the government to bear the burden At the end of 2003. China announced that the pboc would inject foreign currency reserves in the amount of US$45 billion into two of the"Big Four"banks(BOC and PCBC)to improve their balance sheets and enhance the likelihood that these banks can go public in 2005-06(e. g, Financial Times, 01/09/2004; Asia Wall Street Journal, 01/13/2004). Most of the foreign exchange reserves are in the form of us dollars t-bills and other dollar denominated debt securities given their imminent status of becoming publicly listed corporations, BOC and PCBC were recently rated by the Standard and Poors(S&P report"Chinas Banking Outlook 2005")with the same grade BBB-, the lowest grade among all "investment grades. " In issuing their ratings, S&P emphasized this rating is" based on public information,.. and pointed out that the most significant risk in these two banks is the high level of NPLs 12 Similar fund injection plans for ICBC (the largest commercial bank in China and one of the largest in the world in terms of book assets), in the amount of US$15 billion, began in the first half of 2005 (Financial Times, 04/21/2005) Given that as of the end of the first quarter of 2005, China's total foreign exchange reserve was uS$650 billion while the total amount of NPls was 15% of gdp at the end of 2004 or around US$200 billion using the US$1=8.28 RMB exchange rate(recall that China's rmb has been pegged exclusively to the uS dollar at 8.28 to 1), the foreign reserve itself should be more thar enough to remove the NPls off the books of all the banks in China. There are potential problems for the injection plan, with the possibility of creating perverse incentives for the banks being the most serious one. If the state-owned banks that have received or will receive the cash/assets injection believe that there will be a 'bailout during future financial distress, then the moral hazard problem can worsen the current status of NPLs. This is because, in anticipation of a bailout from financial distress, banks lose the incentive to improve efficiency while an incentive to take on risky, negative-NPV projects surfaces. Similar problems occurred during and after the government bailout of the S&l crisis in the US in 1980s(e.g, Kane, 1989, 2003 ) Hence, it is important for the government to credibly commit that the injection plan is a one-time measure to boost the capital adequacy of these banks, and that there will be no bailout plans in the future, especially after they become listed companies. The second problem lies in the fact that the significant increase in foreign reserves is in part due to the presence of large amounts of speculative foreign currencies in 2 Bank of America has recently pledged to purchase a 5% block of PCBC's equity for US$1. 5 billion to $2 billion, while the Royal Bank of Scotland is said to be ready to pay up to $4 billion for up to one fifth of BOC (The Economist, 05/192005)
21 the government to bear the burden. At the end of 2003, China announced that the PBOC would inject foreign currency reserves, in the amount of US$45 billion into two of the “Big Four” banks (BOC and PCBC) to improve their balance sheets and enhance the likelihood that these banks can go public in 2005-06 (e.g., Financial Times, 01/09/2004; Asia Wall Street Journal, 01/13/2004). Most of the foreign exchange reserves are in the form of US dollars, T-bills, and other dollar denominated debt securities. Given their imminent status of becoming publicly listed corporations, BOC and PCBC were recently rated by the Standard and Poor’s (S&P report “China’s Banking Outlook 2005”) with the same grade “BBB–,” the lowest grade among all “investment grades.” In issuing their ratings, S&P emphasized this rating is “based on public information, …” and pointed out that the most significant risk in these two banks is the high level of NPLs.12 Similar fund injection plans for ICBC (the largest commercial bank in China and one of the largest in the world in terms of book assets), in the amount of US$15 billion, began in the first half of 2005 (Financial Times, 04/21/2005). Given that as of the end of the first quarter of 2005, China’s total foreign exchange reserve was US$650 billion while the total amount of NPLs was 15% of GDP at the end of 2004, or around US$200 billion using the US$1 = 8.28 RMB exchange rate (recall that China’s RMB has been pegged exclusively to the US dollar at 8.28 to 1), the foreign reserve itself should be more than enough to remove the NPLs off the books of all the banks in China. There are potential problems for the injection plan, with the possibility of creating perverse incentives for the banks being the most serious one. If the state-owned banks that have received or will receive the cash/assets injection believe that there will be a ‘bailout’ during future financial distress, then the moral hazard problem can worsen the current status of NPLs. This is because, in anticipation of a bailout from financial distress, banks lose the incentive to improve efficiency while an incentive to take on risky, negative-NPV projects surfaces. Similar problems occurred during and after the government bailout of the S&L crisis in the US in 1980s (e.g., Kane, 1989, 2003). Hence, it is important for the government to credibly commit that the injection plan is a one-time measure to boost the capital adequacy of these banks, and that there will be no bailout plans in the future, especially after they become listed companies. The second problem lies in the fact that the significant increase in foreign reserves is in part due to the presence of large amounts of speculative foreign currencies in 12 Bank of America has recently pledged to purchase a 5% block of PCBC’s equity for US$1.5 billion to $2 billion, while the Royal Bank of Scotland is said to be ready to pay up to $4 billion for up to one fifth of BOC (The Economist, 05/19/2005)
