China Begins Instituting Financial Reforms to Legalize Private Lending

China is in the initial phase of its state led financial reform, starting with the private economic powerhouse of Wenzhou in Zhejiang Province in government efforts to support the development of the real economy.

The State Council has already given its word to create a pilot zone for a comprehensive financial reform in Wenzhou. The reform requires the local government to create a financial mechanism that will facilitate any locality’s social and economic development. The Council has given 12 tasks in which Wenzhou should focus on encouraging and supporting the participation of private capital in the reform of local financial institutions during its reform process.

Shenzhen which was the original base for China’s economic reform in the 70s is following suit, also with a guideline for a financial reform. Shenzhen will focus on the development of the real economy which includes the introduction of a pilot two way trans-border loan between the mainland and Hong Kong by establishing the Shenzhen Qianhai Equity Exchange by the end of this year. There are already 16 pilot zones created that will connect technology and finance in cities that seek further financial innovation by offering financial support to scientific and technological enterprises.

A researcher said that the old economic mechanism will face many challenges and to avoid economic recession an economic readjustment is needed together with opportunities for institutional improvement. It is important to adopt several measures that will prevent the economy from shrinking, especially after an economic crisis. Through the analysis of the U.S. financial reforms we saw that it actually represents a process of financial liberalization.

Pilot financial reforms in Shenzhen and Wenzhou will aim to push forward the Chinese financial mechanism. Shenzhen will act as the economic transformation while focusing on incorporating capital from diversified channels in the process. Whenzhou in turn will regulate private capital.

Ending state monopoly

Several days after the executive meeting of the State Council, Premier Wen Jiabao said that the Central Government is determined to break the monopoly that is present in the banking sector. Wen said that banks have been making profits too easily. This is why a small number of large banks still hold a monopoly in this sector, prompting the council to allow private capital to enter the financial service sector, which necessitates the break up of monopolies.

It is obvious that the Central Government is discontented with the state monopoly in the financial sector. The Central Government has issued documents that will support the non-public economic entry into the financial sector, thus encouraging private capital to set up banks in the country’s vast rural areas. However it is still difficult for private capital to enter the financial state since none of the government implemented measures were effective enough to break the banks’ monopoly. The biggest let down for state monopolies in the financial sector is that large state owned enterprises are given bank credits while private businesses and small and medium enterprises are left to fend for themselves.

Among the 12 tasks set for the comprehensive financial reform set by the State Council, the most important one is the encouragement and support of private capital’s participation in the reform of local financial institutions, establishment of village banks, rural financial cooperatives, loan companies and new types of financial organizations in accordance with the law. This will allow private capital to establish privately owned banks using their management personnel selected by their own shareholders instead of being appointed by the government.

Legalizing private lending

Another important part in the financial reform scheme in Wenzhou is to regulate private lending and facilitate private capital entry into the financial sector. Private lending, especially in large sums, is illegal in China. The private economy in Zhejiang Province is more developed compared to other regions, which has resulted in many people being sued for private lending. In 2008, there were 200 cases that involved illegal deposits and 40 cases of fundraising fraud.

Financial reform in Wenzhou will open doors for private finance to enter the banking sector. This move will be significant and should not be underestimated in pushing forward reform in the financial market, especially on the reform for a complete financial system. Private lending is more active in local economies and is more developed. Funds from private lending have gone to the real estate market, with most of the funds are being used for private lending coming from the banking sector. In the event that private lending collapses it will damage the economy in China especially in the eastern coastal areas as well as affecting the real estate market.

The problem with most Chinese private lending lies with the strict control of the legal financial system. To carry out reform in Wenzhou, private lending should be legalized and regulated to prevent potentially dangerous situations as mentioned above, while improving access to capital desperately needed by small businesses.

Benefiting SMEs

The financial reform will influence the financing for SMEs,  solving their financing difficulties to some extent. Ninety percent of enterprises in China are SMEs,  contributing to 60 percent of the country’s GDP, 80 percent of urban job opportunities and 50 percent of the country’s tax revenues. Additionally, 65 percent of the country’s invention patents and 80 percent of research and development of new products are also produced by SMEs.

SMEs need financial support, but financing  has been an unsolved problem to date. A report made by the All-China Federation of Industry and Commerce said that 90 percent of privately owned SMEs cannot get loans from banks. The reason for this is that monopolies by state owned banks have reduced the financial resources that serve the small and medium banks, which restricts their capability to serve SMEs. Difficulty in getting loans has forced SMEs to turn to private lending which in turn has no legal status in the financial legal system.

The financial reform that will legalize private lending will reduce pressure on these businesses, while bringing them in line with the formal financial system. Reforms in Shenzhen propose two policies that support SMEs which offer favorable loans to emerging industries and micro and small enterprises as well as nurturing a multi-level and multi-market financial system.

The 12 tasks for the financial reform in Wenzhou were designed by the China Banking Regulatory Commission and the Central Government. The Wenzhou government and market participants such as private lenders and borrowers were excluded from the process, leading to doubt on the thoroughness of the reform.

Financial reform should be designed from the ground up, as this will cater better to the needs and wants of market participants. Still there are many problems in the financial sector in china that need to be solved, such as breaking the financial monopoly, legalizing private lending and the introduction of market oriented reform of interest rates.

Now is the best time to push for a significant financial reform with the conditions to allow private capital to enter state owned financial institutions, adopting market formation of interest rates and legalizing private lending are all ready. The chance to change should not be allowed to pass, if so these reforms will be a lot more difficult to pursue in the future.

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