Globalization: the Role of Institution Building in the Financial Sector _ The Case Study of China

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Globalization: the Role of Institution
Building in the Financial Sector
_ The Case Study of China

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Globalization: the Role of Institution Building in the Financial Sector
---The Case Study of China
August, 2003
I. Introduction
Financial globalization could be described as a process in which global financial
activities get increasingly integrated with the risk creation mechanism. This
description emphasizes three points. First, financial globalization is not only a process
in which financial activities transcend national borders, but also a process in which
risks spread across the markets. Second, financial globalization is initiated by many
micro-economic entities to seek profits and is driven by the integration of global
financial markets. Third, it is a gradually deepening process with distinct phases.
In general, financial globalization covers five areas: capital flow, monetary
system, financial markets, financial institution, and financial coordination and
supervision.
In China, institution building in the financial sector takes place against the
backdrop of financial globalization. It not only shares common features with other
countries’ experience but also has its own characteristics. Therefore, it is useful to
review the process of institution building in China, to analyze its effect on the

economy and prospects under the framework of financial globalization.
II. Review of Institution Building in the Financial Sector
A. Main driving forces of institution building
A review of the developments of China’s financial sector over the past 20 years
reveals that reform and opening up have been two major forces driving institution
building in the financial sector.
Generally speaking, the fundamental reason for financial system reform is to
increase the efficiency of allocating and utilizing financial resources. The micro
economic entities in the financial system initiate financial innovation through seeking
for financial resources, resulting in improved efficiency of the whole financial market.
The reform is market-oriented and aimed to establish advanced financial system and
sound financial order commensurate with the socialist market economy. Endogenous
institutional reform mainly depends on participation of micro entities. It covers
financial incentive, innovation and discipline mechanism, which drive financial
development as a lasting and inherent force.
Opening up of the financial industry is an important part of the whole opening
strategy of China. Facing financial globalization, it is the rational choice for China to
further open up its economy and benefit from the strategy called ‘improvement
through contact’. Full-scale contact with the international markets means that China
may gain access to global economic resources in a broader scope and at the same time
expose the domestic financial market to the impact of the global financial markets,
whether positive or negative.
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B. The role of FDI in institution building
Over the past 20 years, foreign financial institutions, mainly foreign banks have
played an important role in the opening up of Chinese financial industry. In the early
days of their operation in China, foreign banks’ deposits were generally larger than
their loan portfolios, and most of the excess funds were either deposited in their
overseas headquarters or correspondence banks. In recent years, the growth of lending
has accelerated. The ratios of loan balance to total capital, total assets and deposit

balance have also increased. At the end of June 2003, total assets of foreign banks
amounted to USD41.25 billion and total loan balance amounted to USD19.86 billion.
54 percent of foreign bank loans were granted to support manufacturing industry and
has promoted the development of light industry, chemical industry, and electronic
industry and machinery industry.
Foreign banks also bring more overseas customers to the Chinese market, which
has further promoted the overall increase of foreign direct investment. In particular,
foreign banks have provided intermediate services such as business consultation and
information service in the negotiation of international loans, and such services
constitute an important part in the process of attracting foreign capital.
In addition, foreign banks also play a unique role in institution building in the
financial sector. They help to mitigate financial repression in China, to establish sound
financial system, to enlarge contribution of the financial sector to economic
development and to realize a virtual cycle of financial deepening and economic
development. The role of foreign banks covers the following areas:
1. Competition effect. After the entry of foreign banks into the domestic
market, the monopoly of state banks has been broken. Competition forces Chinese
banks to reestablish their business strategy and operation.
2. Demonstration effect. Foreign banks have demonstrated their advanced
technology, equipments, organization and management to domestic banks. Their
higher profitability has stimulated Chinese banks to upgrade technology and
equipment while improving management.
3. Training effect. Foreign banks provide training programs for their Chinese
employees so as to improve their professional skills. At the same time, foreign
banks also transfer technology and management skills to their Chinese
counterparts. All these have helped to improve the efficiency of Chinese banks.
More importantly, foreign banks not only provide an external financing channel
for Chinese enterprises, but also facilitate the development of the domestic capital
market while they are engaged in investment and securities business. Also, entry of
foreign banks urges the Chinese regulatory authorities to comply with international

