China’s banking reform: Issues and prospects for the future

1. China’s banking reform: Issues and prospects for the future Alicia García Herrero* Bank of International Settlements Representative Office for Asia and the Pacific CASS, Beijing June 7, 2007 *Opinions are mine and not necessarily those of the BIS

2. Roadmap to the presentation • Why do all care for China’s financial reform? • An assessment of the banking reform so far • Restructuring of SOCBs • Financial liberalization • Regulation and supervision 3. How are banks doing? 4. Suggestions for future steps

3. 1. Why do all care for China’s financial reform? • China’s outstanding growth performance justifies optimism • And yet, such huge saving and investment ratios should yield even higher growth ► Banking system is the pillar (over 80%) but does not function properly: potential misallocation of resources ► But also a lot of self-financing key (60% ) and informal financing: risky!! • Success of ongoing bank reform key: • For China’s economic development • For the rest of the world given China’s size & interlinkages

4. 2. An assessment of the reform so far a. Restructuring Organized in three waves, each of them with: • Recapitalization • Disposal of non-performing loans (NPLs) • Partial privatization • Issuance of subordinated debt

5. a. Restructuring (con’t) • Large capital injections to 3 of the 4 largest banks (state-owned commercial banks) • In three waves 20-24% of 2004 GDP injected in the banking system: • This amounts to over 110% of SOCBs capital • Not really a bail-out since • By and large only public-owned banks restructured • Howeer, different public/semi-public entities covering the costs • Distribution of costs not very transparent

6. a. Restructuring (con’t) • Even larger disposal of bad assets: NPLs transferred to Asset Management Companies (AMC): • In first wave, bilateral transfer:one AMC per bank • Disposal of assets aiming at highest recovery value and not speed: • Not much recovered: about 10% of total face value • Financing: 45% financed by PBC credit and 10 year bond issued by AMCs • Not very high yield and doubts about payment: no explicit government guarantee: • Involvement of CB could eventually constrain monetary policy although international reserves are a big cushion! • Fragmentation of government bond market

7. 2. An assessment of the reform so far b. Financial liberalization • Introducing market practices: • Reduction in reserve requirements and in their remuneration • Steady reduction in liquid assets although still high • SOCBs given more responsibility for lending decisions • Some credit quotas removed • Private ownership: joint-stock commercial banks and city commercial banks starting 1999 • Also foreign more recently with WTO commitments

8. b. Financial liberalization (con’t) 2. Liberalizing interest rates • first money and bond market • then loans • finally deposits but not completed: • Corridor of 330 bp or higher: cannot be reduced! • Lack of competition but helps profitability

9. b. Financial liberalization (con’t) Difference between lending and deposit rates

10. b. Financial liberalization (con’t) 3. Opening up to foreign competition: • To greenfield investment due to WTO commitment • However difficult to grow organically in such a large country • Administrative difficulties to open affiliates can also slow down growth of foreign ownership • Sharp increase in foreign participation through strategic partnerships in 3 large state-owned banks • But still no control • Different to

11. b. Financial liberalization (con’t) 4. Steps towards capital account liberalization: • More on inflows than outflows • Although more steps taken recently for the latter mainly to stem off pressures towards exchange rate appreciation • Domestic transactions in foreign currency strongly regulated • Limited foreign exchange exposure although rapidly increasing Much faster liberalization in Latin America

12. 3. How are banks doing? • All in all enormous improvement • Banks are better capitalized but still poor for international standards • Also for private banks (joint stock and city commercial banks) • Rapid asset growth without new capital • Only recently surge in subordinated debt • Still in banks’ hands through interbank • Also IPOs and exposure to foreign rules (HK stock exchange) • Asset quality much better but still poor compared to international standards • Slightly less than 10% of total assets are NPLs)

13. 3. How are banks doing? (cont’) • Efficiency slightly lower than international standards but not a big issue • Profitability, instead, clearly low • Particularly if one considers guaranteed interest rate corridor! • Recent improvement in large state-owned banks but even worse in joint-stock and city commercial banks Quite different from Latin America, spreads even higher and also profitability

14. 3. How are banks doing? (cont’) • García-Herrero, Gavilá and Santabarbara (2006) analyze empirically the main drivers of the improved –albeit still low - profitability of Chinese banks : • Increased capitalization • Higher bank efficiency • Lower bank concentration and market size • smaller weight of SOCBs and increased importance of JSCBs • More private ownership • High real interest rates and inflation also help

15. 4. Conclusions A. On bank restructuring • Need for clear diagnosis of underlying problem: government interference • For NPL stock problem: • Transfer of NPLs should be accompanied by capital injections up to the required solvency ratio to comply with Basel I and with precise timetable • Necessary for soundness but also to improve its profitability • Clarify how AMCs will pay against NPLs received and status of debt issued (only implicit guarantee)

16. 4. Conclusions (con’t) A. On bank restructuring • For NPL flow problem • accelerate SOEs’ restructuring • Help from financial liberalization to evaluate risk and price it properly • Need for better risk management procedures (capacity building) • Regarding privatization, only solvent and viable institutions should be privatized • Transfer control might the quickest way to improve management • Does not need to imply majority ownership • Even if the State retains control: same level playing field

17. 4. Conclusions (con’t) B. On financial liberalization • By the handbook in sequencing of financial liberalization but needs to be finalized! • Completion of bank restructuring important for further liberalization: • If incentive structure does not change, liberalization may not be reflected in banks’ behaviour. • And if it does: reduced spread because of stronger competition: fall in profitability • Even more dangerous if real interest rates and inflation are very low (excess liquidity)

18. B. On financial liberalization (con’t) • Further capital account liberalization as a consequence of more flexibility of exchange rate regime • For the risk of capital outflows to be minized important to have completed domestic financial liberalization and the restructuring

19. 4. Conclusions (con’t) B. On financial regulation and supervision • Important strides particularly in regulation but enforcement an issue • Particularly for capital adequacy! • The spirit of the low probably more important than the letter of the law • Better corporate governance: Strengthened functions and accountability of board of directors • Better bank management techniques, particularly risk management • Before foreign exchange controls lifted: • Rregulations for foreign exposure need to be enhanced • Also deposit insurance scheme • Better and wider external and internal auditing • More disclosure of banks’ balance sheets and income statements

20. 4. Conclusions (con’t) So far so good, even amazingly fine but reform needs to be completed as soon as possible: why? : • Always better to do it in good times with high growth, strong fiscal position and international reserves • Very different from Latin America • Growing challenges • WTO poses challenges for Chinese banking system and also some sectors in the economy (agriculture, etc) • Liberalization process will probably reduce interest rate spreads. • Also fast growth in credit could end up in new NPLs! • Particularly if borrowers are the same…