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«Incomplete financial reform in China is puzzling because Premier Zhu Rongji, a seemingly promarket technocrat, was largely insulated from explicitly ...»

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Maintaining the status quo on interest rates would have been reasonable if the policy community was in consensus about the risks of liberalization. In reality, interest rate liberalization had been a much discussed policy issue since the 1980s and enjoyed considerable support from local officials and bankers. Local officials in prosperous regions wanted liberalized interest rates to speed up the channeling of funds to the private sector (Bo, Zhao, & Liu, 1996). Bank officials felt that interest rate liberalization would foster competition between the state banks (Xie, 1995). Bankers, academics, government officials also felt that interest-rate liberalization would vastly improve the efficiency of capital allocation in China (Zhou, 2000). In sharp contrast to banking centralization, which Premier Zhu implemented immediately on taking power, he delayed significant interest-rate liberalization, despite a strong consensus across the board in favor of it. As a central bank official put it in 2001 (anonymous, personal communication, May 14, 2001), “first, it is not up to the PBOC to decide the issue. The State Council will make a decision on this, although we have already advised them to free it up.” When PBOC Governor Dai Xianlong announced a definite plan to liberalize interest rates in 3 years in 2000, Zhu countermanded Dai and changed the time-frame to a vague “five to ten years” (Gilley & Murphy, 2001).

Instead of general liberalization, the State Council loosened the band around the mandatory rates for limited categories of loans. To increase rural lending, the PBOC in 1999 bestowed rural credit cooperatives greater leeway to adjust interest rates (Chan, 1999). In September of 2000, the PBOC 18 Comparative Political Studies announced that interest rates on foreign currency deposits would be set by the China Bank Association, a newly formed government directed association of bankers. In March 2002, however, the PBOC rescinded this plan for most but the largest depositors, further delaying interest rates liberalization (The Asian Wall Street Journal, 2002). At the end of Zhu’s tenure, the PBOC still set a tight band around the interest rates of deposits, most shortterm loans, and medium and long-term loans. Although local officials and some PBOC officials have lobbied for more than a decade on its behalf, they had little success. Thus, the central bureaucracy’s strong preference for tight control over China’s vast financial resources triumphed over the preferences of local governments and banking experts, causing a prolonged delay in interest rate liberalization.

Setting Up Private Banks

Since the beginning of the reform, private or quasiprivate financial institutions have formed in localities where their services were needed (Tsai, 2002). Deng’s Southern Tour in 1992 further galvanized the expansion of grassroots private financial institutions. According to an estimate by a government think tank in 2004, unregulated private financial institutions had assets equivalent to one third of that held by formal financial institutions (Zhong, Ba, Gao, & Zhao, 2004). Unlike state-owned behemoths, small private banks made mostly short-term loans and had the freedom to charge and give interest equivalent to three times that at the state banks. In localities where they thrived, especially in Zhejiang, Anhui, Jiangsu, and Fujian, private financial institutions captured a substantial volume of deposits from state bank branches, forcing them to increase their deposit rates against PBOC regulations (Lu, Lu, & Hu, 1998). Individual depositors benefited from the higher interest rates provided by these institutions, and private businesses raised much-needed funds that the state banks denied them.

Undoubtedly, nascent financial institutions came with a host of their own problems. First, swindlers, sometimes with the cooperation of local government officials, concocted pyramidal schemes to defraud depositors, causing banking panics, protests, and even riots (Yu, 2001). Moreover, owners of some underground financial institutions used highly coercive means to enforce contracts, which created significant problems for the local police. Private financial institutions also served as tax shelters for individuals or businesses, especially after the implementation of the deposit interest tax in 1999. According to one estimate in 1998, depositors in private Shih / Reform Equilibrium 19 financial institutions were able to evade as much as 10 billion RMB in taxes(Lu et al., 1998). Finally, underground banks on the southeastern coast served as major conduits by which corrupt officials, businesses, and ordinary people could illegally purchase foreign currency and even set up offshore accounts (Jinrong Shibao, 2002).

