1. Ranga Wimalasuriya 06/06/2012
REFORMING CHINA’S FINANCIAL SYSTEM: SUSTAINING PRIVATE SECTOR GROWTH
Introduction
The Chinese economy has been growing exponentially for over two decades with growth
rates averaging 10% since the Asian Financial Crisis of 1997. In the process, the economy has
flirted 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). The
negative real interest rates signify negative real rates of return on savings for depositors and the
majority 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 brought
about significant changes. However, there is a common perception that the hierarchy of China’s
financial system has not aided this change and that deep structural problems are prevalent
within the system. Mckinsey Global Institute stated that the access to credit for individuals and
SMEs 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
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consumer finance, and is years or possibly decades-away from building it to the standards of
the developed world” (WSJ, 2011).
The existing financial institutions, however, fail to efficiently allocate domestic capital to
the private sector (Small and Medium Enterprises) is an issue which curtailed private sector
development according to existing literature. Access to finance plays an important role in
private sector development. The ability to start, expand and innovate for SMEs depends on
finance sector support. SME financing may be affected by a range of factors. These include the
actions 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 to
obtain financing and a lack of collateral SMEs offer for financing.
Small enterprises- those firms that employ fewer than 300 people, earn less than 30
million yuan and have assets less than 40 million yuan and Medium enterprises- those firms that
employ 300 to 2,000 people, have annual sales of 30 to 300 million yuan and own assets worth
40 to 400 million yuan, in spite of financial constraints, SMEs are a significant component of
China’s economy. They have shown exponential growth in the last decade with over four
hundred thousand SMEs operating today ( NSB, Fig 3.). The SME sector produces 68 percent
of China’s exports, over 50% of China’s Gross Domestic Product and 80% of Chinas urban
employment ( Zhu, Wittmann, Peng, 2011). SMEs, therefore, are central for the growth and
development of a country as they expand as large corporations.
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Fig.3
Source: National Statistics Bureau
A study done by Standard Chartered Bank found on average, that the SME sector
accounted for 16 percent of GDP in low-income countries, 30 percent in middle-income
countries and 51 percent in high- income countries; suggesting that SMEs increase in
importance as an economy develops. A report from the Chinese Technology Innovation Beijing
center (CTIBJ) suggested that 68% of SMEs would close down in their first five years in
operation, 13% will exceed 10 years of operation (CTIBJ,2008) and 19% of SMEs faced with
bankruptcy 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 the
flow of capital and sources of capital into the private sector despite claims of capital constraints
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in some source of existing literature. The paper will then draw on a comparative assessment of
the China’s financial system and India’s financial system and identify how each system has
addressed the issue of capital constraints in the private sector.
Literature Review
An 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 weak
capital markets. The banking system has evolved rapidly since the 1990s. In 1979, the system
was solely represented by the People’s Bank of China (PBOC) which acted both as the central
bank and was further responsible for deposits and loans (Linton, IMF). Presently, the banking
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system consists of the “Big Four” state owned commercial banks (SOCBs), policy lending
banks, joint stock commercial banks, city banks, rural and urban credit cooperative (RCCs) and
foreign banks (Fig 3). The big four and the joint stock commercial banks (JSCBs) remain the
dominant players and principle lenders to SOEs and are subjugated by government shareholders
and management. All major banks along with the City Commercial banks (CCB) and the Rural
Commercial Banks (RCB) have been converted into corporate entities subjected to a board of
directors and supervisors (Herd, Pigott and Hill). JSCBs, according to Naughton (2007), are
more efficient and hold considerably lower amounts of nonperforming loans (NPLs) and they
have captured 15% of the total banking-system assets as of 2008. However, their effectiveness
is constrained due to a lack of independence and experienced officials. Former government
officials 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 for
infrastructures and development projects and lend to SOEs and account for 8% of total assets as
of 2003. RCCs, once banking profitable TVEs in the countryside, fell out of favor following the
Asian Financial Crisis. Since 2006, the government has pumped capital into RCCs as a part of
the urban financial bailout (Naughton). Foreign banks, however, play a minute roll in China’s
capital markets even though the government gave access to start-up “private banks in “20
localities”. (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 banks
which 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 the
central government with 9.2 percent belonging to foreign and private banks (fig.5).
