China’s Banking Sector: Overview, Imperfections, and Implications

Bachelor Thesis , Business Studies (2005)

By Marc Hesselink

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Table of Contents

Introduction...... 2 Current Status of ’s Banking Sector...... 3 Future Prospects for the Chinese Banking Sector...... 5 Foreign in China ...... 8 History of Foreign Banks in China ...... 8 Future Impact of Foreign Banks ...... 9 Exchange Rate System...... 11 Flaws of the Chinese Foreign Exchange Market ...... 11 Underdevelopment of the Chinese Foreign Exchange Market ...... 13 Non-Performing ...... 15 Conclusion ...... 20 Literature List...... 21

1 Introduction

This thesis is an overview of the Chinese Banking Sector. It will give a description how the financial market is segmented and it will address the main issues that play a role in the market and which could be possible threats to the market or the market players. As a result this thesis will give an insight in the market imperfections and their influence on the future economic growth of China, in particular how this growth can be endangered. The thesis is separated into different chapters; first of all there will be a close look on the banking sector. This is by far the most important financial sector in contemporary China. As a starting point there will be an overview of the different groups off banks in the Chinese banking sectors. This will be provided in relation with their historic development, which already shows some of the reasons for the problems that occur today. The second part will contain the main threats and issues for the banking sector and how the Chinese government could solve them. Because of their influence on the financial sector and the banking sector in particular two separate fields of interests will be introduced, namely foreign banks in China and the Yuan exchange rate system. As a final point there will be an extensive part about the non-performing loans of the state owned banks, which many authors see as the biggest hazard for China’s financial future. The numbers used in figures, tables, and throughout the text are updated as recently as possible with available data.

Finally it should be mentioned that the literature about banking in China could be confusing due to the use of different words and abbreviations for the same institutions or goods. To make clear what is meant the main examples of this will be summed up.

First of all the Chinese is called the Yuan, Yuan , Yuan Renmimbi or many different other options. Even Chinese state institutions use different official names. Officially Yuan is the word used in Chinese for money (in general) and Renminbi is the name of the Chinese money and literally means ‘Peoples Money’. In this paper the name Yuan will be used, because it is international the most common name for the Chinese currency.

The major abbreviations used are the following: - China Banking Regulation Commission (CBRC) - Joint Stock Commercial (JSCB) - Non-Performing (NPL) - Peoples (PBoC) - State Owned (SOCB) - State Owned Enterprise (SOE)

In other literature, different abbreviations are used for the same institutions, the abbreviations above will be used throughout the text.

2 China’s Banking Sector

Current Status of China’s Banking Sector

The financial system of China is strongly bank focused, it consists for almost 80% out of bank financing. The banking institutions include policy banks, state-owned commercial banks (SOCBs), joint stock commercial banks (JSCBs), city commercial banks, rural commercial banks, urban cooperatives (UCCs), rural credit cooperatives (RCCs), postal savings, foreign banks and non-bank financial institutions (NBFIs). (CBRC-website, 2005)

Figure 1 : Chinese Bank Assets 26,5% SOCBs JSCBs 53,9% City Commercial Banks 5,1% Other Banking Institutions

14,6%

Source CBRC website (2005)

The SOCBs are the main players in the Chinese banking sector (Figure 1). Because of their size they significantly influence the Chinese financial market. The SOCBs are: The Industrial and Commercial Bank of China (ICBC), the Agricultural Bank of China (ABoC), the Bank of China (BoC), and the (CCB) and they control 53.9% of both, the assets and the liabilities of the Chinese banking sector (CBRC-website, 2005). Given the dominance of banking assets in the financial system as a whole, this means that the SOCBs account for about half of the financial assets of the entire nation. Therefore China does not merely have a financial infrastructure that is “banking system” dominated but one that is in fact SOCB dominated. (Barth, Koepp, Zhou, 2004). To understand the contemporary state of the Chinese banking sector it is important to know the history of the establishment of this sector. The SOCBs were formed in 1978 during the first stage political and economic reforms that took place in China. These reforms were initiated by Deng Xiaoping and can be considered as the starting point of China’s impressive . Before 1978 China’s financial system only consisted out of the Peoples Bank of China (PBoC). This was the only legal supplier of money and finance for China since the 1949 establishment of the People’s Republic of China. The PBoC replaced all commercial banks that were present in capitalist China. As a consequence the PBoC was both the as well as a ‘commercial’ bank. The central bank’s responsibility is conducting (Mishkin & Eakins, 2003). From this definition it is shown that the central bank of China is more than that, it was also responsible for the issuances of loans, especially to State Owned Enterprises (SOEs). The financing activities had little to do with profitability; they were implementation of government policy. This is the root cause of the Non-Performing Loans (NPLs), which are such a burden for the Chinese economy. The 1978 reforms are the first change in the PBoC’s monopoly; firstly the ABoC and the BoC spin-offs were created. The ABoC was established to provide the agricultural sector funding, which

3 at that time was the most important sector in rural Maoist China. The BoC was established to handle the foreign exchange market. Only years later the Chinese Communist Party decided to make the PBoC a central bank that only implements monetary policy. Its remaining commercial banking functions were relocated to the CCB (founded 1983) and the ICBC (founded 1984). After the spin-offs, the NPLs are transferred to the SOCBs, but because the SOCBs are still backed up by the Chinese government there is practically no risk of default (Barth, et all, 2004).

The presence of only the four SOCBs does not give the impression that there is a banking system based on market principles. In practice many lending decisions are politically funded, therefore the problem remains that loans are issued which are unlikely to be returned somewhere in the future. However the first step was taken and gradually the SOCBs did get more possibilities to use risk and return considerations for issuing a loan.

Next to the SOCBs there emerged more players in the Chinese banking sector; most important are the JSCBs. These are national commercial banks that have been established since 1987. The JSCBs include , CITIC , Everbright Bank of China, , Guangdong Development Bank, Development Bank, , Pudong Development Bank, Industrial Bank, China Minsheng Banking Co. and Evergrowing Bank (CBRC-website, 2005).

