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Banking Sector Challenges in China

2008: Volume 7, Number 3
1. China’s New Labor Contract Law: An Indian Perspective
2. The Financial Crisis and China’s Future Growth
3. China’s New Labor Law: A View from Foreign Business
4. Banking Sector Challenges in China
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China’s Economy & Financial Market Context

In 1980, as Chinese reforms were just getting under way, the country’s gross national income amounted to 9% of the figure reported by the United States. Last year, China’s GNI had climbed to 51% of the U.S. level. China has been growing at stunning, double-digit rates for years, capturing headlines for achievements in trade, investment, and most recently, the 2008 Olympics. As China exports 30% more than it imports and the U.S. is a top trading partner, trade friction with U.S. has also become a major issue. Clearly, the world is paying attention to China as it develops into a multi-faceted economy with strong growth coming from various sectors — service, manufacturing, tourism, banking and finance and trade, coupled with substantial infrastructural projects.

The world is also paying attention to China in connection with the global financial crisis triggered by the housing and sub-prime meltdown in the U.S. I believe China is in a position to help the West alleviate the impact of the crisis. China’s currency should remain stable. Chinese banks have limited exposure to sub-prime instruments as they rely more on traditional deposits to fund assets. Exports will surely be affected by any global slowdown, but the impact for China may not be as severe as some may think. China should be able to maintain 8%-9% growth, and the crisis may even offer China opportunities to invest in the West and help ease the crisis.

China’s economy is changing. For the first time, the service sector accounted for about 50% of China’s GDP in 2007. This trend is to expected to continue due to increasing domestic consumption and China’s progress in moving up the value-added chain. Since the early 2000s, China has been moving its manufacturing to utilize cheaper labor in Southeast Asia (especially Vietnam). In addition, China is changing the world’s major trading blocs as the Asian pie is growing at close to double digit rates. Case in point, China-India trade was less than $5 billion ten years ago and in 2007, two-way India-China trade was over $30 billion. The same can be said for Latin and South America where trade with China has taken off since the early 2000s. China’s trade with Africa and Middle East has also seen noticeable growth. Simply said, the 19th and 20th century trading blocs made up of the US/Europe/Japan is shifting in favor of China-led Asia/US/EU/Middle East and Africa/Latin America.

For Chinese companies to survive in their domestic markets, they must go abroad to set up offices and manufacturing plants closer to their customers. This strategy can add to profitability given the cutthroat price competition in the domestic market. Brand awareness created from overseas operations can help increase domestic sales. Obtaining financing overseas makes it easier to obtain funding domestically. Operating abroad makes it easier for the Chinese companies to tap into financing in the West and to improve managerial and human resources skills, branding and marketing. Chinese companies are already major investors in Africa, Middle East, and Latin America.

Though the Chinese government has been controlling its overheated economy in 2007 and 2008 via tight monetary policy, authorities are facing up to many different challenges, including the sub-prime crisis and a related reduction of confidence in Chinese stock markets. The Shanghai Index dropped about 65% from its high in October of 2007 to its recent level of 2,000. As the private sector continues to grow, and as the regions seek to develop their own local economies, policy makers in Beijing are likely to find it harder to control the economy, particular with the limited policy tools that are available. In 2008, China is experiencing greater volatility in the economy. The Sichuan earthquake and the flood in the southern region have contributed to higher inflation and to a smaller extent, a drag on the economy. Beijing’s current policy focus is on curbing inflation (currently growing at over 8%) and maintaining financial stability. While the pace of the local currency appreciation is likely to be of secondary importance, a stronger currency is likely to support the authorities’ overall aims.

Recent Developments in the Chinese Banking Sector

In line with this broader economic context, ten years ago there was no Asian bank representation among the world’s top ten largest banks. Who would have thought that in May of 2008, Industrial and Construction Bank of China would become the largest bank in the world in market capitalization of $278 billion! As a matter of fact, as of May 2008, three of the top five banks were Chinese (the others being China Construction Bank as #2 and the Bank of China as #4).

China’s banking sector has made significant progress since the launch of economic reforms and “opening up” in 1980. Generally speaking, the planned reforms and restructuring of the banking industry has been well under way for the past several years. Some of the more profound changes include: significant strengthening of banking supervision, ownership diversification, corporate governance reform, and a consistent and vigorous focus on risk management and internal controls. The “opening up” policy has already benefited the overall vitality of the banking sector with an accelerated pace of reform and improved global competitiveness. Total banking sector assets exceeded $6.5 billion as of the end of 2007. Other key statistics are as follows:

*There are 14 joint stock commercial banks and 114 city commercial banks.

*There are three policy banks owned by the government to support various industries; this role is no longer played by the main banks.

*China’s big five banks (ICBC, Bank of China, China Construction Bank, China Agriculture Bank and the Bank of Communications) accounted for about 57% of total banking system assets.

*Non-performing loans have been reduced dramatically from 40-45% in 2000-2001 to the 2-8% range in 2007.

