Download The Domestic Financial System and Capital Flows

The Domestic Financial System and Capital Flows: China
Chong-En Bai
School of Economics and Management
Tsinghua University
1. Introduction
To be finished
The issue
Related literature
Our contribution
Main conclusions:
•FDI is the largest source of capital inflow. It has been stable in the last few years.
•Capital inflow through the stock market is growing fast.
Speculations
•Inward portfolio investment may grow significantly with the improvement of corporate
governance, the expansion of the corporate bond market, and the relaxation of the
restrictions on foreign investors.
• Outward portfolio investment is not allowed now, but has strong potential.
•The improvement in the quality of intermediation may put downward pressure on FDI.
2. A Brief Overview of the Financial System
In this section, we offer a brief overview of China’s financial system. We discuss the
sizes of various sectors of the financial market, including the banking sector, the stock
market, the bond market, and the insurance sector. We also consider the importance of
these sectors in intermediating investment flows.
China’s financial system is dominated by its banking sector. At the end of 2005,
the total assets in the broadly defined banking sector (including banks, trust and
investment companies, the Postal Savings Bureau, and leasing companies) was 37.5
trillion Yuan, 1 which was twice the GDP figure of 18.2 trillion Yuan. The total deposit in
the banking sector was 30.0 trillion Yuan and the total loan was 20.7 trillion Yuan. 2 In
contrast, the total market capitalization of the stock market was only 3.2 trillion Yuan
even if all shares were valued at the high price of tradable shares. If we only include
tradable shares, the total market capitalization was only 1.1 trillion Yuan. 3 The debt
market is also small. The total balance of government bond was 2.7 trillion Yuan 4 and the
size of the corporate bond market is even smaller. Finally, the total asset of the insurance
companies was 1.5 trillion Yuan.
In terms of the investment flow, the most important source of external funding is
also bank loans. In 2005, the increase in total bank loans was 2.35 trillion Yuan. In
comparison, total funds raised from the stock markets was 188 billion Yuan, of which
only 34 billion was from the domestic A shares market and other 155 billion was from H
shares issued in Hong Kong. The bond market is dominated by the government.
Government bond new issue was 704 billion Yuan and corporate bond new issue was
only 65 billion Yuan.
Given that the total amount of fixed capital investment was 8.86 trillion Yuan, we
can see that much of the investment was not intermediated through the financial system.
Under central planning, investment directly from the government budget played an
important role, but this role has been diminishing. A large part of the investment comes
from retained earnings of the enterprises. David Li offers some analysis of reinvested
earnings using aggregate data.
Another important source of investment is FDI. In 2005, the total amount of FDI
was about 60 billion US dollars. This figure has been stable over the last five years.
Table 1:
1
“Strengthen China’s Financial Industry in the Process of Opening Up.” WU Xiaoling, Deputy Governor
of the People’s Bank of China.
2
PBOC
3
CSRC
4
“Strengthen China’s Financial Industry in the Process of Opening Up.” WU Xiaoling, Deputy Governor
of the People’s Bank of China.
Actual Foreign Investment (100 million US dollars)
Direct
Other
investment
investment
Year
Total
Loans
1995
481.33
103.27
375.21
2.85
1996
548.04
126.69
417.25
4.1
1997
644.08
120.21
452.57
71.3
1998
585.57
110
454.63
20.94
1999
526.59
102.12
403.19
21.28
2000
593.56
100
407.15
86.41
2001
496.72
468.78
27.94
2002
550.11
527.43
22.68
2003
561.4
535.05
26.35
2004
640.72
606.3
34.43
2005
638.05
603.25
34.8
Source: 1995-2004 data come from China Statistical Yearbook, 2005 edition, page 643.
2005 data come from the website of the Ministry of Commerce.
3. A Brief Overview of Capital Flows
In this section, we offer a brief overview of capital flows in and out of China. Part of the
capital flow is intermediated through the financial system, including portfolio investment
though the capital market and the deposits and loans through banking system, including
domestic banks and foreign banks. The most important part of capital flow, namely FDI,
is not intermediated through the financial system. Another non-intermediated flow
consists of trade credits. We will discuss each of these forms of the capital flow.
