Chinese Bank Report Card

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52 THE INTERNATIONAL ECONOMY SPRING 2006 Chinese Bank Report Card The reform road is still bumpy, so forget full RMB convertibility anytime soon. hina 9s banking system has gone through some profound changes, though reform is far from complete. Financial liberalization has yet to fully unleash banking 9s potential to fulfill asset demand, and China 9s mortgage and personal finance markets remain in infancy.

It will take a few more years than expected for bank- ing reform to be completed, despite the World Trade Organization requirements for China to fully open its bank- ing sector to competition by the end of 2006. The banking system is unlikely to col- lapse, however, despite the slow pace of reform and the inherent banking woes. But Beijing must take bold steps to push reform forward.

These include making asset management companies more effective by reform- ing the institutional and legal framework, creating a truly commercial banking culture, and ceding public control of the banking system by allowing eventual full private ownership. Given China 9s reform momentum, its banking reform outlook remains benign. But full capital account (and hence RMB) convertibility will be delayed until bank- B Y C HI L O Chi Lo is an ... more. less.

economic strategist based in Hong Kong and author of Phantom of the China Economic Threat, Palgrave Macmillan, upcoming 2006. C THE MAGAZINE OF INTERNATIONAL ECONOMIC POLICY 888 16th Street, N.W. Suite 740 Washington, D.C. 20006 Phone: 202-861-0791 Fax: 202-861-0790 www.international-economy.com SPRING 2006 THE INTERNATIONAL ECONOMY 53 L O ing reform is completed because the Chinese banking sys- tem cannot handle volatile international capital flows before sound banking practices and regulations are in place. BANKING REFORM PROGRESS China has made some material progress in reforming its ailing banks. Non-performing loans have fallen steadily, as a share of total assets, GDP, and new loans (see Figures 1 and 2). Private analysts estimated that China 9s non-per- forming loans amounted to more than 50 percent of GDP in the early 1990s. But official estimates put them now at less than 10 percent. Even if the true bad debt levels were three times higher, this still represents a sharp improve- ment. Nevertheless, some are still worried that the bulk of the nonperforming loan decline in recent years resulted from bank loan expansion, especially between 2002 and 2004 when bank lending grew by an average of 18 per- cent per year. Fundamentally, China 9s banking sector has undergone some serious reform since 1998, when financial liberaliza- tion and banking clean-up efforts were launched. The process started with fresh capital injections, nonperforming loans carve-outs, and organizational restructuring for the Big Four state banks, which still account for 53 percent of the system 9s assets and liabilities. Beijing issued RMB270 billion (US$32.6 billion) of special-purpose bonds to recapitalize the Big Four in 1998, and set up four asset management companies to buy RMB1.4 trillion (US$170 billion) of bad debts from them between 1999 and 2000. Then at the end of 2003, Beijing used the country 9s huge foreign reserves to inject US$45 billion into the Bank of China and the China Construction Bank. The cash injection allowed the two banks to boost their capital adequacy ratios to over 8 percent and cut non- performing loans to less than 10 percent. These efforts cost Beijing US$260 billion since 1998, about twice the amount South Korea spent on restructuring its banks after the Asian crisis and about the same amount the United States spent on cleaning up its savings and loan industry in the 1980s. Chinese banks have also improved their technical abil- ity since 1998 by raising accounting and regulatory stan- dards. The People 9s Bank of China 9s decision in October 2004 to lift the commercial lending rate ceiling has, in prin- ciple, allowed banks to price loans according to credit risk. Crucially, the China Banking Regulatory Commission was created in late 2002 as an independent bank regulator, the Chinese banking system cannot handle volatile international capital flows before sound banking practices and regulations are in place. Political Power Struggles T hick politics has manifested itself in the struggle between the People 9s Bank of China and China Banking Regulatory Commission. The tussle has severely limited the ability of the CBRC to be a true independent regulator. The CBRC was born of political battling, when Premier Wen was consolidating his power after taking over from Zhu Rongji in late 2002. The People 9s Bank of China, which was closely