Why China's Banking Sector Isn't as Weak as It Might Look -- and Other MythsPublished: December 14, 2005 in Knowledge@Wharton
China's transformation from a stagnant, government-controlled economy marked by corruption and stagnation to a more international free market system has been accelerated by banking and other financial reforms, according to speakers at a conference on China sponsored by the Global Interdependence Center, a non-profit organization based at the University of Pennsylvania and focused on increasing global trade. The change, these speakers add, is being directed by Chinese leaders who feel pressure to continue to deliver economic growth.
Banking reform in China is being bolstered by stronger regulation as well as the upcoming privatization of leading banks, although the system remains weighed down by large non-performing loan portfolios, said Jeffrey R. Williams, president of Shenzhen Development Bank (SDB) and the first foreign president of a Chinese bank. "It's my belief that historians will look back on the 21st century and say that China's entry into the global economy was the defining theme" of that era, he noted.
Williams, an American who has spent his entire career in China, Taiwan and Hong Kong, recalled his first trip to China in 1979 to teach at Peking University, where he earned the equivalent of $100 a month. A colleague lived with her husband and two children in one room in a flat shared with another family. In the winter, teachers and students kept their coats on in the classroom because there was little heat. "It was peaceful and idyllic, but life was extremely tough," he said.
Since then, he added, the change that China has experienced "has been breathtaking in its rapidity and reach." Indeed, the common Western view of China's banking system as crippled by corruption and bad loans, overstates the problems. "The real story is not nearly so gloomy. As China has changed, so has banking."
According to Williams, China is not in danger of a crisis like those that hit Southeastern Asia in 1997 because it has little external debt. Most of China's banking obligations are local. In addition, China has vast foreign reserves and -- unlike Japanese officials who were reluctant to clean up bad bank debt and prolonged the country's decade-long economic slump -- Chinese leaders are taking a strong role in pushing bank reform. "In Japan, a culture of inertia has defeated the central bank and its ability to drive growth. China's leaders are intensely aware that they need to maintain stable growth to meet the needs and aspirations of their people."
Expertise, Not Money
Williams pointed to three main elements of Chinese banking reform. First, he noted, the government has announced a firm timetable of 2007 for the banks to meet World Trade Organization standards for capitalization and limits on non-performing loans. "It has [established] a no-turning-back mindset," said Williams, although he added that it is not clear now whether all of China's banks will be able to meet the deadline.
Second, China has increased the powers of its banking regulation body, the Chinese Banking Regulatory Commission (CBRC). In the past two years, he said, the CBRC, which was once a division of The People's Bank of China, has gained new independence and raised its profile. The CBRC recently issued 127 new regulations geared toward bringing international standards of risk management to Chinese banks.
Finally, Chinese regulators have decided to seek foreign financial investments in order to gain banking expertise. Williams noted that the Chinese Construction Bank, which went public in October, listed on the Hong Kong exchange rather than domestic stock markets. PetroChina used a similar tactic with its 2000 initial public offering on the New York Stock Exchange. A foreign listing, Williams said, provides Chinese companies with a kind of international stamp of approval on their governance standards. "China does not need the money. What is important is that Chinese leaders are looking for expertise and change." He cited an old Chinese saying: "For reading scripture, a monk from outside is best."
Williams' own bank, SDB, is one of 12 "joint-stock commercial banks" operating in the country. The bank was founded 18 years ago by the government of the city of Shenzhen. At that time, it was the center of China's special economic zone, just over the border from Hong Kong where Chinese leaders first began to experiment with capitalism in the late 1970s. Shenzhen City, originally a small fishing village, is now a major financial center with a population of 10 million. SDB, which has branches in 18 cities, was the first company to trade shares on the Shenzhen stock exchange. In late 2004, after Newbridge Capital, a U.S. private equity firm, acquired a nearly 18% share of the bank from entities controlled by Shenzhen City government, Williams was appointed president.
Direct Lines of Reporting
Like most Chinese banks, SDB had problems, including a large portfolio of non-performing loans. Williams said the bank has set out to make changes.
In the past, for example, branch officers had great autonomy over loan approvals, a system which encouraged lending and, in turn, drove up bonuses. The branches also used an incentive system similar to an agricultural reform introduced in China in the 1980s, known as the household responsibility system, whereby a business was required to return a set amount of money to the state, but could keep anything it generated over that amount. "It's a great way to motivate people, but it also leads to a lot of short-term behavior," said Williams.
To rein in risk, he set up direct lines of reporting from headquarters to the credit officers in each branch. A week after this change was announced, regulators sent out a circular urging other banks to adopt a similar system. Williams also improved the bank's human relations department, strengthened internal auditing and published a new code of conduct. SDB is still working on new accounting and information systems and recently signed a deal with General Electric Capital, which will invest $100 million in the bank and help develop new consumer banking products.
