China's banking reform - what you see and what you don't

Economic strategist explains why Beijing must continue being bold in its reform of the banking sector.

China's banking system has gone through some profound changes, though reform is far from complete. Financial liberalisation has yet to fully unleash the banking potential for the asset demand, note the infancy of China's mortgage and personal finance market.

It will take a few more years than many have expected for banking reform to be completed, despite the WTO requirements for China to fully open its banking sector to competition by the end of 2006. The banking system is unlikely to collapse, 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 the asset management companies more effective by reforming the institutional and legal framework, creating a truly commercial banking cultural and ceding public control of the banking system by allowing full private ownership eventually.

Given China's reform momentum, its banking reform outlook remains benign. But full capital account (and hence RMB) convertibility will be delayed until the banking reform is completed because the Chinese banking system 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 (NPLs) have fallen steadily, both as a share of total assets, GDP and new loans (charts below). Private analysts estimated that China's NPL were over 50% of GDP in the early-1990s. But official estimate puts them at less than 10% now. Even if the true bad debt levels were 3 times higher, they still represent a sharp improvement. Nevertheless, some are still worried that the bulk of the NPL decline in recent years was resulted from bank loan expansion, esp. between 2002 and 2004 when bank lending grew by an average of 18% a year.

Fundamentally, China's banking sector has gone through some profound changes since 1998, when financial liberalisation and banking clean-up efforts were launched. The process started with fresh capital injections, NPL carve-outs and organisational restructuring for the Big Four state banks, which still account for 53% of the system's assets and liabilities.

Beijing issued RMB270 bn (US$32.6 bn) of special-purpose bonds to recapitalise the Big Four in 1998, and set up four asset management companies (AMCs) to buy RMB1.4 trn (US$170 bn) of bad debts from them between 1999 and 2000. Then at the end of 2003, Beijing used the country's huge foreign reserves to inject US$45 bn into the Bank of China (BoC) and the China Construction Bank (CCB). The cash injection allowed the two banks to boost their capital adequacy ratios to over 8% and cut NPLs to less than 10%.

These efforts cost Beijing US$260 bn since 1998, about twice the amount South Korea spent on restructuring its banks after the Asian crisis and about the same amount the US spent on cleaning up its savings & loans industry in the 1980s.

Chinese banks have also improved their technical ability since 1998 by raising accounting and regulatory standards. The PBoC's decision in October 2004 to lift the commercial lending rate ceiling have, in principle, allowed banks to price loans according to credit risk. Crucially, the China Banking Regulatory Commission (CBRC) was created in late 2002 as an independent bank regulator, focusing on cutting banks' NPLs and improving their operations.

Most of China's 128 local commercial banks have independent directors sitting on their boards now, and have installed better shareholding and incentive structures that involve some market discipline. Management has also invested in new risk management system and tried to eliminate the conflict of interest problem by separating the roles of making and approving loans.

A better reform strategic focus

The government's reform tactics took a sharp turn, arguably for the better, in 2003 when Wen Jiabao took over from Zhu Rongji the premiership. Mr. Zhu's policy focused on recapitalising the Big Four in return for operational restructuring; but no privatisation. After recapitalisation, the banks were expected to grow their way of the NPL problems before opening up to foreign 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 property, auto, steel and other unprofitable industrial projects.

Mr. Wen has taken a different approach since 2003. He has combined recapitalisation, with renewed fund injection in the BoC and CCB, with privatisation, 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 clean-up has pushed down NPLs sharply.

Confidence rising

Granted, all this does not mean that Chinese banks are now fully commercialised with sound risk management and lending decision. But it suggests that the bad debt situation is more manageable than before. The Chinese authorities have opened the door to foreign strategic investors, who have responded with a strong vote of confidence.

From a trivial US$500 mn cumulative foreign equity stakes in Chinese banks in 2003, overseas investors poured US$18 bn into the Chinese banking system between late 2004 and 2005, with bulk of the investment coming in the second half of 2005 (table below). More funds will flow in, as the 25% cumulative foreign ownership ceiling on individual Chinese banks will be lifted soon.

Major foreign investment deals in Chinese banks


Deal date

Foreign buyer

Target bank (% bought)



(US$ mn)

March 2004

ING Group NV

Bank of Beijing (19.9%)


late 2004


Bank of Communications (19.9%)


April 2005

Commonwealth Bank

Hangzhou City



of Australia

Commercial bank (19.9%)


June 2005


China Construction



Bank (9%)


July 2005


China Construction



Bank (3.6%)


August 2005

Royal Bank of

Bank of China (10%)



Scotland consortium


August 2005


Bank of China (1.6%)


August 2005


Bank of China (9.9%)


August 2005

Goldman Sachs,

Industrial and Commercial



Allianz, AMEX group

Bank of China (10%)



