Money and Banking - SJTU · global nancial crisis, China’s banking system did well from 2008 to...

Money and Banking

Lecture XIII: An Overview of China’s Financial System

Guoxiong ZHANG, Ph.D.

Shanghai Jiao Tong University, Antai

December 12th, 2017

Source: Allen, Gu and Qian (2017)

Road Map

Overview of China’s Financial SystemFinancial Development and Economic GrowthA Brief History of China’s Financial System

The Banking and Non-banking Sector in ChinaAggregate Evidence of the Banking SectorNon-performing Loans and Further Reform in the Banking SectorGrowth of the Non-state Financial Intermediaries

Financial Markets in ChinaThe Stock MarketThe Bond MarketReal Estate MarketAsset ManagementRegulations and Further Changes in Financial Markets

Financial CrisisBanking Crises and Market CrashesCapital Account Liberalization, Twin Crises, and Contagion

Conclusion

Overview of China’s Financial System

Financial Development and Economic Growth

Many empirical studies have demonstrated the positive associationbetween financial development and economic growth:

financial systems allow households and firms to inter-temporally smoothexpenditures and share risks;thereby stimulating consumption from the households and investmentfrom the firms;it also facilitates innovations from the firms;better risk diversification in international financial markets enhanceseconomic growth by exploiting the benefits of international trade.

However, China is an important counterexample to the findings in thefinance-growth nexus literature:

Without a well-developed financial system, it has been one of thefastest-growing economies around the globe.Although China’s real growth has been slowing down slightly to aso-called new normal status in the past years, its success may provide uswith new insights into the finance-nexus literature.

A Brief History of China’s Financial System

Between 1950 and 1978, China’s financial system consisted of a singlebank: the People’s Bank of China (PBOC), which was owned andcontrolled by the central government under the Ministry of Financeand which served as both the central bank and a commercial bank,controlling about 93% of the total financial assets of the country andhandling almost all financial transactions.

In 1977, the PBOC was separated from the Ministry of Finance as atop-tier unit of the State Council, and some of its former commercialbanking businesses were taken over by the largest three state-ownedbanks in China. Later, the Industrial and Commercial Bank of China(ICBC) was formed in 1984, and the Bank of Communications(BComm) was reestablished in 1987.

A Brief History of China’s Financial System, Cont’d

China’s stock market, one in Shanghai [the Shanghai Stock Exchange(SSE)] and the other in Shenzhen [the Shenzhen Stock Exchange(SZSE)], were established in December 1990 and grew fast in the 1990sand 2000s.

The real estate market also went from nonexistence in the early 1990sto a size comparable with that of the stock market by 2007.

Both the stock and real estate markets are characterized by highvolatilities and speculative short-term behavior by many investor.

Following the Asian Financial Crisis in 1997, financial sector reformfocused on state-owned banks and especially the problem of NPLs; theChina Banking Regulation Committee (CBRC) was also established tooversee the banking industry.

The Banking and Non-banking Sector in China

Aggregate Evidence on the Banking Sector

China’s household savings rates have been high in the past decades,similarly to those in other Asian economies.

Bank loans have been one of the important financing sources for hybridsector firms.

The government supports the state-owned sectors much more than thehybrid sectors through granting larger-scale bank loans via state-ownedbanks.

Total Loan Growth in China

Source: Compiled using data from Allen, Gu and Qian (2017)

Loan Size: SOE vs Non-SOE


Non-performing Loans

China’s banking sector is dominated by large state-owned banks, whichimplies that the degree of competition within the banking sector hasbeen low.

CBRC approved the establishment of the first five private banks inChina in 20149; however, most of the commercial banks are majorityowned by the central or local governments, or with the government asthe ultimate controller.

The lack of competitions in the banking sector partly causes the highlevel of NPLs.

Loans from Different Types of Banks


Comparing NPLs and Recent Growth.

We compare NPLs in China, other major Asian economies, and the UnitedStates during 1997C2013 on the basis of the official figures:

China’s NPLs were the highest in the group in 2000C2007, and as highas 20C20.5% in 2000C2001;

However, the level of NPLs (over GDP) in China has shown a cleardownward trend since the peak in 2000C2001, with the total amount ofNPLs also falling during 2004C2011;

In fact, compared with other developed countries that were hit by theglobal financial crisis, China’s banking system did well from 2008 to2010, with NPL to GDP ratios lower than 2.0%.