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Fig 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 resulted
in the banks focusing on financing needs of the government, SOEs and construction firms over
the last decade. Allen, Qian and Qian(2004), compare the financial systems of a sample of
countries (English origin, French origin, German origin and Scandinavian origin) to that of
China. They find that the ratio of total bank credit to GDP is 1.13, higher than German-origin
countries which are known to have heavy bank-dominated financial systems. However, when
they consider bank credit issued only to the private sector (individually owned or publically
traded companies) China’s ratio drops from 1.13 to 0.242 (Fig.6) reflecting the flow of capital
to the public sector (state-owned companies). The second panel of Fig.6 compares the relative
importance of financial markets against banks. “Structure activity” and “Structure size” are
relative size measures which are equal to Log (market size/ bank size), with a smaller value
indicating that the country’s financial markets are small than its banking system; China has the
lowest score suggesting that its banking system is larger than its markets. A World Bank
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quarterly report cited that the recent most stimulus money is directed to benefit SOEs. This is
partly due to the method in which state ownership is distributed in the economy. Most SOEs
claim to have close relationships with the government and banks. SOEs have benefited from the
stimulus 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 remain
underdeveloped. They are smaller than most countries in terms of market capitalization and
total value traded as a percentage of GDP (AKM) and total equity market capitalization is
equivalent to 17 percent of GDP when compared to the average of 60 percent in other emerging
markets (Farrell et al. 2006).
The equity markets are largely controlled by the government and act as a platform to
raise capital for SOEs that require privatization. Listed companies and IPOs on the stock market
are former SOEs that are affiliated to government officials. The bond market lacks confidence
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due to a deficit of institutional investors or a reputed credit agency that offers the investor
confidence to buy in. Large companies, therefore, “prefer borrowing from banks rather than
issuing bonds”. Such actions could crowd out the ability for Small and Medium enterprises to
borrow (AKM).
SMEs
Mu (2002) cites that post-Asian Financial Crisis events left the banking sector with a
signifcant number of NPLs which average 30 percent of assets. He claims that this situation
arose because loans were given out based on preferential treatment to inefficient SOEs and are
further supported by unpaid principal and interest and below- market interest rates. Lending
rates to SMEs were additionally set artificially low which led to rates not being attractive
enough to encourage banks to lend out to SMEs, particularly when banks had high NPLs. This
issue was addressed by the establishment of credit guarantee schemes (CGS) which Mu claims
were helpful in promoting SME’s access to finance since they provide acceptable collaterals and
assist in the mitigation of the poor credit analysis SMEs will otherwise face. However, CGS
face much interference from local governments making it unable to operate in “accordance with
market 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 of
eligible collateral for loans or guarantees, low credit ratings or a lack of credit reporting system
for 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.
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Prasad (2007) suggests that the banking system should be made more robust and driven
by 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 investment
opportunities for individuals and SMEs.
Wang (2004) identifies the scarcity of capital, the lack of specialized financial institutions
to serve SME reform, lack of direct financing channels and the monopoly of state owned banks
as reasons for capital constraints in the private sector. As solutions, he suggests that “China
should 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 independent
and 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 is
unclear 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 to
households and the private sector has risen dramatically. In his structure of household
borrowing from banks, the total loans outstanding to households stood at RMB.11, 258.6
Billion (PBOC), 225 times higher than what it was in 1997. He claims that a majority of the
household loans extended were for business borrowing- 33.3 percent; bank loans to households
stood at 28 percent of GDP more than 45 times the share at the end of 1997. This significant
improvement in capital allocation will help family businesses expand and household
consumption increase. Lardy further states that “China is an outlier on the high side in terms of
consumer credit availability” in comparison to emerging markets. Although his account of
capital access to households is comprehensive and positive, he hardly analyzes this from an
SME perspective. He does not explicitly breakdown household business borrowing and we do
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not get an account of what kinds of businesses these household seem to run. He also fails to
analyze other sources of financing such as FDI and the informal loans market that the private
sector seems to rely on.
In addition to the question of capital constraints, existing literature has cited domestic
SMEs could also be facing a problem of consumption (WSJ 2012). This being the case, SMEs
that are not export oriented will face many difficulties operating due to lack of demand from
domestic customers, driving them out of business. China needs to reallocate capital towards
producing goods and services that Chinese consumers want to consume and this will require
banking changes, especially improving access to capital for SMEs that “make the modern
consumption-driven economy tick”.
