Compared with the progress and status of China’s economy and trade, its financial system seems to be much less impressive and powerful. Many analysts regard it as a major vulnerability in China’s economic development.

The basic facts, however, underscore the success of the system and its global importance today: China has the second largest stock market and bond market in the world; and the four biggest Chinese banks are consistently among the top 10 financial institutions in the world. Actually, China has come a long way in building up a modern financial system, despite many complex challenges. More dramatic progress is anticipated in the next five years, as outlined in the proposals for formulating the 14th Five-Year Plan (2021-25).

Recent progress

China’s financial system is generally composed of the banking and intermediation sector, financial markets, and the informal or shadow finance sector. It is dominated by the commercial banking industry, which has several state-owned megabanks.

The sector’s assets were worth 347.32 trillion yuan ($53.18 trillion) by the third quarter of 2020, according to data from the People’s Bank of China. The banking industry accounted for 90.7 percent of it, the securities industry 2.8 percent, and the insurance industry 6.5 percent. In recent years, although banks still dominate the financial sector, non-banking financial institutions also have considerable influence, far outweighing their share of the total assets.

China has made unprecedented progress in building a financial system supporting the real economy. For the banking and intermediation sector, the government vigorously engaged all major types of financial institutions during the last three years to curb systemic risks. Financial institutions were urged to lower their excessively high leverage ratios and reduce their poor quality and risky assets by about 16 trillion yuan ($2.45 trillion) during 2017-19, according to official statistics.

Positive changes occurred in the financial markets in China, particularly after the 2015-16 stock market turbulence. The Chinese stock market has witnessed breakthroughs in improving the quality of listed firms. After a debate for several years, China introduced a more market-oriented registration-based initial public offering (IPO) system in March 2020.

This is a watershed change in the first Securities Law which came into effect on July 1, 1999. Earlier, firms applying for IPOs in China were subject to often lengthy and somewhat subjective regulatory approvals but the new system is bringing in a bigger pool of firms with great potential.

In addition, China followed the model of the American stock exchange Nasdaq to encourage innovation and established the Science and Technology Innovation Board, or the STAR Market, at the Shanghai Stock Exchange in July 2019. This has helped add many more tech firms to the Chinese stock market.

There has also been progress in the Chinese bond market. The first bond default on the mainland, involving a small solar power company, occurred only as recently as 2014. The subsequent defaults in 2015, 2016 and 2018 still primarily involved non-state-owned firms. In 2020 for the first time a series of high-profile defaults by state-owned firms occurred, shocking investors. Experts said it was a wakeup call to the Chinese bond market to price credit risks more adequately.

Also, in 2017 China began to relax restrictions on foreign ownerships in the financial sector for the first time, which has continued even during the recent tension with the U.S. Such opening up of the financial sector is unprecedented and significant, no matter what its scope, speed or intensity is.

Continuing efforts

Much of the foundation to build up a stronger financial system to support the real economy in the next five years and beyond was laid down recently. Given the new strategy of high-quality development, these recent efforts can be expected to continue and expand during the next five years.

The high-quality development underscores China’s long-term determination to strike a better balance between economic growth and security or risk control overall. This requires greater emphasis on building up the financial system to support the real economy.

It is a wise emphasis, if properly executed. During the next several years, after overcoming the short-term negative impact of the novel coronavirus disease, China will encounter more risks coupled with a lower growth rate consistent with its more developed stage and a more uncertain and less globalized international environment in the foreseeable future. Greater attention paid to avoiding the risks in the financial system will help the economic growth be more sustainable.

In the banking industry, the government plans to substantially enhance its efforts to contain systemic and other risks. The 14th Five-Year Plan is expected to underscore this task as essential to the security of the Chinese economy and its financial sector.

The law on the central bank was revised in October 2020 to let the central bank take greater responsibility for financial stability. The first formal assessment measures on identification and management of the domestic systemically important banks will be soon effective. As a complement to the effort, the government will take various measures to improve the corporate governance of financial institutions.

The great influx of foreign capital in Chinese stock and bond markets in 2020 is an incentive to implement various measures for capital markets. Stricter information disclosure requirements will be imposed on IPO applicants, listed firms and bond issuers. This is crucial to the success of the new IPO registration system and the STAR Market.

This may also lead to more bond defaults, partly due to fewer implicit guarantees and bailouts from the government. Closer monitoring of the corporate governance of listed firms and heavier penalties for market manipulation will also be among the future focuses. This will help the capital markets function better with a more efficient capital allocation to serve the real economy. The market will expect to see the authorities coming down much harder on firms with poor performance in the next five years and even delisting them, which has been rare.

Lessons to learn

While developing a modern financial system to support its high-quality economic development in the next five years and beyond, China can benefit by learning from what has already happened in the U.S. In the aftermath of the 2007-09 global recession, whether and how finance can benefit society is a question raised by many, including Professor Luigi Zingales, former President of the American Finance Association, in his address to the association.

As China’s financial system develops, more extensive use of financial innovations, from derivatives to financial technology, is unavoidable. However, the unpleasant U.S. experience of using innovative derivative products and their role in the 2007-08 global financial crisis shows that financial derivatives are a double-edged sword. Too much complexity makes them unsuitable for supporting the real economy and intractable for financial regulation.

The experience of financialization of commodities in the U.S. since 2004 is also highly relevant. There is a heated debate over whether it contributed to excessive commodity price volatility, and even market dysfunction due to deviations from the fundamental economic forces.

As pointed out by Zingales, the development of financial innovation and derivatives must be based on whether they are really beneficial to society and the real economy. Even if such a market is beneficial to a certain extent, it is not always a case of the bigger the better.

Douglas J. Elliott, a former fellow at the Brookings Institution, concluded in a 2013 report that China’s financial system, despite various types of vulnerability, “has served China well overall during the nation’s rapid [economic] development” during the last three decades.

Now with the transition to a high-quality economic development characterized by a lower growth rate, we may remain guardedly optimistic about further development of the financial system to continue supporting the real economy in China.