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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