reforming china’s financial system

Ranga Wimalasuriya 06/06/2012

REFORMING CHINA’S FINANCIAL SYSTEM: SUSTAINING PRIVATE SECTOR GROWTH

Introduction

The Chinese economy has been growing exponentially for over two decades with growth

rates averaging 10% since the Asian Financial Crisis of 1997. In the process, the economy has

flirted with deflation (1998-99, 02-03, 08-09), high levels of inflation (2007-08, 2010-11),

negative real interest rates (2008-9) and low lending rates averaging 5-6% (2010-11). The

negative real interest rates signify negative real rates of return on savings for depositors and the

majority of households that are responsible for a major share of China’s capital account.

Fig.1 China’s GDP growth Fig .2 Interest Rates

China’s transition from a centrally planned to a market based economy has brought

about significant changes. However, there is a common perception that the hierarchy of China’s

financial system has not aided this change and that deep structural problems are prevalent

within the system. Mckinsey Global Institute stated that the access to credit for individuals and

SMEs in China is far below other developing countries (Mckinsey Global Institute 2009,25).

Some academics have further concurred that “China lacks [the] infrastructure of modern


consumer finance, and is years or possibly decades-away from building it to the standards of

the developed world” (WSJ, 2011).

The existing financial institutions, however, fail to efficiently allocate domestic capital to

the private sector (Small and Medium Enterprises) is an issue which curtailed private sector

development according to existing literature. Access to finance plays an important role in

private sector development. The ability to start, expand and innovate for SMEs depends on

finance sector support. SME financing may be affected by a range of factors. These include the

actions of the banking sector which likely to be more inclined to fund State-owned Enterprises,

the size of the SMEs and stage of its growth which may have implications on its ability to

obtain financing and a lack of collateral SMEs offer for financing.

Small enterprises- those firms that employ fewer than 300 people, earn less than 30

million yuan and have assets less than 40 million yuan and Medium enterprises- those firms that

employ 300 to 2,000 people, have annual sales of 30 to 300 million yuan and own assets worth

40 to 400 million yuan, in spite of financial constraints, SMEs are a significant component of

China’s economy. They have shown exponential growth in the last decade with over four

hundred thousand SMEs operating today ( NSB, Fig 3.). The SME sector produces 68 percent

of China’s exports, over 50% of China’s Gross Domestic Product and 80% of Chinas urban

employment ( Zhu, Wittmann, Peng, 2011). SMEs, therefore, are central for the growth and

development of a country as they expand as large corporations.


Fig.3

Source: National Statistics Bureau

A study done by Standard Chartered Bank found on average, that the SME sector

accounted for 16 percent of GDP in low-income countries, 30 percent in middle-income

countries and 51 percent in high- income countries; suggesting that SMEs increase in

importance as an economy develops. A report from the Chinese Technology Innovation Beijing

center (CTIBJ) suggested that 68% of SMEs would close down in their first five years in

operation, 13% will exceed 10 years of operation (CTIBJ,2008) and 19% of SMEs faced with

bankruptcy in 2011 with 70% of SMEs facing financial constraints (British Embassy Beijing,

2011).

This paper attempts to analyze the growth of SMEs over the last decade and track the

flow of capital and sources of capital into the private sector despite claims of capital constraints


in some source of existing literature. The paper will then draw on a comparative assessment of

the China’s financial system and India’s financial system and identify how each system has

addressed the issue of capital constraints in the private sector.

