Beyond cash china’s emerging payments market

First Data Beyond Cash: China’s Emerging Payments Market 409 The evolution of the Chinese payments market – China’s card market at a glance: Cards issued and transaction volume– Boom tim

First Data Beyond Cash: China’s Emerging Payments Market 3

on the prospects for China’s cards and payments industry

The vast majority of our survey respondents see opportunities for their business in China, naming credit cards as the primary segment for future revenue potential

First Data truly agrees with this assessment As early market entrants to China ourselves we introduced the concept of outsourcing into the Chinese payments industry where the service is being increasingly used both by newcomers and well-established issuers.Like the multi-national banks already active in China, we also leveraged international best practices and payments processing expertise from other markets for the benefit of our Chinese customers First Data offers a range of infrastructure, operations, licensing and outsourcing solutions from card issuing to merchant acquiring and ATM processing for organisations looking to develop their cards and payments business in China

We are committed to the Chinese market and look forward to working with all stakeholders – regulators, banks, merchants, and cardholders – to ensure the ongoing successful development of the industry

I hope this report will provide an interesting perspective on the views of foreign banks and merchants active in China at this critical time

of development in the payments market

Pam Patsley

President

First Data International

First Data International commissioned the Economist Intelligence Unit to write Beyond Cash: China’s Emerging Payments Market, an in-depth review of the burgeoning payments market in China

With the exception of the “First Data Insights” sections in the text and sidebars of the report, the views and opinions expressed herein are those of the Economist Intelligence Unit The Economist Intelligence Unit executed the online survey, conducted the interviews and wrote the report The findings and views expressed in this report

do not necessarily reflect the views of the sponsor

The research drew on two main initiatives:

– The Economist Intelligence Unit conducted a wide-ranging online survey of 152 senior bankers from around the world in March and April 2007 All respondents represent banks that either operate in the Chinese market already or plan to enter the market within the next three years

– To supplement the survey results, the Economist Intelligence Unit also conducted in-depth interviews with 20 senior banking, retail and payment services executives from firms currently operating in China, or intending to enter the market within the next three years

We would like to thank all the executives who participated in the survey and interviews for their time and insights

› June 2007

Who Took Part In The Survey

A total of 152 banking executives worldwide

took part in this survey, all from banks either in

China or planning to enter the market by 2010

Around 34% of respondents were based in

Asia-Pacific, 32% in Europe and 26% in North

America, with the balance from the rest of the

world All respondents came from management

positions, with C-level executives accounting

for about 30% of the total and senior vice

presidents, vice presidents, director, heads

of business units or heads of departments

accounting for a further one-third In terms of

size, firms were split roughly evenly between

those with revenue either above or below

US$1bn; nearly one-quarter had revenue

of more than US$10bn Retail bankers

accounted for 38% of the sample.

First Data Beyond Cash: China’s Emerging Payments Market 4

09 The evolution of the Chinese payments market

– China’s card market at a glance: Cards issued and transaction volume– Boom time in China: GDP growth from 2005 to 2010

11 Opening up the market

– Entry strategies– Partnering for success

14 The potential opportunity

– Holding an edge

16 Operating a cards business in China

– Payment fees and incentive structures– Slim margins: China’s interchange rates set by PBC– Card processing

– Merchant card acceptance and ATM use– Do you take cards? Card acceptance on the rise in China

20 Numerous challenges remain

– Top challenges for payments– Risk management

– Regulatory restrictions – Talent and IT

– Savings culture

24 Bringing merchants on board

– Merchant acquiring– Co-branded cards– The network experience

26 The outlook for the cards business in China

Executive Summary

As China’s economy continues its robust expansion, and as its banking sector finally

opens up to foreign competition, the demand for credit is taking off Local banks have ramped up their operations for the last three or four years in preparation for increased competition from foreign rivals As their efforts bear fruit, the potential for China’s

payment cards market has never looked better

Nowhere is this more so than in China’s emerging market for debit and credit cards

With more than 200m new cards issued last year alone, China’s total number of plastic cards broke though the one billion mark in 2006, with no sign of the pace abating While

a relatively tiny portion of this total—some 50 million—are currently credit cards, growth rates for the sector (both in terms of spending and transaction volumes) are now much higher than for the mass-market debit cards that form the bulk of cards in circulation No surprise, then, that foreign banks are now eyeing this space for opportunity

The main findings of our research are as follows:

