Financial Structural Change, Liberalization and Liquidity Market Integrity in China

Financial Liberalization and Integrity of the Market

Research Paper (undergraduate) 2011 26 Pages

Economics - Monetary theory and policy


Table of Contents


1.0 Introduction

2.0 The Gap between M2/GDP and Financial Assets Value/GDP Ratio

3.0 Government Bond Market

4.0 Capital Market in China

5.0 Monetary Market

6.0 Banking Industry

7.0 Observations and Discussions
7.1 Interbank interest rates

8.0 Implications

9.0 Conclusion

10.0 References


Money market refers to a n exchange for buying and selling of financial and money market instruments where financial institutions make transactions of short-term financial instruments for short-term financing and liquidity management. China’s money market is mainly made up of interbank funding market and bond repurchase agreement market commonly referred to as repo market.

Since the market-oriented economic reform in 1978, China has entered into a stage of financial deregulation and liberalization. With the growth of the national economy and change of national income structure, China’s finance has increased rapidly, which has brought a great deal of changes in the financial structure. In 1978, broad money (M2) balance was near RMB150 billion yuan. By the end of 2001, broad money balance was up to RMB16, 000 billion yuan, an increase of over 100 times in the past twenty years, implying a growth rate of 5 percent a year in 20 years. However, with this financial development and deepening, China needs to liberalize the financial market further and let the liquidity conditions reflect the market realities and integrity.

Some scholars argue that China’s financial liberalization remains incomplete as the behavior of short-term market-determined interest rates is influenced by regulated rates. This paper argues that to have integrity of the market China should further liberalize its retail interest rates to allow all interest rates to better reflect liquidity conditions and the scarcity of capital.

At present, the relevant research of the term structure of interest rates of China is mostly directed against a certain specific market or a certain specific method, lacking market integrity. For constructing a systemic, scientific term structure of interest rate of China, respective term structure of interest rate is deduced from the treasury bond market, bank deposit market, inter-bank borrowing market, bank repo market, and RMB interest rate swap market.

China has taken important steps to liberalize its interest rates. Short-term interbank interest rates were liberalized initially, financial and Treasury bond yields were liberalized soon after, followed later by the liberalization of the corporate fixed income market. The creation of the short-term financing bond in 2005 and medium-term financing note in 2008, with unregulated interest rates and liberal issuance criteria, were major advances in the development of the corporate financing market. In 2007, seeking to make interest rates better reflect market conditions and create a more stable benchmark yield curve at longer maturities, the Chinese authorities also launched the Shanghai Interbank Offered Rate (SHIBOR) benchmark rate system. Ceilings on loan rates and floors on deposit rates were removed last, allowing banks flexibility in setting lending rates above the regulated floor. However, critically, a ceiling on deposit rates and a floor on loan rates still remain in place, with only around two-thirds of loans taking place at rates above this floor. Hence, China needs to liberalize the financial market further to have market integrity which reflects liquidity conditions and the scarcity of capital .

Keywords: Financial Liberalization, Integrity of the Market.

1.0 Introduction

Money market refers to an exchange for buying and selling of financial and money market instruments. In other words this is where financial institutions make transactions of short-term financial instruments for short-term financing and liquidity management.

China’s money market is mainly made up of interbank funding market and bond repurchase agreement market, commonly referred to as repo market. Since the market-oriented economic reform in 1978, China has entered into a stage of financial deregulation and liberalization. However, some scholars have argued that the liberalization is far from complete. With the growth of the national economy and change of national income structure, China’s finance has increased rapidly, which has brought a great deal of changes in the financial structure. In 1978, broad money (M2) balance was near RMB150 billion yuan. By the end of 2001, broad money balance was up to RMB16, 000 billion (16 trillion) yuan, an increase of over 100 times in the past twenty years, implying a growth rate of 5 percent a year in 20 years (Feyzioglu et al., 2009, 2010). The steady growth of broad money balance pushed financial interrelation ratio (FIR)[1] up[2]. In the early phase of economic reforms, the monetization and per capita national income was quite low, so was the FIR. For instance, in 1978, the FIR was less than 40%. With the deepening of economic reform, the FIR grew up rapidly. Up to 2001, it had reached 165% and currently the figure has grown tremendously.

