Financial System Structure
We describe the Chinese financial system in a simplified sense, namely one that barely consists of the banking system, the stock market, and the bond market. For each component, we utilize banking assets, the stock market capitalization, and the bond depository balance, respectively, to measure their slices in the entire financial industry pie (see Figure). In 2008, banking assets amounted to 69% of the entire financial system’s assets. Bonds ranked a distant second with a proportion of 17%. Stocks stood closely behind bonds with a share of 14%. China’s banking system is more than twice as big as its bond and stock markets together.
Figures demonstrate the banking assets structure and the bond structure, respectively. In 2008, half of the banking assets (51%) were owned by the four state-owned commercial banks, namely the Bank of China (BOC), the China Construction Bank (CCB), the Agricultural Bank of China (ABC), and the Industrial and Commercial Bank of China (ICBC). At present, 12 joint-stock commercial banks are performing in China. They held 14% of the entire banking assets in 2008. Municipal commercial banks, operating in regional areas, had a share of 7% in the banking assets in 2008. Other institutions include policy banks, rural commercial banks, rural and urban credit cooperatives, foreign financial institutions, company finance houses, trust and investment corporations, financial leasing companies, automobile finance companies, currency brokers, post-office saving banks, etc. They took the remaining proportion of 28%.
Within the bonds structure, government bonds, central bank bonds, and financial bonds (mostly policy bank bonds) are the three dominating segments. They added up to over 90% of the total bond depository balance in 2008 (see Figure). By contrast, corporate bonds had a small quotient of 5%.
It can be stated that China’s financial system is a banking-centric one. China’s banking system dominates by far in the financial system structure. Among all the Chinese banks, the four state-owned commercial banks possess the largest stake of all banking assets. China’s stock market and bond market are, compared with the size of China’s banking system, underdeveloped. Both of them are dominated by the state. By 2005, the state prevailed with a proportion of nearly 50% in the overall shareholding structure. The bond market is mostly used to issue government and central bank bonds, while corporate bonds are not a common financing tool in China.
Chinese Banking System
Prior to the reform era, China had been following a Soviet-style banking system. The People’s Bank of China (PBOC), founded in 1948 under the Ministry of Finance, had been the only bank in China and combined the roles of central and commercial banking. By 1978, it controlled about 93% of the total financial assets in China and settled almost all financial transactions (Allen et al. 2009).
With the reforms launched, the PBOC became a separate entity by 1979. From 1978 to 1984, its commercial banking businesses were taken over by four large state owned commercial banks (BOC, CCB, ABC, ICBC), known as the Big Four. The Big Four were initially designated a different sector of the economy (foreign trade and exchange, construction, agriculture, industrial and commercial lending) which they were allowed to serve only. Since 1985, the Big Four have been competing in all sectors. During the 1980s, regional banks, in which local governments typically had a big stake, were established in the so-called Special Economic Zones (SEZs) in the coastal areas. Meanwhile, a net of credit cooperatives was implemented in both rural and urban areas.
The asset quality of the four state-owned banks worsened substantially during the 1990s, as their policy-lending for SOE's were typically not repaid. As a solution to this problem, the central government founded three policy banks in 1994 to undertake the policy-lending activities instead of the Big Four, while the Minister of Finance issued 270 billion RMB government special bonds to recapitalize the four banks in 1998. In 1999, four state-owned asset management companies bought the non-performing loans (NPL) at the face value of 1.4 trillion RMB.
Two important bank laws were issued in 1995. The 1995 Central Bank Law of China confirmed the PBOC as the central bank and significantly reduced the influence of local governments on credit allocation decisions. The 1995 Commercial Bank Law officially termed the four state-owned banks as commercial banks, directing them more towards commercial business based on market principles instead of Policy-lending (Berger et al. 2009). New joint-stock banks, some of which privately owned, also entered the market in the mid-1990s. At the same time, foreign investors were allowed to hold minority stakes in regional Chinese banks under regulatory permission.
