Ranga Wimalasuriya 06/06/2012REFORMING CHINA’S FINANCIAL SYSTEM: SUSTAINING PRIVATE SECTOR GROWTH Introduction The Chinese economy has been growing exponentially for over two decades with growthrates averaging 10% since the Asian Financial Crisis of 1997. In the process, the economy hasflirted with deflation (1998-99, 02-03, 08-09), high levels of inflation (2007-08, 2010-11),negative real interest rates (2008-9) and low lending rates averaging 5-6% (2010-11). Thenegative real interest rates signify negative real rates of return on savings for depositors and themajority of households that are responsible for a major share of China’s capital account. Fig.1 China’s GDP growth Fig .2 Interest Rates China’s transition from a centrally planned to a market based economy has broughtabout significant changes. However, there is a common perception that the hierarchy of China’sfinancial system has not aided this change and that deep structural problems are prevalentwithin the system. Mckinsey Global Institute stated that the access to credit for individuals andSMEs in China is far below other developing countries (Mckinsey Global Institute 2009,25).Some academics have further concurred that “China lacks [the] infrastructure of modern
Ranga Wimalasuriya 06/06/2012consumer finance, and is years or possibly decades-away from building it to the standards ofthe developed world” (WSJ, 2011). The existing financial institutions, however, fail to efficiently allocate domestic capital tothe private sector (Small and Medium Enterprises) is an issue which curtailed private sectordevelopment according to existing literature. Access to finance plays an important role inprivate sector development. The ability to start, expand and innovate for SMEs depends onfinance sector support. SME financing may be affected by a range of factors. These include theactions of the banking sector which likely to be more inclined to fund State-owned Enterprises,the size of the SMEs and stage of its growth which may have implications on its ability toobtain financing and a lack of collateral SMEs offer for financing. Small enterprises- those firms that employ fewer than 300 people, earn less than 30million yuan and have assets less than 40 million yuan and Medium enterprises- those firms thatemploy 300 to 2,000 people, have annual sales of 30 to 300 million yuan and own assets worth40 to 400 million yuan, in spite of financial constraints, SMEs are a significant component ofChina’s economy. They have shown exponential growth in the last decade with over fourhundred thousand SMEs operating today ( NSB, Fig 3.). The SME sector produces 68 percentof China’s exports, over 50% of China’s Gross Domestic Product and 80% of Chinas urbanemployment ( Zhu, Wittmann, Peng, 2011). SMEs, therefore, are central for the growth anddevelopment of a country as they expand as large corporations.
Ranga Wimalasuriya 06/06/2012 Fig.3 Source: National Statistics Bureau A study done by Standard Chartered Bank found on average, that the SME sectoraccounted for 16 percent of GDP in low-income countries, 30 percent in middle-incomecountries and 51 percent in high- income countries; suggesting that SMEs increase inimportance as an economy develops. A report from the Chinese Technology Innovation Beijingcenter (CTIBJ) suggested that 68% of SMEs would close down in their first five years inoperation, 13% will exceed 10 years of operation (CTIBJ,2008) and 19% of SMEs faced withbankruptcy in 2011 with 70% of SMEs facing financial constraints (British Embassy Beijing,2011). This paper attempts to analyze the growth of SMEs over the last decade and track theflow of capital and sources of capital into the private sector despite claims of capital constraints
Ranga Wimalasuriya 06/06/2012in some source of existing literature. The paper will then draw on a comparative assessment ofthe China’s financial system and India’s financial system and identify how each system hasaddressed the issue of capital constraints in the private sector.Literature ReviewAn Overview: China’s Financial System Fig .4 China’s Financial Institutions Source: China Statistical Year Book China’s financial system is comprised of a state dominant banking sector and weakcapital markets. The banking system has evolved rapidly since the 1990s. In 1979, the systemwas solely represented by the People’s Bank of China (PBOC) which acted both as the centralbank and was further responsible for deposits and loans (Linton, IMF). Presently, the banking
Ranga Wimalasuriya 06/06/2012system consists of the “Big Four” state owned commercial banks (SOCBs), policy lendingbanks, joint stock commercial banks, city banks, rural and urban credit cooperative (RCCs) andforeign banks (Fig 3). The big four and the joint stock commercial banks (JSCBs) remain thedominant players and principle lenders to SOEs and are subjugated by government shareholdersand management. All major banks along with the City Commercial banks (CCB) and the RuralCommercial Banks (RCB) have been converted into corporate entities subjected to a board ofdirectors and supervisors (Herd, Pigott and Hill). JSCBs, according to Naughton (2007), aremore efficient and hold considerably lower amounts of nonperforming loans (NPLs) and theyhave captured 15% of the total banking-system assets as of 