Accelerating Reforms in China’s Financial System

The modernization and internationalization of China’s financial system is perhaps the last and in some ways, most difficult chapter in the country’s economic transition. Partly driven by China’s WTO commitments, the speed of the financial sector reforms has accelerated in recent years. Most state banks have been incorporated under China’s Company Law, restructured and recapitalized. Many attracted foreign strategic minority partners and the four most important state commercial banks listed successfully on the Hong Kong and (in the case of the Industrial and Commercial Bank of China) domestic stock exchanges. At the same time, efforts are being made to deepen and broaden domestic capital markets, both on the demand and the supply side. Financial sector problems that seemed almost intractable only a few years ago, such as the massive non-performing loans (NPL) overhang and the non-tradable government shares in listed companies, are gradually being resolved. The legal and regulatory framework governing China’s financial system is being adjusted to meet international standards and domestic needs. New financial instruments such as asset-backed securities and short-term corporate bills have appeared on the market. Insurance and financial services industries, including fund management, are also developing rapidly. The least satisfactory aspect of the financial scene is the lack of transparent asset management company (AMC) accounts. Most of China’s enormous NPL debt remains to be paid off, but this does not present a major burden on the economy.

BANK REFORM HAS MOVED INTO HIGH GEAR

Serious banking reforms in China did not start until after the Asian financial crisis of 1997-98. Reforms intensified in recent years, especially after the establishment of the China Banking Regulatory Commission (CBRC) in March 2003. Many of the ongoing reforms are inspired by China’s commitment to remove restrictions on the operations of foreign banks in China by December 11, 2006, exactly five years after its entry into the World Trade Organization (WTO). While outside observers often focus on China’s NPL problems and corruption in state banks, it is clear that structural reforms are moving in the right direction. Management and regulation of the banking sector is becoming more professional and more in line with international standards. Clarity of ownership and of the responsibilities of the management and board has improved. Provisioning restrictions have been relaxed while loan risk classification and interest accrual rules have been adjusted to international standards. The China Communist Party (CCP) Central Financial Work Commission (CFWC), which was created in 1998 (after the Asian financial crisis) to supervise the financial system on behalf of the CCP, was abolished at the 16th Party Congress in late 2002.

Though still very weak in terms of average bank financial strength rating, the banking system as a whole is in a much better shape now than just a few years before. Moody’s Investor Service’s outlook rating for the system as a whole was upgraded to “stable/positive” in July 2006 [1]. The apparent contradiction between a low average financial strength rating of China’s banks and Moody’s “stable/positive” outlook rating for the banking system lies in the expectation of continued strong government support for the big state banks and the positive reform momentum that has now also spread to city commercial banks, rural banks and credit cooperatives. While risk analysis and governance remain weak in many state banks, there has been significant internal restructuring and recapitalization in most parts of the banking sector. The positive momentum that has thus been created is very important as banks continue to dominate financial intermediation in China. It should be noted, however, that with the recent reopening of domestic stock exchanges for IPOs and an enlarged volume of corporate bond issues during the past 12 months, the share of banks in new corporate finance may drop to around 80% in 2006.

Prospects for further improvement appear good. Indirect management of the financial system through monetary policy and regulatory agencies is gradually replacing direct administrative and political controls. What is sometimes difficult for foreigners to understand is that most of China’s top bankers and financial system regulators are not only senior Party members but also highly trained technocrats. With increased foreign participation in China’s economy, these technocrats obtain in-house international peers, which is helpful to them in efforts to reduce domestic political influences on bank operations and to press for the strengthening of bank governance.

China’s state banks have long been used as de facto fiscal agents, channeling funds to state-sponsored projects and enterprises, often for political or social reasons. They were also, like all other state units, responsible for the housing and the social security of their employees, until these functions and responsibilities were reassigned and reorganized during the 1990s. Until that time, the state banks served, in fact, as “social shock absorbers” allowing the preservation of full employment in urban China to be continued much longer than otherwise would have been possible. This unconventional approach to economic reform not only bought time for people and enterprises to adjust to the realities of a market economy, but also led to the accumulation of enormous volumes of NPLs on bank balance sheets. This was not seen as a serious issue until the objectives of China’s market reforms were more clearly defined in the early 1990s and the economy had become more internationalized.

