Term paper on

Chapter 5
Financial markets and economic activity

Submitted By
Group: 4
Sl no Name ID

01 Rizwanul Karim FW201956021

02 Christin Vricilya Munthe FW201956005

03 Raheel Abdul GDW2019201

04 Mirsolieva, Gulrukhsor GDW2019211

Submitted to:
Prof. Henry Haiyun Zhang
School of Banking and Finance

1
University of International Business and Economics

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 Table of Contents
5.1 Introduction...........................................................................................................................................3
5.2 Financial indicators of growth...............................................................................................................5
5.3 Monetary policy.....................................................................................................................................8
5.3.1 Objective of Monetary Policy:........................................................................................................9
5.3.2 Monetary Policy Committee (MPC):..............................................................................................9
5.3.3 Monetary Policy Instruments:.......................................................................................................11
5.3.3.1 Open market operations (OMO)............................................................................................11
5.3.3.2 Reserve requirement ratio, RRR............................................................................................13
5.3.3.3 Central bank loans.................................................................................................................14
5.3.3.4 Benchmark interest rates........................................................................................................14
5.3.3.5 Rediscounting........................................................................................................................15
5.3.3.6 Standing lending facility, SLF...............................................................................................15
5.3.3.7 Medium-term lending facility, MLF......................................................................................15
5.3.3.8 Pledged supplementary lending, PSL.....................................................................................16
5.4 Role of Chinese banks in resource allocation......................................................................................17
5.4.1 Efficiency and financial intermediation (Efficient market hypothesis).........................................17
5.4.2 International expansion.................................................................................................................19
5.4.3 Efficiency in banking sector.........................................................................................................20
5.4.4 Information processing & cost reduction......................................................................................21
5.4.5 Government (Ownership, control of Banking Sector)...................................................................21
5.4.6 Information efficiency in markets (bank and market)...................................................................24
5.4.7 Transaction costs (bank and market).............................................................................................26
5.4.8 Competition in the banking sector................................................................................................28
5.4.9 Foreign Competition.....................................................................................................................29
5.4.10 Current Tax System....................................................................................................................32
5.5 Conclusion...........................................................................................................................................34
References.................................................................................................................................................35

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Chapter 5: Financial markets and economic activity

5.1 Introduction
There has been a lot of research found that financial development has
immense positive impact on real economic activities. [CITATION Lev97 \t \l 1033 ],

suggests that the financial sector contributes to economic growth through five main
channels by:

 Facilitating the trading, hedging, diversifying

 Pooling of risk
 Providing liquidity
 Mobilizing savings
 Facilitating the exchange of goods and services
The analysis of this relationship originated with pre-Keynesian monetary
economics which emphasized the relationship between financial markets and
fluctuations in prices and output. Economists like [ CITATION Haw19 \l 1033 ], [CITATION

RGH28 \l 1033 ], [ CITATION Wic35 \l 1033 ] and [CITATION Fis33 \l 1033 ] accepted that credit
markets perform a key role in coordinating the inter-temporal saving decisions of
households and the investment decisions of firms. The liquidity preference theory
[ CITATION Hic37 \l 1033 ] and [ CITATION Mod44 \l 1033 ] postulates that in a world with only
money and securities, the interest rate is determined by the demand and supply of
money. Post Keynesian developments in the study of financial intermediation in
the economy were by [ CITATION Gur60 \l 1033 ] and [ CITATION Bra63 \l 1033 ]. [ CITATION

Gur60 \l 1033 ], suggested that financial intermediation weakens the relationship

between money and economic activity and makes the economy more dependent on
the complex interaction between debts and assets in the economy. [ CITATION Bra63 \l

1033 ] claimed that monetary policy had important real effects as it affects return on

4
real capital. Study by [ CITATION Gol69 \l 1033 ] , [ CITATION Sha73 \l 1033 ] and [ CITATION

McK73 \l 1033 ] further advanced the relationship between financial structure and real
economic activity to specify a causal role for a country’s financial system in the
process of economic growth. Later studies by [ CITATION Kin78 \l 1033 ] and [CITATION

Min82 \l 1033 ] also found a relationship between the state of the financial system and
economic performance.

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5.2 Financial indicators of growth
A well-developed financial system drives economic growth by enhancing
the efficiency of intermediation through the reduction of information, transaction
and monitoring costs. The relationship implies that economic growth rarely occurs
without a well-functioning financial system [ CITATION McK73 \l 1033 ] ,[ CITATION Sha73 \l

1033 ], [ CITATION Kin93 \l 1033 ] and [CITATION Lev00 \t \l 1033 ] . Theoretically, the financial
policy variables postulated as determinants of economic growth can be classified
into two categories [CITATION KLG87 \l 1033 ] the financial structuralist and financial
repressionist schools. The financial structuralist school suggests that the quantity
of financial variables and its composition influence economic development.
Therefore, factors constituting financial deepening such as aggregate financial
assets to gross domestic production and the composition of aggregate financial
variables are considered to be pervasive factors on economic growth [ CITATION Gur60
\l 1033 ] [CITATION Gol66 \t \l 1033 ] and [CITATION Gol69 \t \l 1033 ]. The financial
repressionist is more a theory ([ CITATION McK73 \l 1033 ] and [ CITATION Sha73 \l 1033 ] that
posits price variables as more pervasive than financial factors on development,
such as the deregulation of real interest rates and real exchange rates as impetus for
economic growth. This theory is also referred to as the McKinnon- Shaw
hypothesis. Thus, economic development is accomplished through the deepening
and liberalization of the financial markets to facilitate in the allocation of capital to
the most efficient investments.

