreign trade and investment; the People’s Construction Bank of China (PCBC), originally formed in 1954, was set up to handle transactions related to fixed investment (in manufacturing); the Agriculture Bank of China (ABC) was set up (in 1979) to deal with all banking business in rural areas; and, the PBOC was formally established as China’s central bank and a two-tier banking system was formed. Finally, the fourth state-owned commercial bank, the Industrial and Commercial Bank of China (ICBC) was formed in 1984, and took over the rest of the commercial transactions of the PBOC. For most of the 1980s, the development of the financial system can be characterized by the fast growth of financial intermediaries outside of the “Big Four” state-owned banks mentioned above. For example, regional banks (partially owned by local governments) were formed in the Special Economic Zones in the coastal areas; in rural sectors, a network of Rural Credit Cooperatives (RCCs; similar to credit unions in the U.S.) was setup under the supervision of the ABC, while Urban Credit Cooperatives (UCCs), counterparts of the RCCs in the urban areas, were also set up. Non-bank financial intermediaries, such as the Trust and Investment Corporations (TICs; operating in selected banking services and non-banking services with restrictions on both the sources of deposits and loans made), emerged and proliferated in this period. All of the new financial intermediaries began to take deposits and make loans, which increased the competition but also contributed to higher levels of inflation. As a result, savings deposits surged after the structural change, while the main investment channel for firms (from the government to SOEs) shifted from budget appropriation (70% in 1978) to loans from state-owned banks (80% in 1982). However, the four state-owned banks had almost no discretion in making loan-related decisions as these were based on quotas allocated by the PBOC. While foreign banks were allowed to set up representative offices beginning in 1979 (Bank of Tokyo set up the first such office in Beijing), it was not until the later period of 1982 to 1985 that a small number of foreign banks was permitted to set up branch offices (for currency exchange operations) in China’s Special Economy Zones. In 1985, the government legalized the status of foreign banks’ branches and their operations in the Zones. The 3 BOC, the oldest bank that is currently operating, was originally established by Sun, Zhongshan in 1912 as a private bank, and specialized in foreign currency related transactions
financial reforms slowed down during 1988-1991 to control inflation, during which considerable (government-run) consolidation took place. For example, many TiCs were merged and were increasingly regulated by the PbOc In 1992, the famous"Southern Tour"by then Chinese leader Deng Xiaoping marked the beginning of another economic boom. In the financial system, this period witnessed a sharp increase in foreign direct investment(FDI), a deregulation of the banking sector characterized by the emergence of many new state/local government owned commercial bankS, and the re-emergence of Shanghai as the financial center of China Reform in the insurance industry kicked off the process within the financial system, with the entrance of four foreign insurance companies(branches)in Shanghai in 1992, in 1995, the first joint venture investment bank was formed between Morgan Stanley and PCBC; in 1997, nine foreign banks were allowed to enter the RMB markets and operations in the Pudong Special Zone in Shanghai. In 1994, three policy banks" were established to take over"policy"related lending in underdeveloped areas, export and import, and rural areas, while the four largest state-owned banks further developed into regular commercial banks, with profit maximization becoming an increasingly more important goal. Along with the growth of banks and financial intermediaries, interbank lending(1994 )and bond(1997)markets were established and the bank debit/credit cards market expanded rapidly. During the same period, the central bank (PBOC) increasingly used interest rates and reserves to manage the liquidity of the banking sector For example, the PbOC sets lower and upper bounds on deposits and loans, while commercial banks can decide the actual rates within the bounds The interbank lending rates were converted toward a uniform system in 1996 The most significant event for China' s financial system in the 1990s was the inception and growth of Chinas stock market. Two domestic stock exchanges, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZsE), were established in 1990, and have experienced remarkable growth since then. However, the legal framework and institutions that support the stock market lag the growth of the exchanges. On a trial basis, Chinas first bankruptcy law was passed in 1986(governing SOEs), but the formal Company Law was not effective until the end of 1999 This version of the Company Law governs all corporations with limited liabilities, publicly listed and traded companies, and branches or divisions of foreign companies, as well as their organization structure, securities issuance and trading, accounting, bankruptcy, mergers and acquisitions(for China Pacific Insurance Company is the oldest insurance company in China that is currently operating. Formerly known by its current name in 1943, its insurance business was revived in 1986
8 financial reforms slowed down during 1988-1991 to control inflation, during which considerable (government-run) consolidation took place. For example, many TICs were merged and were increasingly regulated by the PBOC. In 1992, the famous “Southern Tour” by then Chinese leader Deng Xiaoping marked the beginning of another economic boom. In the financial system, this period witnessed a sharp increase in foreign direct investment (FDI), a deregulation of the banking sector characterized by the emergence of many new state/local government owned commercial banks, and the re-emergence of Shanghai as the financial center of China. Reform in the insurance industry kicked off the process within the financial system, with the entrance of four foreign insurance companies (branches) in Shanghai in 1992;4 in 1995, the first joint venture investment bank was formed between Morgan Stanley and PCBC; in 1997, nine foreign banks were allowed to enter the RMB markets and operations in the Pudong Special Zone in Shanghai. In 1994, three “policy banks” were established to take over “policy” related