What lies ahead for China's financial markets

Picture a country of one billion people with a GDP of approximately US$43 billion. Major banks have roughly 30,000 branches and savings deposits totalling $2.5 billion, about $2.50 per capita. Government revenues and expenditures are roughly in balance, at $13.5 billion each.

That was China in 1978, on the eve of economic reform. Throughout the preceding thirty years since the founding of the People's Republic of China, progress was made in achieving social and political stability, but robust economic growth had eluded China's leadership. Upon Mao's death, the first order of business was to restructure China's economy, creating what his successor and master of China's economic reform, Deng Xiaoping, called a 'Socialist Market Economy.'

More than two decades later, China has a population of 1.3 billion, a GDP of approximately $1.35 trillion, and bank deposits of $1.9 trillion, or about $1,450 per capita (see Figure 1). China is the seventh biggest economy in the world and the first in terms of rate of growth. This level of sustained growth has involved, among other things, a complete restructuring of China's Ministry of Finance (MoF), financial markets and banks.

As the fourth generation of leaders prepares to take power in early 2003 they will face a broad range of challenges in the financial sector, challenges that will require changes as profound as those of the last twenty years, demonstrating that China's reform is not only complex; it is unfinished. In many respects, it is China's banks and other financial institutions that bear the greatest burden of the socialist legacy: decades of central allocation of capital to inefficient State-owned enterprises, frequent shifts in investment strategies, poor corporate governance and internal controls and inadequate management of credit and other risks.

China's major banks struggle with large portfolios of non-performing assets. Temporary relief was won when asset management companies assumed a large fraction of this burden with a huge debt for equity swap beginning three years ago. However the equity has proved difficult to monetise, and the asset management companies themselves have not been as successful as anticipated in restructuring and disposing of the equity acquired. China's equity markets have been nurtured as an alternative source of capital, primarily for the State-owned sector. The growth of the Shenzhen and Shanghai markets, in barely ten years, has been remarkable, but so have the growing pains. From an investor's point of view, the markets have provided mixed returns and considerable risks. China's insurance markets have also undergone restructuring, expansion, and opening up to domestic and foreign competition, in order to help individuals and institutions manage risk in an increasingly marketised economy.

A look back

A look forward to what's ahead for China's banks and financial institutions requires a brief look back, to understand fully the policy framework in which they have developed. There are two key points in this discussion. First, the regulatory and operating entities in China's financial sector are directed by policy forces to make the transition from agents of centrally-planned fund allocation to a role shaped by markets and the commercial needs of efficient fund allocation. Secondly, China is committed to commercialise, not privatise, its Stateowned enterprises. This is more than a semantic distinction. So far, the explicit position of the Communist Party and the government is to attempt to maintain majority ownership of the State's major enterprises while trying to protect the actual operation of the enterprises from the journal • Tackling the key issues in banking and capital markets inefficiencies and distortions caused by control and interference of the government ministries. The mandate is to separate control from ownership.

Given this continued commitment to State ownership, the first and foremost priority in shaping the financial sector is assuring the continued viability of the State Owned Enterprises (SOEs). While the SOEs are reducing their total employment, their crucial role in employment levels will continue to impede their efforts to operate efficiently over the next decade or more. A second, and equally important goal, is to support the government's large, on-going investment in infrastructure. Constant, display-quality infrastructure development is now an inseparable part of China's political economy. The domestic commercial customers of the major financial services providers and regulators are almost exclusively the SOEs. They still account for more than half the control of capital and half the fixed asset investment in China. Major banks such as China Development Bank make over 70% of their loans to development projects supported by the State Council, China's highest executive body.

One of the key prevailing policies of the socialist market economy is separating regulators from operators. This is the reference point for a number of papers, including those from ministries regulating particular industries and organisations like the Chinese Securities Regulatory Commission (CSRC). The CSRC has developed extensive guidelines for corporate governance, that set forth limits on the role of the State in the governance of commercial entities, even where the State owns a large majority share. The policy has also placed considerable pressure on the banks to improve their credit risk management and curtail the unbridled allocation of loan funds to SOEs with no prospect of repayment. SOEs are also under threat from an impending new bankruptcy law that has yet to see the light of day.

