China’s Financial System: Past, Present, and Future*

Franklin Allen† Jun Qian Meijun Qian Finance Department Finance Department Finance Department The Wharton School Carroll School of Management Carroll School of Management University of Pennsylvania Boston College Boston College Philadelphia, PA 19104 Chestnut Hill, MA 02467 Chestnut Hill, MA 02467 allenf@wharton.upenn.edu qianju@bc.edu qianme@bc.edu

First Draft: October 2004 Last Revised: July 21, 2005

Abstract

We examine and compare the role of China’s financial system in supporting the growth of firms and

the economy with that in other countries, and explore directions of future development. First, we find that the current financial system is dominated by a large but inefficient banking sector, and reducing the amount of non-performing loans among the major banks to normal levels is the most important objective for reforming the financial system in the short run. Second, despite the fast growth of the stock market, its role of resource allocation in the economy has been both limited and ineffective. Further development of China’s financial markets is the most important long-term objective. Third, we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, coalitions, and institutions. This sector should co-exist with banking and markets in the future in order to continue to support the growth of the Hybrid Sector (non-state, non-listed firms). Finally, in order to sustain stable economic growth, China should aim to prevent and halt damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a “twin crisis” in the currency market and banking sector.

JEL Classifications: O5, K0, G2. Keywords: banks, non-performing loans, markets, corporate governance, hybrid sector, financial crisis.

* We appreciate detailed comments from Loren Brandt and Tom Rawski (editors of the book “China's Economic Transition: Origins, Mechanism, and Consequences”) that significantly improved the paper. We wish to thank Dong Chen, Ed Kane, Nick Lardy, Anthony Neoh, Phil Strahan, and other participants of the “China's Economic Transition” project for their comments, Qiao Yu and Wuxiang Zhu for assisting us in conducting the firm survey, Ying Xia and Jason Mao for research assistance, and Michael Chui, Richard Herring, and State Street PrivateEdge Group for providing data on financial intermediaries, bond markets, and venture capital & private equity. Financial support from Boston College, the Smith Richardson Foundation, and Wharton Financial Institutions Center is gratefully acknowledged. All remaining errors are our own responsibility. † Corresponding author: Finance Department, Wharton School, University of Pennsylvania, Philadelphia, PA 19104. Phone: 215-898-3629, fax: 215-573-2207, E-mail: allenf@wharton.upenn.edu.

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I. Introduction

We examine the role of China’s financial system in supporting the growth of its economy

and explore the directions of its future development. Almost every functioning financial system

includes financial markets and intermediaries (e.g., a banking sector), but how these two sectors

contribute to the entire financial system and economy differs significantly across different countries.

Although there is no consensus regarding the prospects of China’s future economic growth, a

prevailing view on China’s financial system speculates that it is one of the weakest links in the

economy and it will hamper future economic growth.

A comprehensive examination of all aspects of China’s financial system, and extensive

comparisons with other countries where data is available are provided below. We also discuss what

has worked and what remains to be done within the financial system, and examine how further

development can better serve the entire economy. Finally, we provide guidelines for future research

and policy making on several important unresolved issues, including how China’s financial system

should integrate into the world’s markets and economy.

We draw four main conclusions about China’s financial system and its future development.

First, when we examine and compare China’s banking system and financial markets with those of

both developed and emerging countries, we find China’s financial system is dominated by a large

but under-developed banking system, which is mainly controlled by the four largest state-owned

banks with a large amount of non-performing loans (NPLs). The continuing effort of improving the

banking system, in particular, reducing the amount of NPLs of the major banks to normal levels, is

the most important aspect of reforming China’s financial system in the short run.

We consider three channels through which the NPLs can be reduced and efficiency of the

banking sector improved. The main obstacle in evaluating these solutions is the lack of accurate

bank-level data. First, the entrance and growth of non-state banks and intermediaries should be

encouraged. With more domestic and foreign banks and intermediaries, the banking sector becomes

more competitive, and competition improves the incentives and efficiency of state-owned banks.

Second, the ongoing privatization of state-owned banks will not be completed until the majority of

these banks’ assets are owned by non-government organizations and investors. With (majority)

state ownership, banks will have perverse incentives in selecting borrowers and borrowers (in

particular, state-owned companies) have perverse incentives in selecting investment projects. As a

result, a large amount of new NPLs may surface within the network of state-owned banks as the

government rids old NPLs from the banks’ books. Third, the Chinese government and central bank

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have been injecting foreign reserves into the largest state-owned banks in order to boost their capital

reserves and balance sheets so that they can become publicly listed companies. Using official data

on NPLs, we conclude that it is feasible for the government to assume a large fraction of the

existing NPLs, provided that current economic growth rates (and hence the government’s tax

receipts) can be sustained. However, since the official data may significantly underestimate the

amount of NPLs, we view the reform of state-owned banks and the improvement of the banking

sector as the ultimate solution to NPLs.

Our second conclusion concerns China’s financial markets. Two domestic stock exchanges,

the Shanghai Stock Exchange (SHSE hereafter) and Shenzhen Stock Exchange (SZSE hereafter),

were established in 1990, and have been growing very fast since then. However, their scale and

importance are not comparable to the banking sector for the entire economy. Moreover, the

financial markets have not been effective in allocating resources in the economy, in that they are

highly speculative and driven by insider trading. Going forward, financial markets are likely to play

an increasingly important role in the economy, and the further development of the financial markets

is the most important long-term objective for China’s financial system. We propose several

measures that can increase the size and scope and help to improve the efficiency of the markets.

More specifically, the regulatory environment should be improved; in particular, corporate and

trading laws and legal protection of investors, as well as institutions governing the enforcement of

contracts should be further developed. Second, the large blocks of shares held by various

government entities in listed companies (including state-owned banks) should be reduced by

announcing and carrying out a plan to sell them off slowly over time. Third, more professionals

such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth,

domestic financial intermediaries that act as institutional investors should be encouraged, as they

will play a critical role in improving the efficiency of the markets and strengthening the corporate

governance of listed firms. Finally, new financial products and markets should be developed.

Third, in a companion paper (Allen, Qian, and Qian, 2005), we find that the most successful

part of the financial system, in terms of supporting the growth of the overall economy, is not the

banking sector or stock market, but rather a sector of alternative financing channels, such as internal

financing and trade credits, and coalitions of various forms among firms, investors, and local

governments. Many of these financing channels rely on alternative governance mechanisms, such

as competition in product and input markets, and trust, reputation, and relationships. Together these

methods of financing and governance have supported the growth of a “Hybrid Sector” of non-state,

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non-listed firms with various types of ownership structures. It is important to point out at the outset

that our definition of the Hybrid Sector is broader than privately or individually owned firms, which

are part of this sector. In particular, firms that are partially owned by local governments (e.g.,

Township Village Enterprises or TVEs) are also included in the Hybrid Sector, because: first,

despite the ownership stake of local governments and the sometimes ambiguous ownership

structure and property rights, the operation of these firms resembles more closely that of a for-

profit, privately-owned firm than that of a state-owned firm; and second, the ownership stake of

local governments in many of these firms has been privatized.1 The growth of the Hybrid Sector

has been much higher than that of the State Sector (state-owned enterprises or SOEs, and all firms

where the central government has ultimate control) and the Listed Sector (publicly listed and traded

firms with most of them converted from the State Sector), and contributes to most of the economic

growth. We believe these alternative channels and mechanisms should be encouraged going

forward. They can co-exist with the banks and markets while continuing to fuel the growth of the

Hybrid Sector.

Finally, in our view a significant challenge for China’s financial system is to avoid

damaging financial crises that can severely disrupt the economy and social stability. China needs to

guard against traditional financial crises, including a banking sector crisis stemming from

continuing accumulation of NPLs and a sudden drop in banks’ profits; or a crisis/crash resulting

from speculative asset bubbles in the real estate market. China also needs to guard against new

types of financial crises, such as a “twin crisis” (simultaneous foreign exchange and banking/stock

market crises) that was prevalent in many Asian economies in the late 1990s. The entrance of

China into the World Trade Organization (WTO) introduces cheap foreign capital and technology,

but large scale and sudden capital flows and foreign speculation significantly increase the likelihood

of a twin crisis. At the moment, the rapid increase in China’s foreign exchange reserves suggests

that there is a large amount of speculative money in China in anticipation of an appreciation of the

RMB, China’s currency, relative to all other major currencies. Depending on how the government

and the central bank handle the process of revaluation, there could be a classic currency crisis as the 1 The Hybrid Sector comprises all the firms that are not state-owned or publicly listed, and more specifically, it includes the following types of firms (see Appendix A.5 for details): 1) privately owned companies (but not publicly listed and traded): controlling owners can be Chinese citizens, investors (or companies) from Taiwan or Hong Kong, or foreign investors (or companies); 2) collectively- and jointly-owned companies, where joint ownership among local government, communities, employees, and institutions is forged. See Li (1996) and Che and Qian (1998) for arguments on why an ambiguous ownership structure with local governments is more efficient than well defined private property rights or state ownership in an environment with underdeveloped markets and institutions.

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government and central bank try to defend the currency peg, which in turn may trigger a banking

crisis if there are large withdrawals from banks. In order to prevent such a crisis, policies

improving the financial system should be implemented in conjunction with supportive fiscal and

trade policies.

The remaining sections are organized as follows. In Section II, we review the history of

China’s financial system development, present aggregate evidence on China’s financial system, and

compare them to those of developed and other developing countries. In Section III, we examine

China’s banking system and the problem of NPLs and reforms. In Section IV, we examine the

growth and irregularities of financial markets and listed firms. In Section V, we examine the non-

standard financial sector, including alternative financial channels and governance mechanisms. We

then examine different types of financial crises and how China’s financial system can be better

prepared for these crises in Section VI. Finally, Section VII concludes the paper and is followed by

the Appendix that contains definitions and sources of all key terms and phrases used.

II. Overview of China’s Financial System

In this section we examine China’s financial system, focusing on both the banking system

and financial markets, as well as firms’ financing channels at the aggregate level, including non-

bank and non-market channels. Appendixes A.1 through A.3 contain definitions and sources of

variables used in Table 1 and Figures 1 and 2, while Appendix A.4 contains definitions of different

types of financial intermediaries.

II.1 A Brief Review of the History of China’s Financial System

China’s financial system was well developed prior to 1949.2 The earliest form of capitalism

can be traced back to the late Ming Dynasty (17th century), with commerce initiated in the Zhejiang-

Jiangsu area and further developed during the Qing Dynasty (17th century to early 20th century). The

Opium War (1840s) between China and Great Britain ruined China’s sovereignty, but it brought

Western-style legal and capital systems into China’s coastal areas (until 1949). In 1904, the newly

created Ministry of Commerce (Shangbu) of the waning Qing government issued China’s first

Company Law (Gongsilü), aimed at promoting China’s industrial development. Interestingly,

foreign systems and the Chinese system co-existed and commerce boomed. Despite the entrance

and development of Western-style courts in Shanghai and other major coastal cities (see Lee (1993)

2 For more details on the description of pre-1949 history of China’s financial system and the rise of Shanghai as China’s financial center, see, for example, Chow (2004), Kirby (1995), and Lee (1993).

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for a description on how these courts functioned), most business-related disputes were resolved

outside courts. Late Qing China had a highly commercialized society, and dispute resolution by

guilds (merchant coalitions), families, and local notables based on the detailed regulations of guilds,

family traditions, and customs was commonplace (see, e.g., Kirby 1995). In Section V.4 below, we

argue that modern equivalents of these mechanisms were behind the success of Hybrid Sector firms

in the same areas in the 1980s and 1990s.

The development of China’s financial system from the late nineteenth century to the early

twentieth century was highlighted by the emergence of Shanghai as the financial center of China

and Asia (see, e.g., Lee (1993) for more details). During this period, Shanghai transformed from an

agricultural-based trading hub for surrounding areas into an industrialized center linked to

international goods and financial markets. With thriving entrepreneurial and trading activities,

financial institutions proliferated and financial innovations surged. For example, the number of

Chinese lending institutions (qianzhuang) exceeded 105 in 1875; five of China’s first modern banks

were founded between 1897 and 1908; and by 1936, there were 28 major foreign banks that had set

up branches in Shanghai. Merchants used up to eleven currencies in their transactions, some of

which were printed by local banks; the exchange rate of local currency saw wide fluctuations; many

unregistered local banks (diaotang) engaged in high-leverage credit transactions with little capital

reserves and defaulted frequently. At the same time, merchants’ fear of risk spawned an active

insurance industry, which was first introduced by the British. Insurance on real estate, ships, and

goods became routine, with collateral and personal guarantors accompanying large transactions to

reduce the risk of non-payments; to alleviate the problems of asymmetric information, foreign

merchants hired Chinese middlemen (and guarantors) to select Chinese merchants. Chinese and

foreign merchants also devised the “commission indent system,” an early form of trade credit

allowing firms and institutions to operate with minimum financial resources. Finally, the stock

exchange in Shanghai was the largest in Asia for most of the 1920s and 1930s.

After the foundation of the People’s Republic of China in 1949, all of the pre-1949 capitalist

companies and institutions were nationalized by 1950. Between 1950 and 1978, China’s financial

system consisted of a single bank -- the People’s Bank of China (PBOC), a central government

owned and controlled bank under the Ministry of Finance, which served as both the central bank

and a commercial bank, controlling about 93% of the total financial assets of the country and

handling almost all financial transactions. With its main role to finance the physical production

plans, PBOC used both a “cash-plan” and a “credit-plan” to control the cash flows in consumer

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markets and transfer flows from branches of the bank.

The first main structural change began in 1978 and ended in 1984. By the end of 1979, the

PBOC departed the Ministry and became a separate entity, while three state-owned banks took over

some of its commercial banking businesses: The Bank of China3 (BOC) was given the mandate to

specialize in transactions related to foreign trade and investment; the People’s Construction Bank of

China (PCBC), originally formed in 1954, was set up to handle transactions related to fixed

investment (in manufacturing); the Agriculture Bank of China (ABC) was set up (in 1979) to deal

with all banking business in rural areas; and, the PBOC was formally established as China’s central

bank and a two-tier banking system was formed. Finally, the fourth state-owned commercial bank,

the Industrial and Commercial Bank of China (ICBC) was formed in 1984, and took over the rest of

the commercial transactions of the PBOC.

For most of the 1980s, the development of the financial system can be characterized by the

fast growth of financial intermediaries outside of the “Big Four” state-owned banks mentioned

above. For example, regional banks (partially owned by local governments) were formed in the

Special Economic Zones in the coastal areas; in rural sectors, a network of Rural Credit

Cooperatives (RCCs; similar to credit unions in the U.S.) was setup under the supervision of the

ABC, while Urban Credit Cooperatives (UCCs), counterparts of the RCCs in the urban areas, were

also set up. Non-bank financial intermediaries, such as the Trust and Investment Corporations

(TICs; operating in selected banking services and non-banking services with restrictions on both the

sources of deposits and loans made), emerged and proliferated in this period. All of the new

financial intermediaries began to take deposits and make loans, which increased the competition but

also contributed to higher levels of inflation. As a result, savings deposits surged after the structural

change, while the main investment channel for firms (from the government to SOEs) shifted from

budget appropriation (70% in 1978) to loans from state-owned banks (80% in 1982). However, the

four state-owned banks had almost no discretion in making loan-related decisions as these were

based on quotas allocated by the PBOC. While foreign banks were allowed to set up representative

offices beginning in 1979 (Bank of Tokyo set up the first such office in Beijing), it was not until the

later period of 1982 to 1985 that a small number of foreign banks was permitted to set up branch

offices (for currency exchange operations) in China’s Special Economy Zones. In 1985, the

government legalized the status of foreign banks’ branches and their operations in the Zones. The

3 BOC, the oldest bank that is currently operating, was originally established by Sun, Zhongshan in 1912 as a private bank, and specialized in foreign currency related transactions.

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financial reforms slowed down during 1988-1991 to control inflation, during which considerable

(government-run) consolidation took place. For example, many TICs were merged and were

increasingly regulated by the PBOC.

In 1992, the famous “Southern Tour” by then Chinese leader Deng Xiaoping marked the

beginning of another economic boom. In the financial system, this period witnessed a sharp increase

in foreign direct investment (FDI), a deregulation of the banking sector characterized by the

emergence of many new state/local government owned commercial banks, and the re-emergence of

Shanghai as the financial center of China. Reform in the insurance industry kicked off the process

within the financial system, with the entrance of four foreign insurance companies (branches) in

Shanghai in 1992;4 in 1995, the first joint venture investment bank was formed between Morgan

Stanley and PCBC; in 1997, nine foreign banks were allowed to enter the RMB markets and

operations in the Pudong Special Zone in Shanghai. In 1994, three “policy banks” were established

to take over “policy” related lending in underdeveloped areas, export and import, and rural areas,

while the four largest state-owned banks further developed into regular commercial banks, with

profit maximization becoming an increasingly more important goal. Along with the growth of banks

and financial intermediaries, interbank lending (1994) and bond (1997) markets were established,

and the bank debit/credit cards market expanded rapidly. During the same period, the central bank

(PBOC) increasingly used interest rates and reserves to manage the liquidity of the banking sector.

For example, the PBOC sets lower and upper bounds on deposits and loans, while commercial

banks can decide the actual rates within the bounds. The interbank lending rates were converted

toward a uniform system in 1996.

The most significant event for China’s financial system in the 1990s was the inception and

growth of China’s stock market. Two domestic stock exchanges, the Shanghai Stock Exchange

(SHSE) and the Shenzhen Stock Exchange (SZSE), were established in 1990, and have experienced

remarkable growth since then. However, the legal framework and institutions that support the stock

market lag the growth of the exchanges. On a trial basis, China’s first bankruptcy law was passed

in 1986 (governing SOEs), but the formal Company Law was not effective until the end of 1999.

This version of the Company Law governs all corporations with limited liabilities, publicly listed

and traded companies, and branches or divisions of foreign companies, as well as their organization

structure, securities issuance and trading, accounting, bankruptcy, mergers and acquisitions (for

4 China Pacific Insurance Company is the oldest insurance company in China that is currently operating. Formerly known by its current name in 1943, its insurance business was revived in 1986.

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details see the website of China Securities Regulatory Commission, or CSRC,

http://www.csrc.gov.cn/). We provide a detailed analysis of the status and problems of the stock

market in Section IV below.

The exchange rate policies regarding the RMB have gone through three regimes since 1949.

First, during the period 1949 – 1978, all demand and supply (for firms, individuals, and government

agencies) of foreign currency were collected and distributed through the central government and

PBOC under official rates. Second, between 1978 and 1994, a retention system among SOEs was

introduced at the provincial level so that provincial authorities and enterprises receiving and

requesting foreign currencies (via import/export) were entitled to retain a certain proportion of the

foreign currencies conditional on their fulfillment of export quotas assigned by the central

government. A “dual” exchange system was introduced so that official exchange rate and market

exchange rates coexisted, although the latter was not freely floatable; a special currency, the “RMB

Exchange” was issued and circulated mostly among foreigners (who brought foreign currencies to

China). The retention and central planning regime was replaced by a more market-based system in

1994, which is still operating at present. The exchange rate has been exclusively pegged to the US

Dollar and can fluctuate in a small range (around US$1 = RMB 8.28) under state regulation and

monitoring. Interbank foreign exchange trading is also allowed, while the RMB Exchange currency

stopped circulation. Individuals and enterprises have much more freedom in terms of holding

foreign currencies for various purposes (so that the current account can fluctuate significantly in the

short term), although the (legal) currency flows must go through the BOC. At the same time, the

capital account is still not freely convertible.

Following the Asian Financial Crisis in 1997, financial sector reform has focused on state-

owned banks and especially the problem of NPLs (the China Banking Regulation Committee was

also established to oversee the banking industry). We will further discuss this issue in Section III.

Finally, China’s entry into the WTO in December 2001 marked the beginning of a new era. Since

the eventual opening of the capital account and adopting a floating exchange rate are required by

the WTO, we should expect to see increasing competition from foreign financial institutions and

frequent and large scale capital flows. Perhaps we can even some witness dramatic changes and

intriguing events within China’s financial system shortly after December 2006 (the end of the five-

year transition period after joining the WTO). Finally, institutional investors began to emerge in the

late 1990s although their scale and importance in the financial system was and still is limited. The

first two mutual funds (Guo Tai and Nan Fang) were established in 1998. There are 46 fund

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companies at present, 33 of which are domestic fund companies, and the rest are Qualified Foreign

Institutional Investors (QFII) or joint ventures, which were allowed to enter the asset management

industry in 2003. There are no pension funds or government pension system in place. Under the

old central planning regime, pensions and other social welfare plans were provided and

implemented by individual SOEs. With many SOEs privatized or bankrupt in recent years, these

services are no longer available for an increasing number of senior employees and workers.

Establishing a feasible pension system in the near future is also one of the burning issues for China.

Presently there are no hedge funds that implement “long-short” strategies as short selling is

prohibited in China.

Insert Figure 1 here.

Figure 1 depicts the current structure of the entire financial system. In what follows we will

describe and examine each of the four sectors of the system. In addition to the standard sectors of

banking and intermediation and financial markets, we will document the importance of the non-

standard financial sector and growth of this “other sector” as China’s economy becomes more

integrated into the world economy.

II.2 The size and efficiency of the financial system: Banking and markets

For a comparison of countries, we follow the law and finance literature and in particular the

sample of countries studied in La Porta, Lopez-de-Silanes, Shleifer, and Vishny (hereafter LLSV,

1997, 1998, 2000). Their sample includes 49 countries, but China is excluded. In Table 1, we

compare China’s financial system to those of LLSV sample countries, with some measures for

financial systems taken from Levine (2002) and Demirgüç-Kunt and Levine (2001).

Insert Table 1-A here.

We first compare the size of a country’s equity markets and banks relative to that country’s

gross domestic product (GDP) in the first panel of Table 1-A. China’s stock markets are smaller

than most of the other countries, both in terms of market capitalization and the total value traded as

fractions of GDP. In order to measure the actual size of the market, “total value traded” is a better

measure than “market capitalization,” because the latter includes non-tradable shares while the

former measures the fraction of total market capitalization traded in the markets, or the “floating

supply” of the market (we further discuss this issue in Section IV below). By contrast, China’s

banking system is much more important in terms of size relative to its stock markets, with its ratio

of total bank credit to GDP (1.11) higher than even the German-origin countries (with a weighted

average of 0.99). However, when we consider bank credit issued (or loans made) to the Hybrid

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Sector only, China’s ratio drops sharply to 0.24, suggesting that most of the bank credit is issued to

companies in the State and Listed Sectors. Moreover, China’s banking system is not efficient: its

overhead cost to total assets (0.12) is much higher than the average of French-origin countries

(0.05), the next highest group of countries.

The second panel of Table 1-A compares the relative importance of financial markets vs.

banks (“Structure indices”). China has the lowest scores for both “Structure Activity” (Log of the

ratio of Value Traded/Total Bank Credit) and “Structure size” (Log of the ratio of Market

Capitalization/Total Bank Credit), suggesting that its banking sector is much larger than its financial

markets, and this dominance by the banks over markets is stronger than the average of all LLSV

sample countries. In terms of “Structure efficiency” (Log of product (Market capitalization/GDP) ×

(bank overhead cost/bank total assets)), which denotes the relative efficiency of markets vs. banks,

China has the highest score, suggesting that its stock markets are actually relatively more efficient

than banks compared to other countries. This result is mainly driven by the extremely high costs of

China’s banking system.

We also compare the development of the entire financial system (“Financial Development”),

including both banks and markets in the last panel of Table 1-A. Given that all other countries’

measures were based on private bank credit only, if we only include China’s bank credit made to

the Hybrid Sector, we find that China’s overall financial market size, in terms of both “Finance

Activity” (Log of product of (Total value traded/GDP) × (Private credit/GDP)) and “Finance Size”(

Log of product of (Market capitalization/GDP) × (Private credit/GDP)), is smaller than the LLSV

sample average level, and is only higher than the French-origin countries’ average. In terms of

“Finance Efficiency” (Log of (Total value traded/GDP)/Overhead cost), China’s measure is below

all sub-samples of LLSV countries. Based on the above evidence, we can conclude that China’s

financial system is dominated by a large but inefficient banking sector.

II.3 Firms’ financing channels: Aggregate evidence

The four most important financing sources for all firms in China, in terms of firms’ fixed

asset investments, are: (domestic) bank loans, firms’ self-fundraising, the state budget, and foreign

direct investment (FDI). By far the two most important sources of financing channels are self-

fundraising and bank loans. Consistent with previous evidence on China’s banking sector, bank

loans, including loans from the non-state banks, provide a large amount of funds to firms, and

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constitute a large fraction of firms’ total financing needs.5

Self-fundraising includes proceeds from capital raised from local governments (beyond the

state budget), communities and other investors, internal financing channels such as retained

earnings, and all other funds raised domestically by the firms. Since our current data source, the

China Statistical Yearbook (2000-02), does not provide the breakdowns of “self-fundraising,” we

can only present the total figures. The size of total self-fundraising of all firms has been growing at

an average annual rate of 14% over the period of 1994-2002. Total self-fundraising (for fixed asset

investment) reached US$275.5 billion at the end of 2002, compared to a total of US$106.6 billion

for domestic bank loans for the same year. It is important to point out that equity and bond

issuance, which are included in self-fundraising, apply only to the Listed Sector, and account for a

small fraction of this category. Moreover, self-fundraising is the most important source of financing

for many types of firms. For example, individually owned companies (of the Hybrid Sector), not

surprisingly, rely mostly on self-fundraising (about 90% of total financing). Interestingly, even for

state- or quasi-state-owned companies, self-fundraising is also important in that it captures

somewhere between 45% and 65% of total financing.

The state budget and FDI are the other two important financing sources. As was the case for

all socialist countries, China used to rely on a central planning system to allocate the state budget to

most of the companies in the country. But the state budget now only contributes 10% of state-

owned companies’ total funding. On the other hand, FDI is comparable to the state budget, both in

terms of aggregate size and in terms of the relative importance in firms’ financing. This evidence

confirms that China has evolved from a centrally planned, closed economy toward an open market

economy. For example, in terms of the ratio of FDI over GDP, China attracted more FDI than both

South Korea and Taiwan during the 1990s.