Further, by the end of 2010, the balance of broad money supply (M2) in China was about RMB 62.51 trillion ($9.15 trillion), a year-on-year increase of 25.98 percent but a decrease of 1.7 percent compared with the end of 2009. Narrow money supply (M1) in China at the end of 2010 stood at about RMB 22.96 trillion ($3.36 trillion), indicating an increase of 38.96 percent year on year, while money in circulation (M0) was down by 0.79 percent year on year to RMB 4.08 trillion ($596.95 billion), with net cash flow in the month in question at RMB 251.2 billion, down by RMB 425.2 billion ($36.75 billion) year on year. At the end of 2010, RMB loans of Chinese financial institutions stood at about RMB 41.37 trillion ($6.05 trillion), a year-on-year increase of 29.31 percent, with the growth rate down by 2.43 percent compared with the end of 2009. Further, domestic and foreign currency deposits at Chinese financial institutions increased by RMB 1.514 trillion ($221.51 billion) during 2010. With a year-on-year increase of 26.77 percent, the domestic and foreign deposits stood at RMB 62.72 trillion ($9.18 trillion) at the end of 2010 (Feyzioglu et al., 2009, 2010).

Many factors contributed to the rapid growth of financial assets and FIR, which included the high growth rate of the national economy, institutional reforms and free of financial constraint. More specifically, the high FIR can be attributed to the following factors:

(1) The high growth rate of the national economy and structural change for the national income distribution; in 1978, China’s GDP was 362.41 billion yuan, while it was up to 9,593.3 billion yuan in 2001. The growth of the aggregated output value of the economy led to the increase of per capital GDP. In 1979, the per capita GDP was 376.5 yuan, while it further rose to 7,554 yuan in 2001. China achieved annual Gross Domestic Product (GDP) growth rates of around 10 percent and in 2008 and had grown into the second largest economy after the USA. Its overall GDP reached US$ 3 823.2 billion and currently Chinese GDP stands about RMB 30 trillion (US$4.4 trillion), while its GDP per capita stood at around 19,333.6 yuan (US$ 2 839), placing China amongst the lower middle income countries, due to its sky-scraping population (Arora, Vivek 2008). With the rapid growth of the economy, the pattern of national income distribution has changed as well. The government and enterprises have their share in the national income declining. The households have kept their share growing. Due to such biased structure, the national income has gotten more decentralized and financial balance is decentralized or widely dispersed. Initially the government and enterprises suffered from the shortage of funds. Saving and investment were further separated. As a result, some financial arrangements were needed to bridge the gap between saving and investment, thus transfer saving into investment.
(2) The high financial interrelation ratio and financial deepening; since the economic reform, China has experienced the process of monetization of economic activities. The high monetization ratio shows the improvement of infrastructures for financial development.
(3) Change of institutional framework stimulated the rise of households saving rate; in the transition from a planning economy to a market-oriented one, decentralization of decision-making power or autonomy provide people with more choices. One reason behind this is that the uncertainty of income stream force people to save more in order to assure basic standards of living or prevent the fall of consumption level. The other reason is that people have to save more for more high-valued permanent consumption goods.
(4) Underdevelopment of consumers’ credit in the process of financial liberalization; most of the households and residents in China are the main savers-creditors of the banks. But quite a few of them become the loan borrowers-debtors of the banks. The majority of household savings are lent by the banks to enterprises in spite of the fact that 50% of the bank deposits come from households. Obviously the mis-matched financial relations between households and banks, on one side, led to the high saving rate of households. On the other side, it shows the failure of banks in smoothing the life-cycle of consumers’ income or financial constraint for development consumer credit.

