Development finance in China

In this three-volume series, the project research team set up jointly by the China Development Bank and Renmin University of China examines the theoretical framework and implementation p

constraint in its market system and infrastructure In recent years, the China Development Bank has explored a road of development finance, featuring Chinese characteristics that unite government goals and market mechanism In this three-volume series, the project research team set up jointly by the China Development Bank and Renmin University of China examines the theoretical framework and implementation process, typical cases and innovation in bond market of development finance in China.

Vol 1 Development Finance in China: Theory and

Implementation

Vol 2 Development Finance in China: Case Studies

Vol 3 Development Finance in China: Bond Market Innovation

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Foreword by Chen Yuan vii

Part I The Realistic Environment

and Long-term Financing Plight

1 How Was China’s Long-term Financing Plight Formed 5

2 The Problem of the Existing Financial System 33

Part II The Successful Practice of

Development Finance in China

4 The Formation and Development of China’s

5 The Operating Mechanism of Development

6 China’s Development Finance Model: Micro Cases 159

Part III Theoretical Connotations of

Development Finance

7 Development Finance and Market Formation

8 Development Finance and Social Capital Formation 251

9 New Developments in Financial Development Theories 269

Part IV International Comparison of Policy Finance

12 International Development Financial Institutions 379

13 Policy Financial Mode: International Comparison and Trends 419

At the turn of the century, the financial industry of China is faced with two major issues One is that the Asian financial crisis in 1997 raised a series of questions which need in-depth consideration; The other one is that China undertook to realize all-round opening up to the outside world after five years when it successfully joined the World Trade Organization (WTO) in

2001 Accordingly, we need to decide which path we will take and what countermeasures are needed to enable the financial industry of China to successfully deal with severe challenges and to fully seize this historic opportunity

There are two choices for the financial industry of China One is to copy the complete set of practices of Western countries in financial industry management After all, they have one or two hundred years of history and technology and their financial strength is strong From London to Wall Street, there are countless financial stories The other one is to adopt the measure of introduction, digestion, absorption and re-innovation and to find a feasible way to enhance the finance of China and support sustainable development of China’s economy by constantly “looking into the mirror” in accordance with China’s national conditions and need of reform and development In practice, the China Development Bank (CDB) has chosen the latter

We effectively combine the government’s organization and coordination advantages with the financing advantages of the CDB First, we successfully solved the difficult problem of low quality of the assets, accumulating a set of new methods of asset management with Chinese characteristics; and then we proposed the high target of building an “international first-class bank” from the perspective of the overall situation and world foresight, laying a solid foundation for successful restructuring from a policy bank into a development financial institution Subsequently, through “three credit reforms,” we have established an effective operating model for a development financial institution; in the difficult search for innovative development finance, we reformed and developed a complete set of rules, regulations and methods for China’s long-term financing market with the consensus and resultant force for building the market The development financial theories we have summed

up through practice are theories based on national conditions, which have absorbed advanced principles of financial operations and are committed to the sustainable development of financial theory They come from practice and are

used in practice to be tested in China’s economic development They may be extended to reform and development of other industries to achieve success from the reform and development of the financial industry In other words, they are China’s own theory.

Here, I would like to express my gratitude to the leaders and scholars from Renmin University of China Through their efforts Development Finance

in China: Theory and Implementation, which systematically describes the successful development of China’s finance in the new period, has been completed I would like to thank all the friends at home and abroad whose concern and support have helped the growth and development of China’s development finance Although it is hard to include a great amount of the practice of thousands of employees from the CDB in Development Finance in China: Theory and Implementation with all efforts from different parties, it is an attempt to generalize and summarize the practice of development finance and another historical innovation in China’s economic and financial education

I sincerely look forward to the fact that this book can provide the vast number of young scholars and the younger generation, who are going to be backbone of China’s financial industry for the next ten years, twenty years or longer, with knowledge and strength I sincerely look forward to the fact that China’s financial industry and our great motherland will be made stronger and more prosperous by the efforts of one generation after another

Chen Yuan President of theChina Development Bank

In over 20 years, and especially in the last more than 10 years since reform and opening up began, modern financial theory has been gradually introduced

to China It has undoubtedly broadened the Chinese people’s horizons when viewing financial problems, and enhanced and enriched the people’s perspectives on and capacities for formulating and screening financial policies and their performances, thus promoting the reform and development process of China’s financial industry However, at the same time, people have gradually begun to wonder: the stories of successful financial cases in the Western developed countries can be found in various documents, but why can

we find very few successful financial stories with our local brands? For a big country with more than one billion people, which has successfully resolved the problem of food and clothing, maintained a rapid and smooth development of the economy and created the Chinese economic miracle attracting the world’s attention under the leadership of the Communist Party of China, there must be financial stories worth exploring and summarizing

In August 2004, the topic-based group on “Study of China’s Development Financial Theory System” consisting of the China Development Bank (CDB) and Renmin University of China was formally established It has carried out

a systematic study centering on the successful practice of the CDB since 1994, particularly since 1998, and began to tell China’s own “genuine” stories of financial changes