With the knowledge of the four financing channels at the aggregate level, we now focus on

different types of firms’ financing decisions. The results are presented in Figures 2-A, 2-B, and 2-C.

In all of these figures, each of the four connected lines represents the importance of a particular

financing channel over the time period of 1994-2002, measured by the percentage of firms’ total

financing coming from this channel.

Insert Figures 2-A, 2-B, and 2-C here.

5 For example, firms in the State Sector rely on bank loans to raise more than 25% of their total financing needs. A similar pattern holds for jointly- and collectively-owned companies, both of which belong to the Hybrid Sector. Our survey evidence also indicates that bank loans are important financing sources for the Hybrid Sector.

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First, Figure 2-A (2-B) illustrates how firms in the Listed Sector (State Sector) finance their

investment for fixed assets. While the Listed Sector has been growing fast, SOEs are on a

downward trend, as privatization of these firms is still in progress. Around 30% of publicly traded

companies’ funding comes from bank loans, and this ratio has been very stable, despite the fast

growth of the stock markets (Figure 2-A). Around 45% of the Listed Sector’s total funding comes

from self-fundraising, including internal financing and proceeds from equity and bond issuance.

Moreover, equity and bond sales, which rely on the use of external markets, only constitute a small

fraction of total funds raised in comparison to internal financing and other forms of fundraising.

Combined with the fact that self-fundraising is also the most important source of financing for the

State Sector (Figure 2-B), we can conclude that alternative channels of financing are important even

for the State and Listed Sectors.

Next, we consider how firms in the Hybrid Sector raise funds (Figure 2-C). Self-fundraising

here includes all forms of internal finance, capital raised from family and friends of the founders

and managers, and funds raised in the form of private equity and loans. Clearly, this category is by

far the most important source of financing, accounting for close to 60% of total funds raised.

Moreover, since firms in this sector operate in an environment with legal and financial mechanisms

and regulations poorer than those available for firms in the State and Listed Sectors, financing

sources may work differently from how they work in the State and Listed Sectors, and those in

developed countries.

II.4 China’s “foreign” financial sector

As the largest emerging economy, China has attracted a large amount of foreign investment,

in terms of FDI, joint ventures, holdings of B share stocks, and so on. It will not be surprising that

this trend continues in the foreseeable future. Here we provide a brief overview of China’s

“foreign” financial sector, through which capital flows out of China and to other countries. This

sector is in its infancy, but will probably grow rapidly in the near future as China becomes more

integrated with the rest of the world’s economy and financial system.

Insert Tables 1-B and 1-C here.

Table 1-B compares both the flows (Panel a) and stocks (Panel b) of the inflow and outflow

of FDI in China and other countries and regions. The scale of China’s FDI outflows (both in flows

and stocks) is diminutive (about one tenth) relative to the inflows, and unlike the inflows they have

not exhibited a steady growth trend. While China’s scale of total FDI inflows dominates that of

Singapore, the scale of outflows is much smaller than Singapore, whose financial system is highly

14

integrated into the international system. In terms of the fraction of gross fixed capital formation (or

investment for fixed assets), China’s FDI inflows are again higher than the averages for other Asian

countries, developing countries and the entire world, but the outflows are lower than the averages of

these regions.

Table 1-C provides an overview of cross-border mergers and acquisitions (M&As). Once

again, in terms of total deal value, foreign firms and investors have acquired more Chinese firms

(“sales”) than Chinese firms/investors have acquired foreign firms (“purchases”); while the sale of

Chinese firms to foreign firms and investors is higher than that of Singapore, firms and investors

from Singapore have purchased more foreign firms than their Chinese counterparts. An example of

the cross-border M&A is the Lenovo Group’s US $1.25 billion purchase of IBM’s personal

computing division and subsequent formation of the Lenovo U.S. in 2005 (e.g., Financial Times,

12/08/2004, and http://www.lenovo.com). Founded under the name Legend Co. by eleven Chinese

computer engineers (who worked for the Computation Center in the Chinese Academy of Science)

in 1984, this Hybrid Sector firm enjoyed a fast growth track and was listed and traded on the Hong

Kong Stock Exchange (HKSE) in 1994. Total sales of Lenovo U.S. in 2005 are expected to top

US$13 billion. Despite the small scale of Chinese firms’ acquisitions of foreign firms to date, the

number of the type of acquisitions accomplished by Lenovo are expected to rise exponentially over

the next few years.

China’s banking sector also has a limited amount of investment overseas. According to the

Almanac of China’s Banking and Finance (1996-2003), at the end of 2002, all of China’s

commercial banks (state-owned and non-state owned) have around 670 foreign branches, holding a

total amount of US$160 billion assets and $156 billion liabilities; more than 90% of these branches

and their assets and liabilities belong to the ‘Big Four’ state-owned banks. The entire banking

system (including all non-bank financial intermediaries) has net assets (total assets minus liabilities)

overseas in the amount of US$380 billion. Finally, there are currently 111 Chinese firms listed on

exchanges overseas: 108 in the HKSE, 13 in the U.S. (NYSE and NASDAQ), 3 in the U.K., and 2

in Singapore.

III. The Banking and Intermediation Sector

In this section we examine the status of China’s banking and intermediation sector. After

reviewing aggregate evidence on bank deposits and loans, we analyze the problem of NPLs in the

15

banking sector as well as assess solutions to this problem. Finally we review evidence on the growth

of non-state banks and financial intermediaries.

III.1 Aggregate Evidence on Bank Deposits and Loans

Similarly to other Asian countries, household savings rates have always been high in China.

Given the growth of the economy, the sharp increase in personal income and limited investment

opportunities, it is not surprising that total bank deposits from individuals have been growing very

fast since the mid-1980s, with the 2001 figure approaching RMB 7000 billion (or US$800 billion).

From Figure 3-A, residents in metropolitan areas contribute the most to total deposits beginning in

the late 1980s (roughly 50%), while deposits from enterprises (including firms from all three

sectors) provide the second most important source. The role of deposits from government agencies

and organizations (including non-profit and for-profit organizations) has steadily decreased over

time, while the increasing gap between urban and rural deposits indicates the increasing imbalance

of wealth and living standards in these areas.6 Moreover, ownership of bank deposits is highly

concentrated, in that 60% of all bank deposits are held by less than 10% of the population (China

Daily, and Washington Post Foreign Service, Nov. 2001)

Insert Tables 2-A, 2-B, and Figures 3-A and 3-B here.

Table 2-A compares total savings and bank deposits across China, Japan, South Korea, and

India during the period from 1997-2002. In terms of the ratio of Gross Domestic Savings/GDP (the

term “Gross Domestic Savings” comes from national accounts and includes more categories than

bank deposits), China maintains the highest level (around 40%), while Japan leads the group in

terms of total amount. Looking at the breakdown of bank deposits, interest-bearing “savings

deposits” are by far the most important form of deposits in China, providing a good source for bank

loans and assets. Figure 3-B compares total bank credit extended to Hybrid Sector firms in China,

and privately owned firms (including those publicly listed and traded) in Taiwan and South Korea

during their respective high economic growth periods: China in the 1990s and Taiwan and South

Korea in the 1970s (each year appearing on the horizontal axis indicates the time period for China,

while a particular year minus 20 indicates the time period for Taiwan and South Korea). We can see

that the growth of China’s (bank) ‘hybrid’ credit has been faster than the growth of private credit

that Taiwan and South Korea experienced in the 1970s: with less than 5% of GNP in 1995, the ratio

of total outstanding bank credit to the Hybrid Sector of China reached 25% of GNP at the end of

6 However, depositors in cities include the large population of workers who are rural residents by birth and registration (hukou) but are currently working in cities.

16

1999. Consistent with the aggregate evidence from Section II above and our firm-level evidence

below, we find that bank loans are one of the most important financing sources for Hybrid Sector

firms.

Table 2-B breaks down China’s bank loans by borrower types and loan purposes. The

overwhelming amount of bank loans goes to manufacturing industries with many SOEs, while the

amount of loans made to TVEs, privately- and collectively-owned firms, and joint ventures (the last

3 columns of Table 2-B), which all belong to the Hybrid Sector, is much less.7 According to an

IFC/World Bank report (Gregory et al. 2000), which incorporates data published by the PBOC,

loans made to privately owned firms (part of the Hybrid sector) from all banks is less than 1% of

total loans made in 1998 with half of these loans from state-owned banks.

Researchers have argued that the imbalance between loans made to the State Sector and the

Hybrid Sector reflects the government’s policies of wealth transfer from the Hybrid Sector to the

State Sector via state-owned banks, among other channels. Brandt and Zhu (2000) argue that the

employment and investment growth in the inefficient State Sector have been supported by the

government in the form of cheap bank credits and money creation (or inflation taxes). With

aggregate data between 1979 and 1993, they find that an average of 84% of all new credits from the

state banking system is allocated to the State Sector; more than one-third of the loans were “policy

loans” financed by policy banks and/or the PBOC, which were generally not repaid. However, with

decentralized credit allocation, even state-owned banks diverted some credit to the more productive

firms from the Hybrid Sector, fueling the increasing gap in productivities and profits in these

sectors. To maintain the growth of the State Sector, the government relied more on money creation

to finance the wealth transfer in late 1980s and early 1990s, which contributed to high inflation.

Insert Table 2-C here.

Table 2-C presents evidence consistent with the above arguments. Panel a) presents the

changes (in percentage) in the overall Consumer Price Index (CPI) and those for urban and rural

areas. High inflation was the norm in the early 1990s: for example, in 1989 (1994), price levels rose

by more than 15% (23%) over that of 1988 (1993); during the late 1990s the government tightened

monetary supply to control inflation and as a result, deflation was observed in 1999 and 2002. Panel

b) presents nominal interest rates offered by Chinese banks on savings deposits (of both households

and enterprises), while rates on loans to enterprises are shown in Panel c). Both sets of rates are set

7 Without detailed breakdowns of different types of loans made to different sectors, we cannot estimate the exact share of total loans made to the three sectors.

17

and regulated by the PBOC, while actual rates offered by different types of financial institutions to

various types of depositors and borrowers can fluctuate within boundaries set by the PBOC. A

comparison of rates in Panels b) and c) reveals a large gap between the rates on lending (to firms)

vs. rates on borrowing (bank deposits), which is a source of the government’s subsidization of the

State Sector.

Despite the government’s policy of “taxing” the Hybrid Sector and subsidizing the State

Sector (via the state owned banking system), we find, in Section V.1 below, that the dominance of

the Hybrid Sector over State Sector in terms of employment and investment continued in the late

1990s and into the 2000s. We conclude that alternative financing channels and governance

mechanisms support the growth of the Hybrid Sector.

III.2 The Problem of NPLs and Possible Solutions

China’s banking sector is dominated by four large and inefficient, state-owned banks (ICBC,

BOC, PCBC, ABC). La Porta, Lopez, Shleifer (LLS hereafter, 2002) show that the government

owns 99.45% of the 10 largest commercial banks in China in 1995 (it was 100% in 1970), and this

ownership level is one of the highest in their sample of 92 countries.8 The dominance of the “Big

Four” banks also implies the degree of competition within the banking sector is extremely low.

Table 2-D, based on Demirgüç-Kunt and Levine (2001), compares the five-bank concentration

(share of the assets of the five largest banks in total banking assets) in China, Japan, South Korea,

and Taiwan. At the end of 1997 (and for much of 1990s), China’s concentration ratio of 91% is by

far the highest. However, China’s concentration ratio has been falling sharply since 1997 with the

entrance of many non-state banks and intermediaries.

Insert Table 2-D here.

The most glaring problem for China’s banking sector, and for the entire financial system in

the near future, is the amount of NPLs within state-owned banks, and in particular, among the “Big

Four” banks. Reducing the amount of NPLs to normal levels is the most important task for China’s

financial system in the short term. The main obstacle when we analyze the severity and possible

solutions of the NPLs is the lack of comprehensive and objective data on banks’ profitability

(aggregate and bank-level) and NPLs. The scarcity and deficiency in bank data can be viewed as a

strategic disclosure decision of the government, which fuels speculation that the problem of NPLs

8 Moreover, the LLS result on the negative relationship between government ownership of banks and the growth of a country’s economy seems to apply to China’s State Sector and the status quo of its banking sector. However, in Section V, we show that the high government ownership has not slowed down the growth of the Hybrid Sector.

18

must be severe. Our main data source is the Asian Banker (an international organization) database

on banking systems (including state-owned and non-state owned banks) in major Asian economies,

which is based on government and official records. We also include data from non-government

sources, including case studies from a particular region or bank. Some of this data paints a much

gloomier picture of the NPLs and China’s state-owned banks than the official data suggests. Since

without objective and accurate bank-level data we cannot determine the exact amount of NPLs or

evaluate the feasibility and effectiveness of different solutions, we present both an optimistic view

and a pessimistic view when discussing these issues.

Insert Tables 3-A, 3-B, and 3-C here.

Tables 3-A and 3-B, based on the Asian Banker database, compare NPLs and banking

system profitability in China and other major Asian economies in recent years. First, NPLs, either

as a fraction of total new loans made by all banks (including all non-state banks) or as a fraction of

GDP in a given year, are the highest in China from 2000-02 (Table 3-A). Notice that the official

information on China’s NPLs first became available in 1998, but the figures in 1998 and 1999 in

Table 3-A probably significantly under-estimate the actual size of NPLs in those years. The

comparison includes the period during which Asian countries recovered from the 1997 financial

crisis, and the period during which the Japanese banking system was disturbed by the prolonged

NPL problem. Second, the profitability of China’s banking system, measured by the return to equity

or assets, is also among the lowest in the same group of countries (Table 3-B).

As bad as the numbers in Tables 3-A and 3-B appear, they may still significantly

underestimate the amount of NPLs according to the pessimistic view. For example, Qiu et al.

(2000) estimate that the ratio of loan interest paid to state-owned banks over loan interest owed is

on average less than 50% in 1999, suggesting that the actual ratio of NPLs over total loans made

can be higher than 50% in 1999. The December 1998 issue of Guoyou zichan guanli (Management

of State Assets, p. 38) states that, “as of year-end 1997, bad loans within the entire banking

organizations (including non-state banks) of Hubei Province amounted to RMB84.5 billion, or

43.69% of all bank loans.” These two pieces of evidence suggest that the amount of NPLs (in terms

of fraction of GDP or total new loans made) can be twice as large as the figures in the period 1999-

2002 reported in Table 3-A. Consistent with this view, Lardy (1998) argues that, if using

international standards on bad loans, the existing NPLs within China’s state-owned banks as of mid-

1990s would make these banks’ total net worth negative, so that the entire network of state banks

19

would be insolvent.9

In recent years, the Chinese government has taken active measures to reduce the NPLs and

improve the efficiency of the banking sector. First, four state-owned asset management companies

(AMCs) were formed with the goal of assuming the NPLs (and offering debt-for-equity swaps to

the banks) accumulated in each of the “Big Four” state banks and liquidating them. The liquidation

process includes asset sales, tranching, securitization, and resale of loans to investors.10 Table 3-C

shows that cash recovery on the bad loans processed of these companies ranges from 7% to 35% in

2001 and 2002, while the asset recovery rate ranges from 12% to 75%. A critical issue that affects

the effectiveness of the liquidation process is the relationship among AMCs, banks, and distressed

or bankrupt firms: Since both the AMCs and the banks are state-owned, it is not likely that the

AMCs would force the banks to cut off (credit) ties with defaulted borrowers (SOEs or former

SOEs) as a privately owned bank would do (e.g., Bonin and Huang 2001). Thus, as the old NPLs

are liquidated, new NPLs from the same borrowers continue to surface.

Second, state-owned banks have diversified and improved their loan structure by increasing

loans made to individual lenders while being more active in risk management and monitoring of

loans made to SOEs. For example, the ratio of consumer lending to total loans made for the four

state-owned banks increased from 1% in 1998 to 10% in 2002; by end of 2004, 10% of all

outstanding bank loans (RMB 2 trillion or $242 billion) was extended to consumers. Mortgages,

which account for 90% of consumer credit, grew at an annual rate of 115% between 1998 and 2004

(Economist, 04/21/2005). One problem with the massive expansion of consumer credit is that China

lacks a national consumer-credit database to spot overstretching debtors, although a pilot system

linking seven cities was set up in late 2004. The deficiency in the knowledge and training of credit

risk and diligence of loan officers from state-owned banks is another significant factor in credit

expansion, which can lead to high default rates and large amount of new NPLs if the growth of the

economy and personal income slows down. Accompanying the rapidly expanding automobile

industry, the other fast growing category of individual-based loans is car loans, most of which are

9 For example, the Basle Committee for Bank Supervision classifies a loan as “doubtful” or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step is not taken until principal payment is delayed beyond the loan maturity date or the extended due date, and in many cases, until the borrower has declared bankruptcy and/or has gone through liquidation. 10 One of the four AMCs, Huarong Asset Management Co., sold tranches of securitized NPLs to a consortium of US investment banks led by Morgan Stanley (and including Lehman Brothers and Salomon Smith Barney) and to a joint venture forged between Goldman Sachs and Rongsheng Asset Management Co. in 2002. These deals were approved by the Chinese government in early 2003 (Financial Times, 05/2003).

20

made by state-owned banks.11 The total balance of all China’s individual car loans rocketed from

RMB 400 million (US$48.4 million) in 1998 to RMB 200 billion (US$24.2 billion) at end of 2003

and as much as 30% of all car sales were financed by car loans during this period (Financial Times,

05/25/2005). However, the growth in both car sales and loans has slowed down significantly since

2004 in part due to the high default rates. As many as 50% of debtors defaulted on car loans in

Shanghai and Beijing, where the largest number of cars is sold and loans are made. There are

examples in which loan applications were approved based solely on applicants’ description of their

personal income without any auditing (Barron’s, 12/06/2004).

The above examples on car loans and consumer credit illustrate the importance of reforming

state-owned banks in solving the problems of NPLs and improving the entire banking sector. A

central question in reforming the state-owned banks is the ongoing privatization process. There are

two imminent issues. First, more competition in the banking and intermediation sector, including

the entrance of more non-state (domestic and foreign) banks and intermediaries, is good for

improving the efficiency of both the “Big Four” banks and the entire banking sector. For example,

Park et al. (2003) find that competition among banks and intermediaries leads to better effort of the

banks (especially state-owned banks) and better loan decisions in China’s rural areas. Another issue

is the government’s dual role as regulator and as majority owner. These potentially conflicting roles

diminish the effectiveness in each of the two roles that the government intends to carry out. In

Section IV below, we argue that the non-tradable government shares in all listed companies should

be gradually sold off to ensure that the privatization process is complete. The same procedure

should be applied to the privatization process of state-owned banks. Only after these banks are

(majority) owned by non-government entities and individuals can they unconditionally implement

all profit- and efficiency-enhancing measures.

Third, there has been a boom in the entry and growth of non-state financial intermediaries,

and this trend is expected to continue with more foreign banks entering the domestic credit markets

as a result of China’s entrance into the WTO. In Section III.3 below, we provide more evidence on

the growth of both non-bank and non-state financial institutions. Fourth, the government has been

directly involved in reducing NPLs among state-owned banks by injecting cash into these banks. A

large fraction of the NPLs among state-owned banks resulted from poor lending decisions made for

SOEs, some of which were due to political or other non-economic reasons; thus, it makes sense for

11 A few foreign lenders (e.g., GM and Ford) were recently approved to enter the car loan market by forming joint ventures with Chinese automakers (Financial Times, 05/27/2005).

21

the government to bear the burden.

At the end of 2003, China announced that the PBOC would inject foreign currency reserves,

in the amount of US$45 billion into two of the “Big Four” banks (BOC and PCBC) to improve their

balance sheets and enhance the likelihood that these banks can go public in 2005-06 (e.g., Financial

Times, 01/09/2004; Asia Wall Street Journal, 01/13/2004). Most of the foreign exchange reserves

are in the form of US dollars, T-bills, and other dollar denominated debt securities. Given their

imminent status of becoming publicly listed corporations, BOC and PCBC were recently rated by

the Standard and Poor’s (S&P report “China’s Banking Outlook 2005”) with the same grade

“BBB–,” the lowest grade among all “investment grades.” In issuing their ratings, S&P emphasized

this rating is “based on public information, …” and pointed out that the most significant risk in

these two banks is the high level of NPLs.12 Similar fund injection plans for ICBC (the largest

commercial bank in China and one of the largest in the world in terms of book assets), in the

amount of US$15 billion, began in the first half of 2005 (Financial Times, 04/21/2005).

Given that as of the end of the first quarter of 2005, China’s total foreign exchange reserve

was US$650 billion while the total amount of NPLs was 15% of GDP at the end of 2004, or around

US$200 billion using the US$1 = 8.28 RMB exchange rate (recall that China’s RMB has been

pegged exclusively to the US dollar at 8.28 to 1), the foreign reserve itself should be more than

enough to remove the NPLs off the books of all the banks in China. There are potential problems

for the injection plan, with the possibility of creating perverse incentives for the banks being the

most serious one. If the state-owned banks that have received or will receive the cash/assets

injection believe that there will be a ‘bailout’ during future financial distress, then the moral hazard

problem can worsen the current status of NPLs. This is because, in anticipation of a bailout from

financial distress, banks lose the incentive to improve efficiency while an incentive to take on risky,

negative-NPV projects surfaces. Similar problems occurred during and after the government bailout

of the S&L crisis in the US in 1980s (e.g., Kane, 1989, 2003). Hence, it is important for the

government to credibly commit that the injection plan is a one-time measure to boost the capital

adequacy of these banks, and that there will be no bailout plans in the future, especially after they

become listed companies. The second problem lies in the fact that the significant increase in foreign

reserves is in part due to the presence of large amounts of speculative foreign currencies in

12 Bank of America has recently pledged to purchase a 5% block of PCBC’s equity for US$1.5 billion to $2 billion, while the Royal Bank of Scotland is said to be ready to pay up to $4 billion for up to one fifth of BOC (The Economist, 05/19/2005).

22

anticipation of an RMB appreciation relative to major international currencies. Depending on how

the government and the central bank handle the RMB revaluation process, large movements of the

speculative currencies may cause a twin crisis in the currency market and the banking sector. We

further discuss this issue in Section VI below.

Insert Table 3-D here.

It is clear that the ultimate source of eliminating NPLs lies in China’s overall economic

growth. As long as the economy maintains its strong growth momentum so that the government’s

tax receipts also increases, the government can always assume the remainder of the NPLs without

significantly affecting the economy.13 In this regard, Table 3-D presents a comparison of the ratio

(NPLs + Government Debt)/GDP among China, Japan, South Korea, and the U.S. for the period

1997-2002, where NPLs (government debt) denotes the total outstanding NPLs in the banking

system (government debt) in a given year. The lower the ratio, resulting from low NPLs, low

government debt, or both, the more feasible it becomes for the government to assume the NPLs. We

present two sets of ratios for China: the first set of ratios are based on NPLs numbers presented in

Table 3-A (based on official data), while the second set (presented in brackets) is based on doubling

the size of NPLs (as a fraction of GDP) reported in Table 3-A. Despite its high NPLs, China has the

second lowest ratio among the four countries using official data on NPLs; these ratios are much

higher if NPLs double but they are still comparable with those of the U.S. (low NPLs but high

government debt). Based on this crude comparison, it seems that the NPLs will not be a particularly

arduous burden for the Chinese government due to the small size of its debt, while the same cannot

be said for Japan. Caution is again needed for this conclusion: first, new NPLs in China may grow

much faster than the rest of the countries; and second, the small amount of government debt may

experience a sharp increase given the need for higher fiscal spending in areas such as pension plans

and related social welfare programs.

Overall, the optimistic view on NPLs believes that, despite the large amount of existing

NPLs, the current reform of state-owned banks and development of the banking sector have already

been effective in reducing NPLs, which is why NPLs have been falling in recent years (2000-2002)

in Table 3-A. Given that the economy will probably maintain its current pace of growth, the

government can always write off a large fraction of the rest of the NPLs to avert any serious

problems for China. On the other hand, the pessimistic view believes that NPLs are much bigger

13 See, for example, Sachs and Woo (1997 review article), Rawski (2002), and Wolf (2003) for different views on the prospects of long-run economic growth and statistics on growth in China.

23

than the official statistics suggest to begin with, and that a substantial amount of new NPLs will

continue to arise within state-owned banks. Moreover, the reform of the banking sector will not be

effective because it will take a long time before the government relinquishes majority control of

state-owned banks; during this period, if the growth of the economy significantly slows down, while

the accumulation of NPLs continues, the banking sector problems could lead to a financial crisis.

This could spill over into other sectors of the economy and cause a slowdown in growth or a

recession. In this view, the NPL problem poses the most serious problem to China’s continued

prosperity.

III.3 Growth of Non-state Financial Intermediaries

The development of both non-state banks and other (state and non-state) financial

institutions is crucial for China to have a stable and functioning banking system in the future. In

addition to boost the overall efficiency of the banking system and alleviate the problems of NPLs,

these financial institutions provide funding to support the growth of the Hybrid Sector. For

example, with survey data (in the 1990s) on Hybrid Sector firms and local branches of ABC and

RCCs in the rural areas of Zhejiang and Jiangsu provinces, Brandt and Li (2003) find that while

these firms have been discriminated against in the loan market, the degree of discrimination

depends on loan officers’ incentives and human capital. In addition, Brandt et al. (2003) find that

financial institutions and their relationship with Hybrid Sector firms can drive the incentive of local

government to privatize (partially) government owned firms.

First, we examine and compare China’s insurance market to other Asian economies (South

Korea, Taiwan, and Singapore). Whether in terms of the ratio of total assets managed by insurance

companies over GDP (Figure 3-C), or premium income over GDP (Figure 3-D), China’s insurance

market is significantly smaller than that of other economies. At the end of 2004 total assets

managed were still less than 10% of GDP (while this ratio for the other three economies is over

30%). It is clear that the insurance industry is also significantly undersized compared to China’s

banking industry, and property insurance is particularly underdeveloped due to the fact that the

private real estate market was only recently established (in the past most housing was allocated by

employers). Despite the fast growth of insurance coverage and premium income, at the end of 2000

only 1.8% of the total population was covered by life insurance (resulting in a per capita premium

of only RMB 127 per year); coverage for property insurance is even lower (Almanac of China’s

Finance and Banking).