Table 2 and 3 are the balance of payment tables for 2004 and for the first half of
2005 respectively. In the capital and financial account of the balance of payments table,
the most important item is FDI. In 2004, China received 54.9 billion US dollars of FDI 5
and invested 1.8 billion US dollars directly abroad. As Table 1 shows, the FDI figure has
been stable in the last few years.
Table 2:
Balance of Payments (in thousands of US Dollars): 2004
Item
I. Current Account
A. Goods and Services
Credit
Debit
68,659,162 700,697,007 632,037,845
49,283,643 655,826,577 606,542,934
1.Goods
58,982,275 593,392,511 534,410,236
2.Services
-9,698,632
62,434,066
72,132,698
2.5Insurance Services
-5,742,792
380,783
6,123,574
2.6Financial Services
-44,151
93,945
138,096
-3,522,669
20,544,095
24,066,764
-4,154,861
18,529,736
22,684,596
22,898,189
24,326,335
1,428,146
B.Income
2. Investment Income
C. Current Transfers
II.Capital and Financial Account
A. Capital Account
B. Financial Account
1.Direct Investment
110,659,756 343,350,151 232,690,395
-69,345
0
69,345
110,729,101 343,350,151 232,621,050
53,131,430
60,905,778
7,774,348
1.1Abroad
-1,805,053
275,778
2,080,831
1.2In China
54,936,483
60,630,000
5,693,517
19,689,873
20,262,117
572,244
6,486,438
6,567,007
80,569
0
0
0
6,486,438
6,567,007
80,569
13,203,436
13,695,110
491,675
2. Portfolio Investment
2.1Assets
2.1.1Equity Securities
2.1.2Debt Securities
2.2Liabilities
5
Balance
The FDI figure here is different from that in Table ???. The figure here measures the actual capital flow
and is attained from SAFE and the figure in Table ??? is from the Ministry of Commerce.
2.2.1Equity Securities
2.2.2Debt Securities
3.Other Investment
3.1Assets
10,923,200
10,923,200
0
2,280,236
2,771,910
491,675
37,907,798 262,182,256 224,274,458
1,979,656
51,236,020
49,256,364
-15,897,000
0
15,897,000
3.1.2Loans
-9,657,939
101,615
9,759,554
3.1.3Currency and Deposits
20,206,679
21,241,391
1,034,712
7,327,915
29,893,013
22,565,098
3.1.1Trade Credits
3.1.4Other Assets
3.2Liabilities
35,928,142 210,946,236 175,018,094
3.2.1Trade Credits
18,595,000
3.2.2Loans
13,752,887 174,532,616 160,779,729
18,595,000
0
3.2.3Currency and Deposits
1,561,021
14,538,936
12,977,915
3.2.4Other Liabilities
2,019,234
3,279,684
1,260,451
III.Reserve Assets
IV.Net Errors and Omissions
-206,364,000
27,045,082
478,000 206,842,000
27,045,082
0
Source: State Administration of Foreign Exchange
Table 3:
Balance of Payments (in thousands of US Dollars): First half of 2005
Item
I. Current Account
A. Goods and Services
Balance
Credit
Debit
67,263,509 405,745,648 338,482,139
50,301,866 376,994,208 326,692,342
1.Goods
54,234,373 342,453,248 288,218,874
2.Services
-3,932,508
34,540,960
38,473,468
2.5Insurance Services
-3,066,991
237,275
3,304,266
2.6Financial Services
-15,297
49,583
64,881
4,873,189
15,579,650
10,706,461
4,092,600
14,007,169
9,914,570
B.Income
2. Investment Income
C. Current Transfers
II.Capital and Financial Account
A. Capital Account
B. Financial Account
1.Direct Investment
12,088,454
13,171,791
1,083,336
38,297,931 214,583,855 176,285,924
2,153,993
2,179,851
25,858
36,143,938 212,404,004 176,260,066
22,475,447
29,067,900
6,592,453
1.1Abroad
-3,897,630
206,749
4,104,379
1.2In China
26,373,077
28,861,151
2,488,074
-965,911
7,606,329
8,572,240
-8,458,085
13,669
8,471,754
0
0
0
-8,458,085
13,669
8,471,754
2.2Liabilities
7,492,174
7,592,660
100,486
2.2.1Equity Securities
7,279,000
7,279,000
0
213,174
313,660
100,486
2. Portfolio Investment
2.1Assets
2.1.1Equity Securities
2.1.2Debt Securities
