Crawford School of Economics and Government

Assignment Cover Sheet

Student name Dwitya Estu Nurpramana

Student number u4295352

Course title Chinese Economy

Course code IDEC8021

Submitted to Dr. Ligang Song

Assignment title China’s Problem in Banking Sector and Stock Market

Date submitted 6 June 2008

Word count 5,782

Declaration

Except where appropriately acknowledged, this assignment is my own work, is expressed in my own words and has
not been previously submitted for assessment. I understand that by also submitting my work electronically through
Turnitin, it will be kept in an APSEG database.

_________________________________ __________________
Dwitya Estu Nurpramana Date

Crawford School of Economics and Government

http://apseg.anu.edu.au
CRICOS Provider Number 00120C
 Contents

Contents …………………………………………………………………………… i
Abstract ……………………………………………………………………………. ii

1 Introduction …………………………………………………………………….. 1
2 Financial system evolution in China …………………………………………….. 2
3 Problem in China’s banking sector…………………………………………………. 6
4 Weaknesses in Stock Market ………………………………………………….. 13
5 Summary ………………………………………………………………………… 18

References ………………………………………………………………………… 19

List of Figures
Figure 1 M2 and household saving as ratio to GDP ………….…………………… 4
Figure 2 Market value of stock market as percentage of GDP ……………………. 14
Figure 3 Stock market comparisons in 2004 ………………………………………. 15

List of Tables
Table 1 Estimation of NPLs ratios and cost for cleaning up ………………………. 7
Table 2 The BOC’s NPL ratio …………………………………………………….. 8
Table 3 Asian economic’s NPLs ratio …………………………………………….. 9
Table 4 China’s NPLs after AMC implementation ……………………………….. 11
Table 5 Listed firms’ structure of capital …………………………………………. 16

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 China’s Problem in Banking Sector and Stock Market

Dwitya Estu Nurpramana

U4295352

Abstract
Financial crisis struck that Asian region and ruined the economy, but China can survive
from Asian crisis. However, China also faces its own problem that might be difficult to
deal with. This paper purposes to investigate the problems in China’s financial system
focuses on banking sector and stock market and how China can solve those problems.
Problem in China’s banking sector are stock problem and flow problem. Stock problem
is referred to the bad loan stocks or kwon as NPL. The NPLs are mainly caused by
economic bubble in the beginning of 1990s and soft-budget constraint. In order to deal
with NPLs problem, the authority implements the reform in banking sector which is
recapitulation, loan provision, and debt-equity swap. Flow problem is referred to that
the decisions for giving loans are not based on a commercially sound basis. In order to
deal with the flow problem, the government established China Bank Regulatory
Commission (CBRC) that supervised banking sector in 2003. With the CBRC
establishment some several policies were implemented such as loan classification in five
tier systems and compulsory for banks, capital adequacy ratio (CAR), risk-based
supervision, limitation of the lending to related parties, law enforcement, and CRBC get
on in capacity building program which related to the inspection either on site or off site.

Keywords: NPL, stock problem, flow problem, China

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 China’s Problem in Banking Sector and Stock Market

1 Intoduction
Countries in East Asia were believed as the miracle of economic because of high rate of
growth. They were practiced export oriented economy which led to growth. During
1997 and 1998 the financial crisis struck that region and ruined the economy such as the
decreasing exchange rate and contracting investments, trades, and GDP. Indonesia, the
Philippines, Malaysia, Thailand, and South Korea were the most affected countries.
Conversely, there is one developing country in the region which was little affected by
the crisis, which is China (Yongding, 2001).

Moreno et. al. (1998) state that China with those Asian countries has several common
characteristics that indicate the nature of their financial systems. Sustainable growths in
East Asian countries increase a sense of satisfaction. However, this also led of many
people fail to notice the potential for default in those financial systems. Similarly with
China, which high sustainable saving and high economic growth has also averted from
the awareness from the collapse of financial system. Additionally, China also similar to
the other East Asian countries which has a pattern that banking industry dominated the
financial system. Lending from bank is large as ratio from GDP, whereas the other
industries such as stock and bond markets are less developed. Banking industry has a
problem which can be tracked to the lack of agency problem, in some event can obstruct
the financial stability. Markets for securities that give fixed yield also under developed.
Capital markets are also important, but slightly in small scale and very unstable.

