China’s financial system is fourth largest in the world, behind only those of the United States, the eurozone, and Japan. Thus what happens in China financially will have important consequences for the development of financial markets and economies in Asia and worldwide.

China’s financial depth compares less favorably when scaled by GDP. By this metric, the country lags behind not only the advanced economies but also, among others, Thailand, Korea, and Taiwan. That said, China’s financial depth scaled by GDP is commensurate with that of other countries with comparable per capita incomes, either now, or in the case of the now-advanced countries, historically.

If there is a problem, then, it is not with the size of China’s financial markets but with their structure. In China, as in other countries at a similar stage of economic development, the financial system remains heavily bank-based. Because the information and contracting requirements of the arms-length transactions on securities markets are demanding, such markets are late to develop. Until they do, financial services are provided by banks, which develop relationships and invest in monitoring technologies so as to be able to assemble information on behalf of investors and to discipline borrowers. Over time, bond, equity, and derivatives markets acquire depth and gain liquidity. (According to the pecking-order theory, bond markets first, equity markets later.) The growth of these markets presupposes the existence of a relatively elaborate apparatus of underwriters, ratings agencies, custodians, clearing and settlement platforms, and systems for policing the markets, both self-policing by organized exchanges and regulatory oversight by autonomous securities commissions.

Until all this happens, banks remain the dominant source of external finance in China today, accounting for 60 percent of the sum of bank lending and stock- and bond-market capitalization, a substantially higher share than in other large financial markets such as those in the US, Japan, and Australia. The relative weight of banks in finance is roughly comparable to that in Germany in the 1980s or South Korea in the 1990s (in both, securities markets have since gained additional capital market share). If anything, the weight of banks is higher in China than in other emerging markets at a comparable stage of economic development, reflecting the close control the authorities have exercised, historically, over the operation of the Chinese economy as well as the utility of banks as a policy lever.

Necessarily, developing the Chinese financial system starts with reforming and strengthening the banks. The big Chinese banks, which account for the bulk of bank intermediation, are still majority state owned. Although they are officially commercialized—in other words, they are supposed to operate at arm’s length from the government—questions regarding their commercial and political motivations can arise. Reflecting this, the World Bank, in a study undertaken jointly with a leading Chinese government think tank, has recommended fully privatizing the banks, something that would eliminate much remaining ambiguity about their motives.

But commercialization will produce positive results only if the authorities at the same time remove the presumption that the big banks enjoy an implicit guarantee. The decision to move ahead with implementation of deposit insurance starting in early May 2015, which guarantees deposits (up to a 500,000 renminbi ceiling) rather than guaranteeing the banks themselves, is a necessary but insufficient step in this direction.

More generally, strengthening the banking system requires regulatory rationalization. Traditionally the People’s Bank of China has set a ceiling for deposit rates and a floor for lending rates, ensuring a spread that makes for healthy profits for state-owned banks. In July 2013 regulators lifted some controls over bank lending rates with the goal of permitting the banks to compete more intensively in extending corporate loans. But other controls, notably the ceiling on deposit rates, remain in place at the time of writing, reflecting worries that banks would otherwise engage in “unhealthy” competition for deposits and make excessively risky investments in the effort to meet their deposit-rate commitments.

But deposit-rate limits only encourage the growth of the shadow banking system. Effective privatization and commercialization will require fully deregulating deposit and lending rates so that banks with profitable investment opportunities can compete for both borrowers and funding without having to create unregulated off-balance-sheet financial products. That in turn will require strengthening regulatory oversight of the banks’ lending and investment practices to ensure that deposit-rate competition doesn’t give rise to excessive risk on the asset side of the banks’ balance sheets.

Finally, strengthening the banking system requires widening the regulatory perimeter. It requires increasing supervision and regulation of not just the banks themselves but also their off-balance-sheet subsidiaries, which constitute the shadow banking system. Estimates of the size of the shadow banking system vary widely, given vagaries of data and definition; they generally range from 50 to 80 percent of GDP. Even 50 percent is a substantial number, given that bank lending is officially on the order of 110 percent of GDP. Many of China’s trust funds and other nonbank investment vehicles are in fact operated by banks, which use them to attract funding by offering higher interest rates than permitted on conventional bank deposits and to extend loans that would require them to keep costly capital and provisions were they to be held on the banks’ balance sheets. In turn, the managers of these vehicles have an incentive to seek out risky loan opportunities in the hope of earning income sufficient to meet their interest-rate commitments.

