The Contemporary Aftershocks of China's 1994 Financial Reforms

Above photos from the respective floors of the New York Stock Exchange and the Shanghai Stock Exchange.


The Contemporary Aftershocks of China's 1994 Financial Reforms


Current imbalances in China's banking sector threaten the sustainability of the country's impressive growth rates. The origin of many of these imbalances is endogenous to four major institutional reforms of China's financial system circa 1994. Policies such as the centralized control of capital flows and pegged currency rates, the short-term biased, opaque financing schemes of local governments, and the implicit guarantee and subsequent funding bias of large monopoly State-owned Enterprises connect directly and indirectly to current fault lines within China's financial sector. These institutional policies have created bubbles in the construction and real estate sectors, biased growth towards targeted urban centers and industries monopolized by SOEs, and birthed volatile investment products reminiscent of the toxic US packaged derivatives of the 2008 global financial crisis. Additionally, this paper will explore the possibility of over-investment in China, and its foundations within the banking environment. Some of the steps taken to obscure these institutional fissures have added to global macroeconomic imbalances, such as China's hoarding of foreign currency reserves and low consumption rate. However, on other fronts numerous progressive policies of the past decade have proven forces of liberalization, allowing for greater transparency within China's banking system and lead to efficiency gains in allocating resources. Despite these developments, the fault-lines within the financial system lie deep within the historical policy foundations, and as China's industries and banking system expand onto the greater world stage, the current institutional system may prove untenable.


I. Introduction

            There is little doubt that the 2008 Global Financial Crisis, induced by a collapse of the US credit market, further shifted the global financial center of gravity east. The People's Republic of China made headlines in the first year of the financial crisis by announcing a massive 4 trillion RMB stimulus plan, sending a strong statement to the global economy that they intend to maintain rapid output growth. In part because of this push, China weathered the global recession remarkably well, remaining a magnet for investment and successfully adapting to a weaker export market. As the largest source of global savings, the past few years has seen China add liquidity to an ailing European Union and begin to emerge as a global source of foreign direct investment, rather then just a benefactor. In the aftermath of 2008, China has emerged as an economic leader for the Asian region, surpassing the United States as Japan's largest trading partner and creating the world’s most populous free market with the ASEAN-China Free Trade Area (ACFTA).

            China's successful adaptation to changing conditions has fueled the debate about whether a free-market financial system can function under centralized control. The so-called Beijing Consensus presents a challenge to the liberal growth prescription, the Washington Consensus, which was espoused by the World Bank and IMF in the second half of the 20th century. As the world economic engine revs up once again, a new set of challenges will be presented to the Beijing Consensus. Supporters claim that China's ability to align political and economic intentions provides stability and maneuverability, while critics of the Beijing Consensus maintain that centralized planning and lack of oversight lead to unbalanced growth, which at best is inefficient and at worst is unstable. So far, the central government has been able to navigate two major crises – the 1997 East Asian Financial Crisis and the 2008 Global Financial Crisis – through incremental reforms. However, many of the same remedies that proved resilient to the crises may have also created future fissures in the financial system by encouraging fundamental imbalances.

             The banking system in China dwarfs the domestic stock market as the most important source of funds. According to World Bank data for 2008-2012, China's market capitalization is only 46% of GDP, compared to 104% in the US and 90% in South Korea, while their credit to GDP ratio is 127%. Chinese banks are also some of the most inefficient in the world, with the poorest allocation of resources taking place within the large state-owned banks.[1] The opaque accounting methods coupled with mixed incentives due to government’s financial interventions have jeopardized the institutional infrastructure of the entire system.

            This paper aims to investigate the current threats within the Chinese financial system, and their institutional origins in the liberalizations of the 1980s and the big boom reforms of 1994. It is the position of this paper that these reforms have shaped the current banking system and can shed light upon the question of how well institutions formed by the Beijing Consensus can adapt to the scale of China's growth and the pressures of becoming a financial global leader.

            Many of the obstacles facing the banking system can find their origins in the government-instituted reforms of the late 1980s and early 1990s. It was during these first decades after the Cultural Revolution and China's economic isolation that the seeds of the current institutional framework were sown.

II. History

            China's financial system has been progressively liberalizing since the 1980's, albeit slowly and often interrupted by regressive politics and changing leadership goals. Crucial to understanding the shifting economic landscape is the fact that the Chinese banking system had to be built from the ground up, as the remaining financial infrastructure after the 1948 revolution was essentially negligible. Consequentially, much of the financial infrastructure was constructed piecemeal and the cumulative result of trial-and-error and the mercurial goals of bureaucrats. As such, the path of the Chinese banking system can be classified as taking an evolutional route of incremental – and occasionally radical – reforms.


The Pre-Reform Planning Era (1948-1978)

            At the time the Chinese Communist Party took power in the 1948 revolution, the currency distributed by the defeated Chinese Republic was rendered completely worthless through a complex and rapid series of fluctuations between hyperinflation and scarcity. The first People's Bank of China was founded in 1948 through the consolidation of Huabei, Beihai, and the Xibei Peasant Banks. The bank held a dual function as both China's central bank and its only commercial bank. Party bureaucrats tightly held the purse strings and the bank had almost no autonomy. Under the Soviet-inspired Great Leap Forward's (GLF) rapid industrialization regimen, all official sources of financial support flowed under the central government's oversight. However, even this control was deemed insufficient as Mao Zedong took away much of the PBOC's monetary authority during the “Lost Decade” of the Cultural Revolution (1966-1976). The so-called Planning Era of Chinese history functioned under a very simple, extractive financial cycle: the state took in money through the monopoly profits of the State-owned Enterprises which governed almost all industries, and then fed the same SOEs through newly printed currency or the same remittances of monopoly profits.

