Is Banking Reform in China Still on Track?

By Satya J. Gabriel

One day early during my two-year stay in Nanjing, I decided to change money at a branch of the Agricultural Bank of China. I had been on my way to the Bank of China, where I normally transacted business, when on happenstance I came across this branch of the Agricultural Bank. I had been advised to change money at the Bank of China, but I thought "what the heck" and on a pure whim decided to give the Agricultural Bank a try. Afterall, they had a window labeled foreign exchange.

I didn't realize when I walked in what a novelty my visit would turn out to be. The bank tellers acted as if no one had ever stopped in to change money before. When I gave the smiling young woman a handful of travelers' checks she looked them over the way an archeologist looks at a new find. Finally, she decided to enlist the support of some of her colleagues, who had already stopped what they were doing in order to observe this strange transaction-in-progress (at least I hoped it was in progress). Eventually I got what I'd come for, nice new pieces of paper denominated in yuan: people's money, renminbi. I thanked the teller and said goodbye. She giggled and waved. Well, I'm not about to try and guess the topic of conversation after I left or what they made of this foreigner with his "American Express travelers checks." But one thing I found out not long after that experience was how recently the Agricultural Bank of China had made the transition from a "specialized (sector specific) bank" to one with primarily commercial functions. The banking system in China has been undergoing a thorough overhaul since the promulgation of the new Commercial Bank Law.[1]

This episode in the Agricultural Bank came to mind as I read an English-language translation of the aforementioned law. The Chinese government had an ambitious plan for transforming its banking system into one that more closely resembled the banking systems of the advanced capitalist nations of the West.[2] These banks are expected, over the coming years, to become more competitive, both with each other and with the increasing numbers of foreign banks that have been allowed to operate, on a limited basis, in China. Banks that had never had much to do with ordinary depositors would now have to learn the meaning of customer service. Well, if that teller's smile was any indication, then they don't have far to go in this regard. On the other hand, the Bank of China, where I normally exchanged money and the only bank that would accept a personal check drawn on a U.S. bank, tended to be very slow at handling even the most routine transactions and smiles were not in the job description.

And then again, customer service may not be the most serious concern of the top management in China's commercial banks (both those older specialized banks that are being commercialized and newer commercial banks that have never been anything else). The most serious problem facing the top management in these banks is dealing with their portfolio of non-performing loans. Non-performing loans are loans that are not being repaid (the borrower isn't making interest or principal payments). The worse offenders, in this regard, are state-owned industrial enterprises (SOEs), whose financial performance (measured in terms of interest coverage ratios and the ratio of surplus value to total assets) deteriorated in the 1990s (after these firms were formally separated from the state bureaucracy and forced to contend with greater competition). The state-owned commercial banks had been component parts of a banking structure controlled by the People's Bank of China (PBOC), which served as not only the central bank but as a commercial banking monopoly, as well. The banking structure was closely linked to the SOEs, in an even larger state controlled economic structure, until the early days of the Reform Era, when the commercial banks were separated from the PBOC. In the early days of the reformist regime, it was seen as an improvement to give these commercial banks more clout in determining the flow of capital, reducing the influence of centralized planning bodies, and to narrow the focus of the PBOC to regulating the banks, orchestrating monetary policies, and managing foreign reserves. Nevertheless, bank managers remained an integral part of the governmental bureaucracy, rather than managers of relatively autonomous commercial enterprises. In other words, bank managers were not focused on evaluating the net present value of the loans they issued, rather they were interested in satisfying the government leaders who would determine their career success or failure. In this and other regards, bank managers were no different from the SOE managers taking their loans. Both were simply cogs in the bureaucratic mechanism, a mechanism that was becoming increasingly gunked up with bad loans. The first indication that the bureaucracy was becoming aware of an impending bank crisis came from the People's Bank of China, the central bank, which began tightening credit conditions in the early 1990s in the hope of slowing the acceleration of non-performing loans. It has now become a primary objective of Premier Zhu Rongji to move to the next stage of banking reform. He wants the banks to become more professional in their lending practices, but first the banks have to do something about the loans that were made in the past, loans that were often more political in nature than commercially motivated.

