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China's Road to Greater Financial Stability

Chapter 1. Reform and Development of China’s Financial Sector

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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Information about Asia and the Pacific Asia y el Pacífico
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Since the onset of the new millennium, China has clearly put forward the strategic objective to build a market-oriented and more open economic system. Deepening financial reform and expanding openness to foreigners have become important goals. Guided by this objective, the key tasks include deepening financial institutional reform, developing financial markets, encouraging financial innovation, and advancing reform of price formation mechanisms for interest rates and exchange rates.

Financial market efficiency has continued to improve in terms of resource allocation, and the capacity of financial institutions to guard against risk has been considerably strengthened. Macroprudential regulation has also been continually strengthened, which has effectively guarded against financial risks and realistically helped China preserve financial stability. Thus, through a series of major financial reforms, historic changes have occurred in China’s financial industry.

Establishment of Corporate Governance Systems

The health of financial institutions is the microfoundation of financial stability. After the Asian financial crisis, Chinese authorities realized the urgency and importance of deepening financial reform. Under the unified leadership of the State Council, the authorities initiated the financial restructuring of all types of large financial institutions in 2003 and have essentially completed the restructuring. Substantial progress has been achieved with respect to the reform and development of other types of financial institutions.

Advances have been made in the shareholding reform of the wholly state-owned commercial banks. In 2003, the Chinese authorities used the Bank of China (BOC) and China Construction Bank (CCB) as pilots to launch a joint stock reform of wholly state-owned commercial banks. The reform was carried out by disposing of nonperforming assets, bolstering capital, establishing modern corporate governance frameworks, introducing strategic investors, and conducting public offerings domestically and abroad. The Central Huijin Investment Company was established to serve as the investor on behalf of the state. A market-based approach was adopted to dispose of nonperforming assets in order to reduce losses and best protect against ethical risks. When joint stock companies were incorporated, importance was attached to setting up uniform corporate governance frameworks, and the role of strategic investors was fully developed in such areas as improving corporate governance, introducing international standards and practices, and promoting technical and operational cooperation. With respect to specific operations, the reform employed the principle of gradual progression in proper sequence, with pilot trials first, followed gradually by other steps after experience was obtained.

Based on the preliminary success of the pilot projects, the shareholding reform was then implemented for the Industrial and Commercial Bank of China (ICBC) and Agricultural Bank of China (ABC). Since 2005, the four large commercial banks noted above have successively launched initial public offerings, and all have successively completed dual listings of A shares and H shares. Through these reforms, corporate governance of large commercial banks has been standardized, risk management mechanisms have been upgraded, and asset quality and profitability have improved year by year, underpinning financial health and promoting market competition (Figures 1.1 and 1.2). The reform also played an important role underpinning China’s resilience to shocks during the recent global financial crisis.

Figure 1.1Total Assets of Large Commercial Banks

(Hundreds of millions of renminbi)

Source: Based on data from annual reports of the large commercial banks.

Note: ABC = Agricultural Bank of China; BOC = Bank of China; CCB = China Construction Bank; ICBC = Industrial and Commercial Bank of China.

Figure 1.2Nonperforming Loan Ratios of Large Commercial Banks

(In percent)

Source: Compiled based on data from annual reports of the large commercial banks.

Note: ABC = Agricultural Bank of China; BOC = Bank of China; CCB = China Construction Bank; ICBC = Industrial and Commercial Bank of China.

In terms of rural financial reform, China began to implement a pilot reform program for rural credit cooperatives in June 2003, and gradually expanded the scope of the program nationwide. During the reform process, positive incentive mechanisms for funding support were designed and implemented, and efforts were undertaken to mobilize the participation and support of local governments and rural credit cooperatives. Through the reform, the governance structure of the cooperatives has been continuously optimized, risk control capabilities have improved markedly, and operating performance has continuously improved. As of end-June 2012, 1,858 county-level (municipal) rural credit cooperatives, 247 rural commercial banks, and 173 rural cooperative banks had been set up nationwide. The nonperforming-loan (NPL) ratio of rural credit cooperatives fell to 4.7 percent, while the capital adequacy ratio increased to 10.8 percent (Figures 1.31.6). Additionally, reforms were undertaken of the three rural financial business departments of the ABC and the Postal Savings Bank of China. Finally, the program promoted new rural financial institutions such as town and village banks, and put in place a series of support policies that collectively have played an important role in improving rural financial services.

