by Dr Charles C L Kwong Associate Professor School of Arts and Social Sciences The Open University of Hong Kong

1. From Mono-banking to Internationalization: the Path of China’s Banking Reform and its Impacts on Hong Kong’s Financial Market by  Dr Charles C L Kwong Associate Professor School of Arts and Social Sciences The Open University of Hong Kong

2. 1. The presentation aims at • examining briefly China’s banking sector during the pre-reform period (1949-1978); • reviewing the path of China’s banking reform since the late 1970s; • evaluating China’s policy change in banking sector after its accession to World Trade Organization (WTO) • scrutinizing the impacts of China’s banking reform on Hong Kong financial market

3. 2. The Mono-bank System 1949-1978: Intended Isolation • The establishment of People’s Bank of China (PBOC) in 1948 marked the starting point of the banking system under the PRC rule. Prior to the economic reform in the late 1970s, China’s banking sector was characterized as a mono-bank system in which banks operated under a scheme of ‘Tong Shou Tong Zhi’.

4. 2. The Mono-bank System 1949-1978: Intended Isolation • All cash (deposits) from individuals and enterprises, mainly state-owned enterprises (SOEs), must be held by the PBOC. All credits (loans) to SOEs and state projects were extended by the PBOC. In a nutshell, the PBOC become the centre of settlement for both deposits and credits.

5. 2. The Mono-bank System 1949-1978: Intended Isolation • In the 1950s, the mono-bank system was supported by two extension arms: the Bank of China (BOC) and the People’s Construction Bank of China (PCBC), which were subordinate to the People’s Bank of China (PBOC) and the Ministry of Finance (MOF), respectively.

6. 2. The Mono-bank System 1949-1978: Intended Isolation • The BOC functioned as the foreign exchange division of PBOC while the CBC disbursed funds to finance state-owned enterprises (SOEs) and capital-investment projects blueprinted in the government’s economic plan.

7. 2. The Mono-bank System 1949-1978: Intended Isolation • On the eve of economic reform, all financial institutions merged into the PBOC or the MOF during the Cultural Revolution (1966-1976). The PBOC became a mono-bank performing both the central bank functions (regulating money supply and determining interest rate) and commercial bank function of financing SOEs and state projects. The PBOC before the reform served as the state’s fiscal agent to divert funds to fulfil the planned targets. The State Planning Commission devised the state plans and ranked their priorities. Then the PBOC was directed to channel bank credit to SOEs and state projects.

8. 2. The Mono-bank System 1949-1978: Intended Isolation • The mono-bank system was not in the sense of the conventional views of commercial and central banking. In conformity with the centralist character of the planned economy, the top priority of the central planners was not attached to the consideration of efficiency of the banking system.

9. 2. The Mono-bank System 1949-1978: Intended Isolation • The rigid control and intended closeness of China’s mono-bank was to allocate financial resources for the fulfilment of state plans and to ensure insulation from potential domestic and foreign influence. The repercussion of the mono-bank system was extensive since SOEs received interest free loanable funds which led to severe moral hazard problems among cadres who ran the enterprises. The soft-budget constraints and the associated moral hazard behaviour resulted in massive non-performing loans (NPLs) accumulated in the 1980s and the early 1990s.

10. 3. From Mono-banking to Plural-banking System 1979-1992 • The underlying factor for diversifying banking institutions in the early 1980s stemmed from the economic reforms in the late 1970s, which entails decentralisation of economic activities. Economic reforms allowed a larger role of market in allocating resources and the development of non-state enterprises, mainly collective enterprises.

11. 3. From Mono-banking to Plural-banking System1979-1992 • The share of nominal industrial output decreased from 76 percent to 64.9 percent from 1980 to 1985 while the respective shares by collective enterprises increased from 23.6 percent to 32.1 percent, representing an average annual growth of 18.7 percent for the same period. Expanding non-state sector was accompanied with mounting financial resources held by decentralised units including households, enterprises and local governments.

12. 3. From Mono-banking to Plural-banking System1979-1992 • Table 1 indicates that the share of savings in GDP held by central budget had demonstrated a declining trend while the respective shares held by the decentralised units had exhibited an ongoing uptrend since 1978. Further, the increased connections with the outside world through foreign direct investment and setting up of special economic zones called for a more specialised banks to deal with international financial transactions. The highly centralised mono-banking system in the pre-reform era could no longer accommodate the financial needs brought about by market reform.