The aim of this paper is to identify the characteristics of capital allocation to the private
sector, 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 as
intermediaries for capital allocation to SMEs; and analyze both direct and indirect sources of
financing that have helped firms grow exponentially over the last decade a gap that is present in
current literature related to the topic.The paper will then evaluate four important reforms that
standout from the existing literature: less government control over the financial system
“breaking up the monopoly”, liberalizing interest rates, regulating the informal loans market and
a credit rating system.
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Characteristics of Chinese Capital: Formal Financing
Fig .8
A major source of capital for formal financing arise from household savings, enterprises
savings and government savings. Fig.8 Shows the gross domestic savings in China has increased
since 2000 and comprises more than 50 percent of Gross Domestic Product. Household savings
on aggregate has risen by 6 percentage points over the last 10 years (Prasad and Chan). Chinese
household’s savings rate has continued to increase over the last decade and this is despite a
negative real return rate from the banks. According to Prasad and Chan, this unstoppable
increase in savings or the target savings by households is due to declining public provisions such
as health and education; other factors include the presence of a target savings rate due to China’s
transition to a market economy. A high savings rate such as that depicted by the Chinese
economy may not be beneficial for domestic SMEs that depend on local demand and
consumption for their operations. If the trend continues, China’s economic expansion will slow
down and China’s attempts to adopt a consumer driven model by moving away from an exports
or investments driven model will suffer.
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Capital Allocation Cycle
Fig.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
households
Source: China Statistical Yearbook
Fig. 8 and 9 depicts how dependent formal market financing is on the savings of the Chinese
public. Fig.9 shows the big picture of capital allocation within the Chinese economy. The high
household savings rate contributes a major share of the overall capital allocation within the rest
of the Chinese economy. Household savings, enterprise savings and government savings made
up 78% of the total formal market loans made out in 2005. Government bonds, corporate bonds
and stocks made up the remaining 22% highlighting China’s weak capital markets. The big four
banks are responsible for over 50 % of the total loans made out with foreign banks holding just
1.6%. Clearly, this divide seems to favor SOE funding given the authority the big four hold over
the rest of the financial system.
Shadow banking and the informal loans market hold 30% of all the loans made out and is
therefore an important segment of China’s private sector financing. AKK using a data set of
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twenty four hundred firms found that 43% of firms in China used alternative forms of finance
compared to an average of 9% in emerging markets and Allen, Qian and Qian claimed that the
fastest 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 enterprises
over the last decade despite poor access to formal finance.
The following sections will analyze the sources of financing and analyze both direct and
indirect sources of financing that have helped firms grow exponentially over the last decade and
the 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 private
sector, specifically SMEs in China. There are different sources of funding that domestic firms use
for daily operations or expansion. In the formal market, retained earnings is the cheapest source of
capital and can be implemented without any external constraints, domestic loans from a bank is
the second cheapest source of capital and fundraising through bonds/stock market is relatively
more 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 local
commercial banks and foreign commercial banks, state budget and debt financing through
China’s capital markets. Informal financing refers to “internal finance”- retained earnings, loans
from 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 set
obtained from Dr.David Hall and the investment climate survey conducted by the world bank in
2006 for my analysis. Part 1 explores the macro level climate of credit allocation to the private
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sector in China. Part 2 will attempt to identify the various channels of financing (both informal
and formal ) and the share of each channel regarding firms. Part 3 analyzes total investment in
fixed assets across firms; this will enable us to distinguish the types of firms that have expanded
over the last four years relative to the type of financing and part 4 analyzes capital allocation on a
regional and categorical level.
Analysis part 1
Domestic Credit extended to the Private sector as a % of GDP
Figure 1 depicts the domestic
credit extended to the private sector in
the form of formal loans as a % of GDP.
The graph gives us a general idea of
how strict capital allocation is within
the private sector with relation to
public vs. private credit allocation. This
graph also accounts for housing loans
as 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 on
a firm level( small, medium and large enterprise), industrial level or a regional level. The
horizontally connected lines compare China to the United States, Spain, Germany and India. The
annual World Development Indicators (World Bank, 2004b) in 2002 summarized domestic
credit provided by the banking sector in middle-income countries to be 83 percent of GDP, 49
percent of GDP for low-income countries and 168 percent of GDP for high income countries.