The group systematically researched and studied a series of expositions, articles, news reports and other materials on financial development theories and development finance Under the instruction of Mr Chen Yuan, President of the CDB himself, the thematic framework and basic theoretical system of the topic study were established

The group carefully read and studied a series of documents and materials

on the Chinese economy, financial reform and development, and read a large number of documents, materials, summaries and outlines of the CDB since its establishment in 1994, especially since Mr Chen Yuan presided over the work

of the CDB and personally designed and led the reform and development of the bank in 1998 It selectively went to the grass-roots to carry out thorough and painstaking research and investigation, extensively contacted and communicated with the participants and witnesses of development finance and made great efforts to obtain first-hand information on the development financial

practice, experiencing very rich and vivid cases, facts and voices of this reform

in person

The group directly organized or participated in a number of international and domestic theory symposiums and forums on development finance, and conducted extensive exchanges on the successful practice of the CDB with experts and scholars from economic and financial theory circles, gaining knowledge and understanding of the theoretical and practical significance

of development finance in China’s successful practice from many different perspectives McKinnon, a famous economist, founder of financial development theory and professor of Stanford University spoke highly of the successful practice of the CDB He said that “after communicating with the CDB, I changed

my original ideas, which originated from my past observation on failures of state development banks in other countries”; “The CDB is building a carefully designed mechanism: promoting many enterprises and local governments to cooperate with central government and ensuring repayment of loans with a strong moral code and pressure of the law.”

The group gave a trial lecture on the periodical results of development finance study in classes at Renmin University of China The young students, who have a keen expectation for China’s economy, financial reform and development, had an enthusiastic response to the successful practice achieved

by the CDB They understood and experienced the true meaning of the ideological “relentless pursuit of truth” from the theoretical connotation of development finance and classic cases of China’s development finance, and were delighted by the transformation from hesitation and confusion in Western economics to better times, and then by China’s stories

After reading, studying, correcting, exchanging and amending several times

in one year, An Outline of Development Finance, which has been listed in Project 985, a project of key disciplinary construction of Ministry of Education

of the People’s Republic of China, is now published This book discusses the theoretical connotations and practical significance of development finance in the successful development of China at the turn of the century Part I, “The Realistic Environment and Long-term Financing Plight,” mainly states the background to the emergence, development and successful achievements of development finance in China Part II, “The Successful Practice of Development Finance in China,” mainly discusses the operation mechanism and management models of China’s development finance Part III, “Theoretical Connotations

of Development Finance,” mainly discusses the contribution of the successful practice of China’s development finance to theories of financial development

in the new period Part IV, “International Comparisons of Policy Finance,”

puts forward new patterns and paths of sustainable development for based finance after studying European, American, Asian and international development financial models and conducting a comparative analysis with the CDB.

policy-Practice is the basis of theory and theories are constantly advanced and developed on the basis of practice Therefore it can be said that this book is a theoretical summary and exploration of the past successful practice of China’s development finance It will be constantly developed and advanced in the future exploration of financial theory with richer and higher-level development finance practice

The directors of the steering committee of the Research Team on the Development Finance in China are Chen Yuan, Secretary of the Party Committee and President of the CDB, Ji Baocheng, President of Renmin University of China and Huang Da, Honorary President of the China Society for Finance and Banking, and its deputy directors are Liu Kegu, Vice President of the CDB and Feng Huiling, Vice President of Renmin University of China

The group leaders are Chen Yulu, Vice President of Renmin University of China and Dean of the School of Finance, Renmin University of China and Liu Dawei, Chief Accountant of the CDB Its members include Professor Zhang Jie, Professors Qu Qiang, Zhuang Yumin and Wang Tao from the School of Finance, Renmin University of China, Chen Min, Director of the Policy Research Department of the CDB and Liang Song, Deputy Director of the Policy Research Department of the CDB, and the associated personnel include Cui Xiaofeng, Dong Zhongbin, Liu Xiaolu, Wei Shanwei, and Yu Hongda etc

The experts and scholars who have taken part in the discussions include Wang Dayong, Executive Vice Deputy Director of the expert committee of the CDB and Professor Guo Qingwang, Professor Li Zhenya Professor He Ping, Associate Professor Pang Hong, Associate Professor Gong Minghua, Associate Professor Li Shiyin, Associate Professor Song Wei and Dr Wang Fang from Renmin University of China

The authors of Part I are Zhang Jie and Liang Jian, the authors of Part II are Liu Dawei, Yu Hongda Ma Yong and Wang Lei, the authors of Part III are Qu Qiang, Zhou Yihai and Wang Lei and the authors of Part IV are Chen Yulu, Ma Yong and Wei Shanwei

As this book is presented to readers, we would like to express our sincere gratitude to the relevant government departments, to experts and scholars from research academies and institutes as well as to enterprises and institutions that have warmly supported and helped the study of this topic

Due to pressure of time and for many subjective and objective reasons, this book will have some shortcomings We hope that readers will make comment or criticism.