2.2.2Debt Securities
3.Other Investment
14,634,402 175,729,775 161,095,372
3.1Assets
-18,086,657
3,727,352
21,814,009
3.1.1Trade Credits
-13,153,731
0
13,153,731
-2,211,795
103,610
2,315,404
240,247
803,805
563,558
3.1.4Other Assets
-2,961,378
2,819,938
5,781,316
3.2Liabilities
32,721,060 172,002,423 139,281,363
3.2.1Trade Credits
10,138,571
3.1.2Loans
3.1.3Currency and Deposits
10,138,571
0
3.2.2Loans
9,533,375 127,189,797 117,656,422
3.2.3Currency and Deposits
9,289,947
30,541,293
21,251,346
3.2.4Other Liabilities
3,759,167
4,132,762
373,595
III.Reserve Assets
IV.Net Errors and Omissions
-100,453,380
-5,108,061
Source: State Administration of Foreign Exchange
588,000 101,041,380
0
5,108,061
The second important item is inward equity portfolio investment, shown in Table
4. It has been steadily increasing since 2001, from 849 million US dollars in 2001 to 10.9
billion US dollars in 2004. In the first half of 2005, the figure reached 7.3 billion US
dollars. There is no outward equity portfolio investment and, as Table 5 indicates, debt
portfolio investment does not show a clear trend.
Table 4:
Inward Equity Portfolio Investment (1000 US dollars)
2000
2001
849,000
2002
2,249,000
2003
2004
7,729,000 10,923,200
2005．6
7,279,000
Source: State Administration of Foreign Exchange
Table 5:
Debt Portfolio Investment
2002
2003
399,349
-496,975
714,636
2,280,236
213,174
Credit
1,485,650
22,882
1,577,520
2,771,910
313,660
Debit
1,086,301
519,857
862,884
491,675
100,486
-20,685,864
-12,094,510
2,983,121
6,486,438
-8,458,085
Credit
37,622
14,734
3,000,162
6,567,007
13,669
Debit
20,723,487
12,109,244
17,041
80,569
8,471,754
Balance
Liabilities
Balance
Assets
2004
2005．6
2001
Source: State Administration of Foreign Exchange
The banking sector also plays some role in intermediating capital flows. Domestic
banks take deposits from foreigners. Table 6 shows that both credit and debit have
increased steadily in the last few years, indicating the transaction volume has increased
steadily. However, the net balance does not show a clear trend, except that there is a
sharp increase in net inflow of currency and deposits in the first half of 2005.
Table 6:
Currency and Deposits Liabilities
2000
2001
-53,564
492,185
-2,486,288
Credit
8,782
567,279
1,358,664
8,795,060 14,538,936 30,541,293
Debit
62,347
75,093
3,844,951
8,052,619 12,977,915 21,251,346
Balance
2002
2003
742,441
2004
2005.6
1,561,021
9,289,947
Source: State Administration of Foreign Exchange
Domestic banks also intermediate capital outflows. They deposit funds in foreign
banks, and make loans to foreigners. In 2004 and 2005, their currency and deposits assets
decreased more than they increased, resulting in net inflow and reversing the earlier trend.
There is no clear trend in loan assets.
Table 7:
Currency and Deposits Assets
2000
2001
2002
2003
2004
-6,048,944
-3,213,816
-2,486,288
-6,552,105
20,206,679
240,247
Credit
1,428,243
301,162
1,358,664
662,871
21,241,391
803,805
Debit
7,477,187
3,514,978
3,844,951
7,214,976
1,034,712
563,558
Balance
2005.6
Loan Assets
Balance
-12,959,875
15,313,555
-5,391,120
13,927,400
-9,657,939
-2,211,795
Credit
0
15,736,290
346,619
21,700,806
101,615
103,610
Debit
12,959,875
422,735
5,737,739
7,773,406
9,759,554
2,315,404
Source: State Administration of Foreign Exchange
Foreign banks make loans to domestic firms. The amount of foreign loans to
Chinese firms has been rapidly increasing since 2001. The increase has been faster than
the decrease since 2003, resulting in net inflow greater than inward equity portfolio
investment.
