Abstract

Until 1995, the existence and operations of the People’s Bank of China (PBC) were based upon provisional regulations promulgated in 1986. The four state-owned specialized banks and the universal banks each operated on the basis of specific charters. The new reform strategy adopted by the Third Plenum recognized the need for a strong legal framework to underpin the orderly growth of the financial system. By the end of 1993, four draft financial laws were submitted to the State Council: the Law of the People’s Republic of China on the People’s Bank of China, the Law of the People’s Republic of China on Commercial Banks, the Negotiable Instrument Law of the People’s Republic of China, and the Insurance Law of the People’s Republic of China. These laws were all enacted in 1995. Since 1993, the PBC has also promulgated several regulations to streamline banking operations and strengthen its supervision of the financial sector. Furthermore, other laws, such as that on nonbank financial institutions (NBFIs), are still in preparation. This section discusses the main features of the PBC law (passed in March 1995) and of the commercial bank law (passed in June 1995); these laws can be considered the keystones for the further development of the financial system in a market-based economy.

Until 1995, the existence and operations of the People’s Bank of China (PBC) were based upon provisional regulations promulgated in 1986. The four state-owned specialized banks and the universal banks each operated on the basis of specific charters. The new reform strategy adopted by the Third Plenum recognized the need for a strong legal framework to underpin the orderly growth of the financial system. By the end of 1993, four draft financial laws were submitted to the State Council: the Law of the People’s Republic of China on the People’s Bank of China, the Law of the People’s Republic of China on Commercial Banks, the Negotiable Instrument Law of the People’s Republic of China, and the Insurance Law of the People’s Republic of China. These laws were all enacted in 1995. Since 1993, the PBC has also promulgated several regulations to streamline banking operations and strengthen its supervision of the financial sector. Furthermore, other laws, such as that on nonbank financial institutions (NBFIs), are still in preparation. This section discusses the main features of the PBC law (passed in March 1995) and of the commercial bank law (passed in June 1995); these laws can be considered the keystones for the further development of the financial system in a market-based economy.

Establishment of a Legal Framework for the Central Bank

Ten years after the establishment of the PBC as China’s central bank in 1984, the People’s Congress enacted a law giving the central bank the power to perform central bank functions. The preceding reform years had increasingly shown the need for an autonomous entity with the power to regulate the financial system and conduct monetary policy.

At the time that the Chinese authorities were reassessing the legal framework for the central bank, the case for giving central banks a high degree of independence from the political authorities was being made convincingly worldwide, as illustrated, inter alia, by the Statute of the European System of Central Banks and the European Central Bank (1993). However, the organization, role, and functions of the institution in charge of monetary policy in China have to be assessed in light of Article 2 of the PBC law, which establishes the leadership of the State Council in the formulation and implementation of monetary policy.

Autonomy of the Central Bank

Developments in central bank legislation in several countries suggest that the establishment of a balance between central bank autonomy and the coordination of monetary and other economic policies is a crucial issue. Traditionally, central banks have been granted formal independence, but governments have retained enough power to influence important decisions. More recently, legislation has moved in the direction of granting full autonomy to the central bank in monetary matters, under the assumption that a strong and independent central bank would be in a better position to maintain price stability.12

The Chinese authorities were facing the dilemma of having to give up certain aspects of the traditional political structure to allow the central bank more autonomy versus retaining the present decision-making structure (centralized in the State Council and based on consensus building), within which the PBC could fulfill its mission in a market-based environment. The critical questions were therefore, what type of agency should the PBC become, and how independent should it be from the State Council to perform these functions? It was evident from the outset that, although lessons could be drawn from recent developments in central bank legislation elsewhere, it would be difficult to copy the concept of an autonomous central bank in China at that time. In the Chinese political and institutional setting, an autonomous entity separate from the state would have been inconceivable. Creating such an institution would have amounted to establishing an entity separate from the State Council without any authority, because the state, as represented by the State Council, is the source of all authority.

The solution to the dilemma is reflected in the combination of the provisions of Articles 2 and 7 of the PBC law. Article 2 establishes an agency under the leadership of the State Council, which entrusts this agency with a high level of independence from all other levels of government. Article 7 stipulates that in the exercise of its functions the PBC shall be “free from intervention by local governments, or other administrative organs at all levels, public organizations or individuals.”

The Central Bank as Legal Entity

A related issue is the legal status of the PBC. A central bank must be a legal entity because it must be able to act as an independent legal person, that is, to have paid-up capital, to own assets, to enter into contracts, and to sue and be sued. A corollary to this issue is that of budgetary autonomy, which enables a central bank to undertake operations without having to rely on resources from the government budget.