Significant reforms of the Chinese banking system took place after China joined the World Trade Organization (WTO) in 2001. The 1995 Central Bank Law and Commercial Bank Law were revised to be compliant with the WTO agreement. China Banking Regulatory Commission (CBRC) was established in 2003 to oversee reforms and regulations. CBRC took two strategies to improve Chinese banks’ management and efficiency. In 2003, it allowed foreign investors to own up to 25% of any domestic bank, whereas the ownership from any one investor had to be between 5% and 20%, subject to regulatory approval. Introduction of foreign investors firstly occurred at Chinese joint-stock commercial banks, and then spread to three of the Big Four. Another strategy was to encourage the Chinese banks to issue shares so as to set up external monitoring. Since 2005, some joint-stock commercial banks as well as CCB, BOC, ICBC have gone public in Hong Kong and Shanghai.
Chinese Capital Markets
Under the Chinese planned system before 1978, funds had been allocated to enterprises by the central and local governments. There had been no need for capital markets for enterprises to raise money. After 1978, relaxation policies over the business conduct generated capital demand from economic entities. In this context, bonds, stocks, and future contracts came into being in China. With the two stock exchanges established in Shanghai and in Shenzhen, respectively, the Chinese capital markets were established. The foundation of the Securities Committee and the China Securities Regulatory Commission (CSRC) brought the capital markets under a nationwide regulatory system.
Analogously to other reforms in China’s transition process, the development of the Chinese capital markets has been mainly driven by the central government. New market segments and products were typically launched on an experimental basis, before expanding across the country. In some cases, the development progresses were ceased and corrected by the regulators and then re-launched.
The development of the capital markets was strongly backed by Deng Xiaoping. On his southern tour to promote the reform and opening-up policies in early 1992.
Are securities and the stock market good or bad? Do they entail any dangers? Are they peculiar to capitalism? Can socialism make use of them? We allow people to reserve their judgment, but we must try these things out. If, after one or two years of experimentation, they prove feasible, we can expand them. Otherwise, we can put a stop to them and be done with it. We can stop them all at once or gradually, totally or partially. What is there to be afraid of? So long as we keep this attitude, everything will be all right, and we shall not make any major mistakes. (Deng Xiaoping 1992/1994)
The emergence of stocks can be traced back to the shareholding reforms that were initiated in rural areas in China. During the late 1970s, the earliest joint-stock township enterprises were built up by farmers. In the mid-1980s, shareholding reforms spread to the urban areas. A few large and medium-sized enterprises were permitted to conduct a shareholding experiment and to issue shares. In doing so, the primary stock market emerged. Most of those issued shares were offered to employees of the enterprises and local residents, without participation of underwriters.
They were similar to bonds, as they guaranteed fix dividends, were sold at par, and redeemed on maturity. In 1986, over-the-counter (OTC) transactions appeared for stocks.
In 1990, the central government approved of establishing two stock exchanges in Shanghai and Shenzhen, respectively, aiming at broadening external financing channels and improving the operating performance for former SOEs. From the beginning, short sale of shares was not allowed in the exchange trading. Both exchanges launched their respective composite indices in 1991. By the end of 1991, eight stocks were listed on the Shanghai Stock Exchange (SSE), while he Shenzhen Stock Exchange (SZSE) had six listings. Later, RMB-denominated ordinary shares for domestic residents and institutions to invest in were called A-shares for short. In 1991, China also undertook a pilot scheme to issue shares, known as B-shares, to foreign investors. B-shares are domestically listed, denominated in RMB, but subscribed to and traded in USD or HKD by overseas investors.
Since 1992, the Chinese stock market has boomed and become one of the worldwide largest in a relatively short lapse of time. Starting from 53 in 1992, the number of firms listed on SSE and SZSE increased about 30 times to 1,594 in 2008 (see Figure). More than 2,230 billion RMB and 5.09 billion USD were raised through A-share and B-share offerings, respectively, while the market capitalization totaled over 10 trillion RMB since 2007. More than 40 million investment accounts were opened (see Table). After the rally in 2007, the Chinese stock market reached a market capitalization of over 30 trillion RMB. This volume overstepped not only China’s nominal GDP for the first time (see Figure), but, as exhibited in Table, most of the developed stock markets and ranked No. 2 behind the New York Stock Exchange (NYSE).