13. Table 1: Composition of savings in GDP 1978-1985 Source: Joseph C. H. Chai, China: Transition to a Market Economy, (New York: Clarendon Press Oxford, 1997), p. 118

14. 3. From Mono-banking to Plural-banking System1979-1992 • From 1979 to 1984, four state-owned specialised banks (SBs) were reinstituted and separated from the PBOC. The Agricultural Bank of China (ABC) was re-established in 1979 to handle deposits and lending in rural areas.

15. 3. From Mono-banking to Plural-banking System1979-1992 • The BOC was reinstituted under the State Council (SC) in 1979 to manage the country’s foreign exchange. The People’s Construction Bank of China (PCBC) (renamed as China Construction Bank in 1996) was made subordinate to the SC in 1979 to undertake financing construction and fixed assets investment while the Industrial and Commercial Bank (ICBC), established in 1984, specialised in funding business activities.

16. 3. From Mono-banking to Plural-banking System1979-1992 • On top of reinstituting the SBs, the central government transformed the PBOC into a formal central bank in 1984 by transferring its deposit and lending activities to ICBC. The re-establishment of the SBs and the setting of a formal central bank laid the important foundation of separating central bank and commercial bank functions. The central bank, PBOC, had since then become the main government agency for manoeuvring monetary policy, supervising the financial sector and fine-tuning macroeconomic conditions.

17. 3. From Mono-banking to Plural-banking System1979-1992 • Parallel to the re-establishment of SBs, new commercial banks and non-bank financial institutions (NBFIs) were allowed to open to cater for different financial needs in urban and rural areas. Nine national and regional banks, such as the bank of Communications and the Guangdong Development Bank, were set up in the 1990s. NBFIs also flourished in the 1990s. Up to 1994, about 60,000 rural credit cooperatives (RCCs), 1500 urban credit cooperatives (UCCs), and 590 trust and investment companies (TICs) was set up (Chai 1997: 123).

18. 3. From Mono-banking to Plural-banking System1979-1992 • SBs’ specialised roles had started to blur since the 1980s and each SB had faced increasing competition from other SBs and the new financial institutions.

19. 3. From Mono-banking to Plural-banking System1979-1992 • Though the inflow of foreign direct investment (FDI) had been very substantial since China’s opening up in the 1980s, the presence of foreign bank was very limited in the initial stage of economic reforms. In the early 1980s, only four foreign banks had set up their branches in China.

20. 3. From Mono-banking to Plural-banking System1979-1992 • Though the PBOC enacted the Regulation on Foreign and Joint Venture Financial Institutions in Shanghai in September 1990, their business of foreign banks was subject to many restrictions, including the forbiddance of engaging in yuan (RMB) transactions (Yi 1994: 32-33).

21. 3. From Mono-banking to Plural-banking System1979-1992 • By 1992, a total of 47 foreign banking and financial institutions with 218 branches or representative offices had been set up. This figure represented a negligible share of the branch network of PBOC and the four SBs, which consisted of 125,711 branches and offices across the country. By 1994, foreign banks had total assets of 101.7 billion yuan which was only 0.9 percent of assets of China’s banking sector.

22. 3. From Mono-banking to Plural-banking System1979-1992 • The reinstituting of SBs and the diversification of financial institutions in the 1980s represented only a hierarchical and structural transformation. Though limited competition was introduced, the SBs still dominated the banking sector. The market share, in terms of assets, of SBs was 85.4 percent in 1988 and fell slightly to 84.2 in 1993, and continued to perform the fiscal functions assigned by the central government. SBs were expected to extend loans to SOEs even though many of the state enterprises were loss-making. The soft loans were to maintain the operation of the enterprises by which stable employment could be guaranteed.

23. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • As elucidated above, to avoid massive layoffs by ailing SOEs from the mid-1980s to the mid-1990s, the SBs shouldered the key responsibility of rendering ‘soft loans’ to SOEs to keep the loss-making SOEs floating. This strategy reduced the number of losers under reform, but at the same time piled up NPLs of the SBs. The ratio of NPLs of the SBs reached 20.4 percent in 1994 and was estimated to increase by 2% annually.

24. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • The PBOC lacked effective means of controlling the lending behaviour of the SBs, which were dominantly affected by central directives. The ‘soft loans’ resulted in spectacular rise in money supply and inflation rates. Money supply (M2) increased from 31.3 percent in 1992 to 34.5 percent in 1993 while the inflation demonstrated a hyper growth from 6.4 percent in 1992 to 24.1 percent in 1994. The runaway inflation alarmed central leaders of the possible macroeconomic instability resulting from quasi uncontrolled bank loans by SBs.

25. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • On the other front, since the transformation of the GATT (General Agreement on Tariffs and Trade) to WTO (World Trade Organization) in 1995, China started to request its membership in WTO. As part of the commitments to WTO accession, China was required not only to reduce its tariff and non-tariff barriers for imports, but also open up its telecommunication, banking, financial and insurance sectors to foreign investors.

26. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • Facing both domestic and external pressure on its banking sector, the central government decided to embark an overhaul of the banking system in 1994, with at least three major aims: (1) to develop the PBOC into an independent and full-fledged modern central bank to regulate the national financial market and maintain macroeconomic stability; (2) to commercialise the four SBs by separating commercial lending from policy lending; and (3) to nourish a more diverse and competitive banking sector by allowing more commercial banks, including foreign competitors to enter the market.

27. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • The Law of the People’s Republic of China on the People’s Bank of China (PBCL) was enacted in 1995 to establish a legal foundation for the superior status of the PBOC. The PBCL stipulates that the PBOC, under the leadership of the State Council, devises and implements monetary policy and monitors the operations of the financial sector (Article 2). Article 7 of the PBCL entrusts the PBC with a high level of independence by specifying that the PBOC is free from the intervention of local governments, government departments, organisations and individuals when it performs its central bank and business functions.

28. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • The central government’s decision explicitly urged the establishment of a ‘sound macroeconomic control system’. It was clearly stated that ‘the central bank, the People’s Bank of China, under the leadership of the State Council, should implement monetary policy independently’. The independent status was further elucidated in that ‘the power of the central bank and local authorities over economic administration should be rationally delineated’ and ‘the branches of the People’s Bank of China are certified as agencies of its head office.’

29. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • To enhance the efficiency and profitability of the banks, the Chinese authorities also endorsed in the Third Plenum of the 14th Central Committee to separate policy lending from commercial lending. By this, the four SBs would gradually be transformed into state-owned commercial banks (SOCBs). Policy-based loans are designated to the three policy lending banks established in 1994.

30. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • By do so, the SOCBs could be freed from the burden of ‘soft loans’ and concentrate their businesses in commercial lending based on market disciplines. However, the transfer of policy lending from the SOCBs to the three policy lending banks was more complicated than expected.

31. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • Two points are worth noting. First, the newly established policy banks were reluctant to accept the policy responsibilities, particularly lending to SOEs, previously assumed by the SBs. The SOCBs continued to be a major government-directed funding source for SOEs. Almost half of the short-terms of SOCBs were extended to SOEs in 1997.

32. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • Second, since the policy banks did not receive deposits from the public, their operation was financed by state fund by issuing financial bonds to existing financial institutions, primarily the SOCBs. The state banks were under constant pressure and directives from the PBOC to absorb the financial bonds issued by the policy banks.As a result, commercialization of state banks did not substantially improve the balance sheets of SOCBs in the 1990s.

33. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • Commercialising the SOCBs in 1994 aimed at separating policy and commercial lending, through which enhanced the efficiency of the state banks. However, in practice, the reform failed to institute a credit culture based on market disciplines. Lending decisions were still mainly influenced by state directives instead of profitability consideration.

34. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Commercialization of SBs • The reform was also constrained by lack of Chinese bankers well-vested with knowledge of running commercial banks. The problem of NPLs had been escalating in the 1990s. Some estimates indicated that the ratio of non-performing loans (NPLs) of the Big Four stayed at an alarmingly high level of 40 percent by 1998 (Woo 2003: 5).

35. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • The 1994 banking reform had limited impact on enhancing efficiency of the SOCBs. The central government perceived the need of strengthening the capital position of the Big Four before fulfilling the WTO commitments of opening up the banking sector to foreign competitors. Further, the Asian financial crisis in 1997-98 crystallised the central leaders’ views that the ailing banking sector could be a destabilising factor in the economy when China had established increasing links with the global economy.

36. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • To speed up the pace of improving the balance sheets of the state banks, the MOF injected US$34 billion into the Big Four to lower the NPLs in 1998. The recapitalization was supposed to alleviate the financial burden of the SOCBs arising from the past policy lending. Such recapitalization by the central coffer was planned to be ‘first and final’.

37. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • However, instead of fundamentally cleaning up the NPLs in the SOCBs, four asset management companies (AMCs) were established in 1999 to absorb 1.4 trillion yuan of bad loans from the Big Four. The further recapitalization, amounted to US$75 billion, of the SOCBs in 2003-06 defeated the initial design of an ‘once-and-for-all’ relief plan for China’s debt-ridden state banking system. Table 2 shows that by 2006, official financial support provided for state banks amounted to US$402 billion.