Insert Tables 4-A and 4-B, and Figures 3-C and 3-D here.

24

Table 4-A provides a (partial) breakdown of the different types of banks. In both 2001 and

2002, although the four state-owned banks dominate in every aspect of the banking sector, the role

of the non-big four banks in the entire banking sector cannot be ignored: These banks’ total assets

compose 40% of the big four (the actual fraction is likely to be higher due to incomplete

information on all types of non-bank intermediaries). A similar comparison can be made for

outstanding loans; these banks have less NPLs than the big four banks. Moreover, total new loans

made by the four largest state-owned banks accounted for more than 75% of all new loans in 1997,

while new loans made by “shareholding” banks accounted for less than 7%. In 2001, the share of

new loans made by state-owned banks dropped to 49%, while the fraction of new loans made by

shareholding banks rose to 23.5%.

Table 4-B provides evidence on the growth of non-bank intermediaries. Overall, the growth

of these non-banks intermediaries has been impressive since the late 1990s. In terms of combined

total assets held or managed, the size of all the banks and intermediaries outside of the “Big Four”

state-owned banks (first column in Table 4-B) is about 58.7% of the “Big Four” banks at the end of

2002. Among them, “other commercial banks” (many of them are state-owned), RCCs, and TICs

hold the largest amount of assets; the size of foreign banks and mutual funds (not listed in the table)

is minuscule, and these are likely to be the focus of development in the near future.14 Finally, our

coverage of non-bank financial institutions excludes various forms of informal financial

intermediaries, some of which are deemed illegal but overall provide important financing to firms in

the Hybrid Sector. We will discuss these informal intermediaries in Section V below.

IV. Financial Markets and Publicly Traded Firms

In this section, we examine China’s financial markets, including both the stock and bond

markets, and the recent addition of venture capital and private equity markets. We also compare, at

the aggregate level, how firms raise funds in China and in other emerging economies through

external markets in order to determine if China’s experience in terms of a firm’s fundraising is

unique. We then focus on publicly traded companies and examine their financing and investment

decisions. Finally, we discuss how to further develop financial markets as well as improve corporate

governance and the performance of listed firms.

14 Postal savings (deposit-taking institutions affiliated with local post offices) is another form of non-bank intermediation that is not reported in Table 4-B due to lack of time series data. However, at the end of 1999, total deposits within the postal savings system exceeded RMB 380 billion, or 6.4% of all deposits in China.

25

IV.1 Stock Exchanges and Market Inefficiencies

Since the inception of China’s domestic stock exchanges, the SHSE and SZSE, in 1990, they

have been growing very fast. At the end of 2002, the combined total market capitalization of these

two exchanges ranked 11th among the largest stock exchanges in the world (Table 5-A). However, a

significant fraction of all the (equity) shares is nontradable (see Section IV.4 below for more

details); nevertheless, total market capitalization using tradable shares reached US$170 billion in

2001. Another factor is that the HKSE, where selected firms from Mainland China can now be

listed and traded, is ranked 10th in the world by itself. If we rank the combined size of all stock

exchanges in a country, China would rank fifth, behind the U.S., Japan, U.K., and France.

Insert Table 5-A here.

As fast as the growth of China’s stock markets has been, they are not efficient in that prices

and investors’ behavior are not driven by fundamental values of listed firms. In Table 5-A,

“Concentration” measures the fraction of total market capitalization of an exchange that is coming

from the combined capitalization of the largest firms ranked in the top 5% (by capitalization). The

dominance of large-cap stocks in China is the lowest among major stock exchanges in the world,

with its concentration ratio of 29.4% less than half of that of Tokyo, which has the second-lowest

concentration. On the other hand, stocks are traded extremely frequently in China, as shown by the

highest “Turnover Velocity,” defined as the total turnover for the year expressed as a percentage of

total market capitalization, among the largest exchanges. China’s turnover velocity of 224.2% is

even higher than that of NASDAQ (159.8%), with the well-known trading patterns of many small

and medium technology stocks (while the concentration ratio of NASDAQ is 63.1%). Consistent

with our findings, Morck et al. (2000) find that stock prices are more ‘synchronous” (stock prices

move up and down together) in emerging countries including China than in developed countries.

They attribute this phenomenon to poor minority investor protection and imperfect regulation of

markets in emerging markets. With a large data set of individual trading, Feng and Seasholes (2004)

find that buy and sell trades are highly correlated (occur at the same time period, such as in the

same day) in China, especially among investors who conduct their trades near one of the two stock

exchanges or near firms’ headquarters.

Moreover, there have been numerous lawsuits against insider manipulation and trading. A

good example is the rise and fall of Guangxia Industry Co., Ltd., dubbed as ‘China’s Enron.’15

15 For more details on Guangxia, see the August 3, 2001 issue of the Caijing Magazine (‘Finance and Economics Magazine’), a leader among China’s financial press and the “whistle blower” of the Guangxia scandal.

26

Located in Ningxia Province, one of the poorest areas of China, Guangxia was listed on the SZSE in

1994 as a manufacturer of floppy disks and related products. After reporting poor and deteriorating

performance in its original line of business and in all other diversifying new lines of businesses for

the first five years, the company released unprecedented high EPS (earnings per share of the stock)

at the end of 1999, and claimed that they had mastered the techniques of CO2 fluid extraction and

signed a lucrative, multiple year sales contract with a German company. Subsequently, the

company’s stock price shot up from RMB 14 to RMB 76 in one year and realized an annual return

of 440%, highest among all listed companies in either stock exchange in 2000. After the article in

Caijing Magazine raising doubts about the ‘star’ company was published, CSRC launched an

investigation and found that the reported earnings along with many sales records and contracts,

including the one with the German company, were fabricated, and the company was in fact losing

money. The company’s top executives were criminally charged and its auditors lost their licenses.

Shareholders’ lawsuits were eventually processed for the first time by courts around the country,

after much delay and a change of procedure for handling such cases was approved by the Supreme

Court. The most damaging piece of evidence from this case is that, unlike Enron, Guangxia’s

managers did not use any sophisticated accounting and finance maneuvers to mask their losses

(even by China’s standards); the collective failure of internal and external monitors and regulators

indicates that either these ‘gatekeepers” lack basic professional skills, or proper incentives to do

their job, or both.

The above example also reveals that the inefficiencies in the Chinese stock markets can be

attributed to poor and ineffective regulation. The current process of listing companies fosters both a

problem of adverse selection among firms seeking an initial public offering (IPO), and a moral

hazard problem among listed firms. First, even though there has never been any explicit regulation

or law against the listing of non-state owned firms, the going public process strongly favors former

SOEs with connections with government officials. For example, each candidate firm must obtain

listing quota/permission, disclose financial and accounting information, and is subject to a lengthy

evaluation process; the whole process is inefficient due to bureaucracy, fraudulent disclosure, and

lack of independent auditing. As a result, most of the listed firms are indeed former SOEs (more

evidence to follow in Section IV.4). Second, once listed, managers in firms with severe agency

problems do not have an incentive to manage assets to grow, but rather to rely on the external

capital market to raise funds (mainly through mergers and acquisitions, and seasoned offerings of

27

securities) to pursue private benefits. Due to data limitations, we again present case studies to

illustrate the above problems (for more details, see http://finance.sina.com.cn).

First, the IPO experience of Hongguang Industrial Co., Ltd., with its headquarters in

Chengdu (capital city of Sichuan Province), illustrates the inefficiency of the listing process. With

an IPO price of RMB 6.05 (on the SHSE), Hongguang raised RMB 410 million in June 1996. In its

prospectus, the company claimed that it had made profits in each of the three years prior to the IPO

year, its financial statements were audited by a Chinese CPA firm, and its forecasted 1997 net

income (RMB 71 million) and EPS (31 fen; equivalent to 31 cents) were in line with the disclosed

figures for pre-IPO years. Within one year of its public listing, the company announced that it

incurred a net loss of RMB 198 million and EPS of negative 86 fen. A CSRC investigation revealed

that in order to meet the criteria for an IPO, the company had not only forged its profit records for

all three years prior to the IPO year, but also failed to disclose that its major production facility was

so outdated that it could not maintain normal operations. The company used more than 80% of its

IPO proceeds to pay off its debt, in contrast to the stated purposes in the prospectus, and it actually

under reported the amount of losses in 1997 by 15%. How did such a company obtain the precious

IPO quota in 1996? The municipal government of Chengdu championed the company’s IPO

application by stating that “… this high-tech enterprise will become one of the 100 modern

enterprises of China…” In reality, the listing of this financially distressed former SOE shifted the

burden from the government to the investing public.

Second, following the scandal of Guangxia described above, Sanjiu Medical &

Pharmaceutical Co., Ltd (hereafter the Company), another SZSE listed company, was the target of a

CSRC investigation in 2001. The Company belongs to the Sanjiu Group (hereafter the Group), the

largest domestic pharmaceutical group in China, founded by Mr. Xinxian Zhao in 1985. Since then,

Mr. Zhao pursued an aggressive expansion policy through acquisitions financed by bank debt, but

many acquired companies performed poorly and the Group’s high leverage ratio significantly

constrained its ability to receive more loans and further expand. The solution was the IPO/listing of

the Sanjiu Company in 1999 (a major subsidiary of the Group), which raised RMB 1.69 billion

(around US$200 million). During the first year after its IPO, the Company paid RMB 360 million to

its parent (the Group) to cover acquisitions of six companies, and this practice continued in the

following two years. Essentially, the listed Company became the ‘cash cow’ for the struggling yet

still expanding parent. By May 2001, the Group and associated companies had ‘tunneled’ more than

RMB 2.5 billion from the Company, which accounted for 96% of the Company’s net assets, yet the

28

Group was still in financial trouble with high debt ratios and low return on assets. The joint

financial status of the Group and Company triggered lawsuits by banks, forcing repayment of loans

immediately. How can such ostensible expropriation of the Company’s shareholders’ wealth take

place? Because the Group, through direct and indirect ownership, owns 73% of the Company’s

stock, while Mr. Zhao was the President of the Group and Chairman of the Board of Directors of

the Company.

In Section IV.6 below, we propose specific measures that can be implemented to improve

the efficiency of the stock markets as well as the corporate governance of listed firms.

Insert Figure 4 here.

Finally, Figure 4 compares the performance of major stock exchanges around the world,

with performance measured by the buy-and-hold return in the period 1992-2003 (gross return at the

end of 2003 with $1 invested in each of the valued-weighted stock indexes in the beginning of

1992). The performance of the value-weighted SHSE index (the calculation for the SZSE is very

similar) is only better than that of the Nikkei Index, whose poor performance was caused by the

prolonged recession of the Japanese economy in the 1990s, while underperforming the indexes of

the S&P 500, NASDAQ, and the Hang Seng. Since China’s economy was growing at much higher

rates than the U.S. during the period (over 11% per annum for China vs. 4.5% for the U.S. in PPP

terms), the fact that the SHSE index underperformed the S&P index by 120% suggests that listed

firms are among the low-quality firms in China.

IV.2 Overview of Bond Markets

Table 5-B provides information on the growth of China’s bond markets from 1998 to 2002.

The government bond market did not grow as fast as the stock market, but did have an annual

growth rate of 11.7% during the time period in terms of newly issued bonds, while total outstanding

bonds reached RMB 1,933.61 billion (or US$233 billion). The second largest component of the

bond market is called “policy financial bonds” (total outstanding amount RMB 1,005 billion at the

end of 2002). These bonds are issued by “policy banks,” which belong to the Treasury Department,

and the proceeds of bond issuance are invested in certain industries (e.g., infrastructure, similar to

municipal bonds in the U.S.). Compared to government-issued bonds, the size of the corporate bond

market is minuscule: In terms of the amount of outstanding bonds at the end of 2001, the corporate

bond market is less than one-fifteenth of the size of the government bond market.

Insert Table 5-B and Figures 5-A and 5-B here.

29

In fact, the under-development of the bond market, especially the corporate bond market,

relative to that of the stock markets, is not uncommon among Asian countries. In Figures 5-A and 5-

B we compare different components (bank loans to private sectors or the Hybrid Sector of China;

stock market capitalization; public/government and private/corporate bond markets) of the financial

markets around the world with Figure 5-A (5-B) presenting data at the end of 1995 (2003). First,

compared to Europe and the U.S., the size of both the government (public) and corporate (private)

bond markets is smaller in Non-Japan Asia (Hong Kong, South Korea, Malaysia, Taiwan,

Singapore, Indonesia, Philippines, and Thailand); even in Japan, the size of the corporate bond

market is small compared with its government bond market. Second, consistent with previous

evidence, the size of all four components of China’s financial markets are small relative to other

regions and countries, including bank loans made to the Hybrid Sector (private sector) in China

(other countries). Moreover, the most under-developed component of China’s financial markets is

the corporate bond market (labeled “private” bond market).

Perhaps the most important reason for the imbalance among different financial markets lies

in investors and markets’ ability to “price” the risk of investing in stocks and bonds as well as the

possibility of being compensated by the risk and uncertainty of investing in these (corporate)

securities (e.g., Herring and Chatusripitak 2000). On the other hand, the development of the bank

loans market does not rely on sophisticated institutions, because banks have the expertise (based on

their long-term relationship with firms) to evaluate even opaque and risky firms. In order to price

bonds (or assign the proper interest rate), investors must have accurate estimates of the probability

of default and recovery rate in the case of default. These probabilities are not available without a

sound accounting/auditing system and high-quality bond-rating agencies. Another important fact is

that during a firm’s default, the conflict of interest between the firm’s bondholders and stockholders

usually favor stockholders, because managers of the firm work on behalf of stockholders. This is

true even in countries with strong protection of creditor rights. In emerging economies, creditor

rights protection is much worse and the courts are not efficient, all of which imply that the recovery

rate for bondholders during default will be very low. Finally, the lack of institutional investors

makes matters worse, in that these investors are better at monitoring firms’ managers than dispersed

(small) bondholders.

On the other hand, we already mentioned that stock markets in emerging countries, such as

in China, are not efficient in that prices do not necessarily reflect fundamentals of firms. So why are

investors willing to take the chance of investing in stocks? One reason is the stock market’s ability

30

to provide a better arena than the bond market in fulfilling investors’ motive of speculation, since

stock prices fluctuate more than bond prices (when firms are not in financial distress), and there is

no limit on the upside of holding stock as stockholders own the residual claim of the firm’s assets.

Thus, investors believe, despite the large amount of risk, that they can be compensated by the

possibility of a “lottery-like” winning payoff.

As Herring and Chatusripitak (2000) point out, the lack of a well functioning bond market

reduces the overall efficiency of the financial markets, which is detrimental to the economy. In the

absence of an efficient bond market, the economy will lack a market-determined term structure of

interest rates that accurately reflects the opportunity cost of funds at each maturity.16 The

deficiencies in the term structure of interest rates consequently hamper the development of

derivatives markets that enable firms and investors to manage risk, as well as the effectiveness of

the government’s macroeconomic policies. Therefore, it is imperative that China should develop its

bond markets in the near future along with its legal system and related institutions.

IV.3 Fundraising through Financial Markets and International Comparison

First, we briefly examine the role of financial markets in helping firms raise funds (Table 5-

C). Both the scale and relative importance (compared with other channels of financing) of China’s

markets for finance from outside the firm or External Capital as it is called in the literature are not

significant. For example, for the ratio of External Capital and GNP, the LLSV (1997a) sample

average is 40%, compared to China’s 16% (using only the floating supply or value traded part of the

stock market, rather than the total market capitalization). For the ratio of total debt (including bank

loans and bonds) over GNP, the LLSV sample average is 59%, compared to China’s 35%.

However, if we include all debt, including bank loans, issued to all sectors including the State

Sector, this ratio increases to 79%, suggesting that the majority of debt does not go through the

capital markets, consistent with evidence on bank credit.

Insert Table 5-C here.

Next, we compare, at the aggregate level, external financing (i.e. financing from outside the

firm), in China and other major emerging economies. We also relate the aggregate financing

channels with the growth of the economy during different growth periods, in order to determine

whether the Chinese experience in financing is unique. First, Figure 6-A compares the development

16 Given the small size of the publicly traded treasury bond market and lack of historical prices, we can only plot “snapshots” of a partial yield curve (maturities range from one month to 1 year only) based on pricing data of treasury (government) bonds in the national interbank market. This is far from the standard yield curve covering interest rates on bond maturities ranging from 1 month to 10 years.

31

of stock markets at the aggregate level, while Figure 6-D compares the growth rates of (PPP-

adjusted) GDP. Both Taiwan and South Korea experienced high GDP growth in the 1970s and early

1980s, while the total market capitalization of their respective stock markets accounted for less than

20% of their GNPs during the same period, and the growth of stock markets did not take off until

the mid- to late-1980s. Figure 6-B compares the growth of corporate bond markets: South Korea

having the fastest growth path, while in Taiwan and China the corporate bond markets seem to lag

the development of stock markets. Finally, Figure 6-C compares total equity issuance including

IPOs and SEOs (seasoned equity offerings). With the exception of South Korea, China seems to be

on similar pace in terms of size of equity issuance (as fraction of GNP in a given year) with Taiwan,

India, and Brazil.

Insert Figures 6-A through 6-D here.

From the above comparisons it is clear that the development of China’s external markets

relative to its overall economic growth is not dramatically different from other emerging countries.

One of the common patterns is that the development of external markets trails that of the growth of

the overall economy. This is not surprising given that the development of these markets requires a

minimum efficiency for a country’s institutions including the legal system, accounting standards,

and the development of associated professionals. By contrast, during early stages of economic

growth, alternative institutions and mechanisms alone can support the growth of firms and the

overall economy, as is the case for China based on our evidence. Perhaps similar institutions have

worked well in other emerging and developed economies as well, and future research can determine

whether the Chinese experience also occurs in other countries.

IV.4 Evidence on the Listed Sector

In this section, we focus on publicly traded companies and examine their financing and

investment decisions. One of the goals of this analysis is to draw general conclusions on whether

there are fundamental differences between the Chinese firms and firms studied in previous papers

(LLS 1999; LLSV 1997a, 2000b, 2002). Before doing that, let us look at the unique ownership

structure and corporate governance mechanisms in Chinese firms.

Types of Stocks, Ownership Structure, and Corporate Governance

It is worthwhile to first clarify whether firms from the Hybrid Sector can become listed and

publicly traded. Regulations and laws (the 1986 trial version of the bankruptcy law and the 1999

version of the Company Law) never prohibited the listing of Hybrid Sector firms; and selected firms

from the Hybrid Sector entered the Listed Sector through an IPO or acquiring a listed firm from the

32

inception of SHSE and SZSE. However, the accessibility of equity markets for these firms has been

much lower than that of former SOEs in practice due to the enforcement of the listing standards and

process. As a result, the majority of listed firms are converted from former SOEs. In recent years,

the government attempts to change the composition of listed firms by relaxing regulations toward

Hybrid Sector firms.

Listed firms in China issue both tradable and nontradable shares (Table 6-A). The

nontradable shares are either held by the state/government or by other legal entities (i.e., other listed

or non-listed firms or organizations). Among the tradable shares, Classes A and B shares are listed

and traded in either the SHSE or SZSE, while Class A (B) shares are issued to Chinese investors

(foreign investors including those from Taiwan and Hong Kong). Finally, Class H shares can be

listed and traded on the HKSE and are issued by selected “Red Chip” Chinese companies. Table 6-

B demonstrates that nontradable shares constitute a majority of all shares and most of these shares

are held by the state, while the majority of tradable shares are A shares. Table 6-C provides some

evidence on the relation between ownership and control of the Board of Directors.17 Consistent

with Tables 6-A and 6-B and the “one-share, one-vote” scheme adopted by firms in the Listed

Sector, state and legal person shareholders appoint most of the board members, while the other

directors are appointed by the government.

Insert Tables 6-A, 6-B, and 6-C here.

We next describe standard corporate governance mechanisms in the Listed Sector.18 First,

according to the (1999) Company Law, listed firms in China have a two-tier board structure: the

Board of Directors (five to nineteen members) and the Board of Supervisors (at least three

members), with supervisors ranking above directors. The main duty of the Board of Supervisors is

to monitor firms’ operations (e.g., finance and accounting) as well as top managers and directors; it

consists of representatives of shareholders and employees, while the rest are either officials chosen

from government branches or (retired) executives from the parent companies; directors and top

managers (CEO, CFO, controller, etc.) of the firms cannot hold positions as supervisors. The Board

of Directors serves similar duties as their counterparts in the U.S., including appointing and firing

CEOs. The Chairman (one person) and Vice Chairman (one or two) of the Board are elected by all

17 Information provided here is based on a survey of corporate governance practices among 257 companies listed on the SHSE conducted in 2000 by Integrity Management Consulting and the Research Center of SHSE. For more information on corporate governance in China’s Listed Sector also refer to Tenev et al. (2002). 18 Information presented here is in part based on “Corporate Governance and Enterprise Reform in China: Building the institutions of Modern Market” (World Bank, 2002), and Schipani and Liu (2002).

33

directors (majority votes); at the approval of the Board, the CEO and other top managers can

become members of the Board. Since the Law does not specify that every member of the Board

must be elected by shareholders during general shareholder meetings, in practice some directors are

nominated and appointed by the firms’ parent companies and the nomination process is usually kept

secret (Table 6-C, in particular for former SOEs). Since not all members of either board are elected

by shareholders, a major problem with the board structure is the appointment of and contracting

with the CEOs. With a data set on 625 publicly listed firms that went public during 1993 through

2000, Fan and Wong (2004) find that almost one-third of the companies’ CEOs are either current or

former government bureaucrats; the performance of these firms is significantly worse than other

firms without politically connected CEOs. Based on firm-level compensation data, which became

available since 1998 (due to disclosure requirements), Fung et al. (2001) and Kato and Long (2004)

find that no listed firms grant stock options to CEOs or board members, while the cash-based

compensation level for CEOs is much lower than their counterparts in developed countries, and the

consumption of perks, such as company cars, is prevalent.

Second, the existing ownership structure, characterized by the large amount of non-tradable

shares including cross-holdings of shares among listed companies and institutions, makes it difficult

to carry out value-increasing M&As. According to the China Mergers and Acquisitions Yearbook

(2004), there were 925 M&A’s involving listed firms in 2003 totaling US$9.35 billion, which is

about 1.8% of the total market capitalization. In many deals, a Hybrid Sector firm (non-listed)

acquires a listed firm that is converted from an SOE, but the large amount of non-tradable shares

held by the state remain intact after the transaction.19 On the other hand, such an acquisition can be

the means through which low quality, non-listed companies bypass listing standards and access

financial markets.

The case of Yorkpoint Science & Technology illustrates how this can be done (see

http://finance.sina.com.cn for more details). In 1999, Yorkpoint Group, a privately owned company,

acquired ShenZhen Jinxing, a small-cap listed company specialized in chicken farming and food

products, at the price of RMB 7 yuan per share. The acquired company was soon renamed

Yorkpoint Science & Technology, and immediately announced aggressive investment plans (in

19 If we include the multinational M&As and transactions between parent companies and subsidiaries, the total amount increases to US $47 billion in 2000, $14 billion in 2001, $29 billion in 2002, and $24 billion in the first three quarters of 2003. 68% of all M&A deals (66% in terms of dollar deal amount) are initiated by Hybrid Sector firms, while former SOEs and foreign firms initiate 29% and 3% of the rest, respectively (27% and 7% in deal amount). M&As are most active in coastal regions, and in industries such as machinery, information technology, retail, and gas and oil.

34

internet and dot coms, as well as Nanometer and bio-genetic technologies) to convert the company

from farming and food into a high-tech ‘powerhouse.’ At the same time, Yorkpoint Group set up

seven independent private companies and opened almost 800 stock accounts to prop up the price of

the newly acquired listed company. The price of the company, at RMB 6 prior to the acquisition in

1998, skyrocketed to RMB 126.31 in February 2001 (more than 21 times in less than two years). A

subsequent CSRC investigation uncovered the secrets of the company and its parent group; the

stock price fell all the way back below RMB 10 within a few months; the group was forced out of

the ownership of the company after its founder had expropriated more than RMB 470 million from

minority shareholders.

It can be argued that a factor contributing to the occurrence of the scandals is the lack of

institutional investors (including non-depository financial intermediaries) as they are a very recent

addition to the set of financial institutions in China. Professional investors would perhaps not be so

easily taken in by these simple deceptions. Another factor is that the enforcement of laws is

questionable due to the lack of legal professionals and institutions. For example, ineffective

bankruptcy implementation makes the threat and penalty for bad firm performance non-credible.20

Finally, the government plays the dual roles of regulator and blockholder for many listed

firms, including banks and financial services companies. The main role of the CSRC (counterpart of

the SEC in the US) is to monitor and regulate stock exchanges and listed companies. The

government exercises its shareholder control rights in listed firms mainly through state-owned asset

management companies, which hold large fractions of the state shares. However, since the top

officials of these asset management companies are selected by the government, it is doubtful that

they will pursue their fiduciary role as control shareholders diligently.21 Moreover, the

government’s dual roles can lead to conflicting goals (maximizing profits as shareholder vs.

maximizing social welfare as regulator/social planner) in dealing with listed firms, which in turn

weaken the effectiveness of both of its roles.

Overall, internal and external governance for the Listed Sector is weak, and further

development of governance mechanisms is one of the main objectives for this sector going forward.

In Section IV.6 below we provide some general suggestions.

20 Cross-country information on the efficiency of bankruptcy procedures, based on surveys of lawyers and bankruptcy judges around the world, is available from World Bank (http://rru.worldbank.org/Doingbusiness). Among 108 countries, China’s “goals of insolvency” index is equal to the median of the sample. 21 Gordon and Li (2003) show that the ownership structure and the price differences between A and B shares can be attributed to government collecting monopoly rents from investors and subsidize listed firms that are formerly SOEs. However, this behavior is not as efficient as explicit taxes on investors.