Empirical tests of financial structuralist theory are through the use of case
study approach comparing cross-country financial development with growth rate.
[ CITATION McK73 \l 1033 ] and [ CITATION Lan83 \l 1033 ], examining the direction of
causation between growth and the level of financial intermediation [ CITATION Fri84 \l

1033 ] and [CITATION Ode2a \t \l 1033 ] and testing for financial intermediation variables
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in the economic growth equations [CITATION Gha \l 1033 ]. The financial repressionist
tests by [ CITATION Fry80 \l 1033 ] , [CITATION Kin2a \t \l 1033 ] and[ CITATION Sec93 \l 1033 ]
incorporate the real interest rates in economic growth equations and the results
show a positive relationship. Others include classifying countries according to the
real interest rate levels of positive, slightly negative and significantly negative
values and relating these classifications to economic growth [ CITATION Kha88 \l 1033 ] .

[CITATION Gel89 \l 1033 ] identified the likelihood of reverse causation from economic
growth to real interest rate that makes it difficult to identify the effect of real
interest rate. This led to the use of the approach that relates real interest rate to
incremental output-capital ratio (IOCR) (change in output in relation to investment
spending) [CITATION Agr83 \l 1033 ], [CITATION Gel89 \l 1033 ], [CITATION Kin2a \t \l 1033 ] and
[CITATION Ode2b \t \l 1033 ].

The IOCR equation is presented below:

dY
=¿
Y

Where:

dY
=¿ IOCR or incremental output-capital ratio:
dK

dY
=¿Economic growth or change in the rate of output;
Y

dK =¿Incremental capital investment spending;

dY =¿Incremental output and

dK
=¿The proportion of investment spending (dK) in total output (Y).
Y

Equation (1) suggests that economic growth is the product or function of IOCR
(economic efficiency) and the ratio of investment to GDP. It can be seen from this

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that the effects of financial variables on economic growth have to be through
changes in efficiency or productivity of the resource utilization (IOCR) and/ or
changes in investible resources (dk/Y). Few studies [CITATION Agr83 \l 1033 ] and
[ CITATION Gha \l 1033 ] have focused on the effect of exchange rates on economic
growth under the financial repressions proposition and in all these studies negative
relationships were reported between the exchange rate distortion index used and
incremental output- capital ratio or economic growth.

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5.3 Monetary policy
Since the demise of Keynesian demand–management in the 1970s, monetary
policy has been the primary tool used by the government to steer the economy
through regulating money supply and interest rates. The link between the money
market and the country’s financial system and its real economy is by the Peoples
Bank of China (PBC) regulating money supply and interest rates in order to control
inflation and stabilize the currency. By regulating the effective cost of money, the
PBC can influence the level of aggregate spending or demand by consumers and
corporations. As aggregate spending increases, the inflationary pressure will build
up and the central bank will move to raise the cost of money that banks borrow and
lend in the money markets. Those banks sensitive to this rate increase will mean a
rise in the cost of working capital. With a higher cost of capital, consumers will
spend less and investors will reduce their investment, resulting in weaker
aggregated demand.

At the helm of modern market economy is the central banks and their role of
regulating their price of money to influence their macro-economic demand. Chinas
central bank, the Peoples Bank of China, is responsible for implementation of
monetary policy. Its role as the independent authority for implementing monetary
policy was formalized in 1995 by the new legislation on the PBC, which reinforced
PBC’s role as China’s central bank. The balance between managing money supply
and controlling inflation has become one of the main and constant challenges for
PBC. Since the inception in 1984, PBC has moved gradually to a monetary
strategy aimed at achieving intermediate monetary targets. It has kept the interest
rate low to meet the country’s development goals and each of the four largest
Chinese banks has a specific focus on the development in particular sector. The
PBC falls under the jurisdiction of state council.
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5.3.1 Objective of Monetary Policy:
According to the People’s bank of China (PBC), the objective of the monetary
policy is to maintain the stability of the value of the currency and promote
economic growth. (PBC website)

5.3.2 Monetary Policy Committee (MPC):

Article 12 of the Law of the People's Republic of China on the People's Bank of
China provides "The People's Bank of China is to establish a monetary policy
committee, whose responsibilities, composition and working procedures shall be
prescribed by the State Council and shall be filed to the Standing Committee of the
National People's Congress. The Monetary Policy Committee shall play an
important role in macroeconomic management and in the making and adjustment
of monetary policy."

Rules on Monetary Policy Committee of the People's Bank of China stipulates that
the Monetary Policy Committee is a consultative body for the making of monetary
policy by the PBC, whose responsibility is to advise on the formulation and
adjustment of monetary policy and policy targets for a certain period, application
of monetary policy instrument, major monetary policy measures and the
coordination between monetary policy and other macroeconomic policies. The
Committee plays its advisory role on the basis of comprehensive research on
macroeconomic situations and the macro targets set by the government. The
Monetary Policy Committee is composed of the following members:

The monetary policy Committee

 PBC's Governor
 Deputy Governors (2)
 Deputy Secretary-General of the State Council (1)
 Vice Minister of the State Development and Reform Commission (1)
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  Vice Finance Minister (1)
 Administrator of the State Administration of Foreign Exchange,
 Chairman of China Banking and Insurance Regulatory Commission,
 Chairman of China Securities Regulatory Commission, 
 Commissioner of National Bureau of Statistics,
 President of the China Association of Banks,
 expert from the academia (1)
Source: http://www.pbc.gov.cn/en/3688229/3688311/3688314/index.html

