3.1 Background
The development of the CFS follows an unprecedented path. Coming from a centrally planned economy under Mao Zedong (1949 to 1976), China transformed itself within less than 50 years into the present market socialist economy challenging the market economies of its western counterparts by scale and growth. To dismantle its centrally planned economy and seize the benefits of a system driven by market forces, it studied the workings of Western capitalist economies. It recognized that a system to effectively provide financial intermediation to channel the flow of funds from savings into investment was essential to the workings of a modern market economy. As China’s banking system is a legacy construct from the planned economy, it needed a transformation to empower a more market-based economy. The transformation of the financial sector, therefore, became a priority national strategic objective (Stent, 2016).
3.2 Major banking system reforms and historic context
Just after the establishment of the People’s Republic of China (PRC) in 1949 by Mao Zedong the prior banking system from the Republican era was centralized into the People’s Bank of China (PBOC), which served for the next three decades as the treasurer for government allocation of funds throughout the country. Following the Mao era, Deng Xiaoping launched the “Reform and Opening” in 1978 to transform China away from a pure socialist regime to a nascent “market socialism” aiming to open China to the West in search of capital, technology, ideas, and institutions.
The first reforms were put in place to step by step break up the Mao-era mono-banking system. The Ministry of Finance created four nationwide state banks out of the PBOC: the Bank of China (BOC), the China Construction Bank (CCB), the Agricultural Bank of China (ABC), and the Industrial and Commercial Bank of China (ICBC). However, in the retrospect, these banks were unrelated to modern commercial banks. This is because they disbursed money not based on credit analysis or efficient capital allocation, but, based on the government plan, they loaned to state-owned companies, most of which were mostly inefficient and money-losing (Stent, 2016).
By the mid-1990s, China was transitioning rapidly from a planned economy to a hybrid market economy, but the banking system was not able to keep up with the development as the high amount of non-performing loans on the balance sheets limited their potential to fund entrepreneurial private companies. Furthermore, the banking system still operated as a fiscal agent of the government, as a bursar for the disbursement of government funds. Faced with this development Deputy Prime Minister Zhu Rongji who took on the additional post of Governor of the PBOC, China’s central bank, began with the creation of a modern banking sector in 1992 (Stent, 2016).
(1) Loans were still granted under a planned economy model; (2) The roles of the PBOC and the four state banks had not been clarified or clearly separated so that commercial banks were not real commercial banks, and (3) macro-economic management and market mechanisms had not been properly established so that the economy shifted back and forth from expansion to contraction (Kang, 2009).
To face these problems, Prime minister Zhu’s transformation strategy had three elements which we describe in the following paragraphs:
1) Clean up banks’ balance sheets by stripping bad loans off bank books and housing them in asset management companies, paying for the exercise with government-backed bonds
SOEs in twenty-two out of thirty-eight industrial sectors were losing money in 1996 and their continued operations were only sustained by a steady infusion of credit from the state banks, little of which could be paid back. This cycle led to the accumulation of bad debts on the books of the state banks. To counter this development reformats closed and divested SOEs that lay outside of core strategic industries, such as banking, oil, electricity, and defense. To facilitate the divestment, China 1999 set up asset management companies, for each of the four state banks. Each asset management company purchased non-performing loans from its related bank at face value, paid for by issuing ten-year bonds, to be carried as receivables on the asset side of the balance sheets of the four banks over the next ten years, with interest paid regularly and principal repaid in a single lump sum at the end of the ten years.
The bad loans had been swapped for receivables from asset management companies, which were supported but not guaranteed by the Ministry of Finance, which in Lardy’s point of view did not decrease the state banks’ burden. Since on average the recovery rate of the asset management firms on the bad loans was running around 20 per cent, and these bad loans were the only assets of the asset management companies, ergo the bonds of the asset management companies were carried on the balance sheets of the banks at inflated values. The Chinese asset management companies sold most of these assets to foreign companies that were interested in purchasing distressed assets (Weil, 2012).
2) Break the planned economy cultures of the banks by converting them into corporate entities
The SOE downsizing led SOE managers to prioritize positive cash flow, profitability, and servicing of loans to banks. This initial step in the corporatization of SOEs was followed by restructuring ownership of the SOEs for the core strategic industries.
Formerly, SOEs were owned by ministries and departments of the government, which exercised ownership rights through bureaucratic processes. It was recognized that to be effective, management needed to be embedded in a framework of corporate shareholder value, copied from the market economies of the West, but orchestrated by the state. The pressure of market forces and shareholder corporate structures are thus used by the state to implement dynamism into the SOEs. From the Party’s point of view, this approach permitted the state to retain control over industries at the “commanding heights of the economy” through the state becoming a value-seeking shareholder.
The listing of SOEs in securities exchanges yielded the mobilization of excess funds from the general public to support the growth of these SOEs through public share subscriptions. The creation of the “shareholder state” was completed when government-owned supervision agencies and financial holding companies had been created “to ‘personify’ shareholders and exercise shareholders’ rights” (Wenkui, 2005).
3) Recapitalize the banks and list them on international stock exchanges, forcing them to submit to market discipline
The objective of the State Council’s “Resolution on Financial Sector Reform” of December 1993 was to make it possible to radically transform the four state banks through corporatization, followed by listing on international securities exchanges. Through listing, the banks would be recapitalized with foreign funds, providing them with the international “seal of good housekeeping” that came with due diligence examinations by global investment banks underwriting the listings. A listing would also compel the four banks to become efficient and stable institutions capable of effectively providing financial intermediation to support the future growth of the real economy.
