It is generally accepted that financial sector reform is a complex and highly country-specific undertaking, despite the existence of some general guiding principles regarding its preconditions and sequencing. The length and depth of the process, by definition, depend a great deal on the conditions at the start of the reform. In the unique case of China, financial development had to start from a very low level, for the financial sector was almost nonexistent at the start of the process. Seen against this background, China’s record of financial sector building has been impressive, but the agenda for further reform remains highly challenging as well.
During the first 15 years of reform, China’s financial sector has been developing on the border of two economic systems: plan and market. Thus, the newly established financial institutions—including the People’s Bank of China (PBC)—had to operate in an intermediate control system. The continuing dominance of planning devices in the monetary sector and the authorities’ preference to keep the financial sector as the main vehicle for an interventionist economic development strategy are primarily responsible for the failure of the larger financial institutions to evolve into genuine “commercial banks.” Smaller banks and nonbank financial institutions (NBFIs) have enjoyed more freedom (they were not subject to the core credit plan and were given more leeway in setting lending rates), but they remained for a long time on the margin of the sector’s growth, at least quantitatively.75
The upshot of the reform strategy adopted thus far—an emphasis on institution building with only a small dose of financial liberalization—naturally leads to the conclusion that in the agenda for future financial reform the point of gravity will have to lie on liberalization measures, in particular of the interest rates and the exchange system. To be successful, these liberalization measures will need to be underpinned by other reforms, such as the establishment of a banking supervision function, reform of the banks’ accounting system, and the full separation of policy from commercial lending. In turn, liberalization will give a new impetus to money and capital market development and the concomitant development of new financial instruments. These advances, taken together, will enhance the effectiveness of indirect monetary policy instruments, which will complete China’s transition to a market-based financial system and thereby increase the efficiency of resource allocation in the economy.
Whereas China’s reforms of the past 15 years have been unique—largely because of the existence of an intermediate control framework—this assessment suggests that in the near future China will find itself on a path that looks familiar to several other countries worldwide, namely, one of financial liberalization. Indeed, the measures listed above are on the agenda of many countries that, following their initial years of institution building, are embarking on financial liberalization programs. For example, many countries in Eastern Europe and the Baltics, as well as Russia and other countries of the former Soviet Union, are still in the liberalization phase, even though they went through a shorter period of institution building and virtually bypassed the phase of intermediate controls.
The following subsection highlights the main characteristics of China’s financial sector development. The final subsection reviews the challenges that lie ahead. Both subsections try to point out some lessons for reforms under way in other countries.
Main Characteristics of Financial Sector Development
Diversification of Financial Sector
Starting from a system in which a few “banks” operated as government departments to implement the credit plan—in fact, they played mere accounting roles—the authorities have managed to establish a fairly diversified financial sector, with universal and regional banks and a variety of NBFIs. However, the sector remains dominated by four state-owned banks. These banks lack financial sophistication, owing to the interference of policy-based lending in their management decisions, their internal structures (which give the branches a high degree of independence from their headquarters), and technical factors, such as the lack of modern accounting practices.
Accessibility of Financial Sector
From the early days on, the Government managed to extend the financial system fairly evenly across the vast country, a factor that has certainly added to the country’s high savings ratio and its high degree of monetization. At this stage, the country’s economic reforms in general benefit from this part of the reform strategy. Making the financial system accessible to the entire country is not easy in a country as large as China and is often neglected in financial reforms in many other smaller countries.
Interplay of Government Plans and Market Forces
In line with the approach adopted by several other Asian countries, the Chinese Government tried during the first 15 years of reform to hold a firm grip on financial market development to ensure that the financial sector—in particular, the four specialized banks and the government securities market—remained a major vehicle for its financial policies. However, in both the banking sector and the capital markets, emerging market forces started to interact with the Government’s plans, leading to interesting results. In some cases, market forces reinforced the Government’s actions; in other cases, they interfered with those actions. For instance, the Government remained very selective until the early 1990s in allowing new banks to be established; however, a significant NBFI sector started mushrooming naturally in the mid-1980s. This sector has enriched the financial landscape, but it has also posed challenges for the Government, which was forced to include certain types of NBFIs in the credit plan to ensure that proper coverage was continued.
