Financial SystemJunhui Qian

2015 November

Content• Basics• The Reform of the Financial System• The Banking System• Capital Markets• Stock Markets• Bond Markets• Other Financing

• Future Financial Reform

What is financial system?• Financial system is the collection of rules and institutions that

facilitate the transfer of financial resources between savers and borrowers. • Franklin Allen and Douglas Gale in Comparing Financial Systems:

"Financial systems are crucial to the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow intertemporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks. These functions are common to the financial systems of most developed economies. Yet the form of these financial systems varies widely."

Dimensions of the Financial System• Financing• Provide financing to enterprises and financial products to savers (investors).

• Information• Generate information on enterprises and investment projects so that risk can

be priced and resources can be efficiently allocated.

• Control• Impose discipline on managers of public companies

Content• Basics• The Reform of the Financial System• The Banking System• Capital Markets• Stock Markets• Bond Markets• Other Financing

• Future Financial Reform

The Financial System Before The Reform• Monobank: People’s Bank of China• It is both the central bank and the commercial bank.• The monobank system collects savings, channels funds to work units

according to plans. No information is generated from the process. • The role of the monobank system is passive, accommodating the

needs of the planner. The monobank system does not impose discipline on managers of the work units.

Financial Deepening• As the transition from the planned economy to the market economy

started, more financial wealth (relative to income) had been created and held as claims on banks and enterprises. This process is often called “financial deepening”.• The financial deepening may be measured by the ratio of financial

assets to national income. More conveniently, it is often measured by M2/GDP.

Financial Deepening

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140%

50%

100%

150%

200%

250%

M2/GDP

Financial Broadening• Financial broadening refers to an increase in the variety of financial

institutions and instruments.• Over the past three decades, China had transformed the monobank

into a sophisticated banking system, had developed stock and bond markets, derivatives market, etc. • During the development, there appeared a wide variety of

institutional investors (mutual funds, insurance companies, private equities, hedge funds, etc.) and financial products.

The Transition Pains • “The reform without losers” was achieved by absorbing losses by the

financial system, the banking system in particular. • “The reform with losers” inflicted further pains on the stock market,

which became a financing source for SOE’s. • The reform of the financial system is still ongoing.

Content• Basics• The Reform of the Financial System• The Banking System• Capital Markets• Stock Markets• Bond Markets• Other Financing

• Future Financial Reform

The Banking System• As of 2014, there are 3 policy banks, 5 large commercial banks, 12

mid-sized commercial banks, 133 city commercial banks, 665 rural commercial banks, 89 rural cooperative bank, 1596 rural credit unions, 1 postal saving bank, 4 financial asset management companies, 68 trust companies, etc. • As of 2014, the total asset of the banking system amounted to RMB

172.3 trillion, while the total liability was RMB 160 trillion. • The bank system employs 3.76 million people at the end of 2014.

Total Asset and Liability of the Banking System

Market Share of Different Categories of Banks

Decline of Bank’s Importance in the Financial System

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 20130%

10%

20%

30%

40%

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60%

70%

80%

90%

100%

Share of Loans in Total Financing

Bank Capital Adequacy

37226 -2052yy

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37956 -2052yy

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38322 -2052yy

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38687 -2052yy

yy

39052 -2052yy

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39417 -2052yy

yy

39783 -2052yy

yy

40148 -2052yy

yy

40513 -2052yy

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40878 -2052yy

yy

41244 -2052yy

yy0

1

2

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4

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6

7

CN: Bank Capital to Assets Ratio (World Bank (WDI))

Improvement in Banking Practice

2003-06

2003-09

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2015-06

2015-090

5

10

15

20

25

Rate of NPLs (%)

Interest Rate Liberalization• Interest rate policy as a financial repression. • Interest rate policy leads to inefficient allocation of financial

resources. • Liberalization of interest rates on deposits and loans• The ordering the interest rate liberalization: first foreign, then domestic; first

money market, then loans, then deposits; first long-term big-denomination, then short-term small denomination. • By Nov 2013, only the domestic deposit rate has a upper-limit. • By Oct 2015, all interest rates are determined by the market.

Content• Basics• The Reform of the Financial System• The Banking System• Capital Markets• Stock Markets• Bond Markets• Other Financing

• Future Financial Reform

The Stock Markets• The Shanghai Stock Exchange was opened in 1990 and is now the 5th

largest stock market by market capitalization at 3.9 USD tn. • The Shenzhen Stock Exchange was opened in 1991 and is now the 9th

largest stock market by market capitalization at 2.1 USD tn.• The Hong Kong Stock Exchange is the 7th largest stock market by

market cap at 3.2 USD tn.

Major Stock Exchanges (ranked at Dec 2014 )

Rank Exchange Economy Headquarter Market cap (USD bn) Number of listed companies Monthly trade value (USD bn)1 NYSE United States New York 19351.4 1939 1536.3 2 Nasdaq - US United States New York 6979.2 2430 1154.4

3 London Stock ExchangeUnited Kingdom,Italy,London 6177.2 1286 149.6

4 Japan Exchange Group Japan Tokyo 4378.0 3458 456.2

5Shanghai Stock Exchange China Shanghai 3932.5 995 1853.6

6 EuronextEuropean Union

Amsterdam Brussels Lisbon Paris 3319.1 935 152.8

7Hong Kong Exchanges and Clearing Hong Kong Hong Kong 3233.0 1661 171.8

8 TMX Group Canada Toronto 2093.7 3691 148.9

9Shenzhen Stock Exchange China Shenzhen 2072.4 1618 1063.3

10 Deutsche Boerse Germany Frankfurt 1738.5 595 111.3

Characteristics of the stock markets• Segmented markets (A share, B share, H share)• Low contestability• Rationing of listing opportunity (high IPO price)• Strict regulation, weak law enforcement• Policy-driven market• Large turnover, especially on small-cap stocks