There are some important problems in the Chinese banking sector that can endanger the future stability and growth of the financial market and hence it could be that the economic growth cannot be continued, or this growth could even be reversed in the case of a financial crisis. There have been significant improvements in asset quality, management, and internal control as a result of the banks’ effort over the recent years. Examples are the centralization of control over management decisions and a sophisticated information system. Still, for many banks asset quality is very poor. The China Banking Regulation Commission (CBRC) reported that the ratio of NPLs in the asset portfolio of the Chinese banks was 15% in 2003. For the SOCBs this ratio was even 20%. Consequently the Chinese banks often have a low level of capital adequacy (Li, 2004). This is the most important flaw in the market because it can endanger the future for the Chinese banks. There are more weaknesses, despite of the improvements, most banks work with management information systems that are incomplete or unreliable and with employees that lack sufficient quality and skills. Some problems become worse due to influence in credit decisions by local government agencies. Therefore factors such as supporting the local economy, helping SOEs and developing industries favored by the government continue to play an important role for many banks. Additionally, there is a legacy of an oversized branch network and to many employees on the payroll for the SOCBs. Additionally the SOCBs have an extremely bureaucratic culture that affects customer service and efficient decision-making. All of this seriously decreases the profitability of the SOCBs. On top of this, all banks in China face the problem of incomplete or inaccurate information on their borrowers; many corporate borrowers do not have reliable or complete financial statements and credit information on individuals is hard to obtain or verify. This weakens the banks capability to measure, control, and price credit risks. Finally, there are market imperfections because the Chinese banks cannot set their interests at will, the PBoC determines the bandwidths for both deposits and

4 loans, hence there is little freedom to compete on interest rates. Their could be an interest spree that is too high, which negatively affects consumers because they pay to much interest on their loans and it could affect realistic profitability for the banks if the difference is relatively low (Li, 2004).

Now that an overview of the Chinese banking sector, together with a historic background has been provided and the main problems are being addressed, there will be a close look at the prospects for the Chinese banking sector and an examination of problems and challenges within the future

Future Prospects for the Chinese Banking Sector

Corporate Banking will become increasingly competitive, especially for those banks that target large and creditworthy corporations (Li, 2003). This type of customers is likely to choose for large banks. This is due to the fact that large banks are more likely to be able to sustain large amounts of credit over long periods of time. Therefore the major players in this market will be the four SOCBs. They got the size and the name recognition (for the Chinese market) that favors them over other financial institutions. To satisfy the needs of the large customers, banks should be able to deliver tailor made financial products. At the moment the innovation level for the Chinese banks is not sufficient enough to serve the large corporations. The JSCBs are more able to adapt to the wishes of the large corporations, but in many cases they lack the size to be reliable enough over time. According to the WTO membership agreement (December 11 th 2001), China has to permit foreign banks to do business in all geographical areas after 2007. The international banks that will enter the market are familiar to tailor made banking and they have got the required size, hence they will be the largest competitors for the SOCBs in the near future. Competition will increase dramatically after China opens up for the foreign banks.

Retail banking, especially the home mortgage and credit card business will become important motors for the Chinese banking sector (Li, 2004). Both are in their first stage of development and they will probably lead to rapid growth for the banking sector in the long run. At the moment, just five to ten percent of bank loans are made to individuals, mostly for mortgages, which is very low compared with 40 percent in Kong and 40 to 50 percent in South Korea. UBS Warburg analyst Tracy Yu predicted that as incomes rises (which is happening in big cities like Shanghai) and China encourages consumers to play a bigger role in the economy, loans to individuals will grow by 30 per cent or more per year over the next two or three years. Because of their familiar image towards the Chinese consumers (which are the potential customers for the mortgages and credit cards) and more important their huge assets and believed government support, the SOCBs have an advantage in this grow area as well. High-income people that are able to afford a mortgage or a credit card are concentrated in the South Eastern , hence there is potential for smaller and medium-size banks, which are able to focus their operations on the high prospective areas.

Presently Chinese banks are limited in their options to diversify their operations by introducing non-banking businesses. In developed banking sectors a lot of the income generated by banks consists out of fees that are paid for broking or dealing in

5 assurances, mutual funds and . In December 2003 the Chinese government amended the banking law; banks in China are now able to earn fees by introducing non-banking operations. The amendment to the Law on Commercial Banks has left room for the possibility of banks dabbling in non-banking financial businesses, the law allows commercial banks to engage in non-banking businesses such as securities, insurance and trust services (China Daily, 2003). Because the options for banks in engaging in non-banking operations are still limited, it is not likely that this will be a large grow market for the banking sector, still there are opportunities for the banks to increase their income.

One of the main constraints for the Chinese banking sector is the low return on assets and on equity. For example, return on assets (ROA) for the SOCBs are barely 0.14 percent and return on equity 3.2 percent in 2002 (Wei, 2004). There are several reasons for the low return on assets and equity. First of all there are regulations for the Chinese banking sector that hold down the possibilities for the banks to make profit. The regulations set standards for the interest rates; banks are forced to keep interest returns on a low level. Regulations also limit the capacity for banks to earn fees with intermediate activities, this in contrary to banks in developed financial markets. Another aspect that lowers the ROA is the high tax-burden Chinese banks have to bear; this includes 5% business tax and 33% income tax. The effective tax rate is even higher because loans cannot be written off for tax purposes. The ROA will remain to be low because the NPLs should be absorbed gradually and many banks need large capital investments to build up an IT-system that is up-to-date and will increase future efficiency of the banks. Moreover corporate governance is generally weak in China’s banks, and need for return on equity often cannot adequately constrain the impulse for size expansion. The idea of enhancing shareholder value is not being uniformly emphasized or implemented. Size expansion and excessive competition are quite common in many industries in China. Such tendencies also exist in the banking sector, with low return on equity as its natural consequence (Li, 2004). There are no indications that any of the government regulations or taxes will change anytime soon and there are no prospects that corporate governance will improve as well, so together with the legacy of the NPLs and the necessary investments in IT its is unlikely that the ROA will improve anytime soon. This can be perceived as a structural dilemma for the Chinese banking sector.

