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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.