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    China Business
     Jun 27, 2006
China's financial reform has long way to go
By Swati Lodh Kundu

BANGALORE - Over the past 25 years, China has witnessed steady and fundamental economic reform by embracing market economy. Moving from a socialist economy to a market-oriented economy was in itself a challenge posed by the contradiction. Indeed, an evolving China faces a number of challenges: solving the remaining problems of the old system, resolving the contradictions generated during the period when the new and the old systems co-existed, and establishing a suitable environment for the new one.

China's problems include a stagnant rural economy, poor rural people and a backward rural society, as well as incomplete restructuring of the state sector and state-owned enterprises, serious unemployment in cities, a fragile financial system,



polarization between rich and poor, social disorder and widespread corruption.

Looking at the Chinese financial sector, state-owned enterprises (SOEs) currently still control the most important resources - especially capital.

China suffers serious problems of resource misallocation, as evidenced by declining returns on assets in the banking system and rising levels of non-performing loans (NPLs). These have ramifications for social development and the provision of public goods and services. After all, the operation of the financial system is not just an economic affair; it entails deep implications for how government fulfills its non-economic obligations to society.

The banks have been the main instrument for the Chinese government to achieve its developmental goals. Over the years citizens have proved willing to pump extraordinary amounts of savings into state-owned banks. The government, in turn, has directed those resources to fulfill investment aims that can better be understood as budgetary rather than commercial: the funding of strategic "pillar" industries, specific SOEs, and SOE employee wage and non-wage benefits.

In the typical centrally planned economy, such as China's in the 1960s and 1970s, bank lending was intended to complement the government's production plans, and banks acted as a "cashier" for the government's economic programs. Because of state ownership, equity markets were non-existent.

Over the past 10 years, private companies in China - whether Chinese-owned, foreign-owned or joint ventures - have grown faster than gross domestic product (GDP). These companies now account for half of all output and many new jobs. The share of production from wholly state-owned enterprises, meanwhile, has shrunk to barely one-quarter of GDP. Although many SOEs have been restructured and some are highly profitable, their productivity as a group is still half that of private companies, both in aggregate and by industry.

Nevertheless, SOEs (both wholly and partially state-owned) continue to absorb most of the funding from the financial system. Private enterprises have received only 27% of loan balances. Many of them resort instead to China's large informal lending market, which has an estimated US$100 billion of assets but also higher interest rates.

As well as explaining the large volume of non-performing loans in China's banking system, this pattern of lending also has the effect of lowering overall productivity in the economy. As a result, China is seeing its investment efficiency decline. Whereas it required $3.30 of investment to produce $1 of GDP growth in the first half of the 1990s, each $1of growth since 2001 has required $4.90 of new investment - nearly 40% more than the investment required by South Korea and Japan during their high-growth periods.

The phenomenon of financing biases in favor of SOEs at the expense of private firms has been widely documented. Banks' lending bias in favor of SOEs is in part a policy choice by the government to commit massive financial resources to the state sector; in part it is rooted in the standard operating procedures of the Chinese financial institutions. Until 1998, the four commercial banks, which control most of the banking assets, were specifically instructed to lend to SOEs. As an indication, the lending to the non-state firms by the four commercial banks remained a minuscule portion of their loan portfolio.

The primary lending responsibilities to township and village enterprises and other non-state firms were assigned to the rural credit cooperatives (RCCs) and urban credit cooperatives (UCCs). The deposit base of the RCCs and UCCs was restricted to non-state firms, although this restriction was not necessarily strictly enforced. The deposit base restriction, often coupled with a geographic restriction on their lending activities, severely hampered the ability of RCCs and UCCs to carry out a significant financial intermediation function. Until quite recently, the shares of the total loans by these two types of institutions were quite small. Their branch network does not even approach the level of the state commercial banks.

During the early part of the reform era, standard banking practices also contributed to the lending bias in favor of SOEs. Until 1998, the central bank issued credit plans to the regional branches of the commercial banks. The credit plans were particularly binding on loans made to finance fixed asset investments. These credit plans served two purposes. One was to reconcile the lending priorities of the banks with the investment priorities of the planning agencies, both at the central and at the local level. Each year, the credit plan was formulated in conjunction with investment plans drawn up by enterprises and submitted to the supervisory government departments. Contained in these investment plans were requests for funding, either for fiscal grants or for bank credits. The regional planning agencies aggregated and adjusted these plans and submitted a regional investment plan, along with a funding request, to the then state planning commission at the national level.