Figure 1.3Total Assets of Rural Credit Cooperatives

(Hundreds of millions of renminbi)

Source: The People’s Bank of China.

Figure 1.4Owners’ Equity of Rural Credit Cooperatives

(Hundreds of millions of renminbi)

Source: The People’s Bank of China.

Figure 1.5Capital Adequacy Ratio of Rural Credit Cooperatives

(In percent)

Source: The People’s Bank of China.

Figure 1.6Nonperforming Loan Ratios of Rural Credit Cooperatives

(In percent)

Source: The People’s Bank of China.

Progress has also been achieved in reforming other financial institutions. While reforms of large commercial banks and rural credit cooperatives were being carried out, other financial institutions were also encouraged to reform on their own and with external support. A group of small and medium-sized commercial banks, including China Everbright Bank, China CITIC Bank, and Bank of Beijing, have gradually established modern corporate governance frameworks through financial restructuring, introduction of domestic and foreign strategic investors, and initial public offerings. Reforms of policy banks have also advanced steadily. Breakthroughs were achieved with respect to the reform of the four asset management companies, with the completion of shareholding reform of both China Cinda Asset Management and China Huarong Asset Management.

In the securities industry, comprehensive regulation resulted in the shutting down of a group of illegally operating securities dealers, and another group of securities dealers was restructured according to market principles. The capital adequacy ratios, management standards, and service capabilities of the industry as a whole have been substantially upgraded. Two large insurance companies, the People’s Insurance Company of China and China Life Insurance, took the lead in listing their stocks on international capital markets. Some insurance companies, including China Reinsurance Group and New China Life Insurance, have successfully completed capital infusion and ownership reform work.

The results of China’s financial reforms over the past decade have been positive and the overall strength of the financial industry has improved markedly. As of June 2012, banking industry assets totaled 128.6 trillion renminbi, representing growth of 3.8 times over year-end 2002, with an average capital adequacy ratio of 12.3 percent and a provision coverage ratio of 175 percent. The assets of securities companies totaled 1.6 trillion renminbi and assets under management by fund management companies totaled 2.4 trillion renminbi, representing growth of two times and 19.3 times, respectively, over year-end 2002. Insurance industry assets totaled 6 trillion renminbi, an increase of 9.4 times over year-end 2002 (Figure 1.7).

Figure 1.7Total Assets in the Financial Sector

(Trillions of renminbi)

Source: The People’s Bank of China.

Deepening of Domestic Financial Markets

Since 2002, market-oriented reforms have greatly encouraged financial innovation and improved market outcomes. Efforts have focused on increasing market transparency and establishing a system in which the market segments operate in a complementary manner. This has played an important role in supporting economic development, optimizing social financing needs, and maintaining financial stability.