anticipation of an RMB appreciation relative to major international currencies. Depending on how the government and the central bank handle the RMB revaluation process, large movements of the speculative currencies may cause a twin crisis in the currency market and the banking sector. We further discuss this issue in Section vi beloy Insert Table 3-D here It is clear that the ultimate source of eliminating npls lies in chinas overall economic growth. As long as the economy maintains its strong growth momentum so that the governments tax receipts also increases, the government can al ways assume the remainder of the NPls without significantly affecting the economy. In this regard, Table 3-D presents a comparison of the ratio (NPLS Government Debt) /GDP among China, Japan, South Korea, and the U.S. for the period 1997-2002, where NPLs(government debt) denotes the total outstanding NPls in the banking system(government debt) in a given year. The lower the ratio, resulting from low NPLs, low present two sets of ratios for China: the first set of ratios are based on NPLs numbers presented l c government debt, or both, the more feasible it becomes for the government to assume the NPls. We Table 3-A(based on official data), while the second set(presented in brackets)is based on doubling the size of NPLs(as a fraction of GDP)reported in Table 3-A. Despite its high NPLs, China has the second lowest ratio among the four countries using official data on NPLs, these ratios are much higher if NPLs double but they are still comparable with those of the U. S(low NPLs but high government debt). Based on this crude comparison, it seems that the NPls will not be a particularly rduous burden for the Chinese government due to the small size of its debt, while the same cannot be said for Japan. Caution is again needed for this conclusion: first, new NPLs in China may grow much faster than the rest of the countries; and second, the small amount of government debt may experience a sharp increase given the need for higher fiscal spending in areas such as pension plans and related social welfare programs Overall, the optimistic view on NPLs believes that, despite the large amount of existing NPLS, the current reform of state-owned banks and development of the banking sector have already been effective in reducing NPLs, which is why NPLs have been falling in recent years(2000-2002) in Table 3-A. Given that the economy will probably maintain its current pace of growth, government can always write off a large fraction of the rest of the NPLs to avert any serious problems for China. On the other hand, the pessimistic view believes that NPLs are much bigger ee, for example, Sachs and woo(1997 review article), Rawski (2002), and wolf (2003) for different views on the prospects of long-run economic growth and statistics on growth in Chir
22 anticipation of an RMB appreciation relative to major international currencies. Depending on how the government and the central bank handle the RMB revaluation process, large movements of the speculative currencies may cause a twin crisis in the currency market and the banking sector. We further discuss this issue in Section VI below. Insert Table 3-D here. It is clear that the ultimate source of eliminating NPLs lies in China’s overall economic growth. As long as the economy maintains its strong growth momentum so that the government’s tax receipts also increases, the government can always assume the remainder of the NPLs without significantly affecting the economy.13 In this regard, Table 3-D presents a comparison of the ratio (NPLs + Government Debt)/GDP among China, Japan, South Korea, and the U.S. for the period 1997-2002, where NPLs (government debt) denotes the total outstanding NPLs in the banking system (government debt) in a given year. The lower the ratio, resulting from low NPLs, low government debt, or both, the more feasible it becomes for the government to assume the NPLs. We present two sets of ratios for China: the first set of ratios are based on NPLs numbers presented in Table 3-A (based on official data), while the second set (presented in brackets) is based on doubling the size of NPLs (as a fraction of GDP) reported in Table 3-A. Despite its high NPLs, China has the second lowest ratio among the four countries using official data on NPLs; these ratios are much higher if NPLs double but they are still comparable with those of the U.S. (low NPLs but high government debt). Based on this crude comparison, it seems that the NPLs will not be a particularly arduous burden for the Chinese government due to the small size of its debt, while the same cannot be said for Japan. Caution is again needed for this conclusion: first, new NPLs in China may grow much faster than the rest of the countries; and second, the small amount of government debt may experience a sharp increase given the need for higher fiscal spending in areas such as pension plans and related social welfare programs. Overall, the optimistic view on NPLs believes that, despite the large amount of existing NPLs, the current reform of state-owned banks and development of the banking sector have already been effective in reducing NPLs, which is why NPLs have been falling in recent years (2000-2002) in Table 3-A. Given that the economy will probably maintain its current pace of growth, the government can always write off a large fraction of the rest of the NPLs to avert any serious problems for China. On the other hand, the pessimistic view believes that NPLs are much bigger 13 See, for example, Sachs and Woo (1997 review article), Rawski (2002), and Wolf (2003) for different views on the prospects of long-run economic growth and statistics on growth in China
