Compared to Western economies, such as the United States, China’s financial sector is comparatively small, and its history of financial services and financial markets is relatively new. However, China’s increasing influence on the global economy is undeniable.
Prior to the late 1970s, China was a nation mostly isolated from the rest of the world, with much of its population living in rural areas. In the 1980s, the country began its slow process of economic liberation with the gradual introduction of a market economy which also brought about the development of a financial sector.
In recent years, China has grown into an important market, with a vibrant economy and urban-centered middle class. At the same time, the country’s financial industry has experienced significant development.
China’s current economic challenges appear to be a surprising turn given the nation’s recent record of economic expansion. Even though the economy is growing, the rate of expansion has been slower than many anticipated coming off some of the world’s strictest COVID-19 policies, that included temporary lockdowns of major cities.
While China managed to limit the nation’s COVID death rate in contrast to many other countries, it did so by shutting down important cities for extended periods of time, greatly crippling its economy. In late 2022, China eliminated what was known as its “zero COVID policy.” While this raised hopes that China’s rapid economic growth rate would resume, results to this point have been disappointing.
China’s first quarter 2023 GDP came in at an annualized rate of 2.2%, then slowed to 0.8% in the second quarter. Unlike the U.S., where the federal government provided significant stimulus payments that put individuals and businesses in a stronger position to resume spending once the economy reopened, China didn’t have a similar plan in place.
In addition, tensions appear to be rising between the world’s two largest economies – the United States and China.
In the past few years, China has become one of the most significant players in global capital markets. Its stock market alone makes up close to one-third of the MSCI Emerging Markets Index.
Shanghai and Shenzhen are China’s financial centers. The two bourses were established in 1990 and have developed into large trading centers that compete with established markets. Even though their market capitalization lagged behind the Hong Kong Stock Exchange, their turnover was significantly higher.
In addition to the two stock exchanges, the NEEQ is an equity exchange in Beijing, but it has a much smaller trading volume. In 2021, the Beijing Stock Exchange had been established as a subsidiary of the NEEQ.
According to Statista, both the Shanghai and Shenzhen Stock Exchange have different trading boards which cater to a specific type of enterprise. The Shenzhen Stock Exchange consists of the Main Board, the SME board, and the Chinext.
The bourse in Shanghai has a Main Board and the Star Market. Companies that trade on the two main boards are mature, large enterprises that have a consolidated market position and consistently generate profits.
The Chinext and the Star market are for young start-up companies, especially in the technology sector. Lower listing requirements give companies easier access to funding.
The ambition of Chinese authorities is to create an independent financial market, which would give a big push to the development of China’s financial sector.
However, due to the strict regulation of the Chinese market and its relative isolation from international investors, listing on foreign stock exchanges has become an attractive option for many Chinese companies.
Tech-startups, in particular, seem to prefer international stock exchanges. As a countermeasure, the Chinese government established boards such as the Chinext and Star-A market with more relaxed entry standards.
The creation of the Star Market board was the latest step towards building China up as a world financial center. After the launch of the board in 2019, it quickly became the favored exchange for a series of large IPOs.
One of the key advantages of the Star market is more lenient listing requirements compared to other trading boards in the country. For instance, a company’s profitability is not a prerequisite for the listing process. This is especially beneficial for early-stage tech companies and will most likely attract further prominent IPOs in the future.
In recent years, the real estate crisis and tech sector crackdown put China’s financial system under significant stress. To close regulatory loopholes and address systemic risk, the government launched a new “super regulator,” the National Financial Regulatory Administration (NFRA), with increased authority that will cut across ministries and party bodies.
The restructuring should strengthen China’s long-term financial stability and – coupled with the government’s pro-business messaging and intensified efforts to attract foreign investment – should help create more confidence in China’s economy post-COVID.
China is predicting around 5% growth for 2023, but the country’s longer-term economic outlook remains unclear amid waning exports and weak domestic consumption.
In the past, Beijing has made efforts to de-risk its financial system, including regulatory tightening and attempting to rein in its shadow banking system. But amid these efforts, it has faced shocks from the real estate, the tech sectors and growing local government debt – risks to the financial system that have originated externally.
As part of its restructuring plan unveiled at the last Two Sessions, China’s annual legislative meeting, the government announced the creation of the National Financial Regulatory Administration (NFRA).
The NFRA, which reports directly to the State Council, will regulate, and supervise the entire financial industry, except securities, centralizing functions previously under the China Banking and Insurance Regulatory Commission (CBIRC), the central bank (PBoC), and the securities regulator (CSRC). The move aims to eliminate redundancies and ensure better coordination among government and party stakeholders.
The new regulator will be led by Li Qiang who, as Premier, has authority over the activities of all ministries, enabling him to coordinate across stakeholders and ensuring that the regulator is not outranked by the entities being regulated. Li is also President Xi’s number two in both the party and government, indicating the importance of this effort.
The government’s NFRA will also have mirror organizations within the Chinese Communist Party to oversee key decision making. The newly created Central Financial Commission will assume responsibilities from the State Council’s Financial Stability and Development Committee for financial policy planning, management, and oversight.
