In the study “The Contradiction in China’s Gradualist Banking Reforms,” University of Chicago Graduate School of Business professor Anil K Kashyap and Wendy Dobson of the University of Toronto’s Rotman School of Management survey the recent reforms of China’s banking industry. China’s largest banks have undergone significant changes following China’s commitment to join the World Trade Organization and open the domestic banking market by December 2006.
Kashyap and Dobson take a skeptical view of the gradual pace of banking reform in China and the government’s involvement in bank ownership and decision making. Historically, China’s state-owned banks have made loans to money-losing enterprises in order to maintain employment and social stability, a practice known as “policy lending”—lending based on political criteria and connections rather than creditworthiness. The dependence of China’s state-owned enterprises (SOEs) on banks for their working capital means banks are forced to satisfy conflicting objectives: financing employment and social stability while transforming themselves into commercially viable corporate entities. The authors argue that the Chinese government is proceeding in a way that ignores this contradiction.
“Even after these reforms, banks still won’t have clear objectives to maximize returns for shareholders, because they remain subservient to the government,” says Kashyap. He and Dobson argue that a better approach would be to recognize the contradiction and undertake reforms to deal with it.
China’s Banking System
From 1949 to the 1970s, the People’s Bank of China functioned
as both the central bank and the sole deposit-taking and
lending institution. In the late 1980s, it became the central
bank and financial supervisor, while the “Big Four” (the Bank
of China, China Construction Bank, the Industrial and Commercial
Bank of China, and the Agricultural Bank of China)
became state-owned commercial banks with “policy lending”
mandates. Kashyap and Dobson follow the evolution of these
banks, noting that as of the end of 2005 they still account for
more than half of all bank loans made in China. Furthermore,
Chinese firms still raise very little money through stock and
bond markets.
“A major problem in China is ‘nonperforming loans,’” explains Kashyap. “A nonperforming loan indicates that the borrower doesn’t meet internationally accepted standards for making payments on time.”
To pave the way for bank modernization, nonperforming loans were removed from bank balance sheets in China in 1999. These nonperforming loans, valued at $168.2 billion, were transferred from banks to four newly created asset management companies. The latter issued bonds guaranteed by the Ministry of Finance to the banks.
In 2004 and 2005, further capital injections of $60 billion from foreign exchange reserves helped banks stabilize after writing off remaining bad loans (for the three non-agricultural banks).
The first and second round of recapitalization plus unresolved nonperforming loans implies a total cost to taxpayers of more than $250 billion. Cleaning up the Big Four’s misdirected loans through 2005 can be conservatively estimated as equal to 10.8 percent of China’s GDP in 2005.
China’s problem with nonperforming loans arose for two reasons. First, China’s state-owned enterprises have served as the main source of employment and social safety net for much of the population. Reforms were implemented in ways that minimized unemployment and potential instability. Since China has no formal unemployment program or pension protection, it has been assumed that banks will provide credit to keep people in rural areas at subsistence level.
Second, credit was directed through the banking system to move losses off the Ministry of Finance’s balance sheet. Banks had little incentive to develop skills and expertise in credit evaluation and were not prepared to be effective intermediaries.
Starting in 2005, many of the largest state-owned commercial banks also have had initial public offerings (IPOs). These IPOs were intended to impose market discipline on directors and managers, improve accuracy and transparency to international standards, and subject bank performance to market appraisals of efficiency and profitability.
Kashyap and Dobson suggest that the critical question for banking reform in China is whether the burden and responsibility of “policy lending” will be decisively lifted from the banks.
Several indicators point to continued government influence on bank operations. Creating jobs to absorb surplus labor remains a major priority. Furthermore, investment in China has grown at unsustainable rates: 34 percent in 2004 and 16 percent in 2005. The investment boom has been accompanied by a period of robust bank lending, with loan growth in excess of 15 percent between mid-2005 and mid-2006.
The economy is now faced with declining capital productivity. Approximately 40 percent of industrial SOEs are losing money. Restructuring efforts have mostly involved pruning smaller firms. The ten largest SOEs (among a total of more than 120,000) account for 53 percent of total revenues and a large fraction of total profits, thus any aggregate figures on SOE performance will be heavily influenced by a small number of these firms. However, the banks are mostly exposed to smaller and much less profitable SOEs.