Table 8:
Loan Liabilities
2000
Balance -2,391,224
2001
2002
2003
2004
-1,490,082
-4,139,624
6,614,306
13,752,887
2005.6
9,533,375
Credit
12,200,369 10,304,541 52,077,237 78,874,342 174,532,616 127,189,797
Debit
14,591,593 11,794,623 56,216,860 72,260,037 160,779,729 117,656,422
Source: State Administration of Foreign Exchange
The last but not the least important item in the capital and investment account is
trade credit. In 2004 and the first half of 2005, the outflows of trade credits were 15.9 and
13.2 billion US dollars, amounting to 2.4% and 3.5% of export, respectively. In the same
periods, the inflows of trade credits were 18.6 and 10.1 billion US dollars, respectively,
amounting to 3.1% of import in both periods.
Table 9:
Trade Credits (billions US dollars)
2000
Outflow
2001
2002
2003
2004
2005.6
15.9
13.2
2.4
3.5
Percentage
of export
Inflow
18.6
10.1
3.1
3.1
Percentage
of import
4. The Domestic Financial System and Capital Flows
In this section, we consider the development of each sector of China’s financial system
and discuss its relationship to capital flows. We will present the current state of the sector,
discuss restrictions it faces, analyze the problems, consider possible policy changes and
their impact on capital flows.
4.1. The Banking Sector
China’s banking sector is dominated by state-owned banks. The big four commercial
banks are either fully state owned or just listed on the stock market with the state
maintaining dominant ownership. City commercial banks are majority owned by city
governments. Most of the national joint equity commercial banks are under tight control
of the state even though they are not fully owned by the state, with the government
controlling the appointment of the top management team. One exception is Shenzhen
Development Bank. A US investment company, Newbridge, purchased a major stake of
the bank and acquired the control over the bank’s board. The other exception is China
Zheshang Bank. The bank was originally a joint venture bank established in 1993. Its
ownership structure was overhauled in 2004 and is now owned by 15 shareholders, 13 of
which are private enterprises taking 85.71% of the ownership share. Table 10 presents the
sizes of major commercial banks in China.
Table 10:
Total Assets and Owner's Equity of Major Banks (end of 2004)
Name of Banks
Owner's
Assets
Equity
4,270,443
205,351
China Contruction Bank
3,904,785
194,744
ICBC
5,670,521
162,983
China Agricultural Bank
4,013,769
78,063
Bank of Communication
1,138,634
52,489
China Merchants Bank
602,765
20,881
Shanghai Pudong Development Bank
455,532
13,510
China Minsheng Bank
445,492
12,907
Huaxia Bank
304,326
9,609
Shenzhen Development Bank
204,286
4,684
CITIC Bank
514,822
19,663
Industrial Bank
340,522
10,467
China Everbright Bank a
423,690
-2,915
g
Owned
Banks
Commercial
Bank of China
Total
12 National Joint Equity Commercial Banks
c
negative
Guangdong Development Bank
b
344,500
value
Main City
Commercial
Banks
China Zheshang Bank
d
10,307
--
Evergrowing Bank
d
27,151
--
Bank of Shanghai
219,837
7,299
Bank of Beijing
208,755
7,127
Shenzheng Commercial Bank
d
68,257
--
Tianjin Commercial Bank
d
60,578
--
Sources：The 2004 annual reports of various banks.
Notes: a is from the 2004 annual report of Everbright Holdings; b is from the website of
Guangdong Development Bank; c is from http://finance.sina.com.cn “New Strategic
Investor Will Acquire Control over Guangdong Development Bank”, December 02, 2005;
d is from http://www.cnfol.com “The 2004 Ranking of Top 50 Commercial Banks in
China”, December 7, 2005.
Foreign ownership of banks is restricted but expanding in China. The total
amount of foreign share in a Chinese bank is restricted to no more than 25 percent and
the ownership share of a single foreign investor is restricted to no more than 20 percent.
Despite these restrictions, there is strong interest among foreign investors in ownership
shares in Chinese banks. By the end of 2005, 25 foreign banks had acquired ownership
share in Chinese banks. 6 In the case of Shenzhen Development Bank, the foreign
investor has acquired the control over the board. In 2005, the market share of foreign
banks in terms of Renminbi loans was 0.55 percent but that in terms of foreign currency
loans was 20.97 percent. 7
[Will add discussion of wholly foreign owned banks in China.]
