CHINESE FINANCIAL MARKETS:

INTRODUCTION AND OVERVIEW

THE CHINESE FINANCIAL MARKETS, SPRING 2014

PV VISWANATH

LUBIN SCHOOL OF BUSINESS

P.V. Viswanath

THE CHINESE ECONOMY: A BRIEF HISTORY

• Prior to 1978, China was a command economy; resources were allocated on the basis of a state plan, rather than the use of a price and market system.

• At this stage, the financial system essentially consisted of a monobank, the People’s Bank of China, PBOC, which acted as a central bank, a commercial bank and government treasury all rolled into one.

• After 1978, there was a Dual Track system: Co-existence of a traditional plan and a market channel for the allocation of a good. By the mid-1980s, most state-owned firms were still being assigned a compulsory plan for some output but had additional capacity available for production of above-plan market goods.

Presentation to Confucius Institute Seminar, P.V. Viswanath 2

EARLY DEVELOPMENTS• Rural communities were allowed to run township and village enterprises outside the plan

in order to contribute to local investment and economic growth.

• Foreign businesses were allowed to operate freely in special economic zones in order to increase FDI and facilitate technology transfer. Private economic activity was tolerated.

• Agricultural collectives were given more autonomy to meet procurement targets, which were also reduced. Collectives contracted individual pieces of land to farm households, which managed the plot of land, subject to a contractual agreement that they turn over a certain amount of procurement and tax grain after the harvest.

• All of this required a more responsive financial system that would help in the allocation of resources to growth sectors. In 1979, under the reform policy introduced by Deng Xiaoping, the PBOC was given the function of a supervisory body and of a central bank; by the end of 1979, it was no longer under the Ministry of Finance.

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THE ESTABLISHMENT OF THE SOCBs

• From 1978 to 1984, the banking system moved from a mono-bank system, centered on the PBOC to a two-tier system. The PBOC became the central bank, i.e. in charge of monetary policy and four state owned commercial banks (SOCBs) were established to fund economic development.

• The Bank of China (BOC) specialized in transactions related to foreign trade and investment.

• The China Construction Bank (PCBC) handled transactions related to fixed investment, especially in manufacturing.

• The Agricultural Bank of China was set up to deal with all banking business in rual reas.

• The Industrial and Commercial Bank of China (ICBC) was established in 1984 and took over the commercial transactions of the PBOC.

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THE FINANCIAL SYSTEM DEVELOPS FURTHER

• In the 1980s, financial intermediaries outside the Big Four sprouted.• Regional banks (partially owned by regional governments) were formed in the Special

Economic Zones in the coastal areas.• In rural areas, a network of Rural Credit Cooperatives was set up under the supervision of

the ABC• Urban Credit Cooperatives, counterparts of the RCCs were set up in the urban areas.• Non-bank financial intermediaries, such as the Trust and Investment Corporations provided

selected banking and non-banking services with restrictions on both deposits and loans.

• In the 1990s, stock markets grew. The Shanghai Stock Exchange and the Shenzhen Stock Exchange were set up in 1990.

• The real estate market also grew almost as fast as the stock markets in terms of value.

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REGULATORY SYSTEM• In 1986, the first bankruptcy law was passed, governing SOEs, but it was not effective until

the end of 1999. In August 2006, a new bankruptcy law was enacted and became effective in June 2007.

• In the beginning, the PBOC held regulatory control of the entire financial system, but over time, by the mid 2000s, it ceded control over parts of the system to the China Securities Regulatory Commission (CRTC) and the China Insurance Regulatory Commission (CIRC).

• In 2003, the Central Government established the China Banking Regulatory Commission, which supervises financial institutions under the leadership of the State Council.

• The State Administration of Foreign Exchange (SAFE) manages currency reserves and the exchange rate, under the umbrella of the PBOC.

• The Ministry of Finance is responsible for promulgating accounting and tax rules and the National Development and Reform Commission (NDRC) is responsible for enterprise finance issues and industry policies. These two have an important role in defining future policies.

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STAGE TWO OF ECONOMIC DEVELOPMENT

• Gradually, by the mid-1990s, production under state plans, outside the market, dropped to zero and the entire product sector of the economy had transitioned to a market system.

• Instead of a big-bang approach, Chinese reformers used the planned economy institutions to ease into a market system.

• Emphasis on the capital-intensive sector was replaced by a move towards more sustainable labor-intensive sectors. This allowed the utilization of large numbers of workers who would, otherwise, have suddenly become redundant in a big-bang switch.

• Resources were gradually shifted to the household sector by reducing procurement and allowing production for market. This allowed the rural population to generate savings, which they then ploughed into investment in new enterprises, which were tolerated in the first years. This savings was enabled by the gradualist reforms that maintained stability and led to trust in economic growth.

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THE ROLE OF FINANCE IN DEVELOPMENT

• The government’s share of the economy and of newly generated resources was low, since government monopolies in every sector were removed or at least reduced. Taxation was also low, partly because of the existence of a large informal sector plus a government that did not have a taxation system in place.

