The Chinese financial system vs. the western financial system: Differences and similarities

Wed 31 August 2016

By Dr. Cheng-Yun Tsang

A clear understanding of the key differences and similarities between the Chinese and the Western financial system is essential when it comes to designing and implementing financial regulatory reforms in China. It not only helps policymakers discern whether the problems presented during the Global Financial Crisis were just “Western syndromes” or unavoidable diseases that China will catch sooner or later but also enables regulators to align the country’s regulatory regime with that of the global financial ecosystem through identifying common factors at work that shape the global financial reform.  

China’s financial and banking system has, in many respects, features that are unlike those of its Western counterparts. First, the economic and ideological model of the socialist market economy in China basically renders the market a tool of the State, as opposed to a goal per se, to which the State must achieve. In this context, market infrastructures and mechanisms are used mainly as a means of gathering information, and for regulating the economy in accordance with the overall state directives.[1] Financial and “market liberalization is extended, as long as it does not infringe on the [Communist] Party’s monopoly of power.”[2] China’s financial system and its primary agents (banks) are predominately state-owned, and are tasked with numerous fiscal and developmental missions. 

Second, the way China’s financial policies and regulations are made and implemented is significantly different from that of the Western developed economies (the US, for example). The country’s economic and financial policies (be they fiscal or monetary ones) are controlled, if not decided, by the Politburo (especially its Standing Committee) and Central Committee of the Communist Party, or more precisely, by special interest groups within the Party leadership.[3] Specifically, the Party’s authority over the financial system is exercised mainly through the Central Organization Department (which has the power to appoint the leadership of all major institutions), and through the Central Finance and Economy Leading Small Group[4]. These two organizations, then, directly or indirectly exert influence on the State Council, in which the financial regulatory agencies are instituted. Unlike in the case of most Western central bank governors and certain financial regulators, in which these officials’ discretion and authority is exercised almost independently, the power of financial policymakers in China is nonetheless subject to the Party leadership’s political will. It is not surprising, though, that certain seasoned technocrats (such as Zhou Xiaochuan, who has been in charge of the country’s central bank for more than a decade), are actually very powerful and enjoy a significant degree of freedom to exercise their discretion. 

Third, unlike in developed Western economies (the U.S. in particular), China’s financial system remains a bank-dominated one, where capital markets (e.g. bond markets) are still underdeveloped. This status quo has been transforming gradually since China began to liberalize its interest rates, as evident by the rapid expansion of the country’s shadow banking sector. 

On the other hand, despite the foregoing distinctive features, China’s financial system is not very different from those of Western developed economies, particularly if we compare them in the context of historical evolution. At least two noteworthy points emerge here.  First, the relationship between the banks and the government is very intertwined in both cases. And the sheer power of the largest banks in China shows a picture that is a surprising parallel of the powerful Western banks. For example, like China in its extensive use of policy banks to facilitate fiscal and developmental financing, U.S. national banks in the 1800’s (such as the Second Bank of the United States) also served as the fiscal agent and depository of the federal government. Even today, there is the surprising coincidence that the five largest banks in China and the U.S., both control about 45% of the total bank assets in their respective countries.[5]  

Second, the way market actors respond to financial repression (e.g. interest rates control), government guarantees and credit regulation are similar in both cases, and both subject the wider economy to instability risk. For instance, it was the initially overly-repressed and then gradually-liberalized interest rates on the deposit accounts that gave rise to the rapid growth of China’s shadow banking sector such as wealth management products and trust products. Similarly, it was the ceiling imposed on deposit interest rates by Regulation Q that encouraged the emergence of alternatives to bank deposits, such as Money Market Fund[6] (the U.S.-version of shadow banking). It was also the relaxation of the restrictions on deposit rates, as a result of financial deregulation in the 1980’s, which contributed to the U.S. savings and loan crisis.[7] We do not know, yet, whether China’s interest rate and financial liberalization will have negative consequences similar to those of the U.S. liberalization, but we are certain that a similar kind of financial-market dynamics is at work in China and the U.S.  It is only a matter of time before China arrives at the same stage of financial development as that of the developed Western economies.