2008. However, their effectivenessis constrained due to a lack of independence and experienced officials. Former governmentofficials still operate within senior management acting as a hindrance for efficient banking(HPH). The policy banks were established to fund the central or local governments forinfrastructures and development projects and lend to SOEs and account for 8% of total assets asof 2003. RCCs, once banking profitable TVEs in the countryside, fell out of favor following theAsian Financial Crisis. Since 2006, the government has pumped capital into RCCs as a part ofthe urban financial bailout (Naughton). Foreign banks, however, play a minute roll in China’scapital markets even though the government gave access to start-up “private banks in “20localities”. (Naughton, Linton). The big four account for 53.5 percent of the total assets of financial institutions(excluding the people’s bank of China) as of 2004 with joint stock and city commercial bankswhich claim 20.7 percent, RCCs claiming 8.9 percent of the assets and Policy Banks with 7.7(Naughton). Showcasing that 90.8 percent of all assets are controlled or under the watch of thecentral government with 9.2 percent belonging to foreign and private banks (fig.5).
Ranga Wimalasuriya 06/06/2012Fig 5. China’s major banking institutions, no of institutions, share of total Assets & share of total Loans, Dec, 2005 Linton claims it is this lack of independence in China’s banking system that has resultedin the banks focusing on financing needs of the government, SOEs and construction firms overthe last decade. Allen, Qian and Qian(2004), compare the financial systems of a sample ofcountries (English origin, French origin, German origin and Scandinavian origin) to that ofChina. They find that the ratio of total bank credit to GDP is 1.13, higher than German-origincountries which are known to have heavy bank-dominated financial systems. However, whenthey consider bank credit issued only to the private sector (individually owned or publicallytraded companies) China’s ratio drops from 1.13 to 0.242 (Fig.6) reflecting the flow of capitalto the public sector (state-owned companies). The second panel of Fig.6 compares the relativeimportance of financial markets against banks. “Structure activity” and “Structure size” arerelative size measures which are equal to Log (market size/ bank size), with a smaller valueindicating that the country’s financial markets are small than its banking system; China has thelowest score suggesting that its banking system is larger than its markets. A World Bank
Ranga Wimalasuriya 06/06/2012quarterly report cited that the recent most stimulus money is directed to benefit SOEs. This ispartly due to the method in which state ownership is distributed in the economy. Most SOEsclaim to have close relationships with the government and banks. SOEs have benefited from thestimulus injected (The Economist, world bank.org).Fig .6 Fig.7 Source: Wall Street Journal While China’s banking system is dominant, its stock and bond markets remainunderdeveloped. They are smaller than most countries in terms of market capitalization andtotal value traded as a percentage of GDP (AKM) and total equity market capitalization isequivalent to 17 percent of GDP when compared to the average of 60 percent in other emergingmarkets (Farrell et al. 2006). The equity markets are largely controlled by the government and act as a platform toraise capital for SOEs that require privatization. Listed companies and IPOs on the stock marketare former SOEs that are affiliated to government officials. The bond market lacks confidence
Ranga Wimalasuriya 06/06/2012due to a deficit of institutional investors or a reputed credit agency that offers the investorconfidence to buy in. Large companies, therefore, “prefer borrowing from banks rather thanissuing bonds”. Such actions could crowd out the ability for Small and Medium enterprises toborrow (AKM).SMEs Mu (2002) cites that post-Asian Financial Crisis events left the banking sector with asignifcant number of NPLs which average 30 percent of assets. He claims that this situationarose because loans were given out based on preferential treatment to inefficient SOEs and arefurther supported by unpaid principal and interest and below- market interest rates. Lendingrates to SMEs were additionally set artificially low which led to rates not being attractiveenough to encourage banks to lend out to SMEs, particularly when banks had high NPLs. Thisissue was addressed by the establishment of credit guarantee schemes (CGS) which Mu claimswere helpful in promoting SME’s access to finance since they provide acceptable collaterals andassist in the mitigation of the poor credit analysis SMEs will otherwise face. However, CGSface much interference from local governments making it unable to operate in “accordance withmarket principles”. Zhao et al (2006) using a dataset from the Chengdu SME Administration (CDSMEAB)from 2003 to 2004 identified some main factors affecting SME’s access to capital as the lack ofeligible collateral for loans or guarantees, low credit ratings or a lack of credit reporting systemfor SME, firm sizes (economies of scales)- the banks prefer to lend out to larger-sized SMEs-and political risks faced by bank staff in case of failure to repay loans.