In July 2013 the China Bank Regulatory Commission took a first step in addressing these concerns by requiring commercial banks to register wealth-management products prior to selling them to the public. Deposit-rate deregulation, by reducing the incentive to create such products as a way of attracting household savings, would be a further step in the same direction.

To be effective, supervision will have to extend to other nonbank entities that compete increasingly with the banks. Nonbank firms, both state-owned enterprises (SOEs) and others, use their excess funds to extend credit through “trust loans” and “entrusted loans” to other firms, taking land and other property as collateral. Here, too, banks are involved as intermediaries between the ultimate borrower and lender, allowing restrictions on entrusted loans to be evaded. Fostering effective and sustainable financial development will require bringing shadow banking into the light.

A weakness in the bond market

Bond markets, having started out behind, are now growing relative to the banks. Again, China’s size implies that its bond market accounts for a very large fraction of overall East Asia ex-Japan bond-market capitalization, on the order of two-thirds, while China’s bond market is now the third largest in the world, behind only those of the US and Japan.

Reassuringly, corporate issuance is expanding most rapidly. While corporate issues account for only about a third of the stock of bonds outstanding, they account for half of all new issues. This is a sign that the bond market is increasingly serving the financial needs of the economy.

At the same time, the bond market displays weaknesses. The market is small relative to the scale of the economy, smaller than in other emerging markets such as Brazil, Malaysia, Thailand, and South Africa. It is dominated by short-term issuance: nearly 40 percent of new issuance is of bonds with a maturity under one year, as if investors are reluctant to use this market to commit to long-term finance.

Corporate issuance, for its part, is dominated by majority-state-owned companies, indicating that the private sector is even more underserved by the bond market than suggested by the government-bond/corporate-bond breakdown. According to Nicholas Borst of the Federal Reserve Bank of San Francisco and Nicholas Lardy of the Peterson Institute for International Economics, SOEs account directly or indirectly for 90 percent of corporate-bond issuance. As of 2013, only seven of the top 30 corporate issuers were not majority government owned, and all seven in question were banks. Moreover, a substantial fraction of government bond issuance takes the form of bonds issued by three state-owned policy banks and guaranteed by the central government. The three state banks are presumably stepping in by issuing and then lending for projects for which the private sector finds it difficult to access bond finance. This is all the more striking given the reluctance of the authorities to allow debt issuers to default (in the presence of an implicit guarantee).

In addition, upwards of two-thirds of government bonds are held by banks, Chinese banks in particular. This is in contrast to the situation in other Asian countries with relatively well-developed bond markets, where government bonds are held by private investors, pension funds, and other provident funds. Given that much corporate-bond issuance is by state-owned companies, whose bonds are subsequently purchased by state-owned banks, one wonders how many of these transactions are policy directed as opposed to arm’s length. This raises the possibility of a diabolic loop if, say, local governments get into trouble, infecting bank balance sheets, or banks get into trouble and engage in fire sales of assets that demoralize the bond market.

Nor is this the diverse investor base to which the architects of deep and liquid bond markets aspire. Banks are not active traders. The dominance of banks on the buy side may thus account for the relatively limited liquidity of the secondary market (as measured by turnover, or amount traded as a share of the value of bonds outstanding), in government bonds in particular. Bid-ask spreads in the local-currency government bond market compare unfavorably with those in Korea, Singapore, and Thailand.

The authorities and market participants are doing some obvious things to address these problems. To increase the diversity of the investor base, China opened the interbank bond market to qualified foreign institutional investors (licensed commercial and central banks) in 2012, subject to a quota limit, although data from China’s main bond clearinghouse suggest that foreign investors still hold less than 1 percent of total bonds outstanding. The National Association of Financial Market Institutional Investors, the self-organizing association of bond dealers and investors overseen by the central bank, has taken steps to enhance the transparency of the interbank-bond market and ameliorate contracting problems through publications such as Guidelines for Book Building and Issuance, Code of Conduct for Issuers, and Rules on Bondholders Meetings. And the State Council has authorized trading of government debt futures to enable investors to hedge risks.

