1. H688: Politicaland Economic Development Of China – Term Paper
Development
Needs of China’s
Capital Markets
Chinese Culture University, Fall 2013
A1127392, TimK. Alvner
12/26/2013

2. Introduction:
To avoidfallinginthe “middle income trap”of failingtoprogressaboveaGDP per
capitaof roughlyUS$15000, Chinawill needtoovercomemanychallengesgoingforwards
and will almostcertainlyrequire areorganizationof the economyof similarmagnitude to
that followingDengXiaoping’scontrol of powerin1978. While the politicssurroundingany
future transitionwill (hopefully) be nowhere nearastumultuous,there isahighriskthat the
economicandfinancial structuresof Chinawillbe all the more shaken. Capital needstobe
allowedandencouragedtoflowtosmallerbusinessestoencouragenew ideastobe
capitalizedon,whilenewsavingsmechanismsbeyondthe stockorpropertymarketsneedto
be developedbesidescash,tominimize the sensitivityof property- andstockpricesto
growth. IndealingwithalmostanyprobleminChina,itisimportanttorecognize thatmany
of the aspects of the economicandpolitical systeminteractineverygivenissue,andthis
paperaimsto developanunderstandingof the issuessurroundingthe furtheropeningof the
Chinese capital markets. Additionally,the ambitionistodevelopapossible roadmap for
furtheropeningandwhichgoalsshouldbe targeted.
Background:
Chinahas openeduptremendouslyafterMaoZedong’sdeath,andeverysuccessive
leaderhasbeenable toshape economicdevelopmentverystrongly.DengXiaopingletthe
veryopeningandintroductionandintegrationof capitalistideasintothe Chinese socialist
political system, whileJiangZeminbuiltonthiswithopeningupof stockexchangesand
broadeningtrade tiesabroadwhile attemptingtorekindle communistidealsinternallyin
China.Hu Jintaoonthe otherhand, isseenashavinghad difficultiesconsolidatingpowers
underneathhiminternallyinthe Chinese CommunistParty,andthuswasunable todrive the
economyasstronglyasmanywouldperhapshave wished.Still,one needstoview thisinthe
perspectivethatChinahadnearunbrokengrowthduringthe 2008 GreatFinancial Crisis
underHu and that beingthankstoan (GDP-adjusted) enormousstimulusprogrambeing
passedveryquicklyinChina,andthatthere wasa massive bankingrestructuringtakingplace
in2005 whichpavedthe wayforstrengtheningand extendingthe arenminbi yuanbond
market.Currently,Xi Jinpinghas seemedtostructure poweraround himveryeffectivelyand
showngreatreform-mindednessduringthe recentlyconcludedthirdplenarysessionof the
CommunistPartyof China’sCentral Committee, duringwhichmatters of economic
developmentwere dealtwith.
In goingforwardsandestimatinghow the capital marketswill develop,the reform
needsof China– as viewedinternally –have been adoptedfromthe DevelopmentResearch
Council andWorld Bank’sjointreportChina 2030. Furthermore aqualitativecomparisonto
the state of the differentindividual capitalmarketsindevelopedeconomieswill be done,in

3. an attempttoidentifypotential goalsandambitionsinthe interimforChina.
Currentcapital marketfeatures:
1. Overview
The Chinese capital marketsare largelydominatedbybanks,whobyfiatare the sole actors
inover80% of all secondarymarkettradingoccurringinChinatoday,andlarge playersin
boththe equitymarketandexchange tradedbondmarketswhereotheractorsare allowed.1
Thisis inverysharp contrasttodevelopedmarketswhere the largestmarketparticipantsare
typicallypensionfunds andinsurancecompanies.A more detailedcomparisontothe UK,US,
Japanand Taiwan data will be made (toestimatewhatChinaneedstoattaintoliberalize
currencyexchange further)underthe heading Stabilizing theCurrency Market.Interestrates
are setbythe People’sBankof China(PBoC) whichisnotindependentfromthe government,
and thiscontrol extendstothe banklendinganddepositrates,at6% and 3%2
foraround
twoyearsrespectively.Giventhatinflationoftengoesabove 3%3
there has beenlittlereal
incentive tosave,butgiventhe lackof capital market investmentalternativesinChina,there
still hasbeenanaccumulationof 102.7 trillionRMB (US$16.9 trillion!) indeposits4
.One of
the primaryreasonsthat capital marketliberalizationneedstoaccelerate isthatwithout
sufficientlydeepandliquidcapital markets thatcanabsorbcapital inflows,there isastrong
riskthat the RMB will rise wildlyanddisturbtrade.China’strade surplusisinexcessof
US$120 billion annually,andmore importantlyitmightleadtobankruptciesandlayoffs while
the economyisgenerallygrowing whichwouldfuel socialunrestinChina.
