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“Inside the System” – Does China have to adopt Western Standards?

 5 min read / 

After the Global Financial Crisis, many became quite fond of how China’s Financial System put away the international downturn. It seemed China’s banks were not affected by it significantly. Eventually, the Chinese model became the centre of attention. In Red Capitalism, Carl E. Walter and Fraser J. T. Howie, two experienced bankers who lived in China for several years, provide a deep analysis of the Chinese Financial System. Their analysis focuses on the development of China’s capital and financial markets in the last decades, especially on the progress of an almost non-existent financial sector four decades ago to the superficially diverse and highly complex market of today.

If there is one key question in the book, it would be whether the Chinese Model would be an applicable and desirable model for the West or if China must adopt Western ideas to reform their Financial System. In other words, it’s a comparison between the neoliberal model of the West and the state-capitalist model of China. However, Red Capitalism turns out to be an ode to the Western, capitalistic model which, according to the authors, provided the necessary knowledge for structural change of the Chinese financial system in the 1990s when Zhu Rongji has been the driving force of reform after the Asian Financial Crisis. But, as Walter and Howie state, the course of reforms in China is strongly correlated with the leadership of the Party. Thus, they claim that after Zhu Rongji and his supporters fostered reforms, the new government in 2005 turned away from them and reinforced the remnants of the Soviet-model – especially after the Global Financial Crisis in 2008. Therefore, Walter and Howie state several hypothesis, which will be summarized and analysed in this essay.

Firstly, China’s financial system cannot catch up with the transition process of the remaining economy and its performance is still subordinated to economic growth. Its core is the banking sector, centred by the People’s Bank of China (PBOC) which provides credit to the commercial banks, mainly the “Big Four”. Foreign banks are almost completely excluded holding just a little more than two percent of total domestic financial assets. Contrarily, Hope et al. (2008) argue that the government

“(…) seem persuaded that foreign direct investment in China’s banking industry (…) is one of the better ways both to foster a healthy, competitive financial system and to protect domestic banks from failure during their transition to better overall performance”

Li et al. state that even if foreign banks cannot compete with Chinese banks in a whole, they pressures Chinese banks in specific areas as trade finance and private business finance. Nonetheless, Walter and Howie do state that without foreign investors there would be no national capital market in China today to support their view that China should copy the Western model. Though, they claim that China’s capital markets are actually just being used as a facade as it will not affect the ownership structure of the companies. However, stock markets have been introduced in China because policy-makers wanted to get access to foreign capital and household savings as stock markets have been the only place besides the real estate market, which could produce a return higher than inflation. Thus, secondary markets are mere instruments for getting “new” money for the SOEs.

But in fact, banks being the only significant source of capital inside the System is at the same time the weakest point of China’s economy since the banking sector is characterised by overregulation, protection from competition and poor management. According to Walter and Howie especially the high ratio of NPL poses a huge risk for financial stability inside the Chinese System. These NPLs are the result of lending huge amounts of loans to SOEs which are well known to not being able to pay their debts every time. Hence, the commercial banks are being used as cash cows for the SOEs. Accordingly, Lu et al. show empirically that bank lending is actually biased towards SOEs. They even show that “high-risk” SOEs have been able to borrow more loans than “low-risk” SOEs which proves that there is an ex ante intervention by the government. Yet further proof of an existing system in which China’s government uses banks to support its companies.

Correspondingly, Walter and Howie argue that the valuation of Chinese companies and financials is insufficient since they do not deliver any information about their true performance. It is not really convincing to use the “Western” measures to rate Chinese companies when policy banks lend money to SOEs as they are actually owned by the same stakeholder as SOEs. Furthermore, only two thirds of the shares of listed SOEs are being traded. However, as the global financial crisis or the European debt crisis showed recently, Western rating agencies repeatedly failed to deliver proper ratings which showed the true risk of investing in financial products, companies or even countries, as well.

In conclusion, the history of China’s financial reform in the last decades has been a history of bureaucratic rivalry inside the System. However, who can blame China for not adopting the Western model which actually resulted in the largest crisis since the 1920s. Eventually, China is using its financial intermediaries to support their SOEs which, in turn, are providing social stability by offering jobs for the people. Even with high NPL ratios, the Chinese government proofed to be able to solve occurring problems quickly as they do not have to reconsider foreign interests.


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