The Monetary Policy Committee performs its functions through its regular
quarterly meeting. An ad hoc meeting may be held if it is proposed by the
Chairman or endorsed by more than one-third of the members of the Monetary
Policy Committee. The opinions expressed in the meeting of the Monetary Policy
Committee will be recorded in the form of "meeting minutes". Such minutes or any
resulted policy advice, if approved by more than two-thirds of the members of the
Monetary Policy Committee, should be attached as an annex to the proposed
decisions of the PBC on annual money supply, interest rates, exchange rates or
other important monetary policy issues to be reported to the State Council for
approval. In the case the PBC files its decisions on other monetary policy related
issues with the State Council; it should enclose the meeting minutes or policy
advice of the Monetary Policy Committee at the same time.

5.3.3 Monetary Policy Instruments:

The central bank controls inflation through influencing money supply in the
economy using its tools. According to Peoples Bank of China (PBC), the central
bank of China uses eight instruments to make adjustment to its monetary policy.

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5.3.3.1 Open market operations (OMO)

Outright purchase:

At the outset, the Central Bank concentrated on spot bond outright purchase/sales
and Repo operations with Treasury bond as the main instrument. However, in light
with the rapid and concentrated growth in foreign reserves, the value of the bonds
outstanding in the balance sheet was rather limited and central bank found itself in
a situation of having no more bonds available. To address this problem, in
September 2002, it changed the undue positive Repo in the process of the open-
market operation into the central bank bill, by converting the bonds pledged to
holders in the course of open market operations and using these to conduct its
Repo operations [ CITATION LiY07 \l 1033 ].

Issuance of central bank bills:

Another instrument for OMO is issuance of central bank bills. Since the early
2000s, the growing balance of payments (BOP) surplus via current and capital
accounts have put great upward pressure on the value of the domestic currency in
China. To prevent sharp appreciation of Chinese Yuan, the PBC had been actively
intervening foreign exchange market by purchasing foreign assets, and thus
accumulated massive amounts of international reserves. When the PBC purchases
foreign assets an equivalent amount of base money are released. This puts great
expansionary pressure on China’s economy. To neutralize the expansionary effect
of currency intervention, the PBC issues central bank bills, a type of short-term
central bank debt, to absorb the increase in monetary base caused by intervention
[ CITATION Cun16 \l 1033 ].

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Repo and Reverse Repo:

Now, open markets operations mostly involve two processes called repurchase or
reverse repurchase agreements. The former term means removing liquidity from
the system when the PBC sells short-term bonds to some commercial banks. PBC
also does the opposite for a “reverse” repurchase agreement, buying up those
contracts, so banks have more cash on hand. Those operations allow the PBC to
control money supply and interest rates on a short-term basis; the assets are
normally offered on time frames ranging from seven to 28 days.

Recently, in November 18, 2019 PBC trimmed the seven-day reverse repurchase
rate to 2.50% from 2.55%, the first such cut in more than four years. As the
economic growth of China has eased to its slowest in nearly three decades as well
as credit growth and industrial output have continued to show a cooling economy it
raised concerns for PBC. This change is a signal to the market that policymakers
are ready to act to prop up slowing economic growth.

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5.3.3.2 Reserve requirement ratio, RRR
The reserve requirement ratio refers to the amount of money that banks must hold
as a proportion of their total deposits. Lowering the required amount will increase
the supply of money that banks can lend to businesses and individuals, and
therefore cutting borrowing costs. Increasing the ratio of what banks need to keep
in reserve achieves the opposite result.

Aiming to further support the development of the real economy, optimize the
liquidity structure and lower financing costs, the People’s Bank of China (PBC)
has lowered the required reserve ratio for financial institutions by 1 percentage
point, 0.5 percentage point from January 15, 2019 and a further 0.5 percentage
point from January 25, 2019. Such arrangements are intended to smooth out the
liquidity fluctuations that might emerge as a result of cash injections in the run-up
to the Spring Festival this year, and help financial institutions further strengthen
support for small and micro businesses and private enterprises.

5.3.3.2.1 Effects of reducing RRR:

Increase Liquidity: According to PBC, “The RRR cut will release a total of nearly
RMB 1.5 trillion. Moreover, as the upcoming targeted Medium Term Lending
Facility (MLF) operation and the dynamic assessment of targeted RRR cuts for
financial inclusion will also free up some funds, and the outstanding MLFs due to
mature in the first quarter of this year will not be renewed, a net of approximately
RMB 800 billion of long-term capital will be released”.

Support the real economy: This round of RRR cut and relevant operations will
release an additional net of approximately RMB 800 billion of long-term capital,
thereby effectively increasing loan funding sources for small and micro businesses,
private enterprises and other entities in the real economy. Meanwhile, the
replacement of MLFs will directly reduce interest payments of banks by around
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RMB 20 billion each year, and thus enable lower costs in the real economy by
bank transmission. All these impacts will help support the development of real
economy.

