Assessing Market Competition in the Chinese Banking Industry Based on a Conjectural Variation Model

• Published date: 01 March 2021
• Author: Xiangyi Zhou,Zheng Pei,Botao Qin
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/cwe.12371

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 73–98, Vol. 29, No. 2, 2021 73

*Xiangyi Zhou (corresponding author), Associate Professor, Jinhe Center for Economic Research, Xi’an

Jiaotong University, China. Email: marton@mail.xjtu.edu.cn; Zheng Pei, Postgraduate Student of Industrial

Economics, Antai College of Economics and Management, Shanghai Jiaotong University, China. Email:

zornpei@126.com; Botao Qin, Assistant Professor, Jinhe Center for Economic Research, Xi’an Jiaotong

University, China. Email: bqinecon@mail.xjtu.edu.cn. The authors are grateful for the helpful comments from

Sherrill Shaffer, Long Shi, Tay-Cheng Ma, Yusen Kwoh, Weihong Zeng, Xiaodong Chen, Shengliang Ji, and

Yifan Zhou. Xiangyi Zhou acknowledges fi nancial support from the Chinese Fundamental Research Funds for

the Central Universities (No. SK2020053).

Assessing Market Competition in the Chinese Banking

Industry Based on a Conjectural Variation Model

Xiangyi Zhou, Zheng Pei, Botao Qin*

Abstract

Most literature on market competition in the banking industry neglects to address

strategic interaction among banks. This paper studies interaction among Chinese banks

by dividing banks into two groups: dominant banks (the “Big 5” state-owned banks) and

small- and medium-sized banks (joint-stock banks and large city commercial banks). We

test an oligopolistic model with conjectural variation developed by Spiller and Favaro

(1984). Using data from 2007 to 2016, we fi nd that banking competition is not in the form

of Stackelberg competition per se. Some strategic interactions exist between small- and

medium-sized banks and the largest state-owned bank. We also study the effect of interest

rate deregulation on oligopolies’ strategic interactions. Our results show that interest

rate deregulation stimulates banking competition by reducing collusiveness among the

dominant state-owned banks and enhancing the market power of small and medium banks.

Key words: banking industry, conjectural variation, interest rate deregulation, market

structure

JEL codes: G21, L10, P34

I. Introduction

The degree of market competition in the banking industry has always been of interest to

researchers (Shaffer, 1993; Bikker et al., 2012; Shaffer and Spierdijk, 2015). However,

few studies have addressed strategic interaction among banks. The Chinese banking

industry is concentrated, with a small number of dominant state-owned banks (the so-

called “Big 5”). There are also 12 medium-sized joint-stock commercial banks and

Xiangyi Zhou et al. / 73–98, Vol. 29, No. 2, 2021

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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numerous city-level commercial banks. The question is whether dominant state-owned

banks engage in strategic interactions that differ from those of small banks.

The interest rates that Chinese banks can charge for loans are undergoing

deregulation. Both deposit and loan interest rates were heavily regulated by the People’s

Bank of China (PBC), which is China’s central bank. However, the PBC started a

deregulation process in recent years and has allowed banks to set their own loan interest

rates since 2013. A second question is thus how interest rate deregulation affects China’s

banking competition.

Motivated by these two research questions, we use an oligopolistic conjectural

variation model developed by Spiller and Favaro (1984) to test the competition among

the dominant state-owned banks (SOBs) and the small- and medium-sized banks (SMBs).

We fi nd that: (i) Banking competition is not in the form of Stackelberg competition per

se. Some strategic interactions exist between SMBs and the largest state-owned bank. (ii)

Interest rate deregulation reduces collusive behavior among SOBs, enhances the market

power of SMBs, and increases market competition. Our fi ndings support policy reform

to liberate bank loan interest rates.

Most of the literature that focuses on the market structure of the Chinese banking

industry uses the Panzar–Rosse model. The H statistic is usually interpreted as

a measure of market power. Specifically, H = 1 indicates a long-run competitive

equilibrium; H < 1 indicates the existence of monopoly power; and 0 < H < 1 indicates

monopolistic competition (Panzar and Rosse, 1987). Most studies that employ the

Panzar–Rosse model find that the Chinese banking industry is close to monopolistic

competition (Fu and Heffernan, 2009; Masood and Sergi, 2011), although some fi nd it to

be near perfect competition (Yuan, 2006). However, recent literature raises doubts about

the validity of the Panzar–Rosse test. Both theoretical and empirical studies show that

neither the sign nor the magnitude of H can reliably indicate anything about the degree

of market power (Bikker et al., 2012; Shaffer and Spierdijk, 2015). Another branch of

literature that tests market competition uses the Bresnahan–Lau model (Bresnahan,

1982, 1989; Lau, 1982). One study that employs this model to investigate the Chinese

banking industry finds that the market is near perfect competition (Qin and Shaffer,

2014). The third branch of literature on market competition uses the Bonne indicator

(Bonne, 2008). Fang et al. (2019) use the Bonne indicator and find that competition

in the deposit market, loan market, and noninterest income market was stronger over

the periods of 2003–2005 and 2014–2017. Tan (2017) uses the Boone indicator and

finds that the noninterest income market has a higher level of competition than the

deposit market and loan market. Xu et al. (2016) use the profi t elasticity (PE) approach

developed by Bonne (2008) and show that competition has actually increased over the