Reform

Institutionally, the current system of banks and markets emerged from a highly centralised, unitary banking institution that served as both a central bank, issuing currency and implementing the government's monetary policy, and a commercial bank, providing deposit, loan, and settlement services. The People's Bank of China (PBOC), established originally in late 1948 by assembling three regional banks under Chinese Communist Party (CCP) control, worked with the Ministry of Finance, under the State Planning Commission, to implement the national plan. The operations of the bank were guided exclusively by the annual planning process and the plan itself, which focused on balancing a complex set of interlocking inputs and outputs across all major sectors of the economy. The PBOC served not only as the core of central and commercial banking activities but also as China's insurance regulator and underwriter.

By the mid 1950s, some expansion of the banking system had occurred. The Bank of China (BOC) had been established, under the PBOC, and the People's Construction Bank (PCB), under the MoF. The former was responsible for foreign exchange activities and the latter for capital support of construction and fixed capital investment. Rural Credit Cooperatives were also set up, to take deposits and reallocate funds in the highly diverse agrarian economy. Both the BOC and the PCB were run as departments of their managing agencies, not as independent entities, until the reforms of late 1983 and 1984. At that point, the State Council formally established the PBOC as a central bank, charged primarily with standard central bank functions. A number of commercial and policy banks were separated out, and the People's Insurance Company of China was established as a separate entity. The PBOC now describes its functions as a combination of formulating and implementing monetary policy and supervision of the financial services sector. For the latter, they write, 'The PBOC performs the following functions: To approve, supervise and administer financial institutions and financial markets, to promulgate ordinances and rules concerning financial administration and business, to maintain the legitimate stable and sound operation of the financial industry.'

As we look at the prospects of China's largest banks, such as the Industrial and Commercial Bank of China, the Agricultural Bank of China, Bank of China, China Construction Bank and the State Development Bank, it is important to remember that they have been in existence or have operated semiautonomously for less than twenty years. The first four of these accounted for over 70% of all loans and over 60% of all deposits in China's commercial banking system at the end of the last decade. At the end of the first quarter of 2002, the PBOC reported total deposits in the State banks at approximately US$1.9 trillion and total loans approximately US$1.36 trillion. These banks continue to operate within numerous constraints and non-commercial pressures, not only at the hands of central government, Party officials and bureaucrats who look to the banks to support industries and enterprises of importance to them, but also at the hands of local bureaucrats and officials whose fate is closely tied to the survival of SOEs in their particular region.

The future fortunes and functioning of China's banks are integral to a policy role they cannot fully escape. The banking sector has been a key pillar in the remarkable, sustained growth of China's economy over the last two decades, providing an escalating contribution year on year to the investment and operating funds of the large SOEs. China's political leaders are involved in bank reform and they are deeply involved in the planning for the survival of domestic banks as they now face foreign competition. Foreign reports on China's banking system have raised concerns over the extremely high level of non-performing loans (NPLs), the woefully inadequate reserves, the minute provisions for bad loans and the lack of commercial management. Provisions fall short of what is needed to cover even the most obvious NPLs, which could require the banks to use paid-in capital. But paid-in capital and other assets constituting the net worth of the major banks have steadily declined, from an estimated 13.2% of assets in 1985 to 2.7% by 1997. For that same date, the PBOC estimated that upwards of 25% of bank loans were non-performing, a sum exceeding 20% of China's GDP.

China's banking regulators have directed banks to:

• Adopt tighter accounting standards;
• Begin more rigorous external audits;
• Strengthen corporate governance and internal controls;
• Report biannually on their financial conditions; and
• Promulgate a detailed credit ranking regime to bring NPLs down to established target levels.

