RDP 2014-10: Financial Reform in Australia and China 3. China's Financial System Reforms[23]

Unlike Australia in the early 1980s, China's financial system reforms have occurred as part of a gradual, closely managed transition from a centrally planned economy towards a market-oriented economy. Prior to the period of ‘reform and opening’ initiated in December 1978, interest rates on loans and deposits were set directly by the central government; the interbank market, stock markets and bond markets did not exist; the renminbi was largely unconvertible for current and capital account transactions; and foreign investment was negligible. The decision to reform the financial system occurred at an early stage, and was consistent with a broader retreat from central planning towards a hybrid economic model characterised by a growing role for the market economy but continued high levels of government intervention.

Ambitious reforms to build a modern financial system and reduce the role of the state in the economy in the 1990s accelerated China's move towards deregulation. But rising banking sector fragility and the non-performing loan (NPL) crisis of the late 1990s – combined with the 1997–1998 Asian financial crisis – highlighted the potential risks of moving quickly on financial reform, contributing to a very gradual pace of reform in the 2000s.

3.1 The Expanding Financial System

Initially, economic reforms focused on reducing price controls and creating market incentives in agriculture, and reducing barriers to entry in industries previously controlled by state-owned enterprises (SOEs). This resulted in rapid growth in productivity and output that was accompanied by an expansion of the financial system.

3.1.1 Banking system and interest rate regulation in the 1980s

Banking deregulation in China followed a distinctly different path to that in Australia, in part because of the dominant role of SOEs and state-owned banks in the Chinese economy. In the pre-reform era, household savings were low and banks effectively acted as conduits of trade credit and working capital to SOEs, within limits set by a centrally determined credit plan. At the outset of reform, financial services were provided by three state-owned banks and a network of rural credit cooperatives (RCCs) that provided banking services in rural areas. Through the mid and late 1980s, the authorities approved the creation of numerous new national and regional bank and non-bank financial institutions, regulated by the People's Bank of China (PBC). The PBC had been the dominant financial institution prior to economic reforms, acting as the monetary authority, financial supervisor and primary commercial bank. It was designated as a central bank in 1983.[24] By the mid 1980s, a large number of NBFIs, including urban credit cooperatives and trust and investment companies, had emerged to supplement the SOE-oriented lending activities of banks and to meet the funding needs of the growing non-state sector (Lardy 1998, pp 61–76).

At the start of reforms, the schedule of interest rates for deposits and loans of various tenors and types was set centrally by the government. As the banking system expanded, however, the authorities began to experiment with increased interest rate flexibility. In 1983, the PBC was authorised by the State Council (China's central legislative body) to vary interest rates by 20 per cent on either side of centrally determined benchmark rates.[25] Yet policymakers were originally reluctant to increase the floating range of interest rates, fearing that it would harm the profitability of enterprises (Yi 2009).[26]

The authorities also experimented with floating deposit rates for RCCs and trust and investment companies, but these pilot reforms were aborted when the resulting competition for deposits (particularly by the more poorly performing financial institutions) led to substantial movements of deposits across institutions and violations of interest rate ceilings on other products (PBC 2005). In 1987, the PBC permitted the large banks to increase lending rates for working capital loans by up to 20 per cent over the benchmark rate. In 1990, this flexibility was extended to lending rates for commercial banks and urban credit cooperatives. But problems that had been experienced in pilot efforts to float deposit rates led the authorities, in the same year, to prohibit increases in deposit rates above the benchmark for all financial institutions (PBC 2005).

3.1.2 Capital controls and the exchange rate in the 1980s

Prior to economic reforms, the Chinese Government had imposed a centralised foreign exchange system whereby detailed plans had to be submitted to the authorities for approval in advance of all trade-related or foreign investment-related foreign exchange transactions, foreign investment projects or external borrowing (Prasad and Wei 2005). All foreign exchange earnings had to be sold to the government. This restrictive foreign exchange system had a parallel in restrictions on foreign trade: in the early years of reform, exports and imports were controlled by a complicated schedule of trading rights, import licenses, quotas and tariffs (Lardy 2002, Chapter 2).