This paper critically analyzes how the structure of short term Interest rates and liquidity market reflect liquidity conditions, and discusses the scarcity of capital in China. The paper is organized as follows; in this section we have given a detailed introduction of the subject. In the next section we will talk about the gap between M2/GDP and financial assets value/GDP ratio, this is followed by a discussion on Government bond market in section 3.0. In section 4.0 we discuss capital market in China, and monetary market is discussed in section 5.0. Whereas banking industry is talked about in section 6.0. In section 7.0 we give our observations and overall discussions of the financial structure above. Lastly but not the least, we give the implications of our observations of China’s the structure of short term interest rates and liquidity market in section 8.0 and finally we make our own conclusion, in section 9.0.

2.0 The Gap between M2/GDP and Financial Assets Value/GDP Ratio

In 1978, the total value of financial assets was 115.9 billion yuan in China, with per capita assets of 120.40 yuan. Up to the end of 2001, the balance of financial assets rose to 1, 5333.605 billion yuan, an increase of 132.3 times. Per capita financial assets were up to 1,217.92 billion yuan, an increase of 101.56 times (The People’s Bank of China, 2005). And these figures have grown bigger tremendously recently. As the result of such rapid growth of financial assets, the gap between broad money, (M2)/GDP, and financial assets value/GDP has grown wider. China at that time had no other financial assets except deposits and cash. In this circumstance, broad money balance was almost equal to the total value of financial assets. Since the economic reform, the larger gap between M2/GDP and financial asset/GDP shows that varieties of financial assets have increased and many of them fail to be counted in broad money balance.

More specifically, the deposits and cash have smaller shares in the financial assets structure, while the government bonds, stocks, various funds and insurance have larger shares. In 1979, at the start of the economic reform, China had only deposits and cash, which took 83.57% and 16.43% respectively of the total financial assets. There were no other non-monetary financial assets at all. By the end of 2000, a great change of financial structure had happened, with the share of deposits and cash down to 73.85% and 10.79%, the share of government bonds, stock, and insurance up to 8.92%, 4.28% and 1.24% respectively (P BOC, 2005).

The change of China’s financial structure can be divided into two phases with different motive forces. The first phase is from 1979 to 1991. During this phase, the strong motive for restructure of China’s financial assets came mainly from supply side. In the second phase (starting from 1991), the strong motives for the change of financial structure came from the demand side or sharp contradiction between the demand and strict constraint on supply side. In other words, the shortage of financial instrument failed to meet the demand of households for adjustment of their financial structure. In fact, such strong demand is interest driven. The underlying causes are quite obvious that over thirty years of economic growth has led to the high growth of the national economy. With the growth of their financial assets, households have inherent motives of demand for varieties of financial instruments to optimize investment portfolios and maximize return of investment. Meanwhile the change of institutional arrangement on the supply side gives households more incentives for varieties of financial instrument and assets. With the growth of per capita income and personal wealth, people change their altitude towards the risk and have more capacity to take the risk. All these lead to the increase of investment in high risky financial assets and raise their share in the total financial assets. In addition, the demand for adjustment of financial structure are kept growing, such as the demand for reduction of transaction cost and tools for risk management, etc.

3.0 Government Bond Market

The establishment of government bond market in China is a breakthrough point in restructuring financial assets. In traditional planning economy, the government tried with great efforts to achieve the objective of “No domestic debt and international debt”, which was regarded as one of the advantages of the socialist system. All these wrong ideas and rigid planning system stifled the development of government bond market.

After the economic reform, the Chinese government recovered or issued the first debt security in 1981. Although the total value of the first issue was less than 5 billion yuan, it added a new instrument to China’s financial structure. More importantly, it remarked the beginning of China’s financial structural change. Prior to 1994, the government financed budget deficits by borrowing from the central bank, instead of issuing debt. Although the outstanding of government debt was quite limited, the overdraft from the central bank had the direct effect on creating monetary base and ultimately interest rates. As a result, the monetary base and government deficits changed in the same direction. This phenomenon was vividly described as “collusion” between the Treasury and central bank in China. In the process of the reform, the government had to provide subsidies to some of the interest “losers”, in order to keep a stable environment for the further reform. Moreover, the government had to continue the large-scale investment in order to speed up the capital formation. All these strengthened the hard restraint of the government expenditures and increased budget deficits. And borrowing from the central bank to cover the deficits in turn led to the oversupply of money. This became the main causes for expansion of demand and high inflation in 1994.