5.3.3.3 Central bank loans

To improve the financing environment of small and micro businesses (SMBs) and
private enterprises, the PBC decided to increase the targeted credit line by RMB50
billion to support small and medium-sized banks in expanding their credit supply
to SMBs and private enterprises. In this way, liquidity will be injected into the
targeted sector and the cost of social financing will be lowered. The credit line
targeting SMBs will reach RMB369.5 billion after the raise. City commercial
banks, rural commercial banks, rural cooperative banks, village banks and private
banks may apply to the PBC branches and sub-branches for SMBs-targeted loans,
on the condition that they provide service at the primary level and to the real
economy, and that the loans granted will be used to increase credit supply to SMBs
and private enterprises. The PBC branches and sub-branches should enhance
policy support and grant loans in a timely manner. In 2019, the PBC has stepped
up efforts to support SMBs-targeted lending by strengthening surveillance and
evaluation of the use of funds. Emphasis has been put on targeted liquidity
injection to support the SMBs and private enterprises. By end-June, 2019, SMBs-
targeted lending from the PBC posted a record-high RMB226.7 billion, up
RMB132.3 billion years on year

5.3.3.4 Benchmark interest rates

The PBC controls the benchmark one-year lending and deposit rate, which affects
the borrowing costs for banks, businesses and individuals. It last adjusted those
rates in October 2015 and now allows commercial banks some leeway to go above
or below the official level in determining the interest rates that they charge.

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5.3.3.5 Rediscounting
The PBC offers an option to banks to “rediscount” the loans that they extend to
their customers. The monetary policy tool involves the central bank buying up
existing loans from commercial lenders, giving them some extra liquidity. It’s a
complicated concept, so here’s an example to illustrate the process:

A consumer takes a loan of $10,000 from a bank, with a promise to re-pay $12,500
at a later date. That loan agreement is said to be bought by the bank at a price of
$10,000, which is a discount to the $12,500 it will ultimately receive in return.
Subsequently, the bank sells that agreement to the PBOC for $11,000, which is
another discount — or “rediscount” — of the contract’s paper value of $12,500.

The PBC charges an interest rate on those funds it lends to the banks, which would
influence other borrowing costs in the banking system.

5.3.3.6 Standing lending facility, SLF

Standing lending facility is also a type of PBC lending to commercial banks.
Introduced in 2013, such loans have a maturity period of one to three months —
longer than funding options such as the open market operations. To receive money
through this framework, banks must guarantee assets with high credit ratings as
collateral. That means such funds are usually only available to the larger lenders.

5.3.3.7 Medium-term lending facility, MLF

Chinese banks get funds with even longer maturities, typically three months to a
year from the PBC through the medium-term lending facility. The funding channel,
introduced in 2014, allows the central bank to inject liquidity into the banking
system and influence interest rates for longer term loans. Like the standing lending
facility, banks must put up collateral to receive funds. Unlike the SLF, however, a
wider range of collateral is accepted under the medium-term version. That includes

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government bonds and notes, local government debt and highly rated loans of
small companies.

5.3.3.8 Pledged supplementary lending, PSL

As one of the newest monetary policy tools in China, pledged supplementary
lending was introduced to guide long term interest rates and money supply. Such
funds are injected into selected banks so that they can provide loans to specific
sectors such as agriculture, small businesses and shantytown re-development. The
banks that have received those particular funds are the three Chinese “policy”
lenders: China Development Bank, Agricultural Development Bank of China and
the Export-Import Bank of China.
Source: www.cnbc.com

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5.4 Role of Chinese banks in resource allocation
Chinese financial reforms are aimed at securing sufficient capital for
economic development through efficient resource allocation. While capital
accumulation has primarily been successful, resource allocation is less effective
due to government’s policy lending agenda. The establishment of the three policy
banks in 1994. (banks include are: - the Agricultural Development Bank of China, China
Development Bank and the Export-Import Bank of China) was to free up the state-owned
commercial banks (SOCBs) from this type of lending and instead focus on commercial

activity. This allowed the SOCBs to carry out their lending activity based on
commercial standards and practices.

Efficient resource allocation was one of the underlying reasons for the introduction
of Central Bank Law and Commercial Bank Law in 1995. The reason why China
has been able to continue with its high growth in spite of financial market
problems is the excess of funds available for investment. China by the end of 2006
has a foreign reserve if in excess of USD 1 trillion from trade surpluses and at the
end of 2018 this figure is USD 3.09 trillion. These reserves are being used to invest
in foreign direct investment and securities, such as U.S. treasures, as well as China
are also experiencing very high saving rates. Thus, efficient allocation of capital in
China may not have been as crucial as in other emerging markets.

5.4.1 Efficiency and financial intermediation (Efficient market hypothesis)

The concepts of rational exception [ CITATION Mut61 \l 1033 ] and random walk are
closely related to the rationale underlying the efficient market hypothesis. [ CITATION
Mut61 \l 1033 ], suggests that exceptions of economic agents are essentially the
forecasts of economic theory and are therefore rational. The random walk
hypothesis was developed postulating that asset price changes over time were
comparable to a random series. They form the basis of the much larger theory
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known as the efficient market hypothesis (EMH). The mainstream concepts, issues
and methods in financial economics are based on the theory of efficient market
(see [ CITATION Cut97 \l 1033 ] for a review). The EMH predicts that share prices fairly
reflect, in an unbiased manner, all information that has been fully revealed to the
market. The notion of market efficiency is usually attributed to “rationality” of
traders with “homogeneous” information.