However, China also has many differences with the other East Asian countries which
make China escaped from the Asian crisis. In the crisis period from 1997 to 1998, the
foreign reserve that was hold by China was about 130 billion US dollar, and Chinese
currency relatively constant with the trend toward appreciation. Huge capital inflow that
comes to China is in the form of Foreign Direct Investment (FDI), and it can not be
converted in terms of capital account. Exposure of debt that denominated in foreign
currency was small since the interactions of local markets to international markets are
limited (Fernald and Babson, 1999).

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Even though China can survive from Asian crisis, China also faces its own problem that
might be difficult to deal with. At that period, the stabilization of China’s
macroeconomic was also being pursued by enterprise restructuring. This condition rose
the opportunities for reforming financial sector, on the other hand also caused
difficulties in dealing with the environment which the reform must go on. The
considerable efforts were predicted to be taken in order to clean up the bank’s balance
sheet and to restructure the financial system. The uncertainty condition and the size of
problems in the reform process could cause to the temporary financial problems, which
would end up with the slowing rate of growth and disrupt the reform of financial
system.

Since there are many factors that make China survive from crisis, however China still
has many factors that can influence Chinese economy into financial problem. Therefore,
this paper purposes to investigate the problems in China’s financial system focuses on
banking sector and stock market and how China can solve those problems. The rest of
paper is organized as follows: second section is financial system evolution in China,
third section is problem in China’s banking sector, fourth section is weaknesses in
China’s stock markets, and the last is summary.

2 Financial system evolution in China

The government of China has ambition to attain heavy industrialization in Chinese
economy since the People’s Republic of China was established. The government
thought that with the heavy industrialization, China would be stronger in power of
defense and more secure. As country which has less capital, this policy can be inferred
that the government of China would direct capital from sector that more productive to
the sector that less productive which is sector for heavy industry (Lin et. al., 1994). The
capitals were channeled by Chinese government to enterprises that owned by
government, therefore, intermediaries were not needed. Banks such as People’s Bank of
China (PBC), at that time was only a cashier of government. Inputs were filled to state-
owned enterprises (SOEs) and the outputs were carried away by government, so there

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was no changing in the balance of account. The profits from SOEs are seemingly as the
revenue of government.

Conversely, the policy was not sustainable, even though the policy apparently well-
designed. There were many distortions in the system of allocation. At the end of 1970s,
there was a sharp increase in the ratio of capital to output. It means that the government
of China to add many capitals to the SOEs for preventing the increasing of growth rate
sustainability. However, the growth rate was decrease slowly, which also impacted to
the declining people’s standard of living. Nominal wages were constant in the long
period of time which actually reflected the decreasing of real wages. Finally the revenue
of government got smaller which make people’s anger accumulated. Fan (1998) argues
that fiscal and legitimacy crisis would come if there was no reform.

China’s reform started at 1970s and in gradual form. Local governments, individuals,
and companies were granted more independency and autonomy in order to increase the
incentives. National income redistributions purposed more for individuals than
governments. Therefore, the government revenue as proportion of GDP decreased from
31.2 per cent in 1970 to 22.4 per cent in 1985 and to 10.8 per cent in 1996 (Fan, 1998).

Since the government capacity for maintaining fiscal dropped, it started shifted funds
for supporting SOEs to SOBs. The intervention of government to economic activities
also reduced. In 1984, function of commercial bank transferred from PBC to new four
banks which are specialized and PBC focused as central bank. The banking system
changed from mono system to two systems. SOEs funding now sourced from SOBs.