2. Stock Markets
The Chinese stockmarketisfairlyfragmentedinthatindependenttradingisconductedon
three differentexchanges –the Shanghai StockExchange,the ShenzhenStockExchange and
finallyalsoonthe HongKongStock Exchange.Disregardingthe HongKongStockExchange
givenitsnature of multinational listingsandthatthe regulatoryandpolitical situationof its
operationisnotinfluencedbythe CCP,the Shanghai StockExchange isthe largestinChina,
witha marketcapitalizationin2012 of US$2.547 trillion,makingitthe 7th
largestexchange in
the world.5
Inadditionthe ShenzhenStockExchangehasa marketcapitalizationof
1 Goldman Sachs Asset Management, 2013,FAQ: China’s Bond Market,
http://www.goldmansachs.com/gsam/docs/fundsgeneral/general_education/economic_and_market_
perspectives/china_bond_market_faq.pdf
2 PBoC website
3 PBoC data retrieved from TradingEconomics, http://www.tradingeconomics.com/china/inflation-cpi
4 Bloomberg News,
http://www.bloomberg.com/news/2013-12-09/chinese-banks-funding-set-to-ease-with-certificate-of-
deposits.html
5 World Federation of Exchanges, 2013, 2012 WFE Market Highlights, p. 6

4. US$1.150 trillion6
makingthe mainlandboursescollectatotal capitalizationrepresenting
21.8% of Asianequitymarketcapitalizationsin2012.7
3. Bondmarkets
As of 2012, China’sbondmarketsare the fourthlargestinthe world,ata valuationof 21.73
trillionrenminbi8
,orroughly US$3.579 trillion9
.The Chinese bondmarketissplitupintotwo
separate markets:the inter-bankmarketandthe exchange tradedmarket,withover95%10
of the total marketturnoverrepresentedbythe inter-bankmarket.Total tradingvolume for
2012 wasregisteredaroundUS$35 trillion,implyingthatliquidityisverygood.
The actors in the Chinese bondmarketare generallyclassifiedinfourmajorcategories:
central bankshort-termnotes,government/Ministryof Finance bonds,financial institution
bondsand non-financial corporatebonds.The primarycomponentof financial institution
bondsisthe PolicyBankbondswhichare issuedbythe ChinaDevelopmentBank,
Export-ImportBankof China,andAgriculture DevelopmentBankof China.These banksissue
bondsto back upthe financingof the policyambitionsof the CCP,suchas infrastructure
bonds,bondstoraise capital toallow trade financing,andother politicallymotivatedgoals.
PolicyBankloansalone hadaccumulatedbondissuance of 7.587 trillionRMB, as a group
secondonlyinissuance tothe Ministryof Finance at 7.810 trillionRMB.Non-financial
corporate bondscan largelybe separatedintotwolarge groupings:enterprisebondsand
normal corporate bonds.Enterprise bondsdifferinthattheyare issuedbymajor
state-owned-or-backedenterprisesunderparticularlygoodterms forprojectsinthe national
interestof the PRCandsubjecttoa quota,whereasthe remainderof the companies’issued
debtwouldbe classifiedasnormal corporate bonds. Additionally,enterprisebondsare both
tradedon the inter-bankmarketandthe openexchangemarket,whereasthe normal
corporate bondscan onlybe tradedon the exchange tradedmarket. Enterprise bondsin
issue are valuedat1.934 trillionRMB,while the othercorporate bondshave arelatively
miniscule marketvalueof 548 billionRMB.
Recentdevelopmentsinthe Chinesebondmarketinclude the approval for China
DevelopmentBanktoissue bondsonthe exchange tradedmarket,where financial
institutionshave previouslybeenrestrictedfromsellingdebt.11
Thisis an incredibly
http://www.world-exchanges.org/files/statistics/2012%20WFE%20Market%20Highlights.pdf
6 Data retrieved from World Federation of Exchanges Annual Statistical Query tool:
http://www.world-exchanges.org/statistics/annual-query-tool
7 World Federation of Exchanges, 2013, 2012 WFE Market Highlights, p. 6
8 Goldman Sachs Asset Management, 2013,FAQ: China’s Bond Market
9 As of 25/12 2013,Bloomberg.com, http://www.bloomberg.com/quote/USDCNY:CUR
10 Goldman Sachs Asset Management, “FAQ: China’s Bond Market”
11 Reuters, http://in.reuters.com/article/2013/12/25/china-cdb-idINL3N0K400620131225

5. importantstepinthe furthermarketliberalization,asitallowsmore liquidityto flow tothe
exchangesandallowsawidervarietyandsafertype of bondstobe adoptedbynon-bank
organizations.
