Journal of Financial Economics

REF 102 Chinese Finance

The 12^th five-year plan is going to bring huge changes in the Chinese economy, on its inside structures as well as on its international economic relations. The contribution of the financial sector to these changes will be important. Inside China, sustainable growth will require to free the financial services industry but also to implement a major fiscal reform along with a new configuration of power within the Party. As for the international aspects, the new convertibility of the Yuan for non residents will pave the way for a major role of Hong-Kong and China in the future reshaping of the international monetary system.

It seems that China is trying to reach simultaneously the three objectives of Mundell’s triangle of impossibility: free-moving capital, fixed exchange rate and autonomy in monetary policy. But, even if international capital flows are controlled, they remain nonetheless very important. In order to reach the three objectives, China has to get round the triangle by accumulating huge foreign exchange reserves and by controlling credit with quantitative measures that lead to distortions between the market interest rates and the regulated interest rates.

Today’s China and its economic governance are facing a lot of questions. Understanding Chinese’s banking system, its structure and its regulatory framework give us the chance to better apprehend the country’s economic system. This system has undergone and is still undergoing major reforms. It was entirely dependent on the policy under the communist regime, and since the opening, the country has gradually adapted to international standards. Its structure has evolved and banking laws are modelled gradually to global agreements. However, the Chinese banking system is still under the domination of the government at all levels. Is the banking system really being adapted to international norms or is it just an illusion? What is the scope of the government to continue its reforms?

China’s banking system has performed extremely well during the last few years both compared with its peers in the West but also with its own situation only a few years ago. The improvement in terms of size and profitability comes as a consequence of government restructuring of the banking system based on governmental capitalization and clean-up of bad loans. In addition, the massive fiscal package introduced by China during the global crisis has allowed banks to grow by increasing their lending massively. Such lending has concentrated on local governments’ financing vehicles, whose revenues are very dependent on the prices of land and housing in general. Given China’s overheating and too fast increase in housing prices, the authorities are taking strict measures to reduce the supply of credit (especially to local governments) and also housing and land prices. Both measures may put the future solvency of local government financing companies at risk, with the negative consequences which this may have on the Chinese banking system.

The rise of Chinese banks in the ranking of world banks raises expectations and questions, but what does actually reflect the presence of these big banks among the international leaders? Initially, the transformation of Chinese banks has gone through the consolidation of assets, the contribution of capital from the state and strategic investors and the entry of several of these banks on the stock market. The establishment of the CBRC has confirmed plans to build a controlled banking system and promoting the adoption of internationals principles and standards.

Chinese banks appear in the rankings of major global banks and win ranks each year. But their presence in these rankings is more a consequence of the size and internal growth of China than a real internationalization already established. Indeed, the current strategic model of Chinese banks is turned to the growth of China and to a key role in financing the economy.

However, relatively less unaffected by the recent crisis, Chinese companies and banks are now tempted by a greater internationalization. Chinese investment abroad growing, Chinese banks must also focus on creating a global network able to support the internationalization of Chinese multinationals companies. Moreover, a Chinese financial strategy is being implemented to give an international dimension to its currency, develop its financial market and boost its banking system. These areas of development will be vectors of the internationalization of Chinese banks in the coming years.

The surge of the Chinese bond market is recent. The Chinese State only started to issue debts in 1979. Limited volume of bonds were issued till 1987 and sold by administrative allocation. Secondary market experiences took place in 1987. After 1991, the Finance Ministry selected primary dealers for bond issuing. It is only after the creation of a centralised depository and clearing company, CDC, in 1996, and the opening of an inter-bank bond market in 1997 that the market gathered momentum. Presently it covers all segments of the yield curve and has become the second largest source of funding for the Chinese companies. The development of the Chinese Bond market follows the logic of Asian Bond Market Initiative. New offshore RMB bonds in Hong Kong is part of a move toward the internationalisation of the Chinese currency, which is being prepared by reforms and opening of the Chinese capital markets.

