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 Globalization: the Role of Institution
Building in the Financial Sector
_ The Case Study of China
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Globalization: the Role of Institution Building in the Financial Sector
---The Case Study of China
August, 2003
I. Introduction
Financial globalization could be described as a process in which global financial
activities get increasingly integrated with the risk creation mechanism. This
description emphasizes three points. First, financial globalization is not only a process
in which financial activities transcend national borders, but also a process in which
risks spread across the markets. Second, financial globalization is initiated by many
micro-economic entities to seek profits and is driven by the integration of global
financial markets. Third, it is a gradually deepening process with distinct phases.
In general, financial globalization covers five areas: capital flow, monetary
system, financial markets, financial institution, and financial coordination and
supervision.
In China, institution building in the financial sector takes place against the
backdrop of financial globalization. It not only shares common features with other
countries’ experience but also has its own characteristics. Therefore, it is useful to
review the process of institution building in China, to analyze its effect on the

balance have also increased. At the end of June 2003, total assets of foreign banks
amounted to USD41.25 billion and total loan balance amounted to USD19.86 billion.
54 percent of foreign bank loans were granted to support manufacturing industry and
has promoted the development of light industry, chemical industry, and electronic
industry and machinery industry.
Foreign banks also bring more overseas customers to the Chinese market, which
has further promoted the overall increase of foreign direct investment. In particular,
foreign banks have provided intermediate services such as business consultation and
information service in the negotiation of international loans, and such services
constitute an important part in the process of attracting foreign capital.
In addition, foreign banks also play a unique role in institution building in the
financial sector. They help to mitigate financial repression in China, to establish sound
financial system, to enlarge contribution of the financial sector to economic
development and to realize a virtual cycle of financial deepening and economic
development. The role of foreign banks covers the following areas:
1. Competition effect. After the entry of foreign banks into the domestic
market, the monopoly of state banks has been broken. Competition forces Chinese
banks to reestablish their business strategy and operation.
2. Demonstration effect. Foreign banks have demonstrated their advanced
technology, equipments, organization and management to domestic banks. Their
higher profitability has stimulated Chinese banks to upgrade technology and
equipment while improving management.
3. Training effect. Foreign banks provide training programs for their Chinese
employees so as to improve their professional skills. At the same time, foreign
banks also transfer technology and management skills to their Chinese
counterparts. All these have helped to improve the efficiency of Chinese banks.
More importantly, foreign banks not only provide an external financing channel
for Chinese enterprises, but also facilitate the development of the domestic capital
market while they are engaged in investment and securities business. Also, entry of
foreign banks urges the Chinese regulatory authorities to comply with international

its financial markets on a gradual basis after certain conditions have been met. The
restrictions on market entry and business scope of foreign banks are gradually
loosened and foreign banks will be granted national treatment step by step. This
model often involves three periods, which starts with strict restriction, then loosening
restriction and ends with full liberalization. As Professor Ronald McKinnon pointed
out, China should adopt the gradual liberalization approach, rather than the big bang
approach used by the former Soviet Union and some East European countries.
According to Professor Tobin, China should gradually integrate with the international
financial market, though it should actively participate in the economic and trade
globalization. This is due to the basic economic situation and the development stage
of Chinese financial market.
It has been proved that global financial stability requires effective surveillance
and needs support from the international financial institutions. However, sound macro
economic policy and structural reforms in each country constitute the basis for
meeting such a challenge. Global financial stability is based on stability of individual
country’s financial markets. Also, the stability of individual country depends not only
on the surveillance, guidance and support of the international financial institutions
such as the IMF and World Bank, but also more fundamentally on the soundness of its
monetary and fiscal policy as well as the banking system. Apart from the attack of the
speculators, the Asian Financial Crisis was to a larger extent caused by weaknesses in
macro economic policy and the banking system in related countries.
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D. Major Issues in the institution building process of the financial sector
1. The relationship between financial opening and financial security
China’s decision to join the WTO signifies a step forward in the opening of
financial sector to the outside world. In the mean time, the era of rigid financial
control will come to an end. Coupled with the advancement of e-economy, financial
opening and liberalization will bring great impact on the existing financial system,
and especially on financial regulatory framework. This trend also indicates the
importance of financial security. As far as China is concerned, financial security

following traditional criteria as overdue loans, default loans and bad loans. This static
classification method is quite different from the international accepted methods and
unable to reflect the true quality of loans. In recent years, the application of the five-
category classification method has been advanced thanks to the strong push of the
central bank and the efforts of commercial banks.
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5. Slow progress in market-based interest rate reform
Since interest rates are not adequately determined on market basis, their roles as
signals to the supply of and demand for fund are not fully effective, and sometimes
have negative influence on pricing and risk management of commercial banks.
E. Policy measures to promote institutional building
Institution building in financial sector in China has been mainly achieved through
a series of institutional reforms. China’s financial institutional reform process could
be divided into the following three stages: (1) preparation and strategy exploration,
(2) framework construction, and (3) adjustment and advancement.
During the first stage from 1979 to 1984, the financial sector in China began to
undergo institutional reform. The prominent features of the financial system at this
stage could be summarized as follows:
(1) separation of central banking from commercial banking by establishing a two-
tier banking system,
(2) establishment of specialized commercial banks serving different industries;
and,
(3) Introduction of deposit based bank growth model.
During the second stage from 1985 to 1996, a series of new arrangements and a
primary framework for market-based financial operations were introduced. The main
features are as follows:
(1) The legal status of the central bank was established with the promulgation of
the Central Bank Law and the Regulations on Monetary Policy Committee.
(2) The institutional structure diversified, including the development of non-
banking financial institutions, the establishment of several insurance companies, the