standards and to reduce government intervention. In addition, foreign banks have set a
good example for Chinese banks on how to do business in the international financial
markets.
For China, the role played by foreign banks is like a double-edged sword. While
promoting financial deepening in China, expansion of foreign banks’ market share
might have negative effects on Chinese economy, especially on the financial industry.
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These negative impact include potential shocks to Chinese banks, strengthened
transmission of international financial crisis, and reducing capability of the central
bank to exercise macro-economic management using traditional monetary policy
instruments.
C. Sequencing of institution building in the financial sector
The sequencing of institution building in the financial sector may differ from
country to country. However, there are some experiences worth mentioning for a
developing country like China. First, the government should base the contents and
speed of reform on macroeconomic stability. Second, the adjustment in financial
sector should be consistent with adjustment of the real economy. Third, internal
adjustment should not lag far behind the process of opening up. Fourth, a gradual
approach should be adopted. The government should take into account possible
economic and social consequences, as well as the time frame required for the
domestic markets to adapt to the new system and the management of enterprises to
improve their professional skills.
In view of its overall economy, it is an inevitable choice for China to adopt a
model of ‘limited opening and gradualism’. Most developing countries and a few
developed countries have adopted the model of ‘limited liberalization’. When these
countries opened their domestic financial markets to foreign competition, the
authorities tend to set various restrictive measures in the areas of market entry and
business licensing. Therefore, foreign financial institutions, compared with their
domestic counterparts, face more strict barriers in entering the market, conducting
business and complying with regulatory rules. Gradualism means that a country opens

its financial markets on a gradual basis after certain conditions have been met. The
restrictions on market entry and business scope of foreign banks are gradually
loosened and foreign banks will be granted national treatment step by step. This
model often involves three periods, which starts with strict restriction, then loosening
restriction and ends with full liberalization. As Professor Ronald McKinnon pointed
out, China should adopt the gradual liberalization approach, rather than the big bang
approach used by the former Soviet Union and some East European countries.
According to Professor Tobin, China should gradually integrate with the international
financial market, though it should actively participate in the economic and trade
globalization. This is due to the basic economic situation and the development stage
of Chinese financial market.
It has been proved that global financial stability requires effective surveillance
and needs support from the international financial institutions. However, sound macro
economic policy and structural reforms in each country constitute the basis for
meeting such a challenge. Global financial stability is based on stability of individual
country’s financial markets. Also, the stability of individual country depends not only
on the surveillance, guidance and support of the international financial institutions
such as the IMF and World Bank, but also more fundamentally on the soundness of its
monetary and fiscal policy as well as the banking system. Apart from the attack of the
speculators, the Asian Financial Crisis was to a larger extent caused by weaknesses in
macro economic policy and the banking system in related countries.
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D. Major Issues in the institution building process of the financial sector
1. The relationship between financial opening and financial security
China’s decision to join the WTO signifies a step forward in the opening of
financial sector to the outside world. In the mean time, the era of rigid financial
control will come to an end. Coupled with the advancement of e-economy, financial
opening and liberalization will bring great impact on the existing financial system,
and especially on financial regulatory framework. This trend also indicates the
importance of financial security. As far as China is concerned, financial security

