It’s no secret to anyone that the Chinese economy has been expanding rapidly over the past quarter-century. Nearly all sectors of their economy have been growing. However, the banking industry has not been adapting to match this rapid growth. This could be a cause for alarm because banking, much more so than other industries, plays a critical role in a country’s economy (when it comes to both growth and stabilization).
This is because banking (loans and credit) is one of the main drivers for economic growth. Additionally, a country’s central bank is usually responsible for monitoring things like the money supply and rates of interest. How a country handles its banking can have repercussions throughout its economy.
In this article, we will dwell a little bit on how the banking system in China works as well as analyze the reforms they’re planning on implementing.
How Central Banking Works
If you’re not familiar, a central bank is defined as a financial institution given privileged control over the production as well as distribution of money and credit for a nation or a group of nations. This essentially means that the central bank is in charge of printing money for a country. They can either add more money to a country’s money supply or take money out of it.
Just like commercial banks lend money to consumers so they can get access to the capital they need, central banks lend money to entire countries or governments. In this way, the policies that a central bank implements can have a ripple effect throughout the country.
- A central bank is different from regular banks because they alone have the ability to print money. Regular banks are only able to issue liabilities, such as checking deposits. When governments want to start new projects or implement changes, they will often call on the central bank to print the money necessary (this is usually a popular alternative to raising taxes)
- Another feature of a central bank is its ability to control the country’s interest rate. The national interest rate is the rate at which banks can borrow money from each other. Central banks also influence consumer interest rates. For example, policies that the central bank implements will impact whether you’re able to get a reasonable mortgage on a house
The lower the interest rate, the easier it is for people to receive loans.
Commercial banks (like the one that you use) are responsible for making loans to citizens.
Central banks are responsible for making loans to commercial banks and even governments (although this is just one of their responsibilities).
Let’s take a look at how the United States handles their central banking.
What the U.S. Does
In the United States, the central bank is called the Federal Reserve. The Federal Reserve, despite the official-sounding name, is not actually a government agency and is comprised of 12 regional banks. One of the main reasons that you should be aware of the Federal Reserve and their actions is because they directly impact the interest rate in the United States.
- When the Federal Reserve lowers interest rates, it can lead to more opportunities for investors because lowering the interest rates makes it easier to get access to a loan. A drop in the interest rate is usually followed by a spike in stock prices
- However, when the Federal Reserve decides to raise the interest rate, it makes it harder to get access to financing. This will generally lead to slower economic growth
- As an investor, it’s important to be aware of what the current interest rate is (approximately) and what the Fed’s plans for the future are. This can give you an advantage over other investors
Apart from just controlling the interest rate, the Federal Reserve is responsible for the rate of inflation in the United States. Inflation is the steady increase in the price of goods over time. Essentially, it is the reason that a hamburger in 1950 only cost 20 cents but today, that same hamburger costs $16. As an investor, it’s important to be aware of the inflation rate and always make sure that you are hedging properly so as to protect yourself.
If you were to just keep your cash in a bank account (or, worse yet, stuffed under your mattress) for too long, then your dollars will lose purchasing power. If you’re not careful, inflation can drastically decrease your net worth over time.
Let us now examine China’s central banking system and potential reforms that they might implement.
China’s Banking Reform Explained
China’s central bank is called the People’s Bank Of China. It’s currently one of the largest central banks in the world, with over $3 trillion in foreign exchange reserves. The PBOC was established in 1948, following the communists’ party’s dominance in China. The PBOC is currently responsible for funding public companies along with setting interest rates, regulating financial markets, issuing the Renminbi currency for circulation, regulating interbank lending and monitoring foreign currency exchange.
If you’ve frequented this blog before, then you probably know that the Chinese economy has been growing at breakneck speed over the past 40 years. In 1978, China implemented changes to their economy that allowed it to transition to more of a free market structure. This transition has led to amazing economic growth. However, their banking sector has not had the proper regulations to keep pace. This is important because the banking sector and the economy go hand in hand. Here are just a few manners in which this tends to occur:
➢ The banking sector is responsible for granting loans to consumers to assist them with large purchases (auto loans, mortgages, etc.)
➢ Banks are in charge of lending credit which, above all else, helps grow the economy. Credit is vital because it gives entrepreneurs the resources that they need to create new businesses. Once they’ve built a new business, they have created industries, profits and jobs were there previously was… well, nothing. None of this is possible without the credit offered by the banks to get the ball rolling
➢ Banking, when done irresponsibly, has the capacity to crash other industries. For example, subprime mortgage lending is what led to the 2008 Financial Crisis in the United States
Recently, China’s banking industry was combined into 4 commercial banks which controlled approximately 50% of China’s lending:
- The Industrial and Commercial Bank of China
- The Bank of China
- The Agricultural Bank of China
- China Construction Bank
Having the industry consolidated into just 4 banks that dominate has stifled competition, which leads to less efficiency and effectiveness. It also means that it’s tougher for smaller and mid-sized companies to get loans because the Big Four banks focus mainly on large state-run organizations.
At the same time that these 4 commercial banks were created, three state-owned policy banks were instituted:
- Agricultural Development Bank of China (ADBC)
- China Development Bank (CDB)
- Export-Import Bank of China (EIBC).
Since 1994, these policy banks functioned with the purpose of handling policy-related lending pertaining to central government plans and each of the three state-owned policy banks has a distinct mission.
Economists have been urging China to reform their banking sector for years now and are afraid that it is a ticking time bomb. The Chinese leadership has pledged that reforms are on the way. Mainly, they agreed that they will be opening up the Chinese banking industry for foreign financial institutions and improving the investment climate.
The Brookings Institue believes that COVID-19 context represents the perfect time to accelerate China’s transition toward open financial markets.
Now that the majority of China’s citizens are middle-income earners, they will need to depend less on investment and more on innovation and productivity growth. As the pandemic rages through the country, China will inevitably borrow whatever is needed to stave off depression. However, once they’ve weathered the storm, there will be even more of an incentive to institute reforms because risks will increase during this stimulus-heavy time.
A few manners in which China could implement reform would be to:
- Carefully introduce more flexibility into interest rates and the exchange rate
- Encourage the creation of more private financial institutions (foreign and domestic) to help diversify lending
- Turn to capital account liberalization last because this represents the most difficult dimension
It will be interesting to see if and how China reforms their banking infrastructure. It’s an important topic to stay up-to-date on because any potential reforms have the capacity to increase or decrease the investment-related potential of the country.
We hope that you’ve found this article valuable when it comes to understanding the most recent banking reform initiatives associated with this jurisdictions and for further clarifications, our team of experts is at your disposal.