Literature Review

An Overview: China’s Financial System

Fig .4 China’s Financial Institutions

Source: China Statistical Year Book

China’s financial system is comprised of a state dominant banking sector and weak

capital markets. The banking system has evolved rapidly since the 1990s. In 1979, the system

was solely represented by the People’s Bank of China (PBOC) which acted both as the central

bank and was further responsible for deposits and loans (Linton, IMF). Presently, the banking


system consists of the “Big Four” state owned commercial banks (SOCBs), policy lending

banks, joint stock commercial banks, city banks, rural and urban credit cooperative (RCCs) and

foreign banks (Fig 3). The big four and the joint stock commercial banks (JSCBs) remain the

dominant players and principle lenders to SOEs and are subjugated by government shareholders

and management. All major banks along with the City Commercial banks (CCB) and the Rural

Commercial Banks (RCB) have been converted into corporate entities subjected to a board of

directors and supervisors (Herd, Pigott and Hill). JSCBs, according to Naughton (2007), are

more efficient and hold considerably lower amounts of nonperforming loans (NPLs) and they

have captured 15% of the total banking-system assets as of 2008. However, their effectiveness

is constrained due to a lack of independence and experienced officials. Former government

officials still operate within senior management acting as a hindrance for efficient banking

(HPH). The policy banks were established to fund the central or local governments for

infrastructures and development projects and lend to SOEs and account for 8% of total assets as

of 2003. RCCs, once banking profitable TVEs in the countryside, fell out of favor following the

Asian Financial Crisis. Since 2006, the government has pumped capital into RCCs as a part of

the urban financial bailout (Naughton). Foreign banks, however, play a minute roll in China’s

capital markets even though the government gave access to start-up “private banks in “20

localities”. (Naughton, Linton).

The big four account for 53.5 percent of the total assets of financial institutions

(excluding the people’s bank of China) as of 2004 with joint stock and city commercial banks

which claim 20.7 percent, RCCs claiming 8.9 percent of the assets and Policy Banks with 7.7

(Naughton). Showcasing that 90.8 percent of all assets are controlled or under the watch of the

central government with 9.2 percent belonging to foreign and private banks (fig.5).


Fig 5. China’s major banking institutions, no of institutions, share of total Assets & share of total Loans, Dec, 2005

Linton claims it is this lack of independence in China’s banking system that has resulted

in the banks focusing on financing needs of the government, SOEs and construction firms over

the last decade. Allen, Qian and Qian(2004), compare the financial systems of a sample of

countries (English origin, French origin, German origin and Scandinavian origin) to that of

China. They find that the ratio of total bank credit to GDP is 1.13, higher than German-origin

countries which are known to have heavy bank-dominated financial systems. However, when

they consider bank credit issued only to the private sector (individually owned or publically

traded companies) China’s ratio drops from 1.13 to 0.242 (Fig.6) reflecting the flow of capital

to the public sector (state-owned companies). The second panel of Fig.6 compares the relative

importance of financial markets against banks. “Structure activity” and “Structure size” are

relative size measures which are equal to Log (market size/ bank size), with a smaller value

indicating that the country’s financial markets are small than its banking system; China has the

lowest score suggesting that its banking system is larger than its markets. A World Bank


quarterly report cited that the recent most stimulus money is directed to benefit SOEs. This is

partly due to the method in which state ownership is distributed in the economy. Most SOEs

claim to have close relationships with the government and banks. SOEs have benefited from the

stimulus injected (The Economist, world bank.org).

Fig .6 Fig.7

While China’s banking system is dominant, its stock and bond markets remain

underdeveloped. They are smaller than most countries in terms of market capitalization and

total value traded as a percentage of GDP (AKM) and total equity market capitalization is

equivalent to 17 percent of GDP when compared to the average of 60 percent in other emerging

markets (Farrell et al. 2006).

The equity markets are largely controlled by the government and act as a platform to

raise capital for SOEs that require privatization. Listed companies and IPOs on the stock market

are former SOEs that are affiliated to government officials. The bond market lacks confidence

Source: Wall Street Journal


due to a deficit of institutional investors or a reputed credit agency that offers the investor

confidence to buy in. Large companies, therefore, “prefer borrowing from banks rather than

issuing bonds”. Such actions could crowd out the ability for Small and Medium enterprises to

borrow (AKM).