However, after the four trillion fiscal stimulus package in 2009, theratio of NPLs over GDP has once again shown an upward trend.

Comparing NPLs of China and of Other Countries


NPLs and Government Debt

As a large fraction of the NPLs among state-owned banks, thereforethe natural party to bear the burden of reducing the NPLs is thegovernment;

If we treat the NPL issue as a fiscal problem for China, then theultimate way to solve it would be sustained high economic growth;

China’s local government debt has been growing rapidly in recentyears, mainly because of the large amount of fixed-asset investment ininfrastructure to stimulate economic growth after the 2007C2009financial crisis;

If we aggregate the NPLs and total government debt, China’s totalgovernment burden puts it in the middle of the pack: lower than thoseof Japan, the United States, and India, comparable with those ofTaiwan and Korea;

On the basis of these crude comparisons, it seems that NPLs shouldnot be an arduous burden for the Chinese government (or the bankingsector), whereas the same cannot be said for Japan or the UnitedStates

Comparing Government Debts of China and of Other Countries


Improvement of Efficiency in the State-owned Banks

The authorities in the banking sector in China put forward a series ofmeasures to improve its efficiency in the past decades:

For instance, state-owned banks have diversified and improved their loanstructure by increasing consumer-related loans while being more activein risk management and monitoring of loans made to SOEs;privatization process, which mainly includes the listing of state-ownedbank;

Still there are arrangement of the banking system that can beproblematic for its efficiency:

government?s dual roles in both regulation and majority ownership;poor and inconsistent enforcement of bankruptcy laws and creditorprotection.

Private Firm Saving

The corporate sector accounts for about half of the nongovernmentsavings;

most private businesses were excluded from the formal credit channelsand private investment was primarily financed by firms’ own savings.

Interest Rate Liberalization

From 1996 to 2004, the PBOC liberalized, in succession, the interestrate in the monetary market and bond market, the bank deposit andloan rate in foreign currency, and the RMB agreement deposit rates;

In July 2013, the PBOC removed the lower limit on lending rates,which had been set at 70% of its fixed benchmark;

On May 1, 2015, the deposit insurance system, which guarantees 99.7%of deposits, was launched;

On October 23, 2015, the PBOC removed the upper limit on thedeposit rate.

Development of Other Nonstate Banks

During the period 2001?2013, although the Big Five banks dominatedin every aspect of the banking sector, the role of other banks in thebanking sector cannot be ignored.

As of 2013, other banks (including foreign banks) and creditcooperatives’ total assets constituted more than 70% of those of theBig Five banks;

The CBRC granted private capital the same entry standards to thebanking industry as other capital in May 2012;

In November 2013, the government also allowed private investors thatmeet certain requirements to set up small and medium-sized banks andother financial institutions;

Various forms of informal financial intermediaries, some of which aredeemed illegal but which overall provide a considerable amount offinancing to firms in the hybrid sector.

Loan Size by Loan Type


Development of Other Financial Institutions

The strong demand for capital by the real economy and the limitedloan quota of the traditional banking system have led to the fastgrowth of other financial institutions and of shadow banking, especiallythe trust industry and other small-scale lending companies, since 2009;

The trust industry has overtaken the insurance industry as the largestnonbanking financial sector since 2012;

From 2006 to 2013, trust loans and entrusted loans ranked as the toptwo types of social financing in terms of average annual growth, withrates of 55.8% and 37.8%, respectively;

By September 2014, the amount of outstanding loans made bysmall-scale lending companies was RMB 907.9 billion,19 with anaverage quarter-on- quarter growth rate of 13.2% from 2010 to 2014;

Growth rate of bank deposits was much lower than that of bank loansfor a long period starting from 1979;

Drop in trade surplus and capital inflows after 2009 caused depositsderived from foreign exchange settlement to decline;

In order to meet the required LTD ratio, banks have to raise funds byissuing wealth management products.

