Mission Completed or Problems Unsolved

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Mission Completed or Problems Unsolved

    Mission Completed or Problems Unsolved? A Policy Review

    of China‟s Banking Reform

    Charles C L Kwong

    School of Arts and Social Sciences

    The Open University of Hong Kong

    30 Good Shepherd Street, Ho Man Tin,

    Kowloon, HONG KONG

    Tel: 852-2768 5719; Fax: 2391 3184;


     thPaper presented at the 19 China Economic Association (UK) Annual Conference “China’s Three Decades of Economic Reforms” University of Cambridge, UK, 1-2 April



Starting in the 1980s, the Chinese government has embarked a series of banking reform

    in response to the changing conditions of domestic and international economies. The

    reform in the 1980s marked the starting point of reinstituting the state-owned specialised

    banks (SBs) and these banks functioned primarily as fiscal agents for the central

    government to accomplish planned targets in the 1980s and early 1990s. The modest

    reforms in the 1980s were followed by more far-reaching reforms of transforming the

    SBs into state-owned commercial banks (SOCBs) in 1990s, which reflected the central

    government‟s determination of enhancing the efficiency of the state banks by separating

    commercial lending from policy lending. However, lending decisions were still mainly

    influenced by state directives instead of profitability consideration. The pressure on

    China‟s banking sector has intensified since China‟s admission into the World Trade

    Organization (WTO) in 2001. In response to its commitments of opening up its banking

    sector to foreign banks in December 2006, China has initiated reforms in various

    dimensions to cope with encroaching and intensifying competition for the past six years.


    This paper argues that the banking reform after China‟s accession to WTO has

    accomplished unprecedented positive results, but its long-term success rests on whether

    the SOCBs can continue to improve their asset quality and corporate governance. To

    reach this end, the central government has to further diminish its influence on the

    operation of SOCBs and allow the state banks to be governed by market discipline. It also

    propounds that the current reforms may not be full-fledged enough to sustain China‟s

    future economic development, which is reflected by the noticeable capital constraints

    facing the small- and medium-sized private enterprises, particularly those in rural areas.

    Reinstituting the Specialised Banks in the 1980s: From Mono-banking to Plural-banking System

In the 1950s, China had a simple mono-banking system consisting of the Bank of China

    (BOC) and the Construction Bank of China (CBC), which were subordinate to the

    People‟s Bank of China (PBOC) and the Ministry of Finance (MOF), respectively. The

    BOC functioned as the foreign exchange division of PBOC while the CBC disbursed

    funds to finance state-owned enterprises (SOEs) and capital-investment projects

    blueprinted in the government‟s economic plan (Eckstein 1977: 176-81).

    On the eve of economic reform, all financial institutions merged into the PBOC or the

    MOF during the Cultural Revolution (1966-1976) (Okazaki 2007: 6). The PBOC became

    a mono-bank performing both the central bank functions (regulating money supply and

    determining interest rate) and commercial bank function of financing SOEs and state

    projects. The PBOC before the reform served as the state‟s fiscal agent to divert funds to fulfil the planned targets (Lardy 1998: 61).


    From 1979 to 1984, four state-owned specialised banks (SBs) were reinstituted and separated from the PBOC. The Agricultural Bank of China (ABC) was re-established in

    1979 to handle deposits and lending in rural areas. The BOC was reinstituted under the

    State Council (SC) in 1979 to manage the country‟s foreign exchange. The People‟s

    Construction Bank of China (PCBC) (renamed as China Construction Bank in 1996) was

    made subordinate to the SC in 1979 to undertake financing construction and fixed assets

    investment while the Industrial and Commercial Bank (ICBC), established in 1984,

    specialised in funding business activities (Okazaki 2007: 8; Lardy 1998: 61-4).

    On top of reinstituting the SBs, the central government transformed the PBOC into a formal central bank in 1984 by transferring its deposit and lending activities to ICBC.