SMEs

Mu (2002) cites that post-Asian Financial Crisis events left the banking sector with a

signifcant number of NPLs which average 30 percent of assets. He claims that this situation

arose because loans were given out based on preferential treatment to inefficient SOEs and are

further supported by unpaid principal and interest and below- market interest rates. Lending

rates to SMEs were additionally set artificially low which led to rates not being attractive

enough to encourage banks to lend out to SMEs, particularly when banks had high NPLs. This

issue was addressed by the establishment of credit guarantee schemes (CGS) which Mu claims

were helpful in promoting SME’s access to finance since they provide acceptable collaterals and

assist in the mitigation of the poor credit analysis SMEs will otherwise face. However, CGS

face much interference from local governments making it unable to operate in “accordance with

market principles”.

Zhao et al (2006) using a dataset from the Chengdu SME Administration (CDSMEAB)

from 2003 to 2004 identified some main factors affecting SME’s access to capital as the lack of

eligible collateral for loans or guarantees, low credit ratings or a lack of credit reporting system

for SME, firm sizes (economies of scales)- the banks prefer to lend out to larger-sized SMEs-

and political risks faced by bank staff in case of failure to repay loans.


Prasad (2007) suggests that the banking system should be made more robust and driven

by market principles but he does not specify how his ideas maybe integrated. According to him,

the financial system should be broadened to create alternate sources of funding and investment

opportunities for individuals and SMEs.

Wang (2004) identifies the scarcity of capital, the lack of specialized financial institutions

to serve SME reform, lack of direct financing channels and the monopoly of state owned banks

as reasons for capital constraints in the private sector. As solutions, he suggests that “China

should increase the overall volume and credit proportion for SMEs”, especially bank credit,

develop small and medium financial institutions and reform RCCs so they can be independent

and adopt a flexible interest rate system. Wang’s countermeasures are explained in detail;

however, he has not cited examples of how effectives his proposed measures will be and it is

unclear whether such policy actions will be effective if China should implement them.

On the contrary, Lardy claims that the access to capital especially with regard to

households and the private sector has risen dramatically. In his structure of household

borrowing from banks, the total loans outstanding to households stood at RMB.11, 258.6

Billion (PBOC), 225 times higher than what it was in 1997. He claims that a majority of the

household loans extended were for business borrowing- 33.3 percent; bank loans to households

stood at 28 percent of GDP more than 45 times the share at the end of 1997. This significant

improvement in capital allocation will help family businesses expand and household

consumption increase. Lardy further states that “China is an outlier on the high side in terms of

consumer credit availability” in comparison to emerging markets. Although his account of

capital access to households is comprehensive and positive, he hardly analyzes this from an

SME perspective. He does not explicitly breakdown household business borrowing and we do


not get an account of what kinds of businesses these household seem to run. He also fails to

analyze other sources of financing such as FDI and the informal loans market that the private

sector seems to rely on.

In addition to the question of capital constraints, existing literature has cited domestic

SMEs could also be facing a problem of consumption (WSJ 2012). This being the case, SMEs

that are not export oriented will face many difficulties operating due to lack of demand from

domestic customers, driving them out of business. China needs to reallocate capital towards

producing goods and services that Chinese consumers want to consume and this will require

banking changes, especially improving access to capital for SMEs that “make the modern

consumption-driven economy tick”.

The aim of this paper is to identify the characteristics of capital allocation to the private

sector, specifically SMEs in China. It will attempt to track the flow of capital from its origin

(e.g. households) to China’s financial system and other financial institutions that act as

intermediaries for capital allocation to SMEs; and analyze both direct and indirect sources of

financing that have helped firms grow exponentially over the last decade a gap that is present in

current literature related to the topic.The paper will then evaluate four important reforms that

standout from the existing literature: less government control over the financial system

“breaking up the monopoly”, liberalizing interest rates, regulating the informal loans market and

a credit rating system.