than the official statistics suggest to begin with. and that a substantial amount of new nPls will continue to arise within state-owned banks. Moreover, the reform of the banking sector will not be effective because it will take a long time before the government relinquishes majority control of state-owned banks, during this period, if the growth of the economy significantly slows down, while the accumulation of NPLs continues, the banking sector problems could lead to a financial crisis This could spill over into other sectors of the economy and cause a slowdown in growth or a recession. In this view, the NPl problem poses the most serious problem to China's continued I.3 Growth of Non-state financial Intermediaries The development of both non-state banks and other(state and non-state) financial institutions is crucial for China to have a stable and functioning banking system in the future. In ddition to boost the overall efficiency of the banking system and alleviate the problems of NPLs, these financial institutions provide funding to support the growth of the Hybrid Sector. For example, with survey data(in the 1990s)on Hybrid Sector firms and local branches of ABC and RCCs in the rural areas of Zhejiang and Jiangsu provinces, Brandt and Li(2003)find that while these firms have been discriminated against in the loan market, the degree of discrimination depends on loan officers'incentives and human capital. In addition, Brandt et al. (2003)find that financial institutions and their relationship with Hybrid Sector firms can drive the incentive of lo government to privatize(partially) government owned firms First, we examine and compare China's insurance market to other Asian economies( South Korea, Taiwan, and Singapore). Whether in terms of the ratio of total assets managed by insurance companies over GDP(Figure 3-C), or premium income over GDP(Figure 3-D), Chinas insurance market is significantly smaller than that of other economies. At the end of 2004 total assets managed were still less than 10% of gDP(while this ratio for the other three economies is over 30%) It is clear that the insurance industry is also significantly undersized compared to Chinas banking industry, and property insurance is particularly underdeveloped due to the fact that the private real estate market was only recently established (in the past most housing was allocated by employers). Despite the fast growth of insurance coverage and premium income, at the end of 2000 only 1. 8% of the total population was covered by life insurance(resulting in a per capita premium of only RMB 127 per year); coverage for property insurance is even lower(Almanac of China's Finance and Banking) Insert Tables 4-A and 4-B, and Figures 3-C and 3-d here
23 than the official statistics suggest to begin with, and that a substantial amount of new NPLs will continue to arise within state-owned banks. Moreover, the reform of the banking sector will not be effective because it will take a long time before the government relinquishes majority control of state-owned banks; during this period, if the growth of the economy significantly slows down, while the accumulation of NPLs continues, the banking sector problems could lead to a financial crisis. This could spill over into other sectors of the economy and cause a slowdown in growth or a recession. In this view, the NPL problem poses the most serious problem to China’s continued prosperity. III.3 Growth of Non-state Financial Intermediaries The development of both non-state banks and other (state and non-state) financial institutions is crucial for China to have a stable and functioning banking system in the future. In addition to boost the overall efficiency of the banking system and alleviate the problems of NPLs, these financial institutions provide funding to support the growth of the Hybrid Sector. For example, with survey data (in the 1990s) on Hybrid Sector firms and local branches of ABC and RCCs in the rural areas of Zhejiang and Jiangsu provinces, Brandt and Li (2003) find that while these firms have been discriminated against in the loan market, the degree of discrimination depends on loan officers’ incentives and human capital. In addition, Brandt et al. (2003) find that financial institutions and their relationship with Hybrid Sector firms can drive the incentive of local government to privatize (partially) government owned firms. First, we examine and compare China’s insurance market to other Asian economies (South Korea, Taiwan, and Singapore). Whether in terms of the ratio of total assets managed by insurance companies over GDP (Figure 3-C), or premium income over GDP (Figure 3-D), China’s insurance market is significantly smaller than that of other economies. At the end of 2004 total assets managed were still less than 10% of GDP (while this ratio for the other three economies is over 30%). It is clear that the insurance industry is also significantly undersized compared to China’s banking industry, and property insurance is particularly underdeveloped due to the fact that the private real estate market was only recently established (in the past most housing was allocated by employers). Despite the fast growth of insurance coverage and premium income, at the end of 2000 only 1.8% of the total population was covered by life insurance (resulting in a per capita premium of only RMB 127 per year); coverage for property insurance is even lower (Almanac of China’s Finance and Banking). Insert Tables 4-A and 4-B, and Figures 3-C and 3-D here