consists of, inter alias, the soundness of domestic financial sector and stability of the
liberalized financial market.
2. The disadvantage of domestic banks in competition with foreign banks
Compared with large international banks, domestic banks are generally in an
apparently disadvantaged competitive position. The restructuring of state-owned
banks is yet to gain speed despite the significant improvement that has been achieved.
After China’s accession to the WTO, increasing number of foreign enterprises choose
to do business with foreign banks as they swarm in. Meanwhile, premier domestic
enterprises are also shifting to the securities market for financing, which results in the
erosion of and more fierce competition in the traditional banking market. The
problems of inadequate innovation, weak competitiveness and the loss of premier
customers and professional staff will be more salient for state-owned banks. In
addition, high NPL ratio poses a long-lasting difficulty for the state-owned
commercial banks, which hinders the process of their ownership restructuring.
3. Moral hazard
Since 1996, a set of measures has been taken by the government to prevent and
dissolve financial risks. However, these measures had yet succeeded in addressing the
problem of incomplete contracts, but brought about moral hazard. The merging and
acquisition are not completely the result of market selection and the government itself
took a leading role. The “too big to fail” argument has been under debate in theory all
the times. The operation mechanism of those merged and acquired financial
institutions have not changed fundamentally, however they have increased the number
of branches and staff. In China’s case, it is a fact that the bigger the financial
institutions are, the less possible for them to be closed. The government guided
M&As reduces probability to fail, but it does not necessarily mean improvement of
management and assets quality.
4. Weak financial infrastructure
Business growth of Chinese banks is constrained by the weak infrastructure in
respect of practice in loan classification, accounting, auditing and payment and
settlement. For instance, The NPLs of domestic banks have long been defined

following traditional criteria as overdue loans, default loans and bad loans. This static
classification method is quite different from the international accepted methods and
unable to reflect the true quality of loans. In recent years, the application of the five-
category classification method has been advanced thanks to the strong push of the
central bank and the efforts of commercial banks.
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5. Slow progress in market-based interest rate reform
Since interest rates are not adequately determined on market basis, their roles as
signals to the supply of and demand for fund are not fully effective, and sometimes
have negative influence on pricing and risk management of commercial banks.
E. Policy measures to promote institutional building
Institution building in financial sector in China has been mainly achieved through
a series of institutional reforms. China’s financial institutional reform process could
be divided into the following three stages: (1) preparation and strategy exploration,
(2) framework construction, and (3) adjustment and advancement.
During the first stage from 1979 to 1984, the financial sector in China began to
undergo institutional reform. The prominent features of the financial system at this
stage could be summarized as follows:
(1) separation of central banking from commercial banking by establishing a two-
tier banking system,
(2) establishment of specialized commercial banks serving different industries;
and,
(3) Introduction of deposit based bank growth model.
During the second stage from 1985 to 1996, a series of new arrangements and a
primary framework for market-based financial operations were introduced. The main
features are as follows:
(1) The legal status of the central bank was established with the promulgation of
the Central Bank Law and the Regulations on Monetary Policy Committee.
(2) The institutional structure diversified, including the development of non-
banking financial institutions, the establishment of several insurance companies, the

fast growth of securities industry, the start-up of Shenzhen and Shanghai Stock
Exchanges and the grant of market access to foreign financial institutions.
(3) Significant progress was made in financial deregulation, including the
separation of commercial banking from policy banking by establishing three policy
banks in 1994 and the promulgation of Commercial Banking Law in 1995,
encouraging competition among banks, introducing concept of risk, profitability and
cost in bank management, improving capital management system, introducing
assets/liability ratio regulatory framework, and strengthening internal control.
(4) Macro financial management relied more on indirect adjustment than on
direct control, with extensive application of monetary policy instruments such as
interest rate, reserve requirement and open market operations, while focus of
supervision of commercial banks shifted from credit ceiling to a comprehensive set of
prudential ratios.
(5) Remarkable progress was achieved in institutional innovation of the financial
market. Stock exchanges, inter-bank market and bills market began to operate.
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During the third stage from 1997 till now, the development of a buyer’s market
entailed adjustment and consolidation in the process of financial institution building.
The main features were as follows:
(1) Transferring the non-performing assets of commercial banks to the newly
established AMCs;
(2) Improving the segregated financial supervisory system by establishing
Securities Regulatory Commission, Insurance Regulatory Commission and Banking
Regulatory Commission, and replacing 32 provincial branches with nine regional
branches of the central bank;
(3) Accelerating capital market development by improving its functions and
expanding market capitalization;
(4) Accelerating restructuring of the state-owned commercial banks and putting
property right reform on the agenda;
(5) Rectifying financial order to prevent financial risks;