Rural cooperative finance, targeting small farmers, is one of the three pillars of rural finance in China. Historically, its development has taken three forms of organization: rural credit union, rural cooperative fund and mutual fund. Because of changes in market and policies’ environment, but especially of the abandonment of cooperative principles, the credit union has become a commercial financial institution and cooperative fund disappeared. The current practices of mutual aid funds are paving the way for the future development of the rural cooperative finance relying on the integration of financial and economic cooperatives.

In China, private equity began to rise in 2004-2005. Despite the crisis, the industry reached new highs in 2010. Nevertheless, the two last years have seen important fundraisings on the domestic market coupled with significant investments in mainland China. But the industry still lacks maturity and faces two main challenges: the need of a secondary market as an alternative to IPOs and an improved link with the credit market, mainly for for M&A and build-up operations that increase the allocation of capital in the economy.

The importance of Chinese financial foreign investments is raising the following question: do these operations underlie a strategy to conquer the world or are they just responses to the various constraints facing the Chinese authorities and companies? Our opinion is that a deliberate strategy to conquer the world cannot be inferred from Chinese financial activity, especially as it makes the country dependent on its international environment. Chinese foreign investments seem rather to be determined both by China’s economic policies and by the strategy of Chinese companies reacting to the opportunities of the international environment in which they operate.

Imbalances between the U.S. and China are in three areas: monetary, trade and economy. Two fundamentally different types of economy are the cause of all other imbalances. International trade and foreign investment (flows of goods and capital) transform these differences in trade surplus for China. In reality, a war of currencies between China and the U.S. would be a superficial conflict that hides deeper structural differences between the two economies. International trade transforms them into a quantitative monetary disequilibrium, which is much easier to observe. Today the situation of the United States requires as many internal changes as for his new competitor: China. However, the real challenge is to find out solutions domestically rather than internationally.

Conventional wisdom is that the renminbi exchange rate since mid 2005 has been no more than a simple (crawling) dollar peg. We instead interpret the Chinese authorities as having made the transition away from a crawl or stall against the US dollar or having at least conducted a sustained experiment in a basket management in the period of 2006-2008. The Chinese bilateral dollar exchange rate is not representative of the renminbi management since 2005, the SDR is more representative, while the BIS effective index is the most representative of the three. As it happens, the euro/renminbi rate was representative of the renminbi’s broader movements between June 2005 and December 2010. Moreover, the nominal exchange rate is not the full story of the Chinese exchange rate policy. Since prices have risen faster in China than in its trading partners, the real rise of the renminbi over the period June 2005 to December 2010 has been about 10% larger than its nominal rise. As it happens, the real rise against the euro was also representative of the renminbi’s broader movements.

There is a similarity of pattern between the present international pressures for RMB revaluation and those which were exerted on Japan in the ‘80s for the Yen revaluation. This paper aims at clarifying certain issues of the RMB revaluation debate in the light of Japan’s experience. Two lessons may be drawn from this experience. First the massive revaluation of the Yen against the USD after the 1985 Plaza Agreement did not reduce the US trade deficit, as Japan’s competitiveness was due primarily to the technological quality of its products. The second lesson is that the steep and massive revaluation of the Yen had devastating effects on the Japanese economy, which went through the “lost decade” during the ‘90s.

Mutatis mutandis, these lessons may apply today in the case of China. Its currency is indeed undervalued, possibly by 20-25% on a REER basis. However a revaluation of the RMB of such size would not reduce US and European trade deficits as much as expected, because China’s competitiveness is primarily due to its very low cost of labor. Furthermore, the appreciation should be gradual, although sustained, in order to avoid major economic disruptions. But a steady appreciation of the RMB would be in China’s best interest, all the more as it has presently to adjust its model of development.