Table 11 presents the distribution of assets among various types of financial
institutions from 2000 to 2004. City commercial banks were born in 2001 when some of
the urban credit unions were transformed into city commercial banks. The market share
of the big four banks is still dominant, although it has been steadily declining. The market
shares of all the other categories have been increasing except for that of rural credit
unions.
Table 11:
Distribution of Assets among Financial Institutions
Year
2000
2001
2002
2003
2004
State-owned commercial banks
68.1
64.5
58.7
58.2
53.6
Joint equity commercial banks
10.2
12
13
13
14.9
5
5
5.4
City commercial banks
6
“Strengthen China’s Financial Industry in the Process of Opening Up.” WU Xiaoling, Deputy Governor
of the People’s Bank of China.
7
“Strengthen China’s Financial Industry in the Process of Opening Up.” WU Xiaoling, Deputy Governor
of the People’s Bank of China.
Foreign invested commercial banks
1.2
1.3
1.8
Urban credit unions
4.6
4.8
0.5
0.5
0.6
Rural credit unions
9.3
10.1
9.6
9.6
9.7
Other financial institutions
7.8
8.6
12
12.4
14
Source: Statistical Quarterly of the PBOC, various years.
In addition to the dominance of state ownership, the Chinese government also
exerts control over the banks through interest rate regulations and credit policies that go
beyond banking regulations commonly observed in market economies.
Restrictions on lending rates have been significantly relaxed since January 1,
2004. For commercial banks and urban credit unions, lending rate range expanded to [0.9,
1.7] of the benchmark lending rate determined by the central bank, and for rural credit
unions, the range expanded to [0.9, 2]. The deposit rates are still tightly regulated except
for the bulk rates for deposits of more than 30 million Yuan and with terms longer than 5
years. As a result, the gap between the lending and deposit rates is very high. For one
year term deposit, the rate is only 2.25% while the benchmark rate of one year loan is
5.58%. The lending-borrowing rates differential of 3.33% is very high compared to
international standard.
The large lending-borrowing rates differential maintained by regulation is a form
of financial repression. It gives firms strong incentives to reinvest their retained earnings
because the opportunity cost of their investment, the deposit rate, is much lower than the
official lending rate. It also makes the monetary policy ineffective because the firms will
still reinvest their earnings even if the central banking raises the lending rates.
The central bank also makes and implements credit policies that affect the
operation of commercial banks. Credit policy is considered an important part of
macroeconomic policy in addition to monetary and fiscal policies. It is also used as a tool
to implement industrial policies. The credit policy includes four dimensions. First, it
seeks to control the total scale of credit, for example, by regulating the down payment
ratio of home mortgage and automobile loans. Second, it seeks to implement the
industrial policy by guiding credits towards favored sectors or regions through selective
interest rate discount. Third, it seeks to guide credit away from certain sectors or regions
by directing commercial banks adjust credit lines available to and risk premium
demanded from firms in these sectors and regions. Fourth, it regulates financial
innovation and seeks to control financial risks.
The restrictions on bank ownership and the tight control of the state over the
banking sector including the interest rate regulation and the credit policy, among other
reasons, lead to the poor performance of the banking sector. The banking sector is not
doing well in allocating credits to the most productive use. It still discriminates against
the non-state sector. Bank loans made to state-owned enterprises become non-performing
too often. Entrepreneurial firms on the other hand find it very difficult to get funding.
There is often overinvestment in some sectors, resulting in overheating of these sectors.
At the same time, there is also underinvestment in other sectors, especially with research
and development. State control is an important reason behind the poor performance of the
banking sector. With the interference of the credit policy, credit allocation does not
follow the market force. With strong government control over the governance of the
banks, especially the key personnel decisions, the banks are run by politicians and
bureaucrats rather than by banking professionals; credit allocation decisions are often
determined by political considerations rather than market principles even in the absence
of an official credit policy. With high barriers of entry and exit, new ideas and new
capabilities regarding bank management, products and market reach cannot prevail. The
legacy of central planning is also an important reason behind the poor performance.
Banks are used to acting under the direction of the government; their human capital,
organizational structure, operation procedures and information system are all outdated.