Characteristics of Chinese Capital: Formal Financing

Fig .8

A major source of capital for formal financing arise from household savings, enterprises

savings and government savings. Fig.8 Shows the gross domestic savings in China has increased

since 2000 and comprises more than 50 percent of Gross Domestic Product. Household savings

on aggregate has risen by 6 percentage points over the last 10 years (Prasad and Chan). Chinese

household’s savings rate has continued to increase over the last decade and this is despite a

negative real return rate from the banks. According to Prasad and Chan, this unstoppable

increase in savings or the target savings by households is due to declining public provisions such

as health and education; other factors include the presence of a target savings rate due to China’s

transition to a market economy. A high savings rate such as that depicted by the Chinese

economy may not be beneficial for domestic SMEs that depend on local demand and

consumption for their operations. If the trend continues, China’s economic expansion will slow

down and China’s attempts to adopt a consumer driven model by moving away from an exports

or investments driven model will suffer.


Capital Allocation Cycle

Fig.9

Source: China Statistical Yearbook

Fig. 8 and 9 depicts how dependent formal market financing is on the savings of the Chinese

public. Fig.9 shows the big picture of capital allocation within the Chinese economy. The high

household savings rate contributes a major share of the overall capital allocation within the rest

of the Chinese economy. Household savings, enterprise savings and government savings made

up 78% of the total formal market loans made out in 2005. Government bonds, corporate bonds

and stocks made up the remaining 22% highlighting China’s weak capital markets. The big four

banks are responsible for over 50 % of the total loans made out with foreign banks holding just

1.6%. Clearly, this divide seems to favor SOE funding given the authority the big four hold over

the rest of the financial system.

Shadow banking and the informal loans market hold 30% of all the loans made out and is

therefore an important segment of China’s private sector financing. AKK using a data set of

Stocks

6%

Shadow banking / informal loans market

• 30% of all loans made out

Corporate Bonds

6.4%

Banks & share of Total Loans- formal market

• The BIG Four 50.5%

• Joint Stock Commercial banks 15.4 %

• City Commercial Banks 5.2%

• Urban Credit Cooperatives .5%

• Rural Credit Cooperatives 8.9%

• Policy Banks 15.4%

• Foreign Banks 1.6%

Central Government

SMEs SOEs

Government Bonds

9.5%

• Household Savings

• Enterprise Savings

• Government Savings

78%

Individuals,

households


twenty four hundred firms found that 43% of firms in China used alternative forms of finance

compared to an average of 9% in emerging markets and Allen, Qian and Qian claimed that the

fastest growing Chinese firms used alternative channels of finance rather than formal financing.

Fig 3 compliments these findings with the growth shown by both small and medium enterprises

over the last decade despite poor access to formal finance.

The following sections will analyze the sources of financing and analyze both direct and

indirect sources of financing that have helped firms grow exponentially over the last decade and

the methodology will present how I went about conducting my research.

Methodology

The aim of this paper is to identify the characteristics of capital allocation to the private

sector, specifically SMEs in China. There are different sources of funding that domestic firms use

for daily operations or expansion. In the formal market, retained earnings is the cheapest source of

capital and can be implemented without any external constraints, domestic loans from a bank is

the second cheapest source of capital and fundraising through bonds/stock market is relatively

more expensive source as equity is costlier than debt. Funding can be categorized into two types-

Informal and Formal financing. Formal financing includes bank financing through local

commercial banks and foreign commercial banks, state budget and debt financing through

China’s capital markets. Informal financing refers to “internal finance”- retained earnings, loans

from a family or friend and financing from an underground bank.

I will use data drawn from the China statistical year book from 2000-2010, a data set

obtained from Dr.David Hall and the investment climate survey conducted by the world bank in

2006 for my analysis. Part 1 explores the macro level climate of credit allocation to the private


sector in China. Part 2 will attempt to identify the various channels of financing (both informal

and formal ) and the share of each channel regarding firms. Part 3 analyzes total investment in

fixed assets across firms; this will enable us to distinguish the types of firms that have expanded

over the last four years relative to the type of financing and part 4 analyzes capital allocation on a

regional and categorical level.

Analysis part 1

Figure 1 depicts the domestic

credit extended to the private sector in

the form of formal loans as a % of GDP.

The graph gives us a general idea of

how strict capital allocation is within

the private sector with relation to

public vs. private credit allocation. This

graph also accounts for housing loans

as a part of private sector investment.