Ranga Wimalasuriya 06/06/2012 Prasad (2007) suggests that the banking system should be made more robust and drivenby market principles but he does not specify how his ideas maybe integrated. According to him,the financial system should be broadened to create alternate sources of funding and investmentopportunities for individuals and SMEs. Wang (2004) identifies the scarcity of capital, the lack of specialized financial institutionsto serve SME reform, lack of direct financing channels and the monopoly of state owned banksas reasons for capital constraints in the private sector. As solutions, he suggests that “Chinashould increase the overall volume and credit proportion for SMEs”, especially bank credit,develop small and medium financial institutions and reform RCCs so they can be independentand adopt a flexible interest rate system. Wang’s countermeasures are explained in detail;however, he has not cited examples of how effectives his proposed measures will be and it isunclear whether such policy actions will be effective if China should implement them. On the contrary, Lardy claims that the access to capital especially with regard tohouseholds and the private sector has risen dramatically. In his structure of householdborrowing from banks, the total loans outstanding to households stood at RMB.11, 258.6Billion (PBOC), 225 times higher than what it was in 1997. He claims that a majority of thehousehold loans extended were for business borrowing- 33.3 percent; bank loans to householdsstood at 28 percent of GDP more than 45 times the share at the end of 1997. This significantimprovement in capital allocation will help family businesses expand and householdconsumption increase. Lardy further states that “China is an outlier on the high side in terms ofconsumer credit availability” in comparison to emerging markets. Although his account ofcapital access to households is comprehensive and positive, he hardly analyzes this from anSME perspective. He does not explicitly breakdown household business borrowing and we do
Ranga Wimalasuriya 06/06/2012not get an account of what kinds of businesses these household seem to run. He also fails toanalyze other sources of financing such as FDI and the informal loans market that the privatesector seems to rely on. In addition to the question of capital constraints, existing literature has cited domesticSMEs could also be facing a problem of consumption (WSJ 2012). This being the case, SMEsthat are not export oriented will face many difficulties operating due to lack of demand fromdomestic customers, driving them out of business. China needs to reallocate capital towardsproducing goods and services that Chinese consumers want to consume and this will requirebanking changes, especially improving access to capital for SMEs that “make the modernconsumption-driven economy tick”. The aim of this paper is to identify the characteristics of capital allocation to the privatesector, specifically SMEs in China. It will attempt to track the flow of capital from its origin(e.g. households) to China’s financial system and other financial institutions that act asintermediaries for capital allocation to SMEs; and analyze both direct and indirect sources offinancing that have helped firms grow exponentially over the last decade a gap that is present incurrent literature related to the topic.The paper will then evaluate four important reforms thatstandout from the existing literature: less government control over the financial system“breaking up the monopoly”, liberalizing interest rates, regulating the informal loans market anda credit rating system.
