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Banking on China

China nudges its banking reforms along, tossing an occasional bone to foreign financial institutions

Banks, which perform some of the most important financial functions in a market economy, have been key targets for reform in post-1979 China. This is understandable, as the role of a modern commercial bank is to attract funds and reallocate them to the most efficient users, thereby supporting economic growth. A commercial bank also needs to make a stable profit by offering financially rational and prudent loans that carry a lending rate high enough to cover both operating expenses and interest on deposits.

Among the government's more aggressive reforms has been the modernization of state-owned banks and the creation of new ownership structures. These reforms have yet to force China's previously non-market banks to achieve the most basic but crucial commercial-bank objectives, however. And the gradual pace of the reform process has kept foreign commercial banks, with limited access to the market, from becoming major participants.

The Players and How They Came to Be

China has a long history of commercial banking, but the cu rrent system dates from the 1948 establishment of the People's Bank of China (PBOC). After the founding of the PRC in October 1949, PBOC assumed all of the existing Chinese and foreign banks' functions. PBOC served as a central bank and government treasury, and directed and supervised all specialized subsidiary banks, non-bank financial institutions, and insurance companies. Three major, specialized banks existed under PBOC: the Agricultural Bank of China (ABC), serving the agricultural sector; the People's Construction Bank of China (CCB), specializing in infrastructure finance; and the Bank of China (BOC), which acted as China's foreign-exchange bank.

PBOC held a monopoly on banking functions until 1979. During this period, China had a roughly 40 percent savings rate, and PBOC allocated these savings to industries and agricultural projects according to a national credit plan set by the State Council's State Planning Commission. Ninety percent of investment funds went to large state-owned enterprises (SOEs), which employed about 70 percent of China's largely urban industrial work force of 100 million.

An integral part of China's economic reforms, banking reforms received the government's immediate attention after 1979. The first reforms began with the devolution of various banking functions from PBOC to the three specialized state-owned banks. Spun off as an independent but st ill government-owned commercial bank in 1979, ABC began providing commercial banking services, focusing on agricultural and rural industrial projects. BOC retained its autonomy to conduct foreign-exchange operations. And a reconstituted CCB began financing fixed-asset investments in China.

PBOC became China's official central bank in 1984. To facilitate this transformation, China established the Industrial and Commercial Bank of China (ICBC). ICBC took over from PBOC various commercial banking functions, and became the largest of China's four state-owned banks. Other financial institutions were also launched at this time, such as insurance companies and international trust and investment corporations (ITICs).

China formed three "policy" banks in 1994 to assume the government-directed ("policy") lending functions of the four state-owned banks. These were the State Development Bank, specializing in national infrastructure finance; the China Export-Import Bank, providing trade finance; and the China Agricultural Development Bank, financing agricultural development reforms (see The CBR, January-February 1997, p.16). The Ministry of Finance directed these banks to provide capital or make loans to SOEs or national infrastructure projects.

Following the 1995 release of the Commercial Bank Law and Central Bank Law, ICBC, ABC, BOC, and CCB began to function as commercial banks, subject to new rules and regulations holding them responsible for their profits and losses. The Central Bank Law also furnished a legal underpinning for PBOC's central-bank role.

This period saw the development of other financial institutions to meet the increasingly complex and growing needs of a modernizing economy. One new type of banking institution was the share-ownership commercial bank, in which various levels of government, Chinese institutions, and in rare cases individuals, hold shares. These banks include the Bank of Communications, the Shenzhen Development Bank, the China International Trust and Investment Corp. (CITIC) Industrial Bank, China Everbright Bank, Hua Xia Bank, China Investment Bank, China Merchant's Bank, Guangdong Development Bank, Fujian Xingye Bank, The Shanghai Pudong Development Bank, Hainan Development Bank, and China Minsheng Bank.

Another new type of financial institution was the urban cooperative bank, which evolved out of China's 5,000-plus urban credit cooperatives. This ongoing restructuring process resulted in 88 new urban commercial banks and 3,240 urban credit cooperatives by the end of 1998. There are also still 41,500 rural credit cooperatives. These operations serve mainly individuals and small enterprises.