related to Mr. Zhu and had multiple objectives (of which being a bank regulator was only one of them), had strongly resisted separat- ing the regulatory role from its other roles. When Mr. Wen came to power, he moved to weaken Mr. Zhu 9s agency and installed his protégé Yan Hai-wang to form a team of experts, excluding anyone from the People 9s Bank of China, to create an independent bank regulator 4the CBRC headed by Liu Ming- kang. But People 9s Bank of China governor Zhou Xiao-chuan, who is a favorite of Mr. Zhu, has not given up the turf fight. He uses the People 9s Bank of China 9s mandate of keep- ing overall financial stability to continue to supervise and audit banks, overlapping the CBRC 9s work. 4C. Lo People 9s Bank of China Governor Zhou Xiao-chuan 54 THE INTERNATIONAL ECONOMY SPRING 2006 L O focusing on cutting banks 9 nonperforming loans and improving their operations. Most of China 9s 128 local commercial banks have independent directors sitting on their boards now, and have installed better shareholding and incentive structures that involve some market dis- cipline. Management has also invested in new risk management system and tried to eliminate the con- flict of interest problem by separating the roles of making and approving loans. A BETTER REFORM STRATEGIC FOCUS The government 9s reform tactics took a sharp turn, arguably for the better, in 2003 when Wen Jiabao took over from Zhu Rongji the premiership. Mr. Zhu 9s policy focused on recapitalizing the Big Four in return for operational restructuring but no privatization. After recapitalization, the banks were expected to grow their way out of the nonper- forming loans problems before opening up to for- eign competition. But such a strategy prompted an extreme pro- growth policy that created economic bubbles in various sectors. The state banks tried to grow out of their problems by lending lavishly between 2002 and 2004, thus feeding speculation in prop- erty, auto, steel, and other unprofitable industrial projects. Mr. Wen has taken a different approach since 2003. He has combined recapitalization, with renewed fund injection in the Bank of China and China Construction Bank, with privatization, in particular selling them off to foreign investors. The aim is to use private investors as an external force to push structural changes. The pre-listing cleanup has pushed the amount nonperforming loans down sharply. CONFIDENCE RISING Granted, all this does not mean that Chinese banks are now fully commercialized with sound risk management and lending decision. But it suggests that the bad debt situ- ation is more manageable than before. The Chinese author- ities have opened the door to foreign strategic investors, who have responded with a strong vote of confidence. From a trivial US$500 million cumulative foreign equity stake in Chinese banks in 2003, overseas investors poured US$18 billion into the Chinese banking system between late 2004 and 2005, with the bulk of the investment coming in the second half of 2005 (see table). More funds will flow in, as the 25 percent cumulative foreign owner- ship ceiling on individual Chinese banks will be lifted soon. The Chinese banks are also listing overseas, mainly in Hong Kong, with the Bank of Communications and the China Construction Bank already listed in Hong Kong in May and October 2005, respectively. The market is expect- ing as much as US$20 billion worth of initial public offer- ings from Chinese banks in the coming year. NOT SO SMOOTH However, political, technical, and incentive problems remain in the way of reform. There is a big moral hazard problem with the asset management companies, which are supposed to clean up the banking woes by debt-equity 1 The Big Four 9s Non-Performing Loans 0 5 10 15 20 25 30 35 % GDP % total assets 2004 2003 2002 2001 Percent Sources: CIEC, Hoover Institution, China Banking Regulatory Commission 2 Non-Performing Loans as a Share of New Loans 10 20 30 40 50 60 70 80 2004 2002 2000 1998 1996 1994 1992 1990 NPL/New Loan Ration Source: UBS SPRING 2006 THE INTERNATIONAL ECONOMY 55 L O swaps after restructuring the state-owned enterprises. The program has not worked as planned because there is an incentive incompatibility problem between the asset man- agement companies and many officials and state-owned enterprise managers. Many state firm managers still see these as just another way to salvage the crumbling state- owned enterprises. The banks also have no incentive to recover nonperforming loans because they see the asset management companies as public bailout agencies created to absorb their losses. This situation has improved recently, but the pulse of market discipline is still weak. There is also a