In another area—the government securities market—the market itself initiated secondary market trading, which was afterward officially allowed. This development also posed new challenges for the Government. For instance, the market wanted secondary market price movements to be reflected in the new issues, whereas the Government tried to stick to its administratively set yields and prices. On some occasions, such as in 1993, the Government ultimately had to follow the market and raise the interest rate at issue.
Capital Markets and Money Markets
Capital markets are much more developed than money markets in China. Several factors account for this unusual sequencing. First, the Government had pushed for the issuance of government securities as an alternative means of tapping household savings and complementing financing through the credit plan. Second, banks were not offered many alternatives to invest their “free” resources, particularly during the first years of reforms, and incentives to search for such alternatives were in part undermined by the PBC’s practice of paying high interest rates on deposits made at the PBC. Banks also started channeling some surplus funds through their affiliated NBFIs to circumvent the credit quotas. Third, interbank and intrabank markets were not encouraged for a long time because local authorities were not keen on transferring financial surpluses out of their regions. Fourth, the banks’ administrative organization and the state of advancement of the payments system were not conducive to the development of nationwide money markets.
These reasons help explain why the interbank market—usually the first segment of a money market to be developed—got off the ground so slowly. In addition, the Government was until recently reluctant to issue short-term securities—typically another pillar of money market development—for administrative and logistical reasons. Capital market development, however, has been quite successful, although the market is still very “retail” in nature, lacks liquidity, and is not fully integrated on a national scale. The lack of liquidity is largely due to the missing money market. In general, the establishment of a money market looms as one of the main challenges in the near future, as it will tie together various currently isolated segments of the Chinese financial markets and give a further impetus to capital market development.
Role of the PBC and Underlying Legal Framework
From the first days of its establishment, the PBC has played a significant role in China’s emerging financial system, even though it lacked for a long time the proper legal underpinnings for this job. Until recently, the central bank’s objective was ambiguously defined. In the changing system, it was still considered the lender of first resort, while, as a central bank, it was trying to evolve into the lender of last resort. In the process, these two objectives were bound to collide.
As emerging market forces began to be felt and the financial system expanded, the authorities recognized the need to strengthen the PBC’s supervisory authority. Initially, the PBC’s relationship with the state-owned banks was only that of primus inter pares, but gradually it established its authority over these banks and over the newly emerging parts of the financial system, namely, other banks and NBFIs. In the absence of a legal framework, the PBC has tried to fill the supervisory and regulatory vacuum by supervising the banks and regulating the NBFIs. The PBC was also closely involved in promulgating rules and regulations for securities exchanges and stock markets. However, the country’s political and administrative structure and the tendency to decentralize decision making, combined with the lack of supporting legislation, put the PBC in an awkward position in which local authorities had more influence over PBC branches and branches of the specialized banks than did PBC’s headquarters. This situation has changed only marginally, but it is expected that the PBC law and the commercial bank law will strengthen the authority of the PBC over the financial sector, as well as the autonomy of the financial sector vis-à-vis local authorities.
More generally, the design of the legal framework underpinning financial transactions in a market-based economy has been taking shape only since 1993. The lack of attention paid to the establishment of a legal framework in support of financial development in the first decade of reform probably also delayed the commercialization of the state-owned banks. Their protracted dependence on the Government and its policies has resulted in their failure to become more sophisticated financially and has prevented them from making more effective use of financial instruments in their operations. In addition, the state-owned banks’ internal administrative and managerial structures, which have given branches a high degree of independence from their headquarters, have made it difficult for these banks to operate in a market environment. Technical factors, such as the lack of modern accounting practices, have aggravated these problems.
Transition to Indirect Monetary Policy Instruments
The PBC has also tried to diversify its monetary policy instruments by introducing reserve requirements and lending facilities to banks. Thus far, these modifications have had only limited effects for several reasons. First, the credit plan and related policy-based lending have continued playing a dominant role. Second, the absence of any significant interest rate liberalization has limited these instruments’ usefulness. Third, in the absence of money markets, both instruments were in fact used to channel liquidity from one region to another or from one bank to another: mopping up through the reserve requirements and lending back through the PBC’s lending facilities. As a result, the PBC’s balance sheet has also been inflated.