    The re-establishment of the SBs and the setting of a formal central bank laid the

    important foundation of separating central bank and commercial bank functions. New

    commercial banks, such as the Bank of Communications, and financial institutions were

    allowed to open to increase competition in the banking sector. SBs‟ specialised roles had

    started to blur since the 1980s and each SB face increasing competition from other SBs

    and the new financial institutions.

    The reinstituting of SBs and the diversification of financial institutions in the 1980s represented only a hierarchical and structural transformation. Though limited competition

    was introduced, the SBs still dominated the banking sector, with 71.2 percent of assets in

    the banking sector managed by the SBs in 1986 (Lardy 1998: 224-5), and continued to

    perform the fiscal functions assigned by the central government.


1994 Banking Reform: Commercialization of SBs

    In the 1990s, China faced mounting pressure, both domestic and external, to further

    reform its banking sector. To avoid the massive layoffs by ailing SOEs from the mid-

    1980s to the mid-1990s, the SBs shouldered the key responsibility of rendering „soft

    loans‟ to SOEs to maintain the operation of many loss-making SOEs. This strategy

    reduced the number of losers under reform, but at the same time piled up NPLs of the

    SBs (Naughton 2007: 460-1). The ratio of NPLs of the SBs reached 20.4 percent in 2004

    and was estimated to increase by 2% annually (Lardy 1998: 121-2). Externally, since the

    transformation of the GATT (General Agreement on Tariffs and Trade) to WTO (World

    Trade Organization) in 1995, China started to request its membership in WTO. As part of

    the commitments to WTO accession, China was required not only to reduce its tariff and

    non-tariff barriers for imports, but also open up its telecommunication, banking, financial

    and insurance sectors to foreign investors (Okazaki 2007: 81)

     To avoid further accumulation of NPLs and to pave the way for WTO negotiation,

    the central government decided to embark on an overhaul of the banking system in 1994,

    1with at least three major aims: (1) to develop the PBC into an independent and fully-

    fledged modern central bank to regulate the national financial market and maintain

    macroeconomic stability; (2) to commercialise the four SBs by separating commercial

    lending from policy lending; and (3) to nourish a more diverse and competitive banking

    sector by allowing more commercial banks to enter the market.

    In regard to the first aim, the central government‟s decision explicitly urged the

    establishment of a „sound macroeconomic control system‟. It was clearly stated that „the

    central bank, the People‟s Bank of China, under the leadership of the State Council,


should implement monetary policy independently‟. The independent status was further

    elucidated in that „the power of the central bank and local authorities over economic

    administration should be rationally delineated‟ and „the branches of the People‟s Bank of

    2 To put the decision into practice, a China are certified as agencies of its head office.‟

    Law of the People‟s Republic of China on the People‟s Bank of China (PBCL) was

    enacted in 1995. The PBCL establishes a legal foundation for the superior status of the

    PBC by stipulating that under the leadership of the State Council, the PBOC devises and

    implements monetary policy and monitors the operations of the financial sector (Article

    2). Article 7 of the PBCL entrusts the PBOC with a high level of independence by

    specifying that the PBOC is free from the intervention of local governments, government

    departments, organisations and individuals when it performs its central bank and business


    To enhance the profitability of the banks, the Chinese authorities also endorsed in the

    thThird Plenum of the 14 Central Committee to separate policy lending from commercial lending. By this, the four SBs would gradually be transformed into state-owned

    commercial banks (SOCBs). Policy-based loans are designated to the three policy lending

    3banks established in 1994.

    4China‟s banking reform in 1994, which aimed at commercialising the four SOCBs

    by separating commercial lending from policy lending, unintentionally resulted in

    noticeable capital constraints facing the small- and medium-sized private enterprises,

    particularly those in rural areas. Since the SOCBs were required to operate on

    commercial principles, 44,000 county branches of SOCBs ceased to operate during 1998-

    2001 to cut the operation costs. Rural credit cooperatives (RCCs) become the single most


important financial institution in rural areas to meet the credit demand by the rural

    enterprises. However, despite increase in deposit in RCCs, a rising amount of funds has

    been channelled out of rural areas through depositing funds into the People‟s Bank of

    China or purchasing bonds for which the returns are more stable and less risky. Capital

    shortage has become one of the primary constraining factors for the expansion of rural

    non-farm activities (Kwong 2007a: 395).