At some point these non-performing loans could have serious social ramifications -- rising unemployment and falling aggregate demand -- if banks reduce their lending in order to clean up their tattered balance sheets. It is estimated that there is almost $100 billion in bad loans in the Chinese banking system. [3] As I've indicated in essay number 9, the Zhu administration is trying to avoid a credit squeeze by creating a fund to buy some of the bad loans from banks. The Chinese government does not want banks to equate professionalism with being overly stingy. They just want the banks to do a better job of judging credit risk, without cutting off credit to profitable or potentially profitable enterprises. Nevertheless, even if the banks cut off credit only to unprofitable firms, there will be a significant rise in bankruptcies and millions more unemployed.

China has about 100,000 state-owned enterprises. The average debt-to-assets ratio of these firms exceeds 80 percent. That's small compared to the debt-to-assets ratio of the South Korean chaebol, but the Chinese authorities can take little solace in that. Most of these enterprises are considerably weaker generators of cash flow than the chaebol enterprises. And, unlike the chaebol enterprises, the SOEs have actually faced higher rates of taxation than many of their new private sector competitors, indicating that the central and provincial governments did not only want to be free of obligations to these SOEs but were willing to place them at a disadvantage vis-a-vis foreign firms and other competitors. It is doubtful that this was the intention of the authorities. They were simply following two different sets of policies with regard to the state-owned sector and the non-state-owned sector, which included municipally owned township village enterprises, as well as foreign firms, joint venture firms, and private firms.

I applaud the attempt by the government to get banks to be better stewards of the money depositors have entrusted them with. I've always been an inveterate budgeter, myself (I'm not quite Scrooge, but I do have my moments). But the relationship between the banks and the state-owned enterprises has been very cozy for very long. It is clearly going to be traumatic and problematic if these firms find their money pipeline closed or even made less liquid. Does Zhu Rongji and the rest of the Chinese leadership believe they can generate economic growth and the creation of new jobs fast enough to make up for the lost jobs if state-owned firms start closing their doors in large numbers?

And I cannot help wondering whether the banks have the wherewithal to judge a good credit risk. They have no history of doing fundamental analysis of companies or of judging market conditions. U.S. banks have lots of experience in this regard and yet make serious mistakes all the time. The worse case scenario is one in which the banks deny credit to the firms that show the greatest promise for generating new inventions and innovations and stimulating the long-term development of China and grant credit to firms where they simply know the managers better. Is commercialization any guarantee against this? Won't bankers' habits and long-term friendships play a bigger role than anyone expects? Before you say that commercialization and hard budget constraints should be enough to force bankers to "do the right thing," perhaps you might want to read a few of the horror stories about the behavior that sparked the U.S. savings and loan crisis.

The bankers know, as I do, that the Chinese government does not want them to fail. Zhu Rongji does not want a financial crisis. The bank bail-out package is clear indication of this. Moral hazard, the ability to take risks that someone else will be responsible for if things go wrong, will hardly be eliminated by commercialization and hard budget constraints (how hard exactly are those constraints really going to be?). The intimate relationship between the banks and the central authorities is not going to end simply because of a bit of tinkering with accounting practices. Doesn't Zhu Rongji have to be willing to allow at least a moderate financial crisis in order to enforce the discipline of the market on the bankers?

Nevertheless, there is some sign that bankers are tired of accumulating bad loans and concerned about the long-term ramifications for their careers. Banks have tightened credit in China. The banks have reduced loans and increased their purchase of Chinese government bonds. And the government has made this easy by increasing its bond issues. Thus, whether banks are denying loans to the right firms or the wrong ones would be hard to judge from afar, but it is clear that bankers, at least in the short term, would rather have the Chinese government as their debtor than firms.

