Economic Reforms and Development in China : Economic Reforms and Development in China, Volume 2 9789814298315, 9789814298308

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Economic Reforms and Development in China : Economic Reforms and Development in China, Volume 2
 9789814298315, 9789814298308

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Selected Works of Cheng Siwei This book, in three volumes, presents the thoughts and reflections of the highly regarded Chinese scholar and statesman, Cheng Siwei. The author outlines his theories for bringing economic reform to China in the context of a global economy. Using the principles of complexity science and finance, the author also elaborates on the characteristics and laws of fictitious economy in China and from this perspective, studies such issues as venture capital, financial crises, capital and monetary markets, inflation and deflation, housing system reform, the social security system and enterprise management in contemporary China. The book has been highly regarded by top-ranked Chinese politicians and distinguished scholars and is essential reading for anyone wishing to understand the economic complexities of the development of China.

Published by Enrich Professional Publishing (S) Private Limited 16L, Enterprise Road, Singapore 627660

Website: www.enrichprofessional.com

A Member of Enrich Culture Group Limited Hong Kong Head Office:

2/F, Rays Industrial Building, 71 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China Beijing Office:

Rm 1108A, Culture Plaza, No. 59 Zhongguancun St., Haidian District, Beijing, China English edition © 2012 by Enrich Professional Publishing (S) Private Limited Chinese original edition © 2008 China Renmin University Press Translated by Chan Sin-wai All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage

and retrieval system now known or to be invented, without prior written permission from the Publisher.

ISBN (Hardback)

978-981-4298-30-8



978-981-4298-60-5 (epub)

ISBN (ebook)

978-981-4298-31-5 (pdf)

This publication is designed to provide accurate and authoritative information in regard to

the subject matter covered. It is sold with the understanding that the publisher is not engaged

in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

Enrich Professional Publishing is an independent globally minded publisher focusing on the

economic and financial developments that have revolutionized new China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate and engaging information on China. Printed in Hong Kong with woodfree paper from Japan

Contents Preface

vii

Chapter 1 China and the World in the Context of Economic Globalization

1

Chapter 2 Financial Globalization and Financial Reform in China

15

Chapter 3 Development Plans under the Chinese Socialist Market Economy System

49

Chapter 4 A Theoretical Analysis of Deflation and the Actual Problems Facing China

85

Chapter 5 A Systemic Analysis of Stock Markets in China and Suggestions for Their Adjustment

125

Chapter 6 Strategic Thoughts on Developing China’s Money Markets

181

Chapter 7 Goals and Major Measures for Reforming Commercial Banks in China

237

Chapter 8 Exploring Effective Ways of Developing Rural Finance in China

283

Chapter 9 The Current Situation and Future Outlook of Venture Capital in China

325

Chapter 10 The Transformation of Bonded Zones into Free Trade Zones

363

Notes

399

References

401

Index

417

Preface This book that is displayed before our readers is the study and thoughts on the issues of the reform and development of the economy of China by a Chinese scholar (Chairman of the China Soft Science Research Association, President of the Chinese Society for Management Modernization, Director of the Research Centre on Fictitious Economy and Data Science, Chinese Academy of Sciences, and concurrent Director of Management Science Department of the National Natural Science Foundation of China (1996–2004)), who is also a statesman (Vice-Chairman of the Standing Committee of the 9th and 10th National People’s Congresses), and a leader of a democratic party (Chairman of the Seventh and Eighth Central Committees of the China Democratic National Construction Association). Looking back on the trajectory of my life, I can see that there have been three turning points. The first one took place in 1951 when I returned to work in the Mainland from Hong Kong, which set my direction to serve my country. The second was in 1981 when I went to the U.S. to study business administration; this broadened the scope of my academic studies; and the third one took place in 1995 when I joined the China Democratic and National Construction Association and embarked on a political path. For decades, I have followed the principle of being “upright in behavior, conscientious in work, and industrious in research,” hoping that I could contribute in my own small way to the unification of my motherland and the revitalization of the nation. To me, serving the country is the goal of engaging in academic studies and entering politics, and engaging in academic studies is the foundation of entering politics. To this end, I have been working with my colleagues in Chinese management science circles and using complexity science to study issues relating to the development and reform of China, to make enormous efforts to explore and explain the characteristics and law of development of the fictitious economy, and to actively study and promote the development of venture capital in China. I want the results of all my research to be specific, timely and practical, and the proposals I make, technically feasible, economically justifiable, legally permissible, operationally workable, implementable within time constraints, and politically acceptable to all parties to reduce as much as possible resistance in their implementation. In my research methodology, I have strived to use a comprehensive and integrated approach that combines qualitative and quantitative methods so that my viewpoints are crystal clear and my arguments fully substantiated.

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Complexity science is a science that studies complexity and complex systems. It is a new phase in the development of systems science and is referred to by some scientists as “the science for the 21st century.” In recent years, I have been primarily drawing on the research findings of physical and biological complexity, taking mathematics, economics, and behavioral science as my foundation, and using and developing methods and instruments such as the quantification of qualitative variables, group decision-making, evolutionary computation, and mathematical logic, to explore complex social issues such as enterprise management and housing system reforms, establish the social protection system and reform public service units, transform the functions of the government, open up rural consumer market, foster Chinese multinational corporations, overhaul the rural-township enterprises, develop the western regions, boost the urbanization of rural villages, develop the knowledge economy, meet the challenges of economic globalization, oppose monopoly, adjust energy policy, reform the methodology of formulating plans, and promote the transformation of bonded zones into free trade zones. The fictitious economy is an economic activity that directly uses money to make money. At present, the scope of the fictitious economy in the world has increased rapidly and has far exceeded that of the real economy. In recent years, I have primarily used the principles of complexity science and financial engineering to elaborate on fictitious capital and the characteristics and laws of the fictitious economy, and have attempted to study, from the perspective of the fictitious economy, issues such as chaos and self-organization in the capital and money markets, financial crises, inflation and deflation, reform of commercial banks, rural finance, as well as futures and financial derivatives, Renminbi exchange rates, and real estate finance. Venture capital, which is specialized investment that is risky, portfolio, longterm, equity and professional, has the objective of “helping innovators start their own business and helping investors speculate.” In recent years, I have studied the strategy, legislation, policy, and selection of related projects in the development of venture capital in China, the organizational structure, methods of financing, and operation mechanism of venture capital companies, as well as practical matters such as the preparation of business plans, the selection of projects, management of venture enterprises, and channels for raising capital. I also proposed that the government follow the principle of “supporting enterprises but not controlling them through stock ownership, guiding them but not interfering with them” to encourage the development of venture capital business in the public sector. This book is based on a collection of selected research findings of several

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hundred researchers under my leadership regarding the three aspects mentioned above, which I further analyzed and deliberated on to complete the writing of 18 articles. I have also contributed another 12 articles based on my research, all of which are now published in three volumes. These articles were mainly published in the “Series of Contingency Research on the Issues of Reform and Development in China” sponsored by the National Natural Science Foundation of China and published in journals such as the Journal of Management Sciences in China and Economic Affairs , while some are first published here in this book. Despite the fact that the articles that I previously published cannot fully represent my current ideas, I did not make any revisions for this book so as to preserve their historical authenticity, to see how these ideas have stood the test of time, and to allow readers to follow the evolution and development of my academic train of thought. Whenever I discover something useful from my research and thinking, my principle is to “present my views strongly as I cannot possibly please everyone and to do my best to serve the people so that my conscience is clear.” Apart from writing books and articles, I also make suggestions and proposals to senior leaders of the Chinese Communist Party and put my ideas into practice in my work for the Standing Committee of the National People’s Congress and the Central Committee of the China Democratic National Construction Association. As a scholar, I believe my goals in academic research are not to make decisions on behalf of the government but to support the government’s decisions and promote the scientification and democratization of decision-making in four primary aspects of exploring theoretical foundations, reviewing overseas experiences, improving overall frameworks, and analyzing difficulties in policy implementation. As a statesman, I have to apply my academic research findings to the implementation of legislation and supervision of the National People’s Congress, steadily and thoroughly apply the scientific outlook on development, unremittingly push ahead reform and opening up. I need also to strictly observe the strategy of “ruling the country by law,” promote the development and stability of the country, and safeguard the fundamental interests of the people at large. As a leader of a democratic party, I need to combine my academic research findings with the functions of my participation and discussion of state affairs and democratic supervision, follow a policy of “considering the overall situation, upholding fundamental principles, and making my own contributions,” and play the role that a participating political party should have in Chinese political life. Despite the fact that I have for years been busy in public service and am now over 70 years old, I still have a singular passion for academic studies. I

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make myself read at least one hour every day, write at least one article every month, and publish at least one book every year; I find these activities always “enjoyable, satisfying and never tiring.” This is because I believe that a country like China, which has a long history, a largely rural-based population, and is economically underdeveloped, cannot mechanically copy the experience of Western countries. Only through the blending of theory and practice can China find its own path of development and realize the revitalization of the Chinese people in the 21st century. There’s a line in a poem by Lin Zexu: “I’ll do whatever is in the interests of my country even at the cost of my own life; I would never shrink back because of personal weal and woe.” I want to spend my remaining years working with my management science colleagues in China for the prosperity of the nation, the progress of society, and the well-being of the people. Cheng Siwei February 29, 2008

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China and the World in the Context of Economic Globalization

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 2

Economic globalization means true interdependence between nations and states and is the major trend of world development today. It began in the early phase of the development of capitalism and has existed for hundreds of years. From raw material procurement to commodity trade, then to technology transfer and the export of capital, economic ties among different countries are increasingly tighter. Especially from the 1980’s, the pace of economic globalization has greatly accelerated. Now in the twenty-first century, the characteristics of economic globalization can be summarized as “having knowledge as its base, finance as its core, information technology as its vanguard, and multinational corporations as its carrier.” Regional integration, also called hypo-globalization, has emerged as a new development in recent years. The close relationship between countries in the same region makes mutual understanding and cooperation easier. The European Union (EU) and the North American Free Trade Area (NAFTA) have had notable achievements, although many issues remain to be resolved. Regional integration in Asia, Africa and Latin America is still in progress. Regional integration and economic globalization are complementary. The former enhances competitiveness of a region and builds a better regional environment. It helps form a multipolar world, thereby creating a more secure place for all people. With its long history and culture, its implementation of the socialist system, and its rapid economic development, China must seriously analyze economic globalization as it stands, then determine its own course of action in handling its bilateral and multilateral economic and trade relations. The world also has to further understand China, so as to reduce their biases against the country and enhance their friendship and cooperation with it.

China Needs the World, and the World Also Needs China China Needs the World It has been proved that China needs the world and its development is inseparable from the world. China’s reform and opening up are the two wheels driving the country to its rapid economic development. During the period 1978– 1997, China had an average annual economic growth rate of 9.8%, close to three times the world’s average (3.3%). In those 20 years, the average annual growth rate in developed countries was only 2.5%, developing countries, 5%, and Asian countries, 7.3%. If the growth rate of developed countries was assigned the value

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1, then developing countries had the value 2, Asian countries approximately 3, and China approximately 4. China’s rapid economic growth has greatly improved people’s livelihood. However, we should also clearly see that economic globalization is a doubleedged sword bringing opportunities as well as risks. Economic globalization provides a good opportunity for economic development of various countries. It helps accelerate the international flow of capital, transnational dissemination of information, international transfer of technology, management and other production factors, and the optimal allocation of global resources, thereby expanding trade between countries and facilitating economic development of individual countries and the world. It helps developing countries bring in capital, talented people, advanced technology and equipment, learn modern management techniques, and explore international markets. However, economic globalization also brings risks for developing countries. As the current “rules of the game” of the international economy are formulated under the auspices of developed countries which have economic and technological advantages over developing countries, economic regulations and practices may be unfair and often disadvantageous to the latter. The economic security and national sovereignty of developing countries may even be threatened. In particular, as their financial systems are rather fragile, transnational capital flows will pose a direct threat to them. Major problems affecting confidence in financial markets and the formation of “bubble economies” mean that financial risks may spread more rapidly. In addition, multinational companies, in order to reap large profits, have been engaged in activities that have caused adverse effects on the social and economic development of a host country (especially a developing country), and even on its social stability and economic security. For instance, they transfer their production lines that cause serious pollution to the environment to the host country and they plunder the valuable resources of that country and discriminate and even oppress workers employed in the host country. They transfer profits by increasing the price of imported raw materials from the parent company and lowering the price of export products to the parent company. These companies also transfer capital through internal financing, or engage in activities such as arbitrage and foreign exchange speculation and interfere with the foreign exchange balance of the host country through prepayment or delaying payment. They engage in financial speculation in the host country, with the potential of triggering a financial crisis; and often they control the economic lifeline of the host country, resulting in its abnormal economic development. What is more, at the same time as exporting their products, technology and

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capital, some multinational corporations also attempt to indoctrinate people in the host country with their home culture and values, making a great impact on the social and historical tradition of the host country and causing adverse effects on developing countries. The Chinese government believes that joining the World Trade Organization (WTO) in general has done more good than harm as economic globalization is the major trend of world development and no country can develop behind closed doors. After over ten years of arduous negotiations, China finally achieved its goal of accession to the WTO. Accession to the WTO has added new impetus to China’s economic development. Since 2001 the Chinese economy has entered a new cycle, and its rapid growth has continued for seven consecutive years. In particular, China’s foreign trade, with a much higher growth rate than its economy, has become an important pillar of the country’s economic development. As globalization of the world economy accelerates, China needs to open up further and continuously improve its level of openness.

The World Also Needs China First, China’s aggregate economic volume and its aggregate volume of foreign trade are huge, its foreign exchange reserves are plentiful, and its foreign direct investment (FDI) is among the highest in the world. Therefore, it can be said that without China as a member, the WTO cannot be truly a global organization for trade. Second, China is the largest developing country. Its accession to the WTO will help strengthen the voice of developing countries and change the unfair “rules of the game” that favor developed countries. Such a role for China has gradually been manifested in the ministerial conferences in Doha and Cancun. Finally, China is a responsible developing country; its accession to the WTO will help promote a North-South dialogue, boost cooperation between developed and developing countries, and encourage the formation of a multilateral trading system. Thus, China needs the world, and the world also needs China. Its accession to the WTO has important significance to both China and the rest of the world. China’s sustained and rapid economic development over the years has attracted world attention. However, out of ignorance or prejudice against China, some cannot have an objective and impartial view of its role on the global stage. They do not believe that China has developed as it has over the past few decades; they become alarmists and assert that China will soon collapse, but the facts show that China is becoming increasingly powerful. Though they recognize China’s achievements, they unreasonably believe that China’s development is a

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threat to the world. In recent years, more and more people are aware that China’s peaceful development is beneficial to the world. However, as the fallacies of the “China’s collapse” and “China’s threat” theories are gradually negated by objective facts, they propose the “China’s responsibility” theory, demanding that China bear the same responsibilities as that of the U.S. and Europe. Chinese leaders have on many occasions clearly stated that China is still a developing country and can only take on responsibilities that suit its current level of development. China is not nor would ever become a superpower. It adheres to peaceful development and is willing to make joint efforts with other countries to build a harmonious world. Needless to say, conflicts and disagreements often arise among countries due to their differences in history, culture, values, social and political systems, and for the sake of protecting their national sovereignty and interests. But these should be resolved through peaceful negotiations to avoid clashes and confrontations. To build a harmonious world, various countries should have a common goal in promoting peace and development. They must strengthen their relations, communicate with one another, enhance understanding and trust, and reinforce friendship and cooperation. For the healthy development of economic globalization, the world needs to work together within the framework of the WTO rules to resolve major issues such as trade friction, market access, climate change, and poverty reduction. Therefore, various countries should seek common ground while putting aside their minor differences. They should strive to reach consensus and agreement on the basis of mutual respect, equality and negotiations. All countries should be equal regardless of their size; large countries should not rely on their power or positions to impose their own values and ideas on others. Seeking consensus and reducing differences should be sought in the process of economic globalization and regional integration.

China Needs to Understand the World, and the World Also Needs to Understand China China Needs to Understand the World Being a large country with 5,000 years of history and civilization, China had long established relations and trade with other countries. From the Han Dynasty when Ban Chao explored the Western Region to the Ming Dynasty when Zheng He sailed westwards, Chinese envoys were sent on friendly diplomatic missions to many Asian and African countries. The historic Silk Road had from time immemorial been the land trade route adopted by ancient China to South Asia,

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West Asia, Europe and North Africa via Central Asia. Unfortunately, just as the Renaissance and the Industrial Revolution took place in the West, China started implementing a policy of seclusion in 1655 (Qing Dynasty) and cut off its ties with the world. Then in 1842, the imperialist countries forcibly opened the door to China with their guns and ammunition during the Opium War, turning China into a semi-feudal and semi-colonial society. Finally, after 100 years of struggle, the Chinese people finally had their revolutionary victory in 1949. During the period when New China was founded and before its reform and opening up, China was basically isolated from the West. It had little knowledge of the world and, in particular, the market economy countries. After reform and opening up, China has a better knowledge of the world, but further understanding is needed for its adaptation to the trend of economic globalization. Initially, China has to understand the market economy, especially the features and historical course of countries with this type of economy and the best practices accrued from this system. There are many market economy countries, each of which has its own characteristics. In general, they can be categorized into the Anglo-American model represented by UK and the U.S., the Rhine model represented by France and Germany, and the East Asian model represented by Japan, South Korea and Singapore. These can be broken down further into even more models. We need to seriously study and understand these models and learn from their experiences. Building a socialist market economy with Chinese characteristics is to take advantage of the basic function that the market works on resource allocation so as to pursue efficiency and effectiveness of economic development. For this purpose, we have to learn from the centuries of experience accumulated by other countries in their development of market economy, and then use this experience in China based on its actual situation. We also have to continue upholding the socialist system to ensure fairness and justice in society, particularly the legal rights of vulnerable groups. It is important to strike a reasonable balance between fairness and efficiency, which should complement each other. The pursuit of efficiency without regard to fairness will increase the wealth gap and affect social stability, and eventually will affect the economic development. When fairness is emphasized at the expense of efficiency, financial resources will be insufficient and fairness will be achieved only at a low level. It will then be difficult to meet people’s growing material and cultural needs. The second matter that China has to understand is the rules of the WTO. Many in China do not have an in-depth understanding of these rules. Incidents in recent years after China’s accession to the WTO show us that this is the

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case and that China needs to improve the mechanism of multilateral trade negotiations and enhance its handling of multilateral trade relations. China also needs to actively use these rules to protect the interests of the nation and its businesses. In addition, after fully understanding these rules, China should suggest improvements to them so that the organization would be more equitable to developing countries. The third is to understand the society, history, politics, culture, mentality, language and customs of other countries and the significant roles they play in their social and economic life. Chinese engaged in foreign trade and economic cooperation should have knowledge of the political, social and cultural areas in addition to business knowledge. They should also be conversant in foreign languages, regularly read foreign newspapers and magazines, and keep contact with people of different fields and countries. Only in this way can they fully participate in foreign economic and trade activities.

The World Also Needs to Understand China China’s rapid economic development in recent years has attracted world attention. The country has often been in the past years a hot topic at the World Economic Forum meetings held in Davos, Switzerland. However, the world’s understanding of China is sadly deficient. Other countries, particularly the major developed countries, should know more about China in the following aspects: (1) China is the largest developing country in the world. This can be seen from the fact that its aggregate economic volume in 2007 reached USD3.4 trillion, and is ranked 3rd in the world. For a big country, the importance of its aggregate economic volume is that it can concentrate its efforts on matters that even developed countries have difficulty in doing. For example, China is the 3rd country that has put a man in space. Considering China’s huge aggregate economic volume and its rapid development, some foreigners fail to recognize that China is a developing country and demand that it takes on the same responsibilities as developed countries. Others think that the center of the world economy is moving eastward, and that the 21st century is China’s century. No matter whether these comments arise out of either ulterior motives or good intentions, we should keep a clear head and clarify that China is still a developing country as shown in the following aspects. First, with respect to per capita income, China has a population exceeding 1.3 billion, and its gross national product (GNP) per capita is only about USD2,500, ranked below 100 in the world. Moreover, there are still large regional disparities in China, such as its rural-urban gap and income gap. According to the dollar-aday standard developed by the World Bank and calculated at purchasing power

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parity terms, approximately 130 million people in China still live in poverty. Second, with respect to development stage, China is still in the process of industrialization, dominated by secondary industry, mainly the export of primary products and manufactured goods, but with little output of capital or knowledge. In some developed countries, knowledge-based industries play a leading role while many manufacturing industries have shifted their production abroad. In addition, with respect to financial competitiveness, China is still at a stage where its economy is led by industrial capital; the operational level of its commercial and financial capital is rather low. With few financial products and inadequate market development, its financial competitiveness is rather weak. Although the country has the world’s highest foreign exchange reserves (USD1.53 trillion at the end of 2007), these reserves are mainly in the form of bonds bought from developed countries; actually, China is lending its reserves to the financial capitalists of developed countries. Finally, in the supply of public services regarding culture, education, health care and social security, there is a large gap between China and developed countries. (2) China has a great potential for development. There are several reasons for the rapid development of China’s foreign trade: First, China is better than many other countries in terms of social and political stability, and national unity. Second, China has a huge market potential due to its large population as people’s growth in income will bring increased consumer demand. Third, China’s sustained rapid economic growth continuously offers new business opportunities for investors. Fourth, China has a comparative advantage in labor quality and cost. Smart, capable and studious, Chinese workers are praised by many investors. This advantage will exist for a rather long period, though the wages of Chinese workers will inevitably increase gradually with economic development. Fifth, China continuously improves its soft and hard investment environment. It has modified relevant laws and regulations in accordance with WTO rules. It has also improved the transport and communications facilities by national debt investment. Now the number of users of mobile phones and the Internet in China ranks among the highest in the world, while highway mileage ranks the second. International studies on preferred investment locations show that China often comes out on top. (3) The dual economy, an issue left over from history, is still found in China. After the Opium War, China was transformed from a feudal society into a semi-feudal and semi-colonial society. But in fact, rural society changed from a feudal system to a semi-feudal system, while the cities were changed from a

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feudal society to a semi-colonial society. The economic disparities between the rural and the urban areas continued to widen as they developed along different paths. The dual economy problem was carried over to New China after its establishment, and is yet to be solved. Over the years the income per capita of Chinese urban residents has become three times or more than that of rural residents, and their purchasing power per capita, four times. Urban residents enjoy a much higher quality of life in areas like social security, public services, culture and education than rural residents. Therefore, in the process of building a moderately prosperous society, China must strive to solve the problems facing agriculture, rural areas and farmers. The main way to eliminate this dual economy is industrialization and urbanization through which the rural labor force can be transferred in an orderly manner and farmers’ income increased. Research results show that UK took 200 years to reduce the proportion of rural population from 70% to 30%, which it achieved in 1850 while it took the U.S. about 100 years to achieve it in the 1920s. China’s current urban population and rural population ratio is around 40 to 60. We believe it would be difficult for China to reach the goal of having an urban population of 70% by 2020. It will be a long and arduous task to solve the problem of the dual economy. (4) China is in the process of transforming from a traditional planned economy system to a socialist market economy system. Before reform and opening up, China adopted the traditional planned economy system which was close to the former Soviet Union model. After the change, there were such phases as planned commodity economy, then in the 14th National Congress of the Communist Party of China in 1992, the goals of building a socialist market economy were formally established; and then in the 3rd Plenary Session of the 14th National Congress of the Central Committee of the Communist Party of China in 1993, the Decision on Issues in the Establishment of a Socialist Market Economy System , consisting of some 50 items, was adopted. In the 3rd Plenary Session of the 16th National Congress of the Central Committee of the Communist Party of China in 2004, the Decision of the Central Committee of the Communist Party of China on Some Issues Concerning the Improvement of the Socialist Market Economy , consisting of some 42 items, was also approved. The implementation of these Decisions had a significant and far-reaching impact on accelerating economic reform, further liberating and developing productive forces, facilitating the comprehensive development of the economy and society, achieving the lofty goal of building a moderately prosperous society, and creating a new situation of socialist modernization. As China is in the process of transforming from a traditional planned economy to a socialist market economy, much improvement has been made in

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its systems, operating mechanism and government functions, and the reform has continuously given an impetus to the socialist market economy system. However, due to China’s special conditions, and the fact that it is still in the transformation process, there will be inevitably much room for improvement. Therefore, the country should be supported and encouraged to develop along the right path, and should not be too harshly required to meet the standards applicable to mature market economies of the developed countries.

China Needs to Cooperate with the World, and the World Also Needs to Cooperate with China China Needs to Cooperate with the World With respect to its accession to the WTO, China has adopted a serious, conscientious and responsible attitude. The country actively supports and takes actions to safeguard and develop the multilateral trading system. It has played an active and constructive role in the WTO since its accession on December 11, 2001. In these six years, China has conscientiously complied with WTO rules and earnestly fulfilled its obligations and commitments. It has made great achievements in improving its market economy, enhancing its social and economic development, and integrating fully into the world economic system. First, China has intensified the amendment to and modification of its laws and regulations. Right before and after its accession to the WTO, the Chinese government formulated, amended and repealed over 2,000 laws, administrative regulations and departmental rules in accordance with WTO rules and its WTO commitments, covering various areas including trade in goods and services, trade-related intellectual property rights protection and its transparency, and uniform implementation of trade policies. Through these, China’s trade system is consistent with WTO rules and its commitments. China revised three basic laws on foreign trade and investment, and modified or enacted the Company Law and Banking Law which regulate the behavior of market players, the Trust Law and Contract Law which enhance basic market relations, and the Anti-dumping Law , Antitrust Law , and Law for Countering Unfair Competition , which improve market competition. According to the amendments to the Constitution approved by the National People’s Congress in March 2004, and the Property Law passed by the National People’s Congress in March 2007, all market players are ensured equal legal status and development rights, so that they can enjoy equal status and privileges, and abide by the same rules and responsibilities in a unified market. Second, China has significantly reduced tariffs in the six years since its

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accession in 2001. Regarding trade in goods, China’s average tariff was reduced from 15.3% in 2001 to 9.8% in 2007, of which the average agricultural tariff dropped from 23.2% to 15.2%, while the industrial tariff dropped from 14.8% to 8.9%. China liberalized foreign trade and abolished all non-tariff measures (import quotas, specific tenders and licenses) on imports of 424 tariff lines. China has become one of the world’s most open markets. In order to improve the balance of trade, China has also made efforts to boost imports. Third, China has relaxed access to its markets. It keeps expanding its opening up, especially accelerating the opening up of its service industries. In this sector, China modified and formulated a series of laws and regulations to further open up the country in many areas such as banking, insurance, securities, telecommunications, construction, distribution, law, tourism and transportation. China’s WTO commitments on trade in services have been effectively implemented. In the WTO classification of more than 160 service fields, China has opened 100, close to the average level of developed members (the least developed members have opened 24, developing members, 54, and developed members, 108). China’s efforts to earnestly fulfill its commitments and enhance market opening have won the general recognition and appreciation of many WTO members and foreign investors. China has fully participated in and actively promoted the Doha Development Agenda negotiations. Together with all other WTO members, it paid much effort to facilitate substantive progress in the negotiations and reach a balanced outcome as soon as possible. On June 8, 2007 when President Hu Jintao attended the dialogue meeting between leaders of the Group of Eight (G8) and developing countries in Germany, he expressed in his conversation with the WTO DirectorGeneral that China was willing to make joint efforts with all parties to advance the Doha negotiations so that a comprehensive and balanced outcome could be reached and the goal of the “Development Round” could be achieved. China has also strived to promote the development of regional integration. In 1997, the 10+3 (ASEAN plus China, Japan and the Republic of Korea) cooperation emerged from the Asian financial crisis, starting collaboration and joint development process of East Asian countries. In these ten years, the 10+3 cooperation has been vibrant and growing vigorously under the guidance of the first Joint Statement of East Asia Cooperation . The 10+3 countries have established bilateral good-neighborly partnership, maintained close contacts and enhanced mutual understanding and trust. Within the 10+3 framework, over 50 dialogue mechanisms have been established, and about 100 cooperation projects in 20 areas carried out. The 10+3 cooperation has boosted interdependence and promoted regional prosperity.

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The World Also Needs to Cooperate with China However, the world also needs to cooperate with China as fully as possible. The WTO is a multilateral trading system, and multilateral negotiations are much more complex than bilateral ones. In order to achieve win-win results for the problems plaguing the multilateral trade system, countries need to have mutual understanding, and even compromise, on the basis of equality. In recent years, China’s foreign trade has grown rapidly, bringing with it a large surplus for which it is criticized by some nations. However, it should be noted that first, trade balances are dynamic; they vary over time and change of trade partners. China has a large trade surplus with the U.S. and Europe, while it has large trade deficits with South Korea, Japan and some other Asian countries. Second, trade is mutually beneficial. With respect to Sino-U.S. trade, China can bring in capital, technology and advanced management experience from the U.S., while people in the U.S. can buy Chinese goods which are cheaper. Therefore, Sino-U.S. trade is beneficial to both sides. Third, the trade surplus should be judged from the perspective of foreign exchange balance. Not only the surplus or deficit in the current account but also in the capital account should be considered. Although China has a trade surplus with the U.S. in the current account, a considerable portion of China’s foreign exchange reserves is used to buy U.S. bonds, which is tantamount to lending its foreign exchange reserves to U.S. investors. Fourth, the trade surplus has brought pressure for Renminbi appreciation. The author believes that any major changes in the exchange rate including Renminbi appreciation are not beneficial to China or the world. Therefore, in the near future the Renminbi exchange rate should be kept relatively stable or slightly appreciated at a reasonable and balanced level. Of course, we must take necessary measures to alleviate the pressure of Renminbi appreciation, such as dealing with the rapid growth of foreign reserves, increasing the currency exchange limit of the residents, and relaxing the restrictions on the use of foreign exchange and investing overseas by enterprises. Moreover, we should gradually establish a more reasonable Renminbi exchange rate formation mechanism and eventually make Renminbi fully convertible. As China’s foreign trade develops rapidly, trade friction with other countries will inevitably occur. This requires various parties to work together to seek a reasonable solution. First, the parties concerned must be sincere in solving problems on the basis of equality, consultations, mutual understanding and compromise, but not to overwhelm others aggressively. Second, trade issues should not be politicized. One U.S. congressman was said to have made such a provocative speech: “Look, ships from China are all full while those to China are all empty. You see how serious the problem of the Sino-U.S. trade imbalance

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China and the World in the Context of Economic Globalization

is!” Actually the author thinks that this situation is not surprising. Chinese goods sold to the U.S. are mostly low-value goods such as clothes, toys, shoes and socks, which can only be shipped by sea; however, the U.S. products sold to China are mostly high-value goods such as electronic components, software, and pharmaceutical products, which will probably go by air. Third, parties should actively seek solutions to problems instead of using trade sanctions; any keenness on playing the “trade war” will lead to “lose-lose” results all round. A series of activities of the World Economic Development Declaration were held in November 2003 in Zhuhai, China. The slogan of the Declaration was equality, credibility, cooperation and development. Initiated for the first time by China and administered by myself as Chairman of its Organizing Committee, the event received positive responses from different sectors at home and abroad. It was agreed that this declaration did reflect the needs of the current world economic development, and were acceptable to all the parties. The declaration passed at least three messages to the world: First, China adopts a serious and responsible attitude to participate in economic globalization, taking into account the interests of China and world economic development. Second, as a large developing country, China has the responsibility and obligation to express its views on world economic development as it participates in economic globalization. Third, China’s overall aim is to promote cooperation and development, rather than increasing confrontation, when it expresses its views on world economy. Through this declaration, it is hoped that the world will to a certain extent reach consensus on the issue of economic development. Countries are expected to seek common ground while maintaining differences, all the while attempting to reduce these differences continuously. WTO has established a multilateral trade negotiation mechanism which, however, requires continuous improvement. Multilateral negotiation is a multilateral game; win-win results are possible if the parties concerned can make necessary compromises based on the long-term and global point of view. Favorable results are impossible if each country only serves its own interests and profits at the expense of others. It is hoped that insightful people in various countries will conduct in-depth discussions on trade issues in the framework of WTO, and to reach agreement on basic issues as much as possible. Only in this way can we jointly promote prosperity and development of the world economy, thereby helping to improve the livelihood of people around the world and make our planet a better place.1

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2

Chapter

Financial Globalization and Financial Reform in China

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 2

Introduction Economic globalization in its real sense is interdependence and it has been the major trend of development in the contemporary world. Although scholars in different countries have varied views on the starting point and characteristics of globalization, it can be said that ever since the birth of capitalist societies in the West, the world commenced the process of globalization. From raw material procurement to commodity trade, then to technology transfer and export of capital, economic ties among different countries have been increasingly closer since entering the 20th century. The development trend of economic globalization can be summarized as having knowledge as its base, finance as its core, information technology as its vanguard, and multinational corporations as its support. Since the 1990s, with the development of economic globalization, the advances of science and technology (especially information technology), the large-scale and rapid flow of capital, and particularly the globalization of the financial markets such as foreign exchange, securities, futures and options, financial globalization has gradually become the core of economic globalization. It should be noted that financial globalization brings both opportunities and risks. On the one hand, it helps promote the free flow of capital, enhancing the efficiency of resource allocation, and accelerating economic growth. On the other, it stimulates financial speculation, making it easier to form economic bubbles, speeding up the spread of financial risks, and making the fragile financial systems of developing countries more vulnerable and thus widening the North-South gap. Therefore, formulating correct financial policies and strengthening financial macro-control have become key tasks of countries in handling economic development in the new century. Strengthening international financial cooperation is also necessary, as is closely monitoring the flow of international speculative capital and striving to establish a stable, balanced and equitable international financial system. After 20 years of economic reform and development, China’s economic scale and comprehensive national strength have become increasingly greater, and such achievements are generally recognized by the world. China’s economic reform is an unprecedented and complicated systems engineering project. Under the trend of financial globalization and with the continuous improvement of the socialist market economy system, one of the main tasks for China as a responsible economic power is to reform its lagging financial industry and prevent and eliminate potential financial risks in the process of its integration into economic globalization. In the 3rd Plenary Session of the 16th

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Financial Globalization and Financial Reform in China

National Congress of the Central Committee of the Communist Party of China held in October 2003, it was specially emphasized that we needed to “deepen the reform of financial enterprises, improve the financial control mechanism, and perfect the financial regulatory system.”

Major Tendencies of Financial Globalization At the present stage, financial globalization has the following major tendencies: First, the degree of virtualization of various national currencies has increased. In the history of currency, since Britain first implemented gold standard in 1821, gold has played the role of guaranteeing paper money, which was widely issued at that time. The gold standard gradually came into widespread use in Europe and the U.S., and it became the basis of world currency in 1870. After World War I, the gold standard declined and the gold exchange standard was established. Then after World War II, as the U.S. set a minimum U.S. dollar price for buying or selling gold by foreign central banks, major European countries in 1958 decided that their respective currencies could be freely convertible into gold or U.S. dollars for settling international payments. However, in 1971 the U.S. stopped the free conversion of U.S. dollars into gold at a fixed price (USD35 per ounce) in international payments, and U.S. dollars and other paper currencies then became the bases of the international monetary system and the official role of gold in international currency exchange came to an end. Currency since then “decoupled” from gold completely and could not be freely convertible into gold at a fixed price. Since then currency has been issued by a country based on the total credit of that country and become non-convertible notes (also known as fiat money). At the same time as currency “decoupled” from gold, the degree of virtualization of currencies increased substantially. As people no longer had a “reference” with a fixed value to determine the value of currency, we could only measure its value by the purchasing power of that currency. Moreover, as the mechanism for automatic withdrawal of any currency due to the restrictions of the gold standard no longer existed in the economic system, the purchasing power of the currency was determined by the relationship between the quantity of currency and the output of the real economy. Second, the use of exchange rates between national currencies as policy tools. Currencies of various nations no longer had definite values due to virtualization, and their values, measured by their purchasing power, could vary with time and location. Furthermore, exchange rates could only reflect the international purchasing power of the currencies concerned. Therefore,

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fluctuations of the economic strength of countries may cause the exchange rates between currencies to float. At the same time, governments may thus use exchange rates as a policy tool. They could try to obtain greater benefits from the current account or capital account for the interests of their nations, thereby making exchange rate adjustments the game actions between governments. Theoretically, if governments of concerned nations could proceed to coordinate international exchange rates for the overall interests of the world, it would be possible to gain the Pareto effect and obtain a result satisfactory to all parties. Unfortunately, the nations concerned often put their own interests first, making it difficult to achieve the desired effect of coordination. This situation was obvious in the 1980s in the process of coordinating international exchange rates between developed countries. Between 1981 and 1985, driven by the falling Japanese yen and the rising U.S. dollar, Japan’s exports rapidly increased, striking a 74% increase in exports to the U.S., thereby causing a dramatic increase in Japan’s trade surplus with the U.S. Against this background, a meeting proposed by the U.S. was held on September 22, 1985 in The Plaza Hotel in New York. The meeting was attended by the Ministers of Finance and Central Bank Governors of the U.S., Japan, Germany, France, and UK (G5). The purpose of this meeting was to coordinate the exchange rate policies of the five nations so as to enable them to more appropriately reflect these nations’ economic developments and conditions, and to correct the unbalanced revenue and expenditure under their current accounts. The five governments, after consultations, reached the Plaza Accord which decided that joint actions would be taken to lower the exchange rates for the U.S. dollar against major currencies in an orderly and gradual manner. The Plaza Accord was the first large-scale international joint co-ordination of exchange rates; it achieved the expected results in a short period. As various central banks began selling dollars and buying Japanese yen and Deutsche marks, the dollar fell 8% against the Japanese yen and 6% against the Deutsche mark within one week after the Plaza Accord meeting; then at the end of December 1986, the dollar had devalued to about 20% against the Japanese yen and Deutsche mark. At that time, the nations believed that if the dollar was allowed to keep on depreciating, it would have a negative impact on their economic development. In this respect, the ministers of finance of the U.S., Japan, Germany, France, UK, Canada and Italy (G7) convened a meeting on February 21–22, 1987 at the Louvre in Paris to discuss measures on maintaining relatively stable exchange rates. Italy withdrew, and the remaining six finance ministers concluded the Louvre Accord , under which they unanimously agreed to limit their exchange rate floating ranges to a reasonable scope, and jointly

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intervene in any case of exceeding the limit. However, after the meeting the U.S. did not earnestly implement its deficit reduction program as committed. Particularly after the U.S. stock market crash on October 19, 1987, on the one hand, the U.S. government was only concerned with its domestic economic problems, and allowed the dollar to continue to depreciate, turning the Louvre Accord into a dead letter. On the other hand, the Japanese yen’s continued appreciation constituted one of the major factors for Japan’s bubble economy, which began to burst in 1991 and which then has brought Japan a long period of recession. The experience of exchange rate gaming enabled some insightful people to understand that it is difficult to achieve reasonable coordination when the participating countries are numerous and there is a huge disparity in strength between these countries and the U.S. Therefore, it was considered best to first match up countries within a region to form an alliance that is a match for the U.S. And that was the main driving force for creating the euro. We can expect that with the development of regional integration, there will be a growing tendency towards financial integration among countries in the same region. A recent example is the Asian Development Bank’s consideration of introducing the conceptual Asian currency unit (ACU). Third, the world’s financial markets are rapidly expanding. With the gradual growth of the world economy, the rapid advances in information technology, and the speedy development of financial innovation, the financial markets of countries (especially developed countries) have expanded rapidly. Particularly driven by the fast growth of the U.S. “dot-com bubble” in the period 1997–2000, the fictitious economy, which relied mainly on transactions of fictitious capital such as stocks, bonds, and other financial derivatives, also expanded rapidly. According to the data compiled by the author, by the end of 2000 the size of the global fictitious economy reached USD160 trillion, of which the market value of stocks was about USD36 trillion, the bond balance about USD29 trillion, and the balance of over-the-counter (OTC) transactions of financial derivatives about USD95 trillion. However, the sum of the GNP of various countries that year was only about USD30 trillion. The average daily nominal trading volume of the global foreign exchange market was over USD2 trillion, approximately 50 times of the world’s average daily actual volume of trade, that meant only 2% of the world’s daily flow of capital was actually used in international trade. Fourth, there has been a rapid increase in the scale and speed of crossborder flow of capital. With the development of the world’s financial markets, relaxation of control on capital flow, and advances in information technology,

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financial transactions can be conducted continuously around the clock. Huge amounts of capital can be transmitted within a second to places far away. These factors have all contributed to the increasing scale of the cross-border flow of capital, and a tendency towards short-term capital flow. Between 1986 and 2003, the average annual growth rate of the world economy (real GDP) was approximately 3.5%, and international trade (including trade in goods and services), approximately 6.1%, while the growth of international capital flow was even faster. Fig. 2.1. The trend of international capital flow from 1990 to 2004 USD10 billion

(%)

1,200

35 30

1,000

25 20

800

15 10

600

5 0

400

–5

200

–10

0

–20

–15 1990

1992

1994

1996

1998

2000

2002

2004

Year

The net value of international capital flow Growth rate

Having sorted out the relevant data of the International Monetary Fund (IMF) on international capital flow, and taking the global capital deficits as the net value of the global capital flow, the international capital flow during the period of 1990–2004 was as shown in Fig. 2.1. From this we can work out that the average annual growth rate of the global capital flow during this period was 8.92%.

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Financial Globalization and Financial Reform in China

The growth of the global capital flow slowed down in the early 1990s, but accelerated between 1998 and 2000, reaching an average annual growth rate of 20%. The economic recession of the U.S. started from March 2001, immediately followed by the most serious economic decline in twenty years in almost all parts of the world. In addition, the “9.11” Incident, which not only affected the American economy, but also had a serious impact on the economy of other regions, resulted in a decreased global capital flow in 2001. However, the rise resumed in 2002, and rapid growth was seen in 2003 and 2004. The size of global capital flow in 2004 reached USD960 billion, 29.4% more than the previous year. With respect to the direction of the global capital flow, developed countries as a whole had a net capital inflow in the early 1990s, then a net capital outflow in general between 1993 and 1998, but have recorded a large amount of current account deficits since 1999 and became capital inflow regions. Except for 1991, the U.S. has always been the nation with the largest capital inflow. In 2004 its current account deficits accounted for 69% of the net global capital flow. European Union (EU) countries have generally struck a balance in their capital flows, but in recent years, there has been capital outflow, though in small amounts. Japan has always maintained a high current account surplus, accounting for more than approximately 20% of the world’s demand for capital. Emerging market countries had very high current account deficits in the 1990s, showing a net capital inflow. Then, in 2000, they began to have current account surplus and turned into capital outflow regions. A steady upward trend had been seen and the developing Asian region was the main source of capital outflow, of which China accounted for most of the capital outflows. Since the 1990s (except in 1993) China had been a capital outflow nation, meeting 7.25% of the global demand for capital in 2004. India, another important developing country in Asia, had been a capital inflow nation. In 2001, it changed to become a nation with a small amount of capital outflow. Fifth, there has been a speedy development of financial innovation. Financial innovation refers to various kinds of creative changes within the financial sector caused by demands and driven by profits. The earliest financial innovation can be traced back to the euro-dollar market that first emerged in London around 1957. This market was engaged in U.S. dollar deposits and loans outside the U.S. The market object was the U.S. currency capital flowing outside the U.S. Such businesses on the one hand could avoid the restrictions under U.S. banking regulations and the control of the U.S. bank interest rates, and on the other hand, they could avoid certain restrictions under the financial regulations of the host nation. The emergence of the euro-dollar market helped banks in UK

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and other countries to get the large amounts of U.S. dollars that they urgently needed. It also enabled the banks in the U.S. to avoid the domestic regulations on withdrawing stipulated in the statutory provisions and the restrictions on the saving interest rates. Moreover the commercial notes issued by the parent company which held the relevant bank’s shares could not be treated as a deposit. Furthermore, it provided the Soviet Union and the Eastern European countries, then on one side of the Cold War, with a storage site for U.S. dollar reserves which had less political risks. Therefore, the euro-dollar market developed rapidly. Since then foreign markets have been formed for British pounds, Deutsche mark, Japanese yen and other freely convertible currencies, collectively known as the European currency markets. Based on a field survey by the author, currently the daily trading volume of the euro-dollar at the Chicago Mercantile Exchange (CME) has reached approximately USD2 trillion. Starting from the 1960s, inflation and interest rates in the U.S. had risen sharply. In addition to various factors, including the rapid development of computer technology, the gradual integration of international financial markets, and the unpredictable volatility and control of exchange and interest rates, financial risks had increased and the supply and demand of financial markets had significantly changed. Many financial institutions found that their traditional financial services and products declined in sales, and the old mode of operation was no longer profitable. Many financial intermediary organizations also found it difficult to use traditional financial vehicles to attract capital that they needed for survival. In order to remain solvent and move forward, financial institutions needed to strive for financial innovation. They needed to do research and develop new products and services to guard against financial risks, ensure safe trading, circumvent financial regulations, and lower transaction costs. Examples of these include the negotiable order of withdrawal (NOW), automated transfer service account (ATS), large-denomination negotiable certificates of time deposits (CD), money market mutual funds (MMMF), and repurchase agreements (repo). After the 1970s, with the growth of financial innovation, financial derivatives markets emerged in the U.S., UK, and other countries. This kind of market can be broadly divided into two categories: One being markets constituted by financial products launched by banks, known as over-the-counter trading, even though trading is mostly completed over telephone networks; the other being the tangible market constituted by the trading of financial futures. The currency derivatives traded in the derivatives market include forward contracts, currency and interest rate conversions, forward rate agreements and financial futures

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and options. According to the statistics of the Futures Industry Association in the U.S., financial futures and options accounted for 92% of the global trading volume of futures and options in 2004. The year-end global balance of financial derivatives reached approximately USD95 trillion, of which derivatives of the exchange rate and equity interest categories accounted for 17%, and the interest rate category, 66% respectively. In addition, with the introduction of a large number of financial derivatives, the operation mode of the banking industry has also changed, making crossborder banks more “universal” and enabling off-balance-sheet businesses to increase more rapidly. Sixth, there has been an increasing level of integration of world financial markets. Cross-border financial activities today are a process of using the same financial tools under by the same “rules of the game” to select investors and capital-raisers across the world. Financial markets in different regions and of different types have become interconnected. Capital not only can flow across the border in a particular type of market, but also transfer quickly between different types of markets. This increasingly blurs the boundaries between “long-term capital” and “short-term capital,” and between “international finance” and “domestic finance.” As links between financial markets of various countries become increasingly close, the transmission speed of risks has also increased rapidly, and it can be said that it has reached the stage where “a spark can start a fire that burns the entire prairie.” People still have a fresh memory of the East Asian financial crisis in 1997, the process and causes of which I have studied in-depth. In the second half of 1997, a financial crisis broke out in Thailand and rapidly swept across East Asia, then the whole world. Its force, breath, width and effects were unprecedented. In mid-May 1997, international foreign exchange speculators sold a large amount of Thai baht, making the Thai baht against the U.S. dollar fall to its lowest level in ten years. The Central Bank of Thailand had to intervene in the currency market, spending USD5 billion, to make the Thai baht exchange rate temporarily stable. But the price paid was great: Its foreign exchange reserves fell sharply, recording a deduction of USD4 billion in May alone; the interest rate soared and businesses were overwhelmed, leading to escalating prices and the crash of the stock market. On May 20, Thailand’s finance minister announced his resignation. In view of the fall of Thailand’s foreign exchange reserves to just USD8 billion, the Central Bank announced on July 2, 1997 that it would no longer intervene in the currency market. The Thai baht would adopt a floating exchange rate, and the pegged system which linked to a basket of currencies

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(mainly with the U.S. dollar, with a weight of 80%) and had lasted for 14 years would be abolished. The Central Bank also announced that the commercial bank prime rate would be raised to 12.5%. The Thai baht was devalued by 18%that day. Thailand’s financial crisis finally broke out. Thailand is a major member country of ASEAN, having close economic and trading relations with countries in the ASEAN region. The Thai baht’s adoption of the floating exchange rate system caused extreme turbulence in the foreign exchange market of the ASEAN countries. Indonesia, Malaysia and the Philippines went on to announce devaluation of their currencies. Even Singapore, which had a better established financial and monetary system and market mechanism, also announced the devaluation of its currency. These caused an entire outbreak of the Southeast Asian financial crisis. In October 1997, the regional financial crisis of Southeast Asia began to expand to East Asia. Starting from the depreciation of the New Taiwan dollar, the crisis quickly spread to Hong Kong, then Korea and Japan, constituting a financial crisis of the entire East Asian region. From the latter half of 1998, the East Asian financial crisis had spread geographically out of Asia, affecting Russia, and countries in South America and Africa. Even the U.S., named the “number one economic power,” and Europe, which was launching the integration of currencies, also felt the threat of the crisis. This financial crisis slowed down global economic growth, making the average annual growth rate fall from 3.8% in 1997 to 2.7% in 1998–1999. As a result of the interest rate cut of the U.S. and the European banks, the measures adopted by various East Asian countries to stabilize their currencies, and China’s keeping the Renminbi exchange rate unchanged, the impact of the crisis gradually weakened and the world economic growth was eventually restored to 4.7% in 2000. What deserves special mention is that financial globalization is not exactly the same as financial liberalization. Financial globalization is a product of world economic globalization. In the process of the latter, the interaction of the enterprises and markets of various countries generates a self-organizing effect, causing the world’s financial system to evolve continuously. During the process of this evolution, the objective needs of an appropriate relaxation of financial controls emerge, which are referred by some people as financial liberalization. However, this kind of liberation is relative and limited. For the sake of safeguarding national sovereignty and security, it is impossible for any nation to allow its financial system to be fully free and open. As Caprio and others have pointed out, the worldwide financial crisis has highlighted the shortcomings of the financial liberalization policy.

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The Challenges of Globalization for China For developing countries, financial globalization is a double-edged sword, bringing both opportunities and risks. On the one hand, the capital flows are more diversified and efficient. This will have positive effects with respect to improving the efficiency of the global allocation of resources and promoting the growth of international trade and the economic development of various nations. On the other hand, as financial globalization moves forward, international finance will often experience turmoil, which will be intensified due to the flow of capital. This will then affect the stability of the international financial system, and in particular, put developing countries in a disadvantageous position as regards to market competition. By and large, financial globalization will pose serious challenges to China, a developing country, in the following areas.

China’s Financial Institutions Will Face Fierce Competition Caused by the Opening Up of Financial Markets According to commitments made in 2002 when joining the WTO, China agreed to remove all geographical restrictions within five years after its accession. Restrictions on target customers of Renminbi businesses would be phased out, so as to allow foreign banks to provide services to all Chinese clients. Foreign banks would be allowed to set up branches in the same city, and the approval conditions for which would be the same as Chinese banks. Current non-approved measures on limiting ownership, the form of operation and establishment, establishing branches and issuance of licenses to foreign banks would all be cancelled. Non-banking foreign financial institutions would be allowed to set up to provide automobile consumption credit business, and enjoy equal treatments as the same type of Chinese financial institutions, and foreign banks could provide personal credit services relating to automobile to Chinese residents. However, due to the heavy burden of history, coupled with institutional shortcomings, weak internal administration and insufficient financial innovation, Chinese state-owned commercial banks are indeed less competitive. According to the author’s survey on Hong Kong’s Hang Seng Bank in 2001, its cost was only 24.4% of its income, while the state-owned commercial banks were generally around 90%. The per capita profit before tax of Hong Kong Hang Seng Bank was HKD1.57 million, more than ten times higher than that of the state-owned commercial banks. At that time, the difference in interest rates of one-year deposits and loans at the Hang Seng ranged between 1.7% and 2.2%, while the state-owned commercial banks were 3.6%. Although in recent years, the reforms

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of Chinese state-owned commercial banks have made great progress, their competitiveness is still weak. When compared with banks outside China based on the same international standards, Chinese state-owned commercial banks are weaker in terms of profitability (pre-tax profit / cost), returns on primary capital (pre-tax profit / primary capital), and per capita profits. Moreover, there is also a wide gap between Chinese state-owned commercial banks and foreign banks in areas like service quality, asset quality, corporate governance, and financial innovation. State-owned commercial banks have the advantage of many branches, but this cannot offset their disadvantages of problems with efficiency and service quality. This can be seen from the fact that after liberalization of the foreign exchange deposit business, large amounts of foreign exchange deposits of Chinese financial institutions in Shanghai were switched to foreign banks. This shows that Chinese state-owned commercial banks will face serious challenges in the opening up of the financial market. The gap was also obvious in their competitiveness in the securities businesses. For example, by the end of 2002 Morgan Stanley had total assets of approximately RMB6 trillion equivalent, net assets of RMB335.1 billion, and total revenues of RMB245.7 billion, representing one time, three times and ten times respectively of the sum of all securities companies in China. The per capita assets under its management was RMB320 million, and per capita profit RMB12 million, representing 64 times and 50 times respectively of the average value of all securities companies in China. Comparing China’s securities companies to international investment banks, the gap is very large in areas such as corporate governance, management experience, customer networks, incentive mechanism, and brands and talent. In addition, there is also a large gap in their competitiveness in businesses like futures, insurance and trusts. The Chinese government also has deficiencies in the supervision of financial markets and financial enterprises.

The Influx of Foreign Capital into China Will Have an Impact on Its Financial System Triggered by financial globalization, international capital flows, especially the global disorderly short-term capital flows, have stimulated and aggravated a variety of speculation, causing a serious threat to the stability and safe operation of the international financial markets. China’s financial system will certainly face greater pressure during financial globalization in that its markets are not sufficiently developed, its relevant legal systems are yet to be improved, and its financial supervision is relatively weak. At the same time, the external liabilities

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of local banks are destined to grow significantly, making their structure of assets and liabilities irrational, and thus increasing systemic financial risks. In recent years, the amount of China’s foreign exchange reserves has grown rapidly. In 2004, its foreign exchange reserves increased by USB206.7 billion, up 77% over 2002, and accounted for 35% of China’s Gross Domestic Product (GDP). Especially during the period from October to December that year, the average monthly growth of its foreign exchange reserves reached USD30 billion, far more than the average of approximately USD12 billion during the period from January to September of that year. These were the results of China’s years of speedy economic growth, and rapid expansion of its foreign trade. However, the sum of China’s trade surplus and foreign direct investment in 2004 was only USD92.6 billion, so there were speculative capital flows without actual trade into China, the amount of which was roughly estimated around USD40 billion to USD80 billion. The abnormal growth of China’s foreign exchange reserves was mainly motivated by the expectations of Renminbi appreciation, and made through the following methods: (1) foreign banks hastened to enter China’s interbank bond market; (2) foreign enterprises reduced their stockpile of foreign exchange reserves; (3) the capital outflows of previous years returned; (4) parent companies and their subsidiaries in China or elsewhere transferred capital to China between themselves by means of connected transactions or false contracts, and by increasing the amount of pre-payments; (5) individuals’ net settlement of foreign exchange grew considerably; large amounts of foreign exchange in individuals’ personal accounts were transferred to China, and in 2004 as much as USD30 million were remitted to the personal accounts in China; (6) investment through Qualified Foreign Institutional Investors (QFII); (7) domestic enterprises usually settled by foreign exchange for their exports, seldom purchased foreign exchange for their imports, deferred paying foreign exchange for their imports, and received payment in advance for their exports; (8) the sale of U.S. dollars and purchase of Renminbi through underground banks. According to traditional theory, a country’s foreign exchange reserves should not be less than 25% of its imports, but should at most be 30% to 40%. However, China’s foreign exchange reserves are now more than 100% of its imports. The excessive growth of its foreign exchange reserves makes increases in the price that China must adopt in order to maintain the stability of the exchange rates. At the end of 2004, China’s foreign exchange reserves reached RMB5 trillion. In the absence of appropriate hedging instruments, when there is an influx of foreign capital, the central bank of China has to invest in Renminbi heavily

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in order to stabilize the exchange rates. This is clearly contrary to the central bank’s current stable monetary policy, greatly affects the macro-control effects, and may have the risk of triggering inflation. China’s purchase of foreign bonds with its foreign exchange as its reserves is in fact making available its huge amount of U.S. dollars to countries which recorded a trade deficit with China or other countries. This not only wastes valuable financial resources, but also may enhance the economic strength of China’s trading partners. In addition, there is always the risk that we would be affected from time to time by the changes in international exchange rates and the economic and social changes of other closely connected nations. In particular, the U.S. dollar has been devalued more than 40% since 2002; such devaluation leads to a serious shrinkage of China’s foreign exchange assets. The surge in China’s foreign exchange reserves will also strengthen certain parties’ expectations of Renminbi appreciation, adding pressure on the matter.

The Closer the Ties between Domestic and Foreign Financial Markets, the More Vulnerable China’s Financial Systems to Fluctuations in International Financial Markets In 2004, foreign direct investment (FDI) in China was USD60.6 billion, ranking 1st in the world. The increasing inflow of foreign capital and participation of foreign investors in China’s financial markets will certainly bring closer links between its financial markets and that of other countries. This will intensify the impact of the financial markets of major developed countries on China’s financial markets. For example, the impact of the Federal Reserve’s adjustment of its base interest rate on China’s foreign exchange market is increasingly obvious. On the other hand, China’s financial markets have been keeping pace with international financial markets as far as market fluctuations are concerned. China’s foreign trade has developed rapidly in recent years, and its dependence on foreign trade (the ratio of the total amount of imports and exports against GDP) continues to grow. In 2004, China’s GDP after adjustment was USD1.93 trillion while its total imports and exports were USD115 million. The dependence on foreign trade was 59.5%. As economic exchanges between China and other countries increase, the linkage between China’s financial markets and the world financial markets is also enhanced. Therefore, we can see that financial globalization will increase the efficiency of the allocation of financial resources and be beneficial for promoting financial development in developing countries. On the other hand, with respect to China, which is in the process of economic transition, financial globalization also

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means that the peripheral conditions and external environment of financial development are undergoing drastic changes, and it is an important and urgent task to carry out China’s financial reforms. The author believes that China should pay attention to the following four principles in its financial reforms: First, China must adhere to the concept of socialist market economy, which was a theoretical innovation with very rich contents proposed by Deng Xiaoping. The author ’s personal understanding of this concept is: On the one hand, we must fully exercise the basic role of the market in resource allocation, pursuing high efficiency and high cost-effectiveness in the course of economic development. Therefore, we should be brave enough to learn from the effective experience, practices, organization and management of the market economy accumulated over the centuries of its development in other places, and then adopt the market economy in China in consideration of our national circumstances. It is under the guidance of Deng Xiaoping Theory that the capital markets, joint-stock companies, venture capital, and the insurance industry were established in China, contributing to the flourishing development of the socialist market economy. On the other hand, we must uphold and continue to improve China’s socialist system, safeguard social fairness and justice, in particular, protect the legitimate rights and interests of vulnerable groups. These two aspects are complementary. If we just pursue efficiency at the expense of fairness, the widening gap between the rich and the poor may lead to social instability, and ultimately there will be no efficiency at all. If we are just concerned about fairness at the expense of efficiency, we can only achieve a low level of fairness, which is impossible to meet people’s growing material and cultural needs. During the process of financial reform, we must proceed actively to enhance efficiency. But from a regulatory point of view, attention must be paid to safeguarding social fairness and justice, such as protecting the legal interests of investors when the securities industry is concerned, depositors when the banking industry is concerned, and policyholders when the insurance industry is concerned. Many scholars in their academic research often focus on improving efficiency, but neglect issues of social fairness and justice. For example, there are more studies on the financing issues of the securities market, but less on issues of protecting the interests of investors. This situation should be changed. Second, we must respect the basic laws of market economy development. To develop a market economy, we must respect the basic laws of such an economy, including the laws of value, supply and demand, competition and others. Prices

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should closely follow value, consideration should be given to the interaction between supply and demand, and China’s financial competitiveness is to be enhanced and perfected through competition. The practice of a market economy has repeatedly shown that any breach of the objective laws of such an economy, such as price subsidies or restrictions, may in the long run affect economic sustainability, though short-term effectiveness is possible. Furthermore, if the government shields underdevelopment or restricts competition, it is difficult to optimize resource allocation. Third, the method of systems engineering should be used for management. According to the author’s research, economic activities can be categorized into two models: one being the real economy, and the other the fictitious economy. As far as the real economy is concerned, profits can be generated only after the form of the capital is changed. That means by way of exchange, capital is first transformed into production factors such as labor force, equipment, raw materials, plants, then through the production process into products. Through circulation, the products become commodities which, by way of exchange, are changed back into the form of currency. Only in that way are profits possible and that is the operating model of the real economy. Simply put, fictitious economy means to use money directly to make money. Through a variety of activities in various capital markets, capital may directly generate profits. From the point of view of systems engineering, firstly, the fictitious economic system itself is a whole entity; the securities, banking, insurance, futures and foreign exchange markets are closely related. Secondly, the fictitious economic system and the real economic system have a close relationship with each other. If the real economy is the hardware of the economy, then the fictitious economy is the software. They cannot run without each other. Considering the development of the socioeconomic activities so far, these two kinds of economic activity models are becoming increasingly closely related. Problems arising in the real economy, such as product backlog, become bad debts of banks when reflected in the fictitious economic system. Similarly, problems arising in the fictitious economy, such as stock market crashes, will also affect the real economy. Therefore, we must understand the concept of the system holistically and not just see only some financial activities. We must see the picture in its entirety, and even its interaction with the real economy. Fourth, we must pay attention to careful planning and move forward as a whole. China is in the transition of switching from the traditional planned economy to socialist market economy. Its reform and development are interdependent and progressive, from which we need to be positive and

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cautious. The first step taken in the reform will affect all others that follow. Like a game of chess, instead of thinking on each move every time, one must be ready for the next or even next few moves when making every decision. If the reforms fail and have to start over again, it will inevitably lead to a great loss. When reviewing the three ups and downs of the development of China’s money market, China has suffered considerable losses, particularly in its state-owned assets. Financial reforms require clear objectives, careful planning, good timing, seizure of opportunity, and appropriate progression. When the conditions for reforms are not ready, effective results cannot be achieved; however, when the time has come but no action is taken, the opportunity will vanish. Attention should also be paid to the “limitations” of reform. It is important not just to see the advantages of the reform measures, but also their disadvantages. Both positive and negative factors must be well considered in order to advance appropriately. A good deed when overdone will turn into something bad.

The Process and Achievements of China’s Financial Reforms Under the guidance of Deng Xiaoping Theory, China’s financial system reforms have been conducted with the main objective of building socialism with Chinese characteristics. After China implemented reform and opening up in 1979, the Agricultural Bank of China was quickly restored, and the Bank of China, China Construction Bank and Industrial and Commercial Bank of China were established one after the other. China began to issue treasury bills in 1981, set up the inter-bank market in 1984, establish the bill discounting market in 1985, issue large-denomination negotiable certificates of deposit in 1986, pioneer the issuing of corporate short-term financing bonds in 1987, create a secondary market for treasury bills in 1988, and establish a bond repurchase market in 1991. In the early 1990s, Shanghai and Shenzhen stock exchanges were established in succession, and the China Securities Regulatory Commission (CSRC) was set up. With the progress of reform and opening up, features of marketization of China’s financial system gradually increased. In 1992, the 14th National Congress of the Communist Party of China established the goal of building a socialist market economy. Under the guidance of this goal, China continued to deepen its financial reform, and a variety of joint-stock banks and city commercial banks were set up, forming a preliminary marketization framework for China’s financial systems.

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After 15 years of negotiations, China joined the WTO in 2002. To improve the efficiency of its financial system, China accelerated the pace of the reform of state-owned commercial banks, and also steadily pushed ahead with the reforms on the financial sector, including securities, futures, foreign exchange and insurance. The process of financial reform and development in the last two decades has really been a process of marketization of China’s financial system. After years of effort, a financial system framework that is suitable to market economy development has come into shape.

The Structure of the Central Bank System is Increasingly Sophisticated Before 1984, the People’s Bank of China not only exercised the functions of a central bank, but also provided deposit and loan services to enterprise units and individual residents. By 1993, its main functions had been changed to formulating and implementing monetary policies and maintaining the stability of the value of currency. It also implemented strict supervision over financial institutions to maintain the safe and effective operation of the financial system. The Law of the People’s Bank of China of the People’s Republic of China was passed in 1995, setting the legal base for the People’s Bank of China to act as the central bank. Since then the People’s Bank of China had issued a series of regulations relating to the formulation of monetary policies and risk supervision, which showed that the characteristics of marketization of China’s central bank system became increasingly prominent. In 1998, the People’s Bank of China launched open market operations in the inter-bank bond market, strengthening its functions of regulating the economy with the use of monetary policy tools, and formulating and implementing monetary policies. On April 28, 2003, the China Banking Regulatory Commission (CBRC) was officially established, exercising the banking regulatory functions originally performed by the People’s Bank of China. On December 27, 2003, the 6th Meeting of the 10th National People’s Congress Standing Committee passed the Banking Supervision Law of the People’s Republic of China , the Decisions of the National People’s Congress Standing Committee on the Amendment to the Law of the People’s Bank of China , and the Decisions of the National People’s Congress Standing Committee on the Amendment to the Commercial Banking Law , which clearly established the functions of the China Securities Regulatory Commission, giving it the legal base to supervise banking. At the same time, these laws and decisions re-positioned the functions of the People’s Bank of

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China, and strengthened the bank’s capacity relating to the formulation and implementation of monetary policies, so that the central bank system could be further improved.

The Commercial Banking System Has Been Basically Formed China has since the 1980s started to explore ways of switching from specialized banks to commercial banks. A number of new-type commercial banks and regional commercial banks had been successively established since 1986 to push forward the construction of marketization of the banking system of China. During that period, many central cities in China also gradually established urban credit cooperatives. The reform of financial institutions in rural areas also pushed ahead to a higher level. In 1994, three strategic banks, including the State Development Bank, were set up. In 1995, China promulgated the Law on Commercial Banks . In 1999, China established the four largest asset management companies to divest the non-performing loans of the four stateowned banks so as to preserve the state assets, reduce losses, and diversify risks of the banks. By the end of 2005, a commercial banking system had been formed comprising of the four major state-owned commercial banks, thirteen joint-stock commercial banks, one hundred and thirteen city commercial banks, twelve rural commercial banks, and fifty-eight rural cooperative banks. The external environment and internal management of commercial banks were also greatly improved.

Initial Establishment of the Securities and Futures Markets The stock markets in New China were established after the reform and opening up and under the guidance of the Deng Xiaoping Theory. Since the Shanghai Stock Exchange and Shenzhen Stock Exchange were established in December 1990 and June 1991 respectively and A shares started to be issued, the Renminbi special shares (B shares) and overseas listed foreign shares (e.g. H shares) also began to be issued in 1991 and 1993 respectively. The State Securities Commission and China Securities Regulatory Commission were established in October 1992, and the issuance of shares was expanded to the whole country, marking the official formation of a national securities market. By the end of December 2005, there were a total of 1,381 listed companies (among which 109 were B-share companies). The total market value was RMB3.24 trillion (among which RMB3.18 trillion were A shares, and RMB61.97 billion were B Shares). There were 122 H-share companies and 115 securities companies.

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The Securities Law of the People’s Republic of China (hereinafter the Securities Law ) was implemented on July 1, 1999, regulating China’s securities markets. From mid-May to early June 2001, the Standing Committee of the National People’s Congress set up the Law Enforcement Inspection Group to inspect the implementation of the Securities Law . Based on the problems found and recommendations made by the Law Enforcement Inspection Group, the China Securities Regulatory Commission and other law enforcement departments were to further strengthen the supervision and continuously push ahead the reform of the securities markets; meanwhile, the Standing Committee of the National People’s Congress was to amend the Securities Law . With the approval of the State Council, the China Securities Regulatory Commission promulgated the Notice of the China Securities Regulatory Commission on Piloting the Share-Trading Reform of Listed Companies on April 29, 2005, announcing the launch of the pilot scheme for the share-trading reform. On September 9, on the basis of experience gained in the pilot scheme, the share-trading reform was officially and comprehensively launched. The revised Securities Law was also adopted on October 27 2005 at the 18th Session of the Standing Committee of the 10th National People’s Congress and came into force on January 1, 2006. Since the establishment of China’s futures market in 1990, and its development can generally be divided into three stages. The first stage was the booming stage. From 1990 to 1995, China’s futures market developed rapidly. By 1995, its turnover exceeded RMB10 trillion, with a trading volume of RMB640 million lots. However, a number of serious problems arose due to the fact that many places were engaged in futures but the supervision and legal regulations were inadequate. The State Council therefore decided to make drastic rectifications. The second stage, from 1996 to 2000, was a stage of adjustment and rectification. During this period, as a result of adjustment and rectification, and the rapid development of the stock market, the futures market shrank drastically. By 2000, the futures market was at low ebb, with its turnover lowered to approximately RMB1.6 trillion, and a trading volume of 54 million lots. The third stage, which was from 2001 to the present, was a stage of recovery and development. In 2003, the turnover was RMB10.8 trillion, with a trading volume of 280 million lots. In 2004, the turnover was RMB14.7 trillion, with a trading volume of 320 million lots. We can see from this that China’s futures market has entered into another stage of rapid development. At present, there are three commodity exchanges in Shanghai, Dalian and Zhengzhou, and a total of twelve commodities are listed and traded, such as electrolytic copper,

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aluminum, rubber, fuel oil, soybeans, soybean meal, soybean oil, corn, wheat, cotton, and sugar, which are all industrial or agricultural products traded in bulk.

Continual Improvement of the Foreign Exchange Administration System Changes in the foreign exchange administration system in China can be mainly divided into three stages. From 1949 to1978, it was the stage of the centrally controlled system of income and expenditure in foreign exchange. From 1979 to 1993, it was the stage of foreign the exchange retention system. From 1994 onward, it was the stage of the banking exchange system. At the end of 1996, China had formally accepted the obligations of Article VIII of the International Monetary Fund’s Articles of Agreement to remove all exchange restrictions on current account so that the Renminbi was fully convertible on current accounts. On the basis of the market exchange rate, China formally established the current foreign exchange administration framework, in which “the Renminbi current account is convertible, while the foreign exchange of capital accounts is to be controlled,” thus creating a banking exchange system that was in line with international practice. To establish and improve China’s socialist market economy system, fully exercise the basic role of the market in resource allocation, and create a sound floating exchange rate system which was based on market supply and demand and well-managed, the People’s Bank of China announced on July 21, 2005 that, with the approval of the State Council, a managed floating exchange rate system which was based on market supply and demand and to be adjusted with reference to a basket of currencies was to be implemented with immediate effect. On July 23, the People’s Bank of China decided to adjust the Renminbi exchange rate administration at an appropriate level. After implementing this exchange rate system reform, the Renminbi exchange rate was no longer mainly pegged to the U.S. dollar, but rather to the currencies of major nations and regions which played a major role in China’s foreign trade and economic activities, such as foreign trade, external debts and foreign direct investment, and these were put together to create a basket of currencies with each component currency given an appropriate weighting in the “basket” to form a more flexible Renminbi exchange rate mechanism. Based on the market development conditions and the economic and financial situations, the People’s Bank of China would adjust the exchange rate floating range in a timely manner. Based on domestic and international economic and financial

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situations, market supply and demand, and with reference to the exchange rate changes in the basket of currencies, the People’s Bank of China was also responsible for the Renminbi exchange rate administration and adjustment, upholding the normal fluctuation of the Renminbi exchange rate, maintaining the basic stability of this rate at a reasonable and balanced level, pursuing the basic balance in the balance of payments (BOP), and safeguarding the stability of the macro-economy and financial market. This reform marks a great stride China made in the direction of its exchange rate system marketization.

Steady Development of the Insurance Industry China’s insurance industry has developed rapidly since the resumption of its business in 1979. Between 1994 and 2005, the average annual growth in premium income of China’s insurance industry reached 19.8% (in terms of comparable price). In 2005, the premium income was RMB492.73 billion, of which RMB122.99 million (25%) was from property insurance, RMB324.43 billion (66%) from life insurance, and RMB45.31 billion (9%) from health and accident insurance. By the end of 2005, the total assets of insurance companies were RMB1.52 trillion, with a total of ninety-three insurance companies throughout the nation, including six insurance groups and holding companies, thirty-five property insurance companies, forty-two life insurance companies, five reinsurance companies, and five insurance asset management companies. There were 1,800 professional insurance intermediaries, 120,000 sideline insurance agencies, and 1.47 million insurance salesmen. The premium income realized through intermediaries accounted for 73% of the total premium income.

Prospect for China’s Financial Reforms China’s financial reform is not only a gradual process, but also a process of continuous exploration and improvement. For over 20 years, China’s financial industry has always followed a principle of prudence, and carried out its reform and opening up according to its plan, step by step, level by level, and stage by stage. China’s accession to the WTO brought major changes to its economic and financial environment. Financial globalization will make China’s financial operation increasingly affected by changes in the international financial situation. This requires China to speed up its financial reform and improve the overall quality and competitiveness of its financial industry. In the process of internationalizing China’s financial industry, maintaining the stability of its financial system not only guarantees the needs of investment

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quantity and quality, but also the needs of sharing the benefits of international capital inflows under the situation of financial globalization, and the needs of strengthening ourselves to withstand the impact of the financial crises in other countries. China’s economy is now still in a transitional period, and it is particularly crucial to further push forward financial reforms, raise financial efficiency, and safeguard financial security in order to establish and improve the socialist market economy system. The author believes that against the background of financial globalization and in accordance with the requirements decided by the 3rd Plenary Session of the 16th National Congress of the Central Committee of the Communist Party of China, efforts should be made in the following aspects to promote China’s financial reform.

Persistently Advance the Reform of State-Owned Commercial Banks and Gradually Establish and Improve China’s Banking System Finance is the core of a modern economy and banking is the heart of finance. China’s banking system should include the four parts of the central bank, commercial banks, policy banks and credit cooperatives. (1) We should strengthen the core role of the People’s Bank of China in the financial system. The central bank is the main financial institution of a nation, and it is also the formulator and executor of national monetary policies. It should play the core role as a national bank, the issuing bank and the bank of banks. After the establishment of the China Banking Regulatory Commission, the People’s Bank of China, in its capacity as China’s central bank, not only continues to perform its functions, such as the issuance of money, foreign exchange administration, treasury management, payment and settlement, formulation of financial laws, survey and statistics, but also serves the two new functions of anti-money-laundering and the administration of the credit reporting industry. What is more important is to strengthen its functions relating to the formulation and execution of monetary policies and further raise its level of formulating and executing these policies. The People’s Bank of China should, in accordance with the national economic conditions and economic development objectives, independently formulate monetary policies, control the quantity of money supply and scale of credit, and make a flexible use of the various types of monetary policy tools, such as interest rates and foreign exchange rates, to implement macro-control, steadily push ahead with interest rate marketization, establish a sound interest rate formation mechanism which is determined by market supply and demand and a conduction mechanism of the monetary policy, and guide the money market through the three monetary

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policy tools of rediscount, open market operations, and the deposit reserve system. We should also pay attention to the prevention and resolution of systemic financial frauds, safeguarding national financial security. (2) We should push ahead the reform of state-owned commercial banks. Commercial banks are financial services enterprises with profit-making as their objectives. Their main roles are to act as financial intermediaries to improve economic efficiency, assist enterprises to operate to promote economic development, optimize capital allocation to reduce financial risks, and transmit monetary policies to support macro-control. According to their scope of services, commercial banks can be divided into national, regional and community levels. All commercial banks should follow the requirements decided at the 3rd Plenary Session of the 16th National Congress of the Central Committee of the Communist Party of China, strive to transform themselves into modern financial enterprises with adequate capital, strict internal control, safe operations, sound service and high efficiency. On the basis of exploration and practice, a reform “road-map” of China’s four major state-owned commercial banks has been worked out, which is to “implement the joint-stock system transformation, bring in strategic investors, speed up the handling of non-performing assets, replenish the capital, improve corporate governance, and create the conditions for listing.” Although this “road-map” needs to be adjusted and refined when put into practice, the general direction of reform should be adhered to so as to improve the international competitiveness of China’s commercial banks as quickly as possible, striving to put them in an unassailable position when we completely open up our banking industry to the outside at the end of 2006. Joint-stock commercial banks and city commercial banks should also refer to this “road-map” to improve their legal person corporate governance system, strengthen their internal administration, and be listed for financing if conditions are met. National commercial banks should be strong in capital, have a good legal person corporate governance system and strict internal administration. At present, only the four major state-owned commercial banks, some joint-stock commercial banks and very few city commercial banks meet these requirements. Currently some city commercial banks and rural commercial banks hope to expand their scope of services, and this should be carefully handled. We suggest that the China Banking Regulatory Commission work out the requirements for allowing commercial banks to conduct national-wide business operations, and encourage commercial banks to become bigger and stronger through mergers and restructuring. A vast majority of city commercial banks and rural

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commercial banks should become regional commercial banks, mainly to operate within their local cities or provinces. (3) We should have pilot points to steadily develop community banks. Community banks are small financial institutions established in accordance with the laws and the common interests and demands of the economic subjects within the community (mainly the community residents and small economic organizations). With profits as their objective, they operate independently in accordance with the operating rules of the market economy to provide financial services to the community residents and economic organizations mainly on the basis of local economic activities, and bear the responsibility of community development. As community banks mainly serve the community, though they are small in the scale of their assets (RMB500–1000 million), they have a better understanding of the community’s situation, can better control risks, and the discredit cost of their borrowers is higher. Moreover, as their historical burden is light, they can adopt a more flexible mechanism. As far as we know, there are more than 6,000 community banks in the U.S., with an average asset size of USD110 million, and their deposit business accounted for about 20% of the total amount in the market. We suggest starting to establish pilot community banks in China as soon as possible and proceed steadily on the basis of the experience gained. Following the spirit of “encouraging social capital to participate in the reorganization and restructuring of medium- and small-sized financial institutions and steadily developing financial enterprises of all kinds of ownership under the preconditions of strengthening supervision and maintaining adequate capital,” city commercial banks should allow the participation of private capital, and community banks can even consider having mainly private capital. (4) We should deepen the reform of policy banks. The three policy banks of the China Development Bank, the Export-Import Bank of China and the Agricultural Development Bank of China should follow the direction of further performing their functions to deepen their reform and enhance their capacity for supporting macro-control and promoting economic development. They should, on the one hand, strengthen their internal administration to prevent various kinds of risks, and on the other, study the functions and tools of policy finance to prevent excessive commercialization. (5) We should continue to push ahead with the reform of rural credit cooperatives (RCCs). At the end of 2005, there were still 607 urban credit cooperatives and over 27,000 RCCs in China, many of which, however, had

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already lost their “cooperative” nature. Due also to the absence of owners, their unsound system, poor administration, and policies not being in place, a large number of non-performing loans and non-paying accounts were existent throughout their history. In view of these issues, a reform of RCCs began in 2003, and the state supported the reform with appropriate policies. Based on the experience gained through pilot points, RCCs were gradually transformed into local financial enterprises serving the rural community, with their property rights structure in three different forms: joint-stock system, jointstock cooperative system, and cooperative system. However, as the problems are numerous and deeply entrenched, it will take a long time to complete the reform and improve the rural financial service system.

Develop Multi-Type and Multi-Level Financial Markets and Expand Direct Investment Channels At the end of January 2005, the balance of the saving deposits of urban and rural residents in China exceeded RMB12 trillion, at the end of May, it exceeded RMB13 trillion, and at the end of December, the balance of various Renminbi deposits was RMB28.72 trillion, of which the saving deposits of urban and rural residents reached RMB14.11 trillion. A major cause for the rapid growth in savings was the narrow channels of direct investment in China. The market value of China’s stock markets was only about 20% of their GDP. There were numerous non-tradable shares and the balance of bonds was only about 30% of their GDP, far below the world average. The futures market only had commodity futures with very few varieties. The money market, the foreign exchange market and the insurance market were all undeveloped. For this reason, we need to develop multi-type and multi-level financial markets and establish among them a mechanism that is organically integrated and collaborative to their development so as to suit the preferences of different investors and broaden the channels of direct investment. (1) We should push ahead the share-trading reform to improve the quality of listed companies. The share-trading reform is now pushing ahead smoothly. As of January 9, 2006, 434 listed companies in the Shanghai and Shenzhen stock markets have completed or entered into the process of reform, accounting for 32% of the 1,350 A-share listed companies that should be reformed, representing 37% of the total market value. It is expected that this reform can be completed roughly by the end of 2006. The stock market is a system with a dissipative structure. Its relative stability can be maintained only if there is an exchange of capital and information with

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the outside world. The entry of the social security and insurance funds into the market, the implementation of QFII and the entry of strategic investors will certainly give new impetus to the development of China’s stock market. However, the fundamental solution for the stock market is to raise the quality of listed companies. According to the author’s analysis of the companies currently listed in China, only about 400 companies (about 30%) have a higher investment value and can provide reasonable returns to investors; the remaining listed companies have a rather low investment value, and nearly 300 companies (about 20%) basically have no investment value. For example, according to the reports submitted by the 1,353 listed companies still trading on the Shanghai and Shenzhen stock exchanges in the third quarter of 2005, 36 companies have net assets of less than zero, 62 companies have net assets after adjustment less than zero, and 235 companies have a net profit of less than zero, accounting for 2.66%, 4.58% and 17.37% respectively. Because of this, efforts should be made to improve the governance system of listed companies, strengthen their internal administration, raise their profitability, and, at the same time, establish and improve the delisting system through ways such as delisting, agreements, acquisitions and mergers to force the exit of listed companies with no investment value from the stock market, and allow the listing of companies with a higher investment value to gradually become the “blue chip” shares of the stock market. We also need to establish the short-mechanism and allow deals on credit, margin trading, and long and short positions. In addition, we should steadily push ahead the establishment of the financial derivatives market, starting firstly with stock index futures. (2) We should vigorously develop the bond market, regulate and expand the issuance of corporate bonds. China’s bond market is currently divided into bonds trading in the inter-bank bond market and bonds listed on exchanges, the former being much larger in scale than the latter. In 2004, the accumulated bonds issued in the inter-bank bond market amounted to RMB2.65 trillion (including national debt RMB441.39 billion, central bank bills RMB1.70 trillion, policy financial bonds RMB434.8 billion, and commercial banks’ subordinated debentures RMB74.88 billion), and the accumulated turnover was RMB13.3 trillion (RMB2.5 trillion being spot trading, and RMB9.3 trillion being bond repurchase). At the end of 2004, the total amount of bonds in the inter-bank bond market was RMB4.6 trillion, while the market value of national debt trading in exchange was only RMB438.84 billion, and the outstanding national debt for repurchase amounted to RMB108.17 billion. Corporate bonds are one of the main financing tools of enterprises, with an issuance cost usually lower than that of shares. China’s corporate bond market

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is currently underdeveloped. In recent years the annual issuance of these bonds has been lower than the amount approved by the National Development and Reform Commission, with only RMB32.7 billion being issued in 2004. From now on, China should further regulate corporate bonds with respect of their issuance, interest payment and redemption systems, and expand the quantity of the issuance of corporate bonds. The issuance of corporate bonds should use the assets and future earnings of the enterprise as its guarantee, and be approved by CSRC. The interest of corporate bonds can be determined in accordance with the enterprise’s reputation and within a certain upper and lower range of the benchmark interest rate, and should be paid annually and regularly. Enterprises should establish sinking funds, which should have a small premium each year for random redemption of a certain percentage (usually 3% to 5%) of its bonds. CSRC should designate a trustee for each corporate bond and on behalf of the purchasers, the trustee would monitor the enterprise to pay their debts and take legal actions when necessary. In recent years, some individual enterprises in China have issued a small amount of convertible bonds, and their experience should be noted and used to gradually expand the issuance of these bonds. (3) We should have a rolling issuance of short-term government bonds. At present, China’s government bonds are all mid-term and long-term fixed rate treasury bills, which are poor in liquidity and in luring short-term idle money. At the 40th Meeting of the Chairperson and Vice-chairpersons of the 10th National People’s Congress Standing Committee held on December 16, 2005, the views of the Budgetary Affairs Commission of the National People’s Congress Standing Committee on the implementation of the administration of the balance of government bonds were adopted. This means that starting from 2006, China will follow standard international practices in handling the balance of government bonds to manage the activities of issuing government bonds so as to scientifically administer the scale of government bonds to effectively guard against financial risks. The switch from total amount administration of government bonds to balance administration will help improve the term structure of China’s government bonds, creating the conditions for the rolling issuance of short-term government bonds. The author proposed in 1999 to issue three-month and sixmonth short-term treasury bills and calculate the interest through the discount method. The central bank can use its open market transaction counters to wholesale the bills to large financial institutions by auction on a periodic rolling basis. Since the actual practice is to periodically pay old debts with new debts, it can achieve the effect of reflecting the dynamic market and adjusting the market supply and demand in a timely way. Through competitive bidding, the market can have a weighted average execution price, which is the interest rate of the

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short-term treasury bills. This kind of widely accepted risk-free interest rate can be used as the benchmark interest rate of the financial market, and this is helpful to the realization of regulating the financial market.