The data does not give a break down of how this credit is distributed within the private sector on

a firm level( small, medium and large enterprise), industrial level or a regional level. The

horizontally connected lines compare China to the United States, Spain, Germany and India. The

annual World Development Indicators (World Bank, 2004b) in 2002 summarized domestic

credit provided by the banking sector in middle-income countries to be 83 percent of GDP, 49

percent of GDP for low-income countries and 168 percent of GDP for high income countries.

Domestic Credit extended to the Private sector as a % of GDP

Source: The World Bank . Fig 1.


Ignoring the variables not addressed in the data, China and Germany seem to be on par at 150

and 130 percent of GDP respectively with the United States and Spain close to 230 percent and

India below 100 percent of GDP. The level of domestic credit extended to the private sector for

China being on par with Germany is an encouraging prospect ignoring the variables not

addressed by the data.

Analysis Part 2

In Figure 2. the horizontally connected lines represent how each source of funding is

distributed amongst China’s firms with regard to investment in fixed assets. There are four

sources of funding for investment in terms of fixed assets in China: State Budget, Domestic Loans,

Foreign Investment (FI) and Self fundraising; the sources of funding can differ from country to

country. The State budget was a significant source of financing in the early 90’s with SOEs

heavily dependent on the State budget for operations and the Chinese economy following a

centrally planned system. As of 2009 the state budget accounted for only 5.1 percent of the total

and this maybe due to a result of the Chinese government refocusing spending on education,

healthcare and military defense. Foreign investment refers to foreign funds acting as a source for

domestic firms to invest in fixed assets and is not a measure of foreign investment in ownership

form. Foreign investment sources has reduced to 1.8 percent as of 2009. The two prominent

sources of funding are self-fundraising and domestic loans.

Domestic loans in aggregate occupy 15 percent of the total financing and constitutes 30

percent of financing in large companies (Fig.5). Domestic loans since 2000 have grown at a

CAGR of 19.21%. Self-fundraising comprises of retained earnings, informal loans, funds raised

from local communities ( family and friends) and local governments. Self-fundraising is the


largest source of financing accounts for 77 percent of the total. Self-fundraising is an important

source of financing for many types of firms and it involves both individually owned companies

(private sector) and interestingly state or quasi-state-owned companies as well. An interesting

observation of the data is the downward trajectory of the state budget as a source of funding; this

may have led to increased self-fundraising and might lead to increased foreign investment in the

future.

Analysis part 3

Given we have an understanding of the sources of funding within China’s financial system from

part 2 it will be worthwhile to analyze the categories of firms affected by these sources. The

following figure illustrates the distribution of fixed asset investment in China across firms. Fixed

assets are long-term tangible pieces of property like buildings, real estate, equipment and

machinery that a firm may use in the production of its income. An account of fixed asset

investment across firms will help distinguish the firms that have expanded over the last four years.

Source: China Statistical Year Book, Fig.2


The blue bars represent the total investment value in 100 million Yuan and the horizontally

connected lines show the different categories of firms. SOEs and LLCs seem to have invested the

most over the last 5- years with a CAGR of 19.95% for SOEs. The share of investment for private

enterprises has increased whilst the share for individuals have declined. Foreign firms with funds

mostly from Hong Kong, Macau and Taiwan account for about 7% of the total.

The large share of fixed asset

investment by SOEs indicate the

expansionary path SOEs have taken

over the four year period. This could

be a result of the stimulus package

that was extended by the Chinese

government, better access to

domestic loans through the banking

sector or profits raised through self-

fundraising.

However, construction (property) and infrastructure are two sectors that the Chinese government

has invested a lot of capital in over the last decade and most large construction companies, steel

and cement companies are SOEs. This is could mean that SOEs are directly benefited from this

surge in construction and are therefore served with easier access to capital.