(6) Stimulating domestic demand and combating deflation by implementing a
sound monetary policy;
(7) Expanding the scope of financial service and initiating consumer credit
market; and
(8) The emergence of extensive cooperation among banking, insurance and
securities industries has created the conditions for providing universal-banking
services in the future.
To sum up, China’s financial system reform in the past two decades has been
characterized by institutional innovation, namely the change from planned financial
system to market-oriented financial system and the change from one-tier banking
system to two-tier banking system.
First, the direct policy instruments for macro-economic management has given
way to indirect to market instruments. The central bank shifted its reliance on direct
control of credit ceilings and currency issuance to market instruments such as reserve
requirement, interest rate, central bank lending and open market operations in recent
years to adjust money supply. During this process, the channel for base money supply
has been evolving from through central bank lending to purchasing foreign assets and
open market operations.
At the same time, the spectrum of institutions has become more diversified with
the establishment of 10 joint stock commercial banks, 100 city commercial banks,
large number of urban credit cooperatives, trust and investment companies together
with finance companies, financial leasing companies and fund management
companies.
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F. Role of the government, central bank and international financial
institution in institution building
1. Role of the government
As an indispensable part of the financial system, supervision and regulation of the
government have strong influence on the behavior of microeconomic entities. Aiming
at mitigating risk and encouraging competition, the supervisory authorities adjust

restructuring of 32 provisional branches into 9 regional branches. By doing so, the
PBC has accomplished a historical transition in its administrative regime by replacing
its provincial branch network with regional branches set up in accordance with
regional economic development. As a result, the independence of the central bank in
implementing monetary policy and financial supervision has been strengthened.
While learning experiences from other countries in the restructuring process, the
PBC has never neglected the specific situation in China. For instance, China has
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enjoyed strong balance of payments position after achieving current account
convertibility of the Chinese currency in December 1996, resulting in a stable
exchange rate and a sustained growth of its foreign exchange reserves.
As international experience shows, capital account convertibility requires stable
macroeconomic environment, a healthy financial system, effective financial
supervisory framework and enduring national strength.
While some emerging economies in Asia such as Thailand, Malaysia and Korea
have abolished control on capital account transactions and realized full convertibility
of their currencies; China still sticks to the ‘gradualism approach’ in promoting capital
account convertibility. The existing deficiencies in the economic fundamentals call for
prudent liberalization.
It was such an arrangement that has put China in a better position to confront the
challenge arising from the Asian Financial Crises. At the same time, we have
successfully prevented the negative impact of the confidence crisis on Chinese
economy and competitive currency depreciation, which have in turn contributed to the
financial stability not only in Asia but also in the whole world.
3. Role of the international financial institutions ( IFIs )
The IFIs have played an active role in financial restructuring in China by
introducing international standards and good practice and providing policy advice and
personnel training in specific areas. For instance, China has established its external
debt surveillance system with the assistance of the Bank for International Settlements.
Also, technical assistance from the World Bank has contributed to the establishment

network and outlets. On the contrary, the original strength possessed by domestic
banks in terms of geographic distribution would be weakened, which may have
negative impact on domestic banks.
At the moment, corresponding regulations on on-line banking service are yet to
be put in place, the same situation may also apply to those regulations regarding the
security certification system as well as the modernized payment system. We have
realized that a considerable gap does exist between China and the developed countries
either in the area of information technology and quality control on credit assets or in
financial risk prevention.
In light of this situation, commercial banks in China need to strengthen
development of information technology by cooperating with each other and
mobilizing the best resources among themselves, so as to reduce the cost of
management and business development.
By large, domestic financial institutions should not only focus their attention on
innovation of financial products, but also make due efforts in the application of
information technology, in exploring on-line banking business as well as in promoting
non-bank financial institutions. Efforts should be made in upgrading financial
operations and financial services, and in conducting systematic study on banking
business development, its security system, risk prevention as well as supervision.
Formulation of relevant policy and regulations should aim to promote healthy
development of on-line banking services in China.
The substantial changes in financial system and technology mentioned above
have posted great challenges to China’s financial and supervisory system. From
technical point of view, non-bank financial institutions or even non-financial
institutions are able to evade supervisions due to swift development of on-line
financial services. Therefore, either opening of financial markets or development of
internet-based financial services will constitute big challenges to both the monetary
authority and the financial supervisory authorities.
III. Institution Building of the Chinese Bond Market
A. Current stage of the Chinese bond market