Deutsche Bank

Hauxia Bank (14%)



& partner


source: AWSJ, UBS


The Chinese banks are also listing overseas, mainly in Hong Kong, with the Bank of Communications and CCB already listed in Hong Kong in May and October 2005, respectively. The market is expecting as much as US$20 bn worth of IPOs 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 AMCs, which is supposed to clean up the banking woes by debt-equity swaps after restructuring the state-owned enterprises (SOEs). The programme has not worked as planned because there is an incentive incompatibility problem between the AMCs and many officials and SOE managers. The AMCs want to use debt-equity swaps to address the NPL problems by identifying bad SOEs for restructuring. But many state firm managers still see these as just another way to salvage the crumbling SOEs. The banks also have no incentive to recover NPLs because they see the AMCs as public bailout agencies 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, like credit scoring models, while they do not have enough qualified personnel to spot bad borrowers and price credit properly. Interest rate liberalisation and stringent loan classifications have limited help for building a strong credit culture, which is fundamental to commercialisation.

Turf fight 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 decentralised structure of the banks only makes matter worse. The head office, which wants to centralise control and push down changes, often clashes with the branches, which often cave in to local officials and industrialists' demand for preferential lending.

Thick politics has manifested itself in the struggle between the PBoC and CBRC. The tussle has severely limited the ability of the CBRC to be a true independent regulator. The CBRC was born out of political battling, when Premier Wen was consolidating his power after taking over from Zhu Rongji in late 2002. The PBoC, which was closely related to Mr. Zhu and had multi objectives (of which being a bank regulator was only one of them), had strongly resisted to separating the regulatory role from its other roles.

When Mr. Wen came to power, he moved to weaken Mr. Zhu's agency and installed his protege Yan Hai-wang to form a team of experts, excluding anyone from the PBoC, to create an independent bank regulator - the CBRC headed by Liu Ming-kang. But PBoC governor Zhou Xiao-chuan, who is a favourite of Mr. Zhu, has not given up the turf fight. He uses the PBoC's mandate of keeping overall financial stability to continue to supervise and audit banks, overlapping the CBRC's work.

The PBoC-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 corruption and reflected in the poor profitability of the Chinese banking industry.

In 2004, Chinese banks managed to generate a return-on-assets (ROA) of only 0.5%, the worst in Asia, with lowest capital-asset ratio (chart below). Their returns looked better on an equity basis, with an average return-on-equity (ROE) of 11%. But analysts argue that was because of the Chinese banks' low level of equity (and hence capital).

Arguably, Chinese banks should carry a capital-asset ratio above the BIS standard of 8% to cover their inherent risks. For example, Indonesian banks have an average capital-asset ratio of almost 20% to cushion their risks. If the Chinese banks were to do the same, banking analysts estimate that their ROE would fall below 5%.

Meanwhile, the handicap of the AMCs is seen in the difficulty in asset disposal. They managed to sell off only about half of the bad debts seven years after inception. The average cash recovery rate is about 20%. 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% of total banking assets and liabilities. Their size will grow as financial liberalisation spreads to the rural areas. Hence, Beijing is starting to tackle the problems before it is too late.

Financial liberalisation has changed the banking landscape drastically. It has boosted competition among local banks. Younger and leaner commercial banks (accounting for over 20% of the banking sector) in the more affluent urban areas are competing fiercely with the Big Four. Free from historic burden and more flexible in lending to small- to medium-sized firms, these new players are more adaptable to changes.

The development of new funding and saving vehicles are starting to compete for business with the state banks. As China's 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's increasingly market-oriented economy for savers and companies to diversify financial risks.

Foreign investors will help push China's 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 recapitalisation funds. Rather, the purpose is to create a competitive momentum by bringing in foreign players in the Chinese system.

As the obstacles for the foreign banks to take local RMB deposits and make RMB loans are eventually dismantled, the foreign players will become an immense challenge to the Chinese banks. If Chinese savings shift to the foreign banks in large amounts, the local banks' deposit 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 & acquisitions and bank failures. Beijing must also make the AMCs work effectively. Transferring SOE bad debts to the AMCs and recapitalising the banks are the easy part of reform. The hard part is for the AMCs 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 problems between the SOEs 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 catalyst for this ownership transfer process. But ceding control does not mean the government has no role. It should develop an effective regulatory framework for supervising the system. Strong banks, sound regulations and minimal government distortion are the necessary and sufficient conditions for China to fully liberalise 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 culture. To achieve this needs a mindset change, from the old socialist mentality, to a liberalised and professional attitude. This change will quicken when the older management retires (normally at 60 years old). This will mean another 5 to 7 years from now.

In other words, China's 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's banking sector, despite the WTO requirements that it will have to open up to full foreign competition by end-2006.

Last but not least, Chinese banks will not be able to handle volatile international, esp. short-term, 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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