And the resurrected Central Financial Work Committee, which last operated in 2002, will work to integrate ideology and party-building within the financial system.
The main goal of the NFRA’s centralized oversight is to close loopholes in financial regulation. China has had multiple regulators overseeing the financial sector, including the CSRC, its securities regulator, and the CBIRC, its banking and insurance regulator.
Prior to 2018 reforms that created the CBIRC, China had distinct banking and insurance authorities. With the entire financial system now under purview of the NFRA’s sole authority, the NFRA will be able to strengthen regulation and oversight on financial institutions’ compliance, operational risks, and investor protection, as well as close previous regulatory loopholes.
By delineating regulatory and developmental responsibilities, it will also eliminate conflicts of interest for local entities previously tasked with meeting development targets and supervising financial risk.
Risks to the financial system have often originated outside of the financial infrastructure. The property market crash, for example, has threatened the entire banking system due to local banks over-leveraged in real estate or developers.
It has been challenging to allow a bank or state-owned enterprise (SOE) to go bankrupt because political leaders have outranked financial regulators and have been able to overrule politically damaging bankruptcies.
Now, key decision-makers on financial impact are at the table. With an elevated status on par with key party bodies and SOE heads, and with Premier Li as its chair, it will be harder for anyone to overrule the NFRA, ensuring that sound financial policy is prioritized.
Some local banks are likely to fail, but the risk is not systemic. Past government interventions have led investors to believe that struggling banks and SOEs will be bailed out. But now that the NFRA has ample authority, the central government wants to send a message that it will not always be there to save state banks.
With the real estate crash and over-leveraged small- and medium-sized provincial banks now in crisis, many are likely to be allowed to fail. However, central banks are well-managed and have dealt with the real estate risk, resulting in a banking system that is largely steady. While it may take time for the system to recover fully, these reforms promote long-term stability of the financial system.
This is a positive development for China’s financial system and for foreign firms as China continues to open its financial services market. Several foreign financial services firms have recently received various operating licenses to expand their business in the market after years of delay and negotiation, and several other Western banks are applying for mutual fund licenses as Beijing continues to relax rules on foreign financial institutions.
Chinese authorities have committed to open up further to foreign investors and create a more attractive landscape for private and foreign operations. The 2023 Government Work Report prioritized intensifying efforts to attract and utilize foreign investment. China needs foreign capital to boost its economic recovery.
In late March, the Ministry of Commerce designated 2023 “Invest in China Year,” and government leaders continue to push business-friendly rhetoric. In his first press conference as Premier earlier this month, Li Qiang said that most foreign companies are still optimistic about their development prospects in China, noting that last year China’s utilized foreign investment totaled over US$ 189 billion, a record high and almost US$ 50 billion higher than three years ago.
Similarly, Minister of Commerce Wang Wentao called foreign firms “family,” and Executive Vice Premier Ding Xuexiang’s comments at the China Development Forum have been echoed by multiple officials.
However, it is important to be aware of increased oversight and influence of the Chinese Communist Party in the financial sector. Creation of the Central Financial Commission – a party body overseeing financial strategy and policy – and resurrection of the Central Financial Work Committee – a party body to integrate ideology and party-building within the financial system – will strengthen the party’s influence over decision making within the financial sector.
Despite China’s positive economic outlook for 2023, continued growth longer term is an unknown. While some of the small- and medium-sized real estate developers continue to face challenges, Beijing’s recent policy support to the real estate sector is helping to mitigate systemic challenges.
Analysts expect China’s post-COVID economic recovery to fare better than Beijing’s official target of “around 5%” growth in 2023 – with some predicting 6% – so an improving economy may be just what the country needs to reinforce its efforts to upgrade its financial regulators and de-risk the system.
Since the creation by the Chinese government of the Qualified Foreign Institutional Investor (QFII) program, certain foreign institutional investors are allowed to gain direct access to trade “A-shares” of Chinese stocks, denominated in China’s renminbi/yuan (RMB), on Chinese stock exchanges such as the Shanghai Exchange.
Before the introduction of the program, foreign investors could only trade stocks of China-based companies in the form of “B-shares” traded on Chinese exchanges but denominated in US dollars or Hong Kong dollars, “H-shares” traded on the Hong Kong Stock Exchange, or “N shares,” which are listings of Chinese stocks on stock exchanges in the US.
China’s motivation for creating the Qualified Foreign Institutional Investor program was two-fold: to elicit more foreign investment in Chinese business enterprises, and to further strengthen the RMB’s position as a major world currency.
Once they obtain a qualified investor license from the Chinese government, foreign investors can buy and sell RMB-denominated “A-shares” listed on the Shanghai or Shenzhen Stock Exchanges.
The program is administered by the China Securities Regulatory Commission (CSRC).
The following are the basic requirements for obtaining a license as a Qualified Foreign Institutional Investor (QFII):
The foreign institutional investor (mutual fund management firm) must be assessed by the appointed Chinese government agency as being “reputable and financially sound.” It’s been determined with requirements that the investor show a certain level of assets under management (AUM) – for example, an initial requirement when the QFII program was first launched was that the foreign investor’s total AUM must be at least US$5 million.
