Still a Long Way to Go for China to attain Financial Liberalization...

What is Financial Liberalization

Financial Liberalization is the process of breaking away from a state of financial repression (which is commonly associated with govt. fixing of interest rates to its adverse consequences on the financial sector as well as on the country's economy). So Financial Liberalization is freeing interest rates, reducing reserve requirements to eliminate the directed credit schemes, while stabilizing the price level. But it is a narrow definition, an obsolete one.

Now, Financial Liberalization also involves easing of portfolio restrictions on banks, changes in the ownership of banks, encouraging competition among banks, integration of domestic entities to international markets and changes in the monetary policy. It includes a freely functioning of foreign exchange markets and eliminating restrictions on current payments and transfers.

What is the state of Banking System in China

(We will be limiting ourselves to the banking system in China after 1949 when the present govt. of People's Republic of China (PRC) came into power.)

Rapid nationalization and consolidation of Chinese banks took place in the initial years of PRC taking over and banking sector was the first sector to be completely socialized. However during the 1980's, banking system expanded and diversified to support reforms. First Stock Exchanges were opened in 1986 which were although small in size of operations like the Shanghai Stock Exchange.

Now lately, Chinese banks are functioning more like banks than before. China's banking system has remained in the government's hands even though banks have gained more autonomy. The People's Bank of China (PBOC) is China's central bank which formulates and regulates its monetary policy. PBOC has full autonomy in applying the monetary instruments like setting interest rates for commercial banks. China Banking Regulatory Commission (CBRC) took over the supervisory role from PBOC in 2003.

The Big Four

There are four mammoth government owned banks in China controlling majority of the money in the financial system of China.

1-      The Industrial and Commercial Bank of China (CBC) is the largest bank in China.

2-      The Bank of China (BOC) specializes in foreign exchange transactions of trade finance.

3-      China Construction Bank specializing in medium to long term credit for long term specialized projects like infrastructure and housing.

4-      The Agricultural Bank of China (ABC) specializes in providing funds to China's agricultural sector and offers banking services to farmers and other rural institutions.

In 1995, the operations of the ‘big four’ were commercialized. These are the first tier banks.

There are also second tier banks in China which are having much better asset quality and profit base. These were supposed to be run by private players but even now, major shareholders of these banks are local governments, and state owned and State controlled enterprises.

There are also more than 200 foreign banking institutions in China but they only play a limited role. Throughout the history of PRC, banking system has exerted close control over the finance and money supply.

Firstly, the interest rates for Chinese banks as well as foreign banks holding the deposits of Chinese citizens are regulated. But from 148 categories of interest rates, only 34 categories now reside under the regulation of the govt. The interest rates for rest are simplified or market driven.

Secondly, at the present indirect financing remains the main channel of financing for business companies. It implies that the stock markets have a very limited and highly regulated role, in case companies want to raise money, where companies (firms) can directly borrow from the public (households). Majorly, they will have to access banks which have all the deposits from general public and borrow the money. Due to this, assets of the banking sector are above 80% of the total assets of the entire financial sector. The BIG FOUR accounted for more than 61% of the loans. Second tier banks have assets somewhere around 14% of the total.

Major Restriction - All govt. departments, publicly and collectively owned economic units and social, political, military and educational organizations were required to hold their financial balances as bank deposits. They were also instructed to keep just enough cash to meet daily expenses. Payments for goods and services exchanged by economic units were only done through banks. “This helped to minimize the need for currency and minimize black money”, is what they say. It meant that besides one’s petty expenses, all other monetary transactions were to be done through banks. Considering that the online banking has just been introduced in China in August, 2010, one could imagine how restrictive and harassing this regulation has been for the Chinese corporations and institutions.

China is slowly de-regulating its banking system to keep pace with the rapid development it is encountering in the past decades. But there is still a long way to go for PRC to become financially liberal and stimulate savings and investments. The sequence of reforms, as in China national policy, is to liberalize the interest rate of foreign currency before that of domestic currency, lending before deposit. Large amount and long term before small amount and short term. As the first step, PBOC liberalized the interest rates for foreign currency loans and large deposits but the interest rates for savings deposits and loans in local currency will still take a long time before being liberalized.

There are still many weaknesses in the regulatory and legal system of China. For eg. there is no legal code to handle bankruptcy of financial institutions nor any regulations governing electronic transactions etc. Beside low capital base of asset quality, banks in China also suffer from poor corporate governance and lack of adequate risk management skill.

I recently saw news on the net that – Chains To Launch New Internet Banking System on August 30, 2010. It will allow depositors to check their separate bank accounts information and make "real-time" inter-bank transfers at one place. It’s mainly online banking system introduced very late in a booming economy hindering growth of commerce. Well.. better late than never.

By- Rahul Bansal
A sincere thanks to Amrita Ma'am for helping me.