38. Table 2 Official Financial Support to SOCBs since 1998 Source: Jonathan Anderson, ‘China’s New Banking System,’ p. 173

39. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • Central government’s ongoing financial support has successfully lifted the capital adequacy ratio (CAR) of the SOBs to a level higher than the international standard of 8 percent and reduces the NPL ratio to an official figure of 7.83 percent in 2007 (Q3). The rapid drop in NPL ratio was also attributable to the double-digit credit growth since 2000.

40. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • More importantly, the bailout of SOCBs only transfer the financial burden from the state banks to the AMCs and other government agencies such as the PBOC and the Ministry of Financial, instead if instituting an institutional overhaul to solve the government problems.

41. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • Worse still, the substantial captital injection did not result in corresponding enhancement of the SOCBs’ financial indicators. The NPL ratios of ICBC, BOC, CCB and ABC remained at high levels of 25.4%, 23.7%, 15.17% and 36.63% respectively in 2002. the capital adequacy ratio (CAR), a measure of the capital strength of a commercial bank, was still below the prevailing international standard of 8% (Table 3).

42. Table 3 Capital Adequacy Ratios of the SOCBs (1997-2002) (%) Source: K. Okazaki, “Banking System Reform in China: The Challenge of Moving Toward a Market-Oriented Economy,” p. 24.

43. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • The results of government financial support were even less promising when compared with other Asian developing countries. China’s NPL ratio was still higher than some neighbouring countries such as Indonesia, Thailand, and Malaysia in 2007. The NPL ratio of the SOCBs has consistently higher than the joint-stock commercial banks (JSCBs) in recent years. From 2005 to 2006, the smaller city commercial banks, such as the Zhuzhou City Commercial Bank and the Bank of Dalian, achieved a much faster growth of profitability than that of the SOCBs.

44. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Recapitalization of SOCBs • These figures raise the issue of moral hazard and cost-effectiveness in bailing out these state banks. It is particularly relevant to the future bailout of the Agricultural Bank of China, which is widely believed to be the most severely hit by the massive lending to the rural sector, with a non-performing loan ratio of 24.75 percent reported in 2006. Agricultural Bank may need as much as US$140 billion to reduce bad loans to less than 5 percent, which will be the single largest bailout of a state bank.

45. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Preparing for Market Liberalization? • Despite China’s multi-facet reforms in improving SOCBs’ balance sheet since the late 1990s, China’s approach to opening up its banking sector remained cautious and piecemeal prior to its WTO accession. The central government had relaxed geographical restrictions on foreign banks since 1992. Foreign banks were allowed to operate outside Special Economic Zones (SEZs) and to expand their presence in Shanghai and other seven coastal cities in 1992. In 1994, such relaxation was applied to other selected inland cities.

46. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Preparing for Market Liberalization? • However, geographical extension did not entail corresponding expansion of the scope of business of foreign banks. Until the mid-1990s, foreign competitors were not accessible to RMB-business. It was only in 1996 that RMB-business by foreign banks was tried out in Pudong on an experimental basis. The trial was extended to Shenzhen in 1998.

47. 4. Heading for WTO Accession: Commercialization and Bailout of SBs 1993-2001 Preparing for Market Liberalization? • The advent of foreign competition in the 1990s was very minimal due to the fact that restrictions on foreign banks’ business were still numerous and the branch network of foreign competitors were very restricted compared with local counterparts. On the eve of China’s admission to the WTO, the market share of foreign banks, in terms of assets, was about 1-2 percent.

48. 5. Post-WTO Reforms: On the Road to Internationalization? • China’s accession to the WTO in 2001 represented not only China’s further integration into the global economy, but also China’s commitments of opening up its economy to foreign competitors.

49. 5. Post-WTO Reforms: On the Road to Internationalization? • The embedded strategic thinking of the central leaders was to expose China’s state banks gradually to foreign cooperation and competition after WTO accession, through which enriching the Chinese SOCBs on foreign experience and international standards, and inserting competitive pressure on reforming the inefficient banking sector.

50. 5. Post-WTO Reforms: On the Road to Internationalization? • While foreign investors were keen on entering China’s banking sector in a faster and flexible way, the Chinese government favoured a more step-by-step approach of introducing foreign players. After rounds of negotiations, China was allowed to have a phase-in period of 5 years to incrementally open up its banking sector (Table 4).