If China has a blueprint for banking reforms it is that there should be no blueprint. The experimental approach which has characterized economic reform for almost 20 years continues to be the preferred way forward for Beijing’s planners.
“The Chinese have always religiously stayed away from overall plans and timetables,” says Pieter Bottelier, chief of mission at the World Bank in Beijing. “They have a general direction in mind and then leave the details to the market situation and needs.” As Deng Xiaoping, China’s ailing patriarch, has put it: one should “cross the river by feeling the stones”.
Such caution has the advantage of not causing sudden shocks to the financial system. Operating on a low capital base, China’s state-owned banks, which still dominate the financial sector, are heavily dependent on the continuing confidence of the nation’s household savers.
In ordinary circumstances, depositors might have looked elsewhere for returns. Interest rates generally have been negative in real terms and Chinese banks are not noted for their efficient service or impeccable balance-sheets. An evaluation of their “intrinsic safety and soundness” by rating agency Moody’s resulted in a dismal E+ grade being allocated to three out of four of the main state-owned banks.
The slow pace of financial deregulation within China and tight controls on Chinese investment abroad have staved off any chance of depositors moving funds elsewhere. The only risk for China’s banks, which are burdened by bad debts built up under the planned economy, is that time may be running out. “They can’t indefinitely carry on the current system without running into a banking crisis,” warns Bottelier.
Yet the government has had success in managing its reforms. Under the leadership of Zhu Rongji, vice-premier in charge of the economy, government departments have made significant changes to the system without generating the chaos seen in Russia and other former communist countries which have embarked on economic reform. “China has a good record with economic reform so far,” points out one banker, “so I would hesitate to predict dire consequences.”
This relatively smooth implementation of reforms since 1993, when China’s Communist party decided to move fully toward a market economy, has surprised even the nation’s leaders. “Originally we had anticipated more risk but as it has turned out, we have seen less risk and more success,” said Zhu Rongji in an interview.
While most Chinese banks and government ministries lack officials with experience and a sophisticated understanding of finance, there seem to be enough of them to ensure that the reforms are enacted correctly. An openness to technical assistance from multilateral agencies such as the International Monetary Fund (IMF) and World Bank, together with advice from foreign banks, probably has helped to keep reforms moving in the right direction.
According to Maurice Lee, manager for Beijing at HongkongBank, foreign commercial banks are being showered with requests from Chinese banks to participate in training programmes. For locals, this is a time-consuming process. Meanwhile, foreign bankers face a frustrating wait, the scope of business permitted to them severely curtailed until the government decides that Chinese banks are ready to compete with the internationals. Foreign banks until recently have not been allowed to do business in the local currency and have been encouraged to deal mainly with foreign-invested enterprises rather than local companies.
Frustrated progress
Nevertheless, there are about 400 representative offices and branches of foreign financial institutions in China. The country’s huge market is the lure. Vague promises that the banking sector eventually will be opened up to all-comers appear to have been sufficient to entice them in.
And progress is being made. In November it was announced that as of December 1 1996, the currency, the renminbi yuan, would be convertible on the current account. An experimental scheme launched in April seemingly worked so well that China’s leaders saw fit to extend the experiment to the whole country in July, well ahead of an original deadline of 2000. A Chinese commitment to the imf’s Article VIII, which stipulates current-account currency convertibility, indicated the formality of the December move, allaying suspicions that it was simply a trial run which could be reversed at any moment. Also in December, the central bank, the People’s Bank of China (PBC), announced that a select number of foreign banks with branches in Shanghai’s Pudong district, for the first time would be allowed to conduct local currency business. The patience of foreign banks operating in China since the early 1980s seems to have been rewarded.
On top of this, securities-market officials announced a huge batch of companies to be listed on China’s domestic stock exchanges and on overseas markets. Even in the absence of a formal privatization programme in China, foreign investment banks will have their work cut out in coming months.