Adjust the Exchange Rate System in a Timely Manner and Gradually Realize the Free Convertibility of the Renminbi With the improvement of China’s economic strength and the growth of international trade, and for the purpose of adapting to the development of economic and financial globalization, we should take the realization of the free convertibility of the Renminbi as the ultimate goal of China’s exchange rate system reform. On December 1, 1996, China implemented Renminbi current account convertibility as required by Article VIII of the Agreement of the International Monetary Fund . This was a major breakthrough in the reform of the exchange administration system. In the future, under the preconditions of effective risk prevention, China needs to selectively and step by step relax restrictions on cross-border capital trading activities, and gradually realize the convertibility of Renminbi capital accounts. To achieve this goal, we must study this thoroughly and move ahead gradually based on the situation and power of the nation. As China is undergoing the reform of its financial system and foreign trade system, the conditions for the implementation of capital account convertibility are not mature. At present, we still need to continuously improve the Renminbi exchange rate formation mechanism, and keep the exchange rate of Renminbi fundamentally stable at a reasonable and balanced level. As pointed out by the author in 1999, China has for a long time basically practiced single pegging to the U.S. dollar with a linked exchange rate system, which has been helpful in stabilizing and developing China’s foreign trade, particularly when the performance of the U.S. economy was good, and keeping the Renminbi strong. However, the disadvantage of this exchange rate system was that it would narrow the scope for the central bank to conduct macrocontrol, increase its control costs, and cause the strength of the Renminbi to be over-reliant on the economic performance of the U.S. We suggest changing China’s exchange rate system in a timely manner to a weighted linked exchange rate system pegging to U.S. dollar, euro and Japanese yen, with their weights adjusted according to the economic performance of the U.S., Europe and Japan, and ultimately make the Renminbi freely convertible. The idea could be called a “three-step” strategy to adjust the Renminbi exchange rate system. At that time, the author proposed to consider the order of opening up as

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below: we should (1) relax controls on capital account transactions arising from trading of commodities and services, such as trade credit loans, assets transferred back by non-residents, returns from investment and employment subsidies from domestic enterprises; (2) relax controls on direct investments by first relaxing capital inflows, then capital outflows; (3) ease gradually restrictions on short-term capital flows; (4) for credit loan administration, relax controls on credit loan transactions between state-owned financial institutions and non-residents, and then gradually allow non-financial institutions to have access to international financial markets; (5) for the capital markets, first relax the bond market, then the stock market, i.e. the merging of A and B shares, but with non-residents are required to report the amount of shares they buy; (6) for the money market, restrict local and foreign currency transactions among residents and guide non-residents to buy government bonds; (7) expand the transaction subjects of the foreign exchange market from designated banks to large enterprises, and then from residents to non-residents, but with restrictions on transaction varieties. After years of effort, China’s exchange rate system reform has made considerable progress. There has been a slight appreciation of the Renminbi since the implementation of the “reference to a basket” system on July 21, 2005. The author believes that if the weighted linked exchange rate system is to function better, it is necessary to adjust China’s current currency settlement structure of its foreign trade, foreign investment and foreign debts, change the current situation of excessive weight of the U.S. dollar and reasonably settle on the currency types and their corresponding weights within the “basket.” It should implement “a managed floating exchange-rate mechanism in the style of the exchange-rate target zone administration” and set up an “exchangerate target zone” that has “both the soft and hard power,” considerable size and is readily adjustable. When the market exchange rate reaches the upper or lower boundary of the target zone, the central bank can buy or sell the foreign exchange of the relevant foreign currency through the open market to affect its exchange rate against the Renminbi, thus affecting the amount of money supply. We should pay serious attention to the above-normal growth of China’s foreign exchange reserves in recent years, and adopt the policy of “strictly controlling imports and slightly relaxing exports.” We have to, on the one hand, prevent the inflow of a large amount of unregulated foreign capital, which brings the pressure to appreciate Renminbi and weakens the state control over its monetary base. For this reason, we have to strengthen the verification and supervision of imports and exports to prevent using capital accounts for the collection, payment and settlement of foreign exchange, and use the issuance

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letter of credit for financing. At the same time, we should also strengthen the administration of joint-venture contracts, and strictly forbid the implementation of a fixed rate of returns and a fixed exchange rate on foreign partners or cash their property rights in advance. In addition, we should also pay attention to the control of a variety of hidden foreign debts, and in particular, prevent Chinese organizations from investing in China in the form of foreign capital after raising debts in a foreign country. We should, on the other hand, properly relax the outflow of foreign exchange, further relax the foreign exchange quota held by enterprises, and eventually abolish the mandatory system of foreign exchange settlement and sales. We should further relax the limited number of foreign exchange banks, and eventually remove the administration of the position of foreign exchange of foreign exchange banks. We should gradually relax restrictions on capital outflow to encourage enterprises to make direct investment overseas. We should also relax the investment in overseas financial markets by domestic legal person and natural person. In recent years, capital accounts in China have gradually opened up, and nearly half of about 60 secondary capital accounts have basically done so. The general principle should be that accounts will be opened up only when things can be kept under control. The steps and schedule of opening up the remaining secondary capital accounts have to be determined according to changes in the international financial situation and the administrative capabilities of related departments in China .

Enhance a Comprehensive Supervision of the Financial Industry and Strengthen International Cooperation The supervision of the financial industry is an organic unification of internal and external constraints. First, we have to strengthen the internal constraints on the financial industry, improve the internal monitoring mechanism of financial institutions, and conduct the development of self-discipline in the financial industry. Second, we must strengthen the external constraints on the financial industry, strengthen the enactment of laws and regulations, improve financial legislation, and establish a mechanism of risk warning and crisis management. We have to enhance international cooperation, pay close attention to the development trends of the international financial system, and actively participate in the formulation of the rules and regulations of international finance and the regional monetary and financial cooperation. We have to adopt proper strategies to minimize the impact of external fluctuations on the domestic economy.

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(1) We should establish the goals of financial supervision. The goals should be to safeguard the openness, fairness and equity of the financial market, to encourage and protect legitimate and orderly competition, to effectively guard against and resolve financial risks, and to protect the legitimate interests of depositors, investors and policyholders. China is now in the transition from the traditional planned economy to a socialist market economy. The government is both the creator and supervisor of the market and also the owner of stateowned enterprises, and when the two come into conflict, it often affects the impartiality and efficiency of supervision. To this end, the government should encourage state-owned enterprises to adopt such measures as developing systems, enhancing administration, improving technologies, and becoming market-oriented, to effectively improve their operational performance, and to maintain and add value to state assets. We have to strictly prevent state-owned enterprises from violating the regulations and engaging in stock and futures speculations, or obtaining mortgage loans from banks after virtually increasing their assets through related transactions, or even relending their loans to other enterprises at high interest rates, thus causing damage to market impartiality and increasing financial risks. (2) We should begin our supervision with information disclosure. We should begin the supervision of financial systems with information disclosure, then proceed to information analysis, announcement, and handling. Supervisory organizations should clearly regulate the scope, targets, depth and frequency of information disclosure, and publicize them. Under the principle of equal rights to information, all information relating to the market that should be disclosed should be able to be freely searched and looked up in the relevant media or network. Units disclosing the information should be responsible for the completeness, authenticity and timeliness of the information, and accept the supervision of the regulatory departments, self-disciplinary bodies of the industry and the public. On the basis of information disclosure, professionals can then analyze the information. Through analysis, we can ascertain the current situation and future trend of various financial market instruments to provide reference to market players, and find contradictory or false information and provide it to supervisory departments to trace the clues. When the supervisory departments discover something suspicious, they should, after analysis and verification, identify the nature and severity of the situation in a timely manner, settle on punishments (such as issuance of warnings, reprimanding, suspending business, and disqualification), and quickly announce it to minimize losses as much as possible. When the case is not serious, self-regulatory bodies such

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as unions of industries can execute the penalty. In addition, we should also establish a common litigation system to allow victims to claim compensation from those responsible through legal actions. Supervisory organizations should improve their mechanism of monitoring, early warning and handling financial risks, enhance informatization, establish and improve a unified, efficient and secure payment and settlement system and a widely-covered, effective real-time monitoring system. We should also handle properly the relationship between strengthening financial supervision and supporting financial innovation, and encourage the exploration of innovation of financial systems and financial products. (3) We should steadily promote mixed operation. The development of financial mixed operation has been rapid since the 1990s. After the stipulation of the GS Act on separate operation in the 1930s in the U.S., mixed operations began to emerge in the 1980s, and some European countries and Japan have also gradually embarked on the road of mixed operation. Mixed operation, which is the major trend in the global financial industry, has two common models in these countries: financial holding companies and universal banking. The author believes that mixed operation helps the flow and reasonable use of capital, developing synergy between various kinds of financial institutions and the market, and conducting a systematic monitoring on financial system risks. It should therefore become an ultimate goal of financial reform in China. But under present conditions, China still does not have all the conditions to practice mixed operation. Therefore, we should first establish a sound coordination mechanism between supervisory organizations such as banks, securities and insurance, the central bank and the Ministry of Finance, raise the level of financial supervision, actively develop pilot financial holding companies and universal banks, and steadily promote mixed operation. (4) We should strengthen international financial cooperation. The focus of international financial cooperation is to strengthen the monitoring of the flow of international speculative capital. Rampant international speculative capital is one of the direct causes of financial crises. At present, the total daily trading volume of international financial markets reached USD15 trillion, of which USD7.2 trillion are speculative capital (hot money). Financial speculators are always watching to which way the wind blows, creating disturbances and chasing after high profits. Therefore, foreign economists who advocated financial liberalization began to think that it is necessary to carry out proper monitoring and control of this situation. To adapt to the needs of the gradual opening-up of China’s capital market, we need to study how to monitor the large amount of trading in foreign exchange and shares (especially futures

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trading) through setting up a declaration system, the large amount of capital inflows and outflows through a report and notification system, and the huge amount of financial derivatives trading by real-name transactions with a higher deposit. In addition, we should also strengthen the exchange of information and capital financing among the central banks of various countries to deal with temporary liquidity crises, and put restrictions on investing some weaker aspects that international speculative capital may easily take advantage of. Since the decline of the economic strength of the U.S. in the early 1970s and the increase in the disparities of inflation rates of major industrial countries, which resulted in the collapse of the Bretton Woods System built up after World War II, there has been a co-existence of floating exchange rates and pegged exchange rates and a lack of a stable international monetary system. The author believes that within the next five to ten years, with the maturity of the euro, the recovery of the Japanese economy, and the rapid economic development of Asian countries, the dominant position of the U.S. dollar as the main settlement currency will certainly be challenged. When we further take into consideration the trend of regional financial integration, China should work together with other countries to establish a stable, balanced and fair world currency system, as this will not only help prevent a financial crisis from happening, but also develop world multi-polarization. Financial globalization has now brought about a profound impact on such aspects as the global economy, politics and social life, and will provide a rare opportunity for China’s modernization. To achieve this, we should carefully design strategies for China’s financial reform so that we can draw on advantages and avoid disadvantages as much as possible. The author firmly believes that by eliminating the financial institutional obstacles in China at macro level, strengthening the internal administration of financial enterprises and speeding up financial innovation at micro level, the reform of China’s financial industry will certainly achieve remarkable results.

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Chapter

Development Plans under the Chinese Socialist Market Economic System

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Foreword After the founding of New China, our country had mainly followed the central planning system of the Soviet Union to administer the national economy. The National Planning Commission was responsible for establishing the indicators of the five-year and yearly plans, and using administrative measures to allocate various kinds of resources to departments, local governments, and enterprises. The general procedures of planning were firstly the State Planning Commission making known to local governments and departments the controlled figures of the plan, then the local governments and departments making these figures known to various basic units. Based on these figures, the various basic units would submit their draft plans, which would then be collected and balanced by local governments and departments and submitted to the State Planning Commission. The State Planning Commission would attempt to balance nationwide interests and make coordinated arrangements to draft the plan, which would be submitted to the State Council for examination and approval. After that, the plan would be submitted to the National People’s Congress for approval. When approved, the plan would be made known to various basic units for execution. The advantage of this kind of centrally planned economic system is that the country can harness the strength of the entire country to accomplish great projects, such as the relatively rapid and successful development of the “two bombs and one satellite” (atomic bombs, missiles and satellites). But the shortcoming of this system is the over-concentration of the decision-making power. As it is difficult for the decision-makers to get the information they need for making decisions in a timely, comprehensive and accurate way, this will inevitably lead to poor decisions, low efficiency and high costs, and it will be difficult to make rapid adjustments when the situation changes. After reform and opening up, Deng Xiaoping summed up in detail the experience and lessons in the economic development since the founding of New China, learned from the achievements of contemporary civilization, and followed the theoretical boldness of Marxism, to put forward the innovative idea of practicing market economy under the socialist system. As early as 1979, he had said, “To say that the market economy exists only in the capitalist society and that there is only the capitalist market economy is certainly not true. Why can’t socialism carry out market economy which cannot be said to be capitalism?” Since then, he made this point repeatedly, which gradually dispelled some people’s doubts about the development of market economy under China’s socialist system. Under the guidance of Deng Xiaoping Theory,

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China began to introduce market mechanism to its planned economy, and the market has played an increasingly important role in resource allocation. In the years between 1978 and 1983, with planned economy as the basis supplemented by market adjustment, China carried out an initial reform of the planned system. In the years between 1984 and 1988, China was engaged itself mainly in the establishment of a planned system which consciously applies the law of value, and the development of socialist commodity economy. In the years between 1989 and 1993, China further deepened the planned system reform, significantly reducing mandatory plans so that guidance plans became the dominant form of plans. In his “Speeches in South China” of early 1992, Deng Xiaoping clearly pointed out that “planned economy is not the same as socialism, and capitalism is also planned; market economy is not the same as capitalism, and socialism also has a market. Plans and the market are both economic means.” Based on a series of expositions by Deng Xiaoping, the 14th National Congress of the Communist Party of China held in 1992 passed to establish the lofty target of building a socialist market economic system. In 1993, the 3rd Plenary Session of the 14th National Congress of the Communist Party of China passed the Decisions of the Central Committee of the Communist Party of China on the Establishment of a Socialist Market Economic System to establish a new type of planned system so that the formulation of national economic development plans would gradually adapt to the needs of the establishment of socialist market economic system. In 2003, the 3rd Plenary Session of the 16th National Congress of the Communist Party of China passed the Central Committee of the Communist Party of China’s Decisions on Issues Relating to the Improvement of the Socialist Market Economic System , which pointed out that China needed to “exercise to a greater extent the basic role of the market in resource allocation, enhance the vitality and competitiveness of enterprises, improve the national macro-control, improve the functions of the government in social administration and public services, and provide strong institutional protection for building a moderately prosperous society comprehensively.” Practice over a decade shows that it is entirely possible and extremely necessary to boldly draw lessons from advanced operation styles and management methods such as the joint-stock system and the stock market that reflect production rules of modern society. But we should also clearly see that to develop the market economy in China, which is the largest developing country practising the socialist system, is indeed an unprecedentedly great exploration, and long-term and arduous efforts are still needed. China not only needs to seriously study and learn from the experience and lessons of the development

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of foreign market economy over past several hundred years, but also needs to seriously consider exploring a development path in line with the state of China. In this chapter, the author attempts to use the principles of development economics, econometrics, complexity science and management science, with reference to foreign experience, to explore several important issues of planning under the socialist market economic system according to the specific situation in China. The plans referred to in this chapter are mainly the development plans in a narrow sense relating to social and economic development and excluding the development of politics, morality, and national defense.

The Role of Planning in the Socialist Market Economic System The initiation of the concept of the socialist market economy is of great theoretical innovation, and its essence can be simply summarized as “to raise efficiency through the market economy means and to safeguard impartiality through the socialist system.” That is, on the one hand, to make use of the basic role of the market in resource allocation to raise economic development efficiency and outputs per unit of time and input, and, on the other hand, to adhere persistently to the socialist system so as to safeguard social fairness and justice, particularly safeguarding the legitimate rights and interests of disadvantaged groups. These two aims are complementary. If we only pursue the efficiency of economic development and neglect social impartiality, the gap between the rich and the poor will be widened, which will inevitably affect the stability of social development, eventually leading to the stagnation or even collapse of economic development. If we only emphasize the protection of social justice and do not make efforts to raise economic development efficiency, it would then be difficult to meet people’s growing material and cultural needs, and to have the economic strength necessary to safeguard social impartiality. The most effective economic system is one that should be able to get the best effect in economic activities under certain socio- economic environment. The effect in economic activities mentioned hereinbefore is in a broad sense, including aspects such as economic growth, strengthening of national power, full employment, balanced balance of payments, stable price levels, social justice, personal freedom, and political and spiritual civilization. The priority of these aspects is often subject to the influence of ideology and to a certain extent is determined by the values ​​of the top decision makers. The so-called socio-economic environment includes such aspects as the existing social and political systems, cultural traditions, the size and

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geographical location of a country, population and resource reserves, the development level, and the influence of other countries, which must be taken into consideration when choosing an economic system. Although many countries have now chosen the market economic system, the economic system of each country has its own characteristics. The socialist market economic system in China, therefore, must adapt to its own socio-economic environment. After the 14th National Congress of the Communist Party of China and with over ten years of practice, China has made significant achievements and accumulated rich experience in building a socialist market economic system. But we should also clearly understand that the process from proposing the socialist market economy concept to the establishment of a relatively ideal socialist market economic system and the process of shifting the traditional planned economic system to a socialist market economic system are long, complex, arduous and sometimes even painful. Despite the fact that we have adopted many reforms to our planned economic system, such as renaming the State Planning Commission to the Development Planning Commission in 1998 and the Development and Reform Commission in 2003, further reforms and improvement are still required to meet the needs of the development of the socialist market economy. From the complexity science perspective, enterprises are the most important agents of the market. Enterprises are both producers and buyers, tens of thousands of which autonomously operate, independently make decisions and actively work in the market, promoting the development of economy through their self-organizing functions. We can therefore say that without the free enterprise system, there would not be market economy. But this kind of freedom is relative but not absolute because the decisions made by every enterprise are inevitably affected by the constraints of other enterprises and the influence of external environment. The random movement of tens of thousands of enterprises at the micro level can push the economy towards a certain direction of development at the macro level. The role of the government in the market is to act as hetero-organization, which influences the behavior of enterprises through changing the external environment so as to change the direction of self-organization in the market system. Then the invisible hand of the market and the visible hand of the government mutually promote and guide the development of economy. Generally speaking, the plans formulated by the government reflects its prediction of the national development prospects under a specific objective environment, and its wishes and intentions, but how much the plans can be realized and how effective they can be implemented are largely determined by market forces. When formulating plans, therefore, we should pay attention

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to the information symmetry between the government and the market and try as much as possible to achieve coordination and cooperation between them. Among current market economy countries, how much the government put emphasis on plans and what effects the plans can bring are not the same. By the balance of power between the government’s visible hand and the market’s invisible hand over promoting economic development, market economy countries can be divided into three types. The first type is the government-regulated model, adopted by countries such as the U.S. and UK. Its basic characteristic is that the government allows as much as possible the invisible hand of the market to work. The resource allocation is basically carried out by the market, and the government is mainly responsible for regulating and administrating the market and areas where the market mechanism is difficult to play its role. The major characteristics of this model include safeguarding the operation of market economy through comprehensive legal system, and fully encouraging free competition under the preconditions of having a sound market mechanism and implementing necessary and strict legal regulations on enterprises. Decision-making in economy is highly decentralized. The government does not set up any planning department or develop any national plans or systematic industrial policies, but sometimes the leader of the state or government promotes ideas about the direction of economic development through speeches and reports and affects the decisions of enterprises and individuals through national budgets. The government also on occasion formulate specific plans to solve key issues substantially affecting overall socio-economic development. The second type is the government-guided model, adopted by countries such as France and Germany. Its basic characteristics include the coexistence of free competition and government control, the cooperation of economic leverage and government guidance, and the emphasis on both economic growth and social welfare. The main characteristics of this type include setting up an economic planning department by the government (such as le Commissariat général du Plan in France and the Financial Planning Committee in Germany), making mediumterm guiding plans, and indicating clearly the direction of economic development in order to influence the decisions of enterprises and individuals. Medium-term plans can be adjusted constantly according to changes in economic condition and implemented through annual financial budgets. The government of this model also guides the adjustment of departments, regions and technological structures through industrial policies. The third type is the government-led model, adopted by countries such as Japan, South Korea, and Singapore. Its basic characteristic is that while the market plays the fundamental role of resource allocation, the government maintains

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its strong and powerful intervention and guidance in economic activities. The main characteristics of this type include setting up a planning department by the government (such as the Economic Planning Agency of Japan, the Institute of Finance and Economy of South Korea, and the Economic Development Board of Singapore) to identify the development goals by drawing long-term plans, to show the intention of the government, and to guide the decisions of enterprises and to lead enterprises to develop in a designated direction through plans and industrial policies. The government not only uses strict regulations to compel companies to abide by market rules, but also sets up profit mechanism to induce their behavior, and exploit its close relations with the enterprises to carry out administrative guidance, so that the operation and development of enterprises are under government guidance. China is currently undergoing the transition from the traditional planned economy to the socialist market economy. Since the old system still remains while the new system has not been fully established, the functions of the government are changing and the long-standing situation of “strong government, weak enterprises” still exists. We should therefore recognize that plans are still important for quite a long time, but should also study ways of improving the formulation and administration of plans carefully. The author believes that plans under China’s socialist market economic system should include such plans as social and economic development plans (hereinafter “development plans” for short), which can be divided into four types: long-term, medium-term, specific and annual plans, the main contents and functions of which are as follows:

Long-Term Plans This type of plans mainly includes long-term development goals and major measures generally for ten to twenty years. These plans should be in outline, not detailed, and can be called the National Development Outline . Their major function is to confirm the long-term development direction and goals of the country and propose significant measures that should be taken in order to unify people’s understanding, to contribute to social solidarity, to encourage enterprises and individuals to set their long-term goals and to make efforts to realize them. Longterm plans should on the one hand be of high authority and should not be changed because of the replacement of the government or leader, as they are the basis for formulating other plans. On the other hand, they should have a certain level of flexibility to allow necessary changes through legal procedures according to the changes in objective situations.

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Basically China did not draw up any long-term plans, except the Ten-Year Planning for the National Social and Economic Development Plan formulated in conjunction with the 8th Five-Year Plan in 1991 and the Outline of the Goals of Prospects of 2010 formulated in conjunction with the 9th Five-Year Plan in 1996. In November 2002, the four goals for building a moderately prosperous society in 2020 has been proposed in the report of the 16th National Congress of the Communist Party of China, in which the principles and important measures of various aspects has also been mentioned. These form a framework for a 20year long-term plan, but the party is still waiting to turn its suggestions through legal procedures into a long-term plan representing the country’s will and becoming the basis for making other types of plans.

Medium-Term Plans This type of plans mainly includes the medium-term development objectives of various major aspects of socio-economic development. The author suggests calling them “national development plans,” which are the plans generally for five to seven years. China has the tradition of drawing up five-year plans, and now ten five-year plans have been made, but the 8th and 10th Five-Year Plans have been renamed as “Outline Plans.” Medium-term plans should offer guidance which influences the behavior of enterprises and individuals through scientific prediction, clear objectives, government policies and allocation of public goods, guiding them to act in the direction determined by the plans. These plans should, on the one hand, be scientific so as to predict future situations accurately as possible; on the other, they should also be strategic, setting the priority for various objectives within the plan period.

Special Plans Special plans are mainly plans which are formulated specially for important issues and key areas involving the whole nation, such as national defense, education, science and technology, transportation, resource development, and cultural construction, generally for five to ten years, and they are usually formulated and implemented under the sponsorship of the government. The plans not only include the expected goals, but also the major measures used to achieve these goals, methods of implementation and progress schedules. Their functions are mainly to put together the resources to deal with the key issues in the socio-economic development that have a significant impact on the entire nation, and to eliminate the weak links that hinder socio-economic development.

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Annual Plans Annual plans mainly include annual goals relating to various aspects of socioeconomic development, including quantity indicators such as production, income, consumption, employment, investment and import and export. It has also been our tradition to draw up annual plans that every year those in charge of the planning department have to report to the National People’s Congress how much of the plan of the previous year has been completed and the plan for the year. But with the development of China’s socialist market economic system, annual plans have been gradually transformed into plans of forecast and guidance, and their role continues to diminish. According to the experience of some market economy countries, annual plans would most likely be dropped at last. Some anticipation would be mentioned in the reports of the heads of the government to the Congress, and annual budgets would be used to materialize the key areas in the work of the government. Based on the above analysis and the specific situation in China, this chapter attempts to focus on exploring the technologies of formulating national development plans (mid-term plans) and specific plans. These technologies can also be used by regions and departments as a reference when they prepare their plans.

The Methods and Key Techniques for Formulating Development Plans In keeping with the tradition of medium-term planning, our country regards it appropriate to have the time span of five years for national development plans. As the term of office of members of the ruling party, the People’s Congress and government is five years, while the time for changing the term of office, usually occurs at the beginning of the third year of implementing the five-year plans drawn up by the previous government, it becomes even more important to maintain the continuity of the plans. During the process of developing and improving China’s socialist market economic system, the contents and functions of the national development plans have been gradually changing, and becoming more strategic, macroscopic, guiding, and policy-oriented. As pointed out in the Outline of the 10th FiveYear Plan for National Economic and Social Development of the People’s Republic of China passed at the 4th National People’s Congress held in March 2001, this Outline mainly explicates the national strategic aims, clearly define the government priorities, and leads the direction of the actions of market

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players. The development direction and focus of industries proposed in the Outline are guidance to market players and the government will use means such as economic policies to give its guidance. For the tasks proposed in areas such as infrastructure, technology and education, ecological environment, social security and public services, the government will use the available public resources to practically discharge its duties and strive to complete them. It was clearly proposed in the 3rd Plenary Session of the 16th National Congress of the Central Committee of the Communist Party of China that China needs to “strengthen the study and formulation of the mid-term and longterm planning of the national socio-economic development, and put forward important strategies, basic tasks and industry development policies, to promote a comprehensive national socio-economic development, and accomplish the coordination of economic growth and population, resources and environment.” The formulation of development plans must be guided by the scientific concept of development, making overall plans, taking all factors into consideration and emphasizing the priorities. It was proposed in the 3rd Plenary Session of the 16th National Congress of the Communist Party of China that “we should uphold the principle of ‘man first’ and form the concept of overall, coordinated and sustainable development so as to promote the overall economic, social and human development,” which should be the guidelines in the formulation of China’s development plans. When formulating the development plans, we have to follow, on the one hand, the principle that was proposed in the 3rd Plenary Session of the 16th National Congress of the Communist Party of China, which was to have “a balanced development between urban and rural areas, between different regions, between economic and social undertakings, between man and nature as well as between domestic development and opening-up the world,” while reasonably take care of the interests and demands of various parties and try out best to make overall plans and take all factors into consideration. On the other hand, we have to rationally allocate limited resources, pull all resources to solve key issues which have an important impact on overall economic and social development, remove the weak links that constrain economic and social development, so that we can truly highlight the priorities. Formulating development plans is a complicated system engineering project and a gradually deepening of cognition. Its quality depends not only on the knowledge and experience of the planners, but also on the techniques and methods of working out plans. The main contents, basic methods and key technologies in making medium-term (five years) development plans will be discussed as follows.

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The Main Contents of Development Plans When making development plans, we should include the following aspects:

Target system The target system of a development plan should embody the principle of making an overall plan with all-round consideration, covering as far as possible all aspects of social and economic development. In the first two decades after World War II, the major Western countries mostly took Keynesian theory as basis, with a key development objective of achieving economic equilibrium under the conditions of full employment. However, Keynesian theory, which is a kind of macro-control measures to expand investment and stimulate consumption through state intervention, has led to serious fiscal deficits and inflation, and even to the “stagflation” that appeared in Western developed countries since the mid-1970s. Since then, when making development goals, countries has paid more attention to stability, and formed the “magic quadrangle of macro-control” comprising four goals including sustainable economic growth, full employment, stability of commodity prices and international balance of payments. Since the 1980s, the issues of sustainable development and income distribution (in particular to eradicate) have been generally concerned. In order to be able to quantify various targets and evaluate their degree of realization, we need to use one or several indicators to for measurement. It should be noted that many targets cannot be expressed or measured by simply using one or several indicators. We cannot, for example, only use GNP or GDP to express and measure the level of economic development. Strictly speaking, we should establish a system of indicators for each target, but to avoid complexity, we select the most important one or several indicators. The target systems of development plans and their corresponding indicators are shown in Table 3.1. Table 3.1.

The target systems of development plans and their corresponding indicator systems

Targets

Indicators

To raise the level of economic development

GNP or GDP

To promote rapid economic development

Average annual growth rate of GNP or GDP

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(Cont'd) Targets

Indicators

To increase employment

Unemployment rate or employment rate

To raise residents’ income

Annual per capita income

To narrow the gap of resource allocation

Gini coefficient

To achieve sustainable development

Environmental quality indicators; environmental expenditure per capita

To stabilize commodity prices

Price indicator

To expand the opening up

Ratio of total imports and exports to GDP; Proportion of foreign capital in total social investment

To promote a balanced regional development

Regional GDP per capita

When establishing indicators, we should pay attention to typological differences of their storage, increment, flow, and relative size, to prevent misunderstanding or misguidance. Storage refers to the quantity kept in the system at a certain moment; flow refers to the quantity that flows in and (or) out of the system within a certain period of time (in which the volume of inflow or that of outflow are called unilateral flow, while the sum of them is called bilateral flow). Increment refers to the changes in quantity kept in the system within a certain period of time. The relationship of the three can be shown by the following two formulas: Increment = Inflow – Outflow Storage at the end of the period = Storage at the end of the last period + Increment in this period Generally speaking, the volumes of different types are not comparable. But in order to compare the relative size of a certain volume among various countries, economists often compare a certain volume with GNP or GDP, because GNP or GDP has become a general indicator to express the economic strengths of various countries. To express the relative size of foreign trade of various countries, for example, a universal method is to compare the sum of imports and exports (bilateral flow) with GDP. In contrast, if we compare the

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increment of foreign trade volume with GDP, it will not be of any practical significance. For example, the GDP of a certain country in a certain year is USD1 trillion, with USD290 billion of imports (foreign exchange outflow) and USD310 billion of exports (foreign exchange inflow) which constitute USD20 billion of increment. The ratio of the increment to GDP is 2% that certainly cannot explain the relative size of its foreign trade. This figure would be even more ridiculous if the increment is negative (i.e. the volume of imports is larger than that of exports). What is more, if there is another country with GDP at USD100 billion, imports at USD10 billion, and exports at USD12 billion, then the increment is USD2 billion and the ratio of increment to GAP is also 2%, but the relative sizes of foreign trade of these two countries are obviously different.

Order of priority After establishing the target system, we must also establish their order of priority, which is the relative importance of the targets. The author believes that establishing the order of priority is the core of planning, because it embodies the leaders’ collective value judgment and their judgment of the current and future situation. It is both a guide for the implementation of the set policy and a basis for making all sorts of new policies. Technically speaking, establishing the order of priority is the most difficult task as we need to adopt a scientific method that combine quantification and quality as well as the democratic process of soliciting opinions extensively and making revisions repeatedly. This work cannot be completed by a small number of planners as they are bound by their own vision, level, knowledge, and ability, which makes it difficult for them to establish the order of priority of the target system which maximizes the interests of the country. It should also be noted that some of the targets in the target system are not isolated, for there is synergy or antagonism existing between them. Stability of commodity prices, for example, helps promote economic growth, but excessive economic growth might create serious environmental problems.

The value of indicators The ultimate form of a plan is the assignment of certain values to the various indicators, which represent the expected results of resource allocation conducted in accordance with the order of priority of the target system. It is necessary to take into account the needs of national development and also the possibility of realization so as to get the satisfactory results that we strive for under a variety of practical constraints. In the past, these values ​​w ere established mainly by 61

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planners who used the methods of contrast. But with the development of disciplines such as systems engineering and quantitative economics, and the rapid rise in the capacity of computers, several effective methods of scientific analysis have been developed. By putting together the results worked out by these methods and the experience of planners, more reasonable values can be obtained. It should be stressed that under the market economy system, the values ​​o f these indicators are usually predictive and guiding in nature, but not obligatory. They do not have to be fully achieved, and can be modified according to the actual situation.

Major measures To be able to realize plans, we must take measures to reduce or remove all sorts of restrictions. To minimize the constraints on capital, for example, we must increase and expand the channels of financing, including the use of incomes the next period for the current period by way of loans if we have the confidence to repay the loan with interests. Another example is that in order to reduce the constraints on the skilled labor force, we must develop vocational education and train high-skilled workers, and so on.

The Basic Procedures and Methods of Formulating Development Plans The formulation of medium-term development plans should follow consistently the scientific, democratic, procedural principles, so as to combine planners, leaders, and experts in the field, qualitative and quantitative analyses, and experience-based decision-making by experience and computer-aided decisionmaking with the aid of the computer. Based on the principles of scientific management, the author has summarized the methods and procedures of the study of reform in the soft science into the POSMEP method, and by following this method, the formulation of development plans can be divided into the following six stages. Problem Identification (P). The formulation of development plans begins firstly by posing problems which are the differences between the real situation and the ideal situation. We then have to define the scope of the time and space of the system, and understand the composition and structure of the system. Objective Establishment (O). During the process of conducting objective analyses and establishing the overall framework, planners need to establish the objective system and the order of priority of various objectives (sorted in order or by weight) with leaders and experts in the field. Then on this basis,

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they propose the overall framework of development plans, and analyze this framework together with experts again. As the work of planning progresses, sometimes they even need to modify and supplement the overall framework with the relevant experts. Situation Analysis (S). At that stage, we need to conduct a systematic analysis of the actual situation. We need to conduct a statistical analysis of the entire system, make a case study of individual components of the system, and look back on and predict the development process of the system (in the past and future). When conducting an analysis and prediction of the actual situation, planners should judge together with the experts in the field the degree of reliability of the statistics and decide whether to accept them or not. After they get the results of this statistical analysis, planners should seek for views of the experts in the field, and sometimes they need to work together to structure the data. For some qualitative data, they need to propose methods to quantify them and work with experts on quantification (such as the construction of the AHP Matrix). Planners should select typical cases with experts in the field, settle on the contents and methods of case studies, and help these experts to analyze the results of the study. In addition, planners need to ask experts for help to select the prediction method and assess the reliability of the predictions. Finally, planners should also guide the experts to build databases according to unified requirements, and be responsible for collecting these databases, and divide them generally into three levels: raw data, tactical data for supporting strategic decisions, and data for supporting strategic decisions, to form a unified database. On this basis, we can study to propose the road-map and initial plan for elevating the actual situation to the ideal situation. Model Building (M). At this stage, planners and experts should analyze together the structure, functions, and evolutionary process of the system under study, as well as its interaction with the external environment, so as to determine the main factors affecting the system behavior and the patterns of this influence, and on this basis to build a conceptual model of the system (qualitative model). They should then turn this conceptual model into a quantitative or semi-quantitative model, and, as far as possible, realize it computationally. After that, planners must coordinate with the experts to determine the parameters, boundary and initial conditions of the model, discuss the results of pilot calculations, and then make the necessary revisions to the model. It then goes through a repeated process of computer pilot calculations– expert discussions–model modifications until the model is basically satisfactory. For more complex issues, it is often required to build a model library with

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three levels, including an operating model (mostly used for data processing, such as mathematical regression model), a tactical model (mainly used to describe a

subsystem or a system function) and a strategic model, and to put them together

to conduct flexible call-up, relative correction, and synchronized updating of the model through a model library management system. If necessary, we can also build up a decision-support system that includes a database, a model library, a knowledge library, a methodology library, a text and graphics library, and a human-machine interface, so as to provide better support for decision-making.

Evaluation of Draft Plans (E). At this stage, planners should, together with

experts in the field, work out several draft plans based on the results of the real

situation analysis and model calculations, and conduct a preliminary analysis of

the pros and cons of each draft plan. Then we can make use of the established model to conduct simulations of these draft plans one by one on the computer,

and ask leaders and experts to review the results of these simulations together.

In addition, we can also make use of methods such as scenario analysis, optimization solution, and computer simulation to evaluate the draft plans, and

then make supplement and improvements to these draft plans, and weigh the

advantages and disadvantages to make a choice. When making the choice, we have not only to consider factors in such aspects as politics, technology, economy, law, progress, and operation, but also to take into account people’s behavior,

values and ​​ related norms (such as thinking and morality). As at that time experts of various fields tend to place too much emphasis on the importance of their own fields, in order to deal with conflicts among the various subsystems, we can use

the group decision method incooperative games to obtain the Pareto solution (or compromise value), so that the choice made can be accepted as much as possible

by the relevant parties and the resistance in the process of execution can be minimized. When there is any dispute and difficulty in achieving consensus, we should follow the principle of democratic centralism, so that leaders, with the help of planners and on hearing views of various sides, make decisions.

Plan Formation (P). At this stage, planners, with the relevant experts, should

develop the steps and major measures for implementation based on the selected draft plan, then put forward a plan proposal (including the target system,

indicator system and values, and the main measures to be taken) together with

a written description (including the analysis of resource and environment, the main points and arguments, and feasibility analysis). For the divergence of views

at this phase, planners should fully consult the experts and deal with it with the principle of the minority views subordinating to the views of the majority.

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The Key Techniques for Formulating Development Plans Qualitative variables and their interrelated quantification techniques When formulating development plans, we often come across qualitative variables, which are characterized by the fact that their conditions cannot be directly expressed by numerical values, such as social systems, modes of transportation, the severity of disasters, people’s degree of satisfaction, and so on. The interrelationship between these variables (such as the cause-andeffect relationship, the principal-and-subordinate relationship, and growthand-decline relationship) is rather complex. They all need to go through the process of quantification before we can build up a mathematical model to do the computing. The traditional method of quantification is processing through classification, contrasting, and sorting to turn the various qualitative variables into a one-dimensional vector (usually equally spaced), then further process them with regression analysis, discriminant analysis or factor analysis, in order to determine their quantitative relation. In general, this method is only applicable to ordered qualitative variables. As the size of the quantitative value given to various states by this method only indicates their sequence and cannot represent the extent of their differences, and many variables need to use several attributes of the states to enable a more comprehensive manifestation, this method usually cannot accurately reflect the essential relationship of the various factors, which reduces the credibility of its analytical conclusions. By using multidimensional scaling (referred to as the MDS method),we can process the qualitative variables with quantification, which is characterized by comparing the various qualitative variables with each other and thus obtaining various kinds of measurements in similarities or dissimilarities. Then the states of the quantitative variables can then be expressed as points in Euclidean space so as to facilitate a further analysis of the various relationships between different variables, such as using the correlation coefficient to measure the similarity between them or the strength of their non-linear relationship. This method has been successfully applied to fields such as geology, sociology and psychology. In the formulation of development plans, we can first consider using this method to obtain the relationship among the various qualitative variables, and perform adjustments and revisions in combination with the experience of experts.

The establishment of value systems and their expression techniques Generally speaking, value is a specific interface for the object attributes for

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people having some kind of needs and the meeting of these needs. Value is objective, but it is also closely related to people’s needs, benefits, interests and aspirations which are constrained by certain social and historical conditions. In the process of decision-making, value is manifested as a standard of compromise for the goals that decision-makers hope to achieve and the price they are willing to pay, which is the basis for the evaluation and choice of draft plans. For multi-objective decision-making, we need to build a value system which includes the relevant value standards and the order of priority of the value system. Without a universally recognized value system, it is impossible to establish the order of priority of the target system, and even more impossible to make a choice of various draft plans. The establishment of a value system is a complicated issue. Normally decision-makers themselves cannot clearly express their values, and this requires planners to use methods such as the explanation of regulations, indepth conversations, constant adjustment, and iterative approximation to clarify the relevant value criteria and their order of priority. A mathematical model usually expresses a value system by using a goal set with weighting or priority scheduling. Using the weighting method, the dimensions of various target variables should be consistent, and using the method of priority scheduling, we should also pay attention to the consistency of dimensions of the same level to avoid errors in computation.

Coordination techniques in group decision-making In formulating development plans, we need to rely on a group of decisionmakers and experts in the field to make decisions on the order of priority, the modifications of model, and the selection of draft plans. The establishment of a universally recognized value system creates the conditions for reaching a group decision, yet when making a group decision, we still need to use appropriate methods for coordination. At this time we have to distinguish between two types of decisions. One is collaborative decision-making. In this case, those who take part in decision-making have the same goals, and there is no conflict of interest among them, but as the knowledge and experience of each person are different, they have different views, and it is through mutual exchange and inspiration that they can gradually obtain the optimal decision acceptable to all. To do so, we need to study how we can gradually collect together the scattered views to form the optimal decision for the group. The other is a compromised decision-making. In this case, as the goals of the participants are not the same, there is a conflict of interest among them, but we hope to be

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able to make a decision which is acceptable to all parties. This requires the use of the cooperative game theory to study how to find a point of compromise, such as the Shapley Value Method, Nash Bargaining Solution, and the Banzhaf Power Index. The formation of the value of compromise is the result of repeated exchanges of views among group members, and not the simple linear addition of the views of all members. In group decision-making, we should consider the impact of information asymmetry of various participants, and should allow various members of the group to fully understand the value system and all sorts of information relevant to decision-making. We also have to pay attention to the behavior in group decision-making to prevent the drift of the optimal decision point because of the authority effect or bandwagon effect. In addition, efforts should also be made to rely on modern decision science to develop and improve democratic centralism, making it a decision-making system with Chinese characteristics.

Techniques for a reasonable allocation of resources The so-called reasonable allocation of resources refers to how we can realize, as much as possible, the targets of the plan through optimizing the allocation under the constraint of limited resources, and achieve the planned value of various indicators, which in essence is to seek a reasonable balance between needs and possibilities. As development plans include thousands of variables, and there is a very complex relation between these variables, we therefore have to establish a model and rely on computers for solutions. Currently, the more commonly used models for formulating plans are, for example, the inputoutput model, econometric model, and computable general equilibrium model. These three models have their own strengths and weaknesses and scopes of application. Linear planning is also a widely used optimization techniques, and its essence is to separately transform the targets and the various conditions of constraints into a linear function of decision variables, and then use combinatorial method in mathematics for solution. Some scholars have used the method of linear planning to study the economic plans of Brazil, Chile, India, Israel, Mexico and South Korea, however, due to its inherent limitations, linear planning as a tool for the formulation of plans is still at the experimental stage. The author believes that in formulating development plans, we can consider using the target planning model. Target planning is a mathematical planning method that derives from the limitations of linear planning. Its basic idea originates from Simon’s concept of goal satisficing, which means that we

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minimize the derivations from the goals, each of which has a target or goal value to be achieved. The basic concepts of this idea can be summarized as follows: (1) To introduce positive and negative deviation variables to each condition of constraint so as to change hard constraints into soft ones. To avoid the frequent occurrence of the situation of “infeasibility” in linear planning and increase flexibility in decision-making, corresponding positive and negative deviation variables are introduced to each condition of constraints in goal planning, which turns hard constraints in linear planning into “soft” constraints, greatly increasing the chance of getting feasible solutions. (2) To put the minimum sum of the deviation of the various goal values as the goal function to facilitate the handling of the issue of multiple goals. When handling the issue of multiple goals, we normally have to use the method of weighting for the various goals in the goal function to make their maximal or minimal sum as our goal. This means that all the decision-making variables have to appear in the goal function which becomes too large and complex to solve. On the contrary, goal planning takes the right-end constraint items of each constraint condition in linear planning as its goal value, and takes the minimal deviation sum of each goal value as the goal function, thereby constraining the goal variables only deviation variables. Consequently, since each goal can have at most two deviation variables (of which an unnecessary deviation variable needs not be entered into the goal variables), and the number of goals is a lot less than the number of decision variables, it is very convenient to handle the issue of multiple goals. (3) Using the method of priority scheduling to handle the relative importance of multiple goals can better meet the judgment of decision-makers. The use of linear planning to deal with the issue of multiple goals is usually based on the judgment of decision-makers to determine the weight of each goal. However, but decision-makers usually can only qualitatively judge the relative importance of the various goals, and it is difficult for them to quantify their weight. Goal planning uses the method of priority scheduling to handle the relative importance of multiple goals so as to meet the qualitative judgment of the decision-makers better. In addition, the use of the method of priority scheduling can also reduce the occurrence of inconsistency in the dimensions between decision-making variables. (4) Through defining the goal deviation variables, the issue of multiple solutions can be reduced. In goal planning, the number of decision variables often greatly exceeds the number of goals, and is often greater than the number

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of constraints. This easily generates the issue of multiple solutions when seeking solutions. Therefore, we can request decision-makers to define the scope of each deviation variable that means to set out the allowed scope of changes, so as to reduce the generation of multiple solution problems. It should be pointed out that while quantitative methods and techniques can play an important role in the formulation of development plans and help reduce the issues caused by the subjective speculation and judgment of planners, it is certainly wrong to adopt an attitude of contempt or even rejection; nevertheless these methods are still only auxiliary tools which are not substitutes for human analysis and deliberation. Sometimes the inaccuracy of the raw data or oversimplicity of the models may lead to the computed results being divorced from reality. Thus it can be seen that the key to improve the quality of formulating development plans is to improve the thinking and professionalism of the planners.

Japan’s Income Doubling Program: A Reference Example of Development Plan In the development plans formulated by countries that implement governmentled market economy, Japan’s Income Doubling Program has some reference value to China. The following is a brief introduction of it. At the end of the 1950s, there was a debate among Japanese economists on the prospects of the economic development of Japan. Shimomura Osamu, Director of the Economic Research Institute of the Japan Development Bank at that time, proposed the Theory of the Prosperity Period in History. He believed that the investment in equipment usually brings about an increase of roughly the same amount of GNP after about a year. If there were a full release of aggregate demand, the annual growth rate of Japanese economy could then reach 10%. And by looking at the situation of international balance of payments and domestic supply and demand, the Japanese economy had enormous growth potential. So the Japanese government needed to change and adopt an active policy to mobilize the growth potential of the Japanese economy and to rapidly develop the national economy. In December 1960, the Ikeda Cabinet formally adopted the Income Doubling Program which reflected this point of view. This program could be said to be a programmatic document that guided the Japanese economy to take off towards modernization, and it produced a profound impact on the later development of the Japanese economy. The ultimate goal of this program was to achieve a significant improvement of the national living standard and full employment. To do so, the Japanese

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government must ensure that there was a stable economic growth to the largest

extent, and the practical goal was to double the national income within ten years.

To achieve this ultimate goal, Japan was required to (1) replenish the social

capital (investment in public utilities); (2) guide the industry structure towards

modernization; (3) promote trade and international cooperation; (4) train people and revitalize science and technology; (5) ease the dual structure of the more advanced large enterprises and the less advanced small and medium enterprises

existing together and to ensure social stability. The government also set major

economic indicators such as an average annual growth of 7.8% GDP, structural indicators such as supply, demand and employment, and life development

plans, such as national diet, consumption, housing, living environment and facilities, education, social security, and employment. This plan called for

efforts to narrow the gaps of lifestyle and income between agriculture and

non-agriculture, between large enterprises and small enterprises, between various regions, and between various income classes, to achieve a balanced development of national economy and people’s life.

The whole program was divided into four parts: Overall Review,

Government Public Sector Planning, Projections and Guiding Policies of the Private Sector, and Prospects of National Life. The focus of the work was placed on the public sector, departments directly run by the government which had

the direct means of realization, and so the plan should be practical and feasible.

The roles of the government were mainly to (1) replenish social capital; (2) use measures such as education and training to improve people’s ability and to

revitalize science and technology; (3) strengthen social security and improve social welfare; (4) guide the private industry. For the economic activities of the private sector, the government gave predictions to create an environment

to facilitate enterprises carrying out their activities smoothly, and led the enterprises to directions it set through policies, such as fiscal and financial policies.

Although there were some contradictions and problems in the process of

implementing this program, such as the inventory adjustment in 1962, the

readjustment of the economy in 1963, the stock market crash in 1965, and the

aggravation of inflation, various items of major indicators set by the plan could be completed ahead of schedule. From 1961 to 1970, the average annual growth

rate of the Japanese economy reached 11.6%, far exceeding the target of 7.6% required by the program.

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The Characteristics and Methods of Preparing Major Special Plans There are two types of specific plans: one is general plans, which are special plans included in the development plans, such as the special plans made during the 10th Five-Year Plan period regarding the development of science and technology education, the development of high-tech industry, urban development, the development of water resources, population, employment and social security, and ecological construction and environmental protection. Many of these plans were actually departmental or industrial plans. The other is major plans, which are mainly plans for major issues related to the entire situation and in key areas, such as national defense, education, science and technology, transportation, resource development, and cultural construction. The following mainly focuses on the second type of special plans.

The Characteristics of Special Plans The time span of a special plan is usually five to ten years or even longer, and is usually led by the government in its preparation and implementation. The contents of such plans include not only the desired objectives, but also the main measures taken to achieve these objectives, and the methods of implementation and schedule. The role of a special plan is mainly to concentrate efforts to solve key issues which have a significant impact on the overall situation in socio-economic development and eliminate the weak links that hinder the socio-economic development. Some of the better-known special plans outside China are the Apollo (moon-landing) Program of the U.S. and the research, technological development and demonstration program of the EU. These special plans, when compared with other general development plans, are significantly different in the following areas: (1) While development plans need to start drawing up in a certain base year in accordance with the provisions, a special plan can be proposed at any time by needs. (2) The time span of development plans is usually fixed (for example five years), but the time span of a special plan can be determined by needs. Different plans can have different time spans. (3) The contents of a development plan are comprehensive, focusing on the overall national development, and its target system is more complex. But the contents of a special plan are normally on a specific part of a major issue and so its target system is relatively simple.

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(4) There can only be one national development plan in a certain period, but can be several special plans which can be interactive and collaborative. (5) Development plans can usually be prepared by planning departments, and broken down for implementation by various regions and departments, but special plans are often cross-departmental and cross-regional, and require the central government to set up special units for their preparation, organization and implementation. When designing the process of drawing up special plans and choosing the methods of drawing up, the above mentioned characteristics should be taken into consideration.

The Main Content of Special Plans The content of special plans are usually more specific than that of development plans, and generally include aspects such as the target system, the expected indicators, scheduling, fund allocation, and main measures. Compared with development plans, the target system of a special plan is simpler, and its prioritization is usually easier to handle. However, as special plans are prepared and implemented under the guidance of the government, it is to a certain extend mandatory in nature, and its expected indicators should be reached by all means. In general, the arrangement of the implementation schedule of a special plan is rather clear, and usually divided into several phases, each of which has some clearly stated objectives so as to facilitate inspection and supervision. As regards the allocation of funds, the funds should be allocated reasonably and specifically for use, and other sources of supporting fund should also be settled. The main measures of a special plan should be concrete and specific, and attention should be paid to its coordination with development plans and other special plans.

The Formulation Method of Special Plans The formulation of special plans in developed countries is usually led by the government. Although the formulation methods used are not the same, they generally belong to the type of the Plan-Project-Budget System (PPBS), in which the planning framework is established first, and then broken down into a number of special plans for budget allocation. This kind of method was remarkably successful in the national defense program of the U.S., and adopted by the EU in the research, technological development and demonstration program. Besides, some suggested using the method of Planning-Organizing-

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Staffing-Directing-Coordinating-Reporting-Budgeting (POSDCORB) method. The author believes that China can also use the POSMEP method to draw up special plans, but the characteristics of special plans should be embodied at the six formulation steps. At the problem identification stage, apart from identifying the differences between the actual and ideal situation, we have to identify the key issues that have a significant impact on the overall situation and the weak links that hinder the socio-economic development, so as to provide the basis for the establishment of the special plan. At the goal setting stage, we not only have to make sure the goals and indicator systems, but also make clear what the main tasks are, and how the relationship between the various main tasks is. At the situation analysis stage, in addition to a comprehensive analysis and forecast of the objective environment and available resources, we must also focus on the analysis of international development levels and trends relating to the special plan so as to make clear the current level and the international status of China, and recognize China’s advantages and disadvantages relating to the various aspects of the plan, China’s competitiveness in the world, and the opportunities and challenges it faces. At the model building stage, a quantitative model plays a greater role in such aspects as budget allocation and scheduling. A decision-making supporting system which has such functions as information retrieval, resource allocation, progress monitoring, and co-ordination should also be built. At the draft plan evaluation stage, we should focus on evaluating the feasibility of various draft plans. The selected draft plan should be technically possible, economically reasonable, legally permissible, operationally executable, procedurally achievable, and politically acceptable to all parties, so as to minimize as far as possible resistance in the process of implementation. At the plan formation stage, we should present detailed written documents with a clear explanation of various aspects of the plan, such as the goals, indicators, tasks, division of labor, schedule, budget, and measures. A feasibility research report should also be attached.

Key Techniques for Formulating a Special Plan The key identification techniques To identify the key issues and the weak links that have a significant impact on the overall situation in the process of socio- economic development, we need to

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use a combination of qualitative and quantitative methods. We can, for example, analyze the input and output to establish the impact coefficients and sensitivity

coefficients of each industry in order to identify the pillar industries and weak links.

The influence coefficient of j industry Tj can be expressed as:

(3–1)

n n ∑ b / 1 ∑ ∑ b (j = 1, 2, ..., n) Tj = i=1 ij n j=1 i=1 ij n

n

∑ b is the sum of the j th column (sum of columns) In the above formula, i=1 ij 1 n n ∑ ∑ b are the average value of coefficients of the Leontief inverse matrix. n j=1 i=1 ij the n columns and the influence coefficient T j reflects the degrees of industrial demand, spread and induction produced by various industries of the economy when the j industry increases a unit of end products. If the influence coefficient

is greater than 1, it means that the degree of pushing forward of that industry is

higher than the average level of all industries. Industries with greater influence coefficients are stronger in their inductive effects.

The sensitivity coefficient of i industry S i can be expressed as:

(3–2)

n n ∑ b / 1 ∑ ∑ b (i = 1, 2, ..., n) Si = j=1 ij i=1 n j=1 ij n

n

∑ b is the sum of the ith line (sum of lines) coefficients In the above formula, j=1 ij 1 n n ∑∑ of the Leontief inverse matrix. n i=1 j=1 bij are the average value of n rows, and Si reflects the degree of sensitivity of the demand of the i industry when all industries increase a unit of end products. When the sensitivity coefficient is greater than 1, it means that the constraining role of the industry is above the

average level of all industries. Industries with greater sensitivity coefficients have stronger constraining functions.

According to data provided by National Bureau of Statistics, the first five

industries with the highest influence coefficients and sensitivity coefficients in China in 2000 are shown in Table 3.2. Table 3.2.

The five industries with the highest impact coefficients and sensitivity coefficients in China in 2000

Order

Industry

Influence coefficient

Order

Industry

Sensitivity coefficient

1

Electronic and communication equipment manufacturing

1.33

1

Chemical industry

3.5

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(Cont'd) Order

Industry

Influence coefficient

Order

Industry

Sensitivity coefficient

2

Electrical machinery and equipment manufacturing

1.28

2

Metal smelting and rolling processing industry

2.39

3

Transport equipment manufacturing

1.27

3

Petroleum processing and coking

1.81

1.74

1.72

4

Fabricated metal products

1.22

4

Electronic and communication equipment manufacturing

5

Metal smelting and rolling processing industry

1.19

5

Agriculture

Scheduling techniques The scheduling of a special plan is very complex, which needs to take into account such factors as time, cost, resources, quality, and behavior. Although a program is different from a project, the scheduling of a special plan can still draw on project management technologies, such as work breakdown structures (WBS), and network planning technology. Work breakdown structure is to break down a project into manageable and controllable work modules, which should include the scope of the work, the start and end times, the budget and schedule. WBS is usually expressed as a top-down, layer-by-layer breakdown chart, which is helpful to link up the various work modules with the overall target to define the duties of various parties, and to link up the various work modules together to establish their interrelationship. We can also link up the tasks, organization structures and responsibilities as the basis for estimating the plans and budgets. The role of network planning technology is to find the shortest time required to complete a project and determine how long each task takes to be completed. The most commonly used method in network planning technology is the Critical Path Method (CPM), in which a project is broken down by several independent tasks first by using WBS, and then the tasks are put in a logical sequence; after that, we have to estimate the time required to complete each task, add up all the times required for each route of the various tasks, and work out the total time span for each route. The route which requires the longest time span is the critical path. The critical path determines the progress of the project, so measures must be taken first to ensure that the various tasks on the critical path can be completed according to

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the schedule. The critical path method not only helps arrange progress, but also guides resource allocation.

Organization and coordination techniques When formulating a special plan, the linkages between various departments and various regions are extremely close, and many tasks can only be completed in a cross-region and cross-department manner. So it is necessary to establish a mechanism for organization, coordination and multilateral cooperation. The formulation of a special plan usually involves a number of scientific fields, and experts from relevant disciplines are needed to conduct problem identification, goal setting, and situation analysis from various perspectives. During the period of formulating and implementing a special plan, the various relevant departments and regions need to assign their staff to form a special team, which is to be led by a strong and powerful person with a centralized leadership. Project management models typically include six main areas: (1) what needs to be done; (2) who is to do the work; (3) what everyone should do; (4) how to complete the work; (5) when and how to verify the work; and (6) when and how to assess the progress of the project. This model can be adopted for special plan management with the aid of computers. With the development of information and information system technology, the conditions for setting up a decisionmaking support system for a special plan are essentially mature.

A Reference Example of a Special Plan: The 5th Framework Program for Research, Technological Development and Demonstration Activities of the European Union Since many special plans are embedded with elements of research and technology development, the 5th Framework Program for Research, Technological Development and Demonstration Activities of the European Union is chosen as a reference example. There are ten items in this framework plan, which include four thematic plans: (1) Special plan on the life quality and biological resources management research, technological development and demonstration activities; (2) Special plan on the user-friendly information society research, technological development and demonstration activities; (3) Special plan on the competitive and sustainable growth research, technological development and demonstration activities; and (4) Special plan on the energy, environment and sustainable development research, technological development and demonstration activities; and three horizontal plans: (1) Special plan on demonstrating the international

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cooperation of the European Union’s research; (2) Special plan on the promotion of innovation and encouragement of SME participation research, technological development and demonstration activities ; (3) Special plan on the research of improving human research potential and the socio-economic knowledge base, technological development and demonstration activities; and three auxiliary plans: (1) Direct action plans of the Joint Center through the EU; (2) Plan on the study and training on the protection of ecosystems by the European Atomic Energy Community; and (3) Research plan directly implemented by the European Atomic Energy Community, which was passed by the Joint Center. The period of this framework plan is from 1998 to 2002. For each thematic plan (special plan), its objectives and coordination with other thematic plans are first established. Then the plan is broken down into several specific tasks to define their focus (key action), after which a resource allocation proposal is made. Finally, special matters are explained. We will now take the Thematic Program 1—life quality and biological resources management research, technological development and demonstration activities as — an example, briefly describing its main content. (1) Goal: To link the discovery capacity with the production capacity to solve the needs of society, meet the demands of consumers, and create more wealth and jobs. (2) Tasks: Mainly including key actions of the six areas: food, nutrition and health; control of infectious diseases; “cell factories;” environment and health; sustainable management of agriculture, fisheries and forestry, and comprehensive development of rural areas including mountain areas; and ageing population and disability; and two auxiliary tasks: general research and technology development activities and support for research infrastructure). (3) Fund allocation (4) Additional measures and coordination arrangements In general, this plan is more systematical, and has achieved better results.

Suggestions for Setting Up an Overall Planning Department for Comprehensive Planning and Coordination Planning is the primary task of a leader. Leaders must think about the future, set goals, and consider how to achieve these goals. However, as leaders are often busy with official matters and have to deal with myriad issues every day, they do not have enough time and energy to study and think about planning, and as their understanding and mastering of the technology for plans are limited, it is often difficult for them to turn qualitative analyses and judgments into specific plan

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indicators and measures. To help leaders to gather information, analyze issues and formulate plans, it is necessary to set up a planning department composed of experts. During the periods of practicing central planning system in China, the power of the planning department was strong as it made many decisions. With the advancement of China’s socialist market economy system, the functions of the planning department have been changing like the decrease of its decision-making power and the change in its name from the State Planning Commission to Development Planning Commission, and then to the Development and Reform Committee. But basically, the planning and decisionmaking functions of the planning department have not been separated. On the one hand, this makes the planning department over-concerned with the current specific issues and less concerned about long-term macro issues. On the other hand, this also leads to the situation where many planners are more familiar with the microscopic project management techniques, such as the examination of feasibility study reports, project approval, funding allocation, and progress checking. Planners do not have an adequate understanding of the checking, evaluation, and optimization of systems engineering and related key technologies necessary in making development plans, and the result is that it is difficult for the planning department to fully exercise its functions of carrying out comprehensive planning for development and reform in China. As a systems engineering expert, Qian Xuesen had consistently advocated considering and solving issues holistically, and been against the partition of departments and regions. He pointed out in 1990 that “the situation of our present society is far from ideal. I am not saying individual items which we have great achievements. But generally speaking, there is too much waste in our society and our efficiency is far too low. This is really worrying. We must improve our administration and deepen reform, and the most important thing is to have a holistic perspective, rather than individual issues.” On March 22, 1991, in a speech he gave at the Technology Committee at the 2nd Plenary Meeting of the National Committee of the Chinese People’s Political Consultative Conference, he said, “To my thinking, we must consider China’s science and technology, economy, politics, and national defense today in a holistic manner, and maintain a long-term, macroscopic, and strategic perspective. At present, some views that are long-term, macroscopic, and strategic have not received the attention they deserve.” In 1997 he clearly stated: “The situation in China is that departmental partition is serious, so the most important task is to provide an analysis to the central government, reporting the losses brought about by department partition, and this is perhaps the biggest problem when moving

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forward in our socialist construction. If the National Natural Science Foundation of China can make a report on the losses incurred, I think it would make a huge impact, and will certainly receive attention of the central government. This is because the central government also understands the situation, but we need to have a scientific estimation of the losses we made.” To promote a coordinated development of the construction of socialist material civilization, spiritual civilization, and political civilization in China, Qian Xuesen proposed as early as in 1987 the idea of establishing an overall design department. In 1991 he again proposed specific suggestions for the establishment of the overall design department, stating clearly that its function is to provide consultancy services for the party and state leaders. What it relies on are experts in various fields and industries, documentary information, computer, statistical data information, systems science and knowledge engineering. The author believes that the above-mentioned views of Qian Xuesen are visionary and directional. What is encountered during planning is the uncertainty of the objective world, and this kind of uncertainty comes mainly from the activities of countless subjects in the objective world, the mutual influence and functions of these subjects, and their interaction with the everchanging environment. Since these three aspects have a certain level of randomness, and the limitations of people’s ability to understand the objective world, it is difficult to grasp in real time the status and trend of changes of each subject. Therefore, people can only grasp the development and long-term trend of the objective world in a holistic way, and base on this knowledge to plan the actions that should be taken. When we take a general look at all the countries in the world where the market economy system is practiced, we can find that some countries simply do not set up a planning department, while for other countries which have planning departments, the functions of these departments are primarily on national development planning rather than making decisions on specific issues. In the process of promoting its socialist market economy, China cannot rely on planning to manage all social and economic activities, as was practiced during the period of centrally planned system, but needs to grasp as accurately as possible future trends, and gradually promote building socialism with Chinese characteristics through careful overall planning. To this end the author suggests the establishment of an overall planning department responsible for overall planning and coordination in accordance with Qian Xuesen’s thoughts about the overall design department. What we call comprehensive planning is to help leaders establish the target system and order of priority of long-term development, and also turn the values ​​

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and vision of the future defined by the leaders into a quantitative indicator system. Then the main duties of the planners are (1) to comprehensively, systematically and in a timely manner collect and compile relevant data and information, and make a careful analysis; (2) to use all sorts of methods and means to predict the changes in politics, society, economy, and science and technology that might happen in the future, both at home and abroad, and put them into several scenarios; (3) to clearly express the target system and order of priority according to the leaders’ intentions and judgments; (4) to establish a model that is needed for overall planning and conduct repeated computing and revision; and (5) to propose a quantitative indicator system. What we call overall planning and coordination is to help leaders to allocate resources allocation and formulate policies, and turn the target system and order of priority approved by leaders into a draft plan that can be executed. At this time, the main duties of planners are (1) to predict the resources they can obtain; (2) to establish a model and to undertake repeated computing so as to scientifically and reasonably allocate these resources; (3) to make important special proposals and then to be responsible for making important special plans after getting the approval from leaders; (4) to handle the conflicts of various regions and departments in the process of formulating and implementing plans; and (5) to propose the main measures to achieve targets and draw up the draft plan. The author believes that the establishment of such an overall planning department can better achieve an outlook of development which is comprehensive, coordinated and sustainable and, promote the development of socialism with Chinese characteristics through the following ways:

Beneficial to Realize the Strategies of Comprehensively Building a Moderately Prosperous Society The 16th National Congress of the Communist Party of China clearly put forward four strategic targets for building a moderately prosperous society in 2020 as well as the principles and important measures of various aspects. Whether these targets could be completely achieved or realized still depends on a comprehensive, systematic, and thorough discussion and careful, detailed, and practical planning. For example, in order to achieve the target of quadrupling China’s GDP (up to around USD4 trillion) in 2020, it is necessary to consider how much of the various resources we need to put in, which departments and local governments these resources should be concentrated, how great the constraints are in such aspects as environment, energy, and transportation on achieving this target, how many

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farmers will enter the city, and how many houses and public facilities we need to increase along with the increase of urban population, and so on. The establishment of an overall planning department can turn the ruling party’s ideas into a 20-year long-term development plan and several special plans that have a significant impact on realizing comprehensive, coordinated and sustainable development in China. Then we can follow the “rule of law” policy and turn the ruling party’s ideas into the will of the country through a legal procedure.

Beneficial to Allocate Reasonably All Kinds of Resources What we call a reasonable allocation of resources consists of two levels of meaning, namely possibility and optimization. When allocating resources, we first have to determine how much resources are needed to achieve the intended objectives of the plan. This issue can usually be resolved through the use of methods such as input-output analysis, but we must note the impact of technological advances on the allocation of resources during the period of the plan. The second issue is to determine whether the demand for these resources is adequate. To solve this issue, we usually need to use all kinds of methods to predict the availability of these resources during the plan period, and compared them with the volume of demand. The last issue is to determine how to optimally allocate these resources in order to realize maximally the intended target system. This issue can usually be solved by using methods such as linear programming, goal programming, and computable general equilibrium. The above three issues are very complicated and interrelated. The establishment of an overall planning department will help build a detailed and closely realistic model of resource allocation. We also take the opinions of experts in various fields and undertake repeated computing in order to get satisfactory results, to realize a reasonable allocation of resources under a predetermined target system, and to promote and guide the development of the country.

Beneficial to Handle Properly the Conflicts between the Parts and the Whole Due to the scarcity of resources, various regions always want to get a larger share of resources, and often the situation arises where the interest of the parts is maintained through departmental partition and regional protection, which is not beneficial to the development of the socialist market economy system. As the conflict of interests between the whole and the parts exist in reality, it has to be handled properly. In the past, there was often a certain arbitrariness when

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the planning department handled the issue of the parts and the whole since planners had the power to allocate resources based on “relationships,” and making plans became a kind of bargaining process between those on the two sides of resource allocation and resource demands, and this easily leads to the situation where “those who lobby the authorities end up getting the money they want,” “the child who cries will get the milk to drink,” and “picking the soft persimmon to pinch,” and this may induce all sorts of “rent-seeking” behavior and corruption in government departments. To properly handle the relationship between the parts and the whole, what is most important is that the ruling Communist Party of China has to fully exercise its leadership role of “commanding the overall situation and coordinating the efforts of all quarters,” further establish the authority of the central government, emphasize that local interests must be subordinate to overall interests, and punish according to law those officials who cause serious damage to the interest of the whole for the sake of protecting the interest of the parts. It also has to set up an overall planning department which has no decision-making functions and is not in charge of any specific projects set up. This will help the use of use scientific methods, such as cost-benefit analysis, opportunity costs, shadow prices, to fairly and properly handle the issue of the parts and the whole, and it also helps reduce corruption and waste in resource allocation.

Beneficial to Improve Macro-Control Under the market economy system, the market is the major means of allocating resources and regulating the economy, and it requires every enterprise to use the most economical and reasonable method to produce the goods purchasers need. But due to the consideration of meeting the minimum requirements of the daily necessities of the low-income group, compensating market failure caused by externalities, natural monopolies, naïve enterprises, and institutional inefficiency, preventing people from pursuing personal interests at the expense of social well-being, and easing the impact of changes in the global economy on national economic development, we still need the government to undertake the necessary regulation and macro-control on the national economy, properly exercising its role as the “visible hand.” It is true that in the last decade, China has made considerable progress in macro-control and gained some experience, yet it still needs to continue to explore and improve how to carry out macro-control under the socialist market economy system. The establishment of an overall planning department will help formulate, in a timely manner, effective policies and measures under the preconditions of not violating the basic laws of the market economy (the law of

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value, the law of supply and demand and the law of competition) and through a study of a combination of qualitative and quantitative analyses.

Beneficial to Promote the Decision-Making to be More Scientific and Democratic Making decisions more scientifically refers to the adoption of scientific viewpoints, procedures, methods and means to make decisions, while making decisions more democratically refers to the inclusion of such elements as argumentation, consultation, deliberation and collective discussion in the process of making major decisions. Only in this way can the entire situation be understood as much as possible, the issues to be solved clearly identified, the advantages and disadvantages (which provide a good grasp of the “extent” of the issues) fully assessed, and the general principles better combined, with specific conditions to select the optimal plan so that it can be accepted by all the parties concerned. In this way, the best possible results with the lowest possible costs can be achieved. As the environment faced by decisionmakers is complicated and rapidly-changing, it is difficult for them to make a comprehensive and timely analytical judgment in decision-making; they must use the scientific and democratic methods as important means to minimize errors in decisions. Making decisions scientifically and democratically is complementary. As decisions made based on the results calculated with the use of scientific methods by a small number of experts are often ill-considered or divorced from reality, they are not easily accepted by all the parties concerned. It is therefore necessary to draw on useful ideas to reach consensus through democratic methods and procedures. To enable democratic discussion and considerations to be really effective, we must provide all participants with accurate data and information produced through the scientific method. The establishment of an overall planning department allows us to collect and process data of all aspects, distribute it to the relevant officials, fully exchange views through democratic methods and procedures, and do repeated computing, so that we can get more realistic results to minimize errors in decision-making. An overall planning department could be established within the existing framework of the Development and Reform Commission, whose core members not only need to have good political qualities and rich practical experience, but also have a four-dimensional knowledge structure, namely professional depth, disciplinary breadth, philosophical height, and clear vision. The author sincerely hopes that this chapter will draw attention of the parties concerned on reforming the work of planning in China so that they will

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take effective measures organizationally and technically to make the work of planning better suit the needs of developing the socialist market economy, and play a greater role in the process of building a moderately prosperous society.

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Chapter

A Theoretical Analysis of Deflation and the Actual Problems Facing China

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Foreword After settling the severe inflation of 1992–1995 and successfully realizing the “soft landing” of the national economy, the phenomenon of a continuous fall of prices began to emerge in mid-1997 in China, which has brought a significant impact to economic development. This situation has caused much attention from economists and people concerned, but their analyses and interpretations of the situation differ greatly. Although economics textbooks usually call a continuous fall in prices as deflation, Chinese economists have not been able to come to a consensus on issues such as its definition, criteria for judgment, causes, management, and whether or not it has already existed in China. The history of economic development all over the world over the last 200 years shows that the frequency of deflation is much less than that of inflation. Therefore, economists have conducted many extensive and in-depth studies on inflation, but little on deflation. Several works relating to deflation published in foreign countries in recent years have been mostly based on data and analysis of the developed countries, which are difficult to be applied fully to study the situation of China. Similar books and articles published in China are usually tilted towards qualitative analysis and deliberation, in which some views lack the support of solid evidence. So in this chapter, the author intends to make a preliminary analysis of the definition, causes, and policies of deflation based on research results at home and abroad by applying theories of systems engineering, complexity science, and fictitious economy, and combined qualitative and quantitative methods. The author will also use the results of the above-mentioned theoretical analyses to investigate the causes of China’s deflation in recent years and the major strategies to be adopted.

Deflation is a Kind Of Monetary Phenomenon Like inflation, deflation originally is only a monetary phenomenon, which means that the quantity of money is less than the quantity of goods. In the definitions of deflation given by many economists, however, it is usually related to the fall in price levels. J.E. Stiglitz, an American economist, for example, says in his textbook Economics that “deflation indicates a steady fall in the price level.” P.L. Krugman, P.A. Samuelson and others define deflation in their writings as “a fall in the general price level.” The above definitions cause many people to mistakenly think that deflation is not just a monetary phenomenon, but an economic one. They therefore see deflation and recession as being closely related, and some even believe that

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deflation is a kind of policy. For example, in the volume of Economics in the Encyclopedia of China , deflation is defined as “contracting the quantity of money in the process of circulation to raise its purchasing power or reducing the growth rate of issuance of paper money in order to reduce the degree of its devaluation. It is a policy adopted by the capitalist countries when facing serious fiscal deficits or inflation.” This definition has refuted the viewpoints of many economists and affixed a political label on deflation. In contrast, that book, defines inflation as a socio-economic phenomenon, i.e. “the phenomenon of currency devaluation and price increases caused by the quantity of money issued exceeding the actual quantity needed in the circulation of goods. This is a kind of socio-economic phenomenon exists under the circulation of paper money, which is usually shown by a continual rise of the general price level, which also means the value of goods represented by the currency falls in general.” This definition has then negated the corresponding relationship between deflation and inflation. The author believes that “a fall in the price level” proposed by many of the above-mentioned economists is not the definition of deflation, but the phenomenon of deflation. By reviewing the history of the development of currency, gold had served the function of warranty to the then widely issued paper money ever since the first implementation of the gold standard system in UK in 1821. The gold standard gradually became widely popular in Europe and the U.S., and in 1870 it began to become the foundation of the world currency. It was not until after the outbreak of World War I, because of such reasons as that some countries had restricted and even prohibited the free export of gold, that the implementation of the gold standard came to an end. After the end of World War I, the gold standard system was changed to the gold exchange standard system, and then the legal function of gold in the international monetary system formally come to an end in 1970s. At the same time as money was “depegged” from gold, the degree of virtualization of money greatly increased. It is because people could no longer determine the value of money with a fixed-valued “reference”, and they therefore could only measure the value of money by its purchasing power. In addition, as the mechanism of automatic withdrawal for currencies restricted by the gold standard system was no longer existent in the entire economic system, the purchasing power of money was therefore determined by the relation between the quantity of money and the real economy. People therefore could only equate “a general fall in the price level” that leads to the rise of the purchasing power of money with “a fall of the quantity of money.” In other words, we can only use “a fall in the overall price level” as a criterion to distinguish deflation.

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The author believes that deflation is a monetary phenomenon, which is shown by a fall in the overall price level. The overall price level is usually measured by the price index (mainly the price indexes of consumer goods and services). In 2001, the National Bureau of Statistics of China followed a new categorization and method to make a fixed base price index that was in line with international practice. This was officially made public so as to serve as the main criterion for determining the overall price level. In order to observe more easily the changes in the overall price level, the variable-base (chain) price index is usually adopted. If the index is greater than 100 %, then the currency is inflated, while if the index is less than 100%, then the currency is deflated. Some Western scholars believe that the government tends to “exaggerate” the inflation level, so when the price index is less than 101%, which means the price increases by less than 1%, it can be claimed that deflation has occurred. As this viewpoint still needs to be further deliberated, this chapter still takes a price index of less than 100% as a criterion for determining the occurrence of deflation. The author believes that when we study deflation, we should pay attention to the differences between status and process. When the overall price level of a certain period is lower than that of the previous period, it can be considered that the phenomenon (or sign) of deflation has occurred; and this refers to a status. When the overall price level continues to fall, it can be considered as being in a course (stage) of deflation; and this refers to a process. To distinguish a phenomenon of deflation is relatively easy, and its criteria are generally recognized. However, when judging whether a country is in the course of deflation, since different economists have different interpretations of deflation, the criteria for distinction proposed by them are different too. Some advocate a “single-element theory,” others, a “two-element theory,” still others, a “threeelement theory.” Those who hold the view of “a single-element theory” believe that the definition of deflation is diametrically different from that of inflation. Deflation refers to a general and continuous fall in the price of goods and services. They think that “a continuous fall” does not mean that the price level is necessarily “low.” A “general” fall refers to a general and extensive fall in the price of goods and services rather than a fall in the price level of a particular product or industry. Scholars who hold the view of “two-element theory” believe that there should be two essential conditions for the occurrence of deflation: first, a continuous fall in the prices of goods and services; second, a continuous fall in the supply of money. Accompanying inflation is economic recession. The main

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differences between the “three-element theory” and those of the “two-element theory” lie in using economic recession as a measure of deflation and not an accompaniment of deflation, which means they view deflation as a monetary phenomenon which is related to a fall of the quantity of money in circulation, as leading to a fall in prices, and as usually accompanied by the occurrence of economic recession. Since deflation is a monetary phenomenon, we should not and need not use any criterion other than the overall price level. The author therefore agrees in principle with the “single factor theory” point of view, but believes that the criterion still needs to be further refined and quantified. The author suggests that when a country has a fall in the overall price level of over 80% of the months in the period of over a year, then we can consider that country is in a course of deflation, which is commonly referred to as the occurrence of deflation. Some people believe that the criteria for the occurrence of deflation should be based on a continuous fall of the overall price level within 12 months, but the author thinks that is not appropriate. Seen from the angle of a point in time (for example at the end of each month), the overall price level of month, when compared with that of the previous month, has only the three possibilities: rising (inflation), falling (deflation) and breaking even, and the chances of the occurrence of first two possibilities are higher. The overall price level will therefore continuously be in a state of change, and it is very likely that due to internal and external factors there will be fluctuations, both up and down, such as the occurrence of a short rise during a process of a continuous fall. On the contrary, from the angle of a period of time (for example one year), despite the fact that fluctuations of the overall price level may occur, if the price level most of the time, then it can be considered as inflation. But if it falls most of the time, then it can be considered an occurrence of deflation. The author therefore suggests that from the angle of a period of time, if the price index is greater than 100% for over 80% of time in the period, then it can be considered that inflation has occurred; if it is less than 100% for over 80% of time in the period, then deflation has occurred. We should also note there is usually a time lag between the beginning of the occurrence of deflation and the occurrence of its obvious impact on economic operation. Foreign research shows that it takes one to two years for the impact of the quantity of money supply on the price level to be shown. If the period taken for assessment is shorter, then deflation may have been eased before there is any significant impact. Based on the historical data, as the generally recognized period of deflation is usually more than one year, the author suggests that we

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should use the data of more than one year as the basis for distinguishing the occurrence of deflation, and call the deflation that continues for less than 24 months “short-term deflation,” the deflation that continues for more than five years “long-term deflation,” and the deflation that falls in between “medium-term deflation.” Some economists believe that only when the price index is greater than 100% throughout a period of time and the rate of inflation still continues to increase, can we call it inflation; and when the inflation rate gradually decreases, we can call it non-inflation or disinflation. The author does not entirely agree with this view, but as this chapter focuses on issues of deflation, we will not delve further into this issue. As deflation and inflation commonly occur as monetary phenomena, despite the fact that they are mutually related to and have an impact on economic phenomena, it is not necessary to relate them to good or bad economic situations, nor should we consider that there is an inevitable relationship between deflation and economic recession. If we interpret deflation politically and hold the view that if we admit that there is deflation, then we also admit that there is economic recession, this would not help us make an in-depth study of the regular patterns of deflation, objectively judge the occurrence of deflation, comprehensively analyze the impact of deflation on economic development and take proper measures in a timely manner. The author believes that like inflation, deflation has both advantages and disadvantages. Short-term deflation is sometimes beneficial to economic development, and only medium- and long-term deflation will usually lead to economic recession. So as long as we have a clear head, identify problems in a timely manner, have a clear policy and use appropriate measures, it is entirely possible for us to create advantages while avoiding disadvantages, making use of the beneficial function of deflation on economic development, thus confining its damage to a minimum.

A Historical Review of Deflation As deflation is a monetary phenomenon, when we undertake a historical review of deflation, we should examine it together with the history of the development of currency, and also pay attention to the mutual relationship and impact between deflation and economic phenomena. According to a preliminary study by the author, the history of deflation in the major Western countries can be divided into three phases.