4. Stabilityof the CurrencyMarkets
The RMB is a managedcurrency,havingaso-called“crawlingpeg”toa basketof
currenciesheavilyweighted towardsthe USdollar,where the officialcurrencyexchange rate
isadjusteddailywithincertainparameters.Topreventstrongforeigncompetitiveshocksdue
to currencyfluctuations,thiscrawlingpegtogetherwithcapitalcontrolshavegenerallybeen
usedto shieldChinesecompaniesfromthe worstcurrencyrisks. Foreignerswishingtoinvest
inChina’sdomesticcapital marketsare largelyrestrictedtothe QualifiedForeignInstitutional
Investor(QFII) Programs.The standardQFIIprogramallowsfirmsto use foreigncurrencyto
buyChinese capital marketassets,whereasthe RQFIIallowsthemtouse RMB fortheir
investments.However,manydomesticfirmsuse large international institutionsasassisting
or supplementarymanagersbyofferingtheseforeigninstitutionsapart of theirQualified
DomesticInstitutional Investor(QDII)quota12
.Giventhatthisdataisdifficulttocompare,the
official QFIIprogramwill be usedtoestimate the capital flow contributedbythe capital
marketat present. Asof August2013, the total quotaof the QFIIprogramstandsat US$150
billion,outof whichUS$46.4 billionhasbeenallocatedandapprovedforuse byforeign
financial firms13
while the RQFIIpilotprogramtotal quotacurrentlystandsat270 billion
RMB14
and isintendedtobe expandedtoseveral otherlocationssuchasTaiwan,Singapore
and London,inadditiontoHongKong15
.The maximumcurrentQFIIquotasthushave atotal
of 91116
+ 270 billionRMBor 1181 billionRMB,stackedupagainstatotal 2012 market
capitalizationof the mainlandbondandequitymarketsof 25.43 trillionrenminbi andthus
representing4.64%of the capital marketintotal.Thispercentageismuchtoohighto
describe the currentsituationsinceQFIIholdingscanbe investedinothercapital market
products(suchas private equityproducts)andthe maximumof the quotaallowedisused,
ratherthan the actual quotaapplicable.Mostlikely,the true effectof the QFIIprograms
12 Nina Xiang,for Forbes Magazine,
http://www.forbes.com/sites/ninaxiang/2013/10/03/chinas-qfii-and-qdii-quota-have-unintended-usa
ge/
13 South China MorningPost,
http://www.scmp.com/business/banking-finance/article/1353320/qfii-quota-tipped-make-10-pc-chin
ese-market
14 Monetary Authority of Singapore,2013,RQFII Program – From Hong Kong to Singapore, p. 4
http://www.imas.org.sg/uploads/media/2013/10/10/784_131010_-_RQFII_Update_on_Recent_Dev.p
df
15 Reuters, http://www.reuters.com/article/2013/07/12/china-qfii-idUSL4N0FI20O20130712
16 US$150 billion at25/12 2013 exchangerate.

6. currentlywill fallsomewhere roughlyone-thirdtoone fifthof the estimatedvalue,thus
somewherebetween1.5%and1% of total Chinese capital marketcapitalization.Using2010
data,the US and Japanhad total capital markets valuedatroughly460% of GDP, other
developedmarketsslightlyshyof 400% of GDP, while inChinaitstoodatroughly280% of
GDP.17
One particularfeature of the Chinesecapital marketisthatitis done in
non-securitizedlending,indicatingthatloansgofrombankto lenderinone line andthatrisk
isconcentratedonthe one makingthe loans.
