Dysfunctional banking system fails the innovators

September 8, 2013 by Ken Davies

China’s banks are among the largest in the world (there are now 14 of them in the 2013 Fortune Global 500 list). However, because of a restrictive financial policy climate and their cosy relationship with large state enterprises, they are not yet playing a fully effective role in financing China’s growth and modernization.

Having overcome their lack of financial viability in the opening years of this century, Chinese banks have become riskier since 2008. The central bank allowed this to happen to achieve stimulus, but is now trying to bring banks – and the recently greatly expanded shadow banking system – into line to ensure the stability of the financial system during the current slowdown and restructuring phase of the wider economy.

Before economic reform in the late 1970s, China’s state banks, led by the People’s Bank of China (PBoC), functioned as conduits for state funding of enterprises. In 1984, the PBoC ceased to handle savings and credit and became the country’s central bank. In a reorganisation ten years later, four banks were designated state-owned commercial banks, nominally independent of government: the Agricultural Bank of China (ABC), the Bank of China (BoC), the Industrial and Commercial Bank of China (ICBC) and China Construction Bank (CCB). Government policies were thereafter carried out by three “policy banks”, the Agricultural Development Bank of China, the China Development Bank (CDB) and the China Import and Export Bank (Exim Bank). In 1995, private banks were permitted.

These reforms constituted a necessary, but not sufficient, condition for the creation of a modern banking system. The central bank still lacked independence from government and a clear mandate for targeting a specific indicator, such as inflation. Its armoury of monetary policy instruments was limited to such things as varying the bank reserve requirement (the favourite, even now that it has added instruments such as open-market operations).

Even after banks became nominally independent and state-owned enterprises (SOEs) were reformed in the 1990s, enterprises still did not all get into the habit of repaying loans. Nonperforming loans in the late 1990s were estimated by the government at around 20% of total lending. Foreign bank experts suggested the figure was at least double that proportion, especially in the four big banks.

In 2000, the government tackled the bad debt problem by formally establishing four asset management corporations (AMCs), one for each of the large state-owned commercial banks. The AMCs took on these banks’ distressed assets, thereby cutting them out of the banks’ balance sheets, providing a window of opportunity for the banks to become solvent.

In the first few years of this century, the banks’ balance sheets became healthier as, following reforms in which many loss-making SOEs were culled, the remaining state-owned enterprises moved into profit as a result of productivity improvements and booming world markets. NPLs dwindled to a manageably small proportion.

In 2003, the government set up a China Banking Regulatory Commission (CBRC) to regulate the banking system. This is an improvement in that there is now a regulator which publishes quarterly statistics on the health of the banking system, though these may not yet reflect reality.

The CBRC nonperforming loan (NPL) figure for the second quarter of 2013 is a mere 0.96%, which is widely believed to be an understatement. Local banks may be afraid of being punished for excessive NPLs, especially on loans to local governments. Also, large SOEs often repay bank loans at the same time as they contract new loans of the same size or larger. Although this is not a formal rollover, the effect is the same, but as such loans are paid off they are not considered to be of poor quality. The share prices of Chinese banks also currently suggest much higher NPLs than 1%.

The task of regulation has become more complex with the growth of a large “shadow banking” system alongside the banks.

In recent years, small and medium-sized enterprises (SMEs) and local governments have resorted to non-bank lending because they have had difficulty securing finance from the large commercial banks, which continue to make large loans to state-owned enterprises (SOEs) with whom they have personal connections.

Shadow banking does not take the form of complex derivatives, as it does, for example, in the United States, but is usually direct lending from trust companies and other bodies that are often offshoots of the major banks, as well as from corporate bond issuance. Some non-bank lenders even derive their funding out of the proceeds of bank loans to SOEs that are, like wealthy individuals – and banks – who put their money in trusts, seeking higher returns than they can obtain from bank deposits. (Interest rates charged in the shadow banking system are higher – typically double – those charged for regular bank loans.)

Although such alternative financing sources are a smaller proportion of the economy than in developed countries like the United States, their rapid rise has caused worries about instability. In lending to borrowers who are seen by the banks as too risky, non-banks are subject to a higher degree of risk. This risk can be communicated back to the banks to the extent that their deposits are used for more or less indirect lending through the shadow banking system.

There is no official figure for NPLs in the non-bank sector. These may be as large as, or larger than, bank NPLs, and can have a direct impact on banks’ health to the extent that such lending originates in the banks.

In late June 2013, the authorities decided to curb the shadow banking sector. In the past two months, banks have accordingly increased their share of new loans. While this action has rendered the financial system more amenable to government control, it has not solved the problem of the misallocation of funding that continues to plague that system. The situation is indeed now worse: SMEs and private enterprises will now find it more difficult to fund their operations, no matter how profitable they are. Meanwhile, large “zombie” SOEs bloated with overcapacity from bank-financed investment splurges, will continue to roll over their huge, low-interest loans to keep themselves alive.

The government needs to reform this dysfunctional financial system, which is failing the most active and innovative players in the Chinese economy. Interest rates will have to be liberalised and banks encouraged to apply rational lending criteria.

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