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1821–1913 Money was the only fully liquid asset that could also be converted into other commodities. The use of metal (gold or silver) as currency is at least 4,000 years old, and metal coins, 2,600 years old. In 1821, UK first implemented the gold standard, which was a currency system that was based on a fixed amount of gold or maintained by the value of a fixed amount of gold. Currency could be converted freely at home or abroad into gold, based on gold content. Later, Germany, France and the U.S. also adopted the gold standard, and many other countries followed suit. As the major Western countries implemented the gold standard, deflation in this period was closely related to the practice of the gold standard currency system in various countries. The gold standard has the advantage of limiting the power of the government or banks in over-issuing notes and thus preventing the devaluation of currency that this could cause, and it also helped stabilize the exchange rate. As the currency-to-gold ratio of each country was fixed, the quantity of the issuance of currency was linked to this ratio and the gold reserves of the country. The disadvantages of the gold standard were that due to the relatively slow increase in the amount of gold, which restricted the issuance of currency, it could not meet the needs for an increase in currency as a result of an increase in the total supply during the economic development of the various countries. It restricted the flexibility to adjust the quantity of money supply, which could easily lead to deflation, hinder the interaction among economies of different nations and restrict countries with the ability to settle deficits and their ability of dealing with deflation. Since in this period the currency notes issued by governments were guaranteed by a corresponding amount of gold, short-term deflation, which often occurred, usually would not cause economic recession. In 1839–1843, deflation occurred in the U.S. During this period, prices fell by 42%, investment fell by 23%, and the stock market fell by 34% while the number of banks declined by 23%; consumption however increased by 21%, and the real gross domestic product grew by 15%, indicating that deflation did not cause economic recession. After the end of the Civil War in 1865, the U.S. economy grew steadily, to which the three factors of the export of agricultural products, railway construction and industrialization played an important role. Agriculture in the U.S. developed rapidly as a result of immigration, wasteland development and the scale of agricultural operations, where the export of its agricultural products accounted for 70% of its total exports. The total length of railway lines increased from 30,600 km in 1860 to 150,200 km in 1880 (in which 8,000 miles

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of railway lines were constructed in 1870 alone), and to 193,000 km by 1900. As a result of an increase in investment, the strengthening of management, and horizontal merger, the speed of industrial development was far higher than that of agricultural development. Industrialization was significantly accelerated. In 1869–1878 the ratio of industry to agriculture in the GDP of the U.S. was 1.66, but in 1897–1901 it became 3.26. Although the U.S. economy gained momentum, as the growth of gold reserves could not keep up with the growth of the demand for money, the trend of falling prices was significant. During the thirty-two years in the period of 1865–1897, the GDP rose in twenty-three years, fell in only nine years, while the money supply (M2) fell in twelve years and rose in twenty years. However, the U.S. wholesale price index declined in years, rose in eight years, and remained flat in two years; the agricultural price index declined in twenty-two years, rose in nine years, and remained flat in one year; the consumer price index declined in twenty-two years, rose in three years, and remained flat in seven years. Thus, during the implementation of the gold standard, the deflation caused by falling prices did not necessarily lead to economic recession. However, in 1865–1914, the U.S. economy suffered two recessions, one in 1873–1878 and the other in 1893–1896. These two economic recessions were due to the joint effect of a long-term price fall and credit crises. In the history of currency development, ever since the idle money in the hands of the people was turned into interest-bearing capital, and with the emergence of credit currency, currency began to be virtualized. Banks as intermediary organizations borrow the idle money in the hands of the people, and then lend it out as loans to generate interest. People can also use this idle money in their hands to buy a variety of securities to generate interest, and then the certificates of deposit and marketable securities in their hands are also fictitious capital. The socialization of interest-bearing capital can steer money in the hands of the people who cannot use it for such real economic activities as production and circulation, to the hands of the people who can do so. The latter can also pool the money scattered in the hands of individuals to conduct economic activities of a larger scale for higher yields, and in this way improve efficiency in the use of money. The use of fictitious capital in the financial market to directly carry out activities that use money to generate money is called the fictitious economy. A further development of the fictitious economy is the marketization of negotiable securities. This means that negotiable securities can be traded freely in accordance with its expected gains, which creates a financial market for fictitious capital trading (such as the stock market, bond market, and the

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money market). The marketization of negotiable securities not only enables people to realize their negotiable securities in hand at any time, which greatly enhances the flow of their fictitious capital, but also guides the funds towards the industries with better expected returns, which can further improve the efficiency in the use of capital. In 1898, futures trading emerged in agricultural product market, and gradually extended to industrial raw material markets such as non-ferrous metals and crude oil, which is a new form of fictitious economy. The birth of banks made credit currency the medium of exchange and means of payment, such as checks, bank drafts, and promissory notes, many of which, however, did not have a corresponding value of gold as collateral. Therefore, their value was fictitious. When there is a credit crisis, people would quickly use their credit money and exchange it for gold, which in turn would inevitably lead to people making a run on the banks without adequate gold reserves, causing the closure of banks, bringing about credit crises, and intensifying deflation. Despite the fact that in the years between 1865 and 1871, prices in the U.S. continued to fall for six consecutive years, its GDP continued to grow as its finance remained steady. The negative impact of a prolonged fall in prices, however, was gradually exposed. It gradually diminished the profits of enterprises running on liability operation, which not only resulted in an increase in their debts but also made it more difficult for enterprises to repay them, thus leading them to possible bankruptcy. During this period, the number of enterprises that went bankrupt each year rose from 500 to 2,900 and the total amount of debts of bankrupt enterprises rose from USD17.6 million to USD85.3 million. The supply of currency being greater than the demand over a long period brought about the contraction of the loan capital market and the rise of discount rates. In 1871, the private discount rate in New York rose from 4.7% in July to 9.8% in December, and by October 1872, it rose to more than 12%. In September 1873, many banks that provided capital for railway construction were declared bankrupt, and people withdrew their deposits from them. The rapid contraction of the credit system forced prices to fall further and interest rates to rise rapidly (In October of that year, the private discount rate was as high as 17%), accelerating the bankruptcy of banks, industries and businesses and the fall of the stock market, and even forcing the closing of New York Stock Exchange for ten days. As the government began to buy the national debts in order to ease the tension in the financial market, the situation improved at the end of 1873, and the credit system began to recover from its paralysis. However, as being

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constrained by the gold reserves, the money supply was still tight, and the recession of industries and businesses could not be stopped. The wholesale price index, agricultural products price index and consumer price index continue to fall until 1879; the total rates of the fall within the six years were 33.8%, 33.3%, and 20% respectively. From 1872 to 1878, the annual rate of increase in the number of bankrupt enterprises was 14.4% every year, and the number of bankrupt enterprises in 1878 reached a record high of 1,500 enterprises. During the years of 1873 and 1878, the total amount of the debts of bankrupt enterprises remained high, accumulating to USD12.01 billion in the six years. During this period, the increase in the length of railway lines fell sharply, the stock market was sluggish, prices fell, and the unemployment rate rose; the economy was in doldrums. Facing such a situation, the U.S. government used methods such as increasing reserves through importing gold and buying silver to cast coins, so as to increase, to a certain extent, the supply of money. At the same time, it encouraged domestic and foreign investors to invest on railways, industries and businesses. Starting from 1878, railway stocks and the stocks of industries and businesses rebounded significantly, and the length of the newly built railway lines increased significantly, bringing about the development of other industries and promoting the recovery of the entire economy. In 1879, the agricultural price index, the wholesale price index, and the consumer price index began to rise together with the money supply (M2), and the GDP growth rates of 1879 and 1880 reached 12.55% and 11.87% respectively. As prices began to rise, industries and businesses also became active, the number of enterprises in bankruptcy and the amount of debts began to fall substantially, and there was a great improvement of the U.S. economy. In 1879 and 1880, due to the poor harvests of agricultural products abroad, the prices of agricultural products rebounded significantly, which brought an opportunity to the U.S. as agricultural products accounted for 90% of its total exports. In 1880, the U.S. trade deficit was USD169 million, while in 1881, it turned to a surplus of USD163 million. Due to the combined effects of the above factors, the U.S. finally came out of a deflation that lasted for five years (1873–1878). From the end of the 1870s to early 1890s, due to such reasons as continuous railway construction, the growth of export trade in agricultural products, etc., and the large inflow of capital from Europe, the U.S. economy on the whole moved upwards, but the constraints of the gold standard on the money supply still existed. Between 1888 and 1892, the wholesale price index, the agricultural products price index and the consumer price index fell at 11.6%, 8% and 0.87% respectively, but the GDP was still growing. During the same period, the

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amount of debts of the bankrupt enterprises increased from USD124 million to USD190 million. In addition, from 1888 onwards, the length of newly built railway lines each year dropped significantly. On the whole, the U.S. economy had started to decline from 1892. In March 1893, gold reserves in the U.S. Treasury dropped to below USD100 million. As the trend of a drastic fall emerged in the stock market of the New York Stock Exchange, foreign investors dumped their shares in American enterprises and rushed to buy gold, causing the value of gold leaving the U.S. in 1893 amounted to USD72 million. As depositors lost their confidence in the stability of the U.S. dollar, they all began to withdraw their deposits from the banks. To avoid risks, banks could only reduce or even stop lending to industries and businesses. About 15,200 industrial and business enterprises went bankrupt that year, with a total debt close to USD347 million; nearly 450 banks closed down, and the GDP dropped by about 8% as compared to that of 1892. After 1893, the price level continued to fall. In 1893–1897, the wholesale price index fell from 78 to 68, the agricultural price index from 72 to 60, and the consumer price index from 90.7 to 83.5. Although the economy rebounded briefly in 1895, the economic growth rate of 1896 was negative. During 1894 and 1897, there had been an annual drop of the volume of growth in the export of agricultural products and the length of railway lines. In early 1897, the U.S. economy began to take a turn for several reasons. First, after 1895, gold mines were found in South Africa and Alaska in the U.S., and it was passed that gold could be extracted from the low grade ore through the cyanide reaction process, which greatly increased the supply of gold; the supply of money also accordingly increased, leading to a rise in the prices of agricultural products and other commodities. Second, the industrialization in the U.S. was sped up. By the end of 19th century, industry had become the main economic sector of the U.S. economy. Third, starting from 1897, U.S. exports continued to grow, especially agricultural products, which experienced sustained growth. All these things contributed to the U.S. economy coming out from deflation in the years from 1893 to 1896. The recession that occurred in UK between 1873 and 1879 reflected the consequences of credit crises more clearly. In the 1870s, UK had made considerable investment in the U.S. and Central Europe and exported to them a large quantity of various industrial products. In 1873, when the U.S. had an economic panic caused by the shrinking of railway construction and other factors, the crisis first affected the interest rates of UK through the financial market, creating tension in credit and a reduction of the amount of money

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supply. In September 1873, with the crash in the U.S. stock market, the discount rate of the Bank of England rose and reached 9% on November 7. At the same time, the economic crisis in the U.S. and Central Europe also badly affected UK exports, especially the export of cast iron, which fell from 3.96 million tons in 1872 to 2.59 million tons in 1876. The number of bankrupt enterprises and the amount of insolvency of debts in UK started to rise substantially from 1872. The wholesale price index in UK fell from 120 in 1873 all the way down to 99 in 1879 (in 1913 it was 100); during the same period, the GDP fell to 10.7%. Not until 1880 when the price level began to rise and the retail price index rose to 103 was UK able to come out of recession. From the history of this period, we can see that the money supply was constrained by the gold standard, and that deflation was generally caused by the demand for money being greater than its supply. But it was only under the combined effects of long-term deflation and sudden credit crises that economic recession would be induced.

1914–1945 After the beginning of World War I in 1914, almost every country used nonconvertible notes or restricted the export of gold. During the period from the end of the War until 1928, most countries began to use the gold exchange standard, which means these countries could supplement the gold reserves in their central banks by using currencies (the U.S. dollar and British pound) which could be converted into gold at a fixed exchange rate. Due to the impact of the Great Depression in the 1930s, however, UK and the U.S. officially abandoned the gold standard in 1931 and 1933 respectively, and by 1937 the gold exchange standard was on the verge of collapse. It is true that we can trace the transnational trading of fictitious capital back to the middle of the 19th century when debtor countries like the U.S. and the railway companies in UK, France and Germany issued fixed-rate bonds in the financial markets, however, it was not until the 1920s that there was the beginning of a larger scale of transnational securities investment, the economic ties among the various countries became closer, and the impact of exchange rates on economy was more significant. During the years of 1918 and 1920 after World War I, the GDP of the U.S. economy underwent a sustained growth, and the commodity prices also continued to rise. To stop speculation in the stock market, since December 30, 1919, the New York Federal Reserve Bank started to raise the discount rate several times and the rate was doubled in less than a year’s time. There was a

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great reduction in the volume of money supply, which caused tension on credit. The rise in interest rates also hindered investment, causing the industry and business sectors starting to decline since the summer of 1920. There had been an increase in the number of bankruptcies of industrial and business enterprises, a fall in the price level, and a rise in the unemployment rate. The Federal Government, however, did not expand government spending but turn the budget of 1920 from deficit to surplus, which made the entire country soon fell into economic depression. From the beginning of 1922, as interest rates began to fall, investment was stimulated, industries and businesses started to recover, and the commodity prices began to rise again. It was not until 1923 that the U.S. came out of a deflation that had lasted for over than two years. The U.S. economy experienced a boom between 1923 and 1928. In early 1928, in order to curb excessive speculation in the stock market, the Federal Reserve System began to restrict the money supply to raise lending rates. In the first half of 1929, the Federal Reserve Board directed various Federal Reserve Banks to issue only “productive loans,” and refused to release loans for securities speculation. However, the result was just the opposite. A huge amount of bank capital went into the stock market to keep it bullish, but the problem of lack of capital for enterprises became increasingly serious, resulting in a great reduction in production of the manufacturing and construction industries. On October 24, 1929, better known as “Black Thursday,” the stock market began to dip drastically. In less than three months, market value shrank by about USD25 billion, far exceeding the net national income of the U.S. in the same period. The crash of the stock market led to the closure of banks one after the other, causing a financial panic that people withdrew their deposits one by one. This led to the four-year long Great Depression in the U.S. Between 1929 and 1933, prices in the U.S. fell by 32%, investment by 91%, the stock market by 27%, the number of banks by 42%, actual consumption by 19%, and the real GDP by 30%. The unemployment rate rose rapidly from 1930 onwards with an annual average rate that reached as high as 18.3%, and the wages of workers fell much faster than that of commodity prices. In the four consecutive years from 1930 to 1933, there was a negative growth in M2 with an annual average rate of -8.7%, and the ratio of deposit to currency held in the hands of the public in 1933 was 2.1 times that of 1930. On March 6, 1933, Roosevelt became the U.S. president and made a series of policy measures to alleviate the economic difficulties, such as the Agricultural Adjustment Act , National Recovery Act , Securities Law , Glass-Steagall Act , Exchange Act , and Labor Relations Act . The government also established a series of federal funding agencies to increase all sorts of loans, such as

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Reconstruction Finance Corporation and the Housing Loan Corporation. It also raised the exchange rate of every ounce of gold against the U.S. dollar from USD20.67 to USD35, which greatly increased the money supply. As a result, the M2 started to grow since 1934, and the average annual growth rate from 1934 to 1937 was 9.1%. The production price index and the consumer price index began to rise. GDP also started to grow with the annual average growth rate between 1934 and 1936 being 13%. In this way, the U.S. was able to find its way out of the worst economic depression in history. In UK, long-term deflation between 1920 and 1933 was caused by its policy to restore the gold standard. During the period from 1918 to 1920, the British economy continued to grow. But as a result of the British government’s adoption of a stringent monetary policy to restore the par value of British pound, the money supply, the price level and GDP continued to decline from 1921 onwards, leading to a three-year recession. Under the impact of such factors as the world’s economic growth and advances in technology, the British economy, which was in a period of deflation, began to recover. However, when UK resumed the gold standard in 1925, the overvalued British pound seriously hit British exports, leading to huge trade deficits. At the same time, in order to prevent capital outflow, the British government also adopted a high interestrate policy, which further worsened economic development, and the British economy once again sank into recession. In 1931, UK was forced to drop the gold standard, resulting in a substantial depreciation of the British pound, and with the adoption of protective trade policies, UK was able to emerge from its long-term recession. France in the early 20th century twice experienced deflation (1921–1922 and 1931–1936), both caused by external factors. In 1920, under the pressure of countries like UK and the U.S., France adopted a tight monetary policy to prevent the devaluation of the franc, resulting in a reduction of money supply and a fall in price for two consecutive years in 1921 and 1922, and bringing about a short-term recession. As the French government adopted measures to devalue the franc and lower the interest rate in a timely manner, its economy was able to rebound. Between 1923 and 1930, despite the fact that the French government in the latter half of 1926 began to adopt measures to stabilize the exchange rate of the franc, balance its budget, and increase its interest rate in order to curb inflation, prices still rose steadily due to an increase in net capital inflow and national income. In 1931, the devaluation of currencies of countries such as UK and the U.S. and the fall in prices in the international market resulted in an appreciation of the franc and a reduction in exports. People

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bought the bank drafts of the French central bank, which led to a reduction in money supply, deflation, and a continuous fall in prices which resulted in the French economy experiencing a sustained recession that lasted for six years. The French Government then devalued the franc, prohibited the private sale of gold, and purchased a large number of short-term treasury bills to increase money supply, stimulate demand, and push up prices. France then began to come out of recession in 1937. It can be seen from the history of this period that constraints on money supply by gold reserves gradually weakened, the influence of interest rates and exchange rates became more prominent, and government intervention in their economies began to increase. Governments began to use fiscal and monetary policies to regulate the economy, but it was only under the circumstances of a proper use of policies, a sound financial system, and an enhancement of people’s confidence that a country could avoid a deflation period or reduce economic recession. After the outbreak of World War II, the economies of all countries entered into a war economy track, and there was a total absence of deflation. Some economists therefore believed that it was the war that helped the new policies of Roosevelt, which resulted in a full recovery and rapid growth of the U.S. economy.

After 1945 World recession in the 1930s and the outbreak of World War II brought financial market globalization to a halt. After the war, the European continent was in ruins, many things needed to be done, and there was an urgent need for capital investment. The U.S. passed the Marshall Plan to support Europe, but the liberalization of international trade and international payments that accompanied it paved the way for U.S. capital to go directly into the European market. Through the promotion of the Bretton Woods Agreement and General Agreement on Tariffs and Trade , a huge international financial market was gradually formed. The internationalization of financial markets guided capital to flow to industries with better income in a global scope, which could greatly improve the efficiency in the use of capital, while also forming a new financial market—the foreign exchange market. Futures were also increasingly virtualized, which means that buying futures was used as a means of speculation. From the 1960s onwards, there was the gradual emergence of futures trading in financial commodities such as stocks, bonds, and foreign exchange.

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After World War II, the U.S. set a minimum price in U.S. dollars for the foreign central banks to buy or sell gold. In 1958, major European countries stipulated that they could settle international payments in their own currencies which could be freely converted into gold or U.S. dollars. But in 1971 the U.S. stopped the practice of freely converting U.S. dollars into gold according to a fixed price (USD35 per ounce of gold) in international payments. From then on, the international monetary system was based on U.S. dollar and other notes, and the official role of gold as the world’s exchange rate came to an end. Since then, currency was completely “decoupled” from gold, and it could not be freely converted into gold at a fixed price. Currencies were issued only by the total credit of a country, and became non-convertible notes (fiat money), which greatly increased the degree of virtualization of currencies. Despite the fact that in the international monetary system, the legal functions of gold ended in the 1970s, it is still the most reliable reserve asset. That is why about 45% of the world’s gold has been owned by governments and central banks, and gold is accepted by various countries as a means for international payment. With the formation of the floating exchange rate system resulting from the decoupling of the U.S. dollars from the gold standard, the enhancement of financial innovation, the rapid advances in information technology, the expansion of the degree of financial liberalization, and the development of economic globalization, international finance headed gradually towards integration. There were closer links between domestic financial markets in various countries and international financial markets, and their mutual influences also became larger. The pace of flow of fictitious capital in financial markets became faster, and its volume was also larger, resulting in a continuous expansion of the scope of the fictitious economy. Under the impact of the “multiplier effect,” the total scope of the current fictitious economy in the world has far exceeded that of the real economy. According to the author ’s preliminary statistics, at the end of 2000 the total amount of fictitious economy in the world reached USD160 trillion, of which the market value of stocks and the balance of bonds were about USD65 trillion, the balance of over-the-desk trading of financial derivatives was about USD95 trillion, while the total amount of GDP of these countries of that year was only about USD30 trillion. This means that the size of the fictitious economy was five times that of the real economy. The average daily circulation volume of fictitious capital in the world was as high as USD1.5 trillion, which was about 50 times the average daily real trade volume of the world. This means that only 2% of the daily circulating capital in the world was actually used in international trade,

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while others were used in activities in financial markets that used money to make money. It can be expected that with the development of e-commerce and e-money, the scale of the fictitious economy will continue to grow. From the end of World War II to the 1970s, as countries were busy with economic recovery, the U.S. also entered a period of sustained economic growth. Between 1949 and 1974, the average annual wholesale price index in the U.S. rose by 1.4%, which made it difficult for deflation to take place. After 1971, as the amount of money supply was completely free from the constraints of the gold reserve, governments could print more notes to ensure money supply, and as the situation was relatively peaceful, countries made great efforts and used all sorts of means to stimulate economic development. The overall price level in most cases continued to rise. With its disastrous defeat in the Vietnam War and the failure of the over-ambitious “Great Society” programs, the U.S. experienced serious inflation, leading to the recession of 1973 to 1975. Since the 1980s, the world economy as a whole has been in a period of growth and long-term deflation has rarely seen. The only incident worth noting was the deflation that occurred in Japan in the 1990s. Since 1991, with the bursting of the bubble economy, Japan’s economic growth rate continued to decline, and the country sank into a long-term recession. From 1992, Japan’s comprehensive wholesale price index was on a downward trend, which became more obvious after 1998. A negative growth of the Japanese economy even occurred in the two years of 1997 and 1998. The average annual growth rate of money supply M2 also fell from 11.8% in the latter part of the 1980s to 4% in the 1990s. The unemployment rate continued to rise and reached 4.7% in 1999, a record high after World War II. Since 1998, the Japanese government has implemented a number of measures aiming to stimulate economic growth and improve its economic structure, but so far the effects have been far from obvious. After the 1990s, many countries have witnessed declining rates of inflation (disinflation). From the third quarter of 1997, countries such as China, Singapore, Sweden, and Switzerland experienced deflation while at the same time the gap between actual global output and potential output was the largest since the 1930s. As the deflation that occurred after 1971 took place during the rapid development of the fictitious economy while currency was becoming increasingly virtualized, the causes of its formation were different from those of the previous two stages. This is why the author here calls it as “modern deflation” and intends to further explore its causes and consequences.

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The Causes and Consequences of Modern Deflation The causes of modern deflation are very complicated and as in-depth research has not been carried out yet, there is no consensus of views on them. The first systematic study on deflation was made by Irving Fisher of the U.S. When studying the Great Depression in 1929 to 1933 in the U.S. he believed that the initial state of over-indebtedness and the subsequent deflation were the two most important variables. When an economy in equilibrium is struck by the impact of excessive debts, and assuming that there are no other factors that can affect the price level, then the resulting debt clearance will generate the following nine-step chain reaction: (1) a bargain sale of assets; (2) a reduction of money in deposit and a fall in its speed of circulation; (3) a fall in price level; (4) an acceleration in bankruptcies; (5) a fall in profits; (6) a contraction in industries and businesses and an increase in unemployment; (7) widespread pessimism and loss of confidence; (8) a further decline in the speed of currency circulation; and (9) a rise in real interest rates and a fall in nominal interest rates. There may be differences between the logical sequence of the above ninestep reaction and the actual temporal sequence, and there are also some other responses, and individual responses will also be repeated. Apart from the first and last two steps (debts and their interest rates) of the logical sequence, all other fluctuations come from a fall in price level. We should also note that cash, deposits and the lowering of the speed of their circulation have a direct impact on a reduction in the volume of trading. Excessive debts lead to deflation, and deflation will bring about a rise in the real scale of the outstanding debts, and when the scale of excessive debts exceeds the critical level, this will create the situation where the more the debtors repay, the more debts they owns, forming a vicious circle. For example, at the beginning of the 1929 Great Depression, although the U.S. reduced 20% of the nominal amount of debts through loan repayment in March 1933, as the overall price level dropped by 75%, the real debts rose by 40% [(100% - 20%) × (100% + 75%) = 140%]. During this period, outputs and real income fell very quickly and continuously, making the economic system more unstable. Fisher believes that (1) if deflation is not caused by excessive debts, then the harm it causes will not be so great; (2) if the downward trend in the price level caused by excessive debts is restricted by the force of inflation, then the fluctuations in economic variables will be eased; and (3) if excessive debts have not reached a critical scale, then the economy will head for equilibrium amidst fluctuations. The most common initial conditions that generate excessive debts seem to be

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the extraordinary investment opportunities that could gain high profits, while the low interest capital is the main cause of excessive debts. Compared with the debt bubble of a non-productive nature, the formation of a debt bubble that is caused by seemingly profitable new investment opportunities is much larger and faster. The psychological factors that entice the public to get into debts are (1) high returns in the long run; (2) extraordinary profits in the short run; (3) hasty investment decisions; and (4) credulity to cheaters. The Monetarist School represented by Milton Friedman advocates that money supply is a major factor in deciding economic activities, and believes that the quantity of money has a significant impact on economic activities and price level, and the best way to achieve the objectives of a monetary policy is to work out the growth rate targets of money supply. According to the basic formula of “the stock of money × the speed of money circulation = price × total production of commodities,” in the long term, changes in the stock of money are usually greater than changes in the speed of money circulation (total expenditure / stock of money), and determine the subsequent money circulation speed, while the total quantity of commodities is mainly determined by non-monetary factors, so changes in the stock of money mainly affect the price level. Inflation is caused by an excessive expansion of money, which can therefore be prevented through a proper control of money supply. Friedman repeatedly declares that “inflation is a monetary phenomenon, no matter when and where.” As with inflation, the corresponding phenomenon of deflation is mainly due to an inadequate money supply. Friedman believes that the quantity of money supply is largely determined by monetary authorities that lay outside an economic system, so money supply is exogenous. Deflation is caused by the supply being greater than demand in the commodity market because of the money supply factors is called an exogenous deflation. For example, an excessive and prolonged tightening of monetary policy by a central bank leads to a fall in money supply, which cannot meet the demand for money for real economic development. A reduction in consumption results in the demand being less than the supply, and this leads to a fall in the overall price level. Friedman’s theory was supported by empirical data on the U.S. currency in the 1970s, but with the abolition of the gold standard and the development of financial innovation and the continuous internationalization of financial markets, this theory was questioned repeatedly. J. Tobin, for example, believes that money is endogenous, and while the quantity of money supply is commonly determined by monetary authorities, commercial banks and nonbanking financial institutions within an economic system, it is difficult to be controlled directly by the monetary authorities. The deflation caused by demand

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being greater than the supply of money as a result of an increase of the value of money caused by the internal factors of a real economy is called endogenous deflation. For example, when the supply of commodities and services is greater than demand as a result of technological advances and institutional innovation, and there is a surplus in supply, this leads to a fall in the overall price level. In recent years, the dominant view among international economists is concentrated on interpreting and analyzing the causes of deflation from the perspective of supply. They believe that factors such as the accelerated process of globalization, technological advances and high investment rates give rise to a surplus of global production capacity, which causes deflation. A.G. Shilling, based mainly on the conditions of the U.S., lists 14 kinds of forces that have caused deflation: (1) a reduction of global military spending due to the ending of the Cold War; (2) a gradual reduction in government spending and fiscal deficits in major countries; (3) the central banks of various countries making last-minute efforts to curb inflation; (4) the retirement plans of the seven major developed countries (G7) will result in a reduction of benefits and a slowdown of growth in income and expenditure; (5) the restructuring in English-speaking countries is in progress and will be expanded; (6) a reduction of costs and an increase in labor productivity due to technological advances; (7) an increase in competition due to the dissemination of information through the Internet; (8) bulk purchases by customers will reduce production costs and selling price; (9) the deregulation which is being promoted will encourage lower prices; (10) the globalization of the supply of commodities and services will reduce costs; (11) the expansion of the market economy will increase global supply; (12) the U.S. dollar remains strong; (13) the Asian financial crisis and economic problems will contribute to a global oversupply and lower price levels all over the world; (14) consumers in the U.S. will shift from borrowing and spending to savings. A year later, Shilling reiterated his main ideas, made clear that deflation is

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inevitable and that global deflation has begun, and that the various forces of deflation as stated above could land the world into a long-term deflation. Krugman points out that although recession has not yet come, the School of Depression Economics which studies the problems of world recession has already been revitalized. He focuses on the study of the Japanese deflation in the 1990s, and claims that the deflation was caused not only by factors relating to supply, but also by factors relating to demand. The lack of demand varied with factors such as government structure, stages of economic development, and social traditions. Due to the Japanese economy’s rapid decline in the labor force caused by a slow natural growth in population and overseas emigration, there was a decline in the expected profits of enterprises, resulting in a reluctance to expand domestic investment. The burst of Japan’s economic bubble in the early 1990s led to a reduction in investment by enterprises, a lowering of people’s expected income, which pushed forward and aggregated the level of the lack of overall demand in society, thus creating deflation. He believes that under the situation of low inflation, the fall in prices was not caused by prices being too high, but by expected prices being too low or nominal interest rates being too high. He believes that the Japanese economy was caught in a liquidity trap, where the real interest rate was less than zero for savings and investment to achieve equilibrium in full employment. That means that the public preferred the future rather than the present, and even when short-term nominal interest rates went down to zero, their willingness to save was still higher than their willingness to invest. Consequently, monetary policies could do nothing to prevent deflation, and as deflation continued to spread, it resulted in a prolonged slump in the Japanese economy. Due to incomplete capital market information, those who expect to have an increase in their income are bound by liquidity constraints, and the loans they obtain are difficult to offset the increase of deposits by those who expect to have a reduction in their income. This results in an increase in savings, making real interest rates lower than those in a full market condition, thereby creating a liquidity trap. Krugman believes that even if capital could be fully liquid, due to the limited level of the integration of commodities and labor market, it would restrict the public from shifting their savings abroad to look for better investment opportunities when interest rates were low. Due also to the poor tradability of industries that have a great impact on employment, there is a significant reduction of excessive savings as they are difficult to make into foreign investment. Therefore the export of capital cannot completely solve the problems of a liquidity trap.

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The author believes that when we study the causes that lead to the formation of modern deflation, the following three points should be emphasized: First, the complexity of a monetary system. A monetary system is a subsystem of a financial system, while a financial system is a sub-system of an economic system. According to complexity science, a monetary system is seen to be a complex system consisting of various kinds of related agents, including individuals, enterprises, and banks. Each agent is both a recipient of money and a payer of money. Although each agent determines its actions independently based on certain rules and future predictions, it will also inevitably be affected by the decisions of other agents and the environment. The inter-relationships, influences and roles between agents will produce a self-organizing function to form the hierarchal structure and functional structure of the system, making it to evolve in a certain direction. Deflation is a reflection of the self-organizing function of a monetary system. A monetary system is an open system which is closely connected to the external environment. The changes in external environment will affect the behavior of various kinds of agents and change their self-organizing functions through their mutual influences, causing a change in the structure of the system to adapt itself to environmental changes. A monetary system also has a dissipative structure and is in an unstable state that it needs to rely on a continuous monetary system throughput with the environment to maintain its stability. Second, the fictitious nature of credit money. With the abolition of the gold standard and the development of the credit system, all money has become non-convertible credit money, whose variety has grown increasingly, whose scale has expanded rapidly, and whose level of virtualization has been raised continuously. As credit money is based on the creditability of a nation, a bank or an enterprise as a guarantee, when people’s confidence in this type of credit is greatly reduced, a credit crisis created. People will then withdraw their savings from their banks or cash their commercial paper, so as to increase their cash in hand or purchase government bonds, which will lower the quantity of money supply and lead to deflation. Even the notes that are guaranteed by a nation also have a certain degree of virtualization as their actual value will be reduced by the government’s decision to print more notes or declaration to depreciate its currency. The credit crisis caused by the virtualization of currency will not only result in deflation, but also recession due to a continuous and long-term deflation. Third, the self-enhancement of deflation. While deflation is a monetary phenomenon that falls into the domain of the fictitious economy, it is also closely related to the real economy. This is because a fictitious economic system

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is generated from and affiliated to a real economic system, so the risks generated from a real economic system, such as product backlog and business bankruptcy, will be passed on to the fictitious economic system, causing fluctuations or even drastic changes. Furthermore, the risks in a fictitious economic system, such as crashes in stock index, sharp falls in real estate prices, huge increases in bad debts in banks, and drastic devaluation of currencies, will also have serious impact on the real economy. The author believes that the cause and effect of deflation are not only interactive and bidirectional in nature, but also have some positive feedback, causing the level of deflation to have self-enhancement (self-strengthening), which means it will continue to grow stronger due to the interactive function of its cause and effect. People obtain money through labor and investment incomes in a monetary system, and they pay money through consumption, savings and investment. The income that people use on consumption is their real purchasing power, and their savings are reserves for future consumption, which is also a low-risk indirect investment, whereas direct investment is a higher-risk means of making profits. People’s income distribution structure is subject to the influence of factors such as historical traditions, social systems, income levels, personal preferences, but the most important one is their prediction of expected future incomes and prices. When people’s prediction of their future income is not positive (such as during a recession or a fall in the stock market), they tend to increase their savings, reduce consumption and investment, which will lead to a lower demand for commodities and a reduction in supply. Owing to the cushioning function of commodities in stock, a decrease in demand is usually greater and faster than that in supply, which will lead to a fall in the overall price level causing deflation. When people expect that prices will go down in the future, they will delay current consumption, which contributes to deflation. When people’s immediate desire to consume is very low, it will create a “liquidity trap,” and even when the nominal interest rate comes down to zero, it will still be hard to stimulate consumption, and bank deposits will continue to grow. Enterprises are mainly engaged in real economic activities such as production, circulation and trading. They gain money in a monetary system through selling goods and financing, and pay money through purchasing raw materials for production, paying wages, repaying loans, giving dividends, savings and paying taxes. When enterprises reduce costs through technological advances and better management, the prices of their products will come down because of cost reduction or the need to remain competitive, which will be a cause for deflation. When enterprises expect the future market conditions to be unfavorable (such as when there is an oversupply of goods or an increase

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in interest rates), they tend to reduce production, lay off workers and reduce stock by lowering prices, which will lower the overall price level and thus cause deflation. Banks are mainly engaged in fictitious economic activities such as deposits and loans. They gain money through absorbing deposits and getting back loans in a monetary system, and pay money through giving loans and paying interest. When a bank predicts the future conditions are unfavorable (such as recession or credit contraction), it tends to raise interest rates and tighten lending, which creates tension in the money supply and causes deflation. The interaction of the above agents is usually coordinative in nature, i.e. the actions they adopt when their expectation of the future is unfavorable are mutually reinforcing. A lowering of people’s purchasing power and a rise in interest rate, for example, usually compel enterprises to lower their price of goods so as to reduce stock and get back their money, while a lowering of price stalls purchases as people expect prices to go down further, forcing enterprises to lower prices further. Another example is that when enterprises lay off workers’ incomes will be reduced and their tendency to save money will be increased, further weakening people’s purchasing power. Yet another example is that when enterprises reduce their profits due to price cuts and result in operational difficulties or even bankruptcy, the performance of a bank will deteriorate due to a reduction of loans and an increase in bad debts, which creates a lowering of people’s confidence in the bank, and they will withdraw their deposits which causes tension in the money supply, which, in severe cases, will lead to bank bankruptcy due to runs on deposits. The impact of the capital market on deflation is mainly shown in two aspects: first, when prices begin to come down and the stock market is still bullish, it will divert part of the money supply, diminish the promotional role of the quantity of money supply on demand and spread deflation; second, when the stock market continues to fall, people will reduce consumption due to shrinking of their wealth and turn their investment into savings, which also promotes deflation. History shows that when there is mid- or long-term deflation, the stock market mostly falls as well. Under a market economy system, central banks and governments should stay outside the monetary system, and use various policy measures to affect the behavior of various individual agents and their self-organizing functions so as to adapt themselves to environmental changes. The central bank, for example, can macro-control a money market by the three monetary policy tools of discount rates, open market operations, reserve system and issue more notes in accordance with the stipulations in the currency issuance mechanism,

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and in this way affect the self-organizing function of a monetary system. The government can also use fiscal measures such as changing tax rates and increasing or reducing government spending to affect the operation of a real economic system and further affect the self-organizing function of a monetary system.

The Formation and Characteristics of Deflation in China Despite the fact that economists are still divided over the definition and differentiation criteria of deflation, a continuous fall in China’s overall price level is an indisputable fact. During 1997–2001, China’s year on year changes in the consumer price index are shown in Figure 4.1. According to the assessment criteria proposed by the author, the latest deflation in China can be considered as having begun in June 1997 and ended in September 2000. During this 40-month period, the overall price level for 32 Fig. 4.1.

China’s year on year changes in the consumer price index during 1997–2004

101.2

Consumer price index

100.8 100.4 100.0 99.6 99.2 98.8 98.4

1997

1998

1999

2000

2001

Year

Consumer price index (seasonal factor eliminated)

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months, which is indicated by the chain index, was less than 100. According to statistics, it seems that China has come out of deflation, but as some deeprooted causes of deflation still exist, deflation may make a comeback. Therefore, an in-depth analysis of the causes and special background of the formation of deflation in China and a serious review of experiences and lessons in dealing with deflation have great theoretical and practical significance. Regarding the causes of deflation of this time, there are generally the following several views: (1) Lack of effective social demand. It is believed that China’s deflation was caused by a fall in the quantity of the endogenous currency circulation due to a lack of effective social demand. The causes of a fall in effective social demand are that real economic phenomena, such as a fall in the growth rate of industrial production, a fall in enterprise profitability, and an increase in the number of unemployed workers, rapidly change the expectations of domestic producers and consumers, a reduction of the desire to invest on the part of enterprises, a reduction of productive investment, a fall in consumption desire, a significant drop in the amount of retail sales of consumer goods, a downturn of the market of investment goods and consumer goods, and a further lowering of the overall level of prices, form the inertia operation of the interaction between deflation and economic growth or recession. At present, the underlying causes of the shrinking of total demand are due to the fact that there are hindrances in the economic flow of income, savings, investment, and consumption during the process of changing the financing system, the organic formation of industrial capital, and the urban-rural dual structure. The economic flow was obstructed by income, savings, investment, and consumption. (2) Lack of demand in private investment. It is believed that the main cause of deflation in China has been the shrinkage of domestic institutional credibility and the resulting lack of social (private) investment demand. The key issue causing credit contraction in the entire economy is a tightened monetary policy, but the existence of a series of factors in the socio-economic micro-structure, such as the deterioration in the management of state-owned enterprises, made it difficult for banks to give further loans to these enterprises. State-owned banks in their credit policy also discriminate against private investment, which hinders the channels for non-state-owned small businesses to get loans. The effectiveness of the government to expand state-owned investment as a way to promote economic growth is diminishing, and the main cause of its inability to stop economic growth from falling has been that private investment has not followed suit. The basic cause for not being able to kick start private investment is the effects of systematic contraction. That means when the government

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implements an expanded fiscal policy to promote economic recovery, it also makes arrangements and measures for centralization and administration to prevent risk, which creates a situation in which an expansion of the macropolicy as a tool and institutional contraction coexist, which has to a great extent offset the effects of policy expansion and created some new distortions. (3) External impact. It is believed that China’s deflation originates from the impact of external factors. Blind investment and duplicated construction during 1992–1993 aggregated surplus in production and created the potential for generating deflation in China’s economy. As China’s and world economy are highly mutually dependent, the world economic crisis and global deflation has a huge impact on China’s economy. This kind of impact firstly causes a sharp decline in foreign trade and exports. When external demand is under pressure, the only course to take is to turn to the domestic market which causes it to contract further, thereby accelerating the shrinkage of the oversupplied market. External impacts also lead to a fall in direct foreign investment, creating constraints on China’s economic restructuring. A fall in exports also reduces China’s foreign currency reserves and its power to issue money, resulting in an endogenous contraction of the money supply. Deflation as currently experienced is therefore a mainly “imported” deflation. (4) Excessive productivity. It is believed that excessive productivity is the main cause of deflation in China. At present, China’s real economic growth rate is significantly lower than its overall growth trend, enlarging the output gap and causing enormous unused social productivity. Blind investment and duplicated construction are the sources that create excessive productivity. (5) Shortage in money supply. It is believed that the after effects of the tightened monetary and fiscal policies that lasted five years since 1993 and the tight monetary policy of 1998, especially the tightening of loan policy in the banking system, caused an over-tightening in policy and a relatively small money supply, bringing about and deepening the deflation in 1998. (6) Excessive debts. It is believed that China’s deflation was caused by excessive debts that are caused by the long-term low efficiency of state-owned enterprises. With the rectification of financial institutions and the continuous strengthening of constraints on the scale of bank lending, inefficient stateowned enterprises cannot get loans and their operation becomes increasingly difficult. Due to an increase of the risks of bank loans, a rise in the proportion of non-performing assets, a fall in interest collection ratio, banks become more prudent in lending. At the same time, a surplus in production abilities that formed as inefficient and duplication investment was taking place, pushed down the overall price level, lowered the profits of state-owned enterprises, and

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increased their pressure on loan repayment and interest payments, making their operations more difficult. Due to a fall in the overall price level and a rise in real interest rates, the loans of enterprises became heavier, and the pressure on the financial liquidity of enterprises further increased the difficulties of operation. This forms an endogenous and self-reinforcing deflationary process. Some of the viewpoints mentioned above are reasonable, and this shows that the causes of deflation in China are in general similar to other countries and their characteristics are shaped by the special conditions in China. The author believes that the special background of deflation in China is mainly manifested in the following five aspects: (1) China’s deflation occurred during the process of system conversion. In 1992, Deng Xiaoping proposed to establish a socialist market economy, promoting China to start transforming from the traditional planned economy system to a market economy system. In 1997, this process of system conversion was still in its initial stages, the influences of the old system were still very strong, government functions had not been changed, market forces were weak, the state-owned enterprises faced many difficulties, the growth of fiscal incomes was slow, the progress of financial reform was not fast, and the capital market was just established. These institutional factors played a role in the formation of deflation in China. (2) Deflation occurred soon after China dealt with inflation. To deal with the serious inflation that occurred during 1992 and 1995, the government adopted a tightened fiscal and monetary policy, achieved good results, and successfully implemented a “soft landing” for the economy. Due to the inertia in policy and the after effects, the negative impact of this tightening policy began to surface, helping to bring about deflation. (3) China’s deflation occurred simultaneously with the financial crisis in East Asia. In July 1997, the outbreak of the financial crisis started in Thailand quickly occurred in East Asian, creating serious consequences. The Chinese government, after weighing the advantages and disadvantages, dealt with the crisis properly and in a timely manner, including the announcement of a series of measures such as its refusal to devalue the Renminbi. Although China did not suffer seriously, the international environment and domestic policies helped the occurrence of a deflation. (4) China’s deflation occurred during the process of intensifying reform. After more than ten years of reform, China’s economy grew rapidly and people’s lives had continuously improved. In 1997, China’s reform entered a critical stage, as some reform measures that benefited everyone were basically implemented, and further intensification of reform would inevitably involve

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certain adjustment of interest patterns. This meant that people had to make temporary sacrifices for long-term interests, and also increased their uncertainty of expected future income. Since the social security system was somewhat imperfect, people were likely to reduce their consumption, thereby causing deflation. (5) China’s deflation occurred simultaneously with sustained economic growth. Since reform and opening up, China has enjoyed a rapid and sustained economic growth. During 1978–1997, the average annual GDP growth was 9.8%, about three times the world’s average over the same period. During a deflationary period of 1998, 1999 and 2000, the growth rates were still as high as 7.8%, 7.2% and 8.3% respectively. Some argued that based on these figures China had no deflation, and this is a very special feature to note. After clarifying the above five characteristics, we can use a combination of qualitative and quantitative methods to further explore the main causes of deflation in China:

Demand Lags Behind Supply Since reform and opening up, China’s economy has grown rapidly, as have people’s incomes. However, the growth of the total demand lagged behind the growth of the total supply; the author believes that this is the main cause of deflation in China, which can be analyzed from the following aspects: The growth of people’s income is far below economic growth. According to the author’s calculation based on statistical data, during the period 1988–1997, China’s average annual GDP growth rate was 8.6%, but the average annual growth rates of disposable income per capita of urban residents and rural households were only 5.5% and 3.0% respectively. This makes the growth of the total demand far lower than that of supply, and when China has strived to shake off shortage economy, it could easily result in deflation. Preference for savings is stronger than that for consumption. Traditionally, Chinese people like saving, and there is a strong intention for people to rely on savings to protect their family and future generations. As incomes rise, the proportion of nonproductive expenditure in the income structure has decreased. Sample surveys of per capita balance (the difference between income and expenditure) of urban and rural households in 1990 were RMB243.9 and RMB199.54 respectively, and then increased to RMB1,318.81 and RMB732.79 in 2000 respectively. Most of these balances were turned into savings. Between 1990 and 1997, the national year-end savings of urban and rural residents increased from RMB71.198 million to RMB462.80 million, with an average annual growth

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of 26.4%. With further reforms in state-owned enterprises, property, medical care, and education, people expected that they will have to bear more costs, and since they were not optimistic about their expected incomes, they were more inclined to reduce their current consumption to increase their savings. Especially in rural areas, because farmers are small producers with unstable incomes and weaker ability to prevent risks while their sense of self-protection is stronger, their propensity to save is particularly strong. This is especially the case when prices are low as people tend to expect lower prices in the future, so their current consumption will be reduced even further. Widening of the income gap reduces the overall purchasing power. Since the rapid development of China’s economy and as its economic system is undergoing structural change, residential income gaps have been widened. The consumption level of urban and rural residents increased from 3.0 in 1990 to 3.5 in 1999, and the Gini coefficient, which measures the differences in income distribution, increased from 0.30 in 1988 to 0.47 in 1997, in which the coefficient for rural areas was 0.33, and for urban areas was 0.27 (the author believes that calculating the individual Gini coefficients for rural and urban areas is more in line with the actual situation of the dual economy in China). In 1997, the percentage of rural households over total number of households in which the net income per capita is below RMB3,000, RMB3,000–5,000, and over RMB5,000 were 79.88%, 15.18% and 4.94% respectively. Empirical studies show that lowincome people generally have a higher propensity to consume and a lower propensity to save, while high-income people generally have a lower propensity to consume and a higher propensity to save. As the purchasing power of lowincome urban and rural residents is rather weak, and the fewer high-income earners mean that there is a lower propensity to spend, it therefore seems likely that the purchasing power of urban and rural residents will be weakened by the widening of the income gap. The supply structure does not meet the changes in the demand structure. With the increase in the incomes of the urban and rural residents, the Engel coefficients (the percentage of the expenditure on food over the total expenditure) for urban and rural residents fell from 54.2% and 58.8% in 1990 to 39.2% and 49.1% in 2000 respectively. Possession quantity of consumer durables also rose rapidly. In 2000, every 100 urban households on average possessed 116.56 color TV sets, 80.13 refrigerators, and 90.52 washing machines, while every 100 rural households on average possessed 101.71 TV sets (half of them were black-and–white TVs, and the other half were color TVs), 12.31 refrigerators, and 28.58 washing machines. Many enterprises in China, under

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the impact of the planned economy system, paid little attention to market research and sales and were not sensitive to the significant changes taking place in the demand structure of urban and rural residents. Their development of product improvement and renewal was therefore slow. According to the estimates by relevant departments, the absolute surplus of industrial products in China reach 70% to 80%, while high-tech products are in a serious shortage and have to rely on import. For example, while the textile industry in China has a large reduction of spindles and textile prices are on the decline, it imports over USD6 billion of high-grade textile fabrics every year. When there is a large amount of idle productivity (in 1998, the idle productivity of the entire society was 17.9%), it will create a large amount of inventory backlog, which must be sold at reduced prices. The supply structure does not meet the changes in demand structure will lead to a reduction in price level and suppress the consumption desire of those urban and rural residents with purchasing power, which then easily gives rise to deflation.

Reduction of Private Investment As mentioned earlier, a fall in consumer demand will lead to a corresponding fall in investment demand, and a fall in investment demand will then make it difficult to adjust the supply structure to meet consumer demand, leading to a further reduction in consumer demand, thus forming deflation. After reform and opening up, with the intensification of the economic structural reform, private investment developed rapidly. Because of its role in such aspects as the optimization of market resource allocation, the adaptation to changes in consumption demand, the increase in capital usage rate and the enhancement of economic vitality, its impact on economic development is increasingly significant. The share of private investment in GDP rose from 4.2% in the early 1980s to around 11–12% in the first half of the 1990s. After 1996, however, when the government’s actual investment continued to grow, private investment fell rapidly, showing a zero or even negative growth. This was because the investment desire of investors is largely determined by their expectations concerning the economy and market conditions in the future, that is, their expectation of the returns from their investment, and this expectation is based on consumer demand, and expected price levels and interest rates in the future. When phenomena such as inactive markets, low prices, backlog inventory and lower returns occur, investors’ prediction of economic development prospects tends to be conservative, and their investment behavior will be prudent to avoid risks that become increasingly numerous. On

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the other hand, as the ratio of non-performing assets in the bank becomes too high and uncertainties on the future development of enterprises increase, the tendency of “reluctance to lend” increases, resulting in credit contraction. And as the lending policy of China’s banks has always favored state-owned investment and they maintain a discriminatory policy towards private investment, what the banks tighten is private investment, thereby weakening the ability of private investment. In addition, as Chinese people mainly make indirect investment through the banking system while the stock market is merely a place for speculation rather than a channel of investment, so the investment range limits the development of private investment. Since 1995, government investment has been on the rise. This has especially been the case since 1997 when the rises became even greater, and the growth rate of 1998 was more than double that of 1997. However, as the government investments focused on infrastructure and were mainly operated by all levels of government according to mandatory plans, it served the role of promoting demand for production resources, part of which transformed into remuneration of labor, then turned into savings, which had little impact on the increase of purchasing power. It can be seen that a continuous fall in private investment which has an important role in people’s consumption is one of the major causes of deflation in China.

Inertia in Macro-Control Accelerates the Formation of Deflation The author believes that due to the lack of experience in macro-control in a market economy system, the government has been inert in formulating and implementing its macroeconomic policies. There are often many obstacles before new economic policies are launched, many difficulties when implementing them, and movement is typically slow when making adjustments. In 1992–1995, to deal with the serious inflation and prevent economic overheating, China adopted a moderately tight monetary policy. By 1996, the quantity of money supply, the economic growth rate and the range of growth in price level all came down to a more reasonable level. Although the quantity of money supply started to fall after 1995, due to serious worries about the rebound of inflation, the focus of the Chinese government’s monetary policy targets in 1997 was still anti-inflation. It continued to execute the moderately tightened monetary policy, leading to a shortage in money supply. The impact of the shortage in money supply on inflation can be worsened by two factors. First, the banking system was “reluctant to lend” and increased its reserve ratio substantially. The differences in amount between deposits and loans

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of the financial institutions of the four major commercial banks continuously expanded, it was RMB1.03 trillion in December 1998, RMB1.28 trillion in December 1999, and RMB1.37 trillion in September 2000. At the end of September 2000 the reserves deposited to the central bank amounted to RMB1.44 trillion, and the excess reserves were RMB737 billion, which obstructed the channel of turning savings into demand. Second, a significant portion of money supply flowed illegally into the stock market for speculation and was not transformed into consumption and investment. Another manifestation of policy inertia is that interest rate adjustments are not done in a timely manner. When the inflation rate changes rapidly, if the nominal interest rate remains relatively stable, the real interest rate will inevitably become more volatile. For example, when the inflation rate continues to fall, if the nominal interest rate is not reduced appropriately in a timely manner, then consumers tend to increase their savings to enjoy a higher real interest rate, and enterprises have a heavier burden in debts and higher financing costs, all of which will contribute to the occurrence of deflation. In June 1997, China entered a period of deflation, but then the nominal interest rates for a oneyear savings and lending remained as high as 7.47% and 10.08% respectively, resulting in a fall in the tendency of personal consumption, reduced cutting form of inventory by enterprises to reduce loans, which seriously slowed down the total demand. Although China subsequently lowered the nominal interest rates five times between October 23, 1997 and June 10, 1999, due to the impact of other factors, it could not achieve the desired effect of deflation. That the speed of shifting over to the market economy system is slow is also the manifestation of policy inertia. Some officials were still obsessed with and intoxicated by administrative power. They were accustomed to relying on administrative power to allocate resources, which did not really allow the basic functioning of the market in resource allocation. The progress of China’s economic restructuring had been slow over years, and it was difficult to reform industries such as telecommunications, power supply, and finance. In addition, China is currently in a period of economic system transition, and the mandatory policies of the past still have an after effect on investment, consumption and other economic sectors. Under the situation where China’s financial markets are still imperfect, interest rates have yet to be marketized, and financial institutions are usually run by policy and planned management, some policy measures such as increasing money supply and promoting consumption demand are usually offset by factors such as an incompatible supply structure and a pessimistic expectation of the future, and the impact of money policy on investment is weakened by the substitution effect of labor force.

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External Factors Have Certain Influences On the Formation of Deflation The development of economic globalization has created closer links among national economies to the extent that “a spark can start a fire that burns the entire prairie.” However, although China enjoys the benefits of international resource transfers, it should also bear the same amount of economic risks. In 1995–1996, due to the rise of protectionism in international trade, the impact of foreign trade on China’s economic growth was weakened, though it did not cause significant fluctuations in the macro-economy. But it led to the decline in the management efficiency of domestic export enterprises. In 1997, due to the Asian financial crisis, there was a sharp fall in net exports. In 1995–1996, foreign investment stopped to grow and even declined in 1997. The decline in foreign trade and foreign capital growth rate had certain direct and indirect impacts on the domestic economy. In addition, the decline in net exports, through the channel of funds outstanding for foreign exchange, also reduced money supply. However, according to quantitative analysis, external factors are not the main cause of the continuation of deflation.

Key Measures to Combat Deflation As a result of the Chinese government’s use of a series of measures, such as enlarging fiscal deficits, increasing money supply, and lowering interest rates, China smoothly passed through the period of deflation between June 1997 and September 2000. Judging from the situation after September 2000, the threat of deflation still existed, and monthly deflations occurred from time to time (occurring between October 2000 and March 2002 were seven monthly deflation, one month in break-even, and nine out of the remaining ten monthly inflation with a price index of less than 101%). The author, based on his analysis of the causes of deflation, recommends the following policy measures:

Increase the Incomes of the Urban and Rural Residents and Cultivate Their Purchasing Power China is currently at the stage of developing a well-off society and in a period of system transition. Cultivating the purchasing power of urban and rural residents is not only an important condition for maintaining social stability and sustainable development, but also a fundamental measure to prevent deflation. The key to cultivating purchasing power is to increase incomes, particularly that of middle- and low-income groups.

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At present, the low-income group in China mainly consists of workers being laid off by state-owned enterprises, farmers engaged in grain cultivation and in poor areas, as well as the urban poor. We should separately adopt measures to increase their income. It is recommended that urban residents’ minimum living standards and unemployment benefits should be appropriately increased, and with food and clothing vouchers as a substitute for cash subsidies. As for laid-off workers of state-owned enterprises, the government should bear the transition cost, open personal accounts for them and put into their accounts unemployment compensation according to their length of service and rank to be received with a monthly limit. For those who are not yet re-employed can receive unemployment subsidies or minimum living allowances. For lowincome farmers, it is necessary to help them through tax reform to reduce their burden, and also help them to increase their income by adjusting income structure and expanding their channels of income. At present, the middle class in China mainly comprises civil servants and employees of private enterprises and institutions. We suggest raising their standard wages, regulating their unit subsidies, sticking to performancerelated pay, and prohibiting any illegal income, so as to gradually raise their income in accordance with regulations. At the same time, we have to continue to streamline the civil service personnel and staff of enterprises financially supported by the state and encourage them to seek jobs in society to ease the burden by the state. Expanding the scale and scope of credit issuance is also an effective measure to increase purchasing power. It is proposed to gradually promote production credits in rural areas to meet the financial needs of the agricultural production cycle, and establish personal credit records of residents in large- and mediumsized cities to promote consumption credits for residents.

Improve the Expectations of Urban and Rural Residents on Economic Prospects Improving the expectations of the economic prospects of urban and rural residents is a key measure to stimulate consumption and investment. It is recommended to adopt the following policy measures to enforce their functions: First, the government should announce its goals on long-term economic development and issue policy information regularly, including the objectives of its monetary policies and its implementation plans. The government should also increase the transparency, openness and credibility of the central bank’s monetary policy in order to reduce public suspicion and rumors in society. For example,

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when the Chinese government announced in a timely manner that they would not devalue the RMB after the outbreak of the East Asian financial crisis, this played a very important role of feeing people from anxiety. In a period of deflation, we should, through information distribution, arouse the public expectations of inflation, reduce their preference for excessive savings, and prevent a liquidity trap. Second, to improve the social security system at the four levels (social relief, social services, social insurance, commercial insurance), by four forces (nation, society, unit and individual) and on four aspects (unemployment, pension, medical security and accident protection), in accordance with the principle of “clearly defining the scope to complement each other, clearly distinguishing responsibilities and bearing them reasonably, treating with differentiation to achieve a comprehensive balance” in order to form a reasonable structure of China’s social security system and build a relatively stable and dynamically evolutionary social security system with Chinese characteristics. This can reduce the tendency to seek self-protection by urban and rural residents and help promote present consumption. Third, to strengthen the protection of consumers’ legitimate rights and interests, to rectify and regulate market order, to prohibit fake and pirated goods, to protect the nine consumer rights, such as their right to information, right to fair trade, and right of claim, so as to reduce consumers’ concerns on the goods and promote the consumption market development.

Adjust the Supply Structure and Expand Effective Demand Adjusting the supply structure so as to adapt to the changes in the demand structure is an effective measure to expand effective demand and promote consumption. The supply structure should be able to meet the present needs of consumers in terms of variety, quantity and price, and also suitably meet the future needs of consumers in order to be able to create a new point in economic growth and promote the formation of a new economic cycle. So we must put great emphasis on technological and institutional innovation, remove all sorts of obstacles and be determined to adjust the supply structure. The adjustment of the supply structure should be bilateral. We must, on the one hand, let the government play the role of the “visible hand,” and on the basis of a thorough investigation, make a carefully-laid structural adjustment plan to resolutely eliminate obsolete products which are hard to sell, reduce excessive productivity, close down inefficient enterprises, restructure ill-performed groups, and use all kinds of means, such as law, administration, economy, discipline, to guarantee its implementation. On the other hand, we must also let the market play

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the role of the “invisible hand” to guide enterprises to seek business opportunities in a deflationary situation. For example, we can reduce costs through using new technologies and strengthening management, shrink or even give up markets with bad prospects or businesses in which enterprises are less competitive, seek market opportunities through market segmentation and demand forecast, develop high-tech, patented and feature products, nurture and continue to enhance core competences through training, cooperate closely with other enterprises, or establish strategic alliances, etc.

Encourage Private Investment and Non-State-Owned Economic Development The non-state-owned economy formed by private investment is an important part of China’s socialist market economy. Practice shows that private investment and government investment are complementary and mutually reinforced. With the intensification of reform in the investment system, private investment will become the core part of investment as well. The increase in private investment not only can promote a dynamic growth of small and medium private enterprises, but also the establishment of multi-share enterprises, which helps the promotion of China’s economic development, increases in employment, and alleviating the pressure of deflation. It is recommended to encourage the development of private investment through such aspects as market access, fair competition, reduction of burden, and ease of financing, and to protect the property rights of investors through legislation. At present, deposits are mainly centralized in the four major state-owned commercial banks, so their capital is plentiful, but loan demands are relatively insufficient, causing them to hold bonds rather than selling them to the central bank. On the contrary, the increase in deposits at small and medium financial institutions is insignificant, their capital is insufficient, but their loan demands are much higher. We propose increasing re-lending to financial institutions other than the four state-owned commercial banks, changing the present re-lending restrictions imposed on small and medium financial institutions to support small and medium financial institutions with good creditability and operating conditions through relending, so that they can support private investment and the development of the non-state-owned economy.

Intensify Financial Reforms to Improve the Performance of Banks Credit contraction of banks is not only a cause of deflation, but also an important factor in turning deflation into recession. During the long period of planned market economy system, the four wholly state-owned commercial

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banks, the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China and the Construction Bank of China, served as the government’s “cashiers” and formed a monopoly receiving privileges with the support of the government. But with the development of the socialist market economy, the structural contradiction and mechanism contradiction of these banks, such as the failure to distinguish the Party and the government, mixing up or the functions of the government with those of enterprises, the lack of an incentive and restraint mechanism, and the backwardness of the legal person governance system, all increasingly affect the performance and competitiveness of these banks as financial enterprises. In addition, factors such as overstaffing with low-quality employees, low levels of operation and management, proportion of non-performing loans that was too high, a severe loss of various types of assets, and ineffective macro-regulations, mean that their assets and efficiency indicators per capita are much lower than those of similar foreign banks. For example, according to the 2000 Hong Kong Hang Seng Bank’s Annual Report, its cost only accounted for 24.4%% of its income, while that of the state-owned banks was usually as high as about 90%. The pretax profit per capita of Hang Seng Bank was HKD1.57 million, tens of thousands more than that of state-owned banks. Hang Seng Bank’s one-year deposit and lending interest rate spread was 1.7–2.2%, while that of the state-owned banks in the same period was 3.6%. According to China’s commitments for accession to the WTO, by December 2006, foreign banks would receive the same treatment as Chinese banks when they enter the market, and then the wholly stateowned commercial banks would face serious challenges. Because of this, China must follow the spirit of the National Finance Working Conference held by the Central Committee of the Communist Party of China to conduct a fundamental reform on the wholly state-owned commercial banks, in order to turn them into modern financial institutions with an improved governance structure, a sound operating mechanism, clear operation targets, good financial conditions, and a strong international competitiveness, and to continuously improve their operation performance and competitiveness. To prevent deflation from returning, China should intensify its financial reforms to improve the performance of commercial banks, for which the following measures are recommended: First, to expedite the handling of non-performing assets of banks. One of the causes of deflation is that the bank’s non-performing assets (ineffective money) weaken the country’s money supply. We should then, on the basis of careful checking, adopt methods such as auction, internal transfer, and debt-to-equity swap, to recover or absorb these assets.

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Second, to steadily promote the marketization of interest rates. At present, the level of interest rates in China is low. Due to the banks’ enforcement of selfrestraint, the lowering of their investment demand, the control over interestrate expansion mechanism, a favorable opportunity has now arisen for the marketization of interest rate. We recommend that on the basis of expanding the scope of floating interest rates for bank loans, we gradually lift controls over interest rates for loans and let commercial banks independently decide lending interest rates according to the credit status and the degree of risks of the loan borrowed. The fact that the risk premium is independently controlled by commercial banks helps raise the enthusiasm of commercial banks to offer loans, and even the implementation of the policy of expanding domestic demand. Third, strictly prevent bank capital from illegally flowing into the stock market. When we are in the situation where the overall price level and interest rates are low and returns from the stock market are good, there is a strong tendency for bank capital to flow illegally to the stock market, which will lead to a further shrinkage of investment in the real economy and a reduction in consumption, causing the occurrence and aggravation of deflation. Therefore it is recommended that the central bank and China Securities Regulatory Commission should jointly strengthen their supervision and regulation on this phenomenon, as well as the timeliness and intensity of punishment.

Flexibly Apply Fiscal and Monetary Policies When applying fiscal and monetary policies to deal with deflation, although we might secure some effects on the adjustment of the short-term economic conditions, it may worsen the macroeconomic equilibrium. It is therefore recommended that China should have a proper estimation of the role of its macroscopic policies, pay attention to a proper control of their quantitative limits (degrees), and to a flexible control to prevent the rapid transformation between deflation and inflation. For example, although it is easy to obtain results applying expansionary fiscal policies in the short run, but its effectiveness will gradually diminish, and if attention is not paid to adjusting the economic structure basis to achieve a total quantitative balance, its disadvantages will be greater than its advantages in the long run. It is not possible to maintain a sustainable economic growth if we rely only on expanding fiscal deficits without opening up new sources of capital. Another example is the use of the means of making interest rate cuts, which

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is effective in easing deflation to a certain extent. But when the consumption and investment desires of the public are too low, this will easily lead to the appearance of the “liquidity trap,” making it difficult to have an impact on monetary policies. From May 1, 1996 to June 10, 1999, for instance, interest rates in China were lowered seven times, but various types of deposits in financial institutions still continued to grow from RMB7.60 trillion at the end of 1996 to RMB15.49 trillion at the end of 2001 (of which savings of urban and rural residents increased from RMB3.85 trillion to RMB7.38 trillion). As mentioned before, according to the complexity science, environmental factors, such as policies, must go through a self-organizing function within a monetary system to become effective. Patience is required, on the one hand, to wait for the completion of self-adjustment within the system and, on the other hand, prevent excessive increase in the intensity of policy in pursuit of quick effects, which disrupts the self-organizing mechanism within the system, leading to negative results. In the process of establishing and gradually refining a socialist market economy in China, we will certainly encounter all sorts of issues, including deflation, which have been experienced by foreign countries in their process of developing their market economies. The author is convinced that as long as China follows the spirit of realism and keep up with the times, seriously studies theory, reviews and learns from foreign experience, improves its policy framework, and analyzes the difficulties of implementation, it will certainly be able to continuously gain experience and get theoretical achievements that suit the actual situation in China.

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A Systemic Analysis of Stock Markets in China and Suggestions for Their Adjustment

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Foreword According to the traditional financial theory, the financial market can be divided into the two categories of capital market and money market, based on whether the credit limit period is above or below one year. We can also call the former a mid-long-term capital market, and the latter, the short-term capital market. There are two kinds of financing in the capital market: equity financing and debt financing, but for the money market, it is mainly debt financing. But with the popularity of mixed operation in financial institutions, a higher degree of integration of the international financial markets, and the rapid development of financial innovation, the boundary between the traditional capital market and the money market has become increasingly indistinct. With the development of capitalist production and the increasing expansion of the size of enterprises, it would be difficult for a single capitalist or even a few capitalists to jointly provide the capital demanded for construction and expansion. The issuance of shares to gather together the scattered monetary capital to run a stock company began to emerge in the 17th century, and was popular in countries in Europe and America by the mid-19th century. Private capital is gathered together through joint-stock companies to form social capital, which promotes the establishment and development of large capitalist enterprises. Joint-stock companies have become the main organizational form of large contemporary enterprises. Due to the need to buy and sell stocks, stock exchanges began to appear in UK and the U.S. in the latter half of the 18th century, and then were gradually established in many other countries. Since the beginning of the 20th century, especially after World War II, there has been rapid development of stock markets worldwide. In the last ten years of the 20th century, the rapid growth of the world’s stock markets reached an unprecedented record. According to the statistics of the World Bank, the total market capitalization of stock markets around the world in 1990 was USD9.4 trillion, accounting for 50.7% of the total GDP of various countries. By 2000, it soared to USD36 trillion, accounting for 119% of the total GDP of various countries. The total number of listed companies soared from 25,424 in 1990 to 49,612 in 2000. In developed countries, the stock market is not only a barometer reflecting their economic situation, but also an important factor pushing economic development and a cause of economic fluctuations and instability. China’s first stock was issued by the China Merchants Steamship Navigation Co. Ltd. which was founded in 1873, and the history of China stock exchanges can be traced to the early 20th century. In 1914, the Beiyang Government

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promulgated the Securities Exchange Act , and later in 1917 established the Beijing Stock Exchange. The opening of New China’s stock market after her reform and opening-up was primarily motivated by Deng Xiaoping’s Theory. The establishment of the Shanghai Stock Exchange in December 1990 marks the beginning of the stock market in New China. In June 1991, the Shenzhen Stock Exchange was also established. In October 1992, the State Securities Commission and China Securities Regulatory Commission were established. And the issuance of shares spread across the country, which marks the official formation of a national securities market. To establish a securities market in a country like China—the largest developing country that has long-practiced a planned economy system— it requires not only the foresight and vision of its top leaders, such as Deng Xiaoping, but also the effort to various difficulties be overcome through strenuous practice in order to continue to explore a development path that suits the situation of China. With the support of the National Natural Science Foundation, the author had organized a group of experts and scholars in 2001– 2002 to conduct a systematic analysis on China’s stock market development in its first decade (December 1990 to December 2000). In 2001, the author also led the Law Enforcement Inspection Group of the NPC Standing Committee to examine the implementation of the Securities Law . The overall impression is that China’s stock market is still in its infancy, and while at the macroscopic level it appears to have achieved much, but on the microscopic level, it is full of problems. This chapter intends to adopt the perspective of the fictitious economy and methods of complexity science (the advanced stage of systematic scientific development) to conduct a systematic analysis of China’s stock market in the first decade of its development, recognizing its achievements, identifying its problems, and making some major suggestions for China’s stock market which has now entered into a period of adjustment.

The FICTITIOUS Economy and the Stock Market In 1998, I proposed a theory of fictitious economy while studying the East Asian financial crisis. Now I intend to try to use this theory to explore issues relating to the stock market.

A Brief Description of the Fictitious Economy The fictitious economy is a new term that has emerged in recent years.

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Although its definition is widely disputed, it can be broadly classified into three categories. First, it refers to transactions of fictitious capital such as securities, futures, and options, called the fictitious economy. Second, it refers the economic activities conducted with the tools of information technology, called the virtual economy, also known as the digital or information economy. Third, it refers to the visualization of computer simulation of economic activities, called the visual economy. There is a certain connection among these three categories. Here we shall limit ourselves to the first category. The concept of fictitious capital was first put forward by Karl Marx in his work Das Kapital , Part 5, Volume 3, especially Chapter 25 and beyond where he discusses credit and fictitious capital, he makes a detailed analysis of fictitious capital. He argues that fictitious capital emerged from credit capital (interestbearing capital) and the credit system of banks, including stocks, bonds, and mortgages. Unlike real capital, fictitious capital have no value in itself, but it could generate profits through circulation (a kind of surplus value), in common with real capital. It is true that after a hundred years, many new things have emerged with the development of world economy (such as futures, options and a variety of financial derivatives) and new situations (such as currency being divorced from the gold standard and economic globalization) have also appeared, but Marx’s analysis of fictitious capital still remains as a guideline in researching the fictitious economy. In my view, the fictitious economy refers to the economic activities related to the circulation of fictitious capital mainly based on the financial system. To put it simply, it is an activity of directly using money to make money. People engaging in the fictitious economy are not personally involved in real economic activities such as the production, circulation, and exchange of commodities; they engaged only in the trading of virtual capital. But as virtual capital itself does not have a value, which is to say its value is fictitious, it mainly depends on the subjective estimation of its future earnings by both trading parties. So fictitious economic activities, like those of the real economy, may be profitable or there may be a loss. From the point of view of system science, the fictitious economy can be seen as a system, and the characteristics of such a system can be examined from its internal structure and the interaction between the system and environment in order to reveal how the system has evolved. The fictitious economic system is a complex system composed mainly of natural and legal persons (investors, acceptors and financial intermediaries), and they follow certain rules in the financial markets to conduct fictitious economic activities. According to the views of complexity science, although

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everyone has the freedom to make decisions independently according to their intended goals based on their own understanding of their own strengths, the surrounding environment and their development prospects, each person’s decision, however, cannot be unaffected by other people’s decisions. While it is true that chaos is easily produced due to the nonlinear interactions between components in the system, the self-organizing function of the system can show a certain degree of order and stability. When people have idle money in their hands, in addition to expanding their expenditure and increasing their savings, they also generate the desire to use it to invest for profits. From the point of view of the fictitious economy, all financial market instruments are virtual capital. When investors use this idle money in their hands to buy financial market instruments, this is actually exchanging their right to use their money with a certificate of rights, and they have the right to claim future income and assets from the issuers of financial market instruments. When people make investment decisions, therefore, they have to consider three questions: first, how great are the expected benefits; second, can they really get the benefits; third, how quickly can they recover the cash when they need it. And before investing, investors should consider the profitability, security and liquidity of the financial market instruments that they intend to buy. Theoretically speaking, the profitability of financial market instruments and security has a negative correlation, and as it also has a negative correlation between liquidity, security and liquidity, it therefore has a positive correlation. To meet the demands of different investors, there are a variety of financial market instruments. Financial market instruments in general can be divided into two categories, depending on whether its credit period is more or less than one year. One category is the capital market instruments, including stocks, mortgage loans, corporate bonds, treasury bills that are for more than a year, consumer loans and loans from commercial banks; the other category is money market instruments, including one-year treasury bills, large-denomination negotiable certificates of deposit, commercial bills, bank acceptances, repurchase agreements, and interbank lending agreements. Financial market instruments can also be divided into two main categories of equity instruments and debt instruments according to the nature of investment. Investors can only receive dividends from issuers of equity instruments but cannot directly get repayment of the principal. They can, however, receive principal and interest from the issuer of debt instruments. The existence of secondary financial markets allows investors to sell financial market instruments in their hands and turn them into cash, which greatly improve the liquidity of financial market instruments. However, due to the fact

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that the secondary market price of financial market instruments is uncertain, when investors realize them they may get high income, or suffer huge losses. That is why some call jokingly the financial market instruments “paper money.” Accordance with the above concepts, it can be considered that the money market is a debt instrument market that is tilted towards liquidity, the bond market is a debt instrument market that is tilted towards security, and the stock market is a profitability instrument market that is tilted towards profitability. The origin of the fictitious economy can be traced back to commercial borrowing and lending among individuals. A, for example, is in urgent need to buy raw materials or commodity, but does not have enough money, while B happens to have some idle money. Then A asks B to lend him some money and promises to return the money and pay interests within a certain period. Through this transaction, A gets the right to use the money and can take the money as means of payment to get profits through real economic activities, while B, with the debit note in hand, has secured his title of ownership to the money so that when the lending period is over, he is entitled to claim back the principle and interest from A. At this stage, the debit note in B’s hand is an incipient form of fictitious capital, and its value can be increased through the cycle of borrowing and lending money. At this case, B is not engaged in real economic activities; rather, he makes profit through a kind of fictitious economic activity. We can therefore see that the first stage in the development of the fictitious economy is the capitalization of idle money. In other words, change the idle money in the hands of the people into interest-bearing capital. The second stage is the socialization of interest-bearing capital. This is to borrow the idle money in the hands of the people with banks as an intermediary organization and then lend it to generate interests. People can also use their idle money to buy a variety of securities to generate interest. At this stage, the deposit certificates and marketable securities in their hands are fictitious capital. The socialization of interest-bearing capital can channel money from the hands of those who are not engaged in such real economic activities as production and circulation, into the hands of those who can do so. Simultaneously, small amounts of money among individuals are merged into massive amounts and pooled into relatively large scale economic activities, thereby effectively utilizing the money. The third stage in the development of a fictitious economy is the securities market, that is, where securities can be freely traded according to their expected returns, establishing a financial market for conducting transactions of fictitious capital (such as stock markets, bond markets, money market, etc). The marketization of securities not only allows people to realize their securities at

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any time and hence greatly enhance the mobility of their fictitious capital, but also channels the capital to industries with better expected returns and thus further improves the efficiency in the use of capital. In 1898, there emerged a form of futures trading of agricultural products, and then it was gradually extended to industrial raw materials such as non-ferrous metals and oil, which was a new form of fictitious capital. The fourth stage of the development of a fictitious economy is the internationalization of financial markets, that is, fictitious capital can take part in multinational exchange. Although this process can be traced back to debtor countries such as the U.S. in the middle of the 19th century and the fixed-rate bonds issued by railway companies in the financial markets in UK, France and Germany, it was only in the 1920s that relatively large-scale multinational securities investments began to emerge. However the world economic recession in the 1930s and the outbreak of World War II brought the process of the internationalization of financial markets to a halt. It was not until after World War II, under the impetus of the Bretton Woods Agreement and the General Agreement on Tariffs and Trade , that a huge international financial market was gradually formed. The internationalization of financial markets can channel money to profitable industries on an international scope, which can greatly improve efficiency in the use of capital while at the same time form a new financial market—the foreign exchange market. Futures exchanges have also become more and more fictitious, and buying futures has become a tool of speculation. Since the 1960s, futures exchanges have extended gradually to financial commodities such as stocks, bonds, and foreign exchange. In 1973, options exchanges were introduced. The fifth stage in the development of a fictitious economy is the integration of international finance, in which the financial markets of individual countries and the international financial market relate to each other and influence each other much more closely. With the emergence of a floating exchange rate system caused by the divorce of the U.S. dollar from the gold standard, the strengthening of financial innovation, the rapid progress in information technology, the expansion of the degree of financial liberalization as well as the promotion of economic globalization, fictitious capital flows at a much faster pace in financial markets and in greater amounts. The scale of the fictitious economy is continuously increasing. Under the impact of the “multiplier effect,” the current total scale of the global fictitious economy has far exceeded that of the real economy. At the end of 2000, the total amount of the global fictitious economy reached USD160 trillion, of which the balance of the marketable value of securities and bonds

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was about USD65 trillion, the balance of over-the-counter trading of financial derivatives was about USD95 trillion, but in that year the total national GDP was only about USD30 trillion. That means the scale of the fictitious economy was about five times that of the real economy. The average daily flow of fictitious capital in the world was above USD1.5 trillion, about 50 times that of the total average daily actual trading in the world. This means only 2% of the daily capital flow in the world is really used on international trade, and the remaining capital is used on the activities of using money to make money in the financial market. With the development of e-commerce and electronic money, it can be expected the scale of the fictitious economy will be further expanded. There exists a close relationship between fictitious economic systems and real economic systems, for fictitious economic systems come out from but are also dependent on real economic systems. Real economic systems include the production of physical materials and their related economic activities such as distribution, exchange and consumption, which can be seen as the cyclical movement of capital. When capitalists in the production field, for example, get capital from the financial market, they use it as capital to purchase equipment, raw materials and labor to put into the production process, and then sell their products to get capital, which constitutes the cycling of capital. Capitalists use this part of the capital and the surplus value they obtain through this process to repay the principal and interest according to agreement, and, in this way, complete the cycle of fictitious capital. Due to the close relationship between fictitious and real economic systems, the risks which are produced in real economic systems, such as product backlog and business bankruptcy, will be passed to fictitious economic systems, resulting in their instability. Furthermore, the risks of fictitious economic systems, such as fluctuations in stock index, drastic falls in real estate prices, surges of bad debt in banks, and huge currency devaluations, will also severely affect the real economy. Today, when finance has become the core of the economy, the real economy cannot be separated from the fictitious economy and operate on its own. Therefore, if the real economy system is seen as the hardware of an economic system, then the fictitious economic system can be considered the software of an economic system.

The Fictitious Nature of the Stock Market As the stock market is a fictitious economic system, we can follow the viewpoints of systems science and examine the characteristics of such a system via the internal structure of the system and the interaction between the system

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and the environment in order to reveal its pattern of its evolution. In an article published in 1998, this author first proposed the five characteristics of a fictitious economic system; may we now conduct a more in-depth analysis of these five characteristics by relating them to the stock market.

Complexity The general characteristics of a complex system are its huge size, high degree of coupling, low transparency, dynamism and openness. But the most important characteristic is that its components have a certain degree of intelligence, that is, they have the ability to understand the environment in which they are situated, predict predefined changes, and take action according to predefined targets. These are also the underlying reasons for biological evolution, technological innovation, economic development, and social progress. The stock market is a complex system composed mainly of natural and legal persons (investors, acceptors and financial intermediaries), and they follow certain rules of the stock market to conduct stock trading. From the views of complexity science, although everyone has the freedom to make decisions independently according to their intended goals based on their own understanding of their own strengths, the surrounding environment and their development prospects, each person’s decision, however, cannot be unaffected by other people’s decisions. It is true that while chaos can be easily produced due to the nonlinear interactions between components in the system, the selforganizing function of the system can show a certain degree of order and stability. Neoclassical economic theory assumes that people who are engaged in economic activities are “economic persons,” who seek to maximize their own interests and their behave entirely rationally. According to this theory, the stock prices represent investors’ rational expectations of the future values of variables of the real economy that affect the stock prices, which means that the value of a stock should be equal to the present value of future earnings. But, as Herbert Simon, a Nobel laureate in economics, points out, people engaged in economic activities can only be boundedly rational, because people are limited by the information and knowledge they have. It is difficult for them to understand and predict various possible outcomes. Most can only make decisions based on subjective judgments; it is difficult for them to consider all possible options in decision-making. In addition, people’s values and the words and actions of the people around them will also affect the accuracy of their decisions. In securities trading, investors do not have an adequate knowledge of market

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conditions of the present and future and information about price changes. Because their investment strengths and risk-bearing capacities are uneven, they vary greatly in their knowledge and estimates of the value of investments and estimates, and they also vary in their purpose of investment and the length of the expected period of returns. Many investors do not know how to analyze the technical trends of the market, and some even do not have basic knowledge of stock market investment. They lack the awareness and ability to judge the large amount of market information available, so they usually blindly chase winners and follow trends, listen and believe all sorts of rumors, or even rely on their personal intuition and impulses. There is certainly much chaos in the stock market. However, due to the interaction between people and their external environment that the stock market has, macroscopically and on a long-term basis, developed certain trends, and can maintain relative stability within a certain period, which are the so-called bullish and bearish markets.

Metastability The term “metastable system” refers to a system that is far from a state of equilibrium but which relatively stable as a result of conducting exchanges in matter and energy with the outside world—in systems science this is called a system with dissipative structure. Although this system can achieve stability through its self-organizing function, its stability can be easily destroyed by the slightest disturbance from the outside world. After the destruction of the stability of the system, the system may move within a certain range, entering the stable and moving states alternately. This can be seen macroscopically and means that the system has regional stability, that is, it is stable within a certain range. However, sometimes, when the system loses its stability, it may cause drastic changes, or even the collapse of the system. After the collapse of the system, it may be possible to recover its metastable state through deep structural adjustment, or it may extinct. In general, the greater the inertia of the system, the less likely it is to collapse. The stock market is a metastable system so it must rely on conducting the exchange of capital with the outside world in order to maintain its relative stability. There are many causes for its metastability, but the most fundamental cause is the inherent instability of fictitious capital. The inherent instability of fictitious capital comes from its own fictitiousness. Shares, for examples, do not have real value, but represent the right to get income and are a type of certificate of ownership, granting their holders the legal right to obtain that part of the surplus value they deserve when they

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purchase the shares. Because shares do not have value in themselves, their prices, when traded in the stock market, are not determined in accordance with the objective rules of value, but in accordance with people’s subjective prediction of their future price, also affected by the situation of their supply and demand, which makes it even more deviated from the benefits of real economic activities. When share prices are far from people’s reasonable expectations, a “bubble economy” will be formed that relies on the continuous injection of capital from outside to maintain price stability, however, this is only a false stability and that it easily shattered. When the injection of capital from outside is inadequate, share prices will fall. The instability of the fictitious economic system also comes from the virtualization of currency, which means that currency does not really have a value. Since the separation of currency from the gold standard and the gold exchange standard, even though it still has its value of use as a means of payment, it no longer has the value that can be measured by some kind of real objects. The value of money can only be measured by its purchasing power, which is affected by factors such as the issuance of currency, interest rates, exchange rates, and people’s consumer behavior. The virtualization of money increases the instability of the fictitious economy. The positive feedback that exists in fictitious economic systems increases also their instability. When many people buy a certain kind of share, for example, this will encourage more people to buy this particular share. This sort of interaction among people is the positive feedback, which results in an amplification effect, so that the share’s price will rise or fall drastically.

High Risks The so-called risks in economic activities refer to the differences between people’s expected income and their actual income. This difference comes from the uncertainty of the objective world, people’s limitations in their ability to understand the objective world, and people’s errors in their subjective estimation of expected returns. The stock market, while it is high-risk, also has the possibility of bringing high returns. The high-risks of the stock market come from its own complexity and metastability. The first reason is that the inherent instability of a stock leads to constant fluctuations of its prices, and an increase in the volume of the stock market trading and the expansion of its trading varieties make it even more complicated. The second reason is people’s inability to predict the market and its environmental changes. With no better method for forecasting expected

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returns, errors in decision-making are easily made. The third reason is that the ability of many people to bear risks is limited, and they would be at a loss when facing huge risks, or even amplify the risk due to positive feedback. The last reason is that many people are willing to take high risk to pursue high returns, thus contributing to the continuous appearance of various kinds of high-risk and high-return financial innovations, such as stock index futures and options. In addition, the existence of illegal behavior can also increase the risks of the stock market. First, disclosure of information can be untrue, misleading investors; second, the existence of insider trading can damage the interests of small investors; third, malicious market manipulation allows market makers to gain huge profits. Research findings show that people tend to overestimate their tolerance of risks, and go bankrupt due to excessive risk. Suppose, for example, that a project with an investment of RMB100 million has 80% risk that its return upon success is RMB500 million, and that its risk and return are symmetrical—people often mistakenly believe that as long as RMB500 million are invested into five such projects, they can bear the risks with the success of one project. But according to the calculation of the Adventurer Bankruptcy Laws , if you invest RMB500 million, you have only 67% certainty to be successful at least in one of the five projects. If you want to have 95% certainty to have at least one of the projects be successful, you must use RMB1,400 million to invest into fourteen projects. It can be seen that under this kind of situation, RMB500 million is far short of the necessary amount for risk tolerance.

Parasitism Shares are equity interest certificates issued to capital contributors by share limited companies. They represent the ownership of the share companies by their holders (i.e. shareholders). Since shares are a type of security without a repayment period, investors cannot request divestment after they subscribe to shares at the primary market, and can only sell their shares to other investors in the secondary market. In theory, the prices of the shares, whether in the primary market or secondary market, should be mainly determined by the future performance of the share company, which is equal to its present value of expected future earnings. Although the prices of shares in the stock market often show irregular fluctuations, in the final analysis, shares are parasitic on share companies, while the stock market is parasitic on the real economy. As investors’ judgments on a certain share price are established on the basis of their predictions of its future performance, so the parasitism of

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shares is mainly shown by the fact that their market price is often affected by information relating to the share company which issued the shares, which includes information that the share company voluntarily discloses, information about changes in the external environment, information that is circulating in the society, and so on. The parasitism of the stock market is mainly shown by that fact that its operation cycle is largely determined by the operation cycle of the real economy. The indicators of the operation of the real economy can be represented by GDP, while the indicators of the operation of the stock market are usually represented by stock indexes (such as the Dow Jones Index). Although the stock market cycle may overtake or lag behind the economic cycle, a long-term departure from the economic cycle is definitely not normal. It should also be noted that as the stock market includes many types of shares, the stock index is only compiled from certain selected types of shares through the use of statistical methods, and, as such, it is difficult to fully reflect the operation of the stock market. But then, the adverse effect of the stock market on the real economy cannot be ignored. The rise of the stock market will strengthen people’s confidence in economic prospects and they will increase their consumption as a result of the “wealth effect,” thereby pushing up economic growth. Conversely, when the stock market bubble bursts, people not only reduce consumption, but also rush to sell all sorts of financial assets due to psychological fear, leading to economic recession or even the occurrence of economic crisis. In recent years, some raise doubts about the traditional saying that the “stock market is a barometer of the economy,” and believe that there is no inevitable linkage between whether the situation of the stock market is good or bad and economic conditions. That is because, occasionally, the stock market rises when there is an economic slowdown and falls when there is economic growth. The author believes that, as the stock market is based on and is dependent on the real economy, from a macroscopic and long-term view, the situation of the stock market should reflect in general the situation of the real economy. From the point of view of complexity science, the stock market and the real economy do not have a simple one-to-one linear relationship, but a complex, multivariate, and nonlinear relationship. First, the gross domestic product cannot fully represent the situation of the real economy, and stock market index also cannot fully represent the state of the stock market. Second, they are both affected by many factors, such as international economic environment, social systems, government policies, and people’s confidence—the impact of these factors on the gross domestic product and the stock index is asymmetrical and asynchronous. Third, due to the influence of multiple factors, the stock market

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situation can often depart in the short and medium term from the situation of the real economy in the short and medium term. When there is an economic recession and the returns on investment in the real economy are poor, for example, people tend to put money into the stock market, thus promoting the increase of the stock market. Fourth, due to the aforementioned adverse effects of the stock market on the real economy, the relationship between the two is complicated and mysterious, and it is difficult to see clearly how they affect each other. What needs to be pointed out in particular is that when there are abnormal situations in the stock market, such as over-speculation, market manipulation, and the excessive influence of policies, the development of the stock market and that of the real economy may deviate. However, this is not enough to deny parasitism of the fictitious economy.

Periodicity The evolution of a fictitious economic system in general shows cyclical characteristics, which generally include stages such as the rapid growth of the real economy, the beginning of the formation of the economic bubble, the gradual expansion of currencies and credit, the general rise of various asset prices, the extensive spread of optimism, and the continuous rise of stock and real estate prices. Then there is the bursting of the economic bubble caused by external disturbances, the rapid decline of various financial indicators, the sale of real assets and financial assets by people, and the slowing down or negative growth of the real economy. This kind of periodicity is not simply cyclic, but advances in waves and rises in spirals. The operation of the stock market is also cyclical, alternating between bull and bear markets. As the stock market is mainly based on establishing investors’ optimistic expectations (which in the final analysis are the optimistic expectations of economic development) of future earnings, so from a macro point of view, there are certainly bubbles in the stock market. The expansion and bursting of bubbles cause fluctuations in the stock market. This type of fluctuation also advances in waves and rises in spirals. When the stock market in the U.S. plunged on October 19, 1987 (Black Monday), for example, the Dow Jones Index was less than 3,000 points, while thirteen years later, the Index reached over 12,000 points.