            One of the repercussions of the rapid industrialization scheme was a sharp bias towards industry and urban growth. Urbanization during the GLF developed at the expense of the rural country side, which was forced by government mandate to produce and sell raw materials to the urban industrial sector far below market value–a phenomenon referred to as the price scissors problem of planned industrialization (Knight 1995). Mass migrations from the countryside to the city were prevented through the strict enforcement of the household registration hukou system (户口). The commodities manufactured from the artificially cheap raw materials were then sold back to the countryside at inflated monopoly prices, leading to impoverishment. Furthermore, the accumulation of capital necessary to support building factories and production lines was extracted from the rural areas in the form of taxes and sequestrations of raw materials. Resources were shunted from domestic consumables into heavy industry such as iron and steel. Because official streams for financing entrepreneurship were completely shut down by the central government, the rural population had no recourse but to suffer for the growth of China's urban State-Owned Enterprises (SOEs). The Great Leap Forward and the subsequent Cultural Revolution institutions and policies birthed completely unsustainable systems. After Mao's death, the need for a new economic paradigm led to Deng's 1978 Reforms.

The Reform Era Pre-1994

            The full impact and scope of Deng Xiaoping's economic reforms are broad and beyond the purview of this paper. From a narrow financial standpoint, the most significant development was the establishment of the Big Four state-owned commercial banks as separate from the PBOC.[2] The Bank of China, China Construction Bank, Agricultural Bank of China, and Industrial and Commercial Bank of China (ICBC) were mandated to serve their specific sector of the economy so as to prevent cannibalizing each other's profits. The Bank of China was assigned to foreign trade and exchange, China Construction to the construction and infrastructure sector, Agricultural Bank towards farming, and ICBC for industrial and commercial lending. By establishing these banks, the central government was incrementally weaning SOEs from government appropriations, which constituted a disproportionate 28.1% of Chinese investment in 1980 (Tsui 2012). However, the central government did not want to jeopardize its SOEs through full privatization – profits and taxes from these monopoly firms accounted for 51% of government revenue in 1978 (Guojia tongjiju, pinghengsi 1990).[3] The Big Four Banks served primarily as a government capitalized and guaranteed conduit for the financing of the SOEs, functioning as a close analog to the prior system of direct government financing (Tsui 2012).

            Throughout the 1980's the financial system was further deregulated. One example was the allowance for state-owned banks to compete across sectors in 1985. Because the banks were still managed according to party line, however, competition between the banks was rare as they lacked incentives to efficiently compete (Berger 2009). The banks primarily functioned as a means of funneling money from one sector to another according to government policy. The loans were capitalized through monopoly profits, appropriations by the PBOC, and other forms of financial repression. Profit seeking took a back seat to policy mandates as managers were appointed out of the government bureaucracy, and those that were not were compelled to toe the party line through career incentives. Even in the absence of direct political pressure to fund specific investments, the institutional structure still produced inefficient mixed incentives. Because the government implicitly guaranteed SOEs, there was little chance of default on loans. As a result, loans to the private sector were much harder to attain.

            Nonetheless, the 1980 represented the resurgence of the private sector in China, albeit an under-capitalized one. Within this context a slow privatization of SOEs began through bankruptcy, auctions, management and equity buyouts, and many other methods. Entry barriers were lowered and competition increased, especially as rural, collectively owned Township/Village Enterprises entered former monopoly sectors. Additional responsibilities were given to SOE managers, who took on contractual roles in which they retained part of their profits as a method of improving corporate governance (Tsui 2012).[4] While the Big Four banks were allowed to support and lend to the growing private sector, in practice entrepreneurs need close political ties, guangxi (关系), in order to secure capital. More than just political nepotism, this informal information network was the most reliable available assessment of creditworthiness as there was a lack of reliable accounting and financial data, such as credit history or current total asset value (Allen 2005). State-owned Enterprises became less important to the economy, with the state gross value of industrial output decreasing from 76% in 1980 to 54.6% in 1990 and to 28.2% by the end of the millennium.[5]

                  According to Yasheng Huang (2008), observing just industrial output does not give as good a picture of the importance of private sector growth to the Chinese economy. More significant was the high level of resources being allocated to the private sector. Under this methodology real annual growth rate of fixed capital investment the 1980s in the private sector was 20%, while SOEs were 8.1%. These figures corroborate the idea that the 1980s witnessed a proliferation of the private sector, while the state-owned sector declined from its former preeminence.

            Although the reforms of the 1980s were radical in their departure from the Planning Era, in practice the financial system was still rife with inefficiency and controlled tightly by government. The 1980's therefore presented an assortment of economic results. On one side, the liberalization of the financial system led to some successes, although much of this came from liberalizing foreign financiers access to the Chinese market, rather than liberalizing domestic institutions. For example the loosening of foreign capital controls led to the setting up of Special Economic Zones which attracted a bevy of FDI, albeit focused on politically connected areas such as Shanghai's Pudong district. There were also significant improvements in the rural-urban divide from the gradual phasing out of the price-scissors problem (Tsui 2012). This was primarily due to the introduction of the Household Responsibility System and the Dual-Track System, whereby rural farmers were allowed to sell products at competitive prices after fulfilling government quotas. In 1978 urban residents' real income was 2.57 times that of rural residents, but the ratio then declined to 1.53 by 1989. The first half of the 1980s also saw the national poverty rate precipitously drop from 53% to 31% (Ravallion and Chen, 2007). The profits derived from the entrepreneurial opportunities brought extra capital and informal financing opportunities to rural areas to fund non-farm activities, such as Township and Village Enterprises (TVEs), and built a rural private sector that birthed 10.5 million businesses from 1979-1985 (Huang 2008).