The government of China was depended on the SOEs as protection of employment and
social welfare providers as a result of weaknesses in fiscal capacity and lack of social
security system. This policy made the economy in efficient, but could avoid social
chaos. SOEs were not as profit maker, otherwise just like communities. Most of them
have public facilities such as schools and hospitals. Their competitiveness of generating
profit reduced, which end up with the NPL accumulation in the banking industries. The
banks’ performance was also more difficult to evaluate as the intervention of

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government exist. The responsibility of bank’s managers related to the bad debts can
shift easily to government as it was difficult to differentiate the loss from commercial
business or from government interventions (Lardy, 1998).

In the beginning of reform, relation of government budget, SOEs and SOBs which is
commonly called as iron triangle, appeared very stable. Household disposable income
boosted as a result of high economic growth and improvement as a nature of reform.
Most of the income goes to SOBs because no other choices for alternative investments.
Sixty per cent of individual’s financial assets were in deposit form. The SOBs succeed
to collect households’ money (as shown in the Figure 1, the proportion households
savings to GDP increase steadily from 1978 to 2005), and then the government
employed SOBs to transfer the funds to SOEs.

Figure 1 M2 and household saving as ratio to GDP

Source: Zhongguo Tongji Nianjian, 2005, Statistical Yearbook of China,Beijing.

Additionally, the local government also enforced the iron triangle. Most of SOEs are
owned by local government and in small and medium size. Therefore, the local
government can protect their local enterprises strongly. The bank branches were parallel
in the administration hierarchy and set up in every province and every city. Since the
bank branches closely engaged with local politics, the managers usually faced difficult
situation if they wanted to cut the debt for funding the SOEs. They always met the
asymmetric incentives. If they agreed to lend money to SOEs, it would be bad debts and

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they could use government intervention as a cause reason. Moreover, if they extended
the loan as the local government wishes, the relationship with local government would
improve. As a result, it is not surprisingly that the branch managers always have interest
to maximize the lending and after that asking central bank to transfer more money to
cover their losses. These practices resulted in the increase of inflation difficulty and the
problem in socialist economic system (Naughton, 1998).

Even though, moral hazard rise as a result of government intervention enlarged the
SOE’s bad debts, the fund still kept to flow to the SOEs. However, there were many
reliable and competitive non SOEs which have contribution 75 per cent to total output
and 50 per cent in urban areas could not obtain adequate funding from SOBs (García-
Herrero et. al., 2005).

García-Herrero et. al. (2005) also states that PBC as central bank implemented a reform
policy in order to revamp the system. The old system to lend credit was stopped, and
began to use market instruments such as open market operation and interest rate to
control the allocation of credit. Three policies were launched related to the credit policy
to be implemented by four commercial banks. The interventions of local governments
were reduced by reorganization in the PBC and the big four. Supervision was
introduced and the comprehensive regulation framework of financial system operation
was established.

Deflation and decelerate of economic growth hamper the economy of China since the
Q3 1997. After Asian crises, the financial vulnerability was worried by the government,
therefore, policy to reduce NPL ratio was decided. Some bank managers were fired
because of the large bad debts. It also increases the awareness of bank managers to
increase their lending to the “traditional way” SOE clients. Does it imply that SOBs’
loan now sound better? It is difficult to state. Since the SOBs are indisposed in lending
to new clients like non SOEs, as the accounting system is not standard which make
difficult in risk assessing. Additionally, the managers of SOBs know that the ratio of
NPL to SOEs is financially undesirable, so that with the ratio of NPL to non SOEs

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which is also politically undesirable. Therefore, the SOBs loans are mostly have
guarantee from the government.

3 Problem in China’s banking sector

The banking sector in China went into the twenty-first century with the lack behind
from the sophisticated banking system of market economy. It is because the banking
system in China was created under planned economy which did not have incentives,
skills, and culture that needed for effective and efficient banking system. It also difficult
and take time in order to catch up the capabilities of sophisticated banking system.