Great strides have been made in developing securities markets. Prior to that, for a variety of reasons, the development of China’s securities markets, and in particular its corporate bond market, had been very slow. Based on an earnest review of experiences and lessons, several series of measures were adopted in 2004 to promote financial market reform and development. The first series involved continued development of the over-the-counter market. On the interbank market, institutional investors were positioned as the investment principals to gradually form a hierarchically ordered investor structure with market makers at the core, financial institutions as the principals, and the joint participation of other investors. A second series of measures aimed to reduce unnecessary administrative approvals. In order to conform to the market-oriented financing requirements of enterprises, innovations in the bond market system were encouraged, a registration system was implemented for corporate short-term financing bills and medium-term notes, and an approval system was put in place for corporate bonds and bonds of publicly traded companies. The third series of measures involved fully developing the right set of market incentive and market discipline mechanisms, such as disclosure and credit ratings. These measures played a prominent role in promoting the rapid development of the financial markets, and particularly the bond market. The outstanding bond balances increased from 2.8 trillion renminbi at the end of 2002 to 22.1 trillion renminbi at the end of 2011. As a proportion of GDP, outstanding bonds increased from 24 to 47 percent in the same period (Figures 1.8 and 1.9). According to Bank for International Settlements statistics, in terms of size, China’s bond market ranked third in the world and second in Asia at the end of 2011.

Figure 1.8Outstanding Bond Balances and Their Ratios to GDP

(In trillions of renminbi and percent)

Source: The People’s Bank of China.

Figure 1.9Bond Issuance

(In trillions of renminbi)

Source: The People’s Bank of China.

Chinese authorities have continuously promoted the innovation of products and instruments in bond markets. In recent years, based on market demand, products including short-term financing bills, ultra-short-term financing bills, medium-term notes, and aggregate products have been successively introduced on the interbank market, thus increasing direct financing channels for enterprises and improving the financing structure. The financial derivatives market came into being and experienced marked development with the successive introduction of forward bond trading, renminbi interest rate swaps, securities lending, credit risk mitigation instruments, stock index futures, and securities margin trading operations, thus enriching risk management mechanisms for investors and for the sharing of credit risk. In 2005, a pilot project on credit asset securitization was launched. As of the end of June 2012, 11 financial institutions had issued a cumulative total of 66.78 billion renminbi in securitized products. The securitization of credit assets helps to mitigate capital adequacy pressures on banks as a result of growth in credit assets and strengthens the risk management capabilities of financial institutions.

The authorities have also worked continuously to improve the money, gold, foreign exchange, and stock markets. The pricing function of the money market has been continuously strengthened. Since 2003, an interest rate system has been established in which the Shanghai Interbank Offer Rate (SHIBOR) serves as the benchmark rate, and interest rates for interbank borrowings and repurchases are decided by buyers and sellers. The number of market participants has increased continuously, and transaction volume has increased substantially. In 2002, China instituted reform of the gold market and established the Shanghai Gold Exchange. At present, the early stages of a multilayered gold market combine spot and derivatives trading and exchange and off-exchange trading, catering to institutions as well as individuals. Since 2005, in order to coordinate with reform of the exchange rate formation mechanism, the over-the-counter trading mechanism and market-maker system have been introduced on the interbank foreign exchange market. A price transmission mechanism for the foreign exchange market has gradually taken shape, and the elasticity of the renminbi exchange rate has increased markedly. Progress has been achieved in the reform of the initial public offering system, and the financing function of the equity markets has improved substantially.

Market infrastructure is increasingly sound. Based on market development needs, the National Association of Financial Market Institutional Investors was established to bring into full play the self-regulatory organizational advantages of proximity to the market and a better capability to enhance innovation based on market demand. Infrastructure facilities, including a uniform central clearing system, centralized trading information platform, and secure and stable funds settlement system, were established. To continuously enhance transparency and strengthen market discipline, sound systems were also established, including a market-maker system, settlement agent system, money broker system, disclosure system, and credit rating system.

Advancing the Flexibility of Renminbi and Interest Rate Liberalization

China has made a major breakthrough in advancing the flexibility of the renminbi exchange rate. In July 2005, China instituted a reform of the renminbi exchange rate formation mechanism, establishing a managed floating exchange rate regime based on market supply and demand and adjusted with reference to a basket of currencies. At a time when the impact of the global financial crisis was quite severe, the renminbi exchange rate remained essentially stable, which helped China weather the crisis and promoted global financial stability and rebalancing of the global economy. At present, there is a notable bidirectional floating characteristic of the renminbi exchange rate and a marked increase in exchange rate flexibility. Market mechanisms now play a fundamental role in determining renminbi exchange rate levels (Figures 1.10 and 1.11).