– Retail banks are very bullish on consumer banking in general—and credit cards in particular For many of the retail banks surveyed for this report, credit cards are the main priority When asked what products they believe hold the greatest prospects for China’s personal banking industry, retail bankers were most optimistic about credit cards and bank accounts Fifty-five percent of study respondents believe the prospects for these consumer banking products are ‘highly promising’ over the next three years Debit cards are seen as the next most promising item (45%), although these are directly linked to the prospects for basic bank accounts, followed by wealth and investment management (40%) In fact, respondents report overwhelmingly positive

views for all aspects of the consumer banking sector

– .But the outlook for profits is less certain When it comes to profits in the credit card market, our survey respondents are less confident Forty-three percent agree that it would be difficult to make a profit in the credit card market over the next three years, compared with 36% who remain uncertain and

just 21% who believe it is possible The key issue is tough competition for

customers between local banks growing their market share and foreign rivals trying to establish a beachhead in China This competition inevitably leads

to lower card fees, which keeps earnings low (or negative) In addition, banks are grappling with low rates of revolving credit on cards, resulting from a cultural aversion to accruing debt, together with low fees and interest rates that issuers are allowed to levy on merchants and card users

– Infrastructure is key to growth in the cards market According to the

executives surveyed for this report, improving infrastructure – encompassing

both merchants and ATMs—will play the biggest role in encouraging the

increased acceptance of card payments in China Fully 83% of retail bankers

polled chose this as an essential requirement This component scores far ahead of any other criteria, for example better collaboration between key stakeholders such as banks and payment processors (48%) or publicity campaigns (33%) When asked what the Chinese market needs to support

a payments infrastructure, half of the survey respondents selected better

availability of consumer credit-history data

– Merchant acquisition is a major hurdle Convincing merchants to accept credit cards is a major challenge for banks Eight out of ten retail bankers polled for this report say that local retailers’ preference for cash is either

a ‘very significant’ or ‘significant’ barrier in operating cards and payment services In part, this is because retailers don’t yet feel much pressure from customers to provide payment card facilities in a society where cash is traditionally preferred

– Despite an opening financial market, much risk remains More than half (53%)

of bankers polled for this report selected political risk, relating to policy and regulation, as the biggest existing or potential risk associated with their firm’s operations in China Retail bankers in particular listed licensing risk (chosen by 43%) as a major concern, second only to political risk, highlighting the difficulties associated with getting permission to expand into new regions or markets Along with this, 41% of the respondents expressed a general concern about the outlook for China’s banking industry

Much work needs to be done to promote a plastic card payment culture in China More than anything else, a more extensive card network and infrastructure must be rolled out to promote consumer usage Along with this, databases of consumers’ credit and transaction histories require expansion In addition, Chinese consumers must be encouraged to make the switch from cash-based transactions to plastic cards

Despite these challenges, growth is already strong And in cities such as Beijing, efforts to prepare for the 2008 Summer Olympic Games will help create an environment that supports card payments Although foreign banks entering the market will have their work cut out, the opportunity is simply too big to ignore

Sound practice: five tips for foreign banks entering the Chinese payments market

1 Don’t arrive expecting fast profits The opportunity is huge but the China market

is a marathon, not a sprint

2 Choose your partners carefully All domestic banks are not created equal Find one that has strategic goals similar to your own and be wary of those looking only to extract your expertise for their own purposes

3 Bring skills with you The shortage of local talent means that foreign banks must bring in skilled personnel from abroad to supervise important operational functions Also aim for high rates of local staff retention, both by offering competitive salary packages and structuring employment contracts to discourage defections once employees have been trained

4 Maximise use of the Internet and other technology This will help to compensate for lack of physical branch networks and provide a higher standard of customer service than that offered by local rivals

5 Be focused in choosing your market Rather than selling to a mass audience, creatively explore alternative marketing channels Target market niches and seek co-branding partnerships with local companies offering client bases with attractive demographics

Recommendations for Foreign Banks

�– Respect the culture – China is a very

specific market with characteristics unlike

most other countries

�– Leverage best practice from your bank’s

operations in other countries (e.g

marketing, risk, IT)

�– Build in reasonable timelines for a return

on investment

�– Build and develop a dialogue with

regulators and keep them updated

on your progress

�– Focus on customer service – it is still

a major advantage for foreigners over

local banks

�– Leverage banks’ focus on wealth

management to deliver high-end card

products High net worth customers are

also a major source of fee income even if

they don’t revolve their card balances

�– Be prepared for competition – Chinese

banks are learning very quickly.