Ranga Wimalasuriya 06/06/2012Characteristics of Chinese Capital: Formal FinancingFig .8 A major source of capital for formal financing arise from household savings, enterprisessavings and government savings. Fig.8 Shows the gross domestic savings in China has increasedsince 2000 and comprises more than 50 percent of Gross Domestic Product. Household savingson aggregate has risen by 6 percentage points over the last 10 years (Prasad and Chan). Chinesehousehold’s savings rate has continued to increase over the last decade and this is despite anegative real return rate from the banks. According to Prasad and Chan, this unstoppableincrease in savings or the target savings by households is due to declining public provisions suchas health and education; other factors include the presence of a target savings rate due to China’stransition to a market economy. A high savings rate such as that depicted by the Chineseeconomy may not be beneficial for domestic SMEs that depend on local demand andconsumption for their operations. If the trend continues, China’s economic expansion will slowdown and China’s attempts to adopt a consumer driven model by moving away from an exportsor investments driven model will suffer.
Ranga Wimalasuriya 06/06/2012Capital Allocation CycleFig.9 • Household Savings Government Bonds • Enterprise Savings Corporate Bonds Stocks • Government Savings 6.4% 6% 9.5% 78% Banks & share of Total Loans- formal market • The BIG Four 50.5% • Joint Stock Commercial banks 15.4 % • City Commercial Banks 5.2% • Urban Credit Cooperatives .5% • Rural Credit Cooperatives 8.9% • Policy Banks 15.4% • Foreign Banks 1.6% Shadow banking / informal loans market Central Government • 30% of all loans made out Individuals, SMEs SOEs householdsSource: China Statistical YearbookFig. 8 and 9 depicts how dependent formal market financing is on the savings of the Chinesepublic. Fig.9 shows the big picture of capital allocation within the Chinese economy. The highhousehold savings rate contributes a major share of the overall capital allocation within the restof the Chinese economy. Household savings, enterprise savings and government savings madeup 78% of the total formal market loans made out in 2005. Government bonds, corporate bondsand stocks made up the remaining 22% highlighting China’s weak capital markets. The big fourbanks are responsible for over 50 % of the total loans made out with foreign banks holding just1.6%. Clearly, this divide seems to favor SOE funding given the authority the big four hold overthe rest of the financial system. Shadow banking and the informal loans market hold 30% of all the loans made out and istherefore an important segment of China’s private sector financing. AKK using a data set of
Ranga Wimalasuriya 06/06/2012twenty four hundred firms found that 43% of firms in China used alternative forms of financecompared to an average of 9% in emerging markets and Allen, Qian and Qian claimed that thefastest growing Chinese firms used alternative channels of finance rather than formal financing.Fig 3 compliments these findings with the growth shown by both small and medium enterprisesover the last decade despite poor access to formal finance. The following sections will analyze the sources of financing and analyze both direct andindirect sources of financing that have helped firms grow exponentially over the last decade andthe methodology will present how I went about conducting my research.Methodology The aim of this paper is to identify the characteristics of capital allocation to the privatesector, specifically SMEs in China. There are different sources of funding that domestic firms usefor daily operations or expansion. In the formal market, retained earnings is the cheapest source ofcapital and can be implemented without any external constraints, domestic loans from a bank isthe second cheapest source of capital and fundraising through bonds/stock market is relativelymore expensive source as equity is costlier than debt. Funding can be categorized into two types-Informal and Formal financing. Formal financing includes bank financing through localcommercial banks and foreign commercial banks, state budget and debt financing throughChina’s capital markets. Informal financing refers to “internal finance”- retained earnings, loansfrom a family or friend and financing from an underground bank. I will use data drawn from the China statistical year book from 2000-2010, a data setobtained from Dr.David Hall and the investment climate survey conducted by the world bank in2006 for my analysis. Part 1 explores the macro level climate of credit allocation to the private
Ranga Wimalasuriya 06/06/2012sector in China. Part 2 will attempt to identify the various channels of financing (both informaland formal ) and the share of each channel regarding firms. Part 3 analyzes total investment infixed assets across firms; this will enable us to distinguish the types of firms that have expandedover the last four years relative to the type of financing and part 4 analyzes capital allocation on aregional and categorical level.Analysis part 1 Domestic Credit extended to the Private sector as a % of GDP Figure 1 depicts the domesticcredit extended to the private sector inthe form of formal loans as a % of GDP.The graph gives us a general idea ofhow strict capital allocation is withinthe private sector with relation topublic vs. private credit allocation. Thisgraph also accounts for housing loansas a part of private sector investment. Source: The World Bank . Fig 1.The data does not give a break down of how this credit is distributed within the private sector ona firm level( small, medium and large enterprise), industrial level or a regional level. Thehorizontally connected lines compare China to the United States, Spain, Germany and India. Theannual World Development Indicators (World Bank, 2004b) in 2002 summarized domesticcredit provided by the banking sector in middle-income countries to be 83 percent of GDP, 49percent of GDP for low-income countries and 168 percent of GDP for high income countries.
