Financial reforms to squeeze Chinese banks

Interest rate liberalisation and freer capital flows are the prime candidates for financial reform this year. But there will be negative shocks on Chinese bank margins.

Given the importance of financial stability, Beijing will only take a gradualist reform approach. It will only allow limited freedom for domestic investors to invest overseas via the Qualified Domestic Institutional Investors (QDII) scheme. Hence, do not expect any acceleration in full capital account convertibility, and Hong Kong stocks will not get a boost from Mainland money just yet.

Bolder financial reforms on the way

Beijing has decided to spin off the PBoC's role of regulating banks to an independent agency, the China Banking Regulatory Commission. The PBoC now focuses on central-bank functions in setting monetary policy.

Splitting the central bank's duties helps lessen the conflict of interest - the PBoC prefers stability, a priority that does not sit well with any reform efforts to shake up the banking system. The move underscores the resolve of the new leadership to overhaul the financial system.

Bolder reforms are on the way. The PBoC plans to allow more interest rate flexibility under market forces. Under the current system, the PBoC sets deposit and lending rates for the state banks. Non-state commercial banks have to follow and are not given much freedom to price credit.

But the PBoC has recently approved an unprecedented experiment with banking overhaul in the eastern city of Wenzhou. The city now allows market forces to set interest rates for bank deposits and loans.

It has also lifted the ban on private-sector investment on commercial banks in urban areas, and set up a small-loan system targeted at private businesses. These measures go a long way to correct the distortion of interest rate controls and capital misallocation that stave the private sector of credit.

Another sign that shows the leadership is serious about interest rate liberalisation comes from the Ministry of Finance (MoF), which is mulling hedging in the Chinese bond market. The Ministry is proposing rules to allow investors to use risk-management tools, such as forward contracts and even short-selling, in the domestic Treasury market. The purpose is to encourage Chinese banks, which are the main investors in government bonds, to hedge exposure to the government's ballooning debt.

There is an absence of hedging instruments under the current system. This means that banks now lack the tools to protect themselves against price volatility in the Treasury market as interest rates fluctuate. It is thus obvious that by planning to allow interest-rate-risk hedging, Beijing is expecting to liberalise interest rates soon.

Meanwhile, the PBoC hints that Mainland Chinese could be allowed to invest overseas, including Hong Kong stocks, under the QDII scheme as early as this year. Together with interest rate liberalisation and the Qualified Foreign Institutional Investor (QFII) programme (which allows foreigners to buy in the Chinese A-share market) implemented last year, the QDII scheme is another significant step towards making the RMB fully convertible.

The next steps

Despite all these bold moves, the authorities will only proceed at a controlled pace in liberalising interest rates and capital flows. The PBoC may extend the floating rate experiment to other cities outside Wenzhou. Alternatively, it may set an interest rate floor and allow all commercial banks to set their lending rate above the floor according to market forces before scrapping interest rate controls completely.

No matter what form interest rate liberalisation may take, it is an integral part of China's financial reform. Interest rate controls have become incompatible with a corporate system that is increasingly market-driven.

Thus, allowing interest rates to float is a natural evolution and an extension of China's corporate restructuring. It is also China's commitment to the WTO that she would implement a market-based financial system over time.

However, the move to scrap interest rate controls will also create some shocks in the banking system. This is why the authorities are unlikely to move fast. The spread between lending and deposit rates in Chinese banks have been kept high, at over 300 basis points since the Asian crisis, to keep the banks' profitability.

Letting market forces to set interest rates could inevitably lead to a narrowing of bank spread. There are several forces at play here.

First, the official lending rates are set too high against the backdrop of price deflation, which always tends to weaken credit demand. In the event that lending rates drop after interest rates are floated, margins would be squeezed.

Second, deposit rates might soar, as depositors ask for higher returns to commensurate the high risk inherent in the banking system. This would hurt bank margins also.

Third, both deposit and lending rates might soar as both depositors and lenders ask for higher interest rates to commensurate the high credit risk inherent in the banking and corporate sectors. Bank spread could be squeezed under financial chaos.

Lastly, implementing QDII would put upward pressure on Chinese deposit rates, as capital flows out to chase better returns.

The PBoC wants to minimise the shocks that financial reforms will bring. Hence, it is likely to use an interest-rate floor as the next step of liberalisation. This will also give the big four state banks some breathing space in their restructuring process.

The bottom lines

Increased competition will hurt bank margins. This could be bearish for Chinese banking sector profits, especially for the state banks if they are slow in improving operational efficiency and cutting bad debts. There is thus an inherent structural risk in the Chinese banks IPOs when they are listed in the medium-term.

The operating environment in China's banking system will remain tough, as competition combined with a slow reform pace will cap profit growth. Foreign banks will not be able to leverage off their western banking technology under a restricted environment.

Due to the concerns about bank stability, do not expect full interest rate liberalisation any time soon. The QDII scheme will also be implemented with tight controls.

All this means that full capital account, and hence currency, convertibility is unlikely to come within three years, as some optimists have hoped.

Chi Lo is author of the upcoming book: "When Asia Meets China in the New Millennium - China's Role in Asia's Post-bubble Economic Transformation", Pearson Prentice Hall 2003.