In 1995, the PBOC was officially designated the sole authority to regulate and supervise China's banking sector and in 1998, the government promoted several reforms to address the NPL crisis. New capital of US$32.5 billion was injected to recapitalise the major banks through a special government bond issue. The PBOC lowered reserve requirements from 13% to 8%, and absorbed the new margin of liquidity by selling MoF bonds to the banks, then re-injecting the capital from the bond sales back into the banks. This essentially doubled the capital of the State-owned banks with the Ministry taking on the additional liability through the bond sale. Banks were set guidelines encouraging them to follow IAS procedures for recognising NPLs, and they were required to make loans on a commercial basis. Finally, local governments were banned from meddling in the lending decisions of regional banks. Except for the new capital injection and the double swap, these reforms offered a blend of regulation and hope. Their implementation is a long-term undertaking.

Since this turning point, the PBOC has steadily published new regulations and guidelines. In 2001 a key set of guidelines was published prescribing a credit risk classification scheme for banks, the 'Guiding Principles for Loan Risk Classification.' Most recently, the PBOC issued a draft for comment entitled 'Guidelines for Internal Control of Commercial Banks' in April 2002. During the same month, the PBOC published new guidelines for provisions which classify credit risk according to the 2001 guidelines and require banks to have appropriate provisions against bad debt by 2005.

The banks encouraged an internal transformation to focus on customer relationship management, as well as implementing a range of credit risk and internal loss management processes, many defined by the MoF and PBOC. They are building internal information systems, and reaching for more transparency in their operations and accounting practices. Even the major policy banks are reporting their emphasis on operations and risk management to the public, as well as setting objectives that are typical of well run commercial banks. The conceptual framework for significant progress in the quality of the major banks is in place.

Over ten years, China has steadily moved its accounting practices toward IAS. Historically, banks have not recognized NPLs obscuring their credit profiles. Improvements have focused on a series of changes that provide a clearer picture of the solvency of the major banks and the integrity of their operations. However, accounting firms responsible for implementing changes express frustration at the difficulty of uncovering issues like the identification of structured loans, including the practice of rolling over bad debts and the completeness of related party transactions.

In their newly mandated reports, the major banks have reported progress, including a year-by-year reduction in NPLs, a sharp increase in provisions and the elimination of some of the most egregious accounting abuses that obscured the true financial health of the institutions. Their recent financial reports demonstrate improved provision levels, entirely new risk management processes and powers that are still in the process of being installed. Many independent economists believe the NPL problem is getting worse and may now have reached a level equal to 50% of China's GDP. Industry-wide, China's high saving rates keeps banks with a loan to deposit ratio under 70%, sustaining their liquidity with these NPL levels. Sector-wide data shows some change in the lending profile, with a shift towards more long-term lending and a significant movement of assets into portfolio investment. These trends could obfuscate both credit risk and potential erosion of paid-in capital.

There is no denying that the problems of the banks run deep, and progress is still needed for example in the area of centralised information management and internal controls. The Bank of China, regarded as the best run of the four biggest State banks, has been rocked by a steady stream of embezzlement revelations, including one in its New York branch leading to the removal of a top bank official.

What lies ahead

China's major banks will have a somewhat extended period of protection, compared with what foreign banking executives had expected after World Trade Organisation (WTO) accession. That extra time, in conjunction with the high level of credibility they enjoy among the banking public and the special relationship they have with SOEs and local bureaucrats will assure their survival and growth, barring a sector-wide collapse. China's top bankers are reaching for a leadership position in the Asia-Pacific region as well, commercially through moves such as the initial public offering of the Bank of China's Hong Kong subsidiary in 2002 and diplomatically through an increasing voice at events like the International Monetary and Finance Committee meeting in Washington in spring 2002.

China's WTO commitments have offered the opportunity for foreign banks to establish new operations. To date the pace of entry has been sluggish, slowed in part by incomplete guidelines and high capital and reserve requirements. International bankers expressed concern about the numbers announced in the regulations. According to the foreign-funded financial institution regulations effective from February 2002, foreign-owned banks or foreign-invested joint venture banks must have registered capital equal to 300 million rmb, while other foreign-invested financial institutions require 200 million rmb.