To emphasize the size differential of the capital markets,convertingthe 2010 GDP
fractionsintoactual currencycan be helpful. USGDPwas at US$13.898 trillion,China
US$4.990 trillion,JapanUS$5.040 trillionandGermanyUS$3.299 trillion.18
This impliesthat
US capital marketswere pricingUS$63.93 trillionof assets, Japanese marketsUS$23.18
trillion,ChinesemarketsUS$13.97 trillionandGermanmarketsaboutUS$13.2 trillionin
2010. Now,itisa bigassumptionthatthe structure of the capital marketshasbeenretained
inthe lastthree tofouryears,particularlyinChina(whereGDPhasgrownby over60% since
and the stockmarketcapitalizationhasremainedsomewhatstagnant) butthe dataallows
certaininsightstobe gleamednonetheless.Comparingwithtrade finance andtotal capital
marketcapitalizationinlarge economies,one canattaina basisforqualitativeunderstanding
of the Chinese capital marketrequirements,whichlikelyneedstobe scaledupgiventhe
relativelylarge share of trade anditsbenefitstothe Chineseeconomy. The 2011 value of
Chinese total trade wasUS$3.867 trillion,secondonlytothe UnitedStates’US$3.883 trillion.
Japanhad US$1.685 trillionandGermanyUS$2.576 trillionequivalenttrade.19
Plugging
these datastraightintothe use of 2010 capital marketsize,the UScapital marketswere
16.46 timesthe size of theirtradedgoodsvalue,Japanhada ratioof 13.76, while Chinahad
a value of 3.59timesand Germanygettingamultiple of 5.12 timestradedgoods.One
explanationforGermany’slowervalue comparedtootherdevelopedeconomieswould
obviouslybe the adoptionof the eurocurrency,meaninghigherstabilityof the currencyand
more access totrade on favorable terms.Still,Chinahasa lowerratioat 3.59, obviously
slightlydepressedgivenone yearof growthunaccountedfor,implyingthatthe value is
probablybetterestimatedataround4 ratherthan 3.6. This isstill veryfarbehindboththe
US and Japan,and wouldlikelyalmostdoubleif depositscouldbe employedinthe capital
marketsbyconversionfromcashsavingstopensionfund- andinsurancesavings.
In 2012, the 13 mostnotable pensionmarketshadanaverage of 78% of national GDP
17 McKinsei Global Institute,2011, Mapping Global capital Markets – Update 2011,p. 4
18 World Bank, data accessed through TradingEconomics
19 World Trade Organization,
http://stat.wto.org/StatisticalProgram/WSDBStatProgramSeries.aspx?Language=E&subtopic=
bp;bc WTO

7. (assetfractionunweightedbyGDP) inpension fundassets.20
At the same time,inaggregate
the fundsinthese 13 marketsheld33% in bondassetsand47% inequity.21
The primary
concernfroma financial perspectiveforthese marketparticipantsistoensure astable
streamof cash flowstotheirpensionbeneficiaries,andthisisoftenprimarilyachievedwith
bondsand stable dividend-payingstocks.Giventhatdeposits of householdcashof 43 trillion
RMB22
to serve thispurpose,itisplausible thataverysizeablemarketforChinese pensions
couldveryeasilydevelopif there isthe capital marketoutletforpensionfundsto have
investable targetassets.Forthistohappen,pensionfundsneedtohave accesstoa very
sizeable portionof the bondmarket,whichwouldrequire alarge share of the bondmarket
to move fromthe inter-bankmarkettothe exchangetradedmarket.
In summary,the capital marketsinChinahaslarge domesticcapital poolstodraw on
forfurtherdeepeninginthe formof deposits,whichto42% are heldbyindividualswiththe
remaining58%likelytobe heldin treasuriesof large companies withfew investable assets,
unspentgiventhattheyare waiting toinvestandnotdeployedinanegative real interestrate
environment.
Setting Goals for Future Capital Market Development in China:
In developingthe capital marketsfurther,itwillbe importanttolookatthe specific
needsof the Chinese marketandthe political problemsinherentincapital marketreforms.
The principal needshere are tomake certainthatthe marketdepth of available capital isbig
enoughthatthe issuance of newoncomingdebtwill gosmoothly.Failedissuancescan
create negative feedbackloopswhere there isthe problemof the price of bondsbeing
drivendown,meaningthatoldissuance eitherneedstobe paidforincash as itcomesdue
or refinancedatunrealisticallyexpensive rates.The prohibitivelyexpensive ratesinturn
meansthat the financial positionof the issuerfundamentallygetsworse,andforcesnew
bondsby the same and similarissuerbutissuedlatertobe pricedhigherstill.Repeating
these relationshipswouldultimatelyleadtodefaultswhichwouldmake itevenworse,until
eitherall debtwhichisnotsustainable(atinterestratesatmultiplestofairinterestrates) is
eliminatedorthe governmentstepsintobail outcompanies.Amplecashthusneedstobe
eitherseededbythe governmentorcollectedveryrapidly.Perhapsthe greatestconcern
here isthat the municipal andlocal governmentswouldnotbe able togoto market.Even
thoughthe Chinese central governmenthasaverylow (26%) debt-to-GDPratio23
there are
20 Towers Watson,2013, Global Pension Assets Study 2013,p. 7
21 Towers Watson,2013, Global Pension Assets Study 2013,p. 28
22 The Epoch Times,
http://www.theepochtimes.com/n3/292513-chinese-household-savings-surge-to-50-percent/