During period 1978 and 1993, “reform without losers” the banking operated
inefficiently as a buffering for workers from the consequences of competition.
Constraint in budget, make the banks lent to non-feasible clients (SOEs), which later
cause problem in the banking sector. Problem in China’s banking sector are stock
problem and flow problem. Stock problem is referred to the bad loan stocks or kwon as
NPL. Flow problem is referred to that the decisions for giving loans are not based on a
commercially sound basis (Naughton, 1998).

First problem in banking sector is NPL or the stock problem, which up to now there is
still a mystery about the total amount of NPL in China. The estimation always changes
overtime as the result of inaccuracy in the accounting of banking sector. China also
adopted unique method in the accounting of asset classification which makes this
incomparable internationally. Since 1999, the three categories to classify NPL based on
the loan performances which are overdue, doubtful and bad are implemented. As this
classification did not consist of the highly risk debts which were the interest still paid
and were not overdue, this method had a tendency to underestimate the NPLs.
Coincidentally, in that year the international system for classifying NPL also
implemented at first time (García-Herrero et. al., 2005).

The research of PBC’s Shanghai Branch in Fan (2002) showed that NPLs ratios are
11.71 per cent from ownership proportion, 21.2 per cent from urban commercial banks,
21.24 per cent from credit for urban cooperatives, and 23.86 per cent from credit for

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rural cooperatives. Shanghai is the area that the economic activities are most dynamic in
China; thus the banks condition is relatively better than other areas. Therefore, the NPLs
ratios figure in Shanghai area can not be used to know the problem within country as the
number can underestimate the problem. As shown in Table 1, many scholars attempted
to estimate the China’s NPLs.

Table 1 Estimation of NPLs ratios and cost for cleaning up

Source: Fan, He, 2002, How Far is China Away from a Financial Crisis, Thailand Development
Research Institute, Bangkok.

The NPLs ratios also can be estimated by looking at the financial report of each bank.
The first bank that released financial statement based on the new system was Bank of
China (BOC) among the big four SOBs. The NPLs ratio of BOC in accordance with its
financial statement in 2001 was about 27.51 per cent, which is smaller than NPLs ratio
in 2000 about 28.8 per cent (Fan, 2002).

From Table 2 shows that under old classification method the NPLs ratio of BOC is
about 14.9 per cent, but under new method is about 39.3 per cent. The difference is
come from the shock in changing method. Fan (2002) argues that the BOC in general is
better than the other SOBs, it can be estimated that the average of NPLs ratios in the
other SOBs is about 30 per cent. The NPLs ratios estimation can be confirmed with the
speech of PBC’s Governor Dai Xianglong in Februari 2001 in Fan (2002) that the target
of reducing NPLs ratio of big four SOBs is up to 20 per cent in 2004. The reduction is
about 2 per cent to 4 per cent per annum. Reversing back to the end of 2000, the average
NPLs ratio is about 31 per cent and in March 2002 at China Development Summit

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Forum, the Governor announced that NPLs ratio in 2001 is about 25.37 per cent or in
total around 2.289 trillion renmimbi.

He also estimates that the NPLs ratio of SOBs is about 30 per cent and the cost of
recovery is smaller than 30 per cent. He also estimates the bank restructuring cost. Since
the total of loan in banking sector is around 11.28 trillion renmimbi, the NPLs ratio and
rate of cost recovery are about 30 per cent; therefore the bank restructuring cost is about
2.37 trillion renmibi which is about 25 per cent of GDP. As the Basel standard was not
implemented in the banks’ operation, hence the estimation of bank restructuring cost
should be raised to 30 per cent of GDP.

Table 2 The BOC’s NPL ratio

Source: Fan, He, 2002, How Far is China Away from a Financial Crisis, Thailand Development
Research Institute, Bangkok.

In the Asian Development Bank (ADB) (2001) report related to the Asian recovery,
China NPLs ratio is about 26 per cent and if the asset that transferred to AMC also
included NPLs ratio is 37 per cent (Table 3). China, compared with other Asian
countries which were struck by financial crisis, the ratio of NPLs is the higher.