The Small Foreign Presence

While domestic banks undergo restructuring and expansion, foreign banks are slowly gaining entry into the market. At the outset of the financial reform program, PRC leaders debated whether foreign banks should be allowed to operate in China at all, and if so, in what form and under what conditions. Officials who favored opening the banking industry argued that foreign banks would introduce more competition into the Chinese banking system and thereby improve efficiency. They reasoned that such banks could also be an additional source of foreign capital and would help introduce modern banking standards and practices. Moreover, foreign banks would improve the Chinese foreign-investment environment, particularly by providing banking services to foreign-invested businesses in China.

But other Chinese officials were concerned that foreign banks might come to dominate the domestic banking sector just as they had before 1949. Such domination could then lead to excessive foreign control of the economy. China also wanted to protect its young commercial banks. These concerns are not unique to China- in many countries, foreigners are not permitted to own banks entirely, and many countries have severe limits on even partial foreign ownership. Australia and Canada, for example, permit no more than 10 percent foreign ownership of any one bank; Denmark allows no more than 30 percent; and South Africa sets the limit at 50 percent. Cautious PRC officials also ar gued that China still lacked a legal and regulatory framework to guide domestic- much less foreign-bank operations.

After some debate, Chinese leaders decided in 1979 that opening the banking sector to foreign players was a risk worth taking. Their strategy has been to offer foreign banks access gradually and within certain financial limitations. The Import-Export Bank of Japan became the first foreign bank to open a representative office in the PRC, setting up shop in 1979 in Beijing. Hong Kong's Nanyang Commercial Bank was the first foreign bank to open a branch in China, and it began offering full commercial banking services in Shenzhen in 1982.

In 1985, China promulgated its first set of rules and regulations for the operation of wholly foreign-owned and joint-venture financial institutions located in the five Special Economic Zones. On April 1, 1994, new regulations superseded all past rules and laid the groundwork for foreign participation in Chinese banking. The Regulations Governing Foreign Financial Institutions in the People's Republic of China declared that to establish branch operations in China, foreign banks must have a representative office at least two years old; the branch bank's parent company must have total assets of over $20 billion (foreign bank subsidiaries and financial institutions need only $10 billion); and the bank must be headquartered in a country with sound financial supervisory and administrative systems. The regulations also stipulated that PBOC would regulate all foreign bank activities.

By late 1994, the government had begun permitting foreign banks to conduct foreign-currency business for foreign and overseas Chinese individuals and enterprises both in and outside of China, and for SOEs needing foreign-currency loans. China limited foreign operations to major coastal cities. By 1997, 234 cities, most of them on the coast, had been opened to foreign banks, but foreign banks concentrated their operations in Beijing, Shanghai, Guangzhou, and Shenzhen. The number of foreign banks in China had reached 172 by the end of 1998–153 were representative offices and branches of foreign banks, 7 were joint-venture banks, 6 were wholly foreign-owned banks, and 6 were part of financial companies, either wholly foreign-owned or joint ventures, as reported in International Finance Studies.

Most recently, the International Finance Corp., the private lending arm of the World Bank, invested $22 million in exchange for a 5 percent equity position in the Bank of Shanghai. The only other Chinese bank with foreign investment is China Everbright Bank, in which the Asian Development Bank holds a 3.3 percent equity stake, valued at about $20 million.

Foreign banks' total assets amounted to an estimated $36 billion by February 1999, accounting for 2.58 percent of the assets of China's entire banking sector, according to China Economics Network. China's foreign-currency loans from foreign banks totaled $27 billion, or 23 percent of total foreign-currency loans in the country.

The current PRC banking regime offers foreign banks several advantages over their domestic counterparts. First, they enjoy the preferences given to foreign enterprises in China, such as lower taxes and certain tax exemptions. They also have more freedom than Chinese banks in their personnel and management policies, though at least one senior executive must be a Chinese citizen. And foreign institutions are able to operate without the level of government intervention faced by domestic competitors. They also do not have the non-performing loans that burden Chinese commercial banks.

On the other hand, foreign banks face significant constraints. For example, only a few banks are allowed to conduct renminbi (RMB) business, and they are restricted to limited loan amounts and to certain cities. China also lacks business transparency, making it difficult to obtain accurate accounting and operational information on borrowers. Enforcement of lending rules and loan recovery is also a problem. Issues of ownership and of responsibility for losses are ambiguous, as the demise of the Guangdong ITIC revealed (see The CBR, May -June 1999, p.36). The legal framework and enforcement mechanisms for banking are also far from complete, and experience handling financial failures and problems, including bankruptcy procedures, is lacking. Moreover, there is a dire need for trained personnel to perform modern banking functions.