Recommendations for Local Banks

�– Consider remote distribution channels,

not just branches

�– Differentiate your product offering

�– Use your branch network to exploit

market opportunities outside the four

main cities

�– Centralise your IT infrastructure and mine

your databases

�– Improve customer service

�– Ensure your technology is easy to

use for customers with limited

�– Leverage alternative distribution channels

�– Cross-sell – credit cards are a very useful

product to use as a base for cross-selling

or to sell to existing customers

�– There are a limited number of skilled

people with payments industry

experience – recruit talent, and

retain them

�– Build risk capabilities

�– Build a card acceptance network – fast

�– Look at opportunities to sell card products

to companies – commercial cards help

companies manage cash flow, are a

short-term source of funding, offer

management information on employee

expenses and help to manage

suppliers better

�– Learn from the credit crises that have hit

many emerging markets – ensure you have

good risk management practices before

you start lending to consumers

�– Be prepared to work with regulators

pro-actively to help stimulate the market

for all players

First Data’s

Recommendations

First Data International Insights

The size and rapid growth of China’s economy has led many foreign banks to enter the market in the last five years As shown by the result of this survey, two of the most profitable business segments - retail banking and credit cards – rank at the top of the banks’ agenda

Banks surveyed view their investment as a long-term play This is a wise strategy in a market that is still in the early stages of development However, both local and foreign banks are conscious that this is an opportunity too big to pass up

There are now over 1 billion payment cards in issue across the country Although only

50 million of these cards are full revolving credit cards, it is not surprising that many

of the bankers surveyed see credit cards as one of the most promising products in Chinese retail financial services

Experience from other emerging markets in Asia, Central and Eastern Europe and Latin America has shown that the credit cards offer huge revenue potential from both interest and fee income In addition, banks can cross-sell other banking products to credit cardholders, something that few banks in China are doing now

For foreign banks focusing on the Chinese market, credit cards are an excellent entry product As standalone products they do not need to offer an account package or

a local branch network to market to or serve cardholders While most foreign banks are currently issuing cards in partnership with local banks, this may change as they become more established in the market

While Chinese banks face challenges in getting customers to activate and use their cards frequently, the growing card acceptance infrastructure will make this task easier Banks surveyed rightly highlighted this as a major issue However, it

is a challenge common to many other emerging payments markets Interestingly, progress in the country’s main cities has been very rapid Some 30% of all payment transactions in big cities are now carried out by cards

From First Data’s experience of operating in China, one of the biggest challenges faced by banks is risk management This is also a major finding of the survey The introduction of data analytics solutions to help reduce card application fraud will provide tremendous benefit to the industry Banks also need to monitor transaction information and develop strong collections capabilities Knowledge sharing in this area has been a big part of the co-operation between Chinese banks and their foreign partners This will certainly pay dividends in reduced credit losses and better fraud prevention as the industry develops and transaction volumes increase

The report rightly points out the key role of merchants in developing China’s cards industry As in many emerging markets, cash is still preferred and the favoured means

of payment for many retailers and other merchants Experience in other countries has shown that the industry needs to engage with the merchant community to clearly educate and communicate the benefits of accepting cards These include higher transaction volumes, reduced cash handling costs and less risk of theft

As the survey shows, payment cards have a major role to play in the profitability of the Chinese banking industry and its on going development The foundations for

a profitable cards industry have been successfully implemented By focusing on resolving the highlighted challenges such as expanding the card acceptance and improving the banks’ risk management and marketing effectiveness the industry will

be well set for further growth

Five years after joining the World Trade Organisation (WTO), China introduced regulations to open its retail banking market in December 2006, taking a major step towards the liberalisation of its financial services sector Although some restrictions remain, the change in the rules finally permits foreign banks to provide renminbi-denominated accounts to the market

Many of the banks entering the market are looking at the potential of the burgeoning credit card market Of the 152 banks surveyed for this report, about eight out of ten rate the prospects for credit cards as either ‘highly’ or ‘somewhat’ promising

As might be expected, most foreign banks are targeting their activities at China’s wealthier customers

“We think there is a big opportunity [for credit cards] because of the low penetration

so far,” says Manuel Galatas, head of Asia at a Spanish bank, Banco Bilbao Vizcaya Argentaria (BBVA), which acquired a stake in CITIC Bank last November “The Chinese have on average less than one bank card per person, compared with 1.9 in Hong Kong and 3.87 in the US.” Mr Galatas adds that credit card payments account for just 1% of total consumer spending, compared with about 20% in the US