Figure 1.10U.S. Dollar to Renminbi Exchange Rate

Source: The People’s Bank of China.

Figure 1.11Daily Fluctuation Range of the Renminbi to U.S. Dollar Exchange Rate

(In percent)

Sources: State Administration of Foreign Exchange; and Bloomberg.

The authorities have advanced interest rate liberalization in an orderly manner. At present, market reforms of the money market and bond market have been fully realized, and the SHIBOR is gradually becoming the pricing benchmark for the money market, bills markets, and derivatives market. Since 2004, China has successively lifted controls on the renminbi lending ceiling rate and deposit floor rate. Currently, interest rates on financial institution deposits are permitted to float up to 1.1 times the deposit benchmark interest rate, and interest rates on loans are permitted to float downward to 0.7 of the lending benchmark interest rate. The role of the market mechanism in the formation of interest rates has thus strengthened markedly.

Increasing the Degree of Openness of the Financial Industry

Since 2006, China has fulfilled its World Trade Organization commitments by affording national treatment to foreign-owned financial institutions, lifting restrictions on market access in the breadth and scope of renminbi operations, and pressing ahead with renminbi capital account convertibility, which has greatly increased the level of financial market openness. As of end-June 2012, banks from 15 countries and regions had established 37 wholly foreign-owned banks (with 254 subordinate branches) and two joint venture banks (with seven subordinate branches and one affiliate institution) in China; 76 foreign banks from 26 countries and regions had established 95 branches in China; and another 175 banks from 45 countries and regions had established 204 representative offices in China. The number of joint-venture securities companies and joint-venture fund management companies totaled 12 and 41, respectively, and insurance companies from 16 countries and regions established 55 foreign-owned insurance companies in China, with a total of nearly 1,400 branch and affiliate institutions at various levels. As of end-August 2012, China had approved Qualified Foreign Institutional Investor (QFII) quotas totaling US$80 billion, and 152 foreign institutions possessed QFII qualifications. There is now financial openness characterized by mutual benefit and joint development.

China actively participates in international organizations concerned with international financial industry reforms, standards, and systems such as the Financial Stability Board and the Basel Committee on Banking Supervision in order to promote international financial regulatory reform. China attaches importance to the introduction and implementation of international standards, best practices, and methods. Since the early 2000s, China has given priority to implementing the Basel Accord, with particular emphasis on raising capital adequacy ratios and asset quality. Since 2003, an important component of financial industry reform has been to recognize international standards or make reference to international standards to increase transparency and increase capital requirements, disclosure requirements, and accounting and external audit standards.

Developing Mechanisms for Long-Run Financial Stability

Against a backdrop of increasingly severe volatility in international financial markets in recent years, Chinese authorities have consistently attached importance to maintaining monetary and financial stability. They began studying the macroprudential policy framework and the proper handling of relationships between economic growth and price stability, and guarding against financial risk early on. At the same time, China has attached importance to the development of systems and mechanisms to maintain financial stability.

The authorities have also strengthened and improved macroprudential management. After the international financial crisis erupted in 2008, China began studying ways to strengthen the macroprudential policy framework. The dynamic adjustment of differentiated reserve measures in place since 2010 combines the aggregate adjustment tools of monetary credit and liquidity management with the strengthening of macroprudential management. This plays an important role in enhancing the ability of financial institutions to guard against risk, guiding and providing incentives for financial institutions to take the initiative to preserve financial health, and adjusting the supply of monetary credit. Drawing on international experiences and adapting them to national conditions, China has begun to implement countercyclical capital buffers, excess capital requirements, and forward-looking provision requirements, and has preliminarily established a countercyclical macroprudential management framework. China is now in the process of exploring the establishment of systems for systemic financial risk monitoring and evaluation of correlations within the financial system, as well as those between the financial system and the shadow banking system, and between the financial system and the real economy. The aim is to guard against financial risk across industries, markets, and borders.