Source: China Statistical Year Book. Fig.3

Source: China Statistical Year Book Fig .4


Figure.4 shows the total amount of short loans from the total loans markets given out to

township-village enterprises, enterprises with foreign funds and private enterprises and self-

employed individuals. Freedman et. al (2006) cites that bank lending to SMEs ( private

enterprises and self-employed individuals in fig 4.) in developing economies mostly comprise of

short-term loans . This is because banks make lending decisions based largely on the value of

assets pledged by a borrow rather than a borrower’s expected revenues and cash flows. In Fig 4.

the ratio (d/a) of short term loans to private enterprises and self-employed individuals depict that

only 5% of the total short term loans are distributed to the segment. However, there seems to be

a rise in short term loans from 2% in 2005 to 5% in 2009.

Analysis Part 4

Parts one, two and three analyzed capital allocation to the private sector from a macro level ,

firm level and attempted to evaluate the distribution of short term loans for private firms and

SMEs. Part four will address the level of capital allocation across regions in China; a regional

comparison will help us determine the overall efficiency of capital allocation in China.

In Figure.5, Allen et.al (2005) and Ayagari et. al (2007) conducted studies on the types of

financing within firms across the five regions- Central, Coastal,Northeast, Northwest and

Southwest in China and Figure 5 portrays some of the patterns they inferred. Allen et. al

categorizes financing to Bank Financing and Self- Fundraising; they find that 20.63% of the

financing is drawn out of bank loans and 79.37% through self- fundraising. Ayagari et. al

further breakdown the 79.37% of self-fundraising across regions. Central and Northwest

regions that are inland seem to have the highest percentage of self-fundraising firms. The


Source: Allen et.al (2005) and Ayyagari et. Al (2007), Fig.5

Source: Allen et.al (2005) and Ayyagari et. Al (2007). Fig.6

Coastal and Southwest with better access to ports, tax arrangements and favorable policies show

a higher percentage of bank financing for firms (Ayagari et. al).

Micro, small, medium, large and very large firms are categorized according to their financing

patters in Figure 6 according to Allen et al (2005) and Ayyagari et. Al (2007). Large and very

large firms (30%) seem to use more of Bank financing than the Small , Micro and Medium

enterprises (14- 15 and 22%). Internal financing (self fundraising) seems to be the largest source

of funding across all firms with even the Very large firms (majority of them SOEs) taking up

55% of the total.


Discussion

Micro, small and medium enterprises are more restricted from formal financing than the

large and very large firms (fig 6.) This could be affiliated to the growth stages of the firms with

start-up firms (mainly comprising of small firms) receiving less formal financing due to the

financial system’s lack of a credit rating systems,strong relations with small enterprises or the

inability to better understand the business. Formal financing also requires collateral as fixed

assets and this is a hindrance for a start-up firm or medium enterprise in China. In addition, the

People’s Bank of China over the last three years has hiked reserve ratios and tightened loan

quotas, limiting liquidity in the loan market. The PBC also maintain a ceiling on interest rates

and strict interest rates fail to reflect risks of lending to SMEs from a lender’s standpoint, thereby

restricting banks from lending to SMEs.

This restriction on formal lending has resulted in the increase of self fundraising (retained

earnings, informal loans, family and friends) as a source over the last decade (Fig.2) with both

SOEs and SMEs contributing to its growth in two different ways. Restrictions on capital flow in

the formal financing market has led SMEs resort to self fundraising through retained earnings,

informal loans and family with most firms taping into the informal loans market. SOEs that are

mainly large construction companies on the other hand has taken up the lending practice

(because of their access to easy capital) in the informal loans market to serve SMEs (that are

mostly small property developers) that are restricted to capital from the formal sector. This has

resulted in the expansion of informal lending institutions and evidence of this is seen in Fig.2

with self-fundraising increasing as a source from 70 percent to 80 percent over the last six years.

According to a Credit Suisse report, 60% of the informal lending has been channeled into the

property sector with the biggest borrowers being small and medium size real estate developers.

The informal loans market accounts for nearly four Trillion RMB or about 8% of the formal


lending market with interest rates ranging among 14% to 70%. SOEs gain funding through high

interest rate loans offered to SMEs in the informal loans market and SMEs gain funding through

informal loans supported by SOEs; it is a cycle if not regulated could result in a credit crunch

that could significantly undermine China’s growth and investor confidence.