Foreign banks are not alone in targeting the market Domestic banks also see great opportunity, albeit often in partnership with foreign banks “I believe the credit card business is most promising and will create more profits,” says Hong Lin, a deputy general manager at the Bank of China, which has several overseas stakeholders But it is still early days Much work remains to be done, not least in terms of convincing China’s swelling population of affluent but fiscally conservative consumers of the merits of switching paper for plastic

The Evolution Of The Chinese Payments Market

When the Bank of China issued the mainland’s first credit card in 1986, the event passed with little fanfare Just 36 venues scattered around Beijing accepted the card, and payments could be made only by way of China’s old Foreign Exchange Certificates, an abandoned form of convertible currency that Chinese citizens could not legally possess

How times have changed By the end of 2006, some 50m credit cards had been issued in China, including 30m dual-currency cards, and a further 19m ‘quasi-cards’ that combine the functions of debit and credit cards (see table: China’s card market

at a glance) Indeed, the number of credit cards in circulation at the end of 2006 represents a 39% year-on-year increase However, these figures are dwarfed by the scale

of China’s debit card market, which accounts for the majority of cards in circulation

First Data Beyond Cash: China’s Emerging Payments Market 09 First Data Beyond Cash: China’s Emerging Payments Market 08

China’s card market at a glance

Cards issued and transaction volume

Cards issued, Cards issued, RMB purchasing

2006 (m) total (m) volume transacted,

Source: China UnionPay, Xinhua.

The surge in credit card issuance illustrates the buzz across China’s consumer

lending market In recent years, activity across the sector, including auto and mortgage lending, has grown substantially, from just 6% of total bank lending in 2000 to 11% in

2005 , as China’s emerging middle class begins to demand better banking services This comes on the back of impressive economic growth, which is expected to continue GDP per capita, for example, is predicted to more than double from US$1,740 in 2006 to US$3,790 in 2010 (see table: Boom time in China)

Boom time in China

GDP growth from 2005 to 2010

2005 2006 (a) 2007 (a) 2008 (a) 2009 (a) 2010 (a) GDP (US$ bn, at current

market prices) 2,278 2,689 3,209 3,794 4,390 5,089 Real GDP growth (%) 10.4 10.7 10.2 9.3 8.6 8.1 Population (m) 1,307 1,314 1,323 1,331 1,336 1,342 GDP per capita (US$ at market

exchange rate) 1,740 2,050 2,430 2,850 3,280 3,790

(a) Economist Intelligence Unit estimates.

Source: Economist Intelligence Unit.

With strong prospects for growth and a population of more than 1 billion, China’s consumer banking sector has unsurprisingly drawn the attention of foreign banks They are attracted not only by China’s vast domestic market, but also (and in contrast

to other domestic consumer sectors) by the fact that the retail banking sector has been underserved for so long For example, even though banks in China issued more credit cards in 2006 than existed in the whole country as recently as 2004, the total number of credit cards in circulation, at about 50 million, at end-2006 pales in comparison

to the 640 million credit cards currently circulating in the US If banking services in China are eventually to emulate the structure now seen in the West, where most bank profits come from consumer lending, the current market can be seen as a near-vacuum

waiting to be filled—one of the last great land grabs in the Chinese economy

John Shelley, the executive vice president who directs the Royal Bank of Scotland’s recently-established private-banking partnership with the Bank of China, comments: “This

is not a short-term game, but it’s tremendously exciting, a huge opportunity for the banks that can focus and go about it in an organised way.” One report projects that China’s domestic credit market will grow from just US$2.8trn in 2004 to US$45trn by 2050

15.6

0 10 20 30 40 50 60 70 80 90 100

Access to a larger customer base Rapid growth of the Chinese middle class Our regional clients expect us to have a presence

in China Lending potential to Chinese companies Lending potential to foreign companies in China Lending potential in consumer-credit markets Distribution capabilities of large local banks Taking advantage of the historic WTO-related market opening

Lending potential in mortgage markets Other

First Data Beyond Cash: China’s Emerging Payments Market 10

Of the banks surveyed for this report, the majority (57%) are already active in China, while a further 43% plan to enter between now and 2010 For these banks

in general, access to a larger customer base and the rapid growth of the middle class are China’s key attractions For retail banks in particular, lending potential in the consumer-credit market is high on the list (24%), on a par with opportunities to lend to either Chinese companies or foreign companies in China—and far ahead of the mortgage market, selected by just 7% A significant minority (12%) also see the distribution capabilities of large local banks as a key attraction

Major attractions to market

What were/are the major attractions for your firm in deciding

to invest in China?