Yet liberalization may be slowed this year by the political agenda as the 15th Communist Party Congress (China’s “elections”) takes place and Hong Kong reverts from the sovereignty of the United Kingdom to that of China on July 1. Zhu Min, economic adviser to the president of the Bank of China, predicts that “because there are these big events, there will be a relatively conservative strategy overall”. One Beijing-based analyst suggests that while reforms will continue, the upcoming congress will encourage government officials to shy away from risky decisions; the temptation will be to proceed with the least controversial.
While there is considerable support within China for economic reform, there remain conservative elements wary of letting go of the power they wielded under a planned economy. Even without ideological resistance, in such a labyrinthine government structure, bureaucratic in-fighting can play havoc with reform measures. Witness the fact that although China’s stock exchanges have been functioning for five years, the country still lacks a formal securities law. The number of drafts of this law has now reached double digits. It has been hampered by disagreements over which government agency should yield what power over which securities markets and divisions between the China Securities Regulatory Commission (CSRC), which produced the first drafts, and the legislative committee of the National People’s Congress, which has to pass the proposals into law.
The situation has not been helped by the 1995 collapse of Barings and similar incidents within China. Shanghai International Securities, one of China’s premier brokerages, for example, virtually bankrupted itself in 1995, when a punt on the Shanghai bond futures market went badly wrong. Securities markets, and futures markets in particular, are treated with suspicion by a Chinese government which dislikes volatility and is still getting used to the idea of not being able to control everything. Many futures brokers who enjoy punting on green beans and plywood futures on China’s commodity exchanges were closed last year. “We’re in something of a period of recession,” says one trader.
Zhu Min at Bank of China suggests there is unlikely to be a radical change of pace in the commercialization of state-owned banks in 1997. Rather, Bank of China will focus on “deepening” existing reforms, he says. There probably will be an emphasis on “more technical issues”, such as changes to reserve requirements, which remain unusually high at 20%.
Bankers do not expect until 1998 a definitive move away from the “credit plan”, whereby the government determines how much each of the four major state-owned banks can lend. However, banks are preparing themselves for asset/liability management which will have to be in place once the quota system is scrapped.
Commercialization
In some respects, the pace appears slower only because basic reform measures are in place: the most radical was a 1995 commercial banking law giving Chinese banks for the first time the autonomy to act as such, as opposed to operating as funding arms of the government. And the changes continue. For example, The People’s Construction Bank of China, which bore the brunt of long-term policy lending under the planned economy, has revamped its image by changing its name to China Construction Bank. The word “People’s” was inconsistent with the bright, new commercial bank it aims to be its new logo is displayed on advertising billboards across Beijing.
Nevertheless, China’s banks remain in a sorry state, heavily burdened by non-performing loans made to cash-strapped state-owned enterprises. A Jardine Fleming report suggests Chinese banks have an estimated Rmb1.3 trillion in non-performing loans (29% of total loans). “Writing off these loans would wipe out all the industry’s capital,” the report warns. As these figures suggest, China’s state-owned banks badly need recapitalization. However, even if the government could afford to do this, it understandably is reluctant to proceed until there is a degree of certainty that the new capital will not go to funding more bad loans.
The government has indicated that reform of state-owned enterprises will be a priority in 1997. Any improvement in the state sector clearly will help China’s banks, though inevitably it will be a slow process. For their part, Chinese bankers are candid about the fact that even without this burden, banks face challenges in adapting to a commercial environment. As one banker points out, having been uncommercial for so long, most staff at state banks lack the “skill, concepts and ideas” of how to be a “good commercial bank” one reason for a strong focus on staff training at all of China’s major state-owned banks.
This has made buzz-words out of “strengthening internal controls”. As part of an internal rationalization, China Construction Bank no longer will allow branches at county level and below to approve loans independently. The bank found that unsound, low-level decision-making played a critical role in loans which went wrong.
Bank of China last year ran 10 pilot projects in which it separated its loan and credit departments. According to Zhu Min, such a system of checks and balances had been unnecessary under a planned economy. “Before, there was no risk. Everything was state-owned, so there was no need for a risk-control mechanism.” He says the results of the pilot projects were “excellent the quality of proposal improved tremendously”. The bank aims to extend the separation to the whole country this year.