            On the other side, in the aftermath of the reforms and the shift of resources away from urban areas and SOEs, urban unemployment grew. As private firms began outcompeting many of the smaller SOEs, profits thinned as debts built up through bailouts. The banking system, which had always favored these SOEs due to their soft budget constraints (the implicit bailout guarantee by the government) and cozy political connections, began to run into the red as loans started failing (Tsui 2012). The PBOC began to print more money in order to keep the commercial banks liquid, resulting in high inflation rates. The skyrocketing inflation along with high unemployment rates could be seen as partial sources for the growing public discord which led to the violent Tiananmen Square Protests of 1989.

            In the wake of Tiananmen Square, Jiang Zemin, the former mayor of Shanghai became General Secretary of the Communist Party and subsequently President of the PRC. His economic approach, under the advisory of Deng Xiaoping, was geared towards urban export development along the eastern coastal cities, especially Shanghai. The so-called “Tiananmen Interlude” (1989-1993) saw a return to the urban biased policies of the planning period, severely crippling the rural entrepreneurial movement of the 1980s in its infancy (Huang 2008).

            In 1993 Deng Xiaoping went on his Southern Tour of China to promote the new economic policies, during which he famously announced, "To get rich is glorious" (致富光荣). The tour became an important trigger point for the fragile economy. The frenzy of “hot” investment and the flood of credit that followed necessitated a new set of reforms for the financial sector.

III. The Big Four Financial Reforms of 1994

            The “Tiananmen Interlude” represented a painful recentralization of economic control. The shift of policy from rural privatization to urban central planning and investment severely diminished rural private investment.  This four-year period was almost a return to the centralized Planning Era, which scared many of the politicians who had worked so hard on reform, especially Deng Xiaoping.  The 1994 reforms were put in place as a rough compromise between the strict planning of the Tiananmen Interlude and the unchecked private sector growth of the 1980s.  The 1994 reforms continued to focus on growing the urban industrial sector, except it aimed to achieve this through attracting FDI and a shift to Export Oriented Industrialization (EOI) strategy. The government decided to allow the import substitution SOEs of the Planning Era to become privatized, creating a more efficient domestic market.  The 1994 reforms also set up the financial infrastructure by which to support this shift into export capitalism while allowing the central government to retain control of most financing.

            The four primary reforms of 1994 were the Tax Sharing System, restricting capital account convertibility while liberalizing the current account, pegging the Renminbi, and a plan for reforming the financial sector according to the policy of “Grasping the Large while Releasing the Small” (抓大放小).


Tax Sharing System and Repercussions

            The Tax Sharing System introduced in 1994 was meant to re-centralize public funds and curb the greed of local governments. In practice, however, the policy distorted public finance methods, and has since reshaped the landscape of finance and investment in China.

            While the former tax scheme allowed for somewhat draconian local governments to extort their citizens, the Tax Sharing System funneled all tax revenues directly to the central government in Beijing. The central party would then distribute the money to local governments based on incentives and policy goals. Furthermore, local governments were prohibited from running a deficit. This interdiction resulted in a glut of investment and infrastructure activity in targeted or well-connected areas such as Shanghai or SEZs like Shenzhen, while leaving most provinces and minor cities starved for funds. In a country where state-financed enterprises (even on the local level) still constituted more than half of the industrial output, local governments were desperate for new sources of funding.

            In order to finance new investments, local governments took up a clever go-around scheme–Local Financing Platforms (LFPs). LFPs allowed local governments to avoid the no-borrowing limitation by using land-use rights as sellable assets through real estate auctions and as collateral for bank loans. For example, when local governments wished to finance a new bridge in their city, they could grant land use-rights to an implicitly guaranteed LFP corporation, which could then use the asset as collateral on a loan towards the infrastructure project. The other option was to hold a property rights auction whereby the land was sold off and the money used directly to fund the new bridge.

            Spurred by the Target Responsibility System (目标责任制), local bureaucrats were eager to take on high-risk projects. The TRS subjected local officials to a pay and promotion incentive scheme, which forced them to target lofty, short-term economic quotas and goals (the tenure of the average local appointee is 5 years) (Tsui 2012). The TRS also created cross-regional competition amongst local party cadres, in part encouraging infrastructure and public works development but often becoming plagued by short-term biased outcomes. All of these incentives combined with lax regulation on the LFPs led to ballooning property values and a seeming excess of investment. Furthermore, the local branches of the state-owned banks were incentivized towards giving exessive loans to local state-owned corporations, which led to segmentation of the financial markets (Ohara 2008).

            The question of over-investment in the Chinese economy is a contentious topic amongst economists. Initially, the rapid buildup of much needed infrastructure projects buffered by China's high savings rates produced high returns. Local governments competed to attract capital, especially from FDI. Industrial and technology parks, vocational training, pre-built factories and other business-friendly benefits created a boom in businesses and a rapid increase in output (Yusef 2010). China's annual GDP growth in the mid-1990s was around 12% with gross capital formation rates (%GDP) around 43% (World Bank database). The question remains about whether this incredible “catching-up” growth efficiently used inputs or was an inefficient result of excessive investment from high saving rates and FDI.