23 PRC Ministry of Finance2013 estimate, data accessed from TradingEconomics.

8. majoraccumulationsof debtinthe municipal andlocal governments.Astheselocal
governmentsare notallowedtoseekfinancing atwill onafree market,there are anumber
of societal problemsthathave sprungfromtheirdrivetoraise fundsforfuture investment,
includinglandappropriationfromfarmersforsale ata majorprofit,anduse of “Special
InvestmentVehicles”thatallowthe debttonotbe carriedon the balance sheet of the local
government.24
Theselocal governmentdebts hendinSIV’sandotherwise are officially
estimatedtobe valuedat10.7 trillionRMB, while XiangHuaicheng –formerlyMinisterof
Finance – has estimated total local debttobe inexcessof 20 trillionRMB.25
A processof
encouragingthese SIV’stobe broughtbackto the balance sheetwhenneedsforrefinancing
arise needstobe devised,alsohopefullywiththe side effectthatfarmers’landrightscanbe
strengthenedandenforcedbyanentitywithnoeconomicneedforsaidlandrights.In
deepeningthe financial marketsandusingfinancial intermediariesforpoolingriskand
capital,marketscanbe developedtocoverforinsurance,healthcare andold-age benefits
and thusallowthe Chinese peopletotake more risk,aswell asbecomingmore socially
mobile.These increasesinriskwillingnessandsecuritywillthusallow Chinatoaccelerate
reformstowardsamore dynamiceconomy.Finally,the marketsizeneedstobe significant
enoughthatit can supportfurtherinternationalizationof the Chineseyuanwithoutcausing
disruptive currencychangesorrequiringretractionof the currencyopeningpolicy. Doingthis
will be mucheasierif the level of assetstradedandpricedonthe capital marketsinChinais
not the sole determinantof the netchange onprices,butone factorin a biggerfinancial
structure.If “simple”derivativessuchasoptions,futuresandforwardsare used,the
readjustmentneedsforlargerinvestorswilldecrease,vastlyreducingthe volatilityswingsin
the marketas largerinvestorsdonotneedtounwindthe underlyingafteramistaken
positioning. Interimcapital marketdevelopmentgoalscanthusbe constructedalongthe
followinglines:
1. Marketdepthshouldbe sufficienttoallow pensionfundstoexpandX trillionRMB
peryear/multi-yearperiod.
2. Transferof debtsfromthe Special InvestmentVehiclestothe local orcentral
governmentbalance sheets(potentiallysecuredthroughdebtissued bythe
Ministryof Finance) oughtnotto be subjecttofailedissuance.
3. Buildcapital marketsof sufficientsizethattheywill influence the Chinese yuan
currencycross ratesratherthanvice versa,requiringatotal capital market
capitalizationof 8-10 timesthe Chinese international trade by2020 with
continuedgrowththereafter.
24 World Bank and Development Research Centre, China 2030.
25 Bloomberg Businessweek,
http://www.businessweek.com/articles/2013-12-13/china-rethinks-gdp-obsession-as-local-debt-risks-
rise

9. 4. Builda derivative marketthatcaneasilybe usedtobuyand sell riskformost
exchange tradedproducts.The goal is toallow hedging,speculationandthe
abilitytosupportgrowthandanalysisof the underlyingcontracts.
Some problemswere alreadypresentasof 2011, whenthe total paid-incontributions
to pensionplanswere2.5trillionRMB,withonlyabout300 billionRMBin funded,locked
accounts.The remainderwassupposedlylockedbuthasbeenusedtofundpensionsfor
retireeswhomhadnotpaidintothe system.26
Still,those sumsare relativelyminorin
relationtoforexamplepersonal deposits.