Turnover Rate on Asian Stock Exchanges

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-140%

50%

100%

150%

200%

250%

300%

350%

400%

450%

Hong Kong ExchangesJapan Exchange Group - TokyoKorea ExchangeShanghai SEShenzhen SESingapore Exchange

The Shanghai Composite Index

19901991

19911992

19921993

19931994

19941995

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19971998

19981999

19992000

20002001

20012002

20022003

20032004

20042005

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20112012

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20132014

20142015

0

1,000

2,000

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5,000

6,000

7,000

SSECI (1990-2015)

Investor’s Enthusiasm

20032003

20032004

20042004

20052005

20052006

20062006

20072007

20072008

20082008

20092009

20092010

20102010

20112011

20112012

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20132013

20132014

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20152015

0

2,000,000

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6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

0

2,000

4,000

6,000

8,000

10,000

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16,000

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New A-Share Accounts

IndividualInstitutional

Investor’s Enthusiasm

2014/1

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2015/60

10000

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60000

70000

80000

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100000

0

1,000

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5,000

6,000

Baidu Index on "Stock Market" (Jan 11 2014 - Jun 13 2015)

Baidu Index on "Stock Market" SSECI

Recent Leverage-Up

2010/04

2010/05

2010/06

2010/08

2010/09

2010/10

2010/12

2011/01

2011/03

2011/04

2011/05

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2015/04

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2015/07

2015/08

2015/100

0.5

1

1.5

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2.5

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5

0

500

1,000

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Margin Financing

Margin Financing as Percentage of Float Capitalization (%) Total Margin Financing (RMB bn)

Perc

enta

ge (%

)

Shorting in the A-Share Market

20102010

20102010

20102010

20102011

20112011

20112011

20112011

20112011

20122012

20122012

20122012

20122012

20132013

20132013

20132013

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20132014

20142014

20142014

20142014

20142014

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20152015

20150

0.005

0.01

0.015

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0.025

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Short Position

Short Position as Percentage of Float Capitalization (%) Total Short Position (RMB mn)

Perc

enta

ge (%

)

The Valuation of the A-Share Market (P/E)

19901991

19921992

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Aggregate P/E of A-Share (TTM)

ShanghaiShenzhen

P/E

(TTM

)

The Valuation of the A-Share Market (P/B)

20022002

20022003

20032003

20042004

20042005

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20062006

20062007

20072007

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P/B (Aggregate)

ShanghaiShenzhen

P/B

Ratio

The Opening-Up of the Stock Market• B share markets• QFII and QDII mechanism• Shanghai-Hong Kong Connect (started on Nov 17, 2014)

Hang Seng China AH Premium Index

20062006

20062006

20062007

20072007

20072007

20082008

20082008

20082009

20092009

20092010

20102010

20102010

20112011

20112011

20112012

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20132013

20132013

20142014

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201580

100

120

140

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HSCAHP (2006-2015)

HSCAHPBenchmark

B-Share Markets• Since 1991, listed companies in Shanghai and Shenzhen are allowed

to issue B shares to foreign investors. By 1998, there are 106 B-share stocks (52 in Shanghai, 54 in Shenzhen). • Since 2001, domestic investors are allowed to trade B-share stocks. • As companies were allowed to list in Hong Kong, the B-share markets

stagnated.

The Bond Markets• There are basically three markets for trading bonds: inter-bank,

security exchanges, and OTC. • The majority of the bond trading takes place in the inter-bank market. • In security exchanges, treasury bonds, corporate bonds, and

convertible bonds can be traded, with relatively low liquidity. • Repo and reverse repo operations can be conducted on high-quality

bonds.

Market Capitalizations of Bonds Listed in Shenzhen Stock Exchange

33970 -2052yy

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34121 -2052yy

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34274 -2052yy

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34425 -2052yy

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37165 -2052yy

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37469 -2052yy

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37622 -2052yy

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37773 -2052yy

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37926 -2052yy

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38078 -2052yy

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38231 -2052yy

yy/m

38384 -2052yy

yy/m

38534 -2052yy

yy/m

38687 -2052yy

yy/m

38838 -2052yy

yy/m

38991 -2052yy

yy/m

39142 -2052yy

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39295 -2052yy

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39448 -2052yy

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39600 -2052yy

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39753 -2052yy

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39904 -2052yy

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40057 -2052yy

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40210 -2052yy

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40360 -2052yy

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41122 -2052yy

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41275 -2052yy

yy/m

41426 -2052yy

yy/m

0

50,000

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300,000

Market Capitalization: Shenzhen Stock Exchange: Corporate Bond (China) Market Capitalization: Shenzhen Stock Exchange: Convertible Bond (China)

Other Financing• Entrusted loans • Trust loans• Undiscounted bankers‘ acceptances• Informal lending

Content• Basics• The Reform of the Financial System• The Banking System• Capital Markets• Stock Markets• Bond Markets• Other Financing

• Future Financial Reform

Future Reforms in the Financial System• Lower the entry barrier to and increase competition in the banking

industry. • Reform IPO, and strengthen law enforcement in the stock market. • Deregulate bond market and encourage bond trading in the security

market. • Allow bankruptcies of SOE’s and local government financing vehicles,

so that the latter no longer enjoy the sovereign credit rating.