Based on the evidence presented this paper will suggest four reforms that will help the

financial system address the concerns stated above: less government control over the financial

system “breaking up the monopoly”, liberalizing interest rates, regulating the informal loans

market, a credit rating system.

Suggested Financial Reforms in China

1. Reducing government control of the financial system

Continual government intervention has restricted SMEs access to finance despite the reforms that

have taken place over the last decade.A possible solution would be to increase the PBOC’s

independence from the government to improve SME financing, privatize the four large-state

owned that control nearly 50% of total assets and reduce government control in equity markets.

Increased independence for the PBOC will restrict the authorities from interfering in lending

behavior of commercial banks especially through political appointments to high positions.

China’s equity markets have made considerable improvement over the last decade but further

liberalization to allow public companies access to equity markets and less government entities

will be beneficial to SMEs seeking funding.


2. Liberalize interest rates

Liberalizing interest rates is the process of replacing state-controlled interest rates with

market-based interest rates. China’s interest rates are extremely low and currently yielding

negative real rates of return to savers and hampering SMEs financing from the formal market.

China’s major state-owned banks sit on high profits and nearly 80 percent of it comes from

interest earnings. The liberalization of interest rates will help free up deposits and lending rates

and allow banks spread risk when allocating loans to high risk SMEs that are in need of formal

financing. Secondly, should China liberalize interest rates, it will allow its equity markets and

especially the bond market to develop which is an additional channel of financing for SMEs.

Hence, interest rate liberalization is an essential step for the Chinese economy if SME financing

is to improve.

3. Regulating the informal loans market

The Chinese Banking Regulatory Commission which regulates banks estimates the size

of the informal lending market to be between $500-$800 Billion. Informal loans market is a

significant component of “Self Fundraising” that takes up nearly 80 percent of all financing for

firms. It is an important component of the Chinese financial system and it must be standardized

and brought into the open with clear legal safeguards. The process of regulating could involve

issuing licenses to private lenders and imposing deposit collection and capital requirements and

a cap on the interest rates offered. If the informal loans market is not regulated it will continue to

“eat away at the depositor base of the big banks” (Lardy, 2007).


4. A credit rating system

The Chinese financial system has no credit rating system and often fail to identify a

businesses' credit worthiness; this makes financing difficult for SMEs as they are not well known

firms or maintain no close relations with the bank. Furthermore, the banking staff is also under

pressure given the amount of non-Performing loans that already exist in the banking sector.

Some innovative banks have resorted to analyzing a firm’s cash flows, import or export customs

declaration form and water meter bills to verify activity and this is an option that could be

introduced to the entire banking sector.

Conclusion

The Chinese financial system has undergone many significant changes over the last

decade but SME financing and efficient capital allocation to the private sector remains a problem.

The recent financial crisis has increased the informal loans market and deteriorated formal

financing. Structural problems within the financial system has restricted efficient capital

allocation; these structural problems involve government control of the financial system,

interest rate ceilings, an unregulated informal loans market and the lack of a credit rating system.

It is essential that the Chinese government address these reforms above others if they are to

strengthen its financial system. Reducing government control from the state dominating banking

system and equity markets will require a lot of effort and may be a gradual process but it is

essential that steps are taken to regulate the informal loans market and liberalize interest rates

since China is a growing economy.


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vol.8.- (2011): -. Print.."IMF Working Paper -.- (2010)

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(2009): -

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IMPLICATIONS FOR EUROPE." CEISfo-.- (2007):

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financial-system

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(2011

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street-journal/wenzhou-reforms-point-to-cleanup-of-chinas-financial-system/story-fnay3ubk-

1226313201030>.


Table 1: Definition of Financial Intermediaries/Institutions in China


Source: Law, Finance, and Economic Growth in China


-

reforming china’s financial system

Documents

chinas financial system

growth of smes

indias financial system

banking system

sme sector

rates chinas transition

city banks

major banks