Table of Contents
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 Foreign Exchange Market and Convertibility of RMB
8.0 Observations and Discussions
8.1 Interbank interest rates
8.2 Problems with credit rationing
Money market refers to the market 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 .
Some scholars argue that China’s financial liberalization remains incomplete as the behaviour 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 integrality. 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. And then according to different weights, a synthesized term structure of interest rate of China is constructed out. Finally, empirical research is carried on by use of this method. Empirical results show that the method is better than the traditional methods, and the synthesized term structure curve of interest rate by the method is between various kinds of term structure curves by the traditional methods, reflecting the situation and information of each market on the whole.
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 brought great 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 RMB16000 billion yuan, an increase of over 100 times in the past twenty years.
Money market refers to the market 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 brought great 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 toRMB16000 billion yuan, an increase of over 100 times in the past twenty years. The steady growth of broad money balance pushed financial interrelation ratio (FIR) up. In the early phase of economic reform, 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%.
Many factors contributed to the rapid growth of financial assets and FIR, which included the high growth rate of the national economy, institutional reform 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 9593.3 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 7554 yuan in 2001. China achieved annual Gross Domestic Product (GDP) growth rates of around 10 percent and in 2008 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$4.4 trillion), while its GDP per capita stood at around US$ 2 839, placing China amongst the lower middle income countries, due to its sky-scraping population. With the rapid growth of the economy, the pattern of national income distribution had changed as well. The government and enterprises had their share in the national income declining. The households had kept their share growing. Due to such biased structure, the national income got more decentralized and financial balance was decentralized or widely dispersed. 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 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.
In the subsequent sections we talk about what constitute China’s money market which is mainly made up of interbank funding market and bond repurchase agreement market commonly referred to as repo market.
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 15333.605 billion yuan, an increase of 132.3 times. Per capita financial assets were up to 1217.92 billion yuan, an increase of 101.56 times. And these figures have increased 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-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.
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 structure 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. 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.