The EMH predicts that share prices fairly reflect all information that has been fully
revealed to the market. The implicit assumption in the efficient market hypothesis
is that there always exists a market for stocks to the transacted with little effort or
cost. It states that the capital market is always in equilibrium where there is no
pressure on stock price. As the stock price reflects all relevant information about
the stock, this price must represent its fair market value. Then stock price only
moves in response to new information that, intrinsically, is unpredictable. Hence,
stock price should be random and must follow a Markov process. [ CITATION Fam70 \l

1033 ], mentioned three forms of market efficiency. The weak-form of EMH states
that all information contained in past price movements is fully reflected in current
market price, and suggests that no investor analyzing historical price data can
expect to earn abnormal returns above the expected returns given the investment
risk. The semi-strong form of the EMH states that current market prices reflect
publicly available information. Under the semi-strong form of the EMH, it would
be futile for investors to read financial reports or other published data because
market prices would have adjusted to the information in them when it was first
announced. With the semi-strong efficiency, investors can expect to earn the
returns predicted by the Security Market Line (SML) and should not expect better
returns unless they have information not publicly available. In the strong form,
current market prices reflect all publicly available or privately held pertinent

19
information. In the semi strong form of the EMH, no investor can expect abnormal
returns by analyzing publicly available information and in the strong form, by
analyzing information from whatever source. Abnormal stock returns are
computed as the difference between the return on a stock and its normal return. If
the abnormal return in unforecastable using the chosen information set and is thus
random, then the efficient market hypothesis is not rejected.

The basis of EMH is in the concept of a competitive market where an individual

trader will not be able to affect share prices when buying or selling in such a
market, as long as there are enough share on issue. The traditional analysis of stock
markets is based on the premise of the efficient market hypothesis. Empirical tests
have shown that the EMH is valid in its weak and semi-strong form. Therefore, if
stock prices under the EMH do seem to reflect public information, stock prices
must be fairly valued and in equilibrium. In the context of EMH, this implies that
the stock market reflects the future growth of the real economy because investors
have incorporated this high growth expectation into their investment decisions and
therefore fundamentally justifies the stock prices.

 Equity markets (weak form)

 Capital Asset Pricing Model (CAPM) on markets
 Cross sectional effects (size, E/P and book/market value)
 Volatility
 Predictability

5.4.2 International expansion

Over time, it is likely that Chinese banks will become more aggressive in
expanding their operations not only domestically but also internationally in the
search for new markets and sources of revenue. This has already happened as

20
many state owned entity (SOE) commercial banks have opened up branches and
established subsidiaries in other countries.

5.4.3 Efficiency in banking sector

The state of China’s banking industry is still one lacking in efficient and
competition. Many state-owned banks remain burdened by policy lending while
the monopolistic nature of these banks has not contributed to higher efficiency.

Recently, there have been numerous studies conducted on measuring the efficiency
of commercial banks. [CITATION Dra03 \l 1033 ], study the macroeconomic and
regulatory factors on bank efficiency in Hong Kong using Tobit regression, where
external factors such as GDP and government expenditures are tested instead of
firm characteristics. [ CITATION Che00 \l 1033 ] , adopted the intermediation approach in
the DEA model and found that the increase in market competition and staff salary
may result in lower technical efficiency for banks in Taiwan (China). [ CITATION Gir04

\l 1033 ], study the main determinants of Italian banks’ cost efficiency over the
period 1993 to 1996 and found that X-inefficiencies decline over time for all bank
sizes. [ CITATION Ric02 \l 1033 ], use a data envelopment analysis (DEA) model to
investigate the production efficiency of the US commercial banks during for the
period 1984 to 1998. They found the strong correlation between the efficiency and
independent measures of performance. [ CITATION Pas99 \l 1033 ] , used a sequential
DEA procedure on Spanish banks to segregate the main indicator of banking risk
provision for loan losses into internal and external components. [CITATION Ber97 \t \l

1033 ] conducted research on financial institution’s efficiency of 130 cases from 21

countries. They include banks, savings and loans, bank branches, insurance
companies and credit unions.

21
5.4.4 Information processing & cost reduction
Like what is happening in other countries, information technology is making
a significant impact on the way Chinese banks conduct their business. Information
technology has made possible new ways for banks to organize their activities, in
particular, the further specialization and division of labor. This promotes more
effective internal regulation and supervision by providing more timely and
powerful monitoring mechanisms to strengthen internal control and compliance. In
turn, this would enable rapid response by bank management and regulatory
authorities to emerging problems. The progress in information technology has
significantly lowered transactions and coordination costs of banks.

5.4.5 Government (Ownership, control of Banking Sector)

The financial market reform in China is believed to have only marginally

improved the allocation and use of bank capital. As the public sector remains the
majority owner of banks, they are required to follow the strategic direction of the
government. For political reasons, the Chinese Government sometimes direct
banks to finance SOEs even though they may not be performing profitably. This
creates a situation in which non-performing loans have increased significantly.
According to ceicdata.com, it is recorded NPL ratio high of 12.4% in March 2015
and low of 0.9% in September 2011.

Foreign banks
1%
Rural commercial banks
15%
City commercial banks
10%
Large commercial banks
55%
Join-stock commercial banks
20%