Political Constraints and Conflicts of Interest:
Perhapsthe majorquestionof capital marketreformwill be posedbythe political will
available forundertakingsuchanendeavor.CurrentlyXi Jinpingdoesseemtohave
consolidatedhispowersanddriventhemfurtheralongthe linesof Princelingfactionpolitical
alignmentandinsistingoneconomicreform.Hischallengesindoingsowill be several.First
and foremost,the state roleinthe economyhasledtostrongconnectionsbetweenthe
government,particularlyona lowerlevel,andthe private sector.Involvingthe state-owned
enterprises in this analysis and broadening the view to their procurement and sales channels,
manyoptionsexistformakingillicitgainsgivensufficientconnectionsandaleadership
positionwithinthe CPC.The corruptionproblemcreatestwointerplayingdynamicsfor
corporate bondfunding.First,politicianseagertomaintaingoodconnectionsandaccept
bribesfromcompanies,orwhose friendsorfuture potential employerrepresentsa
state-ownedenterprise, wants to ensure that their business conditions are as good as can be.
Saidpoliticianwill thusworktowardsdirectingcapital tofavoritefirmsbythe means
available to himin the regulatory framework. Second, given a fixedinterest rate environment,
a bank makinga loanwantsto minimize the risk itassumes.Addingthe potential forgood
connectionswitharelatedstate-ownedenterprise andimprovedprofitabilityandcareer
prospectsforthe clientmanageratthe bank,there isverylittle incentive toarrange finance
forindividualsorsmallerbusinesses. The currentsystemof averygoodnetinterestmargin
fundedbelow the inflationrate isanamazingopportunityforanybank,andhasbeena
contributingfactortothe currentfinancial strengthof China’sbanks. Ultimately,bothof
these factorswill worktogethertohamperthe true source of capital:deposits.If large sums
of loanshave alreadybeenmade topoliticallyconnectedcompaniesorothermarket
participants,theywillprotestwildlyanymeanstodivertdepositsawayfromthemselves,
mostlikelybackedupbythe banksthemselves.A freerinterestrate regime islikelyneeded
26 China Daily newspaper,
http://www.chinadaily.com.cn/business/2012-07/24/content_15612162.htm

10. to at leastgive banksthe financial incentivetosupplyloanstosmallermarketactors.Positive
signalshave beencomingoutof Beijing,especiallywithrespecttothe clampdownon
political representationextravaganceandrestrictingsuperfluousorderingof expensivefoods
and liquorbygovernmentofficials. Anothersignal isthe tendencyforrestrainingoperations
of liquiditythathave occurredinChineseinterbankmarketssince the summerof 2013, with
repurchase agreements(repos)beingdone whilereversereposwerenotused.27
Repos
remove liquidityfromthe marketinthe shorttermwhile reversereposaddsliquidity,and
theyare the mainshorttermmoneymarketcontrol tool of the PBoC.By showingthatthe
liquiditywillnotmaterialize assoonasit is askedfor,the PBoCcreatedthe impressioninthe
marketthatbank managementneedstobe alertandmove fastertowardsinterestrate
reformreadiness.
Politically,reformingthe structure of local governmentbalance sheetsandunearthing
all the potential badloansisanotherundertakingthatwill require astrongpoliticalwillto
drive change.Manycurrentpoliticiansare unlikelytoletacrisisoccur ontheirwatchgiven
the strict CPChierarchiesandemphasisonpersonal successwithinthe partyorgovernment
to buildrelationships.Formerpoliticiansare alsonotkeentosee the cadrestrainedunder
themand nowinpowerpositionsthrownintoachallengingsituation,since thisdiminishes
theirowninfluence andadvantagesconferredthroughpolitical service.Political capitalfrom
Xi Jinpinghimself andhisalliesinthe Politburowill likelybe neededtoenactpoliciesthat
rewardbringingunaccounted-fordebtintothe openaswell aspunishingthose thathave
heldoffice duringperiodsof irresponsible local debtaccumulation. Drivingthe policyof
tryingto reininlocal governmentdebtwhilepotentiallyhavingtoexpandthe central
governmentbalance sheettocushionaperiodof reformswill likelybe ahardbargain.Itwill
not necessarilybe onthe overalllevel,butlocal officialswillbe pressuredtoaskforwider
disbursementsandstronglyrejecteverysuggestionof budgetarydiscipline toallow
themselvesthe betterchance toinvestintheirhome areas.