• The banking sector, at this time, played an important part in channeling household saving to the enterprise sector.

• The emergence of new private firms coupled with the adoption of market prices by state-owned enterprises (SOEs) (partially, at first) led to enhanced competition and began to get state-sector managers accustomed to responding to market pressures.

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BENEFITS OF THE GRADUALIST APPROACH

• Rural residents gained from the dissolution of collectives, improved agricultural prices and the rapid growth of nonagricultural production in the countryside.

• Urban residents gained either because they were able to exploit new niches in the economy, or because their economic position was protected by continuing government support for state enterprises.

• However, rising inflation that eroded real incomes, anger at corruption and arbitrary privilege and rising expectations about political and economic change led to the Tiananmen Square uprising. The inflation was because of extreme decentralization in the monetary sector.

• In spite of the strict and violent way in which the protesters were treated, conservative attempts to turn the clock back failed.

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THE POST-1992 STAGE

• Deng Xiaoping ( 邓小平 ), the leader of the country (and the general secretary of the Communist Party), took a Southern Tour in 1992 to endorse the concept and reality of the SEZs that had been authorized a decade earlier and to reaffirm a non-ideological, pragmatic approach to development. In October 1992, the Communist Party Congress endorsed a socialist market economy.

• By the end of 1993, the orthodox planning system was abolished. Non-market contracts with individual enterprises were allowed to lapse. However, although the state’s direct role in producti0n planning was ended, there was a renewed move towards centralization of state authority.

• Whereas in the pre-1992 period, local governments had a lot of autonomy, post-1992, the center took renewed hold of resources.

• At this stage, the economy could have moved in two directions. It could have become a private enterprise-dominated economy, as in Estonia, for example. However, this would have entailed a ceding of power and control over resources by the Communist Party and its elites to outsiders. Hence the party chose an alternative route, where product markets were more-or-less free, yet control over resources was maintained by the party. This meant control over the financial sector.

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TAX REFORM

• Due to the decentralization of the economy, the government’s budgetary revenue share of GDP dropped from 33.8% in 1978 to only 10.8% in 1995.

• In the old system, state monopoly enterprises raised revenues through use of their market power. In the new competitive environment, this was no longer true.

• The solution was to build up a modern tax system. The fiscal reform had three crucial elements: new taxes, a tax assignment and sharing system, and a new central government taxation agency.

• VAT was levied on most manufactured goods at the uniform rate of 17%; very small private enterprises without regular bookkeeping systems were to pay a tax of 6% of gross sales in lieu of VAT. In addition, a 33% profit tax was introduced with uniform rates for state, collective and private enterprises. The system of personal income taxes was unified and made more rigorous; a consumption tax was introduced for cigarettes, alcohol, and a few other luxuries.

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FISCAL REFORM

• The tax reform succeeded in treating all tax payers similarly (SOEs, collectives, and private firms). Multiple taxes with different tax bases and tax rates were merged into the VAT. Finally, the VAT was moved to the central government.

• This resulted in less geographic distortion of incentives for development. Local governments are no longer able to provide tax relief to favored enterprises. This made the tax system more transparent, less costly to administer, and easier for the public to understand. This helped in the government’s efforts to establish an effective tax collection agency.

• Since 1993, the central government has transferred resources to local governments, based on its planning goals, in contrast to the pre-1985 period, when there was net local-to-center redistribution of revenues.

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BUDGETARY PROBLEMS

• It is still the case, however, that the Chinese government is not able to raise as much in revenues as it would like, through taxes.

• China has tried to keep deficit spending at moderate levels, at around 1% of GDP in most years of the 1980s and 1990s.

• However, the Asian financial crisis during the last years of the last millennium, coupled with the change in development strategies in the 1990s led to a greater need for public spending. This led to an increase in the deficit to well over 2% of GDP from 2000 to 2002. As the economy recovered, the deficit dropped, as well.

• Nevertheless, the need for increased spending both for social support and for state-driven capital investment has led to demands for financial resources that cannot be satisfied by normal budgetary revenues.

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THE DEBT PROBLEM

• The government has tried several tacks to deal with this problem.

• The main strategy is borrowing. In spite of this reliance on borrowing, the public debt in China at the end of 2005 was only 17.9% of GDP.

• However, many types of public obligations are not included in this number, e.g. special bonds issued to recapitalize the banking system. Another computation which took a broader perspective came up with a figure of 55% of GDP in 2000. A WSJ computation (September 2013) which included local government borrowing, came up with a figure of 167% of GDP for 2011 and 182% for 2012.

• Furthermore, SOEs also have high levels of borrowings, and in many cases, SOEs can be considered an extension of the Chinese government.

