Chinas Financial Development, Reforms and Challenges Chun Chang Professor of Finance China Europe International Business School

Chinas Latest Financial Reforms and Development Chinas Latest Financial Reforms and Development

Source: CICC Research The State Council CBRC CSRC Commercial Banks Credit Cooperatives CIRC Trust & Investment Securities Firms Exchanges Fund Management Insurance Companies Financial Regulatory Structure Chinas Financial System

Heavy Reliance on Bank Financing (2006) Source: CEIC; CICC Research Chinas Financial System

Japan-Germany-like Financial Structure – Financial assets concentrated in the banking system – No stock markets before 1991 – In 2006, more than 80% of financing is still through banks – insurance industry is growing fast but still underdeveloped – legal framework for private equity financing is just starting Chinas Financial System

The States Dominance of the Banking Industry (Assets, 2006) Source: The Statistics Quarterly PBOC Chinas Financial System

Banks in China State-owned banks: ICBC, CCB, BOC, CAB Joint stock banks: Bank of Communication, China Merchants Bank, Guangdong Development Bank, Minsheng Bank City banks and credit unions: Bank of Shanghai, Bank of Nanjing, Ningbo Commercial Bank Foreign banks: HSBC, Citibank, Standard Chartered,

Progress in Banking Reform – Recapitalization of state banks 4 asset management companies set up in year 2000 to take over US$1,600 billion of non-performing loans US$1108 billion NPLs disposed up to March 2006, cash recovery rate 20.8% US$45 billion capital injection in 2004 for BOC and CCB US$15 billion capital injection in 2005 for ICBC – CCB listed in Hong Kong in 2005, BOC and ICBC in 2006 – Reorganization and recapitalization of China Agricultural Bank and Postal Savings Bank for listing Chinas Financial System

Progress in Banking Reform (2) – Brought in foreign strategic investors before IPO – Foreign strategic investors introduced CCB: Bank of America, Asian Financial Holdings (AFH), holding 14.4% BOC: Royal Bank of Scotland, AFH, UBS, Asian Development Bank, holding 16% ICBC: Goldman Sachs, Allianz et. al. 17% – Foreign investment in banks raised to 25% – Invited private entrepreneurs to take minority stake Chinas Financial System

Comparison of Chinese and Foreign Banks 2002 Source: Banks Annual Reports, CICC Research

Chinas Financial System Comparison of Chinese and Foreign Banks 2005 Source: Banks Annual Reports, CICC Research

ROA & ROE of Listed Chinese Banks 2006, 2007 ROAROE Year 2006First half year of 2007Year 2006First half year of 2007 China Merchants Bank 0.81%1.20%16.70%21.40% Bank of China 0.85%1.06%12.81%14.09% ICBC 0.71%1.05%13.60%19.90% Industrial Bank 0.70%1.02%26.20%29.90% Bank of Communications 0.78%0.93%14.10%17.47% China CITIC Bank 0.60%0.82%14.10%11.70% Shenzhen Development Bank 0.54%0.78%22.40%31.50% China MinSheng Bank 0.61%0.73%22.10%19.00% Shanghai Pudong Development Bank 0.53%0.70%16.50%23.70% HuaXia Bank 0.36%0.44%13.10%17.80%

Nonperforming Loans of Chinese Banks

Chinese Capital Markets – 1540 publicly listed companies on domestic exchanges, 143 on overseas (Feb 2007) – Equity market capitalization of around US$3 trillion (2007) State Shares 33.1%, (non-tradable until 2005) Legal person shares 16.7% (non-tradable until 2005) Tradable individual shares 50.2% – Government bond market cap US$ 364 billion – Corporate bond market cap US$35 billion Chinas Financial System

Progress of Chinese Stock Market Reform Before 2005, state-owned and legal person-owned shares could not be traded on stock exchanges. Large shareholders paid little attention to the prices of tradable shares held by the public. In 2005, the government initiated reforms that made non-tradable shares tradable. This aligned the interests of large shareholders with that of outside shareholders

