ECON 2169 TERM PAPER

Politically Invested
Understanding the problems with Chinas financial markets and their solutions
Robert Daniel Smith 12/12/2011

This Paper will focus on the problems in the Chinese Financial system created by the Government. It will deal mainly with markets, and firms when necessary. The primary premise is Restoring proper financial intermediation through removal of price ceilings, opening of the Chinese Capital Account, breaking apart inefficient firms via public stock offerings, and reforming the Chinese Bond market

Control over the direction of capital is the most powerful form of economic control. Capital investment can transforms slums into industrial parks. Consequently, this enormous power draws the interest of political actors seeking to control capital and increase their own power. That political interest opposes the marketplaces role in directing capital and is a great threat to economic efficiency. The Peoples Republic of China is the worlds largest example of sacrificing efficiency for political control over capital, meaning the central government is robbing the economy of efficient capital allocation for political gain. Closed Capital accounts, State backed financing, a fragile stock market, and a weak bond market create a death grip of poor financial intermediation that surrounds Chinas financial markets. These factors, which originate from the Central Government, have encouraged rampant mal-investment in Chinas economy and created a ticking time-bomb situation. Restoring proper financial intermediation through removal of price ceilings, opening of the Chinese Capital Account, breaking apart inefficient firms via public stock offerings, and reforming the Chinese Bond market will correct the Chinese economys path.

Formal and Informal financial Markets: The Chinese Financial situation is largely characterized by negative real interest rate that results from a government ceiling on nominal interest rates. The credit markets can be modeled by a pair of Loanable Funds Market Graphs; one, denoting the formal Market [below-left], and the other denoting the informal market [below-right]

Sf Savings Supply Curve o re Real Interest Rates o c* - Choices of savings destinations o y Disposable Income o w Wealth Sif Informal Savings Supply Curve o re Real Interest Rates o c* - Choices of savings destinations o y Disposable Income o w Wealth

S = i1-3 Interest Rate Ranges DI Investment Demand o re Real Interest Rates o Profits o Government Directed lending

The two graphs show the two destinations for most Chinese savings. The formal market, which is relatively inelastic, absorbs Chinese disposable income for little return. Most Chinese savers have little choice for where to put their savings and must settle for state banks paltry interest rates. Investment in the Chinese Stock Market is relatively low, its unpredictability and low growth are heavy disincentives to investment as an alternative to saving. There are also no commonly assessable bond markets for savers. The lack of individual financing and future uncertainty about economic-security for Chinese savers encourages them to tuck their money away in state banks. (Cappiell & Ferruc, 2008). These factors reinforce the inelasticity of

Chinese loanable funds, which, in the short run at least, are trapped in low yielding bank accounts. State banks have been matching these savings habits with increasing investment (see Appendix 1). Over time, savers have started to find new sources for their savings; the connection between bank deposits and Chinese interest rates can be seen below.

Since 2004, deposits have grown by 14 percent on a year-over-year (YoY) basis during periods of negative real interest rates, compared to 20 percent growth for periods when the real interest rate was positive. Because Chinas capital account is mostly closed, these deposits are forced to stay within the country and chase higher yields offered in real estate or financial products offered by non-bank financial intermediaries (Borst 2011)

Peterson Institute for International Economics

The dual loanable funds models help illustrate the effects of the Chinese interest rate ceiling. The Green Area on the left graph shows the total investment {assuming: aggregate savings = aggregate investment} that would occur in the Chinese market under perfect market conditions; the orange area shows the same thing under the price control with the same assumptions. In reality, the real amount of lending in the Chinese economy is at a minimum the area of the orange rectangle, and at a maximum the area of the green square. This is because, while the banks remain the primary deposit for Chinese savings, alternatives to the formal banking system exist. On the right graph, the informal market, the orange square represents the informal lending that takes place below the price controlled interest rate; the slope is undefined because there is no incentive for lenders to lend at interest rates that do not go beyond the price