NPLS, AMCS AND STATE BANK RECAPITALIZATION

The final wake-up call came in the form of the 1997-98 Asian financial crisis. China then began to acknowledge the seriousness of the NPL problem and take steps toward its resolution. Four state-owned AMCs were created in 1998 to assume responsibility for the disposal and recycling of about US$170 billion (nominal value) of pre-1996 NPLs that were on the books of large state banks. This was the start of a process that gradually led to the full recapitalization and listing of four of the five state-owned commercial banks and a very large reduction in their NPL ratios. The one exception is the Agricultural Bank of China (ABC)—with a 26.6% NPL ratio at the end of 2005—for which a comprehensive reform plan has yet to be announced. In 2005, a fifth AMC (Huida) was created to deal with NPLs elsewhere in the financial system. By the end of 2005, some $330 billion of NPLs (nominal value) had been transferred to the AMCs, of which about $100 billion had been disposed of in various ways at that time. The average cash recovery rate was about 20%.

As of the end of September 2006, reported NPL ratios were as follows [2]:

Bank category NPL ratio in %

All major commercial banks 7.64

State-owned commercial banks 9.31

Joint stock commercial banks 2.91

City commercial banks 6.07

Rural commercial banks 6.58

Foreign banks 0.81

All banks 7.33

The recapitalization of state banks took various forms, with the steps oftentimes unique for each bank. Most of the funds—$432 billion since 1998 (net of $24 billion worth of equity sales to foreign investors through June 2006)—came from the central government in the form of AMC bonds, Ministry of Finance bonds, write offs, loan-loss disposals and other capital injections [3]. In addition, China’s central bank provided $60 billion from foreign exchange reserves for recapitalization purposes. This was not a “use” of resources in the narrow sense, but a substitution of assets, as explained below. The sale of shares in central government-owned commercial banks to foreign strategic minority partners and through IPOs on the stock exchanges in Hong Kong and Shanghai yielded about $59 billion by the end of September 2006. The total amount of capital used for the recapitalization of central government-owned commercial banks from all sources has thus far been approximately $550 billion. The amount of capital from all sources used for the recapitalization of state banks owned by lower-level governments is harder to estimate; it may be of the order of $20-30 billion. Almost all important commercial banks in China—with the notable exception of ABC—now have a capital adequacy ratio of 8% (BIS standard) or better.

The contributions in foreign exchange—$22.5 billion each for the China Construction Bank (CCB) and the Bank of China (BOC) at the end of 2003, and $15 billion for Industrial and Commercial Bank (ICBC) of China in April 2005 (matched by an equivalent contribution in local currency from the Ministry of Finance in the case of ICBC)—represent an unorthodox departure from normal practices. For the purpose of channeling foreign exchange to the banks, China’s central bank created a wholly owned subsidiary, the Central Huijing Investment Co. which became the owner of the CCB and BOC and 50% owner of ICBC on behalf of the state until its shareholding was diluted as a result of foreign strategic minority participations in these banks, followed by their IPOs. After the listing of state banks, the Chinese state remains their majority owner. On the balance sheet of the Central Bank, foreign exchange reserves were swapped for indirect ownership rights (through Central Huijing) in the banks concerned. The recapitalization of domestic banks with foreign exchange inevitably entails the creation of foreign exchange risks to those banks, unless they are shielded from such risks by special arrangements as were reported to have been made at the time of the transactions.

Yet, the recapitalization of state banks does not mean that China’s NPL problem has been resolved, as a large amount of NPLs remains in the system. The amount still on the books of commercial banks at the end of September 2006 is reported to be $159.5 billion [4]. To this should be added NPLs on the books of the AMCs (an estimated $200 billion at the end of September), of non-commercial banks (such as the policy banks) and non-bank financial institutions (for which no official estimate is available). AMCs are the least transparent part of China’s financial system. They are huge financial organizations, but their accounts are not public and do not appear to be subject to independent external auditors. This author estimates the total amount of NPLs in the system at the end of September to be $450-550 billion. Deducting recoverables (estimated at $100 billion) leaves an estimated ultimate loss of $350-450 billion to be paid for by the government [5]. Since this can be spread over many years, however, the estimated ultimate loss represents a relatively modest burden on the Chinese economy.