            Bai, et al (2006) argued in their study that evidence supports a fairly stable, high return on capital rate in China during this period. Although return to capital dropped from its 25% peak in the 1980s to 20% in the 1990s, this rate still outpaces most other advanced developing nations. The study further claims that investment became progressively more efficient and evenly distributed across sectors and regions, and that increases in Total Factor Productivity allowed the return to capital to keep pace with the high investment rates.

            However according to Huang (2008), this growth was the result of the large flood of investment input and was highly inefficient compared to the private sector growth of the 1980s. Because the government funded projects accrued to SOE companies, the 1990s saw a rapid decrease in private enterprise as they became starved of resources and credit. According to the study, annual growth of fixed asset investment in the private sector in the early 1990s dropped from 19.9% to 2.6%, while investment in SOEs went from 8.1% to 23.8%. Although these levels moved closer toward converging later in the decade, the Tiananmen Interlude had serious consequences for the financing of the private sector, especially the rural private sector, and led to the boom period of SOEs.

            The introduction of the 1994 Tax Sharing System had the unintended consequence of changing the role of banks in local financing. Because local governments could no longer fund projects with tax revenues (at least without the express support of Beijing), local branches of state-owned banks began functioning as treasuries for public works and infrastructure projects. The LFPs functioned to accept loans on behalf of the governments and push the money on to the state-owned construction companies, with the credit being supported primarily by grants of public land rights. In 2010 the National Audit Office estimated current local public debt to be around 10.7 trillion renminbi, although it is hard to account for much of the value because of the loose accounting inherent with LFP transfers. The most serious consequences of the financial repression policies are still being experienced today in the inflated real estate market and the proliferation of risky infrastructure investments, which will be covered later in the paper.


Liberalized Current Account, Restricted Capital Account, and the Pegged Renminbi

            Although the success of the reform era in the 1980s brought about industrial growth, many cadres in the ruling Communist Party worried about losing political and economic control. In addition, there was also a significant paranoia concerning the influences of foreign investment on domestic companies. The 1994 reforms were centered on creating a national macroeconomic policy and the re-centralization of control. The Chinese financial governance faced the economic trilemma prohibiting the co-existence exchange rate stability, a flexible monetary policy, and free capital mobility. In order to retain as much control as possible, the central government chose to peg the yuan, control capital mobility and focus their monetary policy on price stabilization.

            Prior to the 1994 reforms, the hot investment market caused the RMB to be valued at 5.76RMB:1USD, an exchange that many at the time considered overvalued and which continues to be the high water mark between the currencies to date (Bloomberg data). Beijing, in light of its new goal of increasing urban export output, sought to depreciate the yuan. China chose to peg the yuan to the US dollar at a rate of 8.28RMB:1USD. By locking the exchange rate, the Chinese government could no longer use monetary policy as an economic tool.

            Beijing also chose to restrict the capital account by postponing capital convertibility. Paranoia about the entrance of “hot” investment money flowing into the country as well as preventing any shocks from a sudden outflow of foreign investment drove the decision to regulate the capital flows. However, full capital convertibility is generally agreed upon as an important prerequisite to an efficiently functioning international market. Politicians pledged that capital controls were only a temporary measure and that China would move towards liberalizing controls in the near future. However, when the Asian Financial Crisis hit in 1997, Chinese economists credited China's limited exposure to the restrictions, so they have retained the policy into the 21st century (Groombridge 2001).

            Jiang Zemin and the Governor of the PBOC, Zhu Rongji, paired the capital controls with a deregulation and liberalization of the current account, allowing for increased trade and lower protectionist tariffs. The emphasis on competitive advantage in exports combined with policies geared towards attracting FDI appeared to be a successful strategy for output growth as China emerged into a global manufacturing base.[6] However there was still relatively little growth in China's domestic consumption, creating an imbalance that fueled a large current account surplus. China's simultaneous current and capital account surplus, maintained by massive accumulation of foreign reserves, has sparked criticism from the global finance community, an issue that will be explored in a later section.


A New Financial Blueprint

            The proliferation of informal financing schemes, growing inflation, and the flow of investment into the rural, private sector after 1978 caused worries in Beijing that they were losing grip on development. The growing urban unrest coupled with declining profits from uncompetitive SOEs played into these fears. Jiang Zemin, whose primary experience was in the urban sector, saw the solution in refocusing investment policy. As an adept of Deng Xiaoping's deregulation philosophy, however, Jiang Zemin was wary of returning to the bad days of the Planning Era and Tiananmen Interlude. In addition, the Chinese banks were struggling under the pressure of declining asset quality and high rates non-performing loans to SOEs, limiting the availability of credit. Competition on the local level from small banks (both private and state-owned) making large profits by financing the local infrastructure projects (as described in the section on the Tax Sharing System) further degraded the Big Four's profits (Berger 2009).

            Jiang Zemin first limited rampant government spending and investment by limiting the monetary power of the government. The first move in the plan was to address inflation by banning the printing of money by the central bank to finance the public deficit. This was an important compliment to the newly pegged exchange rate and capital controls; although, it meant that the government could no longer encourage growth by pouring liquidity into the market. Instead, Jiang sought to refocus capital flows through redesigning the banking system.

            In order to limit their exposure to the failing loans of the smaller SOEs, the central government began a new wave of privatization. Investment strategy became geared away from import substitution towards export-oriented industries through the establishment of too-big-to-fail SOE monopolies. The 1997 People's Congress consolidated the goal into a single policy called “Grasping the Large while Releasing the Small” (抓大放小). The policy represented a general privatization of most of the smaller SOEs and those larger firms in industries not targeted for development, while simultaneously redirecting the appropriated resources into the monopoly industries, which remained cash cows for the government – the so-called National Champions. The targeted industries were chosen for capitalization because they offered the possibility of gaining global comparative advantage for exports.

