China’s Economic Development Essay


This discussion presents a summary of various chapters of the book that addresses various aspects relating to China`s economic development. In particular, the summary is based on Chinese foreign direct investment and income inequality, its financial reform in banking and securities markets and how Chinese firms raise capital. The summary also reviews the debt financing gap for small business in China and institutional reform in the Chinese banking system.
Key words: banking system, reforms, financial gap, foreign direct investment


Chapter Five 

This chapter is written by Xiaodong, who mainly focused was on foreign direct investment and income inequality in China. The author reviewed the economy of the country starting from China’s economic reform of 1978. He notes that since the reform, Chinese economy has been growing rapidly. On average, Chinese economy has grown at an annual rate of over 9 percent. The country also enjoys low inflation rates that have not gone above 30 percent. In order to boost its economic growth and to narrow its technological gap with developed countries, China adopted a strategic economic policy to facilitate FDI. The strategy has enabled China to become the second largest FDI recipient country.   

The author notes that despite the steady economic growth, China has continued to experience a rising income inequality. This is a great challenge to the country due to the fact that income inequality is a threat to growth; moreover, it can undermine poverty eradication initiatives and contributes to social tension. As China boasts high levels of FDI inflow, it has a substantial reason to fear as FDI has a great impact on economic prosperity and income inequality. Thus China faces some challenges due to a high amount of FDI inflow. Whenever a country intends to boost FDI through strategic policy formulation, it is vital for the country`s policymakers to design such policies that will facilitate economic growth without increasing income inequality. The main source of income inequality is the differences in the level of education and training that result into wage disparities.

The author notes that based on research, foreign direct investment into different sectors can have different implications on a country’s wage inequality. When the country’s policy makers direct FDI into the relevant industries, the investments are unlikely to lead to more social inequality. The author looked at a number of areas as presented below;

How Foreign Direct Investment Can Affect Wages

Foreign funded enterprises (FFE) are capable of raising wages despite having a small employment share. As such, the author emphasizes that it is worth noting that multinational firms may have had an impact on China’s rising income inequality. Statistical data shows that FDI is one of the main contributors to the widening of the wage gap hence resulting into labor migration both within and between the state and the non-state sectors. 

Can the Effect of Foreign Direct Investment on Wages Be Uniform?

The author notes that different types of FDI have different effects on wages. Taking the situation in China into consideration, the country mainly attracts foreign direct investment from newly developed countries or regions. On the contrary, developed countries attract FDI from other developed countries that bring in more skill-intensive technologies. In a situation where inward FDI introduces a skill-intensive technical change, entrance of multinationals can result into an increase in income inequality between skilled and unskilled labor. The two types of FDI can move the relative wage income in opposite directions. This idea should be used to balance the increase in different types of FDI so as to have a moderate general impact on income distribution.

Why is It Important to Consider Product Differentiation?

According to the author, production of different products of different qualities requires the availability of different skill levels in a situation where there is vertical product differentiation. A country’s relative wage and its endogenous choice of the quality of products produced determine its level of skill quality.

Theoretical Predictions

The author notes that it is possible for a small labor economy to decrease the wage gap between skilled and unskilled labor by opening up more markets to attract more FDI with advanced unskilled labor biased technology into high-tech and low-tech sectors. On the contrary, a country’s wage gap and its competitiveness in the high-end product markets can be increased by the presence of skilled labor biased technology. In regard to China, the relative wage of skilled labor to unskilled labor is likely to increase as the country attracts more FDI into high-tech sectors. It is evidenced that lack of product differentiation results to a decrease in the relative wage of skilled to unskilled labor. 

The chapter states that it is important for the countries like China to use favorable policies like tax breaks as a move towards attracting FDI with skilled labor biased technology so as to promote economic growth and reduce income inequality. If China succeeds in maintaining balanced inward FDI while considering both skilled and unskilled labor biased technologies, the country is likely to enjoy technological development and increased competitiveness in the global market. It will also be able to foster a balanced wage increase hence solving the problem of income inequality in the country. 

Chapter 11 

This chapter highlights China’s financial reform in banking and security markets. The authors, Fung & Liu, note that China witnessed an impressive trend in economic growth since its economic reforms of 1978. The steady economic growth is linked to a number of factors including a move aimed at restructuring state-owned enterprises, establishment of viable economic zones to attract foreign investments and promotion of international trade by changing trade policies. The changes that are credited for the economic growth in China and the challenges facing the financial system are discussed in this chapter by Fung & Liu.

The financial system in China can be referred to as a bank-based system as the banks play a more important role in the system than the securities markets. The two scholars emphasize the need for bank reforms to be initiated in the country to address the country’s non-performing loans, capital inadequacy problems and moral hazards. They also emphasize that China needs to develop its securities markets for its firms to raise capital and become attractive for foreign investors. 