Foreign investors must be free of any type of disciplinary action imposed upon them by any financial regulatory authority or agency within the three-year period immediately preceding their application to the QFII program.
Other specific requirements related to the condition to be “reputable and financially sound,” such as the number of years that the foreign investor has been in business, may also be imposed by the CSRC.
There must be a signed Memorandum of Understanding (MOU) between the CSRC and the regulatory financial authority that governs the foreign investor in their home country. The agreement must include an assurance by the foreign investor’s home country regulatory agency that it will carefully supervise the investment firm for the duration of the agreement.
Initially, the CSRC maintained tight quota controls over the access and operational ability of licensed QFII, limiting the total amount of money that the foreign investor could invest in Chinese publicly traded companies during any given year.
The CSRC also limited the total amount of capital that a licensed foreign investor could annually repatriate to its home country. In addition, any movement of investment capital out of China by qualified foreign investors had to first receive approval from the CSRC, after which the money was subject to a three-month “lock-up period” before it could be transferred abroad.
In the years since the QFII program was created, the CSRC has increased the quota amounts and loosened other restrictions that the program had in place.
For example, the quota on the total amount of capital that foreign investors can invest in Chinese securities through the program was raised by more than 100%. The restrictions on moving investment capital back to a foreign investor’s home country have also since been largely done away with, and the three-month lockup period regulation has been abandoned.
The types of securities available to QFII program participants have also been expanded to include exchange-traded funds (ETFs), stock warrants, stock index futures, and various financial derivatives, aside from regular Chinese stocks and bonds. The expanded financial product selection enables qualified foreign investors to, among other things, hedge their investments against foreign exchange risk.
To offset concerns about foreign investors obtaining an ever-increasing share of Chinese securities, a companion program to the QFII was created in 2012 – the Qualified Domestic Institutional Investor (QDII) program, which facilitates the ability of large, domestic Chinese investors to invest in foreign securities markets.
As of 2020, Qualified Foreign Institutional Investors use the services of more than 20 Chinese brokerage firms, with the CSRC approving nearly 200 foreign investors for the QFII program. Among the largest participating institutional investors are UBS Group AG and JPMorgan Chase Bank.
According to a recent report by the consulting firm Deloitte, despite unexpectedly overwhelming disruptions in the past two years such as COVID, geopolitical tensions and growing risks from local governments’ financing vehicles (LGFV), China's economy remains highly resilient.
China’s banking sector’s overall performance is admirable during this challenging macroeconomic landscape. Banking institutions continue ramping up their credit support for the real economy and playing the unique role of the financial sector as the “growth accelerator” to the economy.
At the end of 2022, China’s banking sector recorded total assets in Renminbi and foreign currency of nearly RMB 380 trillion, with year-over-year growth back up to 10%, surpassing the pre-COVID assets growth in 2018 and 2019.
Optimization of the banking loan structure continues. The year-end balance of inclusive loans to SMEs reached RMB 23.8 trillion, up 23.8% year-on-year, with more businesses covered and lower financing costs. The year-end balance of green loans reached RMB 22.03 trillion, up 38.5% year-on-year.
In 2022, commercial banks maintained the upward trend in profitability and achieved a cumulative net profit of RMB 2.3 trillion, up 5.4% year-on-year. While the credit business has increased significantly, commercial banks have realized steady improvement in assets quality, continuously reduced the NPL ratio, increased liquidity coverage and capital adequacy ratios, as well as improved their capabilities in risk control.
The report identifies concerning factors from the 2022 performance of China’s banking sector, such as the significant slowdown in revenue and profit growth among the commercial banks, and the dual pressures from a sluggish economy and the transformation of business model within the banks.
Commercial banks' net interest margins have been narrowing since 2019; the 2022 net margin decreased 16 basis points to a record low of 1.91% for Q4 of the year. The significantly increased proportion of time deposits in the debt structure of commercial banks also reflects the competition in the deposit-taking business and financing costs are both rising.
Following the end of the 3-year transition period of the new asset management regulations, in the midst of a bearish capital market, the asset management market size shrunk in 2022.
Especially in the fourth quarter, the bond market turmoil triggered a wave of financial products redemption at banks resulting the decline of both the number and the volume of wealth management products by 4.41 percent and 4.66 percent respectively, and further eroded the source of profits for banks.
The asset management business among commercial banks is facing many challenges in an unfavorable market environment. Also, banks’ revenue from intermediary business continues to shrink, asset-light business model transformation has become a long-term priority for commercial banks.
In 2023, despite the challenges, China’s banking sector is facing great opportunities. It marks the first year of 20th NCCPC policies and guidelines come into play, as well as the new leadership in the government. A strong and stable macroeconomy is the growth driver of the banking sector and the real economy.
Green transformation, digital economy and tech innovation will provide new momentum to boost China’s economic growth, as well as new opportunities for the financial sector to benefit real economy and maintain sustainable development in banking.
An unprecedented reform in financial regulation is happening. Supporting the real economy, increase domestic demands and risks mitigation will remain the key priorities for Chinese banks.
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