In addition, the authorities have mandated that all transactions on the interbank market must be conducted through the National Interbank Funding Center. Transactions also require legal documentation of transfers of ownership. In part this is a crackdown on so-called proxy holding trades, in which a financial institution transfers a bond from one account to another account belonging to the same individual or financial institution, as a way for the institution in question to boost its standing in industry league tables for trading volumes. On other occasions, it is alleged, the sale is completed at an inflated price in order to create bookkeeping profits. The result of the mandate has been a sharp drop in daily trading volumes, suggesting that historical turnover figures are inflated and market liquidity, so measured, is even less than previously thought.

The decision in 2014 to allow Shanghai Chaori Solar Energy Science and Technology, the solar-cell company, to default is a step toward addressing moral hazard in the bond markets by removing the implicit guarantee. A second step was taken in April of this year when the government of the city of Ordos refused to guarantee the bonds of the troubled Sundry Group of construction companies.

Constraints on the developing equity markets

The Chinese corporate sector has the highest debt-to-equity ratios in the region, reflecting the explosive growth of the corporate-bond market and historical underdevelopment of equity markets. Stock-market capitalization, at about 40 percent of GDP, compares unfavorably to that in other emerging markets such as Brazil, India, and Korea. Moreover, a nonnegligible, if declining, share of that capitalization is made up of nonnegotiable state-owned shares, causing the official Chinese figures to paint a somewhat exaggerated picture. The rate of growth of capitalization is similarly disappointing by international standards, reflecting high volatility on the Shanghai and Shenzhen markets.

Historically, turnover has been relatively high, despite foreign investors’ lack of access to substantial segments of the market. In contrast to the situation in the bond market, retail as well as institutional investors have been willing to participate actively, resulting in market liquidity that compares favorably with the situation in other countries at comparable levels of per capita GDP. But turnover has been declining in recent years, reflecting disenchantment among retail investors and complaints about market transparency and integrity. Recent volatility and especially successive sharp corrections downward in the level of Chinese equity markets may have further demoralized retail investors.

A further constraint on market development is the government’s close control of new listings. Applications for public listings must be approved by the China Securities Regulatory Commission. The commission appears to time listings so as to manipulate share prices. When prices fall, applications for new listings are delayed or rejected. Similarly, the government has allegedly pressured state-owned enterprises and banks to purchase shares when prices are depressed.

In May 2014 the State Council circulated a new policy document on capital-market development reaffirming its commitment to grow equity markets and increase the share of direct financing in total external finance, although it did not specify the steps it was prepared to take. Some of the needed changes are obvious, including speeding approval of public listings while strengthening disclosure and corporate governance requirements for corporations with public listings, as well as refraining from arm-twisting banks and SOEs to buy shares when prices are weak.

A key question is whether China should move faster to liberalize the capital account as a way of fostering financial development and liquidity. This issue arises most immediately in connection with efforts to internationalize the renminbi, it being unlikely that the currency will acquire meaningful unit of account, means of payment, and store of value functions internationally so long as access and use across borders are significantly restricted. The issue also arises in connection with Chinese aspirations for the renminbi to be added to the IMF’s SDR basket, inclusion presumably requiring substantial if not full capital-account liberalization. But the question can also be asked by those concerned about financial development more broadly. Lack of a diverse investor base is a problem for the bond market, and it can become a problem for the equity market if domestic retail investors continue to retreat. More rapidly liberalizing the access of foreign investors would be a way of addressing this problem, and as we’ve seen, Chinese policymakers have already begun going down this road.

Some observers warn that this strategy for attempting to compress the process of building more liquid financial markets has considerable risks. Corporates, both nonfinancial and financial, may respond to the appetite of issue-hungry foreigners by issuing reckless amounts of debt. Banks with easier access to foreign funding may lever up their balance sheets. Firms with governance and transparency problems may bring initial public offerings to market prematurely. Increased exposure to international capital flows may heighten macroeconomic volatility, especially if it precedes the transition to a more flexible exchange rate.

All these are good arguments for why the Chinese authorities should resist the temptation to rely on capital-account liberalization as a driver of domestic financial development and instead attend to basics, including strengthening not only supervision and regulation but also, more generally, rule of law and bureaucratic quality.

In principle, these problems can be addressed. Chinese officials promise that new regulations limiting the leverage of bond-market participants are coming. They promise a more flexible exchange rate, if not necessarily independence for the central bank. But how fast these changes are coming remains to be seen.

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.

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