Accounting for change

It is easy to underestimate the enormity of the challenge of restructuring accounting practices in China. A major effort has been underway since reforms began to achieve consistency with IAS procedures. Global firms like PricewaterhouseCoopers have been an integral part of China's achievements in accounting reform. The MoF has been active in developing Chinese Accounting Standards (CAS) for a decade. Presently, key regulatory entities for accounting in China include the MoF and CSRC, with the former being formally empowered to set standards and oversee the industry and the latter focusing on listed companies and their reporting requirements. The most recent revision of China's law is The Accounting Law of the PRC, promulgated 1 July, 2000.

Accounting, like many other areas of economic reform, began changing at an accelerated pace around 1998. In early 2001, the Ministry implemented the Accounting System for Business Enterprises, and this has been developed step by step to cover most areas of IAS and most enterprise structures, including foreign invested structures. A different but derivative system was implemented at the beginning of 2002, called the Accounting System for Financial Institutions. Use of this system is mandatory from the beginning of 2002 for all listed financial institutions and all foreign-invested financial institutions in China. Its use is strongly recommended for unlisted, domestic financial institutions, except those not yet restructured into joint stock limited enterprises. Large banks that have not restructured use the old accounting system.

Chinese authorities continue to attempt to balance the benefits of achieving consistency between CAS and IAS and the special needs of financial institutions in an economy in transition. As a result, one major difference that still remains between CAS and IAS is the level of administrative guidance provided for CAS adding specificity to China's accounting requirements beyond what is outlined in the statutes. While there is debate about the consistency of implementation and supervision, on paper the accounting requirements for Chinese enterprises listing on domestic exchanges are at least as demanding, if not more so, than IAS.

Conclusions

There are three discontinuous and potentially disruptive factors making it difficult to foresee a steady and linear development of China's banks and financial services industries generally.

Firstly the certainty that a new major wave of restructuring lies ahead for the major players. This will be required if the sector is to continue the push forward towards more commercial and sustainable operations. The second is the change in top Party and government leaders at the end of 2002. As is typical during such transitions in China, those waiting to ascend to top positions respectfully keep their counsel until the mandate to rule is actually in their hands. As a result, not only are we not privy to the specifics of their policy plans for the sector, we are unable to speculate about their broadest commitments to the reform process itself and their individual tendencies in key decision areas.

Thirdly is the role of foreign corporations. The negotiations leading to China's accession to the WTO took nearly fifteen years, and the financial services sectors were very much in focus. The last issue to be settled, on the eve of China's formal accession, had to do with grandfathering special arrangements currently enjoyed by some existing foreign insurance companies in China.

China is committed to opening the banking, insurance and fund management sectors to foreign participation, but the commitments are quite specific and contain safeguards to prevent domestic entities from being overrun. These are generally in the form of joint venturing requirements, geographic limitations and equity ceilings. In as much as there are a limited number of banks and insurance companies licensed in China who could be partners, these companies all work closely with the major regulators. As we come to the end of China's first year of WTO membership, it is evident the regulators are following a go-slow approach to see what impact competition will have on China's domestic players. The protection built into the WTO commitments has been augmented by rules published subsequently for many service industries that establish large capital and reserve requirements, uncertain application processes and timetables and undefined qualification rules. This will be an enduring feature of the Chinese investment environment and it underscores the importance of local knowledge and support in all phases of opportunity analysis, strategic planning, commercial and regulatory negotiations. Nonetheless, direct foreign investment in China will exceed $50 billion in 2002, making it the number one destination in the world and surpassing the US for the first time.

Along with that river of capital, the rapid expansion of foreign participation in all subsectors of financial services is a certainty. We now appear to be on the cusp of dramatic change in this regard.

Recent assessments of China's first year as a WTO member have expressed praise for what has been accomplished but frustration at the slowness of the opening of financial services, and the on-going lack of transparency and legal stability in the compliance process. For the financial services sector generally, this is revealing, for it argues that China's leaders are as uncertain about the ability of key institutions and enterprises to sustain their reform and development as outside experts are. Or, put another way, in the fast track of China's overall economic growth, commercial expansion, wealth creation and marketisation campaign, the financial services sector faces considerable reform challenges in the coming decade and presents huge opportunities for foreign participants.

Remarks: This article was first published in The Journal: Tackling the Key Issues in Banking and Capital Markets.