Another aspect that endangers the Chinese banking sector is the legitimate concern of overheating the economy. Rapid growth in money supply and credit may have stoked overinvestment and subsequent excess capacity in certain sectors of the economy. Both credit and money grew by more than 20% in the first half of 2003, the most rapid rise since 1998. Such trends could, without doubt, weaken an already fragile banking system, however it appears that the government took appropriate measures. New requirements forced the banks to hold 7% instead of 6% in deposits on reserve. As a consequence, bank loans increased with US$ 9.9 billion from October to November 2003; instead of the average monthly increase of US$ 33.2 billion in the first three quarters of 2003. Nevertheless, if growth of money and credit is not checked contentiously to prevent overheating in the economy, it will only add to the precariousness of China’s troubled banking sector (Barth, et all, 2004).

The government’s important task to support the banking sector is in the field of regulation. Banking regulation should promote the health and stability of the banking

6 sector, control systematic risk, protect the interests of bank depositors and enable banks to play the essential role of financial intermediary in the efficient allocation of financial resources in the economy. Banking regulation in China has tremendously improved since the enactment of the ‘People’s Bank of China Law’ and the ‘Commercial Banking Law’ in 1995. Currently, the CBRC is responsible for all regulation in the banking sector. The emphasis of China’s banking regulation in recent years has been to enhance the internal management and risk control of the banks, increase transparency, and improve asset quality and capital adequacy. China has adopted capital adequacy requirements in line with the 1988 Basle-accord. The prescribed stringent method for calculating capital adequacy, required commercial banks to have core capital ratio of at least 4% and capital adequacy of at least 8%. In the next few years, bank regulators will continue to focus on enhancing corporate governance, internal management and risk control, reducing the NPLs and improving capital adequacy. Because the assets of Chinese banks grow in such a pace, the banks have difficulties to raise capital. They encounter problems in maintaining their capital adequacy. Banking regulations are therefore adapted to make it easier to raise capital in both domestic and foreign markets. Also the regulation concerning interest rates is adapted. The setting of interest rates is gradually liberalized, firstly by expanding the bands within which the interest rates may float, this trend will continue in the future up to complete liberalization. The gradual approach is appropriate, if the deregulation leads to excessive competition, it may present a huge shock to the banking system. Hence gradually increasing the ceiling of lending rates will enhance banks’ ability to adjust lending rates according to risk and credit conditions and encourage banks to improve their risk assessment capabilities, and it will help to ease the difficulties faced by China’s smaller enterprises in obtaining loans (Li, 2004).

The points mentioned above about the prospects of the Chinese banking sector show that in the next few years there will be much to gain. The market share of the SOCBs will probably decrease a little in favor of the other banks in the sector, especially the JSCB. Nevertheless the basic landscape of the Chinese banking sector will not change that much. The main tasks of the SOCBs are to find a solution for the NPLs, downsize their personnel and network and improve management and risk control. These goals, especially with regard to the NPLs, cannot be for-filled by the SOCBs themselves; they need government support to be able to solve the problems. It is shown that the prospects for the Chinese banking sector are very favorable, but there is an important task for the government to regulate and deregulate the banking sector in such a way that the banking sector can support the economic growth on the one hand and preventing overheating and undesirable fierce competition on the other.

The following two sections are a close look on two aspects for the banking sector that prove to be important for the further development of the Chinese financial sector and the Chinese banking sector in particular, namely the status of foreign banks in China and the Yuan exchange rate.

7 Foreign Banks in China

China’s WTO membership forces the country to open up its financial market for foreign parties. This is not any different in the banking sector. Since 2001 several foreign banks announced their intentions about entering the Chinese market. Until now, most entrances of foreign banks have been by buying stakes in existing Chinese banks. Despite of the fact that foreign banks only hold less than 4% of the total assets in the Chinese banking sector, their influence on the sector as a whole is much larger. This is due to the competitiveness that the foreign banks bring to the market. The foreign banks have more experience with the rules of international efficient banking than the Chinese ones, therefore the Chinese banks have to adapt if they want to compete with the foreign banks. The influence of the foreign banks will also be relatively large because a large group of Chinese banks will be working together with foreign banks in the near future (Liping, 2004).

History of Foreign Banks in China

First a historical overview, to put the entrance of foreign banks in China in a broader perspective, will be provided: Foreign banks in China are not a novelty, since the colonial era, especially after the forced opening of the Chinese market following the Opium War (1839-1842), there were foreign banks in the so called treaty ports. Their main impact on banking in China was that they inspired Chinese people to found their own modern banks The foreign banks did not deal with Chinese people that much, their main business was to act as a trade portal between China and the Western world (Jernigan, 1896). In 1897 the first modern Chinese bank was established, directly followed by others, especially in Shanghai. Together with a large presence of foreign banks in this area, Shanghai became the financial center of the region. As a result of the banking power of Shanghai, China became an integrated financial and economic system in contrary to the fragmented economy it used to be (Cheng, 2003). After financial problems in the mid 1930s and the hyperinflation in the civil war period (between the nationalists and the communists), the banking sector became state owned and dominated by the only legal bank, the PBoC. During that period, there were no foreign banks on mainland China. The banking sector was completely nationalized, commercial and financial activities were shrinking and the focus was on inward economic development. From the Maoist perspective foreign banks were not needed.

The next stage of foreign banks in China followed Deng Xiaoping’s reforms in 1978. Together with the founding of the SOCBs, foreign banks were allowed back into the country. This stage covers the period between the early 1970s and the late 1990s, in this period a couple of foreign banks (re-)entered the Chinese market. The situation did not change much due to the strict restrictions that were imposed on the foreign banks that established themselves in China. The banks were only allowed in limited geographical locations, the so called Special Economic Zones (SEZs), but even more important, the foreign banks were not allowed to do business with Chinese companies or Chinese citizens. Therefore the foreign banks only served international companies and foreign people that operated in the SEZs. To make even clearer, that the foreign

8 banks were not meant for the Chinese, they were not allowed to do any Yuan transactions or hold Yuan accounts, all the operations were denominated in foreign . Finally all funding for the foreign banks should come from abroad. This also applied for the several Sino-foreign joint ventures that were set up. You could therefore conclude that the opening up off the economy was not really the case in the banking sector. The foreign banks main operations were the niche of the foreign people and companies in the SEZs, their links with the Chinese banking sector were very minimal and actually only present for the necessary assistance to foreign direct investment (FDI) in China (Liping, 2004).