Yongding (2001) argue that the NPLs are mainly caused by; first, economic bubble in
the beginning of 1990s which the NPLs ratio in China is about 10 per cent to 15 per
cent. However, after 1992 the Chinese economy was overheated that led the banks to
shift their money to stock market and real estates for speculation. For cooling down the
economy, the government adjusted the policy in Q3 of 1993, but the bubble already
exploded and caused 200 billion renmimbi of NPLs. The NPLs in China between 1992
and 1997 is increased 4 times.

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Table 3 Asian economic’s NPLs ratio

Source: Asian Development Bank (ADB), 2001, Asian Recovery Report, Manila.

The second cause is soft-budget constraint. Most of loan from SOBs was lent to SOEs
and the probability of default is high. In 1990s, the one-third of total loan still goes to
SOEs implemented by the government. So, this intervention can be a suspect if the bank
managers’ performance is not good. The third is lack of management and supervision.
All of SOBs are having many employees which can obstruct their competitiveness and
profitability because the cost would be high. In 1999, the ratio of profits to SOBs’
employees is about 1.500 dollars which is smaller than the ratio of profits to SOBs’
employees in USA 83.270 dollars, 60.190 dollars in UK, 167.970 dollars in Germany
and 35.54 dollars in Japan. The weak of regulation, lack of supervision, and string
intervention are the characteristic of China’s government, while the regulation in
banking sector is very specialized. It needs a highly understanding in banking activities,
despite the fact that in China it is still shortage.

The NPLs ratio also cause cost in both macroeconomic and microeconomic. Since the
banks must be function well in the economy as intermediaries and monetary policy, the
high NPLs will obstruct the effectiveness of monetary policy. The government tried to
expand the economy by monetary policy but failed, because the burden of NPLs ratio,
regardless of the policy to reduce the interest rate and money growth. The NPLs also
make the economy inefficient. The NPLs is accounted as a third of total loan, then the
loan is a fifth of total fixed investment and total fixed investment is about 35 per cent of
GDP. It can be implied that 2.3 per cent of GDP has been wasted every year in 1990s.
Additionally, most of loans are lent to SOEs which has little rate of return, it means that

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the capacity of economy should be higher if the loans are lent to the non SOEs which
have higher rate of return (Xu, 2005).

In order to handle NPLs problem, the Chinese government reform the banking sector.
First policy is recapitulation. This policy was selling bonds to get fund to recapitalize
the big four SOBs. In 1998, the government success sold bond about 270 billion
renminbi. By the end of 1999, the SOBs reported that the average ratio of equity to
assets was 4.7 per cent. The government also targeted that the SOBs can reach 8 per
cent capital adequacy ratio in 2003. Second is loan provision. Loan provision must be
implemented when lending money. The loan provision must reach 1 per cent of total
loan with purpose to close 1.25 per cent as standard internationally.

The third is debt-equity swap. In 1998, the ratio NPL in the big four was about 25 per
cent and compared with the Asian hit economy was higher. The authority established
new agency in 1999 in order to handle the NPL problem in the SOBs. The agency is
called Asset Management Companies (AMC). The AMC bought NPLs in order to make
SOBs’s financial condition health and then AMC can get shares in SOBs. The AMC
bought about 1.47 trillion renmimbi of NPLs from the big four which have total debt
around 5.66 trillion renmimbi. It can be inferred NPLs must be larger than 25 per cent
as the AMC did not take over all NPLs.

The business situation of big four such as bank’s policies, banks ownership proportion,
urban and rural credit cooperatives, and trust and investment corporations was not
better. One of big four which is the Agricultural Development Bank has NPLs ratio in
1997 bigger than 27 per cent and the number still grows continuously. The AMC
acquired 100 billion renmimbi of NPLs from National Development Bank in 1999 and
this amount is about 15 per cent from the total loan of National Development Bank
(Yongding, 2001). From Table 4 can be seen that NPLs ratio in China reduce steadily
after implementation of AMC.

