Beijing's plans to inject fresh capital to recapitalize the Big Four state banks and to raise the foreign ownership ceiling of Chinese banks to 20% from 15% are crucial reform steps. Increasing foreign ownership will undoubtedly open the way for introducing international practice and expertise and market discipline to the Chinese system. However, these significant steps are still piecemeal, as China's leaders still lack an integrated and strategic vision to bank reform.
The basic problem is that China sees banks and the stock market as different issues in the financial reform process. But they are not - they are like the left and right heart of a body, either one will not function properly alone.
Without an efficient capital market, banks have taken on equity-like risks in the funding process. Most of the state firms still think they do not have to repay bank loans, as those are public funds injected by the government. Policy-driven lending only pushes banks to lend irrespective of credit risk to support the economy. Thus, bank loans are like equity sunk in the state firms.
What's wrong with the current reform direction?
In short, China's banking system loses its market discipline, and is inefficient in allocating capital. An effective way to rectify the distortions is to push stock market reform as part of the overall financial reform strategy.
However, there is still no functional stock market in China so that households have no other way but bank accounts to park their savings. The bulk of hard-earned savings are forced continuously through bank lending to state businesses that are not earning reasonable returns.
Hence, China's economy is built mostly on bank debt. Equity capital is negligible. For example, Chinese companies raised about RMB96 billion of funds in Shanghai, Shenzhen and Hong Kong stock markets in 2002. The amount was less than 1% of GDP. Some investment bankers argue this amount of equity financing is too little for an economy with an annual growth rate of 7-8%.
On the other hand, total loans accounted for over 140% of GDP; one of the highest ratios in Asia. China needs to raise more capital from the stock market to achieve a better funding structure.
The problem with a debt-financed economy is that it breeds moral hazard, creating poor growth quality, which becomes unsustainable in the end. Those firms that are significantly debt-financed tend to be more risk-taking than firms that have significant equity capital. This is because a debt-financed firm is "gambling" with other people's money, as creditors normally do not participate in management.
On the other hand, equity owners of a firm tend to be more prudent, since they have their own money at stake. They may be forced out of the market by the aggressive debt-financed firms. Thus, a highly leveraged economy will consist of heavily indebted companies undercutting each other ruthlessly.
Such destructive acts will make it difficult for businesses to compete through legitimate means. It will create an incentive for some firms to make a profit via illicit means. Corruption, unfair competition and crony capitalism emerge, resulting in financial scandals.
As evident, these characteristics are common to the Chinese economy. Its rapid debt growth is not abating. Domestic credit growth outpaced GDP growth by more than 5 times last year, raising the inevitable suspicion that a lot of credit created had gone to fatten someone's pocket rather than real investment.
To reform the banks meaningfully, China must embrace an integrated approach by nurturing an equity market alongside the banking system. A properly functioning stock market does not only inject market discipline to the system.
It is also a powerful capital allocation mechanism, which provides Chinese households with an option for their savings and entrepreneurs with an additional fund-raising avenue.
The reform obstacles
However, the leadership does not fully understand the functions of the stock market, and has thus pursued policy with a bias to support market levels rather than facilitating capital allocation. International experience, notably from Japan, shows that such a "stock-price-keeping" policy bias would not work for both investors and the economy over time.
China's stock market reform is as daunting as banking reform. There is a mentality obstacle to overcome. Most Chinese see the stock market as a casino and believe the government's goal to set up the stock market is to fund the dire state firms. Indeed, the government has to shoulder most of this blame.
Major stock markets elsewhere allow investors to invest in different types of companies. But Chinese listed companies are predominately state-owned entities. Only about 10% of the 1,200 companies listed on the Shanghai and Shenzhen stock exchanges are free from any state holding.
Most of the private firms that are powering China's strong growth are not listed. Further, daily stock trading is often manipulated by collusion between securities firms and investment management firms.
Beijing has also restricted access to the stock market by imposing IPO quotas on provinces. Such limitation has artificially created an IPO shortage so that the bad state firms could have access to capital.
This has given rise to the so-called "adverse selection" problem, where only bad firms are selected to list on the stock market and offered to investors. Hence, the overall quality of listed companies is poor, and the policy to artificially prop up share prices would not attract real investor demand for stocks.
To change this casino mentality and gain investor confidence, China needs to take some big steps, including selling off the government stake in listed companies, fostering the growth of investment funds to offer retail investors a better alternative to the safety of savings accounts, and allowing allow the more dynamic private companies to list. This last step is also crucial for helping China to build up the much-needed capital stock during this development stage. It is thus vital to open up the IPO market to allow quality companies that meet listing requirements to raise funds in the stock market.
Implications...
Without reforming the stock market, banking reform is unlikely to be thorough. If there is little equity capital in the system, there will always be political pressure on banks to lend to support the economy, as is the case currently.
An underdeveloped stock market also deprives households of their choice of saving vehicles. If they do not buy stocks or other assets, they will keep piling money into bank accounts.
These hard-earned savings will then be used to fund the state companies. The root problem of capital misallocation will remain, despite any efforts to recapitalize the banks. In the end, partial banking reform that leaves out the stock market will only create opportunities for the vested interests to fatten their own pockets, advance their political power and create more bad debts for the system.
Allowing foreign control of Chinese banks will do little to help under a system with incentive problems distorting the functions of the banks and the stock market. The current broken financial system means that foreign equity participation will not necessarily improve the Mainland banks' performance.
This is because the legal, institutional and cultural infrastructure of the local system is more crucial in affecting banks' performance than foreign management. That is why, despite its loan scandals in 2002 and 2003, the Bank of China's New York, London and Hong Kong operations are better run than its operations in the Mainland.
On the other hand, the performance of the US Citibank is constrained by its higher bad-debt ratio at its China unit than other units in the developed markets.
...for the markets
Financial reform is thus a long process. It is unlikely that Beijing will allow full currency convertibility before the Chinese banking woes are fixed so that the system is strong enough to withstand volatile portfolio flows. Beijing will not even allow a wide trading band for the RMB, say more than 5% away from the policy rate set by the central bank, in the short-term due to concerns about systemic stability.
As long as the RMB is under appreciating pressure, which looks likely to continue in the next year, the de facto RMB peg will translate into a benign liquidity environment in China, keeping interest rates low. The authorities have recently used selective tightening measures to cool off the property bubbles in Shanghai, Beijing and the coastal areas. Such a selective policy stance should continue, as Beijing is wary of sacrificing the whole economy for popping the bubble pockets by overall tightening measures.
Chi Lo is author of the new book: "When Asia Meets China in the New Millennium - China's Role in Asia's Post-bubble Economic Transformation", Pearson Prentice Hall 2003, ISBN 0131028421