The current state of foreign banking in China started after the December 11 th 2001 WTO-membership of China. According to the joining agreement China has to gradually open up the banking sector until 2007. A timetable was set up to lift the restrictions. First the geographical restrictions would be discarded, so that foreign banks can operate outside the SEZs. Secondly foreign banks could do business with Chinese firms and later on even with Chinese citizens. It would also be possible for the foreign banks to conduct business in the Yuan next to the foreign currencies. In addition the foreign banks are gradually allowed to participate in the Chinese security markets and the Chinese interbank market. To conclude, foreign banks would be treated on ‘equal footing’ with Chinese banks in the near future after the WTO- membership (Liping, 2004). As a direct effect of the WTO-membership the foreign banks have been rather quick to adapt towards the new opportunities. This is made clear by the following trends: 1. Opening more branches in more Chinese cities 2. Offering an increasing variety of banking services to local customers 3. Developing corporate banking and preparing for money centers 4. Acquiring stakes in domestic Chinese banks

It is clear that foreign banks are expanding in China. There are only a couple of businesses they do not provide, nor would they provide them in the foreseeable future. These are: large scale deposits from the public and credit lending to a large pool of customers. Although a few large banks begun accepting deposits from the public, it will not be the intent for the foreign banks to set up a dense geographical branch coverage to attract ordinary Chinese depositors. Foreign banks have a higher lending- deposit ratio than Chinese banks; 2.38 to 0.78 (PBoC, 2002). The foreign banks are highly selective and restrictive in issuing credit; this reflects their strict standards of credit control and their unfamiliarity with local markets. Both Chinese and foreign banks are subject to the Chinese regulations, such as separating commercial banking from , interest rate ceilings and the inconvertibility of the Yuan. In the light of future deregulation it could be that the foreign banks have a competitive edge over the Chinese banks, but on the other hand in the context of the Chinese domestic market, it will be the Chinese banks that are in the somehow dilemmatic situation of benefiting and suffering from their close relations with the government (Liping, 2004).

Future Impact of Foreign Banks

It is reasonable to expect that foreign banks will become an increasingly important factor in the Chinese banking sector, because of the deregulation in the sector. The

9 deregulation takes place according to China’s accession in the WTO. According to the membership agreement there will be a liberalization of interest rates and currency convertibility, as well as increased freedom for foreign businesses, banks included, to conduct business. It is unavoidable that the increased presence of the foreign banks in China will have an impact on the financial market. The impact can be positive, in the way that it can solve market imperfections, but it can also be negative for the Chinese banks because of the increased competition, if this is too fierce, it could destabilize the banking sector.

First foreign banks can facilitate economic and financial links between China and the rest of the world, historically the foreign banks already facilitate in FDI and related trade activities, but until now the foreign banks only used their own capital resources. When they get access to China’s huge domestic deposit markets, their role as an intermediary will only increase. This aspect is clearly positive for China’s future economic growth; it can facilitate China with the investment it needs. Furthermore foreign banks will bring more competition and inspire the Chinese banking system. Since China still lacks efficient private commercial banks and financial institutions of significant scale, foreign banks stand out as significant commercial players, which are largely independent from government intervention and are economically successful at the same time. Existing Chinese banks would possibly diverge in fast and slow learners with contrary results in performance. There will be an increased number of Chinese banks conducting business in the same way as foreign banks. Most Chinese banks will react positively to increased foreign presence, because their presence helps the Chinese banks to improve managerial and operational efficiency. It should be kept in mind that the presence can also have a negative effect if all Chinese banks try to copy working practices of the foreign banks. Foreign banks will mainly serve corporate customers or prosperous individuals. If all Chinese banks would focus on that same group of customers, there will not be sufficient banking service for smaller customers, probably the ones in rural areas. Finally the re-admittance of the foreign banks could make cities like Shanghai to be financial centers again. The presence of financial centers is important for the further development of China because it will implement the growth of financial markets and financial market options as well as an inflow of capital (Liping, 2004).

The biggest challenge foreign banks will bring up to China is their effect on financial and macroeconomic stability in the long run. Ultimately foreign banks will become alternatives for Chinese money holders and become a channel of financial flow across China’s borders. As discussed, foreign banks will facilitate China’s external economic links, thus they expose China’s economy to external shock. This exposure would not be a significant problem if the economy has a strong domestic base, but China’s export led growth makes the economy weak in respect to its domestic base. If therefore the liberalization is continued without the clearing of the NPLs for the domestic banks, the economy could be very vulnerable if a small economic stagnation would incur. It is likely that foreign banks could depart in the case of such stagnation. If the share of foreign banks in the market is substantial, the domestic banks, which still have their NPLs in their portfolio, will not be able to bear the situation and as a result financial crisis might occur (Liping, 2004). Obviously there is a trade off between opening up for foreign banks, with the favorable effects, and a loss of control over the financial market.

10 Yuan Exchange Rate System

Flaws of the Chinese Foreign Exchange Market

To further deepen the picture of the Chinese financial market it is also important to have a look at the exchange rate market, this exchange-rate system implements some more frictions for the financial market. The main market failure is caused by the de facto pegged exchange rate between the Yuan and the US dollar (as shown by figure 2). Therefore the exchange rate is a tool of the Chinese government to influence the export market, but the exchange rate does not work as a natural mechanism for efficient resource allocation and macroeconomic readjustment.

Figure 2: Yuan per Dollar

8,2800 8,2790 8,2780 8,2770 8,2760 8,2750 8,2740 jul-00 jul-01 jul-02 jul-03 jul-04 jan-00 jan-01 jan-02 jan-03 jan-04 (Source: www.pbc.gov.cn/english)

Since 1994 China works with a unified national foreign exchange market. This market consists out of the interbank market and the foreign exchange surrender and purchase market, between foreign exchange designated banks and enterprises (Xin, 2004). The interbank market is managed by the China Foreign Exchange Trade System (CFETS) and is in the middle of the exchange rate formation. If necessary, because of high volatility, the PBoC intervenes in the market to ensure the exchange rate stability. Interventions are done by large sales or purchases of foreign currencies, mostly US dollars. The inter-bank market is already a large improvement compared to the pre 1994 swap-center market, which was geographical segmented so that exchange rates depended on the planned economy and were highly decentralized. Still the foreign exchange market has difficulties to serve the needs of an open market economy (Xin, 2004).