Ranga Wimalasuriya 06/06/2012Ignoring the variables not addressed in the data, China and Germany seem to be on par at 150and 130 percent of GDP respectively with the United States and Spain close to 230 percent andIndia below 100 percent of GDP. The level of domestic credit extended to the private sector forChina being on par with Germany is an encouraging prospect ignoring the variables notaddressed by the data.Analysis Part 2 In Figure 2. the horizontally connected lines represent how each source of funding isdistributed amongst China’s firms with regard to investment in fixed assets. There are foursources of funding for investment in terms of fixed assets in China: State Budget, Domestic Loans,Foreign Investment (FI) and Self fundraising; the sources of funding can differ from country tocountry. The State budget was a significant source of financing in the early 90’s with SOEsheavily dependent on the State budget for operations and the Chinese economy following acentrally planned system. As of 2009 the state budget accounted for only 5.1 percent of the totaland this maybe due to a result of the Chinese government refocusing spending on education,healthcare and military defense. Foreign investment refers to foreign funds acting as a source fordomestic firms to invest in fixed assets and is not a measure of foreign investment in ownershipform. Foreign investment sources has reduced to 1.8 percent as of 2009. The two prominentsources of funding are self-fundraising and domestic loans. Domestic loans in aggregate occupy 15 percent of the total financing and constitutes 30percent of financing in large companies (Fig.5). Domestic loans since 2000 have grown at aCAGR of 19.21%. Self-fundraising comprises of retained earnings, informal loans, funds raisedfrom local communities ( family and friends) and local governments. Self-fundraising is the
Ranga Wimalasuriya 06/06/2012 largest source of financing accounts for 77 percent of the total. Self-fundraising is an important source of financing for many types of firms and it involves both individually owned companies (private sector) and interestingly state or quasi-state-owned companies as well. An interesting observation of the data is the downward trajectory of the state budget as a source of funding; this may have led to increased self-fundraising and might lead to increased foreign investment in the future. Source: China Statistical Year Book, Fig.2Analysis part 3Given we have an understanding of the sources of funding within China’s financial system frompart 2 it will be worthwhile to analyze the categories of firms affected by these sources. Thefollowing figure illustrates the distribution of fixed asset investment in China across firms. Fixedassets are long-term tangible pieces of property like buildings, real estate, equipment andmachinery that a firm may use in the production of its income. An account of fixed assetinvestment across firms will help distinguish the firms that have expanded over the last four years.