The People’s Bank of China has adopted twice (July 2005-summer 2008 and June 2010-today) currency basket as exchange regime. No information related to composition or functioning of the basket is known. In this paper, we try to estimate in a dynamic approach its composition. The results show in each period, the exchange regime resembles rather a crawling peg vis-à-vis US dollar. The crawling peg permits gradual appreciation of the RMB and its flexibilization. It seems also that the pace of RMB’s appreciation would be regulated so in order to absorb pass-through effect of international commodity price on domestic inflation. Finally, because of the opacity on basket’s functioning, the currency basket is only a form allowing flexibility within the meaning of room of manoeuvre of the Central Bank; it is also a transition regime toward free floating.

China plays a key role in Asian regional integration, serving as an export platform for the region towards the rest of the world. In this respect, China has been instrumental in the development of intraregional trade. Since 2010, the use of the Chinese currency for trade settlement and the implementation of the China-ASEAN Free Trade Agreement further cement China’s leading role in the region. In the monetary and financial realm, China has participated in different regional initiatives including the Chiang Mai Initiative and the Asian Bond Funds. However, China’s contributions to both remain low compared to its huge foreign exchange reserves. Its support of regional integration in Asia remains thus symbolic. Overall, China remains more interdependent with Hong Kong than with the rest of the region. Its increasing trade and financial links with Hong Kong serve as a stepping stone towards its regional integration and in the end towards its world integration.

The following write-up picks up from the recent decisions taken by the Chinese monetary authorities during the second half of 2010. They led to a first step in the internationalization of the Chinese currency, at least to its regionalization. This move is analyzed in a comparison with what had been done previously in other countries of the region, Japan in particular, based on different rationale and especialy very different consequences. Those were mostly negative. This decision is also put into perspective against analyses written since quite a number of years in China and in reviews released in Hong Kong as well, in order to understand that the decision initiated in July 2010 is also a top-down, “sui generis” decision” and has to be understood so. It has to be placed on the background of a plan which takes into account several parameters: the request for greater involvement by China into the monetary system and a potential deterioration of the state of the financial and monetary order. In both cases, the various steps taken during the last year can truly make the renminbi play a role as a “pivot-currency” in the region and this can happen either if this region becomes more integrated within the global monetary and financial system or if the currency “de-synchronizes”, in the hypothesis of regional financial block being built up.

Much has been said and written on the consequences of the Chinese exchange rate policy for final importers of Chinese goods, such as the US and Europe. In this paper, we tackle a different question: whether managing Chinese Renminbi is an effective trade policy tool to gain a competitive advantage with respect to other Asian exporters. If Chinese export structure resembles more and more to those of other Asian exporters managing the CNY exchange rate against their currencies can create competitive advantage to Chinese goods. Notwithstanding similarity between Chinese and other Asian countries export structure is growing at the industry level, more refined, product-by-product data fail to show the same trend, implying a fall in similarities. This is a surprising result, especially concerning Korea and Japan: the more technologically advanced exports of these two countries might feel more and more the competition of Chinese producers “going up the ladder”. As such, the renminbi exchange policy does not seem to alter significantly the trade competition among Chinese countries.

The currently observed turmoil in financial markets, which is believed to have been ignited by the collapse of the American subprime mortgage market, has recently brought to prominence the ideas of Hyman Minsky, member of the post-Keynesian school of economics. Many commentators are of the view that Minsky’s framework of thinking accurately anticipated the current financial crisis. The key mechanism that pushes the economy towards a crisis is the accumulation of debt during the period of prosperity. So, the economy becomes more and more fragile. Financial innovations and deregulation in a context of globalisation are responsible of this situation. It’s an important point of his analysis. It’s an aspect of the “Financial Instability Hypothesis” (FIH). Another aspect of FIH is that during good times, banks and other intermediaries try to lure investors to buy debt by means of sophisticated innovations. So the major role of financial intermediaries in a process of crisis is showed. Definitively, it’s possible to show that the current crisis is an application of Minsky’s model.