Financial Reforms

Great Leap Forward in Equity Market – An average of US$9 billion raised per year from 1991 to 2006 – In 2007, $50 billion new A-shares were issued, taking the first place in the world (the second place US equity markets raised less than $40 billion in 2007) – Shanghai Stock index increased by almost 100% in 2007 Chinas Financial System

Over-Valuation? (P/E) Source: CEIC Chinas Financial System

QFII and QDII Raised QFII quota to US$ 30 billion at the end of 2007 QDII launched in July 2006 – 5 domestic banks: BOC, CCIB, CCB, BOCOM, CMB; 3 foreign banks (Bank of east Asia, HSBC, Citibank); & Huaan Fund Management chosen for experiment – 19 institutions approved, US$14.5 billion investment quota granted QDII quota reached US$42.17 billion by the end of the third quarter in 2007 Local markets (Shanghai & Shenzhen) have 120 million investor accounts in Sept Chinas Financial System

Private Equity – Size estimated around 620 billion RMB in 2007, much of it comes from abroad. – Limited Partnership were authorized in Chinese law in June of 2007 Enormous Potential – Great demand in a vibrant economy for private equity – High risk and cost due to poor legal and financial infrastructure Chinas Financial System

Financial Regulations – Entry regulation Geographic and business restrictions for foreign banks and insurance companies Foreign stake in commercial banks capped at 25% Foreign partners can take up to 33% in JV brokerage firms and fund management companies Approval required for branches & offices License required for domestic institutions Private individuals can only have a minority position Chinas Financial System

Financial Regulations (2) –Interest rate regulation Both lending and deposit benchmark rates are set by the central bank (one year lending rate is now 7.47% and deposit rate is 4.14%) Lending rate has no upper limit and the lower bound is 90% of the benchmark rate. the rates for mortgage loan can be 85%. Deposit rate has the benchmark rate as the upper limit and is allowed to float downward. Interbank rate SHIBOR was introduced on Dec. 1, 2006 and determined by market forces

Chinas Financial System Financial Regulations (3) – Regulation of international accounts Current account deregulated Closed Capital/Financial account with a few exceptions – Managed floating exchange rate regime The RMB pegged to USD at RMB 8.27/USD from mid- 1990s to 2005 It is supposed to be pegged to a basket of currencies since July 21, 2005 The RMB/US$ exchange rate allowed to float no more than 0.5% of the previous days closing, 1.5% against other currencies No timetable for full convertibility

Strong RMB Backed by Foreign Reserves Source: CEIC Chinas Financial System

The Value of RMB – The upward pressure on RMB is driven by the twin surplus (current account and financial account) and is balanced by holding surplus foreign currencies as reserves – To balance the twin surplus and reduce foreign currency reserves, RMB needs to be revalued – The speculation that RMB will be revalued eventually has caused hot money flowing into China and excess liquidity and asset inflation Chinas Financial System

Factors Against Appreciation: Worries about adverse effect on exports and employment Unwillingness to be seen as yielding to foreign pressure Factors in Favor of Appreciation: Domestic inflationary pressure and asset bubbles Interest rate differentials and inflow of hot money Ability to raise interest rate in order to cool down economy Responsibility for the loss of value of foreign currency reserves

Challenges Ahead

Exchange Rate Issues How much and how fast should RMB rise? Free floating, Pegging and pegging to what? When and how to make RMB fully convertible?

Banking Issues How and when to eliminate interest rate regulation and introduce real competition? How to compensate party-appointed bank officials? How to introduce universal banking? How to establish government deposit insurance?

Capital Market Issues Need to develop a more mature market and less government intervention Institutional investors need to play a more important role Need to develop corporate bond market, learn how to price credit risk Information disclosure and insider trading

Other More Important Issues The following issues will have a bearing on how fast Chinas financial reforms will be carried out: Income inequality Political stability and reforms Environmental Issues