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Ignoring the variables not addressed in the data, China and Germany seem to be on par at 150
and 130 percent of GDP respectively with the United States and Spain close to 230 percent and
India below 100 percent of GDP. The level of domestic credit extended to the private sector for
China being on par with Germany is an encouraging prospect ignoring the variables not
addressed by the data.
Analysis Part 2
In Figure 2. the horizontally connected lines represent how each source of funding is
distributed amongst China’s firms with regard to investment in fixed assets. There are four
sources 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 to
country. The State budget was a significant source of financing in the early 90’s with SOEs
heavily dependent on the State budget for operations and the Chinese economy following a
centrally planned system. As of 2009 the state budget accounted for only 5.1 percent of the total
and 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 for
domestic firms to invest in fixed assets and is not a measure of foreign investment in ownership
form. Foreign investment sources has reduced to 1.8 percent as of 2009. The two prominent
sources of funding are self-fundraising and domestic loans.
Domestic loans in aggregate occupy 15 percent of the total financing and constitutes 30
percent of financing in large companies (Fig.5). Domestic loans since 2000 have grown at a
CAGR of 19.21%. Self-fundraising comprises of retained earnings, informal loans, funds raised
from local communities ( family and friends) and local governments. Self-fundraising is the
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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.2
Analysis part 3
Given we have an understanding of the sources of funding within China’s financial system from
part 2 it will be worthwhile to analyze the categories of firms affected by these sources. The
following figure illustrates the distribution of fixed asset investment in China across firms. Fixed
assets are long-term tangible pieces of property like buildings, real estate, equipment and
machinery that a firm may use in the production of its income. An account of fixed asset
investment across firms will help distinguish the firms that have expanded over the last four years.
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The blue bars represent the total investment value in 100 million Yuan and the horizontally
connected lines show the different categories of firms. SOEs and LLCs seem to have invested the
most over the last 5- years with a CAGR of 19.95% for SOEs. The share of investment for private
enterprises has increased whilst the share for individuals have declined. Foreign firms with funds
mostly 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 government
has invested a lot of capital in over the last decade and most large construction companies, steel
and cement companies are SOEs. This is could mean that SOEs are directly benefited from this
surge in construction and are therefore served with easier access to capital.
Source: China Statistical Year Book Fig .4
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Figure.4 shows the total amount of short loans from the total loans markets given out to
township-village enterprises, enterprises with foreign funds and private enterprises and self-
employed individuals. Freedman et. al (2006) cites that bank lending to SMEs ( private
enterprises and self-employed individuals in fig 4.) in developing economies mostly comprise of
short-term loans . This is because banks make lending decisions based largely on the value of
assets 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 that
only 5% of the total short term loans are distributed to the segment. However, there seems to be
a rise in short term loans from 2% in 2005 to 5% in 2009.
Analysis Part 4
Parts 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 and
SMEs. Part four will address the level of capital allocation across regions in China; a regional
comparison 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 of
financing within firms across the five regions- Central, Coastal,Northeast, Northwest and
Southwest in China and Figure 5 portrays some of the patterns they inferred. Allen et. al
categorizes financing to Bank Financing and Self- Fundraising; they find that 20.63% of the
financing is drawn out of bank loans and 79.37% through self- fundraising. Ayagari et. al
further breakdown the 79.37% of self-fundraising across regions. Central and Northwest
regions that are inland seem to have the highest percentage of self-fundraising firms. The
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Coastal and Southwest with better access to ports, tax arrangements and favorable policies show
a higher percentage of bank financing for firms (Ayagari et. al).
Source: Allen et.al (2005) and Ayyagari et. Al (2007), Fig.5
Micro, small, medium, large and very large firms are categorized according to their financing
patters in Figure 6 according to Allen et al (2005) and Ayyagari et. Al (2007). Large and very
large firms (30%) seem to use more of Bank financing than the Small , Micro and Medium
enterprises (14- 15 and 22%). Internal financing (self fundraising) seems to be the largest source
of funding across all firms with even the Very large firms (majority of them SOEs) taking up
55% of the total.