Chinese firms that want to upgrade their technology now face the daunting task of raising capital in an environment where credit, whether borrowed at home or abroad, is very tight. This is particularly the case for those firms that want to borrow hard currency. The banks are particularly wary about making foreign currency loans and foreign lenders have, for the most part, turned their back on all of Asia. When Chinese firms can borrow in international markets, the risk premium is very high, meaning the interest rate the firms must pay is much higher than would be justified by the rate paid on government bonds and the Chinese inflation rate. Put yourself in the shoes of a general manager (chief executive officer) of a Chinese firm that wants to upgrade equipment in order to remain competitive. What do you do in this environment? If you borrow at the higher costs, how does this impact your competitiveness? It's a bit of a catch-22 isn't it? (Of course, if you can finance your investments out of internally generated funds, retained earnings, then the Asia-wide crisis may actually be to your advantage, since it has brought down the prices for buying many so-called capital goods and has made suppliers very flexible in their negotiations.)

But never fear, the Zhu administration may come to your rescue . . . if you have the proper connections. There are some signs of a loosening of the credit squeeze, partly by indirect intervention of the Chinese authorities. Banks have been willing to fund state-owned enterprises that seemed, only a short while ago, to be on a "no money" list and are doing so despite continued ceilings on loan interest rates by the People's Bank of China. Banks have also started pouring money into infrastructure projects again. Infrastructure investment has jumped 20 percent over levels last year. And more funds have been channeled to rural and urban credit cooperatives, grassroots financial institutions that have been an integral part of the economic reform structure since the period of the 1980s when the rural areas were leading the economic growth parade. The growth in lending in both the large bank sector and among the credit cooperatives is clearly a response to pressure (and provided liquidity) from Beijing. Nevertheless, this period of rising liquidity has clearly not provided a solution to the underlying profitability crisis in the banking system. Profits in the banking system have actually been on a steady decline since the early reform years.

Does this mean banking reform is dead? It would be foolish to think that. The Chinese government is still following the path of "touching the stones while crossing the river," but that doesn't mean they've turned tail and run back to the other shore. Zhu Rongji is committed to reform, because he believes it is the only way to keep China on a rapid growth trajectory. His distrust of an unfettered market, however, means that the reforms will be done cautiously. Banks will be commercialized, in a Western sense. It is highly likely that banks will eventually be transformed into publicly traded corporations with substantial non-governmental shareownership. However, one should expect the level of regulation of the banks and interference in bank decision-makings to remain rather high.

Nevertheless, one would hope that the regulators would allow the banks a greater degree of latitude about who they will and will not lend to. In this regard, the sectors with the most to gain from increased competition and commercialization within the banking sector are the town-village enterprises and private capitalist firms, who have been largely locked out of the state banking sector. These firms have been forced to seek their capital in the considerably less well-capitalized banking cooperatives or illegal credit associations or from loan sharks. If reform of the banking sector opens up more formal credit institutions to these firms, which are driving the rapid economic growth in the Chinese economy, then so much the better.

And there is one significant reform already written into the Commercial Bank Law. Unlike banks in Germany, Japan, and many other nations, Chinese commercial banks will not be allowed to become majority owners of industrial enterprises.[4] Despite fears that China will try to reproduce the Japanese keiretsu (or South Korean chaebol) model, China wants to avoid wedding banks too closely with industrial firms. The current Chinese administration is keen on keeping some degree of separation between the financial and industrial sectors. I, for one, think that's a good idea.

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[3] It has been estimated that from 20 to 30 percent of the loan portfolios of state banks are non-performing and 50 percent or more of these non-performing loans may be unrecoverable.

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[4] Restrictions on bank ownership of industrial firms is all the more important under the provisions of the Chinese Bankruptcy Law of 1988, which provides for the privatization of state-owned conglomerates. These state-owned firms are massive in size and scope. The process of commoditizing ownership of such firms will represent a major opportunity for shifting corporate control from the central government to other agents. If banks were allowed to participate in an unfettered way it is likely they could come to dominate the Chinese economy, particularly given their insider information on the relative health of various state-owned enterprises. As it is, these firms may be forced to commoditize their knowledge and assist other agents in picking and choosing among the various assets made available by the central government.

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Copyright © 1999 Satya J. Gabriel, Mount Holyoke College.  
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