Past and Present Financial Reforms in China - Essay Example

China’s Past and Present Financial Reform Due to China’s historical development and size, its reform dynamics so far has been one of a kind. Massive changes in the Chinese economy began much earlier than the transformation of comparable economic structures of the Baltic States and Eastern Europe (Mehran 3). China’s financial reforms have been slow, and its beginnings were quite unique from that of other large economies that tried to change their systems. To a certain extent, China’s financial reforms were more similar to the transformation of several East Asian economies than those of numerous previously centrally planned economies. Deng Xiaoping, at the Third Plenum of the 11th Party Congress of the Chinese Communist Party (CCP) in 1978, criticized the Cultural Revolution and insisted that CCP should prioritize economic growth (Hess 22). This incident is widely recognized as the beginning of China’s financial reform period and undeniable economic wonder, as an outcome of which China became the second biggest and most vigorous economy in the world. This paper discusses the evolution of China’s financial reform. The Development of China’s Financial System In 1978, Deng Xiaoping and his peers from the Party’s Central Committee gathered in Beijing and agreed that financial reform was the only solution to the political and economic problems confronting China (Tam 83). China, during that time, was an impoverished, strictly regulated agrarian economy on the brink of failure. The initial period of financial reforms was characterized by a marked growth of financial institutions. From 1978 to 1988, leading banks, including the central bank, were founded, as well as numerous financial agencies, credit cooperatives, and trust and investment firms at municipal, provincial, and central level (Zhu 1505). In 1983, two highly significant events occurred: first, the People’s Bank of China (PBoC) took on the functions of a central bank; and, second, PBoC’s commercial banking operations were divided into four state-owned, autonomous banks, popularly called the ‘Big Four’— the People’s Construction Bank of China, the Agricultural Bank of China, the Bank of China, and the recently established Industrial and Commercial Bank of China (Hess 25). Institution building began in the initial reform period with the formation of a two-level banking structure. In 1995, central banking experienced a new push when a new policy on the PBoC was implemented that provided the central bank the legal structure to function under the headship of the State Council in a market-driven setting (Riedel and Jin 79). At the same time, with the continuing transition of the PBoC into a legitimate central bank, the instrument structure for financial policy has developed. The PBoC has launched financial policy instruments since the 1980s, like the lending and reserve requirements for the commercial banks, to strengthen its financial policy measures, which were still directed by the credit system. Although the credit system remained the primary financial policy instrument, its efficiency has been declining since the latter part of the 1980s (Chen 304). A fundamental weakness of the institution-building process became noticeable in the 1980s. The banks were structured at the same time as the government and Party administration, with the local Party groups hiring the branch managers. The inclination of local governments toward development and fast access to resources resulted in a swift inflation and credit expansion (Shih 1240). Such institutional defect has remained until now as the local officials’ incentive system is still largely interested in quantitative development. Inflation is currently not much of an issue, yet environmental sustainability of development and social inclusion are a problem, as an outcome of lopsided incentives (Mehran 5). The extensive inflation from 1987 to 1988, alongside absence of leadership capability and corruption, were indeed the major causes of the historical Tian’anmen incidents of 1989. The profound inflation anxiety of Chinese officials felt until today can simply be explained against the circumstances of this era, which almost disappeared in the breakdown of the CCP (Chen 322). Soon after, at the climax of the 1990 share frenzy, the agreement to launch formal stock exchanges took place, in part to monitor and restrain roots of social disorder but also the enhance the productivity of state-owned enterprises (SOEs). Consequently, the Shenzhen and Shanghai stock exchanges began operating in the early 1990s (Chen 322-4). Direct lending of the central bank to the government was terminated in 1994, and arrangements for the implementation of an indirect monetary policy system were initiated. These measures have marked the beginning of the termination of the credit system, in accordance to the plan to launch a market economy. Since 1984, newly established banks were allowed to function together with the state-owned specialized banks, which simultaneously were officially permitted to expand their operations (Riedel and Jin 175). In the latter part of the 1980s, a thriving web of nonbank financial institutions (NBFIs) developed (Leng 98). Thereafter, a dual-track banking structure has been operating, while new banks gain greater autonomy in their functions, and four specialized banks are operated to put into effect the financial strategies of the government as specified in the credit plan. The formation of three policy lending banks and the implementation of the commercial bank law in 1994 and 1995 respectively are intended to make the transition of the four state-owned specialized banks into commercial banks possible (Chen 336). The growth of financial instruments has