Research Team on the Development Finance in China of the China Development Bank and Renmin University of China

The Realistic

Environment and term Financing Plight

Long-has made great achievements, we must clearly understand that China is still

a developing country in transition from the planned economy to a market economy, and the market operation mechanism and various systems supporting market operation need constant construction and improvement Especially in the face of the basic national conditions of a large population, fewer resources, and unbalanced regional economic development, the “bottleneck” problem which constrains economic and social development is very serious and structural contradictions and institutional defects are quite prominent

Specifically, on the one hand, China’s economic structure is irrational and seriously unbalanced In general, under an irrational industrial structure, the industrial structure and employment structure are distorted, the proportion

of added value of tertiary industry is too low while the proportion of primary industry is too high, and the “three rural issues” urgently need to be addressed Regional development is unbalanced and the development of the central and western regions lags far behind that of the eastern region The difference in income distribution among members of the society is constantly widening The structure of a country’s economic development is an important indicator of its level of development Economic development itself is the process of the constant optimization and upgrading of structure Imbalance in economic structure has become a bottleneck restricting China’s sustained and rapid development Since

2004, the contradictions of shortages of coal, electricity, petroleum etc in China have become increasingly prominent and constraints of important resources

on the economy have been constantly enhanced Such a situation is a specific reflection and direct consequence of imbalanced economic development, blind industry investment and low-level duplicate construction

On the other hand, the corporate governance structure is not sound, social credit is deficient and supervision is insufficient; in the finance field, the burden

of non-performing assets of banks is heavy and the quality of listed companies

is not high, the stock market fluctuates violently, and speculative and term actions and the like seriously affect the stability of our financial system

short-As a whole, the underlying reason for these phenomena is the backwardness

of the market and the defects of the systems Backwardness of the market makes it difficult for the market mechanism to effectively play a regulatory role, and the system defects mean that macro-control lacks the foundation of policy implementation and effective control measures The final result is that it

indicator for judging whether a country’s economy is efficient and of sustainable development is to see whether the development of its economy is in harmony with its financial system and methods of financing For this reason, whether

a sound and efficient financial system can be built is the key to whether a country’s economy can be developed steadily It needs to be remembered that in the current stage of development of our country’s market economy, resolution

of the bottleneck issue restricting China’s economic development cannot simply rely on self-regulation of the market The formation of the Western developed market economy system has gone through a long process, and paid a large cost for the system changes Obviously, China can no longer follow the old road of the spontaneous evolution of the Western countries because we do not have time for free evolution and re-development of the market mechanism

or the money to bear the cost of huge natural evolution either Our country should make full use of the advantages of later development and actively cultivate the market consciously to constantly build and improve the system and achieve leapfrog development It is a long-term and difficult task In fact, from a financial perspective, the essence of the above issue is that the financial mechanism does not give full play to the basic role of resource regulation and economic and social development cannot obtain financial support Therefore, to seek a new financial framework suitable for economic development is not only the internal requirement to resolve the bottleneck in economic development, but also an important foundation for maintaining the long-term sustainable development of China’s future economy

This Part tries to illustrate the realistic environment for China’s reform and development and reveal the formation mechanism and basic content of the long-term financing plight Chapter 1 discusses the source of the formation

of China’s long-term financing plight Chapter 2 explains the reason why the existing financial system is helpless in coping with the long-term financing plight Chapter 3 tries to discuss financial options to escape the long-term financing plight

Chapter

How Was China’s

Long-term Financing Plight Formed

The sustained and steady development of any country’s economy is inseparable from support from long-term funding China is no exception In a big country like China, which is in transition from a planned economy to a market economy, the resolution of all kinds of contradictions is inseparable from the rapid development of economy Therefore the demands for long-term funds are particularly urgent This chapter mainly analyzes the formation process of the long-term financing plight from the historical evolution perspective of China’s financing system The three-element overlapping structure formed in China’s financing system means that there is a “vicious circle” of mutual penetration and transfer of risks among finance, banks and the capital market The long-term financing plight means that the long-term funds needed for economic development cannot be found, resulting in a “short-board effect” in our country’s long-term financing at present As a result, this finally damages the sustained and steady growth of the economy.

The Historical Evolution of the Three-element

of the social, economic and industrial structure, playing a crucial role in the formation of long-term capital The traditional function of the treasury and finance is to allocate social funds, and together they constitute the financing mechanism for economic development Due to interaction between and the mutual influence of their respective institutional environments, policy choices, and the institutional arrangements of the treasury and finance, there is complex funds permeability and high policy relevance In the economic transition led

by our government, the treasury and finance systems provide funding support, especially long-term funding support, for sustainable economic growth From the history of the reform of the treasury and finance we can see the true picture

of the evolution of our country’s financing system and the formation process

of long-term capital From the perspective of the evolution of the fiscal and financial systems since the reform, generally speaking the historical evolution

of China’s financing system has roughly gone through three stages

The Period before 1984

China’s financing system in the planned economy period was a financing system with the treasury as the main body, established in the early 1950s At the time, as a very rare economic resource, funds were always kept centrally in the distribution process by the country Through low wages, the price scissor difference between industrial and agricultural products, and other means, the state implemented compulsory savings of a part of the due income of urban and rural residents and gathered these together in the form of state-owned enterprises’ profits turned over to state financial savings and profits turned over

in the form of state finance, and then allocated funds to various industries and fields that needed investment, forming the “unified revenue and expenditure system” of the state-owned enterprises That is to say that all revenues were turned over to state finance, investment activities were formulated by government plans, and investment subjects were appropriated in full amount

by the government In this system, the government was both the largest saving subject and the largest investment subject In income distribution, the financial revenue accounted for a higher proportion in national income and the treasury played a leading role in the transition from savings to investment According

to statistics, 84% of infrastructure investment by enterprises at this stage came from the funds within budget of the state and the means of free appropriation

in full amount by the government were mainly adopted (as shown in Table 1.1)