Ranga Wimalasuriya 06/06/2012The blue bars represent the total investment value in 100 million Yuan and the horizontallyconnected lines show the different categories of firms. SOEs and LLCs seem to have invested themost over the last 5- years with a CAGR of 19.95% for SOEs. The share of investment for privateenterprises has increased whilst the share for individuals have declined. Foreign firms with fundsmostly from Hong Kong, Macau and Taiwan account for about 7% of the total. The large share of fixed asset investment by SOEs indicate the expansionary path SOEs have taken over the four year period. This could be a result of the stimulus package that was extended by the Chinese government, better access to domestic loans through the banking sector or profits raised through self- Source: China Statistical Year Book. Fig.3 fundraising.However, construction (property) and infrastructure are two sectors that the Chinese governmenthas invested a lot of capital in over the last decade and most large construction companies, steeland cement companies are SOEs. This is could mean that SOEs are directly benefited from thissurge in construction and are therefore served with easier access to capital. Source: China Statistical Year Book Fig .4
Ranga Wimalasuriya 06/06/2012Figure.4 shows the total amount of short loans from the total loans markets given out totownship-village enterprises, enterprises with foreign funds and private enterprises and self-employed individuals. Freedman et. al (2006) cites that bank lending to SMEs ( privateenterprises and self-employed individuals in fig 4.) in developing economies mostly comprise ofshort-term loans . This is because banks make lending decisions based largely on the value ofassets pledged by a borrow rather than a borrower’s expected revenues and cash flows. In Fig 4.the ratio (d/a) of short term loans to private enterprises and self-employed individuals depict thatonly 5% of the total short term loans are distributed to the segment. However, there seems to bea rise in short term loans from 2% in 2005 to 5% in 2009.Analysis Part 4Parts one, two and three analyzed capital allocation to the private sector from a macro level ,firm level and attempted to evaluate the distribution of short term loans for private firms andSMEs. Part four will address the level of capital allocation across regions in China; a regionalcomparison will help us determine the overall efficiency of capital allocation in China.In Figure.5, Allen et.al (2005) and Ayagari et. al (2007) conducted studies on the types offinancing within firms across the five regions- Central, Coastal,Northeast, Northwest andSouthwest in China and Figure 5 portrays some of the patterns they inferred. Allen et. alcategorizes financing to Bank Financing and Self- Fundraising; they find that 20.63% of thefinancing is drawn out of bank loans and 79.37% through self- fundraising. Ayagari et. alfurther breakdown the 79.37% of self-fundraising across regions. Central and Northwestregions that are inland seem to have the highest percentage of self-fundraising firms. The
Ranga Wimalasuriya 06/06/2012Coastal and Southwest with better access to ports, tax arrangements and favorable policies showa higher percentage of bank financing for firms (Ayagari et. al). Source: Allen et.al (2005) and Ayyagari et. Al (2007), Fig.5Micro, small, medium, large and very large firms are categorized according to their financingpatters in Figure 6 according to Allen et al (2005) and Ayyagari et. Al (2007). Large and verylarge firms (30%) seem to use more of Bank financing than the Small , Micro and Mediumenterprises (14- 15 and 22%). Internal financing (self fundraising) seems to be the largest sourceof funding across all firms with even the Very large firms (majority of them SOEs) taking up55% of the total.Source: Allen et.al (2005) and Ayyagari et. Al (2007). Fig.6
Ranga Wimalasuriya 06/06/2012Discussion Micro, small and medium enterprises are more restricted from formal financing than thelarge and very large firms (fig 6.) This could be affiliated to the growth stages of the firms withstart-up firms (mainly comprising of small firms) receiving less formal financing due to thefinancial system’s lack of a credit rating systems,strong relations with small enterprises or theinability to better understand the business. Formal financing also requires collateral as fixedassets and this is a hindrance for a start-up firm or medium enterprise in China. In addition, thePeople’s Bank of China over the last three years has hiked reserve ratios and tightened loanquotas, limiting liquidity in the loan market. The PBC also maintain a ceiling on interest ratesand strict interest rates fail to reflect risks of lending to SMEs from a lender’s standpoint, therebyrestricting banks from lending to SMEs. This restriction on formal lending has resulted in the increase of self fundraising (retainedearnings, informal loans, family and friends) as a source over the last decade (Fig.2) with bothSOEs and SMEs contributing to its growth in two different ways. Restrictions on capital flow inthe formal financing market has led SMEs resort to self fundraising through retained earnings,informal loans and family with most firms taping into the informal loans market. SOEs that aremainly large construction companies on the other hand has taken up the lending practice(because of their access to easy capital) in the informal loans market to serve SMEs (that aremostly small property developers) that are restricted to capital from the formal sector. This hasresulted in the expansion of informal lending institutions and evidence of this is seen in Fig.2with self-fundraising increasing as a source from 70 percent to 80 percent over the last six years.According to a Credit Suisse report, 60% of the informal lending has been channeled into theproperty sector with the biggest borrowers being small and medium size real estate developers.The informal loans market accounts for nearly four Trillion RMB or about 8% of the formal