The growth of the domestic financial system in the 1980s coincided with increasing openness to world trade, a dismantling of the pre-reform system of centrally planned exports and imports, and increased international flows of capital. To support inward direct investment, numerous ‘special economic zones’ featuring tax and other incentives to attract foreign investment were established. Regulations announced in 1980 retained centralised foreign exchange management (that is, requiring approval for individual current and capital account transactions) but resident entities and foreigners were allowed to retain or trade a portion of their foreign exchange.

The increased availability of foreign exchange onshore led to the creation of a market-based foreign exchange market (sanctioned by the government) alongside the official market. A dual exchange rate system emerged, with only around 20 per cent of foreign exchange traded at the official rate (Yi 2008). From the mid to late 1980s, the official rate was devalued several times to bring it more in line with the market-determined rate, but the dual system prevailed until 1994.

3.1.3 Growth of financial markets and banking sector fragility in the 1990s

The period beginning in the mid 1990s and ending in the early 2000s saw an expansion of China's financial market infrastructure, but also risks to financial stability. Seeking to diversify funding for the corporate sector, the government opened the Shanghai and Shenzhen stock exchanges in 1990 and 1991, and subsequently allowed the creation of numerous regional exchanges. These exchanges became trading platforms for various financial instruments including equities, government bonds and corporate bonds. Local currency bond repurchase agreements (repos) were first introduced in 1991 on a number of securities trading platforms, and in 1993 on the Shanghai Stock Exchange.

The development of capital market infrastructure centred on the stock exchanges resulted in leakages of bank funding, via securities companies and institutional investors, into the stock market. This aroused concern among policymakers about systemic risks stemming from rapid growth in asset prices. In response, in 1997–1998 the government created separate regulatory frameworks for the banking, trust, securities and insurance sectors, eliminated smaller securities markets and required all banks to migrate their business from the exchanges to the interbank market, which had been expanding since the mid 1980s (Zheng 2007, p 52; Tan 2007, pp 223–224). Between 1997 and 1999, interbank markets for bonds and repos were established, with floating interest rates for government bonds and policy financial bonds.[27]

Although the size of financial markets increased during the 1990s, they remained small compared to the formal banking system, whose fragility was underscored by the NPL crisis of the late 1990s. The crisis had its origins in the rising leverage of the SOEs. Growing competition from the private sector, and declining state support, led to more bank borrowing by unprofitable SOEs, and a sharp rise in inter-enterprise liabilities – or ‘triangular debt’ – as firms incurred debts (often in the form of unpaid bills) to other firms. Some observers estimate that more than half of China's SOEs were insolvent by the mid 1990s (Lardy 1998, p 175).

Despite efforts to reform the SOEs through privatisation initiatives and to improve the asset-liability management of the banks (including imposing a 75 per cent maximum loan-to-deposit ratio), by 1997–1998 the largest four banks' NPLs had risen to between one-quarter and one-third of total assets (Bonin and Huang 2001). Although China's strong capital controls allowed it to weather the 1997–1998 Asian financial crisis, the concurrent NPL crisis heightened policymakers' concerns about domestic financial fragility. The government responded swiftly, recapitalising the state-owned banks, introducing debt-for-equity swaps, and creating four asset management companies to purchase banks' NPLs at face value and begin the process of their disposal (PBC 2000, pp 31–38). Subsequently, NPLs moderated steadily. But the fragility in the banking system that surfaced in the late 1990s contributed to subsequent gradualism in domestic financial reform.

3.1.4 Steps towards interest rate deregulation in the late 1990s–early 2000s

The 1990s saw incremental progress in deregulating bank lending and deposit rates. In 1993, the State Council issued a decision on financial system reforms that incorporated a strategy for interest rate liberalisation (PBC 2003, p 14). Following the deregulation of interbank lending and repo rates in the mid to late 1990s, the PBC resumed efforts to increase the flexibility of bank lending rates. The PBC's objective was to encourage banks to lend to small and medium-sized enterprises, which tended to receive fewer loans than larger firms that were seen to be more creditworthy (Yi 2009). In the late 1990s and early 2000s, interest rate ceilings for bank loans to small and medium-sized enterprises and foreign currency loans, and RCC lending rates, were granted further flexibility (PBC 1999, p 22; PBC 2000, p 26). In October 2004, ceilings on almost all lending rates were abolished while the floor was retained at 0.9 times benchmark.