Table 4-A provides a(partial) breakdown of the different types of banks. In both 2001 and 2002, although the four state-owned banks dominate in every aspect of the banking sector, the role of the non-big four banks in the entire banking sector cannot be ignored These banks' total assets compose 40% of the big four(the actual fraction is likely to be higher due to incomplete information on all types of non-bank intermediaries). A similar comparison can be made for outstanding loans these banks have less npls than the big four banks moreover total new loans made by the four largest state-owned banks accounted for more than 75% of all new loans in 1997, while new loans made by"shareholding"banks accounted for less than 7%. In 2001, the share of new loans made by state-owned banks dropped to 49%, while the fraction of new loans made by shareholding banks rose to 23.5% Table 4-B provides evidence on the growth of non-bank intermediaries. Overall, the growth of these non-banks intermediaries has been impressive since the late 1990s. In terms of combined total assets held or managed, the size of all the banks and intermediaries outside of the"Big Four state-owned banks(first column in Table 4-B)is about 58.7% of the"Big Four banks at the end of 2002. Among them, "other commercial banks"(many of them are state-owned), RCCs, and TiCs hold the largest amount of assets the size of foreign banks and mutual funds(not listed in the table) is minuscule, and these are likely to be the focus of development in the near future Finally, our coverage of non-bank financial institutions excludes various forms of informal financial ntermediaries, some of which are deemed illegal but overall provide important financing to firms in the Hybrid Sector. We will discuss these informal intermediaries in Section V below IV Financial Markets and Publicly traded firms In this section, we examine China's financial markets, including both the stock and bon markets, and the recent addition of venture capital and private equity markets. We also compare, at the aggregate level, how firms raise funds in China and in other emerging economies through external markets in order to determine if China's experience in terms of a firms fundraising is unique. We then focus on publicly traded companies and examine their financing and investment decisions. Finally, we discuss how to further develop financial markets as well as improve corporate governance and the performance of listed firms Postal savings(deposit-taking institutions affiliated with local post offices)is another form of non-bank intermediation that is not reported in Table 4-B due to lack of time series data. However, at the end of 1999, total deposits within the postal savings system exceeded RMB 380 billion, or 6.4% of all deposits in China
24 Table 4-A provides a (partial) breakdown of the different types of banks. In both 2001 and 2002, although the four state-owned banks dominate in every aspect of the banking sector, the role of the non-big four banks in the entire banking sector cannot be ignored: These banks’ total assets compose 40% of the big four (the actual fraction is likely to be higher due to incomplete information on all types of non-bank intermediaries). A similar comparison can be made for outstanding loans; these banks have less NPLs than the big four banks. Moreover, total new loans made by the four largest state-owned banks accounted for more than 75% of all new loans in 1997, while new loans made by “shareholding” banks accounted for less than 7%. In 2001, the share of new loans made by state-owned banks dropped to 49%, while the fraction of new loans made by shareholding banks rose to 23.5%. Table 4-B provides evidence on the growth of non-bank intermediaries. Overall, the growth of these non-banks intermediaries has been impressive since the late 1990s. In terms of combined total assets held or managed, the size of all the banks and intermediaries outside of the “Big Four” state-owned banks (first column in Table 4-B) is about 58.7% of the “Big Four” banks at the end of 2002. Among them, “other commercial banks” (many of them are state-owned), RCCs, and TICs hold the largest amount of assets; the size of foreign banks and mutual funds (not listed in the table) is minuscule, and these are likely to be the focus of development in the near future.14 Finally, our coverage of non-bank financial institutions excludes various forms of informal financial intermediaries, some of which are deemed illegal but overall provide important financing to firms in the Hybrid Sector. We will discuss these informal intermediaries in Section V below. IV. Financial Markets and Publicly Traded Firms In this section, we examine China’s financial markets, including both the stock and bond markets, and the recent addition of venture capital and private equity markets. We also compare, at the aggregate level, how firms raise funds in China and in other emerging economies through external markets in order to determine if China’s experience in terms of a firm’s fundraising is unique. We then focus on publicly traded companies and examine their financing and investment decisions. Finally, we discuss how to further develop financial markets as well as improve corporate governance and the performance of listed firms. 14 Postal savings (deposit-taking institutions affiliated with local post offices) is another form of non-bank intermediation that is not reported in Table 4-B due to lack of time series data. However, at the end of 1999, total deposits within the postal savings system exceeded RMB 380 billion, or 6.4% of all deposits in China