Table 1.1 Proportion of Various Funding Sources in the Total Investment

of the State for Infrastructure (%)

10.7

The 2nd Five-Year Plan 78.3

21.7

The 4th Five-Year Plan 82.5

17.5

1963–1965 88.1

11.9

The 5th Five-Year Plan 77.2

22.8 Source: Liu and Wang 2002.

Since savings and investment had the same subject, there was no fund circulation problem between the surplus sector and the deficit sector Before

1984, the main funding source was mainly state finance and the banks only provided a small percentage of the fixed flow capital or the super-quota flow capital The banks’ credit supply system had almost no influence on the scale

of an enterprise’s financing and its financing decision-making During this period, the banks were not intermediaries for financial circulation but mainly assumed the function of a finance cashier The resource allocation system with the treasury as the main body is reflected by the share of the treasury in China’s state economic and investment capital from 1972 to 1983 (as shown in Fig 1.1) In new capital for production and investment, the highest share of fiscal investment from 1972 to 1983 was 92.3%, and the average was 71.5% over 12 years In this part of the funds, the fixed capital investment used in production and investment by state finance was 100% from 1972 to 1978 After the reform,

in the flow capital used in production and investment, the proportion of state finance gradually declined and the proportion of bank finance gradually increased, from 42.5% in 1972 to 96.4% in 1983

Proportion of fixed capital Proportion of flow capital

The Period from 1984 to 1993

This stage was a stage in which the planned economy of China was gradually transformed into a market economy system The economic reform launched in

1979 brought a profound change to the national income distribution pattern

of our country Its outstanding point was that the national income distribution gradually tilted toward the individual, the share of individual savings increased sharply, and the proportion of government revenue in national income continued to decline (as shown in Fig 1.2) In this situation, it was difficult for the state to relying only on fiscal funds to support economic growth In

1985 China adopted “government appropriations being replaced by loans,” which changed the “finance-based” financing system to the “bank-based” debt financing system

However, the rigid reliance of the state-owned enterprises on fiscal capital exacerbated problems with bank credit funds The banks not only provided state-owned enterprises with most of their liquidity but also the share of fixed capital for production and investment provided by banks to state-owned

Financial revenue Individual savings

Source: Based on the data from China Statistical Yearbook (1979–2005).

enterprises constantly increased The state-owned banking system ensured

a smooth transformation of financing from surplus sector — residents to deficit sector — residents Meanwhile, the government continued to hold the power over allocation of funds through a high degree of control over the four state-owned specialized banks The scope of use of credit funds was further expanded and permeated all fields of economic activity, and a lot of funds were used for fiscal expenditure At this stage, the supply relationship between fiscal and financial funds was further transposed, increasing the pressure on the banks’ fund supply and causing deformation of use of funds The resource allocation system with banks as the main body is reflected in the share of the state-owned banks in the production and investment capital of the state-owned economy from 1984 to 1993 As shown in Fig 1.3, the banks took up the highest proportion in liquidities of production and investment, and the proportion of fixed capital investment also constantly increased from 27% in 1984 to 48.5%

in 1993 In all funds for production and investment, the banks’ share increased from 46.3% in 1983 to 78.3% in 1993

Proportion of banks in the

fixed capital Proportion of banks in the liquidities

Fig 1.3 The Change in Banks’ Share in the Production and Investment

Capital of the State-owned Economy (1984–1993)

The Period from 1994 to Present

The three-element overlapping structure of the financing system was gradually formed with the market-oriented reform of China’s economic system In 1992, Comrade Deng Xiaoping’s speech on his inspection tour to the South laid down

a political theory foundation for the socialist market economy; the 14th Congress

of the Communist Party of China definitively set the establishment of a socialist market economic system as a target model for China’s economic reform; the 3rd Plenary Section of the 14th CPC Central Committee fully and systematically expounded the basic framework and strategic plan for establishing a socialist market economic system; the 15th Congress of the Communist Party of China further defined that building the socialist economy was to develop a market economy under socialist condition Proposals of such socialist market economic theories created the conditions for resolving the deep-seated contradictions that had existed in the investment and financing system for a long time Since then, the market-oriented reform of the investment and financing system of our country has entered a new stage of development In the investment field, with advancement of the market-oriented reform, the investment pattern with coexistence of multiple-element investors began to form and different investment subjects chose different investment fields in accordance with different economic benefits, social benefits and the market demand of projects Generally speaking, the competitive projects with a higher return on investment and more flexible market regulation mainly take enterprises as fundamental investors; infrastructure, basic industries and other projects with a long construction period, large-scale investment and long payback period, which bear upon the national economy and the people’s livelihood, belong to the policy investment; projects of public welfare investment are the government direct responsibility