            The newly remodeled financial system was designed to segregate finances to the growing private sector, refocus capital towards party goals, and take the pressure of non-performing loans off of the commercial banking system. To achieve this goal, the central government established three policy banks as separate entities from the Big Four commercial banks: the Agricultural Development Bank of China (ADBC), the China Development Bank (CDB), and the Export-Import Bank of China (Chexim). The Ministry of Finance also issued 270 Billion RMB worth of 30-year government bonds to the Big Four in order to recapitalize their lending abilities (Berger 2009). In practice however, separating the policy banks from the commercial banks did little to ameliorate the degradation of assets.  By 1999, the Big Four’s non-performing loans made up 20% of their total loans, roughly 1.4 trillion RMB. Because the SOE's were guaranteed by the government and therefore protected from bankruptcy, implicitly the banks loaning to them were protected from risk of default. Moreover there was little incentive for the commercial banks to refocus their efforts on the private sector, which would have necessitated the adoption of high-skill due diligence in data collection and analysis, an ability that most large Chinese banks lacked at the time (Allen 2003).


            The redesigning of the Chinese financial system in 1994 served to correct the rampant investment of the late 1980s, as well as redirect capital towards the suffering urban sector. In many ways it was a reactionary policy to the high unemployment, growing inflation, and overvalued currency of the early 1990s. The policy succeeded in establishing the impressive export engine witnessed in 21st century China. However, the refocusing of investment and recentralization of capital flows impeded the entrepreneurial growth of the prior decade by severely diminishing fixed capital formation in the private sector, despite private entrepreneurship showing the most promising growth potential (Huang 2008). The repercussions of the redesign have shaped the industrial and financial institutions of modern China.

IV. Contemporary Consequences of the 1994 Reforms

            Although the changing of leadership at the turn of the century to the Hu Jintao-Wen Jiabao administration represented a significant policy shift, the 1994 financial reforms still provided the foundation for the gradual reforms of the growing financial system. The system did experience some benchmark external changes coming into the 21st century. The most significant development was China's entrance into the WTO in 2001. In order to gain admission, China eliminated thousands of tariffs on foreign goods, removed barriers towards foreign investment, and updated its accounting system to allow greater transparency for foreign firms (although many still complain that the accounting standards are still not up to international standards). The ascension into the WTO–a membership they had been denied in 1985 and had been working towards ever since–was the culmination of the current account liberalizations implemented during 1994. According to a survey of the past decade of WTO membership by The Economist (2011), China's GDP has quadrupled since joining and its exports have increased fivefold since eliminating over 7,000 tariffs and trade barriers. With its rapid integration into the global market, new pressures have built upon the financial institutions in place. This pressure has revealed fissures in the infrastructure put in place by 1994 reforms.

            Further into the 21st century, China has continued the gradual liberalization of its financial markets. For example, by relaxing control over the interest rates on large, long-term loans and foreign currency, the Chinese central bank took important steps towards more efficient market pricing. However, many of the original controls placed by the 1994 reforms remain. There are still caps on deposit interest rates and a floor on lending rates, precipitating distortions such as low household deposit rates, misaligned incentives for banks to compete, bias away from funding new entrepreneurial projects, and a lack of proper market indicators (Feyzioglu 2009). These issues were exacerbated by the 2008 Global Financial Crisis and the subsequent stimulus package. The imbalances threaten the underlying stability of the Chinese economy. Below are outlined some contemporary obstacles to adaptation which have grown from the 1994 reform institutions.


The Shadow Finance System and the 4 Trillion RMB Stimulus

            During the 1997 Asian Financial Crisis, China's financial system proved surprisingly resilient to the economic contraction that ravaged its neighbors. The Global Financial Crisis in 2008 gave China the global stage to prove its banking sector could again sustain an even greater shock. As many developed nations debated between stimulus and austerity packages, there was, perhaps, an aspect of political showmanship in the Communist government's 2008 announcement of a 4 trillion RMB (US $586 billion) domestic stimulus package, an unprecedented 16% of total GDP. For comparison, the United States' stimulus, announced in 2009, was still larger at $787 billion; however that was relative to an economy almost three times as large. Furthermore, China's stimulus package was composed almost completely of a spending expansion aimed at increasing aggregate demand, contrasted with the United States', which was over a third tax cuts geared towards paying down debt.[7]

            Despite the impressive headline, closer inspection of the package showed that the central government intended to fund only a quarter of the total payments, with the rest coming out of local government's budgets (Financial Times 2008). Many of these local governments were already struggling to make ends meet out of their current revenue streams. In order to raise the extra funds mandated towards infrastructure and public works projects, bureaucrats once again relied on LFPs to take on large loans from the state-owned banks. These loans were primarily collateralized with public real estate. As banks around the world were contracting their credit pool, the Chinese central government mandated expansion.

            As European banks retrenched and global credit contracted, Chinese banks rose to fill the liquidity gap. Credit was further expanded through a record issuance of corporate bonds in all of Asia. In 2009, there were only about $20 billion USD worth issued, estimated to grow to $120 billion into 2013 (IMF 2012). As credit expanded in China in reaction to the GFC, the effects of the crisis were further complicated by global volatility in real estate prices, sparked by the collapse of the US housing market. Many experts speculate that this has created a fragile bubble in the Chinese housing market. According to IMF statistics (2012), the 16% annual rise in China's domestic credit market has been matched by an almost 40% annual increase in housing prices from the period 2008-2011.