Since its establishment in 1984, the PBC had been a line department under the State Council. The 1995 PBC law is innovative in that it gives the central bank all the features of a legal entity, although it does not refer to the notion as such. Under Article 8, the PBC is endowed with paid-up capital and, in accordance with the provisions of Article 40, has to complete an annual balance sheet and a profit-and-loss account, to be published in an annual report. Moreover, Articles 37 and 38 confer a reasonable degree of budgetary independence on the PBC.

The assertion in Article 38 that “losses sustained by the PBC shall be offset by state allocations” is important because it will insulate monetary policy from losses that could be generated by quasi-fiscal activities undertaken by the PBC. The unusual provision that the PBC’s budget is to be incorporated into the central government budget and subject to verification by the State Council reflects the present-day reality in China. However, independence of the PBC from all other levels of Government is reinforced by the PBC’s independent control over its budget.

The leadership of the State Council is also demonstrated by its power to nominate the Governor and Deputy Governors of the PBC. The absence of a management board, in turn, reinforces the authority of the Governor in the day-to-day management of the PBC and, in fact, allows for a more direct participation of the State Council in the decision-making process of the PBC because there is no intermediary body between the Governor and the State Council.

Primary Objective of the Central Bank

At the heart of effective central bank autonomy is a clear definition of the primary objective. The past practice of giving central banks multiple objectives—promoting economic growth, full employment, and price stability—has generated policy conflicts and made proper assessment of the central bank’s performance difficult. These insights have recently led to a different approach whereby central banks are endowed with only one principal objective, the promotion and maintenance of price stability.

Among recent central bank legislation, the Statute of the European System of Central Banks and the European Central Bank is a clear example of establishing price stability as the primary objective of a central bank. The wording of Article 3 of the PBC law follows closely these recent developments as it stipulates that “the aim of monetary policies is to maintain the stability of the value of currency and thereby promote economic growth.” The relationship drawn between economic growth and price stability clearly acknowledges the assumption that the best way central banks can promote economic growth in the longer term is by ensuring price stability. In this respect, the PBC law contrasts with broader definitions of the primary objective for the central bank in some neighboring countries, such as Japan, Korea, and Malaysia.13

The PBC law makes no reference to the external stability of the currency. This is not unusual in modern central bank legislation, although in some countries the relevant law refers to domestic and external stability.14 The law is also silent on the responsibility for defining the exchange rate arrangements. This omission is consistent with legislation in other Asian countries,15 although there is a tendency in modern central bank legislation to confer such responsibility on the government.16

Responsibility for Formulating and Implementing Monetary Policy

Effective monetary policy also requires operational autonomy, that is, the responsibility for formulating and implementing monetary policy. Recent developments in central bank legislation point to the appropriateness of increased autonomy in the formulation and implementation of monetary policy. However, there are also countries where responsibility is shared between the central bank and the government, with specific provisions made to facilitate the coordination of monetary policy with fiscal and other economic policies, and to settle conflicts.17

Under the new law, the PBC’s operational autonomy is not complete. Article 2 stipulates that “the People’s Bank of China shall formulate and implement monetary policies and exercise supervision and control over the financial industry under the leadership of the State Council.” This leadership is reinforced by the establishment of a monetary policy committee, placed fully under the supervision of the State Council, which is also in charge of prescribing its functions, organization, and working procedures. The establishment of the monetary policy committee can help establish the autonomy of monetary policy within the State Council and thus solidify the credibility of China’s monetary policy. The PBC, however, is fully responsible for implementing monetary policy measures.

Functions of the Central Bank

The functions of the PBC used to be confined to managing the issue of currency, which could involve quasi-fiscal activities, and implementing the credit plan. However, the changing institutional structure of the financial system and the development of a market-based economy called for new functions for the PBC.

Supervision of financial institutions is a function that has assumed greater importance in many countries with the liberalization of financial systems and the development of markets. There is no definite answer as to whether the central bank or another agency should undertake this function; there are pros and cons to separating monetary policy and prudential control, and country experiences provide a wide spectrum of successful solutions to the problem.18

The decision in China has been to give the PBC a large and direct responsibility in supervising the financial system. Article 4 of the PBC law specifies the role of the PBC in supervising and controlling financial institutions and the financial market, and Chapter V of the law deals entirely with the supervision of financial institutions, focusing on the health of individual institutions and the financial system as a whole. The law establishes the supervisory authority of the PBC over the state commercial banks and gives the PBC all means needed for effective supervision.

The decision to combine monetary policy and prudential control in the PBC is appropriate for China, as it is for other transition economies. The evidence is mounting in these countries that monetary stability can be seriously affected by the operations of insolvent banks. Furthermore, the need to strengthen the PBC’s leadership over the state commercial banks suggested that this objective could be better achieved by vesting the two functions in one and the same agency.

