China’s Financial System: Past, Present and Future
Franklin Allen
Wharton School
China Week March 27, 2008
Conventional Wisdom
• China’s Legal and Financial Systems are its weak link • Unless they are rapidly improved there will be a financial crisis and China’s growth will drop significantly • China needs to adopt US style institutions to continue its success
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Alternative View
• China’s formal legal and financial systems have significant problems but this has not stopped growth so far • Internal finance and alternative finance do a good job in supporting growth • There may be a financial crisis but the government should be able to manage it • The reason for China’s success may be the flexibility of its current system
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GDP with simple Exchange rates Rank Country /Region GDP 2006 (US$ bil.)
GDPs with PPP* Country /Region GDP 2006 (Int’l $ bil.)
GDP with constant prices Country /Region GDP annual growth (19902006) 10.2%
GDP per capita with constant prices Country /Region GDP per capita annual growth (19902006) 9.2%
1
U.S.A
13245
U.S.A
13021
China
China
2
Japan
4367
China
9984
Vietnam
7.6%
Vietnam
5.9%
3
Germany
2897
Japan
4171
Malaysia
6.2%
Korea
4.8%
4
China
2630
India
4159
India
6.1%
Taiwan
4.5%
5
U. K.
2374
Germany
2559
Korea
5.5%
India
4.2%
6
France
2232
U.K.
2122
Taiwan
5.3%
Malaysia
3.7%
7
Italy
1853
France
1935
Bangladesh
5.2%
Poland
3.7%
8
Canada
1269
Italy
1791
Sri Lanka
4.9%
Sri Lanka
3.7%
9
Spain
1226
Russia
1727
Sudan
4.9%
Thailand
3.7%
10
Brazil
1068
Brazil
1701
Thailand
4.7%
Bangladesh
4
3.1%
Comparison of Major Economies: GDP and Growth
GDP in 2006 Rank 1 2 3 4 5 6 7 8 9 10 Country US Japan Germany China UK France Italy Canada Spain Brazil
GDP (US $ bil.)
GDP in 2006 on PPP basis* Country US China Japan India Germany UK France Italy Russia Brazil
GDP (Int'l $ bil.)
Annual growth rate of GDP constant prices (1990 - 2006) Country China Vietnam Malaysia India Korea Taiwan Bangladesh Sri Lanka Sudan Thailand
Growth rate (%)
13,245 4,367 2,897 2,630 2,374 2,232 1,853 1,269 1,226 1,068
13,201 9,984 4,171 4,159 2,559 2,122 1,935 1,791 1,727 1,701
10.2 7.6 6.2 6.1 5.5 5.3 5.2 4.9 4.9 4.7
* The PPP conversion factor is obtained from The World Bank Development Indicator (Table 5.6, World Bank. For details on how to calculate the indicator, see “Handbook of the International Program,” United Nation, New York 1992.
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Other successful countries
Only three large countries have been as successful: • Japan • South Korea • Taiwan China can probably do better but no large country has done so by a significant amount
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Why is China’s economy so successful?
• Conventional wisdom is that what is needed for a successful economy and a high growth rate is:
– Good legal system – Good financial system – Good corporate governance
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Why is China’s economy so successful?
• But
– Legal system is not good – Financial system does not work well – Corporate governance is poor
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China’s legal system
Creditor rights: • China 2 vs. 3.11 English common law 2.3 for all countries Shareholder rights: • China 3 vs. 4 for English common law
3 for all countries
Legal infrastructure: • Poor and corruption endemic
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China’s Financial System
Banks: • Bank credit/GDP 1.11 vs. 0.73 for other countries • Overhead Cost/Assets 0.12 vs. 0.03 “ “ • NPLs Peak 22.5% of GDP vs. 16% for Japan
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Banking System: Non-performing Loans
Non-performing loan as a percentage of GDP Year China U.S. Japan 1997 -0.8 5.1 1998 2.0 0.8 12.7 1999 9.7 0.8 12.6 2000 22.5 0.9 11.1 2001 20.0 1.1 15.6 2002 13.0 1.0 14.1 2003 11.0 0.9 11.3 2004 10.7 0.7 7.3 2005 7.3 0.7 4.0 2006 (Q2) 6.3 0.7 2.4
S. Korea 3.1 6.7 12.2 6.9 2.5 1.8 1.9 1.5 1.0 0.8
India -3.1 3.2 2.8 2.8 3.0 2.5 2.2 1.7 1.4
Indonesia 0.1 5.2 2.0 3.8 2.7 1.7 2.0 1.5 2.1 2.1
Taiwan 6.5 7.9 9.1 10.3 13.0 10.4 7.7 5.1 3.2 --
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(NPLs + Net Government Debt)/GDP
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Note: China U.S. Japan S. Korea India Indonesia Taiwan
-0.11 0.21 0.36 0.34 0.29 0.28 0.27 0.23 --
0.54 0.50 0.45 0.40 0.39 0.42 0.45 0.46 0.47 0.47
0.40 0.63 0.64 0.65 0.83 0.90 0.86 0.81 0.84 0.89
0.04 0.11 0.19 0.13 0.11 0.10 0.13 0.17 0.22 0.25
-0.46 0.62 0.53 0.50 0.54 0.48 0.47 0.47 0.46
--0.24 0.31 0.30 0.23 0.22 0.19 0.16 0.15
--0.25 0.24 0.33 0.37 0.33 0.32 ---
Government debt uses Net Government Debt for US and Japan; Outstanding Treasury Bonds for China, Korea, Indonesia, and Taiwan; Total Government Debt for India.
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Banking System: Reforms
• Solve NPL problem • Reduce cost structure • Emphasize lending to Private/Hybrid sector
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China’s Financial System (cont.)
