Rural Finance in Poverty-Stricken Areas in the People's Republic of China. Xuechun Zhang
rates exceeding this threshold are not protected by law and are deemed usury. In a market economy, however, the lending rate should be linked with lending risks, and the interest rate on riskier loans should be higher. In a developing country such as the PRC, there are many uncertainties associated with loans, so annual interest rates of 15% to 30% are normal. Artificially limiting the private lending rate to within four times the bank loan rate renders illegal a large number of private lending activities.
In addition to repealing laws that hinder the establishment of a competitive financial market, laws and regulations should encourage such establishment. For example, to facilitate financial innovation, laws should confirm the integrity of individual and enterprise capital property rights, guarantee the legitimate investment rights of individuals and enterprises, and allow nonfinancial enterprises and individuals to lend their proprietary funds to other enterprises and individuals according to lawful agreements.
Second, when amending or drafting laws on taking deposits from the public, disturbing financial order, or usury, attention should be paid to distinguishing financial fraud from investment activities. The primary purpose of financial regulation is to avoid the moral hazards brought about by financial institutions taking deposits from the public, such as sacrificing depositors’ interests to maximize profits. Normal lending activities between individuals and enterprises that do not belong to this category should be legalized. The maximum penalty for the crime of illegally taking deposits from the public should be relaxed according to the type, purpose, and potential risk of loans. Anti–financial fraud laws should be instituted, but the crime of illegally disturbing financial order should be eliminated. Laws on market-based interest rates should be drafted, and the threshold interest rate for usury should be increased to eight times the benchmark bank loan interest rate or more.
Normal lending activities between individuals and enterprises that do not belong to this category should be legalized
Third, commercial bank law should be amended and the criteria for the entry of private banks should be relaxed. Lending shops, private lending agencies, and microcredit institutions with a long history of operation, good business records, adequate scale, and the desire to establish banks should be allowed to upgrade into banks according to the requirements for commercial banks, and prudential regulation should be applied. The key to a competitive financial market is to allow competitive financiers and financial institutions to grow into intermediaries of that market. This requires the creation of opportunities for informal financial institutions to grow into formal ones, bringing about meritorious competition in which superior institutions succeed and inferior ones fail.
Current law stipulates that national commercial banks must have no less than CNY1 billion in registered capital, city commercial banks must have no less than CNY100 million, and rural commercial banks must have at least CNY50 million. These high thresholds have resulted in a gap between informal and formal financial institutions, which is not conducive to the market entry and growth of small and medium-sized banks. Consideration should be given to reducing these thresholds and emphasizing the quality rather than the size of financial institutions. Community-based financial institutions are not necessarily big, but they can operate more efficiently than large commercial banks. In the United States, for example, credit cooperatives based on enterprises, schools, large organizations, and communities play an important role among financial institutions. They remain important in several waves of acquisition, primarily because they can take advantage of community information dissemination and contracts enforcement. Because national banks do not have such advantages, community-based credit cooperatives are irreplaceable.
Fourth, laws regarding microcredit institutions, cooperative finance, and informal finance should be promulgated. In the early stage of reform, microcredit institutions should be prohibited from taking deposits, cooperative financial institutions should have their membership and scale restricted, and the size of informal finance should be controlled. Nonprudential regulation should apply to these three types of institutions.
Fifth, international experience can be used to formulate laws or regulations on community reinvestment in the PRC. For example, the United States’ Community Reinvestment Act requires a community-based financial institution to meet the lending needs of the community, predicated on compliance with principles of operational safety and soundness. Other than that, there are no rigid requirements on loan percentages. In Thailand, on the other hand, all community-based financial institutions must use 20% of their deposits in agriculture.
Finally, antimonopoly laws should be enacted to protect fair competition, policy finance laws should be enacted to enhance the effectiveness and transparency of policy finance, and the investment activities of major shareholders in financial institutions should be regulated.
Promoting the Domestic Opening of Financial Markets
The key to opening financial markets to domestic players is to endow enterprises and individuals with lawful financial rights, enabling those most effective in capital utilization to lawfully participate in financing activities. This requires innovation in financial systems and instruments, though decisions about which systems and instruments are the most effective should be left to markets rather than to governments. Legalization of informal finance is part of opening the market to domestic players, because informal finance is the means by which enterprises and individuals allocate credit resources based on market price signals.
Opening to Informal Finance
Informal finance covers lending between individuals and enterprises, lending through moneylenders (brokers), rotating savings and credit associations, pawns, chambers of commerce, underground banks, trade financing, and so forth. In some places, Buddhist temples serve as a platform for financing activity. In the PRC, these financing modes used to be called underground finance or illegal finance; they are now known as informal finance.
The key to opening financial markets to domestic players is to endow enterprises and individuals with lawful financial rights, enabling those most effective in capital utilization to lawfully participate in financing activities
Finance is an extension of trade in goods, and credit from transaction is the foundation of finance. The famous Shanxi Draft Bank was developed based on industrial capital, and other communities have managed to combine industrial capital with financial capital. However, there were no banks or specialized banking regulatory authorities in the PRC during the late 19th and early 20th centuries. In Hong Kong, China, there still is no central bank, although a few financial institutions print Hong Kong dollars. So-called formal financial institutions grow out of successful informal financial institutions, the only difference being whether an institution is accepted by regulatory authorities. The development of formal finance will not and should not restrict the existence and development of informal finance, and the financial rights of individuals and enterprises should be protected, not constrained.
In developed market economies where the criteria for market entry are much lower, there are few informal financial institutions. Formal financial institutions employ some informal finance principles, such as the “church steeple” principle that the borrower is much more important than collateral or the courts. A good financial institution should be able to see its clients and know what they are doing, as from the steeple of a church.
A good financial institution should be able to see its clients and know what they are doing, as from the steeple of a church
The discrimination against informal finance in the PRC stems from the protection of state-owned financial institutions, but such protection actually dumps the baby with the bathwater. At present, existing informal finance is based on individual credit, addresses information asymmetry, guaranties loans through social capital, complements formal finance, and can become an important mechanism for interest rate discovery.
First, informal finance is based on individual credit. An individual’s credit record is established through culture; folk custom; geographic, kinship, personal, or business relationships; and other social networks that keep detailed “records” about reputations, business activities, and social relationships. Moneylenders,