Instruments of Monetary Policy

Because operating procedures for the conduct of monetary policy evolve in line with market developments, the listing of instruments in a central bank law should be general, with a minimum of specifications, to allow the central bank the greatest flexibility possible in conducting monetary policy.

In the case of China, moreover, the drafting of the law had to take into account the transitional period that the country was going through, as direct instruments were being gradually phased out and indirect instruments were not yet fully operational. In the transition to market-based monetary policy, the central bank law had to allow the continuation of direct controls while also giving a clear signal with respect to the direction in which the authorities wanted to go. The list of monetary instruments in Article 22 of the PBC law reflects this shift from direct to indirect monetary management. All the instruments listed belong to the category of indirect instruments, including the PBC’s buying and selling of government securities in open market operations and its use of reserve requirements. Also, under Article 27, the PBC can determine the amount, interest rate, and duration of its lending to financial institutions without previous approval from the State Council.19 This important provision empowers the PBC to engage in active interest rate management—a clear break with past practice, in which interest rate changes had to be approved by the State Council. Meanwhile, direct controls can be retained under Article 22(6), which allows the use of any instruments other than those specifically listed, provided that they are defined by the State Council.

Because Article 25 prohibits overdraft facilities, PBC credit to the banks can take the form of rediscount or loans only, that is, credit with a predetermined maturity. However, the law does not formally prohibit uncollateralized lending. Although the recent policy of the PBC has been to increase the importance of collateralized lending through the rediscount window, the bulk of the PBC’s credit to the banks still takes the form of uncollateralized lending. The phasing out of such lending may take a long time, as it is related to bank reform in general and the development of proper collateral in particular.

Regional Participation in Monetary Policy

The complexity and geographical size of China raised the question of regional participation in the formulation or implementation of monetary policy. Germany and the United States provide two models of a centralized organization with regional participation.20 In the case of China, the involvement of the local governments in formulating or implementing monetary policy was a sensitive issue. Decentralization of economic decision making in the early reform years had shifted a share of economic power from the center to local governments. At times, this shift proved to be a major hindrance to effective implementation of monetary policy, as local authorities demanded additional borrowing from the local PBC branches, thereby exceeding the quota assigned under the credit plan.

In order to preserve the uniformity of monetary policy and to remove a major source of conflict between local and national interests, the PBC law makes no mention of the participation of local governments in the formulation of monetary policy. On the contrary, Article 7 explicitly rules out provincial participation in the implementation.

The relation between the PBC headquarters and its branches was another sensitive issue to consider in drafting the law. The PBC’s branch network has had a significant role in implementing the credit plan; however, with the diminishing importance of the credit plan, the importance of the PBC network in implementing monetary and credit policies is also bound to diminish. Therefore, the move toward indirect monetary management could be seized to redesign and reduce the PBC’s branch network. In light of the historical reality that local branches depend as much on local authorities as on the PBC headquarters (see Huang (1994)), the PBC’s authority over its branch network was not evident; the law had explicitly to give PBC headquarters the autonomy to decide on the number, location, and functions of its branches. Article 12 establishes the clear leadership of the PBC headquarters over its branches, which implies a break with past practice.

Summary: How Much Autonomy for the PBC?

Although the PBC law establishes a fair degree of operational autonomy, the PBC remains an institution under the leadership of the State Council. This leadership encompasses the formulation and implementation of monetary policy; the nomination of the Governor and Deputy Governors of the PBC (under Article 9); the operations of the monetary policy committee (under Article 11); and the supervision of the PBC budget (under Article 37).

The law reveals a deep understanding of the technicalities, implications, and constraints involved in conducting monetary policy in a market environment. The PBC is vested with all the functions of a modern central bank, including the conduct of monetary policy; the issue of the currency; the centralization and administration of the foreign exchange reserves of the country;21 the supervision of financial institutions and financial markets; and oversight of payments and clearing systems. It is also important that a measure of accountability is introduced in Article 40, which obligates the PBC to publish an annual report with the relevant financial statements.

The new PBC law should be viewed as a further step in developing China’s legal system and in developing a central bank with a strong ability to implement effective monetary policy. The new law, however, remains a compromise, reflecting new trends in central banking worldwide, as well as China’s present stage of constitutional and legal development, in which the power is controlled by the Party and vested in the State Council. In these circumstances, greater independence from these sources of authority would most likely reduce the law’s effectiveness. As such, the law falls short of western concepts of central bank autonomy, but it creates a central bank with a well-defined primary objective and a higher degree of autonomy than in some neighboring countries.

In the present circumstances, the best assurance that the primary objective of the PBC—as set forth in Article 3, “to maintain the stability of the value of the currency and thereby promote economic growth”—will have to come from the Government’s resolve to fight inflation. Finally, the route followed in adopting the PBC law illustrates the pragmatism of the Chinese authorities in the financial reform process. In many respects, the law does not break new ground; it builds on evolving practices and reflects the consensus built on the many policy issues that it raised.