Retail bankers only

Opening Up The Market

New rules introduced in December 2006 under the terms of China’s 2001 accession to the WTO now allow foreign banks to incorporate locally and to create retail businesses Indeed, if foreign banks want to enter the credit card market they must incorporate locally

As this report was being written, an initial group of four banks had already received approval to incorporate locally, and a further eight were still completing official paperwork Several more had plans to incorporate in the near future (see Appendix for a full list) Although this first wave of entrants must still wait for final amendments to domestic regulations, and final approvals to allow them to operate branch systems, foreign banks can now effectively compete on an equal basis with local banks

First Data Insights

It’s A Long-term Play

84% Percent of respondents are optimistic about the prospects for credit cards in China

Foreign banks give long-term prospects of the credit card industry in China a strong vote of confidence, but recognise that it is a long term play Right now, credit cards are

a marginally profitable business for most issuers, with the programmes of some new entrants still loss-making

At present, the Chinese cards market depends heavily on fee income while interchange rates have already fallen to levels more common in highly developed credit card markets However, the mix of profitability in the Chinese cards industry may well change in the future This would happen if the Chinese government decided to relax its interest rate policy, allowing issuers much more leeway on the interest rate they charge for credit card lending.

The industry’s big problem is that so few cardholders currently revolve their balances This leaves the credit card industry in China without one of its major sources of revenue and profits The challenge for issuers in China

is to develop pricing and marketing strategies that can sustain profitability over the long term Banks in China need to realise that interest income is not the only revenue they should

be looking for Fee income is also important Payment products offering valuable sources

of fee income include:

– Prepaid cards (e.g top-up fees, balance checks)

– Commercial cards – as well as helping companies manage cash flow and expenses more effectively, commercial cards generate substantial fee income for issuers

– Charge cards (e.g issuing fees, late payment fees, etc)

– Money transfers – these account for up to 40% of fee income at some Central and East European banks

– Foreign exchange fees.

Partnership with a national bank

Partnership with a city commercial bank

Joint venture with a national bank

Strategic equity stake in a Chinese institution

Joint venture with a city commercial bank

Wholly-owned branch network

combine strategic equity stakes with organic growth

Overall, just one in ten banks plan to go it alone, primarily because the scale of the Chinese market makes it unfeasible for all but the largest banks “You cannot really work in China without a partner,” says BBVA’s Mr Galatas “For global banks that have been in China for years it is possible For the rest of us, we can do it by ourselves, but it is a very, very long-term strategy.”

Market entry strategy

In light of recent market-opening measures, what entry strategy would you

consider to be the most feasible for a foreign bank or cards issuer?

Local-foreign bank alliances have been in place since 2001, when HSBC made the first such investment in the Bank of Shanghai The increase in the number

of alliances is more recent, however In 2003, Citigroup purchased 4.6% of the Shanghai Pudong Development Bank, which was followed by HSBC’s 19.9%

stake in Shanghai-based Bank of Communications (BoComm) the following year Both investments were made with the specific goal of kick-starting co-branded credit card units in an environment where neither Chinese partner had significant card businesses before the alliances were formed The Citigroup unit launched

in early 2004 and has since expanded to ten cities The HSBC/BoComm credit card centre began operating in late 2004, and by March this year had issued

more than 2m dual-currency credit cards Both operations have placed emphasis

on developing sophisticated online banking capabilities, partly as a result of building their infrastructure from the ground up and partly to create distribution channels to compensate for their lack of extensive branch networks

Partnering for success

Equity tie-ups allow banks entering the market to generate instant economies

of scale by leveraging their partners’ existing distribution channels, client bases, and local business and political contacts According to a director at a French

bank currently looking for an investment partner, “China is huge and we are a modest European bank No modest European bank has ever managed organic-only growth in China You need to know the language, people and clients very well.”

Branch Networks Direct Selling Telemarketing Postal Campaigns E-mail Campaigns Internet

Highly Effective Limited Effectiveness Moderately Effective Don’t Know

First Data Beyond Cash: China’s Emerging Payments Market 12

Survey respondents also acknowledge the importance of branch networks when it comes to marketing and distributing payment cards Nine out of ten retail bankers polled for the report rated branch networks as either ‘highly’ or ‘moderately’ effective, with direct selling the only other channel that was positively rated, by 80% of respondents Alternative channels, including the Internet, e-mail, postal campaigns and telemarketing, were rated

as effective by less than half of bankers

us enhance our own credit risk control capabilities.”

