Financial Development: China’s experience in an international perspective Vivek Arora

1. Financial Development:China’s experience in an international perspectiveVivek Arora ASIA-PACIFIC FINANCE AND DEVELOPMENT CENTER 2006 BIENNIAL FORUM on FINANCIAL POLICIES TO SUPPORT INNOVATION AND GROWTH Shanghai, September 21-22, 2006 The views in this presentation are those of the author and do not represent those of the IMF or IMF policy.

2. Outline • Financial development and growth • Some general considerations • Aspects of financial development • China’s recent experience and challenges • Conclusion

3. 1 Financial Deepening and Development Financial development and economic development move in tandem. Advanced economies Emerging market economies Developing economies 160 140 120 100 80 60 40 Credit in percent of GDP 20 0 0 20 40 60 80 100 120 GDP per capita (United States = 100) Sources: IMF, International Financial Statistics; and Penn World Tables . 1 Average values 1970–2000. Financial development and growth • Financial deepening correlated with economic development Source: WEO (2004)

4. Financial development and growth (ii) • Direction of causality? Virtuous circle, but on balance: more developed financial sector helps boost economic growth. • More developed financial system—with competition among banks, sound institutions, and developed securities markets—can improve allocative efficiency of investment. • Growth regressions: significant positive impact of financial depth on growth; moreover, impact comes from productivity enhancement.

5. Financial development: Competition as the facilitator of innovation Competition is the facilitator of innovation. And…the process by which less-productive capital is displaced with innovative… technologies is the driving force of wealth creation. Alan Greenspan, 2002

6. Financial development: aspects • Banking sector that efficiently intermediates savings, and is well supervised/regulated. • Commercial orientation (diversified ownership helps), risk management, internal controls, governance. • Capital (equity/bond) markets: • contribute to long-run growth (Levine, 1997), • provide efficient saving vehicles for retail and institutional investors, helping to diversify financial holdings. • increased diversity of funding sources can improve robustness of financial system to shocks (REO, 2006).

7. China’s experience

8. Investment level and efficiency • Compared with other countries, China’s investment rate is high. • But allocative efficiency may be low: • Private enterprises contribute ½ of GDP but account for only ¼ of bank credit (Tran, 2006). State enterprises contribute 1/5 of GDP but account for 2/3 of credit. • Marginal productivity of capital has fallen over time, from 16% in early 1990s to under 13% in 2004, suggesting that efficiency of investment is declining (IMF 2005a). • Suggests scope for intermediating savings more efficiently.

9. Dominance of bank lending • In Asia as a whole, bank credit accounts for nearly ½ of total financing, compared with less than 15% in the United States. (Although Euro area, at 40%, is closer to Asian levels.) • But China’s financial sector is bank-dominatedeven relative to other Asian countries. Bank credit (140% of GDP) accounts for 2/3 of total financing.

10. Equity capitalization and corporate debt stock Source: McKinseyGlobal Institute Global Financial Stock Database; McKinsey Global Institute China’s equity and debt markets are relatively small

11. Enterprise financing • Enterprises finance about 90% of investment from internal funds (around 50%) and bank loans; almost none from bonds. • Developing bond/equity markets could improve intermediation and increase incentives for banks to lend to SMEs. • Expanded bond market would help lower need for internal financing by enterprises.

12. Implications of reform • Wider range of household credit instruments can increase access to financing by small businesses (Tran, 2006). • This, and more diversified portfolios, can help households to smooth consumption. • Consumption-smoothing and external corporate financing helpful for rebalancing demand, a key macroeconomic imperative.

13. Reform experience • Authorities placing emphasis on improving financial services to support sustainable economic development (Governor Zhou, 2005). • Bank reform at forefront of strategy. Significant steps have been taken, including: • Financial restructuring of CCB, BoC, ICBC completed • Rural credit cooperatives being reformed, • Bank supervision being strengthened. • At the same time, some progress in development of capital markets.

14. Equity market development Equity market development: • Easing restrictions on sale of government shares in listed entities, • Allowing IPO pricing to be more market determined, • April 2005 reform launched to convert state-owned shares to tradable shares in listed companies, • Streamlining financial requirements for listing, making it easier for small firms to list, while strengthening disclosure requirements. But, like in several other emerging markets, liquidity is still low and trading concentrated. Equity as a share of total financing is lower in China (1/5) than in Asia as a whole (1/3) and in the United States (nearly 40%).

15. Bond market development Progress has been stronger at the short than at the long end. • Like in many Asian countries, China’s bond market is dominated by the government sector. • Corporate bond market is shallow and illiquid: even more so than in other countries (although comparable to India). • Underdeveloped local institutional investor base and regulatory impediments (over-regulation, regulatory cap on corporate bond rates) hamper development. • Special working group established in February 2004 to improve regulatory practices. • But, until market system and corporate governance improve, bond issuance likely to remain controlled. • At the short end, significant progress in 2005, as PBC: • opened short-term corporate bills market, • established interbank market for asset-backed securities.

16. Conclusion • Financial development positively associated with growth. • China’s investment rate is high, but allocative efficiency less so. • Financial sector can play a role by intermediating savings more efficiently. • China is making progress in various aspects of financial sector development (particularly bank reform) but challenges remain.

17. References • Greenspan, A., 2002, “Regulation, Innovation, and Wealth Creation,” Remarks before the Society of Business Economists, London, September 25. • International Monetary Fund, 2006, Asia & Pacific Regional Economic Outlook. • _____, 2005a, People’s Republic of China: 2005 Article IV Consultation, IMF Country Report No. 05/411, November. • _____, 2005b, Global Financial Stability Report (September), Chapter IV, “Development of Corporate Bond Markets in Emerging Market Countries.” • _____, 2004, World Economic Outlook (April), Chapter 4, “Are Credit Booms in Emerging Market Economies a Concern? • Levine, R., 1997, “Financial Development and Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35 (June). • Rajan, R., and L. Zingales, 2003, Saving Capitalism From the Capitalists (New York: Crown Business Publishers.) • Tran, H., 2006, “Financial Sector Reforms in China and India,” Remarks at Conference on Recent Research on Hedge Funds, Northwestern University, August. • Zhou, X., 2005, “Speeding up Financial Reform to Support Economic Development of the West Region in China,” speech by Governor Zhou at the High-Level Forum on Economic Development and Financial Services, Chongqing, November 15.