Driving Forces of Nonbank Lending

Both lending and deposit interest rates were regulated, the lendinginterest rate was lower than the growth rate of output, leading to highdemand for financing;

Strict enforcement of a 75% cap on bank loan-to-deposit (LTD) ratiosin an environment with deposit rate ceilings;

PBoC imposes loan quotas in some restrictive areas (e.g., the realestate industry and industries with overcapacity) through windowguidance to commercial banks;

Wealth Management Products


Financial Markets

Real Returns in Different Stock Markets


The Stock Market

Performance of the value-weighted SSE index (the calculation for theSZSE is very similar) was below those of theDAX(Germany) andtheS&P500 (United States), about the same as those of the FTSE(United Kingdom) and the CAC (France), and above that of theNikkei ( Japan);

The SSE was ranked the seventh largest market in the world in termsof market capitalization, and the SZSE was ranked the eleventh;

The Hong Kong Stock Exchange (HKSE), where selected firms frommainland China have been listed and traded, was ranked the sixthlargest in the world;

The Stock Market, Cont’d

Despite the recent rapid development in China’s stock market, there isabundant evidence that the market is still not efficient:

Stock prices are more synchronous in emerging markets, includingChina, than in developed countries;

The degree of manipulation and insider trading in China is greaterthan in the United States;

IPO must go through a process of approval by the CSRC, morepolitically connected firms are more likely to be listed;

Once listed, firms are rarely delisted in China.

The Bond Market

The government bond market had an annual growth rate of 22.3%during the period 1990-2013 in terms of newly issued bonds;

The second largest bond market is called policy financial bonds, issuedby policy banks, which operate under the supervision of the Ministryof Finance, and the proceeds of bond issuance are invested ingovernment-run projects and industries such as infrastructureconstruction;

Since 2011 the corporate bond market has been larger than theTreasury bondmarket;

Since May 2012, unlisted and small and medium-sized companies havebeen allowed to issue corporate bonds in the stock exchanges. Further,in January 2015, both the sponsorship and the screening systems forbond issuance were removed;

By the end of July 2016, China’s domestic bond market capitalizationwas RMB 41.63 trillion ($6.28 trillion), a total very close to that of thedomestic equity market.

Volumn of Newly Issued Bonds


The Bond Market, Cont’d

Future development of the bond market in China has several challenges:

lack of sound accounting and auditing systems and high-quality bondrating agencies;

lack of a well-constructed yield curve, given the small size of thepublicly traded Treasury bond market and a lack of historical prices;

regulation fragmentation: one interbank bond market established in1996 and regulated by the PBOC and NDRC, and a corporate bondmarket established in 2007 and regulated by the CSRC and the twostock exchanges.

The Real Estate Market

Prior to 1998, government control was dominant and mortgages werenot designated for retail customers and households. Chinese citizensworking for the government and for government-owned companies andorganizations could purchase properties at prices significantly belowmarket prices

Reform policies introduced in 1998 aimed to end the distribution ofproperties by employers and to establish new housing finance andmarket systems;

Since then, the development of the real estate sector has beenstimulated by the residential housing reform and by the growth ofindividual mortgages, along with rising household income and demandfor quality housing;

China?s continuing economic growth (especially in private sectors),urbanization and industrialization, limited land supply, and increasingforeign direct investments and institutional investments will furtherenhance the liquidity and long-term prospects ofChina?s real estateassets.

Real Estate Investment in China, 1996 - 2015


The Real Estate Market, Cont’d

Real estate prices in major cities have risen sharply in recent years,and whether these fast growing prices are bubbles and how to cooldown the markets are among the most closely watched and hotlydebated issues in China.

If housing prices grow significantly faster than disposable income, theremay exist bubbles in the housing markets.

Housing Price and Disposal Income


Asset Management

The development of the mutual fund industry in China started in 1992,when the first fund (ZiBo) was established;

After having only a handful of funds in 1998, China has 65 fundcompanies managing 1,621 different funds as of the fourth quarter of2013;

The most popular investment style is actively managed (domestic)equity, with only a few index funds and exchange-traded funds. Manymutual fund companies are owned by securities and other financialservices companies;

The first fund managed by a QFII was set up in 2002 after theannouncement of the QFII Act; As of November 2013, there were atotal of 251 approved QFIIs operating in China. The approvedinvestment quotas reached $49.1 billion;

Qualified domestic institutional investors (QDIIs) to invest in overseasmarkets was approved in July 2006; by November 2013, QDIIs hadapproved investment quotas of $81.4 billion.