The Linkage and Interactions between the Money Market and the Capital Market The money market and the capital market are integral and interlinked parts of the financial market. A well-regulated money market can guide the savings of those

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who have surplus capital to be converted into investment in the capital market, while the liquidity and the short-term characteristics of money market instruments can make them a necessary complement to the capital market instruments as well as an important means of reducing risks. In developed financial markets, despite the fact that the money market and the capital market have different characteristics and instruments, the flow of capital and a combinatory use of the various financial instruments allow them to establish a complete financial market system. The linkage between the money market and the capital market is mainly shown by the overlaps of these two market subjects. Some financial institutions and non-financial institutions enter the money market as well as the capital market. As all financial institutions and non-financial institutions may invest in the money market, it gives them a convenient way to use the debts in the money market to balance its own capital structure, while the varieties of the money market instruments also provide them with many opportunities for investment and arbitrage. Especially in countries where a mixed operation of financial institutions is allowed, in order to make the largest possible profits with certain security, financial institutions must dynamically adjust their asset structure, the proportion of the total returns on investment in the money market of many financial institutions gradually increase. With the application of modern technology in the financial industry and the changes of concepts of financial regulation, the investment subjects of the money market have also become increasingly diversified. In developed financial markets, the capital market and the money market are interdependent, and the boundaries between the two have become more and more indistinguishable. In developed financial markets, in addition to central banks, market participants can operate in the money market and the capital market. Securities companies, for example, while holding a large number of shares and longterm bonds, can also hold short-term bonds and participate in lending and repurchasing in order to adjust the security and liquidity of their capital and gain certain incomes in interest. In addition, due to the high risk of capital market instruments, investors tend to use money market instruments to form a better portfolio to diversify risks, and for the sake of maintaining the liquidity of their capital, market participants are also required to operate in the two markets simultaneously. Although the instruments, the yields and the risks of the money market and the capital market are not the same, the subjects of the markets are basically the same, they can dynamically adjust the structure of their assets and liabilities through comparing the price, earnings, liquidity and risks of these instruments.

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The interaction of the money market and the capital market is mainly shown in the bidirectional flow of the capital. In theory, according to the Gordon growth model, a kind of equilibrium exists in the capital prices between the money market and the stock market. Under the circumstances of equilibrium, share prices and the interest rates in the money market have a negative correlation. When one of these rises or falls, it will certainly cause the other one to fall or rise so as to achieve a new equilibrium. When interest rates fall, investors usually prefer to borrow capital from the interbank market or to sell short-term securities in the money market in order to obtain the capital needed to purchase long-term securities in the capital markets, and as a result of capital flowing from the money market to the capital market, this will push up the prices of long-term securities. Conversely, when the interest rates of the securities rise, the demand of securities will drop, the capital will flow from the capital market to the money market, and when the prices of securities fall, the capital will flow from the money market to the capital market. But the actual situation is much more complicated than the theory. For example, when the money market is imperfect and there is a lack of effective money market instruments, it will encourage capital to flow to the capital market. Another example is that when the financing conditions in the capital market are too loose, it will facilitate the flow of credit capital to the capital market in large quantities. Some scholars attempt to use the traditional law of value to analyze the financial market and believe that when the price of a certain financial market instrument exceeds its value, its price will fall, otherwise it will rise. The author believes that as financial market instruments are fictitious capital, they do not have their own value, it is difficult to apply the law of value, but the law of supply and demand can still apply. When the demand of a financial market instrument in the market is greater than the supply, its price will rise, and when the supply exceeds the demand, its price will fall. The causes of the changes in supply and demand do not lie on the deviation of price from value, but on the investor behavior that causes the self-organizing effect. The financial market belongs to the fictitious economic system and has its own intrinsic complexity. Although each subject of the financial market makes its own independent decisions according to its own forecasts of the future, from a micro point of view, there are a lot of random fluctuations and chaos in the financial market. But as the decisions of each subject of the market are inevitably affected by the decisions and conditions of other subjects, a kind of self-organizing effect will be produced, and therefore, from a macro point of view, the development of the financial market also show some fragments

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of certainty and law of fuzziness. The author believes that in the analysis of financial markets, full consideration must be given to the decision-making behavior of market players, in particular, their irrational behavior. In choosing financial market instruments, for example, profitability-tilted investors mostly prefer equity instruments and security-tilted investors mostly prefer debt instruments. But when the stock market is bullish, as investors have full confidence in its rise, then not only profitability-tilted investors will increase their investment in the stock market, security-tilted investors will also turn around to enter into the stock market because they believe that the risks of suffering losses are relatively small. At that time, the effect of raising the interest rates of the money market to reduce of the amount of money flowing into the stock market is much smaller than the effect when the stock market is bearish. According to the law of supply and demand, the increase of capital flowing into the stock market will inevitably lead to a rise in the stock market, which will further increase the confidence of investors and attract more capital to flow into it. When the stock market is rising rapidly, profitability-tilted investors will even give up their rational law that there should be risk-return symmetry and continue to buy at high price because they believe there will be people who offer higher prices to buy. Since 1995, for example, people have been encouraged by the extremely successful listing of companies such as Netscape, Amazon, and AOL, and believe in the myth of “investing in the Internet industry one year is comparable to investing in traditional industries for 100 years,” which pushed up the Internet shares in the NASDAQ. In May 1997, the online bookstore Amazon.com was listed. By November 30, 1998, the shares of Amazon rose by 2,300%, despite the fact that its turnover in 1998 was USD293 million, a loss of USD6,100 million. But people were optimistic about its prospects and continued to buy its shares, believing that they could probably make more money. After three months, its shares jumped 400%, and its market value reached USD40 billion. Before Christmas 1999, the NASDAQ stock index crossed the 4,000 points, and climbed higher and higher. By March 10, 2000, it rose to its highest level ever—5,048 points. Facts, however, show that to rush to listing before an enterprise reaches its mature stage is actually shifting the risks which should be borne by the venture capitalists to the public, which could have very serious consequences. In 1999, 486 companies in the U.S. issued new shares, of which 242 were newly established entrepreneurial Internet companies and 224 were without records of earnings. The great differences between the share prices and their performance led to the gradual loss of investor confidence, eventually causing the crashing of the Internet stocks in 2000. The NASDAQ index slipped from its highest

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point after the crash and continued to fall. In 2000, the largest fall of the year in the last 30 years was created—a fall of 39.3%, a loss of about USD3 trillion in market value, and close to 150 Internet companies in the U.S. closed down. At the beginning of 2001, the NASDAQ stock index continued to fall rapidly. On March 13, it fell below the 2,000 mark, and had reached its lowest point of around 1,400. According to Webmergers.com’s statistics, at least 493 Internet companies went bankrupt between January 2000 and May 2001, of which 55% announced their bankruptcy in the first five months of 2001. Conversely, when investors lack confidence, even frequent lowering of interest rates will not necessarily drive the flow of capital to the stock market. In recent years, for example, due to its economic downturn, the stock market in Japan is still sluggish though the bank’s interest rates have reached their lowest point. Thus it can be seen that the interactive relationship between the capital market and the money market is a very complex one. We should not only see the shift between the two antagonistic effects, but also the synergy that complements each other.

China’s Stock Market is Still in its Infancy The Shanghai Stock Exchange and Shenzhen Stock Exchange were established in December 1990 and June 1991 respectively while A shares, the Renminbi special stock (B shares) and overseas listed foreign shares (such as H shares) were also successively issued in 1991 and 1993 respectively. However, as China’s stock market in its initial stage was far from perfect, and the various parties concerned, such as investors, listed companies, securities firms and the Commission, lacked experience, there were many twists and turns in the process of its development. Behind the many drastic rises and falls of the stock market rises were a series of issues such as insider trading, the announcement of false information, fraudulent investors, market manipulation, and excessive speculation. On July 1, 1999, the Securities Law of the People’s Republic of China, which regulated the securities market in China, began to be implemented. The promulgation and implementation of the Securities Law was to promote the process of the legalization and regulation of the securities markets in China. It further clarified the functions and positioning of the securities regulatory authorities, continuously raised the level of regulatory operation of market players such as listed companies and securities companies, enhanced investors’ legal consciousness, and instilled more confidence in the development of the market.

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At the beginning of 2001, the Standing Committee of the National People’s Congress, according to law, decided to conduct a law enforcement inspection of the implementation of the Securities Law , and formed the National People’s Congress Securities Law Enforcement Inspection Team, headed by the author. This team conducted an inspection of the implementation of the Securities Law from mid-May to early June 2001. It firstly heard reports on the implementation of the Securities Law by the China Securities Regulatory Commission, the State Economic and Trade Commission, the People’s Bank of China, the Supreme People’s Court, and the Supreme People’s Procuratorate respectively. Then the team was divided into four groups (with Zhou Zhengqing, Li Yining, Zhou Daojiong, and Zhang Xiao serving as team leaders) and went to Shanghai, Shenzhen, Chengdu, and Wuhan for on-site inspections, and made arrangements for the five cities of Beijing, Guangzhou, Lanzhou, Harbin, and Xiamen, to conduct self-examination of the implementation of the Securities Law in these cities. The Inspection Team heard reports on the implementation of the Securities Law from local governments, local securities regulatory authorities of the China Securities Regulatory Commission, the Shanghai Stock Exchange and Shenzhen Stock Exchange, held forums with some listed companies, securities companies, securities-related intermediary service institutions, investors, experts, and scholars, and made field trips to Shanghai Stock Exchange, Shenzhen Stock Exchange, some listed companies, and securities companies. After returning to Beijing, the Inspection Team held forums respectively, and extensively listened to views and suggestions from various quarters. The Standing Committees of the above-mentioned five cities, as requested, also reported their inspections to the Standing Committee of the National People’s Congress. After the inspection work was concluded, the author, on behalf of Inspection Team, made a report at the 22nd Meeting of the 9th National People’s Congress on June 28, 2001. The author has for years been concerned with the development of the stock market in China. Through this law enforcement inspection, the author has a deeper understanding of the situation and problems of China’s stock market. The overall feeling is that as it is still in its early stage, it has considerable progress from a macro perspective, but it has many problems on the micro level. Within a decade, China’s stock market has gone from nothing to something and from small to large, and has achieved remarkable success, with a great improvement in its market size and level. By the end of 2000, the total market value of the stocks reached RMB4.81 trillion (of which RMB1.61 trillion were of the circulation market value), domestic listed companies reached 1,088, and the total number of investor accounts in the Shanghai and Shenzhen stock exchanges

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reached 56 million. There were 34 securities investment funds, with a total fund size of more than RMB55 billion.

Stock markets in China play an important role of pooling scattered social

capital and convert it into large long-term capital. By the end of November

2000, the total domestic and foreign financing of stock markets in China reached RMB944.32 billion, of which the total accumulated capital raised by domestic listed companies were RMB484.61 billion, that by overseas listed

companies, RMB143.91 billion (USD17.38 billion), and that by red chips, RMB315.80 billion (USD38.14 billion).

During these ten years, a large number of state-owned enterprises made

initial public offerings, opening up a channel of direct financing to promote the upgrading and updating of traditional industries, reducing the asset-liability level, accelerating the pace of technological reform and promoting the use of

high and new technology, and promoting the adjustment of industrial structure

and product structure. More importantly, the listing has effectively promoted

changes in the operational mechanism of state-owned enterprises, enhanced the vitality of enterprises, so that listed companies, in accordance with the

requirements of modern enterprise system, initially established a corporate governance system, accelerated the process of decision-making scientification, operation marketization, regulation socialization, and operation responsibility legalization. This enabled them to play a leading and exemplary role in the

reform and practice of establishing a modern enterprise system for state-owned

enterprises, and to lay a foundation for elevating the overall quality of the national economy.

The development of China’s stock market over the last decade shows

that the securities market has played an important role in promoting the

development of China’s economy. As pointed out by Jiang Zemin: “To practice the socialist market economy, there must be a securities market. Establishing a healthy, orderly and safely operated securities market plays an important role in optimizing resource allocation, adjusting economic structure, raising more social capital, and promoting the development of national economy.”

While we fully affirm the results obtained from China’s stock market in the

last ten years, we should also soberly see that compared to the mature stock markets in developed countries and regions, the Chinese stock market is still in

its infancy, and there are some problems that need to be carefully studied and

solved. According to our analysis, these problems can be summarized into the following eight aspects.

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Its Scope Is Smaller and Its Depth Is Shallower It is true that the development of China’s stock market has been fast, but on the whole it seems to be small in scale. According to calculations from World Bank data, the value of China’s stock markets accounted for only 1.6% of the world’s stock market value in 2000, while that of the U.S. accounted for 46.2%, and Japan, 12.6%. The ratio of China’s stock market value and GDP was 33.4%, while that of the U.S., 181.8%, that of Japan, 104.6%, and that of H.K., 383.2%. Moreover, there are a large number of non-tradable shares (state-owned shares and legal person shares) in China’s stock markets, the circulating shares accounts for only around one-third of the total capital stock. Due to the small scale of the stock market and the prevalence of excessive speculation, stock markets in China have not become a barometer of the economy, which is one indicator showing that China’s stock market is still in its infancy. The most important issue caused by the small scale of the stock market is its poor stability. From the point of view of systems engineering, the so-called stability is about whether a system has the ability to restore to its original state when it deviates from its original status under some kind of interference. As the stock market is a dissipative structure of a fictitious economic system, so the interference mainly comes from changes in the net capital inflows (reflecting demand on the buyer’s side) and the number of circulating capital (reflecting supply on the seller ’s side). From a holistic (macroscopic) perspective, when the net capital flow increases and the number of circulating capital remains unchanged, the market value of the stock market will rise. When the number of circulating capital increases (including the listing of new companies and listed companies issuing new shares) and the net capital flow remains unchanged, the stock market will fall. From the perspective of individual stocks (microscopic perspective), when the net capital flow increases (buy more and sell less), the stock price will rise, and when net capital flow decreases (buy less and sell more), the stock price will fall. Clearly, in theory, the larger the size of the overall stock market, the better its stability, and the larger the plate of individual stocks, the better its stability. The reasons for the occurrence of many twists and turns in China’s stock market in its first decade were to a great extent caused by the serious imbalance of the supply and demand relation between capital and circulating shares. At that time the price level of shares was mainly determined by the amount of money chasing stocks, making it difficult to truly reflect the intrinsic value of the shares. Before May 1992, for example, the Shanghai Stock Exchange had only eight

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companies such as Yanzhong Industrial Co. Ltd. publicly traded, known as the “Old Eight Stocks,” with a nominal value that could be circulated of less than RMB8,000 million, which was far from meeting the demands of investors. In the stock market, therefore, it was only buying and no selling, and there were market prices but no market. On May 21, there was the launching of a new stock and the relaxing of share prices, the index of the Shanghai Stock Exchange rose from 616 points at the close of the market to 1,265 points within that single day. By May 25, it climbed to a peak of 1,420 points. It was not until more than two months later when a large batch of new stocks was listed that the index fell below 1,000 points. Another example is that some listed companies entrusted the large amount of capital they raised to securities companies for its financial management, which in practice was actually equivalent to flowing back to the stock market the capital they raised from the stock market, this would therefore push up share prices and lower the stability of the stock market. At the same time, this would weaken the function of raising capital from the stock market and optimizing resource allocation, which greatly increase the speculation of the stock market. In addition, during the first decade, especially before 1996, the shares issued and listed belonged basically to small-size enterprises. Not only the size of the assets of the companies was small, the total share capital and the circulating capital were also very small. By the end of 2000, of the 1,076 listed companies, 307 companies had a circulating capital of below 50 billion shares, accounting for 28.53% of the total number of listed companies, 409 companies were with between 50 to 100 million shares, accounting for 38.01% of the total number of listed companies, and 360 companies were with more than 100,000 shares, accounting for 33.46% of the total number of listed companies. As these listed companies were smaller in size, the amount of money the market manipulators (commonly known as dealers) needed to intervene and push up share prices sharply was also lower. And as these listed companies were smaller in size, they could further expand their share capital through stock dividends and share transfers, while at the same time create the conditions for dealers to raise share prices and have price recovery patterns.

The Majority of Shares Cannot Be Circulated Due to the differences in investment subjects, shares of listed companies in China can be divided into state-owned shares, legal person shares and public shares. Out of the consideration of preventing the loss of state assets, maintaining

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the controlling position of the state in key industries and enterprises and other aspects, the current state-owned shares and legal person shares are not allowed to be listed or traded, only public shares can be circulated in the stock market. As the circulated stock value in China’s stock market in recent years accounted for only about one-third of the total market value, actually most of the shares of listed companies in China cannot be circulated. The consequence of having over half of the shares not in circulation is not only an artificial inflation of the size of China’s stock market, but also a great reduction of the stability of the stock market, making it easy for “dealers” to manipulate the market. A more serious problem is that this would cause a conflict of interests between holders of the public shares and holders of the state-owned shares and legal person shares. As the interests of the holders of state-owned shares and legal person shares cannot be directly reflected in the prices of the shares, so they usually hold a speculative attitude towards the rise and fall of the share prices. In order to enable their listed companies to have high placement, for example, they usually deliberately disclose good news (including false information) to boost up share prices, or even use all sorts of means to directly manipulate the rise of share prices. When share prices fall, in order to obtain more social capital, they would still adopt the method of issuing new shares to increase the supply of shares, causing share prices to fall even further. Under the circumstances in which the status of listing is still a tight resource, even if a company suffers heavy losses, with the support of the government and coordination of operations of the major shareholders, it can still easily and cost-effectively implement the reorganization of assets. The extensive existence of non-circulating shares also created the issue of “the same shares with different values,” that is, the value of non-circulating shares is way below that of circulating shares, which made it difficult to maintain fairness in the stock market. Although in the calculation of the total market value, usually the non-circulating shares are calculated according to the market price of the circulating shares, when the non-circulating shares are actually sold, it is difficult for investors to buy at market prices. From May 19, 1999 to August 30, 2001, the total market value of China’s stock market rose about 90% in two years. The total market value of A Shares of the Shenzhen and Shanghai stock exchanges reached RMB4.61 billion, and their circulated stock value was RMB1.46 billion. Under these circumstances, it was decided by relevant units to carry out the reduction of state-owned shares at market price, which suddenly intensified the conflicts of the same shares with different values. Under the situation in which the net flow of capital had shown a decreasing trend, a large number of state-owned shares entered the stock

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market, which would inevitably lead to the slowing down of the stock market, coupled with the investors’ views on the pricing of state-owned shares, they all dumped the shares, causing the crash of the stock market due to the burst of the “bubble.” The fact that most of the shares were not in circulation also hindered the improvement of the legal person governance system of listed companies. As a number of listed companies were dominated by state-owned shares, their management basically was not regulated by investors and the general meetings of shareholders were sheer formalities, resulting in the ineffective prohibition of illegal behavior such as the promulgation of false information, insider trading, fraud, and market manipulation.

The Stock Market Can Only Be Buying Long and Not Selling Short Since it is clearly stipulated in the Securities Law that shares can only be traded by cash transactions, prohibiting the behavior of buying long and selling short, the current stock trading system of China is still a unilateral long mechanism, it lacks the short mechanism, and is becoming a “unilateral market.” “A unilateral market” will lead investors to excessive speculation and short-term behavior, bringing to the market an atmosphere of “buying long” speculation, which means that only by pushing up share prices can investors gain profits through buying low and selling high. Once there is any good news, investors go all out, and to avoid risks, they prefer short-term trading, which leads to frequent and great fluctuations in the stock market. Due to the unilateral nature of the trading mechanism, investors, securities companies, listed companies, regulatory departments and governments all hope that the stock market has more rises and less falls, leading to, from a long-term perspective, the maintenance of the upward trend of China’s stock market, whether individual stocks or stock indexes. Once the stock market continues to fall, the majority of investors will be caught, or they will hastily sell off their shares and suffer losses, creating a series of problems. As it is difficult for most investors to do anything when the stock market continues to fall, they can only stand by, which will weaken the “popularity” of the stock market. The biggest problem of a “unilateral market” is the difficulty of eliminating the systemic risks for investors. According to the results of empirical research, not only the scale of volatility of China’s stock market is greater, its overall risk is higher and the proportion of systemic risks in the overall risks is also higher. The proportion of the systemic risks in the stock markets of the U.S., UK and France accounted for 26.8%, 34.5% and 32.7% of the overall risks respectively,

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while the systemic risks of China’s stock market accounted for 65.7% of the overall risks. As currently the stock market in China does not have a sell short mechanism and also lacks risk hedging instruments, so if investors do not withdraw from the stock market, it is difficult for them to avoid systemic risks. Investors’ withdrawal from the stock market can be considered as passively selling short, which means that investors sell their shares to hold money as they foresee that the future of the general trend or individual stocks will be poor, so they leave the stock market and stay on the sidelines to avoid being “stuck,” to avoid or reduce the actual potential losses. The purpose of passively selling short is to avoid risks. At that time, as the capital of investors is in an idle state, the demand to add value to the capital temporarily cannot be achieved, investors therefore generally are willing to go short and sell the shares only in some rare circumstances. Some investors buy shares at low prices while hoping that they will soon rebound from the bottom to make profits. Of course, the introduction of a short-mechanism in the stock market will also benefit speculators. In making the Securities Law , our country prohibits selling short with the main consideration of preventing the generation of all kinds of risks and the spread of risks. But weighing the pros and cons in a holistic way, the introduction of a short-mechanism will help ensure the stable operation of the spot market. And judging from the actual operation of the stock market, non-regulatory credit transactions have existed from time to time. It is recommended to ease the situation positively, and when conditions are ripe, the methods of credit transactions of shares and stock index futures can be introduced. This will help gradually form equilibrium in the struggle of buying long and selling short, curb the trend of excessive speculation and short-term behavior, and prompt investors to shift to the concept of value investing.

The Impact of Policies Is Rather Significant Lots of evidence shows that government policies and official statements about China’s stock market are one of the major causes that lead to the abnormal changes in stock market prices. In 1991–2001, for example, the 25 shares with the highest and lowest daily returns in the Shanghai Composite Index corresponded to related policies and information releases. Therefore, academia and the public vividly call China’s stock market a “policy market.” As mentioned earlier, the stock market largely reflects the changes in the real economy, but it may lead or lag behind changes. But it should be noted that the stock markets in any country or region are not only affected by the impact of the changes in the situation of the real economy, but also by government

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policies and official statements. This is because the stock markets in any country or region will respond to the launching of government policies or the disclosure of important information. On the other hand, when there are abnormal fluctuations in the stock market, any government would launch policies to influence market trends. The prices, returns and fluctuations of an efficient and healthy stock market, from a macroscopic and long-term perspective, should be mainly affected by the impact of the situation of the real economy, and its responses to policies should also be appropriate. If the government intervenes too much in the stock market, or the market overreacts to policies, then the market prices, returns and fluctuations are driven long-term mainly by policies, it means that there are serious flaws in the market, and there is no way for the market to play its basic function of optimizing resource allocation, and it becomes a “policy market.” According to our research, the relationship between China’s economic cycle, the stock market cycle and the policy cycle is shown in Figure 5.1. Fig. 5.1.

The relationship between China’s economic cycle, the stock market cycle and the policy cycle during 1900–2003

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It can be seen from Fig. 5.1 that since 1991-2000, the policy cycle has run on a half-cycle, the stock market cycle has also run on a half-cycle, and the running of these two cycles is almost completely synchronic. This shows that our stock market and policies are closely related. From 1991 to the first half of 1996, the direction and operation time of the three cycles are basically the same, showing a strong synchronicity. Starting from the second half of 1996, the obvious departure of the stock market cycle and the economic cycle was primarily due to the operation of the policy cycle, which means the bull market in the second half of 1996 of China’s stock market was supported by the policy cycle, rather than driven by the rise of the economic cycle. We use CGARCH (combination of general autoregressive conditional heteroskedasticity) model, and by describing the characteristics of the changes in the volatility of China’s stock markets over time, to analyze the impact of policies on market volatility. The results show that there is an existence of short-term time-varying volatility in China’s stock market, and there is also a significant long-term time-varying volatility. Great changes in the short-term time-varying volatility are often caused by policy intervention, and this creates the occurrence of a break in mean reversion process of long-term volatility (the process of gradual decline in volatility), and move conversely to a higher longterm volatility. Thus it can be seen that policy intervention is the direct cause of great changes in the volatility of the stock markets in China. We will also discuss whether there is the existence of overreaction to policy in China’s stock market. So-called overreaction refers to the phenomenon when a certain incident (such as the introduction of a policy) causes changes in the stock prices exceeding a reasonable level of expectation, which is shown in the market by the fact that after the occurrence of the incident, there are more than expected level of drastic changes in the share prices, this is followed by reverse correction, and the share prices revert back to their rightful level. The main cause for the occurrence of overreaction is due to the fact that investors tend to overestimate the current information, underestimate the historical information, and they therefore will make a super-rational response to current information, and share prices will rise or fall greater than the expected level. After a period of time, when investors can reasonably assess and readjust the impact of the incident, then share prices will make a negative correction, that is, the shares will have exceptional falls or rises in the negative correction. We use event analysis method (event study) to conduct an analysis of four representative policy events (the promulgation and implementation of the Securities Law on July 1, 1999, the announcement of Insurance Funds Entering the Market and Allocating and Selling New Shares to Secondary Market Investors on February

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14, 2000, the Notice on the Placement of Shares of Listed Companies in 1996 on January 27, 1996, and the editorial in the People’s Daily on “A Correct Understanding of the Current Stock Market” on December 16, 1996), and found that stock markets in China did have overreactions to policies. As the impact of the policy cycle on the operation of China’s stock market cycle is far greater than its impact on the economic cycle, the prices, returns and volatility of the market are on a long-term basis mainly driven by policy, and as there is overreaction to policy, so it can be taken that the stock market in China is influenced too much by policy, and has the characteristics of a “policy market.” The consequence of being a “policy market” in the last years of China’s stock market is that many investors (especially the small and medium investors) have a tendency to rely too much on policy information. And because China’s stock market is unilateral, it is only possible to make money in a bull market, so many investors firmly believe that the rise of shares is the main trend, falls in the market are but a temporary phenomenon, and as the government is not happy to see falls, it will eventually try to prop up the market to rescue it. The “policy market” will also encourage excessive speculation in the stock market. As soon as there is disclosure of policy information beneficial to the market, investors will flock to the market, scramble to buy shares, pushing the stock index to a new height within a short time, resulting in the rapid expansion of the stock market bubble. The “policy market” also conveniently enables some dealers to manipulate the stock market. They often push up share prices by means of creating and distributing false “insider information” to go with their various means of speculation, and then withdraw from the market to reap huge profits.

Excessive Speculation Is Getting More Serious Generally speaking, moderate stock market speculation is not harmful, but also beneficial to the operation of securities markets. First, it helps the activeness of share trading, enhances market liquidity, and accelerates cash flow. Second, as speculators dare to bear the risks of the issuance of new shares, it promotes the issuance of new shares. Third, investors’ speculative behavior of buying low and selling high is also able to adjust the supply and demand relationship of the market, and it helps to stabilize share prices. The author believes that a mature stock market is one for moderate speculation, which maintains a dynamic equilibrium between investment behavior and speculative behavior. Despite the fact that fluctuations will result under the influence of the external environment, the market can usually maintain a relatively stable operation, and

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while it plays its role of promoting economic development, it will also bring satisfactory returns to the majority of investors. In fact, many investors in the stock market have motivation not only to invest but also to speculate, but the proportion varies from individual to individual and the specific circumstances of the market. But if the motivation of speculation of the vast majority of investors is obvious, this allows the formation of an excessively speculative market. At that time, investors will usually ignore the business performance of enterprises, so that blue chip stocks are left in the cold, while shares which allow speculation of various kinds are being sought after, thus seriously weakening the resource allocation function of the stock market. Excessive speculation in the market will also contribute to short-term behavior, providing the conditions for the making of illegal market manipulation by dealers. The great risks that accompany excessive speculation are a hidden danger that causes serious turmoil in the securities market, which will further cause harm to the economy and society. To judge whether a stock market is excessively speculative mainly depends on whether investment subjects focus on the short-term price or long-term value of the investment targets (listed companies), and whether the market has divorced itself from the pattern of risk-return symmetry. From the perspective of investment, share prices should be equal to the present value of expected future earnings (called a rational price), so the fluctuations of share prices should not exceed the fluctuations of the rational price which is determined by dividends. However, due to the existence of the speculation factor, fluctuations in share prices exceed the fluctuations of the rational price. To verify the excessive volatility and effectiveness of the stock market, Robert Shiller proposed in 1981 his famous variance-bounds test. He defines “the discounted value of future real dividend” as the post-event rational prices of shares, and a comparison of the volatility of shares prices with the volatility of post-event rational prices (variance) can represent its excessive volatility. The author believes that it can in general also represent the extent of speculation in the stock market. According to Shiller’s calculations, fluctuations in the Dow Jones Index in the U.S. during 1928 and 1978 were 13 times the volatility of post-event rational prices, and fluctuations in the Standard and Poor Index during 1878 and 1978 were 56 times the volatility of post-event rational prices. We selected a data sample from the Shanghai Stock Exchange from January 1993 to December 2000 and conducted a variance-bounds test, and the results show that the volatility of the Shanghai Composite Index was 69 times the volatility of post-event rational prices.

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That the share prices in China’s stock market are seriously deviated from their rational prices is also shown the relatively insignificant role that dividends play in the explanation of share prices. According to our research, the explanatory power of dividends on changes in share prices in China’s stock market is only 10% (one year) and 20% (two years), while the explanatory power of dividends in the stock market of the U.S. is 48% (one year) and 53% (two years). It can be seen from the above two points that the extent of speculation in the China’s stock market is much higher than that of the U.S. It should be pointed out that the behavior of listed companies also contributes to the extent of market speculation. Listed companies in China basically do not pay dividends, and even if they do, they do so mostly by way of stock dividends, and less by way of cash dividends. At the end of 1999, only eight companies in the Shanghai and Shenzhen stock exchanges had paid stock dividends and interests totaling over RMB1 billion. In 2000, the stamp duties paid to China’s stock market and the brokerage commissions investors gave to securities traders were more than RMB90 billion, but the total amount of profits of listed companies were only more than RMB 50 billion, out of which the taxinclusive dividends for distribution were only RMB 14 billion. As it was difficult for investors to get profits from dividends, so they could only pursue income coming from buying and selling, thus increasing the extent of speculation in the stock market. In the stock market, only those shares which are generally regarded by investors as being worth investing can have their price-earnings ratio reaching a higher level. However, it was found in a statistical analysis of China’s stock market that there is a strong negative correlation of the operation performance of an enterprise and the price-earnings ratio of its shares. The share prices of some enterprises with poor operation conditions are relatively high, while the share prices of listed companies with better financial conditions are relatively low. From the perspective of the entire market, the level of price-earnings ratios of blue chips enterprises is much lower than that of listed companies with very poor financial conditions. This also shows the trend of excessive speculation in China’s stock market. To determine whether the market has divorced from the law of risk-return symmetry, we used the classification system of the CITIC style index to conduct data analysis, which consists of three kinds of scale style indexes and six types of style and value / growth sub-indexes. The scale style indexes include a Large Cap Index (CITIC Large Cap), a Mid Index (CITIC Mid Index), and a

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Small Cap Index (CITIC Small Cap). The six style sub-indexes include Large Cap Value Index, Large Cap Growth Index, Mid Cap Value Index, Mid Cap

Growth Index, Small Cap Value Index, and Small Cap Growth Index. Of these,

those with high net assets / total market value (referred to as B / P values) are

called the high-value type, and those with the low value are called growth type. Our data shows that in China’s stock market although the net assets per share

of Large Cap and Mid Cap value type shares are slightly higher than those of the growth type shares, their differences are not very significant (around 10%),

while Small Cap Growth shares of net assets per share are a far cry from Small Cap Value shares (which nearly doubled). But the differences between the net

assets per share of Small Cap growth shares and the Small Cap value shares are extremely significant (nearly double). The average price of the growth shares is significantly higher than the value stocks.

The data shows that the income per share of Large Cap shares and the net

asset profit ratio are on average higher than those of Mid Cap shares, while

the financial performance of Small Cap shares is the worst. Among the Large Cap shares and Mid Cap shares, the financial performance of growth type

enterprises is generally better than that of value type enterprises. Of these, the financial performance of Large Cap growth shares is most outstanding, the two indicators of earnings per share and net asset profit ratio are about 50% higher

than those of the Large Cap value shares, as these enterprises generally have stronger asset strength, a better perspective in the industry, and the support of government policy. But it is worth noting that the financial incomes of small-

cap value shares are significantly better than those of Small Cap growth shares. This is because the Small Cap growth shares have a collection of mostly loss-

making enterprises with a negative value in their earnings per share and net asset profit ratio, which indicate that such shares are on the whole operating in a state of losses.

In a normal (moderately speculative) stock market, the risk (fluctuations

in share prices) and return (the gains made from fluctuations in share prices)

are generally symmetrical, that is, the higher the gains of shares, usually the greater the corresponding risks, and those risk-free shares (no fluctuations in share prices) have no returns (gains from speculation). But in an excessively

speculative market, due to the intervention of various human factors, it could deviate from the law of risk-return symmetry. The risk-return relationship of the

various styles of shares in China’s stock market from January 1998 to December 2000 is shown in Fig. 5.2.

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Fig. 5.2. .

The risk-return relationship of the various styles of shares in China’s stock market from January 1998 to December 2000

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The vertical axis in Fig. 5.2 is the market profitability, shown by the annual average value of the share price differences with that of the end of the month and that of the end of previous month and comparisons with the share prices of the end of last month. The horizontal axis are the market risks, shown by the profitability variances, including Large Cap, Large Cap Value, Large Cap Growth, Mid Cap, Mid Cap Value, Mid Cap Growth, Small Cap, Small Cap Value, and Small Cap Growth. It can be seen from Fig 5.2 that in China’s stock market the Small Cap shares with poor financial conditions and operation performance poorer than expected have the highest market rate of returns, followed by Mid Cap shares, and the Large Cap shares with the best operation performance have the lowest rate of return. Among the circulating caps of the same scale, the rate of return of the value shares is generally higher than that of the growth shares, of which Large Cap Growth shares with the best financial performance have the lowest market rate of return and the highest market risks. This is because the caps of these companies are larger, their “field” is limited, and it is difficult for them to bring large profits to investors in the short run, so usually investors are not interested in these shares, leading to a significant underestimation of the intrinsic value

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of these companies and they become “blue chip junk shares” on the market. On the contrary, some shares with poor performance or even PT and ST shares are long sought after in the market. The above situation fully illustrates that the stock market in China has deviated from the law of risk-return symmetry, but the distortion of this kind of risk-return relationship is caused to a large extent by arbitrage conducted by dealers who make use of information asymmetry, and so it is difficult for the majority of investors to enjoy the benefits of low risks-high returns. It is reported that in 1999, of the 44 million stock investors, 29.66% of them made profits, 4.56% of them broke even, which means more than 65% of them suffered losses, of whom 50% suffered great losses, with a loss amount of more than 35%. And according to an online survey, in the great bull market in 2000, only 39.68% of stock investors made money in the secondary market from January to October, the number of investors who suffered losses accounted for 43.22%, and 17.09% of the investors basically broke even.

Stock Market Bubbles Are Really Enormous A right amount of bubbles will help enhance people’s confidence in gaining profits from speculation in the stock market and attract more capital to enter the stock market, thereby increasing the level of activity in the market. But the ever-expanding of bubbles would induce people to over-speculation, eventually causing the bursting of these bubbles and causing people to panic. At that time, it is possible that as people rush to sell their shares, it creates an “overcorrection” of the stock market, which means shares prices are lower than their rational prices, producing “sunspots” (i.e., negative bubbles). Some scholars advocate dividing stock market bubbles into rational bubbles and irrational bubbles. The former refers to the formation of bubbles when share prices deviate from their rational prices in a short term. The latter refers to the formation of bubbles as a result of the irrational behavior of investors when the market is ineffective, has incomplete information, and there are differences in investors’ expectations. Then investors could continue to buy shares when share prices in the market are very high and believe that they can sell them with even higher prices, and this is what is called the “great fool” phenomenon. Some other scholars advocate dividing the stock market bubbles into deterministic bubbles and stochastic bubbles. The former, once produced, will continue persistently according to the trend, its speed of growth is stable, and is not related to expectations. The size and changes of the latter are uncertain and they depend on the expectations and other random factors, and there is

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the possibility of bursting in any period. Stochastic bubbles are closer to the situation of the real market, and are the more typical of bubbles. The author proposes to base on the principles of indeterminacy in decision science and divide the stock market bubbles into the two major types: objective bubbles and subjective bubbles. The former arises from the objective existence of indeterminacy in the economic fundamentals. The latter is generated from the errors of subjective estimation of the prospective of the stock market. As mentioned earlier, the rational price of shares equals to the present value of their future earnings. They are determined by future earnings and the discount rate (interest rates), both closely related to economic fundamentals, and need to be predicted according to the past and current data. Although in recent years with the rapid development of information technology and the great improvement in forecasting techniques, there has been the emergence of many new technologies such as data mining, knowledge discovery in databases, symbolic data analysis, and intelligent mining, which have greatly improved the accuracy of prediction and could to a certain extent grasp the changes in the operation performance of enterprises and the direction of interest rates, and this guides investors to adjust their investment strategies accordingly. However, due to the uncertainty of the objective world and people’s limitations in their ability to understand this kind of uncertainty, there will inevitably be errors existing between the predicted results and actual results. The resultant bubbles are an objective reality in the stock market, and they can be called objective bubbles. According to the principles of complexity science, in a complex system where you have participants, people’s subjective estimations of the future are vastly different. But due to interaction between people, and the guiding function of the external environment on human behavior, it will generate a kind of self-organizing function, driving the system to continue to move in one direction. The subjective bubbles in the stock market are formed as a result of this type of self-organizing function, and this would further generate positive feedback (greater fools), resulting in the share prices being much higher than their rational prices. In the stock market, the price-earnings ratio (P/E value), which is the ratio of the market price of the shares of a listed company and the net profit per share, is an important index to reflect the formation of bubbles, as the higher the price-earnings ratio, the more likely the formation of bubbles. The essence of P/E values ​​is the relative price of the shares, which can directly reflect the situation in which the market price of the shares are not in line with the level of profitability. This is an importance indicator of determining the rationality of share prices and a significant indicator of determining the financial bubbles.

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There are many factors affecting the price-earnings ratio of the overall market, most notably the potentials of economic development and market interest rates. Under normal circumstances, the maximum allowable value of price-earnings ratios should not exceed the reciprocal of the rate of returns (i.e. discount rate) acceptable to investors. If we take the interest rate of a five-year fixed deposit (2.30% after interest tax reduction) in 2000, then the maximum allowable priceearnings ratio is 43.4. In 1996–2000, the rise of the Shenzhen Composite Index was 461.40%, while that of the Shanghai Composite Index, 273.41%. In 2000, the average priceearnings ratios of A shares in the stock exchanges in Shanghai and Shenzhen were 58.22 times and 56.03 times respectively, which were greater than the maximum allowable value of the price-earnings ratios over the same period. As the returns for the calculation of the price-earnings ratio are accounting returns, it is estimated that an average of about 10% of the announced profits come from investment in the stock market. In addition, the statistical calculation of the average price-earnings ratio does not include loss-making enterprises, so the actual price-earnings ratio should be higher. The dividend rate is the ratio of dividends on stock prices. When dividend rates are too low, it means the share prices are too high, and it also means that the bubble level is too great. According to statistics, during the four years between 1996 and 1999, listed companies which adopted cash dividends were only 26 companies per year on average, accounting for on average only 3.3% of the number of listed companies per year. Of the 61 companies that had announced their annual reports in the middle of 2000, their average cash return rate was only 0.83%, while the bank deposit interest rate was 2.25% (1.8% after reduction of interest rate tax) over the same period. In addition, the dividend rates of the Shenzhen and Shanghai stock exchanges in 1995 could only reach 20% to 50% of the rate of returns of national bonds, which also shows that share prices in China’s stock markets are too high. China’s stock market bubbles can be divided into three levels: first-level bubbles come from the premium in the issuance and listing of securities in the primary market; second-level bubbles come from gains in price difference in the trading of securities in the secondary market in securities; and thirdlevel bubbles come from gains in price difference generated from the rise of share prices of the listed companies through mergers, acquisitions and asset restructuring. Using the dynamic first-order autoregressive method of testing, we found that, when compared to mature foreign markets, there are relatively too many bubbles existing in the current operation of China’s stock market.

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The accumulated bubbles of the Shanghai Composite Index and Shenzhen Composite Index between the years 1991 and 2000 were 63.4% and 58% respectively, while during the same period the average annual accumulation of bubbles of the Dow Jones Index was 19.5%. From a comparison of the bubbles on the Shanghai and Shenzhen stock exchanges and how composite indexes operate when the stock index has a significant rise, it shows that stock market rises are largely driven by bubbles. Although the level of development of bubbles shows a declining trend, when compared with that of mature markets, the bubble level is obviously too high. After August 2001, with the fall of China’s stock market, the level of the bubble in the market also dropped considerably, but for various reasons, some bubbles (such as first-level bubbles) are currently difficult to remove.

The Common Prevalence of Short-Term Behavior Short-term behavior usually refers to the behavior of an operating cycle of share operation within six months to obtain short-term margins, which is currently a common phenomenon in China’s stock market. As investors usually exhibit speculation by “buying shares when their price is up and selling them when their price goes down” when they chase after short-term margins, which means they are not too concerned about corporate performance, but rely mainly on market transaction information (technical analysis) or other information to make investment decisions, this creates the emergence in China’s stock market of such characteristics as high price-earnings ratios, the falling in favor of the blue chips by the market, high turnovers, and high volatility. Turnover rate is the rate of the transaction volume and the number of circulating shares or the amount of transactions and the circulation market value. The turnover rate of the Shanghai market and Shenzhen market in the turnover of capital is much higher than the level of the mature capital markets in the West. The turnover rate of Tokyo and London markets is less than 50%, while the turnover rates of other markets, such as those of New York, China Hong Kong, Thailand, and Singapore in the last few years did not reach 70%. The annual average turnover rate of the A-share market in China in 1992–2000 was around 400%, which shows that on average investors in the secondary market hold a stock for just around three months. And every year, there are a small number of individual stocks whose turnover rates reach the level of 1,000% or even 2,000%. China’s stock market does not chase after blue chip shares. The more important condition for the rise and fall of the market is the size of the shares

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in circulation. The trend of the stock market is determined more importantly by the concept factor, the dealer factor, and policy and rumor factors, and share prices to a great extent are divorced from the business performance of enterprises. Our survey results show that 76.3% of investors completed their cycle of stock operation in less than six months, only 7.3% of the investors had their stock operation cycle of more than one year. In other words, at present, investors mainly operate in the short term, while the number of long-term investors is comparatively few. There is also a considerable part of investors who are of the super-short-term operation, and investors whose cycle of operation is less than one month cycle even accounted for 27% of the total. Thus it can be seen that investors in China’s stock market in general have short-term investment behavior. Most valued in the investment in China’s stock market are the policy environment of the country and the domestic and foreign environment, followed by dealer manipulation, while the fundamentals of the companies are the least considered. According to a sample survey, 40.6% of investors have little or even no understanding of the operation situation of the enterprises whose shares they hold, which further verifies the short-term behavior characteristic of stock market investors in China. Currently in China, investors in the stock market can be divided into the three categories of institutional investors, individual investors and private equity investors. These three categories of investors all show their short-term nature. Institutional investors are mainly securities investment funds and securities companies. As funds have the advantages of largeness of scale, plentiful capital, and professional staff, it is natural for them to have the urge to manipulate the market, and be driven by the need for huge profits, so their behavior is inevitably short-term. Securities companies, due to the lack of their own funds, regardless of their use of lawful means (such as stock-secured loans) or illegal means (such as misappropriation of clients’ deposits, borrowing funds or attracting deposits in disguise) as the sources of funds to speculate in shares to obtain huge profits, the short-term nature and high costs of these funds will inevitably lead to short-term trading behavior. Individual investors in China’s stock market are mainly small-to-medium investors. As they have few channels to understand information and it is difficult to ensure the authenticity of the information, they cannot make rational judgments, and it is difficult for them to make long-term investment decisions. The capital of individual investors is limited, and they invest mainly in the stock

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market. This investment accounts for a high proportion of their total household assets, so they cannot bear the risk of making long-term investment to gain profits and the risks of loss. Because of excessive speculation and the existence of excessive bubbles in China’s stock market, and the lower level of investors’ risk sensitivity, they are willing to bear the risks which are even greater than the risks corresponding to their actual incomes, so they have actually become a risk-tilted type of speculators. Private equity funds are funds established by raising funds specifically from a small number of investors through a non-public way. Due to the lack of an appropriate legal basis, there are no open and legitimate private equity funds in China, and they cannot exist in various alternative forms, such as studios, financing agencies, and company or contractual form of private equity funds. It is estimated that by June 30, 2001 the size of private equity funds in China will be around RMB700 billion to RMB900 billion, mainly using the form of financing agencies. Due to the short-term nature of the funding sources and under the pressure of the repayment of capital and interest, fund managers’ investment behavior is inevitably short-term.

The Inescapable Responsibility of Market Manipulators Market manipulation refers to the behavior of artificially manipulating share prices by individuals or institutions through means such as fraud, misguidance, and creation of false prices to entice others to participate in stock trading for their own personal gains (including gaining profits directly or indirectly or shifting risks). The behavior of market manipulation is on surface an investor’s activity of securities investment, but in essence, this is an illegal use and abuse of the right of investors to buy and sell securities. The Interim Provisions on the Management of the Issuing and Trading of Stocks promulgated by the State Council in 1993 and Provisional Measures against Securities Fraud prepared by the Securities Committee of the State Council all listed market manipulation as prohibitive behavior. When the Securities Laws were officially implemented in 1999, it made a further provision on market manipulation behavior and expressly prohibits anyone from obtaining benefits or transferring risks through the following unfair means: (1) controlling the prices of securities trading through pooling capital, stocks, or information to jointly or continuously buy or sell securities, either acting individually or collectively; (2) affecting the prices of securities trading or trading volumes by working in collusion with others to buy or sell securities at time, prices, and methods previously agreed upon; (3) affecting the prices of

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securities trading, or the volume of securities trading, through purchase or sale that does not transfer ownership, considering the buyer or seller himself as the trading object; and (4) manipulating the prices of securities trading through other means. Examples include making use of the opening or closing time to conduct focused trading to manipulate share prices or using a false declaration to manipulate share prices. The securities market in China is an emerging market. Due to various reasons such as market factors, the construction of a legal system, and law enforcement and regulation, the Chinese stock market, as experienced by many mature markets at their early stages, has experienced market manipulation, with manipulation in individual market being particularly serious. We normally use the method of identifying the abnormal fluctuations of certain share prices to determine whether there is market manipulation. Guo Jun and others use the excess-vibration-extent of stock price (the vibration extent of share prices minus the share index vibration extent of the same period) as an indicator to measure the characteristics of dealer manipulation, and use the large position ratio (the number of the total number of circulating shares held by individual account holders who hold more than 100,000 shares) to assess the dealer factor and conducted an analysis of the data of Shenzhen stock market in 1999–2000. The results show that the dealer factor has a significant impact on the excess-vibration-extent of stock prices, and it can be said that dealer manipulation exists in the stock market in Shenzhen. During the five months between June 1996 and May 2001, the China Securities Regulatory Commission dealt with 16 cases of market manipulation. When we compare the vibration extent of the composite index made up of these 16 stocks with the corresponding weighted composite indexes of the Shanghai and Shenzhen stock markets, the increase of the Shanghai market was 50% of Shenzhen’s, and the standard deviation of the former was about two times of the latter. If the fluctuations of the weighted composite index represent the fluctuations of the market, then it can be considered that share price fluctuations caused by share price manipulation are about twice that of the fluctuations in the market. The major method in the market manipulation of China’s stock market is by what is called “playing the dealer,” and the basic process of manipulation of the process generally go through the five stages of absorbing shares, dishwashing and pulling up prices, creating share price shocks, extensive pulling up of share prices and the selling of shares. Dealers who manipulate the market are mainly institutional investors, including securities companies, fund companies, listed companies and (or) its

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major shareholders, other institutional investors and large fund holders and so on. Of the above-mentioned sixteen cases of market manipulation investigated by the China Securities Regulatory Commission, seven of the market manipulation subjects were securities companies, and another one, though the subject of manipulation was not a securities company, securities companies nevertheless provided the indispensable financial support. In other words, securities companies accounted for nearly 50% of market manipulation cases. Through manipulating trading prices and trading volume of shares, dealers create a false picture, change the relation of supply and demand in the market, mislead other investors to follow the trend of buying shares when they go up and sell them when they come down. Dealers may sell their shares to get huge profits after pushing up their prices, or pull up share prices to get profits in the future after pressing down share prices to absorb chips, while other investors who do not know the truth, or those who take the chips thrown out by dealers at a high price will be stuck, or suffer direct losses when they throw off their shares at a low price. This will severely damage their legitimate rights and interests, the loss of fairness and justice in the market, thus undermining the sound operation of securities markets and hampering the healthy development of the economy. In addition, market manipulation also adversely affects fluctuations in bank credit and mortgage loans for securities. As stock trading is characterized by its concentration and rapidity, its risks will easily spread, and if they are not properly controlled, the transaction risks of individual stocks may evolve into systemic risks of the entire market, and even lead to the collapse of the market. One of the important reasons for the collapse of the stock market in the U.S. in the 1930s was market manipulation, and therefore the U.S. was the first country to establish antimarket manipulation terms in the Securities Trading Laws in 1934, and other countries or region also established laws to prohibit and seriously punish market manipulation, considerably narrowing the room of such activities of the dealers. Although China’s securities laws expressly prohibit market manipulation, due to the fact that China’s stock market is a unilateral market in which we look forward to more rises and less falls, its restrictions on the behavior of dealers are strict, and some even think that dealers are indispensable in the market as they are the “discoverers of stock market potential” and “voluntary analysts of changes in share prices,” and advocate chasing after and following the dealers. These appeasement remarks of the dealers lead to the popularity of market manipulation, and the 16 cases investigated are only the tip of the iceberg. It should be pointed out that the larger traders in the stock market are not the

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same as dealers who manipulate the market, the role of these traders should be to raise the rationality of investment, and not to disrupt fairness in the market.

Major Measures for Regulating and Developing Stock Markets in China The author believes that the issues of the above-mentioned eight aspects are the main problems that existed in the initial stages of China’s stock market. These problems not only undermine the fairness and impartiality of the stock market, but also allow a small number of people to engage in frenzied speculation and profiteering, while the rights of most investors suffer serious damage. This also greatly weakens the role of the stock market in the optimal allocation of resources and promotion of national economic development. We must therefore address the abovementioned problems, find out their causes, and take effective measures to regulate and develop the stock market in China. It was emphasized in the Proposal of the CPC Central Committee for the Formulation of the 10th Five-Year Plan for National Economic and Social Development to “regulate and develop the securities market,” and it proposed that the stock market should “support the industrialization of highnew technologies,” “encourage large and medium state-owned enterprises to implement the joint-stock system through regulated listing,” “nurture and develop institutional investors,” “strengthen market supervision and information disclosure of listed companies,” and “adapt to the trend of development of cross-border investment, and make use of long and medium term foreign investment to actively explore the use of various kinds of ways for acquisitions, mergers, investment funds and securities investment.” These statements further indicate the future direction for the development of securities in China. After the great bull market from May 1999 to June 2001, the market value of China’s stock market continued to fall. By the end of 2002 it was 20.3% lower than the end of 2000 (of which the value of circulating shares fell 22.5%), and it could be said that China’s stock market had entered a period of adjustment. We should seize the time, conscientiously sum up the lessons we learned from the development of China’s stock market over the past decade, and conduct a practical adjustment of the stock market in China in the following eight aspects:

Clearly Adjusting the Guiding Ideology As we all know, the stock market in China was developed based on Deng

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Xiaoping’s Theory. He pointed out as early as in 1979 that “to say that a market economy exists only in a capitalist society and that there is only the capitalist market economy is certainly not true. Why is it that socialism cannot engage in a market economy? This cannot be said to be capitalism.” After that, he also made several discussions of this point repeatedly to reduce the concerns of some people in the development of securities market under the socialist system in China, and contributed to the establishment of the two securities exchanges in Shanghai and Shenzhen. In the series of speeches given by Deng Xiaoping during his south China tour in early 1992, he clearly pointed out that “a planned economy is not equivalent to socialism, because there is planning under capitalism too; a market economy is not capitalism, because there are markets under socialism too. Planning and market forces are both means of controlling economic activity.” He also pointed out that “are securities and the stock market good or bad? Do they entail any dangers? Are they peculiar to capitalism? Can socialism make use of them? We allow people to reserve their judgment, but we must try those things out. If, after one or two years of experimentation, they prove feasible, we can expand them. Otherwise we can put a stop to them and be done with it. We can stop them all at once, gradually, totally or partially.” According to this series of expositions by Deng Xiaoping, the 14th National Congress of the Communist Party of China in 1992 affirmed the goal of establishing a socialist market economy. The developments of the last decade proves that boldly drawing from advanced production management methods and management methods reflect the laws of modern society, such as the jointstock system and stock market, are entirely possible and extremely necessary. But we should also clearly see that to develop stock markets in China, which is the largest developing country practising the socialist system, requires longterm and arduous efforts. We must seriously study and absorb the experience and lessons of foreign stock markets during the process of their development in the last several hundred years, and also seriously consider exploring a development path in line with China’s national conditions. The author believes that the development of China’s stock market must adapt to the socialist market economy system. The essence of the socialist market economy on the one hand plays the basic role of the market in allocating resources to improve the efficiency of economic development, while on the other adheres to the principles of socialism to safeguard fairness and justice in the society. We therefore have to carefully study and absorb the experience of developed countries in their development of the stock market, and vigorously promote the healthy growth of China’s stock market to fully exercise the role that the stock market plays in the optimization of the allocation of resources

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and promote economic development. We also have to pay great attention to the regulation and supervision of the stock market, strictly investigate and punish all sorts of violations to provide a fair and just opportunity for all investors to make profits. It can be seen from the process of the development of the fictitious economy that marketable securities are a product of socialization of the interest-bearing capital and the stock market is a product of the marketization of marketable securities. The basic role of the stock market is to provide investors with opportunities to invest directly, and provide enterprises with opportunities to obtain direct financing. For investors, as the risks of the stock market are high, their expected rate of returns of the shares of enterprises is higher than that of bonds, and only such enterprises have investment value. For enterprises, as investors are also required to bear risks, they should have higher profits to share with investors so as to be able to attract capital from investors. The adjustment of the guiding ideology of China’s stock market, therefore, should be a return to the basic role of the stock market. This on the one hand allows investors’ capital to invest those enterprises listed in the stock market they believe have investment value, and to make their own decisions about whether to hold onto their shares and wait for dividends or sell them to get cash and let speculators to bear the appropriate risks. On the other hand, the stock market should allow enterprises with the ability to make good profits but with inadequate capital to obtain the capital they need from the stock market, and though the choice of investors to force those listed companies with investment value out of the stock market. Only in this way can the stock market play the role of optimizing resource allocation. We must resolutely prevent excessive speculation in the stock market, and never allow the stock market to become a place for frenzied speculation by a small number of people, a place for profiteering, or to allow it to become a place where some enterprises can “wantonly misappropriate” and obtain cheap financing.

Strengthening and Improving Market Supervision In October 1992, the State Council decided to set up the State Council Securities Commission and the China Securities Regulatory Commission in order to have unified supervision and management of the national securities market, and extend the places for the issuance of shares from a few pilot places such as Shanghai and Shenzhen to the entire country. According to the Reform Proposal for the System of Securities Supervision Bodies of the State Council, China Securities Regulatory Commission completed the structural reform

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for the implementation of vertical leadership of local securities regulatory bodies. It established nine securities supervision offices, two direct offices, and twenty-five special commissioned offices for the entire country. As required by the Securities Laws , the securities regulatory authorities conducted a shutdown of the exchanges concerned before the implementation of the laws, and changed the examination system of the issuance of shares to the approval system, strengthened the obligations of information disclosure of listed companies and relevant agencies, supervised the improvement of the corporate governance structure of listed companies, and implemented the “separation of the three areas of assets, personnel and finance” between listed companies and their controlling shareholders. The regulatory authorities strengthened the supervision of the day-to-day running of listed companies, implemented the management of securities companies by their categories, strengthened the business supervision and guidance of intermediary service agencies such as investment and advisory companies, and reformed the securities registration and settlement system, which play an active role in guaranteeing the normal operation of the securities market and preventing violations of the securities laws. The China Securities Regulatory Commission also investigated and punished the illegal activities of a number of listed companies and securities firms, such as illegal financing, insider trading, market manipulation and fraud, the procuratorates of the entire nation to create files to investigate cases of securities law violations, and the people’s courts at all levels to complete legal proceedings of some criminal cases in securities. As there is a large gap between the regulatory efforts and legal requirements of the China Securities Regulatory Commission, which serves as a statutory authority of securities regulation, we propose the following four ways to improve the work of the China Securities Regulatory Commission. The first way is to clearly establish the responsibilities of the securities regulatory authorities. The main duties of the securities regulatory authorities should be to safeguard the fairness and equity of the securities market, so that the stock market returns to the basic position of direct investment and direct financing. They should provide equal investment environment for all investors to allow them to gain their reasonable returns under the premise of bearing their own risks. As the ability of the small and medium investors to access to information is relatively weak, and their ability to bear risks is even poorer, they are the vulnerable groups in the stock market. The securities regulatory authorities must seriously and timely investigate and deal with various illegal behavior of looting the wealth of the small medium investors, and through the system stop allowing the dominance of a particular shareholder

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in a listed company, which ignores the legitimate rights and interests of small shareholders. There also has to be an approval system which is fair, just and open, provide equal market access to all types of ownership enterprises, have quality enterprises which can give investors higher returns more opportunities for financing, while eliminating the risk-free arbitrage conditions of the primary distribution market to prevent the stock market from becoming a place for some enterprises to “misappropriate.” The securities regulatory authorities should not be responsible for the ups and downs in the stock market, or even prop up or rescue the market from their position as owners of state assets. Under very special and extremely necessary circumstances, the securities regulatory authorities may through legal procedures request the government conduct an appropriate and temporary intervention of the market. The second way to improve the work of the Commission is grasp accurately the focus of market regulation. False information is a relatively common problem in the offering, listing, and annual reports of listed companies. First, some companies overvalue their assets, falsely report their profits, and false package their shares in order to issue and list their stocks. The second is that many listed companies violate the wishes of investors and randomly change the direction of investment of the raised capital, indirectly causing untrue information. According to the author ’s understanding of the situation in Shanghai, listed companies which changed the direction of using the raised capital within two years reached 40%, while those which made such a change within a year were also more than 10%. A considerable part of the raised capital returns to the stock market through various channels are used to engage in stock speculation. Third, a small number of listed companies intentionally disclose false information. To collaborate with dealers to engage in the speculation of their shares, some listed companies correspondingly issue information at different stages to mislead investors. In January 2001, for example, the major shareholders of Daqing Lianyi announced publicly that a high percentage of bonus shares would be given to investors, causing the rapid rise of its share price. Shortly thereafter, the secondary shareholders made negative remarks publicly, which caused the plummeting of its share prices, causing many investors to suffer heavy losses. According to the statistics of the Xiamen City, of the 16 listed companies in the city, those with non-regulatory information disclosure accounted for around 20%. From the point of view of law enforcement, the situations in other locations were even more serious. It can be seen that the focus of securities market supervision should be placed on information disclosure. We should take practical and effective measures to prevent listing through false packaging of shares and prevent

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listed companies from changing the direction of the investment of raised capital at random to harm the interests of investors. We have to further improve the standards of information disclosure, promote the process of internationalizing accounting standards, and safeguard the authenticity, accuracy, completeness, compliance and timeliness of information disclosure in listed companies and relevant intermediary organizations. Information disclosure can not only improve the situation of information asymmetry between investors and prevent a small number of people from getting profits by using insider information or fraud with the use of false information; it also provides favorable conditions to discover problems. After the disclosure of information, then professionals such as chartered financial analysts (CFA) and investors themselves can undertake their own analyses, and raise the issues they find to the securities regulatory authorities. Regulatory authorities, after verifying the issues, will announce them publicly, and deal with them according to the gravity of the issues. Attention must be paid to the strengthening of the management of securities companies, listed companies, intermediary organizations, designated news media and some stock analysts to prevent them from collusion and the disclosure of false information to mislead the public and investors. The second is to pay attention to the function of the market. While the healthy development of the stock market is inseparable from government supervision, we also have to pay attention to the self-organizing role of the market. Administrative examination and approval of matters relating to such aspects of the issuance, listing, and trading of shares should be minimal. There should be open applications and approval according to procedures or decisions made based on market conditions and filing to the securities regulatory authorities. At the same time, we should fully exercise the role of self-regulatory organizations as bridges and links between the government and the market, such as conducting annual inspections and assessment of the financial position, and operating performance of enterprises as well as the quality of services of their members. These organizations should conduct guidance on the business activities of their members, investigate violations by members and handle them according to the law. They need also to resolve conflicts between members, be able to maintain their legal rights and interests, give them legal and business education, organize business exchange, and conduct professional accreditation for some professional positions and so on. Lastly, we have to continuously strengthen the means of supervision. We have to make use of advanced information technology to establish a national real-time stock trading system and a monitoring and early warning system so

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as to be able to detect abnormal phenomena, such as unusual fluctuations in share prices, and analyze the causes to enable the adoption of prompt actions. We have to grant the necessary power of investigation to the China Securities Regulatory Commission through legal procedures to prevent a flight of capital and the escape of suspected criminals. We need to further strengthen the teambuilding of the securities regulatory authorities and improve the political ideology, service quality and professional skills of the securities regulators. Staff of the regulatory authorities should handle matters according to law, be fair and clean, and not be allowed to make use of their positions to seek illegitimate profits. Interdepartmental collaboration among units such as the China Securities Commission, banks, courts, and prosecutorates should be strengthened to establish a unified coordination mechanism for the enforcement of law to intensify the crackdown on major cases of illegal securities.

Raising the Quality of Listed Companies At present, the quality of many listed companies in China is low, and they have no investment value. In 1999, 2000 and the first half of 2001, the asset profitability of listed companies in China was 4.01%, 3.58% and 1.83% respectively. According to a recent joint study conducted by the Shanghai University of Finance and Brunel University, it was shown that of all the listed companies in China, 70% were in a state of consumption. It is true that there was a considerable profit in the books, yet the profit was actually “bought” by raising capital, or paper wealth, and they could not realize the real cash earnings to create value for investors. At the same time, as the cost of fraud is lower, the suspicion of enterprise fraud was about 20% of the listed companies, and it was found, on the basis of taking away the observation value of fraud suspicion, that listed enterprises are in a state in which both the capital and profits increased, but their value creation value declined significantly. According to our survey, one of the important factors that accounts for poor business performance and the lack the ability for long-term development is due to the lack of reasonable and effective corporate governance of listed companies. By the end of 2002, listed companies in China reached the mark of 1,223, most of them were formed from the restructuring of state-owned enterprises, which resulted in the proportion of uncirculated state shares reaching a height of 40% in China’s stock market, and some listed companies even reached as high as 80%. Some listed companies in China are under the strict control of their major shareholders, and even have one company under two names. There are also listed companies in which there are no distinctions of the people, finance

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and things of the controlling shareholders, such that the listed companies become the “automatic teller machine” of the major shareholders or groups. In the last few years, for example, the controlling group of the KMK Co. Ltd. had borrowed away RMB900 million, which have not yet been returned, and a RMB260 million payable capital was appropriated, causing the “fleecing” of the company’s assets, and putting the company into a position of serious insolvency. Some listed companies were active in financing, but negative in distribution, damaging the interests of investors. In 1999, for example, listed companies which did not pay dividends accounted for 69.1% of the listed companies in the current period, while those in 2000, a share of 49.1%, and even some listed companies with good business performance did not pay dividends on the ground of needing the capital urgently to increase their production, causing the dissatisfaction of investors. The intervention of the local government on the market access, operation process and exit mechanism of listed companies has severely weakened the function of optimizing resource allocation in China’s stock market. For example, the securities laws stipulate that listed companies which fail to fulfill the legal requirements of listing should be suspended or terminated for listing. But due to the intervention of local governments, a number of companies which had lost their listing conditions could not withdraw from the market for a long time, thus seriously affecting the efficiency of the securities market. The major direction of the adjustment of the property rights structure of listed companies is equity interest diversification. It was pointed out in the Decision of the Central Committee of the Communist Party of China on Major Issues Concerning the Reform and Development of State-Owned Enterprises that “diversity of equity interest helps form a regulated corporate legal person management structure. It is necessary to develop companies featuring multiple investment subjects, except for a small number of enterprises that should be monopolized by the state.” Equity interest diversification helps realize the policy of common economic development with public ownership as the main core and other diverse forms of ownership, and can also help the state, through the be-in-place system of state contributors, solve the issue of over-reliance on the government and the government having unlimited liability of enterprises. Issues such as unclear property rights and confusion over ownership and right of operation that exist in our collective and private enterprises should also be resolved through the method of equity interest diversification. In theory, in companies with equity interest diversification, the shareholders meeting is the highest authority of the company, but due usually to the

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number of shareholders and their mobility (as there are many equity interest transactions through the stock market), in reality the board of directors on behalf of shareholders exercise the powers of the owners. Because of the high concentration of equity interest and the dispersion of public shareholders, the board of directors is manipulated by major shareholders or controlled by insiders, it is relatively difficult to form an independent board to ensure a sound management and decision-making mechanism. According to a questionnaire survey, people who believed that the board of supervisors is the main power of constraint accounted for a mere 3.4%. Due to irrational equity interest structure, the interests of managers in many enterprises cannot be guaranteed by a transparent mechanism, and therefore often gain benefits for controlling shareholders or even themselves in decision-making, which significantly harm the interests of minority shareholders. Under this circumstance, the performance of a company to a greater extent depends on the quality and “conscience” of managers, or is dependent on the degree of openness of the controlling shareholders. To solve the issue of the dominance of a single shareholder, both the surface and what goes beyond it needs to be dealt with. We have to take effective measures, on the one hand, to address such issues as seizing the assets of the listed companies by major shareholders. As to the mutual guarantee between a listed company and its major shareholders, we have to regulate it strictly according to law to prohibit the listed company from providing guarantees to major shareholders unilaterally. Transactions relating to the listed companies and their major shareholders must be conducted strictly according to law and disclosed according to regulations. Through relevant guidance documents, we clearly state the qualifications, conditions, remuneration, rights and responsibilities of independent directors so that they can truly play a supervisory role. On the other hand, we have to adjust the equity interest structure of listed companies. As it is at present quite unlikely to have a significant increase in the proportion of circulating shares, we can allow the transfer of shares among state-owned enterprises so that each listed company has at least three large shareholders. We also have to improve the meeting systems of shareholders, board of directors and board of supervisors.

Guiding Investors to Change Their Ideas Many medium and small investors are active participants in China’s stock market, and they are also the most vulnerable groups in the stock market. In the adjustment process of the stock market in China, we not only need to use

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various means, including political and legal means, to protect the interests of investors, but we also need to strengthen the education of medium-to-small investors so that they are able to be change their ideas. The first thing to do is to correct the investors’ understanding of the stock market. They need to realize that there are risks in investing in the stock market, and that the higher the degree of speculation, the greater the risks. When they lack the ability to bear the risks even if they succeed in getting profits through temporary speculation, their long-term speculation will probably end in losing everything. Medium and small investors, in particular, must prevent themselves from engaging in excessive speculation, and choose as much as possible listed companies with higher investment value to do long-term investment. The second task is to improve the analytical ability of investors. Increasing investors’ ability to carry out independent analyses of the value and trends of individual shares when there is a greater free-flow of information disclosure ensures that they can make their own investment strategies and prevent them from the damage caused by acting and blindly following rumors or dealers. The last aspect is to enhance the legal awareness of investors. According to surveys conducted by the author in places such as Shanghai, Shenzhen, and Wuhan, many medium to small investors have never read the Securities Law , and they did not even know the legal rights they have. To achieve this, we should educate investors so that they understand how to properly exercise their right of share ownership and free handling, their right of information access, their right to know and vote on major issues of listed companies, as well as the right of distributing corporate earnings and asset surplus.

Making Great Efforts to Train Institutional Investors At present, the circulation of shares in the market is too scattered, and the proportion of institutional investors is too small. According to statistics, of the total number of share accounts of the Shanghai Stock Exchange at the end of 2000, the proportion of individual investors reached up to 99.56%, while the proportion of institutional investors accounted for only 0.44%. The situation in the Shenzhen Stock Exchange was similar. The equity interest of the publicly circulating shares was highly scattered amongst individual shareholders, resulting in a lack of effective and direct control by public shareholders in listed companies and there has been a strong tendency to “hitch a ride.” Training institutional investors is of paramount importance to the improvement of the investment structure of the securities market in China. Firstly, we have to further develop securities investment funds, focusing on the development of open-

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end funds, and strive to turn these funds into the mainstream of the fund industry in the next five years. We have to gradually implement the registration system for the establishment and distribution of funds, create an environment that is helpful to innovative market mechanisms, explore innovative fund varieties for such funds that suit insurance and social security, and introduce timely funds such as bond market funds and money market funds. We have to study and broaden the scope of business of fund management companies and allow them to engage in businesses such as private fund raising, and commissioned asset management. We have to study the relaxation of restrictions on the eligibility of fund management companies and fund initiators, and gradually allow various institutions and individuals to engage in the establishment of fund management companies, explore the new equity interest structure of the management company, and select fund management companies with good conditions to be pilots in listing. Next, we have to accelerate the training of insurance institutional investors. We need to explore flexible ways for insurance funds to enter the market, encourage fund management companies to be bold and innovative, and design fund products that meet the characteristics of the insurance funds to better serve insurance companies. We can then allow insurance companies to set up either with their own capital or jointly with other insurance companies, special pilot points for the management of insurance funds, and then when conditions are ripe, we can consider giving permission to allow insurance companies to be involved in the initiation of the establishment of a fund management company, thus further developing the funds industry and the securities market in China. Lastly, we should actively explore a professional management system for social security funds. By setting up a social security fund, we can relax investment restrictions, gradually open up the securities market to the social security fund, introduce the competition mechanism, and explore the building up of a professional and marketized social security fund management and supervision mechanism that is mainly led by the management of commissioned professional institutions. We actively explore the various kinds of social security fund management models such as management by commissioned fund management companies, the creation of annuities by life insurance companies, investment-linked insurance and bonustype insurance, to achieve the positive interaction between the social security fund market and the securities market.

Promoting Securities Companies to Change to Modern Investment Banks With the development of China’s securities market, securities companies

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have continued to grow. By the end of 2002, there were 126 securities companies, and more than 3,700 securities business departments. Overall, the situation of the majority of the securities companies is good, but there are also a number of companies engaging in illegal businesses, and market manipulation still occurs. Some securities companies are involved in illegal dealings and manipulation of share prices, seriously disrupting the order of trading. There are also some securities companies which have issues such as clients’ overdraft and misappropriation of clients’ deposits. There are individual securities companies that are involved in malicious speculation, and provide financing to clients, buying and selling shares on behalf of their clients, and opening personal accounts to engage in the self-management of shares. We must therefore take effective measures to correct and deal with illegal operations and criminal acts such as securities and services market manipulation, malicious stock speculation, customers’ overdraft and misappropriation of clients’ deposits. The current scale of China’s securities companies is generally small, and there is still a considerable gap in financial strength, business scope and operation experience when compared with foreign investment banks. The sum of the registered capital of all the securities companies in China is less than that of a wellknown foreign investment bank, and the differences in their financing capacity are even greater. The current main businesses of China’s securities companies are securities underwriting and securities brokerage, other businesses such as corporate mergers and acquisitions (M&A), leveraged buyouts (LBO), project financing, asset management, corporate finance, and venture capital are yet to be developed. At present, China’s securities companies do not yet have the ability to do securities underwriting in the international market, and are far from meeting the requirements of the development of multinational corporations in China. We therefore propose supporting two to three securities companies with better foundation to move towards the direction of developing modern investment banks. We must strive to improve the ethical and professional quality of the staff of securities companies, establish an appropriate incentive mechanism, and seriously punish illegal behavior such as embezzlement and self-dealing. At the same time, we have to have a strict qualification examination and verification. It is proposed to establish as soon as possible the Chartered Financial Analyst (CFA) system which meets the needs of China and can also be in line with international standards.

Regulating the Development of Other Intermediary Organizations The Securities Law requires that intermediary services agencies such as accounting firms, law firms, and asset appraisal firms must provide related services such as

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the issuance of securities listing according to law. But some institutions, in order to benefit themselves, deviate from professional ethics to make false accounts for enterprises, provide false certificates, and some even meet the illegal or unreasonable requests of listed companies to prepare whatever accounts they want, what kind of reports they request, to open the door to listing with false packaging. In the first half of 2000, for example, of the four suspected illegal cases of listed companies in Sichuan, three accounting firms and one asset appraisal firm were involved. To strengthen the professional self-discipline of intermediary organizations, raise the professional ethical level of the professionals, we must strengthen the supervision of intermediary organizations. Accounting firms should exercise their main function of auditing by their registered accountants, provide independent, objective and impartial audit reports and other relevant information to investors, be responsible to investors, the share issuing company and the community, comply with professional regulations and relevant technical regulations, improve their operational capacity, maintain a good image and public confidence. Any breach of contract, negligence or fraud which is audited by audited units or causes losses to other interested parties will be investigated and bear the administrative, civil and criminal responsibilities according to law. Law firms engaging in the securities business have to ensure the authenticity, accuracy and completeness of the legal opinion reports and various relevant legal documents they issue, and they are strictly prohibited to provide false proofs. We also have to improve the standards of qualifications for lawyers who are engaged in securities legal services, and gradually train professional securities lawyers. The assets evaluation reports of assets evaluation firms are the important basis for the reform of the joint-stock system of state-owned enterprises and asset restructuring of listed companies, the accuracy, objectivity and impartiality of which must be ensured, and we should never allow random changes to meet the requirements of objects being assessed. We must adhere to international regulations to prepare the methods and procedure of asset evaluation, especially in the assessment of intangible assets which require strict regulations. We also have to especially train a batch of qualified asset assessors. In addition, some companies, such as investment companies, investment a d v i s o r y c o m p a n i e s , a n d f i n a n c e c o m p a n i e s , a f t e r re g i s t r a t i o n w i t h the Department of Business Administration, start to act as a business of financing agency, controlling a great deal of money to speculate in the stock market, which has an adverse impact on the market and has to be regulated by legal means.

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Further Improving the System of Securities Laws After the promulgation and implementation of the Securities Law , as some of its contents are relatively principled, the securities regulatory authorities need to make corresponding regulations and related implementation measures. We have to conduct further cleaning up of previous related rules according to related rules in the Securities Law , and promptly make some new implementation measures according to legal stipulations and the situation of market development. Up to June 2001, five administrative regulations, such as Public Offering Review Committee Ordinance and Stock Issuance Approval Process , which were promulgated by the China Securities Regulatory Commission, had been approved by the State Council, and the Commission also made and promulgated more than 130 pieces of departmental regulations, such as Measures for the Administration of Issuing New Shares by Listed Companies and Measures to Check Securities Companies . At the same time, according to legal requirements, more than 250 laws, regulations and regulatory documents before the promulgation of the Securities Law were cleared, and one hundred and fourteen documents were voided. The Shanghai and Shenzhen stock exchanges also cleared and made a batch of business regulations in accordance with the Securities Law and regulations on measures of supervision to ensure the effective implementation of the laws. However, with the implementation measures that have been introduced stocks still could not meet the needs of developing the securities market, while the relevant regulations and the regulations of the Securities Law did not match, and there was a lack of necessary coordination among some laws. Firstly, the Securities Law stipulates that when false information issued by securities issuers causes investors to suffer losses in securities trading, the issuers, directors, supervisors, and managers should bear the responsibilities of repayment. In the absence of specific measures, individual investors find it difficult to sue. In many cases it is very difficult to give proof to the prosecutor, and the court also believes that this provision is not specific and therefore finds it difficult to accept. The case of an investor in Sichuan, for example, suing to Hongguang Company came to nothing as the court believed that there was no case to make. But with the promulgation of the Notice Relating to the Acceptance of Dealing with Civil Disputes on Securities Due to False Statement s by the Supreme People’s Court on January 9, 2002, and the introduction of Several Notices Relating to Civil Damages Caused by False Statements When Investigating the Securities Market on January 9, 2003, it can be said that they have provided a strong legal basis for the protection of investors. Secondly,

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law enforcement agencies, such as the Ministry of Industry and Commerce, the Ministry of Public Security, the Procuratorate, and the court, are not consistent in their standard of knowledge on how to handle criminal cases of securities violations, which affects the handling of some cases. Thirdly, the relationship between the Securities Law and some aspects of the law, such as the Civil Procedure Law , are not clear, as a result that some law enforcement units can easily go to securities exchanges to enforce the execution of the deposits of clients, or even arrest people, seriously affecting the order of securities trading. As the introduction of the Securities Law was made during the financial crisis in Asia to effectively prevent risks, some contents of the Law are not specified, while others have more stringent requirements. In addition, with the further development of the securities market, some new issues are generated that affect the further implementation of this law. We suggest conducting an in-depth study of and proposing legal strategies for issues such as mixed operation, stock index futures, the entry of social security funds into the market, the development of the securities market after joining WTO, and law enforcement jurisdiction of the securities regulatory authorities. For some relatively general provisions in the Securities Law , they have to be substantiated through developing details about their implementation, such as Provisions on the Supervision of the Securities Market , Provisions on the Supervision of Listed Companies , and Provisions on the Administration of Securities Companies . We have to strengthen the study on the relationship between the Securities Law and the Company Law , Trust Law , Civil Law , Civil Procedure Law , Criminal Law , Criminal Procedure Law , and conduct modifications or interpretations of the relevant laws accordingly if necessary to make them more coordinated, and provide effective support and protection to law enforcement. Securities regulatory authorities have to keep discovering new situations and new issues from practice, conduct institutional innovation to further develop and improve the securities market in China. The Securities La w is the fundamental law for the securities market. Only when the majority of securities regulators, practitioners, and investors know the law, understand the law, and truly act according to law can effective implementation of this law be guaranteed. To achieve this, we have to further carry out the work of studying, publicizing and implementing this law. We have to encourage the news media, securities regulators and operators to use any means possible to promote the Securities Law and its supporting regulations. We should promote the Shanghai Securities Supervisory Office’s practice of requiring securities companies to give every investor who opens an account a copy of the Securities Law . Leading cadres at all levels, regulators

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and responsible personnel of securities operation institutions should take the lead in learning and using the law, strictly prohibit illegal intervention in the stock market, and be a model of administrating according to law, supervising and managing the securities market according to law. Listed companies, securities institutions, securities investment consultant institutions, securities practitioners and relevant news media must base their business on the law and specifically strengthen the work of learning, publicity and education to deepen their understanding of the Securities Law . The majority of investors must raise the awareness of risk and self-protection awareness through learning, and learn to use the law to protect their legal rights. The stock market in China is at low ebb, and this is an opportune time for changes. The author believes that under the strong leadership of the Central Political Committee and the State Council, and after two to three years of hard work, we can restore the quality of the stock market and set out again with the bright prospect.

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Chapter

Strategic Thoughts on Developing China’s Money Markets

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 2

Foreword According to the traditional definition, a financial market that issues and transfers credit instruments within one year is known as a money market. The definition of a money market can be divided into a broad one and a narrow one. Those who hold the view of a broadly defined money market believe that we should incorporate the bank credit market into the domain of money market. The American economist Peter S. Rose, for example, believes that the money market has provided a market and a mechanism for those who have short-term cash surplus to finance those who have short-term cash deficits. Those who hold the view of a narrowly defined money market, however, incorporate the exchange of short-term debt instruments into the scope of money market. The American finance specialist Marcia Stigum, for example, holds the view that a money market is a wholesale market of low-risk and highly mobile short-term debt bills. In this chapter, the author focuses on discussing the money market in its narrow sense, and suggests defining the money market as a trading market of highly mobile short-term debt instruments. The main characteristics of a money market are as follows: (1) Trading is mainly conducted between those who have cash in surplus and those who need cash, which means it is mainly reflected in regular clients and not capital clients of the financial institutions (companies). (2) Trading is short-term, usually within one year. Actually, a large number of trading contracts are within three months. (3) The varieties of trading are highly fluid short-term credit instruments, mainly short-term bonds and notes, such as treasury bills, bank acceptances, commercial bills, large-sum negotiable certificates of deposit, repurchase agreements, federal funds, euros, interest rates and currency swaps, note issuance facilities, money market certificates of deposit, money market deposit accounts, negotiable order to pay accounts, and so on. Due to the variety of tradings, all the needs of the supply and demand sides can be met. (4) Each instrument forms its own market, and there is a close connection among the various markets. All these markets form the entire money market. (5) Market participants are many and varied. The demand side of the money market in the U.S., for example, includes a variety of international and domestic banks, the Department of Finance, a wide range of types of companies, the Federal Home Loan Bank and other federal agencies, dealers of money market instruments, and many state and municipal governments. For the supply side, in addition to the types mentioned above, it also includes insurance companies, public and private pension funds, and other financial institutions.

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(6) The mode of transactions is mainly wholesale. Each transaction involves a large amount of money, and usually dealers who have professional experience and specialize in a certain market are entrusted to conduct the transactions. (7) Transactions in the money market of the supply side are a kind of investment with high liquidity and low risk, and which yields a certain income. (8) Honesty and trust play an important role in money market transactions. Normally, both sides can quickly complete a transaction of a huge amount by phone. Even if either side feels that the transaction concluded is not worthwhile, the agreement cannot be broken. If unintentional errors appear in the transaction, the two sides should endeavor to resolve them reasonably. The role of the money market in economic development is mainly shown in the following four points: (1) It promotes a balance between supply and demand of capital to support economic development. It allows enterprises to get financing rapidly to make up short-term deficits when they lack capital, or use their short-term surplus on investment to make profits. During the course of their operations, the flow of their capital may have ups and downs. When an enterprise sells a batch of products and has not yet received payment, for example, they may not have enough money to settle the payment for them to buy the raw materials they need to maintain their production, they therefore need to borrow from the money market. When the enterprise receives payment, apart from the repayment of loans, they may have idle surplus capital, and they can invest it into the money market to get some income. In countries where the market economy is well developed, their ministries of finance and various levels of local government also take the money market as an important means of adjusting their short-term capital shortage. (2) It collates idle capital to raise efficiency. In the society, there are all kinds of units and individuals who put the idle money they hold into the bank, and the bank is duty-bound to turn this idle money into interest-bearing capital. Then apart from the usual investment loans and consumer loans, investment into the money market is an important way of generating interests. What is more, the money market can gather together capital in banks to form a strong credit treasury, and in this way links up the banking system as an entity such that it can rapidly meet the demands for many short-term capital and at the same time raise the liquidity and efficiency of capital. In addition, the money market is the major place for short-term liquidity management of financial institutions and position management of commercial banks. (3) It promotes capital flows to optimize capital allocation. The money market can channel short-term capital quickly to those who need them and are

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capable of making the largest profits through the market mechanism, so that the people who need them can integrate the lowest costs into the money they need. This allows the use of market mechanisms to support the superior and eliminate the inferior, thereby raising the efficiency of the operation of macro-economy. (4) It transmits monetary policies to strengthen macro-control. The money market plays an important role in the transmission mechanism of monetary policy and provides the government with an effective means of macro control. The transmission process of the market monetary policy of the central bank, whether it is through credit (amount) transmission channels or interest rate (price) transmission channels, is inseparable from the money market. The central bank’s open market operations, rediscount windows, and interest rate adjustments, make their impact on the whole economy through the money market. Only those monetary policies governed by direct lending do not need to go through the transmission mechanism of the money market. Although academics generally hold the view that the history of the money market can be dated back to the early 19th century when the discount market emerged in UK, it was only after World War II that the world’s money market really developed, and the characteristics of such development can be summarized into rapid growth in scale, rapid changes in the market and constant innovation. For example, the daily trading volume of the U.S., the most developed country in the money market, currently reaches several hundred billion dollars, an increase of several dozen-fold when compared to the 1960s. The scale of the various markets is also changing constantly, such as the rise of the interest rate swap market in the U.S. in the 1980s, the rapid emergence of options and their related products, the rapid expansion of the commercial paper market, the scale of which exceeded the short-term treasury bills markets. The development of the money market in the U.S. is characterized by its incessant financial innovation. Compared with other financial markets, restrictions on money market innovation in the U.S. are minimal. If someone would like to launch a new money market instrument, or want to use a new way to sell existing instruments, there usually are no problems in doing so. And if this innovation achieves remarkable results, then all will follow suit, and it will be rapidly and widely promoted. There is a huge gap between the current degree of development of the money market in China and that of other developed countries such as the U.S., and this gap has become increasingly difficult to meet the needs of the economic development of China’s socialist market. In this chapter, the author intends to begin with the what has been practiced in the world money market and the actual situation in China, apply the theories and methods in the areas

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of complexity science, the fictitious economy, and systems engineering, and make a preliminary investigation into strategic issues such as the growth and regulation of China’s money market.