In order to fit the above investment system reform, an in-depth oriented reform was also conducted in China’s financial system In the case of the fiscal system, it was mainly implemented as reform of the tax distribution system, which separated the regular budget from the construction budget, implemented double-entry budget management, made clear the market position of state-owned enterprises, and broke the pattern whereby they were affiliated to the administrative organs and under the direct management of the administrative organs In the case of the financial system, it was mainly the commercialization reform of the state-owned banks, which realized separation

market-of policy financial and commercial finance, organized and established three policy banks including the CDB and established the central policy financing

system The capital market, especially the establishment and development of the securities market, created the conditions for enterprises to raise funds and engage in capital management activities through direct financing channels Regarding the relationship between finance and banks, the Budget Law in 1994 and the Law of the People’s Republic of China on the People’s Bank of China initially defined the relationship between finance and the central bank, and specified the boundary of fund transfer between them.

Diversification of investment subjects demands diversification of financing channels In the competitive fields with enterprises as the principal investors, funds for investment projects came mainly from indirect financing from the commercial banks and direct financing from the capital markets; in infrastructure, basic industries and other fields with a long construction period and large-scale investment, which bear upon the national economy and the people’s livelihood, the investments for projects were mainly made by the government’s concentration of the necessary financial and material resources through economic entities (such as large state-owned enterprise groups) and extensive encouragement of localities and enterprises to participate in the project investment, and the funds mainly came from finance, banks and the capital markets; the funds for public welfare came mainly from budget funds Thus in the financing of infrastructure, basic industries and other fields which bear upon the national economy and the people’s livelihood in our country, the

“three-element overlapping financial structure” appeared, as shown in Fig 1.4

In Fig 1.4, there is a common area between finance, banks and the capital markets, which is the dashed area in the figure It means that in the government-led process of economic transition, infrastructure, basic industries and other investment fields which bear upon the national economy and the people’s livelihood need both fiscal and financial market to circulate the necessary funds for these projects Due to specificity of projects in these areas, it is hard

to meet the demand of sustained and steady development of the economy for funds during the transition process of China’s system by simply relying on a single financing channel Moreover, in this three-element overlapping structure

of financing, the funds raised from different sources are basically long-term funds The three-element overlapping structure of the financing is a special institutional arrangement for the transition period of China’s economy

Indirect Financing and Long-term Financing

Financing Plight of State-owned Commercial Banks

Owing to the government’s control over finance, the state-owned banks are government offices rather than enterprises Accordingly they are able

to separate the function of financial intermediation and the function of public administration The financial intermediation function emphasizes

“competitiveness” and “profitability”; whereas the public administration function emphasizes “publicity” and “sociality.” The results are often that the latter replaces the former and even that the former is sacrificed for the sake of the latter The state-owned banks do not determine fund release in accordance with funds supply and demand in the market and the benefits of the banks

On the contrary, they determine fund release in accordance with the needs of economic growth speed, structural balance, reform of state-owned enterprises and even social stability and unity Even after the establishment of the three policy banks, the state-owned banks still undertake a lot of policy-related businesses According to survey statistics of the People’s Bank of China, by the end of 1997 non-performing loans of the four major state-owned banks caused

by policy factors accounted for about 53.7% of non-performing loans in the same period The state-owned banks actually bore the cost of the gradual transition

of China’s economic system reform Many state-owned enterprises not only occupied credit funds of state-owned bank for a long time, but also made use of merger, division, acquisition of quality assets, false bankruptcy or other forms

of restructuring to achieve their goals of escaping, abolishing or suspending

Fig 1.4 Three-element Overlapping Structure of China’s Financing System

Capital

Fiscal

debts By 2000, 62,656 enterprises had opened accounts for restructuring in the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, the China Construction Bank and the Bank of Communications Among them, 32,140 enterprises escaped and abolished debts and the principal and interest of the loans that they escaped and abolished amounted to RMB 185.1 billion, accounting for 32.31% of the principal and interest of restructured enterprises Among the enterprises that escaped and abolished debts there were 22,296 state-owned enterprises, accounting for 69.37% of the total The principal and interest escaped and abolished by state-owned enterprises amounted to RMB 127.3 billion, accounting for 68.77%.1

Such a huge cost of reform is excessively borne by the state-owned commercial banks, resulting in a series of issues in the state-owned banking system of our country These issues are prominently shown in two interrelated aspects: firstly, the low capital adequacy ratio; secondly, the high ratio of non-performing assets Statistics show that by the end of 2003, the average capital adequacy ratio of all the banking financial institutions of our country including policy banks was 6.3% or so, and that of the four major state-owned banks was only 5% or so,2 far below 8%, the minimum standard for capital of Basel Concordat At the same time, the proportion of non-performing assets

of China’s four major state-owned banks was high (of which most were performing loans) The non-performing loan ratios of the four major state-owned banks by the end of 2003 are shown in Table 1.2 By June 2004, total outstanding non-performing loans had reached RMB 1,663 billion after the completion of financial restructuring, accounting for 13% of the GDP after the China Construction Bank and the Bank of China completed fiscal restructuring

non-in 2004 And most of them were non-performnon-ing loans by state-owned banks.3