Potentiallymostdirectlypoliticallyproblematicisthe implicationthatfora capital
marketopeningtoworkinfull,incentivesneedto existforpeopletoactuallyfeedcapital
intothe capital system.There needstobe afunctioning- orverywell guaranteedprogramin
place to fund into,with tangible benefits to almost all involved parties. The problem with this,
as wasillustratedwiththe pensionfundsystem,isthatthese systemsneedtobe large,
probablytothe painlimitof what“gradualism”can accept.If the financial pool doesnotend
up large enoughtohandle volatility,andthe systemsinplace foritare possible toabuse or
circumventthen itisunlikelythatanyinsurance orpensionfundwill reachcritical massand
be of goodeconomicvalue tothe clientsandreduce risksandcostscomparedtothe bank
27 Bloomberg News
http://www.bloomberg.com/news/2013-12-19/china-rate-swap-surges-to-record-as-reverse-repos-ke
pt-on-hold.html

11. depositalternative.A programat2.5 trillionRMBcan likelyneverfunctionandlikelyneeds
at least10 trillioninpensioncapital tofullyfunctioninacountryas large asChina.
Employment of Offshore Financial Centers:
For developingthe firstpilotprojects –andusingthemas a benchmarkforfinancial
institutionsstilllearningpricing,marketmakingandunderwriting–smalleroffshore financial
centerscanbe tremendouslyuseful.Chinaiscurrentlyinthe positionthatitcan use several
nearbyfinancial centerssuchasHong Kongand Singapore,flushwithtalentpossessingthe
bestabilitytounderstandChinathat isaccessible outside the mainland.However,there
mightbe several problemsinlaunchinglarge-scale policypushesatthese places,giventheir
relative differencetothe local Chinese marketwithrespecttoregulationsandbusiness
practices. The recommendationhereismostlikelytouse these areasasidentifiersof whatis
possible,andthe marketacceptance andpricingof productsthatwouldbe novel inChina.
Hong Kongobviouslyservesasthe mainfinancial hubandtestingspotpartiallybecause
of itslegal regulationsfollowingBritishrule,andpartiallybecause of the humancapital
accumulatedinthe city.Additionallybeingapartof Chinalegallyandculturallyat leasttoa
higherdegree thanotheroffshore alternativeswilllikelygiveHongKongagood edge upin
the abilitytoact as a continuedfinancial services hub.Eventhoughitwill be facing
competitionfromShanghai(especiallyafterthe openingof the Free Trade Zone inthe fall of
2013) HongKongcarriesthe advantage of beingveryeasytoisolatefromthe restof
mainlandChina,allowingthe optiontoabortforother reasonsthanan unsuccessful financial
productadoption.Shouldafinancial innovation be verypopularbutleadtobankingsystem
problemsorunexpectedlackof liquiditythenthere will be littleproblemrestrictingitin
Hong Kongand notadopt it.ConceptslaunchinginShanghai virtuallyhavetobe proven
givenShanghai’sgreateraccessibilityforthe restof China’sinvestors.Singaporecarriesa
numberof advantagessimilarlytoHongKong,butthe businessmix (private bankingand
wealthmanagement),distanceandlowerabilitytointegrate renminbi trade finance will
probablyputSingapore asthe secondoffshorecenter.
Taiwanhas an interestingopportunityto positionitself asa strongphysical tradingand
value-addingintermediate destinationforChinese goods.GivenTaiwan’semphasisonsmall
businesses28
and relativelywell-developedservice industryalongwithitsgrowthtransition
successstory29
,itshouldhave muchto offerChinaintermsof insightsforhow tobuild
certaincapital marketcomponents.The nationallymandatedinsurance policiesandoverall
structure isone example of howaninitial investmentbythe Taiwanese governmenthas
28 1.280 million small enterprises registered in Taiwan in 2011,Ministry of Economic Affairs,
http://www.moeasmea.gov.tw/ct.asp?xItem=770&CtNode=331&mp=2
29 Ministry of Economic Affairs, http://www.moeasmea.gov.tw/ct.asp?xItem=72&CtNode=263&mp=2

12. reducedfuture costsdramaticallyandincreasedqualityof service.The culture of high
savingsratesinTaiwan30
and similarpressuresonthe propertymarketshould be valuable
insightsinthe Chinese capital markets.Taiwan’soverall availabilityof venture capital and
verystructuredapproachtoSME funding31
shouldplace itas a prime example asforhow to
generate awide arrayof small businessesthatare quicklyable tocapitalizeontheirbusiness
plans.If Chinaadoptssimilarmethodsandgainssuccessfromit,itwouldallow retoolingof
the QFII programstoshiftclosertoventure capital andallow importingof foreignknow-how
inthat industrywhenthe mostcommoncapital marketsare nolongerinneedof a shielded
environment.