The Development Process of Money Markets in the World The development process of money markets in numerous countries and regions in the world shows that their money markets gradually develop together with their economy. It was through a long period of practice and exploration that they gradually grew and continuously improved, a process closely related to the specific historical and cultural background of these places. Regardless of the transition from the money market in its early period to the modern money market and the continual self-improvement of the modern money market, there has never been a universal model that is applicable to all countries. By looking back on the development process of the world’s money markets, however, we can still find some common characteristics and patterns in the development of money markets. At present money markets in various countries and regions in the world can be broadly divided into four types. The first type is the money markets of such countries as the U.S. and UK, which are relatively more mature and complete, have a higher degree of marketization and a lower degree of government intervention. The second type is the money markets of countries such as Japan, Germany, and France and other countries, which are also more mature and complete, have a higher degree of marketization, but a greater degree of government intervention. The third type is the money markets of some countries or regions with emerging market economies, such as Singapore, Hong Kong, Taiwan, South Korea, and the Philippines, which in some aspects are rather special, but still need further improvement. The fourth type is the money markets of developing countries, such as China, India, and Indonesia, which are still in the process of establishment. Of these, the first type represents the mainstream of the world’s money markets, and this is the also the focus of our discussion in this section. The rise of capitalist societies in Europe pushed forward the development of the market economy, and also created the conditions for the germination and birth of money markets. The development of money markets can be divided into two periods: from the early 19th century to the 1950s, the traditional money market (commercial paper and treasury bills market) period, and thereafter it was the new-type money market period, which is still developing and

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improving. Countries and regions moved from being traditional money markets to new money markets at different times, and their paths of development were also different. It is generally held that the earliest money market was the bill discount market that emerged in UK in the early 19th century. At that time, bank credit was used to conduct bill discounting based on the basis of commercial credit. The majority of domestic transactions used bills, and in general commercial bills were used as a clearing tool for external transactions. It is true that later in other European countries, such as Germany, France, and Italy, there were banks which discounted commercial bills, but the scale was much smaller than that of UK. According to statistics from London, Paris, New York, and Germany in early 1873, the balances of bank deposits in London accounted for 66.3%, while remaining three cities accounted for only 7.2%, 22.1% and 4.4% respectively. Lombard Street in London, the main banking center in UK, became the largest financial center in the world, and could usually provide a substantial amount of short-term capital with good security and reasonable returns. But then for a long period of time (from the early 19th century to the mid-1950s), the money market in UK was only a bill discount market. By the end of the 19th century, the discount market in UK began to expand from the discount of commercial bills to the operation of treasury bills and short-term bonds issued by the Ministry of Finance. After the Great Depression in the 1930s, the discount of commercial paper gave way to the discount of treasury bills. It was only after the Radcliffe Report , in which it was proposed that discount companies should discount commercial bills, that commercial bills replaced treasury bills to become once again the major discount instrument in the discount market. It is true that the development of money markets in the U.S. lagged behind that of UK, but the commercial bills market was the earliest money market that emerged in the U.S. During the American War of Independence and the American Civil War, the secondary market of the financing bills, which were issued to finance wars, was once very active. The abnormal economic prosperity that was created by the booming of the military industry during World War II again stimulated the money market, in particular the development and prosperity of government bonds and the treasury bills market. After the war, the money market, which had treasury bills and government bonds as its main trading instruments, developed further with the support of the government, and the Wall Street in New York replaced Lombard Street in UK to become the largest financial center in the world. After World War II, as the European continent was a scene of devastation and many things were waiting to be done, capital investment was urgently

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needed. The U.S. passed the Marshall Plan to support Europe, but its attached conditions regarding the liberalization of international trade and international payment paved the way for direct entry of American capital into the European market. The Bretton Woods Conference of 1944 made the U.S. dollar the only international currency linked to gold and established its status as a world currency, which helped the merging and acquisition of European enterprises by multinational corporations of the U.S. The General Agreement on Tariffs and Trade , which was established in 1948, weakened trade barriers and increased trade opportunities for foreign subsidiaries. In addition, the U.S. government, through areas such as diplomacy, law and tax, encouraged American enterprises to engage in foreign investment and protected their investment freedom and security, resulting in the rapid growth of American multinational corporations. Multinational companies, as a medium of economic globalization, not only promoted international technology transfer and the development of international trade, but also pushed forward multinational flows of capital, which brought up a number of financial problems to be solved. At the same time, due to the advances in scientific technology, capital-intensive new industries, such as computers, semiconductors, and petrochemicals, began to emerge, and their rapid growth required the support of a lot of capital. The internationalization and diversification of the supply and demand of capital drove the development of the money market into a new period. In the late 1950s, various kinds of new-type money markets in parallel with the discount market emerged in UK. Of these, the most important was the Eurodollar market that emerged in London around 1957, which engaged in the business of U.S. dollar deposits and U.S. dollar loans outside the U.S. with American capital flowing outside the borders of the U.S. as its market objects. In this way, it could avoid the constraints of the banking laws and regulations of the U.S. and would not be controlled by the banks interest rates of the U.S. or the restrictions of the financial regulations of the host countries. The emergence of the Eurodollar market was advantageous to banks in countries such as UK to borrow a large amount of their much-needed dollars, allowed banks in the U.S. to avoid domestic restrictions on the withdrawal of the statutory reserve and the interest rates on deposits. And as the commercial bills issued by the parent companies which controlled the shares of the bank were not taken as deposits, the Eurodollar market also provided a place to store the less politically risky U.S. dollar foreign exchange reserves for the Soviet Union and Eastern European countries which were in a state of cold war with the U.S. The Eurodollar market, therefore, grew rapidly. From then on, various currencies which were freely convertible, such as British pounds, Deutsche mark, and the

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Japanese yen, formed their foreign markets, which were collectively known as the European currency markets. In addition, interbank markets, certificates of deposit markets, and local institution bond markets also emerged in UK. By the 1980s, the size of the abovementioned new-type money markets exceeded that of discount markets. Beginning from the 1960s, the inflation rates and interest rates in the U.S. rose sharply. In addition, factors such as the rapid development of computing technology, the gradual integration of the international financial market, and the difficulty of predicting and controlling volatile exchange rates and interest rates, increased financial risks and drastically changed the situation of supply and demand of the financial market. Many financial institutions found that their traditional financial services and the sale of their financial products were on the decline, and the old way of doing business was no longer profitable. Many financial intermediary organizations also found that the traditional financial instruments they used could hardly absorb the money they needed for their survival. In order to survive and develop, financial institutions had to work hard to achieve financial innovation, develop new products and services to prevent financial risks, ensure the security of transactions, avoid financial regulation, and reduce transaction costs. To circumvent the law that banned the payment of interests on check deposit, for example, a Massachusetts mutual savings bank found in 1970 that as long as a type of check was called a negotiable order of withdrawal (NOW), then the account that issued this order may be legally treated not as a checking account and interests therefore could be paid, and in this way the savings and loan associations and mutual savings banks could attract more capital for loans. The automatically converted savings accounts (ATS) also came into being for this purpose. By this, the balance in a check account above a certain amount of money would automatically be transferred to an interestpaying savings account, and only when a savings account issued checks would the money required for payment be automatically transferred from the savings account to the checking account. When a company account at the end of a business day had over a certain amount of their deposits in their check account, it was automatically transferred to the next day’s repurchase agreements for investment, so that the bank could pay interests to the company. Another example is Citibank, which, for the sake of circumventing the control of the maximum limit on time deposit rates, launched in 1961 negotiable certificates of deposit (CD) to attract capital with a higher rate of return and raise its mobility with its transferability. However, as the minimum amount of the negotiable certificates of deposit was USD100,000 and it was difficult

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to attract small and medium investors, money market mutual funds (MMMF) began to emerge in the U.S. in 1972, which could be bought at a fixed price (usually USD1), and foundations could pool these sporadic funds to invest in short-term money market securities (such as treasury bills, commercial bills, and certificates of deposits). Investors could also issue checks based on their funds held in the form of shares. As legally shares of money market foundations are not deposits, they are not subject to the statutory reserve requirements and management regulation restrictions on the prohibition of interest payment and could therefore be paid interests higher than those on bank deposits. Yet another example is that in order to avoid the payment of deposit reserve and regulations on insurance, repurchase agreements (repo) emerged in the U.S. in 1969, that is, banks used treasury bonds as collateral to borrow from a large number of short-term capital owners, and signed a written agreement to guarantee that they would repurchase within a certain period (usually between one day and two weeks) at a specified price (which in fact was equivalent to the loan principals plus interests), and in the case of breach of contract, all collateral would be owned by lenders. At present, repurchase agreements have become an effective financing tool for banks in the U.S., and large companies were the important lenders in this market. After the 1970s, with the development of financial innovation, financial derivatives markets began to emerge in countries such as the U.S. and UK. This type of markets can be divided into two categories. One is the market consisting of financial products issued by banks, known as counter transactions, but most transactions in this market were completed by telephone. The other is the physical market consisting of transactions in financial futures. The currency derivatives transacted in the derivatives market included forward contracts, currencies and interest rate conversion, no agreement on the interest rate options, and financial futures. Although the interbank market appeared in Japan in 1903, it was only after World War II that its money market really developed. Before 1969, it was mainly an interbank market, which was largely unsecured interest rates among banks. At the same time, the money market characterized by the “repo market” began to appear. From 1970, the money market in Japan began to liberalize, and there had been endless innovations in money market instruments. In 1972, the yen market emerged in Europe, and the Bank of Japan (Central Bank), by its discount activities conducted through the discount market, the public trading of bills and repurchase agreements, also began to rise in large Japanese cities. In 1975–1976, the Japanese Ministry of Finance took measures to put the repo market a step further towards normalization.

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The liberalization of the money market that began in 1978 accelerated the development of the money market in Japan. In October of that year, the Japanese money market introduced short-term credit instruments of a period of only seven days, later three-year coupon bonds were also allowed to circulate. After April 2, 1979, the Tokyo market abolished the “standard rate system” for the interbank market and the bills market, that is, the interest rate of the interbank market and the bill market will be decided by the supply and demand sides of the funds through the medium of short-term capital firms, and this was a system which was difficult to change. On May 16, 1979, negotiable certificates of deposit were introduced into the market, and in the same year, the Japanese Ministry of Finance allowed non-Japanese residents to participate in the activities of the repo market. In October 1979, all bill discounting markets implemented free floating interest rates. The following year, the Japanese government announced the cancellation of the limit on the high price in the sale of bonds to allow the market to really liberalize the market, as the Bank of Japan, which represents the government, could only influence the financial market through the market. At the end of 1980, the Japanese government adopted a liberalization measure and abolished many foreign exchange controls on currencies, and only those contents involved in the Foreign Exchange and Foreign Exchange Control Law were not included in the liberalization list. By 1984 Japanese yen exchange restrictions were also abolished and this promoted the minimization of the amount of CD. In 1988, reform was made on the time limit of the trading of bills, further reducing the transaction period. After the 1990s, reform was carried out on lending transactions. The money market in Canada emerged in the 1930s, but was limited to only short-term treasury bills. In the 1950s and 1960s, the economy of Canada developed rapidly, and its financial system began to change drastically. Beginning in 1953, under the initiation of the Bank of Canada, the various registered banks and large securities investment institutions began to work together to establish a modern currency market. After the mid-1950s, a variety of short-term financial instruments other than short-term treasury bills, such as various corporate notes, bonds and short-term bonds of local governments, also began to appear in the money market, leading to the rapid expansion that market’s business. By the end of the 1950s, most of the non-banking financial institutions also participated in money market transactions. From the early 1970s, a large number of foreign banks subsidiaries entered the Canadian banking sector, issued short-term financial instruments to raise funds from the Canadian money market, gave credit loans to industrial and commercial

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enterprises, and by the early 1980s had become important participants in that

particular market. By the end of 1980, short-term commercial bills issued by foreign bank subsidiaries in the money market in China accounted for about 18% of the total.

Since the early 1990s, due to the extensive application of information

technology in the financial sector and the development of the integration of international financial markets, there were endless innovations in areas such as financial instruments, transaction forms, and financial organizations in the

money markets of countries such as the U.S., and the market had become more

active, and its structure, more complicated. At present U.S. money market has

formed a perfect market system with many sub-markets, and is the world’s most advanced money market. But it should also be noted that in recent years,

monetary settlement based on currency forward contracts, currency futures contracts, currency options, currency futures and the currency swap market, not only increased the liquidity of the global currency markets, but also increased their risks.

Although the development paths of the money markets in various countries

and regions are different, with the development of economic globalization and the strengthening of integration of international financial markets, the differences in money markets are gradually narrowing, and in the future will lead to the same destination.

The Fictitious Economy and Money Markets According to traditional financial theories, financial markets can be divided

into the two categories of the capital market and the money market, based on

whether the credit limit period is above or below one year. The former is also known as the long-term capital market, and the latter, the short-term money

market. In the capital market, there are two kinds of financing: equity financing

and debt financing. In the money market, there is mainly debt financing. But with the popularity of mixed operation of financial institutions, the rise in the level of integration of international financial markets, and the rapid development of financial innovation, the boundary between the traditional

capital market and the money market has become increasingly indistinct. In 1998, the author, in order to study issues relating to the East Asian financial

crisis, proposed the theory of the fictitious economy and now intends to try to use this theory to explore related issues of the money market.

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An Overview of the Fictitious Economy The fictitious economy is a new term that has emerged in recent years. Although its definition is widely disputed, it can be broadly classified into three categories. First, it refers to transactions of fictitious capital such as securities, futures, and options, called the fictitious economy. Second, it refers the economic activities conducted with the tools of information technology, called the virtual economy, also known as the digital or information economy. Third, it refers to the visualization of computer simulation of economic activities, called the visual economy. There is a certain connection among these three categories. Here we shall limit ourselves to the first category. The concept of fictitious capital was first put forward by Karl Marx in his work Das Kapital , Part 5, Volume 3, especially Chapter 25 and beyond where he discusses credit and fictitious capital, he makes a detailed analysis of fictitious capital. He argues that fictitious capital emerged from credit capital (interest-bearing capital) and the credit system of banks, including stocks, bonds, and mortgages. Unlike real capital, fictitious capital have no value in itself, but it could generate profits through circulation (a kind of surplus value), in common with real capital. It is true that after a hundred years, many new things have emerged with the development of world economy (such as futures, options and a variety of financial derivatives) and new situations (such as currency being divorced from the gold standard and economic globalization) have also appeared, but Marx’s analysis of fictitious capital still remains as a guideline in researching the fictitious economy. In my view, the fictitious economy refers to the economic activities related to the circulation of fictitious capital mainly based on the financial system. To put it simply, it is an activity of directly using money to make money. The origin of the fictitious economy can be traced back to commercial borrowing and lending among individuals. A, for example, is in urgent need to buy raw materials or commodity, but does not have enough money, while B happens to have some idle money. Then A asks B to lend him some money and promises to return the money and pay interests within a certain period. Through this transaction, A gets the right to use the money and can take the money as means of payment to get profits through real economic activities, while B, with the debit note in hand, has secured his title of ownership to the money so that when the lending period is over, he is entitled to claim back the principle and interest from A. At this stage, the debit note in B’s hand is an incipient form of fictitious capital, and its value can be increased through the cycle of borrowing and lending money. At this case, B is not engaged in real economic activities; rather, he makes profit through a kind of fictitious economic activity.

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We can therefore see that the first stage in the development of the fictitious economy is the capitalization of idle money. In other words, change the idle money in the hands of the people into interest-bearing capital. The second stage is the socialization of interest-bearing capital. This is to borrow the idle money in the hands of the people with banks as an intermediary organization and then lend it to generate interests. People can also use their idle money to buy a variety of securities to generate interest. At this stage, the deposit certificates and marketable securities in their hands are fictitious capital. The socialization of interest-bearing capital can channel money from the hands of those who are not engaged in such real economic activities as production and circulation, into the hands of those who can do so. Simultaneously, small amounts of money among individuals are merged into massive amounts and pooled into relatively large scale economic activities, thereby effectively utilizing the money. The third stage in the development of a fictitious economy is the securities market, that is, where securities can be freely traded according to their expected returns, establishing a financial market for conducting transactions of fictitious capital (such as stock markets, bond markets, money market, etc). The marketization of securities not only allows people to realize their securities at any time and hence greatly enhance the mobility of their fictitious capital, but also channels the capital to industries with better expected returns and thus further improves the efficiency in the use of capital. In 1898, there emerged a form of futures trading of agricultural products, and then it was gradually extended to industrial raw materials such as non-ferrous metals and oil, which was a new form of fictitious capital. The fourth stage of the development of a fictitious economy is the internationalization of financial markets, that is, fictitious capital can take part in multinational exchange. Although this process can be traced back to debtor countries such as the U.S. in the middle of the 19th century and the fixed-rate bonds issued by railway companies in the financial markets in UK, France and Germany, it was only in the 1920s that relatively large-scale multinational securities investments began to emerge. However the world economic recession in the 1930s and the outbreak of World War II brought the process of the internationalization of financial markets to a halt. It was not until after World War II, under the impetus of the Bretton Woods Agreement and the General Agreement on Tariffs and Trade , that a huge international financial market was gradually formed. The internationalization of financial markets can channel money to profitable industries on an international scope, which can greatly improve efficiency in the use of capital while at the same time form a

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new financial market—the foreign exchange market. Futures exchanges have also become more and more fictitious, and buying futures has become a tool of speculation. Since the 1960s, futures exchanges have extended gradually to financial commodities such as stocks, bonds, and foreign exchange. In 1973, options exchanges were introduced. The fifth stage in the development of a fictitious economy is the integration of international finance, in which the financial markets of individual countries and the international financial market relate to each other and influence each other much more closely. With the emergence of a floating exchange rate system caused by the divorce of the U.S. dollar from the gold standard, the strengthening of financial innovation, the rapid progress in information technology, the expansion of the degree of financial liberalization as well as the promotion of economic globalization, fictitious capital flows at a much faster pace in financial markets and in greater amounts. The scale of the fictitious economy is continuously increasing. Under the impact of the “multiplier effect,” the current total scale of the global fictitious economy has far exceeded that of the real economy. At the end of 2000, the total amount of the global fictitious economy reached USD160 trillion, of which the balance of the marketable value of securities and bonds was about USD65 trillion, the balance of over-the-counter trading of financial derivatives was about USD95 trillion, but in that year the total national GDP was only about USD30 trillion. That means the scale of the fictitious economy was about five times that of the real economy. The average daily flow of fictitious capital in the world was above USD1.5 trillion, about 50 times that of the total average daily actual trading in the world. This means only 2% of the daily capital flow in the world is really used on international trade, and the remaining capital is used on the activities of using money to make money in the financial market. With the development of e-commerce and electronic money, it can be expected the scale of the fictitious economy will be further expanded.

The Role of the Money Market in a Fictitious Economic System The fictitious economy is a complex system, comprising mainly natural persons and legal persons (investors, investment beneficiaries, and financial intermediaries), who operate fictitious economic activities in financial markets in line with the rules of the market. According to the views of complexity science, each individual has the autonomy to make decisions on the basis of his understanding of the environment and its prospects. Nevertheless, his intended targets and decisions will always be influenced by the decisions of others.

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Although this non-linear function gives rise to chaos in the system, the selforganizing effect leads to a certain order and metastability. When people have idle money in their hands, in addition to expanding their expenditure and increasing their savings, they also generate the desire to use it to invest for profits. From the point of view of the fictitious economy, all financial market instruments are virtual capital. When investors use this idle money in their hands to buy financial market instruments, this is actually exchanging their right to use their money with a certificate of rights, and they have the right to claim future income and assets from the issuers of financial market instruments. When people make investment decisions, therefore, they have to consider three questions: first, how great are the expected benefits; second, can they really get the benefits; third, how quickly can they recover the cash when they need it. And before investing, investors should consider the profitability, security and liquidity of the financial market instruments that they intend to buy. Theoretically speaking, the profitability of financial market instruments and security has a negative correlation, and as it also has a negative correlation between liquidity, security and liquidity, it therefore has a positive correlation. To meet the demands of different investors, there are a variety of financial market instruments. Financial market instruments in general can be divided into two categories, depending on whether its credit period is more or less than one year. One category is the capital market instruments, including stocks, mortgage loans, corporate bonds, treasury bills that are for more than a year, consumer loans and loans from commercial banks; the other category is money market instruments, including one-year treasury bills, large-denomination negotiable certificates of deposit, commercial bills, bank acceptances, repurchase agreements, and interbank lending agreements. Financial market instruments can also be divided into two main categories of equity instruments and debt instruments according to the nature of investment. Investors can only receive dividends from issuers of equity instruments but cannot directly get repayment of the principal. They can, however, receive principal and interest from the issuer of debt instruments. The existence of secondary financial markets allows investors to sell financial market instruments in their hands and turn them into cash, which greatly improve the liquidity of financial market instruments. However, due to the fact that the secondary market price of financial market instruments is uncertain, when investors realize them they may get high income, or suffer huge losses. That is why some call jokingly the financial market instruments “paper money.” Accordance with the above concepts, it can be considered that the money market is a debt instrument market that is tilted towards liquidity, the bond

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market is a debt instrument market that is tilted towards security, and the stock market is a profitability instrument market that is tilted towards profitability. Based on the fundamental differences among the three markets, and taking into account the rapid pace of capital flow, the author therefore suggests that the money market be defined as a high liquidity short-term debt instruments market. As the money market transactions are mainly carried out by debt instruments which are highly liquid and can be quickly turned into fictitious capital, the design of money market instruments therefore has the following characteristics: (1) Short credit period. The credit period of money market instruments is usually less than three months, and the shortest is one day (overnight call). As the credit period is short, the price fluctuations of the debt instruments in the money market transactions are small, and the risk of investing in them is very low. The risks facing investors include, among others, market risks or interest rate risks, reinvestment risks (that is, the risks caused by investors who reinvest the profits from financial assets to assets that have low profits in a certain period in the future), default risks, liquidity risks, inflation risks, and policy risks. Generally speaking, the function of risk prevention of money market instruments is better than that of the capital market instruments. The prices of short-term securities in the money market, for example, are more stable than bonds and shares, and they are sold in the form of a discount, so the risks of default are relatively low. (2) Goodwill-based. According to the traditional Real Bill Doctrine, the issuance of bills must be based on physical transactions, and this is the only way that they can be accepted. After an enterprise sells a batch of products, for example, it may be in urgent need of floating capital before it receives the payment for the products, then it can use its orders and invoices as a basis to issue commercial bills of an equivalent amount, and these bills can be accepted in the process of acceptance, discount, and transfer. This type of bills market that is based on real economy is more secure. But in today’s highly developed money market, it is difficult to verify the basis of physical transactions for each type of money market instruments, as in reality we can only base the issuance of bills on the goodwill of the issuer. For example, as long as the bills issuer continues to fulfill their take-or-pay obligation, the goodwill they created will make the bills that are issued generally acceptable. In recent years, due to the improved credit rating system and advances in information technology, it has become more convenient for bills buyers to accurately and in a timely manner find out information on bills issuers, thus promoting the development of the commercial bills market.

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(3) Interest rates increase with the risks. According to the law of risk-return symmetry, the interest rates of debt instruments increases with their risks. The risks of the treasury bills market, for example, are lowest, and hence their interest rates are the lowest. The interest rates of the repo market and largedenomination negotiable certificates of deposits market are lower than those of commercial bills. (4) Large transactions. As the profitability of the money market is lower, we can only reduce transaction costs by conducting large transactions. In the money market in the U.S., for example, brokers only get a commission of one U.S. dollar from a transaction of USD1 million, so only transactions of USD100 million are worth doing. As the amount of money in each transaction is relatively huge, it is difficult for ordinary retail clients to enter the market directly, but they can do so indirectly through mutual funds. (5) Use mortgages as a means to achieve liquidity. Economic subjects such as enterprises, governments, and families would constantly conduct adjustments on their asset structure according to the economic situation and changes in the objective situation in order to have the best combination of liquidity, security, and profitability. In reality, asset structure is mainly determined by factors of the current interest rate structure, level of profitability, price level and its expectation of the various assets. The money market is a place to combine liquid financial assets. It can increase the liquidity of assets as well as promote the combination of the supply side and the demand side of short-term capital, thereby enhancing the efficiency in the use of capital. Commercial banks, for example, can get short-term capital from the repo market by using long-term bonds as mortgages, thereby improving the liquidity of their asset portfolios. (6) Seek to legally circumvent regulations. Due to the high liquidity and low profitability of money market instruments, their designers tend to avoid financial regulations legally to raise their profitability, thus generating various kinds of financial innovation, which bring new opportunities to investors while posing new challenges to the monetary authorities. The emergence of the euro, for example, was to avoid the control on reserve in the financial regulations of the U.S. and the regulations restricting foreign loans of American banks and multinational corporations, avoid being subjected to the restrictions on bank interest rates in the U.S., and to be free from the constraints of some parts of the financial regulations of the host country. The emergence of the transferable notice of withdrawal (NOW) was to avoid the regulation prohibiting the payment of interests to check deposits. The introduction of large-denomination CD was to circumvent the control on the ceiling of interest rates on fixed deposits. The emergence of the back purchase agreement (repo) was to

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circumvent the regulations on the payment of reserve and insurance premium. Economists have put forward different theories for the abovementioned phenomenon. W.L. Silber, for example, believes that financial innovation is a “self-defense” behavior adopted by the micro-financial organizations to seek maximum profits and reduce the financial repression that is caused externally (such as the various rules and regulations). E.J. Kane holds the view that the act of financial innovation is generated when external market forces combine with market mechanism and institutional internal demands to circumvent all kinds of financial control and regulations. S. Davis, R. Sylla, and D. North of the Institutional School believe that financial innovation as an integral part of institutional reform has mutual impacts on and a reciprocal relationship with economic systems.

The Linkage and Interactions between the Money Market and the Capital Market The money market and the capital market are integral and interlinked parts of the financial market. A well-regulated money market can guide the savings of those who have surplus capital to be converted into investment in the capital market, while the liquidity and the short-term characteristics of money market instruments can make them a necessary complement to the capital market instruments as well as an important means of reducing risks. In developed financial markets, despite the fact that the money market and the capital market have different characteristics and instruments, the flow of capital and a combinatory use of the various financial instruments allow them to establish a complete financial market system. The linkage between the money market and the capital market is mainly shown by the overlaps of these two market subjects. Some financial institutions and non-financial institutions enter the money market as well as the capital market. As all financial institutions and non-financial institutions may invest in the money market, it gives them a convenient way to use the debts in the money market to balance its own capital structure, while the varieties of the money market instruments also provide them with many opportunities for investment and arbitrage. Especially in countries where a mixed operation of financial institutions is allowed, in order to make the largest possible profits with certain security, financial institutions must dynamically adjust their asset structure, the proportion of the total returns on investment in the money market of many financial institutions gradually increase. With the application of modern technology in the financial industry and the changes of concepts of financial

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regulation, the investment subjects of the money market have also become increasingly diversified. In developed financial markets, the capital market and the money market are interdependent, and the boundaries between the two have become more and more indistinguishable. In developed financial markets, in addition to central banks, market participants can operate in the money market and the capital market. Securities companies, for example, while holding a large number of shares and longterm bonds, can also hold short-term bonds and participate in lending and repurchasing in order to adjust the security and liquidity of their capital and gain certain incomes in interest. In addition, due to the high risk of capital market instruments, investors tend to use money market instruments to form a better portfolio to diversify risks, and for the sake of maintaining the liquidity of their capital, market participants are also required to operate in the two markets simultaneously. Although the instruments, the yields and the risks of the money market and the capital market are not the same, the subjects of the markets are basically the same, they can dynamically adjust the structure of their assets and liabilities through comparing the price, earnings, liquidity and risks of these instruments. The interaction of the money market and the capital market is mainly shown in the bidirectional flow of the capital. In theory, according to the Gordon growth model, a kind of equilibrium exists in the capital prices between the money market and the stock market. Under the circumstances of equilibrium, share prices and the interest rates in the money market have a negative correlation. When one of these rises or falls, it will certainly cause the other one to fall or rise so as to achieve a new equilibrium. When interest rates fall, investors usually prefer to borrow capital from the interbank market or to sell short-term securities in the money market in order to obtain the capital needed to purchase long-term securities in the capital markets, and as a result of capital flowing from the money market to the capital market, this will push up the prices of long-term securities. Conversely, when the interest rates of the securities rise, the demand of securities will drop, the capital will flow from the capital market to the money market, and when the prices of securities fall, the capital will flow from the money market to the capital market. But the actual situation is much more complicated than the theory. For example, when the money market is imperfect and there is a lack of effective money market instruments, it will encourage capital to flow to the capital market. Another example is that when the financing conditions in the capital market are too loose, it will facilitate the flow of credit capital to the capital market in large quantities.

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Some scholars attempt to use the traditional law of value to analyze the financial market and believe that when the price of a certain financial market instrument exceeds its value, its price will fall, otherwise it will rise. The author believes that as financial market instruments are fictitious capital, they do not have their own value, it is difficult to apply the law of value, but the law of supply and demand can still apply. When the demand of a financial market instrument in the market is greater than the supply, its price will rise, and when the supply exceeds the demand, its price will fall. The causes of the changes in supply and demand do not lie on the deviation of price from value, but on the investor behavior that causes the self-organizing effect. The financial market belongs to the fictitious economic system and has its own intrinsic complexity. Although each subject of the financial market makes its own independent decisions according to its own forecasts of the future, from a micro point of view, there are a lot of random fluctuations and chaos in the financial market. But as the decisions of each subject of the market are inevitably affected by the decisions and conditions of other subjects, a kind of self-organizing effect will be produced, and therefore, from a macro point of view, the development of the financial market also show some fragments of certainty and law of fuzziness. The author believes that in the analysis of financial markets, full consideration must be given to the decision-making behavior of market players, in particular, their irrational behavior. In choosing financial market instruments, for example, profitability-tilted investors mostly prefer equity instruments and security-tilted investors mostly prefer debt instruments. But when the stock market is bullish, as investors have full confidence in its rise, then not only profitability-tilted investors will increase their investment in the stock market, security-tilted investors will also turn around to enter into the stock market because they believe that the risks of suffering losses are relatively small. At that time, the effect of raising the interest rates of the money market to reduce of the amount of money flowing into the stock market is much smaller than the effect when the stock market is bearish. According to the law of supply and demand, the increase of capital flowing into the stock market will inevitably lead to a rise in the stock market, which will further increase the confidence of investors and attract more capital to flow into it. When the stock market is rising rapidly, profitability-tilted investors will even give up their rational law that there should be risk-return symmetry and continue to buy at high price because they believe there will be people who offer higher prices to buy. Since 1995, for example, people have been encouraged by

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the extremely successful listing of companies such as Netscape, Amazon, and AOL, and believe in the myth of “investing in the Internet industry one year is

comparable to investing in traditional industries for 100 years,” which pushed up the Internet shares in the NASDAQ. In May 1997, the online bookstore

Amazon.com was listed. By November 30, 1998, the shares of Amazon rose by 2,300%, despite the fact that its turnover in 1998 was USD293 million, a loss of

USD6,100 million. But people were optimistic about its prospects and continued to buy its shares, believing that they could probably make more money. After

three months, its shares jumped 400%, and its market value reached USD40 billion. Before Christmas 1999, the NASDAQ stock index crossed the 4,000

points, and climbed higher and higher. By March 10, 2000, it rose to its highest level ever—5,048 points.

Facts, however, show that to rush to listing before an enterprise reaches

its mature stage is actually shifting the risks which should be borne by the venture capitalists to the public, which could have very serious consequences.

In 1999, 486 companies in the U.S. issued new shares, of which 242 were newly

established entrepreneurial Internet companies and 224 were without records of

earnings. The great differences between the share prices and their performance

led to the gradual loss of investor confidence, eventually causing the crashing of the Internet stocks in 2000. The NASDAQ index slipped from its highest point after the crash and continued to fall. In 2000, the largest fall of the year

in the last 30 years was created—a fall of 39.3%, a loss of about USD3 trillion in market value, and close to 150 Internet companies in the U.S. closed down.

At the beginning of 2001, the NASDAQ stock index continued to fall rapidly. On March 13, it fell below the 2,000 mark, and had reached its lowest point of

around 1,400. According to Webmergers.com’s statistics, at least 493 Internet companies went bankrupt between January 2000 and May 2001, of which 55% announced their bankruptcy in the first five months of 2001.

Conversely, when investors lack confidence, even frequent lowering of

interest rates will not necessarily drive the flow of capital to the stock market.

In recent years, for example, due to its economic downturn, the stock market in Japan is still sluggish though the bank’s interest rates have reached their lowest point.

Thus it can be seen that the interactive relationship between the capital

market and the money market is a very complex one. We should not only

see the shift between the two antagonistic effects, but also the synergy that complements each other.

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The Experience and Lessons in the Development Of Money Markets in China It is true that before the founding of New China, some prototypes of the money market had already emerged. But it was not until after reform and opening up that we really started to explore development path of China’s money market. It is generally believed that the money market in China was formed in the early 1980s. From then on for nearly 20 years, the development of the money market in China went through a tortuous and winding path. It was not after 1998 that we began to get on the right track, but we were still a long way from meeting the target of a mature money market. We should look back objectively, seriously sum up the experience and lessons of the development of the money market in China and further establish its future development strategies. The money market in China started much earlier than the capital market. In 1981, China began to issue treasury bills. In 1984, it initiated the interbank market. In 1985, it started to build a bill discounting market. In 1986, largedenomination negotiable certificates of deposit were issued. In 1987, pilot issuers issued short-term business financing bonds. In 1988, China began to build a secondary market for treasury bills. In 1991, a national bonds repo market was built up. But due to reasons such as unsuitable structure, inflexible mechanism, immature market, conceptual backwardness of investors, inadequate planning and insufficient experience, almost every sub-market has gone through the twists and turns of having “chaos once it is opened up, and closed down once there is chaos.” The development of the interbank market, for example, has gone through three cycles of ups and downs.” In October 1984, the People’s Bank of China reformed the traditional credit loan system under which deposits and loans are centrally controlled, allowing “actual loans being mutually dependent on actual deposits,” so that banks may lend money to each other. The new system changed the situation of top-down vertical allocation of credit capital. In January 1986, the State Council promulgated the Provisional Regulations on Bank Management , which clearly allowed interbank lending and borrowing of capital in specialized banks. In that year interbank markets were established in five cities including Guangzhou. In March 1988, local branches of the state-owned commercial banks in various places contributed a membership fee, and put their money together to form financing companies to engage in interbank lending as their main business. But in October of the same year the People’s Bank of China delivered a document requesting the improvement and rectification of the interbank market, and at the beginning of 1989, it even

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delivered the document demanding the removal of the financing companies. In March 1990, the People’s Bank of China promulgated the Trial Measures for the Administration of Interbank Lending , which for the first time provided regulations on the interbank lending business and ratio requirements. But since 1992, the interbank market had fallen into chaos. By June 1993, there were over 1,700 financing intermediary organizations in provinces, prefectures and counties. At the end of May 1993, the amount of net loan borrowing outside the national banking system was RMB105.5 billion, but in June 1993, the People’s Bank of China began to rectify the situation. In September 1995, it began to establish a national interbank market, covering all interbank lending into its network. In November of the same year, the People’s Bank declared the removal of over 50 financing centers, capital markets and all kinds of intermediary organizations established by commercial banks. Remaining were 43 financing centers launched and established by the People’s Bank of China. On January 3, 1996, the national interbank market began to operate, and the total turnover of that year was RMB587.1 billion, a decrease of 41% when compared to that of last year. In July 1997, financing centers of the People’s Bank of China started to clear the overdue accounts, and the annual trading volume of the lending market dropped to RMB414.9 billion. In October of the same year, the financing centers of the People’s Bank stopped its own lending business. In March 1998, the People’s Bank of China removed all its financing centers. By the end of 1998, financing centers of the People’s Bank of China cleaned up and recovered overdue accounts of over RMB16 billion, and recovered chain debts of over RMB400 billion. Of the 43 financing centers in the country, seven of them in places such as Shanghai, Wuhan, and Chengdu were cleaned up completely and removed, while one-third of branches completed 50% to 80% of their tasks of cleaning-up. During this period, the amount of the credit lending and borrowing in the interbank market fell drastically from RMB820.5 billion in 1995 to RMB98.9 billion in 1998, and it was not until 1999 that it recovered gradually. In 1996, the National Interbank Lending Center was established in Shanghai. By the end of 2001, there were 553 members of the interbank market, and the annual trading volume in 2001 was RMB4.91 trillion, of which bond repurchase accounted for 81.8%, credit lending, 16.5%, and cash bond trading, 17%. The development of the bill discount market also underwent a tortuous road. After several years of experimentation, the People’s Bank of China and the Industrial and Commercial Bank of China promulgated in 1985 the two documents of the Interim Rules of the People’s Republic of China for the Acceptance and Refusal of Commercial Bills and the Account Auditing

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Procedure for the Acceptance and Refusal of Commercial Bills to encourage the implementation of commercial credit as notes among the industrial and commercial enterprises. In April 1986, cities such as Beijing, Shanghai, Guangzhou, Chongqing, Wuhan, Shenyang, Harbin and Nanjing launched pilot projects to use commercial bill acceptance and discounts to recover debts in arrears, allow specialized banks to conduct bills discounting for industrial and commercial enterprises. But the discounted bills were restricted to commercial acceptance bills and bank acceptance bills based on the commodity trading, while allowing the various specialized banks to do rediscount business among themselves. In 1986, the People’s Bank of China promulgated the Interim Measures for Rediscount in the People’s Bank of China and branches of the People’s Bank of China began to handle rediscount business of the central bank. However, some serious problems in the bills market, such as the irrational flow of capital, the loss of constraints on commercial bills, and bill cases, especially the counterfeit bills, began to appear, and in 1988, the accepting and discounting of bank bills were stopped. In November 1994, to launch the business of commercial bill acceptance and discount, the People’s Bank of China arranged special capital to be used respectively for the rediscount of the discounted bills in the five industries relating to coal and four other products including cotton. In 1995, the People’s Bank of China again expanded rediscounting to the sale of livestock products in some areas, and increased a certain amount of rediscount. At the end of the year, the balance of rediscount at the central bank was RMB32.2 billion, and total rediscount processed reached RMB84.4 billion. In 1995, the National People’s Congress passed the Negotiable Instruments Law , which promoted the development of the bills market, the commercial bills issued by enterprises, the number of commercial banks, and the amount of rediscount of the central bank, resulting in the formation of regional bills markets. In 2000, the total commercial bills issued in the country amounted to RMB744.5 billion, the balance was RMB367.6 billion, the accumulated amount of discounts was RMB644.7 billion, and the balance was RMB153.6 billion. The accumulated amount of rediscounts was RMB266.7 billion, and the balance was RMB125.8 billion. In 1987, the enterprise short-term financing bonds that were initially issued by the People’s Bank of China at pilot points were proved an unsuccessful experiment. At that time, economically efficient enterprises were allowed to issue to units and individuals short-term financing bonds of the periods of three months, six months, nine months, or twelve months, with the provision that the interest rate could not exceed 6% (which was equivalent to the lending interest rate for flowing capital). The provincial branches of the People’s Bank

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of China assessed the applications of the issuing enterprises according to the sum determined by the head office. At the end of 1988, the sum issued was only RMB1.2 billion. In February 1989, the People’s Bank of China issued the Notice on the Issue of Short-Term Financing Bonds of Enterprises which clearly proposed to officially open the short-term financing bills market on a pilot basis, and it also stipulated that this kind of short-term financing bonds could be transferred among enterprises, traded in the capital market, and also issued as agents or underwritten by various financial institutions. As a result, the volume of issuance of short-term financing bills increased sharply. From 1987 to 1995, the issuance of enterprise short-term financing bills reached a total of RMB99.3 billion. But as there were only a small number of transfers in individual towns and cities, it had not essentially formed a secondary market. A considerable number of enterprises which issued financing bonds were unable to repay upon the expiry of bonds and they had relied on issuing new bonds to repay old bonds. After 1996, bond repayment crises occurred consecutively in some provinces and cities. The development of a market for large-denomination negotiable certificates of deposit even ended in failure. During the second half of 1986, the Bank of China and the Bank of Communications started to issue large-denomination negotiable certificates of deposit. Later, the People’s Bank of China allowed all state-owned commercial banks to issue them. In May and November 1989, the People’s Bank of China issued the Methods of Managing Large-Denomination Negotiable Certificates of Time Deposit and Notice on the Issues Relating to the Transfer of Negotiable Certificates of Deposit respectively. Between 1990 and 1993, the annual total amount of negotiable certificates of deposit issued by various commercial banks was about RMB50 billion, all target managed according to the targets set by the People’s Bank of China. The interest rate was 5% to 10% higher than that of fixed deposits of the same period, which helped absorb deposits. But as the minimum denomination for individual buyers was only RMB500 and the minimum denomination for enterprise buyers was only RMB10,000, which was well below the minimum denomination of foreign countries. And as most buyers were individuals, the liquidity of these certificates was poor. A secondary market could not be formed. In 1998, the People’s Bank of China stopped issuing large-denomination negotiable certificates of deposit. China’s treasury bills were first issued in 1981. From then on, they had been issued annually, with a time limit of three to five years. They only had an issuance market and no circulation market. Beginning from 1988, treasury bills were allowed to be circulated and transferred in 61e cities in two batches

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on a trial basis. In 1991, the Treasury began to organize the “underwriting” of treasury bills, introducing market mechanism into their primary market, resulting in a substantial increase in the scale of the issuance of treasury bills. In 1993, there was an important advancement in the treasury bills market, which was the establishment of the primary dealer system. The issuance of large quantities of treasury bills through the forms of “underwriting” or “tender” was only for primary dealers, from dealers to brokers, and from brokers to final investors. By 1994, there was the formation of the system whereby large quantities of treasury bills were issued to institutions, which re-distributed the bills to individual investors. This system also included the launch of the three-year treasury bill receipts which could be paid in advance though they were not listed, the further diversification of the time limits and varieties of bonds, and the permission to hold bonds by state-owned commercial banks. Trading networks such as the stock exchanges in Shanghai and Shenzhen and the Wuhan Securities Trading Center were opened for spot, repurchase and futures trading of treasury bills. Take the Wuhan Securities Trading Center as an example. In 1994, the total volume of treasury bill trading reached RMB456.6 billion, of which RMB211 billion were spot transactions, and RMB245.6 billion were futures transactions. Since the cessation of government bonds futures in 1995, the secondary market for government bonds was dominated by spot trading and bond repurchase transactions. In 1997, the People’s Bank of China requested all commercial banks to withdraw repo and spot trading of government bonds from the stock exchanges of Shanghai and Shenzhen and securities trading centers in a number of cities. In 1998, it closed the securities trading centers at various places, and centralized the interbank government bonds repurchase trading at the national interbank lending centers. In 1996, the Ministry of Finance, after consultation with the People’s Bank of China and with the approval of the State Council, decided to restructure the China Securities Trading System Corporation Ltd. into the China Depository Trust & Clearing Co., Ltd. to take up the business of unifying the registration, custody and settlement of government bonds in the entire country. Interbank bond market participants should open their bond custody accounts at the Central Securities Clearing Company. Bond custody account holders based on their functions were managed according to categories. Category A members could manage self-operated and agency businesses, while Category B members could only manage self-operated business. Bonds settlement was operated through the central bonds book-keeping system of the Central Clearing Company, and the monetary settlement of bond transactions was conducted through account transfers. By the end of 2001, there were 670

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market members (mostly the head office and their authorized branches of state-owned commercial banks, insurance companies, other commercial banks, foreign banks, rural credit cooperatives, certain securities companies and fund management companies), but only 358 members were actually involved in trading. In 2001, the interbank repurchase volume of repro transactions (unilateral and unidirectional) was RMB4.01 trillion, and the trading volume of government bonds repurchase at the stock exchanges in Shanghai and Shenzhen was RMB1.53 trillion. The development of China’s money markets in the last two decades has been full of twists and turns; it has neither grown in scale nor become mature. The author believes that its experience and lessons can be summed up in several points. First, the money market must not serve as a long-term lending market. Originally the function of a money market in a financial system was to make up for the shortage of money through short-term liquidity management, but it did not actually serve this function in the 12 years before 1997. Commercial banks did not take the money market as a platform for liquidity management and cash management, but turned it into a long-term lending market for the purpose of money-making by pursuing profitability at the expense of liquidity. Many financial institutions, did not consider their risks and loan repayment ability and borrowed interbank money they could bear to expand their lending and investment, and supported local governments to get funds to engage in repetitive projects. To avoid regulation, branches of state-owned commercial banks lent to their directly-owned trust investment companies so that they could issue loans, speculate in the stock market and the property market, and the lending period was up to three to five years. Some related departments and local governments violated the regulation of “non-financial institutions are not allowed to engage in the activities of interbank lending” and involved in the interbank lending market which was restricted to financial institutions and banks, so that they could misappropriate credit loans to expand their fixed asset investment under the pretext of interbank lending. Some grass-roots banks used interbank lending to bypass the loan limit to grant loans to enterprises. Some financial institutions which participated in interbank lending activities violated the management regulations on interbank interest rates and the extension of the borrowing period to raise the interest rates and extend the lending period without authorization. Some financial institutions which participated in interbank lending violated the regularities on settlement and standard of fees, and received cash, rebates and commissions. It was roughly estimated that at the end of May 1993, the sum of money raised nationwide reached around

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RMB100 billion, the net amount of money state-owned banks lent to institutions outside of their system reached RMB105.5 billion, and the interbank interest rates exceeded 18%. This has seriously disturbed the order of the financial market, generated a large amount of overdue loans, and created huge financial risks. It was reported that at the end of 1998, the amount of recovered overdue loans worth over RMB16 billion. Second, banks must not be allowed to set up intermediary organizations by themselves. Banks are an important market subject in the money market. They can be the supply side, or the demand side, but must not be the intermediary side. During the process of developing China’s interbank market, banks often set up their own financial institutions to enter the market as “every miller draws water to his own mill.” This could not optimize the allocation of money and would make it difficult to diversify risks. In 1992, for example, different levels of banks in various provinces, regions (districts) and counties established their own lending markets, and there were more than 1,170 interbank institutions, resulting in multi-level management and multi-unit lending, and causing serious problems and huge losses. After 1993, the People’s Bank of China decided to run its own lending business, phased out the financing centers, financial markets, and various intermediaries set up by commercial banks, and only kept the 43 financing centers it originally set up. These financing centers, which served as intermediary institutions in the money market, were mostly division-level units within the provincial branches of the People’s Bank of China, and some of their municipal offices and planned capital offices (divisions) had the same group of people under two designations. The intermediary institutions that were set up by the central bank to engage in profit-making business in the money market confused the role of the central bank as market organizer and regulator, contributed to the corruption and irregularities in the central bank, distorted market interest rate signals and the risk mechanism, and seriously weakened the central bank’s regulation of the money market. It was not until March 1998, that the People’s Bank of China decided to remove all its financing centers. Third, we should never allow various places to partition the unified money market. Before 1996, for example, most lending transactions were carried out within the provinces and autonomous regions, and because financial centers in various places did their lending in their own way, there were huge differences in the lending interests in various places, and as cross-provincial movement of capital was restricted by local protectionism, it was difficult to form a unified national market. Another example is the national debt repurchase market in various places differed in such aspects as debt confirmation, proportion of real

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mortgage securities, handling fees, trading and settlement rules, the trading regulations of trading revenues were not entirely the same or even mutually incompatible, to the extent that the same institution had to pay a membership fee when joining a local market. The People’s Bank of China delegated most of its management functions of the money market to its branches at provinces and autonomous regions. Before June 1993, the quasi-legal personification of the actions of branches of state-owned commercial banks, the unhealthy mechanism of unified risks and liquidity of the entire bank, the earning of high interest rates by its branches through interbank lending to other banks with huge loans,, many of which were trust and investment cooperatives and non-financial companies trust and investment cooperatives, bringing about the development of the bubble economy at the time and generating a lot of bad debts. Sometimes it even went as far as to have interbank lending among branches of a commercial bank, which were really off-book loans under the pretention of interbank lending, and they listed the incomes as non-ledger assets which were put into their coffers. The reasons behind such behavior are that the delay in reforming state-owned commercial banks, the localized behavior of branches, the imperfections of the credit authorization system and the bank, resulting in the incurring of huge costs on subsequent rectification and regulation. Fourth, the central bank, in developing the money market, must not only block but also guide. The development of money market in China is relatively short. Due to a lack of experience and inadequacies in its systemic design, it is unavoidable that there would be problems at the beginning of setting up its submarkets. Faced with this situation, the central bank should carefully analyze the causes of the problems, seek measures for improvement, and should not hastily shut down the market as its solution. There were many problems when China started to build its securities market. By taking measures to improve its system and make reasonable guidance, the market could gradually grow and become better. As reform is path-dependent, every step backward has to pay a corresponding cost. This has given a pretext to people who are responsible for reform to shirk their responsibility, and an opportunity for those people who make use of inadequacies in the system to make profits to escape. Fifth, the central bank must not ignore the policy function of the money market. Before 1997, the People’s Bank of China did not play an important role in the transmission mechanism of monetary policies in the money market and start its open market operations, but mainly relied on credit line management (i.e. credit scheme) in the planned economy system as the main instrument of its monetary policy. This situation began to change only until after the People’s Bank of China issued in 1997 Provisional Regulations on Management of Open

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Market Business and Primary Dealers which specified the relationship between the People’s Bank of China and its primary dealers and the qualifications, rights and obligations of the primary dealers and established the scope and trading method of the open market operations instruments, and the launching of the central bank’s open market operations in the interbank bond market in 1998. The volume of business transactions of that year was RMB176.1 billion, and it was increased to RMB707.6 billion in 1999. In that year, the base currency that the central bank invested through the open market business was RMB190.7 billion, which accounted for around 50% of the newly added base currency of the central bank. In 2001, the central bank launched 54 open market operations in the forms of repurchase and buying in and selling off of bonds in the national inter-bank bond market, and the total annual amount of bond trading was RMB1.68 trillion. Sixth, the development of China’s money market must not be divorced from the specific situation in China. The development of the money market in the Western countries is mainly a bottom-up process, that is, when the development of market economy reaches a certain stage, and after the emergence of new financing needs and a competitive environment, then people spontaneously create new financial instruments or financing methods to meet new needs and evade financial restrictions, and then the government makes correspondent financial regularities to regulate their administration. But in China, under the impact of the traditional planned economy system, the development of the money market and even the entire financial market is a top-down process, that is, when the economy develops to a certain stage and when the government believes that the time is ripe to introduce new reform measures, it launches a relatively theoretical and idealized market framework that has not been practiced locally, and then fine-tune this framework based on its actual implementation, and thus the emergence and development of China’s money market has been strongly branded with policy-making behavior of the government. In the process of building and improving China’s socialist market economy system, the growth of the money market should neither follow the top-down traditional model, nor the wholly bottom-up Western model, but should organically combine these two models, gradually reducing government interventions, encouraging banks to be independent and innovative, paying attention to the summing up of and bearing this past experience in innovation, and continuously improving the effectiveness of supervision. For many years, due to the inadequate growth of the money market in our country and lower capital turnover rate, our money market could not fully exercise its role in promoting national economic development. As enterprises

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and individuals who are temporarily short of cash cannot borrow money from those who have money in surplus through the formal money market, this leads to the rapid growth of illegal private finance. It is understood that “underground banks” have been very active in the coastal and developed private economic areas, and they have even become the mainstream in the supply of shortterm loans in individual cities. They not only could mobilize quickly tens of millions of Renminbi within a day, but also run the bill discount business. Some “underground banks” also collaborated with gangs to engage in illegal economic activities. It would not be effective to deal with these issues only by ”blockage” and “prohibition,” it should be resolved by actively developing the money market, and only in this way could we guard against possible financial risks and political risks. The target model of China’s money market should have the basic characteristics of a mature money market, which mainly include the six aspects of subject diversification, object diversification, interest rate marketization, operational regulation, trading networkization, and efficient supervision. The following is a preliminary discussion on how these six aspects help cultivate the money market in China:

Subject Diversification Diversification of market players (market participants) is an important condition to promote the maturation and improvement of the money market. A developed money market is usually a diversified subject market, which is usually highly open and widely inclusive. At the early period of the development of the money market, market transactions were limited to that between banks and large enterprises as well as between banks. At that time, the main function of the money market was for enterprises to get short-term loans, or to meet the needs of commercial banks carrying out liquidity management. Later, out of the need of the government to promote economic development, new financing instruments such as treasury bills continued to emerge, the government and the central bank gradually entered the money market, gradually turning into an important place for the central bank to transmit its money policies. Then later, with the development of financial innovation and the government’s relaxation of financial regulations, there were increases in money market instruments, continuous elevation of financing efficiency, continuous lowering of transaction costs, and the continuous increase in attractiveness to both the supply and the demand sides for loans, thus promoting a continuous growth in the types and size of

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the money market. In addition, as many countries lowered their qualification for market access for and relaxed restrictions on many institutions to enter the money market, market participants had been on the increase. In addition, with the emergence of intermediary organizations which specialized in money market transactions, market transaction costs were reduced, transaction efficiency were raised, and also allowed many traders who did not have the professional knowledge or professional qualifications to participate directly or indirectly in the money market. This allows some countries, a large number of subjects to participate in the money markets, including, for example, the central bank, commercial banks, non-banking financial institutions, investment institutions, intermediary organizations, enterprises, governments and their subsidiary bodies, the foreign central banks and commercial banks, and domestic and foreign residents. But it should be noted that due to the level of development of the money markets in various countries and the differences in government regulations, the subjects in various sub-markets of the money market are also different. The major traders in the commercial bills market in the U.S., for example, are large companies (domestic and foreign), commercial banks, insurance companies, pension organizations, and foreign investors. The major traders in the federal funds market are limited to certain financial institutions, such as commercial banks, savings and loan associations, certain federal organizations, and government securities brokers, and largely the commercial banks. The major traders in the treasury bills market are governments (federal, state and local governments), the Federal Reserve Bank, commercial banks, nonfinancial companies and foreigners. The euro currency market in London allows financial institutions all over the world to do transactions there. But Japan strictly divides the money market into two major parts: the interbank market and the short-term open market. The interbank market is a market for financial organizations such as banks. Its trading subjects mainly include city banks, local banks, mutual savings banks, trust banks, long-term credit banks, foreign banks, insurance companies, securities companies and short-term capital firms (intermediary organizations). The open market is a short-term money market traded by national financial institutions, enterprises, individuals, foreign banks, and foreign monetary authorities, but individuals are not allowed to trade in the repo market. It should also be pointed out that intermediary organizations as the major subjects of the money market have special significance. They can be divided into two categories. One category is brokers who act only as intermediaries and do not engage

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in trading. In countries where money markets are well developed, brokers are commonplace. They usually maintain contacts with loan suppliers and demanders by phone, mediate between them, conclude transactions, and receive commissions from both sides based on a certain percentage of the transaction amount. In the interbank market, for example, with the growth in the amount of interbank lending and the continuous expansion of the interbank market, the complexity of interbank borrowing has also greatly increased, and gradually there was the emergence of brokers who act especially as trading intermediaries for the supply and demand sides of loans. Furthermore, federal funds brokers in the U.S. and brokers in U.K. banks play an important role in raising trading efficiency and reducing transaction costs. The other category is financial companies which both act as intermediaries and engage in trading. They generally borrow money from the national banking system and other financial institutions, and then use the money on short-term securities trading, discount and repurchase transactions. They can also get their money from the central bank through rediscounting, and serve to some extent as transmitters of monetary policies. The typical representatives of companies in the short-term securities markets are discount banks in UK and short-term capital companies in Japan. Short-term capital companies in Japan, for example, serve as monetary intermediaries between the interbank lending market and the bills trading market. They also independently engage in such trading businesses of a small amount of short-term capital, short-term government securities and certificates of deposit, bank acceptances and other trading business, and they also act as brokers of foreign currency loans. They play a very important role in the capital liquidity in the money market in Japan. They are not only channels for the flow of local surplus capital to metropolitan financial institutions, but also an important channel for banks (mainly city banks) to maintain their deposit reserves. They are the transmission organizations of Japanese banks for executing their monetary policies, and Japanese banks, as the eventual lenders, frequently carry out open market operations and lending through short-term capital companies according to the needs to regulate the market. To promote the development of money markets in China, we should gradually relax restrictions on the qualifications of the market players and promote subject diversification. This is because all market players in varying degrees have the desire to demand for raising their capital liquidity and the supply of capital supply. Market subject diversification allows a better functioning of the supply and demand mechanism in the money market to try to satisfy the demands of both the supply and the demand sides, further improve financial efficiency, and promote economic development.

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At present, the following four issues exist in China’s money market subjects:

Their Structure is Relatively Simple Of the current trading subjects in China’s money markets, state-owned commercial banks occupy a most advantageous position, but their level of activity in the money market is not satisfactory. Enterprises have for a long time been over-reliant on bank loans, and seldom carry out financing through the money market. The finance departments in the government have not become an important provider of a larger scale and relatively standardized short-term financial instruments. And as the central bank does not hold a large amount of actively adjustable short-term securities, which makes it difficult to actively conduct macro-financial control through the money market, is makes demands in the money market convergent, lacking liquidity, and hindering the development of the money market.

Their Behavior Lacks Self-Discipline At present, China’s state-owned commercial banks and state-owned enterprises still lack the incentive and self-restraint mechanism, and their self-discipline is relatively poor. Under this situation, the behavior of trading subjects will not be restrained by their ability of repayment or operation risks, and driven by profits, they cannot be prohibited to behave in a non-regulatory manner, such as indiscriminate lending, indiscriminate financing, and fake repurchases despite repeated prohibitions. At that stage, the main purpose of the subjects trading in the market is to misappropriate and speculate, which will inevitably reduce their credibility. Some operators of state-owned enterprises, for example, regard financial channels as a place for expropriation. They borrow money without repaying it, making it difficult for the bills market and the corporate bonds market to develop healthily. Some state-owned commercial banks use the means of “mending the west wall by tearing down the east wall” and use the shortterm loans they raise in the money market to make long-term investment. Some financial institutions use the loans they raise from the money market to make high-risk investments, such as real estate, securities, and foreign exchange. This not only worsens their reputation in the market, but also creates serious financial risks.

Their Own Strength is Weak The capital adequacy of most state-owned commercial bank does not meet the

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requirements of the Basel Agreement , and their inadequate strength in capital will inevitably affect their trading in the money market. In 1998, the Ministry of Finance approved the issuance of RMB270 billion special national bonds to replenish the capital of state-owned commercial banks, which greatly raised the recapitalization rate of state-owned commercial banks. As most of the stateowned enterprises lack capital, particularly short-term capital, they would not only lose many business opportunities, but also sometimes affect their normal operation of the enterprises.

Their Financing Concepts are Outdated Indirect financing has been the major method of capital allocation in China. Enterprises and individuals have become accustomed to bank deposits and loans, and know very little about the various methods of direct financing, especially the various types of money market instruments. By the end of 2000, for example, the total amount of deposits in financial institutions in China was RMB12.38 trillion, of which the deposits of residents were RMB6.43 trillion, and the deposits of enterprises were RMB4.41 trillion, but the market value of shares in circulation was only RMB1.61 trillion, and that of corporate bonds, only RMB86.2 billion. This out-dated idea of over-relying on indirect financing will certainly cold-shoulder the money market which serves as a channel for direct financing, thus suppressing the demands for the money market and hindering their development. In view of the specific situation in China, the author suggests that in pushing ahead the diversification of the money market players, we should gradually perform well in the following four aspects.

Actively Developing Intermediary Organizations Intermediary organizations (brokers and finance companies) play an important role in the money market. Professional brokerage intermediary organizations can perform functions such as to conduct matching in the quantities and duration of financing for the supply side and the demand side, seek and provide the best price information, serve as a witness for both sides in trading, and provide services to traders who need to remain anonymous, which can thus reduce the transaction costs, and that is why most transactions in the money market are done through the brokerage intermediary organizations. They not only can complete transactions promptly and to the satisfaction of the supply and demand sides, significantly and greatly reduce the transaction costs, but make use of the effects of the economies of scale to promote a healthy and

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rapid development of the secondary market. In addition, some intermediary organizations can also play the role of transmitting monetary policies in the open market operations. Currently, there is a lack of intermediary organizations in China’s money markets, and they need to be nurtured gradually. We suggest allowing qualified investment trust companies at the initial stage of developing intermediary organizations, to engage in intermediary business in the money market, playing a role similar to that of financial companies. When the size of the money market is large enough, we can allow brokers to enter the market.

Gradually Relaxing the Entry Requirements We have to make rules for the market demands according to the actual situation and market, and should embody the spirit of justice, fairness and openness to make the money market an open market. Those who meet entry requirements could enter the market, and those who fail to meet the conditions must withdraw from the market. If a bank has a legal person qualification, for example, that meets the requirements of the Basel Agreement and other requirements for entry into the market, then it can enter the interbank market. The establishment of the entry system of the bills market is mainly focused on defining the eligibility of the bond-issuing subjects in the primary market with an emphasis on the creditworthiness of issuers, their capital strength, solvency, etc., while participants in the secondary market should be allowed to enter the market transactions as long as their source of capital is legitimate.

Encouraging Direct Financing for Enterprises Over the years, due to various reasons such as financing structure and ownership constraints, it has been difficult for enterprises to give liquidity management the position it deserves. In addition, with their long-standing over-reliance on bank loans, the existence of market malpractice, and the weakening of the contractual consciousness in the bills market, enterprises lack the enthusiasm and initiatives to carry out financing through the money market. The extensive use of bills in enterprises has been suppressed.

Establishing the Money Market Funds Money market mutual funds are open-end funds that are released to the public in the U.S. Purchasers buy a number of fund shares at a fixed price (usually USD1), and money market mutual fund managers use these funds to invest in profitable short-term money market instruments (such as treasury bills and commercial

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bills). In addition, buyers can issue checks on the funds that they hold in the form of shares in the mutual funds. Money market mutual funds are open-end funds which can pool together a large number of funds scattered between institutional and individual investors, invest the funds into the money market to make profits, thus attracting a large number of institutions and individuals to become the subjects in the money market.

Object Diversification The diversification of transaction objects (money market instruments) is another important condition to promote the maturity and improvement of the money market. Developed money markets are usually markets with diversified transaction objects, a wide variety of money market instruments with high quality, and there is a close continuity and interactive relationship among the various instruments, which provide the market players with rich choices and flexible conversion. During the process of developing the money market, the development of money market instruments has experienced a continuous process of innovation, enrichment and improvement. As mentioned earlier, during the early stages of development of the money market, commercial bills and bank promissory notes were the only two instruments available for trading. Since then, with the establishment of the central banking system in various countries and the strengthening of regulations on the banking industry, the daily liquidity demand of the banks increased, which led to the gradually development of interbank lending. With the participation of the government and monetary authorities, new credit instruments such as treasury bills, short-term government bonds, central bank financing of new securities emerged one after the other in the money market. After World War II, with the diversification of demand and the development of financial innovation, a large number of new money market instruments, such as the Eurodollar, large-denomination negotiable certificates of deposit, and negotiable withdrawal notices, also emerged. The characteristics of the development of money market objects can be summarized as follows: The first is the variety and diversity of the various types of credit instruments and a wide range of market transaction targets. The second is the frequent innovation of credit instruments which stimulate the prosperity and activity of the entire market. The third is in the same submarket there is a variety of credit instruments available for trading. In the U.S., for example, the large-denomination negotiable certificates of deposit market include markets for the trading of a variability of deposits, such as the domestic

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market, negotiable certificates of deposit, Eurodollar certificates of deposit market, and the market of the “Yankee” certificate of deposit market (Yankee CDs) that is issued by branches of foreign banks in the U.S. to institutional investors but not to the American citizens. The fourth is the ownership of many credit instruments that bear the national and regional characteristics, such as the exchange funds bills in Hong Kong and the currency stabilization fund bonds and commercial invoices in South Korea. At present, there are several issues existing in money markets in China.

The Overall Scale of the Market is Relatively Small Money markets in developed countries have reached a substantial scale. The year-end balance of the major money markets in the U.S. in 1995, for example, reached USD2.08 trillion. According to the data collected by the author, the year-end balance of the major money markets in the U.S. in 2000 reached USD5.4 trillion. In contrast, the scale of China’s money market is much smaller. According to data cited in the article by Li Yang and others, the total amount of trading in China’s money market in 2000 amounted to RMB5.86 trillion (approximately equivalent to USD700 billion), which was 65% of the gross domestic products for the year. The author believes that if we calculate the balance in accordance with international practice, then the gap between the scale of China’s money markets and that of the U.S. will be even greater. According to the data of the Central Depository Trust & Clearing Co., Ltd., for example, the amount of settlement in the interbank bond market trading in 2001 was RMB4.09 trillion, and by December 31 bonds in nominal value under the trust of the company was only RMB2.00 trillion. Another example is that by December 31, 2000, the balance of commercial bills, discounts and rediscounts were 49.4%, 23.8%, and 47.2% respectively of the trading amount.

Unbalanced Development of the Market In the money markets of developed countries, they basically form a market system consisting of a number of sub-markets, each sub-market specializes in one type of money market instruments, provide specialized services to their market players, and it was largely a balanced and coordinated development among the various sub-markets. In the money market of the U.S., for example, the coordinated development of the sub-markets has unified its money market, which plays an important role in the financing of short-term capital and the transmission of monetary policies. The major sub-markets in the money market are the treasury bill market, the federal funds market, the commercial bills

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market, and the negotiable certificates of deposit market, while the status of other markets is auxiliary. In China, apart from the lending market and the repo market, most of the sub-markets, such as the commercial bills market and the short-term bond market, are still underdeveloped.

Lack of Connection Among the Sub-Markets In mature money markets, there is a close relationship and mutual influence between the various sub-markets, and capital can flow freely between the various sub-markets. Market players can conduct rapid selections and replacements based on the profitability, risks and liquidity of market instruments to form a complete money market system. In China, however, submarkets of the money market mostly revolve around their primary market to form a relatively independent and basically closed market, which is difficult to form a unified money market system. In addition, as the various sub-markets in China’s money market make it difficult for these markets to grow. The trading of the bills markets, for example, is mainly conducted between the central bank and commercial banks and enterprises. The bond market was artificially split up into the Shanghai Stock Exchange market, the Shenzhen Stock exchange market and the interbank bond markets. The interbank market is confined to the commercial banks. Some sub-markets (such as large-denomination negotiable certificates of deposit market) were even closed due to risks.

The Imbalance of the Primary and Secondary Markets The development of the primary and secondary markets of the money market in China is unbalanced as the primary market receives the special attention of market subjects while the secondary market is often neglected. The liquidity of money market instruments is mainly manifested in the secondary market, and some money market instruments, such as large-denomination negotiable certificates of deposit, short-term bonds, and commercial bills, lose the liquidity they should have because of their lack of growth in the secondary market, which hinders the development of these sub-markets. In view of the special situations in China, we suggest that when we push forward the diversification of the money market, we should concentrate on doing our work properly in the following four areas:

Regulating the Development of Short-Term Bonds Short-term bonds include short-term treasury bonds and short-term corporate

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bonds, generally of the durations of three months, six months and twelve months. Of these the short-term bonds are short-term debt instruments issued by the government, which function as an important means for the government to adjust the surplus and deficiency of capital. Because of their short duration, they are easy to sell and their price changes quickly with market fluctuations. The government can guarantee the repayment of its debts through revenue from tax and issuance of notes, so they are the most liquid and safe of all money market instruments. They can therefore be regarded as an instrument for the central bank to implement open market operations and regulate the supply of money in the market. The fiscal year of the U.S. federal government, for example, is October 1 of the previous year to September 30 of the following year. But personal income tax, a major source of income for the federal government, can only be fully collected in April each year, so short-term treasury bills can help the Treasury to adjust for seasonal surpluses and deficits. This type of treasury bond is sold at the premium price, and they are mainly held by banks, and to be realized by the government at face value when they expire. At present, bonds issued in China include common-type national bonds which are issued regularly, and the special-type bonds which are issued irregularly. There are three types of common-type national bonds: certificated bonds, book-entry treasury bills, and bearer (physical) bonds, whose durations can be of three months, six months, one year, two years, three years, five years, seven years, or ten years. There are three types of special-type bonds: directional bonds (bonds collected from pension insurance funds, unemployment insurance funds and other social insurance funds), special treasury bills (bonds that are issued to the four major state-owned commercial banks to supplement the capital of the wholly state-funded commercial banks) and the special treasury notes (ten-year interest-bearing bonds invested and issued by the Ministry of Finance to the four major state-owned commercial banks for the urgently needed infrastructure construction for the national economy and social development). Since 1981, common-type bonds in China have been mainly medium-term (three to five years) treasury bills, while only bonds of the durations of three months, six months, and one year have been available for one-year short-term national bonds, and the amount issued was small. Company bonds are also known as enterprise bonds, which include financial bonds, industrial bonds and utility bonds. At present, corporate bonds in China are mainly financial bonds, of which very few are short-term bonds. According to the statistics of the Central Depository Trust & Clearing Co., Ltd., the total amount of bonds issued in the national inter-bank bond market

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in 2001 was RMB474.85 billion, an increase of 21.6% compared to 2000. Of these, the amount of treasury bonds issued accounted for 44.7%, the amount of bonds issued by the State Development Bank accounted for 44.2%, the amount of bonds issued by the Export-Import Bank of China accounted for 10.3%, and the amount of bonds issued by China International Trust and Investment Corporation accounted for 0.8% of the total amount of bonds issued, durations of ten years and more than ten years accounted for 39.9%, between five to ten years accounted for 29.1%, between one to five years were 23%, and less than one year accounted for only 8%. It can be seen that the scale of the shortterm bond markets in China is small, and it is difficult for them to function as monetary policy instruments.

Expanding the Interbank Market Interbank lending is a kind of credit lending between banks, with the interest rate agreed upon by both parties, and its main role is to meet temporary (usually overnight) capital requirements. Because the U.S. interbank lending is designed to meet statutory reserve requirements, the targets for lending are deposits in the Federal Reserve System, and that is why they are called federal funds. At present, the trading varieties of China’s interbank market are loans for one day, seven days, twenty days, thirty days, sixty days, ninety days, and one hundred and twenty days. The maturity is mainly for more than seven days, but overnight maturity rarely occurs. The volumes of one-day maturity in 1996, 1997, and 1998, for example, accounted for 2.16%, 6.49% and 5.9% respectively of the total trading volume. This shows that China’s interbank market is mainly used for short-term financing, rather than regulating the reserve position and this is contrary to the primary role of the interbank market. In addition, the quantity of interbank lending in China is currently relatively small. According to statistics from the National Interbank Funding Center, the amount of interbank lending in 2001 was RMB 808.2 billion, accounting for only 16.5% of the trading volume of the Center. To promote the development of interbank market, we should gradually link the interbank lending market with the deposit reserve system of the central bank, and let the interbank market fully exercise its role of adjusting the deposit reserves.

Promoting the Liquidity of Enterprise Capital Financing and investment are the two basic financial management tasks of enterprises. However, due to institutional and structural constraints of

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enterprises in China over the years, financial management, in particular liquidity management is at a low level. The main channels of handling shortterm capital are bank loans and deposits, the efficiency of which is low. To encourage enterprises seeking financing from the money market to meet their shortage of short-term capital shortage, we should make great efforts to develop commercial bills and bank acceptance bills. Commercial bills are shortterm debt instruments issued by big banks or large enterprises, mainly sold to financial intermediary organizations and other enterprises. Bank acceptance bills are bank bills issued by enterprises and promised by banks to realize them on a specified date. Banks have to stamp “promised to pay” on the guaranteed bills and at that time the banks require enterprises to deposit a certain amount of money into their bank accounts, and charge a handling fee to the enterprises. Enterprises can use the abovementioned two types of bills to repay the debts they owe in purchasing goods or services, and bill owners can get these two types of bills on discount on the secondary market to obtain cash. In China, we still do not have commercial bills issued by enterprises for the purposes of financing. At present, a vast majority of commercial bills are converted into bank acceptances, then enterprises which receive the money take their bank acceptances to another commercial bank for discount, and that bank can also go to another bank for rediscount, or to the central bank for rediscount. In this way, the commercial banks enjoy the status of monopoly, but they also become a major bearer of the risks of the bills market, which is not advantageous to the development of the bills market. We suggest that the franchisee windows of commercial banks and companies specializing in bills compete for the business of bills acceptance and discount, and complete the clients’ commission of bills trading (not discount). To attract enterprises to invest their short-term surplus capital into the money market, we should develop money market instruments such as largedenomination negotiable certificates of deposit whose profitability is greater than that of bank interest rates, as well as money market instruments such as repurchase agreements which have high liquidity. We propose that commercial banks issue negotiable certificates of deposit with a face value of more than RMB100,000 and sell them to enterprises. These enterprises pay a fixed interest annually and repay the principal upon the expiry of the certificates, and trading of these certificates in the secondary market is allowed. Repurchase agreements are mainly used by commercial banks to finance large enterprises to adjust their capital. They are actually short-term loans (generally no longer than two weeks) with treasury bills as collateral. Their main function is their ability to use medium- and long-term debt instruments

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in short-term financing. Borrowers sell the treasury bonds they own to lenders according to the price they agreed on and promise in their agreement to repurchase treasury bills with a price slightly higher than the selling price within period specified in the agreement. If the borrowers cannot purchase them on the due date, these treasury bills will go to the lenders. At present, the national bonds repo market in China is mainly conducted among banks. The amount of interbank bond repo transactions in 2001 accounted for 72.4% of the total amount. In the future, we should take measures to encourage large enterprises to enter the bond repurchasing market.

Steadily Promoting Financial Innovation Financial innovation that began to emerge in the 1960s in the U.S. generated all kinds of derivative instruments, which played an important role in such aspects as promoting the development of the money market and raising the efficiency of financial operations. When we affirm the positive role of financial innovation, we should at the same time also prevent its negative effects. We suggest actively and thoroughly studying the derivatives markets in the money market and their role in risk management services, properly controlling speculation, and gradually improving the regulatory rules. When the market framework of government bonds and quasi-government bonds are basically sound, we should seize the opportunity to introduce bond derivatives. When Renminbi is freely convertible, we should also issue based on offshore Renminbi (generally known as European bonds).

Interest Rate Marketization The money market is a highly liquid one. Those with capital surplus and those who need capital are interactive in the rapidly changing and highly competitive market, seeking with great effort to find the most favorable market instruments and trading conditions, with the interest rate acting as a barometer for the cost of using the capital and also as a regulator of the relationship of supply and demand in the market. Thus it can be seen that a necessary condition for the effective operation of the money market is to achieve interest rate marketization, that is, a floating interest rate that is formed by market mechanism so that it can adapt to different risks, liquidity and periods. In a free-trading money market, market subjects would carry out comprehensive surveys and analyses based on various factors, such as the performance of their business activities, the situation of capital supply and

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demand, and changes in the macroeconomic environment, and decide on the transaction interest rates through negotiations on the supply side and the demand side. The sub-market trading of money market subjects is conducted on the basis of taking into account its risks, liquidity and profitability. The existence of the secondary markets brings liquidity to the money market instruments to allow capital to be flexibly transferred among various strong alternative tools. Market players make choices of different money market instruments under different circumstances. This will bring a closer link to these tools, which can improve the effectiveness of the money market. When market transparency is very high and information asymmetry is very small, a number of transactions of a certain money market instrument in a certain period of time will form the market interest rate of instrument. Despite the differences in the liquidity and riskiness of the various money market instruments, their interest rates will vary, but as each market subject at any time changes its market instruments and adjust its own asset structure according to its own needs, the interest rate differences of these instruments are small. The interest rate of the majority of money market instruments in China is based on bank deposit and lending rates, and not on the characteristics of the various instruments, and determined by the supply and demand situation in the market. This also widens the gap among the interest rates of money market instruments, and cannot create the effect of mutual substitution. The prerequisite of interest rate marketization is that a benchmark interest rate had been established through the market, and from there, we build up a reasonable interest rate structure. The interest rate structure of the money market includes the risk structure and term structure. The so-called risk structure is to determine their own different interest rates in accordance with the differences in the riskiness and liquidity of the various money market instruments. We must then select the interest rate of a money market instrument with the lowest risk and strongest liquidity to be the benchmark interest rate, while the interest rates of other money market instruments should follow the law of risk-return symmetry, and add risk premium to the benchmark interest rate. The so-called term structure of interest rates is that for money market instruments with the same riskiness and liquidity and to suit the preferences of investors on short-term instruments, we add a liquidity premium that is based on the expected short-term average interest rates to the interest rates of longterm instruments. In addition, taxation on the money market instruments and tax exemption regulations will also affect the structure of interest rates. Despite the fact that the risks of municipal bonds are higher than those of short-term treasury bonds, for example, but as the interest incomes of municipal bonds are

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exempted from federal income tax, so their interest rate can be lower than that of the short-term treasury bills. As short-term government bonds are backed by the government, there is virtually no default risk, and they can be quickly converted to cash with a low cost. These bonds can be seen as instruments of lowest riskiness and strongest liquidity. We should therefore use the interest rate of short-term government bonds as the benchmark interest rate of the money market. However, due to the small size of the short-term government bonds in China, the issuance interest rate is determined with reference to bank deposit interest rates over the same period. As this interest rate has not been really marketized, it has not served its expected function of promoting the marketization of interest rates. The author in 1999 proposed to study the issuance of short-term treasury bills of the durations of three months and six months, use the method of discount to work out the interest, and let the central bank, through its open market operations desks, auction the treasury bills in wholesale to the large financial institutions according to a regular and rolling schedule. Since in actual operation, this is to periodically use the new debts to cover the old debts, it has the effect of dynamically reflecting and timely adjusting the relation of supply and demand in the market. Through auctioned price, the weighted average of the trading price can be formed, which is the interest rate for short-term treasury bills. The kind of generally recognized risk-free interest rate can serve as the benchmark interest rate of the money market, which helps to achieve the rationalization of the interest rate structure of the money market. As interbank lending is a market with a huge scale of trading and a very short credit period and both the supply side and the demand side hold a lot of market information, the interbank interest rates can timely and accurately reflect the relationship of supply and demand of money in the money market. These rates are the most sensitive interest rates in the money market, and the main factor that affects the returns of other money market instruments. Therefore, this sub-market’s relationship with other sub-markets is closest. Any slight changes in this sub-market will quickly spread and be transmitted to the entire market, bringing changes to the income structure and transaction size of other sub-market instruments in the money market. The main subjects of the various money markets will closely monitor the interbank market interest rates at any time to grasp the trend of interest rates in the money market. The internationally adopted London Interbank Offered Rate (LIBOR) is an interest rate for the durations of three months and six months agreed by five banks in UK every day at 11 a.m. Banks follow this interest rate and conduct their transactions with USD10 million as their unit.

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In developed countries, the interbank interest rate is generally the benchmark interest rate of the monetary policy of the central bank. Central banks can use it to judge the tightness of the market liquidity situation and determine actions and measures to be taken. A relaxed monetary policy, for example, will lower the target interest rates of the interbank borrowing market, and a tightened monetary policy will raise the interest rate. It can be seen that the interbank market interest rates form a restraining effect on the interest rates of all other money market instruments. In 1996, after the establishment of the China National Interbank Funding Center in Shanghai, a unified interbank lending rate (CHIBOR) was formed, and it can be said this interest rate was the first step towards realizing interest rate marketization. It was suggested that CHIBOR was to be adopted as the benchmark interest rate of the money market in China because it was more influential and referential. The author, however, does not agree with this idea. This is because, on the one hand, the interbank lending interest rate is not the interest rate with the least risk, and on the other hand, as the size of the current interbank lending market in China is relatively small and the proportion of overnight lending is small, it is difficult for CHIBOR to accurately and timely reflect the relationship of supply and demand in the money market like LIBOR, and serve the guiding role of a benchmark interest rate. In addition, as the interest rates of deposits and loans, which currently account for a large part of the capital liabilities of banks, are still under strict planned control, it is difficult for the interbank market interest rates to play a role. Furthermore, the non-regulatory behavior of market players and strong speculation cause great fluctuations in the interbank interest rate, which makes it difficult to play the role of stabilizer of the market. Led by the benchmark interest rate, the surplus side and the demand side of capital could form interest rates for various money market instruments according to the law of the market. Market players can adjust their investment portfolios according to their own situation and forecasts of future interest rates.

Operational Regularization In mature money markets, the major operators are the various kinds of financial institutions, including the three major categories of deposit-based institutions (such as banks and credit unions), contractual savings institutions (such as life insurance companies, pension funds, and government pension funds), and intermediary and operating institutions (such as financial companies). They must follow certain regulation in their sources of capital, use of capital, business flows, and operating

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rules, maintain close ties with the central bank of the country, and some financial institutions also to some extent serve as transmitters of monetary policies. The sources of capital of deposit-based institutions, the majority of which are banks, are deposits of individuals and institutions, and the capital is mainly used on personal loans (mainly consumer loans), institutional loans (primarily industry and business loans), mortgage loans, treasury bills and so on. Banks as the largest financial institutions for those with capital surpluses and those with capital demand can reduce transaction costs through economies of scale, and reduce adverse selection caused by asymmetric information (lending money to the most unreliable people) and moral risks (borrowers after getting the loans use them on high-risk speculative ventures and not on predetermined purposes.) In the money market, banks get their capital through the sale of certain financial instruments (liabilities) and make profits by using their capital to buy some other financial instruments (assets), and this process is called “asset conversion.” Banks should attract deposits from those with capital surplus through quality service, and make the largest possible returns for their clients through financial innovation with the precondition that it does not contravene the relevant regulatory laws and regulations. The sources of capital of contractual savings institutions are insurance premiums that people pay to keep their insurance policies valid or forced savings for employees and employers, and their capital is mainly for corporate bonds, mortgage loans, treasury bills, shares and others. The main sources of capital for financial companies are commercial bills, shares, bonds, and others, and their capital is mainly for personal credit loans and institutional credit loans. Commercial banks are the most important subjects of the money market in China. With the long-term implementation of planned economy in the past, the four wholly state-owned commercial banks: the China Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, and the China Construction Bank, served as “cashiers” of the government, and gained monopoly power and some privileges with the support of the government. But with the development of the socialist market economy, contradictions in the structure and mechanism in these banks, such as the lack of distinction between the functions of the party and those of the government, the lack of distinction between the functions of the government and those of the enterprises, the lack of incentive and restraint mechanisms, and the backwardness of legal person governance system, has had a growing impact on the performance and competitiveness of financial enterprises. This is coupled with such factors as excessive and low-quality staffing, low level

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of operational management, excessive proportion of non-performing loans, severe loss of various types of assets, and ineffective macro-regulation, which result in their per capita assets and efficiency indicators being well below those of similar banks outside China. According to the 2000 Hang Seng Bank Annual Report , its cost accounted for only 24.4% of the total revenue, while the state-owned banks are usually about 90%. The per capita pre-tax profit of Hang Seng Bank was HKD157,000, which is several dozen times higher than that of the state-owned banks. The differences in interest rates of one-year deposits and loans were from 1.7% to 2.2%, while it was 3.6% for the state-owned banks. Even joint-stock banks established according to the governance structure of modern enterprises could not get out of the old path of planned economy system in such aspects as personnel management, and in the course of their operation, there has been a continuous tendency of reverting their mechanism to that of the state-owned banks. According to the pledge China made when joining the WTO, by December 2006, foreign banks entering into China would be treated as equals of Chinese banks; wholly state-owned commercial banks, therefore, will face serious challenges. For this reason, we must carry out a fundamental reform of the wholly state-owned banks in accordance with the spirit that was proposed at the national conference on financial work recently held by the Central Committee of the Communist Party of China, and reform wholly state-owned commercial banks into modern financial enterprises with sound governance structure, healthy operating mechanisms, clearly targeted operations, good financial conditions, and strong international competitiveness, while at the same time continuously improve their business performance and competitiveness. The People’s Bank of China, being the central bank of China, not only bears the responsibility of regulating the money market, but also establishes and improves the transmission mechanism of monetary policies through the three monetary policy instruments of rediscounting, open market operations, and reserve system, to conduct macro-control on the money market. The effective operation of the rediscounting system depends on the level of development of bills market. Only when there is a well-developed bill market can capital operation in commercial banks relies to a large extent on the specific channels of average discounts, and the central bank can lead the market interest rate through adjusting the rediscount rate to regulate the supply and demand of capital in the market. The central bank, through open market operations, invests or withdraws base currencies through transaction instruments in the money market, and then generates an impact on the entire social economy through currency generation mechanism. Through this means, monetary policies immediately make an impact

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on the money market, and from there the impact will be spread to other areas of the national economy. The implementation of the statutory reserve system complemented the development of the interbank market in the sub-markets of the money market with the operating situation of the interbank market providing the basic market information for the central bank to adjust the reserve ratio and implement macro-control.

