THINK TANK | Lessons from China on Financial Development and Stability

A huge strategic challenge confronting the China (PRC) is how to transition toward a more market-based and efficient financial system without disrupting financial stability.

By Asian Development Bank

Image Attribute: The Lujiazui financial district of Pudong, Shanghai, the financial and commercial hub of modern China / Wikipedia /  CC BY 3.0

A huge strategic challenge confronting the China (PRC) is how to transition toward a more market-based and efficient financial system without disrupting financial stability. Drawing lessons from the PRC experience for the rest of Asia is difficult because of its unique financial system. In particular, the PRC financial system is set apart by having grown very large relative to GDP at an early stage in economic development (Figure 1)

Figure 1: Credit to GDP and per capita GDP, 2013 

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Nevertheless, as many other Asian economies share with the PRC a quest for smooth and stable financial development, its experiences hold valuable lessons for the rest of the region. And, like the PRC, some Asian economies have achieved relatively high financial development as measured by quantitative indicators but now faces more difficult challenge of improving the quality of financial intermediation.

Figure 2 : Share of banking assets held by entities more than 50% state-owned, 2010

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Several useful lessons can be drawn from the PRC experience to inform other Asian economies implementing financial reform. The first is that it is possible to rapidly improve the efficiency of state-owned banks, which remain important in many Asian countries (Figure 2). State-owned banks in the PRC went from being technically bankrupt in the late 1990s to earning large profits less than a decade later. The turnaround required a large injection of capital from the central government and indirect support to offload bad loans to asset management companies. But reform went much further than a simple bailout. State owned banks dramatically retrenched their staff and branches to boost efficiency. An independent banking regulator was established, and a separate body was created to manage the state’s equity interests. The banks brought in strategic foreign investors and sought listings on international exchanges to reinforce improved corporate governance. The result of reform was a dramatic increase in the operational efficiency and profitability of commercial banks in the PRC (Table 1).

Table 1: Bank performance in the People’s Republic of China versus the G-20 average (%)

The second lesson from the experience of financial reform in the PRC is that an incremental approach can have unintended consequences. The authorities in the PRC soundly rejected the big bang approach to financial reform advocated for many developing countries in the 1990s. In the wake of the collapse of many economies following the dissolution of the Soviet bloc, and the turmoil in Asia during the Asian financial crisis, the PRC approach of slow and incremental financial reform seemed vindicated. However, the slow progress of many financial reforms, most notably on exchange rates and the liberalization of interest rates on deposits, has created adverse side effects. The glacial pace of interest rate liberalization has given rise to an unsustainably large increase in credit and the creation of a large shadow banking system. Measured and incremental financial reform may be preferable to overnight liberalization. However, the lack of reform can also create risks within the financial system.

The final lesson to be drawn from the experience of the PRC is the difficulty of rooting out implicit guarantees and moral hazard in a financial system that is dominated by state-owned actors. The PRC has one of the largest banking systems in the world, yet it is only now in the process of creating a deposit insurance system. The Government of the PRC therefore, faces a large implicit liability. Even worse, depositors assume that banks will guarantee returns on a variety of other financial products, such as trust and wealth management products, without regard for whether the issuing bank has any legal responsibility to guarantee anything. The government is, therefore, the ultimate guarantor of these products as well. What is required to meaningfully reduce moral hazard are a paradigm change in the approach of regulators and the introduction of private financial institutions that are allowed to fail.

This article is an excerpt from Asian Development Outlook 2016, Subregional Coordinators, Christopher Hnanguie and Dominik Peschel for Central Asia, Yolanda Fernandez Lommen for East Asia, 2015  ASIAN DEVELOPMENT OUTLOOK 2015 FINANCING ASIA’S FUTURE GROWTH. © Asian Development Bank [and/or Publisher]. https://openaccess.adb.org/ Available under a CC BY 3.0 IGO license.