Banks also are keen to unravel strands of the huge infrastructure they have built up as instruments of the planned economy. Between them, China’s major state-owned banks have hundreds of thousands of employees and one of the highest density of bank outlets-to-population in the world. Zhu Min says that of his bank’s 1,200 branches, 515 are “not in good shape”. However, because of pressure from local governments, it is proving politically difficult to close branches and lay off workers. Nevertheless, the banks do intend to close some branches this year.
Private banks
Despite government fears that state-owned banks are not yet ready for competition, there has been some liberalization. In 1995 the central bank allowed the establishment of China’s first wholly private bank, the Minsheng, or People’s Livelihood Bank. According to Davin Mackenzie, head of the International Finance Corporation in Beijing (which is keen to become involved in private banking in China), there are already a dozen or more private or semi-private banks and they are “growing by the week”. People’s Bank of China has authorized the Asian Development Bank (ADB) to take a stake in one such bank, Everbright, the first foreign participation to be allowed in a Chinese financial institution. However, bankers point out that if the ADB had been a foreign commercial institution rather than a multilateral agency, this almost certainly would not have been allowed.
Nevertheless, foreign banks gradually are being allowed to widen their scope of business. Last December was something of a breakthrough, as the long-coveted renminbi currency business finally was opened to a select number of banks on an experimental basis. The four initially chosen to pilot the scheme were HSBC, Citibank, Tokyo-Mitsubishi Bank and the Industrial Bank of Japan, though this was quickly followed with another batch of four in January. These were Standard Chartered, Sanwa, Dai-Ichi Kangyo Bank and Shanghai-Paris International Bank, a joint venture between Banque Nationale de Paris and the Industrial and Commercial Bank of China.
Renminbi lending
Now it is a matter of establishing how, in practical terms, renminbi lending will work. How will foreign banks be able to fund their renminbi lending? Foreign-invested enterprises tend to be net renminbi borrowers. However, the central bank has made it clear that foreign banks will not be allowed to accept renminbi deposits from state-owned enterprises or Chinese individuals.
“We would like to see the funding problem solved,” says Lee of HongkongBank. If deposits are just from foreigners, then the amounts “will be very small”. This means foreign banks will rely on borrowing from the central bank (which apparently will be allowed, though it is not clear to what extent) and the nascent inter-bank market. The market was established at the beginning of last year and is still functioning on what Chinese bankers refer to as an “experimental” basis.
Up to 60 days, inter-bank rates are market-determined. The establishment of the market is thus a vital step in the process of liberalizing interest rates in China. This process remains at a preliminary stage, with lending and deposit rates still fixed by the PBC. But while it is a positive development in terms of China’s market reforms, it creates a problem for foreign banks. If they are borrowing at floating rates in the interbank market, they still have to lend at the rates fixed by the PBC. There is not a swap market in China to hedge this mismatch, so foreign banks are left with something of a “technical problem”, according to Lee.
As yet, there is also no forward market for banks to hedge their renminbi exposure. A market was supposed to have been established in 1996 but the proposal was cancelled “because they were frightened of speculation and volatility”, says one banker.
One solution may be to participate in a growing market in Hong Kong, where renminbi can be hedged on a non-delivery basis. Bankers remain unsure, however, whether the PBC approves of this informal market and hence are cautious about developing it.
Still, most foreign banks in China probably would like to be in the shoes of the eight banks selected for the renminbi currency business. Provided the experiment goes according to plan, certain other banks probably will be given a renminbi mandate this year. Bankers also hope that the experiment will be extended beyond Shanghai.
This year also promises to be one in which more bank branches are established in Beijing, a much-coveted city off-limits to foreign bank branches until 1995. So far, seven banks have been authorized to set up Beijing branches but the process is likely to accelerate in 1997, nine or 10 approvals being expected by the end of the first quarter.