focused on the slow but important growth of capital markets in China. In 1981, capital markets started to grow when the Chinese government continued issuing government securities. Immediately afterward, other kinds of bonds, alongside enterprise shares, emerged, although their release was rigidly monitored and regulated by officials. Secondary markets in stocks and bonds have been permitted to function since the later 1980s, and their operations have contributed to the growth of capital markets (Zhu 1515). The Shenzhen and Shanghai stock exchanges have become the backers of the thriving capital market operations of China (Walter and Howie 89). Since the late 1970s, advancements in market liberalization and development, which were the third pillar of financial reform, have continued to linger behind the institution-building program (Zhu 1517). Although the four state-owned specialized banks are supposedly allowed to operate outside their established area of expertise, their insufficient capability, the persistent control of the credit plan, and the restricted freedom of the customers to decide on their banking activities have hindered the capacity of these banks to function effectively; the initial efforts to liberalize the local financial sector were begun from 1986 to 1988, immediately after the PBoC was transformed into a central bank (Tam 105). Adherence to credit quotas was loosened, and banks were permitted to dictate lending rates at will within pre-stated margins above the determined rates. Nevertheless, inflationary trends from 1987 to 1988 temporarily stopped these liberalization attempts. Since the 1990s, NBFIs and banks have again been awarded the liberty to determine lending rates within pre-stated margins (Rovekamp and Hilpert 25). The lack of nationally structured capital markets, which is a noticeable aspect of the financial sector of China in the 1990s, is linked to the governmental characteristic of the process of establishing interest rates and the absence of a modernized payments and settlement system. This absence of nationally consolidated interbank and capital market has, consequently, impeded the shift to indirect monetary policy instruments (Shih 1244). Market growth has perhaps advanced the most in the external arena. The creation of the swap centers in the late 1980s signaled the formation of a crude foreign exchange market in China. Up to the early 1990s, this market’s revenue, administered by the swap centers under the management of the State Administration for Exchange Control (SAEC), progressed gradually (Mehran 8). A new stage began in 1993 when the officials made a decision to consolidate the exchange rates implemented in the various swap centers and, thus, to build a single national foreign exchange market. Such consolidation was reached in 1994. Simultaneously, the swap rate and the official rate were consolidated (Walter and Howie 94). In view of these past reforms, the financial reform program for the coming years will definitely have to place emphasis on greater competitiveness of the banking system, growth of the money market, and higher flexibility in interest rates (Zhu 1510). Changes in these sectors, which will jointly boost each other, will facilitate a more organized fund allocation in the economy and bring about a more productive use of the existing instruments of indirect monetary policy and the launching of open market activities as the primary indirect monetary policy instrument of the PBoC (Hess 26). Zhou Xiaochuan—PBoC’s governor since 2002, head of the Chinese securities regulator from 2000 to 2002, and President of China Construction Bank from 1998 to 2000—alongside Zhu Rongji, the fifth Premier of the PRC from 1998 to 2003, created and executed a wide-ranging reform agenda, which started in 1998 with a central bank restructuring intended to boost its regulatory performance and limit the involvement of provincial Party heads in lending assessments by establishing nine regional branches in place of provincial PBoC offices (Hess 26-27). An important incident was the downfall of the Guangdong International Trust & Investment Corporation (GITIC) in 1999, which is, thus far, the only official failure of a leading financial institution in China. It massively affected the global financial sector and put trust in China at risk (Leng 143). Hearsays that Chinese banks were officially busted spread rapidly, and in 1999 Zhu had to respond to these speculations in a definite and remarkably straightforward manner (Rovekamp and Hilpert 27): I think that those creditor banks and certain financial institutions are too pessimistic in their view on this, i.e. that a financial crisis has broken out in China, that it cannot meet its payment obligations and acts in bad faith. The Chinese economy continues to grow rapidly; we have 145 billion USD in foreign exchange reserves now; our balance of payments is balanced. We are completely able to repay our debt, but the question is whether this kind of debt should be repaid by the government or not? Zhu dealt with the problem of moral risk—the widespread idea that Beijing would shoulder the costs—quite strongly and instructed the termination of a huge number of urban credit cooperatives and trust companies all over China. However, the most significant outcome of the GITIC misfortune was that Zhu instructed a quick refinancing of the Big Four and ordered their reform (Rovekamp and Hilpert 27). Patterned after the United States’ Resolution Trust Corporation, Asset Management Companies (AMCs) were created for every bank, which managed their non-performing loans. Bank reform ended in the global entry of the Big Four. Other major reform programs involved the establishment of a national social security fund, the creation and launching of