In addition to the plan of listing the Chinese Banks on foreign stock exchanges to use market forces as a transformant, China further professionalized its financial system and signaled its high commitment to international standards like the Basel Principles. The first Commercial Banking Law was passed in 1995. In 1996, China joined the Bank for International Settlements (BIS), and in 1997 committed to full compliance with bank supervision principles set forth by BIS’s affiliated organization, the Basel Committee on Banking Supervision. Taken together with accession to the World Trade Organization (WTO) in 2001, China’s commitment to the Basel Principles signaled that the Chinese banking system would move in the direction of global best practices. Within a few years, the state banks reported asset quality, profitability, and provisioning against loss which ranked them among the highest in the world, indicating the success of the program.
3.3 The Chinese Financial system today
Debt - Bank lending:
Legal developments facilitated an increasing flow of bank loans to small enterprises. Ambiguities in the 1995 Security Law made banks reluctant to accept movable assets as collateral. As a result, in the middle of the 2000s about two-thirds of all collateralized loans in China were secured with real property. Since private and family businesses typically own little real property, such as factories and warehouses, China’s legal regime worked against lending to private businesses. In 2007 the National People’s Congress passed the Property Rights Law, clarifying for the first time that movable assets, such as machinery and equipment could be used as collateral for bank loans. This law facilitated an increase in bank lending to small, mostly private, businesses.
Figures 1 and 2 taken to show that privately controlled firms’ access to credit substantially improved starting in 2010 (Society, 2011, 2012, 2013).
However, state firms were able to borrow on average on three times more favorable terms than private companies (Economist, 2012). Nevertheless, this changed in the past years. Interestingly, registered private industrial firms had more than twice the interest coverage of state-owned and state-controlled industrial companies in 2012. This divergence explains the increase in lending to the private sector illustrated in Figure 3 (China, 2013).
Debt - Bonds:
While bank lending to the private sector and household businesses has expanded and private firms appear to have substantial access to loans, corporate bond financing remained the almost exclusive domain of state-owned and state-controlled companies. This situation resulted partially due to the fact, that private sector companies were unfamiliar with this debt instrument, but in past years more and more private firms have conducted corporate bond financing rounds.
The principal obstacles to the development of a more sophisticated and dynamic bond market are the absence of a risk-free rate at which bonds can be priced. Large SOEs, issuing enterprise bonds, have in the past found it easier and no more expensive to simply take out loans from commercial banks instead of issuing bonds. SOEs may then find the bond markets more attractive as sources of funding, lowering their reliance on bank loans.
Equity - Stock market:
China has stock markets in Shanghai and Shenzhen, which began formal operations in 1991. This creation process included establishing listing quotas for ministries and provincial governments, which not favored state-owned companies within their respective jurisdictions favouring industrial sectors eligible for equity financing (Walter & Howie, 2003). By the mid-1990s the share of state firm listings amounts to three-quarters of all listed companies (Commerce, 2012). In 2000 the quota listing system was abolished, and securities firms began to play a larger role in identifying and developing listing candidates. As a result, the share of state companies declined steadily to less than half by 2010. The surge in private company listings also reflects the opening of the ChiNext Board in 2009. This board targets innovative, growth-oriented firms and, because of its lower capital requirement, accommodates smaller firms. From 2010 through 2013, private firms raised RMB660 billion through initial public offerings in the Shanghai and Shenzhen markets, compared with the state companies’ RMB166 billion (Gately, 2014). This outlines the strong importance of equity financing for private companies.
Equity - Private investments:
The state sought to expand the scope of businesses open to private firms by encouraging all financial institutions to raise the share of their loans to non-state enterprises and by decreasing legal barriers to entry. The State Council launched this initiative in 2005 with a directive that came to be known as the 36 Articles. It specifically called for encouraging private investment in many sectors previously reserved exclusively for state firms including electric power, telecommunications, railroads, civil aviation, and petroleum.
From 2012 through 2015 the pace of private investment slowed markedly, to only 1.3 times that of state investment, and in 2016 fell well below that of state investment. Several factors appear to underlie this change. First, by 2014 private firms already accounted for over three-quarters of investment in manufacturing. The service sector began to displace the industry as the major source of growth starting in 2013.
Recent reforms in the Chinese financial sector
The development of the CFS is progressing at a fast pace. A recent development to further increase the government’s control of the CFS, is the shift of bank credit away from the private sector in favor of state-owned firms, at least through 2016 (Lardy, 2019a). Nevertheless, a reason for this is the increasing demand of private sector companies for other fundraising channels which provide them with more capital like public equity markets as well as public and private debt markets.
China’s financial sector has also been undergoing an accelerating transformation towards further opening-up in line with the country’s plan. It now provides foreign financial institutions with improved operational accessibility thanks to financial reforms carried out by the Chinese government in recent years. As planned and committed, the Chinese government rolled out a series of policies in 2019 to reform the financial sector on the full scale (Cheng, 2019b).
These reforms include removing the requirement of asset level to set up entities in China, removing approval procedures for foreign banks to conduct RMB business, and lowering RMB time deposit limits taken by foreign banks’ domestic branches. The removal of foreign ownership caps was realized in banks and financial assets management in May 2018 (Cheng, 2019a).
Other reforms in the equity and bond market reflect the improvement made by China’s financial sector opening-up. Following the expansion of the daily trading quota of the Mainland-Hong Kong Stock Connect in May 2018, the Shanghai-London Stock Connect was launched in June 2019, enabling companies and investors on each side to trade on the other’s market.