(6) Stimulating domestic demand and combating deflation by implementing a
sound monetary policy;
(7) Expanding the scope of financial service and initiating consumer credit
market; and
(8) The emergence of extensive cooperation among banking, insurance and
securities industries has created the conditions for providing universal-banking
services in the future.
To sum up, China’s financial system reform in the past two decades has been
characterized by institutional innovation, namely the change from planned financial
system to market-oriented financial system and the change from one-tier banking
system to two-tier banking system.
First, the direct policy instruments for macro-economic management has given
way to indirect to market instruments. The central bank shifted its reliance on direct
control of credit ceilings and currency issuance to market instruments such as reserve
requirement, interest rate, central bank lending and open market operations in recent
years to adjust money supply. During this process, the channel for base money supply
has been evolving from through central bank lending to purchasing foreign assets and
open market operations.
At the same time, the spectrum of institutions has become more diversified with
the establishment of 10 joint stock commercial banks, 100 city commercial banks,
large number of urban credit cooperatives, trust and investment companies together
with finance companies, financial leasing companies and fund management
companies.
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F. Role of the government, central bank and international financial
institution in institution building
1. Role of the government
As an indispensable part of the financial system, supervision and regulation of the
government have strong influence on the behavior of microeconomic entities. Aiming
at mitigating risk and encouraging competition, the supervisory authorities adjust

financial framework and promulgate supervisory regulations. The regulations may
have impediments on banks’ activities. However, banks may also initiate some new
financial activities in order to enhance their profitability. Also they may create some
new operating models, such as new organizational structure or new financial products,
which go beyond the existing supervision boundary. Nevertheless, the authorities may
regard these initiatives as evasion of financial supervision and therefore, work out
new regulatory measures to follow such development.
Nonetheless, a neutral solution would be finally found to balance the cost and
benefits for various sides as the pressures increasingly mount on the authorities.
Lastly, financial innovation and the economic environment tend to be mutually re-
enforcing.
When reviewing the whole process of financial restructuring in China, it is not
difficult to find the pervasive role played by the government. Intervention by the
government in different ways and of different purposes has different effect on the
arrangement of reform. An exogenous intervention of the authorities on the financial
industry would cultivate the exogenous features of the institutional reform, which
would constitute external pressure on the financial institutions. Therefore, such a
reform would be less forceful in improving microeconomic performance.
2. Role of the central bank
The central bank has played a role of policy designing and implementation in the
process of institution building in the financial sector. The promulgation of The Central
Bank Law in March 1995 has legally confirmed the status and responsibility of the
People’s Bank of China (PBC) as the central bank. With dual responsibilities on
monetary policy and financial supervision, the PBC has designed and implemented a
serious of financial reform programs under the leadership of the State Council and
with collaboration of relevant government ministries. In the process of designing
reform programs, the PBC has learnt from valuable experiences of the developed
economies and followed the principles of market economy at the same time.
For instance, after learning from experiences of several countries, the
organization of the PBC has undergone a break-through reform in 1998, with the

restructuring of 32 provisional branches into 9 regional branches. By doing so, the
PBC has accomplished a historical transition in its administrative regime by replacing
its provincial branch network with regional branches set up in accordance with
regional economic development. As a result, the independence of the central bank in
implementing monetary policy and financial supervision has been strengthened.
While learning experiences from other countries in the restructuring process, the
PBC has never neglected the specific situation in China. For instance, China has
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enjoyed strong balance of payments position after achieving current account
convertibility of the Chinese currency in December 1996, resulting in a stable
exchange rate and a sustained growth of its foreign exchange reserves.
As international experience shows, capital account convertibility requires stable
macroeconomic environment, a healthy financial system, effective financial
supervisory framework and enduring national strength.
While some emerging economies in Asia such as Thailand, Malaysia and Korea
have abolished control on capital account transactions and realized full convertibility
of their currencies; China still sticks to the ‘gradualism approach’ in promoting capital
account convertibility. The existing deficiencies in the economic fundamentals call for
prudent liberalization.
It was such an arrangement that has put China in a better position to confront the
challenge arising from the Asian Financial Crises. At the same time, we have
successfully prevented the negative impact of the confidence crisis on Chinese
economy and competitive currency depreciation, which have in turn contributed to the
financial stability not only in Asia but also in the whole world.
3. Role of the international financial institutions ( IFIs )
The IFIs have played an active role in financial restructuring in China by
introducing international standards and good practice and providing policy advice and
personnel training in specific areas. For instance, China has established its external
debt surveillance system with the assistance of the Bank for International Settlements.
Also, technical assistance from the World Bank has contributed to the establishment

