China’s banking reform: Issues and prospects for the future

Why do all care for China’s financial reform? China’s outstanding growth performance justifies optimism  And yet, such huge saving and investment ratios should yield even higher growt

China’s banking reform:

Issues and prospects for the

future

Alicia García Herrero*

Bank of International Settlements Representative Office for Asia and the Pacific

CASS, Beijing June 7, 2007

Roadmap to the presentation

1 Why do all care for China’s financial reform?

2 An assessment of the banking reform so far

A Restructuring of SOCBs

B Financial liberalization

C Regulation and supervision

3 How are banks doing?

4 Suggestions for future steps

1 Why do all care for China’s financial reform?

 China’s outstanding growth performance justifies optimism

 And yet, such huge saving and investment ratios should yield even higher growth

► Banking system is the pillar (over 80%) but does not function properly: potential misallocation of resources

► But also a lot of self-financing key (60% ) and

informal financing: risky!!

 Success of ongoing bank reform key:

– For China’s economic development

– For the rest of the world given China’s size & interlinkages

2 An assessment of the reform so far

a Restructuring

Organized in three waves, each of them with:

 Recapitalization

 Disposal of non-performing loans (NPLs)

 Partial privatization

 Issuance of subordinated debt

a Restructuring (con’t)

 Large capital injections to 3 of the 4 largest banks (state-owned commercial banks)

– In three waves 20-24% of 2004 GDP injected in the

banking system:

– Not really a bail-out since

– Howeer, different public/semi-public entities covering the costs

• Distribution of costs not very transparent

a Restructuring (con’t)

 Even larger disposal of bad assets: NPLs transferred to Asset

Management Companies (AMC):

– In first wave, bilateral transfer:one AMC per bank

– Disposal of assets aiming at highest recovery value and not

speed:

• Not much recovered: about 10% of total face value

– Financing: 45% financed by PBC credit and 10 year bond issued

by AMCs

• Not very high yield and doubts about payment: no explicit government guarantee:

• Involvement of CB could eventually constrain monetary policy although international reserves are a big cushion!

• Fragmentation of government bond market

2 An assessment of the reform so far

b Financial liberalization

1 Introducing market practices:

– Reduction in reserve requirements and in their

remuneration

• Steady reduction in liquid assets although still high

– SOCBs given more responsibility for lending decisions

• Some credit quotas removed

– Private ownership: joint-stock commercial banks and city

commercial banks starting 1999

– Also foreign more recently with WTO commitments

b Financial liberalization (con’t)

2 Liberalizing interest rates

– first money and bond market

– then loans

– finally deposits but not completed:

• Corridor of 330 bp or higher: cannot be reduced!

• Lack of competition but helps profitability

b Financial liberalization (con’t)

0 2 4 6 8 10

12

14

16

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Reference rate on deposits (1 year) Reference rate on loans (1 year) Ceiling rate on loans (1 year) Lowest rate on loans (1 year)

330 bp

Difference between lending and deposit rates

b Financial liberalization (con’t)

3 Opening up to foreign competition:

 To greenfield investment due to WTO commitment

– However difficult to grow organically in such a large country – Administrative difficulties to open affiliates can also slow

down growth of foreign ownership

 Sharp increase in foreign participation through strategic

partnerships in 3 large state-owned banks

– But still no control

 Different to

b Financial liberalization (con’t)

4 Steps towards capital account liberalization:

 More on inflows than outflows

– Although more steps taken recently for the latter mainly to stem off pressures towards exchange rate appreciation

 Domestic transactions in foreign currency strongly regulated

– Limited foreign exchange exposure although rapidly

increasing

Much faster liberalization in Latin America

3 How are banks doing?

All in all enormous improvement

•Banks are better capitalized but still poor for

international standards

•Also for private banks (joint stock and city commercial

banks)

•Rapid asset growth without new capital

•Only recently surge in subordinated debt

•Still in banks’ hands through interbank

•Also IPOs and exposure to foreign rules (HK stock

exchange)

•Asset quality much better but still poor compared to

international standards

•Slightly less than 10% of total assets are NPLs)

3 How are banks doing? (cont’)

 Efficiency slightly lower than international standards but not a big issue

 Profitability, instead, clearly low

– Particularly if one considers guaranteed interest rate corridor! – Recent improvement in large state-owned banks but even

worse in joint-stock and city commercial banks

Quite different from Latin America, spreads even higher and also profitability

3 How are banks doing? (cont’)

 García-Herrero, Gavilá and Santabarbara (2006) analyze empirically the main drivers of the improved –albeit still low - profitability of

Chinese banks :

– Increased capitalization

– Higher bank efficiency

– Lower bank concentration and market size

JSCBs – More private ownership

– High real interest rates and inflation also help

4 Conclusions

A On bank restructuring

– Need for clear diagnosis of underlying problem: government

interference

– For NPL stock problem:

• Transfer of NPLs should be accompanied by capital injections up to the required solvency ratio to comply with Basel I and with precise timetable

• Necessary for soundness but also to improve its profitability

• Clarify how AMCs will pay against NPLs received and status

of debt issued (only implicit guarantee)

4 Conclusions (con’t)

A On bank restructuring

– For NPL flow problem

• accelerate SOEs’ restructuring

• Help from financial liberalization to evaluate risk and price it

properly

• Need for better risk management procedures (capacity building)

– Regarding privatization, only solvent and viable institutions should

be privatized

• Transfer control might the quickest way to improve

management

– Does not need to imply majority ownership

• Even if the State retains control: same level playing field

 4 Conclusions (con’t)

B On financial liberalization

– By the handbook in sequencing of financial liberalization but needs to be finalized!

– Completion of bank restructuring important for further

liberalization:

• If incentive structure does not change, liberalization may not be reflected in banks’ behaviour.

• And if it does: reduced spread because of stronger

competition: fall in profitability

• Even more dangerous if real interest rates and inflation

B On financial liberalization (con’t)

– Further capital account liberalization as a consequence

of more flexibility of exchange rate regime

• For the risk of capital outflows to be minized

important to have completed domestic financial liberalization and the restructuring

4 Conclusions (con’t)

B On financial regulation and supervision

 Important strides particularly in regulation but enforcement an issue

– Particularly for capital adequacy!

– The spirit of the low probably more important than the letter of the

law

 Better corporate governance: Strengthened functions and

accountability of board of directors

 Better bank management techniques, particularly risk management

 Before foreign exchange controls lifted:

– Rregulations for foreign exposure need to be enhanced

– Also deposit insurance scheme

 Better and wider external and internal auditing

4 Conclusions (con’t)

So far so good, even amazingly fine but reform needs to be completed

as soon as possible : why?

:

1 Always better to do it in good times with high growth, strong fiscal position and international reserves

– Very different from Latin America

2 Growing challenges

– WTO poses challenges for Chinese banking system and also some sectors in the economy (agriculture, etc)

• Liberalization process will probably reduce interest rate spreads

– Also fast growth in credit could end up in new NPLs!

– Particularly if borrowers are the same…