Self-regulation and Government Regulation

A good example of regulation through market forces and self-regulationis provided by the capital markets in the United Kingdom in thenineteenth and early twentieth centuries;

Reputation and trust were important factors in the smooth operationof these markets;

China?s hybrid sector is another example of a situation where marketforces are effective. Formal regulation and legal protections do not playa major role, yet financing and governance mechanisms are quiteeffective;

However, government regulation in the financial sector, along the linesof the government interventions after the Great Depression in the1930s and the subprime financial crisis in 2008 in the United States,may allow China?s markets to function better.

Sale of Government Shares in Listed Firms

One major problem of the Chinese stock markets is the large amountof shares in listed companies owned by the government andgovernment entities;

The Chinese government attempted sales of state shares of selectedfirms in 1999 and 2001, but halted the process both times after shareprices plunged and investors grew panicky about the value of the entiremarket;

In 2005, the government announced a plan of fully floating state share;By the end of 2006, 96% of all listed companies at that time hadcompleted share reforms.

Development of New Financial Products

On April 16, 2010, China launched an index future tracking theShanghai based Hushen 300, the index of 300 Shanghai-andShenzhen-listed Class A shares;

Along with this index future, margin trading and short selling of shareswere also permitted;

In addition, the insurance industry has expanded remarkably throughissuing insurance investment products;

The trust industry has overtaken the insurance industry since 2012 asthe largest sector within the nonbank financial industry, as a largenumber of structured wealth management products have been issuedafter 2009 to support the growth of real estate and infrastructure;

In March 2005, the State Council approved the pilot implementation ofasset securitization, including credit asset securitization in China?sinterbank market and corporate asset securitization by securitiescompanies;

In August 2013, the State Council released a statement to scale up thepilot of securitization of good-quality bank loans in the interbankmarket as a part of a financial market liberalization project.

Financial Crisis

Banking Crisis

In China, there are several factors that could trigger a banking crisis:if NPLs continue to accumulate or if economic growth slows downsignificantly, it is possible that withdrawal of funds from banks willoccur, which might cause a banking crisis;the close nexus between banks and the real estate sector may also causeproblems: if real estate prices fall suddenly and unexpectedly, defaultson bank loans could increase enough to trigger a banking panic andcrisis.

The government?s dual role as a regulator and as a majority owner canbe problematic, it can also be beneficial in terms of both preventingand coping with crises.

Capital Account Liberalization and Twin Crisis

In recent years, authorities have sought to make the Chinese currencymore widely used internationally and to accelerate capital accountopening;

With capital outflow and the RMB exchange rate becoming moreflexible, authorities had to sell US dollars and purchase RMB tomaintain the domestic currency?s value when necessary, leading to anegative flow of foreign reserves;

Given the rapid growth and recent decline in foreign exchange reservesand the high volume of speculative capital inflows and outflows inanticipation of an RMB revaluation in the past decade, a currencycrisis that may trigger a banking crisis is a possibility;

Quickly adopting a full float can help to avoid a twin crisis and thusreduce the overall economic cost of a currency crisis.

Contagion of Financial Crisis

Another phenomenon that has been present in many recent crises (e.g.,the 1997 Asian Financial Crisis) is contagion of financial crises;

instance, a credit crunch in the interbank market occurred in June2013 when 7-day interbank repo rates soared to 11.62%, which was thehighest daily fixing since 2003. The PBOC stepped in by injectingcapital and rebuilding confidence in the interbank market, largelyresolving the market confusion.

In 2015, the CSI 300 index, rose from 2,050 to a high of 5,178, thencollapsed and lost 34% in 20 days, with 1,000 points of the indexerased in 1 week alone. This crash was also ended by a series ofinterventions by different authorities;

A more serious threat is the real estate market, particularly if there isa significant drop in housing prices accompanied by bankruptcies andforced selling.

Conclusions

Compared with other developed and emerging economies, China?sfinancial system has been dominated by a large banking system;

Stock and bond markets have also supported the state sectors byallowing SOEs and other government entities to raise funds throughthe issuance of stocks and bonds;

The alternative financial sector has played an important role insupporting the growth of the most dynamic sector of the economy;

A significant challenge for China?s financial system is to avoiddamaging financial crises that could severely disrupt economic growthand stability.

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