lending in underdeveloped areas, export and import, and rural areas, while the four largest state-owned banks further developed into regular commercial banks, with profit maximization becoming an increasingly more important goal. Along with the growth of banks and financial intermediaries, interbank lending (1994) and bond (1997) markets were established, and the bank debit/credit cards market expanded rapidly. During the same period, the central bank (PBOC) increasingly used interest rates and reserves to manage the liquidity of the banking sector. For example, the PBOC sets lower and upper bounds on deposits and loans, while commercial banks can decide the actual rates within the bounds. The interbank lending rates were converted toward a uniform system in 1996. The most significant event for China’s financial system in the 1990s was the inception and growth of China’s stock market. Two domestic stock exchanges, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE), were established in 1990, and have experienced remarkable growth since then. However, the legal framework and institutions that support the stock market lag the growth of the exchanges. On a trial basis, China’s first bankruptcy law was passed in 1986 (governing SOEs), but the formal Company Law was not effective until the end of 1999. This version of the Company Law governs all corporations with limited liabilities, publicly listed and traded companies, and branches or divisions of foreign companies, as well as their organization structure, securities issuance and trading, accounting, bankruptcy, mergers and acquisitions (for 4 China Pacific Insurance Company is the oldest insurance company in China that is currently operating. Formerly known by its current name in 1943, its insurance business was revived in 1986
details see the website of China Securities Regulatory Commission, or CSrC http://www.csrc.gov.cn/).Weprovideadetailedanalysisofthestatusandproblemsofthestock market in Section Iv below The exchange rate policies regarding the Rmb have gone through three regimes since 1949 First, during the period 1949-1978, all demand and supply(for firms, individuals, and government agencies)of foreign currency were collected and distributed through the central government and PBOC under official rates. Second, between 1978 and 1994, a retention system among SOEs was introduced at the provincial level so that provincial authorities and enterprises receiving and requesting foreign currencies(via import/export)were entitled to retain a certain proportion of the foreign currencies conditional on their fulfillment of export quotas assigned by the central government. a dual" exchange system was introduced so that official exchange rate and market exchange rates coexisted, although the latter was not freely floatable; a special currency, the" RMB Exchange"was issued and circulated mostly among foreigners(who brought foreign currencies to China). The retention and central planning regime was replaced by a more market-based system in 1994, which is still operating at present. The exchange rate has been exclusively pegged to the US Dollar and can fluctuate in a small range(around US$1= RMB 8.28 )under state regulation and monitoring. Interbank foreign exchange trading is also allowed, while the rmB Exchange currency stopped circulation. Individuals and enterprises have much more freedom in terms of holding short term), although the(legal) currency flows must go through the BOC. At the same time, e o foreign currencies for various purposes(so that the current account can fluctuate significantly in the capital account is still not freely convertible Following the Asian Financial Crisis in 1997, financial sector reform has focused on state owned banks and especially the problem of NPls (the China Banking Regulation Committee was lso established to oversee the banking industry ). We will further discuss this issue in Section Ill Finally, China's entry into the WTO in December 2001 marked the beginning of a new era. Since the eventual opening of the capital account and adopting a floating exchange rate are required by the WTO, we should expect to see increasing competition from foreign financial institutions and frequent and large scale capital flows. Perhaps we can even some witness dramatic changes and intriguing events within China's financial system shortly after December 2006 (the end of the five- year transition period after joining the WTO). Finally, institutional investors began to emerge in the late 1990s although their scale and importance in the financial system was and still is limited. The first two mutual funds( Guo Tai and Nan Fang)were established in 1998. There are 46 fund
9 details see the website of China Securities Regulatory Commission, or CSRC, http://www.csrc.gov.cn/). We provide a detailed analysis of the status and problems of the stock market in Section IV below. The exchange rate policies regarding the RMB have gone through three regimes since 1949. First, during the period 1949 – 1978, all demand and supply (for firms, individuals, and government agencies) of foreign currency were collected and distributed through the central government and PBOC under official rates. Second, between 1978 and 1994, a retention system among SOEs was introduced at the provincial level so that provincial authorities and enterprises receiving and requesting foreign currencies (via import/export) were entitled to retain a certain proportion of the foreign currencies conditional on their fulfillment of export quotas assigned by the central government. A “dual” exchange system was introduced so that official exchange rate and market exchange rates coexisted, although the latter was not freely floatable; a special currency, the “RMB Exchange” was issued and circulated mostly among foreigners (who brought foreign currencies to China). The retention and central planning regime was replaced by a more market-based system in 1994, which is still operating at present. The exchange rate has been exclusively pegged to the US Dollar and can fluctuate in a small range (around US$1 = RMB 8.28) under state regulation and monitoring. Interbank foreign exchange trading is also allowed, while the RMB Exchange currency stopped circulation. Individuals and enterprises have much more freedom in terms of holding foreign currencies for various purposes (so that the current account can fluctuate significantly in the short term), although the (legal) currency flows must go through the BOC. At the same time, the capital