In the first decades of China’s stock market, regulators and exchanges preferred listing of big SOEs in several industries. From 2001 on, the SZSE began to explore the possibility of building up a Growth Enterprises Market (GEM). As the first step, the SZSE set up the Small and Medium-sized Enterprises (SME) Board in May 2004. By the end of 2008, there were 273 firms listed on the SME Board in Shenzhen, having raised over 120 billion RMB through IPO's and refinancing (see Table).
To attract foreign investment, China’s opening-up policies covered the stock market as well. The introduction of B-shares in 1991 was the first step to open up China’s stock market to the outside world. Soon thereafter, domestic firms were allowed in 1993 to go public on overseas stock exchanges. The Chinese stocks listed and traded in Hong Kong, New York, London, and Singapore are, in reference to A- and Bshares, also called H-shares, N-shares, L-shares, and S-shares. From 1993 to 2007, Chinese firms raised more than 100 billions USD through overseas listings (see Figure). Since overseas listings connected domestic firms to international capital market more closely, the B-share market became less important in fund raising (see Table).
On its WTO accession, China made a few commitments concerning the securities industry. First, foreign securities firms could directly trade in B-shares. Second, representative offices of foreign securities firms in China could apply for special membership at all domestic exchanges. Third, Foreign Service providers could set up joint ventures for securities trading and fund management, with initial shareholdings capped at 33% and 49% within three years after the WTO accession. Fourth, within three years of the WTO accession, foreign securities firms could set up joint ventures with shareholding not exceeding 33%, and the joint ventures could, without the need to enlist the service of an Chinese intermediary, underwrite A-shares, underwrite and trade B-/H-shares and government/corporate bonds, as well as launch funds (CSRC 2008).
By the end of 2006, Beijing had complied rather fully with China’s 2001 securities industry WTO commitments, both in formal (legislative and regulatory) terms and in implementation of WTO mandated regime (Howson 2007). The authorities also adopted some additional policies in opening up the stock market. For example, in November 2002, foreign companies were allowed to purchase state-owned shares and legal person shares of Chinese listed firms. In February 2006, foreign investors were allowed to make strategic investments in the A-share of listed companies.
In December 2002, the CSRC launched the Qualified Foreign Institutional Investor (QFII) program, which licenses foreign institutional investors to trade A-shares on the secondary market. By the end of 2007, 52 foreign institutional investors had been granted the QFII status, 49 of which had been allocated quota of totally 10 billion USD, while five foreign banks had been permitted to provide QFIIs custodian services (CSRC 2008).
By the end of 2007, there were seven Sino-foreign securities firms and 28 Sino foreign fund management companies operating in China, of which 19 firms had a foreign shareholding of above 40% (ibid.). Four representative offices of foreign securities firms became special members of the Shanghai and Shenzhen Stock Exchanges; 39 and 19 foreign securities firms were trading B-shares on Shanghai and Shenzhen Stock Exchanges, respectively (ibid.).
Meanwhile, the authorities further promoted connections to overseas capital markets. In May 2006, the Qualified Domestic Institutional Investor (QDII) program was launched, allowing licensed domestic institutional investors to invest in overseas markets. By the end of 2007, 15 fund management firms and five securities firms had been granted QDII status with an aggregate investment quota of 24.5 billion USD (ibid.).
From 1954 on, the central government issued its first treasury bonds (T-bonds), so-called Economic Construction Bonds, for five years in succession. In 1959, the issuance of T-bonds was stopped. In 1981, the central government re-launched T-bonds. T-bonds in the early 1980s typically had a long maturity (10 years) and were non-transferable. From 1982 on, a few enterprises took the initiative to issue enterprise bonds. In 1987, the State Council stipulated that further enterprise bond issuances were subject to approval by the PBOC, and that PBOC, the State Planning Commission, and the Ministry of Finance would set a cap on the total amount of enterprises bonds to be issued annually. A third type of bonds, so-called financial bonds, appeared in 1984. They were issued by banks to support the completion of construction projects that ran short of funds. Since then, they have served as a regular financing tool for Chinese banks.