China`s stock market has experienced a major transformation from a purely domestic A-share market to a B-share market. The implementation of the Qualified Financial Institutional Investor (QFII) program allowed foreign financial institutions to invest in China`s domestic financial markets.  Fung & Liu observe that this is what transformed the Chinese financial system. The authors looked at a number of areas as discussed below; 


Banking Reforms

The “Big Four” state-owned banks of China are facing a stiff competition from their foreign rivals that offer better payments, bonuses, and training opportunities. The authorities and domestic banks have developed restrictive regulations and exceptional measures as a move aimed at slowing down foreign competition. For example, Fung & Liu note that foreign banks are expected to have at least US$72.3 million in operating capital to be allowed to operate fully. The banks are only allowed to open one branch every year. China’s central bank known as the People’s Bank of China expects foreign banks to maintain 60 percent registered capital in local currency. Some domestic banks have also tried to price out foreign banks by offering loans with lower interest rates.  

However, Fung & Liu observe that the restrictions set cannot safeguard the domestic banks from the competition forever as China promised to allow foreign banks an equal access to Chinese individuals and businesses. The Chinese government was prompted to take effective measures to prepare its domestic banks for the upcoming competition.

The “Big Four” and the Non-performing Loan Issue

According to Fung & Liu, the main problem that is facing the banks is idea huge amount of non-performing loans inherited from the policy loans in the earlier regime. Capital injection and debt are the main strategies used by the Chinese government to ensure equity swaps so as to reduce the NPL. In 1998, the government issued RMB270 billion in bonds so as to avail capital for the Big Four. It initiated four government asset management companies to control bad debt. As a move towards strengthening the lending oversight, the Chinese Banking Regulatory Commission and its local branches were established. The government also introduced new banking rules to be used by the Big Four so as to reduce NPLs. Moreover, a five-level loan classification system was introduced with an aim to increase transparency of banks` operations. The government stated lending, corruption and malfeasance as the main causes of the NPL-related problem.  

The government decided to privatize part of the banking sector hence making several banks list their shares at stock exchanges. China Banking Regulatory Commission also came up with a set of rules that provided an opportunity to both locals and foreigners to trade futures, options and other instruments. Regulatory changes that allow derivatives trading are expected to have a great impact on the development of financial markets. 

Chapter 12 

This chapter is about how Chinese firms have been able to raise capital. It is written by three authors Fung, Leung &Zhu, who note that before the share system reforms and the establishment of the stock exchanges the most important source of financing for firms in China were state bank loans. The scholars note that the economic reforms implemented since 1978 enabled China to implement various bank policies aimed at improving capital adequacy and efficiency by adopting risk-return principle of granting loans. Due to the stock market reforms, Chinese firms were able to raise external capital through issuance of debts and shares instead of bank loans.

Fung, Leung & Zhu observe that though Chinese enterprises are able to issue equities in the financial markets, bank loans are their main source of funding. Apart from the bank loans, the enterprises raise funds through equity financing as seen in initial public offerings and seasonal offerings. Issuance of equities is seen as a better option compared to other financial mechanisms due to the policy constraints and market impediments among other factors. Most firms in developing countries heavily depend on external funds, particularly new issues of shares. There are various sources of financing in China. The sources range from short-term financing derived from cash and credit management, to external financing and equity financing. Each of these financing options has tradeoffs.

Since 1990, the equity market has remained the main source of financing for businesses in China. The country has its equity market separated into tradable and non-tradable shares. The difference between the two is that tradable shares are offered in the public marketplace while non-tradable shares are held by promoters that are, in most cases, government or government-authorized institutions and enterprises. Tradable shares are differentiated into two categories namely tradable A-shares and tradable B- shares. A-shares are priced in domestic currency while B-shares are priced in foreign currency. Based on research, Chinese firms mainly raise capital through the equity market. This source is less bound to cash payments besides being subject to less restrictive monitoring as opposed to bank loans and corporate bonds.

The equity market’s capital-raising ability heavily depended on the performance of the secondary market. The most active IPO Periods in the Chinese stock market were also its peak years. Chinese B-share market was launched in 1992. It presents an avenue for foreign investors to participate in the development of Chinese economy through equity ownership in Chinese stock market. At the initial stages, the share market was narrow and could not meet the high financial needs of large SOEs. 

Fung, Leung &Zhu observe that the main shareholders in most Chinese companies are non-floatable shareholders. The shareholders control the firms’ operations. Bilateral negotiations can be used to trade the shares mainly at book values. However, there is much discount of the book value that is relative to the market values of the shares.

Thus, the chapter indicates that the functions of the stock market are vital as they provide Chinese companies with essential financing sources. The most important equity-raising activity for the economy is IPOs. The controlling shareholders of the non-tradable shares prefer issuing tradable shares to facilitate an improvement of the book values of the non-tradable shares. Financial reforms in China came as a result of the country’s biasness in equity financing. A number of factors contributed to the situation including equity costs, regulatory restrictions and market segmentation among others. The pattern of financing for Chinese firms has been largely affected by changes in regulatory policy.