Efforts to reform deposit rates also resumed towards the end of the decade. In 1999, the PBC took tentative steps towards liberalising wholesale deposit rates by allowing banks flexibility to negotiate contract interest rates for large-scale commercial deposits with insurance companies (PBC 2003, p 15). Similar to the experience of the 1980s, broader reforms to deposit rates were delayed by concerns that upward flexibility would lead to unhealthy competition among banks that would diminish their margins. A small-scale trial to reduce ceilings on RCCs' deposit rates in 2002 failed to achieve expected results, leading once again to such efforts being postponed (Guo 2013). But there was increasing recognition that the floors on deposit rates were redundant, and by October 2004 the floor on interest rates had been abolished for all deposits (Yi 2009). The 2004 reforms marked the start of a policy to manage only the floors of lending rates and the ceilings of deposit rates, effectively guaranteeing a minimum net interest margin for the banks.

3.1.5 The currency regime and capital controls in the 1990s

Moves to increase the flexibility of interest rates occurred alongside changes to exchange rate policy. In January 1994, the official and market-based exchange rates were unified at the prevailing market rate. This resulted in a large official devaluation of the renminbi (Figure 9). The exchange rate was initially allowed to follow a managed float which resulted in gradual appreciation, but the authorities reimposed a peg to the US dollar during the Asian financial crisis, with this peg remaining in place until 2005.

Figure 9: Chinese Renminbi

The 1994 exchange rate reform resulted in changes in the implementation of China's foreign exchange controls. The interbank China Foreign Exchange Trade System (CFETS) was established, initially with the PBC as the sole market maker and counterparty. Most enterprises were required to sell all foreign exchange earnings above certain limits to authorised banks, which would in turn convert these funds to renminbi on the CFETS. Importers seeking to purchase foreign exchange for trade settlement were required to submit import contracts and other documentation to authorised banks.

In 1996, China formally achieved convertibility on the current account, defined as the sum of trade in goods and services, net income from foreign investments and labour remittances. While current account transactions still required the submission of supporting documents, and most foreign exchange earnings had to be sold to the banks, these transactions no longer required formal approval from the authorities. But capital account transactions remained tightly controlled: all foreign exchange transactions affecting the foreign assets or liabilities of domestic residents either required official approval or were explicitly prohibited (Le 2007, p 114).

Similar to the Australian experience, inward direct investment continued to be encouraged, and expanded significantly from the mid 1990s, albeit remaining subject to review by relevant authorities and to the government's industrial policies. In contrast, portfolio flows such as transactions in capital market securities or money market instruments were generally prohibited without prior approval (Prasad and Wei 2005).

While the period between the early 1990s and the early 2000s saw modest changes in capital controls, it is likely that China's experience during the Asian financial crisis increased the government's level of comfort with the prevailing arrangements (Yu 2013). Despite large currency depreciations among China's trading partners during the crisis, which led to a loss of competitiveness for Chinese exporters, policymakers resisted the temptation to engage in competitive devaluations and instead decided to peg the renminbi to the US dollar and accept export losses (Hu 2010). While China's trade performance during the crisis was poor, the strong capital controls in place provided substantial insulation from speculative capital flows. Following current account convertibility in 1996, policymakers initially planned to achieve capital account convertibility within 5–10 years (Huang et al 2013, p 109), but the Asian financial crisis, and rising banking sector stress in the late 1990s, contributed to these plans being postponed.