Various reform measures have been taken to tackle these problems. Restrictions
on interest rates have gradually been relaxed. Interest rate liberalization is to follow the
policy of “foreign currency first, local currency later; loan rates first, deposit rate later;
bulk and long term deposit rates first, small and short term deposit rates later,” and a
mechanism of having the market determining the interest rates with the central bank
influencing the rates indirectly is to be established gradually. 8 The credit policy has
gradually become less restrictive. It has been moving from administrative, quantity
8
“An Introduction to Interest Rate Liberalization,” PBOC.
control towards more market oriented measures. The governance of the banks has been
improving. From being treated as government agencies to being treated as enterprises
with more autonomy, banks now have a much stronger market orientation than before.
Having being corporatized, banks are gradually being listed on the stock market and
subject to more investor scrutiny and market pressure. Foreign ownership has been
relaxed. Some foreign strategic investors are playing important governance and
management roles. As a result of the credit policy reform and the governance reform,
credit decisions have become more market oriented.
As we discussed earlier, the banking sector has importance influence on capital
flows. Therefore, some of the bank reform measures have significant implications for
capital flows. Currently, deposit rates are very low with interest rate regulation. This
discourages currency speculators from depositing their funds in China’s banks. If deposit
rates are liberalized and become higher, there is likely to be more capital inflow through
the banking sector in the form of currency and deposits. With the relaxation of foreign
ownership of China’s banks, more foreign investment in the banks is expected. This will
also increase capital inflow. With the improvement in the performance of the banking
sector, it may play a more important role in intermediating investment funds, including
capital flows. We will discuss this further when we consider FDI in greater details later.
4.2. The Stock Market
Formally established at the end of 1990, the short history of China’s stock market has
witnessed a bumpy ride. As Table 12 shows, the total market capitalization of the stock
market as a percentage of GDP was 5.94 percent in 1995, rose rapidly to 53.75 percent in
2000, and sharply declined to 18.61 percent in 2005. At the end of 2005, there were 1381
listed companies on the two stock exchanges, the Shanghai Stock Exchange and the
Shenzhen Stock Exchange. These firms issue A shares denominated in the local currency
or B shares denominated in foreign currency. Some firms are listed on overseas stock
markets, most issuing H shares on Hong Kong Stock Exchange.
Table 12:
End of Year
2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995
Number of
domestically
listed firms
1381
Total market
capitalization
(billion
yuan)
3243
Market
capitalization
of tradable
shares
(billion
yuan)
1063
Raised funds
(billion
yuan)
188
Turnover
(billion
yuan)
3166
Number of
investor
accounts
(million)
73.4
Stamp duty
collected
(billion
yuan)
10.3
Total market
capitalization
as share of
GDP
18.6
23.2
36.4
37.4
45.4
53.8
32.3
25.3
23.5
14.5
5.94
The A shares of each listed company are divided into three categories, stateowned shares, legal person shares, and tradable shares. The first two types of shares are
held by the government, government agencies, state-owned enterprises, or other
enterprises. They were not tradable on the stock exchanges until very recently when the
government started the process of gradually making all shares tradable. The process is not
completed yet. At the end of 2005, there were 216 billion state-owned shares, 165 billion
legal person shares, 232 billion tradable A shares, 23 billion tradable B shares, and 41
billion other tradable shares. The total stock market capitalization was 3.2 trillion Yuan,
while the market capitalization of all tradable shares was 1.1 trillion Yuan. The share of
market capitalization of firms which had completed the reform of making all shares
tradable was 21.17%.
Many of the problems in China’s stock market are common to other emerging
markets. However, two features are special to China and we will focus our discussion on
them here. One is the separation of three types of shares. The other is the dominant role
of the government and the resulting soft budget constraint problem in stock market
policies and regulations.
The separation of three different types of shares has its costs in terms of low
market efficiency, controlling shareholder dominance, and poor functioning of the market
for corporate control. First, with three different types of shares and two of them not
tradable, there are two segmented markets for securities with the same claim on cash flow.