Trading Networkization With the development of information technology, the trend of trading networkization emerged in the money market characterized by a trade media center, Internet technology, and remote computer trading. The open market and the so-called “fourth market” (bilateral telecommunications trading market), for example, are in the midst of and in the gradual transition to a unified electronic trading network. Networkization has the advantages of high efficiency, fastness, and transparency, which will help improve the consistency and efficiency of the market, and also better realize the functions of market statistics, and this is advantages to the regulation of the central bank. Information and settlement are the two major necessary conditions for running the money market, so trading networkization should include the construction and operation of information networks and settlement networks. Money market information (such as interest rates, trading volume and other information) is an indispensable part of economic information for society as a whole, and has a significant impact on the running of that society and its economy. This information must be rapidly transmitted to all market players through networked information systems so as to reduce the loss of efficiency caused by information asymmetry. The role of the settlement system that is formed by computer networks is to quickly and accurately complete settlement and clearing and ensure that transactions are safely and smoothly conducted. T h e m a j o r f u n c t i o n s o f i n f o r m a t i o n s y s t e m s a re t o i s s u e p u b l i c announcements by government departments, notices of bond issuance by bonds issuers, market information and its related statistical materials. The information systems of the current money markets in China include three parts: chinamoney. com.cn established by the National Interbank Funding Center, chinabond. com.cn established by the Central Depository Trust & Clearing Co., Ltd. and financialnews.com.cn. China Money (www.chinamoney.com.cn) was launched on June 12, 2000. It consists of two parts: information for the public and provision of information

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only to market participants. At present, it has opened the three quote systems for bond repurchase, spot bond trading, and credit lending. The China Bond Information Network (www.chinabond.com.cn) was launched in late September 1998. It provides a variety of bond market information, such as types of bonds, size, distribution trends, market information, statistics, business training, membership forum, policies and regulations, research activities, etc. Financial Times is a nationwide, comprehensive, economics newspaper jointly founded by eight financial institutions including the People’s Bank of China. Apart from reflecting the activities of the money market on an irregular basis, it has also created a section on everyday financial market analysis and a special session on the money market, featuring analytical articles on the policies, regulation, market construction, and market operation of the money market and information on interbank bond market and national interbank lending market. Its website is at www.financialnews.com.cn. Although the money market network in China has begun to take shape and played an important role in promoting the money market in China, yet there are still many inadequacies. In the future, we should focus on the following areas and make further improvement:

Expanding Its Scope of Service At present, the scope of service of the trade network of the money market in China covers mainly the interbank repo, credit lending, and spot trading, which is still relatively narrow. In the future, we should follow the development of financial innovation and the construction of banking informatization, gradually adopt the right credentials, such as promissory notes and negotiable certificates of deposit, in the form of paper, and practise of transference by endorsement to establish a trading network which includes bills, large-denomination negotiable certificates of deposit and other financial derivatives, so as to achieve paperless trading. And we should make efforts to link the networks of financial institutions, the money market and capital market, to build a unified financial network.

Improving Its Quotation System We should make necessary improvement on the quotation system of the existing interbank bond market to facilitate smooth spot trading in the interbank bond market. The first improvement is to have a false name with a marked price, that is, only after a transaction is completed that the quotation system will disclose

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each party’s true identity, but in the case of intentional quotation, the real name and the marked price is allowed. The second improvement is to institute a marked price and a real quotation, that is, as soon as the price is quoted, and accepted by the other party, it cannot be changed. The third improvement is to quote both the price and quantity, quoting the price but not quoting the quantity is not allowed. When the quotation of the two parties is the same or less than the quantity quoted, the deal must be concluded. Negotiation is possible only when the price or quantity is higher than the quotation. The fourth improvement is to prevent breach of contract. The interbank money market center monitors the behavior of two-way quoters through the information system of the money market. When there is any violation of regulations or there is any failure to follow the quotation, there will be compensation required by the contract or punishment given, depending on the seriousness of the case. The fifth improvement is to open up quotation. Information on money market transactions should be open by publicizing information on open market transactions, and broaden the scope of information available to small and medium investors. The sixth is information service. The quotation system should be attached with a large amount of information relating to politics, economy, finance, and market to provide transaction information to traders as reference.

Strengthening Market Analysis To conduct analyses on the situation and trends in the money market is the scientific basis for investment and financing. Trading networkization enables market information to be delivered to the concerned parties in a timely manner, and it also creates the conditions for strengthening market analysis. When promoting trading networkization of the money market, we must also strengthen our market analysis so as to improve the level of development of the money market in China. To conduct analyses of the financial market is something that requires strong professionalism and knowledge. In the U.S., a chartered financial analyst (CFA) qualification system was set up for this specific purpose, and so far only tens of thousands of people who have obtained this qualification certificate. At present, there is a lack of talent and experienced people in financial market analysis. We recommend introducing the CFA qualification system to enhance the training of talent suitable for China. Money market analysis is to make use of theoretical principles, such as riskreturn symmetry, loanable capital, term selection, and liquidity premiums, to evaluate the profitability, riskiness and liquidity of money market instruments

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to find out better opportunities or potential errors. One of its basic tasks is to create a yield curve that reflects changes in interest rates within a period to provide reference for investors. With the further improvement of bilateral quotation system, we can prepare the treasury bond yield curve. It is an important benchmark for pricing new debts as well as creating the necessary conditions for products such as long-term derivatives. The national bond rate of return that is formed by the liquidity of the secondary market reveals the overall level of market interest rates and also provides a scientific basis for the central bank to set its monetary policies. It is also an important reference for all investors in the market, and a help to promote interest rate marketization.

Improving the Method of Settlement At present, the Central Depository Trust & Clearing Co., Ltd is allowed to operate only the settlement services of transaction settlements of interbank spot bonds trading and closed-end repurchase; it is not yet allowed to provide many other types of business settlement services such as open repurchase and pledge. This company handles settlement business based on instructions received from the two parties in trading to match various factors. The settlement of bond transactions is a real-time total amount settlement of each transaction; that is, it is free of payment, payment upon sight of bonds or delivery of bonds upon sight of payment, but delivery versus payment (DVP) is yet to be realized. DVP not only can synchronize the delivery of capital and bonds, but also allows the central bank to establish a flexible, efficient and safe liquidity adjustment mechanism. For this we require cooperation with and support from the relevant administrative departments. On the other hand, we should also achieve the organic linkage and smooth operation of bonds bookkeeping system of the central clearing agency and the national payment system managed by the central bank.

Improving the Payment System At present, the main transaction varieties in the money market in China are bonds repurchasing and lending, of which seven-day short-term trading accounts for around 70% of the total trading volume, with the average amount of each transaction being over RMB100 million. Objectively, this means that on the settlement day the money transfer system should be able to transfer the money in the payer account to the payee account with absolute certainty. Trading in the debt instrument market requires the linkage between the settlement system of bonds and the money payment system, to achieve the

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simultaneous dovetailing of debt instruments and settlement of money in order to maximize efficiency and reduce risks. At present, the system that supports the settlement of money in money market trading is the electronic interbank of the People’s Bank of China. Despite the fact that the receipt amount it transferred has absolute certainty, there are frequent delays due to the excessive transfer links when transferring out from the payer account into the payee account. As there are too many links to handle, it is impossible to achieve linkage with the debt settlement system, making it difficult to meet the monetary needs of the market. In light of international experience, a modern payment system that was set up, administered and operated by the central bank should have realtime gross settlement (RTGS) as its central function, institutional money market participants as its main target of service, and bulk transfers of money concluded instantly with absolute certainty. This system should also be linked up with the bond settlement system to achieve the simultaneous settlement of money of bonds traded and automatic repurchase financing. The latter is a bond repurchase agreement signed in advance by commercial bands or the central bank. When commercial banks lack money to make bulk transfers, the central bank automatically handles their short-term repurchase financing by mortgaging qualified bonds that are held in the bond settlement system of the commercial banks to the central bank, and after the commercial banks receive the money debited on the day, they automatically and immediately repurchase the bonds they mortgaged and then repay the money. This flexible, efficient and safe liquidity adjustment mechanism can guarantee the efficiency of real-time gross settlement as well as the safety of central bank money, raise the interest of the commercial banks to purchase bonds and participate in bond trading.

Efficient Regulation In the series of speeches given by Deng Xiaoping during his south China tour, he put forward the idea of ​​a socialist market economy. The author believes that this theoretical innovation points the way to resolve the contradiction between efficiency and equity in the development of China. On the one hand, the fundamental role of the market in resource allocation had to function to pursue high efficiency in economic development, and on the other hand, the socialist system has to be upheld to safeguard social fairness and justice. This idea should also be the basic principle for financial regulation in China. We have to fully utilize the financial market, which is a product of the economically highly developed Western markets, to accelerate economic development in China, and

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we have to protect investors, especially the legal rights of small and medium investors. The author believes that under the socialist market economy system, the government should follow the law and monitor the money market through policy guidance, timely control, risk prevention, and safeguarding fairness. We should also combine top-down administrative supervision with bottomup public monitoring to continuously improve the effectiveness and efficiency of regulation. In developing China’s money markets, we should focus on the following to ensure adequate regulation.

Exercising the Functions of the Central Bank The central bank in a money market is both a regulator and a participant; its participation can be either indirect or direct. Indirect participation refers to the way the central bank, through the operation of monetary policies, affects the level of reserves of commercial banks so that they enter the money market with a balanced capital, and this indirectly affects the supply and demand of capital in the money market. Direct participation refers to the way the central bank, through open market operations, directly affects the supply and demand of capital in the money market, which leads to changes in the level of shortterm interest rate, which further affects the supply and demand of capital in the capital market and long-term interest rates, the capital situation of commercial banks, and their overall level of interest rates. By effectively transmitting monetary policies to the micro-economic operating subjects, the central bank exercises an effective control on the operation of the macro-economy. Generally speaking, indirect participation mainly occurs in the interbank lending market, while direct participation generally occurs in the short-term securities markets (including the bills market and the bonds market). The central bank can also create some money market credit instruments to meet the needs of monetary policies. This not only can promote the development of the money market, but also have an effective participation of the central bank to ensure the implementation and transmission of monetary policies. The People’s Bank of China is the central bank in China. At present, it mainly adopts direct control to exercise its macro-control of the economy, chiefly by affecting the operational behavior of financial institutions centered around commercial banks as their core through such means as loan size, credit loan schemes and cash schemes. With the development of China’s money market, the central bank’s monetary policy control could be shifted from direct control

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to indirect control, which is to exercise implementing economic control through the reserve system, rediscounting policy, and open market operations.

Strengthening Information Disclosure Information disclosure is the manifestation of the principles of openness and fairness of the money market. The purpose is not only to enhance transparency so that all market players get the information they should have and reduce the losses caused by information asymmetry, but also provide the public with timely, complete and accurate market information, which can be used to analyze and monitor the market and help prevent all sorts of risk. Supervision of financial markets in developed countries generally starts from information disclosure, then it goes through analysis, announcement and processing. Supervisory departments should promulgate clear regulations on the scope, indicators, depth and frequency of the disclosure of money market information. In line with the principle of equality in the right to know, all market-related information that should be disclosed should be able to be freely retrieved from and examined in the relevant media or network. The unit that discloses information should be responsible for the timeliness, completeness and accuracy of the information, and accepts the supervision of regulatory authorities, industry self-regulatory bodies, and the people. In light of information disclosure, information can be analyzed by professionals. Through analysis, the current status and trends of the various money market instruments can be shown, which provides reference for market players, and contradictory or false information can also be found, which provides regulatory authorities clues to take up. The regulatory authorities, when finding clues indicating something suspicious after analysis and verification, they should identify their nature and seriousness in a timely manner, decide on the measures to deal with them (such as warning, reprimand, suspension of business, or disqualification), and quickly publicize it to reduce losses. The punishment for cases that are not very serious can be meted out by self-disciplinary bodies such as the association of the industry. In addition, we should also establish a collective ligation system to allow victims to claim compensation from those responsible according to law.

Deepening Institutional Construction In order to ensure proper operation of money markets and to promote their sustained, stable and healthy development, the central bank should exercise supervision and administration of the participating institutions, trading

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behavior, scale of financing, terms of financing, and interest rates for financing. At present, China’s central bank adopts a regulatory approach that is based mainly on administrative measures. When problems arise, due to the lack of market rules, the government should be responsible for solving them. This easily generates “stop-gap measures” which will even affect future reforms as a result of path dependency effects. We should, through institutional construction, establish a set of sound money market regulatory rules, so that the regulatory subject is clear and authoritative, the regulations specific, and the measures of regulation are effective, to minimize direct intervention from the central bank. With social and economic development, we should gradually strengthen industry self-regulation and public supervision, and allow participants to manage their activities on the basis of following market norms and with the constraints of human morality and habits.

Removing Monopoly Privileges Under the traditional planned economy system, the four major state-owned commercial banks, with the support of the government, established the status of their monopoly in the money market and obtained some privileges, which was then understandable at that time. But under the socialist market economy system, monopoly and privileges are major causes of low efficiency of the market and the breeding of corruption. In undergoing and deepening financial reform, we must resolutely remove monopolies and privileges to allow banks as financial enterprises to compete on an equal basis, which can help the healthy development of the financial system and achieve the optimization of social benefits. It can be seen that in the realization of subject diversification, we also have to give market players an equal status in order to improve the operational efficiency of the money market.

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Chapter

Goals and Major Measures for Reforming Commercial Banks in China

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Foreword Under the market economy system, commercial banks play a leading role in a nation’s economy and its financial operations in the following aspects: (1) They act as financial intermediaries and raise economic returns. Commercial banks act as an intermediary for those with excess capital and those seeking capital. When social units and individuals deposit their idle money into banks, banks have the obligations to turn this idle money into interest-bearing capital, and use it as loans for investment and consumption. Commercial banks can pull together the idle capital in society, lower the transaction cost of people who supply capital and people who need capital, and satisfy their diversified demand so as to raise efficiency in the use if capital. Through market mechanism, commercial banks can direct capital to flow to people who need it and are capable of obtaining the highest revenues, which can rapidly satisfy the demand for a large amount of short-term capital, while at the same time raise the liquidity and utilization efficiency in the use of capital. Apart from this, the banking system, by linking up with the money market to become one entity, can pull together capital of various banks to form a powerful credit capital, and thus, able to speedily satisfy the need for a large amount of short-term capital while at the same time raising the liquidity and utilization efficiency in the use of capital. (2) They help enterprises operate and promote economic development. Commercial banks play an important role in helping enterprises in their use of capital. They can help enterprises to quickly raise capital to make up their short-term deficit when they lack capital, or invest their short-term surpluses to obtain profits. In their course of operation, the liquidity of enterprises goes up and down. For example, when an enterprise sells a batch of products and has not yet received payment, it may not have sufficient capital to continue buying the raw materials needed to maintain production, and they then need to borrow money from a bank. When an enterprise receives payment, after repaying the loans, it may have some surplus capital which is idle for the time being, it can put the money into a bank to get returns from interests. From this it can be seen that commercial banks can provide help to enterprises in capital operation, which promote their development. (3) They optimize capital allocation and lower financial risks. Commercial banks, through an understanding and a professional analysis of the credibility and use of capital of borrowers, can obtain more information than individual investors, which enables them to optimize their capital allocation and lower the risks of depositors (indirect investors). Commercial banks usually invest

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the capital they collect into several different projects, and in this way diversify risks. Besides, commercial banks also allow depositors to withdraw their deposits at any time according to agreed conditions, and also protect the rights of a large number of small depositors through the deposit insurance system, which prevents incidents that affect the stability of society, such as bank runs, from happening. (4) They transmit monetary policies and support macro-control. The transmission procedure of the money market policies of the central bank is inseparable from commercial banks; be it credit (quantity) transmission channels or interest rates (price) transmission channels. The open-market operations, rediscount assessment and interest rates adjustments of the central bank of China must go through the commercial banks to exert their influence on the entire economy. As commercial banks are important transmitters of monetary policies, they can provide the government with an effective means of macro-controlling the economy. From the 1980s onwards, commercial banking in developed countries, such as in the U.S., underwent massive and far-reaching changes. Following the rapid economic globalization and advances in information technology and financial innovation, the financial markets of all nations became ever more closely intertwined, causing the external environment and internal management of commercial banks to undergo constant changes. In the 30 years between 1949 and 1978, China practiced planned management of a “unified” financial system. The banking industry was under the strict control of the government, and all their businesses had to be developed according to plans, and completing the plans became their major target. The People’s Bank of China functioned both as a national organization and a commercial bank, and all its decisions came from the government. During the ten years of the Cultural Revolution China’s financial system was greatly damaged under the leftist ideology, and banks basically were reduced to being a “great money wagon” and a “cashier” for the government. After 1979, China entered into a new period of reform and opening up. Following repeated deepening of the financial reform, it was established that the People’s Bank of China functioned only as a central bank and China’s commercial banking continued to make great strides. By the end of 2003, four major state-owned commercial banks, eleven joint-stock commercial banks, one hundred and twelve city commercial banks, and three rural commercial banks formed the commercial banking system, and the external environment and internal management of commercial banks were also greatly improved. But it is difficult for China’s commercial banks at their present state to meet the needs

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for developing and improving China’s socialist market economy system, and it is even more difficult for them to cope with the challenges and competition arising from global financial integration. The reform of commercial banks (especially the state-owned commercial banks) has therefore become the most important matter in the reform of China’s financial system. With the progress of the commercial banks in China, increasing concerns from relevant parties and scholars have been expressed on the reform and development of these banks. According to the author’s search, in the year 2004 alone 2,776 articles on commercial banking were published in domestic journals and magazines. The author has been studying the fictitious economy since 1999 and has dealt with issues regarding many aspects of commercial banking reform, and has already published his research findings in several monographs. This chapter looks back on the development path that commercial banking in China has taken and analyzes the present state of China’s commercial banks, and by using theories and methods of complexity science, fictitious economy, management science, and monetary banking, attempts to investigate several major issues on such aspects as the target model of China’s commercial bank reform and its implementation procedures so as to provide support for policies to actively and steadily advance China’s commercial bank reform.

The Development Path of China’s Commercial Banks Despite the fact that the beginning of banking can be traced to 2000 BC when monasteries in Babylon engaged in the business of money exchange, it is generally believed that modern banking appeared in Venice, Italy in 1580, and contemporary banks commenced in 1694 when the Bank of England was established. In China, bank-like “money houses” and “exchange shops” appeared at the end of the Ming Dynasty. After the Opium War, foreign banks came to China to start financial business and grabbed huge profits with their privileges. The first bank in China was the Oriental Banking Corporation established by the English in 1845. In 1897, the Commercial Bank of China became the first Chineserun bank to commence operations. In the 1930s during the regime of the Chinese Nationalist Party (also known as the Kuomintang or KMT), which ruled the Old China, the Party established the central bank, the Bank of China, the Bank of Communications, the Farmers Bank of China, the Central Trust of China, the Postal Remittances and Saving Bank, and the Central Cooperative Bank (known according to their Chinese names as

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the four banks, two bureaus, and one treasury) which formed the backbone of the banking system which also included banks in provinces, cities and counties and banks jointly run by the government and the private sector. Apart from this there were also national capitalists who established private banks and money houses, of which approximately a third were founded in Shanghai, but the majority was small in scale and strongly speculative, and their impact on the economy was extremely limited. Following successive victories in the Civil War, the People’s Bank of China was established at Shijiazhuang City on December 1, 1948, and it began to issue Renminbi. In February 1949, the People’s Bank of China was relocated to Beijing. Before and after the establishment of New China, on the basis of the “Common Programme” passed at the 1st Plenary Session of the Chinese People’s Political Consultative Congress held in Beijing in April 1948, the bureaucrat capital banks were taken over, gone into liquidation based on their situations, or restructured into specialized banks, The four banks jointly run by the government and merchants were reorganized into public-private jointly operated banks, while banks run by individuals were reorganized and overhauled. All privileges for foreign banks in China were removed and foreign currencies were prohibited from circulating within the country. After the founding of New China, China adopted the planned economy system and formed a “unified” banking system under the People’s Bank of China. Banks were not divided into specialized systems, and each bank became an integral part of the People’s Bank of China, making the latter a commercial bank that handled deposits, loans, and remittances as well as the central bank which was responsible for the state’s macro-control and regulation. During the Cultural Revolution and under the leftist ideology, bank could no longer be independent. In September 1969, the People’s Bank of China was even merged with the Ministry of Finance to be its second-tier unit, which basically relegated it to be the government’s “great money wagon” and “cashier.” Many political leaders did not understand the importance of the bank’s work, thinking that banks were but a “great money wagon” handling payment and expenditure. They would think of banks only when they needed money; and some even mixed up financial capital with credit capital, and resorted to administrative procedures to handle matters and did many things that violated the law of economy. In October 1976, with the end of the Cultural Revolution, the banking system in China began to resume and was rebuilt. In December 1978, the 3rd Plenary Session of the 11th National Congress of the Central Committee of the Communist Party of China was held, and it began to radically correct the mistakes of the

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Cultural Revolution and “leftist” leaning, and China entered a new period of reform and opening up. China’s banking industry, under the guidance of Deng

Xiaoping’s Theory, started to embark on the road of reform and opening up. Since 1977, the development of China’s commercial banks can be divided generally into the following stages:

The Stage of Rebuilding the System (1977–1986) Despite the fact that in March 1978, the head office of the People’s Bank of

China resumed its position as an independent unit at the ministry level while its dual functions and responsibilities as a commercial bank and the central bank remained unchanged. From early 1979 onwards, under the policy of reform and

opening up, the government successively designated the Agricultural Bank of

China to take charge of the rural financial business, the Bank of China, which was

split from the People’s Bank of China, to take charge of the foreign trade credit and foreign exchange business, the People’s Construction Bank of China, which

was split from the Ministry of Finance, to take charge of the long-term investment and loans, and then at the end of 1981 the China Investment Bank was established

to be responsible for receiving loans from international financial institutions and

on-lending of capital to domestic enterprises. On September 17, 1983, the State Council promulgated a document specifying that the People’s Bank of China was

to function as the central bank; concurrently it decided to establish the Industrial and Commercial Bank of China to take over commercial banking services, such

as credit loans and savings originally handled by the People’s Bank of China. By

then, the banking system in China was more or less formed, with the central bank as the leading bank and the four major state specialized banks as its backbone.

In October 1984, the 3rd Plenary Session of the 12th National Congress of

the Central Committee of the Communist Party of China issued the Central Committee of the Communist Part of China’s Decision on Economic System

Reform. In order to develop “a planned commodity economy,” China’s banking system expanded rapidly. In 1985, the People’s Bank of China launched measures

that allowed appropriate overlapping of business for specialized banks and “banks can choose enterprises and enterprises can choose banks,” encouraging the four specialized banks to be sufficiently competitive with each other. This put

an end to the “supply system” of the “centrally controlled system of the income

and expenditure” of bank capital, and the four specialized banks also started to branch out to the rural area, and provided loans for the rural and township enterprises that were flourishing at that time.

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The Stage of Expanding Development (1987–1996) The progress in reform and opening up provided the impetus for reform and development of the banking industry. In December 1986, Deng Xiaoping requested that “to take a bolder approach to financial reform, so that banks perform all the functions of banks.” In 1987, the People’s Bank of China proposed to establish a socialist financial system with the central bank as the leader, all other banks as the core parts, and the co-existence and collaboration of responsibilities of various financial institutions. Under the guidance of the spirit of the 13th National Congress of the Communist Party of China in 1987 and the 14th National People’s Congress in 1992, China’s banking industry continued to expand and grow amidst its reform. Although it was proposed during the early period of reform and opening up that state specialized banks needed to carry out enterprise reform and implement commercialized management, the fact that these specialized banks were engaged in both policy loan business and commercial loan business made it hard for them to become real commercial banks, and unfavorable to financial macro-control. In November 1993, after the 3rd Plenary Session of the 14th National Congress of the Central Committee of the Communist Party of China proposed “to establish policy banks and separate policy business and commercial business,” within the following year the government established the China Development Bank, the Export-Import Bank of China, and the Agricultural Development Bank of China to specially handle policy loan business, and in this way created favorable conditions to change state specialized banks to wholly state-owned commercial banks. On May 10, 1995, at the 13th Meeting of the Standing Committee of the 8th National Congress, the Law of the People’s Republic of China on Commercial Banks was passed, clearly setting out the nature and position of commercial banks and their relationship with other financial market players, and providing legal protection for commercial banks to make their own management decisions and improve the quality of their asset. At the end of 1996, China’s four major state-owned commercial banks had 153,069 branches and 1,686,800 staff. At the same time, to promote reform and opening up, other types of banks also developed rapidly. After the Bank of Communications was re-structured in July 1986 into a general joint-stock national bank, 12 joint-stock banks were established successively: the China CITIC Bank, China Merchants Bank, Shenzhen Development Bank, Yantai Housing Saving Bank, Bengbu City Housing Saving Bank, Fujian Industrial Bank, Guangdong Development Bank, China Everbright Bank, Huaxia Bank, Shanghai Pudong Development Bank,

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Hainan Development Bank, and Minsheng Bank. By the end of 1996, these thirteen joint-stock banks altogether had 3,748 branches and 85,500 staff. In January 1986, under the direction of the State Council, the Ministry of Posts and Telecommunications and the People’s Bank of China, in their respective capacities as investment owners and business regulators, jointly promulgated the Agreement on Launching Postal Savings , and decided to run postal saving business on an experimental basis in 12 cities including Beijing and Tianjin. The Postal Law of the People’s Republic of China adopted at the end of 1986 made postal saving one of the businesses of postal enterprises so that postal saving could be spread to the entire country, forming a “quasibank” system. In 1995, the People’s Bank of China began to set up pilot city cooperative banks in 16 cities on the basis of urban credit cooperatives. In February of the same year, Shenzhen City Commercial Bank, the first city commercial bank in China, was established, and by the end of 1996, there were 18 city cooperative banks in business.

The Stage of Deepening Reform (1997–2002) After nearly 20 years of reform and development, China had, by the end of 1996, formed a huge commercial banking system with the four major stateowned commercial banks as its backbone, and it played an important role in supporting China’s economic and social development. But due to the fact that it was difficult to abolish immediately the outdated ideas and historical burden left behind from the days of planned economy and, in addition, the systemic defects during the initial stages of the construction of a socialist market economy, the task of reform were onerous. The East Asian financial crisis that took place in mid-1997 sounded an alarm bell in China’s financial enterprises, with risk prevention issues of commercial banks becoming a concern. At that time the main problems of the four major state-owned commercial banks were: First, the financing of loan capital still carried a strong sense of planned economy. This is especially the case when “changing allocated funds into loans”” were practiced on state-owned enterprises, turning originally the subsidies from the Ministry of Finance to the state-owned enterprises into loans from banks to these enterprises, so that while the explicit financial subsidies of state-owned enterprises was on the decline, they received more and more implicit subsidies from state-owned banks in the form of loans. In 1985, of all the subsidies received by state-owned enterprises, those from financial channels accounted for only 24.2%, but by 1994, they accounted for 43.6%. As the ability of many state-owned enterprises in making profits was poor, their debts ratio

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was high, they relied heavily on banks for financing, and yet they found it difficult to repay the capital and interest on time, thus leaving a lot of nonperforming loans. Second, there was too much government interference in bank operations. Governments at all levels sometimes directly interfered in the operation and management of banks, and used administrative instructions to force banks to grant their loans to enterprises in difficulties, so that they could make arrangement for the staff they laid off, pay the outstanding taxes, or even make up their deficits. At the end of the year, some provincial or municipal governments even instructed banks to give loans to enterprises for tax payment to meet their fiscal target. Third, the bank management is size-oriented and cost-oriented in order to maximize their interest. On the one hand, the abnks were enthusiastic about expanding their size, but on the other hand, they were also keen on increasing the expenses and expenditure of the bank, especially for high-end office buildings and training centers, leading to a decline in profits. It was reported that for the period 1989–1998, the balance of credit assets of the four major stateowned commercial banks increased 11-fold, but the total amount of their profits increased only by 26% while their management fees increased by 8.9 times. Fourth, the internal management of banks was weak and there was a lack of effective risk prevention measures. In the banking business, borrowing new loans to repay the old ones, granting loans to receive interests, extending the lending period at random, and signing and issuing of acceptance drafts in a rolling manner were commonplace. In their non-credit assets, there were problems such as what was on the book did not tally with what was actual, deliberately using past subjects at random or on a pretext. In their off-balance sheet business, there existed such phenomena as violating the regulations in handling the signing and issuance of drafts and giving rights and credit beyond the limits. Due to such factors as weaknesses in internal management of banks, the ineffectiveness in auditing, and failure to trace the mistakes of those responsible, the risks of bank assets were greatly increased. It was true that from 1998 onwards, the Chinese Government continually pushed ahead with reforming commercial banks and strengthening their supervision. But before 2002, the reform of China’s commercial banks was mainly at the superficial level, such as changing in their operating mechanism, improving in their administrative system, altering in their business scope, and adjusting to their business networks, and the government’s supervision over state-owned commercial banks was also relatively weak.

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A Critical Stage of Reform (2003 to the Present) After 15 years of negotiations, China entered the WTO in 2002. It was then committed to lifting all regional restrictions within five years. It will gradually abolish restrictions on Renminbi services to target, allow foreign banks to provide services to all clients in China and establish branches within the same city and the conditions for approval will be the same as those of Chinese banks. It will remove all existing measures that restrict the ownership, operation and establishment of foreign banks, the setting up of their branches, and issuance of permits. It will allow the setting up of non-foreign financial institutions that provide credit business to car consumption, and they will enjoy the same treatment given to similar Chinese financial institutions. Foreign banks can also provide vehicle loan services to Chinese residents. With the opening up of financial industry and under the threat of the entry of foreign capital, the development of China’s commercial banks (especially the state-owned commercial banks) faced serious challenges in the following aspects: (1) Weak competitiveness. Due to factors such as a heavy historical burden, defects of the system, poor internal management, and insufficient financial innovation, the competitiveness of China’s state-owned commercial banks was fairly weak. Based on the author’s research on Hong Kong’s Hang Seng Bank in 2001, its expenditure amounted to 24.4% of its income while that of the stateowned banks usually reached around 90%. The Hang Seng Bank’s profit per capita before tax was HKD1.57 million, over ten times higher than that of stateowned banks. The rate difference for one-year savings and loans of the Hang Seng Bank was then 1.7% was between 2.2%, and while for China’s state-owned banks the rate difference was 3.6%. (2) High rates of non-performing assets. According to the statement of “overdue debts, idle debts, and bad debts,” at the end of 2002, the balance of non-performing loans of financial institutions of the banking industry was RMB2.60 trillion, excluding the one-time transfer of RMB1.4 trillion of nonperforming loans to the four asset management companies in 1999–2000. At the end of 2003, the balance of non-performing loans of financial institutions of the banking industry was RMB2.44 trillion, and the non-performing loan rate was 15.19%. According to the five-tier approach, the average non-performing loan rate of the four major state-owned commercial banks was 19.74%, and the nonperforming loan rate of the world’s top one hundred banks was only around 5%. Based on the five-tier approach, the balance of non-performing loans of the major commercial banks by the end of the first quarter of 2005 was RMB1.83 trillion, accounting for 12.4% of the balance of total loans. (See Table 7.1)

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Table 7.1.

Non-performing loans of major commercial banks at the end of the first quarter of 2005

Amount (RMB100 million) Total balances of nonperforming loans

Proportion of loan balance (%)

1827.45

12.40

Balance of substandard loans

341.01

2.30

Balance of doubtful loans

935.30

6.30

Balance of loss loans

551.14

3.70

Amount (RMB100 million) Major commercial banks

Proportion of its own loan balance (%)

1712.84

12.70

State-owned commercial banks

1567.05

15.00

Joint-stock commercial banks

145.79

4.90

City commercial banks

107.38

11.50

Rural commercial banks

3.62

6.10

Foreign-funded banks

3.60

1.20

From Table 7.1 we can see that the ratio of the balance of non-performing loans of state-owned commercial banks was as high as 86% of the total balance of non-performing loans, and its ratio against their own balance of loans was as high as 15%. (3) Low capital adequacy ratio. In the early 1980s, the state as the owner of state-owned banks stopped injecting capital into them. It was not until after the occurrence of the East Asia financial crisis that the government approved in August 1998 to issue special bonds of RMB270 billion to allow the four major state-owned commercial banks to replenish their capital, but it did not establish a regular channel for capital replenishment. For a long period, the capital adequacy ratio of the four major state-owned banks did not reach the 8% regulatory requirement. At the same time, there was a large gap in the withdrawal of reserve for bad debts. In 2003, the state allowed commercial banks to issue secondary bonds to change the Bank of China and

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the China Construction Bank into the joint-stock system through Central Huijin Investment Ltd., which used foreign currency reserves to inject USD45 billion to replenish the capital of these two banks. It was reported that the overall capital adequacy ratio of China’s 113 city commercial banks at the end of 2004 was only 1.36%. To overcome the above serious challenges, the Chinese government decided to further strengthen its supervision of commercial banks and pushed ahead with their reform. Beginning from 2003, the reform of China’s commercial banks continued to go into a deeper level, entering into the key stage. The focus of reform had shifted to institutional changes (including both their system and mechanism), heading towards the direction of building modern financial enterprises. Pursuant to the Decision on the Plan for Restructuring the State Council adopted at the 1st Plenary Session of the 10th National People’s Congress on March 10, 2003, the China Banking Regulatory Commission (hereafter as Banking Commission) was officially established on April 28, 2003, with duties of monitoring banking regulation and management originally exercised by the People’s Bank of China. The 3rd Plenary Session of the 16th National Congress of the Central Committee of the Communist Party of China held in October 2003 emphasized the need to “deepen the reform of financial enterprises, improve the financial control mechanism and financial regulatory system”. The 6th Meeting of the Standing Committee of the 10th National People’s Congress of the People’s Republic of China adopted on December 27, 2003 The Law of the People’s Republic of China on the Regulation of and Supervision over the Banking Industry , Decision of the Standing Committee of the National People’s Congress of the People’s Republic of China Relating to the Amendment to the “Law of the People’s Republic of China on the People’s Bank of China,” and Decision of the Standing Committee of the National People’s Congress of the People’s Republic of China Relating to the Amendment to the “Law of the People’s Republic of China on Commercial Banks,” which clearly stipulated the functions of the Banking Commission was to follow the law to monitor and supervise the banking industry. These decisions also redefined the functions of the People’s Bank of China and strengthened its functions relating to the formulation and implementation of monetary policies. At present, the reform of China’s commercial banks is on full speed. Of the four major state-owned commercial banks, three—the Bank of China, the China Construction Bank, and the Industrial and Commercial Bank of China—are in the midst of changing over to the joint-stock system and preparing for overall listing. Some joint-stock banks and city commercial banks also actively bring

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in strategic investors to improve their governance and internal control, and the Banking Commission also gradually steps up its regulation and supervision of commercial banks. But we should also clearly see that the task of reforming China’s commercial banks remains formidable; it requires clear goals, careful planning, differential treatment as well as steady progress.

Changing Commercial Banks into Modern Financial Enterprise According to the Decision of the Central Committee of the Communist Party of China on Some Issues Concerning the Improvement of the Socialist Market Economy (hereafter as the Decision ) adopted at the 3rd Plenary Session of the 16th National Congress of the Central Committee of the Chinese Communist Party held on October 14, 2003, it was necessary to further deepen the reform of financial enterprises. Commercial banks, securities firms, insurance companies, and trust and investment companies shall become modern financial institutions with adequate capital, effective internal control placement, secured operation, and satisfactory profitability and service quality. Of the 1,000 largest banks in the world announced by the English magazine The Banker in 2002, apart from the four major state-owned commercial banks in China, the rest were all joint-stock commercial banks, and the majority was listed banks. The main characteristic of joint-stock commercial banks is that shareholders bear the responsibility of the bank with the shares they hold, while banks bear the responsibility of their debts with all their assets. Shareholders as capital contributors to a bank enjoy their rights as its owners based on the proportion of their contribution to the capital of the bank and take part in its major decisions of the bank, while the banks as a legal person enjoys all equity rights formed by the investment of shareholders, civil rights and bear civil responsibilities according to law. The Decision of the 3rd Plenary Session of the 16th People’s Central Committee of the Chinese Communist Party pointed out that there was a need to “choose and transform some qualified state-owned commercial banks into the joint-stock system, speed up handling non-performing assets and replenish their capital, to meet the requirement for listing.” The reform of the joint-stock system of China’s state-owned commercial banks is the foundation of bank reforms in other areas, and also an important link in the reform of China’s financial system. According to relevant regulations, in changing over to a company, a state-owned shall change its system of operation gradually and systematically, make an inventory of assets and verify its capital, determine

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property rights, clear creditors’ right and indebtedness, value assets, and set up a standardized internal management structure in accordance with the law, and conditions and requirements of administrative regulations At the end of 2003, the joint-stock system transformation of the two stateowned commercial banks, the Bank of China and the China Construction Bank, formally commenced, the main contents of which were: to follow the requirements of modern commercial banks to set a standard corporate governance structure and a strict internal responsibility and rights form good financial binding and internal risk-prevention mechanism, restructure the assets, speed up the handling of non-performing assets, replenish the capital, and establish a good financial basis with strict financial standards. It should be acknowledged that the joint-stock system transformation of state-owned commercial banks is a formidable and complicated task. Because of this, we suggest making careful planning steadily moving ahead in the following areas:

Establishing Property Rights First, an improvement in joint-stock system transformation is the establishment of property rights, especially their structure. Property rights include corporate rights and their related rights. Corporate rights are the rights of economic benefits that a corporation as a legal person enjoys, which mainly include the rights and quasi-rights of things, creditor ’s rights and intellectual property rights. A legal person of a corporation enjoys the right of ownership, the right to use, the right to transfer and the right of disposal of their assets. Property rights structure refers primarily to the distribution of property rights and related distribution of these rights. Generally speaking, the properties of a company’s legal person are commonly owned by many holders according to their different shares, and the related rights should also be distributed according to the size of the shares. All the property of China’s state-owned commercial banks, like all stateowned enterprises, is owned by the state, so it has the problem of the “absence of owners.” This means theoretically the state is the owner of state-owned commercial banks, but in reality, it is very difficult for the owner to exercise his related rights in state-owned commercial banks. Many operators of state-owned enterprises tend to consider themselves the as representatives of the owners, evading supervision and abusing their powers, resulting in “insider control.” On the other hand, local government officials and operators of state-owned enterprises held the view that as the property rights of state-owned enterprises and state-owned commercial banks belong to the state, the debts that

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enterprises owe to the bank are only an issue “within the family.” This leads to a serious drawback of “the government bears infinite responsibility and the banks are controlled by insiders.” Factors such as capital, non-performing assets, governance system, internal risk controls also affect the healthy development of commercial banks. The key to reforming the property of state-owned commercial banks is to change the banks into share companies or limited liability companies so that state-owned capital enters banks in the form of equity interest. Then, as a capital contributor, the state or its delegate organization, send its representatives to attend the shareholders’ meetings, and be elected to the board of directors in these meetings, and in this way realize the separation of ownership and the right of management. Even though in the situation of some countries, such as the U.S., the government directly holds the shares of commercial banks. In China’s case, it is more suitable to have shares held by government-backed investment companies or foundations. This is why with the approval of the State Council on December 16, 2003, the Central Huijin Investment Ltd. (hereafter as Huijin Company) was established, as a wholly state-owned company, and with the Ministry of Finance, the People’s Bank of China, and the State Administration of Foreign Exchange as its corporate shareholders. This company was responsible for injecting capital into the Bank of China and China Construction Bank, the pilot bank for transforming into in implementing the joint-stock system. And as a capital contributor, for supervising banks to put into practice the various reform measures, improving the corporate governance structure, and make efforts to obtain competitive investment returns and bonuses from their equity assets. The establishment of the Huijin Company marks the beginning of the Chinese government to adopt the form of an investment company to set up the model of a state-owned capital contributor. But there are many aspects in its system and mechanism that still need to be further improved. Huijin Company at present has positioned itself as a representative of the state to exercise the rights and obligations of a capital contributor on large stateowned financial enterprises, maintain financial stability, prevent and resolve financial risks, effectively utilize foreign exchange reserves, and take on the responsibilities of maintaining the value of foreign exchange reserves. The investment records of this company from its inception to September 2005 are as follows: In December 2003, a capital of USD22.5 billion was injected into the Bank of China; In December 2003, a capital of USD 20 billion was injected into the China Construction Bank;

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In December 2003, a capital of USD 2.5 billion was injected into the China Jianyin Investment Securities Company Ltd.; In June 2004, a capital of RMB3 billion was injected into the Bank of Communications; In April 2005, a capital of RMB15 billion was injected into the Industrial and Commercial Bank of China; In June 2005, a capital of RMB10 billion was injected into China Galaxy Securities; In July 2005, a capital of USD5 billion was injected into the Export-Import Bank of China; In August 2005, a capital of RMB2.5 billion was injected into the Shenying and Wanguo Securities and a provision of RMB 1.5 billion loan; August 2005, a capital of RMB1 billion was injected into the Guotai Junan International and a provision of RMB1.5 billion loan; In August 2005, a capital RMB5.5 billion was injected into the China Galaxy International Financial Holdings Limited; In September 2005, a capital of RMB10 billion was injected into the China Everbright Bank. It can therefore be seen that the business scope of the Huijin Company had expanded from the injection capital into the two state-owned commercial banks of the Industrial and Commercial Bank of China and the China Construction Bank as authorized by the government to the injection of capital into other commercial banks and securities companies. Some academics, apart from raising doubts on the legal status of the Huijin Company and the legitimacy of injecting capital into commercial banks with the foreign exchange reserves of the state, also hold different views on the position of the Huijin Company. Some consider the macro target of maintaining financial stability and the micro target of making profits on investment cannot be achieved at the same time. Some believe that the Huijin Company should be seen as a purely governmentbacked holding company, whose responsibilities are to hold shares, appoint shareholders, but does not engage in business operation, somewhat similar to the Temasek Holdings in Singapore.1 Some even clearly point out that the Huijin Company should be a non-profit-making organization. If the Huijin Company overemphasized its macroscopic function of maintaining financial stability like the State-owned Assets Supervision and Administration Commission (State Assets Commission), it would become a State Assets Committee of Finance, its legal status is questionable, because the establishment of the State Assets Committee was passed at the 1st Plenary Session of the 10th National People’s Congress. Senior management of the

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Huijin Company, which is a limited liability company, all have the status of civil servants. Their status violates the current the regulation in the Company Law which states that “civil servants of the state are not allowed to serve concurrently as directors, supervisors or managers of a company.” As to the argument that Huijin Company is a non-profit-making organization, this conflicts with the stipulation in the Company Law that “companies follow the law to independently manage all their legal person properties, and are solely responsible for their profits and losses.” In short, if we overemphasize the macroscopic functions of the Huijin Company, and regard it as a State Assets Committee of Finance, and it becomes a “financial fire brigade,” this will contradict the direction that China’s financial system reform. The author proposes that the Huijin Company should comply with the regulations in the Company Law , be run as a wholly state-owned holding company whose main line of business is to invest in financial enterprises. It has the legal person property rights of all its assets, performs the functions and duties as a capital contributor to the financial enterprise they invest, and takes the share returns rate and property returns rate as major indicators to assess its performance. This can actually support the macroscopic function of the People’s Bank of China to maintain financial stability at a microscopic level.

Bringing in Strategic Investors It was pointed out in the Decision made at the 4th Plenary Session of the 15th National Congress of the Central Committee of the Communist Party of China that “it is necessary to develop companies featuring multiple investing entities, except for a small number of enterprises that should be monopolized by the State.” Equity diversification not only helps realize the policy of a common economic development with public ownership in a dominant position together with and diverse forms of ownership but can also allow the state, in its capacity as capital contributor, to directly resolve enterprises’ overreliance on the government and the government having infinite responsibility for enterprises. Equity diversification not only avoids the various problems caused by “the exclusion of dominance of a single shareholder,” especially regarding the issue of “insider control” of state-owned commercial banks, but also helps to improve corporate governance and internal control of state-owned commercial banks. Therefore the change of state-owned commercial banks to the joint-stock system is not simply about renaming xx bank into xxx limited company or a stock company limited, but also the actual realization of equity diversification. In recent years, some commercial banks have been actively seeking investors

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outside China, so as to raise their reputation, increase their capital and improve their management. Financial institutions outside China have also taken a fancy for the opportunities brought about by the rapid development of China’s economy, the enormous potential of the Chinese financial markets, and the close relation between China’s banking industry and the government, they therefore actively seek to purchase the equity of commercial banks in China. The earliest example of bringing in strategic investors in China’s commercial banks occurred in 1997 when the Asian Development Bank purchased the equity of the China Everbright Bank. In September 1998, the International Finance Corporation obtained 5% of the equity interest in the Bank of Shanghai. In 2001, the Hongkong and Shanghai Banking Corporation Limited and Shanghai Commercial Bank (HK) bought shares of the Bank of Shanghai, totaling 18% of its shares. In October 2001, the International Finance Corporation bought shares in Nanjing City Commercial Bank, amounting to 15% of its equity interest. In January 2003, the Citibank bought 15% of the equity interest of the Shanghai Pudong Development Bank. On December 17, 2003, the Industrial Bank formally signed an equity investment agreement in Fuzhou with the Hang Seng Bank of Hong Kong, the International Finance Corporation, and the Government of Singapore Investment Corporation Pte Ltd., pursuant to which the Hang Seng Bank bought 15.98% of the equity interest in the Industrial Bank. By the end of 2004, there were ten overseas financial institutions investing in the equity of Chinese-funded banks, with a total amount of investment amount of USD2.66 billion, and an actual amount of investment of USD2.41 billion, and together with the working capital of foreign banks, the total amount of foreign capital actually deployable by financial institutions in the banking industry in China was USD3.79 billion. Since 2005, the pace of China’s commercial banks in attracting strategic investors clearly accelerated. By the end of September 2005, seven joint-stock commercial banks and seven city commercial banks in China have brought in foreign investors. Following the China Everbright Bank, the Shanghai Pudong Development Bank and the Industrial Bank, Newbridge Capital also held 17.89%of shares of the Shenzhen Development Bank, obtaining the actual control rights of the bank, while General Electric (GE) would invest around USD100 million to obtain 7% of the bank’s shares. The Hongkong and Shanghai Banking Corporation also held 19.9% of the shares in the Bank of Communications, the first overseas-listed domestic bank. The China Minsheng Bank sold 1.1% of its shares to the International Finance Company, 4.6% of its shares to Temasek Holdings, and the bank was in the midst of bringing in strategic investors such as Newbridge Capital from the U.S. In the first half

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of September, Singapore’s Pangaea Capital Management bought 6.9% of the shares in Huaxia Bank (289 million legal shares) held by the Sandong Lianda Group by auction with the price of RMB3.5 per share, coming up to a total amount of RMB1.01 billion. It was reported that Deutsche Bank took the lead and signed a preliminary agreement with Huaxia Bank to target 14% of the shares in Huaxia Bank in the capacity of a strategic investor, and the evaluated amount was around USD330 million. The Citibank recently expressed its intention to increase its share ratio in the Shanghai Pudong Development Bank to 19.9%. On September 6, Standard Chartered, through its wholly owned subsidiary Standard Chartered Bank (Hong Kong) Limited, became the sole foreign strategic investor in the China Bohai Bank which was yet operative, holding 19.99% of the shares of the bank, with an investment of around USD123 million. Following the Bank of Shanghai and the Nanjing City Commercial Bank, city commercial banks such as the Bank of Xi’an, the Bank of Beijing, Hangzhou City Commercial Bank, and Jinan Commercial Bank completed their restructuring and successfully brought in overseas investors. Among them, the Bank of Xi’an sold 5% of its shares to the International Finance Corporation and Canadian bank Scotiabank (2.5% each) at the price of RMB53,760 per share. The Bank of Beijing sold 19.9% of its shares to the Internationale Nederlanden Groep N.V. of the Netherlands at RMB1.78 billion, and the International Finance Corporation also bought 5% of the equity of the bank. The Hangzhou City Commercial Bank sold 19.9% of its shares to the Commonwealth Bank of Australia. The Jinan Commercial Bank sold 11% of its shares to the Commonwealth Bank of Australia at a price of USD75 million. The Nanchong City Commercial Bank in Sichuan signed a strategic cooperation agreement with the Deutsche Entwicklungs Gesellschaft (DEG), the Sparkassen International Development Trust (SIDT), and the Sparkassenstiftung fuer internationale Kooperation (SBFIC). DEG and SIDT offered to buy EUR3 million and EUR1 million of shares in Nanchong City Commercial Bank respectively, accounting for 10% and 3.3% respectively of the total amount of shares after the increase in capital and enlargement of shares, and SBFIC would provide technological support. The three major state-owned banks have also been speeding up to bring in strategic investors. On June 17, 2005, the Bank of America paid USD2.5 billion to buy shares of the China Construction Bank, and pledged to buy USD500 million more shares when the bank made an initial public offering (IPO) so that its shareholding reached 9%, and then gradually reached 19.9%. Asia Financial Holding Pte. Ltd, a wholly owned subsidiary of Temasek Holdings, spent

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acquired 5.1% of the bank’s equity interest for USD1.47 billion. Temasek agreed to acquire no less than USD1 billion of shares therein when it makes an initial public offering. It was also learned that Credit Suisse First Boston would offer to purchase shares in the China Construction Bank when it made its initial public offering. Temasek Holdings spent used USD3.1 billion to buy 10% of the shares in the Bank of China. Not only that, it also pledged to purchase USD500 million shares of the bank when it made its initial public offering. The Royal Bank of Scotland paid USD3.1 billion to buy 10% of the shares of the Bank of China. The Royal Bank of Scotland, as the initiator, provided a capital of USD1.6 billion, and it also joined Merrill Lynch and the Private Funds of Li Ka Shing to form a consortium to jointly hold 10% of the shares in the Bank of China, with the latter providing a capital of USD750 million each. The bank’s negotiations with the United Bank of Switzerland and the Asian Development Bank are still in progress. They would provide a capital of USD500 million and USD100 million respectively to get 1.6% and 0.3% of the bank’s equity. Goldman Sachs, Allianz, and American Express have agreed to provide a capital of around USD3 billion to buy 10% of the shares in the Industrial and Commercial Bank of China, the largest bank in China. According to the transaction arrangements, Goldman Sachs and its related investors could provide a capital of USD1.8 billion, the German insurance company Allianz, USD1 billion, and American Express, USD200–300 million. The goal of this transaction was eventually to list the Industrial and Commercial Bank of China overseas in 2007. Although the plan of the Bank of China and the Industrial and Commercial Bank of China of bringing in strategic investors were yet to be approved, and some adjustments may be necessary, a decision on the plan would soon be made, and it is estimated that there would be a speeding up of the pace of changing the Agricultural Bank of China into its joint-stock system and bringing in strategic investors. At the end of September 2005, a total of 19 overseas financial institutions became shareholders of 16 Chinese-funded banks, with a total amount of investment close to USD16.5 billion. This sum did not include the China Bohai Bank, a joint stock commercial bank soon to be in business, and the Fushan City Commercial Bank, which was acquired by the Industrial Bank, wait a 24.98% ownership by foreign capital, and a capital of RMB500 million. When bringing in strategic investors, we need to consider four important issues: first, the share price of Chinese banks; second, the meaning and connotation of the concept of strategic investor, or in short, its definition and scope; third, whether there can be a further relaxing of the limit on the proportion of shares that can be purchased by foreign capital can be relaxed; fourth, whether bringing in strategic investors outside China would affect China’s financial security.

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Whether or not Chinese banks are being “sold cheaply” Recently some raised the point that when state-owned commercial banks brought in strategic investors, the price of their shares was set excessively low, claiming that Chinese banks were being “sold cheaply.” The ground of their argument is that the three major state-owned commercial banks were selling 10% of their shares at the price of around USD3 billion, which, when judging from their resources, such as bank profits, networks, brand-name and creditability, this set price was really too low. Take the Industrial and Commercial Bank of China as an example. It has over 220,000 domestic branches, and is controlling about 20% of the assets of banking industry in China. In 2004, the Industrial and Commercial Bank of China achieved a profit of RMB74.7 billion. To spend USD3 billion on a 10% equity of in the Industrial and Commercial Bank of China means that foreign investors almost did not pay any premium to enable them to get this 10% equity and could also obtain 100% investment return rate within four years, and this has not taken into account the premium when the Industrial and Commercial Bank of China was listed in the future. The author is of the view that the above argument seems biased. First, the choice of strategic investors and the setting of share prices are actually determined by mutual negotiation between the selling and buying parties. There are many risks due to the heavy historical burden of state-owned commercial banks, the large number of staff, their irrational structure, and excessive government intervention, as well as frequent internal scandals, and stringent limits on the proportion of shares that can be owned by foreign capital, the differences been Chinese foreign countries in taxation systems, accounting standards, and labor system. Therefore, of the many foreign banks, few were willing to take the risk of purchasing shares of Chinese commercial banks, and investors “did” not “swarm in” as exaggerated by some. Moreover, foreign parties during negotiations usually ask for a “systematic discount” due to the aforementioned factors, causing difficulties for the Chinese side to propose a higher asking price. This is especially so since state-owned commercial banks do not have adequate provisions for the drawing of non-performing assets, resulting in the over-estimation of shareholders’ equity and profitability. For example, when the International Financial Company bought shares in the Bank of Shanghai in 1999, the Bank of Shanghai followed Chinese accounting principles and worked out that the net asset per share was RMB2.1–2.2. But the foreign side followed the auditing results of PricewaterhouseCoopers (about USD2 billion bad debt provision could be drawn from the USD3.5 billion shareholder equities) as its basis of calculation and worked out the net asset per share to be only RMB1.07,

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a one-fold difference (the final compromised price was set at RMB1.41). Even when both parties have settled on a price, some foreign businessmen are still worried about hidden risks and require the Chinese side to provide “risk guarantees.” For example, the Huijin Company promised the Bank of China and the China Construction Bank that the net asset per share from now on will not be lower than the purchasing price of the foreign party, and if they fail to make their initial public offering in three years, the Huijin Company will buy back the equity interest from the foreign party. Next, we should acknowledge that the competitiveness of China’s stateowned commercial banks is extremely poor and their credibility relies primarily on the support of the state’s reputation. As state-owned commercial banks run their monopolized operation with the support of the state, many issues remain hidden. For example, deposit and loan interest rates are decided by the state, foreign exchanges that enterprises gain have to be converted into Renminbi and deposited in the bank. Leading and cadres can be appointed or removed by the government. Capital is injected into banks by the state, and non-performing assets are handled in its own way. If we compare Chinese state-owned commercial banks with foreign banks by the same international standards, then the indicators of the profitability of China’s state-owned commercial banks (profits / costs before tax), tier 1 capital return rates (profits / tier 1 capital before tax), and profit per capita, etc. are lower. With regard to service quality, property quality, corporate governance, and financial innovation, China’s state-owned commercial banks are far inferior to those of foreign banks. Despite the fact that state-owned commercial banks have many branches, they still cannot offset their disadvantages in efficiency and service quality. One example is that after the opening of foreign exchange business, a large amount of foreign exchange deposits in Chinese financial institutions in Shanghai went to foreign banks. Therefore, the sale of equity by state-owned commercial banks as a price to gain advanced management experience and technological skills from foreign banks should be a win-win transaction. Lastly, we should see that at present the purchase of shares of China’s commercial banks by foreign parties has a lot to do with their forecast of the banks’ future value, and as there are many uncertain factors, there will be great differences in the valuation of the same bank. JP Morgan, for example, estimated that a reasonable assessment of the total market value of the China Construction Bank would be between RMB403 million and RMB475 million, but Goldman Sachs put it between RMB281.7 million and RMB368 million. After negotiations and according to the present agreements, the net asset

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premium rates of the three major state-owned commercial banks are between 10% and 17%, and their selling prices are still slightly higher their net assets, the proportion of shares owned by foreign capital is lower than 25%. The experience gained from the listing of the Bank of Communications and the China Construction Bank in Hong Kong shows that the addition of foreign strategic investors raised the reputation of China’s banks, which allowed them to have a high premium when they make initial public offerings. And as our side has the majority of shares, a large part of their profits belongs to us. From this it can be seen state-owned banks have not been “cheaply sold.” Naturally, if we bring in strategic investors after making more progress in the reform of state-owned banks, we definitely could sell our banks at a better price. But due to the fact that by the end of 2006, any qualified foreign capital will be able to enter our banking industry, we cannot wait any longer to bring in strategic investors to raise the competitiveness of China’s commercial banks.

Definition and scope of strategic investors According to traditional definitions, strategic investors refer to investors who hold shares for the long term and can help investment targets in aspects such as high and low-end products, markets, management or social connections. The China Banking Regulatory Commission proposed four guiding criteria for strategic investors in state-owned banks, namely longterm shareholding, optimization of governance, business cooperation, and avoidance of competition. Practice shows that these four criteria have basically been followed, and some strategic investors also agreed to have technological cooperation or provide technological support. The Bank of America, for example, not only promised to send 50 experts to China to help setting up banks, but also agreed not to open new branches and wind up their existing retail bank business. Another example is that the Bank of China and the Royal Bank of Scotland will have an extensive cooperation in areas such as credit card and company business and build up a close relationship to cooperate in the areas of the infrastructure of bank operation, such as corporate governance and risk management. The scope of strategic investors has gradually extended from financial institutions to investment companies, funds and enterprises. Currently, the strategic investors brought in by state-owned commercial banks are mostly overseas investors. From now on, we should bring in domestic investment companies and enterprises, and allow commercial banks to buy shares from each other, so as to better realize the diversification of equity interest.

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Whether we can further relax the limits on the proportion of equity acquisition of foreign investors On December 8, 2003, the China Banking Regulatory Commission issued the Administration of Equity Investment of Overseas Financial Institutions in Chinese-funded Financial Institutions Procedures , regulating the conditions and procedures for equity investment of overseas financial institutions, and raised the proportion of equity investment of a single overseas financial institution from 15% to 20%, but the total number of shares of foreign capital should not exceed 25%. This resolution was to be implemented on December 31, 2003. As currently almost all commercial banks with foreign equity participation have already reached or are about to reach the upper ceiling of this stipulation, some therefore have raised the question as to whether the proportion of equity acquisition by foreign capital can be further relaxed. Generally speaking, the advantages of relaxing the limits of the proportion of equity acquisition by foreign capital outweigh its disadvantages. It can bring in more foreign capital, raise the capital of the bank, help the foreign side to better play its role in improving legal person governance and internal management of the bank. Moreover, the announcement of the policy on relaxing the limits on the proportion of foreign capital also helps encourage the entry of foreign capital and strengthens their confidence regarding equity acquisition. We can consider relaxing the proportion of foreign capital equity acquisition initially to 33%, then finally to 49%. This of course does not mean that all banks will let foreign capital have 49% of their shares, and in order to maintain the controlling power of the state, the shares of foreign capital in the four major state-owned commercial banks should not exceed 33%.

Whether bringing in overseas strategic investors affects China’s financial security During the two decades when China practiced its policy of opening up to the world, from time to time people raised the question of whether bringing in foreign capital might affect national security, while others were worried that the introduction of overseas strategic investors may affect the state’s financial security. It is therefore necessary to do a serious analysis on this issue. National financial security is a macro concept that concentrates on a comprehensive prevention of risk in areas such as government bonds, exchange rates, savings, and financial markets. As the fictitious economy has its parasitism and metastability, a healthy development of the real economy is a prerequisite to prevent its financial risk, and an enhancement of the microscopic

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foundation of a financial system is an important guarantee of macro stability. It should be noted that under the traditional system, state-owned commercial banks accumulated a large number of non-performing loans, moral hazards, and low efficiency rates, and these are the greatest threats to China’s financial security. The author is of the view that the aim of China’s commercial banks’ to bring in strategic investors is for their capital, but more importantly, for relying on outside forces to improve their system and raise their standard. Despite the fact that the ultimate goal of the foreign capital entering China is to gain profits and some of the ideas and methods of foreign investors are at variance with those of the Chinese counterparts, yet at least they share the same goals of improving the management of the banks. The entry of foreign capital is also helpful for us to rectify the “government–banks–enterprises” relationship that was formed under China’s planned economic system which is at odds with the market economy, and run banks as real banks so as to strengthen the micro foundation of China’s financial system. It was reported that before the Shanghai Bank brought in foreign capital in 1999, its annual bonuses had reached 20% of its profits. But when foreign capital shareholders entered the Board of Directors, they immediately proposed that balancing the short-term and long-term benefits of shareholders to realize the organic combination of the “maximization of shareholders’ returns” and the “long-term development of the bank.” As a result, the annual bonuses fell gradually from 20% to 10% to enhance the bank’s ability of self-accumulation and self-development. After a run-in period of more than five years, good progress had been made. By the end of 2004, the total assets of the bank reached RMB220 billion, the rate of return on common stockholders’ equity was 18.42%, the capital adequacy ratio was 10.4%, the non-performing loan ratio was 4.99%, and the realized profit before tax was RMB1.82 billion. Foreign capital equity acquisition also strengthened business cooperation between Chinese banks and foreign banks, one example being the Shenka International credit card, which the Hongkong and Shanghai Bank helped the Bank of Shanghai to promote and it also provided overseas clients through special arrangements. Another report stated that within a year after the Jinan City Commercial Bank brought in the Commonwealth Bank of Australia, its capital adequacy ratio went up to 8.88%. At the same time the bank made drastic reforms on six areas: information technology, credit management, risk management, market sales, financial management and capital management as well as improving its double credit rating system of its credit business, thus strengthening its ability to control credit risks.

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According to relevant WTO agreements, China will gradually remove the restrictions on the management of foreign banks in China. The competition between foreign and Chinese banks will further intensify. It is predicted that within ten to fifteen years, the share of foreign capital in China’s financial market is likely to reach 30%. This being the situation, it is not appropriate for China’s highly uncompetitive commercial banks, to compete with foreign banks. They should cooperate and also compete with foreign banks so as to become better, stronger and bigger as quickly as possible, finally achieving the target of taking a greater portion of the market in a stable manner. When it comes to the matter of principle, certainly our side should argue strongly with good reasons but should not easily give in. An example is that when Citibank purchased the equity of the Shanghai Pudong Development Bank, the foreign side insisted on using American laws while the Chinese side insisted on using Chinese laws, and finally it was decided to use the Chinese laws according to the place of registration, but when there was any dispute, they would use laws of the third party—the laws of Singapore. After bringing in foreign strategic investors, the senior management of commercial banks should follow the relevant laws and regulations of the state, paying attention to protecting state secrets.

Stepping up the Handling of Non-Performing Assets As mentioned before, the non-performing asset rate of China’s state-owned commercial banks is comparatively high. There are basically four reasons for this. First, according to government directives, banks had to provide policy loans, and under a planned economy system, banks for a long period had to shoulder the task of being the government’s “cashier” to give loans according to government directives and plans, and they basically had no independence. With the establishment of the three policy banks in 1994 and after the promulgation and implementation of the Commercial Banking Law in 1995, the situation changed for the better, but government officials still were not willing to relax control over the banks’ credit funds and forced them to use these funds on designated industries and enterprises, resulting in situations such as making loans for “political achievement engineering,” “footing bills” for losses due to corruption and policy mistakes, “transfusing blood” to state-owned enterprises on the verge of collapse, and “advancing money” to enterprises which had difficulty in paying taxes. Second, as some badly managed state enterprises get fewer subsidies from fiscal channels they turn to the government for support and receive their capital from bank loans and the losses caused by the blind

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expansion and poor operation of these enterprises become the non-performing assets of the bank. Third, the moral hazard of workers within state-owned commercial banks creates losses. Fourth, there are losses caused by policy mistakes and poor administration and management. Commencing in 2002, the way China’s commercial banks used to calculate non-performing assets had gradually shifted from being a four-tier category that had been used for a long period to a five-tier category which is one generally adopted internationally, and the results of calculations of these two categories differed greatly. By the end of 2002, for example, the total amount of nonperforming assets of the four major state-owned commercial banks, according to the four-tier category, was RMB1.70 trillion, and the non-performing loan rate was 21.41%, when calculating according to the parameter of the fivetier category, was RMB2.08 trillion for the total amount of non-performing loans, and 26.12% for the non-performing loan rate, with the latter being 4.71 percentage points higher than the former. To use the five-tier category system to replace the four-tier system is not only helpful in bringing the system in line with international parameters, but also more importantly change the assessment of loan quality from post-assessment (overdue debts, sluggish debts, and bad debts) and pre-assessment (normal, interest, secondary, doubt and loss) so as to be able to discover problems at their earliest and take measures in a timely manner. To this end the China Banking Regulatory Commission decided on July 13, 2003 that commencing from 2004, wholly state-owned banks and joint-stock commercial banks removed the coexisting four-tier category system and completely went over to the five-tier category system. To help banks handle non-performing assets, four asset management companies—the China Cinda Asset Management Co. Ltd., the China Huarong Asset Management Corporation, the China Great Wall Asset Management Corporation, and the China Orient Asset Management Corporation—were specially established in 1999 for the four major state-owned commercial banks of the China Construction Bank, the Industrial and Commercial Bank of China, the Agricultural Bank of China and the Bank of China. By 2004, RMB1.4 trillion of non-performing assets were divested. Using this kind of “one-on-one” method of establishing an asset management company for each state-owned commercial bank to divest the bank’s nonperforming assets has many shortcomings. First, as the asset management companies were born out of the state-owned commercial banks, they basically followed the governance model and management style of these banks. This system thus lacked innovation, and problems similar to the banks would

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inevitably occur when handling non-performing assets. Second, this “internal transfer” style of a quick divestiture did not make a serious analysis of the reasons for the formation of each non-performing asset, which therefore leaves behind many hidden dangers. Third, as these asset management companies were established in haste and their operation lacked regulation, there are many loopholes in aspects such as the conditions of divestiture, assets pricing, and handling methods. Fourth, as it was announced at the establishment of these asset management companies that their macaulay duration was ten years, it was likely that this enticed some senior management and staff to make shortterm actions and moral hazards, and doing all sorts of things to benefit their companies or even themselves. In addition, the supervision of these asset management companies were not very strict, so many problems appeared. Auditor General Li Jinhua, in his audit report for 2004, announced the audit results on assets, liabilities and profits of the four major asset management companies, the China Cinda Asset Management Co. Ltd., the China Huarong Asset Management Corporation, the China Great Wall Asset Management Corporation, and the China Orient Asset Management Corporation and their branches. It randomly checked the non-performing assets of the RMB554.4 million that these financial institutions acquired by these asset management companies, and they accounted for 39% of the total amount of their acquisitions. Generally speaking, these asset management companies have played a positive role in promoting the activation of the non-performing assets of the banks and preventing and resolving financial risks, but the problems of abuse in laws and regulations and substandard administration still exist. According to relevant statistics, by the end of 2004, the non-performing assets handled by the four asset management companies added up to RMB675 million, a handling rate of 53.9%, and the cash recovered added up to RMB137 million, a cash recovery rate of 20.2%. This audit turned up all kinds of abuse of regulations, substandard administration and clues to some key criminal cases, amounting to RMB71.55 billion, and accounting for 13% of the amount randomly audited. The main problems brought to light in the audit report included: First, illegally abuse regulations to divest and acquire non-performing assets. Some commercial banks and asset management companies are not too strict in the process of divesting and acquiring non-performing loans, so some loans which did not meet the conditions of divestiture were being divested to asset management companies, which caused the difficulty of fixing some financial claims and auditing, and as they did not investigate the causes and responsibilities that led to the formation of non-performing loans. This concealed the issues of regulation violations in the process of lending and cases

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of financial crimes. Second, there was abuse of the regulations in handling non-performing assets with a low price. In the process of handling nonperforming assets, some asset management companies violated procedure, gave false assessments, performed black-box operations, and with collusion from within and without. Low-price buy-backs caused the handling of some assets to be set at a low price, resulting in varying degrees of losses of state-owned assets. Third, the financial management of some asset management companies was chaotic. They violated regulations to appropriate assets and handle the recovered capital to benefit their staff or deposit public funds in personal accounts, creating the loss of the capital recovered. Their management of debt assets was not strict, and there was a large amount of deposits outside the company’s accounts or illegally used for their own gain. The announcement of this audit result caused shock and made everybody stand to attention. The Budgetary Affairs Commission of the National People’s Congress proposed carrying out a comprehensive audit of the four asset management companies. The China Banking Regulatory Commission quickly issued Guidelines on Due Diligence in the Disposal of Non-Performing Financial Assets , requesting financial institutions in the banking industry put in place a comprehensive system for regulating non-performing financial assets, improving the policy-making mechanism and operation procedures, and strictly following the principles of openness, fairness, impartiality, competition. Financial institutions need to select the best practice when handling assets, practise openness in handling information, raise the transparency of the handling, and strive to realize the maximization of the value recovered from handling. Zhou Xiaochuan, Governor of the People’s Bank of China, also proposed eight improvement measures, which included improving the laws and regulations for the legislation of the handling of assets, attracting private and overseas handlers to enter the market, reforming the four asset management companies to prevent them from being institutionalized and bureaucratic, imitate the market to set the price, to avoid soft constraints, establish an internal encouragement mechanism, reform the handling and work procedures, promote the growth of an intermediary mark, and adopt measures to handle the relationship between asset management companies and the original divested subjects. As for the handling of joint foreign investment non-performing assets, some Chinese state-owned commercial banks in recent years have taken some action. On July 9, 2002, for example, the Construction Bank of China signed a Memorandum of Understanding and an Agreement on Training Services with the Korean Asset Management Corporation in Beijing. On June 5, 2003,

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the Industrial and Commercial Bank of China signed a Memorandum of Understanding with the Goldman Sachs Group of the U.S. in Beijing, with both parties agreeing to carry out strategic cooperation to handle non-performing assets, which included the establishment a jointly-funded enterprise to jointly invest and handle the non-performing assets of a value of around several billion Renminbi, the creation of a jointly-funded service entity and the development of a joint training of asset management. On July 8, 2003, the Construction Bank of China and Morgan Stanley held a formal signing ceremony in Beijing on a Transaction Agreement for Pilot Points for the handling of non-performing assets. This project was the first project that a state-owned commercial bank cooperated with a foreign capital to handle non-performing assets, and also the first time for Morgan Stanley to use the “one-on-one” style of agreement to acquire the non-performing assets of a state-owned commercial bank. What is worth noting is that as the institutional reform of China’s stateowned commercial banks has not yet been completed. Although the relative number of non-performing loans has been reduced, the absolute number continues to rise. In 2000, the balance of the wholly state-owned commercial banks was RMB2.74 billion, which, after divesting RMB1.39 billion, the balance was RMB1.35 billion. By early 2004, however, it was RMB1.70 billion according to the four-tier category, an increase of RMB367.7 million, which reach RMB1.99 billion according to the five-tier category, an increase of RMB638 million. The author is of the view that the handling of non-performing assets of China’s state-owned commercial banks should go on the path of marketization, attracting both foreign and domestic investors to enter the non-performing asset market. The non-performing asset market began in the 1980s in the U.S. during the savings and loan crisis. In recent years, international investors have become increasingly interested in China’s non-performing loan market. This on the one hand was due to the size of the non-performing asset market which was around USD500 billion, the largest market outside Japan. Based on PricewaterhouseCoopers’ estimates, the accumulated amount of investment of overseas investors in China’s non-performing asset market was only USD10–15 billion, so the market potential is comparatively great. This was also because after the East Asian financial crisis, the profits of international banks and capital from their investment in the non-performing asset markets of countries such as Korea, Thailand, Japan and Malaysia in 1998–2000 were huge (the average return rate was 20–30%), China was a new market for them to open up. It can be predicted that more and more overseas investors will enter China’s non-performing asset markets. It was reported that in April 2004, the Asian Development Bank and the International Finance Corporation jointly

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established Yangtze China Investment, the first domestic fund to invest in the non-performing assets of banks. While we actively bring in foreign capital to enter China’s non-performing asset market, we should make efforts to guide private domestic capital to enter this market. The Chinese people have a large amount of idle capital, and with the stock market currently in depression and under the situation in which the investment in real estates is restricted, it is completely possible that a part of this capital is shifted to the non-performing asset market. The author proposes that under the premise of strictly controlling risk, we should experiment with the establishment of private equity funds and encourage them to enter the nonperforming asset market. The author is of the view that China’s state-owned commercial banks should handle non-performing assets using the method of “differential treatment and gradual digestion.” The author proposes to treat non-performing asset before the end of 2003 as “old debts,” in which the non-performing assets caused by the government should be borne and handled by the government, including the injection of capital from the Ministry of Finance or the divestiture of nonperforming assets. The remainder can be absorbed by the commercial banks themselves. The non-performing assets after the end of 2003 belong to “new debts,” which should be digested by the commercial banks themselves, and this quantity should be reduced year by year. Some advocate following overseas experience and use the method of asset securitization to handle the non-performing assets of the banks. But as the nonperforming assets of China’s four major state-owned commercial banks are chiefly claims which are difficult to be recalled and will not produce a steady cash flow in the future, the result of securitizing this kind of asset is actually transferring its risks to investors in the securities market, so it is therefore still unsuitable to use it at the present time.

Supplementing Capital At present, the source of capital for China’s four major state-owned commercial banks, being restricted by their property rights structure, is unilateral, and their capital replenishment mechanism is mainly dependent on the increase of capital from the state, which means the state uses its fiscal capital or raises capital through issuing special financial bonds to put into state-owned banks as their own capital. Although this kind of method is simple and easy to put into practice, fiscal capital in the end are limited, and with the expansion of the size of the banks it is impossible for the state to continue to inject capital into state-

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owned commercial banks, and make social capital available through the issuance of bonds undoubtedly adds the burden of debts to the state. This type of fund injection by the state easily cause banks to rely on the state, and makes the state bear unlimited responsibility for the banks, and it also causes the state to have excessive control of banks, which is not helpful to the marketization reform of state-owned banks. According to regulations in the Basel (New) Capital Agreements (hereafter as Basel II ), the capital adequacy ratio of commercial banks must satisfy the 8% minimum requirement, and the supplementary capital is restricted to be within 100% of the core capital (which means that the core capital must not be lower than 4%). The calculation method for the capital adequacy ratio is to divide supervisory asset by risk-weighted assets, and risk-weighted assets equal to credit-weighted assets + 12.5 x (market risks and operations risks capital requirements). Based on what was published in Vol. 7 (2003) of The Banker in UK, Wang Xiaofeng made a comparison of the capital adequacy rates of the major commercial banks in China and those in the U.S., Japan, and India and found that it was 7.63% for China (average for 12 banks), 13% for the U.S. (average for 32 banks), 10.83% for Japan (average of 27 banks), and 12.23% for India (average for 20 banks). To meet the requirements of listing, China’s commercial banks must replenish their capital to raise their capital adequacy ratio. At the end of December 2003, through the Huijin Company, the state injected capital of USD45 billion to the Bank of China and the China Construction Bank as pilot units to change to the joint-stock system. When interviewed by a reporter of the Xinhua News Agency, the spokesman of the State Administration of Foreign Exchange said that using foreign exchange reserves to inject capital into banks is not a fiscal allocation, but a type of capital input. On April 21, 2005, a proposal by the Commercial and Industrial Bank of China for requesting a capital injection of USD15 billion for reforming the bank into the joint-stock system also received formal approval by the State Council. It should be pointed out that the state’s capital injection into state-owned commercial banks is only a kind of expedient strategy that helps them meet the criteria for listing. To make the capital adequacy ratio of China’s commercial banks actually really reach and be maintained at the international level, we must take measures to enlarge the numerator of the capital adequacy rate and reduce its factor. The numerator of the capital adequacy ratio is the regulatory capital of commercial banks, including their core capital and supplementary capital. The core capital of China’s commercial banks includes paid-up capital, capital surplus,

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surplus reserves, and undistributed profits, while the supplementary capital mainly includes risk reserves for loans, risk reserves for investment, and longterm bonds of five years or above. To increase regulatory capital, we propose taking the following measures: (1) Bringing in strategic investors. Bringing in domestic and overseas investors can directly increase paid-up capital, as has been discussed before. (2) Setting an appropriate proportion of retaining surpluses and bonuses. To pursue performance and satisfy shareholders, some of China’s commercial banks often proceed from the perspective of short-term profits and use all kinds of methods to increase profits on the books, so as to give shareholders comparatively high bonuses. This type of “kill the goose to get the eggs” method is not recommendable. We propose that the China Banking Regulatory Commission make rules and regulations to appropriately set the proportion of retained surpluses and bonuses, try its best to guarantee the reserves for production deduction for capital surplus and surplus reserves, appropriately increase undistributed profits, and for commercial banks failing to reach the capital adequacy ratio, we should control their bonuses at the lowest limit. (3) Improving the non-performing assets reserves system. For a long period, the bad debt reserves of China’s four major state-owned commercial banks were only around 0.5%, which is far below international standards, and should be gradually raised step by step. On the basis of the five-tier category that is implemented for loans of commercial banks, we can consult overseas experience in setting up reserves for non-performing assets and the five kinds of loans of normal interest, secondary, doubtful and loss loans, which could be calculated into 1%, 10%, 20%, 50% and 100% respectively. (4) Issuing secondary bonds. In recent years, issuing long-term secondary bonds has become an internationally important source of supplementary capital for commercial banks. According to analysis by Merrill Lynch of the capital structure of large international banks, on average the share of ordinary share capital was 60%, that of secondary bonds was 25%, and priority shares, minority equity interest, and other forms of assets added up to around 15%. Based on the Basel Accord regulations, commercial banks can reckon subordinated term debts not exceeding 50% of their core capital in the supplementary capital. On December 9, 2003, the China Banking Regulatory Commission issued the Notice on Subordinated Term Debts Reckoned in the Supplementary Capital , allowing commercial banks to raise capital from targeted creditors to issue fix-term secondary bonds not less than five years (including the fifth year), and calculate them into the supplementary capital.

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(5) Issuing convertible bonds. Convertible bonds and convertible preference bonds are the main types of convertible securities. At present, only convertible bonds are allowed to be issued in China. Holders of convertible bonds, apart from having all the rights of ordinary bonds holders, can exchange them for ordinary shares. According to regulations in China, convertible bonds can be considered tier-2 capital, and if exchanged for ordinary shares they then can be considered tier-1 capital. (6) Appropriately reducing taxes. At present the tax burden of China’s commercial banks is generally on the high side. To promote the reform of commercial banks, we can consider an appropriate reduction of taxes. But it should be clearly stipulated that the returns resulting from tax reduction should be used to raise the capital adequacy ratio, and should not be allowed be used for profit distribution. As the denominator for the capital adequacy ratio is risk-weighted assets, we propose that measures should be adopted to appropriately reduce the amount of venture capital. Corporate and personal loans are the main businesses of China’s commercial banks, but these assets are of higher risk, and according to the current regulations of the China Banking Regulatory Commission, the risk weighting is 100%. At present, credit assets of China’s commercial banks account for around 60% of their total assets, while it is only around 40% for some major overseas banks. This being the case, we should appropriately reduce high-risk loan business and increase loan businesses that have a lower risk weighting (such as secured housing loans), intermediary business and offbalance sheet businesses. It should also be pointed out that according to the rules of the Basel Accord , when the total amount of expected losses exceeds the total amount of eligible reserves, the differences should be deducted 50% each from the core capital and supplementary capital. From this it can be seen that reducing the number and amount of non-performing assets plays an important role in raising the capital adequacy ratio.

Establishing and Improving the Corporate Governance System For a long period, as the state has not really been able exercise its power as their owners, presidents of state-owned commercial banks not only possess the right to operate the enterprises, many of them even consider themselves as representatives of the state (the owner of the banks) and arrogating all authority to themselves, and they would always handle issues from the perspective of personal or unit’s benefits, some even break the law and violate discipline,

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seriously harming the interests of the state. The reason why the China Banking Regulatory Commission brings in strategic investors as an important step in the joint-stock system reform is mainly because it hopes to improve the corporate governance system of state-owned commercial banks through bringing in strategic investors. According to modern theories of enterprise management, factors influencing the performance of enterprises are firstly market structure, and secondly, enterprise behavior. Enterprise behavior includes the quality of enterprise leaders, the level of internal management of the enterprise, and business strategy, these three factors are closely related to corporate governance. Apart from the influence of such factors as the history, culture, law and economics of the country concerned, corporate governance is also under the influence of property rights structure, decision-making method, and strategic goals of companies. Theoretically speaking, in a company with diversified equity interest, the shareholders’ meetings are of the highest authority. But usually due to the magnitude and liquidity of company shareholders (equity interest transactions through the securities market are extremely frequent), in reality the Board of Directors mostly represent shareholders to exercise the authority of the company’s owners. As a result, the functions and authority, structure and working methods of the board of directors become the core issue of corporate governance. It is stipulated in the Company Law of the People’s Republic of China (hereafter as the new Company Law ) implemented on January 1, 2006 that the boards of directors for limited liability companies are to be incorporated by three to thirteen persons, and the boards of directors for share-system limited companies are to be incorporated by five to nineteen persons, whose members shall be elected at shareholders’ meetings. We can currently see overseas strategic investors are mainly concerned with the functions of the board of directors, the situation of the appointment of the senior management, internal auditing, risk control, and the right to nominate independent members of the board of directors. They usually insist on having a certain number of seats in the board of directors, and relevant directors must hold key positions as chairpersons of special committees (especially the risk management committee, remuneration committee, and audit committee). They also pay great attention to the functions of each committee of the board of directors, including the regulations of the board and its decision-making system. The board of directors should be responsible for the choice of general manager and bear the responsibilities of the consequences of their choice. In

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China, when state-owned commercial banks select leaders, they often take “reliability” and “obedience” as their primary criteria, and this is one of the main reasons that cause the low performance of the banks. The position of general manager of a commercial bank should be taken up by a professional banker who acts according to good morals and has integrity, knows the banking business very well, and has organizational ability and leadership skills. Some always worry that capable professional bankers are not reliable, but actually we only need to have sound incentives and a supervisory mechanism to make capable people becoming reliable, otherwise it is also impossible to make reliable people become unreliable. Independent directors are also known as outside directors, who must be chosen for the position from people who are unrelated to the interests of the companies and whose main duties are to protect the rights and interests of the medium and small shareholders. Despite the fact that Article CXXIII of China’s new Company Law clearly stipulates that listed companies must have independent directors, but the specific measures regarding the qualifications for directorship, the process of appointment and removal, remuneration, rights and interests, and responsibilities of independent directors have yet to be formulated by the State Council. This author believes that the board of directors of a commercial bank with diversified equity interest, one third should be independent directors, and that the chairperson of the risk management committee, remuneration committee, and audit committee must be taken up by independent directors.