Stock Markets • Market cap/GDP 0.32 vs 0.47 for average of other countries • Float/GDP 0.1 vs. 0.27 “ “
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Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Stock Market NYSE Tokyo SE Nasdaq London SE Euronext Osaka SE Deutsche Börse TSX Group BME Spanish Exchanges Hong Kong Exchanges Swiss Exchange Borsa Italiana Australian SE India (BSE+NSE) China(Shanghai+Shenzen)
Total Market Cap (US$ billion) 12,707,578.3 3,557,674.4 3,532,912.0 2,865,243.2 2,441,261.4 2,287,047.8 1,194,516.8 1,177,517.6 940,672.9 861,462.9 826,040.8 789,562.6 776,402.8 749,597.1 447,720.3
Concentration (%) 55.8 56.9 59.3 82.2 68.8 56.7 73.2 63.1 NA 78.6 76.0 61.9 79.8 78.4 40.5
Turnover Velocity (%) 89.8 97.1 249.5* 116.6 115.0 5.9 67.9 66.2 57.7 39.7 100.5 134.9 81.1 70.9 97.0
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Selling off Government Shares
• Government has started to sell off state owned shares • Benefits of the reform
– Enhance corporate governance mechanisms – Reduce conflict of interest between small and large shareholders, better protection of small shareholder – Management/state government will be more marketvalue oriented – maximize shareholder value – Increase liquidity – Capital market advancement
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Selling off Government Shares (cont.)
• In order to minimize the impact on the stock market when the state shares become tradable
– Current tradable shareholders get some form of subsidy: – This helps increase the % of non-state ownership – CSRC limit the sales of these newly tradable shares (the old non-tradable shares) – CSRC imposes:
• Non-tradable shareholders cannot sell their shares within certain period of time after their shares become tradable • When they are allowed to sell, they can only sell one small proportion at a time, NOT a large amount at one time;
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Other Financial Markets and Institutions
• Public debt market
– Reasonable size – Needs to develop complete yield curve
• Corporate debt market
– Almost non-existent
• Insurance sector
– Very early stage of development
• Pension and mutual funds
– Also at early stage
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China’s Corporate Governance
• Majority of shares in most listed companies are owned by the government or government entities • Government determines appointment of directors • System is opaque • Government has broader objectives than wealth maximization
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Financial Markets: Reform
• Stick to plan to sell off state holdings of shares. • Encourage the development of financial institutions such as insurance companies, pension, and mutual funds that can help provide some stability and professionalism to the markets • Continue regulatory reforms and corporate governance reforms
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Why is China’s economy so successful? (cont.)
Three sectors: • State Owned Enterprises (SOE’s) • Listed Companies (mostly former SOE’s) • Private/Hybrid Sector
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Why is China’s economy so successful? (cont.)
Growth rates for Industrial Output 1996-2002: • State and Listed Sectors: 5.4% • Private/Hybrid Sector: 14.3% Approximate shares Industrial Output 2002: • State and Listed Sectors: 33% • Private/Hybrid Sector: 67%
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Reason for China’s success
Private/Hybrid sector has been extraordinarily successful Counterexample to conventional wisdom • Standard mechanisms in terms of the financial system, legal system and corporate governance as bad or worse than in the State and Listed sectors
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Private/Hybrid Sector: Survey Evidence
Summary Statistics
Age of the firm # of employees Size (Total Assets in mil. US$) D/E ratio Net income (in mil. US$) Return on Assets mean min max Std.dev
11.4 1634.3 55.3 2.1 2.5 0.1
3 90 0.6 0.38 0.2 0.00
27 5552 337.3 14.95 9.0 0.34
6.7 2107.8 82.7 3.4 2.8 0.1
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Survey Evidence on Financing Channels
Startup financing
50% 40% 30% Friends 20% 10% 0%
0% 20% State/local Budget Trade Ethnic Chinese FDI VC Others
Financing in growth period (year 3-8)
30% Friends Pri vate Credit Agent
Banks
Founder /family
private credit agent
VC
Ethnic Chinese
Others FDI
10%
Credits
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Survey Evidence on Corporate Governance
Possibility of being acquired
70% 60% 50% 40% 30% 20% 10% 0% not possible Very likely possible
Conce rns of loss in case of faile d busine ss
100% 80% 60% 40% 20% 0% Economic loss in vrious sense Reputation in various sense Legal /Safety consequenc e
Relationship with local government
50% 40% 30% 20% 10% 0% Government invest/own partially support, return not demanded demand profit sharing no relationship
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Alternative Financial Sector: Reforms
• Do not regulate or impede the operation of this sector • Encourage the development of this sector as much as possible
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How does the Private/Hybrid Sector function?
• Historically, China did not use the legal system in commerce • However, it had a highly commercialized society • How did this operate? • Other systems for dispute resolution were used instead
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Alternatives to the legal system in 19th Century China
Dispute resolution (see Kirby 1995): • Longstanding custom • Regulation of Guilds and Families • Local notables We need to understand the modern equivalents
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What should China do going forward?
“The modern corporation on a Western model would be the essential vehicle for private economic development”
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What should China do going forward?
• This was not written today but rather was the view of the drafters of China’s first Company Law in 1904 (Gongsilu) • It turned out to be very wide of the mark (Kirby 1995) • Chinese firms on the mainland and later in Taiwan did not use the provisions of the law but again conducted commerce outside the legal system
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Conclusions
• China’s formal legal and financial systems have significant problems but this has not stopped growth so far • Internal finance and informal finance do a good job in supporting growth • There may be a financial crisis but the government should be able to manage it • The reason for China’s success may be the flexibility of its current system
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