and application of the five-category loan classification system in Chinese banking
industry. Actually, all domestic commercial banks adopted the five-category loan
classification system in early 2002. The idea of setting-up four AMCs to dispose jof
non-performing loans of the state-owned banks and the practice thereafter have also
benefited from technical assistance of the World Bank.
China has taken active measures to increase its transparency and meet relevant
international standards and guidance since its WTO accession. Efforts have been
made to further increase the transparency of macroeconomic statistics, fiscal policy,
monetary policy, banking information disclosure, as well as the securities and
insurance industries. New improvements have been made in promotion of good
governance structure as well as implementation of international accounting standards.
In general, these measures have gained wide international acclaim.
G. The role of new technology in institution building
With fast development of modern information technology and financial
engineering in recent years, the tendency of providing financial services through the
Internet has become increasingly clear. Though threat from e-commerce on the
traditional commercial services have been somewhat limited due to inconvenience of
goods distribution, challenges of on-line financial services to the traditional banking
services would go beyond any technical barriers, because the nature of on-line
financial service is the processing of information.
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The fast development of the Internet technology has influenced substantially the
economic and financial behavior, and it indicates the arrival of the era of competition
for on-line financial transactions, and it may also bring about a huge shock to the
traditional business of the financial industry. Foreign banks stationed in China will be
national treatment of foreign banks are being phased in line with China’s WTO
commitment, and the original geographic and customer restrictions on foreign banks
regarding their foreign exchange and RMB business will also be phased out.
With strong portfolio and rich experience, foreign banks could expand quickly
their market shares through on-line banking and overcome their limited business

network and outlets. On the contrary, the original strength possessed by domestic
banks in terms of geographic distribution would be weakened, which may have
negative impact on domestic banks.
At the moment, corresponding regulations on on-line banking service are yet to
be put in place, the same situation may also apply to those regulations regarding the
security certification system as well as the modernized payment system. We have
realized that a considerable gap does exist between China and the developed countries
either in the area of information technology and quality control on credit assets or in
financial risk prevention.
In light of this situation, commercial banks in China need to strengthen
development of information technology by cooperating with each other and
mobilizing the best resources among themselves, so as to reduce the cost of
management and business development.
By large, domestic financial institutions should not only focus their attention on
innovation of financial products, but also make due efforts in the application of
information technology, in exploring on-line banking business as well as in promoting
non-bank financial institutions. Efforts should be made in upgrading financial
operations and financial services, and in conducting systematic study on banking
business development, its security system, risk prevention as well as supervision.
Formulation of relevant policy and regulations should aim to promote healthy
development of on-line banking services in China.
The substantial changes in financial system and technology mentioned above
have posted great challenges to China’s financial and supervisory system. From
technical point of view, non-bank financial institutions or even non-financial
institutions are able to evade supervisions due to swift development of on-line
financial services. Therefore, either opening of financial markets or development of
internet-based financial services will constitute big challenges to both the monetary
authority and the financial supervisory authorities.
III. Institution Building of the Chinese Bond Market
A. Current stage of the Chinese bond market

Prior to 1997, China’s bond market mainly comprised exchange-based bond
transactions and over-the-counter (OTC) transactions of bearer’s treasury bonds at
banks.

Due to the different trading terms issued in these two markets, transactions
between them could not be fulfilled. Volatility of the stock markets has significant