The Commercial Bank Law

Following the March 1995 passage of the central banking law, the People’s Congress enacted the Law of the People’s Republic of China on Commercial Banks on May 11, 1995. The law, which aims to transform major domestic commercial banks into independent commercial entities, marks a further step in building a strong, comprehensive, and relatively independent banking system.

A Two-Tier Commercial Banking System

The commercial bank law establishes a de facto two-tier commercial banking system comprising (i) commercial banks, subject to prudential ratios and other international standards of portfolio risk and profitability, and under the supervision of the PBC, and (ii) the three policy lending banks, which are not subject to this law but whose operations are guided by individual charters. As indicated in Section III, separate legislation is in the making for NBFIs, such as trust and investment companies (TICs) and securities companies.

As set out in Article 2, the law applies to commercial banks, that is, corporate persons established for handling such operations as accepting deposits from the public, providing loans, and handling settlements. Article 13 clarifies that this definition includes urban and rural cooperative banks, for which the minimum required capital is lower. The law also applies to foreign-owned commercial banks, Sino-foreign joint-venture commercial banks, and subsidiaries of foreign commercial banks. As explained in Article 4, a central feature of the new law is that commercial banks shall operate independently, bear risks on their own, and take responsibility for their own profits and losses. Also, no organization or individual will be allowed to interfere with commercial bank operations.

Reinforcement of the PBC’s Authority

Under Article 11, the PBC is responsible for licensing new commercial banks. Moreover, as provided for under Article 12, the law concedes much discretion to the PBC in examining applications for the establishment of a commercial bank, authorizing it to consider the state of economic development and the situation of competition among banks. However, commercial banks wholly owned by the state (the four state commercial banks) are under the direct supervision of the State Council. The leadership of the State Council over the state commercial banks is made clear in Article 41, which stipulates that they can be called to support state policies; losses incurred from providing such loans shall also be assumed by the state.

The commercial bank law is also designed to bolster the control—already enshrined in the PBC law—of the PBC over the banking sector. Under Article 38, the PBC is responsible for setting credit levels that the banks cannot exceed. Specific financial ratios are also defined in the law, such as the loan-to-deposit ratio (currently, commercial banks are allowed to lend out 75 percent of the total value of their deposits) and exposure limits (loans to a same borrower shall not exceed 10 percent of total capital). The law establishes transitional arrangements for the four state commercial banks to be adopted by the State Council.

Separation of Banking and Nonbanking Activities

According to the provisions of Article 43, commercial banks are no longer allowed to invest in NBFIs (such as TICs or security companies) or in nonfinancial enterprises. In an effort to make banks concentrate on lending to enterprises, the law establishes a “China wall” between commercial banking operations and other operations that are deemed to be more volatile and speculative.

These provisions are reinforced by Article 46, which prohibits the use of interbank lending to extend fixed-asset loans. Interbank lending should be confined to cover settlement deficiencies and to bridge temporary liquidity shortages. These dispositions, although they may be difficult to enforce, aim at limiting investment in fixed assets, which contributed to the country’s high inflation rate in recent years.

Enhancing Financial Discipline

The provisions of Article 48 are intended to improve financial discipline in state-owned enterprises. It stipulates that enterprises can open only one basic account with a single commercial bank. This provision intends to reduce the number of fraud cases by preventing enterprises from moving cash among different banks for nonapproved purposes.

Summary

The new commercial bank law is an important step toward designing a framework within which the financial sector can and should develop. The law delineates the activities of both the banking system and the nonbank financial sector. Overlapping activities—and the accompanying existence of a gray area between banks and NBFIs—have long been a weakness of China’s financial system. Consistent with the law on the PBC, this law obliges commercial banks to comply with the PBC’s supervision and prudential control, thereby enforcing the central bank’s position as regulator of the financial system.22 Equally important are the provisions of Article 22 that make each commercial bank, as a legal entity, responsible for the liabilities of all its branches. This provision is intended to mark a clear break with past practice, which permitted branches to act like independent units.

However, several provisions in the law will, by necessity, be temporary because they reflect—and will affect—current problems and Chinese realities. Thus, revisions might be needed during the next stages of the reform. For instance, the provision in Article 48 that enterprises should have their accounts in one bank is understandable in light of current fraudulent actions. However, this provision may over time stifle competition among banks. The law also provides a special position to the state commercial banks in that they “should provide loans for special projects approved by the State Council.” This provision and the corresponding obligation of the Government to make restitutions for all losses incurred through such mandated loans is meant to protect these banks from irregular pressure from local authorities, but it may also prolong the granting of policy loans through these institutions. If this were to happen, the process of commercializing these banks will be hampered, which will affect the degree of competition in the banking system.

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