control, but there are some funds that will remain in the informal market regardless of interest rates. Examples of these include illegal activities, savers without access to formal markets, and low-interest, inter-family lending (Li, 2009). The area of the green square in the informal market plus the orange square represents the total area of informal lending. The slope of the supply curve marketed S = i2 is key to determining the area of the green square and is mainly determined by the return of investment in the informal market compared to the formal market and the availability of investment opportunities. The informal financial market in China has a long history of destruction and revitalization; the most important part of the history is how the market fared during periods of economic reform. Pawnbrokers, Money Houses, and Rotating Credit and Savings Associations were all very active prior to the Communist Revolution in China, but by 1958, private finance had been completely eliminated. When Property rights started making a comeback in the 80s, informal finance surged to fill the financial void left by years of socialism and the government slowly adopted policies specific to the different types of finance; Pawnbrokers have become the only informal institution to begin operating publically, Money Houses have been forced to work unpublicized, informal money collection and private equity funds have operated in and around government attention (Jiang, 2009). Currently, the informal market appears to have become a serious alternative to saving in low yielding banks. Black Market institutions can offer high rates of return for funds, which are then diverted to capital starved areas of the economy. In survey from 2006, China was found to have 42.7% of new financing through other means of financing; this category included underground and informal lending, and the category was substantially smaller in other developing nations: India (4.09%), Brazil (2.27%), or Indonesia (8.80%) (Ayyagari, DemirgucKunt, & Maksimovic, 2008).While these percentages will have most likely changed after the massive stimulus spending through Chinese banks, they still demonstrate massive underground lending. The Chinese Government has put the figure at 33.12% in the past (Li, 2009). Firms that are unable to obtain bank loans provide a destination for these informal funds; Firms have reported Lack of collateral, perceived lack of feasibility of project and incompleteness of application as the three reasons why their applications are rejected, with lack of collateral leading with 66% of the sample (Ayyagari, Demirguc-Kunt, & Maksimovic, 2008).

Chinese Interest rate controls rob the economy of productivity in two ways. Firstly, by propping up state owned firms and providing inefficient firms with financing, and Secondly by pushing funds outside the formal markets, into the informal ones, where they subject to poor intermediation. In a survey of Chinese firms by the World Bank, there was a specific population that deserves attention. In the survey, some firms reported using the government help to acquire bank loans, 16% of the firms that used bank loans; these firms were found to have no improvements in growth, reinvestment or productivity (Ayyagari, Demirguc-Kunt, & Maksimovic, 2008). This supports the assertion that the government is intervening in the credit markets to support non-profit oriented firms. The fact that Chinese interest rates are so low makes it unlikely that these firms will have to pay a significant return to the banks. Moodys also reported that the banking systems non-preforming loans could reach between 8% and 12% of total loans (Zhang & Long, 2011). This reporting confirmed the common suspicion that the Chinese banking system is plagued by non-preforming loans. The economy has also experienced a decrease in the marginal product of capital, in a country with a low capital-to-labor ratio, a falling marginal product of capital may also signal an inefcient allocation of capital (Cappiell & Ferruc, 2008). Chinas control of capital is also creating an adverse selection problem in informal markets. The data available on informal markets suggests that they are subject to poor financial intermediation. Informally funded firm often fare poorly, the World Bank survey found no that they did not experience high growth or increases in productivity (Ayyagari, DemirgucKunt, & Maksimovic, 2008). Without banks to research potential lending opportunities, asymmetric information creates risk in the informal market. There is still some evidence that the Chinese banks are responsible, rational actors trapped by the political environment, providing hope for their role in economic reform. For instance, banks have proven that they have some ability to intermediate effectively with private corporations; a sample of private enterprises with access to formal bank financing was found to have the fastest rates of growth, high reinvestment rates, and productivity growth (Ayyagari, Demirguc-Kunt, & Maksimovic, 2008). This suggests that Chinese banks are able to pick private winners. It can also be argued that the Chinese financial environment makes the banks actions more justifiable. A lack of financial reporting and credit histories increases the risk of non-SOE firms; after all, the SOEs are backed by the government in theory making them a relatively low risk borrower. The Banks have no incentive to seek out others since they cannot charge higher