Some foreign banks remain frustrated by the basics of China's banking sector–they find it difficult to understand why the government permits the four largest state-owned banks, though inefficient, technically bankrupt, and deficient in customer service, to continue to grant loans, absorb savings from the general public, and otherwise dominate the banking industry.

The Downside of Gradual Reform

Before 1978, Chinese banks simply collected savings and allocated them according to quotas set by the central government. Even though this system was relatively easy to administer, it did not permit capital allocation based on market forces or individual investment decisions by banking officials, enterprise managers, or entrepreneurs.

This dearth of market mechanisms created problems the government has tried, with limited success, to solve. The most serious problem has been the government's interference in capital allocation, principally by directing banks to base financing decisions on social and political considerations rather than market criteria. Ban ks served as implementers of government policy rather than as independent business units basing lending decisions only on the creditworthiness of the borrower. The most serious consequences of this system have been large SOEs' dependence on non-recourse loans and the resulting gr owth on the state banks' books of non-performing loans.

The cumulative level of non-performing loans–loans classified as substandard, doubtful, and loss–is officially estimated at ¥1 trillion ($120.8 billion). This is equivalent to 12.5 percent of China's 1998 GDP or China's entire 1998 fiscal revenue. But some analysts estimate that bad loan levels may run as high as ¥2.5 trillion ($302 billion). Non-performing loans represent up to 20 percent of China's state-owned banks' assets. Based on the internationally recognized 8 percent capital-adequacy standard, all four of China's state-owned commercial banks are insolvent.

The Asian financial crisis and its aftermath have only exacerbated China's banking problems. The falling demand from Southeast Asia for Chinese products and steeper competition from both foreign and domestic private-sector products have reduced SOE income and ability to repay loans. A foreign-investment decline has reduced the amount of foreign exchange available to SOEs interested in upgrading their operations. Finally, in the wake of the overall domestic economic slowdown, Chinese consumers have been cutting down on their spending and instead are focusing more on saving for retirement, medical costs, and children's needs. Savings now total nearly ¥6 trillion ($724.6 billion), even though the central bank has lowered savings interest r ates seven times over the last three years. Interest rates remain attractive, however, because of the nationwide price deflation.

Are Beijing's Best Efforts Enough?

To sustain high levels of economic growth and to support the country's integration into the world financial system, the Chinese government has taken a number of initiatives to speed up economic reforms, particularly in the banking and SOE sectors. The government aims to move China's banks toward world standards of commercial organization, service, and competitiveness by

• Improving central bank independence to permit it to carry out monetary policy without political influence from any level of government. To this end, Beijing has reorganized PBOC into nine regional branches, each with the power and autonomy to carry out monetary policy.
• Reducing the burden of past policy loans that are primarily to blame for the state-owned commercial banks' insolvency. The government injected ¥270 billion ($33 billion)–financed by Treasury-bond issues–into the banks in August 1998 to bring them up to the international banking standard for adequate equity of 8 percent of total assets.
• Adopting a new loan classification system to help bring China's loans up to international standards and to improve the management of loan portfolios. The system, which PBOC adopted in April 1 998, categorizes loans either as "pass," "special-mention," "substandard," "doubtful," or "loss."
• Relaxing control over interest rates, allowing commercial banks to float loan interest rates within a limited range. This is to encourage lending to small and medium-sized companies, providing liquidity to firms thus far all but shut out of the market.
• Strengthening China's supervisory and regulatory environment and implementing sound banking practices. Banks will be responsible for profits and losses, and unsound or failed financial institutions can be taken over, closed, or declared bankrupt.
• Establishing asset-management companies to address the bad-loan problem. These companies are similar to the US Resolution Trust Corp. (RTC), which dealt with the assets of the country's failed savings and loan institutions.
• Further opening China's banking sector to foreign banks, thereby exposing Chinese banks to foreign practices and competition. This seems to have accelerated recently as part of government efforts to open up the financial services industry, probably in response to World Trade Organization (WTO) accession requirements.

More Breaks for Foreign Players

Indeed, China has lifted several restrictions on foreign banks in the last few years. Since 1997, 25 foreign banks h ave been permitted to conduct RMB business with foreign-funded businesses in Shenzhen and Shanghai on an experimental basis. They also gained permission in 1998 to participate in syndicated loans to Chinese businesses. A group of six Chinese and foreign banks became the first to undertake such a loan, agreeing in December 1998 to extend ¥80 million ($9.7 million) to the Shanghai Tyre and Rubber Co. Ltd.

