[MUSIC] How has China reformed its financial system? In this presentation, I want to first give a broad introduction to the key features of China's financial system. Secondly, I want to talk about the goals of reforming the banking system in China and the policies that have been adopted to achieve these goals. And finally, I want to address the current challenges facing the performance of banks in China. Now in terms of financial depth, here measured as the ratio of bank credit or stock market capitalization, as a share of GDP, we can see that in both cases depth has increased over time. And so today, bank lending accounts for over 140% of GDP. And stock market capitalization is over 40%. In comparative context, these numbers are relatively high. Many people consider financial depth as a key way of promoting economic growth. So countries that have greater depth tend to grow faster. For bank credit, you can see that the extent of bank lending in China is very comparable to the amount of lending in other major economies. And in terms of stock market capitalization, China is on the low side similar to Germany. Both China and Germany have financial systems that are mainly driven by bank lending as opposed to capital markets. If we look at the specific financial institutions that are important in the Chinese banking system, we can see that state owned banks remain dominant. China has four major specialized state-owned banks that covered different sectors of the economy, the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China which deals with international transactions and the China Construction Bank. Together, these specialized banks account for 47% of deposits and 42% of loans. There are also policy banks in China which are responsible for policy-based lending. And these account for 14% of loans, they don't really take deposits. And finally, the Bank of Communications is a major state-owned bank in China. Together, the state-owned banks listed here account for the majority of both deposits and loans. The other banks and financial institutions Include some financial institutions which are also carefully regulated by the People's Bank of China. For instance, rural credit cooperatives, urban credit cooperatives and other cooperative banks. It also include non-financial institution such as trust companies then leasing companies and others. Now, what is the main challenge for reform? Unlike other sectors, banking reforms have been relatively slow and immature. They're dominated by state owned enterprises, the banks. The prices until very recently, had a strong planned component. Of course the price for banks is the interest rate and these have for most of the reform period been carefully controlled by the People's Bank. Finally, although WTO in principle allowed for foreign banks to come into China, in fact entry is quite restricted because of the strong advantages that state-owned banks have in terms of the size of their networks and the implicit deposit guarantees of the government. Now, the key challenge for reforming the banking system is to improve the efficiency of financial intermediation to make profit-orientation more important in bank lending. To be concern, as we discussed in the presentation about soft budget constraints, is that state on banks will care about things other than profits and introduce other government goals into the lending decisions of banks and this can lead to inefficient intermediation. The real goal of a financial system is to take the scarce resources of the economy and make sure those financial resources go to the highest return projects. If we think about the sources of inefficiency caused by low regulated interest rates, which have occurred in China and also occur in many other developing countries, we can start by thinking about what a market equilibrium would look like for savings and investment. In here, we can think of the savings curve is being a supply curve for funds, where the price is the interest rate, and the demand curve is the investment curve Is how much firms and other borrowers want to borrow money to make investments. And so that's downward sloping, and like in any supply and demand graph, there's going to be an intersection point which determines the equilibrium interest rate and the equal within the amount of savings and investment in the economy. Now, under this system, all of the borrowers are going to have reservation interest rates that are above the interest rate, that is being determined by the market. So we're going to have high return projects that beat the rate of interest, so that they can repay their loans and still make money. Now what happens if we regulate the industry at a low level? Well, we get a disequilibrium outcome, where the amount of demand for the loans is going to vastly exceed the amount of supply of funds. So here the demand now is much greater at a lower interest rate. But the supply funds is lower, and we have lower overall investment. In addition, anybody who has a rate of return on their project above this low interest rate is going to want the loan. And you can see that this will include a lot of firms who have projects which are much worse than the demanders under the market equilibrium in the green shaded area. Thus the outcome of this financial repression is that we actually have lower savings and more inefficient lending because of inefficient credit rationing. If we look at the evidence on nonperforming loans in the Chinese banking system, it actually looks quite good in the sense that there's been a huge improvement in the later part of the 2000s compared to the period when state owned enterprises were being restructured and a lot of the most unprofitable enterprises were shut down, relieving this pressure of the non performing loans. However, although it's hard to see clearly in this figure there has been a slight increase in nonperforming loans Over the last several years. What are the reform policies that China has adopted to try to improve the performance of the banking system? Well, the first is to decentralize decision making and give greater incentives of the bank managers to pursue profitable lending. Banks have been given more leeway in deciding on the amounts of lending, so credit plans were shifted from binding to guidance. And managerial incentives have been improved, so that managers have direct incentives to achieve higher rates of repayment and to be directly responsible for loans. A second era reform, has been to support specialized banks, to be more, commercially oriented, first by, concentrating the policy lending, in the policy banks. In other words, instead of asking the specialized banks to do both commercial and policy lending, they've taken the policy parts out and put them in the specialized policy banks. So the specialized banks can really focus on being commercial banks. Second, to get rid of the past bad loan problem, they've recapitalize the specialized banks by moving all of the old bad loans to asset management companies for resolution to clean up their balance sheets. A third area of reform is ownership reform, and this is quite critical because this is what really affects the incentives of the bank managers the most. So, there's been some public listing of specialized banks, so that shareholders also can be a check on the management of the banks. And also some foreign ownership has been allowed t o allow for Chinese banks to learn from the best practices of foreign banks. There's also been an effort to improve competition by allowing greater entry of foreign and private banks into the banking sector, although this has achieved somewhat limited results. And finally, China has adopted international capital standards for bank regulation. Meaning that the reserve requirements required to make sure the banking system is stable and not subject to the kind of crisis that occurred in 2008 is enforced in China. They've also liberalized interest rates, allow them to be market determine, and this is a very reason reform for loans that's occurred in 2013 and for deposits in 2015. Despite all of these reforms, there still is a soft budget problem, because state-owned banks still favor state-owned enterprises. And still because they're state owned despite these reforms in the end listen to the directives of the Central Bank that is often thinking about policy goals unrelated directly to the profitability of bank lending. Now, if we look at this recent evidence on bank performance, we see that there has been the slight increase in nonperforming loans in recent year. And of course it's always hard to assess the true degree of nonperforming loans because bad loans are easily hidden by banks when deposits are growing. You can just give borrowers new loans to repay old bad loans. But there is other evidence of poor financial intermediation. The quality of loans was compromised when there was a huge surge in credit to try to provide macro-stability after the global financial crisis. And also in 2016, there has also been a pretty large credit expansion. And this forces banks to just loan quickly to meet macro-management goals without really being able to monitor the quality of those loans. Also, we know that state-owned banks continue to be favored. It's possible that private banks are getting more access than before but most private banks still complain about not having sufficient access to finance from state-owned banks. And finally, because a lot of lending in recent years has gone towards real estate and home-ownership, given the concerns about a housing bubble in China, this also introduces some systematic risk to the banks in China. Now, what can China do now to improve performance going further? Well, I think it's fair to say that one thing that they should do and probably will do is continue deepening the reform policies in all the areas that I described earlier. The interest rate liberalization that has been recently accomplished also sets the stage for two possible major reforms in the future, which could also increase the performance or ability of banks to intermediate funds efficiently. The first is that by liberalizing interest rates, China now is in a position where if it chooses it can also liberalize exchange rates and make them floating exchange rates. And that would allow China to use the interest rate more as a tool of macroeconomic management that indirectly affects the money supply and credit in the economy without the more crude and efficient interventions in bank lending that have been occurring previously. And secondly, if China liberalizes interest rates and exchange rates, it can then move to capital account liberalization. Which means opening up the economy to foreign investment flows, both in and out, and this would also improve the efficiency of capital allocation, but could also introduce some risks to financial stability related to international financial flows.