Needless to say, partnering with local firms is not without its challenges—and risks

One concern is simply the number of available partners, which is steadily declining

as more foreign banks enter the market Another is that deals can take a long time

to conclude According to Gerard Van Empel, director of development at Holland’s Rabobank, which finalised a 10% investment in Hangzhou Rural Cooperative Bank last November, the deal took several years to complete Others warn about having

to deal with much bureaucracy, especially within larger banks

But those banks that have concluded successful deals with local Chinese banks have been encouraged by progress so far “There’s a real desire and willingness to take on new ideas,” comments RBS’s Mr Shelley “We have long debates about individual points, and reaching a decision on something sometimes takes a long time, but once a decision

is made I’ve been very impressed with the speed with which they execute.”

To Partner Or Not To Partner

Although a very attractive market for foreign banks, there is no clearly favoured market entry strategy

The message is clear – most respondents say that the main attraction of the Chinese market for them is access to the country’s huge customer base Far less obvious from the survey is a clear preference among foreign banks for a specific route to market entry Almost all first and second-tier banks are now

in strategic alliances with foreign partners Credit cards are often the first product on which both partners work together, but an increasing number of foreign banks are now preparing to launch their own credit cards in China There are three ways that banks usually enter the China market: (1) direct investment

in a bank; (2) partnership with a bank; (3) being a wholly owned foreign entity (WOFE) that conducts business by themselves As

“all roads lead to Rome”, all three ways can provide a bank a start to its business in China Both central and local governments are very supportive of both partnerships and

of WOFEs establishing operations in China Our experience of entering into the China market is initially-go-alone First Data has had success in bringing international expertise into the China payment market After five years of being in the market, we are also looking into establishing partnerships in different areas of electronic payments business

First Data Insights

The Potential Opportunity

For those banks that have made the decision to enter the Chinese market, there is much optimism Nearly nine out of ten banks (87%) polled for this report say they are optimistic about their firm’s revenue growth in China between now and 2010 But this optimism is tempered with realism, with about twice as many (59%) respondents saying they are ‘somewhat’ optimistic, rather than ‘highly’ optimistic (29%)

Profit/revenue prospects

How optimistic are you about your firm’s revenue and profit growth prospects

in China over the next three years?

This uncertainty is especially true when it comes to generating profits Although two-thirds

of bankers say they are optimistic about their profit growth prospects in China over the next three years, just 21% say they are ‘highly’ optimistic and nearly half (46%) say they are ‘somewhat’ optimistic

The main reason is competition China’s banks have made remarkable operational advances in the five years they have had to prepare for market opening, and they retain one major advantage: a huge branch network that dwarfs that of the foreign banks Indeed, the first four foreign banks to obtain licences now have just over

100 branches between them By contrast, the Industrial and Commercial Bank of China (ICBC) has 18,000 branches, the Bank of China (BOC) has 11,000, and the Agricultural Bank of China (ABC) has nearly 25,000 All of China’s ‘big four’ banks (ICBC, BOC, ABC and China Construction Bank) now have foreign stakeholders, which will gain access to this branch network The banks’ grassroots reach, together with the depth of their existing client bases, virtually guarantees that local players will remain in the driving seat for the foreseeable future

For many foreign banks, credit cards are the main priority, providing a self-contained

business line that allows them to build brand, gain experience and establish a beachhead to the high-medium end of the market Retail bankers are most optimistic about both credit cards and bank accounts, with 55% saying that the prospects for these products are ‘highly promising’ over the next three years Debit cards areseen as the next most promising item (45%), although these are directly linked

to the prospects for basic bank accounts, followed by wealth and investment management (40%) Indeed, there are overwhelmingly positive views of the

prospects of every field across the consumer banking sector

Bank accounts Debit cards Credit cards Co-branded cards Prepaid cards Mortgages Personal loans Financial planning/wealth management Personal investment services Vehicle financing

Highly Promising Limited Prospects Somewhat Optimistic Don’t Know

0 10 20 30 40 50 60 70 80 90 100

Risk management Product development Distribution Marketing Customer relationship management Ability to derive income from service fees

Ability to derive income from penalty charged

First Data Beyond Cash: China’s Emerging Payments Market 14

Prospects for products

How do you view the prospects for China’s personal banking industry?