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Table 4 China’s NPLs after AMC implementation

Source: China bank regulatory Commission.

Second problem in banking sector is flow problem which is referred to that the decision
for giving loans are not based on a commercially sound basis. Suitable incentives
creation is essential for the “flow” of lending which is formed by return in the market
and careful with the risk. Basically, the gradual change could improve gradually the
incentives environment in the China’s banking sector. The accumulation of high NPL
ratio is the price that must be paid as the result of flow problem. However, it not true.
SOBs still operated inefficiency which means that poor decision in lending money
continuously to be made which cause the increasing of NPL ratio (Naughton, 1998).

The inefficiency of banks’ activities would affect all the banking system. Since the
function of banks are as an intermediation institution and as provider for liquidity. Many
financial institutions can be intermediaries, but only bank that can be liquidity provider.
As liquidity provider, banks always face the difficulties when the liquidity is needed in
term of large, various, and agricultural economy. In term of large and various
economies, the liquidity should be vary for fulfilling the need in different regions and
based on different factors. Furthermore, the liquidity in agricultural economy means that
continuing element for demand of liquidity is large.

In China’s banking system, the adjustment of regular volatility for demand of liquidity
and the adjustment of regional is the net position between bank branches and the central
bank. Transfer from central bank to the bank branches is necessary especially at the
peak season such as harvest time. Regional bank branches are in passive position related
to the management of their liquidity needs. They depend on the central bank for
additional fund when they need. This system is not working properly, since there were

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many cases that local banks could not provide money when the harvest occurs,
therefore, promissory notes were given to farmers for later payment.

Related to the function of the banking system that performed improperly, there are also
factors that affect the inadequate incentives bank employees. The first factor is
ownership. Since SOBs as part of the government, the problems in budget constraint,
incentives, and risk management still exist. Reward in the generating income and
maintain of low default rate is part of contract that is given to the loan officer. However,
to design contract that consist of profit sharing is difficult. Especially when the loan
officers have strategy postpones the problem by rolling over the loans. None employees
that want to improve the operation by revamp the administration and procedure.

The second factor is supervision. Lack of supervision is serious problem. Loan officers
have authority to decide giving loan to the clients. They also have to identify and to
monitor the credit risk. After loan is given, the supervision weakens. Banks only
categorize loan based on the repayment status, they never evaluate the changes of
creditworthiness or make projection for clients’ cash flows. There are no units that
taking care the problem of loan.

The third is skills. Most of staff in credit unit do not have adequate skills in cash flow
analyses, measuring the ability of repayment, and identify the risk. Reporting is also
based on personal judgment and with inconsistent criteria. Any information related to
clients is repeatedly missing which result loan classifications are not accurate.

Those factors make the capability of SOBs to differentiate good loan and bad loan based
on the commercially sound basis is limited. Additionally, with many authorities in the
decision of loan and weak supervision, the opportunities for fund diversion and
corruption are large.

In order to deal with the flow problem, the government established the body that
supervised banking sector. The body is China Bank Regulatory Commission (CBRC)
which established in 2003. With the CBRC establishment some several policies were

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implemented. First is loan classification in five tier system and made this system
compulsory for banks when they give loan to clients. Second is the implementation of
capital adequacy ratio (CAR). This ratio must be fully implemented by the end of 2007.
Third is risk based supervision. The implementation of risk based supervision is by new
system that assesses risk which is called CAMEL. CAMEL assesses capital not only by
quantitative criteria, but also qualitative criteria, such as capital, profitability,
management competence, liquidity, and asset quality. Fourth is limitation of the lending
to related parties in order to make banks focus the lending to corporate sector. Fifth is
the law enforcement. CBRC can enforce sanction if the banks break the law or
regulation. Finally, CRBC get on in capacity building program which related to the
inspection either on site or off site (García-Herrero et. al., 2005).