3.2 China's Evolving Financial Reform Agenda

In the past decade, the overall framework of tight internal financial regulation, strong controls on portfolio capital flows and a steadily appreciating currency has remained in place, although there have been a number of significant changes. First, the regulatory framework has been strengthened, including through the creation of a separate banking regulator in 2003. Second, interest rates and the exchange rate have been given increased flexibility. Third, the emphasis of monetary policy has shifted. The PBC continues to guide individual banks' credit extension to priority sectors (‘window guidance’) and has maintained informal loan quotas. But it has phased out mandatory credit ceilings, and has made more use of interest rate changes, required reserve ratio adjustments and open market operations. Fourth, further restrictions on capital flows have been removed, in particular those relating to inbound FDI in manufacturing. While control of portfolio flows has remained tight, since the late 2000s efforts by the authorities to promote the internationalisation of China's currency have seen growth in offshore renminbi deposits and an increase in avenues for cross-border flows.

3.2.1 Banking sector deregulation

According to Huang et al (2013, p 97), between 1996 and 2007 around 120 types of interest rates underwent reform. In general, the approach to interest rate liberalisation followed the sequencing principles of ‘foreign currency interest rates before local currency interest rates’, ‘loans before deposits’, ‘long-term wholesale interest rates before short-term retail interest rates’, and ‘rural areas before urban areas’ (PBC 2000, p 26; PBC 2005). In 2012, the PBC reduced the floor on lending rates and increased the flexibility of deposit rates slightly. In 2013, it abolished all restrictions on lending rates (except for rates on individual mortgages).

Although lending rates are now largely liberalised, authorities have been reluctant to remove ceilings on regulated deposit rates. In late 2013, as a preliminary step towards deposit rate liberalisation, the PBC announced that banks would be given the flexibility to set negotiable rates on interbank CDs. In March 2014, the PBC's Governor stated that deposit rates could be liberalised within 1–2 years (PBC 2014).

While policymakers have remained cautious about formally deregulating deposit rates, a significant de facto liberalisation of deposit rates has occurred in recent years. In response to the global financial crisis of 2008–2009, the authorities initiated a large-scale loosening of credit conditions to support growth (Figure 10). With banks restricted in lending by loan-to-deposit ratios and local governments restricted from borrowing directly on capital markets, the policy easing led to a rise in borrowing from corporate entities established by local governments, and significant intermediation of funds through NBFIs – particularly trust companies – working in cooperation with commercial banks. Banks were able to fund loans off-balance sheet to local governments, property developers and manufacturing firms by issuing ‘wealth management products’ (effectively term deposits with interest rates that were much higher than regulated deposit ceilings).

Figure 10: Chinese Total Social Financing

3.2.2 Capital controls

Since the early 2000s, capital controls have continued to be eased very gradually, although FDI in the services sectors (including financial services) continues to be limited and portfolio flows remain, to a large extent, forbidden. As a share of GDP, both gross and net flows have not increased dramatically compared with the 1990s, although they remain well above the level of the 1980s (Figure 11). Restrictions on foreign exchange purchases for foreign currency loans and pre-approved strategic foreign projects were eased in the early 2000s, and in 2002 a Qualified Foreign Institutional Investor (QFII) program allowed approved foreign institutions to invest foreign currency in domestic equities. This scheme has been expanded and approved QFIIs can now invest foreign currency in equities, bonds, securities funds, stock index futures and other financial instruments permitted by the securities regulator. The renminbi QFII (RQFII) scheme, initiated in late 2011, allows selected foreign financial institutions to invest renminbi obtained offshore in approved onshore assets. The Qualified Domestic Institutional Investor (QDII) scheme, initiated in 2006, allows authorised domestic institutions to invest funds raised onshore in selected offshore investments.

Figure 11: Chinese Gross and Net Capital Flows

Notwithstanding the expansion of these programs, FDI has continued to be the largest contributor to flows registered on the Chinese capital account in recent years, along with ‘other’ flows that appear to be mostly related to banks' and firms' short-term internal financing and trade credit (Figure 12). In 2013, total FDI (i.e. the sum of inward and outward FDI) was worth approximately US$330 billion, or roughly 3.5 per cent of GDP. Cross-border portfolio investment schemes are relatively modest by comparison. PBC data indicate that the foreign liabilities of banks and other deposit-taking institutions (domestic-owned and foreign-owned) in China totalled approximately US$360 billion as at the end of February 2014 – much greater than the roughly US$82 billion of net foreign investment accounted for by the QFII and RQFII schemes at that time. However, even total foreign liabilities represent only 1.4 per cent of the total liabilities of the banking system, implying that the Chinese banking system's current exposure to international markets is small.