Supporting Qualified Joint-Stock Banks to Seek Financing by Listing on the Stock Exchange The development of international commercial banks frequently enlists the help of the capital market to collect capital. In 2002, there were over 900 listed banks on the New York Securities Exchange, making up 30% of the total number of listed companies. There were also over 900 listed banks on the NASDAQ Exchange, making up 19% of the total number of listed companies. Well-known commercial banks such as Citibank, Chase Manhattan, and State Street are all listed banks. There are over 160 listed banks on the Tokyo Stock Exchange. There are also over 40 listed banks, of which the Hong Kong and Shanghai Bank and the Hang Seng Bank are well-known blue chip shares. From 1991 until now, the five joint stock banks in China, which include the Shenzhen Development Bank, the Shanghai Pudong Development Bank, the China Minsheng Bank, China Merchants Bank, and the Huaxia Bank have all

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listed in China, while the Bank of Communications and the Construction Bank of China have listed on the Hong Kong stock market. Strategically speaking, China’s commercial banks should actively create the conditions so that they can list so that they can make use of the capital market to replenish their capital, expand their size, open branches overseas, and follow the rules of the capital market to improve the system of corporate governance and internal management. But strategically speaking, we still need to study seriously such issues as the modes of listing (segmental listing or holistic listing), location of listing (overseas listing or domestic listing), the best time for listing, the pace of listing, the choice of the underwriter, and the issuing price. Segmental listing is the mode of listing adopted by many large-scale stateowned enterprises. For state-owned commercial banks, this means to first establish a group holding company, then under the overall framework of group reform, follow the requirements of listed companies to restructure and split up assets, and put together quality assets that meet the conditions of listing to form a subsidiary and change its structure for listing. The listed subsidiary company can turn around to gradually acquire the asset of the group company through capital operation, and finally complete the holistic listing of the entire stateowned bank. The Bank of China had the experience of segmental listing. On July 15, 2002, the BOC Hong Kong (Holdings) Limited announced the sale of 2.3 billion equity interest to Hong Kong investors, which amounted to 25% of its share capital, of which 2.17 billion shares were for global offering, with the IPO price between HKD6.93–9.5, intending to collect HKD14.3–19.5 billion, equivalent to USD2–3 billion. The company decided to go for public and global offering and 50% of the shares for sale were subscribed by financial groups and real estate developers in Hong Kong. Before it was listed, the headquarters of the Bank of China shifted the HKD7.4 billion non-performing assets of the BOC Hong Kong to a registered asset management company that the Bank of China Group set up at the Cayman Islands so that the Bank of China International could meet the requirements of listing in Hong Kong. The advantage of segmental listing is that it makes it quicker for subsidiaries to be listed to meet the criteria of listing and this is like going into a battle with a light pack, making them more competitive in the stock market. But its advantage is that this would add difficulties and burden to the parent company. And as the parent company and the listed company have complex, integrated relationship, it is difficult to avoid related transactions. In China’s stock market, the cases of the parent company (major shareholder) misappropriating or forcibly using the capital of the listed company or even draining away all

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the capital of the listed company are not uncommon. This not only harms the rights and interests of public investors, but also seriously affects the healthy development of the stock market in China. Weighing the advantages and disadvantages of segmental listing, it is more appropriate to have holistic listing. On the whole the greatest difficulty is that the scale of the four major stateowned commercial banks is too large, their historical burdens too heavy, and it is difficult for them to quickly meet the criteria of listing. As the domestic stock market is still bearish, it is hard to accommodate such a huge large-cap stock. Our government therefore decided to allow them to be listed overseas successively, and adopted emergency measures such as changing quickly from banks to companies and injecting capital into them so that they could meet the requirements for listing. As they hoped to be able to be listed as early as possible, there was not much flexibility in the choice of time for listing, but attention should be paid to the arrangement of the sequence and time intervals of the listing of a few of the commercial banks. As the strength of securities traders in China was inadequate and they lacked the experience of overseas underwriting, usually overseas securities traders were selected and used. On June 23, 2005, the Bank of Communications successfully landed on the H-shares stock market and became China’s first domestic bank to realize overseas holistic listing, obtaining good results. The bank made a global offering of 4.69 billion H-shares, with a multiple of over-subscription of retail investors reaching a 205-fold, and a multiple of 27-fold of over-subscription of institutional investors, occupying the fourth place in the IPO history of Hong Kong. The issuing price per share was HKD2.5. On the day of listing, its opening price was HKD2.8, and it closed at HKD2.83, 13% higher than the issuing price. On October 27 in the same year, the China Construction Bank was successfully listed in Hong Kong, making a global offer of 26.49 billion H-shares, of which 1.99 billion shares were for public placing in Hong Kong, the rest was for international placing. The par value per share of the China Construction Bank was RMB1, the issuing price was HKD2.35, and the total amount of issuance was HKD62.2 billion, creating the highest record in the total amount of capital raised for listing in the history of Hong Kong. On the day of listing, it opened at HKD2.38 and closed at HKD2.35, on a par with the issuing price. It is predicted that the Bank of China and the Industrial and Commercial Bank of China will also be listed overseas in one or two years. The settling of the issuing price is an important decision in the processing of listing. If the price is on the low side, it will damage the interests of the

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current shareholders. If the price is too high, it might affect the stability of its future performance in the market. The process of settling the price normally starts with the design of the main underwriter, and finally decided by the senior management of the bank. The pricing models normally include the priceearnings ratio (P/E, return received from every share apart from the market price), price-to-book ratio (P/B apart from market price), discount dividend model (DDM) and with the same kind of enterprises as a contrastive estimate. The Bank of Communications when setting prices selected the Price Earnings Ratio and the Price-to-Book Ratio as indicators, and combined asset quality, profit-making model, predicted future income growth, and the elevation of management techniques to set prices. It also proposed five principles when setting prices: first, follow the principles of the market, taking the numerical values of the P/E and the P/B of the same industry as reference; second, fully protect the interests of regular investors, and prices cannot be too low; third, consider the interests of new investors, and so the price cannot be set too high, or else it will fall after listing and investors will be disappointed; four, maintain national profits and the results of the reform of China’s banking industry, by setting prices in a reasonable way to avoid incurring the depreciation or loss of national assets; fifth, consider the stability of the market after listing. After repeated discussions with underwriters, the highest limit within the original price areas was chosen; it was HKD2.5 per share, with a P/B ratio of 1.6 times. A very important principle that was followed by the China Construction Bank in determining its issuing price was to try as much as possible to suppress short-term speculation and try as much as possible to enhance long-term stability. Proceeding from a long-term perspective, we need to leave behind some space for future development of the market, consider the returns of the investors, and at the same time also consider the requests of other agencies and those in the same trade. In the early phase of road shows, the bank initially settled the IPO in Hong Kong price of should in the first steps in Hong Kong determine the range of the IPO price was HKD1.8–2.25 per share, then later based on market situation, it was adjusted upward to HKD1.9–2.4 when it was in London, and eventually it was settled on HKD2.35 in New York. Listing China’s state-owned commercial banks on the market helped them to replenish their capital, raise their popularity, and improve their corporate governance, but listing also gave them a severe test. This is especially the case when such issues as joint-stock reform, capital replenishment, and their handling of non-performing assets were hastily completed with the adoption of some emergency measures under the strong support of the state. Many deeprooted institutional issues remain unresolved, and the internal moral risks

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and external administrative interference still exist. It is still possible that these issues will be exposed after listing, and that this will cause them to be sued by investors and severely punished by the supervisory authorities (especially in the case of overseas listing). Therefore we should clearly realize that for state-owned commercial banks, listing is just “the first step in a ten-thousandmile long march,” they still need to continue to deepen reform, strengthen governance, expand business, and try hard to innovate to enable them to continuously raise their international competiveness to ensure that they make the list of world-famous large banks.

Improving Internal Management Commercial banks in China, especially state-owned banks, have problems and inadequacies in numerous areas, such as their system, structure, concept, tradition, organization, personnel, skills and business. What is more, as their departments are overstaffed, their units are too large, their workers too many, their functions overlapping, their manner heavily bureaucratic, and their efficiency low, it is therefore necessary for them to strength their internal management in the following aspects.

Organizational management At present, state-owned commercial banks set up branch organizations level by level according to administrative districts. Despite the fact that they have implemented the unified legal persons system, they still keep the five levels of management from their headquarters to bank offices, and practise the system of management by level. Their internal management is based on the variety of businesses or departments where their products are hosted. For example, many commercial banks have international business departments, real estate loan departments, settlement business departments, and capital business departments. And there are also many non-operational departments, such as labor wage department, personnel department, education department, administration department, departed and retired cadres management department and other relevant Party departments. A drawback of this kind of organizational structure is that vertically, the chain of agency by agreement is too long, and horizontally, functional departments are too many, and it is difficult for them to gear themselves to the needs of the market and customers; this causes lower efficiency, slower decision-making, poorer service quality, and the phenomenon of insider control is comparatively common, it is therefore difficult to effectively avoid moral hazard. To change the situation, we suggest

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that China’s commercial banks should consider the foreign experience to carry out a restructuring of their workflow, and build an organizational structure that is market-oriented, client-centered, and product-dependent, which means vertically establishing a three-tier organization of Headquarters–Strategic Business Unit (SBU)–Branches, and horizontally established the first-line organizations that are geared to the market, second-line organizations that manage strategies, and third-line organizations that provide support. Firstline organizations include a customer relationship management department which categorizes customers according to their type as well as a financial products management department which divides products according to their type. Second-line organizations include departments such as strategic planning, risk management, and financial and administration management. Third-line organizations include human resources management, operations center and technical support departments, which are chiefly responsible for keeping materials of customers and conduct operational handling of various kinds of businesses.

Customer relationship management Customers of commercial banks chiefly include types such as other financial institutions, domestic enterprises, and transnational corporations. To provide quality and efficient services to win and keep these customers, commercial banks usually implement an account manager system, and it is the responsibility of the account manager to attract new customers, provide them with comprehensive financial services such as deposits, loans and foreign exchange, and provide business services such as acting as investment and financial management consultants. Account managers are responsible for coordinating the relationship between the bank and its customers, and they serve as a liaison department between the two. Account managers externally represent the bank to liaise with customers and provide services, and internally represent customers to various departments of the bank to provide the service they need.

Financial products management Commercial banks usually deal in many kinds of financial products, such as cash, securities, trade financing, and loans, and with the development of demand for diversification and personalization in financial products, the design, assessment, and management of these products are becoming more and more complicated, and the management of these products requires

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special professional knowledge, and this is where account managers find themselves inadequate for this job. Because of this, we also need to implement a product manager system. Product managers are responsible for changing the direction to the opening up of financial products, and guarantee the regulation, systemization and internationalization of financial products. The product manager selects or develops suitable financial products according to the demand of the clients provided by the customer manager, and the customer manager recommends them to his clients or gets them onto the market.

Risk management There are all kinds of risks existing in the business of commercial banks, including credit risks, national and transferable risks, market risks, interest rate risks, liquidity risks, operational risks, legal risks, reputation risks and so on. The business of a bank is essentially about getting corresponding returns through bearing risk, therefore the core ability of a bank is its ability to manage risk. For this, it also has to implement a risk manager system for risk managers to conduct reasonable assessment and setting the price of risk in all sorts of businesses. Risk managers can join account managers and product managers to form a customer relations team where the account manager is responsible for coordination and liaison, giving feedback on the demands of clients to different product managers, product managers will then be responsible for providing that kind of product and service, and the risk manager will be responsible for the supervision, control and management of relevant risks. The accounting and auditing of related business will be centralized in the finance department, and the handling of business will be centralized at the operations center.

Strategic management Strategic management is the highest level and primary task of modern management. According to modern management model, strategic management usually includes the making and implementing of strategies. Strategic targets are the soul of an enterprise, and they are made on the basis of an enterprise’s objective estimation of its future long-term situation. Strategic targets have four levels, which include general operating performance targets, owners’ rights and interests targets, clients’ interests targets, and social benefits targets. The strategic management department of a commercial bank should make a serious analysis of society, industry (competitor), market (customer), and the internal resources and core ability of the bank itself and base on this analysis to practically work out the targets of the enterprise, propose the major measures

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to achieve the targets and the progress of their implementation, and make necessary adjustments during the process of implementing these measures.

Human resources management Banks belong to the financial services industry, and their operational performance is to a large extent determined by the quality of their staff. In recent years, state-owned commercial banks universally practice the “official rank” system, and as this pyramid-style administrative promotion mechanism provides an extremely limited number of posts, it leads to the drain of a large number of core staff in their thirties. Because of this, the author proposes that the human resources management of commercial banks should follow the methods of enterprises, establish business manager posts, which are parallel to the series of posts in administrative business and enjoy equal treatment in such aspects as monetary income and benefits, and establish regular and systematic training and assessment system. The author proposes selecting some colleges with better foundation to try out a M.A. in Financial Management (FMBA) class to conduct professional training for middle level and above staff of commercial banks in batches, to gradually form a high quality team of bank personnel.

Promoting Financial Innovation From the 1960s onwards, the United States’ rate of inflation and interest rates skyrocketed, and factors such as the rapid development of computing technology, the trend of integration of the international financial markets, and the difficulty to predict and control the fluctuations of the exchange rates and interest rates, all caused financial risks to increase, which greatly changed the situation of supply and demand in financial markets. Many financial mechanisms discovered that their traditional financial services and the sale of their financial products increasingly declined, and the old style of management was no longer profitable. Many financial intermediary organizations also discovered that it was difficult to use traditional financial instruments to attract the capital they needed for survival. In order to survive and develop, financial institutions had to make great efforts to carry out financial innovation, conduct research and develop new products and services to avoid financial risk, guarantee the safety of trading, avoid financial supervision, and lower transaction costs. The business of China’s commercial banks is mostly limited to the traditional area of deposits and loans, and business innovation of China’s joint-stock commercial banks takes up no more than 10% of the average proportion of

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its business income, which in comparison, is lower than commercial banks in Western developed countries which have over 40% of their income coming from their innovative business. The main varieties of financial instrument innovation are: money market mutual fund, junk bonds, commercial bill market, and asset securitization. The money market mutual funds had only an asset of USD4 billion in 1977, but by 1999 its amount reached USD1.5 trillion, a staggering speed of development. Junk bonds began to be issued in 1977 from an investment company, and by the latter part of the 1980s, the junk bond business of investment banks exceeded a total amount of over USD200 billion. Commercial bills are short-term securities issued by commercial banks and enterprises. By 1999 their scale reached USD1,200 billion and was the fastest-growing financial instrument. The bill market also opened up a transaction market for money market mutual funds, and attracted the entry to this market from the pension funds and insurance funds. In the last 20 years, the most important financial innovation was asset securitization, which originated in 1970. Asset securitization is to turn illiquid assets into liquid assets and change them into tradable securities in the capital market. Commercial banks, for example, packaged their real estate mortgages into assets, issued securities in small denominations, sold them to third parties and investors, so in this way, commercial banks gained service fees, returns in interests and capital, and handled large quantities of non-performing assets. In 1999, the total amount of asset securitization reached USD1 trillion. Later, asset securitization was extended to car loans, and credit card receivables, and the transaction quantity of the latter in 1999 reached USD100 billion.

Concluding Remarks The reform of commercial banks has been the focus of the reform of China’s financial system, and the reform of the four major state-owned commercial banks has been the most important of all. After China’s accession to the WTO, in order to meet challenges in the finance area, China has worked out, on the basis of exploration and practice, the “road-map” for reforming the four major state-owned commercial banks, which is to “implement the joint-stock transformation, bring in strategic investors, speed up the handling of nonperforming assets, replenish capital, improve corporate governance, and create the conditions for listing in the stock market.” This “road-map” has begun to be implemented and even though it is still necessary to make necessary adjustments and refinements in practice, we should hold fast to the major

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direction of reform, raise as quickly as we can the international competitiveness of China’s commercial banks, strive to put them in an unassailable position when we completely open up our banking industry to the outside at the end of 2006. At the same time, we should also clearly realize that listing is just a continuation of reform and far from being its end. We still must further strengthen corporate governance and internal management, gear them to the needs of the market and customers, continue to raise the quality of financial services, and strive to turn as early as possible China’s commercial banks into modern financial enterprises with adequate capital, strict internal control, safe operations, and good services and returns.

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Exploring Effective Ways of Developing Rural Finance in China

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Foreword: The Great Significance of Developing Rural Finance China is a densely populated, less advanced and unevenly developed country with a population that is largely rural. The issues of agriculture, rural areas and farmers (referred to as the “three rurals”) must be solved in the process of realizing China’s modernization. First, this involves food security in our country. There are 1.3 billion people in China, accounting for 21% of the world population. However, the arable land in China stands at 2 billion acres, accounting for only 7% of the world’s arable land. If China’s food supply was unable to meet demand, it would be difficult to count on the international market to solve our problem. In recent years, there has been a drop in food production in China. The acreage for growing food has decreased on a yearly basis, and food production has decreased and reached a historic low in 2003, with only 860 billion cattles. Second, without solving the “three rurals” problem it would be difficult for China to realize modernization. Modernization theories in the West hold that modernization means industrialization and democratization. Industrialization is gradually realized on the basis of agriculture. At the initial stage of industrialization, we count on the scissors gap between the prices of industrial and agricultural products to accumulate capital, and on farmers turning into workers for the labor force that is needed. To develop industry, we must have the rural consumer market as 60% of our population is in the rural areas, and without raising farmers’ purchasing power, many industrial products would not be able to sell, and the progress of industrialization would be hindered. An important indicator of industrialization is urbanization, which is to facilitate the transfer of agricultural labor to the city. Britain spent more than 200 years to lower the rural population from 70% of the total population to 30%, and succeeded in 1850. The U.S. spent about 100 years to achieve the same goal in 1930. The current ratio of urban-rural population is 40% to 60%, and the task of realizing the transfer of labor force is very arduous. One of the most important conditions to realize democratization is the scientific, cultural and educational level of farmers. A correct understanding and application of democracy is built on some solid land of foundation of in science and technology, culture, education, and economic development. Some under-developed countries, which are still poor and largely illiterate, copy wholesale the Western system of democracy. Some countries have more than 100 political parties. They end up with people living in dire poverty, and this is a severe lesson for developing countries to learn.

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Third, without solving the problem of the “three rurals,” we cannot realize socialist modernization. Our modernization is different from that of the West. What we want to achieve is socialist modernization, which is not only industrialization and democratization, but also making efforts to narrow the gap of income distribution and realize common prosperity of the people. At present, the dual economy structure still exists in China and there are marked differences between cities and rural areas in levels of economic development, pattern of economic activities, and means of economic operations. This dual economic structure is the legacy of history. After the Opium War in 1840, feudal society, which lasted for more than 2,000 years in China, began to disintegrate, the rural areas becoming semi-feudal societies and the cities semi-colonial societies. With the economies of the cities and rural areas developing along different lines, a dual economy structure was formed. Thus after the founding of New China and during the early stage of the development of our new democratic and socialist society, there was a dual economic structure. According to statistics in 2003, the urban per capita income was about three times the rural per capita income and the purchasing power of urban residents was about four times that of rural residents. The social services that urban residents enjoyed, such as social security and cultural education, were much better than those in the rural area. Without dealing with this dual economic structure, it would be difficult to narrow the gap between the rich and the poor, achieve common prosperity, social fairness and justice, or socialist modernization. Therefore, in order to achieve the lofty target of building a moderately prosperous society by 2020, we must seriously and practically solve the problem of the “three rurals,” promote agricultural development, maintain stability in the rural areas, and raise farmers’ income. According to the theory of development economics, economic growth can be divided into three parts: growth caused by capital input, growth caused by labor input, and growth caused by input of integrated elements (including management, technology and education). The rural labor force in China is far too large and we need to make more effort in transferring this labor force to the industrial and service sectors. The input and production of integrated elements need to go through a relatively long process. Institutional innovation, improvement of management, technology development and promotion of products, development of compulsory education and vocational education, all these are inseparable from the support of capital. Therefore, the most urgent task is to increase capital input in the “three rurals” in order to promote a fast rural economic development. Only when an agriculture-based rural economy is developed can we maintain the stability of the rural areas and increase farmers’

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income. The author therefore believes that at this stage, we must vigorously develop rural finance, ensure an adequate supply of capital to meet as much as possible the financial needs of agriculture, the rural areas and farmers, and gradually solve the “three rurals” problem, which is an important strategic issue that must be handled properly in the process of realizing modernization in China. To build socialism with Chinese characteristics and develop socialist market economy system in China, more attention has gradually been paid to rural financial issues, which has attracted the attention of a number of scholars. As far as the author knows, several hundred articles on rural finance have been published in academic journals in recent years and several monographs have also been published. The author started to pay attention to and study issues relating to rural finance in 1999 and did some investigation and thinking. This chapter intends to work on this basis, using relevant theories from disciplines such as institutional economics, complexity science, and fictitious economy principles, and focusing on the discussion of the institutional construction of a rural financial system in China.

The Development Process of Rural Finance in China and the Challenges it Faces The origin of modern rural finance in China can be traced back to the early 1920s when the first credit union in modern China was established in Xianghe County in Hebei Province. In the 1930s, in the areas then under the rule of the Kuomintang government, some commercial banks faced economic crisis in the rural areas and the severe situation of farmers going bankrupt. With the demonstration and promotion of the relief activities for rural finance carried out by public interest organizations, they took part in the action of “capital going back to the farmers” and gave loans to the rural areas. The central and local governments of the ruling Kuomintang also set up special departments and financial organizations to give relief and loans to rural areas, and these actions achieved some success in helping farmers to repay their debts, redeem their land, and purchase the necessary production and living resources. Under the rule of the Chinese Communist Party, many rural credit cooperative organizations were set up successively in the Central Soviet Area and later in all the revolutionary base areas, which largely satisfied the financial needs of rural areas and contributed to the consolidation and development of the base areas. Since the founding of New China, the development of rural finance in China can be broadly divided into the following five periods:

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The first period lasted from 1949 to 1957, which was a period for growth of rural finance based mainly on rural credit cooperatives (hereinafter referred to as RCC). By the end of 1949, there were about 800 RCCs. In the period 1949–1953, as a result of the advocacy and promotion by the government, there were many pilot RCCs in the rural area. By the end of 1953, there were 9,841 rural RCCs, and a relatively complete system of democratic management was established with township or administrative villages at their core. Farmers who joined the cooperatives were required to pay a certain sum of money for their shares. By the end of the year, they received a bonus according to the money they paid. There were also credit departments or credit groups affiliated to supply and marketing cooperatives. Since 1955, with the rapid expansion of the three cooperative movements of production, supply and marketing as well as credit in various rural areas, there was faster development of these RCCs. By the end of 1957, 80% of the rural areas has set up credit cooperatives. There were altogether 88,368 RCCs, absorbing a deposit of RMB2.06 billion, with RMB310 million of share money from the members of cooperatives. Despite the fact that RCCs during this period were small in scale and their management was far from perfect, the nature of their cooperation was fully realized, and the overall development was healthy. During the early period of the founding of New China, rural financial services were managed by branch offices at all levels of the People’s Bank of China. To adapt to the new situation in the development of rural economy after land reform, and strengthen the leadership of the rural credit cooperative organizations, the Government Administration Council of the Central People’s Government on August 10, 1951 decided to formally establish the Bank of Agricultural Cooperatives, which was responsible for the business of investment funds and fund allocation for areas such as agriculture, forestry, and water conservancy, and leading the RCCs. However, the Bank of Agricultural Cooperatives in 1952 was revoked, and the Rural Financial Authority of the People’s Bank of China became responsible for the leadership and management of the work of rural finance. After gaining the approval of the State Council, the Agricultural Bank of China was officially established on March 1, 1955, whose main tasks were to guide the credit unions, mobilize extensively the accumulated capital of the rural areas, use rationally the national agricultural loans, support the development of agricultural production, and promote the transformation of small-scale rural economy socialism. However, due to the unclear division of responsibilities between the grass-roots Agricultural Bank of China below the country level and the People’s Bank of China, and the lack

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of capital and personnel, the State Council resolved in April 1957 to remove the Agricultural Bank of China and integrate it into the People’s Bank of China for management purposes. The second period is 1958–1976, a period of stagnation in rural finance development. In 1958, RCCs were delegated to the communes for management. In 1959, they were further delegated to production brigades for management. Under the influence of the “extreme left” line, the cooperative system was seriously distorted. The financial and business management of RCCs were mainly under the leadership of the production brigades. Their profits and losses were audited by the production brigades. They lost their status of independent operators. Due to the destruction of normal credit relations, a large sum of money was misappropriated. Deposits reduced rapidly, falling from RMB2 billion at the end of 1958 to RMB970 million by the end of 1962. Although the RCCs restored their independent status in 1962, their business was still under the leadership of the People’s Bank of China. In 1963, the Agricultural Bank of China was reinstated. It had a unified management of capital for supporting agriculture and agricultural loans, and a unified leadership of the work of RCCs. But this did not last long. In December 1965, the Agricultural Bank of China was revoked for the third time. In 1966, the RCCs were once again delegated to the communes and production brigades for management. During the “Cultural Revolution” period, RCCs were nominally entrusted to the management of the poor and lower-middle peasants. It actually caused serious damage to cadres, capital security and business activities. RCCs in many places were on the brink of bankruptcy. The third period is 1977–1984, a recovery period for rural finance. The State Council issued in 1977 the notice Several Provisions on the Overhaul and Strengthening of the Work of Banks , in which it was clearly stated that “the RCCs are collective financial organizations and they are also the grass-root organizations of the national banks in the rural areas.” It was also stipulated that RCCs were to be managed by the People’s Bank of China. On February 23, 1979, in Notice No. 56 of the State Council: Notice on the Reinstatement of the Agricultural Bank of China , it was stipulated that the main tasks of the Agricultural Bank of China were to centralize the management of capital to support agriculture, lead the RCCs, and develop rural financial services industry. It also stipulated at the same time that the RCCs were financial organizations of collective ownership and the grass-root organizations of the Agricultural Bank of China. As the Agricultural Bank of China managed the state financial allocation, commercial credit business, and cooperative financial

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organizations, it established the “official” nature and monopoly status of the bank in rural finance. As all the deposit and lending business of the Agricultural Bank of China were arranged under the state mandatory plan, the bank adopted the planned economy to run the RCCs according to the bank’s plan. Although there was some recovery and development of the business of RCCs in this period, they also gradually lost their autonomy, and gradually stepped onto a “government-run” road. The fourth period is 1985–1995, a period in which rural finance developed further. There are five main aspects to this development. (1) Commercial banks began to enter the rural areas. In October 1984, the 3rd Plenary Session of the 12th National Congress of the Central Committee of the Communist Party of China made the Decision of the Central Committee of the Communist Party of China on Economic System Reform . To develop “a planned commodity economy,” the commercial and financial system in China expanded rapidly, and the monopoly status of the Agricultural Bank of China in the rural finance was gradually eroded. In 1985, the Central Committee of the Chinese Communist Party in its Ten Policies to Further Invigorate Rural Economy clearly stated that the Agricultural Bank of China had to implement corporate management and improve capital efficiency. The People’s Bank of China also introduced a specialized banking business which could properly alternate with the policies and measures under the rubric of “a bank can choose an enterprise, and an enterprise can choose a bank” so as to encourage moderate competition among the four specialized banks, thus breaking down the “supply system” of “unified revenue and expenditure” of bank capitals and also confirming that the collection and purchase of farm and sideline products were the self-operated business of the Agricultural Bank of China. According to this policy and its measures, some commercial banks began to spread their tentacles into the rural areas, providing loans to village and township enterprises which were then enjoying a great boom. (2) Reform of the RCCs continued. In 1984, Notice 105 of the State Council transmitted its Views on Reforming the Management System of RCCs by the Agricultural Bank of China, in which it was proposed to turn the RCCs into “autonomous, self-financing,” public, cooperative financial organizations. Since then, the Agricultural Bank of China conducted a series of reforms of such aspects as democratic management, business management, and organizational construction of the RCCs, which brought about a great development in RCC business. By the end of 1995, there were 50,219 independent accounting RCCs, 2,409 county cooperatives, with owners’ equity reaching RMB63.2 billion, of which RMB37.8 billion were paid-in capital, and the total assets was RMB985.7

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billion. The amount of deposits reached RMB717.3 billion, of which savings deposits were RMB619.6 billion, absorbing above 60% of rural savings. Loans reached RMB517.6 billion, accounting for over 60% of the total agricultural production loans, over 80% of loans for farmers, and over 70% of loans for village and township enterprises. (3) Rural policy finance began to develop. According to the decision of the State Council, the Agricultural Development Bank of China, a policy bank which was especially responsible for such businesses as the management of the collection and purchase of farms and sideline products and loans, was established in June 1994. Its functions were defined as: To provide special discount government loans for subsidiary agricultural products such as grain, cotton, edible oil, pork, and sugar, the collection and purchase, distribution, and wholesale loans for subsidiary agricultural products such as grain, cotton, and oil, loans for grain, cotton, edible oil processing companies, loans for poverty alleviation, loans for economic development in former revolutionary base areas, areas inhabited by minority ethnic groups, remote and border areas and poverty-stricken areas, loans for developing industries in povertystricken counties, loans for integrated agricultural development, other discount interest loans for agriculture, and loans for the construction and technological upgrading of small-scale infrastructure in agriculture, forestry, animal husbandry, and water conservation. (4) Postal savings emerged as a new force. In January 1986, under the auspices of the State Council, the Ministry of Posts and Telecommunications and the People’s Bank of China, in their respective capacities as owners of the investment and business regulator, jointly issued an Agreement on Running Postal Savings, and decided to run postal savings business as a pilot scheme in 12 cities, including Beijing and Tianjin. The Postal Law of the People’s Republic of China that was adopted at the end of 1986 officially put down postal savings as one of the businesses of postal enterprises, and postal savings as a result became a major force in carrying out the business of savings in rural areas throughout the country. (5) Irregular finance rose quietly. In the early 1980s, with the development of the rural household contract responsibility system in China and during the process of cleaning-up rural grassroots property, rural cooperative foundations began to grow in 1984. These foundations were mutual-aid community organizations built up by rural collective economic organizations and farmers in accordance with the principles of voluntary mutual benefits and onerous utilization. Their capital mainly came from collective capital. They also absorbed farmers who acquired their shares with their capital. The deposit

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period was long, the interest rates were lower than those of credit unions, and the prospective borrowers were mainly farmers in villages or townships whose loan amounts were small. By the end of 1992, of all rural cooperative foundations, those at the township level reached 174,000 and those at the village level, 112,500, accounting for 36.7% of the total number of townships and 15.4% of the total number of villages respectively, raising capital amounting to RMB16.49 billion. After 1992, the money paid for individual shares in the cooperative foundations rose rapidly, and the dividends for the money paid for individual shares were higher than that paid for collective shares. In 1994, rural cooperative foundations began to use the name of “money kept on behalf of the clients” to absorb short-term deposits, and they mainly provided huge loans to township enterprises with their deposit and lending interest rates higher than those of the RCCs. This not only changed the nature of the cooperative foundations, but also increased their potential risks. The fifth period is from 1996 to the present, a reform period for rural finance, which focused on vigorous promotion of rural credit cooperative reform. In August 1996, the State Council promulgated the Decision of the State Council on the Reform of Rural Financial System , which made decisions on the conducting of major reforms of the rural financial system. It required firstly that RCCs separate themselves from the administrative subordination of the Agricultural Bank of China, and then on this foundation, turn RCCs into actual cooperative financial organizations that allowed farmers to buy shares, members to be democratically managed, and serve the shareholding members. By the end of 1996, there were 49,532 grass-roots RCCs, and 2,409 united cooperatives. Deposits amounted to RMB879.4 billion, of which savings deposits were RMB767.1 billion. Their assets reached RMB1.45 trillion. Loans reached RMB629 billion, of which agricultural loans were RMB148.7 billion, and new agricultural loans accounted for 40% of the total loans. By the end of the year, RCCs had basically completed the work for “decoupling,” which gradually exposed the potential risks that they had accumulated over time, such as the poor credit-asset quality, severe losses and insolvency. In order to strengthen the supervision and trade management of RCCs and effectively prevent and mitigate risk, in June 1997, the State Council decided to set up a rural cooperative financial supervisory authority within the People’s Bank of China to be responsible for the work of national reform of RCCs and assume the work of industry management and regulation of RCCs. The People’s Bank of China in that year promulgated the Provisions on the Administration of the RCCs to reform the RCCs according to the cooperative society system, which was that the RCCs were to be composed of member shares, the implementation

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of democratic management by members, and that they mainly provided financial services to their members. In 1998, the State Council adopted Views on Further Reforming, Rectifying and Regulating the Work of Managing the RCCs of the People’s Bank of China and continued to follow the cooperative system of voluntary purchase of shares, democratic management and services mainly for members of the cooperatives, to reform the system of the RCCs. In 1998, Premier Zhu Rongji proposed to deepen rural financial reform in view of the problems that had emerged while reforming the RCCs. RCCs were to serve as a financial link to the majority of farmers and a major source of rural finance under the new situation to address to the “difficulty that farmers had of obtaining loans.” This involved reforming the property rights system of RCCs and implementing their risk responsibilities. In January 1999, the State Council promulgated a document which officially announced the universal banning of rural cooperative foundations. In the same year the People’s Bank of China began to conduct pilot reforms of the RCCs in Jiangsu Province. The contents of these pilot reforms were (1) on the basis of asset and capital verification, merge the various RCCs and county (city) union societies with legal persons into a single legal entity; (2) RCCs were to change their operational mechanism and improve the financial services and management level of RCCs; (3) clarify the relationship of property rights, improve the corporate governance structure, and achieve self-restraint and self-development of the RCCs; (4) through mainly the use of means such as the internal conversion mechanism of credit cooperatives, increase of revenue, restriction of expenditure, and gradual digestion, coupled with the support of matching policies, to digest the historical burdens of credit cooperatives; and (5) set up the Jiangsu Province Rural Credit Union. To promote the work of pilot reforms, the state introduced a fiscal and financial supporting policy: (1) the uncollectable doubtful loans and the entire amount of dead loans of the non-performing loans of the RCCs were to be separated, the People’s Bank of China then would make arrangements to provide special interest-free loans to 50% of the amount that was separated, the total amount of the loans was RMB5 billion with a limit of five years; (2) starting from 2000, based on the amount of savings absorbed yearly by postal savings institutions in each county and units below county in Jiangsu Province, the People’s Bank of Jiangsu was to provide matching central bank loans to RCCs in Jiangsu; (3) the People’s Bank of China would start a special deposit according to a capital-guaranteed principle for the seasonal idle money of credit unions; (4) the Bank would allow credit unions to implement a flexible floating interest policy; (5) the ratio of the drawing of bad debt reserve would in principle be raised from 1% to 2%, and some could

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be higher; (6) when the union society received the housing transfer tax of the mortgage loan assets, the policy of cleaning-up the rural foundations would be implemented; and (7) Jiangsu Province was to draw from what was retained by the RCCs a certain proportion of the special risk compensation capital and put it into their budget for helping RCCs in serious insolvency. In May 2003, the State Council approved the expansion of the pilot reform of the RCCs from the original province (Jiangsu Province) to eight provinces (Jilin, Shandong, Jiangxi, Zhejiang, Shaanxi, Chongqing, Guizhou, and Jiangsu), requesting these provinces to follow the general requirements of “establishing their property rights relations, strengthening their restraint mechanism, enhancing their service functions, getting the appropriate state support, and shouldering the responsibility by local governments.” This speeded up the reform of the management system of the credit unions and property rights, and gradually turned credit unions into community-based local financial institutions which held the shares of farmers, rural industrial and commercial clients and various economic organizations and served farmers, agriculture and the development of rural economy. The main content of the pilot reforms were first, to take the legal person as a unit to reform the property rights system, establish property relationships, improve the corporate governance structure, differentiate different kinds of situations, and determine different property rights relationships; second, to reform the management system of credit unions and give the responsibility of managing the credit unions to local governments. To fit in with the reform of the RCCs, the State made four complementary measures to give its support: The first was to give compensation to the RCCs which suffered losses in paying extra inflation-proof subsidy interests as a result of implementing the macro-economic policies of the state to set up inflation-proof bank savings. The specific measures to be taken would be confirmed by the Ministry of Finance the actual amount of inflation-proof subsidy interest paid by the RCCs during the period 1994–1997 so that it could be appropriated by state finance by installment. The second was that from January 1, 2003 to the end of 2005, the RCCs in the pilot western regions were to be exempted from paying corporate income tax. RCCs in other pilot regions were to pay corporate income tax in half according to the amount of the tax they should pay. Beginning from January 1, 2003, a 3% tax rate would be levied on the business tax of all the RCCs in pilot areas. The third was that two methods would be adopted to give appropriate financial support to RCCs in the pilot areas: The People’s Bank of China will provide a part of the special re-lending loans to the RCCs or the People’s

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Bank of China would issue special central bank bills. The interest rate of the special re-lending loans would to be determined by halving the interest rate of the reserve deposition of financial institutions, and its period is based on the situation of the pilot areas and would be divided into three, five, and eight years. The special re-lending loans were to be uniformly borrowed and returned to provincial governments. The central bank bills issued by the People’s Bank of China would not be bought in cash by credit unions, but would be used to replace non-performing loans of RCCs. These bills would be for a two-year period, and their interest would be paid yearly with an appropriate interest rate. But these bills could not be circulated, transferred and mortgaged, and they could not be settled in advance with conditions. These two methods would be selected according to pilot area and rural credit cooperative. The fourth was to implement a flexible interest rate policy in areas where local private lending is active. The interest rates of rural credit cooperative loans would be allowed to float flexibly. The loan interest rate could float within the range of 10 to 20 times the benchmark lending rate. The interest rates of small credit loans to farmers would not go up, individual loans of high risks may slightly (not more than twelve times) go up, while loans for farmers in the affected areas could still appropriately float downward. In August 2004 the State Council held a work conference in Beijing on deepening the pilot reforms of the RCCs to sum up the pilot work of the previous stage, and decided to designate 21 provinces, cities, and counties, including Beijing, as pilot units to further deepen the reform of the RCCs. The State Council also requested that the eight pilot provinces (or cities) that began as pilot areas sum up their experiences as a basis to further deepen this reform. The provinces, cities, and counties which took part in this pilot should follow the spirit of the documents of the State Council, grasp the focus of reform, and implement the relevant policies. They should pay attention to the work of publicity, mobilize the people, guide public opinions, encourage and guide farmers and other sectors of people to actively support and participate in the reform. Despite the fact that in recent years, all sectors of people have intensified the reform of rural finance and made considerable progress, the issue of the difficulty for farmers in obtaining loans has not been fundamentally resolved, and there is still a huge gap between the financial services provided by financial institutions and the financial needs of farmers as well as other difficulties and problems. The serious challenges facing the development of rural finance in China are in the following areas:

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An Inadequate Supply of Credit Loans and an Outflow of Rural Capital Since 1998, loans to agriculture and township enterprises by various financial institutions accounted for a proportion of only about 11% of the total amount of loans by financial institutions, and there was but also a downward trend. For 1999–2002, they were 11.7%, 11%, 10.8% and 10.5% respectively. In 2003, the proportion of GDP in the added value of agriculture was 14.8%, but agriculture accounted for less than 6% of the balance of loans of the entire financial sector. In addition, the deposits of farmers in financial institutions were greater than their loans, and the difference between deposits and loans expands each year. The amount of deposits of farmers in the entire country exceeding their loans increased from RMB735.79 billion at the end of 1997 to RMB940.37 billion in 2001. What deserves our attention was a large outflow of rural capital, and the major outflow channels were postal savings and commercial banks. Postal savings in the rural areas took deposits but provided no lending, and all the deposits were put into the People’s Bank of China to get interest. The balance of postal savings deposits in the rural areas rose from RMB171.06 billion at the end of 1997 to RMB442.14 billion at the end of 2002. There were still lots of capital flowing out of the rural areas through state-owned commercial banks. According to the statistics on 61 counties by Anhui Province, there was an increase of RMB23.7 billion in the deposits in the four major state-owned commercial banks in 2003, while loans decreased by RMB3.51 billion. There was some capital that flowed out of the rural areas through the purchase of bonds, lending to other banks, and lending to urban clients by RCCs. At present the balance of the bonds bought by credit unions in the entire country is around RMB200 billion.

It Was Difficult for Rural Households to Get Loans from Financial Institutions and Private Lending Was Active One of the important businesses of RCCs is to extend small loans and guaranteed loans to rural households. According to statistics, at the end of March 2004, close to 580,000 rural households in the entire nation received small credit loans, and nearly 11 million rural households received guaranteed loans. However, according to sample surveys of the Rural Investigation Team of the National Bureau of Statistics of China, the majority of rural households found it difficult to get loans from the regular financial institutions (banks and credit unions), and their main source of borrowing money was private lending. In 2000–2003, the annual average of the money farmers borrowed from financial

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institutions was RMB65 per capita with RMB190 per capita from private lending, accounting for 25% and 75% respectively of the total amount of money borrowed. In economically developed areas such as Jiangsu and Zhejiang, private finance was even more active. Of the money borrowed by farmers in the two areas of Jiangsu and Zhejiang, borrowing from banks and credit unions accounted for only 22.9% and 16.8% respectively, and rural households who borrowed from banks and credit unions were only 28% and 25% respectively of the total number of households.

Small Credit Loans for Farmers Could Not Fully Meet Their Needs The small credit loans that farmers take are quite small, usually under RMB5,000, and the repayment period was short, typically six months to one year, and some only for two or three months, which was hardly comparable to the production cycles of forestry and aquaculture, and this easily made it impossible for farmers to repay their loans on time, further increasing the difficulty for them in obtaining loans. In addition, due to the large amount of capital needed for industrialization management, such as large-scale planting and aquaculture and the development of agricultural processing, and because the production cycle was longer, and the initial investment was higher and more risky, it was difficult for small credit loans to meet these requirements.

Services Provided by Financial Institutions were Relatively Simple, and Agricultural Insurance in Particular Seriously Lagged Behind Most rural areas basically only have traditional deposit and loan business, other services, such as settlement, insurance, consultation, and foreign exchange, are minimal. In recent years, agricultural insurance has shrunk. In 2003, the income of agricultural insurance premium in China was only RMB460 million, accounting for about 0.5% of the premiums of property insurance for the whole country. Hunan, for example, is rich in rice, but rice insurance that existed since 1984 has basically been terminated. In 2003, the income of agricultural insurance premiums was RMB891,000, accounting for 0.44% of the income from property insurance premiums of that year. The income of agriculture insurance premiums for Jiangxi Province in 1992 accounted for 3.5% of the income from premiums of that year, and it was lowered to 0.15% in 2002. The income from agricultural insurance premiums for Liaoning Province in 2003 was only RMB224,000, less than one-tenth of that of 1993. Faced with such severe challenges, we should soberly realize that the development of rural finance in China should not be dealt with by a superficial

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“stop-gap” approach. We need to consider the actual situation of “agriculture, farmers, and rural areas” in China, conduct an in-depth theoretical analysis and deliberation, and strengthen the building of a rural financial system in China in accordance with the principle of using the right medicine.

The Fictitious Economy and the Construction of a Rural Financial Sysytem Although the word “system” has been widely used in recent years, its actual interpretation varies from person to person. It is generally held that a system is a set of regulations or behavioral norms to be commonly followed and for managing things according to a certain procedure. In academic circles, it is generally held that a system is one that involves aspects such as politics, economy, and culture formed under certain historical conditions. The Institutional School of Economics that arose in the U.S. at the beginning of the 20th century emphasized the study of institutions, and analyzed the role of institutional factors in the development of the social economy. They maintained that issues of the organization and control of an economic system are more important than resource allocation, income distribution, and levels of income, product, and price. They emphasized the huge role that factors such as society, history, politics, psychology, and culture play in social and economic life, and advocated the application of the methods of institutional analysis and structural analysis. The inspiration we draw from the views of Institutional Economics is that in order to fundamentally resolve issues of rural finance, such as farmers’ difficulty to get loans, we must begin with an analysis of social and economic factors of our rural areas, and further strengthen the construction of a rural financial system. Complexity science is a science that studies complexity and complexity systems and an advanced stage in the development of systemic science. This branch of science emerged in the early 1980s and is still in the exploratory stage. Despite the formation of its five schools of dynamics, chaos, adaptive systems, structures, post-modernism, it has not established a mature paradigm. The author has used complexity science to analyze institutional issues and holds the view that institutions should include both system and mechanism. System refers to the state and organization of a system at a given point of time, and mechanism refers to the process and motivation of the evolution of a system. Structure and mechanism are sometimes interdependent, for structure is the starting point and result of evolution, and mechanism is the path of evolution. Due to the interaction among the various agents in the system and

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the interaction between the system and external environment, a kind of selforganization will be produced within the system to form the hierarchal structure and functional structure of the system, and make the system to evolve in a certain direction. As the system is dynamic and in constant evolution, it would not be enough to rely on static structural analysis, such as power analysis, interest group analysis, and regulatory analysis. As pointed out bluntly by D.C. North, a prominent institutional economist: “We live in a dynamic world of economic change, but our theory is static.” The fictitious economy involves an economic activity model that corresponds to the real economy. Simply put, in real economic activities, capital must go through the mutual conversion to its physical form and the cycle of exchange– production–circulation–exchange to generate profits. But in fictitious economic activities, capital does not need to go through this cycle to produce profits. The development of the fictitious economy has gone through the stages of capitalization of idle money, socialization of interest-bearing capital, marketization of securities, and internationalization of financial markets. At present, it has entered the stage of international financial integration. A fictitious system has such characteristics as complexity, metastability, high riskiness, parasitism and periodicity. As the fictitious economy does not include physical production activities, it cannot create wealth by itself, but it can redistribute the wealth created by the real economy, it therefore can directly create the effect of using money to make money without going through the cycle of a real economy. The author has used the method of the fictitious economy to study such issues as the capital market, the money market, venture capital, deflation and financial crises in China, and achieved preliminary results. This method may also be used to study the issue of rural finance.

The Economic System of China’s Rural Areas During its long period of feudalism, the small-scale peasant economy, which had farmers as owners and as tenants as its core, had been the main economic system in rural China. After the founding of New China, various events such as the agricultural cooperative movement, setting up of people’s communes, and the “Cultural Revolution,” affected its economic system with the status of farmers continuously changing. At present, the small-scale peasant economy still occupies the dominant position in the rural area. Small-scale economy has the following basic features: (1) Rural households are taken as the basic unit. In rural areas, individual families are at present still mainly taken as the production units and living

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units. Individual farmers, with the help of their family members, independently complete their production procedure that mainly produces farm-based products, and this does not require external collaboration. Family members live together, and their property is mainly shared by family members. (2) Individual private ownership is its basis. Individual farmers, through contract agreements, obtained the right to use small plots of land on a longterm basis, and owned, in varying degrees, farm tools, farm animals and other production information. In a better policy environment, farmers generally have higher operating autonomy and enthusiasm for production, allowing rural society to have certain stability. (3) The scale of production is small and the conditions of production are simple. Each rural household usually tills only a few acres of arable land, uses hand tools, and relies mainly on human and animal power for production. Since the scale of production of rural households is small, and their ability to resist natural and market risks is poor, they may fall into poverty, or even bankruptcy, thus affecting their stability. (4) Co-existence of self-sufficiency and barter. The agricultural products produced by farmers, apart from satisfying their need for food, also allow them to obtain cash through the sale of these products and their services, and they use this cash to purchase their daily necessities through barter. (5) Their attachment to the land. The long-term existence of the smallpeasant economy has created farmers’ strong attachment to the land. Despite the fact that the income of rural households is becoming diversified, with many farmers even migrating to cities for work, but still find it hard to sever with tradition, culture, dignity and emotions that involve agriculture and the land. (6) Their emphasis on their relationship with family members and friends. Although small-scale peasant economy is a self-sufficient economy based on rural households, farmers living in the same village usually maintain a relatively close relationship, lending help to each other among family members and friends and human contacts are more frequent. This kind of relationship often leads to the formation of a variety of informal rules which has an impact on the operation of the rural economy. When studying rural economy issues in China, we should, on the one hand, understand the characteristics of the small-peasant economy which at present still occupies a dominant position in the rural area of China and analyze in depth its actual situation, and on the other, we should also note the changes that have taken place since reform and opening up, and accurately grasp the trend of its development.

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The Saving and Lending Behavior of the Rural Households in China According to the principles of institutional economics, people’s habits, customs and behavior patterns play a key role in the functioning of a society. From a narrow definition of rural finance, rural households in rural areas are the major targets for saving and lending. When we study issues of rural finance in China, we should therefore first study the saving and borrowing behavior of rural households. Due to the differences in level of regional development and income levels of rural households, their saving and borrowing behavior is different, and it in general has the following common characteristics: (1) A strong tendency to have self-protection-style saving. As rural households in China have long been small producers with unstable income, their ability to guard against risk is relatively low, their sense of self-protection is relatively strong, and they therefore usually tend to prefer to save when they have to make a choice between consumption and saving. It can be held that their motivation of saving is mainly preventive, that is, the purposeful, long-term and compulsory saving of rural households is to prepare themselves for any future consumption that might then exceed the affordability of their income levels. The consumer behavior of rural households is constrained by their income and also influenced by tradition and customs, and as it comes out of the motivation for self-protection, so in general it appears to be relatively conservative, and often rural households in general would only spend money when they build a house and have marriages, while they are usually rather frugal during ordinary times. In addition, the present lack of a rural social welfare and production insurance system greatly restricts the immediate consumption of most rural households, especially the more affluent ones. According to statistics from the National Bureau of Statistics, China’s per capita net income of rural households from 1986 to 2003 rose from the RMB423.8 to RMB2,622.2. After deducting for inflation, the average annual growth was 3.7%, and the growth of the savings of rural residents was far greater than that of income.1 Although the state in recent years has adopted means such as interest rate cuts and levying taxes on interest on deposits as an attempt to weaken residents’ propensity to save, the savings of rural residents continued to grow, and this shows that their motivation for saving is mainly a kind of self-protective saving, and not saving just to obtain the interest it accrues. (2) Their reluctance to borrow is gradually changing. Originating from the self-protective tradition that has been formed as a result of the long existence of the small-peasant economy, farmers in China mostly view having debts as

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bad and a loss of face. Therefore, when farmers face economic difficulties the immediate measures they take is to increase their income through sideline production or sell their services. When it is really difficult for them to ride out the storm, they privately seek the help of relatives and friends and they would not borrow from financial institutions unless the situation is desperate. In recent years, however, with the development of the market economy, this thinking is gradually changing, and the number of loans per capita for rural households has been on the rise.2 (3) The proportion of loans borrowed from relatives and friends is still high. According to the sample survey of the Rural Investigation Team of the National Bureau of Statistics, in 2000–2003, farmers borrowed a sum of RMB60 per person per year from banks and credit unions, and borrowed RMB190 by private lending, which accounted for 25% and 75% of the total amount of money borrowed. It is understood that in private lending, the majority of loans were from relatives and friends. When relatives and friends request loans, most farmers would try to help. The author, when conducting an investigation in Hunan, met a farmer with good credit who borrowed four times from credit unions, three of which were for his relatives and friends. The existence of this kind of situation mainly comes from the importance attached to relations among relatives and friends in a small peasant economy, and is also attributable to the weakening of rural financial services, high thresholds for loans, and complicated procedures. Small loans among relatives and friends in the rural areas usually do not have any written documents and interest is not usually paid, but borrowers must try their best to repay the debts, and do unpaid work or provide other “favors” in return. But with the development of the market economy in rural areas and the expansion in amount of loans being lent, requests for written acknowledgements and payment of interest have grown enormously. Some farmers in urgent need of money who cannot borrow from their relatives and friends are even forced to borrow from loan sharks.

The Present State of the Fictitious Economy in the Rural Area of China Seen from the five stages of development of the fictitious economy proposed by the author, the fictitious economy in rural areas has just entered the second stage, that is, at the early stage of turning idle money into interest-bearing capital. The first stage of the fictitious economy is the capitalization of idle money, that is, idle money is turned into interest-bearing capital. The origin of the fictitious economy can be traced back to commercial borrowing and lending

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among individuals. A, for example, needs to buy seeds, fertilizers or pesticides, but does not have enough money, while B happens to have some idle money. Then A asks B to lend him some money and promises to return the money and pay interest within a certain period. Through this activity, A gets the right to use the money and can take the money as means of payment to get profits through real economic activities, while B, with the debit note in hand, has guaranteed his title of ownership to the money so that when the lending period is over, he is entitled to claim back the principle and interest from A. At this stage, the debit note in B’s hand is an incipient form of fictitious capital, and its value can be increased through the cycle of borrowing and lending money. At this case, B is not engaged in real economic activities; rather, he makes profit through a kind of fictitious economic activity. Then the idle money has been changed into capital that can produce interests. As mentioned earlier, private borrowing and lending in China’s rural areas are mainly based on connections with relatives and friends. As most small loans do not need to pay interests, and do not have a written debt receipt, they therefore do not belong to the scope of the fictitious economy. But with the development of the market economy in rural areas and the increase in the amount of loans, requests for loan receipts and payment of interests have grown daily. When people in rural areas have idle money and want to lend it to generate interest, and while others need to borrow money for various reasons, it is often difficult to realize free borrowing and lending because the two parties often do not know each other or there is no one to serve as guarantor and this has given birth to borrowing and lending agents. When a borrowing and lending agent has facilitated the two parties of borrower and lender to reach an agreement, the agent would charge a handling fee or guarantee fee from the borrower. The second stage in the development of the fictitious economy is the socialization of interest-bearing capital. Fictitious economic activities built on private relationships are usually small in scale, and thus it is difficult to optimize the choice of investment targets, and they lack measures to defuse risk. This has generated the need for interest-bearing capital socialization, and it has given birth to banks. Banks as an intermediary organization borrow this idle money in the hands of the people, merge it and then lend it to people who need money and whose ability to make money is high. Enterprises which conduct indirect financing through bank loans have to bear higher costs. If enterprises have direct financing, such as issuing bonds to society, their financing cost would be lower than the interests on bank loans, and investors can also have profits that are higher than the bank’s interest on saving. In

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addition, enterprises can also issue shares to raise capital, sharing risks and profits with investors. People therefore can still use their idle money to buy other marketable securities, such as shares and bonds, to yield interest. Thus it can be seen that the socialization of interest-bearing capital has produced various forms of fictitious economy such as banks as well as bonds and shares. The socialization of interest-bearing capital can direct money in society from the hands of people who never engage themselves in real economic activities, such as production, circulation, and exchange, to the hands of those people who use them in real economic activities, and it can also merge money that is dispersed among various people to conduct economic activities that are of a larger scale and of higher profit, which can optimize the direction of investment and improve efficiency in the use of capital. Due to the existence of the dual economy structure in China, the degree of socialization of interest-bearing capital in rural areas is still relatively low. A great majority of farmers put their idle money in the bank, and only a small number of farmers lend their idle money to village and township enterprises or participate in the equity of village and township enterprises, and farmers who own bonds and shares can be said to be rare. And because of a shortage of supply of regular financial channels, there are still some irregular financial activities. It can be held that at present and in the next 10 to 20 years, the fictitious economy in rural areas in China will remain at the socialization stage of interest-bearing capital, mainly through indirect investment and financing activities conducted among financial institutions. There is a close link between a fictitious economic system and a real economic system, for a fictitious economic system is born from a real economic system and dependent on it. The risks born from a real economic system will be passed to a fictitious economic system, leading to its instability. And the risks of a fictitious economic system would also severely affect the real economy. As finance has become the core of the economy today, the real economy cannot be divorced from the fictitious economic system and operate on its own. Therefore, if the real economic system is seen as the hardware of an economic system, then the fictitious economic system can be regarded as the software of an economic system. There are two major types of risks in the real economy of China’s rural areas: The first is natural risks which are losses caused by various disasters that are difficult to be withstood by human power, and the second is market risks which are losses brought about by market demands and price changes. These two types of risks can make it hard for farmers to repay loans, so they pass the risks to a fictitious economic system, resulting in the formation of non-performing assets in financial institutions.

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The risks of the fictitious economy in the rural area of China are mainly credit risks, that is, the risks of the failure of the borrower to follow the agreement to repay the loans upon their expiry. This is caused partly by the risks of the real economy, and also partly by the breaking of the promise by farmers and township governments to repay their loans upon their expiry. As our business and financial credit systems are still inadequate, commercial banks therefore are usually reluctant to give credit loans to farmers and focus on giving guaranteed loans, including guaranteed loans, mortgage loans or collateral loans. At present, rural credit loans, which are mainly small credit loans set up to ease farmers’ difficulty in getting loans, are for the RCCs to issue loan certificates based on their assessment of the credits of farmers, and the amount of each loan is between RMB2,000 and RMB10,000, and no guarantees are necessary. Beginning from 2002, the system of RCCs comprehensively implemented small credit loans. By the end of March 2004, the remaining amount stood at RMB136.5 billion. However, some RCCs, in order to reduce risk, even farmers who hold loan certificates also need to provide guarantees in applying for loans, and each loan had to go through a detailed review, which had in fact turned it into a small guaranteed loan. In the above three types of guaranteed loans, mortgage loans are few in number, which is because the number of movable property of farmers are small, and hard to assess and realize, and their houses and the land they contracted are not suitable to serve as collateral. The number of collateral loans is slightly higher, and the collaterals are mainly deposit books and treasury bills. Largest in number are guaranteed loans with the guarantor shouldering all the responsibility for the debt. To solve the difficulty of lending to farmers without guarantees, the People’s Bank of China in 2000 issued the Guidance to the RCCs on Their Management of Farmers’ Co-Guaranteed Loans , requiring them to open up farmer coguaranteed loans to provide loans to members of co-guarantee groups. Coguarantee groups are voluntarily formed by five to ten rural households which have no direct family relationship and who need loans. The basic principle of lending is “multi-household co-guarantee, deposits on schedule and repayment by installments.” Members of co-guarantee groups are responsible for and guarantee the loans of the borrower. When the borrower cannot repay the loan principal and interest on schedule, they have to repay the loan on their behalf. This practice of mutual monitoring among farmers in the groups lowers the default rate and reduces the risk of credit, and it developed rapidly. By the end of March 2004, the balance of co-guaranteed loans reached RMB65.2 billion,

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and the actual balance was much higher than this amount as some small credit loans also adopted the practice of co-guaranteed lending. However, due to excessive pressure in monitoring, borrowers were over-cautious in the selection of projects and business activities, and the cost of financial institutions in their pre-lending investigation, in-lending checking and after-lending monitoring was high. It can be seen that when studying issues relating to the rural financial system, we should start from the actual economic situation in our rural areas, analyze their supply and demand of capital, and build the target model for the construction of the rural financial system.

The Real Economy in Our Rural Areas and Their Financial Needs When we take a holistic look at the development process of our small peasant economy over the last several thousand years, we have developed from the totally self-sufficient situation when we “had to work when the sun rises, rest when the sun sets, dig a well for water, and farm a field for food” to the situation of today where self-sufficiency and barter co-exist. Real economic activities are using money to buy fertilizers, pesticides, agricultural tools, seeds and other production materials, producing agricultural products through the process of agricultural production. Apart from keeping a part of the products they need for their own consumption, farmers take the remaining part to the market for sale to get money to buy other consumer goods. As the land area that most farmers cultivate is small and the production conditions are primitive, their monetary income is mainly used to maintain simple reproduction, purchase necessities, housing, finance weddings and funerals, education, and medical treatment, etc., and when their income cannot meet their expenditure, or when they face special difficulties such as natural disasters, the need for financing will be generated. Since reform and opening up, although the income of our farmers has greatly improved, due to reasons such as the low labor productivity of small peasant economy, a general oversupply of agricultural products, and a heavy tax burden on farmers, many rural households which rely only on agricultural income find it difficult to maintain their simple reproduction and simple life, and can only rely on means such as running sideline business and working outside their hometown to make their ends meet. According to data released by the National Bureau of Statistics, the net annual income of rural households per capita in 2003 was RMB2622.24, of which income from animal husbandry and fishery was RMB1,165.58, accounting for only 44.4%, which was much lower than the

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66.5% in 1990. In 2003 the average rural household consumption expenditure per capita was RMB1,943.30, of which cash expenditure was RMB1,576.64, which was higher than income from agriculture, forestry, animal husbandry and fisheries. Due to the fact that rural real economic activities that were based on the small peasant economy were hard to sustain, the following three types of real economic activities in rural areas emerged in recent years, resulting in major changes in the demand for rural finance. First, the emergence of large-scale operation rural households. Some farmers who engaged in farming and aquaculture gradually expanded their reproduction in order to emerge out of poverty. Since many farmers did not have enough money, they usually borrowed from relatives and friends or financial institutions at the beginning, but because of their lack of credit, financial institutions generally would not hastily give loans to them. With the expansion of the scale of their operations, the amount of money they needed also increased, and they were more inclined to borrow from financial institutions, and financial institutions were willing to provide loans to large operators of farming and animal husbandry with good credit and good prospects of development. Many successful farmers who were large operators of farming and animal husbandry have become more affluent, which encouraged more farmers to step onto the road of large scale operation, resulting in a strong demand for rural finance. Second, the development of village and township enterprises. In the mid1980s, village and township enterprises created on the basis of the rural collective economy began to emerge in the relatively developed areas such as Jiangsu, and soon expanded to various areas in the country. As the mode of their operation was more flexible and could better adapt to market demand, coupled with strong government support, the average annual growth rate of its output in the first few years was over 20%, and the average annual increase of employees was more than 10%, which became an important factor in the increased income of farmers. Beginning from the 1920s, the development of village and township enterprises gradually slowed down, and many township and village collective enterprises were transformed into individual, private or joint-stock enterprises. With the increasing commercialization of financial institutions, reliance on loans from financial institutions could not meet the financial needs of village and township enterprises, some informal financial institutions took advantage of this need and provided high-interest loans to them. Third, the rise of the agricultural industrialization model of “companies plus Rural Households.” In the latter part of the 1980s, companies with

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rural households as the main form of agricultural industrialization began to emerge in eastern Shandong Province, and then gradually expanded to the entire country. The main mode was to take agricultural products processing or circulation enterprises as the powerhouse, and through contractual relationships such as contracts or orders, led rural households to carry out specialized production, and linked up closely the production, processing and sale of agricultural products. As this system promoted the development of the rural market economy under the preconditions of essentially not changing the independent operations of rural households and their right of contracted land operation, it was more suitable for the current situation of agriculture, rural areas and farmers, and it therefore had faster development in recent years. It was reported that at present China had 372 national leading enterprises, 1,839 provincial leading enterprises, and there were more than 200,000 other leading enterprises. In 2002, the area of the “orders” of crop farming reached 327 million acres, accounting for approximately 14% of the total cultivated area, of which about half of it were completed by the leading enterprises. As agricultural production has its seasonal characteristics, it often requires a large amount of investment at the beginning of its production cycle, so rural households or leading enterprises need to borrow from financial institutions.

The Supply Channels of Rural Finance in China and the Organizational Behavior of Financial Institutions The supply channels of rural finance can be broadly divided into the four areas of policy finance, commercial finance, cooperative finance and private finance (irregular finance), which are supported by the four types of financial institutions: policy banks, commercial banks, RCCs and private banks respectively. As mentioned earlier, a shortage in the supply of money is currently the main issue of rural finance in China. The author is of the view that to understand the reasons that cause the problems and seek their solutions, we should analyze the organizational behavior of related financial institutions as a starting point. Organizational behavior is a study of the human behavior and experience in the context of an organization and the behavior that is produced by the organization in the context of the environment. From the perspective of complexity science, the behavior of an organization is determined by the self-organizing function that is created by the interactions among individual members (individuals and groups) and between organizations and the external environment, but the behavior of an organization would also produce a

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counter-effect on the behavior of its members. It can be seen that in analyzing the behavior of a financial institution, it is necessary to understand the behavior of its internal members as well as the situation of its environment.

The Agricultural Development Bank of China The Agricultural Development Bank of China (abbreviated as the Agricultural Development Bank) is a major policy financial channel in China other than our current financial allocation. The bank was founded in June 1994, and in that year it completed the organization and establishment of its provincial branches, while the actual business at the county-level branches was commissioned to the Agricultural Bank of China. In 2002, the Agricultural Development Bank completed the work of organizing and establishing its county-level branches. By the end of 2003, the Agricultural Development Bank had close to 2,000 institutions, which included 35 first-tier branches, 294 second-tier branches, 1,607 sub-branches, 3 business offices, and 34 credit loans units, with 59,000 employees. The agricultural development and poverty alleviation loans shouldered by the Agricultural Development Bank at the early period of its organization and establishment were placed under in the management of the Agricultural Bank of China in March 1998. At present its duties and responsibilities are limited to the provision of policy loans to the acquisition of grain, cotton and edible oil, which are largely equivalent to those of a fund entrusted institution, a far cry from the policy financial demands of providing policy financing to support agricultural development. The kind of the positioning of its functions led the Agricultural Development Bank to focus on the completion of its tasks in the acquisition of agricultural and sideline products, and did not expand its financial business in accordance with the responsibilities of banks. Due to its failure to open up other financing sources, the source of their capital mainly relied on refinancing from the central bank. By the end of April 2004, the loan balance of the Agricultural Development Bank was RMB684.7 billion, the deposits of savings were RMB24.8 billion, and loans from the central bank were RMB630 billion, accounting for 92% of its loan balance.

The Agricultural Bank of China The Agricultural Bank of China, which was founded in 1950, experienced four restructuring and three mergers. According to the stipulations of the Circular of the State Council Concerning the Fourth-time Re-establishment of the Agricultural Bank of China issued in 1979, the main tasks of the bank were to

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centralize the management of agricultural capital, focus on handling credit loans for the rural area, lead the rural credit unions, and develop rural financial business. It could be said that it is a specialized bank which engages in rural financial business. Although since 1985, some commercial banks began to spread its tentacles into the countryside, and provided loans to the then booming village and township enterprises, the Agricultural Bank of China remained the largest agriculture-related commercial bank. But with the rapid development of China’s urban economy, and the slowing down of the development of village and township enterprises, the four major state-owned commercial banks, including the Agricultural Bank of China, began to withdraw from the rural area in the latter part of the 1990s out of the commercial consideration of lowering costs and reducing risks. It was reported that during the four-year period from 1999 to 2002, the four major state-owned commercial banks withdrew and merged 31,000 grass-roots institutions below the regional and county levels. By the end of 2003, of the RMB1.37 trillion of loan balances of state-owned banks in the entire country, the loan balance of agriculture and village and township enterprises was RMB282.86 billion, accounting for only 2.06%. While the Agricultural Bank of China was withdrawing from the rural area, it shifted its business to support the industrialized operation of agriculture, specially formulating corresponding policy of credit lending and service measures, supporting contract farming and the development of the leading enterprises of “company + base + rural households.” By the end of 2003, the loan balance of agricultural industrialization was RMB65.4 billion, of which RMB39.9 billion was released in that year. Of the 371 key leading enterprises announced by the ministries and commissions of the state, 238 received the support of the Agricultural Bank of China, with a loan balance of more than RMB15 billion. At present, the Agricultural Bank of China has also undertaken a number of policy financial services, including poverty alleviation loans, loans for rural infrastructure construction focusing on restricting power grids, loans for rural urbanization, and others.

Rural credit cooperatives After the founding of New China, RCCs have grown continuously amidst twists and turns. By the end of 2003, RCCs had a total of 35,544 legal persons, a reduction of 2,547. Of these, 31,448 were first-level township (town) RCCs, 153 were county-level credit cooperatives, 2,460 county (city) unions, 3 rural commercial banks, 1 rural cooperative bank, 65 district (city) unions, and 7 county-level unions. By the end of 2003, the total number of employees of these

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financial institutions was 675,711. The total assets of RCCs in the country were RMB2.69 trillion, their total liabilities were RMB2.70 trillion, and the balance of deposits was RMB2.41 trillion. It stands to reason to say that RCCs are cooperative financial organizations which should be collectively owned by farmers. Farmers voluntarily put together their money to become shareholders, collect deposits and give loans in the local rural areas, collectively own the assets, practise democratic management internally, and apart from accumulated public capital, still obtain dividends. But in their actual development process, most of the RCCs become agencies and grass-root units of a national bank, and they increasingly shift in the direction of commercial finance. There are two major reasons to account for this kind of behavior. First, the property rights are not clear. According to provisions in the articles, the property rights of RCCs should belong to their members. But in reality, the proportion of internal staff shares and external legal person shares has gradually expanded, which, coupled with strong government intervention, resulted in the rather common phenomenon of insider control, and the General Assembly of rural credit cooperative members, their Board of Directors, and their Board of Supervisors exist mostly in name, and it is difficult for them to play a supervisory role. This makes getting profits their main operating principle and they even focus on getting profits for insiders. Although some RCCs suffer losses, their staff still maintains a relatively high salary. Second, there was a lack of policy support. RCCs, which were geared to the rural area, served tens of thousands of scattered rural households. They not only had to establish many business outlets in the area, but also allowed loan officers to travel to rural households to do business, while the loan amount was relatively small, the transaction cost was obviously very high. In addition, they lacked effective means to resolve all kinds of risks in rural finance, which inevitably led to the decline in the effectiveness of RCCs. Due to reasons such as the absence of ownership, imperfections in the system, poor management, and lack of policy, they have throughout their development generated a large amount of non-performing loans and losses, and as the burdens of RCCs were heavy, some credit unions were unable to support agriculture. By the end of 2002, 53.46% of RCCs in China had more liabilities than assets, amounting to RMB177.9 billion, and many RCCs could only rely on re-lending by the People’s Bank of China to maintain their operation. Since the state lacked policy support, many RCCs could not support farmers with small credit loans. According to a questionnaire survey conducted in 2002 by a county branch of the People’s Bank

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on all credit loan borrowers of RCCs in 2002 on its small credit loan business, 70% of the loan officers had a negative attitude towards small credit loans. As loan officers “grabbed the large and abandoned the small,” and “abhorred the poor and loved the rich,” it made it more difficult for farmers who were poor and constrained with low incomes to get loans.

Private banks As the supply of regular financial institutions was far from meeting the needs of rural finance, and their harsh lending conditions and complicated lending procedures often discouraged farmers, apart from private loans from relatives and friends, various private financial (irregular financial) institutions came into being, with private banks as their core. After reform and opening up, private banks began to emerge in some developed areas. These private banks normally began to develop through lending agents, engaging mainly in the business of deposits and lending and made profits through the interest rate difference between deposits and loans. During the latter part of 1984, four private banks in Zhejiang and Wenzhou had successively been given approval by the local government to do business, and some private banks developed rapidly. In January 1986, the State Council issued Provisional Regulations of the People’s Republic of China for the Control of Banks , and stipulated that individuals were not allowed to establish banks or other financial institutions, or operate financial business. After that, although the public private banks in Wenzhou were delisted and closed, the private banks that engaged in lending business in the rural area did not disappear. This was especially the case after the 1990s. Due to the increasing demand for money in the rural economy and the reduction of the supply of money caused by the departure of commercial banks and the removal of rural cooperative foundations, private financial institutions, represented by private banks, had much room for development. Their clients not only included rural households who needed to develop production and township enterprises which needed to maintain their operations, but also some township government and villagers’ committees which required money to complete the tasks assigned by their superiors. Because of their high deposit interest rates, it helped them to absorb the idle money in farmers’ hands. Though their lending rates were higher, their procedures were simpler, so borrowers and lenders needed private banks and supported their development. But as the operation of private banks was an illegal financial activity, their operational activities were rather secretive, and sometimes they presented themselves in the identity of a lending agent.

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According to a survey by a branch of the Agricultural Bank of China in the Wenzhou City, about 83.3% of rural households borrowed through private lending activities, the size of private lending in Wenzhou accounted for one third of the total rural capital market. Some capital of the banks even became the “capital” of high-interest loans.

The Target Model for the Construction of China’s Rural Financial System and Related Policy Recommendations Based on the above analysis, it can be seen that China’s rural financial reform really is a lofty task and has a long way to go, and we need to choose a path of development that is based on the national situation of China. The author is of the view that when studying this issue, we have to firstly determine the target model for the construction of China’s rural financial system, and then work out the measures and steps to achieve this target model by analyzing the current situation as a starting point, and further propose related policy recommendations.

The Target Model for the Construction of China’s Rural Financial System Based on the specific situation of the rural area in China and with reference to the experience of foreign countries, the author believes that before 2020, the target model for the construction of China’s rural financial system should include the following four characteristics.

Financial support and market operation Before 2020, China’s agricultural industry will remain a weak industry and farmers will still be a disadvantaged group. To develop rural finance, we must rely on the “visible hand” of the government to provide the necessary financial support. However, such financial support should not be done through the methods of the government departments directly providing money to rural areas or indirectly providing subsidies to rural households, but should be done through careful policy design and proper institutional arrangements, relying on the “invisible hand” of the market and the operation of various types of financial institutions to improve the effectiveness and efficiency of the use of capital. The government policy should provide policy financial institutions most

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of the capital and the necessary initial working capital. It should also provide support for them to issue bonds, and then through policy financial institutions provide necessary policy support to the commercial financial institutions and rural cooperative financial institutions to support farmers. The government should also provide policy preferences (such as reserve reductions and tax exemptions) and the necessary financial support (such as debt guarantees and loss subsidies) to rural cooperative financial organizations and some commercial organizations which support agriculture. In addition, relevant government departments should also provide investment to social-welfare type of business in rural areas, and promote the development of social business in rural areas through various forms of subsidies.

A triple balance of power, each performing its own duties China’s rural finance should consist of the three forces of policy finance, commercial finance and cooperative finance. Among these three forces, there should be a clear division of labor with each performing its own duties. The role of policy finance is to use various financial means to promote the economy and social development of rural areas through establishing financial institutions by the government and relying on the support of financial resources. Its principal businesses include, among others, the provision of midand long-term loans with preferential conditions to farmers who need them for production, the proper provision of interest subsidy to commercial banks in their lending to farmers compensations for the transaction cost and risks, and the provision to insurance companies for reinsurance subsidies for greater natural risks. It can also provide low-interest loans for low-return projects such as improving the conditions for agricultural production and expanding production scale. Direct investment can also be carried out. The role of commercial finance is mainly to provide a variety of financial services to rural households, village and township enterprises and leading enterprises through various types of financial institutions and through the operation of the market. Its principal businesses include absorbing local deposits, providing short-term and short-term to mid-term loans to rural households for production purposes and providing floating capital, technology improvement loans and bill discounts to township enterprises and leading enterprises. Cooperative finance is mainly to provide simple financial services to members and local farmers through cooperative financial organizations formed voluntarily by the farmers. Its principal businesses include providing small,

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short-term, low interest loans to farmers for production and consumption and helping farmers to borrow from policy financial institutions and commercial financial institutions.

Deposits and loans are a core and should be a comprehensive package In the next 10 to 15 years, the main business of China’s rural financial institutions will still be the absorption of deposits from rural households and provision of loans to rural households. With the development of rural market economy, we should gradually develop financial services such as settlement, foreign exchange, financial consulting, leasing, trust, insurance, credit cards, safe deposit box, and issuance and trading agency of securities, eventually creating a better and comprehensive package for the rural financial service system.

A sound legal system for the growth of the market The development of rural finance must be guaranteed by a complete legal system to regulate the behavior of market subjects, the basic relationship among market subjects and the order of market competition. We should follow the relevant principles in the Chinese Constitution and using the Agriculture Law and Financial Law as the parent laws to establish the legal system for China’s rural finance. When we look at laws of rural finance in various countries, our country should at least have a number of laws, such as the Agricultural Loan Act , Agriculture Credit Act , Agriculture Insurance Law , and Cooperative Finance Law , and supplement these laws with the necessary administrative regulations. With the development of the rural market economy, the increase in rural credit loans will progressively rely more on financial markets, especially the raising of capital by issuing bonds. To do this we have to make great efforts to cultivate China’s bond market. Besides national bonds, policy financial bonds, and corporate bonds, we can add agriculture bonds to this type of bond, and establish a system for their issuance, distribution and regulation. The insurance market can start first with production insurance to guard against natural risks and market risks, and then it can gradually develop into other types of insurance, such as property insurance and life insurance.

The Strengthening of the Functions of the Policy of Financial Institutions The Agricultural Development Bank is currently the only rural policy financial institution in China. We need to greatly strengthen its functions to turn it into a specialized bank of policy agricultural loans. At present, the Agricultural Development Bank is limited to the provision

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of policy loans for the acquisition of cotton and edible oil. As a commercial bank, the Agricultural Bank of China has also assumed the policy lending tasks such as the issuance of interest-subsidized poverty alleviation loans. The shortcoming of this practice is that commercial banks, in their pursuit to enhance their own performance, are not willing to make any effort to operate low-efficiency policy finance tasks. They also use their low-efficiency finance activities as grounds for government subsidies. Some commercial banks lend the interest-subsidized rural poverty alleviation loans to wealthy rural households who are not the most in need of money, or even misappropriate capital for the acquisition of agricultural products, or pass on the losses and risks they suffer in their commercial operation activities to the policy business they operate. In addition, it is also inappropriate for government departments to directly engage in policy financial activities in the forms of money allocation or subsidies as this often leads to excessive government intervention in financial operations, resulting in issues of unfairness. It is obvious that we should centralize all the functions of policy finance in the hands of the Agricultural Development Bank. To achieve this, we should adopt the following measures to make adjustments and restructuring of the Agricultural Development Bank: First, put the financial policy business such as interest-subsidized poverty alleviation loans currently operated by the Agricultural Bank back to the Agricultural Development Bank as soon as possible, and clearly specify the functions of this bank. Second, the Agricultural Development Bank capital should be replenished, its property rights clarified, and a legal person governance system should be established and perfected. We suggest approving its total capital at RMB50 billion, which would be borne by the central government and local governments by the ratio of seven to three. Directors would be appointed based on the ratio of capital contribution and three rural financial experts would be hired as independent directors to form the board of directors. The chairman of the board would be appointed by the State Council while the general manager would be nominated by the board, and appointed with the approval of the State Council. Third, policy finance of the Agricultural Development Bank should gradually be expanded in the next five years: (1) long-term low interest or interest-free loans should be provided to projects for the construction of rural infrastructure (such as roads, communications, and power network) and social development (such as hospitals and cultural centers); (2) long-term low-interest loans or direct investment should be given to low-return projects for the improvement of the conditions for agricultural production and the expansion of the production scale; (3) low-interest loans should be given to RCCs; (4) appropriate interest

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subsidies should be given to compensate trading costs and risks to commercial banks commissioned by the Ministry of Finance to support farmers with loans, and to provide insurance companies with reinsurance subsidies for greater natural risks. The required operating capital for the above items come mainly from financial allocation, and partly from relevant capital established by the government. Fourth, in accordance with WTO rules, the domestic policy to support a g r i c u l t u re re s u l t i n g i n t r a d e d i s t o r t i o n a n d re q u i r i n g re d u c t i o n o f commitments is known as the “yellow” policy, and it is expected that from now on the space to provide discount interest and subsidy to rural finance will be increasingly constrained. Because of this, we should actively create conditions so that commercial finance that supports agriculture and rural cooperative finance can operate soundly, and the focus of support of the loan guarantees provided by the Agricultural Development Bank for project credit loan schemes promoted by the government should also be shifted to projects such as scientific research, technology promotion, food safety storage, natural disaster relief, environmental protection, and adjustment of agricultural structure to conform to the “Green Box” policy of WTO.

Encourage Commercial Financial Institutions to Support Agriculture Of the four major commercial banks in China, the Agricultural Bank of China should be a specialized bank that engages in rural finance, but as the transaction costs for loan projects to support agriculture are higher and more risky, not only the Agricultural Bank of China gradually withdrew from rural areas and watered down its support to agriculture, even RCCs, which were originally rooted in the rural areas, moved more towards commercial finance, lacking the enthusiasm to support agriculture. It can be seen that in order to encourage commercial financial institutions to support agriculture, we must take effective measures to resolve the two issues of high transaction costs and greater risk. The main reasons for the high transaction costs involved in loan projects to support agriculture are as follows: first, the loan amounts are relatively small, and the cost of processing a RMB200,000 loan is clearly much lower than that of processing 40 loans of RMB5,000 each; second, as loan applicants live in scattered places, loan officers have to spend more time and effort to go there to understand the situation and handle the procedures; third, the general educational level of loan applicants is not high, loan officers often need to help them to fill in loan application forms and handle loan procedure; fourth, as the business turnover of the grass-root networks is small, it is difficult for income so

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attained to make up the expenditure for their establishment and maintenance. As it is difficult to lower the transaction costs of loan projects that support agriculture, some suggest adopting the method of raising lending rates to compensate for the cost, but this would add more burdens on rural households with loans and would not help promote agricultural development. The author suggests using methods of discount interests or subsidies which would not add an extra burden on farmers who take out loans, but also encourage commercial financial institutions to support agriculture. The capital needed for discount interest or subsidies would be shared by the central and local governments which the Agricultural Development Bank would then approve. The risk of loan projects that support agriculture mainly involve the following three aspects: The first are risks from natural disasters. When confronted with huge natural disasters, farmers are often unable to repay their loans. These risks can only be resolved through the insurance of the farmers. But because of low premiums and high claims, commercial insurance agencies are usually unwilling to accept it. The author suggests the insurance companies apply for re-insurance, with the reinsurance premiums partly coming from financial subsidies, and commissions the Agricultural Development Bank for its approval. The second are market risks. When the demand for agricultural products reduces or their prices go down, the income of farmers would be much lower than the expected amount, thus affecting their repayment ability. To resolve such risks, we should vigorously promote agricultural industrialization and expand the coverage of orders. At the same time, we should make great efforts to develop the agricultural futures market, and reduce the losses caused by market risks to a minimum through hedges. The third are credit risks. This mainly refers to, apart from the above two reasons, the borrower’s breach of contract and the risks of not repaying the loan upon its expiry. This kind of risk has to be resolved by various means. According to the actual situation of China’s rural areas, we suggest dividing the commercial financial institutions that support agriculture into two levels: that Agricultural Bank of China mainly gears itself to meet the needs of the leading enterprises and large-scale village and township enterprises for agricultural industrialization, while RCCs, with the appropriate support of the state, gear themselves to meet the needs of rural households and small- and medium-sized village and township enterprises. Rural commercial banks could cover both levels. In the course of the pilot reform of RCCs in Jiangsu, rural commercial

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banks were established at the three county-level cities such as Changshu, Zhangjiagang and Jiangyin. The author went to Jiangsu twice in 2002 and 2004 to conduct research on new developments that have emerged from rural financial development, and it seemed that their performance was on the whole satisfactory. There are several characteristics of this kind of county commercial banks. First, they operate according to the joint-stock or joint-stock cooperative system and their property rights are relatively clear. Second, they mainly serve local customers, their information is more symmetrical, and the cost of the clients’ loss of credit is also higher. Third, there are more network points in rural areas. These points are close to rural households and can better play the role of supporting agriculture. Fourth, their internal system is relatively sound and their administration is regulated. We suggest gradually expanding pilot points in county-level cities with good conditions, take effective measures to support their development, constantly improve their corporate governance system, but also protect their independent legal status so as to prevent their operation from the unreasonable interference of local governments and provincial union cooperatives. The following measures are proposed to encourage commercial financial institutions to support agricultural development: (1) Preserve and improve the small credit loan system for rural households, which is mainly for supporting them through difficulties to maintain their simple reproduction (such as the purchase of seeds, fertilizers, pesticides, and simple agricultural tools) and their temporary needs. The amount of each loan is usually under RMB5,000, with its date of expiry matching the cycle of agricultural production and an interest rate the same as or slightly lower than the normal interest rate. This type of loan needs no guarantee, but loan officers should cooperate with the village committee on the work of farmers’ credit certification. (2) Improve and expand the system of guaranteed loans for rural households to use it mainly for supporting them to expand their reproduction on a small scale, and meeting their needs such as housing and sending their children to college. The amount of loans is usually under RMB50,000, and the loan period is usually less than one year. (3) In order to compensate the transaction costs and risks of these two types of loans, we propose giving business tax exemption to RCCs and rural commercial banks the income from these two types of loans. If a loss does occur, then the Agricultural Development Bank of China could give them appropriate discount interest loans. The Agricultural Development Bank of China can

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then commission some specific businesses in policy finance to RCCs and rural commercial banks and give them certain commission fees. (4) Regulate the development of rural postal savings. We propose that the absorption of postal savings deposits in rural areas should be deposited into the People’s Bank of China with the same conditions as other commercial financial institutions, and then the People’s Bank of China can lend them to RCCs and rural commercial banks in the form of re-lending to ease their difficulty of capital shortage. (5) Continue to address the historical burden of RCCs. We must seriously and practically implement the confirmed support of financial subsidies and tax reliefs, including, among others, the following four approaches: issuance of value-ensured savings deposit and interest subsidies, temporary exemption of income tax for credit unions that participate in the pilot scheme in the western regions, provision of appropriate funding support for credit unions through the means of re-lending and special bills by the People’s Bank of China, and expansion of the floating range of lending rates of the credit unions which take part in the pilot scheme. (6) Establish loan guarantee companies. These companies could be formed with joint capital contribution from local finance and private capital mainly for providing guarantee for big clients in planting and breeding to apply for loans from commercial financial institutions. According to the survey conducted by the author in June 2004 in Jiangyin City in Jiangsu Province, Jiangyin Fumin Limited by Guarantee played a positive role in supporting rural households to appropriately expand their scale of operation to get rich. Currently the guarantee ratio is generally between one to five and one to eight, the recovery rate is 100%, the annual after-tax profit rate is about 5%, and has withdrawn risk reserve which is about 5% of the registered capital. (7) Stipulate that the proportion for supporting agriculture in the balance of loans of the Agricultural Bank of China should not be less than 12%, and the proportion of the balance of loans for supporting agriculture in rural commercial banks should not be less than 60%. Projects which are in line with state industrial policy, have an important role to play in agricultural development, and whose transaction costs and risks are high, therefore the Agricultural Development Bank of China can give an appropriate interest discount. (8) Develop agricultural production insurance so that big clients in planting and breeding can insure their future income, and then apply for bank mortgage loans for their expenditure on the production process. For example, a big

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client in pig-farming can, after purchasing piglets, apply for insurance from insurance companies, and then apply for mortgage loans for purchasing feed by presenting the insurance policy to the bank.