Despite these problems, many bankers and financial experts within the government supported the legalization of informal financial institutions.

Career bankers felt that legalizing private banks would increase the efficiency of capital allocation and allow the PBOC to monitor their activities much more effectively (anonymous, personal communications, November 25, 2000; June 23, 2001). Thus, from a purely bureaucratic standpoint, the central bank had an interest in legalizing these institutions. Bankers at the local level especially noted that when the center directed financial resources to SOEs, informal finance provided much needed capital to the vibrant small and medium enterprises. On the coast, at least, private banks had begun to take reputation seriously and kept a good record of paying depositors, and private businesses increasingly relied on them for financing (Tsai, 2002).

Given their record, local cadres increasingly recognized private banks as a vital and integral part of the local economy. Local PBOC officials and township cadres in Zhejiang openly praised informal credit associations and banks for their crucial role in supporting rural development. Rather than banning them, local officials supported legalizing and regulating private institutions(Cui, Li, & Wu, 2001). In 2000, when the Shanghai regional office of the PBOC decided to close down private banks in Zhejiang, local cadres mobilized their personal connections in Beijing to fight the closure.

At first, the Shanghai PBOC office agreed to delay action until further investigation had been completed. In the end, however, one of the oldest and most reputable private banks, operated by the Dongfang Group in Wenzhou, was indicted for “illegally absorbing deposits” and was promptly shut down (D. Chen, 2001).

Instead of slowly allowing private banks to form, the Zhu Administration heightened the suppression of private banks. One of Zhu’s first acts as premier was closing down hundreds of private and quasiprivate financial institutions that had sprung up in the early 1990s. In June 1998, the State Council promulgated Order 247, titled “Methods of Suppressing Illegal Financial Institutions and Illegal Financial Business Dealings.” According to this decree, illegal financial institutions included “all institutions that are set up to absorb deposits, release loans, conduct clearance, discount notes,...

without the approval of the PBOC”(State Council, 1998, p. 30). Although this included financial institutions operated by the local authorities, local 20 Comparative Political Studies government and police were supposed to help suppress these institutions. As the Wenzhou case reveals, implementation of this regulation was extremely difficult.

From both the technocratic and bureaucratic standpoint, the persistent criminalization of private banks makes little sense. Legalizing private banks would increase the efficiency of capital allocation, support local growth, and drastically reduce the monitoring swamp faced by the PBOC. Allowing private banks to enter the market would further increase competition and prepare Chinese banks for foreign competition. Politically, Zhu could have found powerful allies in the party to push for the legalization of private banks. Despite the high opportunity cost and the enormous monitoring quagmire of suppressing private financial institutions, Zhu hardly changed the status quo during his tenure. The status quo was maintained mainly to retain financial resources directly under the control of the central government (anonymous, personal communications, November 10, 2000; June 23, 2001). Zhu could only achieve his policy goals and expand his influence in the Politburo if he kept China’s vast financial resources in the state banks.


Incomplete financial reform in China is puzzling because Premier Zhu Rongji, a seemingly promarket technocrat, had firm control over financial policies in 1997 with little pressure from social groups and minimal interference by leftist ideologues. Yet at the end of Zhu’s 5-year term as premier, the financial sector remained dominated by the state and continued to channel the bulk of savings toward the state sector. Theories that describe reform as a neat policy bundle and theories that assume technocratic preferences for reform simply cannot account for this partial reform equilibrium.

Rather, continuing gross inefficiency in the financial system can best be understood by examining the political and careerist incentives of those who decided on the policies. Although fairly insulated from societal pressure, the technocrats faced political threats from within the party. Their concern for political survival produced a bundle of policies that maximized their financial control, bolstered their administrative accomplishments, and minimized policy risks.