In April 1988, experiments with OTC trading of T-bonds by individual investors were made in a few big cities. Two months later, the permission for individual transactions expanded to 28 provinces and municipalities, and 54 large and medium-sized cities (CSRC 2008). By the end of 1988, trading of T-bonds had spread across the country. The secondary bond market emerged. In December 1990, trading of T-bonds was introduced by SSE. In 1995, all OTC bond markets were closed by the central government, because the once uncontrolled business caused high risks. In consequence, SSE and SZSE became the only legal bond markets. In 1996, a big amount of book-entry T-bonds began to be issued and repurchased on SSE and SZSE, which marked the formation of bond market on exchanges.
In 1997, Chinese commercial banks withdrew from bond business at exchanges. In the same year, the PBOC established the inter-bank bond market on the basis of China Foreign Exchange Trading System. Besides commercial banks, other financial institutions such as insurance companies, credit cooperatives, securities firms, securities investment funds, finance houses, foreign institutional investors, non-financial institutions, and pension annuities gained access to the inter bank bond market in the following years. International institutions were permitted to issue bonds denominated in RMB, known as Panda bonds. The types of bonds issued by financial institutions included short-term, ordinary, foreign currency, subordinated, hybrid and asset-backed bonds, bond forwards, and enterprise bonds. Since 2002, commercial banks have offered, as an extension of the interbank bond market, counter services for individual investors and SMEs to trade in T-bonds. In January 2009, commercial banks listed on Chinese exchanges were experimentally allowed to return to the bond market at exchanges.
As early as in October 1990, Zhengzhou Grain Wholesale Market was opened, and forward contracts were introduced there. In October 1992, Shenzhen Nonferrous Metals Futures Exchange made the first standard futures contract in China. In 1993, the commodity futures market flourished. There were over 50 commodity futures exchanges and more than 300 futures brokerage companies across the country. Meanwhile, T-bond futures came into existence. In December of 1992, SSE introduced the first T-bond futures. In early 1995, the number of exchanges dealing in T-bond futures increased to 14.
However, the futures market was fraught with speculations and manipulations due to insufficient regulation (CSRC 2008). In 1993, the State Council emphasized that its Securities Committee and the CSRC were the regulators of the Chinese futures market and began to clear it. Futures brokers which were either unqualified or acting illegally were closed or suspended. Dealing of a number of commodities, including steel, sugar, coal, rice, and rap oil, was suspended. In May 1995, trading of T-bond futures was suspended as well. In 1998, the existing 14 futures exchanges were consolidated into three (Shanghai, Dalian, Zhengzhou).
From 1999 to 2002, the State Council and the CSRC promulgated the first regulations on futures trading, exchanges, and brokerage firms at the futures market, starting to establish a legal and regulatory framework. From 2004 on, new commodity futures contracts were introduced, including cotton, fuel oil, corns, soybean, sugar, soybean oil, purified terephthalic acid (PTA), zinc, rapeseed oil, linear low-density polyethylene (LLDPE), and palm oil. The three commodity futures exchanges have been gradually unifying their trading rules and expanding the use of a common trading portal. In May 2006, the first Sino-foreign futures joint venture was established, marking the start of foreign participants in China’s futures market. In September 2006, the China Financial Futures Exchange (CFFEX) was set up in Shanghai. The preparation on introduction of stock index futures is still ongoing. Up to now, Trading Rules of China Financial Futures Exchange has been promulgated; and nearly 80 members have been licensed for transactions (cf. CFFEX 2008). Mock trading of stock index futures has been ongoing for testing purposes since October 2006, but there is still no fixed plan or schedule to launch the stock index futures. In January 2008, the Shanghai Futures Exchange (SHFE) introduced the first futures contract on gold.
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