Source: CBRC

22
Figure: Non-performing loans of commercial banks 2015 (100 m Yuan)
In 2015, the largest NPL ratio was at the large commercial banks of 55% which
consisted of 5 large banks namely Industrial and Commercial Bank of China,
Agricultural Bank of China, Bank of China, China Construction Bank, and Bank of
Communication. The second was Join-stock commercial banks (12 banks), third
was Rural commercial banks (1.373 banks), fourth was City commercial banks
(133 banks) and the last was Foreign banks (40 banks).
Dealing with bad loans is challenging for any government and failing to deal with
bad loans in a timely manner can incur steep costs. Eventually, when the
accumulated weight of NPLs can no longer be ignored and the government must
step in with a bailout. Financial crises are usually caused by a loss of confidence in
financial institutions, not a surfeit of NPLs. However, NPLs can help drive that
loss of confidence by creating liquidity problems for banks. Banks need the interest
payments generated by loans to pay what they owe to depositors and to other
funding sources. When loans go bad and those interest payments stop, banks might
struggle to meet their obligations. It’s not that the banks are broke. Rather, they
likely have plenty of assets “loans made to borrowers “but turning those assets into
cash on short notice isn’t easy. Hence, banks might find themselves teetering on
the edge of insolvency. In such a situation, the central bank can step in and lend to
banks in return for collateral, ensuring that banks have sufficient cash to preserve
confidence in the system.
China has greater control over market liquidity than other countries. Capital
controls mean that the PBOC can print money and it won’t drain overseas.
Meanwhile, printing money isn’t a politically charged issue in the way that it is in
other countries, nor is government intervention in the markets. The consensus in
Beijing is that stability comes before all else. That gives the PBOC the latitude to
move more quickly than other central banks, should the situation demand its

23
intervention. The authorities can also impose solutions on market participants that
might not be in their commercial interests. For example, Beijing can force
distressed financial institutions into mergers on short notice, or it can demand that
big banks keep lending to smaller financial institutions even in the midst of a cash
crunch. To complement those advantages, the PBOC has in recent years built up an
alphabet soup of lending tools (most notably the Standing Lending Facility and
Short-Term Lending Operations) to ensure banks can borrow from the central bank
whenever they need to.
Still, the provision of sufficient liquidity is merely a Band-Aid. It buys time for
banks that must then use it to gradually reduce their accumulated NPLs. Despite
Beijing’s best efforts, two related uncertainties still cloud the approach’s long term
viability: the slowing economy and political resolve.

16.0 14.20
14.0 12.70
11.40
12.0 10.0010.10 10.60
9.10 9.60 9.20 9.50
10.0 8.40 8.30 7.80 7.70 7.40
8.0 6.90 6.70 6.80 6.60
6.0
4.0
2.0
-
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Year

Source: www.ceicdata.com
Figure: China’s GDP growth 2000-2019
As growth slows, banks could find it more challenging to dispose of sufficient
volumes of NPLs without government support or severe economic disruption.
Meanwhile, senior leaders’ commitment to pursuing financial prudence over
stimulating the economy could be seriously tested.
The public believe that the government remains the lender of last resort in the
event of a financial meltdown in the banking sector. The China’s economy may be

24
susceptible to a final crisis that in the past had plagued countries such as Thailand,
South Korea, Malaysia and Indonesia. They all suffered from the same debilitating
structural problems of slack prudential oversight, a fragile bank-dominated
financial system, and a largely public-sector dominated financial sector. China’s
tight control of foreign exchanges on its capital accounts enabled her to emerge
from the Asian financial crisis relatively unscathed.

5.4.6 Information efficiency in markets (bank and market)

Analyzing the efficiency in the Chinese financial market is challenging because of

the difficulties in accessing information on the Chinese banking system. The
evaluation of efficiency can be conducted wither through the profit or cost
efficiency methods. Empirical studies suggest that privatization and privatization
to strategic foreign investors is often associated with better performance
improvement, while partial privatization and continuing government ownership
only bring about limited or no performance improvement of divested firms
[ CITATION Cla05 \l 1033 ] . The empirical results would strongly point to favorable
efficiency effects from the reform initiatives implemented by the Chinese
government to reduce state ownership and increase foreign ownership of Chinese
banks. [ CITATION Che05 \l 1033 ], find that the Big 4 banks and the small joint stocks
banks are cost efficient compared to the medium-sized join-stock bank.
The extant literature on bank efficiency in emerging economies suggests a strong
correlation between high growth rates and significant reform of the banking system
and financial market infrastructure. It also supports the propositions that state
ownership of banks is associated with restricted access to credit for small and
medium enterprises (SMEs), low bank efficiency and slower economic growth in
emerging markets.

25
One of the key benefits of market reform is the introduction of competition,
particularly foreign competition, to help bolster efficiency. Empirical research
from the East European transition economies suggests foreign banks to be the most
efficient followed by private, domestic banks, and then state-owned banks [ CITATION
Bon5a \l 1033 ]. However [CITATION Yil \l 1033 ], study on transition nations finds that
foreign banks are more cost efficient, but less profit efficient than private, domestic
and state-owned banks.
The recent partial privatization (in 2005 and 2006) of the Big-4 Chinese banks to
take on minority foreign ownership is a significant step forward banking system
reform and according to the literature is expected to have a positive impact on bank
efficiency. However, there is very little extant research on the determinants of
Chinese bank efficiency or the likely future efficiency from financial market
reforms, such as privatization and introduction of foreign bank ownership,
competition and institutional environment [ CITATION Has09 \l 1033 ] . [CITATION Has091

\t \l 1033 ], suggest that in a high growth market like China more banks are attracted
to the market and thus local banks face greater Competition, which results in low
level of efficiency among banks in the region.
The lack of sufficient literature on the impact of minority foreign ownership of
banks on efficiency poses a challenge in being able to appreciate the extent of this
situation. The findings from [CITATION Gup05 \l 1033 ] on the positive effects,
pertaining to profitability, productivity and investment, of minority private
ownership through partial privatization of majority state-owned non-financial
companies may provide some evidence to support why it may increase efficiency
in the Chinese banking sector.