Retail bankers only

Nevertheless, when it comes to profits in the credit card market, the outlook is less certain Fully 43% of respondents agree that it would be difficult to make a profit in the credit card market over the next three years; 36% remain uncertain and just 21% disagree

Holding an edge

Foreign banks believe they hold a significant competitive edge over their local rivals

This is especially true when it comes to risk management and product development, where 39% and 36% of retail bankers respectively rate the capabilities of domestic Chinese banks as ‘poor’ or ‘very poor’ On most measures, the majority of survey respondents rate local banks as ‘fair’ However, when it comes to distribution, one-third

of retail bankers rate their local rivals as ‘good’ or ‘very good’, higher than any other capability, given the substantial advantage of domestic Chinese banks in this area

Rate local banks

In your view, how good are the current capabilities of domestic banks in China, with regards to the following aspects of consumer lending?

Retail bankers only

Finding Ways to Reach Out

Branch networks are effective distribution channels for payment cards – the internet and direct selling are also well regarded

The opportunity to market and distribute payment cards to 1.3 billion consumers expected to have per capita income of

$5,000 in the next 10 years is a major attraction for local and foreign banks Reaching many of these potential customers will be a challenge Given the huge branch networks of China’s largest banks, it is not surprising that 87% of survey respondents see branches as either highly or moderately effective distribution channels

However, this advantage could be leveraged far more effectively Up to now most bank branches have been run as autonomous units or even separate businesses Centralising and analysing the data in each branch could provide a ready-made credit card target segment for institutions of all sizes This would enable banks to segment their customer base, develop product propositions and cross-sell card products

to existing retail banking customers

Branches are not the only distribution channel for card products China has the second largest number of Internet users in the world.

Offering financial services by mobile phone

is another viable option, which would enable banks to get around the absence of – and the cost of building - nationwide branch networks This would be especially valuable in provincial areas, where mobile phones are widely used Also, interesting distribution partnership models are developing in other markets that may be relevant to China Some banks are now partnering to share expertise For example, one bank could manufacture a card product for distribution by a partner organisation This happenes in Europe where Barclaycard manufactures revolving credit card products for distribution through Swedbank branches in the Nordic countries As the trend for banks to

do everything from manufacturing, distribution and processing themselves becomes less prevalent, this model will gain ground and could

be of major interest to foreign banks looking to partner with local Chinese banks

(continued on next page)

First Data Insights

0 10 20 30 40 50 60 70 80 90 100

Bank accounts Debit cards Credit cards Co-branded cards Prepaid cards Mortgages Personal loans Financial planning/Wealth management Personal investments services Vehicle financing

Credit/debit card merchant acquiring

Already offering Plan to start offering within 3 years

No immediate plans to offer

Operating A Cards Business In China

Eight out of ten retail banks surveyed for this report either already offer basic bank accounts or plan to start doing so within the next three years Beyond that, about three out of five either offer or plan to offer debit cards, with about two-thirds either already offering or planning to offer personal loans and credit cards These account for the dominant products being offered by retail banks, with mortgages, wealth management services and other retail banking services all trailing behind

Dominant product offerings

Which of the following is your firm offering in China, or planning to start offering within the next three years?

Retail bankers only

All banks entering the cards business will need to deal with one key player:

China UnionPay, or CUP, the Chinese equivalent of Visa or MasterCard Any renminbi-denominated card issued in China, whether a debit or credit card, carries the CUP brand Since its inception in 2002, CUP also operates the key payments network in China, providing an inter-bank and inter-country card network, which enables interoperability between different banks and cards In this aspect of its business, however, there is no competition in China, as CUP currently operates

as a monopoly “There is only one network, period,” explains an executive from an international card issuing company

First Data Insights

It should be noted that Chinese banks have

not used direct mail to market cards However,

several issuers have started to use lists bought

from list brokers Also, Chinese banks are

using specialist service providers who do card

acquisition to recruit new customers

Finally, other possible distribution channels

include non-bank partners, such as retailers

and mobile phone providers This would enable

banks to reach a much wider customer base.