SDB's capital ratio has improved from 2.3% to 3.3%; when it hits 4% the bank will be able to sell subordinated debt, which could bring the ratio up to 6%, said Williams. This is still short of the 8% required by 2007, but, he noted, "we are breathing easier."
Finding the Key
In addition to banking and other reforms, China is also looking to foreigners for new ideas that will allow the country to continue its astonishing economic growth, according to Ted Chu, senior manager of economic and industry analysis at General Motors and a conference speaker.
Chu, who was raised in Shanghai and earned graduate economics degrees at Georgetown University, was a macroeconomist at the World Bank. He cautioned that his remarks do not necessarily reflect the opinion or policies of General Motors. "Please allow these personal observations, not as a professional economist or a representative of a car company, but as one who has been raised in China and is now a citizen of the U.S. and has some understanding of both societies."
Chu noted that change has been remarkably fast in China where per capita GDP has grown 10-fold since 1970, the fastest in the world. China passed Germany in motor vehicle sales in 2002 and is expected to pass Japan next year with sales of over six million vehicles. Such growth has implications for the global economy, Chu said. For example, 60% of Chinese GDP is now linked to global trade and Chinese reserves of over $700 billion help finance the U.S. trade deficit. "Chinese exports to the U.S. are rising dramatically and exports from the U.S. to China are also rising dramatically. There is a lot of potential ahead."
Western analysts have attempted to explain what is going on in China with broad strokes, according to Chu. He pointed to rapid economic growth, urbanization, a high savings rate, cheap labor, strong foreign direct investment, inequality, environmental pollution and over-investment as some of the generalizations about China that are frequently made. Discussions of these issues usually focus on "China today and its short-term growth, but do not provide insights into the future," said Chu. He compared the practice of basing opinions about China's future on the current situation to looking for a lost key at night only under a streetlight.
At the beginning of the 20th century, he noted, economists forecast that Argentina would develop a stronger economy than the United States. A similar bet might have been made on Japan in the 1980s. "Looking at Japan's numbers and statistics gave the impression that Japan was going to take over the world. Today, we are very relaxed about Japan."
Now the attention is on China, said Chu, who went on to discuss some of the common perceptions about China. First, many people believe China's key economic advantage is its vast supply of cheap labor. Chu challenged that idea. "I would like to suggest that cheap labor is not China's advantage, but its problem."
China's biggest economic challenge today is how to stimulate domestic demand, especially private consumption. Chinese workers are not paid well and therefore lack the purchasing power to consume, according to Chu. He said that looking around the world, cheap labor does not necessarily mean a country is competitive. He pointed to the African nations as an example. Other countries have high wages but are not competitive, such as Germany, Italy and Japan. Still other countries, he said, pay high labor rates but remain competitive. The United States, United Kingdom and South Korea fall into this category.
That leaves a handful of nations, including China, Thailand, India, the Czech Republic and Russia, as examples of countries that are inexpensive and competitive. "China becomes the manufacturing floor of the world, not because of cheap labor, but because China has the most open and flexible market," said Chu, adding that productivity improvements and structural reform of economic systems have driven down manufacturing employment in China from 54 million jobs in 1994 to 30 million in 2004.
As China faces higher costs of production inputs, such as energy, the country is under pressure to increase productivity and innovation. "This leads to a two-way Gold Rush. On the one side, Chinese firms are spending a lot on research and development to go up the value chain. On the other side, foreign firms are rushing into China to take advantage of low costs."
Chu downplayed concerns that China's growth will be cut short by projected shortages of resources. "The most reliable signpost for the future is not with statistics but with ideas," he said, noting that China has been importing ideas on a scale that is unprecedented since the Meiji Restoration in Japan in the mid-19th century.
For example, China is studying international accounting standards and looks to Britain, the United States and Hong Kong for securities laws. China is borrowing ideas about military systems from France, developing a Central Bank along the lines of the United States Federal Reserve system and looking to Singapore for exchange-rate policies. Japan's economic power was short-lived because its leaders never promoted fair trade and economic openness, Chu added. "In global developments these days, we tend to worry about things like the spread of bird flu, but the biggest problem is national and political barriers to the spread of the best ideas."
Chu is often asked whether China's political system represents an ideological conflict with the West that would require investors and businesses to consider a big risk premium when it comes to China. Chinese leaders are indeed trying to remain in power, he said. But he went on to say that in a true dictatorship, government retains control through brutality and terror, and ultimately is doomed to fail if it tries to maintain a closed society and does not have the psychological support of the population.
Chu finds it ironic that many countries considered to be operating under a capitalist system actually have more examples of socialism than China. "It is the Communist party that is trying all it can do to adopt capitalist reforms," he said. "The Communist party is not promoting this on the basis of ideology, but only because it works."