            Economists look at statistics such as the price to rent ratio to determine whether real estate prices are in a bubble or just following a higher supply and pattern. Rents, which are very responsive to market forces and also change more often, act as a baseline by which relative prices can be judged. The price–to–rent ratio in Beijing and other major cities in 2010 approached 500:1, far above the international alarm level of 300:1 (Business Insider, 2011).[8] Over the period from 2000 to 2011, investment in real estate and construction grew from 2% of GDP to 11%, as people moved their money from other assets into the “safer” real estate market (Global Property Guide, 2012). It should also be noted that SOEs paid on average 27% more for equivalent plots of land, prompting further distortions of market prices (Wu 2010).

            In the aftermath of 2008, China began instituting strict regulations to curb the housing bubble's growth, especially in light of the injection of the massive 4 trillion RMB stimulus package. Regulations included heavy penalties for speculators turning over properties within a year of purchase, limits on the hoarding of properties, and an increase the mortgage interest rates for investors and developers (Lardy 2011). In 2012, the bubble showed some tentative signs of deflating, a dangerous turn as collateralized local debt hovered around 10 trillion RMB (this is despite it being illegal for local governments to run deficits). Falling real estate prices is welcome news for Chinese citizens, but for local governments still relying on land auctions to raise revenue, the desperation for alternative access to capital is once again apparent.

            In recent years, the proliferation of Wealth Management Products has supplied this alternative financing. Extremely low official borrowing rates by the PBOC has meant that domestic household savings have a negative real interest rate for normal deposits (Lardy 2011). This has led average Chinese, along with China's swiftly expanding wealthy population, to find alternative ways to augment their savings. Much of it has been funneled directly into the real estate market, but with recent volatility, many think that this market has already peaked. Local banks, in order to fill their depositors’ demand, have instead been selling Wealth Management Packages (WMPs). These products have been likened to the toxic Collateralized Debt Obligations (CDOs)–composed of risky mortgages and debts–which were sold to US hedge funds in the lead-up to the 2008 crash. Despite claims by banks that the WMPs are exclusively offered to the most creditworthy customers (similar to the qualifications for Accredited Investors in the US), lack of disclosure makes it impossible for independent regulators to oversee to whom the products are actually going (Reuters 2012). According to a report on Chinese WMPs by Fitch Ratings (2012), these financial products rarely provide any details about where and how the funds are invested, yet they promise returns beyond that normal deposits, often upwards of 5% (compared to the 3.02% interest rate mandated by the central bank for normal deposits). As of the end of 2012, the size of the WMP market is estimated at 13 trillion RMB ($2.09 trillion USD), about 25% of GDP, and is growing rapidly. Banks often keep the invested funds off of their balance sheets, while simultaneously counting them as part of their deposit reserves. The WMPs draw on the large domestic savings rate and rising domestic wealth in order to fund credit and investment expansion by the banking sector.

            As the massive stimulus funds have been implemented, fuel has been added to the debate on over-investment. While previously building project seemed to inevitably lead to high returns, the boom in liquidity following the stimulus has lowered the quality of assets, both in terms of interest rate and risk. It is estimated that investment utilization rate has fallen from 90% in 2000 to just 60% in 2011 (in the United States it is about 80%)(Min Zhu 2012). According to the Economist (2012), experts fear that as infrastructure projects and corporate bonds are producing lower returns, banks have started to use their WMP funds like a Pyramid Scheme– funneling money from the short-term investments to pay off the longer term high-interest products.

            China Banking and Regulatory Administration has been attempting to cap the glut of WMP sales without toppling the whole house of cards. They have banned products with maturities of less than one month, and they have tried to require banks to keep their WMPs on separate balance sheets from their normal deposits. In December 2012, however, the system was dealt a large shock as a single WMP sold by medium-sized, private Hua Xia Bank failed to pay a maturity despite being sold as a fixed-income product. The incident sparked protests outside of the bank and a debate over whether the central bank should bail out the troubled asset. Recently, China Construction Bank, one of the big four, has also been accused by customers of not supporting a WMP, which has lost investors 30%. In view of the sensitivity of the issue, China has forbidden domestic media from covering the failure (Reuters 2012). It is now up to the central government to decide whether they will guarantee the WMPs, or let them fail in order to teach banks and investors a lesson.

            The 4 trillion RMB stimulus in 2008 initially shielded China's economic boom from the global credit contraction following the Global Financial Crisis. The release of new investment capital, three quarters of which was foisted upon local governments to raise and distribute, has revealed many of the fault-lines still distorting in the Chinese financial system. The long-standing cozy relationship between local governments and banks created by the Tax Sharing System, coupled with lower returns on public projects, has led to the proliferation of non-performing loans. The public land used as collateral for those loans has inflated in price; although threats of the real estate bubble soon popping has compounded investor fears. Private savings, eager to avoid the low-interest rates mandated by the PBOC have since migrated into opaque Wealth Management Products. The boom of these un-guaranteed assets, which according to Reuters now make up 13% of total domestic deposits, has sparked speculation that the domestic credit market may face similar risks to the United States in 2008.


The Renminbi and Macroeconomic Imbalances

            During the 2012 US Presidential Debates, China was mentioned 53 times by both candidates (CNN 2012). Economists from across the political spectrum debated whether the candidates were using China as a scapegoat for both the trade deficit and public debt, or conversely, that the US was not being tough enough in forcing China to promote domestic consumption. Much of the debate focused on whether China should further appreciate the RMB in order to correct its large current account surplus, with the candidates taking various positions on how appreciation would help or hurt the deficit.[9] Beyond the partisan debates, however, it is a concerning fact that China's massive current account surplus has been financed through its stockpiling of foreign reserves, mostly in US bonds.