New listings
China’s stock markets remain tiny in comparison to the size of GDP. However, after nearly two years of consolidation, during which China’s securities-market authorities did not allow new listings in the domestic investor-reserved A-share market, 207 new companies were listed in 1996.
Fan Fuchun, a director at watchdog CSRC, says he believes the pace of new listings will continue into 1997. Recently the State Council, China’s cabinet, issued a Rmb10 billion quota for new listings, double the previous quotas granted.
It seems the country’s stock-markets are moving beyond the experimental stage, driven by state-owned enterprises’ desperate need for capital and by the huge demand from China’s savers for investment outlets beyond the banking system. This is despite fears that the exchanges are still inadequately regulated and open to manipulation and that wild swings in the market could cause social instability.
Development also is taking place in the market for B-shares, the only ones listed on China’s domestic exchanges that foreigners are allowed to buy. So far only 86 B-share companies exist; they have a total market capitalization of less than $4 billion. Foreign brokers complain the companies listed are too small in size and poor in quality to be of interest to large institutional investors. The result has been chronic illiquidity in this market.
The CSRC appears to be addressing such criticisms. It recently issued a list of 33 new companies to be listed as B-shares. In the past, such shares tended to be for Shanghai and Shenzhen companies, the stock-markets still being considered as local experiments. The list of 33, however, includes companies from around the country. At least one, refrigerator manufacturer Qingdao Haier, is a national brand-name: with a successful marketing strategy and a good reputation for after-sales service, it is not your typical Chinese state-owned enterprise. Such an attribute is likely to go down well with investors.
Investment bankers expect the list of 33 to be, on average, larger in terms of individual market capitalization than previous B-share listings. Publication of the list also appears to favour larger listings. Under a previous system, the government issued an overall quota which then had to be divided between companies.
The CSRC also has announced that 38 Chinese companies are to be listed on international stock exchanges. An additional 15 companies previously scheduled for listing have not yet come to market. After two quiet years in which almost no new Chinese companies were scheduled, this new list has been welcomed by investment bankers. Encouragingly, some of the big names of previous batches should finally come to market this year. Most notable are the two regional airlines: China Eastern is being brought to market by Morgan Stanley and China Southern is a Goldman Sachs deal.
Carl Walter, chief representative for CSFB in Beijing, attributes the new momentum in listings to the ending of China’s three-year austerity programme. “When they stop things around here, they stop everything all at once,” he says. “Now inflation is under control and they’re going to start up again, they just start up everything all at once . . . so now we have a frenzy again.” Walter sees a “two-year window” to “make some money, get some deals done and then sit it out again for a while”.
However, jaded by experiences of bringing Chinese companies to market, corporate financiers are approaching the newly listed candidates with greater caution: investment bankers are not charging into China with quite the same enthusiasm as in the boom years of 1993 and 1994. “We’re quite busy and hope to have a good year but with equity deals in China you don’t know if you can do them or not until they actually get done,” as one banker puts it.
Others are equally guarded. “Until you open the box, you don’t know what’s in there,” says Fumiaki Nishi, chief representative for Nomura Securities in Beijing. Most Chinese companies preparing for listing have required lengthy restructurings and many have performed abysmally once listed. This will not change overnight. Bankers are resigned to the fact that, after more than 40 years of a planned economy, it will take some time for Chinese state-owned enterprises to adapt both to the needs of a market economy and to becoming listed companies.
This is aggravated by the problem that Chinese companies are not always willing to sell shares at a price at which international investors are prepared to buy them. Datang Power, a power producer in northeast China, is a case in point. The company began to prepare for listing in 1994. However, a London stock exchange listing, finally scheduled to take place at the end of 1996, was aborted after the company and the underwriters failed to reach agreement on pricing.
Also, according to one Beijing-based US investment banker, the list of 38, which includes highways, power and pharmaceutical companies, is not on the same level as the previous large batch issued in 1994. “If you look at this [latest] list and compare it to the second list of 22, there are a lot better, greater Chinese companies in that batch than in this one, in terms of prominence of companies and the quality of companies.”