China’s bond and stock markets, and the accession of China to the World Trade Organization (WTO) (Hess 27-28). Helmut Schmidt (2006 as cited in Rovekamp and Hilpert 28) has emphasized the crucial need of Zhu for China to accede to the WTO so as to sustain the great force for his local reforms. Other scholars identify the same reasoning existing today; for instance, Prasad and Ye (2013 as cited in Rovekamp and Hilpert 28) proposed that the purpose of choosing the Renminbi (RMB) as the global currency could be utilized as facilitator for a “broad agenda of domestic policy reforms” (Rovekamp and Hilpert 28). As an outcome of the incomplete reforms of the Zhu administration, the present financial structure of China is typified by several major characteristics. First, it is a bank-oriented structure with the bulk of corporate and household funds stashed in major banks and almost the entire financial risk lumped up on their balance sheets. In comparison to other developed economies and developing markets, the bank lending sector’s sizeable share in China is striking (Zhu 1518). Second, as the state fully owns almost all banks or carries high stakes in them, the financial sector of China is also largely owned by the state (Shih 1248). Third, China’s capital markets are weak. Bond markets are ruled by central bank bills, which the state-owned banks are obliged to purchase, and government bonds. Consequently, most bonds are controlled continuously by banks, and significantly low trading exists (Hess 30). Fourth, similar to the entire economy the financial sector is governed by Party-led special interest groups or the CPP, the stakes of which have to be evaluated in a continuous bargaining procedure. Fifth, interest rates in formal institutions are established governmentally to guarantee the productivity of the banking sector and regulate the distribution of financial assets (Hess 30). Sixth, there is a developing shadow banking industry, which comprises underground lending, leasing operations, trust products, entrusted loans, bank acceptance bills, and micro loans and is approximated to total 30 trillion RMB by the conclusion of 2012 (Hess 31). Specifically, financial security is threatened by the trust industry, like moral risks, surges in off-balance sheet exposures, liquidity and credit hazards. Officials were informed of these threats and began in 2012 to implement steps to regulate the shadow financial sector. Lastly, excluding the shadow banking industry, the financial sector is not market-oriented and does not take into consideration risk and market valuing of capital (Rovekamp and Hilpert 29-30). Besides regulating the interest rates, officials establish trimestral quota on the overall worth of loans for banks owned by the state and offer ‘window guidance’, which quantities they must lend to which industries (Rovekamp and Hilpert 30). In 2007, the CEO of the Shenzhen Development Bank, Frank Newman, made a declaration to explain this (Hess 31): There’s also a complication right now because macroeconomic policy is to not have lending grow too fast. If we wanted to grow at 30% a year in our lending, I don’t think the People’s Bank of China would let us at the moment no matter how much capital we had because it is trying to control the rate of growth in the country. As stated Walter and Howie (2012: 112), the absence of the market dynamics arising from the extensive power of the Party over state-owned enterprises and banks and the capital distribution by governmental order rather than by market processes is perhaps the major issue in China’s financial sector vis-à-vis global standards. Discussion and Conclusions Past financial reforms in China have shown a unique form of being highly effective in creating a wide-ranging structure and expanding transaction size but incapable of enhancing corporate governance and liberalizing market processes. The financial sector of China is now similar to the contemporary financial system in developed countries. Quantitative indicators reveal the remarkably huge financial resources of China (Zhu 1520). Nevertheless, China is still falling behind in liberalizing major financial market prices, particularly exchange and interest rates. Almost all commercial banks still resemble state-owned enterprises rather than listed companies (Zhu 1520-21). Such distinctive trend of financial reform is strongly associated with the general asymmetric liberalization strategy implemented by the government. Although majority of the goods have been totally freed up, factor markets are still greatly malformed. Such malformations seem to diminish the corporate arena while burdening households (Shih 1253). Such asymmetric strategy explains the unique economic approach of China with both severe structural inequities and extraordinary growth outcomes. Authoritarian financial strategies, like regulation of capital movement, credit allocation, exchange rate, and interest rate, are major types of factor market malformations. The level of financial suppression in China at present is not merely greater than global standards but is also greater than normal for developing economies (Chen 337). Astonishingly, these policy malformations in the financial sector did not stop drastic and fast-paced economic development. Indeed, previous studies verify that financial suppression in fact contributed to economic progress; at least in the past reform periods (Walter and Howie 92). These circumstances demonstrate that the officials have no other options but to fully accomplish the shift to a market structure in the financial arena. Works Cited Chen, An. “The 1994 Tax Reform and Its Impact on China’s Rural Fiscal Structure.” Modern China 34.3 (2008): 303-343. Print. 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