26
5.4.7 Transaction costs (bank and market)

Increased operational efficiency in each bank is different. Most banks seek to

reduce costs by increasing operational efficiency, particularly through reductions
in staff numbers and branch network. By reducing staff numbers, they want to cut
back total payroll and save costs. The other way is by increasing employee
productivity to disburse more loans, increase investments, and generate more
revenue, thereby improving cost efficiency. It is also possible to save costs by
absorbing low-interest deposits and decreasing interest expenses, or generate more
revenue and become more cost efficient by sufficiently and effectively lending out
deposits as loans or making investments, all while complying with the legal
provisions of bank reserve funds.
As a cost-containment measure, they have also increased account fees to
discourage excessive use of those transactions facilities whose fees are still pitched
well below cost. An important pricing strategy is the structuring of fees to
encourage a shift to electronic payment methods. Payment systems are critical
components of an economy. As modern economies grow more complex and
transactions between buyers and sellers more anonymous, fast, reliable, and
trustworthy, the importance of payment systems grows. As Federal Reserve
Chairman Powell stated: “An efficient payments system provides the infrastructure
needed to transfer money in low-cost and convenient ways. Efficient systems are
innovative in improving the quality of services in response to changing technology
and changing demand.”

27
600,000.00

500,000.00

400,000.00

300,000.00

200,000.00

100,000.00

-
2010 2011 2012 2013 2014 2015 2016

Sources : PBC (People’s Bank of China)

Figures: Bulk Electronic Payment System in China 2010-2016

According to People’s Bank of China annual report, we find that Electronic

payments maintained their rapid growth momentum. It was gradually increase
from 2010 until 2016. This graph also showed us that banks in China have
succeeded in increasing operational efficiency with the result of increasing use of
electronic payments.

5.4.8 Competition in the banking sector

Competition in the financial sector can be classified as brand competition-

entities offering the same products or services compete with each other, substitute
competition-competition among products that are close substitutes and budget
competition-various products competing with one another given a consumer’s
budget. As banks are the mainstay of the financial system their stability and
solvency is important for ensuring the financial stability of the economy.
Sometimes, this is the justification why unhindered competition may not be
desirable in the banking industry.

28
The competition for local banks comes from foreign banks and private Chinese
banks as the Chinese government prepares to approve more privately owned
commercial banks in the future. The government is expected to approve the
establishment of 10 more private commercial banks in a move aimed at preparing
the sector foe more intense foreign competition.
In China, many of these barriers in banking came from regulatory constraints on
where or how banks could operate. The expectations from financial deregulation
include more readily available bank credit, better compensation for savers for their
bank deposits, bank will become more competitive and innovative, less volatile in
interest rates, competitive pressures will increase and banks will be exposed to
more risks and lower profitability. Competition and entry (barriers to entry) are the
two main factors driving prices down towards marginal costs.

The deregulation of the China’s banking sector has seen the opening up of the
sector to greater foreign involvement. This provides an opportunity for
consolidation of the Chinese banking structure in terms of its competitive
environment. Structural consolidation could see a greater number of mergers or
strategic alliances among local banks and between domestic and foreign banks.
The traditional issues of consolidation arise from the structure-conduct-
performance (SPC) paradigm, the dominant industrial paradigm from the 50s to the
70s. The premise of SCP is that industry performance through the firm conduct is
dependent on market structure, which in turn is a function of basic market
conditions [CITATION Car \l 1033 ]. These basic market conditions include the
conventional supply and demand conditions, informational efficiency and
transaction costs. The structure of the market refers to the degree of concentration,
which determines bank pricing behavior and profits [ CITATION Dun86 \l 1033 ] and
[CITATION Ber89 \t \l 1033 ]. With the increase in foreign bank participation in the
29
Chinese economy, market conditions are bound to change in concentration and
bank profits leading to changes in competition. [ CITATION Gel87 \l 1033 ] and [ CITATION
Spi84 \l 1033 ] study the effect of regulatory reform on bank competition by
investigating the competitive impact of the relaxation of entry restrictions in the
Uruguayan banking industry and conclude that strategic interactions across banks
and across different markets decreased after the regulatory reform.
5.4.9 Foreign Competition

In Australia, the entry of foreign banks and transformation of building societies

into banks resulted in the market were expected to introduce more competitive
over time. However, foreign banks did not make an impact on the dominant
position of the Australian banks in the retail and commercial market. This was
largely due to the large customer franchises that Australian banks had established
through their extensive branch networks.

The Chinese banks recognize the challenges brought about by international

competitors and have responded by lifting their performance by addressing the
competition issues from different perspectives. Recently, Chinese banks have
improved their services in anticipation of heightened competition from foreign
banks. They have improved their services especially in the area of personal credit.
Personal credit amounted to 15 billion Yuan in 2003, accounting for 10 percent of
the total credit extended by banks. Payment services to individual customers by
Chinese have been extended with the promotion and offer of the use of debit cards.
The deposits with Chinese banks have continued to grow at a moderate rate. Most
upgraded banking services occur in urban areas, in response to the competition
posed by foreign banks.

Foreign banks are still bound by regulatory restrictions in conducting business in

China. The level of foreign competition in the Chinese financial market is

30
influenced by the preferred policies to protect the domestic banks. In a free market,
banks are encouraged to compete with each other based on their own strengths;
however, policy-induced competition is more the rule in China.

The bank of International Settlements (BIS) capital adequacy provisions in Basel I

is a standardized approach to prudential regulation and its implementation was
supposedly triggered by the regulatory advantages of the Japanese banks over the
US banks (under the then Glass Steagall Act). Thus, Basel I was more on bringing
about a level playing field amongst globally active banks than to enhance the risk
management systems.