Source: Allen et.al (2005) and Ayyagari et. Al (2007). Fig.6
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Discussion
Micro, small and medium enterprises are more restricted from formal financing than the
large and very large firms (fig 6.) This could be affiliated to the growth stages of the firms with
start-up firms (mainly comprising of small firms) receiving less formal financing due to the
financial system’s lack of a credit rating systems,strong relations with small enterprises or the
inability to better understand the business. Formal financing also requires collateral as fixed
assets and this is a hindrance for a start-up firm or medium enterprise in China. In addition, the
People’s Bank of China over the last three years has hiked reserve ratios and tightened loan
quotas, limiting liquidity in the loan market. The PBC also maintain a ceiling on interest rates
and strict interest rates fail to reflect risks of lending to SMEs from a lender’s standpoint, thereby
restricting banks from lending to SMEs.
This restriction on formal lending has resulted in the increase of self fundraising (retained
earnings, informal loans, family and friends) as a source over the last decade (Fig.2) with both
SOEs and SMEs contributing to its growth in two different ways. Restrictions on capital flow in
the 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 are
mainly 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 are
mostly small property developers) that are restricted to capital from the formal sector. This has
resulted in the expansion of informal lending institutions and evidence of this is seen in Fig.2
with 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 the
property 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
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lending market with interest rates ranging among 14% to 70%. SOEs gain funding through high
interest rate loans offered to SMEs in the informal loans market and SMEs gain funding through
informal loans supported by SOEs; it is a cycle if not regulated could result in a credit crunch
that could significantly undermine China’s growth and investor confidence.
Based on the evidence presented this paper will suggest four reforms that will help the
financial system address the concerns stated above: less government control over the financial
system “breaking up the monopoly”, liberalizing interest rates, regulating the informal loans
market, a credit rating system.
Suggested Financial Reforms in China
1. Reducing government control of the financial system
Continual government intervention has restricted SMEs access to finance despite the reforms that
have taken place over the last decade.A possible solution would be to increase the PBOC’s
independence from the government to improve SME financing, privatize the four large-state
owned 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 lending
behavior of commercial banks especially through political appointments to high positions.
China’s equity markets have made considerable improvement over the last decade but further
liberalization to allow public companies access to equity markets and less government entities
will be beneficial to SMEs seeking funding.
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2. Liberalize interest rates
Liberalizing interest rates is the process of replacing state-controlled interest rates with
market-based interest rates. China’s interest rates are extremely low and currently yielding
negative 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 from
interest earnings. The liberalization of interest rates will help free up deposits and lending rates
and allow banks spread risk when allocating loans to high risk SMEs that are in need of formal
financing. Secondly, should China liberalize interest rates, it will allow its equity markets and
especially 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 financing
is to improve.
3. Regulating the informal loans market
The Chinese Banking Regulatory Commission which regulates banks estimates the size
of the informal lending market to be between $500-$800 Billion. Informal loans market is a
significant component of “Self Fundraising” that takes up nearly 80 percent of all financing for
firms. It is an important component of the Chinese financial system and it must be standardized
and brought into the open with clear legal safeguards. The process of regulating could involve
issuing licenses to private lenders and imposing deposit collection and capital requirements and
a 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).
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4. A credit rating system
The Chinese financial system has no credit rating system and often fail to identify a
businesses' credit worthiness; this makes financing difficult for SMEs as they are not well known
firms or maintain no close relations with the bank. Furthermore, the banking staff is also under
pressure 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 customs
declaration form and water meter bills to verify activity and this is an option that could be
introduced to the entire banking sector.
Conclusion
The Chinese financial system has undergone many significant changes over the last
decade 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 formal
financing. Structural problems within the financial system has restricted efficient capital
allocation; 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 to
strengthen its financial system. Reducing government control from the state dominating banking
system and equity markets will require a lot of effort and may be a gradual process but it is
essential that steps are taken to regulate the informal loans market and liberalize interest rates
since China is a growing economy.
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I. BILIOGRAPHY:
1. Allen, Franklin, Jun Qian, and Meijun Qian. "China's Financial System: Past, Present, and
Future." (2004).
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25. Ranga Wimalasuriya 06/06/2012
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27. Ranga Wimalasuriya 06/06/2012
Table 1: Definition of Financial Intermediaries/Institutions in China
28. Ranga Wimalasuriya 06/06/2012
Source: Law, Finance, and Economic Growth in China