The uncertainty about when the shares will be made equal in terms of trading rights also
adversely affects the market. Consequently, the efficiency of the stock market is low,
which in turn affects the role of the market in allocating capital and in improving
corporate governance. Second, when state owned shares and legal person shares are not
tradable, the largest shareholder, often the government, has a dominant position in the
firm. The position gives the largest shareholder too much control over the firm at the
expense of other shareholders. Even if the largest shareholder wants to reduce its
dominant position so as to committing to treating other shareholders fairly, it cannot sell
its shares easily because its shares are not tradable on the stock market. Finally, the
separation makes it very difficult for the firm to be taken over even if the firm performs
very poorly. As a result, it is difficult for the poor management team to be replaced.
The dominant role of the government manifests itself not only in the form of the
state having dominant shares in most listed firms, but also in the form of frequent bailout
of the market by the government. There are many channels through which interest groups
pressure the government to bailout the market and the securities companies play an
important role here. There are 145 securities companies in China. Most of them are
owned by various levels of the government. Only 5 of them are joint ventures. Most
securities companies have a brokerage business. Investors maintain brokerage accounts
with these firms. Meanwhile, these firms also invest their own funds in securities and
they therefore have their own accounts. Officially, there should be a firewall between the
brokerage accounts owned by the clients of a securities company and the company’s own
account and transfer of funds between these two types of accounts should be prohibited.
However, the regulation is poorly enforced. Securities companies often divert funds from
their clients’ brokerage accounts to their own account to invest in securities. If the
investment pays off well, they return the funds to their clients’ accounts and keep the gain
from the investment. However, they sometimes lose money from the investment and
therefore cannot return the diverted funds to their clients. If this problem gets very
serious, there is the risk that the securities company goes bankrupt. In this case, the
clients of the company will suffer heavy loss even though they did not make risky
investment themselves. Such events may cause political trouble because the government
is supposed to enforce the firewall between the clients’ accounts and the company’s own
account and it is the failure of the government regulation that causes the loss to these
clients. In the face of such political trouble, and also under pressure from various levels
of government who own the securities company, the regulatory authority often bails out
the firm directly by pumping money into the company or indirectly by popping up the
stock market. The bailout is not only costly in terms of the resources needed, it also
creates expectation of future bailout, thus leading the securities companies to continue
their practice of diverting funds from clients’ accounts to their own account and sewing
the seeds for additional bailout in the future. The expectation of the bailout induces
investors to ignore the downside risk of their investment, encourages risky investment,
and leads to stock market bubbles.
Te be continued with the following outline:
•Reform measures:
•Making all shares tradable: the process
•Allow securities companies to fail while protecting small investors.
•The expanding of H shares.
•Nov. 1, 2002, foreign investors were allowed to purchase state-owned shares and legal
person shares.
•Nov. 5, 2002, QFIIs (qualified foreign institutional investors) were allowed to invest in
the domestic capital market.
•By the end of 2005, 43 QFIIs with 5.93 billion USD of quota.
•Dec. 31, 2005, strategic investors through private placement.
•The role of the stock market in capital flows.
•The effects of the reforms on capital flows.
4.3. The Bond Market
The bond market
New issue each year
(unit: 100 million yuan)
1998 1999 2000 2001 2002 2003 2004 2005
Corporate
148
158
83
147
325
358
327
654
Government 3809 4015 4657 4884 5934 6280 6924 7042
The bond market
•The corporate bond market is rapidly expanding.
•Restrictions on the method of issuing, the issuers, and the interest rates are soon to be
relaxed.
Domestic bond
Foreign bond
Currency and maturity mismatch?
Capital inflow through the bond market (liabilities)
Capital inflow through the bond market (assets)
Capital inflow through the bond market (assets)
•Investors: insurance companies, the Social Security Fund, QDII (?)
Outflow?
4.4. FDI
FDI (non-intermediated)
FDI (non-intermediated)
•Reinvested profits. (Find information)
•Why does China attract so much FDI and at the same time export capital by purchasing
government bonds abroad?
•Return differential between FDI and foreign government bonds.
The reasons for FDI:
(1) FDI brings know-how that is lacking in China
(2) The domestic financial system does not do a good job intermediating investment,
and FDI is equivalent to contracting out of financial intermediation.
(3) Poor protection of domestic investors but better protection of foreign investors.
(4) Brings in capital
Empirical work on FDI: to study the role of FDI indirectly by considering the
determinants of foreign equity shares in joint ventures.
The empirical study supports reason (1) but not reason (4)
•If the domestic financial system improves, the effect on FDI is not clear.
5. Conclusion
To be added.