Ranga Wimalasuriya 06/06/2012lending market with interest rates ranging among 14% to 70%. SOEs gain funding through highinterest rate loans offered to SMEs in the informal loans market and SMEs gain funding throughinformal loans supported by SOEs; it is a cycle if not regulated could result in a credit crunchthat could significantly undermine China’s growth and investor confidence. Based on the evidence presented this paper will suggest four reforms that will help thefinancial system address the concerns stated above: less government control over the financialsystem “breaking up the monopoly”, liberalizing interest rates, regulating the informal loansmarket, a credit rating system.Suggested Financial Reforms in China1. Reducing government control of the financial systemContinual government intervention has restricted SMEs access to finance despite the reforms thathave taken place over the last decade.A possible solution would be to increase the PBOC’sindependence from the government to improve SME financing, privatize the four large-stateowned that control nearly 50% of total assets and reduce government control in equity markets.Increased independence for the PBOC will restrict the authorities from interfering in lendingbehavior of commercial banks especially through political appointments to high positions.China’s equity markets have made considerable improvement over the last decade but furtherliberalization to allow public companies access to equity markets and less government entitieswill be beneficial to SMEs seeking funding.
Ranga Wimalasuriya 06/06/20122. Liberalize interest rates Liberalizing interest rates is the process of replacing state-controlled interest rates withmarket-based interest rates. China’s interest rates are extremely low and currently yieldingnegative real rates of return to savers and hampering SMEs financing from the formal market.China’s major state-owned banks sit on high profits and nearly 80 percent of it comes frominterest earnings. The liberalization of interest rates will help free up deposits and lending ratesand allow banks spread risk when allocating loans to high risk SMEs that are in need of formalfinancing. Secondly, should China liberalize interest rates, it will allow its equity markets andespecially the bond market to develop which is an additional channel of financing for SMEs.Hence, interest rate liberalization is an essential step for the Chinese economy if SME financingis to improve.3. Regulating the informal loans market The Chinese Banking Regulatory Commission which regulates banks estimates the sizeof the informal lending market to be between $500-$800 Billion. Informal loans market is asignificant component of “Self Fundraising” that takes up nearly 80 percent of all financing forfirms. It is an important component of the Chinese financial system and it must be standardizedand brought into the open with clear legal safeguards. The process of regulating could involveissuing licenses to private lenders and imposing deposit collection and capital requirements anda cap on the interest rates offered. If the informal loans market is not regulated it will continue to“eat away at the depositor base of the big banks” (Lardy, 2007).
Ranga Wimalasuriya 06/06/20124. A credit rating system The Chinese financial system has no credit rating system and often fail to identify abusinesses credit worthiness; this makes financing difficult for SMEs as they are not well knownfirms or maintain no close relations with the bank. Furthermore, the banking staff is also underpressure given the amount of non-Performing loans that already exist in the banking sector.Some innovative banks have resorted to analyzing a firm’s cash flows, import or export customsdeclaration form and water meter bills to verify activity and this is an option that could beintroduced to the entire banking sector.Conclusion The Chinese financial system has undergone many significant changes over the lastdecade but SME financing and efficient capital allocation to the private sector remains a problem.The recent financial crisis has increased the informal loans market and deteriorated formalfinancing. Structural problems within the financial system has restricted efficient capitalallocation; these structural problems involve government control of the financial system,interest rate ceilings, an unregulated informal loans market and the lack of a credit rating system.It is essential that the Chinese government address these reforms above others if they are tostrengthen its financial system. Reducing government control from the state dominating bankingsystem and equity markets will require a lot of effort and may be a gradual process but it isessential that steps are taken to regulate the informal loans market and liberalize interest ratessince China is a growing economy.
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Ranga Wimalasuriya 06/06/2012Table 1: Definition of Financial Intermediaries/Institutions in China
Ranga Wimalasuriya 06/06/2012Source: Law, Finance, and Economic Growth in China