35

Evidence on Ownership, Financing, Payout Policy, Valuation, and Performance

In this section, we examine and compare various characteristics of listed firms in China with

those of other countries. Our results on China’s Listed Sector are based on a sample (panel data) of

more than 1,100 listed firms that we collected from SHSE and SZSE, for the period of 1992-2000

(the data sets are available from the “Asia Emerging Market Data Base” of the Taiwan Economic

Journal, http://www.tei.com.tw/main.html). Table 7-A presents summary statistics for a “snapshot”

of the sample firms at the end of 2000. From Panel a), the average market capitalization is US$ 448

million (the median is US$ 355 million), the average leverage ratio, measured by the ratio of long-

term debt and common equity, is 32% (the median is 9%). In short, these are large firms operating

in virtually all industries. Panel b) compares listed firms converted from the State Sector vs. those

non-state firms. First, 80% of the sample of listed firms (921 out of 1,163 firms) used to be state-

owned and the state/central government still holds a majority of the stock; for the remaining 242

firms, the largest shareholder is not the state.22 Second, the two groups of firms are similar in terms

of most of the financial ratios, except for leverage: firms that used to be state-owned have much

higher leverage than the other group, partially due to the large amount of bank loans accumulated in

these firms prior to their IPO.

Table 7-B compares the ownership structure of these firms to those from the LLS (1999)

sample, which includes over 1,000 listed companies from 33 countries. The main result of LLS

(1999) is that countries that protect minority shareholders poorly (strongly) tend to have more

concentrated (dispersed) ownership, as shown in the first two panels of Table 7-B. The ownership

structure of listed firms in China, shown in Panel C of Table 7-B, is consistent with the prediction

of Burkart et al. (2003), and closer to that of other Asian firms documented in Claessens et al.

(2000) than to the LLS (1999) results. The dominant owner of 60% of our sample firms is the

(central) government, while for 13.6% of firms the dominant owner is founders’ families. Only

0.44% of all firms are widely held so that no shareholder owns more than 10% of stocks.23

Insert Tables 7-A, 7-B, and 7-C here.

Table 7-C provides some evidence on financing sources at the firm level. The ratios for all 22 Using the same data set at the end of 2002, we find that only 60% of the publicly traded firms listed the state as their largest shareholder; around 20% of firms do not have state shares; 13% of firms are previously family-owned and the founding family remains the controlling shareholder. A small portion of the listed firms is actually fully floating (without non-tradable shares), and widely held by investors (no one owns more than 5%). 23 We also find that for 24.17% (1.83%) of firms, the dominant shareholder is a financial company (another listed firm). Since we do not have ownership data for this financial company (listed firm), we do not know whether this company (listed firm) is widely held or not. But given the fact that state-ownership is prevalent in listed firms and banks, it is reasonable to assume that they are not widely held.

36

the countries (except for China) in the table are taken from LLSV (1997a). The evidence in Table 7-

C is consistent with previous evidence at the aggregate level: in terms of total equity, the listed

Chinese companies do not rely on external markets as much as their counterparts in LLSV

countries, but they rely heavily on debt, in particular bank debt, more so than firms in the LLSV

sample countries.

Next, we examine dividend policy and valuations of listed firms in China, and compare

them to firms studied by LLSV (2000b, 2002). Making the most out of the available data, we

performed three different sets of empirical tests and found similar results.24 First, LLSV (2000b)

find that firms in countries with poorer protection of outside shareholders tend to have lower

dividend ratios due to more severe agency problems. Using the dividend/earnings ratio as a proxy

for dividend policy, we find that on average Chinese firms tend to under-pay dividends to their

shareholders compared to firms in the countries studied in LLSV (2000b). Second, LLSV (2002)

find that firms in countries with poorer protection of outside shareholders tend to have lower

Tobin’s Q, measured by the market-to-book assets ratio. When we examine Tobin’s Q of listed

firms in China, we cannot reject the hypothesis that on average their Tobin’s Q is lower when

compared to countries with better shareholder protections (LLSV 2002).

Finally, we review the main results from existing research on listed firms’ performance.

First, using various performance measures researchers find that the post-IPO firm performance

deteriorates steadily over time. For example, with a sample of firms that issue B shares (to foreign

investors) and H shares (listed and traded on the HKSE), Aharony, Lee, and Wong (2000) find that

all firms’ earnings fall after the IPO year, while ROA peaks in the IPO year and declines thereafter.

They also find that listing standards were much lower for former SOEs operating in “protected”

industries (e.g., energy and raw materials) than for firms operating in other industries. Second,

empirical evidence reveals that ownership structure in listed firms affects firm value and share

prices, and in particular, the government ownership stake negatively affects firm value. Based on a

large sample of SOE-turned listed firms, Wei et al. (2005) find a significant negative relation

between firms’ Tobin’s Q and the ownership stake of the government and legal institutions (non-

tradable shares), while foreign ownership is significantly positively related to Q. Similarly, Bai et

24 The data sets that we employ include accounting and financial information for 1,100+ listed firms from China (1990-2000). The LLSV (2000b, 2002) results are based on information for over 4,100 firms from 33 countries (1989-1994). While detailed firm-level data for the LLSV sample are not available to us, we do have their cross-sectional summary statistics by country, as well as the regression results across countries. Detailed descriptions of these tests are available in Appendix B of Allen, Qian, and Qian (2005).

37

al. (2004) construct a composite corporate governance index (ownership structure including shares

held by state, top managers, and foreign investors, and board independence) for listed firms, and

find it to be positively associated with firms’ valuation (market-to-book ratio and Tobin’s Q). Third,

researchers have documented a significant price discount of B shares (held by foreign investors

until 2001) and H shares (listed and traded on HKSE) relative to A shares (held by domestic

investors) of the same firm, in contrast to the pricing premium of foreign shares observed in other

countries. A reasonable explanation for the share discount is the illiquidity (and infrequent trading)

of B and H shares resulting from a more severe degree of asymmetric information and foreign

investors’ fear of ‘lemons’ in the markets (e.g., see Asani et al. (1998) on the analysis of A vs. B

shares, and Wang and Jiang (2003) on the explanation of A vs. H shares).

Insert Figure 7 here.

Overall, because investor protections are weak (and the agency problem is severe) in the

Listed Sector in China, both the dividend ratio and Tobin’s Q are low compared to similar firms

operating in countries with stronger investor protections. In summary, the overall evidence on the

comparison of China and other countries’ external markets is consistent with LLSV (1997a, 1998)

predictions: With an underdeveloped legal system and weak investor (both shareholder and

creditor) protection, the fact that China has small markets for finance from outside the firm comes

as no surprise. Figure 7 compares China’s legal system and markets for finance from outside the

firm to those of LLSV countries. The horizontal axis measures overall investor protection in each

country, while the vertical axis measures the relative size and efficiency of that country’s markets

for funds external to the firm.25 Countries with English common-law systems (French civil-law

systems) lie in the top-right region (bottom-left region) of the graph, while China is placed close to

the bottom-left corner of the graph.

IV.5 Private Equity/Venture Capital and the Funding of New Industries

Allen and Gale (1999, 2000a) have suggested that stock market-based economies, such as

the U.K. in the 19th century and the U.S. in the 20th century, have been more successful in

developing new industries than intermediary-based economies such as Germany and Japan. They

argue that markets are better than banks for funding new industries, because evaluation of these

industries based on experience is difficult, and there is wide diversity of opinion. Stock market-

based economies such as the U.S. and U.K. also tend to have well-developed systems for the

25 Appendix A.1 contains definitions of variables used to construct the investor protection index (x-axis), while A.3 contains definitions of variables used to construct the external markets index (y-axis).

38

acquisition and distribution of information, so the cost of information to investors is low. Markets

then work well because investors can gather information at low cost and those that anticipate high

profits can provide the finance to the new firms.

An important part of this process is the private equity/venture capital sector (see, e.g.,

Kortum and Lerner, 2000). Venture capitalists are able to raise large amounts of funds in the US

because of the prospect that successful firms will be able to undertake an IPO. In a cross-country

study of venture capital, Jeng and Wells (2000) using data from 1986-1995 for 21 countries

document that venture capital is less important in other countries. Their main finding is that the

existence of an active IPO market is the most important determinant of the importance of venture

capital in a country. This is consistent with the finding of Black and Gilson (1998) in a comparison

of the US and Germany, that the primary reason venture capital is relatively successful in the US is

the active IPO market that exists there.

The reason that China should develop active venture capital (VC) and private equity (PE)

markets is to provide financing for new industries. What is unusual about China is that it currently

has the ability to develop both traditional industries, such as manufacturing, and in the near future

new, high-tech industries, such as aerospace, computer software, semiconductors, and bio-genetics.

This is different from the experience of South Korea and Taiwan in the 1970s and that of most other

emerging economies in the 1990s (except for large countries such as India), as all these other

countries focused on or have been focusing on developing manufacturing industries. In terms of

developing traditional industries (e.g., Korea and Taiwan in 1970s), China has already followed suit

in first introducing advanced (relative to domestic companies) but not the most advanced

technologies from developed countries; and “nationalizing” these technologies within designated

companies, before moving toward the more advanced technologies. Allen and Gale (1999, 2000a)

argue that banks are better than financial markets for funding mature industries because there is

wide agreement on how they should be managed so the delegation of the investment decision to a

bank works well. This, and the economies of scale in information acquisition through delegation,

makes bank-based systems more efficient in terms of financing the growth in these industries.

Given this, the banking system can contribute more in supporting the growth and development of

these industries than markets.

China, along with a few other emerging countries such as India, also has the plans and

capability to also establish its own high-tech industries and become a major player in these

industries worldwide in the shortest period of time possible. Its ability to accomplish these goals, in

39

addition to the size of the economy and population, also comes from its solid education system up

to college level and to graduate level for selected areas of engineering and sciences, as well as the

large number of returning students from abroad. To this end developing advanced financial markets

and a venture capital industry is important to finance the growth of these advanced industries.

Insert Tables 8-A, 8-B, 8-C and Figure 8 here.

Consistent with our previous findings, China’s venture capital industry, since its inception in

the 1980s, is underdeveloped and its role in supporting the growth of young firms is very limited.26

However, in recent years China has become one of the most attractive venues among emerging

economies for private equity and venture capital. Private equity investment includes venture capital,

leveraged buyouts, mezzanine financing (round of financing prior to IPO), and other related

investments. Table 8-A (Panel a) lists and ranks the top 20 countries in the world in terms of total

private equity investment in 2004. China ranks ninth on the list, trailing Japan and South Korea

among Asian countries, and has attracted a total of US$1.67 billion investment in 2004. Panel b)

shows that over 85% of all PE investment during the period of 1998-2003 ends up in either the U.S.

or Europe, with the Asia Pacific area finishing a distant third. Table 8-B compares PE funds,

through which a majority of investment is channeled to (start-up and distressed) companies, in

China and other regions. As of 2004, China has a total of 26 funds, with total fund capitalization

US$1.46 billion; the number of funds and fund capitalization are far below those of South Korea

and India, two of China’s main competitors in the Asian markets other than Japan. Next, Table 8-C

presents the top ten VC investment deals of China in 2003. With the exception of one firm

operating in ‘traditional’ industries (Kasen Industrial Group, producing leather and feather & down

products), all other companies are in ‘new’ high-tech industries, while most investors are major

players in the international PE markets.27

It is worthwhile to briefly explain the structure of VC-backed firms (also known as

‘portfolio firms’), the VC companies (which form a portfolio of firms to finance), and financing at

different stages in China. Many VC companies, as described in Table 8-B, are wholly foreign

owned, and are registered in tax havens such as the Cayman Islands for tax purposes. These VC

companies then channel capital from their investors (e.g., from limited partners) to portfolio

26 Moreover, based on interviews conducted with 36 venture capitalists in 24 venture companies, Bruton and Ahlstrom (2002) find that the limited formal rules and regulations are often ineffective, while alternative mechanisms based on reputation and relationship are the norm in all stages and phases of the industry. 27 For example, The Carlyle Group, which financed Amperex Tech and I based in Washington, D.C., has $24.8 billion of capital under management, while Warbug Pincus LLC, which financed Kasen and is located in New York, has $14 billion under management.

40

companies, most of which are registered in China, as either a joint venture (foreign ownership less

than or equal to 50%) or a solely foreign-owned firm (foreign ownership no lower than 51%). These

portfolio companies enjoy tax advantages in China, and usually receive strong support from local

government, as the ability to attract foreign capital is an important aspect of their political

performance. Exit strategies for VC investors include trade sales and IPOs. In the case of a trade

sale of an offshore VC company, investors directly sell their shares in the company without any

concern for the approval procedure from the Chinese government. With the onshore (VC company

registered in China) structure, if the majority of investment capital is from overseas (so that the

portfolio company is qualified as solely foreign-owned), the sale of the equity stake is subject to the

approval of the original approval authority. If the investment is made by a domestic entity, no

approval is required and the sale of the equity interest will become effective after it has been

registered with the State Administration of Industry and Commerce.

Most of the VC companies established under the offshore structure have been looking for

the possibility of an IPO in foreign securities markets; mainly the GEM (Growth Enterprise Market)

of the HKSE, or Nasdaq.28 A portfolio company registered in (Mainland) China can apply to be

listed on a foreign exchange (including the HKSE), and this application must also be submitted to

the CSRC. Figure 8 illustrates the distribution of industries of exited VC-backed firms in 2004, and

similarly to Table 8-C, most of these companies are in high-tech industries, while the IPO firms

were all listed in overseas exchanges. Among these firms is Shanghai-based Semiconductor

Manufacturing International Corporation (SMIC), which went IPO on March 17, 2004 and became

Nasdaq’s largest-ever venture-backed IPO (it raised $1.8 billion based on a $6.6 billion market

capitalization). The company, incorporated in 2000, produces 0.35-micrometer to 0.18-micrometer

and finer line integrated circuits. Prior to the IPO (as Table 8-C indicates), SMIC received $390

million in VC funding by an American investor group comprised of Walden International, NEA,

Doll Capital, Oak Investment Partners, H&Q Asia Pacific and Shanghai Industrial Holdings. Key to

the company’s rapid technology development is an R&D team made up of engineers from North

America, Europe and Asia, as well as a network of international technology and manufacturing

28 The main boards of the SHSE and SZSE are not considered to be an ideal place for PE investors to exit. Listing candidates must have a long track record of profitability, and go through a lengthy process of scrutiny; moreover, only the company’s publicly offered shares may be traded on the exchange while VC investors’ equity stakes cannot. However, any company with a Chinese interest is still subject to the regulation of the CSRC (June 2000), which stipulates that the IPO of a foreign company with a Chinese interest cannot proceed without filing with the CSRC and receiving a ‘no-action’ letter. This regulation is aimed at closely monitoring the capital outflow, which can occur to a foreign company with Chinese nationals holding its shares.

41

partners – in other words, a truly global Chinese company.

IV.6 Further Development of Financial Markets

As we have documented, the financial markets in China do not currently play nearly as

important a role as banks. Going forward, if China wishes to develop high-technology industries as

discussed in Section IV.5 then it is important that it develop better financial markets than it

currently has. In addition if it is to improve risk management possibilities for its financial

institutions and firms it needs to develop new financial products and markets. Finally, if there is to

be an alternative to banks for raising large amounts of capital, then China needs deep and efficient

markets.

In recent years the stock markets, in particular, have performed poorly. This is somewhat

surprising given the robust performance of the real economy and the fact that China has been

growing so fast. We attribute this poor performance to a number of factors including the following.

(i) Poor self-regulation and formal regulation.

(ii) The large overhang of shares owned by government entities.

(iii) The lack of trained professionals.

(iv) The lack of institutional investors.

(v) Limited financial markets and products.

It is important that these weaknesses be overcome. However, these are problems that will

need to be tackled over the long run. They cannot be solved in a few years. We discuss each in turn.

Improve Regulations

There are two ways in which markets are regulated in practice and each has advantages and

disadvantages.

(1) Market forces and self-regulation.

(2) Government regulation.

A good example of regulation through market forces and self-regulation is provided by the

capital markets in the UK in the nineteenth and early twentieth century (Michie, 1987). The role of

government regulation and intervention was minimal. Despite this the markets did extremely well

and London became the financial capital of the world. Many firms and countries from all over the

world raised large amounts of funds. Reputation and trust were an important factor in the smooth

operation of these markets. For example, in an important paper Franks, Mayer, and Rossi (2003)

compare the early twentieth century capital markets with those in the mid-twentieth century.

Despite extensive changes in the laws protecting minority shareholders there was very little change

42

in the relevant ways in which the market operated. The authors attribute this to the importance of

trust.

We argue below that China’s Hybrid sector is another example of a situation where market

forces are effective. Formal regulation and legal protections do not play much role and yet financing

and governance mechanisms are quite effective. In this case, as we shall see, it appears that

competition as well as reputation and trust work well.

In contrast, the examples of fraud and other problems of manipulation and the inefficiency

of markets recounted in Section IV.1 suggest that in China’s formal financial markets these

alternative mechanisms do not work well. Although such mechanisms may develop in the very long

run as in the nineteenth and early twentieth century UK , it seems that in the short run at least it is

likely to be necessary to have formal government regulation of the type developed in the US in the

1930s as a response to the stock market collapse that started in 1929 and the Great Depression.

Allen and Herring (2001) describe the operation of this type of regulation. The Securities

Act of 1933 set up the Securities and Exchange Commission and was concerned with regulating

distributions of securities. It specified what information companies must provide when issuing

securities in the public markets and required prospectuses with a significant amount of affirmative

disclosure. The Securities Exchange Act of 1934 was concerned with publicly traded stocks after

they were issued. It has been amended on numerous occasions. Among other things it required

publicly traded firms to file accounting returns periodically, market manipulation was outlawed and

insider trading was made illegal. These two acts were closely followed by four others with the last

being the Investment Advisers Act of 1940, which was designed to prevent abuses by managers of

investment companies. Finally thirty years later, the Securities Investor Protection Act of 1970 was

designed to protect investors in the event of a broker going bankrupt.

There is evidence from many countries that this type of formal regulation is effective.

Based on a study of securities laws with the focus on the public issuance of new equity in 49

countries (China is not included), LLS (2003) find that disclosure and liability rules helps to

promote stock market development. Given China’s poor disclosure rules, accounting standards, and

judicial systems, the LLS (2003) result can be used to explain the status of China’s stock markets.

To improve the quality of government regulation, Glaeser, Johnson, and Shleifer (2001) argue that

regulators must be properly motivated. The turnover velocity of China’s markets documented in

Table 5-A for 2002 was actually even higher in the late 1990s, and the improvement is in part due

to advances in the quality of regulation.

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One of the most important functions of a financial system is the acquisition and use of

information to facilitate the efficient allocation of resources. China is in the process of improving its

accounting and related disclosure standards, particularly for publicly listed and traded companies.

This is important and should be done with due diligence. Lessons can be drawn from various

countries’ experience. However, the importance of improving accounting standards should not

understate the importance of an efficient banking system, in particular, one that provides funding

and monitoring to firms. This is true also because the status of China’s accounting profession makes

it difficult to quickly improve the transparency of the markets.

The accounting reform started with the enactment of regulations governing the enterprises

with foreign investment, which provided the necessary accounting infrastructure to assist companies

in attracting foreign direct investment. The ASBE (Accounting Standards for Business Enterprises)

of China, together with the 13-industry regulation board, have been trying to move China’s

accounting practice of SOEs toward the IAS (International Accounting Standards). However, the

most glaring problem in China’s accounting system is the lack of independent, professional

auditors, similar to the situation of legal professionals. The added problem on the reform of the

accounting system stems from the lack of an effective judicial system to protect companies’ assets

from embezzlement and other frauds. This implies that the proposed IAS-based standards may be

counterproductive within China’s current infrastructure: With few auditors understanding and

enforcing the new standards, and given the lack of an effective judicial system, embezzlement of

company assets and other forms of fraud may occur more frequently under IAS-based standards, as

compared to an alternative system with a much simpler set of accounting standards (e.g., Xiang

1998).

Another example of imperfect regulation is the restriction on short sales. Bris et al. (2003)

find that limiting short sales contributes to the high co-movement of stock prices, but does not tend

to increase the probability of a market crash, as commonly feared by governments in emerging

countries. Obviously, supportive institutions to facilitate short sales and margin accounts must be

first developed before allowing shorting selling in China.

Sell Government Shares in Listed Firms

One of the major problems Chinese stock markets face is caused by the large amount of

shares in listed companies owned by the government and government entities shown in Table 6-B.

This overhang creates great uncertainty about the quantity of shares that will be tradable going

forward. Investors fear that if prices go up then the government will sell their holdings and this will

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prevent further price rises or even depress them. This uncertainty has caused share prices to stagnate

despite the very high levels of growth in the economy. In order to remove this uncertainty, the

government should announce a plan for selling these shares slowly over time. Each year a small

amount (i.e. small relative to the usual amount traded) would be sold so that the market could easily

absorb the shares. Such a plan might take several decades to complete. Once announced, the plan

should be carried out without any deviation even if prices rise significantly.

The Chinese government attempted sales of state shares in 1999 and 2001, but halted the

process both times after share prices plunged and investors grew panicky about the value of the

entire market. Despite unsatisfactory outcomes in previous trials, the central government seems to

be determined to carry out the sales of state shares, in part because it plans to extract money from

selling these shares to build up pension reserves, arguably one of the most urgent tasks at present

(as mentioned before there is no pension system in place). In fact, it has recently announced to

resume sales of nontradable shares in selected companies (e.g., South China Morning Post,

05/22/2005). Two remarks are in order. First, the government’s commitment in implementing a

gradual sales plan is superior to a series of (partially) unanticipated, large-scale trials that are

subject to termination if a significantly negative market reaction is observed, because the former

plan reduces the aggregate uncertainty of the market going forward.

Another important issue is whether small amounts of shares of all firms in which

government entities own blocks or large amounts of a few firms should be sold. The difference is

that if small amounts in every firm are sold then the government will cease to be the majority owner

quite some time from now. On the other hand, if they sell large blocks in a few firms then they will

cease to be the majority owner quickly. Responsibility for governance will instead shift to private

owners and experience of this will be gained sooner. We believe a combination of these methods

should be used. Selling shares in a large number of firms will minimize the price impacts. On the

other hand, it is important to develop experience of private control as soon as possible.

Finally, if history can serve as a barometer for future practices, then the prospects for the

privatization of state shares in China should be optimistic. Similar “share issue privatizations”

(SIPs) plans, in both developed countries such as the U.K. in the 1980s and emerging and

transitional economies, have been successful by and large, in that the performance of privatized

firms on average greatly improves after the privatization and the overall stability of the economy

does not seem to be negatively affected (e.g., Boubakri et al. (2005) provide a study of privatized

firms in 39 countries from 1980 to 2001; Megginson and Netter (2001) survey this literature).

45

Moreover, in addition to the aforementioned Wei et al. (2005), who find a significantly negative

(positive) relation between Tobin’s Q and remaining state (foreign) ownership in China’s SOE-

turned-listed firms after the privatization, Sun and Tong (2003) find that further SIP (and a lower

government stake in the listed firms) positively affects listed firms earnings, sales, and total

productivity.29

Train More Professionals

This is the most important factor in terms of improving the enforcement of laws and

contracts. First, an independent and efficient judicial system requires a sufficient supply of qualified

legal professionals. The Ministry of Justice of China states that there are 110,000 lawyers and 9,000

law firms as of 2002, while Orts (2001) estimates that there are 150,000 lawyers in China, roughly

the same number of licensed attorneys as in the state of California. Lawyers represent only 10% to

25% of all clients in civil and business cases, and even in criminal prosecutions, lawyers represent

defendants in only half of the cases. Among the approximately five million business enterprises in

China, only 4% of them currently have regular legal advisers. Moreover, only one-fifth of all

lawyers in China have law degrees, and even a lower fraction of judges have formally studied law at

a university or college. As mentioned before, a similar situation exists for auditors and accounting

professionals.

Encourage the Development of Institutional Investors

In most developed stock markets institutional investors, such as insurance companies,

pension funds, mutual funds, and hedge funds, play an important role. They employ well-trained

professionals who are able to evaluate companies well. This causes markets to have a higher degree

of efficiency than if they are dominated by individual investors. In addition there can be advantages

in terms of corporate governance if institutional investors actively participate in the monitoring of

firms’ managers and are directly involved in firms’ decision-making process as blockholders of

stocks. For example, in the U.S., pension funds such as Calpers have become the symbol of

shareholder activism that strengthens corporate governance, while in Japan and Germany, financial

intermediaries serve similar purposes. For China, an effective way to improve the efficiency of

China’s stock markets as well as corporate governance of listed firms is to encourage further

development of domestic financial intermediaries that can act as institutional investors. With their

29 Using data from auctions and private transactions of legal institution shares, Chen and Xiong (2001) find that the price discount of these nontradable shares relative to the prices of floating/tradable shares of the same company ranges from 78% to 86%; this sizable discount implies that the large amount of nontradable shares significantly raises the cost of (equity) capital for listed firms.

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large-scale capital and expertise in all relevant areas of business, financial intermediaries can

provide a level of stability and professionalism that is sorely lacking in China’s financial markets.

Currently institutional investors such as insurance companies and mutual funds are very

small in terms of assets held. One way to encourage the development of such intermediaries is to

give tax advantages to various types of product such as life insurance.

Develop More Financial Products and Markets

Another issue is to develop more financial products so that investors can form diversified

portfolios with more than just stocks. First and foremost, corporate bond markets should be

developed, along with better enforcement of bankruptcy laws and bond rating agencies. Second,

more derivative securities such as forwards, futures, and options on commodities (already in place

and trading) as well as on other securities should be introduced to the market, so that investors and

firms have more tools for risk management. Third, insurance companies should offer more products

related to property insurance and auto insurance, while other financial services companies should

develop the market for asset-backed securities.