As the result of the unprecedented expansion of bank lending in China from 2002 through 2004 as well as other factors, there are also potential NPLs in the system that could become real during a recession or significant economic slowdown. In its Global Nonperforming Loan Report 2006 (issued on May 3), Ernst & Young estimated potential NPLs in the system at the end of 2005 at $225 billion and the total of actual plus potential NPLs at $911 billion. Beijing protested the Ernst & Young estimate and accused it of being unfounded. A few days later, on May 12, the London head office of Ernst & Young issued a statement apologizing for the issue of its erroneous report, which “… did not go through our normal internal review and approval process before it was released to the public and, as it contains errors, we are withdrawing.” If Ernst & Young’s estimate of potential NPLs in the system at the end of 2005 is realistic (which is hard to judge), the difference between Ernst & Young’s estimate of total NPLs remaining in the system (including potential ones) and this author’s corresponding lower estimate is $136-236 billion.

RECENT CAPITAL MARKET REFORMS

Recent legal and regulatory changes have significantly improved conditions for corporate and capital market development in China. The changes include: a new Company Law, a new Securities Law and regulations, new mergers and acquisitions (M&A) rules for foreign investors, a new Bankruptcy Law and other measures, such as new accounting and disclosure standards for listed companies. Better protection for minority shareholders, increased access by foreigners to China’s domestic A-share market for M&A transactions and other improvements, such as a more pragmatic approach to solving the problems associated with the government’s non-tradable shares in listed enterprises, appear to have restored confidence in the local stock markets. The suspension of new domestic IPOs—pending a solution for the conundrum of the non-tradable shares—was lifted in June 2006 and since that time, record volumes of new IPOs have been launched on the domestic stock exchanges. Share prices recovered from a 5-year malaise. The road now seems clear for the rapid development of domestic equity markets. Many mistakes that had been made since the establishment of the Shanghai and Shenzhen stock markets in late 1990 have been corrected. It now seems possible that these markets will finally become instruments to improve corporate governance in China and serve as substantially more important sources of new capital for corporations as well as more effective channels for the privatization of state-owned enterprises. If domestic share market development is combined with accelerated opening of the capital account, as is both feasible and desirable, it should be possible before long to merge the domestic A and B share markets and permit arbitrage between H shares traded on the Hong Kong stock exchange and corresponding A-shares traded on the Shanghai and Shenzhen exchanges.

In spite of these significant financial sector reforms, a number of challenges remain as China attempts to achieve a comprehensive economic transition. Debt markets have seen positive development in recent years, but much remains to be done in this area. The corporate bond market, although expanding more rapidly than before, remains small and underdeveloped. Ratings agencies have not yet become truly independent and yield curves remain rather flat. By far the most important issuers of domestic bonds are the Ministry of Finance and policy banks – in particular China Development Bank. Most bond trading is in the form of repossession contracts for liquidity management. Lower-level governments are not yet permitted to issue bonds in China. Significant new developments in the last two years include: (1) the emergence of a rapidly growing short-term corporate bill market; (2) the issue of asset-backed securities—the most recent development in this area is the issue of NPL-backed securities; and (3) the development of derivative markets to facilitate exchange rate risk hedging. The latter development should permit greater exchange rate flexibility in the months and years ahead. Central bank bills, issued in large quantities since late 2003 for the absorption of excess liquidity (due to credit expansion and foreign exchange reserve accumulation) are traded in the inter-bank market, which has grown enormously since its creation in 1993. All in all, it is fair to say that China’s financial system is in better shape now than a few years ago and that reforms are moving in the right direction.

Notes

1. Moody’s Banking System Outlook 2006: China rates the average (weighted by assets) for all banks about halfway between E+ and D- (the highest rating being A- and the lowest E). Only Pakistan, Ukraine, Indonesia, Georgia, Kyrgyzstan, Lithuania, Venezuela, Argentina, Bolivia, Uruguay and Vietnam rank lower than China in Moody’s survey.

2. Source: China Banking Regulatory Commission, https://www.cbrc.gov.cn

3. Moody’s Banking System Outlook 2006: China, Appendix II.

4. China Banking Regulatory Commission, https://www.crbc.gov.cn.

5. To avoid confusion: this amount is not additional to the author’s estimate of funds that have been used for bank recapitalization. It simply represents the portion of recapitalization funds provided in the form of long-term government debt that remains to be paid off. A large part of this is in the form of AMC bonds.