The non-performing loans of the four state-owned banks were obviously higher than those of joint-stock banks and foreign banks in the same period For example, the non-performing loan ratio of the joint-stock banks of our country was 8.4%; that of Citibank and HSBC were respectively 2.7% and 3%; whereas that of the four major state-owned banks amounted to 20.4%.4 According to statistics, among the non-performing loans of the state-owned banks 30% stemmed from intervention of the government at different levels, including the central government and local governments, and 30% of them from credit support for state-owned enterprises The large amount of non-performing assets

of the state-owned banks was a true reflection of the reform cost paid by them for supporting transition of the economic system.5

Moreover, since the reform, there has been an obvious upward trend in the financial support cost of the state-owned banks, which is shown as follows:

Firstly, the cost of reform of the four major state-owned commercial banks

is increasing The commercialization reform is an inevitable result of the requirement that the four major state-owned commercial banks meet the needs

of the socialist market economy and give better play to their role in financial support Since the commercialization reform of the four major state-owned banks, the cost input by the state as the owner of the banks has shown a rapid growth trend In 1994, in order to meet the separation of policy businesses and commercial businesses required by the commercialization reform of state-owned banks specializing in policy businesses of the state-owned banks In order to meet the 8% standard of bank capital adequacy ratio of the Basel Concordat and enhance the ability of the state-owned banks to resist risk, the Ministry of Finance issued special treasury bonds of RMB 270 in March 1998

to make up the capital of the state-owned banks In order to reduce the performing assets of the state-owned banks, the Ministry of Finance invested RMB 400 billion for the four major state-owned banks to respectively establish four asset management companies, and issued 10-year Treasury bond of RMB

non-1 trillion (US$non-12non-1 billion) guaranteed by the Ministry of Finance to purchase the non-performing loans of the state-owned banks with a book value of RMB 1.4 trillion Nevertheless, the cost paid by the state for the commercialization reform of the state-owned banks did not improve the operating status of the

Table 1.2 The Non-performing Loan Ratio of the Four Major State-owned

Banks in 2003

Bank of China

China Construction Bank

Agricultural Bank of China

Total

Industrial and Commercial

Bank of China

The Four Major

State-owned Banks Proportion in the Total Amount of

Loans (%)

Amount of performing Loan (billion US$) 42.8 23.5 87.6 79.5 233.4

Non-16.3 9.3 21.5 24–27 20.4

3.0 1.7 6.2 5.6 16.5

Proportion in GDP (%)

Source: Website of China Banking Regulatory Commission.

state-owned banks The proportion of non-performing assets remained high and the capital adequacy ratio was also constantly declining In 2003, the Chinese government launched the commercialization reform process of the state-owned banks once again The biggest difference between this reform and the previous one was the change from incremental reform to stock reform The cost and difficulty of stock reform are much greater than the incremental reform At the end of 2003, the state injected foreign exchange reserves of US$45 billion into the Bank of China and the China Construction Bank, implementing advance shareholding reform as new capital in the name of the Central Huijin Investment Co., Ltd and used the ownership rights and interests of more than RMB 300 billion originally held in the name of the Ministry of Finance to write off the bad debts of these two banks and in complement submitted the bad debt reserve that had not been sufficiently submitted In 2005, the state continued to promote the commercialization reform of the Industrial and Commercial Bank

of China and the Agricultural Bank of China The commercialization reform

of these two banks was more complex and difficult because the Industrial and Commercial Bank of China is the biggest of the four major state-owned banks and externality of its reform was strong The proportion of non-performing assets of the Agricultural Bank of China was the highest among the four major state-owned banks and its economic benefits were also the worst On April 21,

2005, the State Council approved the Industrial and Commercial Bank of China’s program for implementing joint-stock reform The state used foreign exchange reserves of US$15 billion to replenish the capital of the Bank According to the pre-determined plan, the four major state-owned banks needed an injection of

at least US$120 billion, but the recent Standard & Poor's report believed that the Chinese government needed at least US$160–200 billion to complete aid and reconstruction for these two banks.6 In the process of this commercialization reform of state-owned banks, the huge capital injection can be regarded as the government paying the cost of financial support for the state-owned banks.Secondly, the cost of defusing non-performing assets is increasing Since

2000, under the fixed assessment index that non-performing loan of the four major state-owned banks decreased by 2% to 3% each year, the non-performing loan ratio decreased from 33.37% in 2000 to 20.36% at the end

of 2003 That the non-performing loans ratio of the four major state-owned banks can miraculously decrease by nearly 10% in a few years is not because there has been a fundamental improvement in the banking system but because the rapid expansion of the loan base and the long-term trend of loans means the denominator of the non-performing assets ratio has become bigger and bigger In the loans from state-owned banks, the medium and long-term loans

increased gradually, as was most prominent in 2003 Of new loans in 2003, medium and long-term loans accounted for 94.5%, an increase of 43.5% over