V. The Non-standard Financial Sector and Evidence on Hybrid Sector Firms

In this section we study how the non-standard financial sector supports firms in the Hybrid

Sector to raise funds and to grow from start-ups to successful industry leaders. We also examine the

alternative governance mechanisms employed by investors and firms that can substitute for formal

corporate governance mechanisms.30 Due to data limitations, much of this evidence is by necessity

anecdotal or by survey.31 Since the non-standard sector is matched with firms in the Hybrid Sector,

it is important to emphasize again that the Hybrid Sector comprises all the firms that are not state-

owned or publicly listed, includes the following types of firms: 1) privately owned companies (but

not publicly listed and traded): controlling owners can be Chinese citizens, investors (or companies)

from Taiwan or Hong Kong, or foreign investors (or companies); 2) collectively- and jointly-owned

companies, where joint ownership among local government, communities, and institutions is forged

(see Appendix A.5 for definitions of each type of firms). We include firms that are partially owned

30 Some of our evidence coincides with the anecdotal evidence in Naughton (1995). McMillan and Naughton (1992) also make similar arguments regarding the role of alternative mechanisms in supporting the growth of non-state firms in China. Unlike their work, we also provide survey evidence. 31 All firms including Hybrid Sector firms must disclose accounting and financial information to the local Bureau of Commerce and Industry, and most of the reports are audited. However, these data are then aggregated into the Statistical Yearbook without any firm-level publications.

47

by local governments (e.g., TVEs) in the Hybrid Sector, because, first, the operation of these firms

resembles more closely that of a for-profit, privately-owned firm than a state-owned firm, and

second, the ownership stake of local governments in many of these firms has been privatized.

We first compare the Hybrid Sector with the State and Listed Sectors to highlight the

importance of its status in the entire economy in Section V.1. We then present anecdotal evidence

on firms in two highly successful regions in Section V.2, and then evidence based on a survey of 17

firms in Jiangsu and Zhejiang provinces in Section V.2. Finally, Section V.4 provides discussions of

alternative financing channels and governance mechanisms that support the growth of the Hybrid

Sector.

V.1 Comparison of Hybrid Sector vs. State and Listed Sectors

Before we present survey and anecdotal evidence on how the non-standard financial sector

supports the growth of the Hybrid Sector, it is important to point out the status of the Hybrid Sector

in the overall economy. Figure 9-A compare the level and growth of industrial output produced in

the State and Listed Sectors combined vs. that of the Hybrid Sector from 1990 to 2004.32 The

output from the Hybrid Sector has been steadily increasing during this period and exceeded that of

the other two sectors in 1998. The total output in 2004 is close to US$1500 billion for the Hybrid

Sector, while it is around US$800 billion in the State and Listed Sectors combined. The Hybrid

Sector grew at an annual rate of over 14% between 1990 and 2004, while the State and Listed

Sectors combined grew at around 5% during the same period.33 In addition, the growth rates for

investment in fixed assets of these sectors are comparable (China Statistics Yearbooks; not

reported), which implies that the Hybrid Sector is more productive than the State and Listed

Sectors. In terms of capital-industrial output ratios, collectively-owned and privately owned firms

are on average more than twice as productive (for every $1 invested) as SOEs (Gregory et al. 2000).

Moreover, many Hybrid Sector firms do not have easy access to the standard form of financing,

namely, bank loans, like SOEs do. As mentioned above, loans made to privately owned firms

32 Due to data limitations (of the Statistical Yearbooks), our calculations underestimate the output of the State and Listed Sectors. We use the output produced by SOEs and listed firms in which the state has at least a 50% ownership stake as the total output for these sectors, but this calculation excludes output from listed firms that are not majority owned by the state; the output for the Hybrid Sector is the difference between the total output of China and the above figure for the other two sectors. However, as our sample of more than 1,100 listed firms shows, only around 20% of all listed firms do not have the state as the largest owner, hence the total output of these firms is not likely to change our overall conclusion on the dominance of the Hybrid Sector over the other two sectors. 33 There is an ongoing process of privatizing SOEs. Potentially this may bias the growth rate of the Hybrid Sector higher, as there are firms shifting from the State Sector to the Hybrid Sector. However, the overwhelming majority of SOEs are transformed into publicly traded firms (the Listed Sector). Thus this process is unlikely to change the validity of the results above.

48

consist of 1% of all loans made in 1997-98. All of these facts make the growth of the Hybrid Sector

even more impressive.

Finally, there has been a fundamental change among the State, Listed, and Hybrid Sectors in

terms of their contribution to the entire economy: the State Sector contributed more than two thirds

of China’s GDP in 1980, but in 2004 it contributed less than one-third of the GDP; in 1980, (non-

agricultural) privately owned firms, a type of Hybrid Sector firm, were negligible, but in 2001 they

contributed 33% of GDP after growing at an average rate of 20% during this period [China

Statistical Yearbooks, 1998-2000]. The above trend of the Hybrid Sector replacing the State Sector

will continue in the near future.

Insert Figures 9-A and 9-B here.

Figure 9-B presents the number and growth of non-agricultural employees in the three

sectors.34 The Hybrid Sector is a much more important source for employment opportunities than

the State and Listed Sectors. Over the period from 1990 to 2002, the Hybrid Sector employs an

average of over 70% of all non-agricultural workers; the TVEs (part of the Hybrid Sector) have

been the most important employers providing (non-agricultural) jobs for residents in the rural areas,

while (non-agricultural) privately owned firms employ more than 40% of the workforce in the

urban areas. Moreover, the number of employees working in the Hybrid Sector has been growing at

1.5% over this period, while the labor force in the State and Listed Sectors has been shrinking.

These patterns are particularly important for China, given its vast population and potential problem

of unemployment.

V.2 Anecdotal Evidence in Two Successful Regions

WenZhou and Nearby Regions

Wenzhou, a city in the Zhejiang Province, is the home of some of the earliest and most

successful firms of the Hybrid Sector, while entrepreneurs in the region are known for their keen

business senses and innovations, as well as sharp management skills.35 The success of this region is

not surprising given its prominent history of mercantile prowess that can be traced back to the

nineteenth century. As the post-1979 reform began, this region, with low income but high “social

potential for growth,” or “human capital in the form of latent mercantile skills,” immediately took

34 Our calculations of the total number of workers employed by the Hybrid Sector actually underestimate the actual work force in the sector, because the Statistics Yearbooks do not provide employment data for all types of firms (by ownership structure) in the Hybrid Sector. 35 McMillan and Naughton (1992), McMillan and Woodruff (2002) point out entrepreneurs facilitate the transition from a planned economy to a market-based economy by, for example, starting up firms and entering industries dominated by state-owned enterprises.

49

off. The path of their success from a poor farming region to nation-wide sales networks was dubbed

the “Wenzhou model.”

They usually start their family-run businesses in townships with a similar product emphasis,

in order to have easy access to the necessary technology, human capital, and potential clients and

partners. Thus we observe specialization by regions, such as electronic parts and products in

Hongqiao and Liushi, buttons in Qiaotou, and “Shengzhou, Zhejiang . . . is home to more than

1,100 necktie producers. Combined, they . . . produce 90% of the neckties in China – and 40% in

the world” [JIANG Yan, “City of necktie trying to create added value,” China Business Weekly 22-

28 Nov. 2004, p.8.]. This specialization can be a result of firms’ attempt to signal to potential

customers that they are competitive by locating the firm in a region filled with other firms

producing and selling similar products. During recent years certain developed areas have shifted

product emphasis from labor-intensive products such as clothes to more high-tech products such as

parts of computers. The main product development strategy for many entrepreneurs is to aim at

“exporting” products to other regions, including to foreign countries, instead of selling them locally.

The failure rate for start-ups in most industries is high. New product strategies often start

with mimicking successful or popular products. Patent laws are difficult to implement so often

disputes are settled among the entrepreneurs themselves (McMillan and Woodruff (1999b) present

similar evidence on disputes resolved outside courts in Vietnam). To overcome this problem, some

entrepreneurs expend effort and money to ensure that the key parts of their new products are

difficult to disassemble and to copy. On the other hand, coalitions and institutions among

entrepreneurs and their partners arise to regulate and enforce patent laws and other business-related

disputes. In the aforementioned town of Qiaotou, where 750 firms producing buttons are located,

the Chamber of Commerce, a non-government organization, enacted and enforced a regulation

called “Regulations on Protecting and Managing New Products” immediately after it was founded

in 1996 (Gregory et al. 2000, IFC report). With a small fee, member firms can apply for protection

of their new style buttons (a ‘patent’) for a period of two to three months; the short period of

protection coincides with the rapid design replacement in the industry. With the strong endorsement

of the local government, the Chamber regularly inspects the local markets to find copies of

‘patented’ buttons, and punishes violators in the form of verbal warning, fines, or a ban of selling

products in the area.

KunShan and Surrounding Areas

Kunshan County, which is in Jiangsu Province and close to Shanghai, is famous for

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attracting foreign direct investment, especially from Taiwanese investors. Some of the most

effective government policies have included setting up special development zones with favorable

land and tax policies. In 1997, Kunshan set up a high-tech development zone, in which enterprises,

in the ownership form of joint ventures, cooperatives, and solely owned by foreign investors, can

take full advantage of a tax waiver and tax reduction for the initial periods. Firms whose high-tech

products are export-oriented can enjoy even more tax advantages. There is a center in the special

zone established by the local government (for more information, go to http://www.china-

hitech.org/hitech/chinese/qiye.asp). It acts as the liaison between the local government,

entrepreneurs, and foreign investors, and the regulator as well as service provider for enterprises

operating in the zone. Enterprises in the zone are required to report their operating and financial

information to, and are regulated by the center, but they understand that the center will almost never

interfere with their internal decisions. The center’s officials are mainly from the local government.

The high-tech development zone grew very fast since its inception.

During the early stage of the special zone, investors from Taiwan were willing to commit

their capital to these start-ups and refinance them when necessary. Actually the reason that many

investors are from Taiwan is no coincidence. Many people in Kunshan have relatives in Taiwan and

through them investors obtained information on the investment opportunities. The Taiwanese

investors also came to understand that although there were almost no formal investor protections,

local government officials have an incentive to cooperate with the development of the special zone

and create an economic boom in the local economy. This is the case because a booming economy

can greatly enhance the chance of an official being promoted, in addition to participating in profit-

sharing. During the early stage of development Taiwanese investors did not stay in the area as they

often do now. As a result, there was virtually no monitoring of the entrepreneurs, and complete

separation of ownership and control.

V.3 Survey Evidence

In designing our survey, we follow Graham and Harvey (2001, survey of U.S. CFOs),

Johnson, McMillan, and Woodruff (2002, survey of Eastern Europe countries), and McMillan and

Woodruff (1999a, 1999b surveys on Vietnam); the survey questions and the tabulation of answers

are available at http://www2.bc.edu/~qianju/research.html. To our knowledge, the only other

surveys on China’s Hybrid Sector are conducted by Gregory et al. (2000) of the IFC (affiliated with

the World Bank) in Beijing, Chengdu, Shunde (of Guangdong Province), and WenZhou; and by

Cull and Xu (2005) of the World Bank in 18 cities from all regions of China. Both surveys have a

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much bigger sample size than ours, and we will cite results from them; however, these surveys do

not provide detailed information on financing channels and corporate governance mechanisms.

Insert Table 9 and Figure 10-A here.

As Table 9 shows, among the 17 firms that we surveyed, one firm is from suburban

Shanghai, three are from Jiangsu Province, and the remaining 13 are from Zhejiang Province. These

firms operate in a wide range of industries. The average age of the firm is over 11 years, and they

employ an average of over 1,600 employees. The average size of (book) assets is US$55 million,

with the average return on assets being 10%. Finally, on average firms are highly levered, with

average (private and bank) debt/ (private) equity ratio reaching 2.1. Figure 10-A provides more

background information for the survey firms. There are significant variations in both firms’ past

performance and their expected future performance (top two histograms). In terms of ownership

structure (2nd panel of histograms), both at startup and the time of the survey, the two dominant

forms are “founder and family,” and “shareholding,” which resembles a private equity structure.

Around 35% of the founders of our sample firms worked in TVEs prior to starting up their own

firms (bottom histogram); the experience from other Hybrid Sector firms is valuable for the

entrepreneurs, as they gained knowledge on how to run such a firm. In addition, 23% of the

founders worked in SOEs and 18% worked in government agencies; their connection with the State

Sector and the government is also valuable as it provides them an advantage in gaining support

from government officials and access to formal channels of financing such as bank loans.

Financing Channels

Figure 10-B presents evidence of financing channels of the firms. First, it is not surprising

that during the startup stage, funds from founders’ family and friends are an important source of

financing (top left histogram). Moreover, funds from friends, in the form of private loans and

equity, are also very important during the firm’s subsequent growth period (top right histogram).

Consistent with our finding, the Gregory et al. (2000) IFC survey finds that more than 90% of the

initial capital came from the principal owners and their families and friends. For some firms in our

survey, there are no formal written contracts between the friends/investors and the entrepreneurs,

implying that reputation and relationship based implicit contractual agreements have worked

effectively. Entrepreneurs from other former socialist countries also rely on their families and

friends heavily during the startup stage (IFC reports in 1993, 1999). This pattern of self-financing is

clearly different from that of developed countries: for example, Berger and Udell (1998) find that

insider financing for small and medium firms in the U.S. during their startup stage is well below

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50% for most firms. Second, internal financing, in the form of retained earnings, is also important

(not reported in Figure 10-B): survey firms retained an average of 55% to 65% of their net income

for reinvestment during the initial 2-3 years of existence. In the Gregory et al. (2000) survey firms

rely on retained earnings to obtain 20% to 40% of all financing needs (during 1995-1998), which is

the second most important financing source behind an owner’s own capital.

Third, funding from financial intermediaries is one of the most important sources for our

surveyed firms. In terms of startup financing, over 40% of firms surveyed surprisingly regard

“banks” as either a “very important” (25-50% of total funding needs) or an “extremely important”

(more than 50% of total funding needs) financing source. The four largest state-owned banks are

ranked the highest in terms of providing funds, while other state-owned banks are ranked second.

However, it is not clear that state-owned banks provide the cheapest start-up financing channel for

all Hybrid Sector firms. The caveat is that many of our surveyed firms that received start-up

financing from state-owned banks had already established a close relationship with those banks

before their inception as shown in Figure 10-A. By contrast, firms in the IFC/Gregory et al. (2000)

survey rely on bank loans for less than 10% of their startup financing.

As important as the role of bank loans firms’ startup financing is, not a single firm from our

survey rates banks as very important or extremely important during their growth period (top right

histogram of Figure 10-B). Financing from private credit agencies (PCAs), instead of banks, is the

most important channel during these firms’ growth period. As documented by Tsai (2002), PCAs

take on many forms, from shareholding cooperative enterprises run by professional money brokers,

lenders and middlemen, to credit associations operated by a group of entrepreneurs (raising money

from group members and from outsiders to fund firms; zijin huzushe), from pawnshops to

underground private money houses. These private lenders, sometimes the target of law enforcement

and government regulation, usually charge high interest rates and/or require a large amount of

collateral on loans in the beginning, but are willing to renegotiate loan terms and contracts based on

payment records; they can force liquidation should the entrepreneurs default, and the associated

loan contracts resemble junk bonds to a certain degree. Similar findings are reported in Gregory et

al. (2000): About half of their survey firms have at some point in their history resorted to the

informal credit market; access to this market is usually based on networking between the PCAs and

firms through common friends and reputation and relationships serve to solve the problem of

asymmetric information; indeed, third party guarantees can substitute for the use of collateral, while

most loans have short maturity as a way for the lenders to ‘put the borrowers on a short leash.’

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On average, each of our surveyed firms currently has a loan relationship with 4.3 banks or

other financial intermediaries, with the maximum (minimum) being 12 (1). Collateral value counts

for 82.6% of the loan value on average with a maximum (minimum) of 120% (20%). Fixed assets

are the most popular form of collateral, with third party guarantees being the second most popular

form. These facts imply that financial institutions, state or private, seem to understand the risk of

start-up firms and try to “price” this risk in their loan contracts. In a few cases the local government

provides the third party guarantee, indicating an active role played by government officials in

supporting the growth of the firms. Firms in the IFC/Gregory et al. (2000) survey rely on bank loans

for 10% to 12% of total financing needs during their growth period (loans from credit unions and

other non-bank intermediaries account for 8%-10% of total financing needs), and the accessibility

to bank financing seems to improve as a firm becomes larger (or more successful); 28% of the 760

Hybrid Sector firms in the Cull and Xu (2005)/World Bank survey have at least one bank loan,

while firms from the coastal and more developed regions seem to have easier access to banks.

During firms’ growth period (Figure 10-B), there are a few other channels that are important

sources of financing, in particular, investment from “ethnic Chinese” (investors from Hong Kong,

Taiwan, and overseas Chinese), mostly in the form of private loans and equity. This financing

source, as compared to investment from non-Chinese foreign direct investment (FDI), relies on the

relationship between the investors and the entrepreneurs. Other sources include trade credits among

business partners, state and local budgets, and FDI. When asked about which financing channels are

least costly (bottom histogram in Figure 10-B), while most of our surveyed firms point to short- and

long-term bank loans, almost 60% of firms indicate trade credits among business partners. From the

Cull and Xu/World Bank survey, firms rely on trade credit to purchase as much as 19% of their

input, while McMillan and Woodruff (1999a) find a similar role of trade credit among Vietnamese

firms.

For start-up firms, securing land and other fixed assets is important for their survival. While

not reported in the figures, more than half of surveyed firms purchase the “operation-rights” of the

land from the government who has the ultimate control. The operation-rights contract is typically

long-term (20-50 years).36 In terms of fixed assets, 16 out of the 17 firms purchased and own all of

their fixed assets. Among them, 9 firms purchased their fixed assets from the State Sector, and 7 out

36 With operation rights, a firm has more control over the land than under a “land rental” contract. For example, firms can rent the land to another party once obtaining the operation rights from the government. Land rental contracts have shorter terms on average (5-10 years).

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of the 9 firms considered the price they paid to be the same as the market value of the assets.

Finally, when asked about the prospects of going public, founders and executives list “access to

large scale funding” and “reputation increase” as the most important benefits, and the “disclosure of

valuable information to competitors and outsiders” and “large amount of fees paid” to the

government, investment banks, and consulting firms as the most critical disadvantages of going

public.

Insert Figures 10-B and 10-C here.

Corporate Governance

Figure 10-C provides some information on governance mechanisms. First, over 60% (30%)

of firms believe that if their own firm is not run efficiently and is in financial distress, it is

“possible” (“very likely”) to have its assets purchased by another firm or investor, while no one

answered it is “not possible” for this to occur. Consistent with our evidence, Gregory et al. (2000)

find that 25% to 55% (20% to 50%) of surveyed firms across different industries were involved in

horizontal (vertical) integrations or acquisitions. When asked about what type of losses concern

them the most if the firm failed (top right histogram in Figure 10-C), every firm’s

founders/executives (100%) said reputation loss is a major concern, while only 60% of them said

economic losses are of major concern.

Not reported in the figures, we also asked firms about product market competition. 40% of

surveyed firms believe that if their firm is not operating efficiently, within 3-6 months 20% of its

market share will be taken away, while 80% of firms’ founders/executives believe the entire market

share of the firm will be taken away in 2 years. A critical factor determining the degree of

competition in an industry is entry barriers of new firms. First, 16 out of our 17 firms applied for a

license (required) before the business started, with 50% of them indicating that it takes 2 weeks to 1

month to go through the procedure and 37.5% say it takes 1-2 months. The main problem for the

application for a license seems to be dealing with government bureaucracy. To ease this problem,

most of the firms’ founders/executives ask the friends of government officials to negotiate on their

behalf, or the firms can offer profit sharing to government officials. Of the firms surveyed by

Gregory et al. and the IFC (2000), 18% cited legal restrictions (in terms of ownership structure) and

15% cited the lack of distribution channels (strongly favoring SOEs) as major barriers to entering

new markets; nevertheless, only 12% of surveyed firms’ executives thought SOEs are their main

competitors, while 81% see other domestic firms of the Hybrid Sector as their main competitors.

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The success of a firm in the Hybrid Sector also depends on the support from local

government. Over 40% of our survey firms state the local government “support” the growth of the

firm without demanding profit sharing, while for some other firms, the government is either a

partial owner or demands profit sharing without investing in the firm (bottom histogram in Figure

10-C). Consistent with our evidence, Cull and Xu (2005) find that in coastal areas and in more

developed regions, 35% to 58% of survey firms say that they have the support of local government,

while only around 20% of survey firms from underdeveloped regions give the same answer; in most

cities and regions, survey firms spend less than 0.1% of their total sales as ‘informal payments’ to

local government officials (the highest is 1.38% in Xian). The supportive attitude of the local

government toward firms in the Hybrid Sector is remarkable considering the fact that the Chinese

government is widely regarded as corrupt and disrespectful of property rights (e.g., La Porta et al.

2004).

We have mentioned that the lack of legal professionals, among other reasons, significantly

reduces the effectiveness of law and contract enforcement through China’s judicial system. How do

entrepreneurs and firms in the Hybrid Sector feel about going to courts to resolve disputes? In the

World Bank survey (Cull and Xu, 2005), firms in most regions and cities rely on courts to resolve

less than 10% of business-related disputes (the highest percentage is 20%), with a higher reliance on

courts in coastal and more developed areas, despite the fact that in most regions well over 50% of

survey firms believe that the legal system will protect their contractual and property rights. One

reason that firms go to courts to resolve a dispute is because the courts are authoritative so that the

dispute will be resolved even though the resolution may not be fair (e.g., Clarke et al. 2005). This

line of reasoning reflects the political power of the (government-run) courts rather than their

expertise or fairness, but any misuse or abuse of this power can easily yield worse outcomes for the

firms and their partners than other out-of-court resolutions. McMillan and Woodruff (1999b)

document similar patterns of the use of courts vs. out-of-court resolution of disputes in Vietnam.

V.4 Discussion on How the Non-standard Financial Sector Works

In this subsection we discuss mechanisms within the non-standard financial sector in

supporting the growth of the Hybrid Sector. There are two important aspects to alternative financing

channels in the Hybrid Sector. The first is the way in which investment is financed. The second is

corporate governance. We consider each in turn.

Once a firm is established and doing well, internal finance can provide the funds necessary

for growth. Allen, Qian, and Qian (2005) find that about 60 percent of the funds raised by the

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Hybrid Sector are generated internally. Of course, internal finance is fine once a firm is established

but this raises the issue of how firms in the Hybrid Sector acquire their “seed” capital, perhaps the

most crucial financing during a firm’s life cycle. Allen, Qian, and Qian (2005) present evidence on

the importance of alternative and informal channels, including funds from family and friends and

loans from private (unofficial) credit agencies. There is also evidence that financing through illegal

channels, such as smuggling, bribery, and other underground or unofficial businesses also play an

important role in the accumulation of seed capital. Though a controversial issue for the

government, our view, based on similar episodes in the history of other developing countries, is that

depending on the precise nature of the activity and as long as the purpose of money making is to

invest in a legitimate company, it may be more productive for the government to provide incentives

for investment rather than to expend costs discovering and punishing these activities.

Perhaps the most important corporate governance mechanism is competition in product and

input markets, which has worked well in both developed and developing countries (e.g., McMillan

1995, 1997; Allen and Gale 2000b). What we see from the success of Hybrid Sector firms in

WenZhou and other surveyed firms suggest that it is only those firms that have the strongest

comparative advantage in an industry (of the area) that survived and thrived. A relevant factor for

competition in an industry is entry barriers for new firms, as lower entry barriers foster competition.

Djankov, La Porta, Lopez-de-Silanes, and Shleifer (DLLS hereafter, 2002) examine entry barriers

across 85 countries, and find that countries with heavier (lighter) regulation of entry have higher

government corruption (more democratic and limited governments) and larger unofficial

economies. With much lower barriers to entry compared to other countries with similar (low) per

capita GDP, China is once again an “outlier” in the DLLS sample given that China is one of the

least democratic countries, and such countries tend to have high barriers to entry. As mentioned

above, our survey evidence reveals that there exist non-standard methods to remove entry barriers in

China, which can reconcile these seemingly contradictory facts.

Another important mechanism is reputation and relationships. Greif (1989, 1993) argues that

certain traders’ organizations in the 11th century were able to overcome problems of asymmetric

information and the lack of legal and contract enforcement mechanisms, because they had

developed institutions based on reputation, implicit contractual relations, and coalitions. Certain

aspects of the growth of these institutions resemble what works in China’s non-standard financial

sector today, in terms of how firms raise funds and contract with investors and business partners. In

addition, Greif (1993) and Stulz and Williamson (2003) point out the importance of cultural and

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religious beliefs for the development of institutions, legal origins, and investor protections.

The above factors are of particular relevance and importance to China’s development of

institutions. Without a dominant religion, one can argue that the most important force in shaping

China’s social values and institutions is the set of beliefs first developed and formalized by Kong Zi

(Confucius). This set of beliefs clearly defines family and social orders, which are very different

from western beliefs on how legal codes should be formulated.37 Using the World Values Survey

conducted in the early 1990s, LLSV (1997b) find that China has one of the highest levels of social

trust among a group of 40 developed and developing countries.38 We interpret high social trust in

China as being influenced by Confucian beliefs. Throughout the paper we have presented evidence

that reputation and relationships make many financing channels and governance mechanisms work

in China’s Hybrid Sector.39

There are other effective corporate governance mechanisms. First, Burkart et al. (2003) link

the degree of separation of ownership and control to different legal environments, and show that

family-run firms will emerge as the dominant form of ownership structure in countries with weak

minority shareholder protections, whereas professionally managed firms must be the optimal form

in countries with strong investor protection. Our survey evidence on the Hybrid Sector and

empirical results on the Listed Sector, along with evidence in Claessens et al. (2000, 2002), suggests

that family firms are a norm in China and other Asian countries, and these firms have performed

well. Second, the common goal of sharing high prospective profits can tie local and foreign

investors with entrepreneurs and managers to overcome numerous obstacles and achieve just that.

Under this common goal in a multi-period setting, implicit contractual agreements and reputation

can act as enforcement mechanisms to ensure that all parties fulfill their roles to make the firm

successful. Profit sharing also makes it incentive compatible for officials at various levels to support

the growth of the firm.