Starting from 1994, the government was no longer allowed to borrow directly from the central bank. The main aim of this reform was to give the central bank more independence for operation of monetary policy and more power to manage monetary supply. This completely cut off the “umbilical cord” between the government and central bank. Since then, the government had to rely upon debt issuing for deficit financing. The change of deficit financing had not only softened the government budget restraint but has also restructured the repo market. As the government more and more relied upon debt financing, the “provisional source” of government revenue had turned into a “enduring” one, the government debt outstanding grew up like the snow ball. The quick growth of the budget deficits and debt financing resulted in the rise of government debt/expenditure ratio.

At the end of 2001, the overall government debt/expenditure ratio was over 36%. Since the local governments have no autonomy in debt issuing in China, the central government debt /expenditure ratio was as high as 50% (PBOC, 2005). Obviously, the central government has a heavy burden of debt. Under the pressure of heavy debt, the positive fiscal policy will gradually fade out with the decrease of debt financing. In spite of the growth of government debt outstanding, most of them have the function of deficit financing, investment in construction project and regulation of aggregate demand. Objectively, they played quite an important role in conversion from a plan economy into a market economy and adjustment of China’s finance structure.

Due to their special functions, most of the government debts are long term one

(3 year and 5 year bond), because none of them are designed for regulation of financial market and liberalization of interest rates. It is expected that in future China will adjust the term structure of government debt, increase the issue size of short-term notes and issue frequency, in order to provide a benchmark for financial market and liberalization of interest rates in China. Once this is achieved, then it will consequently restructure the way short term Interest rates is structured and liquidity market which will ultimately alter the liquidity market integrity conditions and the scarcity of capital in China.

4.0 Capital Market in China

In early 1980s, some Chinese enterprises started to explore new financial channels for growth of production, because the state credit structure could not satisfy their demand for funds. Meanwhile, some newly-developed enterprises in the reform which had long been excluded by the state credit plan had to seek for their own financial resources elsewhere for the survival and development. A new form of organization with funds pooled as a share of input came into being. This is the development of stock companies in China. But such spontaneous stock market had not aroused the attention of the government or included in the government-sponsored reform outline in the commencement. As a result, the stock market developed slowly in 1990s. And most of the enterprises relied upon the stock as just a tool of financing. With the deepening of the reform, it is universally accepted that without the restructuring the property rights, the enterprise could not establish efficient management structure. From then on, the government stepped in and used the stock market as a tool to restructure the state enterprise management system. The development of the stock market soon was put on the agenda and included into the government regulated financial institutional system. The interference of the government in stock market, not only avoided the shortage of supply of institution arrangement due to free-rider problem, but also reduced the uncertainty in institutional innovation. All these contributed to rapid development of stock market.

Since the government interfered in stock market with its own target, the stock market growing up in a market-oriented reform was still stamped with strong features of the planning economy and market integrity was lacking. For instance, the quota for stock issue was strictly controlled by the government, which turned “shell resources” into “scarce resources”. Rent-seeking activities were rampant in stock issuing. As it is mentioned earlier, the government wanted to use stock market to restructure the state enterprises ownership structure and become the big shareholders of the state enterprises. Great varieties of shares, such as state share, share of legal entity and public shares, emerged in stock market. In addition, the government prohibited trading of state share and shares of legal entity in order to prevent the loss of the state assets. Such irrational rigid control, led to low efficiency of China’s stock market. Other issues that could have contributed would be that traditionally everywhere, firms prefer sourcing funds for their investments from banks as opposed from stock markets, a situation called ‘ puzzles of financial structure’ due to a number of factors. Some of these could be;


[1] The financial interrelations ratio is the quotient of the aggregate market value of all financial instruments in existence in a country at a given date to the value of its tangible net national wealth.

[2] In the course of economic development a country’s financial superstructure grows more rapidly than the infrastructure of national product and national wealth. Hence the financial interrelations ratio has a tendency to increase.


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financial structural change liberalization liquidity market integrity china



Title: Financial Structural Change, Liberalization and Liquidity Market Integrity in China