Support the Development of Cooperative Financial Organizations In market economy countries like the U.S., France, and Japan, rural cooperative financial institutions are well-developed and are the main force behind rural finance. Our government has repeatedly stressed that RCCs are cooperative financial organizations, and in their recent reform, also proposed that they should play a major role in the provision of rural finance. But over the years because of excessive intervention of local township governments, unclear property rights, high degree of insider control, and a lack of a strong supporting policy, the majority of RCCs have not only suffered operational losses, but also gradually moved towards being commercial financial institutions. Since the beginning of the reform of RCCs in 1999, the trend of increased losses has been curbed, and there has been a reduced loss and an increased profit for three consecutive years. In 2002, there were 23,643 RCCs in the country that made a profit, accounting for 66.52% of the total, and this is an increase of 3,047 cooperatives and the amount of profit was RMB59.23 billion. In 2002, there were 11,901 RCCs that suffered losses, a reduction of 5,664 cooperatives when compared to 2001, and the amount of losses was RMB11.707 billion. When balancing profit and loss, the amount of reduced losses of the RCCs in the country for 2001, 2002, and 2003 were RMB3.05 billion, RMB72.03 billion, and RMB53.22 billion respectively. By the end of March 2004, the deposit balances of RCCs in the country were RMB2.58 trillion, the balance of loans was RMB1.89 trillion, of which agricultural loans accounted for 43.3%, and loans to village and township enterprises accounted for 32.6%. In the balance of agricultural loans, the ratio of loans to rural households and loans to agricultural economic organizations ratio was about four to one. We should adhere to the internationally recognized “seven principles for cooperatives,” which are (1) that cooperatives operate as voluntary and open organizations; (2) that they have democratic management and practise one person one vote; (3) that they are non-profit-making and that members should be involved in distribution; (4) that the cooperative be autonomous and debtfree; (5) that members should be given education, training and information; (6) that the cooperative should gain society’s involvement; and (7) that it should exhibit sociality among members. Rural cooperative financial institutions are financial institutions where rural households voluntarily become shareholders,

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and which are managed in a democratic manner according to the “one person one vote” principle, taking the shareholding rural households as their main targets of service, with profit-making not being their main purpose, and are mutually beneficial to members. However, as many issues regarding the system have yet to be resolved, the majority of RCCs in China currently are not truly cooperative financial organizations, and it is difficult for them to be the main force in rural finance. In the pilot points of this reform of RCCs, it was established that as far as the property rights structure of RCCs is concerned, there are the three systems of the joint-stock system, joint-stock cooperative system, and cooperative system. These systems are to be independently decided by the provinces which participated in the pilot points according to their own situation and can adopt the three organizational forms of the joint-stock commercial bank, joint-stock cooperative bank, and cooperatives as their organizational models. And the responsibility of the industry management of the RCCs could be entrusted to the provincial government organizations, and establish the supervisory management system of “the state has macro-control to strengthen supervision, the provincial government manages in accordance with law to fulfill its responsibilities, and the RCCs have self-discipline and bear their own risks.” It can be expected that if there is a lack of strong support and leadership of the rural cooperative financial organizations, most RCCs will gradually be transformed into commercial financial institutions. It would then be more difficult for these commercial financial institutions to meet the financial needs of low-income rural households out of the consideration of cost reduction and risks prevention, which will further stimulate the development of private finance in the rural area. In the construction of our rural financial system, we must face the fact that the current cooperative finance is weak and private finance is still under development. With the support and guidance of the government, we should come together and absorb the strengths of various sources, and positively and steadily restructure the cooperative financial organizations in the rural area. To achieve this, the author has the following suggestions to make: First, encourage RCCs that are willing to adhere to the road of cooperative finance to be transformed into real cooperative financial organizations. We must seriously emend the constitutions of RCCs according to the spirit of a cooperative system and combine it with the specific local situations, attract rural households who need loans to become shareholders, call general meetings and general assemblies of the members in accordance with the principle of “one person one vote,” pass the constitution for electing the council and board

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of supervisors, and the director of a RCC is to be appointed by the council. To avoid insider control, members’ shares (including the original shares of the group) should be above 70%, and the shares of the employees of RCCs should be set at below 20%. The state needs to exempt business tax and income tax for cooperative financial organizations and reduction of reserves, and give them preferential measures such as appropriate re-lending when their loans are larger than their deposits. Second, support RCCs to serve local rural households. We should allow financial organizations to engage not only in the traditional businesses such as the provision of clearance, exchange, and savings, but also provide intermediary businesses such as consulting, buying and selling securities, insurance agency, and leasing agency. For all the places where cooperative financial organizations are established, the Agricultural Development Bank of China can be commissioned to serve as an agent to manage some actual business of policy finance, and give them some agency fees. Commercial banks may also be entrusted to conduct credit ratings on rural households who apply for loans. Third, help RCCs establish a mechanism for their members to share the risks and enjoy the profits together. RCCs take the county credit unions as their legal person, operate independently and are self-financed. Members would not receive interest for the shares they buy, but would get dividends at the end of the year according to the shares they hold.

Lead Private Finance into Compliance Due to the supply and demand imbalance for rural finance, the high cost and great difficulty by rural households in obtaining loans from regular financial organizations, and their lower deposit interest rates as well as the development of rural economy, it is indisputable that private finance is quite prominent in the rural areas. Apart from the revival and proliferation of various traditional forms of “cooperatives” and “private banks,” all forms of financing activities such as “loan societies” and “foundations” have begun to become popular in a more or less open manner. From survey findings of over 20,000 rural households in 31 provinces, cities and districts in the country conducted by the Policy Research Office of the Central Committee of the Communist Party of China, and Office of Rural Fixed Observation Points of the Ministry of Agriculture, private lending in rural areas is still the main source of loans for rural households. In 2002, the average amount of accumulated loans per rural household was RMB1,414, RMB394 more than that in 2000. Of the amount of loans borrowed, 71.8% came from private lending (24.1% higher than that of 2000), about RMB1.02 per

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household. What is more, the proportion of interest-bearing loans (the majority of which are high-interest loans) in private lending was as high as 53.3%. According to a rough estimate based on 200 million rural households, the loans provided by the private lending market to farmers in China’s rural areas in 2002 were as high as over RMB200 billion, of which interest-bearing loans exceeded RMB100 billion. It is true that the active private lending market in rural areas has to some extent promoted the growth of agricultural production and the activities of non-agricultural production and business, and can help farmers to overcome some of the difficulties they encounter in life. However, as the various levels of governments and financial regulatory departments mainly adopt measures to restrict and combat private finance, the private lending market in rural areas has not been incorporated into the normal scope of management for regulation and support. The extensive existence of extremely non-regulatory behavior in private finance has disrupted the normal financial order in the rural areas, increased the burden of farmers’ repayment of loans, and can easily lead to a variety of civil disputes and criminal cases, affecting social stability. We therefore suggest adopting the methods of guidance and interception to bring private finance, the “wild horse,” to submission. First, protect the legal rights of creditors and debtors in private lending and limit high interest rates. In Some Advice of the Supreme People’s Court on the Trial of Loan Cases by the People’s Courts issued by the Supreme People’s Court on August 13, 1991 for implementation, it was stipulated that “the handling of loan cases by the People’s Court should follow the principles of voluntariness, mutual benefits, fairness and legality so as to protect the legal rights of creditors and debtors, and limit high interest rates.” It was stipulated in Article VI that “private lending interest rate can be appropriately higher than the bank interest rate, which can be understood by the local people’s courts according to their actual situations, but the highest rate should not exceed the bank lending rates of similar loans by four times (including the interest rate on capital). Beyond this limit, the excess interest shall not be protected.” This stipulation could continue to be implemented, but we suggest changing “four times” to “three times.” Second, encourage private capital in rural areas to participate in the equity of commercial financial institutions. We should allow commercial banks in rural areas to absorb natural persons to buy their shares. Every one of them should at least buy RMB50,000 worth of shares, and get dividends according to the number of shares they own. Before equity participation, operators of underground banks should end on their own existing business activities, and

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properly handle the remaining issues. Staff with high political quality, public spiritedness and strong business skills can still work in commercial banks. Third, guide “loan societies” and “foundations” for transformation into cooperative financial organizations. The shares privately held by rural households can be shifted to shares or deposits on a voluntary basis, and they get their dividends or interests according to the regulations of the cooperative financial organizations. The structure and procedures of transformation should be conducted in accordance with the regulations established by China’s Bank Regulatory Commission. People originally in charge, if they have high political quality, public spirit and strong business capacities, can be elected into the council or general assembly, or be employed as staff through the council. Fourth, resolutely crack down on all kinds of illegal financing activities of the Rotating Savings and Credit Associations and tai societies. We have to strengthen publicity and education so that the majority of rural households understand the risks and hazards of these societies. For those who cause the collapse of these societies, they should be held accountable and brought to justice. For illegal financing activities, we should persuade and stop them in a timely manner and handle their cases properly. For gangs which colluded with criminals in usury in the rural areas, we must resolutely suppress them. In the process of building a moderately prosperous society in China, rural finance has played an important role in such aspects as developing agricultural production, allowing farmers to increase their income and maintaining stability in the rural area. When improving and perfecting the construction of the rural financial system in China, we must pay attention to the unity of stages and continuity. We should neither go beyond reality to be impetuous and adventurous nor yield to reality to evade contradictions. We should promote agricultural productivity and the development of social undertakings in the rural areas through the development of rural finance, in order to lay a solid foundation for us to realize modernization in China.

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9

Chapter

The Current Situation and Future Outlook of Venture Capital in China

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 2

Characteristics of Venture Capital and an Overview of its International Development So-called venture capital refers to a kind of commercial investment behavior involving investing capital into technologically innovative areas, which potentially have higher risks of failure, with the expectation of getting high capital returns when the investment is successful. In essence, this means investing in a group of high-risk and high-return projects, and selling or listing in the stock market those successful projects to realize the divestment of the owners’ equity, which not only can compensate for the loss of the unsuccessful projects, but also provide higher returns for the investors. Venture capital has the following five major characteristics: (1) It is a high-risk investment (risky investment). As venture capital is primarily for supporting innovative technologies and products, the risks in such aspects as technology, economy and market are very high, and the success rate is only around 30%. According to the descriptions of some of the experienced venture capitalists in the U.S., in general only one-third of the projects they invest in are very successful, another one-third breaks even, and the remaining one-third go down the drain. However, as the return rate on successful projects is quite high, it can still attract investors to speculate in them. (2) It is a portfolio investment. In order to diversify risks, venture capital is usually made in a project group that contains multiple projects. It makes use of the high returns it gets from listing or selling successful projects to realize divestment, offset the loss in the unsuccessful projects, and obtain profits. (3) It is a long-term investment. It usually takes three to seven years for venture capital to get returns through divestment, and we have to make continuous capital increments for hopeful projects during this period. (4) It is an equity investment. Venture capital is an equity capital rather than a debt capital. As such, its focus is not on the current profits and losses of its investment targets, but rather on their development prospects and capital appreciation so as to get high returns after divestment. During the growth stages of the enterprises supported by venture capital (hereafter called venture enterprises) when they expand their size and develop their market, their cash flow is usually negative and when we look at their business performance, they usually make losses. Therefore investors are generally not willing to invest in these enterprises. But venture capitalists take consideration of the owner’s equity, believing investing is worthwhile as long as the value of these venture enterprises keeps growing. (5) It is a professional investment. Venture capital not only provides capital to entrepreneurs, its managers also bring with them the knowledge, experience

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and extensive social connections they have accumulated, actively participate in the management of the venture enterprises they co-founded with entrepreneurs, offer their advice on areas such as the reform of the organizational structure, the direction of the business, the strengthening of financial management, and the appointment of the leading members of the enterprise. They try their best to help entrepreneurs be successful. The U.S. is the first country to develop venture capital, and it is also currently the country with the largest scale of venture capital in the world. A serious analysis and study of its experiences and lessons is valuable as an important reference for the development of venture capital business in China. It is true that venture capital as a special form of investment can be dated back to the 1920s and 1930s when some wealthy families and individual investors in the U.S. provided startup capital for companies such as Eastern Airlines and Xerox which turned out to be successful. It is generally held that the founding of the American Research and Development Corporation in 1946, the first venture capital company in the world, marked the beginning of venture capital. Venture capital in the U.S., having gone through the huge ups and downs in its development: its formation in the 1950s, its growth in the 1960s, its decline in the 1970s, its revival in the 1980s, and its temporary setback in the early 1990s, began to show its power from the middle of the 1990s and became an important force to drive ahead the economic development of the U.S. There are two parameters relating to the statistical data on the scale of venture capital: one is commitments to venture capital, referred to as commitments, and the other is the amount raised by venture backed companies, which is the actual input made in backed enterprises from venture capital, referred to as amount of investment. Since 1992, there has been a rapid growth of venture capital in the U.S., and its return rate has also increased significantly. During the 20 years between 1975 and 1994, the average rate of return on venture capital was only 13.1%, but the return rates for 1995, 1996 and 1997 were as high as 48%, 40% and 36% respectively. There was a rapid growth of venture capital in the U.S. during the period 1996–2000. The actual amount of investment, the number of projects supported and the average size of investment in 2000 were 76, 25 and 31 times of that of 1996 respectively. During the three years of 1998–2000, in particular, the total actual amount of venture capital in the U.S. nearly doubled each year. It is reported that during the most prosperous period of venture capital in early 2000, there were about 7,000 venture enterprises in the Silicon Valley where every day 30 people became millionaires, about 500 new venture enterprises opened their doors, and the same number of venture enterprises closed down.

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Table 9.1 sums up the statistical data of venture capital in the U.S. from 1998 to 2005. According to the data in Table 9.1, the changes in the total amount of venture capital in the U.S. from 1998 to 2005 are shown in Fig. 9.1. Table 9.1.

Statistical data of the size of venture capital in the U.S. during 1998–2005 1998

1999

2000

2001

2002

2003

2004

2005

Number of venture capital



202

249











Committed investments (USD100 million)



345.4

690.8











163.4

452.2

852.8

345.7

209.6

185.8

210.4

216.2

2,200

3,874

5,447

2,934

2,190

2,007

2,120

2,139

500

700

1,100











Actual investments (USD100 million)

Number of projects supported

Average size of investment (USD10,000 / project)

The raw data in this table are taken from the PricewaterhouseCoopers Money Tree Survey in Partnership with Venture One , with an analysis and processing by the author.

Note:

Fig. 9.1.

The changes in the total amount of venture capital in the U.S. during 1998–2005

Amount of investment (USD1 million) 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000

0

1998

1999

2000

2001

2002

2003

2004

Year

The amount of investment of venture capital organizations

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As shown in Fig. 9.1, the total amount of venture capital in the U.S. reached

the peak of nearly USD100 billion in 2000, but fell rapidly in 2001. But if the

data is to be taken on a quarterly basis, we can see that venture capital in the U.S. started to show a downward trend from the second quarter of 2000. The first

quarter of 1999 was USD 5.09 billion, the second quarter, USD 8.32 billion, the third quarter, USD 8.97 billion and the fourth quarter, USD15.81 billion. The first

quarter of 2000 was USD19.35 billion the second quarter, USD18.93 billion, the

third quarter, USD16.76 billion, and the fourth quarter, USD13.71 billion. The first quarter of 2001 was USD10.11 billion. On a yearly basis, it should be said

that 2000 was the peak, but on a quarterly basis, the first quarter of 2000 was the peak, and it started to slip thereafter, which in general coincides with the trend

of economic development in the U.S. For 2002, 2003, and 2004, basically it was maintained at the level of USD18–20 billion.

According to the data shown in Table 9.2, it is expected that venture capital

in the U.S. will again start to rise slowly. Table 9.2.

Note:

Capital-raising of venture capital in the U.S. (Unit: USD1 million) Total amount of capital raised

Rate of investment

Rate of noninvestment

Balance of capital raised

1999

44,540.26

94.54%

5.46%

2,432.78

2000

64,029.30

79.94%

20.06%

12,841.52

2001

38,839.38

67.43%

32.57%

12,651.27

2002

11,380.00

58.66%

41.34%

4,704.90

2003

7,853.20

35.93%

64.07%

5,031.25

2004

15,765.60

17.92%

82.08%

12,940.30

The primary data in this table are taken from The PricewaterhouseCoopers Money Tree Survey in Partnership with VentureOne.

It can be seen from Table 9.2 that most of the capital raised in 2000 and 2001 were invested. The investment rate in 2000 was 79.94%, in 2001, 67.43%. But after 2002, this figure dropped sharply. In 2002, the investment rate was 58.66%, while in 2004, only 17.92% was invested. This shows that in recent years, the amount of capital raised in venture capital in the U.S. was still relatively large. But as venture capitalists had learned the lessons from the burst of the bubble of Internet stocks, they became more prudent in their investment. Then came

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the problem of excessive capital accumulation, which was estimated to be in the region of USD53.6 billion, and this capital eventually had to be invested. It can therefore be predicted that with the growth of the economy in the U.S., the venture capital business in the U.S. will also continue to develop. The development of global venture capital is more or less the same with the U.S. The amount raised for global venture capital and the amount of investment from 1998 to 2004 are shown in Fig. 9.2. Fig. 9.2.

The amount raised for global venture capital and the amount of investment during 1998–2004

USD1 billion 300

262

250 200 133

150 100

154

177

93

124

50

103

70

0

1998

1999

2000

Amount invested Note:

180

192

2001

86

2002

115 112 82

2003

2004

Year

Amount raised

The data in the Figure are taken from PricewaterhouseCoopers, Venture Economics , NVCA, CVCA Annual Report , EVCA Annual Report , AVCJ Report , Latin American private equity investment analysis , SAVCA survey of private equity .

Global venture capital is currently concentrated in North America and

Europe. In 2004, the amount of venture capital in North America accounted for 66% of the total amount of global venture capital, an 8% increase as compared

to that of 1998; the amount of venture capital in Europe accounted for 26% of total amount of global venture capital, an increase of 2% as compared to that of 24% in 1998. The proportion of the amount of venture capital in the Asian and

Oceania region accounted for 6% in 2004, a decrease of 1% as compared to that

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The Current Situation and Future Outlook of Venture Capital in China

of 1998. The proportion of the amount of venture capital of other areas fell from 11% in 1998 to 2%. The names, amounts of venture capital, their proportion in relation to the total amount of global venture capital, and their proportion in relation to their country’s domestic GDP of the top 10 countries in the amount of global venture capital in 2004 are shown in Table 9.3. Table 9.3. Rank

Top 10 countries in global venture capital Country

1

The U.S.

3

Japan

2

4

5

6

7

8

9

10

UK

France

Germany Spain

The Netherlands Sweden Italy

China

Others Total

Amount (USD1 billion) 113.7

23.7 6.6

6.5

4.7

2.4

2.1

2.0

1.8

1.4

12.0

176.9

Percentage in the world (%) 64

13 4

4

3

1

1

1

1

1

7

100

Percentage in GDP (%) 1.0

1.1

0.1

0.3

0.2

0.2

0.4

0.6

0.1

0.06 0.0 0.3

Looking holistically at the development of global venture capital in recent years, we can see the following common characteristics.

The Role of Venture Capital in Promoting Economic Development Has Become Increasingly Evident The practice of venture capital in the U.S. and other developed countries shows that venture capital can promote economic development in the following aspects:

Promoting economic growth and increasing employment In the 1980s, for example, the U.S. managed to raise its economic efficiency and benefits through adjusting its economic structure, streamlining its organizations and relaxing its regulations, but this resulted in the loss of 44 million jobs. Under this situation, the U.S. supported the development of technology industry with venture capital and created new markets and new enterprises,

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which not only created 73 million jobs, but also achieved a sustained growth of its economy in the mid-1990s. According to a survey of the Organization for Economic Cooperation and Development (OECD), from 1984 to 1991, the number of new companies founded in the U.S. was four times that of France, and eight times that of Denmark. From 1992 to 1996, 85% of the new jobs in the U.S. were created by small enterprises. According to National Venture Capital Association statistics, in 2003, 10 million people in the U.S. were employed by companies which had a venture capital background, and the annual sales of these companies were USD1.8 trillion. In the early 1980s, due to economic difficulties, its irrational policies in science and technology, the drastic recession of the emerging industries, and stagnancy in its traditional industries, products of UK lost their competitiveness in the world market, and its economy further deteriorated. Under this situation, the British government hoped to use venture capital to stimulate its economic growth and launched a series of measures to support it. For over 10 years, the amount of venture capital in UK had an annual growth of 30%. In 1984, the amount of overseas and domestic investment of venture capital in UK was GBP190 million. By 1996, it reached GBP18.53 billion, 97.52 times of that in 1984. By 1997, the amount of venture capital in UK was 20% of the total amount of venture capital of Europe, making UK the second largest venture capital country in the world. At present 90% of UK’s investment in the areas of science and technology rely on venture capital, while 85% of this venture capital is used on the development of emerging industries. With the support of venture capital, the amount of investment on high-tech areas, such as the biotechnology and information technology industries, was nine times that of 1984, making UK a leader in these areas. This also created a 15% annual increase in employment opportunities. In the last decade, the small and medium sized high-tech companies alone created one million new jobs.

Promoting technological innovation and entrepreneurship Companies backed by venture capital tend to pay more attention to research and development, particularly companies in the high-tech industry, such as biotechnology and medical technology. They put a large amount of venture capital on research, which not only promotes technological innovation, but also indirectly contributes to the raising of the people’s value. The developed venture capital market not only provides Americans with more jobs, but also gives thousands of young people the opportunity to start an

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The Current Situation and Future Outlook of Venture Capital in China

enterprise to exploit their capabilities. In the U.S., venture capital has helped many innovators to realize their dream of starting an enterprise, which has created huge benefits for society, promoted the sustained development of the American economy, brought huge returns to investors and great fortunes to venture capitalists. In recent years, what is most eye-catching has been a number of high-tech enterprises that went out of the Silicon Valley into the world. These “babies,” which were fostered by venture capital, grew rapidly to become the main force that enhanced the competitiveness of the American economy. It is estimated that each year before and after 2000, close to 1,000 venture enterprises were created in Silicon Valley alone, but after a few years, one-third each of these enterprises either succeeded or merely survived, or went under.

Raising the effectiveness of enterprise management According to statistics, during the period 2000–2003, the performance of U.S. companies backed with venture capital in aspects such as the creation of jobs and the growth of sale was on the whole better than that of companies without such backing. The annual growth ratio in the employment figure of venture enterprises was about 6.5%, while the average employment figure in the private enterprises had an average annual reduction of 2.3%. The amount of annual growth in sales for venture enterprises was close to 12%, while the annual growth rate for the total sales for domestic companies in the U.S. was only 6.5%.

Raising investment returns On the whole, the return rate of venture capital is higher than that of other investment instruments. The average return rate for venture capital during 1965–1985 in the U.S., for example, was 19%, which was two times that of stock investment and five times that of the long-term bonds investment. The annual net return of venture capital in UK in 1996 was 14.2%, which was higher than the return rates of other financial assets in the same year: the net income ratio of stocks was 11.7%, bonds, 7.6%, and cash assets, 6.1%. In recent years, despite the fact that global venture capital was at a low ebb, its return rate remained at a high level.

Venture Capital Focuses on Investing in High-Tech Areas Venture capital mainly invests in high-tech industries such as information technology and life sciences. At present, there are, for example, 4,000 venture

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capital companies in the U.S., with a total venture capital of over USD100 billion, and they have made a great contribution to giving the U.S. the leading position in the global information industry, making information networks, bioengineering, financial engineering, medical care and semiconductor the fastest growing industries in the U.S., with thousands of high-tech projects getting the support of venture capital every year. The venture capital structure in the U.S. is shown in Fig. 9.3. Fig. 9.3.

The venture capital structure in the U.S.

% 70

59.09

57.99

60

62.55

64.86

60.19

55.11

55.58

31.42

32.23

11.57

11.68

10.59

1.84

1.79

1.59

50 40 30 20 10 0

31.50 19.71

10.24

27.02 9.96

26.40 18.32 15.89

1.09

0.28

0.47

1998

1999

2000

0.94

2001

2002

2003

IT

Bio-industry

Service industry

Others

2004

Year

As shown in Fig. 9.3, the IT industry in the U.S. has in recent years been accounting for about 60% of its total investment. Bio-industry has taken up more than 10% and continued to rise, now exceeding 30%. The service industry has been on the decline, accounting for about 10%, with other industries accounting for 2% to 3%. Venture capital in Europe also mainly invests in high-tech fields such as information technology and biotechnology.

The Main Channel for Venture Capital Withdrawal Is by the Sale of Equity Interest When a venture capital company has successfully nurtured an enterprise, it has to realize its owners’ equity through divestment. The most common method is to have

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The Current Situation and Future Outlook of Venture Capital in China

an initial public offering (IPO) of the venture enterprise or sell its equity interest (mainly by selling it to large enterprises through mergers and acquisitions, or, in some cases, selling it to employees or entrepreneurs). Though venture enterprises grow very fast, they remain quite small in size, and as they need to continue to get additional capital to grow, their performance indexes can hardly meet the requirements of the traditional securities market. That is why it is necessary to create a securities market that is geared to medium and small-sized enterprises (especially medium and small-sized high-tech enterprises). The NASDAQ Small Cap Market in the U.S., for example, has lower listing requirements and is particularly suitable for the financing of medium and smallsized high-tech enterprises, and can also provide a divestment exit for venture capital. Such a market is often referred to as the second-board market. When a listed company becomes more mature in its operation, it can usually be further upgraded to the NASDAQ National Market (the Main Board) for listing. This dual stock market structure provides convenience for second listing after a leveraged buyout. Before the 1980s, the initial public offering (IPO) was the main withdrawal method for global venture capital. The 1990s was the period with the largest venture capital withdrawals, but with a decline in the proportion of initial public offerings. Beginning in 2000, along with the global economic downturn, the withdrawal of venture capital became increasingly difficult, the number of withdrawal projects and withdrawal values declined gradually, and there was especially a drastic fall in the amount of IPO and the number of enterprises. In 2000, the number of venture enterprises that withdrew through the method of IPO was 1,883, raising a capital of USD210 billion from listing. In 2003, the number of venture enterprises that withdrew through the method of IPO was only 864, and the raised capital plunged to USD50 billion. In 2004, there was an increase in the number of venture enterprises that withdrew through the method of IPO and the amount of capital raised through listing, which were 1,516 enterprises and USD124 billion respectively. On the whole, equity interest transfer had become the main channel for the withdrawal of venture capital. Take the U.S. as an example. Fig. 9.4 shows the number of venture projects that withdrew by methods of IPO, mergers and acquisitions during 1973–2004. In 2000, the number of venture enterprises withdrawn by IPO in the U.S. was 264, and by mergers and acquisitions, 316. In 2003, the number of venture enterprises withdrawn by IPO plummeted to 29. In 2004, the number of venture enterprises withdrawn by IPO rose higher to 93, and the capital raised was USD11.01 billion, while in the same year, the amount of withdrawals through mergers and acquisitions reached USD15.21 billion, and the number of projects withdrawn was 333.

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Fig. 9.4.

The number of venture projects that withdrew by methods of IPO, mergers and acquisitions in the U.S. during 1973–2004

Projects 700 600 500 400 300 200 100

mergers and acquisitions

03

20

01

20

99

97

19

19

95

19

93

19

91

89

19

19

87

19

85

19

83

81

19

19

79

19

77

19

75

19

19

73

0 Year

IPO

Source: PricewaterhouseCoopers, Thomson Economic Commission, NVCA 2004 annual report.

In recent years, the proportion of venture capital withdrawals through IPO in Europe accounted for only about 10%.

Venture Capital Received the Support and Encouragement of the Government Although venture capital plays an important role in promoting economic development, due to its higher inherent risks, investors only dare to invest with the support and encouragement of the government. To this end governments of various countries support and encourage the development of venture capital through legislation. For example, although venture capital grew rapidly in the U.S. in the 1960s, due to reasons such as economic recession, the sluggish stock market, strict regulation over pension funds, and an oil crisis, the venture capital industry shrank drastically. With the appeal and promotion of venture

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The Current Situation and Future Outlook of Venture Capital in China

capitalists and entrepreneurs, some congressmen and the Carter administration worked strenuously to create a favorable policy environment for venture capital. The Congress passed consecutively five bills consecutively during the four-year period of 1978–1981 which helped the development of venture capital. The Revenue Bill in 1978, for example, reduced the capital value-added tax from 49.5% to 28%, which provided stimuli for long-term equity investments, resulting in a ten-fold increase of the committed amount of the venture capital in 1979 over that of the previous year. The Economic Recovery Tax Act in 1981 further reduced the capital value-added tax from 28% to 20%, thus doubling the committed amount of venture capital in that year. The measures taken by various countries to encourage and support venture capital in general include tax reductions, provision of guarantees, and risk subsidies.

THE BACKGROUND AND HISTROY OF THE RISE OF VENTURE CAPITAL IN CHINA After the implementation of the policy of reform and opening up, China sent a large number of scholars to study in the U.S., some of whom, including the author, began to notice the development of venture capital in the U.S. and its role in promoting high-tech industrialization, and attempted to introduce venture capital into China. In March 1985 the Central Committee of the Communist Party of China promulgated the Circular of the State Council Concerning the Approval of the National Development Zones for New and High Technology Industries and the Relevant Policies and Provisions in which it was stated that “entrepreneurial investment can be set up to give support to the work of developing high-tech which is fast-changing and highly risky.” This decision signaled the beginning of venture capital industry in China. In September 1985, the State Council officially approved the establishment of the China New Technology Venture Investment Co. Ltd., becoming the first national financial institution specializing in venture capital in mainland China. In 1986, the State Science and Technology Commission’s White Paper on Science and Technology first proposed strategic policies for the development of venture capital industry in China. From then on, some local governments and government departments set up some small companies whose main business was science and technology financing. Barred by conceptual and institutional obstacles, non-synchronization between scientific and technological reform and economic reform, blocked channels of financing, slow-growing capital market, imperfect contractual relationship, irrational distribution system, and

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obscure intellectual property, venture capital business in China could not make any headway, and its development was extremely slow. Some venture capital companies even went astray, and used their capital on usury, stock speculation, buying futures, and real estate operations, and they were eventually ordered by the government to close down for their serious violation of rules and regulations and incurring huge losses. Beginning from the early 1990s, overseas investors set up China investment funds and began to invest in China, such as the IDG Capital Partners and China Walden Venture Fund. It is true that many of these fund managers had experience in venture capital. Most of them, however, believed that the market environment for the development of venture capital in China was not yet mature, most of their investments were therefore made on the reproduction expansion of the existing enterprises, and very few of them were really engaged in venture capital. With China’s progress in reform and opening up, its conditions to develop venture capital in China gradually matured, and the development of China’s socialist market economy also created the objective demands for venture capital. First, the socialist market economy under construction in China provided a foundation for the development of venture capital business in China. Second, there was a huge number of valuable results in scientific research which were ready for transforming into innovative products. Third, a team of high-quality enterprise managers was gradually formed. Fourth, Chinese people had huge savings in the bank (at that time it was more than RMB5 trillion), which could be directly turned into investment. Fifth, consulting services such as technology, finance and law were developing. Sixth, the securities market in China was getting mature. All these created favorable conditions for the development of venture capital in China. In the Decision Relating to the Structural Reform during the “Ninety Five–Year Plan” Period promulgated by the State Council in 1996, the need to develop venture capital was reiterated, and some government departments and local governments also actively explored and promoted venture capital. Under these circumstances, the Central Committee of the Democratic National Construction Association, of which the author was the chairman, proposed Suggestions on Speeding up the Development of Venture Capital Business in China at the 9th National Congress of China’s National Political Consultative Congress in March 1998. This proposal was listed as the No.1 Proposal at the Congress. It received the support of the relevant government departments and the attention of all walks of life, creating an upsurge of interest in the development of venture capital business in China.

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The Current Situation and Future Outlook of Venture Capital in China

First, many departments under the State Council responded actively. The State Planning Commission expressed its appreciation of the proposal in the reply. Second, some local governments took immediate actions, especially those in Beijing, Shanghai and Shenzhen. They took the lead in promulgating policies and measures to promote venture capital. Third, venture capitalists at home and abroad, such as the Ministry of Science and Technology and IDG, were optimistic about the prospects of venture capital in China and they also actively sought opportunities of cooperation in other areas, and some competitive investment companies at home were also excited about the emerging opportunity. Fourth, many domestic high-tech enterprises began to seek support to develop venture capital. Fifth, studies and discussions on venture capital flourished. Seminars were frequently held, and the National Natural Science Foundation of China and the Ministry of Science and Technology also developed key research projects on venture capital, and proposed many suggestions to conduct research on such aspects as legislation, management, and finance to support venture capital. Sixth, the mass media in China sensitively grabbed this new topic and gave a continuous coverage to publicize it, which played a positive role to guide public opinions in promoting the development of venture capital. Despite the fact that there were conceptual, institutional and legal obstacles in the process of its development as well as problems and mistakes, it was in this period that venture capital industry in China really developed rapidly. It is roughly estimated that thanks to the efforts made during the five years between 1997 and 2001, a better foundation had been laid for the development of venture capital industry in China. It is roughly estimated that by the end of 1996, there were only 38 venture capital enterprises in China. By the end of 2001, there were 246 enterprises, about six times that of the end of 1996. The total amount of capital managed by venture capital enterprises at the end of 1996 was only RMB3.61 billion, but by the end of 2001, it was RMB40.523 billion, about eleven times that of the end of 1996, and the increase in these five years is very significant. Beijing, Shanghai, Shenzhen had become the centers of the development of venture capital in China. By the end of 2001, there were 150 venture capital enterprises in these three cities, accounting for 60% of the entire nation, and the total amount of venture capital was RMB28.78 billion, accounting for 70% of the entire nation. These three centers have their own characteristics. In Beijing, there are many innovative companies enterprises clustered at Zhongguancun. In Shanghai, there is the Zhangjiang Hi-Tech Park supported by the high-tech industry. In Shenzhen, driven by the annual Hightech Trade Fair, a high-tech industry belt has been formed.

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Since 2002, under the influence of a sluggish world economy and a recession of international venture capital, the development of venture capital in China has encountered many difficulties and entered into a period of adjustment. Taking a holistic look at the development of venture capital industry in China since 2002, we can see the following characteristics.

A Steady Increase in the Total Volume of Venture Capital and the Amount of Investment, But a Gradual Shrinkage in the Proportion of Domestic Venture Capital As there are at present still no official statistics on venture capital in China, we can only use questionnaire surveys to obtain incomplete results. An overview of venture capital in China between 2001 and 2005 obtained by questionnaire survey is shown in Table 9.4. Table 9.4. Year

An overview of venture capital in China during 2001–2005

Number of Total amount of survey samples venture capital (RMB100 million)

Proportion of Number of Amount of foreign capital investment investment (%) projects (RMB100 million)

2001



405.3

21.9

210

50.0

2002









55.9

2003

180

325.3

5.0

315

37.1

2004

141

438.7

15.0

325

37.8

2005

150

464.5

33.9

307

54.7

Due to the fact that the state had not made unified laws and regulations for

venture capital, relevant policies were not in place to support and encourage venture capital, the channels of withdrawal were far from smooth, and the

capital markets at home and overseas continued to remain poor. There was a great shrinkage of the value of some enterprises. This caused the capital of a majority of the domestic venture capital enterprises in China to be bogged

down in the enterprises they invested, which made it difficult for them to make profits and there was no way to withdraw their capital. This greatly reduced their ability of re-investment, and there was a great reduction in the amount of capital growth of venture capital and its number of institutions. But as overseas

investment institutions were optimistic about the prospects of China’s economic

development, and continued to strengthen their venture capital business in

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The Current Situation and Future Outlook of Venture Capital in China

China, the number and amount of investment projects showed an upward trend. On the surface, it seems that the results of one rising and the other falling was a steady growth in the amount of investment and the total volume of venture capital in China. But in reality, the influence of venture capital at home was gradually eroded. Some domestic venture capital institutions had shifted to invest in financial and intermediary services markets, and were no longer engaged in businesses related to venture capital. Others had even completely left the field of venture capital. At the same time, more and more international venture capital companies specially set up China investment funds or expanded the amount of investment capital in China. In June 2005, for example, Intel announced the creation of a USD200 million venture capital earmarked for science and technology enterprises in China. Accel Partners, a venture capital company in Silicon Valley in the U.S., announced in July to jointly set up a fund amounting to USD250 million to focus on science and technology enterprises in China. Softbank Asia Infrastructure Fund (SAIF) in August successfully raised USD643 million, and planned to invest 70% of them in Greater China and so on. It is roughly estimated that of the total amount of venture capital that could be invested in mainland China, 40.7% of it was in the hands of foreign institutions and institutions backed with foreign capital. Famous overseas venture capital institutions increasingly developed their venture capital business in mainland China in a direct entry manner. Well-known international investment companies, such as 3i and Blue Run, or funds set up their offices in mainland China in 2005. Of the RMB19.57 billion (about USD2.42 billion) venture capital funds newly raised in 2005, the proportion of institutions with a foreign background was still as high as 85.95%, while that of the domestic institutions was only RMB2.74 billion, accounting for 14.05%. According also to some sources, a capital of around USD5 billion coming from 40 international venture capital institutions will come to Beijing to seek cooperation partners in the first half of 2006.

There Are Still Some Differences in Investment Concepts and Operational Practices between Domestic and Foreign-Capital Venture Capital Institutions In 2005, the most active foreign institutions in China were IDG Technology Venture Investment, Softbank Asia, Shanghai Hua Ying (TDFVC), Draper Fisher Jurvetson (DFJ), Intel Capital, 3i, Warburg Pincus, TechVentures and others. The relatively active domestic venture capital institutions were the Shanghai New

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Margin Ventures, Shenzhen Innovation Investment, Legend Capital, Chinese Merchants Information Technology Co. Ltd., Shandong High-Tech Industry Co. Ltd., Tsinghua Leaguer and others. Of the 150 venture capital institutions that answered the questionnaire survey in 2005, 114 were domestic institutions while 36 were institutions with a foreign background. According to the author’s analysis, there are several obvious differences between these two types of investment institutions. (1) Investment strength. It is obvious that the investment strength of foreign venture capital institutions is significantly higher than that of the domestic venture capital institutions. The total amount of capital controlled by 36 foreign institutions was RMB67.55 billion, of which RMB18.91 billion could be used in Mainland China, an average of RMB526 million per institution. The total amount of capital controlled by 114 domestic institutions was RMB29.41 billion, of which RMB27.54 billion could be used in Mainland China, an average of only RMB248 million per institution. (2) Investment intensity. The investment intensity of foreign venture capital institutions was significantly higher than that of the local venture capital institutions. In 2005, foreign institutions invested a total of 143 projects with a total amount of RMB3.11 billion, an average investment intensity of RMB21.75 million per project. Domestic institutions invested a total of 215 projects with a total amount of RMB2.36 billion, an average investment intensity of RMB10.97 million per project, which was 100% lower than that of foreign institutions. (3) Investment phases. Some years ago, the investment phases of foreign investment institutions were slightly faster than those of the local venture capital institutions. In the last three years, domestic venture capital gradually restrained their tendency to go for quick profits and increased their investment in the startup phase and development phase of the projects. In 2005, the start-up phase of the investment of foreign institutions took up 14.7%, the development phase, 43.1%, the expansion phase, 26.5%, the maturity phase and others, 15.7%. For the investment of domestic institutions, they were 22.5%, 42.8%, 20.3 and 14.4% respectively, roughly the same as their foreign counterparts. (4) Pool of talent. The number of professional managers in foreign venture capital institutions is higher than that of the domestic venture capital institutions. In foreign institutions, the proportions of investment managers ranging from ten to twenty, between ten and five, or less than five were 32%, 43% and 18% respectively. In local institutions, they were 19%, 36% and 38% respectively. (5) Investment focus. The focus of venture capital in China was close to the trend of global venture capital, which was in the fields of high technology

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The Current Situation and Future Outlook of Venture Capital in China

such as information technology, biotechnology, and new materials. But the focus of investment of foreign institutions and that of the domestic institutions was different. For foreign institutions, the top five industries with the largest amount of investment were semiconductor industry (48.0%), IC industry (11.9%), communications / telecommunications industry (10.8%), new energies (9.3%) and internet industry (3.4%). For domestic institutions, the top five industries with the largest amount of investment were the medical services industry (11.2%), new materials industry (8.0%), biotechnology industry (7.2%), new energy sources (5.3%), software (5.0%). It can be seen that the foreign institutions put more emphasis on semiconductor and information technology, while domestic institutions, pharmacy and biotechnology.

Beijing, Shanghai, and Shenzhen Have Become the Top Choices for Venture Capital It can be seen from the results of the questionnaire survey that in 2005 there were venture capitals in various places in China, which may be attributed to the fact that governments of these locations hoped to develop venture capital at home. However, 83% of foreign venture capital was concentrated in the three cities of Beijing, Shanghai and Shenzhen, while the remaining 17% was in eastern China. The ratio of the total amount of venture capital in China in the three cities of Beijing, Shanghai, and Shenzhen, which were favored by foreign investors, increased steadily. In 2003, 2004 and 2005, they were 51.0%, 55.0% and 59.9 %respectively. In 2005 the venture capital in the three cities of Beijing, Shanghai and Shenzhen accounted for 31.2%, 11.2% and 17.5% of the total amount respectively, and the ratios of foreign capital in venture capital accounted for 71.2%, 63.6%, and 25.4% respectively. This is also the case if we look at the annual amount of venture capital. The three cities of Beijing, Shanghaiand Shenzhen accounted for about 50% of the total amount of venture capital in China. It can also be seen that these three cities were also the places which received more venture capital.

Overseas Listing Has Become a Major Channel to Withdraw Venture Capital Projects Backed with Foreign Funds According to a survey on 118 venture capital institutions in 2005, of all the 1,500 and 97 venture capital projects, on-going projects accounted for 56.6%, withdrawals by way of equity interest transfer, 19.3%, withdrawals by way of IPO, 11.5%, IPO under preparation, 8.8%, and projects in liquidation, 3.8%. Of the 553 projects already withdrawn, withdrawals by way of equity transfer

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accounted for 55.9%, withdrawals by way of IPO, 33.1%, and withdrawals by way of liquidation, 11%. The ratios of investment projects of local institutions withdrawn by the three ways mentioned above were 69%, 17% and 14% respectively, while those of the investment projects of foreign institutions were 35%, 58% and 7% respectively. In recent years, due to a prolonged slump in the domestic capital market, coupled with the current implementation of controls on currency exchange of capital projects in China, venture capital institutions prefer withdrawal by overseas listing. Of the 183 projects withdrawn by way of IPO, as many as 139 projects were listed overseas, accounting for 76%, and over 40 projects were listed at home, accounting for 24%. This is especially the case with institutions with a foreign background. As they were still not legally allowed to set up venture capital funds in China, they therefore usually adopted the approach of “both ends overseas,” having both fund-raising and divestment overseas. Of the 126 venture capital projects listed, 112 of them (88.9%) were listed overseas, only fourteen of them (11.1%) was domestically listed. The first choice for overseas listing of China’s venture capital projects is the NASDAQ Small Cap Market in the U.S. Ever since the listing of the first Chinese company on the market, there has been so far a total of 25 Chinese enterprises listed on the NASDAQ, and a “China Board” was formed. As overseas investors were optimistic about the economic development of China, Chinese enterprises listed in the NASDAQ also had good performance, such as portals like Sina, Netease, and Sohu in the early period, and SNDA, Focus Media, and Baidu in the last two years. The listing of Suntech Power in the New York Stock Exchange in 2005 also obtained very good results. Other enterprises listed on Hong Kong Main Board or GEM, and Singapore also obtained good results.

Future Outlook of Venture Capital in China Since the beginning of the 21st century, three new trends have emerged in the development of world economy: first, the knowledge-based economy will become a new social form; second, the fictitious economy will become a new mode of economic activity; and third, the network economy will become a new way of economic operation. These three trends pose serious challenges to China. To meet the challenges arising from these three trends, we have to first raise the efficiency of knowledge transfer, so that knowledge can be turned as quickly as possible into an important factor in the development of productivity. Second, we have to raise the efficiency of capital operation to enable higher capital gains. Third, we have to raise the efficiency of economic operation to bring

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about comprehensive, coordinated and rapid economic growth. China is now facing the important task of raising these three efficiencies simultaneously, and venture capital is an important means of raising these three efficiencies through supporting innovation. Jiang Zemin, in his report to the 16th National Congress of the Communist Party of China, stated the goal of building a moderately prosperous society in an all-round way and pointed out that: “we must give play to the role of venture capital and develop a mechanism of capital operation and human capital pooling for promoting scientific and technological innovation and start-ups.” The main characteristics of the knowledge economy are for knowledge-based industries to occupy a key position in an economic structure, knowledge-related integrated factors to play a leading role in economic growth, knowledge factors to have a crucial influence on the development of productivity, and knowledge cost to be an important component in the product cost. Whoever owns the necessary knowledge can occupy the commanding heights of technology, and hold an invincible position in a competition which has become increasingly fierce. To achieve technological innovation and high-tech industrialization through the support of venture capital will help us strive to become, in this age of knowledge economy, a “brain country” which can “produce” knowledge and has the key technology with independent intellectual property rights, but not degrade ourselves to a “limbs country” which can only apply knowledge and introduce technology. In a relatively peaceful environment, the competition among countries is mainly a competition of economic strength, which is in essence a competition of one’s strength of science and technology. What is most important in the competition of the strength of science and technology is a competition of the strength of talents, the most crucial of which is a competition of the innovative ability of the talents. Without a large pool of talents with innovative abilities, it would be difficult for China to raise its international competitiveness. In this sense, venture capital business is to give innovative talents an area to apply their abilities, enable their innovations to be converted quickly into commercialized products and technologies, create great wealth for society, and let investors obtain satisfactory returns, while at the same time give themselves the opportunity to realize their own value. I t c a n t h e re f o re b e s e e n t h a t t o re a l i z e t h e l o f t y g o a l o f b u i l d i n g comprehensively a moderately prosperous society, we must persistently develop venture capital business in China. But as China is a developing country in the process of shifting from the traditional planned economic system to a socialist market economic system, and as venture capital is a product that comes

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from a background of a highly developed market economy, the development of venture capital business in China must therefore go through a long process. It will gradually mature with the progress of reform and opening up in China and its development of science and technology. The author proposed in 2001 that the goal of China’s development in venture capital business should be to strive to build up a better system of venture capital in around 10 years’ time and reach a scale of actual investment of around RMB10 billion per year. To achieve this, the author proposes to take the following three steps as development strategies: (1) Make every effort to promote venture capital business in China under the operation of the existing legal framework. We can, for example, create a venture capital consultancy and management company to assess and recommend venture capital projects for domestic and foreign investors and manage the projects under the commission of the investors. Projects would be mainly from two sources: first, we can certainly select some good projects from the 270,000 projects, which are not yet transformed, out of the 300,000 projects conducted in China each year; second, we can use the inventions or patents owned by overseas Chinese or Chinese scholars. Before introducing legislation relating to venture capital funds in China, we can adopt the method of recommending projects to individual investors, so that innovators and investors put together their capital to establish venture enterprises to realize the transformation of scientific and technological achievements. The evaluation of investment projects must be combined with management to ensure its objectivity and accuracy. If investors have sufficient capital and are willing to join with others, then several investors can also provide the capital to establish venture capital companies in accordance with regulations in the Company Law , hire professionals to manage the companies, and engage themselves directly in venture capital business. These companies are usually led by the government and established by government funding through its subordinate investment companies with the main purpose of promoting local venture capital and the development of high-tech industries. Venture capital companies which are weaker in financial strength usually need to seek co-investors or strategic investment partners from outside. (2) Establish venture capital funds and formulate relevant regulations and management rules to attract domestic and foreign capital. When gathering venture capital, we usually invest in a group of projects and also continuously put in more capital in promising projects. As the demand for capital becomes larger, it is usually necessary to establish funds so as to attract enough capital from society to meet the demand. Foreign venture capital funds are of three

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types: independent funds sought from the public, funds associated with large enterprises, and funds associated with financial institutions. As a venture capital fund is a special form of fund, special management rules must be formulated to provide detailed specifications on areas such as financing, management, supervision, and termination of the fund, and the qualifications, rights and responsibilities of fund initiators. With these rules and regulations in place, we can publicly raise funds from domestic and foreign investors, turn consultancy and management companies or investment companies into fund managers, and operate according to limited partnership. (3) Establish a better venture capital system to provide support and exit for venture capital. The government must develop measures to encourage venture capital through legislation, including, for example, the provision of capital, subsidies, guarantees, interest subsidies, and tax reductions, and formulate relevant regulations on mergers, acquisitions, and the listing of venture capital. It should also formulate rules and regulations governing various venture capital intermediary organizations. After seven years of hard work, despite some difficulties and twists and turns, venture capital business in China has basically completed the first step. As China currently does not allow the establishment of privately-financed funds or the implementation of limited partnership, domestic venture capital institutions are mainly in the form of limited liability companies, and operate according to the model of investment companies or investment management companies. For the form of their organization, according to a survey on 132 venture capital institutions conducted in 2005, 104 of them adopted the form of limited liability companies, accounting for 79% of the total number; 12 of them adopted the form of joint-stock limited liability companies, accounting for 9% of the total number; and seven of them adopted the form of partnership enterprises, accounting for 5% of the total number. For the mode of their operation, according to a survey on 110 venture capital institutions conducted in 2005, those operating in the mode of investment companies accounted for 47%, those operating according to the investment management companies accounted for 16%, and those operating according to investment and investment management companies (both using their own capital to operate and managing other venture capital under commission) accounted for 37%. At present, venture capital in China is being operated in accordance with the corporate system and major decisions must be approved by the board of directors, and this system of corporate legal person governance is to solve the issue of conflicts of interests between the owners and operators. To gradually shift over to the limited partnership system, we should, under the framework of legal person corporate

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governance structure stipulated by China’s Company Law , give more power to project managers so that they have more autonomy, which helps train venture capitalists in China so that we have a batch of qualified general partners when we change over to operate according to limited partnership in the future. At present, there is still some certain blindness in the investment policies of some venture capital companies. They decide to invest in some projects which sound good but have not been seriously investigated and assessed, and dare not invest in projects with good prospects for fear of risks. This is why some companies set up an advisory committee to help them in decision-making. The author believes that venture capital companies in China should not at the beginning follow companies which in general set up a number of levels, such as departments, bureaus, units, and offices, following the shape of the vertical structure of a multi-level pyramid. They should try to be flat, semi-autonomous learning organizations with only the two levels of the general manager and project manager, and each project manager can be assigned with one to three assistants. The author proposes that venture capital companies in China adopt the following way of financing, abbreviated as a soft commitment financing method: first, the shareholders pay a registered capital, usually in the region of RMB30–100 million; second, draw 10–20% of the registered capital as seed capital to support projects at their start-up stage and better prepare for the long-term development of the company; third, venture capitalists adopt a soft commitment method for their investment in venture enterprises. The rights of capital contribution are distributed according to equity interest and are transferrable among the shareholders. Shareholders of venture capital companies should promise that after projects recommended by managers are discussed and passed by the Board of Directors, every shareholder should contribute capital in proportion to their equity interest in the company, and their right of capital contribution can be transferred to other shareholders. Capital can be invested through a company, and shareholders can also directly invest in the venture enterprises. The greatest advantage of this type of soft commitment is that the company gets the money only when it decides to invest in a project. First, this is to prevent the company from having a lot of money in hand at the beginning stage with no projects to invest, which put a lot of pressure on the management. Eventually they may take the risks in investment by engaging themselves in real estate, buying futures, and stock speculation instead of making venture capital investments. Second, the prevention of moral hazards, because when capital worth millions or even billions of dollars are in the hands of the management of companies which are not sound in their structure, this easily generates moral hazards. Third, shareholders

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have the preemptive rights of capital contribution in the next round of financing, while outside investors can be invited to contribute to any outstanding amount. To further promote the development of venture capital business in China, we need to make continuous efforts in the following six areas:

Establish Venture Capital Funds and Operate Them in Accordance with the Limited Partnership System At present, venture capital business in China is still in the exploratory stage and an effective way that suits the national conditions of China in regard to the organizational structure, financing methods and operational mechanism of venture capital companies has yet to be formed. The most serious problem is the lack of credit in business, which leads to the emergence of a succession of problems such as breach of faith, default of debts, violation of contracts, and even defrauds. On the one hand, some technology holders are accustomed to “having their salaries paid by the government,” so they have a weak sense of responsibility towards investors, and even refuse to accept supervision from them. On the other hand, some venture capital companies dare not take risks to develop their business, and even prefer to invest their capital into securities and the development of real estate to seek short-term benefits, thus weakening the role of venture capital in supporting innovation. The author therefore recommends that we refer to the experience of the U.S., establish venture capital funds, and operate in accordance with limited partnership. Venture capital institutions in the U.S. can be broadly divided into four types: investment institutions affiliated to banks, investment institutions affiliated to large enterprises, medium-to-small investment institutions supported by the government, and independent venture capital institutions. As independent venture capital institutions perform better, investment institutions affiliated to banks and large enterprises are also gradually transformed into venture capital institutions with relative independence. As it is stipulated in the tax laws of the U.S. that returns on partnership investment are not required to pay corporate taxes but just personal income tax, most of the venture capital institutions are formed with the adoption of limited partnership. Usually the general partners and limited partners both contribute capital to form a venture capital fund, in which the general partners are the venture capitalists. Although their contribution usually accounts for only 1-2%, they are responsible for the administration and management of the fund, and hold unlimited liabilities over the fund. The limited partners do not participate in the administration and management of the fund and have only limited liabilities. The partnership of each fund usually lasts from seven

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to ten years. A limited partnership enterprise usually has three to nine general partners who can manage several mutually independent funds at the same time. The advantages of this type of organization are a balance of the responsibilities, rights and profits of venture capitalists, flexibility in operation and higher efficiency.

Formulate and Implement Regulations and Laws Advantageous to the Development of Venture Capital With the development of venture capital in China, the Standing Committee of National People’s Congress has also made active efforts to promote legislation regarding venture capital. First, there was the decision of the Standing Committee of the National People’s Congress on December 25, 1999 concerning the Amendment to the Company Law of the People’s Republic of China : Supporting eligible high and new technology joint-stock limited companies to enter the securities market for direct financing will

contribute to the development of the high and new technology industry.

The high and new technology joint-stock limited companies shall, in attracting funds for development through the capital market, stick to the industrial policies of the state and shall be eligible for the conditions

of the high and new technology industry. The exchange of listed stocks

within the separately organized exchange system shall be carried out in accordance with the characteristics of the high and new technology

joint-stock limited companies. With regard to the lack of experience in this work and the risks, this work shall be carried out in a planned, step-by-step, active but steady way…. For a high and new technology

shareholding limited company, the percentage of promoters’ amount of investment by pricing their industrial property rights and non-patented technologies in the company’s registered capital and the conditions for the

company’s issuance of new shares and applications for listing of its stocks are prescribed by the State Council separately.

The original requirements in scale stipulated in the Company Law (the registered capital should not be less than RMB50 million) and three consecutive years of profitability were two obstacles for the listing of high and new technology enterprises. This is because the growth period of new and high technology enterprises shows two characteristics: one is that they start on a small scale, and the other is that as their continuous growth needs investment, their cash flow at the initial stage may be negative. This amendment, therefore, has created the conditions for the listing of high and new technology enterprises, and provided an exit of divestment for venture capital.

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At the same time, the Standing Committee of the National People’s Congress also initiated the legislation of investment fund, which originally intended to include the three areas of securities investment funds, real estate investment funds and venture capital investment funds, but as many people at that time believed that the conditions for establishing real estate investment funds and venture capital funds were not yet mature, the Law of the People’s Republic of China on Securities Investment Fund was finally turned into the Laws on Funds for Investment in Securities and was passed on October 28, 2003. The Standing Committee of the National People’s Congress also passed the Trust Law of the People’s Republic of China in April 2001 so that there were laws for the development of the trust industry. On October 27, 2005, the Company Law and the Securities Law were amended and adopted at the 18th Session of the Standing Committee of the 10th National People’s Congress of the People’s Republic of China and came into force on January 1, 2006. The Amendments to these two laws, having absorbed international experience and considered the conditions of China, have great significance to the development of enterprises and the capital market in China and serve an important role in promoting the development of venture capital business in China. The amendments to the Company Law were in fact an overhaul of the company laws. From the number of amendments made, it can be seen only about twenty articles in the existing Company Law has maintained their original contents, while the rest were added, deleted or modified. The amended Company Law has 13 Chapters with 219 Articles. It is true that the number of articles is smaller than that before the amendment, but its legislation is more scientific and advanced, its structural system is more rigorous and rational, its regulatory contents are more substantial and practicable. The amended Company Law, when compared with the original, has the following advantages for venture capital: (1) The “threshold” for the establishment of a company was lowered. The establishment of a joint-stock company does not need to be approved by State authorized government departments or provincial governments. If the conditions in the Company Law are met, any investor can set up a joint-stock company. It also allows the establishment of a “one-man company” with only one shareholder. It reduces the minimum registered capital of a limited company from between RMB100,000 and RMB500,000 to RMB30,000, and a stock company from RMB10 million to RMB5 million. This will help the establishment of innovation-type medium and small-sized enterprises. (2) The implementation of a system of paying registered capital by

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installments, allowing companies to pay their registered capital in two years, and investment companies to pay their registered capital in five years. This can protect investors as they could invest capital according to the needs of company operation, and avoid the excessive accumulation of capital during the early stage of the establishment of the company when the business has not yet been fully developed, thus improving efficiency in the use of capital. This will help to achieve the aforementioned “soft commitment” financing method. (3) The relaxation of the original requirement that the aggregate amount of the investment shall not exceed 50% of the net assets of the company. This requirement is a fatal obstacle for venture capital companies for if they are only allowed to invest 50% of their capital, the remaining 50% of their capital would have nowhere to go. The new Company Law stipulates that a company can invest in other enterprises, and there are no restrictions on the ratio of the amount of investment and net assets. (4) A huge relaxation on the ways of capital contributions by shareholders. The new Company Law states that “a shareholder may make capital contributions in cash, in kind, or intellectual property rights, land use right, or other non-monetary properties that may be assessed on the basis of currency and may be transferred according to the law, excluding the properties that shall not be treated as capital contributions under any law or administrative regulation.” Therefore, other property rights, such as credits, equity interest, mining rights, and exploration rights can be used as capital contribution property. It also stipulates that other forms of capital contribution can be as high as 70% of registered capital of the company and removes the requirement in the original law that intellectual property stake cannot exceed 20%. This also helps the development of venture capital. If the shares of intellectual property are too low, some holders of good technology would not be willing to collaborate with venture capital companies. (5) For limited companies, there are regulations stipulating that the distribution of dividends will not be made in accordance with the proportion of capital contribution or a preemptive right to subscribe capital will not be based on the proportion of capital contribution, and there are regulations which stipulate that shareholders do not exercise voting rights in accordance with capital contribution. At the same time, this strengthens the protection of the rights of shareholders, and clearly stipulates that shareholders can request access to the accounting books of the company. Before the establishment of limited partnership, these regulations help venture capitalists strengthen their control of the enterprises they invest in. The amended Securities Law has first expanded the manner and scope of

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securities trading. It has given authority to the State Council to make laws and regulations separately as forms of concessions to deal with the five types of issues, i.e. separate business operation, separate business supervision, spot trading, margin trading and short sale of securities, stock speculation by stateowned enterprises, and bank capital entering into the stock market. This has changed the management methods practised in securities companies in the past while improving their risk control mechanism. Second, it has strengthened the power of supervisory departments while constraining their exercise of power, and also stipulated their relevant legal responsibilities. Third, it has further improved legal responsibilities, and increased the penalty clauses by a third to forty-seven articles. Fourth, it has expanded and strengthened the power of protection of the rights of investors. It has established a protection fund for securities investors, stipulating that a third-party depository be implemented for the trading capital, and securities and capital of clients cannot be misappropriated and forcibly executed. Fifth, it has raised the transparency of information disclosure, laying down clearly the major legal responsibilities for issuers, listed companies, senior executives of listed companies, and all kinds of intermediary organizations. On November 14, 2005, with the approval of the State Council, the National Development and Reform Commission and other 10 ministries and commissions jointly issued the Interim Measures for the Administration of Startup Investment Enterprises (abbreviated as Interim Measures ), which were implemented from March 1, 2006. The launch of these Interim Measures officially recognized the status of the venture capital industry, which can gradually solve all kinds of discrimination and issues encountered by the industry in its development. At the same time, based on the foundation of the Company Law and the Securities Law , it has made relevant regulations on the behavior of venture capital, such as investment and financing, exit, and company establishment, and also other aspects such as its legal protection and regulation. It is true that there are still many flaws in these Interim Measures , but generally speaking, they serve the role of promoting the development of the venture capital industry. To promote the development of venture capital in China, we should consider making a Venture Capital Promotion Law which should include contents such as the protection of the rights of investors, the protection of the intellectual property rights of innovators, permission to set up venture capital funds through private equity, and the establishment of second board markets, and relevant measures to promote venture capital, such as issues relating to tax reduction, subsidies, interest discounts for venture capital, and solving the problem of loan guarantees for startup enterprises.

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At the same time, other relevant laws and regulations should be amended accordingly. To implement limited partnership for venture capital funds, for example, it is necessary to increase the content of limited partnership in the existing Partnership Enterprise Law , and make corresponding amendments in the tax laws so that personal income tax rather than corporate income tax will be levied on partnership enterprises.

Create Exit Channels for Venture Capital During 1997–2000, when global enthusiasm for venture capital was at its height, many people in China also called for a speedy establishment of a second board to provide an exit for venture capital. The author at that time held the view that to hastily set up a second board market was very risky because many enterprises were still only in their infancy, it would be difficult to predict whether they would succeed or fail, and to allow these enterprises to get financing from the capital market was in fact to shift the risk that the venture capital institutions should bear to public investors. The Standing Committee of the National People’s Congress, in consideration of the need to promote the development of venture capital and pay attention to the prevention of risks, amended the Company Law at the end of 1999, allowing new high-tech enterprises to be listed in the technology sector board markets of both the stock exchanges at Shenzhen and Shanghai. Despite the making of this decision, there were still some people doing their best to advocate for the establishment of a second board, and even asserted that “there will not be venture capital if there is no second board,” resulting in the delay in the implementation of this decision. After the recession of enthusiasm in venture capital in the world, not only could a second board not be established, but also the establishment of a technology sector board was shelved. To promote the establishment of a second board market, the author in 2002 made a “three-step” proposal. The first step is to put together 20 or 30, or 30 to 50 small company stocks with higher levels of technology approved by the China Securities Regulatory Commission to create a single board. As this would not lower the conditions for listing, it would be accepted more easily by all parties concerned, and as the number of this part of enterprises is not too small, their listing will not be of much impact on the market. The second step is to reduce some of the conditions appropriately to gradually expand this board. The third step is to separate this board when the conditions are ripe to establish a complete, independent second board market. After much study and careful preparation, the Small and Medium-sized

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Enterprise Board (SME board) was launched on the Shenzhen Stock Exchange on May 28, 2004. On June 2, the first initial public offering of the first SME stock was issued. As some people were worried about the difficulty of identifying the science and technology enterprises, so the name of the SME board was adopted. The SME board is an important part of the existing main board. The laws, regulations and department rules that it operates are the same as those of the main market. Listed companies on the SME board have to meet the conditions of initial public offering on the main board and the requirements of information disclosure, but the SME board is operated independently and its supervision, codes and indexes are different from those of the main board. Some people said suspiciously that as the “threshold” for the listing in the small and medium enterprises board is based on the standards for examination and verification of share issues for the existing main board initial offering for examination and approval, it therefore excludes those small enterprises with better performance but have not met the conditions of listing. After weighing the pros and cons and to speed up the launching of this board, we will first maintain the existing conditions for listing, and it would be better to gradually lower the conditions when conditions are ripe. The launch of the SME board signals the beginning of the establishment of a multi-level capital market in China. This will provide SME in China a channel to conduct financing through the capital market, venture capital in China, and also many investors a new investment opportunity. However, the establishment of the SME board is the first step of a thousand-mile journey. It will take a lot of hard work to build the Shenzhen Stock Exchange into the NASDAQ model of multi-level capital market. After the establishment of the SME board, the Shenzhen Stock Exchange, based on its desire to establish strict regulations, devoted all its efforts to meet its demands of creating a board of integrity, and focused on strengthening its institutional construction. Regulations that have so far been announced included, for example, Special Provisions for Companies Listed on the Small and Medium-Sized Board of the Shenzhen Stock Exchange , Special Provisions for Trading on the Small and Medium-sized Enterprise Board of the Shenzhen Stock Exchange , SME Guide to Listed Companies in the Construction of Integrity of the Shenzhen Stock Exchange , Shenzhen Stock Exchange Guidelines on SME Board Recommendations , and Guide for the Conduct for Directors of the Listed SME , all of which have an important impact on the construction of the internal system and the regulations of operation of the companies listed on the SME board.

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Over the past year, the SME board has continuously grown and achieved good results. By the end of 2005, 50 companies have issued their initial offerings in the SME board, which included 38 private enterprises, and 12 state-owned shareholding enterprises and collective shareholding enterprises. The total amount of financing was RMB12 billion, the scale of financing was between RMB119 and 473 million (an average of RMB240 million), the total scale of issue was RMB1.38 billion shares, the scale of issue was 13.40 million to 51 million (an average of 27.52 million shares), and the total average share capital after issuing was 91.16 million shares. This board has now become an important part of the capital market in China. Its trading volume accounts for about 12% of the Shenzhen Stock Exchange Main Board, the overall quality of the listed companies is higher than those on the Main Board, and the proportion of stocks held by institutional investors represented by capital has reached 30%. Of the existing 50 listed companies, 33 are high and new technology enterprises, accounting for 66%. On November 21, 2005, the share-trading reform program of these 50 companies was passed in whole, and they resumed trading, and it became the first board that has realized “full circulation.” On overseas listing, with the successive cessation of the Notice of the State Administration of Foreign Exchange on Issues Concerning Improvement in the Administration of Foreign Exchange in Connection with Mergers and Acquisitions by Foreign Investors (Notice No.11 ) and the Issues Relevant to Registration of Overseas Investment by Individual Residents in China and Foreign Exchange Registration for Merger and Acquisition with Foreign Investment Circular (Notice No.29 ), and the promulgation and implementation of the Notice of the State Administration of Foreign Exchange on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents to Engage in Financing and in Return Investment via Overseas Special Purpose Companies (Notice No. 75 ), the channel for overseas listing continues to be smooth, and the management of relevant government departments on overseas listing will be more regulated.

The Training of Venture Capital Professionals What are the main difficulties of venture capital? Some think that the difficulty lies with the lack of capital, others put it to the non-existence of a second board market in China. The author is of the view that the biggest difficulty is the lack of professionals, especially qualified venture capitalists. Managers of venture capital funds (i.e. general partners) are often referred

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to as venture capitalists. Despite the fact that their investment in the funds accounts for only 1–2%, they bear the full responsibility for fund management. They are generally professionals who specialize in a specific field and also experts in management and finance, and they are the key figures in determining the success or failure of venture capital. Their main role is to use their expertise and experience to raise capital and invest. Not only do they have to rely on their expertise and experience to carefully select promising projects from hundreds and thousands of project proposals to make investment decisions, but they also attend meetings of the board of directors of the companies they invest in, guide and help the development of enterprises. The general partners, apart from drawing from the annual management fees (usually 2.5% of the total amount of the funds) as their salaries, they can, more importantly, also get 20% of the investment income of the funds, which prompts them to choose good projects and strengthen the management of the enterprises they invest in, try to improve the investment income of the funds, and rely on performance to win the trust of investors and get their due returns. The main role of venture capitalists is to support innovators to start up their business and help investors speculate. To achieve this, professionals are required to operate venture capital. The urgency of this issue is that: first, there are at present a large amount of research output that needs to be transformed but there is a lack of assessment of their prospects for commercialization, and we need professionals with expertise and experiences in such areas as technology, management, and finance to do the assessment. At present, most of our venture capital funds do not invest in projects, and the crucial issue is that those involved lack the ability to assess venture capital projects. Second, scientists have the enthusiasm to start up their business but often lack the knowledge and experience in financing and management. A scientist may have a very strong ability to innovate, but may find it difficult to develop enterprises to realize the commercialization of their innovations, which needs the collaboration of the venture capitalists. Third, both foreign and private investors are willing to make venture capital, but find it hard to get trustworthy agents. They always run into the dilemma where “reliable people are not capable, and capable people are not reliable.” Before they can find a capable and reliable agent, they will not invest their money without worries. The main function of having venture capitalists sitting at the board of directors of venture enterprises is to perform financial monitoring and control (regulating financial management and making decisions on key issues such as capital increment, business suspension, listing, and sale), and they also have

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to assist the enterprise to establish a strong core of management, including for example the chief executive officer (CEO), chief technology officer (CTO), chief financial officer (CFO), vice-president (sales) and vice-president (marketing). In their agreement with investors, it should be clearly specified in writing that venture capitalists have the final decision on important financial and personnel issues. China’s innovators tend to have the misconception that anyone with technological abilities can be a good chief executive officer. This is in fact not the case. According to the U.S. statistics, only about 50% of innovators still serve as the chief executive officer of the enterprises they founded, the other 50 % cannot hold this position because their management abilities are inadequate. According to the views of Randy Komisar, an American venture capital specialist, a network technology enterprise needs different qualities from its chief executive officer at different stages of its development. It is crucial for the chief executive officer at the start-up stage of the enterprise to have innovative ideas and indomitable spirits. The chief executive officer at its growth stage should have strong organizational skills and a keen sense of the market trend. The chief executive officer at its mature stage should have the abilities of strategic management and is capable of adhering persistently to its strategic orientation and adapting flexibly to the changing environment. As it is normally difficult for a start-up entrepreneur to have all the three qualities at the same time, an enterprise must choose the most suitable chief executive officers at different stages of its development. Innovators in China should know their own limitations. They should not insistently serve as chief executive officers if they do not have management competence, or else they will ruin their enterprises. When supporting innovators to start up their enterprises, venture capitalists have the following five major tasks to perform: First, assess the prospects of commercializing the products of the innovators. This kind of assessment and judgment relies on their experience and business acumen, or even business intuition. Second, help innovators to formulate their business development plan. Third, organize innovators to present their results and business development plans to investors and try to convince investors to invest. Fourth, help investors and innovators to sign an agreement to establish a venture capital enterprise, and participate in its establishment. Fifth, join the board of directors of the invested enterprise on behalf of investors, make decisions on important financial and personnel issues and take up the responsibility of corporate restructuring and divestment. Venture capitalists help the speculation of investors mainly in the following four aspects: First, they help investors select from hundreds and thousands of proposals the projects with the best prospects of commercialization. Second,

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they judge the quality, personality and capability of an innovator through interviews and preliminary cooperation. The most important ability of a venture capitalist is their ability to judge a person’s capability. It is through interviews with the innovator and conversation and cooperation with the innovator that their quality, personality and capability are judged. If the quality of the person is inferior and their personality is not good, then the investor cannot invest in the project no matter how good it is because things usually go wrong once an investment is made. Third, they join the board of directors on behalf of investors to supervise and guide the operators and try as much as possible to make the enterprise a success. Fourth, they select the appropriate opportunity to realize divestment through listing or sale of the enterprise so as to bring huge profits to investors. Venture capitalists should have the following five qualities: First, they must have an enterprising mind, a sense of responsibility and business acumen. He can immediately identify a good project and give up a bad project decisively. Second, they must have extensive experience in handing interpersonal relations and be good at identifying the quality, ability and credibility of a person. Third, they must be familiar with corporate governance, financial operations and relevant laws and regulations. As a rule, innovators very capable in technology, but lack knowledge in management, finance, and law and venture capitalists can fill this gap. Fourth, they must have expertise and practical experiences in more than one professional field. If a venture capitalist knows nothing about the professional field, they cannot communicate effectively with innovators. The author has met many venture capitalists in foreign countries that used to be technicians, then studied finance and management and obtained an MBA degree later. They then went into venture capital industry. Fifth, they must be able to maintain good relations with people in the financial, technological, legal and political fields, which is particularly important in China. Some highly-paid general managers of venture capital companies hold PhD and MBA degrees, know technology and management, and also have foreign experience in venture capital. As they do not know the practical situation in China well, nor can they maintain good relationship with others, they can hardly make good achievements. Some have even discharged of their positions. The training of Chinese venture capitalists should be: (1) identify and train people with great potentials through practice; (2) develop a plan to send people with certain experience in venture capital abroad for further training; and (3) hire overseas Chinese who are experts in venture capital to return to work in China; fourth, set up an incentive mechanism for venture capitalists.

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Cultivate the Culture Helpful to the Development of Venture Capital As China is in the process of moving from the traditional centrally planned economy to the socialist market economy, there are really many problems in aspects such as the legal system, the management mentality of the government, the procedures and methods of administration, and people’s ideas and concepts, which makes it difficult to meet the requirements of developing new investment tools such as venture capital. These problems are caused by longterm factors such as culture and concepts and it is unlikely that we can find a solution in the short term. We should therefore make efforts to cultivate a culture helpful to the development of venture capital and gradually change all sorts of outdated concepts. Broadly speaking, culture includes all the ability and habits that a member of society has, which greatly influences people’s value judgment and thus their behavior. Value is an objective attribute that people can pursue to meet their particular needs, such as economic value, cultural value, scientific value, historical value and so on. Value judgment is the preferences shown when people choose to realize certain values of targets, things, and actions. The author believes a culture that helps the development of venture capital in general should include the following aspects: First, we must cultivate entrepreneurship. Entrepreneurship and venture capital are closely integrated. The term “entrepreneur” does not refer to all business operators for business operators without the spirit of innovation and entrepreneurship cannot be called “entrepreneurs.” We have to, therefore, cultivate innovation and the spirit of entrepreneurship, encourage the development of creativity, encourage innovation, encourage risk-taking, but also at the same time tolerate failure. Second, there must be a spirit of honesty and trust. In the venture capital industry, the construction of the culture of honesty and trust is very important. The venture capital industry needs the mutual trust and cooperation between venture capitalists and innovators to make it successful. Many of the problems now being encountered in China are related to honesty and trust. Investors who promise to invest, for example, in reality may hold off investing their capital, or do everything possible to withdraw their capital soon after their investment. Technologists may promise a technology to a number of their “husband’s families.” As soon as they find that the returns of this family are unsatisfactory, they take away the technology and cooperate with other “husband’s families.” Venture capital is a combination of knowledge capital and real capital. Venture capital is to use real capital to support fictitious capital such as knowledge

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capital and social capital, and combine them to jointly start up a business. But the biggest problem with fictitious capital is that its value is indeterminate. It is only when it is realized can we determine the value it has. But without fictitious capital such as knowledge capital, venture capital will lose the target it supports. Third, an atmosphere must be created for free discussion and exploration. An innovative thing at its birth is always imperfect and not fully recognized. It is only by free discussion and a free exchange of views can we gradually improve this innovation and have it accepted by more and more people.

Establish a Support System for Venture Capital After years of effort, China has basically established a venture capital support system, which includes the following aspects: (1) There are organizations hosting forums on venture capital. It is roughly estimated that in recent years about 10 forums have been held each year. China Venture Capital and Private Equity Forum, co-hosted by the Central Committee of the China Democratic National Construction Association and Ministry of Science and Technology, has been held annually in April for eight years. (2) Research institutions have been established. In 2003, China Venture Capital Co. Ltd and Hong Kong Polytechnic University jointly funded the establishment of the China Venture Capital Research Institute (Hong Kong). The Institute is located in Shenzhen and has been established for three years. At present, the work there is satisfactory. (3) There has been the publication of China Venture Capital magazine, now a quarterly. (4) There has been the publication of the China Venture Capital Yearbook for three years in a row, which has had an English version since 2004. (5) A China venture capital web site has been established and has gradually become more like the Venture One in the U.S. which provides industry information to those in the venture capital industry. (6) There has been the publication of a book series on venture capital. Five books have now been published. They are about the role of the government in venture capital and the evaluation of venture capital projects. (7) There has been the training of venture capital professionals in China. With the approval of the Ministry of Education, Renmin University of China established a doctoral program in venture capital in China. Facts have proved or will prove that “advancing in waves and rising in spirals” is the general law of development of the fictitious economy, which

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includes venture capital. In early 2006, the Chinese government put forward the goal of building an innovation-type country, which will certainly provide a good opportunity for the development of venture capital in China. With the background of the continuously rapid, coordinated, and healthy development of China’s economy and through a proper formulation of policies and hard work, venture capital business in China will certainly develop faster.

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Chapter

The Transformation of Bonded Zones into Free Trade Zones

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 2

The Current Situation and Trends in the Development of Free Trade Zones As the name suggests, the so-called free trade zone is a zone where free trade can be conducted. Broadly speaking, a free trade zone is a special economic zone created by a country to achieve certain economic objectives through special economic policies and means so that it is separated from other zones. Thus it covers, by definition, a free trade zone, a free port, a free zone, a foreign trade zone, an export-processing zone, a free industrial zone, a free border zone, a transit zone, a bonded warehouse zone, and other kinds of economic zones. It is now generally acknowledged that the free port established in Genoa Bay, Livorno (Florence’s outer harbour) in 1547 is the world’s first free trade zone. In fact, the first prototype of a free trade zone in human history can be traced to the heyday of Phoenician Asia (1101 BC–AD 241) in the ancient period, when foreign merchants were allowed to freely enter and leave Ter, the southern port of Phoenicia, and Carthage, its North African colony. After the 17th century, in order to expand their foreign trade, some European countries, such as UK, the Netherlands, Portugal, France, and Germany, declared famous port cities along their coasts to be free ports, or set aside some of their areas to set up free zones. They also set up free trade zones in their overseas colonies or semi-colonies. Before World War II, there were a total of 75 free trade zones, located in 26 countries and regions. After World War II, with the development of the world economy and the continuous expansion of the scope of international trade, free trade zones increased rapidly like mushrooms. It is roughly estimated that there are now over 1,200 free trade zones, of which 425 were set up by 15 developed countries, accounting for 35.4%, and 775 by 67 developing countries and regions, accounting for 64.6%. At the same time, the functions of free trade zones have also been expanding. Raw materials, components, semi-finished and finished goods can be freely imported or exported in such zones. In these zones, business activities, such as the import and export trade, entrepôt trade, bonded warehousing, commodity display, manufacturing, disassembly, modification, labeling, sorting, and processing mixed with other goods, can also be conducted. Against the backdrop of the extensive rise of global free-trade zones, the Customs Cooperation Council (predecessor of the World Customs Organization) in May 1973 drew up the Kyoto Convention (International Convention on the Simplification and Harmonization of Customs Procedures ), which defined a free-trade zone as: “‘free zone’ means a part of the territory of a Contracting

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Party where any goods entered are generally regarded, insofar as import duties and taxes are concerned, as being outside the customs territory.” Similar definitions were made in the U.S. Foreign Trade Zone Commission General Regulations and EC Customs Code with a confirmation of its legal status and operation mechanism. Attention must be paid to distinguish free trade zones from free trade areas as the latter refers to the mutual removal of tariffs or other trade restrictions between the two or more separate customs territories of member countries (Article XXIV of the GATT Agreement ), such as the North American Free Trade Agreement (NAFTA) made by the U.S., Canada and Mexico. To avoid confusion between the two, some scholars even suggested that the former be called a free port, and the latter, a free trade zone. Based on the analyses of the existing free trade zones, we can broadly summarize the following characteristics of a free trade zone: (1) Isolated and closed. A free trade zone is a region fenced off from other areas of a country, with an average area of generally less than 10 square kilometers. In that sense, the Manaus free trade zone in Brazil, which has an area of 2.21 million square kilometers, cannot in fact be mentioned in the same breath. (2) Inside the territory but outside the customs territory. Although the free trade area of a country is located within its national borders, it lies outside the customs territory of the country. The customs authority does not levy tariffs on imported and exported goods crossing the national border, but duties are duly imposed on imported or exported goods crossing into the customs territory. Except in special circumstances, the customs authority does not implement the usual regulatory system. (3) Complete freedom. Under the preconditions of following the laws stipulated in the country where the free trade zone is located, enterprises and individuals in the zone enjoy complete freedom. The first is freedom of trade, such as there are no restrictions on import and export trade and entrepôt trade, but running retail business is usually not allowed. The second is freedom of transport, such as the exemption of customs procedures, non-compulsory pilotage, a crew’s freedom to land, and the simplification of procedures regarding health and quarantine and immigration. Yet another is the freedom of investment, and there are usually no restrictions on industries. Finally, financial freedom, such as the freedom to choose billing currency and to convert foreign currencies, and capital is free to come and go. (4) Preferential policies. The government where the free trade zone is located usually gives a number of policy preferences to enterprises in the zone, such

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as income tax relief, relaxation of its credit loan policy, provision of investment matching, acceleration of capital depreciation, protection of investment safety, and provision of land, water, and electricity at preferential prices. (5) Port-zone combination. Most free trade zones are created in ports with large cargo-handling capacities and geographical advantages, such as Hamburg in Germany, New York in the U.S., and Rotterdam in the Netherlands. Under special circumstances, these zones can also be created in such places as river ports and air ports. Taking a holistic view of the development and current situation of many of the world’s free trade zones, we find that some experience success while others fail, and it can be said that academic assessment of free trade zones is mixed. American economist A.O. Hirschman was a pioneer of scholars who are optimistic about free trade zones. He holds the view that the governments of developing countries should encourage “unbalanced growth,” establish free trade zones, realize their integration with the international economic system and management standards. This will not only help promote the economic development within the zones and their surrounding areas, but can also serve as a model for other places in the country. Economists who hold this view, based on the actual rapid development of the free-trade zones after World War II and the many benefits they brought, including the expansion of export, the earnings of foreign exchanges, the increase of employment opportunities, the use of local raw materials, the promotion of technology transfer, and the attraction of foreign capital, believe that free trade zones are a stimulant to the global economy, a core factor to the growth of regional economic grouping, and a driving force of economic globalization. A pioneer of those scholars with pessimistic views on the free trade zone is Gunnar Myrdal, a Swedish Nobel laureate in economics. He applied the two concepts of “echo” and “proliferation” from physics to analyze the movement of regions and the whole country at different stages of development, and advocated that the government should implement egalitarian policies, strengthen the diffusion effect, and reduce the echo effect to minimize regional disparities. Economists who hold this view believe that the setting up of free trade zones will hinder trade and resource flows between these zones and outside areas, thus strengthening the echo effect and increasing regional disparities, which does not seem, on the whole, to be worth the effort. It occurs to the author that both views have some truth, but each also has its biases. Uneven regional development in many countries is an objective reality. To accelerate economic development, developing countries should invest their

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limited resources firstly to more developed areas to achieve better results. But when development has reached a certain stage, attention should be paid to narrowing the gap between regions as much as possible through reasonable distribution of industries and allocation of resources. Under the guidance of Deng Xiaoping Theory, China set up special economic zones and bonded zones in coastal areas during the initial period of reform and opening up, and adopted special preferential policies to encourage their accelerated development. When the entire country achieves the basic well-off stage, it will lose no time in pushing ahead with the development of the western region, and make efforts to reduce the regional gap. This practice has proved successful so far and has fully proved that as long as the policy is properly grasped and strictly administered, the free trade zone can play a role in actively promoting economic development. Economic globalization means true interdependence between nations and states and is the major trend of world development today. In recent years, with the ending of the “Cold War” between East and West, the world situation on the whole has eased. Economic development has been given more attention by all countries. The continued expansion in the size of multinational corporations, the rapid development of science and technology (especially information technology), and the fast mobility of vast amounts of capital have accelerated considerably the process of globalization. This is especially the case when the WTO was established in 1995 to replace the GATT as the platform for many countries to develop free trade, which has more effectively promoted the development of economic globalization. Economic globalization has provided a good opportunity for countries to develop their economy. The free flow of capital, the transnational dissemination of information and the optimal allocation of global resources serve to speed up the commercialization of achievements in science and technology, and raise the productivity of society in order to maintain a longer period of sustained economic growth, which helps developing countries bring in capital, talent, advanced technology and equipment, learn modern management, and expand the international market. But it should also be noted that economic globalization is a double-edged sword: it has opportunities and risks, the main risk being that with growing confidence, an economy bubble will easily form and there will be a rapid transmission of financial risk. What is more, as the “rules of the game” of current international economy are made by the developed countries which have economic and technological edges, developing countries are often placed in a disadvantageous position, and even their economic security and national sovereignty may be threatened.

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In order to adapt to the pace of economic globalization, free trade zones have been gradually showing the following trends: (1) The number of free trade zones continues to grow. Some believe that economic globalization will reduce trade barriers between countries, which would weaken the role of free trade zones and even lead to the disappearance of these zones. But the facts show that as free trade zones have played a role in aspects such as attracting foreign investment, expanding foreign trade, increasing employment opportunities and enhancing economic strength, the number of free trade zones both in the developed and developing countries has continued to grow in recent years. In the U.S., for example, there were 92 free trade zones (mainly foreign trade areas with both industry and trade) at the end of 1983. By the end of 1994, they increased to 199, and 256 by the end of 2001. These zones exist in almost every major port city in the U.S., which has become the country with the largest number of free trade zones in the world. According to reports in the literature, the U.S. adopted the concept of the foreign trade zone for the purpose of passing the bills. The developing countries in Asia and Latin America, mainly develop exportprocessing free trade zones. In the 1980s, there were more than 70 free trade zones in more than 40 developing countries in the world. By 2001, there were a total of 775 free trade zones in 67 developing countries. In recent years, free trade zones began to emerge in the developing countries in Africa. (2) The gradual expansion of the impact of free trade zones. With the development of economic globalization and the expansion of free trade, the impact of free trade zones has gradually expanded. While their role of attracting capital and technology gradually spread to areas outside the zones, a number of preferential policies and incentives are also implemented outside the zones, thus further developing the exemplary and leading role of the free trade zones. More importantly, the developed and developing countries could use these free trade zones as an economic platform for strategic cooperation, combining goods, capital and technology of the developed countries with the labor, land and policies of the developing countries, making the investment countries and the country that created the zones receive their benefits respectively, achieving “win-win” results. The development of free trade zones has also to some extent contributed to the lowering of trade barriers between countries and the strengthening of economic and trade cooperation, thus promoting the formation of a single market and free trade area. In the 21st century, efforts by various regions and countries in seeking to create free trade zones have exceeded far more than the multilateral free trade plan of the WTO. For example, it was first

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proposed by the U.S. and subsequently endorsed by the Inter-American Summit of 34 countries to create the Free Trade Area of the Americas that ranged from Alaska in northern America to Tierra del Fuego in the south, covering the whole of America. Another example is the China-ASEAN Framework Agreement on Comprehensive Economic Cooperation , which was signed in the afternoon of November 4, 2002 by Zhu Rongzi, then Chinese Premier, and leaders of 10 ASEAN countries after attending the meeting between China and ASEAN leaders, which decided, among other things, to build a China-ASEAN Free Trade Area by 2010. (3) The tendency for functions to integrate. Since the 1970s, free trade zones that focused on entrepôt and import-export trade, and those on export processing have begun to integrate together. The functions of free trade zones expanded, and gradually became integrated. Hamburg Freeport in Germany and the Colon Free Trade Zone in Panama, for example, were engaged only in trans