interest rates, and they are under central government pressure; therefore, it makes sense for them to seek out stable state firms. It has also been asserted that firm size and visible cash flow, regardless of ownership, are large determinants of banks lending practices (Anderson 2006). Despite their current unprofitability, Chinese banks will need to be on forefront of economic reform. A strong financial sector is critical for healthy economic growth. In order to strengthen the Chinese financial markets, the government needs to liberalize interest rates. The governments price ceiling on deposit rates limits competition between banks and gives banks no incentive to become more efficient; the ceiling is also the primary control of interest rates ( Feyziolu, Porter, & Takats, August 2009). Removing the deposit rate is the fastest way to restore the market interest rate, increase bank competition, and reward Chinese savers. Removing the ceiling would also reduce the incentive for savers to put their money in the informal market by giving them higher return on deposits, the correlation between real interest rates and deposit growth has already by established (Borst, 2011). The government would also have to allow newer banks to compete with the large ones and reduce the capital requirements on new banking branches. The smaller banks will use deposit rates to compete with the larger ones, and it is likely that large banks will shrink their deposit bases to lower costs and compete with the highly profitable small banks ( Feyziolu, Porter, & Takats, August 2009). Allowing foreign banks to compete by giving them national treatment would also improve intermediation. Overall, increasing competition in the banking sector would improve financial intermediation and would help improve efficiency in the Chinese economy. Allowing banks to identify and pursue the most profitable investment opportunities will reward firms that are productive. Interest rate pressure will end bank led subsidization of debtor firms, or else banks will be run out of business over competition for depositors. The need for banks to compete will create harder budget constraints on firms, forcing them to become more efficient or fail; eventually, only profit maximizing firms should be able to obtain bank loans. (Scissors, Lecture, 2011).

Reforming the Chinese Capital Account: The Chinese holdings of US Dollars could range between 2 and 2.5 trillion, yet the Chinese are unable to use this currency because of the central governments controls on investment (Scissors, 2011). Opening the Capital Account would create some big, and potentially quick, changes to the Chinese economy. Therefore, its understandable that the central government would be extremely weary of account liberalization, especially given its current situation. The government currently engages in massive sterilization programs to absorb capital inflows from trade. The Peoples Bank of China is required to buy the excess foreign currency in exchange for RMB, essentially adding new currency to the economy; however, as Friedman famously illustrated, money growth would lead to an increasing price level. To avoid inflation, the PBC issues bonds to financial institutions to absorb the new RMB and raises the reserve requirement (Greenwood, 2008). This would explain a correlation between foreign currency reserves and the reserve requirement. This correlation can be established with a simple linear regression; pre-arranged datasets for reserve requirement over time were difficult to find. Linear Fit 1 = .0050668 0 = 5.43117 R Square = .942543 Root Mean Square Error = 1.295351 Residual Distribution: N(0,) ANOVA F Ratio = 98.425 P Value = .0001
**2011 Surplus and reserve requirement are from September

Testing H0: The Reserve Requirement and foreign reserves move independently H1: The Reserve Requirement moves dependent on foreign reserves = .01; P Value .0001 < .01; Reject H0, Accept H1; There is significant evidence that the reserve requirement is set in response to foreign currency reserves. As can be seen, there is a clear correlation between the reserve requirement and the Chinese foreign currency surplus; these results and the PRCs recent move to reduce the reserve requirement ratio after news of a shrinking trade surplus should confirm the procedural use of sanitization policy (Bloomberg News, 2012). While this strategy is currently working for China and allowing it to manipulate its currency, it has 2 major faults. The First, and more obvious is that China cannot raise the reserve requirement indefinitely as banks would have to stop lending completely; the second is a scenario where the return on foreign assets starts to become less that the cost of sterilization bills due to interest rate rise/asset interest rate lowering (Greenwood, 2008). China may actually have to concern itself with the second reason since its primary asset is US Treasury Bonds, which have a low yield currently, and since China is likely to face inflationary pressure, which requires raising interest rates. If China were to face inflation, it could also raise the reserve requirement more but at the cost of putting strain on its financial system. If China were to abandon sterilization policy, then it would experience monetary growth as liquidity started flowing bank into the economy though banks; this happened to Malaysia in the 90s after it had to abandon the policy (Greenwood, 2008). Chinas best move is to perform structural adjustments while using economic tools that are distortion minimizing. China can, over time, allow capital to flow back into the economy if it allows the market to properly adjust to inflation. This means that China will have to liberalize its interest rates from the deposit ceiling so they can be used to contract lending. Higher interest rates would reduce lending and help curb overinvestment. While the adjustment will most likely still be painful, it is necessary to reform bad Chinese financial policy for the sake good intermediation. Additionally, China will be able to withstand macro-economic shocks better after restructuring. The government should also continue opening its capital account by allowing money to more freely enter and exit the country. However, the government should enact banking sector reform before opening the floodgates; there are still so many sections of Chinese financial

markets that can be improved. The government also has good reason the fear rapid depreciation of its assets if the Yuan was allowed to fully appreciate (Cappiell & Ferruc, 2008). This could create huge capital loses, trigger outflows of money, and change the current trade dynamic. But allowing the firms and people to send money abroad, and vice-versa, is necessary for Chinas development. Acknowledging the fact that Chinas current policy is unsustainable, it is in the best interest of the Chinese to give it financial institutions time to adjust to competition before setting a series of shocks on them.