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CONTRASTING STYLES OF ECONOMIC REFORM

1980s Reform 1990s ReformZhao Ziyang (premier from 1980 to 1987): Cautious, consensual decision-making

Zhu Rongji (vice-premier from 1993, premier 1998-2003): Rapid, personalized decision-making

Introduce markets where feasible; focus on agriculture and industry

Strengthen institutions of market economy; focus on finance and regulation

Dual-track strategy Market unification, unite dual tracksParticularistic contracts with powerful incentives

Uniform rules: Level playing field

Competition created by entry; no privatization

State-sector downsizing; beginnings of privatization

Decentralize authority and resources Recentralize resources, macroeconomic control

Inflationary economy with shortages Price stability, goods in surplusReform without losers Reform with losers

Table 4.1 from Naughton, The Chinese EconomyWhat will 习近平 Xi Jinping’s style be? This is yet to be seen.

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FINANCIAL REPRESSION• One way that the Chinese government has tried to retain access to resources is by financial

repression. Although there exist bond and stock exchanges, it is not easy for firms to list on the stock exchange. Permission to issue bonds is also not easy to obtain. As a result, the stock and bond markets are not really avenues for public investment.

• Individuals are still very limited in the avenues available to them to save. The main outlet is banks, which do not pay very high rates of interest. Furthermore, SOEs are favored by banks in terms of lending. Private enterprises cannot get bank loans that easily.

• One proof of this financial repression is the attempt by many Chinese investors to invest large amounts of money in stock markets and in real estate markets. As a result of a lot of money chasing small amounts of available supply, stock markets and real estate markets are often way overvalued. Furthermore, because of the lack of transparency, there is a lot of volatility in these markets, as well.

• The market inefficiency of the Chinese stock markets is well documented.

• Furthermore, any other way of channeling resources to private investment is illegal, which has given rise to a large informal financial system, sometimes called shadow banking.

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FUNDAMENTAL PROBLEMS?• There was a banking crisis following the Asian financial crisis towards the end of the 1990s which involved a

very high proportion of nonperforming loans (NPLs); this was resolved by the creation of asset management companies (AMCs), which were essentially bad banks that took over the NPLs of the state-owned banks. These AMCs then tried to collect on these bad loans. Loans that were uncollectible were ultimately written off. The government underwrote this writing off plus the recapitalization of the state-owned banks by the infusion of capital through the issuance of special bonds.

• The continuing need for financial resources was partially resolved by the sale of shares in SOEs and SOCBs to foreigners and foreign financial institutions. For example, Bank of Communications in 2005 was the first Chinese lender to list abroad. This issue was heavily oversubscribed. However, there is evidence that these IPOs were stage-managed through “management of earnings,” i.e. earnings manipulation. Furthermore, most of the shares in these state owned enterprises were held by the government; hence the price of these shares reflected, in a certain sense, a scarcity value.

• The growth in the Chinese economy during the late 1990s may also have been fuelled by the aggressive purchase at cheap prices of agricultural land and dispossession of farmers. Obviously, this process could not continue forever.

• In other words, there are grounds for considering whether the Chinese financial and economic system is basically unstable. This is a dialogue that is taking place both abroad and in China. Students should have some background to be able to evaluate this discussion.

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OTHER ISSUES• A lot of the saving is done in the rural areas; however, the ratio of loans made to deposits is very low. This

reflects a conscious strategy to benefit urban areas over rural areas for political reasons. This impetus towards urbanization has been renewed under Xi Jinping: the Central Economic Conference, which took place in early 2013 stated that “a new model of urbanization will provide the largest potential for promoting domestic spending and calls for an orderly urbanization of migrants from rural areas.” Hence in order to understand the financial system, it is necessary to study the rural-urban divide.

• NPLs are also a problem -- a state-owned asset-management firm, China Orient Asset Management Corp., said in a report in September 2013, that Chinese commercial banks are facing a resurgence in nonperforming loans. It said in a report this week that the bad-loan ratio at commercial banks is expected to reach 1% to 2% this year, while the volume of new bad loans will climb more than 5% from a year earlier.

• However there is general disbelief that this number is correct. Even if the true number is 5% as claimed by some sources, this is still much less than the 20% that may have reigned in 2005. The current ratio for the US is 3.9% and 10.1% in Cyprus according to World Bank data.

• Still it is not just the current number that is problematic, but rather the fact that there have not been fundamental changes in the way banks hand out loans.

http://www.ibtimes.com/china-banks-bad-debt-cause-concern-not-if-history-any-guide-1387487

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LOOKING FORWARD

• What is the role of financial securities markets in China? Will they become more important in terms of being a conduit for resource mobilization and resource allocation?

• Will the banking sector become more privatized? Will it become more commercialized and more competitive?

• Why are credit cards still not as popular as might be imagined in the second largest economy in the world? How will this be affected by the growth of online shopping?

• Although more than 50% of Chinese GDP is from the private sector, much of the corporate sector is still partly or fully owned and controlled by the government. Is the corporate sector likely to be privatized in the future? How will this affect corporate governance? What will be the role of the M&A market?

• Will the informal sector wrest effective control of the economy from the government or will the government be successful in imposing control?

• These are some of the questions that we will we dealing with in the rest of the course.