First Data Beyond Cash: China’s Emerging Payments Market 16

ATMs were introduced in China 20 years ago, but they only became truly convenient in 2002 when CUP was set up and established a network that linked them all together The CUP network facilitates any inter-bank card transaction made through an ATM or within a retail outlet The only exception is for travellers in China carrying a card issued outside of China, which is then processed through the relevant card company’s international network

Rival international card brands, such as Visa and MasterCard, can only issue cards

in China (via their member banks) that are denominated in another currency, such

as the dollar, euro or yen Alternatively, their member banks can issue a single card that is dual-currency, including both a renminbi-denominated account and

a foreign-currency-denominated account, in conjunction with CUP, so that the card bears both brands All this makes CUP the dominant player in the overall Chinese card market In 2006, its member banks issued 144m new bank cards, accounting for about 68% of the total for the year In credit cards, however, Visa and MasterCard are leaders, in terms of the number of cards issued, although CUP

is working to catch up By the end of 2006, there were some 3m “UnionPay” credit cards, a ten-fold increase on the previous year

The implication for banks setting up in China and wanting to issue denominated cards is that they can only issue CUP-branded cards, unless they wish to provide foreign-currency-based cards In addition, all transactions conducted with any renminbi-based card, whether CUP-branded or dual-branded, will be conducted through CUP’s network

renminbi-For its part, CUP is working to expand acceptance of its cards in the international market By the end of 2006, it had concluded deals in 24 countries, providing acceptance for Chinese tourists or business travellers carrying a CUP card within some 55,000 merchants and more than 235,000 ATMs As might be expected, transactions from CUP-branded cards have soared: in 2006, some Rmb25.5bn (US$3.3bn) was transacted on these cards in markets outside of China, a 99% increase on 2005, according to CUP

Payment fees and incentive structures

One of the realities for banks issuing cards in China is the low fees that are set by the central bank, the People’s Bank of China (PBC) The maximum interest rate for card borrowing is set at a relatively modest 18.25% annually By comparison, international practice commonly charges several hundred basis points more for less-creditworthy customers or different types of loans such as cash advances Government rules also stipulate what merchant acquirers can charge merchants

In most countries, the biggest component of this fee (known as the interchange rate and paid by the merchant acquirers to the card issuers) is dictated by market forces In China, however, maximum interchange rates for all local-currency transactions are set by the PBC While these rates vary slightly depending on what type of product or service is being purchased (see table: Slim margins), they generate inefficiencies, according to an executive with a major foreign card company, because they do not reflect the actual cost to the issuer For example, merchants are charged the same rate for debit card and credit card purchases, despite the fact that respective transaction costs differ Nor do Chinese interchange rates reflect varying risks that different types of transactions may represent

Slim margins

China’s interchange rates set by PBC

Merchant type Issuer interchange China UnionPay

reimbursement fee service fee Public hospital and public school 0 0

Supermarket, airline, tour operator, gas station 0.35% 0.05%

Other retailers (department stores, etc) 0.70% 0.10%

Hotel, restaurant, entertainment, jewellery 1.40% 0.20%

Source: PBC.

Chinese interchange rates are not only already lower than international norms

(which are currently about 0.7–0.8% per transaction, compared with an international average of 1-1.6%), but competition between local banks is increasing the pressure

to reduce these rates further

Banks setting up a cards business in China will also struggle to attract customers Strong competition in the market means that few banks can charge cardholders

annual fees Indeed, most have taken to offering special promotions to draw new customers Some banks use this to try to boost card usage, by offering to waive card fees as long as customers use their cards a certain number of times per year

In other examples of margin-cutting incentives, Standard Chartered, offers gold bowls to customers opening fixed deposit accounts with at least Rmb80,000

(about US$10,000) Meanwhile, London-based HSBC and its Chinese partner,

BoComm, launched a campaign in 2006 offering credit card clients interest-free installment payments on purchases of Rmb1,500 or more (US$195) Customers pay

a monthly service charge of up to 0.72%, but are exempted from the annual 18.25% interest charge as long as they pay their monthly installments Such price wars are widespread in Chinese consumer markets and commonly lead to long periods of losses for participants “Chinese customers in general are savvy and are looking for interest-free, fee-free debt, and less for revolving debt,” explains one executive at

a major European bank

Another group of customers that requires incentives (typically through discounted rates) is the retail community Three out of four retail bankers surveyed for this report agree that card issuers will have to offer strong incentives to merchants to encourage the adoption of payment cards within their businesses

Card processing

A key barrier to growth in the market selected by bankers was China’s underdeveloped

or immature back-end banking infrastructure, such as payment processing In taking this on, many executives try to meet the challenge by handling the job in-house Just 5% of retail banks polled say they have outsourced their card processing in China so far, although a further 17% expect to do so Nearly one-third say they will not outsource, and about the same proportion do not know

For some, card processing is a core capability: “We think that card processing is

an area where we have strategic expertise,” says one survey respondent But for others where this isn’t the case, the outsourcing of card processing makes sense

As another respondent points out, “The initial set up cost [for outsourcing] is high without a medium-sized customer base.”