4 Weaknesses in Stock Market

Stock market in China compared with banking sector is relatively small, based on the
volume transaction. Start in the beginning of 1996, the stock market growth. However,
the stock market develops in the environment that artificially controlled. China’s stock
market is divided into two which are in Shanghai and Shenzhen. After rapid listing in
the beginning 1996, the total market value in both markets was 986 billion renmimbi at
the end of 1996 or equal to 14.5 per cent of GDP (Naughton, 1998). This rapid listing
was because the conversion of SOEs to joint-stock company with limited liability. The
SOEs conversion was a privatization using stock market for selling shares in order to
get additional fund and giving more reliable information about the firm. Privatization
also commonly used and success in western countries for additional source of funding.
When enterprises that listed in China’s stock market, the proceeding from stock sales
not received by the government, but went to the firms. This policy was implemented
because the government worries about firms’ financial position. Therefore, many
companies pleased to list in the stock market, because the new large source of funds.

As shown in Figure 2 that indicates the up and down of China’s stock market as ratio of
GDP. The figure proved that China’s stock market develops to medium size as there
was an up trend until 2000. However, in the period 2001 and 2005 the China’s stock
market value decreased by 50 per cent when there was a 50 per cent raise in China’s

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GDP. The declining indicates that there was something happen with the market that
made it move in difference way with the Chinese economy.

Figure 2 Market value of stock market as percentage of GDP

Source: China Securities Regulatory Commission.

Compare with some stock market in the worlds, China’s stock market in 2004 was the
bottom of the group as shown in Figure 3. China is the same position with the mexico.
However, the comparison is not accurate, as the circulating shares and non-circulating
shares have same values, while actually the shares sold at discount. The circulating
shares value is only 7 per cent of GDP. The figure should be the total market
capitalization and the value of circulating shares, which would make China in the
bottom among developing countries and faraway from the developed countries.

At the beginning of development in China’s stock market, SOEs that listed in the stock
market was more than 90 per cent of total listed companies and still continues until the
end of 2004. The listing of SOEs was not only as an alternative for new source of funds,
but also obviously as part of the state enterprises reform. However, the quick
privatization by listing in the stock market made the stock market slowed down. This is
a common example that the reform in gradual form could stuck in middle of changing
process (Fan, 2002).

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Figure 3 Stock market comparisons in 2004

Source: World Development Indicators.

When the SOEs listed in stock market the government and new owners still possess
control to the SOEs since the majority of stocks owned by them. However, they also
worried about the reducing of the control to the enterprises and decreasing of profit.
Therefore, they did not simply allow the shares to be circulated. For the circulated
shares, the number increased steadily until 2000, but not more than one third of total
shares. In 2001, the authority implemented policy to divide the shares into circulating
and non-circulating shares, but not success up to 2005. Hence, basically the circulating
and non-circulating shares not changed at least until 2004.

In Table 5 shows that the largest non-circulating shares owner is still government 46 per
cent in 2001. Sponsor’s shares and sponsor legal person are usually controlled by
government. Shares that are owned by sponsor legal person usually can not be traded in
the stock market, but the shares can be transferred by private placement and about 5.3
per cent of those shares were traded by private placement during 2005.

Circulating shares are divided into three categories. A-shares are primary shares that
only for Chinese citizens and denominated in Chinese currency. B-shares are reserved
for international investors and in foreign currency denomination. H-shares are shares

15
from Chinese companies that listed in Hong Kong stock market or other stock market
outside China. Usually A-shares are more expensive rather than B-shares and H-shares,
since the alternative investments for Chinese citizens are limited and segmented market
(naughton, 2007).

Table 5 Listed firms’ structure of capital

Source: China Securities Regulatory Commission.

The consequence of market segmentation is the low control of contestability. When the
government still control the majority listed companies, the private sector does not has
any opportunity to take over the control of listed companies. This situation makes stock
market difficult to improve good corporate governance. Until now, China’s stock
market can not serve well because the stock market is only as a corporate control
market. Furthermore, privatization trough stock market is minimal when the
government still as the major of shares owners.