Chapter 13 

This chapter is written by Zhao & Li who focus on the debt financing gap for small business in China. The authors note that small and medium-sized enterprises are highly valued due to their contribution to job creation, initiation of technological innovations and enhancement of competitiveness. The development of such enterprises has attracted a significant global attention.

On a broader scale, the two scholars report that there are two groups of resources of finance, namely, internal and external resources of finance. The internal resources are initial equity investment and capitalization of profits. On the other hand, internal financing is basically provided by financial institutions and capital market. The two categories of resources impact differently on capital cost, corporate governance, extent of risk and tax-shields. Zhao & Li emphasize that businesses need to select the optimal financing instrument in order to maximize the market value.

The authors add that debt instruments and equity instruments can be used to finance business. In a situation where a debt financing gap occurs in SMEs, the problem can be overcome with equity financing. Debt financing can also be used to cover equity financing gap. However, in a situation where the equity financing gap and the debt financing gap coexist, it becomes difficult for SMEs to finance the operations as seen in China. 

Based on the results obtained from most studies, external financing is vital for the development of SMEs with particular regard to those that are involved in high-tech ventures. High-tech industrialization and technological innovation are promoted by financial innovation. SMEs at different stages of their life cycle have varying optimal financing choices. The early stage investments are dominated by private equity financing while the use of bank loans will be applicable because SMEs have developed their credit history. 

Banks and other financial institutions often neglect high-tech SMEs. The small loan volume for SMEs raises the marginal costs of financial institutions to the extent that it reduces marginal profit to zero. Additionally, Zhao and Li note that the high failure rate of SMEs makes banks reluctant to issue loans to them. Small businesses heavily depend on small banks for credit. The businesses are largely dependent on loans as opposed to large publicly traded firms. Small businesses mainly borrow from particular financial institutions with which they have developed long-term relationships. The scholars base their argument on the results provided by most studies to emphasize that it is important to develop small banks and other financial institutions as it would help in making loans to small businesses.

Zhao and Li also note that moral hazard can be prevented by monitoring borrowers. The authors emphasize that such an initiative can only be undertaken effectively by local banks that have adequate information about local firms, local projects and people. The banks gather adequate information through their long-term interaction and relationship with the local community. According to Zhao and Li, the SMEs’ financing difficulties that are experienced in China are due to the mismatch of size between SMEs and financial institutions. The mismatch occurs due to the limited number of small banks in China. Based on this understanding, it is evident that the best way to solve SMEs` financing problems in China would be to establish non-state-owned financial institutions.

SMEs in China face several financial difficulties. Though some of the causes of the difficulties are similar to other countries, others are specific to China. The problems of information asymmetry and moral hazard highly affect SMEs in their attempts to get loans from banks. The scholars observe that it is difficult to access reliable information about SMEs as such information is regarded as internal; hence it is kept away from the public.  

Thus, SMEs remain to be a substantial force in technological innovation. The financial services given in China restrict the innovation capacity of SMEs hence preventing the sustainable development of Chinese economy. In their recommendation, Zhao and Li point out that to solve the problem of debt financing gap for SMEs, stakeholders should be involved in a systematic process that would gradually reduce the conflict between demand and supply of funds. 

Chapter 14

The chapter discusses institutional reform and the Chinese banking system. Chinese institutions, like China Insurance Regulation Commission, China Security Regulation Commission, and China Banking Regulation Commission, are vital to the process of facilitating economic growth. The author notes that the main role of the PBOC was to ensure an effective macro-control of the financial market as it strengthened the position of the PBOC to stand strong as the central government’s arm in market control. He adds that commercial banks in China are not established by registration but by the approval of the PBOC according to the regulations of the Company Law of the People’s Republic of China. The law is known as the Company Law and the Commercial Banking Law. The appointment of administrative personnel in the banking system is done based on the provisions of the Provisional Regulations that are set to govern Senior Financial Professionals Management.

The author observes that China is making advancements in regard to reforms related to the commercial banking system to facilitate efficiency so as to compete favorably with foreign banks after joining the WTO. However, the assessment of China’s banking mechanisms and performance shows that the reforms, established to achieve specific objectives, have not fully managed to achieve them. The challenges encountered in the process of making the policies effective, as seen in the corporate control structure, capital organization structure and operation management mechanism, clearly show that the system is most likely to face harsh competition from foreign banks within the first five years.

China’s commercial banking system has two main types of capital property: state-owned capital property and stock-holding capital property. State-owned capital property has the biggest share of commercial banking capital properties. Its total assets in 1998 accounted for 88.9 percent of domestic commercial banking capital properties. The state-owned banks have a stronger market power due to the government support as opposed to non-state-owned commercial banks. However, the banks have great deficiencies in their capital property management structure. The deficiencies are caused by unclear capital property rights between the state and the banks.

With such challenges, the author advises that the government of China needs to establish effective protective measures that can facilitate the survival of domestic banks in line with the WTO. Arguably, the main policies that need to be established are those that relate to market access, national treatment and most-favored nations.