V1 Stock Exchanges and market Inefficiencies Since the inception of Chinas domestic stock exchanges, the SHSE and SZse, in 1990, they have been growing very fast. At the end of 2002 the combined total market capitalization of these two exchanges ranked 1 among the largest stock exchanges in the world (table 5-A).However ignificant fraction of all the (equity) shares is nontradable(see Section IV 4 below for more details); nevertheless, total market capitalization using tradable shares reached US$170 billion in 2001. Another factor is that the hKse. where selected firms from mainland China can now be listed and traded, is ranked 10 in the world by itself. If we rank the combined size of all stock exchanges in a country, China would rank fifth, behind the U.S., Japan, U. K, and france Insert Table 5-A here As fast as the growth of China's stock markets has been, they are not efficient in that prices and investors'behavior are not driven by fundamental values of listed firms In Table 5-A Concentration" measures the fraction of total market capitalization of an exchange that is coming from the combined capitalization of the largest firms ranked in the top 5%(by capitalization). The dominance of large-cap stocks in China is the lowest among major stock exchanges in the world, with its concentration ratio of 29.4% less than half of that of Tokyo, which has the second-lowest concentration. On the other hand, stocks are traded extremely frequently in China, as shown by the highest"Turnover Velocity, defined as the total turnover for the year expressed as a percentage of total market capitalization, among the largest exchanges. China's turnover velocity of 224.2% even higher than that of NASDAQ (159.8%), with the well-known trading patterns of many small and medium technology stocks(while the concentration ratio of NAsdaQ is 63. 1%) Consistent with our findings, Morck et al. (2000) find that stock prices are more synchronous'"stock prices move up and down together) in emerging countries including China than in developed countries They attribute this phenomenon to poor minority investor protection and imperfect regulation of markets in emerging markets. With a large data set of individual trading, Feng and Seasholes(2004) find that buy and sell trades are highly correlated(occur at the same time period, such as in the same day )in China, especially among investors who conduct their trades near one of the two stock exchanges or near firms' headquarters Moreover, there have been numerous lawsuits against insider manipulation and trading. A good example is the rise and fall of Guangxia Industry Co, Ltd, dubbed as"China's Enron For more details on Guangxia, see the August 3, 2001 issue of the Caijing Magazine ('finance and Economics Magazine), a leader among China's financial press and the " whistle blower" of the Guangxia scandal
25 IV.1 Stock Exchanges and Market Inefficiencies Since the inception of China’s domestic stock exchanges, the SHSE and SZSE, in 1990, they have been growing very fast. At the end of 2002, the combined total market capitalization of these two exchanges ranked 11th among the largest stock exchanges in the world (Table 5-A). However, a significant fraction of all the (equity) shares is nontradable (see Section IV.4 below for more details); nevertheless, total market capitalization using tradable shares reached US$170 billion in 2001. Another factor is that the HKSE, where selected firms from Mainland China can now be listed and traded, is ranked 10th in the world by itself. If we rank the combined size of all stock exchanges in a country, China would rank fifth, behind the U.S., Japan, U.K., and France. Insert Table 5-A here. As fast as the growth of China’s stock markets has been, they are not efficient in that prices and investors’ behavior are not driven by fundamental values of listed firms. In Table 5-A, “Concentration” measures the fraction of total market capitalization of an exchange that is coming from the combined capitalization of the largest firms ranked in the top 5% (by capitalization). The dominance of large-cap stocks in China is the lowest among major stock exchanges in the world, with its concentration ratio of 29.4% less than half of that of Tokyo, which has the second-lowest concentration. On the other hand, stocks are traded extremely frequently in China, as shown by the highest “Turnover Velocity,” defined as the total turnover for the year expressed as a percentage of total market capitalization, among the largest exchanges. China’s turnover velocity of 224.2% is even higher than that of NASDAQ (159.8%), with the well-known trading patterns of many small and medium technology stocks (while the concentration ratio of NASDAQ is 63.1%). Consistent with our findings, Morck et al. (2000) find that stock prices are more ‘synchronous” (stock prices move up and down together) in emerging countries including China than in developed countries. They attribute this phenomenon to poor minority investor protection and imperfect regulation of markets in emerging markets. With a large data set of individual trading, Feng and Seasholes (2004) find that buy and sell trades are highly correlated (occur at the same time period, such as in the same day) in China, especially among investors who conduct their trades near one of the two stock exchanges or near firms’ headquarters. Moreover, there have been numerous lawsuits against insider manipulation and trading. A good example is the rise and fall of Guangxia Industry Co., Ltd., dubbed as ‘China’s Enron.’15 15 For more details on Guangxia, see the August 3, 2001 issue of the Caijing Magazine (‘Finance and Economics Magazine’), a leader among China’s financial press and the “whistle blower” of the Guangxia scandal