account is still not freely convertible. Following the Asian Financial Crisis in 1997, financial sector reform has focused on stateowned banks and especially the problem of NPLs (the China Banking Regulation Committee was also established to oversee the banking industry). We will further discuss this issue in Section III. Finally, China’s entry into the WTO in December 2001 marked the beginning of a new era. Since the eventual opening of the capital account and adopting a floating exchange rate are required by the WTO, we should expect to see increasing competition from foreign financial institutions and frequent and large scale capital flows. Perhaps we can even some witness dramatic changes and intriguing events within China’s financial system shortly after December 2006 (the end of the fiveyear transition period after joining the WTO). Finally, institutional investors began to emerge in the late 1990s although their scale and importance in the financial system was and still is limited. The first two mutual funds (Guo Tai and Nan Fang) were established in 1998. There are 46 fund
companies at present, 33 of which are domestic fund companies, and the rest are Qualified Foreign Institutional Investors(QFIl)or joint ventures, which were allowed to enter the asset management industry in 2003. There are no pension funds or government pension system in place. Under the old central planning regime, pensions and other social welfare plans were provided and implemented by individual SOEs. With many SOEs privatized or bankrupt in recent years, these services are no longer available for an increasing number of senior employees and workers Establishing a feasible pension system in the near future is also one of the burning issues for China Presently there are no hedge funds that implement long-short " strategies as short selling is prohibited in China Insert Figure l here. Figure 1 depicts the current structure of the entire financial system. In what follows we will describe and examine each of the four sectors of the system. In addition to the standard sectors of banking and intermediation and financial markets, we will document the importance of the non- standard financial sector and growth of this"other sector" as China s economy becomes more integrated into the world economy 1.2 The size and efficiency of the financial system: Banking and markets For a comparison of countries, we follow the law and finance literature and in particular the sample of countries studied in La Porta, Lopez-de-Silanes, Shleifer, and Vishny(hereafter LLSV, 1997, 1998, 2000). Their sample includes 49 countries, but China is excluded. In Table 1, we compare China's financial system to those of lLSv sample countries, with some measures for financial systems taken from Levine(2002)and Demirguc-Kunt and Levine(2001) Insert Table 1-A here We first compare the size of a country's equity markets and banks relative to that country 's gross domestic product(GDP)in the first panel of Table 1-A. Chinas stock markets are smaller than most of the other countries, both in terms of market capitalization and the total value traded as fractions of gdP In order to measure the actual size of the market. "total value traded" is a better measure than"market capitalization, because the latter includes non-tradable shares while the former measures the fraction of total market capitalization traded in the markets, or the"floating supply of the market (we further discuss this issue in Section IV below ). By contrast, Chinas banking system is much more important in terms of size relative to its stock markets, with its ratio of total bank credit to GDP (1. 11) higher than even the german-origin countries( with a weighted average of0.99). However, when we consider bank credit issued (or loans made )to the Hybrid
10 companies at present, 33 of which are domestic fund companies, and the rest are Qualified Foreign Institutional Investors (QFII) or joint ventures, which were allowed to enter the asset management industry in 2003. There are no pension funds or government pension system in place. Under the old central planning regime, pensions and other social welfare plans were provided and implemented by individual SOEs. With many SOEs privatized or bankrupt in recent years, these services are no longer available for an increasing number of senior employees and workers. Establishing a feasible pension system in the near future is also one of the burning issues for China. Presently there are no hedge funds that implement “long-short” strategies as short selling is prohibited in China. Insert Figure 1 here. Figure 1 depicts the current structure of the entire financial system. In what follows we will describe and examine each of the four sectors of the system. In addition to the standard sectors of banking and intermediation and financial markets, we will document the importance of the nonstandard financial sector and growth of this “other sector” as China’s economy becomes more integrated into the world economy. II.2 The size and efficiency of the financial system: Banking and markets For a comparison of countries, we follow the law and finance literature and in particular the sample of countries studied in La Porta, Lopez-de-Silanes, Shleifer, and Vishny (hereafter LLSV, 1997, 1998, 2000). Their sample includes 49 countries, but China is excluded. In Table 1, we compare China’s financial system to those of LLSV sample countries, with some measures for financial systems taken from Levine (2002) and Demirgüç-Kunt and Levine (2001). Insert Table 1-A here. We first compare the size of a country’s equity markets and banks relative to that country’s gross domestic product (GDP) in the first panel of Table 1-A. China’s stock markets are smaller than most of the other countries, both in terms of market capitalization and the total value traded as fractions of GDP. In order to measure the actual size of the market, “total value traded” is a better measure than “market capitalization,” because the latter includes non-tradable shares while the former measures the fraction of total market capitalization traded in the markets, or the “floating supply” of the market (we further discuss this issue in Section IV below). By contrast, China’s banking system is much more important in terms of size relative to its stock markets, with its ratio of total bank credit to GDP (1.11) higher than even the German-origin countries (with a weighted average of 0.99). However, when we consider bank credit issued (or loans made) to the Hybrid