Bank data suggests other problems with the banks lending practices. The largest banks are especially exposed to corporate customers in sectors targeted by government policies (housing, energy, telecommunications), increasing banks’ vulnerability to economic shocks. Recent studies also suggest that state-owned banks in China are losing market share to other financial institutions more quickly in the provinces that have more profitable corporate customers. Moreover, the banks inadequately account for credit risk when pricing their loans, and continue to have substantial bias toward lending to state-owned and politically connected borrowers.
Well-functioning banking systems are dependent on a governance framework that creates accountability at the very top of the organization. China’s Big Four banks have govern- ment officials as directors and Communist Party appointees among senior management, undermining bank independence. The Big Four face strong pressure to retain employees even though they may lack experience and the skills for a modern bank. Overall, anecdotal evidence supports impressions that the outlook for long-term profitability is cloudy at best, despite the progress made by recent bank reforms.
The Risks Ahead
Many of the loans granted after the capital injections of 2004
and 2005 are poised to go bad. Two events could trigger a
banking crisis: the entry of foreign banks in 2007 and a possible
macroeconomic slowdown. Kashyap and Dobson conclude
that foreign entry is a relatively insignificant threat because
foreign banks seem to have little interest in battling Chinese
banks for domestic lending share.
A macroeconomic slowdown seems more likely, since 12 percent of loans already are classified by the banks as being at risk, despite record growth. In July 2006, China’s top leaders took the unusual step of warning the public that the economy was at risk of overheating.
In a market-based economy, the goal of profit maximization would naturally deter continued investment in sectors with excess capacity. Moreover, businesses that did seek bank financing would face increased borrowing costs because of the risks. Chinese firms’ incentives also are dulled by lack of corporate governance and the incentives provided by many local governments, including ongoing pressures to absorb surplus labor.
The authors attempted to estimate bank loan losses that might result from a macroeconomic slowdown on borrowers’ performance. Using loan rating classifications, the authors estimate that if a slowdown took place in late 2007, writing off nonperforming loans would total 7.2 percent of GDP. This would mean that 1.8 percent of growth each year between 2004 and 2007 was paid for with loans that would wind up going bad.
The authors suggest two alternative visions for banking reform in China that would balance the objectives of stability and efficiency. One alternative is to move policy lending to transformed policy banks to eliminate distortions involving management, regulation, and reporting systems.
Similar to the “good bank/bad bank” strategy used in Japan after World War II, this model isolates bad loans into a business within the bank. By giving stature to the “bad bank” and staffing it with management dedicated to resolving nonperforming loans, customers won’t receive new loans or special consideration from the “good” side of the original bank.
The profit-generating loans would be transferred to the good bank. Remaining staff would need to build management information systems that permit modern credit evaluation and risk management. Freed from the burden of making loans for social stability, the transparency of the remaining operations would be greatly enhanced.
Another alternative would be to separate the largest stateowned banks along deposit taking and lending functions and turn them into “narrow banks.” This would shift the burden of continuing policy lending to policy banks. Smaller banks and foreign institutions would take over lending functions, and the extensive branch networks and staff of these banks would be preserved. Imposing limits on the range of investment options would further increase their attractiveness as organizations for other banks and financial services companies to partner with.
Gradualism with Realism
Kashyap and Dobson note that they are not arguing for a “big
bang” solution or the privatization of banks in China. However,
if the Chinese government wishes to retain majority ownership
of large banks, it must be recognized that the banks are
likely to remain inefficient, low-margin, low-growth businesses
that will lose market share to smaller banks whose ownership
and employment contributions are of less interest to
the government.
The cost of another bank bailout may be acceptable to the government if it is viewed as the cost of maintaining stability. However, with better policies, the money could be more productively used to fund government programs such as improving rural-urban and regional inequality.
“China can afford to muddle along, periodically bailing out its banks, but the government could save tremendous amounts of money by relieving the banks of the contradictory requirements of supporting social stability and trying to operate profitably,” says Kashyap.
“The contradiction in China’s gradualist banking reforms,” Wendy Dobson and Anil K Kashyap. Prepared for the Brookings Panel on Economic Activity, September 2006.