Chinese Banks Walk a Fine Line Between Market and Government





SCOTTISH economist Adam Smith laid the foundation of modern economics with his 1776 treatise An Inquiry into the Nature and Causes of the Wealth of Nations. In this seminal work he argued that in a market economy the government should be little more than a “night watchman,” and give full play to market forces.


In the wake of the Great Depression in the 1930s John Maynard Keynes published The General Theory of Employment, Interest, and Money. He proposed government intervention to ensure “effective demand,” since private sector decisions sometimes lead to inefficient macroeconomic outcomes.


Keynes and Smith thus spearheaded the two competing schools of thought that battle for supremacy in modern economics, one advocating hands-on and the other hands-off government economic policies.


The optimal role of government in the marketplace was a hot topic of debate after Lehman Brothers collapsed in 2008 and financial crisis ensued. Unlike the 1930s depression, which was triggered by excessive output from the productive economy and low consumption capacity, the current economic crisis has been attributed to a lopsided relationship between the market and government. Specifically, the relationship between a shrinking productive economy and rapidly expanding and loosely regulated speculative economy was deemed to be detrimental to long-term economic stability. As this relationship soured and the tenuous foundations of leveraged speculations – subprime loans – began to crumble, legions of financial institutions plunged toward bankruptcy.


The existing banking systems in the U.S and EU came into being with the post-war birth of the Bretton Woods system in 1944. In this system, the U.S. dollar, tied in value to gold, became the world’s fiat currency. Under the new order, which continues in a modified form to this day, a central bank takes charge of the issuance and management of the currency, be it the Dollar or the Euro. Commercial banks are generally required by law to maintain a particular percentage amount of total deposits as reserves.


Reserve ratios are determined by relevant indexes such as the capital adequacy ratio (CAR). Reserve ratios nowadays are also dependent upon the nature of banks’ business activities: a bank that engages in derivatives trading, for example, must maintain a higher reserve ratio.


By loaning out deposits, banks, in a way, create money. Given a required reserve ratio of 10 percent, $90 of 100-dollar consumer deposit can be loaned out to a third party. If the third party deposits this loaned money in the bank from which it was issued, $100 has suddenly turned into $190 on the bank’s schedule of assets. The extent to which money is “created” by this loan-deposit cycle depends heavily upon banks’ reserve ratio requirements. And to the extent that low reserve requirements create exponentially larger amounts of money than higher reserve ratios, the opposite is also true: high reserve requirements can drastically reduce the money supply.


The Chinese banking system was modeled on those in the U.S. and European countries, but also took on features to adapt to local conditions. Reforms were introduced into the financial sector in the middle - and late 1990s. The first reform included the overhaul of the municipal, provincial and autonomous regions’ self-standing branches of the People’s Bank of China, the central bank, turning them into trans-regional operations.


The second reform was to establish the China Securities Regulatory Commission, the China Insurance Regulatory Commission and the China Banking Regulatory Commission. This freed the central bank to concentrate on the formulation and regulation of monetary policy. The third reform initiated the transformation of commercial banks into entities that operate independently, take responsibility for their gains and losses, and take on financial assets at their own risk. The fourth reform was to shift the mainstay of bank loans to collateral and mortgage loans. This stands in contrast to the prevalence of credit loans in the U.S. and EU.


Before the financial crisis hit, highly innovative American and European banks invented a myriad of financial instruments that led to higher leveraging on financial products. The freewheeling market gradually spun out of control. Countries in the eye of the ongoing financial typhoon all feature expensive social security systems, high consumption and low savings rates. Their people had grown accustomed to shopping with future incomes on the basis of cheap credit.


The picture is very different in China. Its underdeveloped financial market hinders financial innovation and discourages derivatives. The banking sector is still largely state-controlled, and entry to the market is restricted. Financial markets are hence dominated by state-owned banks, and the growth of private financial service providers is held back. Branches of the big state-owned commercial banks are mostly found in more populous cities, and are few and far between in outlying and less developed regions.


China’s social security net still has holes. Most people still foot the large part of their medical and education bills out of their own pockets, and thus have no option but to save heavily. This naturally erodes consumption.


In summary, Chinese banks face less market freedom and more state intervention, and their business is anchored on deposits. In contrast, American and European banks have more market freedom and less state intervention, and the majority of their profits come from off-balance sheet activities. Regulation of such Western financial institutions is primarily achieved through technical oversight.


As major banks in the U.S. and EU collapsed, became mired in debt or saw large sums of money wiped off their asset value schedules, Chinese banks, unscathed and still growing, have risen to prominence. Meanwhile the steady appreciation and stability of Renminbi currency and the growing presence of Chinese businesses abroad are paving the way for China’s commercial banks to take up leading positions in the global market. The rise of China’s banking institutions is welcomed by many developing countries. Many are on the search for new sources of capital to oil their growth in the wake of scale-backs or retreats from operations by banks from crisis-hit developed countries. Chinese banks are in the prime position to fill the capital vacuum.