The market flaws create several imperfections; the major problems that are still present in the Chinese foreign exchange market will be discussed below. The first point that strikes is the low trading volume by the CFETS According to the Bank of International Settlement (BIS) the Yuan trading in 2002 only accounted for US$ 97.19 billion a day. This is not only very low compared to developed markets; even

11 compared with much smaller neighboring countries. It only covers 1/6 of China’s export at that time. More recent figures show that China still has an extremely low trading volume in the Yuan, if figures are compared with local countries that are also in a developmental stage. For examples the trading volumes in the Yuan for April 2004 accounted US$ 614 million a day, compared to US$ 1,612 million, US$ 2,301 million, US$ 2,869 million, and US$ 6,642 million respectively for Malaysia, Indonesia, Thailand and India the trading volume of the Yuan is strikingly low (BIS, 2005).

The second major flaw is the structure of the Chinese banking sector; almost all (90%) transactions in the inter-bank foreign exchange market is done by the SOCBs, half of that by the BoC. Even if trading volumes increase the foreign exchange market will be dominated by the SOCBs, or maybe even by only one bank; BoC. This implies a very centralized monopoly market, which is probably incapable of good resource allocation and/or required efficiency.

A strange aspect of the market is the trading system of currencies. Currently price formation and market clearing are done without dealer involvement. It is done by an electronic system that matches supply parties with the demand orders on a basis of price and time. Hence there is no dealer in between which would lead to stable in the currency market. Moreover there is very poor market liquidity for foreign reserves because of this unstable stream of transactions. It can be argued that this trading system reflects the principles of fairness, impartiality and price priority (Xin, 2004), but transactions can only take place if buyers and sellers are in the market simultaneously and with matching prices. Obviously this is not always the case and hence transaction is not continuous, the volume is limited and the market liquidity is poor. As a result the exchange trading volume figures fluctuate dramatically (Xin, 2004).

The fourth flaw is the limited scope of transaction instruments. On a traditional exchange market there are many derivative foreign exchange instruments like swaps, options, futures and forwards, all of this next to the regular spot-market. In contrary, in China there is virtually only a spot market that exchanges the Yuan solitary with four foreign currencies; namely the most important one the US dollar, the Yen, the HK dollar and the euro. By nature the limited options make transaction quantities lower, especially because the spot market, according to figures of the BIS, is relatively small compared to the derivatives exchange markets. In April 2004 average daily turnover of forwards was US$ 208 billion, swaps were US$ 944 billion and OTC foreign exchange derivatives were US$ 853 billion, compared to that the spot market was only US$ 621 billion (BIS, 2005).

Fifth, the costs and risks for centralized foreign exchange trading and settlement are high. If the market expands these costs will increase tremendously, because a large increase of manpower and material resources is needed to accommodate all the transaction. Corresponding to centralized transactions, the CFETS bears the settlement risks. As convertibility of the Yuan increases and a real floating regime is adopted, the number of transactions entities and their foreign exchange positions will increase rapidly. Some relatively weak entities may fall into failure to properly handle credit or exchange risks. The other problem is that ultimately the PBoC bears the exchange rate risk because it backs up the CFETS. This leads to a common lack of

12 risk constraint among market players, who may engage in large numbers of highly risky transactions. As a consequence, the stability of the whole foreign exchange market may be seriously damaged (Xin, 2004).

Underdevelopment of the Chinese Foreign Exchange Market

The root cause of the problems mentioned in the section above is the Yuan exchange rate to the dollar, which is extremely stable. The Chinese interbank foreign exchange market remains underdeveloped, partly due to the Yuan not easily being exchangeable, and legislation which does not allow individuals and enterprises to freely exchange their foreign reserves. Exchange transactions are not as regular as in liberal developed exchange markets. Next to that, the extremely stable exchange rate held back development of the market.

The current Chinese foreign exchange mechanism, which was introduced in 1994 with the centralization of the exchange market, is a so-called market based managed floating regime. This means that the fluctuation of the exchange rate is within a certain band, this to minimize exchange rate risk for the Chinese economy and FDI. As a result the fluctuation, since the 1997 Asian financial crisis, in the Yuan to the dollar is minimal, in practice it is almost a pegged exchange rate. This has a great impact on the development of the foreign exchange market. In a system with a real floating exchange rate, the rate is determined by supply and demand and there is no central bank or government that intervenes extensively in the market, the exchange rate formation features a high level of marketization (Xin, 2004). In contrary with a de facto pegged exchange rate like the Chinese one, the rate reflects the central bank’s intentions, because China’s central bank (PBoC) is directly ruled by the government, the Chinese exchange rate reflects the governments vision on how to develop the Chinese market. This inflexibility of the exchange rate restrains the development of the foreign exchange market. There are little market forces in the exchange rate formation. Presently, China uses an obligatory purchase and surrender system. Foreign exchange positions of designated banks are subject to ratio regulation. Chinese enterprises are obliged to sell all their foreign receipts that exceed a quota to the designated banks and these banks are required to put their foreign exchanges that exceed their quota in the inter-bank market after they conducted the financial transactions for the enterprises. China’s Balance of Payments (BoP), that is export minus imports, has a large surplus the past years; therefore a lot more foreign accounts are flowing in, especially US dollars, compared to accounts flowing out. Enterprises, which cannot stock their foreign reserves, pass those reserves over to the designated banks. Those banks are passing the surplus of foreign currencies on the inter-bank market. Because none of the market players, individuals, enterprises and financial institutions is allowed to freely buy or sell foreign exchange there is a distortion of the market. Inflow is larger than outflow, thus supply of foreign exchange is larger than demand. This should result in appreciation of the Yuan. Because of policy reasons, ‘cheap exports’, the Chinese government does not want the Yuan to appreciate, therefore the PBoC has to increase demand by accumulating foreign reserves. The PBoC is by far the largest buyer in the interbank market, it purchases the supply that is not covered by the demand, to keep the Yuan stable compared to the US dollar (Xin, 2004).