Although banking reform continued into the Wen Jiabao Administration, the government remained focused on painless fixes involving massive capital injections. To further diminish NPL ratios in the state banks, the new Shih / Reform Equilibrium 21 premier ordered the central bank to inject 45 billion dollars into two ailing state banks from China’s enormous foreign exchange reserve. With this massive injection, the two banks, China Construction Bank and Bank of China, readied to sell a minority stake to foreign investors and small investors through listings in Hong Kong. However, most members on these two banks’ boards are government officials (Shih, 2005). Ironically, although foreign investors are increasingly able to take minority stakes in state banks, domestic private investors are still unable to set up privately owned financial institutions.

Is the problem of partial reform equilibrium unique to postcommunist countries? A cursory examination of the evidence suggests that the influence of insiders on reform trajectory might be an underemphasized aspect of financial reform in Latin America. Although a rich literature provides valuable insights about the causes and process of financial liberation in Latin America, much of the discussion sees financial reform as a dichotomous variable (Boylan, 2001; Maxfield, 1993). These frameworks provide powerful explanations for financial reform, but not all policies beneficial to a healthy financial market were enacted with the same eagerness. As Mishkin (2000) points out, an important aspect of financial liberalization is the construction of regulatory capacities, which guard against moral hazard and adverse selection.

Yet financial reform in many Latin American countries favored liberalization and privatization and neglected financial regulations. As a result, bankers in many cases took advantage of the arbitrage opportunity to borrow heavily from abroad and lend or speculate in domestic currencies, leading to financial bubbles and crises (Alston & Gallo, 2000; Hastings, 1993).

Instead of explaining the success of liberalization alone, a more comprehensive explanatory framework would account for both financial liberalization and the apparent lag in regulatory reform in the financial market.

For example, the first round of financial liberalization in Chile benefited a small group of connected bankers enormously (Hastings, 1993; Silva, 1996). In this example, although the Western training of the “Chicago Boys” explains privatization and capital account liberalization, it does a poorer job explaining insider privatization and the lag in building regulatory structure. Instead, an explanation focusing on the Chicago Boys’ close ties with the financial conglomerates does a better job of explaining these outcomes (Silva, 1996). Perhaps Olson’s (1965) original observation remains valid, despite the torrent of literature claiming otherwise. Policy changes do not occur because they benefit society as a whole; they occur because a small group of actors gain enormously in the process, which gives them incentive to push policies toward the new equilibrium.

22 Comparative Political Studies Notes

1. In November of 1997, Zhu promised western provinces that subsidized loans to western China would not be affected by the centralization (see Zhu, 1998).

2. According to the People’s Bank of China categorization, nonstate lending includes working capital loans to joint-ventures set up by Hong Kong, Taiwan, and Macau firms (sanzi), individual enterprises (geti siying), joint-ventures and “other,” and medium-term and long-term loans to “other.” See Division of Statistics of People’s Bank of China, 2000.

3. This nonperforming loan (NPL) figure represents the mean of estimated NPL by various groups. See Berger, Nast, and Raubach, 2002.

4. “At face value” means at the original amount of the loan plus accrued interest. Normally, one would never purchase a NPL at face value because of the high-risk profile of a nonperforming loan.


Aberbach, J. D., Putnam, R. D., & Rockman, B. A. (1981). Bureaucrats and politicians in western democracies. Cambridge, MA: Harvard University Press.

Alston, L. J., & Gallo, A. A. (2000). Banking system under convertibility: The roles of crises and path dependence. Cambridge, MA: National Bureau of Economic Research.

The Asian Wall Street Journal. (2002, March 8). China renews control over setting rates on foreign deposits. The Asian Wall Street Journal, 2002, p. M7.

Aslund, A. (1995). How Russia became a market economy. Washington, DC: Brookings Institution.

Berger, L. W., Nast, G. R., & Raubach, C. (2002). Fixing Asia’s bad-debt mess: A banking crisis crippled Asia’s economies in 1997. A bad debt crisis threatens to do so again unless governments and banks crack down on nonperforming loans. McKinsey Quarterly, 12, 139.

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