Restructuring China’s Rural Credit Cooperatives: Lessons Learned

1. Restructuring China’s Rural Credit Cooperatives: Lessons Learned Wang Jun, Senior Financial Sector Specialist EAP Region, the World Bank December 5, 2005

2. What led to the reform pilot in 2003 • Main features of the reform pilot • Lessons learned Main points of the presentation • A brief history of the RCCs • Recent attempts at restructuring the RCCs • Objectives and options • Objectives • Financial restructuring • Diversity in organization formats • Incentives • Financial restructuring should be accompanied with operations restructuring • Role of government • Role of foreign and private investors

3. Agricultural Bank of China • Agricultural Development Bank of China • Postal Savings and Remittances • The RCCs over time have become the only comprehensive FI in the rural financial market Main players in China’s rural financial market • How the RCCs became a virtual monopoly in rural finance Established as a specialized agricultural bank, but a became commercialized state-owned bank and withdrew from the countryside after 1998 Established in 1994 with the objective to take over policy lending from the ABC, and became a funding vehicle for procurement of grain, cotton and edible oil. A deposit-only financial institution that has been regarded as a capital sucking machine on the rural financial market, with about 80% of its over one trillion deposits taken from the countryside.

4. The conflicting mandates only aggravate moral hazard prevalent in the RCCs But the RCCs were subject to conflicting mandates • Social objectives • Commercial objectives • Support agricultural production • Poverty reduction • Rural financial stability • Support the rural economy • Support various policy initiatives by the local government • To become commercially sustainable over time • To be transformed into commercial entities with all forms of corporate governance in modern financial institutions • To introduce commercial managerial systems and controls by mimicking commercial banks

5. The RCCs were subject to stakeholders with conflicting objectives • The government • Central • Local • The regulatory authorities • CBRC • PBC • The market: • ABC • PSRB • Money lenders • RCCs • The owners/clients: • Members • customers And they were no different than state-owned banks in the rural financial market

6. Improve corporate governance • No one-size-fits-all approach • Align incentives of stakeholders • To improve service functions of the RCCs in the rural financial market Main objectives of the RCC reform pilot • A three-pronged approach to restructuring the RCCs • Ownership transformation • Create all forms of corporate governance • Consolidate ownership at the county level • Rural commercial banks • Rural cooperative banks • RCC union at the provincial level • Hand over managerial responsibilities to the provincial government • Allow the CBRC to concentrate on regulation and supervision of RFIs • Fund historical losses through monetization and fiscal support

7. The RCCs were given two options to compensate historical losses • A re-lending facility • Special CB notes • Local governments borrow from the PBC to cover 50% of the historical losses with cut-off date of December 31, 2002 • Maturity ranges from 3 to 5 to 8 years depending on circumstances of the RCCs • Interest rates charged were half of the that for required reserve • And insolvency data were calculated according to a formula set by the PBC, which specified loss ratios to each category of loan classification • A special note with two-year maturity, issued by the PBC to reforming RCCs in exchange of NPLs • The special notes were not tradable, endorsable and could not be used as collateral • But could be redeemed ahead of maturity with conditions attached • Redemption of the special notes were conditioned upon improvements in RCC reforms, and would be verified based on performances of individual RCCs • Criteria for redemption include: ownership transformation; corporate governance; capital adequacy; NPL ratio, etc. In the end almost all provinces opted for the special notes

8. Capital adequacy of the 8 provinces before and after financial restructuring, 2002-04, in percent

9. Aggregate capital of RCCs in the 8 provinces participating in the pilot • Capital Adequacy Ratio • Unit: % • Net Capital • Unit: RMB100 Million The aggregate negative capital of all RCCs stood at 122.74 billion at end 2002.

10. Portfolio quality of RCCs appeared to have improved in the 8 pilot provinces, but did they really? • Non-performing loans • Unit: RMB 100 million • Non-performing loans • In percent And the average NPL ratio of all RCCs combined ws 37% at end 2002 The aggregate NPLs stood at 505.9 billion yuan at end 2002

11. Looks can be deceptive: are the RCCs really making money?Profitability of RCCs in the 8 provinces • Unit: RMB100 Million

12. Volume of loan growth maybe, but hard to tell if agricultural lending also grew • Outstanding Loans • Unit: RMB100 Million • Outstanding Agricultural Loans • Unit: RMB100 Million

13. August 2004 • July 2003 The RCC reform pilot was given little time for experimentation 8 provinces participated in the pilot • Jilin • Jiangsu • Jiangxi • Shandong • Shanxi • Guizhou • Zhejiang • Chongqing 21 other provinces were brought in, with the exception of: • Hainan which opted not to participate in the pilot • Tibet where there are no rural credit cooperatives The hastiness in pushing the pilot, slightly one year into it, to the rest of the country seriously damaged credibility of the pilot scheme.

14. Examples of perverse incentives • The option to set up provincial RCCU • The option for PBC special notes • All provinces chose to set up a RCC union at the provincial level, and personnel appointment became an obsession • All eligible RCCs “chose” to be converted to Rural Cooperative Banks • All provinces chose the PBC special notes as the funding option, given the apparent financial advantages • In order to meet the requirements for redemption, local government offered guaranteed dividends payment to new shareholders • Some bank regulators ended up being owners of RCCs under their regulation and supervision, especially in localities where new equity was hard to mobilize

15. The role of government remains dubious • Under the central government • The option for PBC special notes • First the PBC, later the CBRC, served as both owner and regulator • RCC managers were appointed by the government agencies at various levels • The CBRC is supposed to limit its role to regulation and supervision • The government protected the RCCs from market competition • The government officials driving the RCC reform pilot got promoted or reassigned elsewhere, casting uncertainty over the future of RCC reform • The provincial government assumed managerial power and run the RCCs through the provincial RCC Union • RCC managers now appointed by the RCC Union representing the provincial government • The “fit and proper test” by the CBRC sometimes become overbearing • The government continues to protect the RCCs from market competition through entry and exit policies The central bank is preparing another pilot to introduce credit-only commercial microfinance institutions in 5 provinces, with the objective to increase competition in the rural financial market while bringing in commercially sustainable microfinance to improve access to finance

16. The role of foreign and private investors in RFIs • Limited experiment in equity participation by foreign and private financial institutions in the emerging RFIs • IFC and Rabobank in Hangzhou RCCU • IFC and Rabobank in Tianjin Rural Cooperative Bank • Equity participation in the PBC sanctioned credit-only MFIs in selected provinces, which could serve to break the monopoly of RCCs in those localities • Other experiments