Reform and Development of Chinese Financial System

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Reform and Development of Chinese Financial System
Cao Yuanzheng, BOCI Chief Economist
March, 2007

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Basic features of Chinese economy
Traditional centrally-planned economy
Transition
Market economy
Industrialization
Modern industrial economy
Traditional agricultural economy
Modern Chinese economy sees a transition from
traditional planned economy to market economy
like the former Soviet Union and Eastern European
countries. Meanwhile, it witnesses the same
industrialization process as seen in any other
developing country.
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Primary mission of financial reform in the
transitional period
Traditional planned economy is a kind of
fiscal-dominated economy. The activities of
financial institutions fall into the category of
fiscal activity.
Mission Oneestablish a sound financial system,
which is independent of fiscal-oriented financial
system (eg. the dual banking system composed of
the central bank and commercial banks) Mission
Tworealize the commercialization of financial
institutions, which will assume sole
responsibility for its profit or loss and all the
risks (enterprization of financial institutions)
Fulfilling the two missions at the same time is a
radical reform. China adopts the reversed
way------ gradual reform.
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The orientation of financial policy during
industrialization
Economic modernization relies on the development
of industrialization. During the
industrialization, financial arrangements in
developing countries always serve as a supporter
of industrialization.
Function One domestically, try to reduce the
cost of capital, usually with discriminatory
admittance restrictions, and interest rate,
especially interest spread control. Function Two
externally, try to accelerate capital inflow,
usually by foreign exchange control, export
reward and import control.
If the above mentioned policies are adopted, the
financial system will normally be characterized
by industrialization policies and always
concentrates on indirect financing, with
commercial banks dominating the structure. This
is the situation in China.
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The cooperation strategy of industrial sectors
and financial reform and development in China
Mid to late 1980s to 2003
After 2003
Setting up state asset management system
independent of fiscal system regulating the
social asset system by legislation
State-owned Enterprise reform aiming to establish
free enterprise system promoting the development
of non state-owned enterprises
Industrial sector
Constructing market-oriented financial system
independent of government fiscal system
gradually eliminating ownership prejudice, with
interest rate, exchange rate and business line
strictly under control
Corporatization of state-owned financial
institutions with controlled deregulation of
interest rate, exchange rate and business line
permitting qualified investors to set up
financial institutions
Financial sector
Free enterprise system is decisive in the
establishment of industrial sectors, and
consequently, reform is indispensable. Financial
sector should act in concert, which is necessary
not only for reforms, but also for
industrialization. With the establishment of free
enterprise system and industrialization entering
the mid-to-late period, the corporatization of
financial institutions has taken place.
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Accomplishment of Mission One(1978-2003)
1990 Shanghai and Shenzhen Stock Exchanges were
established and the Peoples Bank of China issued
Provisional Measures on the Administration of
Securities Companies, clarifying that securities
companies are the specialized financial
institutions engaged in securities business.
Divided operation emerges.
2003 CBRC was established, symbolizing the
establishment of financial system characterized
by divided operation and divided supervision
1993 Divided management was formulated in State
Council documents as a principle CSRC and CIRC
were established.
2000
1950-1980
1990
1988 Non-banking businesses, such as trust fund,
securities and insurance emerged the Peoples
Bank of China assumed the supervision task
1984 The establishment of ICBC, ABC, BOC and CCB
marked the formation of dual banking system,
which is composed of the central bank and
commercial banks.
Before 1980 Highly concentrated planned economy
fiscal-dominated economic activities no
financial market.
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Launch of Mission Two(2004-2006)
Target
Financial Institutions--- corporations involved
in monetary business
Target 1 The relationship between finance and
banks is defined by the amount of investment --
limited liability companies (Corporation)
Target 3 Emphasizing external supervision ---
third party supervision, professional and
independent of government
Target 2 Internal operating system--- well
structured corporate governance
Measures 1. Establishing China Banking Regulatory
Commission 2. Emphasizing supervision with the
core indicator of debt/asset ratio

• Measures
• Introducing strategy investors and carrying out
  share-holding reform
• Setting up board of directors which appoints
  management

Measures 1. Disposing bad debts and injecting
capital 2. Building balance sheet meeting the
requirements of commercial bank operation
Milestone The share-holding
reform and listing of BOC, ICBC, CCB and Bocom
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Preliminary effects of Mission Two continuous
improvement of asset quality

• Through reform, the asset quality of financial
  institutions (esp. commercial banks) has been
  continuously improved , and NPL ratio has
  declined substantially.