Finally, there is a strand of literature studying transitional economies, such as Russia, China,

Vietnam, and Eastern European countries, from Socialist systems to market systems. It is important

to point out why China differs from other transitional economies. First, with the exception of

37 Also see Pye (1982), Chen (1996), and Chow (2002) for more description on the influence of Confucius’ beliefs in Asian businesses and their style of negotiation. 38 Interestingly, the same survey, used in LLSV (1997b), finds that Chinese citizens have a low tendency to participate in civil activities. However, our evidence shows that, with effective alternative mechanisms in place citizens in the developed regions of China have a strong incentive to participate in business/economic activities. 39 Moreover, Gomes (2000) demonstrates that a managerial reputation effect can replace formal governance in an IPO firm. Evidence from the Chinese venture capital industry (Bruton and Ahlstrom 2002) also supports this view.

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Russia, China’s economy is much larger and more diversified than other transitional economies.

With a small and homogenous economy, a country can adjust its legal and financial systems to the

strengths of its economy much more easily than a large country can. The recent economic struggle

in Russia proves this point (e.g., Shleifer and Treisman 2000). The success of China’s Hybrid

Sector demonstrates that alternative mechanisms can work wonders even in large and diversified

economies.

Second, it is probably easier for other countries to adopt drastic reform measures in the short

run. China, under the influence of Confucius’ views, is different, in that people traditionally hold

the belief that fundamental changes in society should be gradual and be fully implemented only

after they are proven correct; this view was reinforced after the destructive Cultural Revolution;

however, this view does not prevent regional experiments conducted at a smaller scale.

Accordingly, China adopted a gradual, “dual track” path in its economic reform, in that the

continued enforcement of the existing planning system goes alongside with the fast-paced

development of financial markets, as compared to the “big bang” approach taken by some other

countries (e.g., Lau et al. 2000).

Third, the role played by the government during the reform process is very different in

China than in most other transition economies, in particular, Russia.40 While the Chinese

Communist Party largely remains autocratic, government officials, especially those in the most

developed areas (e.g., Jiangsu and Zhejiang Provinces), played an active supporting role in

promoting the growth of the Hybrid Sector. This is different from the “grabbing hand” role played

by government officials in other countries (Frye and Shleifer 1997). The reason for this supporting

role is three fold. First, as Li (1998) points out, starting in the early 1980s, the central government

of China implemented a mandatory retirement age for almost all bureaucrats at various levels,

which made the officials younger and more familiar with capitalist ideas. In Russia, officials from

the old regime were entrenched and able to extract rents from the new economy without any

contribution. Next, during the early stages of China’s reform, TVEs, in which local governments

were partial owners, provided the most important source of growth in the Hybrid Sector. The

enormous success of TVEs and the promotion of the associated officials provided examples and

incentives to other officials to follow suit. Finally, as discussed above, profit sharing with firms in a

40 In a broader context, LLSV (1999) find that governments in countries with French or socialist origins have lower quality (in terms of supporting economic growth) than those with English common laws and richer countries. But clearly China is a counterexample to LLSV’s argument on government.

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multi-period setting also makes it incentive compatible for officials at various levels to support the

growth of the firm.

VI. Financial Crises

Financial crises often accompany the development of a financial system. Conventional

wisdom says that financial crises are bad. Often they are very bad, as they disrupt production and

lower social welfare as in the Great Depression in the US. Hoggarth et al. (2002) carefully measure

the costs of a wide range of recent financial crises and find that these costs are on average roughly

15-20 percent of GDP. It is these large costs that make policymakers so averse to financial crises.

It is important to point out, however, that financial crises may be welfare improving for an

economy. One possible example is the late nineteenth century US, which experienced many crises

but at the same time had a high long run growth rate. In fact Ranciere et al. (2003) report an

empirical observation that countries which have experienced occasional crises have grown on

average faster than countries without crises. They develop an endogenous growth model and show

theoretically that an economy may be able to attain higher growth when firms are encouraged by a

limited bailout policy to take more credit risk in the form of currency mismatch, even though the

country may experience occasional crises (see Allen and Oura (2004) for a review of the growth

and crises literature and Allen and Gale (2004a) who show that crises can be optimal).

In this section, we consider financial crises in China. Given China’s current situation with

limited currency mismatches any crisis that occurs is likely to be a classic banking, currency or twin

crisis. It is perhaps more likely to be of the damaging type that disrupts the economy and social

stability than of the more benign type that aids growth. The desirability of preventing crises thus

needs to be taken into account when considering reforms of China’s financial system. First, we

examine how China can prevent traditional financial crises, including a banking sector crisis and a

stock market or real estate crisis/crash. We then discuss how China should be better prepared for

new types of financial crises, such as the “twin crises” (simultaneous foreign exchange and

banking/stock market crises) that occurred in many Asian economies in the late 1990s.

VI.1 Banking Crises and Market Crashes

Among traditional financial crises, banking panics, caused by the fact that banks do not have

sufficient liquid assets to meet total withdrawal demands (anticipated and unanticipated), were often

particularly disruptive. Over time one of the most important roles of central banks came to be to

eliminate banking panics and ensure financial stability. To a large degree central banks in different

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countries performed well in this regard in the period following the Second World War. However, in

recent years, banking crises are often preceded by a substantial rise in market prices (“bubbles”) in

the real estate or stock markets to levels that are much higher than during normal times. At some

point the bubble bursts and assets markets collapse. In many cases banks and other intermediaries

are overexposed to the equity and real estate markets, and following the collapse of asset markets a

banking crisis ensues. Allen and Gale (2000c) provide a theory of bubbles and crises based on the

existence of an agency problem. Many investors in real estate and stock markets obtain their

investment funds from external sources. If the providers of the funds are unable to observe the

characteristics of the investment, and because of limited liability on the investors, there is a classic

risk-shifting problem (Jensen and Meckling 1976). Risk shifting increases the return to risky assets

and causes investors to bid up asset prices above their fundamental values. A crucial determinant

for asset prices is the amount of credit that is provided for speculative investment. Financial

liberalization, by expanding the volume of credit, can interact with the agency problem and lead to a

bubble in asset prices.

As discussed above in Section III, if NPLs continue to accumulate and/or if growth slows

significantly then there may be a banking crisis in China. This may well involve withdrawal of

funds from banks. However, given the government's strong position regarding the low level of debt

pointed out in Table 3-D, it should be possible for the government to prevent this situation getting

out of control. On the other hand, given that the real estate market in Shanghai and in other major

cities (largest volume and most developed) has already gone through a few episodes of bubbles and

crashes (see China Industry Report, Http://www.cei.gov.cn, and http://house.focus.cn for more

details), it is quite possible that similar episodes in the future could cause a banking crisis that will

be more damaging to the real economy. With booming real estate markets, there will be more

speculative money poured into properties with a large amount coming from bank loans. The agency

problem in real estate lending and investment mentioned above worsens this problem. If the real

estate market falls significantly within a short period of time, there could be large defaults on bank

loans that can trigger a banking panic and crisis. This perhaps represents the most serious risk of a

financial crisis in China.

VI.2 Capital Account Liberalization, Currency Float, and Twin Crises

After the collapse of the Bretton Woods system in early 1970s, a new breed of financial

crisis emerged. Lindgren, Garcia, and Saal (1996) find that about three quarters of the IMF’s

member countries suffered some form of banking crisis between 1980 and 1996, and their study did

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not include the subsequent Asian financial crisis in 1997. In many of these crises, banking panics in

the traditional sense were avoided either by central bank intervention or by explicit or implicit

government guarantees. But as Kaminsky and Reinhart (1999) find, the advent of financial

liberalization in many economies in the 1980s, in which free capital in- and out-flows and the

entrance and competition from foreign investors and financial institutions follow in the home

country, has often led to “twin” banking and currency crises. A common precursor to these crises

was financial liberalization and significant credit expansion and subsequent stock market crashes

and banking crises. In emerging markets this is often then accompanied by an exchange rate crisis

as governments choose between lowering interest rates to ease the banking crises or raising them to

defend the home currency. Finally, a significant fall in output occurs and the economies enter

recessions.41

Liberalization of the Capital Account and Financial Sector

The entrance of China to the WTO (World Trade Organization) potentially introduces cheap

foreign capital and technology, but large scale and sudden capital flows and foreign speculation

significantly increase the likelihood of a twin crisis. The first key question is, when and to what

extent should a country open its capital account and financial sector to foreign capital and foreign

financial institutions? The prevailing view, expressed by McKinnon (1991) and Dornbusch (1998),

is that success or failure of this policy hinges on the efficiency of domestic financial institutions,

while Fischer (1998) and Calvo (1998) have promoted reforming the financial sector as a pre-

condition to liberalizing. This latter view assumes that financial liberalization does not alter the

efficiency of domestic financial institutions. But this policy change affects both the supply and price

of capital, two important determinants of lending contracts. With a model of endogenous financial

intermediation, Alessandria and Qian (2005) demonstrate that an efficient financial sector prior to

liberalization is neither necessary nor sufficient for a successful financial liberalization.

Applying these ideas to China, even though the overall efficiency of China’s banking sector

(especially state-owned banks) is low compared to international standards, banks can have a

stronger incentive to limit the moral hazard concerning borrowers’ choices of investment projects

41 Chang and Velasco (2000, 2001) develop a model of twin crises based on the Diamond and Dybvig (1983) model of bank runs, where crises are “sunspot” phenomena rather than due to aggregate uncertainty. On the other hand, money enters agents’ utility function, and the central bank controls the ratio of currency to consumption, so that different exchange rate regimes correspond to different rules for regulating the currency-consumption ratio. In some regimes, there exists both a “good” equilibrium in which early (late) consumers receive the proceeds from short-term (long-term) assets, and a “bad” equilibrium in which everybody believes a crisis will occur and these beliefs are self-fulfilling. If the bad equilibrium occurs, there is a twin crisis.

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through monitoring and loan contracts, following capital account liberalization. Therefore, even

absent any advancement in banks’ monitoring technology, the efficiency of the banking sector

improves and the liberalization can generate a large welfare increase, since it leads to both a larger

scale of investment and a better composition of investment projects. This is more likely to occur

with low interest rates in international markets (so that cost of capital for domestic banks is also

low). A financial sector liberalization, which allows foreign financial institutions to enter China’s

lending markets, can further improve welfare as more competition in the banking sector further

discourages moral hazard in investment. As long as the adverse selection problem is not severe

(entrance of borrowers with negative-NPV projects in the markets), financial sector liberalization

will further improve welfare. Overall, liberalization of the capital account is likely to be beneficial

for China.

Currency Crisis and Banking Crisis (A Twin Crisis)

A currency crisis that may trigger a banking crisis is a possibility. The rapid increase in

foreign exchange reserves in recent years suggests there is a lot of speculative money in China in

anticipation of an RMB revaluation. If there is a revaluation or if after some time it becomes clear

there will not be one then much of this money may be withdrawn. What happens will depend on

how the government and central bank deals with this situation. If they allow the currency to float so

they do not use up the exchange reserves then any falls in the value of the RMB may occur quickly

and this may limit further outflows. If they try to maintain the peg then there may be a classic

currency crisis. This is in turn may trigger a banking crisis if there are large withdrawals from

banks as a result. Quickly adopting a float and avoiding a twin crisis would be much preferable.

Financial Contagion

Another phenomenon that has been important in many recent crises (e.g., the 1997 Asian

crisis) is that financial crises are contagious. A small shock that initially affects only a particular

region or sector can spread by contagion within the banking system or asset markets to the rest of

the financial sector, then to the entire economy and possibly other economies. Contagion can occur

in a number of ways. In the Chinese context where financial markets are relatively unimportant it is

most likely they will occur either from contractually interconnected financial institutions or large

asset price movements that cause spillovers to financial institutions.

Allen and Gale (2000d) focus on the channel of contagion that arises from the overlapping

claims that different regions or sectors of the banking system have on one another through interbank

markets. When one region suffers a banking crisis, the other regions suffer a loss because their

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claims on the troubled region fall in value. If this spillover effect is strong enough, it can cause a

crisis in the adjacent regions, and a contagion can occur which brings down the entire financial

system. Allen and Gale (2004b) show how large price falls can come about as a result of forced

liquidations when there is a limited supply of liquidity in the market. Cifuentes, Ferrucci, and Shin

(2005) show that contagion is likely to be particularly severe when these two factors interact.

Insert Table 10 here.

Given China’s current financial system, what is the likelihood of financial contagion caused

by contractual interlinkages as in the interbank market or because of a meltdown in asset prices if

there are forced sales? China’s interbank market grew very quickly since its inception in 1981; in

fact, the growth of this market was so fast, with the participation of many unregulated financial

institutions and with large amount of flows of funds through this market to fixed asset investment,

that it exacerbated high inflation in the late 1980s. Since then the government and PBOC increased

their regulation by limiting participation of non-bank financial institutions and by imposing

restrictions on interest rate movements. In 1996 a nation-wide, uniform system of interbank markets

was set up. It contains two connected levels: the primary network, which includes the largest PBOC

branches, large commercial banks, and a few large non-bank financial institutions, and the

secondary network that includes many banks and non-bank institutions and their local branches (see

China Interbank Market Annual Reports for more details). Table 10 describes the growth of the

interbank market in recent years: the growth of trading volume of instruments with short maturities

(overnight and one week) has been fast, while trading of securities with longer maturities has been

low and steady. It can be seen that interlinkages are significant and potentially create a possibility

for contagion.

With regard to a meltdown of asset prices, this can happen because of a limited supply of

liquidity if there is a rapid liquidation of assets. It seems unlikely that this can occur and cause a

serious problem in China’s securities markets. A more serious threat is real estate markets if there

are bankruptcies and forced selling. This could potentially interact with bank interlinkages and

cause a systemic problem. As mentioned above, a crash in real estate markets is probably the most

likely cause of a financial crisis in China.

VII. Summary and Concluding Remarks

One of the most frequently asked questions about China’s financial system is whether it will

stimulate or hamper its economic growth. Our answer to this question, based on examining the

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history and current status of the financial system and comparing them to those of other countries, is

in four parts. First, the large but inefficient banking sector has been the dominant force in the

financial system, and has played a central role in funding the growth of all types of firms. It is

currently plagued by the problem of NPLs, which, if not corrected properly, may cause major

economic difficulties. Second, the stock market has been growing fast since 1990 until a few years

ago, but has played a limited role in supporting the growth of the economy. However, the role of

the financial markets is likely to change in the near future and they will play an increasingly

important role in the economy.

If we can summarize that the role of the banking sector and financial markets has been that

they have done enough not to slow down the growth of the economy, our third conclusion is that

alternative financing channels have had great success in supporting the growth of the Hybrid Sector,

which contributes most of the economic growth compared to the State and Listed Sectors. The non-

standard financial sector relies on alternative financing channels including internal finance, and on

alternative governance mechanisms, such as those based on trust, reputation and relationships, and

competition to support the growth of the Hybrid Sector. Going forward, we believe that these

alternative financing channels and governance mechanisms should be encouraged rather than

replaced. They should be allowed to co-exist with the banks and markets and continue to fuel the

growth of the Hybrid Sector.

We conclude by pointing out the most significant challenge for improving China’s financial

system: Economic stability is crucial for the continuing development of the Chinese economy, and

the stability of the financial system relates to economic stability in three dimensions. The

continuing effort to reduce and eventually bring down NPLs to normal levels is important in

avoiding a banking crisis, while the effort to improve the regulatory environment surrounding the

financial markets (including governance and accounting standards) can certainly help prevent a

stock market crash/crisis. The entrance of China to the WTO introduces cheap foreign capital and

technology, but free capital inflow and foreign competition and speculation also bring the risk of a

twin crisis (foreign exchange and banking/stock market crisis), which severely damaged emerging

economies in Asia in 1997. In order to guard against such a crisis, policies toward improving the

financial system must be made along with supportive fiscal and trade policies.

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Appendix A: Descriptions of variables used and their sources

A.1. Creditor/Shareholder Rights Variables, (Table 5-C and Figure 7) Variables Description Sources Legal origin Identifies the legal origin of the company law or commercial code of

each country. Reynolds & Flores (1989), LLSV (1997a)

One share-one vote 1) Equals one if ordinary shares carry one vote per share, and zero otherwise; 2) equals one, when the law prohibits the existence of both multiple-voting and nonvoting ordinary shares and does not allow firms to set a maximum number of votes per shareholder irrespective of the number of shares owned, and zero otherwise.

Company law or commercial code

Proxy by mail allowed

Equals one if shareholders can mail their proxy vote to the firm, and zero otherwise.

Company law or commercial code

Shares not blocked before meeting

Equals one if firms cannot require shareholders to deposit their shares prior to a general shareholders’ meeting (to prevent selling shares), and zero otherwise.

Company law or commercial code

Cumulative voting or proportional representation

Equals one if shareholders can cast all their votes for one candidate to the board of directors (cumulative voting) or a mechanism of proportional representation in the board by which minority interests may name a proportional number of directors to the board is allowed, and zero otherwise.

Company law or commercial code

Oppressed minorities mechanism

Equals one if minority shareholders have either a judicial venue to challenge the decisions of management or the assembly or the right to step out of the company by requiring the company to purchase their shares when they object to certain fundamental changes (e.g., mergers and asset dispositions); equals zero otherwise. Minority shareholders are defined as those shareholders who own 10% of shares or less.

Company law or commercial code

Preemptive rights Equals one when grants shareholders the first opportunity to buy new issues of stock, and this right can be waived only by a shareholders' vote; equals zero otherwise.

Company law or commercial code

Percentage of share capital to call an extraordinary shareholders' meeting

The minimum percentage of ownership of share capital that entitles a shareholder to call for an extraordinary shareholders' meeting; ranges from 1% to 33%.

Company law or commercial code

Antidirector rights The index is formed by adding one when: (1) the country allows shareholders to mail their proxy vote to the firm; (2) shareholders are not required to deposit their shares prior to the general shareholders' meeting; (3) cumulative voting or proportional representation of minorities in the board of directors is allowed; (4) an oppressed minorities mechanism is in place; (5) the minimum percentage of share capital that entitles a share- holder to call for an extraordinary shareholders' meeting is less than or equal to 10% (the sample median); or, (6) shareholders have preemptive rights that can be waived only by a shareholders' vote. The index ranges from zero to six.

Company law or commercial code

Mandatory dividend Equals the percentage of net income that the company law or commercial code requires firms to distribute as dividends among ordinary stockholders. It equals zero for countries without such a restriction.

Company law or commercial code

Restrictions for going into reorganization

Equals one if the reorganization procedure imposes restrictions, such as creditors consent; equals zero otherwise.

Bankruptcy and reorganization laws

No automatic stay on secured assets

Equals one if the reorganization procedure does not impose an automatic stay on the assets of the firm on filing the reorganization petition. Automatic stay prevents secured creditors from gaining

Bankruptcy and reorganization laws

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possession of their security. It equals zero if such a restriction does exist in the law.

Secured creditors first

Equals one if secured creditors are ranked first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm. Equals zero if nonsecured creditors, such as the government and workers, are given absolute priority.

Bankruptcy and reorganization laws

Management does not stay

Equals 1 when an official appointed by the court, or by the creditors, is responsible for the operation of the business during reorganization. Equivalently, this variable equals one if the debtor does not keep the administration of its property pending the resolution of the reorganization process. Equals zero otherwise.

Bankruptcy and reorganization laws

Creditor rights An index aggregating different creditor rights. The index is formed by adding “one” when: (1) the country imposes restrictions, such as creditors' consent or minimum dividends to file for reorganization; (2) secured creditors are able to gain possession of their security once the reorganization petition has been approved (no automatic stay); (3) secured creditors are ranked first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm; and, (4) the debtor does not retain the administration of its property pending the resolution of the reorganization. The index ranges from zero to four.

Bankruptcy and reorganization laws

Legal reserve requirement

The minimum percentage of total share capital mandated by corporate law to avoid the dissolution of an existing firm. It takes a value of zero for countries without such a restriction.

Company law or commercial code

Efficiency of judicial system

Assessment of the "efficiency and integrity of the legal environment as it affects business, particularly foreign firms" produced by the country risk rating agency Business International Corp. It "may be taken to represent investors' assessments of conditions in the country in question." Average between 1980 and 1983. Scale from zero to ten; with lower scores, lower efficiency levels.

Business International Corp.

Rule of law Assessment of the law and order tradition in the country produced by the international country risk rating agency, International Country Risk (ICR). Average of the months of April and October of the monthly index between 1982 and 1995. Scale from zero to ten, with lower scores for less tradition for law and order (we changed the scale from its original range going from zero to six).

International Country Risk Guide

Corruption ICR's assessment of the corruption in government. Lower scores indicate that "high government officials are likely to demand special payments" and "illegal payments are generally expected throughout lower levels of government" in the form of "bribes connected with import and export licenses, tax assessment, policy protection, etc." Average of the months of April and October of the monthly index between 1982 and 1995. Scale from zero to ten, with lower scores for higher levels of corruption (we changed the scale from its original" range going from zero to six).

International Country Risk Guide

Risk of expropriation

ICR's assessment of the risk of "outright confiscation "or "forced nationalization." Average of the months of April and October of the monthly index between 1982 and 1995. Scale from zero to ten, with lower scores for higher risks.

International Country Risk Guide

Repudiation of contracts by government

ICR's assessment of the "risk of a modification in a contract taking the form of a repudiation, postponement, or scaling down" due to "budget cut backs, indigenization pressure, a change in government, or a change in government economic and social priorities." Average of the months of April and October of the monthly index between 1982 and 1995. Scale from zero to ten, with lower scores for higher risks.

International Country Risk Guide

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Accounting standards

Index created by examining and rating companies' 1990 annual reports on their inclusion or omission of 90 items. These items fall into seven categories (general information, income statements, balance sheets, funds flow statement, accounting standards, stock data, and special items). A minimum of three companies in each country was studied. The companies represent a cross-section of various industry groups; industrial companies represented 70%, and financial companies represented the remaining 30%.

International accounting and auditing trends, Center for International Financial Analysis and Research

Secondary source: LLSV(1997a, 1998)

A.2. Financial System Variables, (Table 1-A)

Variables Definition Original Source Bank Credit Ratio of total credit deposited into banks from private

sector /GDP. IFS, WDI, and country specific publications

(Total) value traded

Ratio of domestic equity traded on domestic exchanges /GDP.

IFS, WDI, EMFB, and country specific publications

Market capitalization

Ratio of domestic equities listed on domestic exchanges/GDP.

Int’l Financial Statistics (IFS), World Development Indicators (WDI), Emerging Markets Factbook (EMFB), and country specific publications

Overhead cost Overhead cost divided by total bank system assets. Levine’s calculations (2002) Structure- size Log(Market capitalization/Bank credit); measure size of

markets and banks. Levine (2002)

Structure-activity Log(Value traded/Bank credit); measure size/trading volume of markets and banks.

Levine (2002)

Structure-efficiency Log(Market capitalization ratio × Overhead cost ratio); measures relative efficiency of markets vs. banks.

Levine (2002)

Structure regulation Sum of the four categories in regulatory restriction. National regulatory authorities Regulatory restriction

The degree to which commercial banks are allowed to engage in security, firm operation, insurance, and real estate: 1- unrestricted; 2-permit to conduct through subsidiary; 3-full range not permitted in subsidiaries; and 4-strictly prohibited.

National regulatory authorities

Finance-size Log (Market capitalization ratio × Private credit ratio) Levine (2002) Finance-activity Log (Total value traded ratio × Private credit ratio) Levine (2002) Finance-efficiency Log (Total value traded ratio/Overhead cost) Levine (2002)

Secondary source: Beck, Demirgüç-Kunt, and Levine (2002), and Levine (2002).

A.3. External Financing Variables, (Table 5-C and Figures 6 and 7)

Variable Description Sources External cap / GNP

The ratio of the stock market capitalization held by minorities to GNP in 1994. The first variable is computed as the product of the aggregate stock market capitalization and the average percentage of common shares not owned by the top three shareholders in the ten largest nonfinancial, privately- owned domestic firms in a given country. A firm is considered privately owned if the State is not a known shareholder.

Moodys International, CIFAR, EXTEL, WorldScope, 20-Fs, PriceWaterhouse, and various country sources

Domestic firms / Pop

Ratio of the number of domestic firms listed in a given country to its population (in millions) in 1994.

Emerging Market Factbook and World Development Report (WDR) 1996.

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IPOs/Pop Ratio of the number of initial public offerings of equity in a given country to its population (in millions) for the period 1995:7-1996:6.

SDC, AsiaMoney, LatinFinance, GT Guide to World Equity Markets, and WDR 1996.

Debt/GNP Ratio of the sum of bank debt of the private sector and outstanding nonfinancial bonds to GNP in 1994, or last available.

International Financial Statistics, World Bondmarket Factbook.

GDP growth Average annual percent growth of per capita gross domestic product for the period 1970-1993.

WDR 1995.

Market cap/ sales

The median ratio of the stock market capitalization held by minorities to sales in 1994 for all nonfinancial firms in a given country on the WorldScope database. Firm's stock market capitalization held by minorities is computed as the product of the stock market capitalization of the firm and the average percentage of common shares not owned by the top three shareholders in the ten largest nonfinancial, privately owned domestic firms in a given country. A firm is considered privately owned if the State is not a known shareholder in it.

WorldScope.

Market cap/ cash-flow

The median ratio of the stock market capitalization held by minorities to cash flow in 1994 for all nonfinancial firms in a given country on the WorldScope database. The firm's stock market capitalization held by minorities is computed as the product of the stock market capitalization of the firm and the average percentage of common shares not owned by the top three shareholders in the ten largest nonfinancial, privately owned domestic firms in a given country. A firm is considered privately owned if the State is not a known shareholder in it.

WorldScope.

Debt/sales Median of the total-debt-to-sales ratio in 1994 for all firms in a given country on the WorldScope database.

WorldScope.

Debt/cash flow

Median of the total-debt-to-cash-flow ratio for all firms in a given country on the WorldScope database.

WorldScope.

Secondary source: LLSV(1998), China details from Shanghai and Shen Zhen Stock exchanges, and firms’ annual reports. A.4. Definitions of Financial Intermediaries/Institutions in China (Tables 4-A, 4-B, and Figures 1 & 3)

Institutions Definition State-owned Banks (Big four) There are four 100% state owned banks, BOC, PCOC, ICBC, and ABC.