The planning agency and the central bank then worked to reconcile the investment requests with funding requests and made further adjustments. The state council finally approved the consolidated investment and funding plans and issued them to ministries and regional governments for implementation. Because many of the non-state firms, especially the private firms, operated completely outside this bureaucratic chain of command, they were unable to submit their investment lists in the first place. Thus the credit plan formulation process itself already excluded a large number of non-state firms.

Interest-rate policies have also benefited SOEs. Until the mid-1990s, interest rates on the working-capital loans for the non-state firms were mandated to be 20% higher than the same type of loans to the SOE sector. Since then, the SOE loan rates have been used as a benchmark from which rates on the non-state firm loans are allowed to fluctuate upward by 20%. However, the true size of the windfall conferred on the SOEs far exceeds the 20% spread between SOEs and non-state firms. In more recent years, interest rates have become considerably more flexible, although there are still substantial curbs on interest rates imposed by the state. The cumulative effect of these banking policies and practices has been a severe credit constraint on the non-state firms-domestic private firms in particular - despite the latter's phenomenal growth and dynamism.

Even the rapid development of the equity markets has been directed primarily to benefiting SOEs. As one expert commented, "The securities market is essentially a state securities market conceived and designed to support corporatized SOEs." According to one estimate, SOEs accounted for about 90% of the 1,200 listed companies on the two bourses, namely the Shanghai and Shenzhen stock exchanges, in 2003. After 1997, when the policy toward the private sector is considered to have been liberalized, a total of only four non-state-firm initial public offerings took place (in 1998 and 1999). In the mid-1990s, the equity financing of non-state firms became more difficult. In 1995, the authorities closed several regional stock markets that served small and medium-size firms, ending a source of funding for private firms.

The stock market is also not liquid, with only about 40% of A and B shares available for trade, and SOE shares are generally non-tradable, which prevents China's stock market from performing a vital function that other stock markets do perform-effecting changes in corporate controls of the listed firms. Capital is still not allocated efficiently, as the state still privileges inefficient SOEs and its own projects over the more productive private companies. Political interference remains strong with the stock market functioning as an appendage of state policy. Given these problems, it is not surprising that the Chinese economy, by and large, has remained heavily bank-dominated.

Given such bias it is quite clear that the single most important constraint on private-sector growth is capital shortage. This strong financing bias in favor of SOEs at the expense of private firms entails a number of important implications. One is the accumulation of NPLs in China's banking sector. There is wide recognition of the NPLs in the Chinese banking sector but estimates vary as to their size. The official estimate of NPLs in the four state banks is $164 billion as on March. However, other estimates vary between $300 billion and $500 billion.

One should of course be cautious in reading and interpreting these numbers. One difficulty in arriving at a precise estimate has to do with different classification practices. The Chinese standards in loan classification are more generous than those prevailing in other countries.

There are a number of important differences. First, the Chinese classification is tied not to the status of the borrower but to the status of the loan payment. For example, if a borrower defaults on one loan but not on a second loan, the Chinese bank increases the provisions only against the loan actually defaulted rather than against the entire loan portfolio of this borrower.

Second, classification of bad loans is tied to the repayment of the loan principals but not to the interest payment.

Third, the provisions are made not against the riskiness of the loan portfolio but against the actual default actions. Thus during a period of real-estate crash, Chinese banks would not normally increase their bad-debt provisions against their real-estate exposure as long as the borrower is in compliance with the terms of the loan.

Indeed, the state-owned Chinese banks need to reform big-time. This has also become imperative as part of China's World Trade Organization commitment. China officially entered the WTO in December 2001. With the transitional period nearly over, the banks would be required to participate in global economic cooperation and competition under the principles of free trade, represented by the rules of the WTO. Among others, this requires establishment of laws and regulations that promote fair competition.

Likewise, China must eliminate restrictions on foreign investors and foreign companies under the commitments it made upon acceding to the WTO. Hence, it will soon be forced to open up the banking sector to foreign investment. And once that happens, the state-owned banks will lose out if they do not reform. Keeping this in mind, the Chinese authorities are looking at having these banks listed in foreign bourses. However, this is no guarantee for reform.

In fact, hardly anything else is being done to bring the banks into shape. Aided by generous government bailouts, the banks have worked to restructure themselves over the past several years. But changing old habits takes time: a recent paper by economists at the International Monetary Fund found little evidence that Chinese banks' lending decisions had become more commercial. Given the renewed surge in lending, China is staring at levels of NPLs that could blow up in its face. Even the industry regulator, which has been leading the reform effort, seems unwilling to break some taboos.

Indeed, China could have either of two starkly contrasting futures: a move toward a market economy under the rule of law, with a civilized political order, or a move toward crony capitalism.

Swati Lodh Kundu is a freelancer based in Bangalore, India. She has a master's degree in economics from the University of Calcutta.

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