    It is evident that 20.7 percent of the capital of township-village enterprises (TVEs)

    was financed by bank loans in 1985 and reached a historic high of 30.7 percent in 1992,

    but the figure shrank to 12.1 percent in 2002 (Kwong 2007a: 396). The efficiency-

    enhancing banking reform in 1994 lacks a parallel development of a full-fledged rural

    financial market to divert adequate financial resources to rural enterprises, particularly to

    the small- and medium-sized ones. Most of the TVEs are small-sized firms in terms of

    workers employed, output value, value added, and fixed assets. Clear and accurate

    financial reports of the small-sized enterprises are rare in China‟s countryside either

    because it is unaffordable for the enterprises to have qualified accountants to compile

    their financial reports, or because they deliberately hide their “real” transactions to avoid

    possible taxes and fees collected by local governments. Local banks and RCCs thus incur

    very high transaction costs to evaluate the credit risks of each project. Because of adverse

    selection caused by asymmetric information, lenders in the countryside tend to extend

    5loans to large enterprises which indicate low credit risks and high repayability.

    The 1994 banking reform marks the beginning of commercialising the SOCBs, but

    the actual banking operation entailed no practical changes in the 1990s. The SOCBs was

    still largely state-owned and in lack of credit culture. Lending decisions were still mainly


influenced by state directives instead of profitability consideration. Some estimates

    indicated that the ratio of non-performing loans (NPLs) of the Big Four stayed at an

    alarmingly high level of 40 percent by 1998 (Woo 2003: 5).

    1998-2006: From WTO Accession to Full Liberalisation

    The 1994 banking reform had achieved limited results in enhancing efficiency of the

    SOCBs. The central government recognised that the financial conditions of the SOCBs

    must be improved substantially before formally admitted into the WTO. In addition, the

    Asian financial crisis in 1997-98 alarmed the central leaders that the fragility of the

    financial sector can bring about severe macroeconomic instability and enormous

    difficulties in the economy. Decisive steps were taken to improve the balance sheets and

    corporate governance of the state banks.

    Bailout of State Banks

    To speed up the pace of relieving the NPLs of the SOCBs, the MOF injected US$34

    billion into the Big Four in 1998. The recapitalization was supposed to alleviate the

    financial burden of the SOCBs arising from the past policy lending. Such recapitalization

    by the central coffer was planned to be „first and final‟ (Anderson 2007: 172). However,

    the subsequent establishment of four asset management companies (AMCs) in 1999 to

    absorb 1.4 trillion yuan of NPLs from the Big Four and the further recapitalization,

    amounted to US$75 billion, of the SOCBs in 2003-06 defeated the initial design of an

    once-and-for-all‟ relief plan for China‟s debt-ridden state banking system. Table 1 shows

    that official financial support rendered to the state banking sector reached an amount of

    6US$402 billion, which is about 16 percent of China‟s GDP in 2006.


Table 1 Official Financial Support to SOCBs since 1998

    Item Date Amount (US$ billion) Source Capital injection 1998 34 Ministry of Finance to Big Four

    AMC carve-out 1999 5 Ministry of Finance AMC carve-out 1999 48 People‟s Bank of China AMC carve-out 1999 120 People‟s Bank of China Capital injection 2003-06 75 People‟s Bank of China to Big Four

    Subsidized NPL 2004-06 100 People‟s Bank of China carve-out

    Tax relief for NPL 2004-06 20 Ministry of Finance write down

    TOTAL 402

    Source: Anderson 2007: 173

    Central government‟s ongoing financial support has successfully lifted the capital

    adequacy ratio (CAR) of the SOCBs to a level higher than the international standard of 8

    78percent and reduced the NPL ratio to an official figure of 7.83 percent in 2007 (Q3).