13 This system has some clear beneficial aspects, Chinese enterprises are very price competitive on the international market, but it has major drawbacks on the development of a competitive foreign exchange market. The function of the foreign exchange market is limited to settlement for enterprises or banks that exceed their foreign account quota. Allocation of foreign exchange is up to the government instead of allocation by market mechanisms. In this underdeveloped market, brokers are not necessary and a dealer system, which would increase liquidity and create a real market price, is not established. The government settles and clears the market by means of the PBoC, hence absorbing all the risk; because of this there is little exchange rate risk for the several market players. The market players do not need to hedge by using diversified financial instruments, a situation which holds back the development of a forward market. A direct result of this underdeveloped market is that there are not many opportunities for banks to raise additional income, next to interest income, in the exchange market. Next to that there is barely a derivative market for foreign exchange, so another missed opportunity for Chinese banks to diversify their income.

A macro-economic problem is the Chinese government bearing all the exchange rate risk. As shown by the Asian Financial crisis of 1997 the government can get serious problems with a pegged exchange rate. At the moment China does not have this problem because of the high BoP surplus, but there can be future risks, for example if the dollar appreciates. Many countries are aware of this risk and therefore transform their foreign exchange system into a floating rate. According to the IMF-statistics, the ratio of IMF members adopting the floating regime de jure rose from 34.6% in 1990 to 55.5% in 1998. But in terms of the de facto exchange rate regime, the ratio grew from 20.1% in 1990 to 44.1% in 2001 (Bubula & Otker-Robe, 2002)

As shown the exchange rate regime in China is far from perfect, according to figures you could almost say that there is barely an exchange rate market. This can be harmful for the future economic growth and for the development of alternative financial markets next to the banking sector. The most important influence of the exchange rate regime is that it is a possible source of financial distress. The possibility will make reluctant and the impressive growth of China could therefore even be reinforced if necessary changes in the exchange rate regime are implemented. The measures are not only necessary because of the WTO membership agreement, but they are also necessary out of the aspect of the development of the Chinese financial market.

14 Non-Performing Loans

A loan becomes non-performing if the probability of payments being made is close or equal to zero, due to misfortune or mismanagement of the borrower. All loans are made with the expectation that interest will be paid and that the principal will be repaid, however on average some loans will turn out to be not paid back. There will be a premium on the interest to cover this risk and therefore the Non-Performing Loans (NPLs) are just a calculated expense for doing business in the banking sector. In China the NPLs are particularly large, this is due to government policy. This chapter will provide a closer look on the development of the NPLs and their influence on the financial sector/banking sector, possible solutions to get rid of the NPLs, as well as the risk they expose towards a possible financial crisis.

The basis of many of the NPLs originates in the policy debts. These policy loans were made to unprofitable state enterprises, so that the enterprises would not go bankrupt, which would lead to unemployment. The policy loans are as much as 42% of the loans of the Chinese banking sector (He, 2002). The likelihood that a material fraction of these loans will be repaid is small (Ma & Fung, 2002). According to many authors this is a big threat for the growing Chinese economy (Dornbusch & Giavozzi, 1999), (Lardy, 1998, 1999), (Lau, 1999). On the contrary many Chinese economists do not think the NPLs are a possible threat that can cause a financial crisis (Fan, 2002), (He, 2002). According to Gordon (2003) there is no good reason to believe that the policy loans will threaten the soundness of China’s financial system, if the right measures are being taken to decrease the influence of the NPLs. First the modernization of the banking sector should continue and second it should be made acceptable to reduce the loans/subsidies for unprofitable state enterprises as soon as possible, without causing undue hardship to their workers.

There were two historical reasons for the Chinese government to issue the policy loans. The first one was the failure of the market to be able to bear prices that would make investment profitable for enterprises. These low prices on the other hand would contribute to the welfare of the country if those investments would be made by the enterprises. For example, by issuing policy loans, extremely low rental and electricity rates did not hold back investment in building houses and electrical power plants. By issuing the policy loans the government supported the economic growth (e.g. cheap electricity) and welfare for the people (e.g. housing) (Gordon, 2003). During the 1980s the issuance of policy loans was substantial, this was done to support the economic growth initiated by the economic reforms. In some cases the loans were unprofitable, but could be called successful, For example, although the cars assembled in China cost about twice as much as cars imported from Japan, it helped to develop a car industry in China that is competitive nowadays (Gordon, 2003). This is the political economic principle of the developmental state. According to economic theory this is a profitable long-term government policy, despite of the unprofitable short-term loans. (Wade, 1991). Another reason for the policy loans, especially linked to the 1990s, is to save SOEs from liquidation. State enterprises in textiles, heavy machinery, electrical equipment, mining and other industries used knowledge and equipment that was 25 years out of date. Some of the worst performing SOEs were so obsolete that they could not even cover the material cost of production. This implies for example that the price received for garments was not even enough to pay for the

15 cotton that is used in the production. In this case the firm’s loss would be lower if the company did not produce and just paid the workers for doing nothing. This makes clear why the policy loans are so sizeable. However, this is very damaging for the Chinese economy. These loans will most likely not be paid back and the required money is taken out of the capital market. China would have been more prosperous if these funds would have been used to finance future growth markets. China has not been able to manage their SOEs in such a way that they could renew their inefficient industries. The reason that China kept open the SOEs, even those that made loses on their current operations, has to do with the social responsibility which enterprises have in China. In the West you could say that the responsibility of the enterprises is to make profit and the state is responsible for the welfare and the security of the workers. Under Mao this responsibility was reallocated to the SOEs and the farm collectives. Therefore the enterprises provided employment, income, housing, health care, children’s education and retirement pensions. If therefore a SOE would disappear, because it is unprofitable, it will result in a disaster for the employees. They would not only loose their job, but also their life necessities. This made it impossible and unwanted for the Chinese government to change the system of the policy loans. The system cannot be changed overnight because that would result in poverty and social chaos, which is what happened in the former Soviet Union after the fall of communism (Gordon, 2001).