Recommendations:
Detaileddiscussionof howtoreformthe systeminChinatorootoutcorruptionand
gainpolicyadherence isoutsideof thispaper’sscope.The authorrecognizesthatit is
extremelyimportantforthe successof anyreform, butthe complexityof the issue andthe
lack of crucial available information makes this virtually impossible to tackle from the outside.
For the discussionbelow,the readerisaskedtomake the unreasonableassumptionthatthe
problemiseithersolvedornot significantlyaffectingperformance of the suggestedpolicies.
Firstand foremost, governmentinvolvementisneededtocreate the conditionsfor
investorstopool money.Thiscouldbe done through the Ministryof Finance issuingdebtand
usingthe proceedstobuySpecial InvestmentVehicle debttobe placedinan investablefund
allowedtotrade onthe exchanges,where goodassetsare keptonthe booksandbad assets
soldoff at a discount.Thiswill increasethe value of SIV’s,allowingthe local governmentsto
offloadthemmore easily,curbthe refinancingneedsandpotentiallycreate profitsforthe
governmentunitsdouse fordevelopmentalpurposes.If thisisdone aggressivelyenoughat
the start, momentumcouldleadgoodassetstobe valuedhigherthanatinitial purchase and
leadto a profitforthe central governmentaswell.
Now, a largerpool of accessible capital isneeded,andshouldbe drawnfromnew
depositswhere possible andexisting depositswhenotherwise required.Givenlikely
concentrations of deposits withlargercompaniesandwealthierfamilies,thisisaprojectthat
can preferably be attemptedinTier1and potentiallysome Tier2citiesinChinatobeginwith
withina3-5 yeartime frame.The core of this ideaisto give (very) discountedadditional
social securityservices suchashealthcare coverageforalarge (minimum2-3monthsof
salary) shiftof moneyintothe advance paidpensionsysteminashort time tobuildthe
capital buffers.Thiscapital canthenbe freelyinvestedinexchange tradedproducts,butthe
30 DGBAS, retrieved from TradingEconomics,
http://www.tradingeconomics.com/taiwan/personal-savings
31 Ministry of Economic Affairs,
http://www.moeasmea.gov.tw/ct.asp?xItem=766&CtNode=343&mp=2

13. participatingbankswillneedtomeetcertainminimumquotasontheirexchangetraded
bondissuance toremainas participatingbanks.Thiscaveatistoallow further marketdepth
to accommodate additionalcapital rushingintothe market.
In the thirdphase,followingasettargetof assetsin these pension-systemdrivenpools,
liberalizationof the interestrate structure canaccelerate,allowingmore market-based
interestrates.Followingthis,the price of bankloansshould be setonthe marketand make
bondissuance more attractive forlargercompaniesandstate-ownedenterprises,leaving
depositstobe employedinthe service of small- andmediumenterpriseswhich have less
access tothe bigstructuredbondmarket.Thusbanksinthe Tier1 citieswill primarilybe
lendingtosmallerfirms.
Givenindicationsof the earlysuccessof the marketexperience asawhole,the system
can thenbe furtherexpandedtoothercities,withperhapsa2-3 yearlag and a givenpension
fundassettargetbetweeneverynumberedtierof cities.Assumingtax reformhastakenhold
ingreaterparts of mainlandChina,the systemshouldatthe firstexpansionstagealsohave
the stabilitytoacceptbondissuance straightfromthe richerlocal governmentsandassist
themintheircontinuedgrowthefforts.
AssumingChina’s GDP growswith7% per yearon average until 2020 and trade keeps
pace (hopefullyunreasonable assumption),China’stotal trade valuewouldbe roughly50%
higherthantoday,at US$5.788 trillion.Forallowingnearintervention-free currencytrading
at thistime,inthe termsthat othercapital marketsshow are acceptable,Chinawouldneed
at leasta US$46.3 trillioncapital marketcapitalization,whichwouldbe anincrease of about
85% of today’smarketvalue assumingtotal capital marketvaluesare 280% of GDP in 2013.
To put itin perspective,it’sanincrease of 22.5% of the marketcapitalization-to-GDPratio
spreadoutover6 years, or 3.44% per year,whichisnotunreasonable assumingunbroken
growth.Chinawouldthusbe able toliberalizethe RMB muchmore,and enjoythe benefits
of havingthe renminbibe anincreasinglyattractivereserve currency.