They carry out commercial banking functions. However, they are heavily regulated and interfered with by the PBOC, such as the imposition on interest rate restrictions and loan allocations.

Other Commercial Banks There are a variety of commercial banks in China with a variety of different types of ownership in addition to the four largest state-owned banks. They can be owned by central government, local government, communities, and individual persons or enterprises. They carry out the functions of commercial banks, and are heavily regulated by the PBOC, mainly on interest rates.

Policy Banks They are three policy banks in China, all created in 1996 and belonging to the Treasury department. They are the Development Bank of China, the Import and Export Bank of China, and the Agriculture Development Bank of China. These banks carry out policy financing roles. For example, issuing bonds or make loans for the development of specified projects or certain sector of the economy.

Rural Credit Cooperative A Credit Cooperative is a non-profit organization, providing financial

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(RCC) services, such as lending and savings to its members. Rural Credit Cooperatives are owned and operated by communities in rural areas, and are widespread in China. They started in 1984, and were overseen by the Agriculture Bank of China until 1996. They were then regionally merged and overseen directly by the PBOC.

Urban Credit Cooperative (UCC)

This is the counterpart of the RCC in the city. In 1996, they were regionally merged and became called City Commercial Banks.

Postal Savings These are deposit-taking institutions run by the Bureau of Post Savings, and regulated by the PBOC. Local branch offices are affiliated with the post offices in the same area, and provide wire transfer, distribution of treasury bills, and also act as agencies for insurance or retirement funds.

Asset Management Company The four Asset Management Companies were set up in 1998 to help the financial restructuring of the four major state-owned banks’. They are specialized in managing and recovering the NPLs transferred from the four banks.

Trust and Investment Company In a TIC, a trustee accepts, manages, or uses the trust capital or trust properties in accordance with the special objectives or requests designed by the trust creator. It provides bank (custodial, payment, guarantees) and non-bank (security issuance, financial leasing) financial services. Its loan is restricted to “circulating funds”, i.e., working capital (< 3 months). Its sources of funds include: government Treasuries, government departments that administer enterprises, labor protection and welfare institutions, research institutions, academic associations and other foundations.

Non-deposit Financial Intermediaries (e.g., finance companies

By law, these companies cannot take deposits. They raise capital from organizations and investors and make loans to individuals or businesses.

Mutual Fund An open- or close- end fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives.

A.5. Definitions of Different Types of Firms in China (Figures 2, 9 and 10)

1. State-owned enterprises: Noncorporation economic units, such that the entire assets are owned by the state and which are registered in accordance with the “Regulation of the People's Republic of China on the Management of Registration of Corporate Enterprises.” Excluded from this category are the solely state-funded corporations in the limited liability corporation. Note: The government is the de facto owner, and they choose managers to run the firm. Even though these firms do enter the credit plan, this process is constructed and enforced by state banks, which are also under the control of the government.

2. Collective-owned enterprises: Economic units such that the assets are owned collectively and which are

registered in accordance with the “Regulation of the People's Republic of China on the Management of Registration of Corporate Enterprises.” Note: Local government can be regarded as the agent of central government. Therefore, any firm owned by local government is also owned by central government. Collective ownership here means the communities in cities or rural areas joining the ownership.

3. Township-village enterprises (TVEs): Enterprises and economic units located in rural areas, collectively-

owned or with most of its investment from residents in these rural areas. An enterprise in a rural area is legally registered as a TVE where rural communities or residents invest more than 50% of the firm’s total assets or act as the control owners in the operation of enterprise. Note: There can be firms that are both collectively-owned and TVEs, as long as they are in the rural areas and have more than 50% of total assets coming from residents from the same rural area/county. The difference is that TVEs are all located in rural areas while collectively-owned firms can be in cities; also TVEs can be solely owned by residents of that rural area and the local government has no ownership or control over the firm.

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4. Jointly-owned firms: Economic units established by two or more corporate enterprises or institutions of the same or different ownership, through joint investment on the basis of equality, voluntary participation, and mutual benefits. They include state joint ownership enterprises, collective joint ownership enterprises, joint state-collective enterprises, and other joint ownership ventures. Note: Enterprises involved with foreign investment/ownership are not in this category. They are in the Category of “Enterprise with Foreign investment,” which has three different types.

5. Limited Liability Share-holding Corporations: Economic units registered in accordance with the

“Regulation of the People's Republic of China on the Management of Registration of Corporate Enterprises,” with total registered capital divided into equal shares and raised through issuing stocks. Each investor bears limited liability to the corporation depending on the holding of shares, and the corporation bears liability to its debt to the maximum of its total assets. Note: The above is essentially the same as the definition of US public companies, but these Chinese companies have nontradable shares that are the by-product of the reform process.

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77

Table 1-A A Comparison of Financial Systems: Bank- vs. Market-based Measures (Value-weighted approach)

Measures English

Origin* French Origin*

German Origin*

Scandinavian origin*

Sample average

China

Bank credit/GDP 0.62 0.55 0.99 0.49 0.73 1.11 (0.24) a

Overhead Cost/Bank Total Assets

0.04 0.05 0.02 0.03 0.03 0.12

Total value traded/GDP

0.31 0.07 0.37 0.08 0.27 0.11

Bank and Market size

Market Cap/GDP 0.58 0.18 0.55 0.25 0.47 0.32 Structure Activity -0.76 -2.03 -1.14 -1.83 -1.19 -1.07

(0.46) a Structure Size -0.10 -1.05 -0.77 -0.69 -0.55 -1.24

(0.29) a Structure Efficiency -4.69 -6.00 -5.17 -6.17 -5.17 -1.48

(-3.07) Structure aggregate 1.21 -0.05 0.66 0.13 0.72 N/A

Structure Indices: Markets vs. banks**

Structure regulatory 7.02 8.21 10.15 7.72 8.95 16 Finance activity -1.18 -3.38 -0.84 -2.86 -1.58 -0.85

(-2.38) Finance size 5.10 4.29 5.22 4.60 4.95 -1.02

(-2.55) a Finance efficiency 2.18 0.44 2.85 1.04 2.01 -0.60

(1.14)

Financial Development (Banking and market sectors)

Finance aggregate 1.23 0.13 1.47 0.48 1.05 N/A Notes: All the measures for countries other than China are from Levine (2002); measures on China are calculated using definitions from Levine (2002) (see Appendix for list of definitions) *: The numerical results for countries of each legal origin group is calculated based on a value- (GDP of each country) weighted approach; **: Measuring whether a country’s financial system is market- or bank-dominated, the higher the measure, the more the system is dominated by markets; a: numbers in brackets indicate bank credit issued to the Hybrid Sector of China (instead of total bank credit); Sources: Almanac of China’s Finance and Banking (2000); China Statistical Yearbook (2000)

78

Table 1-B Inflows and Outflows of Foreign Direct Investment

Panel a) FDI Inflows and Outflows Total amount (in US$ million) As % of gross fixed capital formation

Average 1985-95

1999 2000 2001 2002 2003

Average 1985-95 2000 2001 2002 2003

China Inward 11,887 40,319 40,715 46,878 52,743 53,505 6.6 10.3 10.5 11.5 12.4 Outward 1,591 1,775 916 6,884 2,518 1,800 1.0 0.2 1.5 0.5 0.4 Singapore Inward 4,512 16,067 17,217 15,038 5,730 11,409 32.0 62.8 60.1 25.6 45.7 Outward 1,518 7,517 5,298 17,063 3,699 5,536 8.5 19.3 68.2 16.5 22.2 United States Inward 44,434 283,376 314,007 159,461 62,870 29,772 5.2 15.8 8.1 3.3 1.5 Outward 42,571 209,391 142,626 124,873 115,340 151,884 4.7 7.2 6.4 6 7.5 South, East and South-East Asia Inward 30,189 109,115 142,683 102,228 86,326 96,915 5.4 15.2 10.8 8.7 9.7 Outward 16,634 39,216 80,031 45,063 34,652 23,487 2.9 8.7 4.8 3.6 2.4 Developing Economies Inward 50,773 231,880 252,459 219,721 157,612 172,033 4.5 14.9 13.1 9.9 10 Outward 21,620 75,488 98,929 59,861 44,009 35,591 2.0 6.1 3.6 3 2.1 World Inward 181,704 1,086,750 1,387,953 817,574 678,751 559,576 3.9 19.8 12.0 10.1 7.5 Outward 203,620 1,092,279 1,186,838 721,501 596,487 612,201 4.6 17.1 10.8 9 8.4

Panel b) Stocks of FDI Total amount (in US$ million) as % of GDP 1980 1990 1995 2000 2002 2003 1980 1990 2000 2002 2003 China Inward 1,077 20,694 134,869 348,346 447,966 501,471 0.5 5.8 32.2 35.4 35.6 Outward -- 2,489 15,802 25,804 35,206 37,006 -- 0.7 2.4 2.8 2.6 Singapore Inward 6,203 30,468 65,644 112,571 135,890 147,299 52.9 83.1 121.5 153.9 161.3 Outward 3,718 7,808 35,050 56,766 85,374 90,910 31.7 21.3 61.3 96.7 99.5 United States Inward 83,046 394,911 535,553 1,214,254 1,505,171 1,553,955 3.0 6.9 12.4 14.4 14.1 Outward 215,375 430,521 699,015 1,293,431 1,839,995 2,069,013 7.8 7.5 13.2 17.6 18.8 South, East and South-East Asia Inward 211,039 337,082 581,012 1,195,687 1,259,136 1,352,409 27.4 20.8 36.6 35.6 34.6 Outward 4,515 41,042 181,812 577,763 560,966 607,488 1.0 2.6 18.1 16.2 15.9 Developing Economies Inward 301,974 547,965 916,697 1,939,926 2,093,569 2,280,171 12.4 14.7 29.3 31.9 31.4 Outward 60,239 128,561 308,624 793,297 796,503 858,681 3.6 3.8 12.4 12.6 12.2 World Inward 692,714 1,950,303 2,992,068 6,089,884 7,371,554 8,245,074 6.6 9.3 19.3 23 22.9 Outward 559,629 1,758,216 2,897,574 5,983,342 7,209,582 8,196,863 5.8 8.6 19.1 22.6 23

Source: (United Nations) UNCTAD, World Investment Report 2004; http://www.unctad.org/fdistatistics.

79

Table 1-C Overview of Cross-country Mergers & Acquisitions (in Millions of US dollars)

1995 1996 1997 1998 1999 2000 2001 2002 2003 China Sales 403 1 906 1 856 798 2 395 2 247 2 325 2 072 3 820 Purchases 249 451 799 1 276 101 470 452 1 047 1 647 Singapore Sales 1,238 593 294 468 2 958 1 532 4 871 556 1 766 Purchases 892 2 018 2 888 530 4 720 8 847 16 516 2 946 5 018 United States Sales 53,237 68 069 81 707 209 548 251 934 324 350 184 880 73 233 69 670 Purchases 57,343 60 744 80 869 137 421 120 310 159 269 96 039 78 429 82 395 South, East and South-East Asia Sales 6,278 9 745 18 586 15 842 28 431 21 105 33 114 16 807 20 167 Purchases 6,608 17 547 17 893 6 001 11 335 21 139 24 844 10 778 16 978 Developing economies Sales 16,493 35 727 66 999 82 668 74 030 70 610 85 813 44 532 42 130 Purchases 13,372 29 646 35 210 21 717 63 406 48 496 55 719 27 585 31 234 World Sales 186,593 227 023 304 848 531 648 766 044 1 143 816 593 960 369 789 296 988 Purchases 186,593 227 023 304 848 531 648 766 044 1 143 816 593 960 369 789 296 988

Source: UNCTAD, World Investment Report 2004; www.unctad.org/fdistatistics

80

Table 2-A Comparison of Total Savings and Deposits (in US$ billions)

1997 1998 1999 2000 2001 2002 China

Gross domestic saving* 373 386 391 421 447 487 Gross domestic saving/GDP (%) 41.5% 40.8% 39.5% 39.0% 38.5% 39.4% Demand depositsa -- -- 60 71 127 109 Savings depositsb -- -- 720 777 891 1,050 Time depositsc -- -- 114 136 171 199

Japan Gross domestic saving* -- -- 742 641 577 603 Gross domestic saving/GDP (%) -- -- 14.8% 14.3% 13.8% 13.3% Demand depositsa 152 181 220 227 211 259 Savings depositsb 105 127 138 117 91 -- Time depositsc 2,161 2,540 2,724 2,392 1,821 1,934

South Korea Gross domestic saving* 108 126 141 135 127 147 Gross domestic saving/GDP (%) 33.7% 34.4% 33.5% 32.6% 30.9% 29.3% Demand depositsa 25 31 37 35 38 47 Savings depositsb 48 81 117 123 144 173 Time depositsc 33 96 128 163 162 212

India Gross domestic saving* 90 88 107 105 114 120 Gross domestic saving/GDP (%) 23.1% 21.5% 24.1% 23.4% 24.0% 24.0% Demand depositsa 26 28 29 30 31 35 Time depositsc 126 140 158 175 197 231 Source: The Asian Banker data center 2003, http://www.thesianbanker.com. Notes: *: Gross Domestics savings, from the national accounts, and includes more categories than the sum of the three types of deposits in banks; a: Demand deposits, balance of the accounts can be withdrawn on demand of customers; b: Savings deposits, interest-bearing accounts that can be withdrawn on demand; c: Time deposits, savings accounts or CD with a fixed term, withdrawal must be given advance notice.

Table 2-B Breakdown of Bank Loans (end-of-year figures in RMB 100 Millions)

Year Total

Loans Short-term Loans

Industrial Loans

Commercial Loans

Infrastructure Construction

Agricultural Loans

Loans to TVEs

Private/Indivi- Dually-owned

JVs & Coopera- tive firms

1994 39,976.0 26,948.7 9,948.3 10,509.8 617.2 1,143.9 2,002.4 155.9 792.3 1995 50,544.1 33,372.0 11,774.7 12,837.1 799.3 1,544.8 2,514.9 196.2 999.1 1996 61,156.6 40,210.0 14,213.3 15,332.6 973.8 1,919.1 2,821.9 279.8 1,346.3 1997 74,914.1 55,418.3 16,526.6 18,356.6 1,591.1 3,314.6 5,035.8 386.7 1,891.0 1998 86,524.1 60,613.2 17,821.5 19,752.4 1,628.7 4,444.2 5,580.0 471.6 2,487.5 1999 -- 63,887.6 17,948.9 19,890.9 1,476.9 4,792.4 6,161.3 579.1 2,985.8 2000 99,371.1 65,748.1 17,019.3 17,868.5 1,617.1 4,889.0 6,060.8 654.6 3,049.8 2001 112,314.7 67,327.2 18,636.7 18,563.4 2,099.6 5,711.5 6,413.0 918.0 3,263.5 2002 131,293.9 74,247.9 20,190.5 17,973.1 2,748.0 6,884.6 6,812.3 1,058.8 2,697.4

Source: Statistical Yearbooks of China, (1985 – 2003).

81

Table 2-C Inflation and Interest Rates in China

Panel a): Inflation Rate (% Change of Consumer Price Index over the Previous Year)*

1989 1991 1994 1997 1999 2001 2002 Change of CPI 18.0 3.4 24.1 2.8 -1.4 0.7 -0.8

Urban Area 16.3 5.1 25.0 3.1 -1.3 0.7 -1.0 Rural Area 19.3 2.3 23.4 2.5 -1.5 0.8 -0.4

Panel b): Nominal Interest Rates for Savings Deposits (%)**

Maturity 1996.05.01 1997.10.23 1998.3.25 1998.7.1 1998.12.7 1999.6.10 2002.2.21 3 Months -- 2.88 2.88 2.79 2.79 1.98 1.71 6 Months -- 4.14 4.14 3.96 3.33 2.16 1.89 1 Year -- 5.67 5.22 4.77 3.78 2.25 1.98 2 Year -- 5.94 5.58 4.86 3.96 2.43 2.25 3 Year -- 6.21 6.21 4.95 4.14 2.70 2.52 5 Year -- 6.66 6.66 5.22 4.50 2.88 2.79

Panel c): Nominal Interest Rates for Loans (%) Maturity 1996.05.01 1997.10.23 1998.3.25 1998.7.1 1998.12.7 1999.6.10 2002.2.21 6 Months 9.72a 7.65a 7.02a 6.57b 6.12b 5.58c 5.04c

1 Year 10.98a 8.64a 7.92a 6.93b 6.39b 5.85c 5.31c

1-3 years -- 9.36 9.00 7.11b 6.66b 5.94c 5.49c 3-5 years 14.94 9.90 9.72 7.65b 7.20b 6.03c 5.58c

>5 years 15.12 10.53 10.35 8.01b 7.56b 6.21c 5.76c

Notes: *: Percentage change of the CPI index over the previous year with a positive (negative) number indicating an increase (decrease) in price levels; **: Nominal interest rates on savings account (both of households and enterprises) offered by Chinese banks; these rates are set and regulated by the PBOC; a: Set and regulated by the PBOC, the actual lending rates on loans made by RCCs can be 10% higher or lower than the rates presented in the table; b: As of November 1998, the lending rate for small enterprises could be 20% higher than nominal interest rates, and the lending rate for medium and large enterprises could be 10% higher than nominal interest rates. For all financial institutions, the lending rate could be 10% lower than nominal interest rates, but for RCCs these rates could be 50% higher than nominal interest rates; c: As of September 1999, the lending rate for medium and small enterprises could be 30% higher than nominal interest rates; for large-sized enterprises, the lending rate could be as much as 10% higher Source: China Statistical Year Book 2003

Table 2-D A Comparison of the Five-bank Concentration Ratios in Asia

China Japan South Korea Taiwan

1990 0.84 0.23 -- 0.52 1991 0.91 0.22 0.58 0.49 1992 0.91 0.20 0.32 0.46 1993 0.91 0.20 0.26 0.41 1994 0.90 0.20 0.26 0.39 1995 0.90 0.20 0.25 0.37 1996 0.87 0.23 0.25 0.37 1997 0.91 0.25 0.27 0.35 1998 0.72 0.18 -- -- 1999 -- -- -- -- 2000 0.51 0.19 0.23 0.37 2001 0.54 0.25 0.22 --

Source: Demirgüç-Kunt and Levine (2001).

82

Table 3-A A Comparison of Non-performing Loans of Banking Systems

1997 1998 1999 2000 2001 2002 China n/a 2.0 (2.2) 9.5 (10.6) 18.9 (24.9) 16.9 (22.7) 12.6 (15.2) Hong Kong 1.3 (3) 4.3 (10.2) 6.3 (13.9) 5.2 (12.6) 4.9 (12.9) 3.7 (9.6) India n/a 7.8 (1.6) 7.0 (1.6) 6.6 (1.6) 4.6 (1.7) 2.2 (0.8) Indonesia 0.3 (0.2) 11.8 (4.6) 8.1 (2.0) 13.6 (3.2) 9.9 (2.2) 4.5 (0.9) Japan 2.7 (5.4) 5.1 (10.8) 5.3 (10.9) 5.8 (11.5) 9.2 (15.3) 7.4 (12.8) South Korea 2.9 (5.1) 4.8 (6.3) 12.9 (12.9) 8.0 (8.6) 3.4 (3.4) 2.5 (2.6) Taiwan 2.4 (3.2) 3.0 (3.9) 4.0 (5.7) 5.2 (7.6) 6.2 (9.4) 4.1 (5.2)

Notes: NPL is measured as % of total loans made, and as % of GDP (numbers in brackets). Both the loan and NPL are the aggregate of all banks in a country. Source: The Asian Banker data center 2003, http://www.thesianbanker.com.

Table 3-B A Cross-Country Comparison of Banking System Profitability

The profitability is measure as the return on average Equity (ROAE), and return on average Assets (ROAA). The latter is presented in the brackets. Source: The Asian Banker data center 2003, http://www.thesianbanker.com.

1997 1998 1999 2000 2001 2002 China 6.6 (0.21) 4.0 (0.2) 3.2 (0.18) 3.9 (0.21) 3.5 (0.21) 4.16(0.21) Hong Kong 18.7 (1.8) 11.0 (1.0) 18.2 (1.6) 18.8 (1.6) 15.7 (1.4) 15.6(1.4) India 17.0 (0.9) 9.7 (0.5) 14.2 (0.7) 10.9 (0.5) 19.2 (0.9) 19.6(1) Indonesia -3.8 (-0.3) n/a n/a 15.9 (0.3) 9.7 (0.6) 21.1(1.4) Japan -18.6 (-0.6) -19.2 (-0.7) 2.7 (0.1) -0.7 (0) -10.4 (-0.5) -14.5(-0.6) South Korea -12.5 (-0.6) -80.4 (-3.0) -34 (-1.5) -7 (-0.3) 15.8 (0.7) 13.1(0.6) Taiwan 11.2 (0.9) 9.5 (0.8) 6.9 (0.6) 5.1 (0.4) 4.0 (0.3) -5.2(-0.4)

Table 3-C Liquidation of NPLs by Four Asset Management Companies (RMB 100 million yuan)

Book value of Assets

Assets Recovered

Cash Recovered

Asset Recovery Rate

Cash Recovery Rate

2001 Dong Fang 182.9 85.1 44.2 46.5 24.2 Hua Rong 232.1 125.4 75.5 54.0 32.5 Great Wall 531.1 63.0 36.9 11.9 6.9 Xin Da 299.0 225.0 104.9 75.3 35.1 Total 1,245.1 498.6 261.5 40.0 21.0

2002 Hua Rong 320.4 114.3 102.0 35.7 31.8 Great Wall 454.8 79.4 54.7 17.5 12.0 Dong Fang 221.0 106.0 55.7 47.9 25.2 Xin Da 331.0 174.6 105.1 52.7 31.8 Total 1327.3 474.3 317.5 35.7 23.9 Source: Almanac of China’s Finance and Banking 2003, 2002.

83

Table 3-D A Comparison of NPLs and Government Debt (%)

The following table compares the ratio of (NPLs + Outstanding Government Debt)/GDP, in percentage, among China, Japan, the U.S., and South Korea for the time period 1997-2002, where the NPLs are the total outstanding non-performing loans in a country’s banking system, and Outstanding Government Debt is the figure at the end of each year. The figure in brackets for China is the value of the official number for NPLs is doubled. The lower the ratio, which results from low NPLs, low government deficits, or both, the less severe the problem of the NPLs becomes.

Year China U.S. Japan S. Korea 1997 -- 65.6 80.0 6.5 1998 12.3 (14.4) 63.4 96.2 10.5 1999 23.7 (34.3) 61.4 107.3 20.0 2000 40.4 (65.4) 58.3 115.9 16.7 2001 39.2 (62.1) 58.4 136.5 12.7 2002 33.8 (49.1) 60.5 - - 12.0

84

Table 4-A State- and Non-state Banks in China (RMB billion)

Types of Banks Total Assets

Total Deposits

Outstanding Loans

Profit NPL rate (%)

2002 4 State-owned Banks 14,450.0 11,840.0 8,460.0 71.0 26.1 Other Commercial Banks 4,160.0 3,390.0 2,290.0 -- -- 1) Joint Equity 2,990.0 -- -- -- 9.5 2) City Commercial Banks 1,170.0 -- -- -- 17.7 Foreign Banks 324.2 -- 154.0 15.2 -- Urban Credit Cooperatives 119.0 101.0 664.0 --

-- Rural Credit Cooperatives -- 1,987.0 1,393.0 -- --

2001 4 State-owned Banks 13,000.0 10,770.0 7,400.0 23.0 25.37 Other Commercial Banks 3,259.0 2,530.7 1,649.8 12.9 -- 1) Joint Equity 2,386.0 1,849.0 1,224.0 10.5 12.94 2) City Commercial Banks 873.0 681.7 425.8 2.4 -- Foreign Banks 373.4 -- 153.2 1.7 -- Urban Credit Cooperatives 128.7 107.1 72.5 2.6 -- Rural Credit Cooperatives -- 1,729.8 1,197.0 -- -- Source: Almanac of China’s Finance and Banking 2000-2003.

Table 4-B Comparison of Assets Held by China’s Non-Bank Intermediaries

(Total assets in RMB 100 million)

This table compares total assets held by banks and non-bank intermediaries during the period 1986-2003.

Year State-owned Banks

RCCs UCCs Insurance Companies

TICs Non-deposit Intermediaries

Other Commercial Banks

Foreign Banks (branches)

1995 53,733.4 6,791.0 3,039.2 -- 4,586.0 489.7 5,369.1 42.9 1996 65,827.4 8,706.6 3,747.8 -- 5,637.0 820.2 7,699.8 55.3 1997 79,144.1 10,122.0 4,989.4 -- 6,364.0 1,004.2 9,486.1 75.8 1998 88,609.3 11,431.1 5,606.3 -- 8,025.0 1,209.7 11,281.8 118.4 1999 99,706.3 12,392.4 6,301.5 2,604.1 9,075.0 1,370.8 13,768.9 191.4 2000 107,937.3 13,930.6 6,784.9 3,373.9 9,759.0 1,608.2 18,282.6 379.2 2001 111,882.2 16,108.0 7,800.2 4,591.3 10,883.0 2,236.7 22,557.0 341.8 2002 135,496.0 22,052.1 1,192.3 6,494.1 15,441.0 4,081.0 29,977.2 317.9 2003 -- 26,746.2 1,487.2 9,122.8 -- 4,955.8 -- --

Source: Almanac of China’s Finance and Banking 2000-2003.

85

Table 5-A A Comparison of the Largest Stock Markets in the World (2002)

Rank Stock Market Total Market Cap (US$ billion)

Concentration (%)

Turnover Velocity (%)

1. NYSE 9,015 61.3 94.8 2. Tokyo 2,095 60.6 67.9 3. Nasdaq 1,994 63.1 159.8* 4. London 1,800 84.5 97.3 5. Euronext 1,538 72.3 153.6 6. Deutsche Börse 686 72.0 125.1 7. Toronto 570 67.8 67.9 8. Swiss 547 81.2 138.6 9. Italian 477 66.1 120.7 10. China (Hong Kong) 463 83.0 39.7 11. China (Domestic) 463 29.4 224.2

Notes: 1. All figures (except those relating to China’s domestic exchanges) are from http//:www.fibv.com, the web site of the

international organization of stock exchanges. The Chinese data is from http://www.csrc.gov.cn , the web site for the China Security Regulation Committee (CSRC).