            According to the balance of payments identity, the sum of the current account (CA), capital account (KA) and change in foreign reserves must sum to zero (CA+KA+ΔR=0).[10] China, by maintaining a trade surplus along with a net inflow of capital has balanced out the equation by buying up large stockpiles of foreign reserves. In the four years following the 1994 reforms, the value of China's foreign reserves went from 22.4 billion to 142.8 billion USD in 1997 (State Administration of Foreign Exchange, SAFE).[11]

            This “have your cake and eat it too” policy of dual surpluses allowed for rapid growth and fixed capital formation, while large foreign reserves allowed the RMB to remain stable and largely undervalued to promote exports. However, the fragile balance brings with it fears of inflationary pressure. The PBOC, China's central bank, functions primarily to maintain stable prices to counteract inflation through various strategies, such as sterilization. Internationally, this policy has led many economists and foreign politicians to accuse China of fueling global macroeconomic imbalances. A recent study by Alfaro et al. (2011) shows a significant correlation between sovereign debt and negative growth rates. The deficit numbers have grown even more pronounced into the 21st century. According to SAFE, China's foreign holdings account at $3.181 trillion USD by the end of 2011, mostly in the form of US government bonds.

            China's buildup of foreign reserves has worked so far to sustain growth, but many economists agree the system is limited in the long term. Policy makers have been taking steps towards reform. In 2005, China responded to international pressure by reforming its rigid pegged currency to the current “Band-Basket-Crawl” system. At the end of each working day the central bank announces the central parity exchange rate for the next day’s trading. The exchange rate is then allowed to fluctuate within a “band” of .3% against a secret formula of currencies (“basket”), including the Japanese Yen, US dollar, Euro, and Korean Wan. The central bank has allowed the currency to slowly appreciate over the past 8 years (“crawl”), so as not to add volatility to trading (Tsui 2012). This system has also allowed the Central Government to exercise greater monetary policy to motivate growth and contain inflation.

            Many western governments have claimed that the move to the BBC system is not sufficient to reverse the macro imbalances. Chinese economists have countered that a move to a fully floating currency at this time would be highly risky, and that the current domestic bond market is still too immature. Currently, the domestic bond market is used primarily by the central bank to “sterilize” the market, an action denoting the absorption of excess currency to prevent inflationary effects. For a country with a floating currency, a readily responsive bond market is necessary to implement effective monetary policy.

            The central government has taken steps to grow the bond market in order to internationalize the RMB. One prominent example is the so-called Dim Sum Bonds, named after the famous Hong Kong dishes. Dim Sum bonds represent any Renminbi bond sold outside of the mainland but still denoted in yuan, and were first launched in Hong Kong by the China Development Bank in 2007. Since, there have been 34 releases with a total value of 80 billion RMB (Yue 2011). In 2012 the first bonds were allowed to sell in the London markets by non-Chinese or Hong Kong banks. Coupled with the liberalizations on the RMB bond market, the years since the 1994 reforms has also brought important deregulation in other aspects of the currency.

            It wasn't until 1997 that foreign banks were allowed to transact with local firms in RMB, and even then they were limited to the Pudong Special Economic Zone in Shanghai. They were forbidden from doing business with consumers until 2002 (Berger 2009). Deregulation of Renminbi banking expanded rapidly into the 21st century following the entrance of China into the WTO. The RMB Clearing Agreement in 2010 expanded the types of institutions that could issue RMB denoted accounts to include securities and insurance companies, along with asset management firms. The restrictions on interbank transfers denoted in yuan were also lifted. In the private sector, McDonald's served as a pioneer firm by releasing the first corporate bonds denoted in RMB by a foreign firm. The new role of the RMB on the international stage caused Eddie Yue (2011), Deputy Chief Executive of the Hong Kong Monetary Authority, to herald the agreement as an “Unprecedented Opportunity for financial institutions.”


            The international fixation upon the Renminbi will continue as the currency adjusts and adapts to its new global role. Its foundation at a devalued peg in the 1994 currency reforms helped to create a powerful yet unbalanced export economy into the early 2000s. The dual surpluses in the current and capital account allowed for unprecedented investment, but were matched by ballooning foreign exchange reserves, inflationary threats necessitating hands-on control by the central bank, and the fueling of global sovereign debt (primarily that of the United States). The Band-Basket-Craw system of 2005 was implemented to gradually reform the system, building up an international and domestic bond market, and establishing the Renminbi for a global role in the 21st century.


The Reign of the State-Owned Enterprises

            Since instituting the 1997 “Grasping the Large while Releasing the Small” policy, China's incremental reforms have had mixed effects on the public sector. The SOEs represent both the largest obstacle and the biggest asset in China's growth – the government is still dependent on SOE profits and enjoys their international prestige, although the private sector remains stifled because of the financial bias.

            With its characteristic gradualist approach, China seeks to incrementally adapt its existing SOE giants. Since removing the law requiring foreign companies to enter the market with a domestic partner, the majority of US FDI in China has changed to wholly-owned foreign enterprises (AmCham-China 2010). Increasing competition from the foreign firms has forced SOEs to modernize and become more adaptable in order to maintain their monopoly power. One of the primary ways they have achieved that is by allowing minority equity ownership through public offerings on the Chinese and Hong Kong stock markets. Specifically for the banking industry, many of the state-owned banks have used IPOs to try and adopt foreign best practices.