worry that the Chinese banks may rely too much on technical solutions, such as credit scoring models, while they do not have enough qualified personnel to spot bad borrowers and price credit properly. Interest rate liberalization and stringent loan classifications have limited help for building a strong credit culture, which is fundamental to commercialization. Turf fights makes the reform road bumpier. While reform incentive is strong at the head office level, it still has difficulty in filtering down to the branch level. The decentralized structure of the banks only makes matter worse. The head offices, which want to centralize control and push down changes, clash with the branches, which often cave in to local officials and industrialists 9demand for preferential lending. The aim of the Chinese bank sales has not been to get money for banking reform. In fact, the local banks are flooded with liquidity from both the depositors and the recapitalization funds. Major foreign investment deals in Chinese banks Deal date Foreign buyer Target bank (% bought) Amount (US$ mn) March 2004 ING Group NV Bank of Beijing (19.9%) 214.8 Late 2004 HSBC Bank of Communications (19.9%) 2,250.0 April 2005 Commonwealth Bank of Australia Hangzhou City Commercial Bank (19.9%) 77.6 June 2005 BankAmerica China Construction Bank (9%) 2,500.0 July 2005 Temasek China Construction Bank (3.6%) 2,500.0 August 2005 Royal Bank of Scotland con- sortium Bank of China (10%) 3,100.0 August 2005 UBS Bank of China (1.6%) 500.0 August 2005 Temasek Bank of China (9.9%) 3,000.0 August 2005 Goldman Sachs, Allianz, AMEX group Industrial and Commercial Bank of China (10%) 3,000.0 September 2005 Deutsche Bank & partner Hauxia Bank (14%) 330.0 Sources: AWSJ, UBS 56 THE INTERNATIONAL ECONOMY SPRING 2006 L O Thick politics has manifested itself in the struggle between the People 9s Bank of China and China Banking Regulatory Commission. The tussle has severely limited the ability of the CBRC to be a true independent regulator. The CBRC was born of political battling, when Premier Wen was consolidating his power after taking over from Zhu Rongji in late 2002. The People 9s Bank of China, which was closely related to Mr. Zhu and had multiple objectives (of which being a bank regulator was only one of them), had strongly resisted separating the reg- ulatory role from its other roles. When Mr. Wen came to power, he moved to weaken Mr. Zhu 9s agency and installed his protégé Yan Hai-wang to form a team of experts, excluding any- one from the People 9s Bank of China, to create an independent bank regulator 4the CBRC headed by Liu Ming-kang. But People 9s Bank of China governor Zhou Xiao-chuan, who is a favorite of Mr. Zhu, has not given up the turf fight. He uses the People 9s Bank of China 9s mandate of keeping overall financial stability to continue to supervise and audit banks, overlapping the CBRC 9s work. The People 9s Bank of China-CBRC power struggle has created regulatory inefficiency. It has also dampened the outlook for a truly independent financial regulator. Political intervention in the banking system will remain an issue. These problems are aggravated by serious corrup- tion and reflected in the poor profitability of the Chinese banking industry. In 2004, Chinese banks managed to generate a return on assets of only 0.5 percent, the worst in Asia, with low- est capital-asset ratio (see Figure 3). Their returns looked better on an equity basis, with an average return on equity of 11 percent. But analysts argue that was because of the Chinese banks 9low level of equity (and hence capital). Arguably, Chinese banks should carry a capital-to- asset ratio above the BIS standard of 8 percent to cover their inherent risks. For example, Indonesian banks have an average capital-to-asset ratio of almost 20 percent to cushion their risks. If the Chinese banks were to do the same, banking analysts estimate that their return on equity would fall below 5 percent. Meanwhile, the handicap of the asset management companies is seen in the difficulty of asset disposal. They have managed to sell off only about half of the bad debts seven years after inception. The average cash recovery rate is about 20 percent. But this rate is going to fall, as the better quality assets have been sold off. FORCES TO PUSH AHEAD Despite the problems, reform momentum is strong. The CBRC has started a clean-up effort on the rural credit co- ops and postal savings since 2003. These institutions account for over 25 percent of total banking assets and liabilities. Their size will grow as financial liberalization spreads to the rural areas. Hence, Beijing is starting to tackle the problems before it is too late. Financial liberalization has changed the banking landscape drastically. It has boosted competition among local banks. Younger and leaner commercial banks The banks also have no incentive to recover nonperforming loans because they see the asset management companies as public bailout agencies created to absorb their losses. 