    The rapid drop in NPL ratio was also attributable to the double-digit credit growth since

    2000. However, from a comparative perspective, even after many years‟ government

    support, China‟s NPL ratio is still higher than other Asian developing countries including Indonesia, Thailand, and Malaysia in 2007. The NPL ratio of the SOCBs has consistently

    higher than the joint-stock commercial banks (JSCBs) in recent years, though the JSCBs

    9have not received much financial support by the central government. From 2005 to 2006, the smaller city commercial banks, such as the Zhuzhou City Commercial Bank and the

    Bank of Dalian, achieved a much faster growth of profitability than that of the SOCBs

    (KPMG 2007: 4, 27).


These figures raise the issue of moral hazard and cost-effectiveness in bailing out these

    state banks. It is particularly relevant to the future bailout of the ABC, which is widely

    believed to be the most severely hit state bank by the massive lending to the rural sector,

    10 Agricultural Bank with a non-performing loan ratio of 24.75 percent reported in 2006.

    11may need as much as US$140 billion to reduce bad loans to less than 5 percent, which

    will be the single largest bailout of a state bank.

    Banking Supervision and Corporate Governance

    The most important step of strengthening banking supervision is the setting up of China

    Banking Regulatory Commission (CBRC) in 2003 to regulate all banks and depository

    institutions. One of the major tasks of the CBRC is to ensure that the SOCBs are

    operating under prudent commercial bank practices such as the 10-plus loan classification

    system and the internal rating based loan system to evaluate the potential risks of loans

    extended to the market (Hansakul 2006: 4). It is a vital step to develop a credit culture

    among SOCBs to avoid piling up NPLs.

    Three of the Big Four (ICBC, CCB, BOC) were listed on stock exchanges in Hong

    Kong and Shanghai in 2005/2006 to allow more market discipline to monitor the

    performance of the SOCBs. To increase their operation efficiency, SOCBs are required to

    trim down their branch network as well as the staff teams. The number of branches

    declined substantially by 25 percent during 2002-2005, but the downsizing of employees

    had recorded a much slower pace of 7 percent for the same period (Hansakul 2006: 4).

    The SOCBs are still burdened with overstaffing. The after-tax profit per employee was

    only about one-tenth of that of the Japanese counterparts with comparable assets (Muroi

    2007: 2). Capital injection has furnished the SOCBs with notable improvement in CARs.


Nevertheless, from a comparative perspective, SOCBs still lags behind the performance

    of other global banks, particular in terms of NPL ratios (Table 2).

    Table 2 Performance Indicators of SOCBs and Global Banks 2006

    Banks CAR NPLs ratio ROA ROE ICBC 14.05 3.79 0.66 10.47 CCB 12.11 3.29 0.85 14.03 ABC n.a. 23.43 0.11 6.91 BOC 13.59 4.04 0.89 11.29 Citigroup 11.65 0.12 1.14 17.98 Banking of America 11.89 0.1 1.45 15.62 HSBC Holdings 13.5 1.56 0.91 14.68 Barclays Bank 11.7 1.78 0.52 18.97 UBS 14.7 0.6 0.53 22.86 Source: Compiled based on the data from KPMG (2007: 19, 21-2, 28-30)

    Note: CAR=capital adequacy ratio; NPLs ratio=Non-performing loans ratio; ROA=Return on Assets (after-

    tax profits as a percentage of total assets); ROE=Return on equity (after-tax profits as a percentage of total


    Foreign strategic partners are now more welcome not just for their capital, but also

    for their knowledge in bank practices, product design, and international exposure. The

    following table reveals the foreign partners of three of the Big Four (ICBC, CCB, BOC).

    However, the influence of foreign partners in the Chinese banks should not be

    overemphasised since the ceiling of foreign ownership in a Chinese bank is 25 percent

    while the ceiling of a single foreign bank is capped at 20 percent. The state remains to be

    the major shareholder of the Big Four. Though the state banks have tried to recruit

    foreign bankers to join their senior management, this outside talent, in general, served in

    the state banks only for a short period of time. Their inputs for improving the banking

    12efficiency are therefore very limited.


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