The challenge for the Chinese government is to solve the problem by modernizing its industry and applying a market leaded issuance of loans. On the other side this should not bring too much hardship on the workers. At the moment China is trying to find a solution for the NPLs problems, the first step they implemented was the founding of four Asset Management Corporations (AMCs), one alongside every SOCB. The AMCs are independent institutions that took over about half of the policy loans of the SOCBs. Especially the NPLs of the worst performing enterprises were transferred to the AMCs. After this shift the SOCBs were ordered to behave like western banks, which implies only credit extension if the expectations are profitable and a high probability of interest payments and principal recovery. This way no new NPLs are being granted (only reasonable amounts that are comparable to western commercial banks). Because of the high rate of bank financing in China, this measure will strengthen the efficiency and profitability of China’s investments. SOCBs will be judged on their profitability, not on their conformity with request of government bureaus that demand financing for unprofitable SOE. The remaining NPLs at the SOCBs are put under normal bank practices according to default. At best the SOCBs would manage to get the borrowers profitable again, so that the debt could be repaid and in the worst cases the debtors would be declared bankrupt and their assets are being sold to recover at least part of the loan.

The AMCs were charged to make the best of the enterprises whose policy loans were transferred to them. Their task was to get rid of the NPLs without too much pain for the workers, their target is to make the Chinese financial sector healthier. One of their options was selling the enterprises to other companies in the hope that new management would turn matters around. The buying companies can be either public or private. Enterprises that are profitable in operations but cannot meet their interest obligations are re-structured by substituting debt for equity, hence improving their capital structure. Some enterprises can get additional financing if its management demonstrated that it is improved and that they can take advantage of investment

16 opportunities. The most unfortunate enterprises that would never be able to recover are shut down or forced to bring down operations, their older workers are forced in retirement, younger ones are laid off, and the middle aged ones are kept under reduced pay or get terminal leave payments. An interesting other solution is that some NPLs are being sold at deep discount to western banks (e.g. Goldman Sachs, Citibank). The main philosophy behind this is to create a benchmark. The Chinese could get a close look on how western commercial banks are dealing with NPLs (Gordon, 2003). If pictured like above, the policy loans do not seem that much of a problem to solve. It looks like the NPLs can be cleared without large financial losses. This is not the case, in reality the Chinese government backs up all the loans of the AMCs and hence there are no risks for the SOCBs. In the long run much of the NPLs have to be brought up by the Chinese government because they will never be repaid. The idea behind the split up of the AMCs of the SOCBs is to be able to not issue new policy loans and therefore make the SOCBs act as ‘western’ banks, The AMCs function is also to spread and delay the government payments to clear NPLs and to recover at least some of them.

Now that a clearer insight in the nature of policy loans and their non-performing part is provided we have to investigate their risk on the Chinese financial sector and the Chinese economy. In a worst case scenario there would be a financial crisis. The first reason such a crisis can appear is a . This would happen if the Chinese depositors decide that assets do not protect their accounts and hence they would demand their money, because they are afraid that they will not get it returned some day. This effect is exponential, the more people which demand their money back, the less likely it becomes that banks are able to meet this demand and hence even more people demand their money back. This is the start of a financial crisis; a recent example of a bank run is the 2002 Argentinean financial crisis (Shapiro, 2003). People are more likely to be the first to withdraw money because banks operate on a sequential service constraint (first come-first serve). This would even increase the effect of a bank run because people do not want to be the last in the waiting line; the last ones will get nothing if the bank fails (Mishkin, 2004). Because of the danger of bank failure for the entire financial sector, central banks will back up banks that are ‘to big to fail’. The SOCBs are definitely too big to fail and the PBoC will always guarantee the pay back of deposits by providing money to the SOCBs. In this case money taken out of accounts will flow back to the banks after a while because deposits will earn a positive interest rate and cash money will earn zero. This is exactly what happened in the United States during the great depression. As a reaction on bank runs in the United States the US government founded the Federal Deposit Insurance Corporation (FDIC), which provided a safety net. Trust was restored and bank failures dropped dramatically, in the United States from 2,000 a year in the beginning thirties to only 15 annually in the 1934-1981 period (Mishkin 2004). In China it will go simultaneous if bank runs might occur. This could happen because people do not trust the banks anymore due to their large share of NPLs in the loan structure. However because the government owns the banks, the deposits are widely held and there is no question about the government responsibility and guarantee of the deposits, the Chinese government will always back up the SOCBs therefore a loss of trust in the banks is unlikely (Gordon, 2003).

The second threat to the banks is that the Chinese people decide that they have too much wealth in the form of bank deposits. This is becoming more likely; more and

17 more people are getting richer because off the flourish of the Chinese economy. They might decide that they want to take money out of deposits to spend it, or invest it in higher risk, but also higher expected return assets, like stocks, bonds and real estate. This could be initiated by a high rate of inflation. In this case the SOCBs can get problems with matching the NPLs with liabilities and hence the entire bank structure will get a mismatch between assets and liabilities. To investigate the likeliness of such an event happening it should be split up into two different sections. First the Chinese people going on a spending spree, until now the Chinese hold the deposits and this is unlikely to change unless the real interest rate is larger than zero. The real interest rate is the interest rate minus the expected inflation, according to the fisher-equitation (Shapiro, 2003). Inflation in China was 4.1 % in 2004 (PBoC-website), this is not extremely large, so Chinese people will not go on an unrealistic (extremely large) spending spree. Second there is the move of keeping bank deposits towards investing in other financial assets. The extent to which portfolio composition is changed is partly depended on the availability of other financial assets. Until now the development of alternative financial markets like a stock market and/or a bond market lags behind the development of the banking sector as shown in previous chapters. Bank deposits of the increased wealth match the increased bank financing. In the short run this trend is positive for China, because a large flow of money from bank deposits towards other financial assets, before the reduction of the NPLs, would put a large burden on the profitability and positive NPV investment possibilities of the banks. The banks would have too little money to invest, because almost all their assets would be in the NPLs. The other possibility is that money from deposits would be used to invest in real estate (private or investment). This trend is actually happening, partly due to government policy (Gordon, 2003). This is a positive trend for the banks because the real estate investments are matched with mortgages that are in the rule positive NPV investment opportunities for the banks. The banks will loose deposits, but they will gain profitable assets and unless the loss of deposits is not substantial, it will not be a threat for the banks.