            One of the ways they have tried to increase their efficiency and productivity is by allowing for partial foreign ownership. According to a paper by Berger, Hasan, and Zhou (2009), the adoption of partial foreign ownership through IPOs by three of the Big Four Banks (the exception being the Agricultural Bank of China) has led to improved performance and lower NPL rates. Although by their measurements fully private banks are still the most efficient operators, banks with a minority foreign equity holding have a 20% higher profit efficiency over purely state-owned banks. The researchers hypothesize these efficiency gains are due to foreign membership on the governing board, training in global best practices, technology transfer, and new risk management techniques.

            Despite much better performance in terms of allocation efficiency and profits, China is not yet ready to move towards totally private banking and release the hulking Big Four state-owned banks. Their existence still provides an outlet for implementing industrial policy as well as produce profits for the central government. By allowing for minority equity holdings by foreign banks, policy makers hope to incrementally reform the system. In a country where the banking industry dwarfs the stock market, even incremental efficiency gains will have a large long-term impact on growth prospects.


V. Conclusion

            In the face of much skepticism, the first decade of the 21st century has seen China sustain its incredible development into an elite global economy. The People's Republic has sustained an average annual growth rate of 10% over the past 30 years and is currently responsible for generating a fifth of the world's new economic activity, now boasting the world's second largest GDP. While many national development stories of the 20th century proved sclerotic, such as the growth nations of South America and Southeast Asia, China has sustained its incredible industrialization engine and led many to herald the 21st century as The Asian Century with China at its center.

            The development of the region, however, is hardly predetermined. The Achilles heel of Chinese growth may lie in the banking sector. Despite its superlative growth pedigree, The Middle Kingdom still retains many of the extractive institutions endemic to developing countries. Policies from the early reform years designed to centralize power, maintain political and industrial monopolies, and obfuscate economic information lie within the framework that support the financial system. Financial repression still creates mixed incentives amongst investors and managers. These institutional fissures present a significant threat to the sustained growth of China, especially as it progresses into a new stage of development and global integration, such as shifting towards outward foreign investment and increasing domestic consumption.

            The origin of many of these issues originated from four major institutional reforms of China's financial system circa 1994. Policies such as the centralized control of capital flows and pegged currency rates, starving local governments of public financing creating misaligned growth incentives, and the implicit guarantee and subsequent funding bias of large monopoly state-owned enterprises connect directly and indirectly to current fault lines within China's financial sector. These institutional policies have created bubbles in the infrastructure and real estate sectors, biased growth away from private Small and Medium Enterprises (SMEs) towards targeted urban centers and state-owned industries, and birthed volatile private investment products reminiscent of the United States' notorious packaged CDOs of the 2008 global financial crisis.

            China has taken a gradualist approach to fixing the problems stemming from the 1994 reform institutions. Numerous progressive policies of the past decade have shown signs of liberalizing and allowing for greater oversight of China's banking system, already leading to efficiency gains and greater transparency. Deregulation allowing for public equity offerings and partial foreign ownership in banks, the release of Dim Sum Bonds, and the retooling of the exchange rate to the Band-Basket-Crawl system are all examples of incremental liberalizations. As economic integration continues into the next decade, international scrutiny over Chinese financial and monetary policy will likewise increase, along with pressure to liberalize interest rates. Going forward, China's financial system will also have to respond to new demands from changing demographics, such as the efficient implementation of urban and rural pension systems (RPPP and PSPI), rising health care costs, and other aspects growing the social net. The gradualist reform strategy may be able to continually adapt to changing conditions. However, if current imbalances within the Chinese banking system–such as dependence on real estate prices and risky investment products–precipitate a significant shock to the system, a more radical reform of the Chinese financial system would follow.





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[1]   One can look at many statistics for inefficiency, such as NPL ratio (which was 12.6% in 2002) (Allen 2005) or profit efficiency (Berger 2009)

[2]   Though the historical founding of each of these banks happened at different times, their use in the modern era was established by the 1978 reforms. Their historical founding dates were BoC (1912), CCB (1954), ABC (1979), and ICBC (1984). (Berger 2009)

[3]   This statistic sourced and translated from Tsui (2012)

[4]   However, it is still said in China that one of the best methods of distinguishing a truly private company from an SOE is to look how long the CEO has been in power. The central government likes quick overturns in their corporations, while private firms tend to hold on to talented managers. (Huang 2008)

[5]   State Statistical Bureau (2000), Zhonggou tongji nianjian 2000. Sourced from Tsui (2012)

[6]   There is contention amongst economists over the role state strategy held in export sector growth. For a more complete discussion of the role of state decision making in the development of China's export market, see The East Asian Miracle, John Page (1994)

[7]   This also makes sense considering the fundamental issues facing each country. China's total private and public debt to GDP ratio was only 160% compared to 350% for the United States (Lardy 2012).

[8]   Additionally, this figure doesn't focus on urban areas, where the discrepancies are the most severe.

[9]   For arguments for revaluation of the RMB and the effects on global imbalances, see the Peterson Institute's Fred Bergsten's testimony in front of the US Senate Committee on Finance (2006). For arguments against the importance of China's controlled exchange rate see David and Lyric Hughes Hale's article for Foreign Affairs titled Reconsidering Revaluation (2008).  One can also look at Nobel Laureate Joseph Stiglitz's (2010) argument that a revaluation of China's currency might actually be bad for the American economy:

[10] In this calculation, foreign reserve trades are considered “below the line”–not a part of the capital account calculation. This is also leaving out the Errors and Omissions, which make up a significant portion of most nations' balance of payments, though is especially pronounced in official Chinese data.

[11] This data sourced from Chinability. Accessed December 16, 2013. <>