Measures initiated in 1999 have further expanded the role of foreign banks in China. Foreign banks are now permitted to operate in any Chinese city. PBOC also relaxed geographic restrictions on foreign banks authorized to conduct local-currency business. The six banks licensed to conduct such transactions in Shenzhen are now able to handle clients in Guangdong and Hunan provinces and the Guangxi Zhuang Autonomous Region, while the 19 banks in Shanghai may extend their RMB business to Jiangsu and Zhejiang provinces, subject to certain conditions.

China has increased RMB lending levels this year, from 35 to 50 percent of total RMB deposits, for foreign banks licensed to lend in local currency. Foreign banks may also now borrow long-term RMB funds from domestic banks on China's interbank lending market. Citibank's Shanghai branch recently received a one-year interbank loan of ¥50 million ($6 million) from the Bank of Communications. And the Shanghai Pudong Development Ban k provided ¥160 million ($19.3 million) in 3-5 year loans to the Shanghai branches of Bank of America Corp., Credit Lyonnais, and the Industrial Bank of Japan to support foreign-invested enterprises. This is the first time since 1949 that China has allowed Chinese-foreign interbank loans. This step may open the door to greater cooperation between Chinese and foreign banks in China.

Keeping the Crisis at Bay

Mounting bad loans to SOEs, the use of loans for stock and real-estate speculation, slackening domestic demand for Chinese products, and falling foreign demand and investment have sparked speculation about the chances of a banking crisis in China. It is true that China's four state-owned commercial banks remain basically insolvent and uncompetitive. Should they be judged by international banking standards, they would be declared bankrupt. Should they be thrown into full and open competition with foreign banks, they would fail. And should they be declared bankrupt or fail, they would frighten away the Chinese savers who are keeping the financial system afloat.

As part of the commercialization process, China's state banks were supposed to abandon the directed-credit system and begin to make loans based on traditional banking criteria. China finally phased out the traditional quota system for credit in 1997 and initiated new borrowing requirements. Commercial banks were also supposed to increase their level and scope of service in other areas such as risk management and credit analysis, and adopt accounting practices that would accurately reflect current assets and liabilities.

Though the Chinese government has tried to force its commercial banks to become more accountable for their profits and losses, it is also asking them to help promote a government demand-led, Keynesian-style pump-priming operation designed to enable China to spend its way through the Asian recession. Thus, as Nicholas Lardy has recently noted, just as Premier Zhu Rongji was promising to hold the state banks to stringent standards of accountability, the government once more ordered the banks to help fund the economic stimulus–with loans that will most likely never be repaid. The lack of domestic and foreign demand for SOE-made goods will make it harder for SOEs to pay back any loans, old or new.

One ironic consequence of China's banking reforms is that their success might in fact serve to highlight the banks' weaknesses, leading to a serious drop in their international credit ratings, with the risk of large-scale withdrawals by PRC depositors. Only convincing government guarantees will continue to inspire savers' confidence.

Foreign banks in China will no doubt continue to monitor the Chinese economy carefully, as economic performa nce will have spillover effects on the banking sector. The government is still using the banks as tools in its economic stimulus program. In October, PRC officials moved to spur the lagging economy by cutting bank reserve requirements, which they hoped would induce banks to make more funds available to borrowers. Foreign banks will watch for signs of recovery, for the better the economy, the higher the domestic demand for goods and services including loans–loans which would go to companies increasingly able to repay them.

China will likely continue to open the door further to foreign banks to meet WTO requirements and attract foreign investment. Most Chinese officials have come to realize that a more competitive banking environment will improve both service in the industry and bank profitability. They also value the opportunity to learn from foreign banks.

The pace of China's banking sector opening to foreign participation will remain modest, however. Until a strong legal and regulatory regime has been implemented, this may be a wise strategy. According to current regulations, large foreign banks are welcome in the Chinese market. But to succeed when eventually permitted to conduct large-scale operations, these banks must understand China's banking and business environment thoroughly.

Ji Chen (j1chen@castle.cudenver.edu) is on the finance faculty of the College of Business and Administration, University of Colorado at Denver. Stephen C. Thomas (sthomas@carbon.cudenver.edu) is an associate professor of Chinese politics at the University of Colorado at Denver. The authors would like to thank the Center for International Business Education and Research at the University of Colorado at Denver's Institute for International Business for its generous research support.