The authorities have also promoted financial safety net development. In order to strengthen mechanisms for cooperation and information sharing between the People’s Bank of China (PBC) and the China Banking Regulatory Commission (CBRC), Securities Regulatory Commission, and Insurance Regulatory Commission, a national centralized financial statistics information system has been established. This has strengthened cooperation and the regulation of new crosssector products. Early warning systems and correction mechanisms have been strengthened, grounded in early detection and early correction to prevent the transmission and spread of financial risk. In the process of risk correction, the emphasis is on strengthening the tools available to the central bank as lender of last resort and effectively reducing ethical risk and the cost of financial assistance. In order to promote the establishment of a market-oriented risk correction arrangement, the Securities Investor Protection Fund, Futures Investor Safeguard Fund, and Insurance Protection Fund were successively established. A third-party custodian system for the trading and settlement of client securities was implemented to prevent securities companies from engaging in illegal acts such as misappropriation of client settlement funds. After in-depth study and discussion, there has been progress with respect to the deposit insurance program, and efforts are currently focused on refining and implementing the program in a push to establish this system as quickly as possible.

The authorities have established a system to protect the interests of financial consumers. With the rapid development of financial markets and the increasing variety of financial products, the proper handling of the relationship between developing the industry and protecting the interests of financial consumers has become increasingly important. The 2012 National Financial Work Conference proposed giving higher priority to protecting the interests of financial consumers. Drawing on international experience, special financial consumer protection entities have been established at the PBC and regulatory agencies. These entities are responsible for studying financial consumer protection policies, establishing and refining financial consumer interest protection mechanisms and protective measures, and receiving, investigating, and handling financial consumer complaints.

Completion of the First IMF Financial Sector Assessment Program

The current global financial crisis demonstrated the importance of comprehensively evaluating financial systems. As early as 2003, China conducted a self-assessment of financial sector stability in accordance with the IMF’s Financial Sector Assessment Program (FSAP) framework and the relevant international standards. At the G20 summits held in Washington and London in November 2008 and March 2009, all member countries committed to submitting to FSAP assessments by the IMF and the World Bank. In order to fulfill its commitment, China formally launched its first FSAP assessment in August 2009. Through the joint efforts and close cooperation of Chinese and foreign parties, the assessment concluded successfully in November 2011. The relevant assessment reports—People’s Republic of China: Financial System Stability Assessment (FSSA), China: Financial Sector Assessment (FSA), and People’s Republic of China: Detailed Assessment Report of China’s Implementation of International Standards and Principles in the Financial Field (DAR)—have already been published.1

The assessments found that China’s financial system has achieved marked progress with respect to commercial transition and financial health, and that the health of the financial system has continually strengthened. The assessments pointed out the need for China to accelerate the commercialization of the financial system in order to continue to improve financial regulation, establish sound and mechanized frameworks for financial stability and crisis management, further perfect the financial infrastructure, and expand financial coverage. Undertaking the FSAP assessment was an important test of the outcomes of China’s financial system development in recent years. It has aided in the integration of international experience into an examination of financial institution health, and it has afforded China’s financial sector a more sober awareness of the risks and challenges it faces.

Although notable results have been achieved through China’s financial reforms, the country’s financial system will face new challenges as the economic development model shifts and structural adjustments proceed, particularly amid continuing economic and financial globalization. The government’s recently published Twelfth Five-Year Plan for Financial Industry Development and Reform addressed the need to comprehensively promote financial reform, openness, and development, and to significantly strengthen the financial industry’s overall position, international competitiveness, and risk-resistance capacity.2

Looking forward, China will continue to deepen financial reforms and expand financial openness in order to increase market orientation and globalization and to build a modern financial system that is structurally sound, secure, and efficient, thus markedly increasing its level of service to the real economy.

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