The lack of regulation and disclosure standard exist until 2001 in the China’s stock
market. Therefore, after that time the effort to improve disclosure was implemented.
The corporate must post their report on the internet in a timely fashion. Standard of
accounting and transparency are getting better. However, the standards of regulation
and disclosure still not as good as in the market in developed economy. Especially the
regulations, which protect the shares ownerships by government, but have an impact to
the weak protection for minority.

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As the government control the most companies in the stock market, the stock market
unavoidably affected by policies change. Study by Morck et. al. (1999) resulted that
most changes in market is as a respond to the changes in the government policies, rather
than the changes in fundamentals of the firms. They also found that 40 emerging stocks
were moving together in some weeks compared in the other markets. In other words, the
investors must gamble that the Chinese government will change their policy in the stock
market.

Generally, the stock markets in the world are organization that self-regulated. Market
participants built system that can monitor each other for shared benefit. Conversely, the
stock market in China inherently has large opportunities for doing collusion in the
process of self-regulated. The participants in Chinese markets are managers, securities
firms, and the authority. Managers have to secure the companies’ listing opportunities.
Securities firms have power to monopolize trading and listing procedure, which 100 per
cent up to 2002 owned by local government. The authority has the power to make
permission for listing (Naughton, 2007). By those three participants, the Chinese stock
markets were manipulated, especially in the Initial Public Offering (IPO). Most of the
IPOs were underpriced, so the parties can buy the shares and make profits. The SOEs
would be guided by securities firms in the listing process, and for rewards the securities
firms would get rights to buy new shares and keep some portion in their account.
Moreover, the authority would get paid from the listing SOEs for the placing in the list.
This type of manipulation from the insiders drove the Chinese stock market for many
years.

Because of many problems in the Chinese stock market that make it inefficient and put
in weakness situation, the government started a reform in China’s stock market since
2001. The first effort was selling the non-circulating shares that owned by states which
10 per cent from all new listing shares go to social security fund. Even though the
course of action to sell the non-circulating state owned shares rapidly turn around, the
measures of regulatory were still maintained (naughton, 2007). The market participants
inferred that the government’s guarantee which usually implicit already over. The
second was increasing the disclosure of the firms’ information and transparency. This

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policy makes market participants responsive with scandals that exist in the stock market
which make stock market was abused and manipulated.

5 Summary
Financial crisis struck that Asian region and ruined the economy, but one developing
country in the region which was little affected by the crisis, which is China. China with
those Asian countries has several common characteristics that indicate the nature of
their financial systems such as high growth, high saving, banking industry dominated
the financial system, and less developed in other industries such as stock markets. Even
though China can survive from Asian crisis, China also faces its own problem that
might be difficult to deal with. Therefore, this paper purposes to investigate the
problems in China’s financial system focuses on banking sector and stock market and
how China can solve those problems.

The banking sector in China went into the twenty-first century with the lack behind
from the sophisticated banking system of market economy, because was created under
planned economy. The banking operated inefficiently as a buffering for workers from
the consequences of competition and lent money to non-feasible clients (SOEs). This
practices end up with the problem. Problem in China’s banking sector are stock problem
and flow problem. Stock problem is referred to the bad loan stocks or kwon as NPL.
The NPLs are mainly caused by economic bubble in the beginning of 1990s and soft-
budget constraint. In order to deal with NPLs problem, the authority implements the
reform in banking sector which is recapitulation, loan provision, and debt-equity swap.

Flow problem is referred to that the decisions for giving loans are not based on a
commercially sound basis. In order to deal with the flow problem, the government
established China Bank Regulatory Commission (CBRC) that supervised banking sector
in 2003. With the CBRC establishment some several policies were implemented such as
loan classification in five tier systems and compulsory for banks, capital adequacy ratio
(CAR), risk-based supervision, limitation of the lending to related parties, law
enforcement, and CRBC get on in capacity building program which related to the
inspection either on site or off site.

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