2002 According to the data provided by the China Monetary Policy Report in the third quarter of 2003, the proportion of the balance of medium and long-term loans in the balance of all the loans increased from 39.4% in 2000 to 54.4%

at the end of September, an increase of 15% The four major state-owned banks were the major lenders of the new loans What is most worrying was that medium and long-term loans were concentrated in the overheated real estate field The credit operations of real estate increased from RMB 310.6 billion

at the end of 1998 to about RMB 2.5 trillion in 2004, accounting for 14.7% of total RMB loans Industries with overheated investment are vulnerable to the impact of tightening macro-control in producing non-performing loans This

in turn affects the state-owned commercial bank reform process, and further increases the cost of disposal of new bad assets Disposal of the bad assets of state-owned banks has been very expensive New bad assets will affect the commercialization reform process of the state-owned banks again and further increase the cost used to deal with new non-performing assets The non-performing assets of about RMB 1.4 trillion, stripped out from the state-owned banks when the four asset management companies were established in 1999, were liquidated at about 25% and the cash recovery rate was about 20% by the first quarter of 2003 From June to July 2004, the Bank of China and the China Construction Bank transferred non-performing assets of US$33.9 billion in total

to China Cinda Asset Management Corporation — the highest recovery rate According to estimates by the China Banking Regulatory Commission, the non-performing assets disposed of by asset management companies in June 2004 were no more than US$68 million and the cash recovery rate was 19.9% As the good assets had already been sold at the initial stage, the marginal recovery rate of asset management companies began to decline, disposal time of non-performing assets will be longer and the cost will become higher and higher The duration of asset management companies is only 10 years According to estimates, they would lose US$150 billion Who would pay for the huge cost of dealing with the non-performing assets?

The issue of non-performing assets has been the biggest problem in China’s banking sector and a major source of systemic risk for China’s banking Accordingly, it becomes a heavy burden for the next reform and development of China’s banking sector, although from the current situation the non-performing loan issue of the banks will not lead to financial crises and, if necessary, our government has sufficient funds to replenish the capital of the state-owned banks According to the commitments made by China when joining the WTO,

China’s banking sector in 2006 would be fully open to the outside world The entry of foreign banks would make China’s state-owned banks face fiercer competition and more challenges The commercialization reform of state-owned banks still continues, but there is a very big distance between the proportion of non-performing assets and 10%, the international regulatory standard With the advance of time and the deepening of reform, reform will become increasingly difficult, and the cost of reform of state-owned banks will rise It means that the state will inject more funds into state-owned banks.

In short, the state-owned banks have undertaken the important task of providing the economic reform with all kinds of funding support and have undertaken the reform cost of a gradual transition of China’s economic system The constant rise in financial support costs of state-owned banks, the constant decline in operating results and the constant accumulation of risk have become

an obstacle to further deepening economic reform The commercialization reform of state-owned banks launched again in 2003 was to completely separate their financial intermediation functions from their functions of public administration and to manage and operate state-owned banks in accordance with the three-performance principle After the commercialization reform of the state-owned banks, commercial funds would tend to be used in projects which are effective in short term The restrictions on funds’ safety and profitability make it difficult to meet the demands of current economic development for a variety of financing, especially the demand of sustainable economic growth for long-term capital If the issue of the long-term shortage of funds needed for development such as the “three rural issues,” infrastructure and basic industries

is not addressed, it will eventually become a shackle restricting the sustainable and stable development of the economy

The Financing Difficulties of Policy Banks

As the government’s banks, policy banks play a role as the main body of control and are an important macro-control tool for implementing national policies So far, our country has no special law for policy banks In practical work, the traditional policy banks work as cashiers of the government and have serious system defects They mainly rely on government subsidies and implement the operating goal of break-even and a narrow profit margin Due to the special nature of policy business, large-scale investment, good social benefits but high risks, in order to enhance the ability to resist risk the government should ensure adequate capital of policy banks However from comparison of the adequacy ratios of capital among domestic and foreign policy banks, it can

macro-be seen that the capital adequacy ratios of China’s policy banks are generally low As shown in Fig 1.5, the average capital adequacy ratio of China’s three policy banks is 8.67% while that of the policy banks of other countries is 14% Except the CDB, which has a relatively high capital adequacy ratio, compared with foreign policy banks the capital adequacy ratios of the other two policy banks are obviously low Moreover, capital replenishment of China’s policy banks simply relies on the government’s capital injection or financing of debts guaranteed by the government Use of a single channel will further reduce the capital adequacy ratio with increased loan size Low capital adequacy ratio directly affects the ability of China’s policy banks to resist risk How to control and resolve operational risks while supporting economic growth becomes the main contradiction faced by China’s policy banks.

Note: CBD is the China Development Bank (China) CEIB is the Export–Import Bank of China ADBC is the Agricultural Development Bank of China KfW is Kreditanstalt für Wiederaufbau DBJ is Development Bank of Japan KDB is the Korea Development Bank DBS is the Development Bank of Singapore

Source: “Report on Top 1000 World Banks,” The Banker, a British magazine (July 2002).