*Over 29,000 credit cooperatives are operating in China.

There have also been major foreign investments in local banks. Here are some of the highlights:

*Over 20 banks had been granted local banking licenses in 2007, with the first group being Citibank, HSBC, Standard Chartered Bank and Bank of East Asia.

*Since the early 2000s, foreign banks have been acquiring equity interests in local banks (20% maximum under current law and 25% for groups of financial institutions). They include HSBC, Bank of America, Royal Bank of Scotland, Deutsche Bank, Scotia Bank, Standard Chartered Bank, Citibank, Goldman Sachs, AE Bank, ING Bank, ANZ, Commonwealth Bank of Australia, among others.

The Current Banking Regulatory Environment

To strengthen China’s banking regulatory and supervisory framework, the China Banking Regulatory Commission (CBRC) was set up in April of 2003 to assume supervisory responsibility from the People’s Bank of China, which serves as China’s central bank. Up until that time, the People’s Bank held dual responsibility for both monetary policy and banking system supervision. To support these reforms, the CSRC (China Security Regulatory Commission) and CIRC (China Insurance Regulatory Commission) were also set up in 2003.

Financing Issues

Local companies have been relying heavily on bank financing as the corporate bond market is not fully developed. Tightening monetary policy (the reserve deposit ratio was increased 6 times this year to 17.5% currently) and loan reduction guidelines have made it difficult for local companies to obtain financing since the fourth quarter of 2007. On a quarterly basis, CBRC has asked both local and foreign banks to reduce their loans outstanding (10-15% range) as a way to prevent banks from excessive lending, in particular to property lending. Recently, local banks have been given permission to invest their customers’ money in U.S. stocks and mutual funds to provide diversification and options for investors. Changes in local security laws since late 2007 also make it easier for local companies to obtain financing from local and foreign banks using short term assets as collateral.

Though competition is intense in China, many banks, both local and foreign, recorded substantial growth in earnings in 2007 (30-60% increases are not uncommon). With Chinese banks having cleaned up their balance sheets, they are in a very good position to acquire banks outside of China to allow them to enhance their international exposure and to reduce concentration in terms of geography and product offerings. Recent examples include a Chinese bank buying a minority interest in United Commercial Bank in California (UCB bought Summit Bank in Atlanta a few years ago), another local bank buying equity interest in an Africa bank, and another buying a majority interest in a commercial bank in HK.

While major Chinese cities are well-served by local and foreign banks, one serious problem the country is facing is the lack of financial institutions’ presence in smaller villages and counties in China. It is estimated that about 3,000 villages and counties in Western China have no banks at all. Farmers and small business owners simply have little access to bank loans to support their businesses. Micro-finance has been growing leaps and bounds in rural areas, as directed by the People’s Bank and CBRC, to help alleviate these funding problems. The spread of formal bank branches to rural areas, however, is also needed.

Challenges facing Chinese Banks

In summary, challenges facing the Chinese Banking Sector include:

*Penetration of banking in first, second and third tier cities is much deeper than in rural areas.

*Foreign bank assets, though growing, are only about 5% of total banking system assets. *Control over second and third-tier banks in their nationwide expansion. On a micro level, headquartered banks find it more difficult to control the growth of smaller branches in remote areas simply due to lack of good management information system (MIS), credit and compliance risk approval and control, funding issues, and qualified employees.

*Better control of foreign exchange inflows via electronic registration and reporting to manage the flows of “hot” money.

*Develop a corporate bond market to provide alternative funding sources for local companies.

*Close monitoring of small and medium-sized enterprises that are facing serious financial stability resulting from CNY appreciation, loss of export orders from the US and Europe, and tightened loan policy.

*Brand consciousness is quite low among Chinese consumers in credit card products and thus many local banks are not making money on card business.

*Extremely low fee income as percentage of total income, making capital costs for Chinese banks higher. For example, a typical bank in the US would earn 25%-45% of their income from fees, while Chinese banks currently earn only 1%-15% .

*Consumer education and awareness about banking products are very limited and could create problems for banks introducing new offerings. Banks have not done a good job explaining to their customers the risks associated with certain bank product offerings. Banks customers have a habit of turning to local authorities complaining about banks’ ignorance in handling their accounts and managing their cash and investments. For example, bank customers obtain very little information on the risk and returns associated with structure deposits and yield-enhancing investments. Quite a number of banks were fined by the CBRC due to insufficient disclosure and customer education. In the U.S., banks need to obtain certification to sell structure products while in China, this type of procedure does not exist yet.

Despite the challenges, there is good reason to be confident that the Chinese authorities will continue to focus on reforms and structural changes to further improve and strengthen the banking and financial sectors. Further opening up of domestic financial institutions to the rest of the world and globalization of domestic banks (in the form of foreign branches, equity investment and joint ventures with banks in the West) will bring about a more stable financial system driven by market forces of supply and demand.

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