2. All figures relate to the period of 01/01/2002 to 12/31/2002. 3. Concentration measures the fraction of total market capitalization of an exchange that is coming from the combined

capitalization of the largest firms ranked in the top 5% (by capitalization). 4. Turnover velocity is the total turnover for the year expressed as a percentage of the total market capitalization. 5. (*) The published number for Nasdaq includes double counting. The number shown is half the published number

to make it comparable to the figures for the other exchanges.

Table 5-B China’s Bond Markets: 1990 – 2002

(Amount in RMB100 million) Treasury Bonds Policy Financial Bonds Corporate Bonds Year Amount

Issued Redemption

Amount Balance Amount

Issued Amounts

Redemption Balance Amounts

issued Amounts

Redemption Balance

1990 197.23 76.22 890.34 64.40 50.07 84.88 126.37 77.29 195.44 1991 281.25 111.60 1,059.99 66.91 33.67 118.12 249.94 114.31 331.09 1992 460.78 238.05 1,282.72 55.00 30.00 143.12 683.71 192.76 822.04 1993 381.31 123.29 1,540.74 -- 34.29 108.83 235.84 255.48 802.40 1994 1,137.55 391.89 2,286.40 -- 13.54 95.29 161.75 282.04 682.11 1995 1,510.86 496.96 3,300.30 -- -- 1,708.49 300.80 336.30 646.61 1996 1,847.77 786.64 4,361.43 1,055.60 254.50 2,509.59 268.92 317.80 597.73 1997 2,411.79 1,264.29 5,508.93 1,431.50 312.30 3,628.80 255.23 219.81 521.02 1998 3,808.77 2,060.86 7,765.70 1,950.23 320.40 5,121.13 149.89 105.25 676.93 1999 4,015.00 1,238.70 10,542.00 1,800.89 473.20 6,447.48 158.20 56.50 778.63 2000 4,657.00 1,525.00 13,674.00 1,645.00 709.20 7,383.28 83.00 0 861.63 2001 4,884.00 2,286.00 15,618.00 2,590.00 1,438.80 8,534.48 147.00 -- 1,008.63 2002 5,934.30 2,261.20 19,336.00 3,075.00 1,555.70 10,054.10 325.00 --

Annual growth rate

32.8%

32.6%

29.2%

38.0%

33.2%

48.9%

8.2%

N/A

16.1%

Source: Aggregate Statistics from the People’s Bank of China (China’s Central Bank), 2000 - 2003.

86

Table 5-C A Comparison of External (Outside the Firm) Capital Markets (Mean)

Country English-origin Average

French-origin Average

German-origin Average

Scandinavian- origin Average

LLSV Sample Average

China (2002)

External capital/GNP 0.6 0.21 0.46 0.3 0.4 0.49 (0.16)Domestic Firms/Pop 35.45 10 16.79 27.26 21.59 0.93 IPOs/Population 2.23 0.19 0.12 2.14 1.02 0.05 Total Debt/GNP 0.68 0.45 0.97 0.57 0.59 0.35 GDP growth (one-year) 4.3 3.18 5.29 2.42 3.79 6.77 Rule of Law 6.46 6.05 8.68 10 6.85 5 Anti-director Rights 3.39 1.76 2 2.5 2.44 3 One share = one vote 0.22 0.24 0.33 0 0.22 1 Creditor rights 3.11 1.58 2.33 2 2.3 2

Sources: LLSV (1997a) paper; Almanac of China’s Finance and Banking (2003).

87

Table 6-A Types of Common Stock Issued in China

Tradable? Definition State-owned

shares** Shares that are controlled by the central government during the process in which firms are converted into a limited liability corporation but before they are listed. All these shares are managed and represented by the Bureau of National Assets Management, which also appoints board members on firms’ boards.

Entrepreneur's shares

Shares reserved for firms’ founders during the same process described above; different from shares that founders can purchase and sell in the markets

Foreign owners Shares owned by foreign industrial investors during the same process Legal entity

holders Shares sold to legal identities (such as other companies, listed or non-listed) during the same process

No (Private block

transfer possible)

Employee shares Shares sold to firm’s employees during the same process A Shares Chinese companies listed in Shanghai or Shenzhen Stock Exchanges, and shares

sold to Chinese (citizen) investors B Shares Chinese Company listed in SHSZ or SZSE, but shares are sold to foreign

investors

Yes (New issued shares)

H Shares Chinese Company listed in Hong Kong (shares can only be traded on the HK Exchange but can be held by anyone)

**: There are sub-categories under this definition

Table 6-B Tradable vs. Non-tradable Shares for China’s Listed Companies

Year State/total shares

Non-tradable^/total shares

Tradable/total shares

A/total shares A/Tradable shares*

1992 0.41 0.69 0.31 0.16 0.52 1993 0.49 0.72 0.28 0.16 0.57 1994 0.43 0.67 0.33 0.21 0.64 1995 0.39 0.64 0.36 0.21 0.60 1996 0.35 0.65 0.35 0.22 0.62 1997 0.32 0.65 0.35 0.23 0.66 1998 0.34 0.66 0.34 0.24 0.71 1999 0.36 0.65 0.35 0.26 0.75 2000 0.39 0.64 0.36 0.28 0.80 2001 0.39 0.64 0.36 0.29 0.80 2002 N/a 0.65 0.35 0.26 0.74 2003 N/a 0.64 0.35 0.27 0.76

^: Non-tradable shares include “state-owned” and “shares owned by legal entities”; *: tradable shares include A, B, and H shares; Source: China Security Regulation Committee Reports (2000) and http://www.csrc.gov.cn

Table 6-C Ownership and Control in the Listed Firms of China

Company Ownership and Control (%)

Shareholder type Ownership Control (board seats) State 24 21 Legal person 44 48 Employees 2 3 Tradable Shares 30 4 Total 100 76

Source: Table 4.6 p.83, “Corporate Governance and Enterprise Reform in China, Building the institutions of Modern Market,” 2002, World Bank publication.

88

Table 7-A Summary Statistics of Listed Firms (in US$ millions)

Data source for Tables 7-A, 7-B, and 7-C: Firms are listed in SHSE and SZSE (as of December 2000), data downloaded from Taiwan Economic Journal’s “Asia Emerging Market Database” (http://www.tei.com.tw/).

Panel a): Key financial items and ratios (whole sample) Mean Median Min Max Std. Dev Number of obs

Market Cap. (US$ mil) 448.2 354.9 0.0 8190.2 513.9 1174 LT Debt / Common Equity 0.3 0.1 0.0 6.9 0.6 981

Net Income 99.6 502.0 -1,215.9 21,718.6 721.0 979 EPS 0.2 0.2 -3.2 1.6 0.4 979

Proceeds from Stock Sales 163.6 0.0 -290.8 29,379.2 987.0 975 (272) Dividend 50.8 18.4 0.0 8,106.0 270.2 979 (617)

Retained Earnings 26.4 33.2 -2,125.7 2,210.18 234.4 979 (951) Bonds Issue 0.8 0.0 0.0 521.0 17.3 975 (6)

Long Term Borrowing 634.9 233.1 0.0 157,053.1 5,073.7 974 (895) Panel b): Listed firms converted from SOEs vs. non-state firms

Types of listed firms and sample size

Market Cap. (US$ mil.)

Tobin’s Q

Dividend/ Earnings

Dividend/ Net sales

L-T Debt/ Book Equity

Return on Assets

Previously SOEs (921) 490.62 0.50 0.48 0.06 0.35 0.028 Previously non-SOEs (242) 454.94 0.51 0.11 0.06 0.24 0.028 Difference in means (t-test) 1.03 -0.19 0.85 -0.08 3.00* 0.004

Notes: the numbers in the brackets in Panel A are the statistics of nonzero observations; *: significant at 1%.

Table 7-B Comparing Ownership Structure of Listed Firms

Panels A and B are taken from LLS (1999). The first row is the average of Asia countries included in Claessens et al. (2000), excluding Japan. The last row for China includes our sample of 1147 listed firms.

Country Widely Held

State Family Widely Held Financial

Widely Held Corporation

Panel a): LLS (1999) Sample with Large Firms High anti-director average 34.17 15.83 30.42 5 5.83 Low anti-dir. Average 16 23.67 38.33 11 2 Sample average 24 20.19 34.81 8.3 3.7

Panel b): LLS (1999) Sample with Medium Firm Size High anti-dir. Average 16.67 10.33 50.92 5.83 1.67 Low anti-dir. Average 6 20.87 53.8 6.67 2.67 Sample average 10.74 16.19 52.52 6.3 2.22

Panel c): Asian firms Asia (no Japan, from Claessens et al. 2000)

3.09 9.36 59.36 9.66 18.55

China (our calculations) 0.44 60 13.56 1.83* 24.17** Notes: 1) “Widely held” firms are defined as no large shareholder holding more than 10% of shares; “State” (“family”) firms are those with controlling shareholder being the state (a family); “Widely held financial” (“widely held corporation”) are those with controlling shareholder being a widely-held financial company (widely-held corporation). *: For these Chinese firms, we identify the dominant shareholder to be a financial company, but we are not sure whether the financial company is widely held or not; **: For these Chinese firms, we identify the dominant shareholder to be another listed and traded corporation, but we are not sure whether this corporation is widely held or not.

89

Table 7-C External Funding at Firm Level

Country English origin average

French origin average

German Origin average

Scandinavian origin average

LLSV sample average

China

Market cap / sales 0.69 0.51 0.63 0.37 0.58 0.06 Market cap / cash flow 5.16 3.85 7.48 3.25 4.77 0.52 Debt / sales 0.26 0.27 0.3 0.28 0.27 0.67 Debt / cash flow 2.01 2.06 3.18 2.42 2.24 5.34

Sources: LLSV countries – WorldScope, and LLSV (1997a); data for China is based on a panel of 7377 firm-year (1174 listed firms, 1992-2000) observations, with each ratio being the mean of the pooled panel of firms during the same time period.

90

Table 8-A Ranking of Private Equity Investments around the World

Panel a) Top 20 Countries in PE Investment in 2004 (US$ billion) Country Ranking Investment Funds Country Ranking Investment Funds

Value Raised Value Raised 1 USA 59.20 43.94 11 Netherlands 1.28 2.40 2 UK 15.86 17.56 12 Sweden 1.19 2.52 3 Japan 7.19 1.36 13 Canada 1.00 1.35 4 France 4.98 2.39 14 India 0.86 0.26 5 Italy 3.58 2.27 15 South Africa 0.82 1.11 6 Australia 2.93 0.20 16 Israel 0.77 N/A 7 Germany 2.91 1.40 17 Indonesia 0.65 N/A 8 Korea 2.84 0.27 18 Singapore 0.54 0.10 9 China 1.67 0.34 19 Finland 0.52 0.18

10 Spain 1.57 1.03 20 Denmark 0.48 0.25

Panel b) Cumulative Investments and Funds Raised (1998-2003; US$ Billion) Region Investment Fund

Value Raised Global 690.63 901.45 North America 411.93 600.32 Europe 182.96 221.62 Asia Pacific 64.23 58.15 Middle East & Africa 13.25 11.86 Central and South America 18.26 9.50

Source: “Global Private Equity 2004,” by PricewaterhouseCoopers, LLP, and State Street PrivateEdge Group.

Table 8-B Private Equity Funds in China and Other Countries (2004)

Panel a) Comparison by Region (US$ mil.) World location Number of PE Funds Total Fund Capitalization Ave Cap Med Cap

East Asia 1,038 40,254 38.8 30.9 East Europe 1,357 58,673 43.2 275 South America 27 2,546 94.3 80.3

Panel b) Comparison by Countries (US$ mil.) Nations Number of PE Funds Total Fund Capitalization Ave Cap Med Cap

Australia 122 5,142 42.1 31.9 South Korea 243 4,297 17.7 4.8 India 86 2,816 32.7 1.5 China 26 1,457 56.0 25 South Africa 22 1,245 56.6 11.6

Source: State Street PrivateEdge Group.

91

Table 8-C Top Ten Investment Deals of China VC in 2003

Rank Company Investors Amount

(million USD) Industry

1 SMIC H&Q Asia Pacific, Walden Intl 300

Semi-conductors (integrated circuit) Manufacturing

2 CSMC 3i, Crown, Cratal, etc. 67

Semi-conductors (integrated circuit) Manufacturing

3 Asia Netcom SAIF, Newbridge 60 Telecommunication

4 UP Tech Walden, Intel Capital 50 Telecommunication 5 Shanda SAIF 40 IT

6 Amperex Tech Carlyle, 3i 30 New Energy

7 Photonicbridges Legend Capital, JAFCO, Acer VC 23 Telecommunication

8 Kasen Indu Corp. Warburg Pincus 22 Traditional

9 Maipu (Sichuan)Comm

Intel Capital, Guide Fund, HSBC Fund 15 Telecommunication

10 Elong.com Tiger Technology Fund, Bluebridge Capital 15 Internet

Source: State Street PrivateEdge Group, and Centre for Asia Private Equity Research Ltd.

92

Table 9 Summary Statistics for Survey Firms (as of Dec 2002) The sample, based on the authors’ survey, includes 17 firms: 1 from Shanghai, 3 from Jiangsu Province, and 13 from Zhejiang Province. The Sample covers firms in the industry of chemical products (3), fabric making and printing (3), metal products (2), medical and health products (2), realty management (2), auto repairing (1), food processing (1), agriculture product processing (1), electronic products (1), and handcraft and art products (1). Some firms are in multiple business lines.

Mean Min Max Std. Dev Age of the firm 11.4 3 27 6.7 # of employees 1634.3 90 5552 2107.8 Size (Total Assets in mil. US$) 55.3 0.6 337.3 82.7 D/E ratio 2.1 0.38 14.95 3.4 Net income (in mil. US$) 2.5 0.2 9.0 2.8 Return on Assets 0.1 0.00 0.34 0.1

Table 10 Trading Volume of National Interbank Market (RMB 100 Million)

Maturity Over night 7 days 20 days 30 days 60 days 90 days

120 days

2001 1,038.81 5,606.93 933.53 352.84 94.00 47.26 8.67 2002 10,593.31 20,864.67 776.87 562.88 132.76 154.45 39.35 2003 6,418.86 14,563.13 565.97 441.05 101.38 101.84 28.10

Source: China Interbank Market Annual Reports (1999-2003).

Figure 1 Overview of China’s Financial System

China’s Financial System

Banking and Intermediation Sector

Financial Markets Non-standard Financial Sector

Policy Banks

Commercial banks

Stock market (SHSE, SZSE, HKSE)

Bond market

Informal Financial Institutions

Coalitions/ institutions among HybridSector firms and their investors

State Owned

Partially state owned

Government bond

Corporate bond

Private owned and Foreign

Non-bank Financial Institutions

RCC, UCC, Postal Savings

TIC, Mutual Funds, Finance Companies

Foreign sectors (FDI, Capital Flows)

Venture Capital /PE

Real Estate

0%

10%

20%

30%

40%

50%

60%

1994 1995 1996 1997 1998 1999 2000 2001 2002

Calendar Year

Perc

enta

ge

State Budget Bank LoanForeign Investment Self-fundrasing

Figure 2-A. Financing sources for the Listed Sector

0%

10%

20%

30%

40%

50%

60%

1994 1995 1996 1997 1998 1999 2000 2001 2002

Calendar Year

Perc

enta

ge

State Budget Bank LoanForeign Investment Self-fundraising

Figure 2-B. Financing sources for the State Sector

0%

10%

20%

30%

40%

50%

60%

70%

1994 1995 1996 1997 1998 1999 2000 2001 2002

Calendar Year

Perc

enta

ge

State Budget Bank LoanForeign Investment Self-fundraising

Figure 2-C. Financing sources for the Hybrid Sector

Figures 2-A, 2-B, and 2-C examine financing sources (for the investment of fixed assets) of different types of firms in China. In all three figures, each of the four connected lines represents the importance of a particular financing channel over the time period 1994 to 2002, measured by the percentage of firms’ total financing coming from this channel. Figure 2-A presents financing sources for firms in the Listed Sector, Figure 2-B presents results for firms in the State Sector, while Figure 2-C presents results for firms in the Hybrid Sector.

95

Components of Bank Deposits

0%

10%

20%

30%

40%

50%

60%

1979 1982 1985 1988 1991 1994 1997 2000

Year

% o

f tot

al d

epos

its

Enterprise (% of total)

Budgetary(% of total)

Govt. Agency andorganizations(% of total)Urban Savings(% of total)

Rural Savings(% of total)

Figure 3-A Sources for Bank Deposits in China

Bank Credit /GNP

0

0.05

0.1

0.15

0.2

0.25

0.3

1995 1996 1997 1998 1999

Year(China), Year-20(Taiwan and S. Korea)

ratio

China

Taiw an

S. Korea

Figure 3-B Comparing Bank (Private) Credit

96

Assets Managed by Insurance Companies

0

10

20

30

40

50

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Year

% o

f GD

P ChinaKoreaTaiwanSingapore

Figure 3-C A Comparison of Assets Under Management of Insurance Companies

Insurance Industry Comparison

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

1985

1987

1989

1991

1993

1995

1997

1999

2001

Year

Pre

miu

m in

com

e/G

DP

ChinaKorea

Figure 3-D Comparing Premium Income of Insurance Companies

97

Performance of Stock Indexes

0%

200%

400%

600%

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Year

Tota

l ret

urn SHSE

NikkeiHang SengNASDAQS&P 500

Figure 4 A Comparison of Performance of Stock Indexes (1992-2004)

0

20

40

60

80

100

120

140

160

Euro ar

ea

United K

ingdo

m

United Stat

esJap

an

Non-Ja

pan Asia

China

% of GDP

0

20

40

60

80

100

120

140

160% of GDPBank loans

Stock market capitalisationBond market (public)Bond Market (private)

Figure 5-A A Comparison of Financial Markets in 1995

98

0

20

40

60

80

100

120

140

160

Euro ar

ea

United K

ingdo

m

United Stat

esJap

an

Non-Ja

pan Asia

China

% of GDP

0

20

40

60

80

100

120

140

160% of GDPBank loans

Stock market capitalisationBond market (public)Bond market (private)

Figure 5-B A Comparison of Financial Markets in 2003

Sources: Based on figures in Allen et al. (2004). Direct sources include International Financial Statistics, International

Federation of Stock Exchanges, Japan Securities Dealers Association, IFC Bond Database, Thai Bond Dealing Centre, Thomson Financial, CEIC and various central banks, ECB. Statistical Year Book of China 1996, 2003, 2004.

Notes: a). Bank loans are domestic credit extended to the Hybrid Sector in China and to the private sector in all other countries. All bank loan data, except Taiwan, are reported in line 32d in the International Financial Statistics (September 2003, end-1995);

b) All outstanding bond data are as of (end-2003 and end -1995), except for Japan and Singapore (end-2002 for 2003), Indonesia (end-2000 for 2003) and the Philippines (end-1999 for 2003). United Kingdom (end-March 1995 for end-1995);

c) Bond figures for Hong Kong, Korea, Malaysia, Taiwan, the United States, the United Kingdom and Japan are from central banks. Figures for Indonesia and the Philippines are from IFC Emerging Markets Information Centre Bond Database. Figures for Thailand are from Thai Bond Dealing Centre. Figures for Singapore are estimates based on data from MAS and Thomson Financial;

d) Public sector refers to government bodies and quasi-government entities; Private sector refers to non-public sector and includes financial institutions, corporations and overseas institutions;

e) Bank loans (total amount and percentage of GDP) in the euro area refer to end-2002 for 2003; f) Euro Area includes: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands,

Portugal, and Spain; Non-Japan Asia includes: Hong Kong, Korea, Malaysia, Taiwan, Singapore, Indonesia, Philippines, and Thailand.

99

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

Year

Mar

ket c

ap./G

NP Taiwan

KoreaChinaIndiaBrazilIndonesia

0%

5%

10%

15%

20%

25%

30%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

Year

Cor

pora

te b

ond/

GN

P

TaiwanKoreaChinaIndonesia

Figure 6-A: Market cap/GNP ratios Figure 6-B: Corporate bond market

0%

1%

2%

3%

4%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

Year

IPO

&SE

O/G

NP Taiwan

KoreaChinaIndiabrazil

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

1981 1984 1987 1990 1993 1996 1999 2002

Year

GD

P (p

pp) g

row

th ra

te

BrazilChinaIndiaIndonesiaKoreaTaiwan

Figure 6-C: Equity Issuance Figure 6-D: GDP growth rates

Figure 6-A compares the time series of stock market capitalization/GNP ratios across six emerging economies, Figure 6-B presents the time series of the ratios of the amount of corporate bonds outstanding /GNP, while Figure 6-C presents the time series of IPO and SEO (in a given year)/GNP. The calculations for all the ratios in these three figures are based on local currencies of a country in a given year. Figure 6-D compares time series of the growth rates of GDP, and the growth rates are calculated using PPP-adjusted GDP figures in order to avoid biases caused by different currency policies.

100

Figure 7 Comparison of legal and financial systems

Figure 7 compares China’s legal system and external financial markets (i.e., those for raising funds from outside the firm) to those of LLSV countries (LLSV, 1997a, 1998). Following LLSV (1997a, 1998), the score on the horizontal axis measures overall investor protection in a country. It is the sum of (overall) creditor rights, shareholder rights, rule of law, and government corruption. The vertical axis measures the (relative) size and efficiency of that country’s external markets. The score of a country measures the distance of the country’s overall external markets score (external cap/GNP, domestic firms/Pop, IPOs/Pop, Debt/GNP, and Log GNP) to the mean of all countries, with a positive (negative) figure indicating that this country’s overall score is higher (lower) than the mean.

2013

126

54

32

11

0 5 10 15 20 25

UnknownIT (in the narrow sense)

Biotech/Healthcare IndustryNew Materials

Service IndustryTraditional IndustryTelecommunications

Enviroment ProtectionPhotoelectricity/Machineryelectricity

New Energies

Figure 8 Distribution of Exit VC Firms by Industries in China

(Source: State Street PrivateEdge Group)

Singapore (E) HK (E)

Malaysia (E) US (E)

South Africa (E) Japan (G)

Taiwan (G)Thailand (E)

France (F) German (G)

Brazil (F)Argentina (F)

Mexico(F) China

UK (E)

India (E)Pakistan (E)

Indonesia (F)

South Korea (G)

-4

-2

0

2

4

6

8

10 12 14 16 18 20 22 24 26

Investor Protection

Exte

rnal

Mar

ket

101

Industrial Output by Sectors

0

300

600

900

1200

1500

1990

1991

1992

1993

1994

1995

1996

1998

1999

2000

2001

2002

2003

2004

Year

$ B

illio

n

SOE and Listed Sectors Hybrid Sector

Figure 9-A Comparing the Sectors – Industrial Output

In this figure we plot total “industrial output” for State (SOEs) and Listed (publicly listed and traded firms) Sectors combined and for the Hybrid Sector (all the rest of the firms) during 1990 to 2004. Data source for this table is the Chinese Statistical Yearbook 1998 - 2004.

Employment by Sectors

0

50

100

150

200

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Year

Mill

ion

pers

ons

SOE and Listed Sectors Hybrid Sector

Figure 9-B Comparing the Sectors – Employment

In this figure we plot total number of workers employed by the State (SOEs) and Listed (publicly listed and traded firms) Sectors combined and by the Hybrid Sector (all the rest of the firms) during 1990 to 2004. Data source for this table is the Chinese Statistical Yearbook 1998 - 2004.

102

Founder's previous experience

SOE

Collective JV Others

GOVT

TVE

Private Firm

0%5%

10%15%20%

25%30%35%40%

Figure 10-A Background Information of Survey Firms

In all of the above histograms, the vertical axis represents the percentage of firms’ managers/founders who provide the same answer for a particular question in the survey. In the bottom three histograms, “GOVT” stands for firms that have local government as the majority owner; while “JV” stands for joint ventures.

Ownership when startup

Partner

TVE

Share-holding

Others

GOVTForeign

Founder/ family

0%

10%

20%

30%

40%

Current ownership

Partner Foreign

TVE

Share-holding

OthersGOVT

Founder/ family

0%

10%

20%

30%

40%

Annual return in the past 5 years

<0

0~0.1

0.1~0.2

0.2~0.3 >0.3

0%

10%

20%

30%

40%

Expected annual return in the next 3 years

<0 0~0.1

0.1~0.2

0.2~0.3

>0.3

0%

10%

20%

30%

40%

103

Least costly financing sources

State budget

FDI

IPO, bond

Trade credits

Ethnic Chinese

Private equity/debt

LT bank Loan

ST bank loan

Family & friends

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%Pe

rcen

tage

of f

irms

Figure 10-B Financing Channels of Survey Firms

Relationship with local government

0%

10%

20%

30%

40%

50%

Governmentinvests/ow ns

partially

Supports,return is notdemanded

Demandsprofit sharing

Norelationship

Figure 10-C Governance Mechanisms of Survey Firms

Figure 10-B presents survey results on firms’ financing channels: Each bar represents the percentage of firms regards a financing source as very important (25-50%) or extremely important (>50%) during their start-up and growth periods. Notes: PCA = private credit agencies; Budget=state/local budget, and VC = venture capital. Figure 10-C presents results on selected governance mechanisms among these firms.

Possibility of assets being acquired

Very likely

Not possible

Possible

0%10%20%30%40%50%60%70%

Concerns following the failure of firm

Legal /Safety consequence

Economic loss in various

sense

Reputation loss

in various sense

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Startup financing

Others

FDI

Friends

Founder

Budget

PCATrade

Credits

VC

Ethnic Chinese

Banks

0%

10%

20%

30%

40%

50%

Financing in growth period (year 3-8)

VC

FDI

Others

Budget

Founder

Friends

Banks

PCA

Trade Credits

EthnicChinese

0%

10%

20%

30%