Financial Sector Reform

1. Financial Sector Reform • 1980s not really considered as part of economic reform • Banks were seen as the state’s “cashier” for its chosen economic programs—as a result there was build-up of NPLs • By mid-1990s, need recognized and necessity to clean up bad debts • Zhu Rongji recognized that the problems were not cyclical but structural and rooted in the financial system • Extra urgency from • Asian Financial Crisis • WTO entry

2. Financial Sector Reform

3. Financial Sector Reform • Main role of state banks--feed the SOE sector • Led to huge portfolio of non-performing loans, perhaps 25% of GDP (Naughton) • True net equity value of large state commercial banks almost certainly negative • Requires internal restructuring and $200 billion in fresh capital according to Bottelier (former head of the World Bank in China)

4. Bank lending: Sowing the seeds of destruction • The Chinese Banking Regulatory Commission has adopted a regime that is more nuanced, discrete and intransparent. • By tightening the reserve requirements ratios (RRRs) three times this year, Beijing has signaled that it was serious about enforcing a tight monetary policy. • Compared with restrictions on loans, the RRR has the advantage of limiting the fundamental ability of banks to lend. • Despite the apparent slow in both monetary and loan growth, banks with ample liquidity found innovative ways to lend Under the guidance system. • A rise in the RRR rate does not necessarily mean a tighter monetary policy stance. Stiffer requirements only partly offset other central bank actions and foreign exchange inflows as companies bring home the proceeds of oversees business. • As long as real interest rates remain negative in response to rising inflation, retail bank deposits become ever more unattractive.

5. Financial Sector Reform • Zhu Rongji’s policy—three main elements • Restructure the banking system to allow more commercialization and free state banks from local politics • allow Central Bank to play increased regulatory role • get non-performing loans off the books of banking system

6. Financial Sector Reform • People’s Bank as a Central Bank • 1994 division into a three tier banking system: commercial banks (four former State banks—Industrial and Commercial Bank, Bank of China, China Construction Bank, and Agricultural Bank of China), policy banks (China Development Bank, Agricultural Development Bank and Export-Import Bank), and smaller regional and main banks of the SOEs (Pudong Development Bank, Shenzhen Development Bank, Huaxia and Bank of Communications) and non-bank financial institutions such as the rural and urban credit cooperatives (more profit oriented and with more flexible loan rates) • Four major banks still under state authority but greater capacity to make loans on a commercial basis • Account for 70% of the domestic banking business • Most important source of capital for enterprises

7. Financial Sector Reforms • 1998 Reform--reorganize 31 provincial branches of PBOC into 9 regional centers to reduce political interference from provincial leaders • But state banks still often seen as funders of state’s severe fiscal shortfalls • 1998 and 1999, PBOC did move to close the Guangdong International Trust and Investment Corporation • Major measure--move non-performing loans off books of four commercial banks

8. Financial Sector Reform • AMC set up for each commercial bank • First = Cinda for the China Construction Bank • Capital for AMC provided by Ministry of Finance and owned by Central Government not the bank. But many employees were shifted over from the relevant bank • SOE debt solution--AMCs acquire at face value loans from banks to SOEs • In 1998-99, $170 billion was transferred with a further $50 billion in 2004

9. Financial Sector Reform • Official expectation is to recoup 30 to 40% of the 1.1 trillion yuan in NPLs—acquire at face value loans from banks to SOEs • Unofficial expectations--lucky to get 10% • By end 2004, the 4 AMCs had written off or sold assets worth around $80 billion but had recovered only about 20 percent of face value of the loans • SETC recognized 600 SOEs for help to rise to 1000 • Can be solvent once debt was cleared • Future market niche existed • Well managed

10. Financial Sector Reform • AMCs have had trouble meeting their mandate in part because of a triple mandate • 1) Maximizing asset recovery • 2) Lessening the financial risks facing the big four banks • 3) Restructuring SOEs BUT (Steinfeld)—little capacity or power to do this. Now resides with SASAC. • Problem for State banks is that their customer base has not changed significantly—SOEs are still the main clients, still occasional pressure from government to expand social stability loans

11. Financial Sector Reforms • Despite reforms further bank recapitalization is necessary • Pressure comes from the requirements dictated by WTO entry • As of 2007, foreign banks are able to open free-standing branches • Measures to improve the banking system • Formation of the China Banking Regulatory Commission (2003) to improve supervision and regulation • Capital injection into 3 of the major banks to improve balance sheets and bring CARs in line with international norms • January 2004, $45 billion injected from foreign exchange reserves • October 2005, the China Construction Bank IPO raised $9.23 billion with stock rising 8.5% • Newbridge purchase of controlling stake in Shenzhen Development Bank, faield experiment • End October ’05, 18 financial institutions committed $18 billion to 16 Chinese banks

12. Financial Sector Reforms • Criticism of the recent reforms has been a part of the “leftist” backlash • Claim that finance is a strategic sector that should not be allowed to fall into foreign hands • Intense criticism has had a limited impact on policy • Mid-December 2005, State Council met to consider whether state banks are being sold too cheaply • Main policy adjustment is to bring in domestic stakeholders—National Social Security Fund can take a 10 billion Rmb stake in two state banks

13. Financial Sector Reform • To make banks attractive further recapitalization may be necessary but is it worthwhile • Yes, but other requirements must be met • Corporate governance will have to improve • Loan criteria will need to be tightened and risk management improved • Political lending to state firms will need to be reduced if not cut off • China will need to keep with liberalizing domestic interest rates • Seek fuller integration between domestic and international capital markets • Eventually move to a more realistic valuation of the currency Ending preferential policies and lending practices will help direct valuable resources to the non-state sector

14. The Rise Of The Shadow Financial World • In response to a hostile regulatory environment, a host of grey market institutions and arrangements has emerged to get around formal restrictions in China’s heavily controlled financial markets. • Annual flow are projected to be around $305bn , which amount to roughly one-third of gross domestic product. • The People’s Bank of China has difficulty in controlling liquidity and getting the banks to meet the loan quotas. • The remaining of loans comes from a variety of trust companies , finance companies, leasing companies and underground banks that are less regulated than the banks or subject to conflicting regulators. • The insistence by Beijing that there are no financial institutions outside the supervisory and regulatory system, has caused credit growth to exceed official targets, fuelling inflationary pressures. • If credit growth became too great, China would face more inflation in the short term and possible excess capacity in the longer term. That vicious cycle could lead to a resumption of profitless growth and social unrest. • If China tighten the monetary noose too hard, it would have a big contradictory impact both at home and abroad, given that Chinese imports have become an important source of global growth. • The informal underground banks rely on personal networks and will keep operate as long as their scale remains personal. But as they expand, the personal knowledge and constraints invariably break down. • Unless financial reforms take place coupled with interest rate deregulation, more money will go underground and banks will not have the incentives to lend to small and medium enterprises and diversify their loan books.