3 Asian Banks 9 Return on Assets and Capital Ratios 0.0 0.5 1.0 1.5 2.0 0 5 10 15 20 25 China Taiwan Korea Malaysia Singapore Thailand Indonesia India Hong Kong Return on assets (percent) Capital asset ratio Return on assets (LHS) Capital asset ration (RHS) Source: Fitch SPRING 2006 THE INTERNATIONAL ECONOMY 57 L O (accounting for over 20 percent of the banking sector) in the more affluent urban areas are competing fiercely with the Big Four. Free from historic burdens and more flexi- ble in lending to small- to medium-sized firms, these new players are more adaptable to changes. The development of new funding and saving vehi- cles are starting to compete for business with the state banks. As China 9s emerging capital markets mature, there will be large shifts of saving and borrowing from the banking sector to the capital markets. The stock and bond markets will play a bigger role in China 9s increasingly market-oriented economy for savers and companies to diversify financial risks. Foreign investors will help push China 9s bank restructuring by providing the skills in risk management, financial product knowledge, and innovation. The aim of the Chinese bank sales has not been to get money for banking reform. In fact, the local banks are flooded with liquidity from both the depositors and the recapitalization funds. Rather, the purpose is to create a competitive momentum by bringing in foreign players in the Chinese system. As the obstacles are eventually dismantled for the foreign banks to take local RMB deposits and make RMB loans, the foreign players will become an immense chal- lenge to the Chinese banks. If Chinese savings shift to the foreign banks in large amounts, the local banks 9deposit base, and hence lending ability, will be eroded. Thus, the local banks are racing against time to improve. POLICY AND MARKET IMPLICATIONS To take reform further, China must take bold steps to allow take-overs, mergers and acquisitions, and bank fail- ures. Beijing must also make the asset management com- panies work effectively. Transferring state-owned enterprise bad debts to the asset management companies and recapitalizing the banks are the easy part of reform. The hard part is for the asset management companies to sell these bad assets to debt workout specialists to recoup the losses. This can only be done by thorough financial and institutional reforms to eliminate the incentive prob- lems between the state-owned enterprises and the AMCs and create a liquid market for these special assets. Eventually, the government must cede control of the banking system and allow full private ownership. In this sense, strategic foreign investors are brought in as a cat- alyst for this ownership transfer process. But ceding con- trol does not mean the government has no role. It should develop an effective regulatory framework for supervising the system. Strong banks, sound regulations, and mini- mal government distortion are the necessary and suffi- cient conditions for China to fully liberalize its financial markets without worrying about the stability of the state banks. It will take some years for Chinese banks to shed the communist legacy and establish a true commercial cul- ture. To achieve this needs a mindset change from the old socialist mentality to a liberalized and professional atti- tude. This change will quicken when the older manage- ment retires (normally at age sixty) 4another five to seven years from now. In other words, China 9s banking reform will likely take a few more years than most have expected to be fully completed. This means that the business scope will remain limited in China 9s banking sector, despite the WTO requirements that China will have to open up banking to full foreign competition by the end of 2006. Last but not least, Chinese banks will not be able to handle volatile international capital flows before they are fully reformed. This means no fully opened capital account for a few more years. In other words, there will be no full RMB convertibility until the bank restructuring process is completed. Æ Chinese banks will not be able to handle volatile international capital flows before they are fully reformed. This means no fully opened capital account for a few more years. In other words, there will be no full RMB convertibility until the bank restructuring process is completed.

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