Up Front

The Chinese Financial System and How It Affects Us

Douglas J. Elliott

In another remarkable display of the widespread ramifications of globalization, we have seen in recent weeks that we are affected by how the Chinese manage their domestic financial system. The Chinese central bank encouraged a sharp increase in the interest rates on borrowings by banks from other banks. This, in turn, made borrowing in the “real economy” more difficult and more expensive, partly through squeezing the less regulated “shadow banking” sector that often fuels firms that have difficulty tapping the traditional banks. In turn, the drying up of funding altered the near-term prospects for the Chinese economy as a whole, signaling lower growth prospects. The fear of slower Chinese growth then hit stock commodity markets around the world. The importance of China, and the central role of its financial system in fuelling that nation’s growth, led Kai Yan and me to write a comprehensive overview of the Chinese financial system.

On the surface, the Chinese financial system looks fairly European in structure. Banks dominate the Chinese financial system, providing about three-fifths of total credit to the private sector. This is not too different from Europe, but contrasts with the US, where financial markets and non-bank lenders provide significantly more credit than banks. The Chinese banking system is also fairly concentrated, with five banks splitting almost half the total loan market, less concentrated than many European countries but more concentrated than in the US.

A major difference with more developed financial systems, however, is the high level of state ownership and control. The five largest Chinese banks are majority-owned by the central government and there are significant government stakes in many of the other banks. Further, the government intervenes far more actively in banking decisions than in the West. Most important, the central bank explicitly sets maximum interest rates for deposits and minimum interest rates for loans, and often sets target levels for loan volumes. State and Communist Party leaders at all levels also have other levers for influencing banking decisions, including control over the careers of the most important bankers, who often move in and out of government roles.

The new Chinese political leadership, which has only been in place for months, is trying to reshape the Chinese economy for a new era of slower growth while tackling multiple policy challenges, such as rising indignation about inequality and pollution and other quality of life issues. Reform of the financial system will be critical to the success of many of these wider reforms since they will require major changes to the pricing and allocation of credit to provide the right incentives for change. For instance, banks continue to lend disproportionately to large, state-owned enterprises. Yet privately owned businesses in China provide more of the impetus for growth, despite being relatively starved of funding. This in turn has led to the strong growth of “shadow banking” that is less regulated.

One of the tough challenges will be to reduce the relative importance of the shadow banking system, which has come to represent real dangers due to its informal structure and paucity of regulation, while finding other ways to channel funds to the most dynamic companies in the economy. This appears to be largely what lies behind the recent tightening of funding in the banking markets engineered by the People’s Bank of China, the Chinese central bank. Banks, particularly outside of the Big Five state-controlled banks, increasingly supply funds to shadow banking. The PBOC wanted to send a clear signal that banks should pull back from this, or at least be much more careful in how they do it. A good way to encourage care by financial intermediaries is to make their funding more expensive, so that they then choose to allocate it only to the best borrowers.

China’s financial system will be worth watching carefully in both the near and long term. It is of great importance both for its role in enhancing or holding back the development of China’s economy and because it will also affect the rest of the world, depending on how finance in China evolves over the next decade. Although the system is vulnerable to a number of risks and its opacity means that still more dangers may lie under the surface, it has served China well overall during the nation’s rapid development. As the country slows its breakneck growth rate, and works towards the necessary evolution to greater economic sophistication and international integration, the financial system is likely to continue to support the larger economy. However, it will have to evolve very considerably to do this effectively and China faces many pitfalls. It is encouraging that the new political leadership shows signs of understanding the need for this evolution, and its challenges. It is, though, much too early to tell whether this apparent understanding will be translated into workable reforms.