A major structural setback of Chinese banks is under-capitalization. The size of the

captive private deposit base of China’s state banks is the impetus that helps to keep
the banking system afloat given its undercapitalization. These banks will find it
difficult to survive in an open and competitive market. Chinese banks also lag
behind foreign banks in international networks, range of services and modern
management expertise and experience. While foreign banks in China play a
peripheral role in the domestic market accounting for only a small market share of
business activity, they fill an important role in bringing modern financial
management practices to China.

In December 2006, China’s State Council issued the ‘Regulations on the

Administration of Foreign-Funded Banks’ governing foreign banks’ activities as
the next stage in opening China’s banking industry to international competition.
Under the new rules, foreign banks will have to incorporate subsidiaries in China
as wholly- owned banks or Chinese -foreign joint venture banks in order to
participate in the retail Renminbi business and bank card business. These
conditions mean that most foreign banks will have to restructure their operational
structures in China.
31
Most foreign banks prefer to operate through branches or strategic investments of
less than 25 percent in domestic banks (which are not subject to the regulations).
Only a handful of foreign banks have incorporated whollyowned or joint venture
subsidiaries in China. In June 2010, there are over 120 foreign banks operating in
China but they share just under 2 percent of the banking market in 2010.

Foreign banks find themselves restricted in competition for two reasons. First,
foreign banks are restricted to doing business in limited geographical cities thus
cannot compete effectively with local Chinese banks. Second, they could only
conduct Reminbi business for the foreign companies and individuals. At the end of
1999, there were 157 foreign branches in China *. Furthermore, the difficulty of
obtaining a bank license to operate banking services in China resulted in the large
number of foreign bank representative offices. Hence, foreign banks are patiently
awaiting the further deregulation and internationalization of Chinese banking
sector to develop and grow their business.

China’s accession to WTO has seen several favorable conditions becoming

available to foreign banks. They initially include conducting local currency
business with foreign clients in four cities: Shanghai, Dalian, Shenzhen and Tianjin
and offering auto financing to Chinese customers. Subsequently, four additional
cities will be open to foreign banks each year to conduct local currency business
and foreign currency business will be allowed without geographic restrictions.
Foreign banks will be able to conduct local currency business with Chinese
corporations two years after WTO accession and free to conduct local currency
business with corporate and private individuals five years after accession. It is
expected that geographic restrictions on foreign banks will be gradually removed.

Foreign banks operating in China do not rely on implicit government guarantees

for repayment of loans to Chinese companies anymore. This has resulted in foreign
32
banks stopping their lending to Chinese companies, but instead extending credit
mainly to foreign multinationals and Chinese joint ventures with creditworthy
foreign companies.
5.4.10 Current Tax System

China's current tax framework was put in place after the tax reform in 1994
to meet the needs of the socialist market economy. Since the beginning of 21st
century, the Chinese government has made a series of adjustments of and
improvements to the tax system, which have guaranteed the government's revenue
stream and contributed to the country's rapid economic growth.
China’s Financial Markets in the 2000s and beyond (2012) mentioned that
the two main types of taxation applicable to banks are business tax and income tax.
Since the initial launch in 2012, the Value added tax or VAT reform (initially
applying to only a few sectors) has been rolled out nationwide (to replace business
tax, which was a turnover tax imposed on the sale of immovable property, and on
sales of intangible goods and certain services that were not subject to VAT).
Additional sectors were added to the scope of the reform over time (including
railway transportation and postal service as from January 2014; the construction,
real estate, financial services and lifestyle services sectors as from 1 May 2016).
As from 1 May 2016, the scope of VAT covers all goods and services, and
business tax no longer is imposed. China continues its value-added tax (VAT)
reform journey in 2019. The Ministry of Finance (MoF) and State Taxation
Administration (STA) further issued circulars to deepen the VAT reform in China.
Effective from 1 April 2019, VAT rates are lowered from 16%, 10%, and 6% to
13%, 9%, and 6%, respectively. Commercial banks are presently taxed rate with
regard to Income Tax with 25 percent based on profit. The corporate income tax

33
rate on commercial banks is higher than foreign banks. Foreign banks are subject
to a tax rate of 20 percent. (State taxation administration website)
The revenue tax is regarded as having a serious impact on profitability and
hinders the banks in generating sufficient retained earnings to strengthen the
capital base. There is also a tax-based disincentive in the tax deductibility of
specific loan-loss provisions at 1 percent. This has severely discouraged
commercial banks from making adequate provisions that are needed to reflect
their NPLs position and comply with supervisory rules. The tax treatment of loan-
loss provisions would lead to overstatement of profits, which are further subject to
tax. The relatively higher taxes Chinese banks are paying compound the
difficulties they face in capitalizing their balance sheet from theirs operations. The
Chinese taxation policy would also need to be reformed to allow banks better
incentive to make sufficient provisions for bad loans and build their capital base.

5.5 Conclusion
The endogenous growth literature presents much evidence that financial
development is a major determinant of economic growth. The theoretical
underpinning of the relationship between these two factors is based on the
argument that by reducing transaction costs, a well-developed financial system
performs several critical functions to enhance economic intermediation efficiency.
In moving towards a mature market economy, China needs to develop further its
financial markets and the institutions necessary to facilitate effective monetary
policy. China’s strong economic performance requires continuing financial
development that provides for efficient allocation of resources to minimize
microeconomic slacks in order to optimize economic development.

34
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