Whatever the difficulties of listed Chinese enterprises, foreign brokers in Shanghai and Shenzhen hope ultimately to participate in the domestic stock markets. And though deeply concerned by the potentially destabilizing effects of large inflows and outflows of capital, China’s regulators promise that foreigners eventually will be allowed to participate in the A-share market. Yet they remain reluctant to specify a timetable.
Again, however, the end of last year marked something of a step forward as Chen Yuan, vice-governor of the PBC, announced that foreign fund managers would be allowed to set up joint-venture fund-management firms. The regulators hope that foreign fund management will bring a greater institutional element to China’s stock exchanges, counteracting the volatility caused by an overwhelming dominance of individual, retail investors in the market.
To keep foreign capital out of the A-share market, it is likely that the Chinese partner will be responsible for raising funds and the foreign partner for fund management. Given China’s huge domestic savings rates, this could be an extremely attractive arrangement for foreign fund managers. According to one estimate, some 30 applications for such joint-venture fund-management firms have already been made to the PBC.
Year of the bond
The ministry of finance made rapid advances last year in its efforts to move to a system resembling that of a market economy from an unpopular arrangement whereby a quota of non-tradeable bonds was allocated to state-owned banks and other institutions to distribute to end-investors. Suitably impressed observers dubbed 1996 as “the year of the bond.”
Of 10 transactions last year, eight were tradable. The volume of bond issuance rose to its highest level Rmb195 billion for the year. Gao Jian, director-general of the state-debt-management department at the ministry of finance, expects this to rise to between Rmb200 billion and Rmb250 billion in 1997. Until 1994, the size of the domestic bond market was inconsequential, as the budget deficit was financed largely by borrowing from the central bank.
Since then reforms have been rapid. Particularly critical in 1996 was the decision to move fully to an auctioning system, allowing supply and demand, for the first time, to set yields in the primary market. Previously the yield was set administratively typically at a percentage point above the bank deposit rate of an equivalent maturity. Also important were the efforts of the ministry of finance to introduce a range of maturities into the domestic bond market, establishing a meaningful yield curve for the first time. Maturities now stretch from three months to 10 years. Gao says there will be further change in 1997, including the development of a nation-wide settlement system and the introduction of a fixed timetable for issues.
The ministry of finance appears committed to allowing foreigners to participate in the developing bond market. According to Gao: “We see foreign participation as a healthy step for the local markets and also for the integration of the local market into the international capital markets.”
Still too unsophisticated
As a first step, China International Capital Corporation (CICC), a joint-venture investment bank between Morgan Stanley and China Construction Bank, is likely to be allowed to participate in the bond market as a primary dealer. However, Gao estimates it will take another three to five years before the market is opened to foreign institutions, depending on other factors such as how soon the renminbi becomes a convertible currency on the capital account.
Foreign investment banks remain guarded about the opportunities in a market which will still have to go through some important institutional changes before it functions as a normal bond market. Also, although local bond dealers do now trade more on fundamentals and less on rumour compared to even a few years ago, participating institutions are still relatively unsophisticated.
Among key institutional changes to look out for are the abolition of a 5% tax on profits if bonds are sold before maturity. This tax cannot be offset against loss-making trades. As one banker points out: “This makes it very expensive to do what dealers should be doing: providing liquidity.”
Even more critical will be allowing dealers to go short, a practice currently impossible. “The ability to hedge yourself as a dealer or investor is the key to developing a really vital, liquid market,” says one US banker. Chinese regulators, however, fear the potential for speculative activity. CICC has suggested the intermediate solution of allowing dealers to go short by placing bonds with the central bank. The PBC could then monitor the extent to which dealers are going short.
It is unlikely, however, that the government will allow the re-opening of the bond futures market, which was closed after a scandal in 1995. That scandal unfortunately has become something of a symbol of the dangers of financial markets and of the need to control potentially speculative activity.
Bond futures remain a highly controversial topic. Changes, however necessary to market development, illustrate the difficulties that reform-minded officials face, particularly in 1997, a politically sensitive year.