Figure 12: Chinese Gross Capital Flows

3.2.3 The exchange rate

Following its ‘re-pegging’ during the Asian financial crisis, the USD/CNY exchange rate was effectively fixed until July 2005, when the PBC announced that it would manage the renminbi in a +/−0.3 per cent band (later +/−0.5 per cent) against an undisclosed basket of currencies. This arrangement marked the beginning of a period of steady appreciation of the renminbi against the US dollar, aside from a two-year pause beginning in mid 2008 associated with the global financial crisis. Appreciation pressures on the renminbi, and the steady inflow of foreign currency due to the trade surplus (and, to an increasing extent, capital account inflows) following China's accession to the World Trade Organization in 2001, meant that the PBC needed to intervene in the spot foreign exchange market to maintain the trading band.[28] This contributed to a more than quadrupling of China's foreign exchange reserves to US$3.8 trillion between 2005 and 2013.

Since mid 2005, the renminbi has appreciated by around 30 per cent against the US dollar and by around 40 per cent in real effective terms. In April 2012, the PBC widened the renminbi's daily trading band against the US dollar from +/−0.5 per cent to +/−1 per cent around its daily central parity rate (‘fixing rate’), set by the PBC (via the CFETS) each trading day as part of its management of the renminbi against a basket of currencies.[29] From March 2014, the band was increased further to +/−2 per cent. Officially, the exchange rate is deemed to be freely floating within this trading band, with the PBC intervening to maintain the band. If movements of around 2 per cent per day relative to the previous trading day's spot rate were permitted, this would amount to a degree of exchange rate flexibility that is similar to most countries with floating exchange rates. However, as the band is defined relative to a reference rate set by the authorities each trading day, the central bank retains considerable control over the direction of movements in the exchange rate.

Steady development of the onshore foreign exchange market over the past decade has seen growing use of instruments to hedge foreign currency exposures. Prior to the mid 2000s, only spot foreign exchange transactions could occur on the CFETS. In 2005, foreign exchange (deliverable) forwards were introduced; foreign exchange swaps were introduced in 2006 (Xie 2009, p 476), and now record monthly turnover comparable to that of the spot market. But the lack of volatility in the exchange rate, restrictions on the use of foreign currency in China and controlled access to offshore markets have limited the depth and liquidity of these hedging markets.

Official efforts have been made to ‘internationalise’ the currency in recent years, allowing a pool of renminbi to accumulate offshore where it is freely tradeable (subject to local regulations). This has facilitated the development of a range of offshore renminbi-denominated financial products, including foreign exchange products and hedging tools. The internationalisation process has the potential to bring significant benefits to Chinese firms. As international trade is increasingly denominated in renminbi, firms may be better able to reduce currency mismatches on their balance sheets, mitigating vulnerabilities that could arise as the exchange rate becomes more flexible. Another possible advantage is that as capital account liberalisation proceeds, the entry of non-residents to China's domestic financial markets will increase the depth of these markets, increasing the availability of counterparties for Chinese entities seeking to hedge their foreign currency liabilities (Lowe 2014).


A time line of reforms is presented in Appendix B. [23]

The PBC coordinated with the State Planning Commission to develop the national credit plan. It was legally confirmed as the central bank in 1995. [24]

This authorisation was given in State Council Document No 100 (1983). [25]

For this reason, the upward flexibility of lending rates was reduced to 10 per cent in 1996 (Yi 2009). [26]

Policy financial bonds are used as a source of funding by China's policy banks – namely, the China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China. [27]

The need to sterilise the domestic liquidity impact of these purchases of US dollars/sales of renminbi led to more intensive use of required reserve ratio adjustments in the second half of the 2000s (Ma, Yan and Liu 2011). [28]

Having effectively pegged the renminbi against the US dollar since 2008, in June 2010 the PBC announced that it would allow increased flexibility in the exchange rate, managing the renminbi against an unspecified basket of currencies. [29]