“China’s Financial System: Growth and Risk,” (with Franklin Allen and Jun QJ Qian), Foundations and Trends in Finance, forthcoming.
One of the enduring puzzles surrounding China's rapid economic growth during the recent decades is how it was achieved with an underdeveloped financial system. Despite more than 30 years of successful reforms, the development of the financial sector is still lagging. Based on a large number of previous studies of financial systems, the relationship between the structure of financial systems and economic growth in the real economy differs significantly across countries. In this essay we first give a brief review on the finance-growth nexus. After that, we provide an updated and comprehensive review of China’s financial system and compare it with financial systems in other countries. We discuss what has worked and what has not within the markets and intermediaries in China, and further consider the effects of the recent development of China's financial system on the real economy. We also examine a non-standard financial sector, which operates beyond the markets and banking sectors and consists of alternative financing channels, governance mechanisms, and institutions.Finally, we provide prospects for future research on several unresolved issues, including how China’s financial system can integrate into the world’s markets and economy without being interrupted by damaging financial crises.There is no doubt that China's financial system has experienced dramatic development in recent years and the economic growth rate remains high relative to other countries after the global financial crisis.
We draw four main conclusions about China’s financial system and its future development. First, compared with other developed and emerging economies, China's financial system has been dominated by a large banking system. Although in recent years, the banking system saw the entrance and growth of many domestic and foreign banks and financial institutions, the whole banking system is still dominated by the five largest state-owned banks. All of the "Big Five" banks have already been publicly listed in recent years, with the government still being the largest shareholder and remaining in control. This ownership structure has served these banks well in terms of avoiding major problems encountered by major financial institutions in developed countries that were at the center of the 2007-2009 global financial crisis.Moreover, the level of non-performing loans (NPLs) over GDP was steadily decreasing after reaching its peak during 2000- 2001 but it is increasing again after the 2008 global financial crisis.This rise is due to the large number of investment projects in infrastructure that were undertaken in order to boost the economy after the crisis, making the high NPL ratio one of the main risks in the banking system again. Given the uncertainties of the global economy and the ongoing financial reforms and economic structural reforms in China, the country's financial development and economic growth may meet challenges in the near future.
Our second conclusion concerns China’s financial markets. In recent years, both China's stock market and bond market have witnessed significant development.However, their current scale and importance are not comparable to those of the banking sector and they may not be effective in allocating resources in the economy, because they remain speculative and driven by insider trading in the equity market. Nevertheless, markets are likely to play an increasingly significant role in the economy, based on the direction of the ongoing reforms in the financial sector. We discuss several issues and potential problems related to increasing the size and scope and improving the efficiency of the stock and other financial markets.
Third, the alternative financial sector has played an important role in satisfying the financing demand and maintaining the high growth rate in the real economy. In an earlier paper, Allen, Qian and Qian (2005, AQQ hereafter) argue that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is not the banking sector or financial markets, but rather a sector of alternative financing channels, such as informal financial intermediaries, internal financing and trade credits, and coalitions of various forms among firms, investors, and local governments.In recent times this sector is often referred to as the “shadow banking system.”This financial sector has supported the growth of a “Hybrid Sector” with various types of ownership structures.Our definition of the Hybrid Sector includes all non-state, non-listed firms, including privately or individually owned firms, and firms that are partially owned by local governments (e.g., Township Village Enterprises or TVEs).
Finally, a significant challenge for China’s financial system is to avoid damaging financial crises that can severely disrupt economic stability.These crises include traditional financial crises: a banking sector crisis stemming from an accumulation of NPLs and a sudden drop in banks’ profits; or a crisis/crash resulting from speculative asset bubbles in the real estate market or stock market.There are also other types of financial crises, such as a “twin crisis” (simultaneous foreign exchange and banking/stock market crises) that struck many Asian economies in the late 1990s.Since its entrance to the World Trade Organization (WTO) in 2001, the integration of China’s financial system and overall economy with the rest of the world has significantly sped up, but on the other hand, large scale and sudden capital flows and foreign speculation increase the likelihood of a twin crisis.Given the rapid growth in China's foreign exchange reserves, there has been a large amount of speculative, “hot” money flowing into China in anticipation of a continuing appreciation of the RMB, China’s currency, relative to all other major currencies, especially the US dollar. Depending on how the government and the central bank handle the process of opening up the capital account, there could be a classic currency crisis as the government and central bank try to defend the partial currency peg, which in turn may trigger a banking crisis if there are large withdrawals from banks.