Interest Rate Liberalization
Interest rates are being liberalized late in the process. For a long time, political resistance against interest rate liberalization was strong, mainly because of the weak financial position of the state-owned enterprises (SOEs). While a simplification of the administrative interest rate structure and more flexibility in setting the rates could have been introduced earlier in the reform process, large-scale liberalization of the rates could only have taken place if other reforms affecting the functioning of the financial sector had been addressed earlier, such as the organization of the state-owned specialized banks and bank accounting. The decision of the Third Plenum dealt with this chicken-and-egg problem directly.
Exchange System
The Chinese authorities have so far proceeded with determination in liberalizing the exchange system and opening the economy. Recent years have witnessed a rapid succession of decisions that have almost invariably been taken earlier than outside observers had expected and much faster than stated in the timetables.
The Chinese exchange system is de facto already very close to current account convertibility. The authorities have indicated that China will accept the obligations under Article VIII of the IMF’s Articles of Agreement with respect to current account convertibility before the year 2000. This timetable may well turn out to be a very conservative estimate; with the exchange system already quite open, full convertibility of the renminbi may well come soon after current account convertibility.
At this time, foreign sector liberalization is moving faster than domestic liberalization. Because large capital inflows have supported the balance of payments since 1993–94, there was no pressure on the exchange rate, and the foreign exchange system reforms have proved successful so far. However, difficulties in monitoring liquidity in the system arising from the unavailability of domestic sterilization instruments complicated the PBC’s monetary management. In the circumstances, external liberalization might become a driving force for further domestic liberalization, for example, with respect to interest rates.
The Challenges Ahead
The current actions of the authorities to liberalize interest rates and establish a nationally integrated interbank market are at the core of their efforts to establish a liberal and efficient financial system by the end of the century. To be successful, however, these plans need to be complemented by further progress in other areas of financial sector reform.
Commercialization of State Banks and Level Playing Field
Commercialization of the four state banks needs to be expedited. To this end, the policy lending banks should become the only vehicles for noncommercial lending. Reform of the banks’ accounting system is another necessity, as is the further development of the legal framework for financial transactions.
Domestic and external liberalization should also go hand in hand with the leveling of the playing field for domestic and foreign banks. With the further opening of the financial system, the current regulatory constraints on foreign banks in relation to domestic banks will have to be addressed. Foreign banks can, through competition and example, contribute to the modernization of the Chinese banking system.
Increasing openness will also place ever greater demands on both commercial banks and authorities. In order to be competitive, Chinese commercial banks will have to integrate foreign operations into their general banking under the planned accounting reforms. Also, great strains will be placed on banks’ risk-management functions until the relationship of branches to head offices has been settled: overall risk management must be centralized.
Prudential regulation and bank supervision must cover all aspects of banking in a unified manner, regardless of whether operations take place in China or in a branch abroad, or in local or foreign currency. Effective overall supervision remains difficult in the current decentralized framework. In this connection, there will also be increasing pressure to integrate under one body the supervisory responsibilities that are currently divided between the PBC and the State Administration for Exchange Control (SAEC).
Foreign Exchange Market Development
Foreign exchange trading in the wholesale market can develop along two routes. Trading can continue to be channeled through the China Foreign Exchange Trade System (CFETS), or direct trading between banks may emerge. The CFETS may also continue to have a role, at least for a while, in ensuring uniform access to foreign exchange also for smaller enterprises and outlying regions. In the longer run, as Chinese banking is integrated into the international financial system, standard international trading procedures will be adopted, including direct trading between market participants. The evolution of the direct-dealing market will also help introduce modern risk-management techniques to Chinese banks.
Coordination of Monetary and Exchange Rate Policy
Removing the few remaining constraints on capital movements will further accentuate the need for a strengthening and integration of monetary and foreign exchange operations and their management under one authority. To this end, the SAEC, if it continues to exist as an independent organization, must coordinate its operations on a daily basis with the open market desk that will emerge at the PBC. The ability of the authorities to manage monetary aggregates efficiently will be critical to further stable growth.
Real Sector Reform
The effectiveness of these domestic and external financial sector reforms will depend largely on progress achieved in structural reforms in other sectors of the Chinese economy outside the control of the monetary authorities. In this respect, the reform of the SOEs will be of extreme importance. The PBC will have to take advantage of progress in the reform of the real sector and utilize every opportunity to expedite the process of financial liberalization. An additional and welcome advantage is the strong commitment at the highest political level to move ahead in developing market mechanisms, as evidenced by the enhanced authority given to the PBC in the new central banking law.