Improving competition and stock markets: This is the firm analysis policy complement to Chinas much needed market reform; noncompetitive behavior by Chinese firms can be resolved by government action and the use of the stock market. Currently the Chinese government pursues a pro-monopoly approach; this approach keeps Central Partys strategic industries under the control of a few state owned enterprises. Dominance over financing keeps these SOEs thriving. In order for the Chinese to increase its economic efficiency, it must first institute financial reforms; otherwise, some of the competition distortions will remain. Secondly, the Monopolies need to be broken up, and then their ownership needs to be addressed. Simply breaking up the large SOEs is the first step to increasing competition. It would be nave to suggest that taking six state run firms and breaking them into thirty would magically create competition; the result would most likely just be thirty inefficient firms competing for financing. This is because the SOEs are not profit maximizing (Scissors, Lecture, 2011). The solution to this requires one firm adjustment and one market adjustment. The market adjustment is the financial reforms that make the banks profit seeking so that they have an incentive to lend to efficient firms. This keeps firms from solely relying on credit. The firm adjustment is the issue of firm ownership. The trouble here is effectively privatizing the new firms as too much government intervention would likely distort their value. The proposed solution is using an existing market to privatize the firms while improving the market. The Chinese stock market can serve as a vehicle for privatization. The market has only been used to date to raise revenue of select SOEs and get rich-quick-schemes for the privileged (Keidel, 2007). The current stock market is overrun by a small number of large firms. There is

also the problem that Chinas stock markets, like its bond markets, are immature and hampered by poor information about listed companies (Keidel, 2007). China will have to rely upon securities regulations and improving information on companies; without the governments help, firms will ideally also have to become more open to attract financing. Increasing the firms listed on the Chinese stock market will provide more choices for investors. Once there is a spread in the profit of different firms, there should be an increase in demand for profitable firms which will help bring more rationality to the stock market. An apparent relationship between profit and stock price will increase confidence in the market, promote healthy intermediation, and encourage the developments of financial instruments like mutual funds. Appropriately addressing the issue of firm ownership should increase competition and help modernize Chinas stock market. Improving Chinese Bond Markets: Improving the bond market can improve firm performance by allowing the market to accurately price firms debt relative to their performance; however, it requires institutional reforms and a partially reformed Chinese economy. The current state of the Bond market is not encouraging:
Chinese formal domestic bond markets consist largely of exchanges in the negotiable share of treasury bills outstanding, certain large corporation company bonds, sale of paper by specialized banks, including the central bank and development banks, to commercial banks, and experimental sale of RMB denominated paper by international institutions like the International Finance Corporation and the Asian Development Bank. (Keidel, 2007).

Chinas bond markets will take time to develop and cannot be rushed. Active government intervention will not improve the market; instead the government should back off the bond markets and focus on other areas of financial reform. There is reason to believe that companies and municipalities may turn to the bond market as capital from traditional sources becomes tighter; this could expand the market, but create major structural problems in the future (China Economic Review, 2011). Credit rating agencies and years of reliable bond market growth will allow the bond market to become an important source of financial intermediation. The Chinese should have already allowed the market to mature, but will now have to wait to receive the

benefits. Once profit maximizing firms break away from the pack of firms, they can begin focusing on bond markets as an additional source of financing. A mature bond market should be viewed as the one of the most important benefits China will receive if it carries out real economic reforms. Conclusion: The Chinese Financial System has been distorted by state capitalism to serve political motives; resurrecting it to serve the purpose of long run economic growth requires years of heavy reforms. Liberalizing the interest rates and removing state interference in the banks, specifically deposit ceilings and lending floors, will allow the market to improve financial intermediation and the efficiency of banks. Allowing smaller banks to compete for depositors will pull fund to newer banks and out of the informal market. After reforming the banking sector, the Yuan can finally become an international currency if China liberalizes its capital account effectively. These financial reforms will begin the first stages of firm profit orientation, whereas the government can then break apart monopolies. The stock market will provide a vehicle of privatization for these firms. After the dust settles, China can explore its bond market further. All these reforms require awesome political might, and are unlikely with the current government. It seems that regime change, within the party or a takeover, is the only way these reforms could be enacted; thus, Chinas economic development will be set by its political development pace.

Appendix 1:

Appendix 2:

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