NPL ratio of commercial banks
( )
8
2006E
2007E
6
4
2
0
CMB
BOC
BOC
Bocom
CCB
ICBC
Minsheng
SPDB
SDB
IB
Huaxia
(
(China
)
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Preliminary effects of Mission Two profitability
of commercial banks steadily strengthened

• The profitability of Chinese banking has shown a
  sound rebound, now at mid-upper level when
  comparing with some countries.
• Going forward, we expect the overall
  profitability of Chinas banking sector to
  improve further. First of all, with the
  continuous improvement of asset quality, credit
  cost will keep decreasing and provision to
  expense ratio will decline secondly, net
  interest spread will possibly keep moving upward
  thirdly, non- interest income will expand.

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Steady Improvement in Investment Value of China's
Commercial Banks
ROE starts to rise with the requirement of
capital adequacy ratio being met
Return on Equity
----------------------------
P/B
Cost of Fund-Natural Growth Rate
Expansion and stable business environment
resulting in a decline in the cost of fund
Strong growth in macro-economy with improved
banking regulation mechanism will promote a rapid
growth of natural growth rate
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New Environment for the Development of Chinas
Financial Sector(I)

• Market-oriented micro-foundation and competitive
  enterprises system has basically taken shape,
  financial institutions no longer need to support
  state-owned enterprises

Breakdown of VAIO
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New Environment for the Development of Chinas
Financial Sector (II)

• In the mid-to-late stage of industrialization,
  financial institutions no longer need to fully
  perform policy financial functions

Constitution of GDP
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New Environment for the Development of Chinas
Financial Sector (III)

• China's financial sector has entirely
  liberalized, financial institutions will face
  competitions from global extent

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Challenges Financial Institutions are Facing
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Parties with surplus fund
Lenders are more sensitive to interest rate
Competitions from other products with
high-interest rate
Deposits
Competitions from non-banking financial
institutions
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Banks
Loans
Competitions from other loan products
Borrowers are more sensitive to interest rate
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Parties with insufficient fund
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New Trend in the Development of Chinas Financial
Sector(I)

• On the macro side, interest rate and exchange
  rate liberalization has started

RMB/US Exchange Rate since Exchange rate
Mechanism Reforms
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New Trend in the Development of Chinas Financial
Sector (II)

• From the structural perspective,indirect
  financing has started giving way to direct
  financing

The proportion of direct financing and indirect
financing in China
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New Trend in the Development of Chinas Financial
Sector (III)

• On the micro side, the trend of transformation
  from divided operation to integrated operation
  has emerged

• According to revised Law on Commercial Banks
  effective from February 1, 2004, the integrated
  banking business experienced a certain degree of
  liberalization, and banking, insurance and
  securities industries have interwoven with each
  other in the real economic world
• CITIC Group CITIC Group was established in
  2002. It has now become an integrated financial
  holding group which is involved in banking,
  insurance, securities, fund and trust businesses.
  It comprises CITIC Industrial Bank, CITIC
  Securities, CITIC Funds, CITIC Trust Investment
  and Citic-Prudential Life Insurance Company.
• BOC GroupBOC established BOCI (investment bank)
  and BOC insurance in HK to diversify its
  financial service business and to expand the
  business from HK to mainland
• Ping An Insurance Group Ping An Insurance has
  also developed from a pure insurance company to a
  integrated financial group which offers various
  financial services including insurance,
  securities and trust.

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Outlook of Chinas Financial Sector

• The overall restructuring and potential listing
  of Agricultural Bank, and the commercialization
  reform of China Development Bank indicate that
  the policy functions of the state-owned banks
  will be reduced, with commercial features being
  enhanced
• Marked by the preparation of Shanghai Financial
  Futures Exchange, the rapid growth of fixed
  income product will promote both transformation
  of financial sector from indirect financing to
  direct financing and the interest rate
  liberalization.
• Take approved RMB bonds issuing in HK market as
  sign, the convertibility of RMB and
  liberalization of exchange rate mechanism have
  been further improved
• Marked by the approval of fund management company
  established by commercial banks, financial
  institutions have started engaging in cross
  selling and integrated operation.

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Advantages of integrated operation

• Profitability of
  different financial institutions

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Conclusions
Chinas economy is experiencing the fastest
growth in the world, and is expected to maintain
a relatively high growth in a considerable long
period. With further implementation of financial
sector reforms and liberalization of the sector,
Chinas financial sector has the potential to
achieve the fastest growth in the global context.
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Thank you very much!