Fig 1.5 Comparison of Capital Adequacy Ratios among Chinese and

Foreign Policy Banks

18%

DBS DBJ

CEIB CDB

Firstly, the credit risks formed by historical factors are difficult to resolve The main purpose of establishing China’s policy banks was to take on the original policy financial business of the four major state-owned specialized banks and to remove barriers to the commercialization of the state-owned specialized banks Therefore, since their establishment, the three policy banks have been carrying a heavy burden of non-performing assets formed by policy bad debts In particular the Agricultural Development Bank of China and the CDB respectively received a large amount of non-performing credit assets from the former Agricultural Bank of China, the China Construction Bank and six state professional investment companies According to relevant investigation and comprehensive analysis of the CDB, in the original capital balance of

“replacement of appropriation by loan,” the amount that could be repaid on time by enterprises accounted for about 10%, 30% needed an extension period although they had ability to repay, and the remaining 60% formed bad debts.Secondly, the risks arising from the specificity of business fields have certain latency In the three policy banks, the CDB mainly plays the function of macro-control, supports economic development and the strategic adjustment of economic structure, and provides long-term fund support for the construction

of major projects and their supporting projects in infrastructure, basic industries and pillar industries that affect the lifeline of national economic development The Export–Import Bank of China (EIBC) mainly provides policy funds for the export of China’s mechanical and electrical products, complete sets of equipments and high-tech products, and all kinds of foreign contracts and overseas investments Meanwhile, the EIBC is also a main enlending bank of the loans of foreign governments and the loan issuing bank for the Chinese government’s concessional loans in aid to foreign countries In order to ensure national food security, protect the interests of farmers and promote the development of agriculture and the rural economy, the Agricultural Development Bank of China mainly provides fund support for the purchase and sale of agricultural products such as food, cotton and oil, and national special reserves The loan and investment projects of China’s policy banks are specific Loan programs generally are in the industries and fields with low economic benefit, good social benefit, long cycle and high risk In a loan project with a long cycle, if there is no rigorous risk management, the risk of the project is vulnerable to overall economic trends, the operational situation of the project’s borrower, changes in interest rates, and other market factors The loans of the Agricultural Development Bank of China are more special Let us take loans for purchasing food, cotton and oil as an example After loans are disbursed, because a large amount of the products cannot be sold and huge amounts of

disbursed loans for purchasing food, cotton and oil continue to become food and cotton in stock of state-owned food and cotton enterprises Due to their short physical life cycle, food and cotton will become rotten and deteriorate when they are out of date Considering the sharp drop in food and cotton prices after joining the WTO, and high storage costs, the Agricultural Development Bank of China may find it hard to recover its purchase loans, thus forming huge non-performing assets By the end of the first quarter of 2004, the ratio of non-performing loans of the Agricultural Development Bank had reached 57.07%, ranking highest in China’s three policy banks.7

Thirdly, the risk management mechanisms are weak Although the loan risks

of policy banks mainly stem from policy factors, the banks’ own risk control and compliance operations are also a factor which cannot be ignored for reducing formation of non-performing assets As a cashier of the government, China’s traditional policy banks in fact become a window of fiscal expenditure Their rights of independent choice and decision-making are weak so that it is difficult

to for them to form a sound risk management mechanism Let us take the Agricultural Development Bank of China as an example In the unrecoverable loans, many funds for purchasing food and cotton are misappropriated and diverted, some loans for purchasing food and cotton are used for local fiscal expenditure, and some are even diverted to speculate in shares and real estate

By 1997, the accumulative suspended fiscal repayment of food enterprises was

as high as RMB 23.9 billion, of which suspended repayment in 1991 was RMB 24.74 billion, the losses from 1992 to 1996 were RMB 53.5 billion, and the loss

in 1997 was RMB 45.6 billion By the end of 1996, grain and cotton enterprises had misappropriated and diverted RMB 77.6 billion in loans for purchasing and secondary operating businesses misappropriated RMB 33.4 billion Misappropriation exceeding the scope of policy businesses was up to RMB

13 billion and deposit of bull accounts was RMB 2.95 billion The above four items amounted to RMB 126.9 billion, which accounted for 21% of the loans for purchasing food and cotton Due to the weakness of the risk prevention mechanism, these misappropriated policy loans finally form the non-performing loans of the Agricultural Development Bank of China.8

Gradual accumulation of these risks is not only a threat to the survival and development of the policy banks, but also can mean that the state carries

a heavy debt burden which is not conducive to the stability and sustainable development of the entire national economy By comparing the non-performing loan ratios of domestic and foreign policy banks in 2002 (as shown in Fig 1.6b),

we can see that except for the CDB, the non-performing loan ratios of China’s domestic policy banks were high, of which the non-performing loan ratio of

the Agricultural Development Bank of China was 21% Low capital adequacy ratio and high non-performing loan ratio are the status quo of the policy banks

of China except for the CDB To maintain operation policy banks can only rely

on the government’s financial subsidies This low-efficiency and high-risk situation affects not only their own return on assets (as shown in Fig 1.6a), thus restricting their capability for long-term operations, but also limits their function in financial policy Policy finance just becomes another fiscal item and cannot form a virtuous sustainable circle necessary for finance Moreover policy finance is an important provider of long-term stable funds, and in these circumstances it cannot meet the demand of economic growth for long-term stable funds

Source: Same as Fig 1.5.

(a) Return Ratios on Assets of Domestic

and Foreign Policy Banks in 2002

Fig 1.6 Comparisons of Return Ratios on Assets and Non-performing

Loan Ratios of Domestic and Foreign Policy Banks