The biggest threat to China could be the risk exposure to the international mobility of capital. The main implications of this threat are documented by Stiglitz (2002). Many banks and corporations of third world countries borrow money abroad, mainly in US dollars. This borrowing is mostly short-term and the money will be invested in long- term assets. The assets will earn money in the local currency but their costs are denominated in foreign currencies (mainly dollars). The money is borrowed abroad because of lower interest rates. The interest rates are partly lower because of lower expected inflation and partly because fiercer competition in the more mature financial markets. The risk exposure created by this practices could lead to a financial crisis if economic hardship occurs. This would be the case if the economic situation leads to a depreciation of the local currency towards the dollar, for example if imports are higher than exports or inflation in the home country is higher than in the United States. This would lead to financial problems for the banks and corporations because their income (local currency) depreciates towards their costs (dollars). To prevent this the central bank has to intervene in the market by buying the own currency, because this cannot go on for ever (depletion of foreign reserves, or an end to borrowing possibilities), the foreign issuers of the financing will withdraw their capital or ask higher interest. They are able to do so because their financing is short-term. These practices will result in an outflow of capital and hence assets are not supported by liabilities anymore. The home country’s banks and corporations are therefore

18 threatened by bankruptcies. As a result there will be a financial and economical crisis, but also a social crisis because of the influence on the inhabitants of a country (Stiglitz, 2002). There are several reasons why China is not vulnerable for this worst- case scenario. Firstly most foreign debt in China is long-term instead of short-term debt, together with the fact that most FDI is mainly direct equity investment instead of financial investment it is impossible that capital can flow out of the country fast and at will. Secondly China holds a large account of US dollars and other foreign accounts as reserves. This is due to a large BoP surplus in the past years (Figure 3). This is contrary to most developing countries, which run a BoP deficit, due to increased imports. In China exports increase even faster than the rising imports. The large BoP surplus is a buffer against the depreciation of the Yuan and even in worse times, where imports could outweigh exports, there is still a large foreign account reserve that can back up the Yuan (Gordon, 2003).

Figure 3 : Balance of Payment 2003 (million US$) Balance Credit Debit Current Account 4587481,2 51958038,6 47370557,4 Capital and Finance Account 5272594,2 21963061,2 16690467,1 Reserve Assets -11702310 0 11702310 (Source: China Statistical Yearbook 2004)

It should also be mentioned that the total amount of debt in China is not particularly high, this is important because this could make the interest burden so high that it would temper or even reverse economic growth. The international precaution line for debt as a percentage of GDP is 60% (Gordon, 2003). In China the AMC’s NPLs are 18%, foreign debt 15%, and domestic debt 14% of GDP in 1999. This amounts to 47%, which is much below the 60% precaution line (source: www.safe.gov.cn). Therefore the interest burden is not a direct threat to the financial system.

All the above mentioned threats and their implications for the Chinese financial system show that despite that there is no discussion about the fact that the NPLs should be cleared and especially that no new policy loans should be provided, the NPLs are not significant enough to bring down the Chinese financial system and in particular the banking sector. From a political economic point of view it remains interesting how the change from social security provided by the enterprises towards social security provided by the state affects the people of China. The term ‘’ symbolized the high level of security and low level of income they experienced. By implementing market mechanisms the income of the Chinese rose, but enterprises became less responsible for the welfare of the workers. Their traditional source of security is traded for the capitalist source of security, private wealth. Individual deposits rose from practically zero in 1980 to a large part of the equivalent to US$ 8.1 trillion in bank deposits in 2002. This shows that indeed the Chinese are accumulating wealth to provide for their security. This is an important precondition to have economic stability (steady consumer expenditures), without the social security provided by the enterprises. This economic stability is important for trust in the market. The points mentioned above show that the distribution of wealth and the social impact it will have is important for the development and stability of the financial market and the banking sector. The impacts of these changes in China go beyond the scope of this study, but certainly can have an effect on the future development of the Chinese financial sector and the economic growth.

19 Conclusion

Every section already summed up the most important points on the end. Therefore this conclusion will briefly mention the main points out of every section to give an overview of the points discussed in the thesis.

It is shown that there are some imbalances in the Chinese Banking sector. One main problem is that the financial sector is over-focused on bank financing. Another main problem is the large share of NPLs in the loan structure. The problem of over- concentration on bank financing is even increased by the extremely large share of the SOCBs in the Chinese banking sector. This will continue to be a structural problem because the SOCBs are likely to remain the most important players in the banking sector. The imbalance will improve a little bit because the relative size of the SOCBs will probably decrease a little bit because there will be more opportunities for smaller banks and foreign banks. Despite of the increasing financing possibilities besides bank financing, on the upcoming stock and bond markets, bank financing will remain by far the most important sector for financing in China. The future prospects for the Chinese banking sector are positive, the Chinese people will become increasingly wealthy and therefore need bank services. The business customer section will grow as well, because of the increased demand for financing in all of China’s growing production sections. The most important task for the government is in the field of regulation and deregulation. Deregulation is necessary to develop the banking sector. Many opportunities will show up for the banks, but processes should continue gradually to prevent for chaos. The entrance of foreign banks can be both seen as a threat and as an opportunity. They will definitely increase competition, but this could lead to the efficiency the Chinese banking sector needs. There will be more choice for Chinese businesses to get their bank financing. The pegged exchange rate is a problem because currently there is no macro-economic readjustment in the exchange rate. This could be welcome in preventing overheating of the economy and it would lower the exchange risk exposure for the Chinese government. Business and growth are hold back due to the low convertibility of the Yuan. Another problem is that other finance options are partly hold back because the pegged exchange rate leads to underdeveloped financial derivatives. The final section shows that the NPLs are still the main problem for the Chinese banking sector, everybody agrees that the NPLs should be cleared as soon as possible, this would make the banking sector much healthier and capable of supporting the Chinese economic growth. On the other hand it is also shown that the NPLs have a good reason to exist and that they will no be a direct threat for a financial crisis in the short run.

If China is able to implement the right measures, the future looks bright. The Chinese banking sector will become more competitive and efficient and will hence be better able to serve the wishes of the Chinese people and companies. The already impressive growth of China could even be enforced as the banking sector is able to improve its’ financing capabilities. This would lead to lower costs for the borrowers and the possibility for smaller companies, which at the moment face problems of getting financing, to raise money.

20 Literature List

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