China’s Antiquated Financial System: The Creaking Grows Louder

In April, Chinese Premier Wen Jiabao took aim at China's powerful state-owned banks. According to Reuters, he said at a discussion with local businesses: "Frankly, our banks make profits far too easily. Why? Because a small number of major banks occupy a monopoly position, meaning one can only go to them for loans and capital. That's why right now, as we're dealing with the issue of getting private capital into the finance sector, essentially, that means we have to break up their monopoly."

Wen's attack on China's big banks, followed two weeks later by the Chinese central bank's move to widen the renminbi-to-dollar trading range from 0.5% to 1%, raises the question of whether China is about to accelerate bank and financial system reforms. Against the backdrop of the spectacular fall of Chongqing Communist Party boss Bo Xilai, who upheld the heavy hand of the state-owned enterprises in the economy, and the dramatic escape of political prisoner Chen Guangcheng, are liberal reformers now gaining momentum as China undergoes its next leadership transition this fall?

Experts say further financial liberalization is in the cards, as both domestic and external pressures mount. "The fall of Bo Xilai pushes up reform forces in the Chinese party, government and society, and that's a good sign," says Hoest Loechel, professor at Frankfurt School of Finance and Management in Germany and a visiting professor at the China Europe International Business School (CEIBS) in Shanghai. Pieter Bottelier, senior adjunct professor at the Johns Hopkins University School of Advanced International Studies (SAIS) and former World Bank chief of resident mission in Beijing, predicts: "Liberalization of bank interest rates could come very soon, by the end of the year, linked to further internationalization of the renminbi (RMB)." He notes that the People's Bank of China (PBOC) says the time is right for China to open its capital account in phases, starting over the next three years, transitioning to full financial liberalization in five to 10 years.

To date, the state-dominated financial sector has funded the extraordinary growth in China's real economy, averaging 10% a year over the last 30 years. "The striking thing about China's reform model is that they have used the financial sector as a tool to achieve reform in the real economy," says Bottelier. But, says Gary Liu, deputy director of the China Europe International Business School's Lujiazui International Finance Research Center in Shanghai, this system can also end up holding back the domestic economy."Soon, this lag in financial sector reform will drag down growth in the real economy," especially as China aspires to transition from a low-wage, investment-led, manufactured export-based economy to a higher-margin, consumption-led, knowledge-based economy. "If you want innovation, one precondition is an efficient financial system," Liu notes. "That's why the U.S. is so strong in innovation, because U.S. companies, at whatever stage of growth, can borrow money — from private equity, banks or the stock market. In China, many small- to medium-sized enterprises (SMEs) have to bribe government officials to get loans."

Though China's top banks have acquired private shareholders via initial public offerings over the last decade, the government still controls bank deposit and lending rates, and maintains ownership stakes and considerable control of banks. The Big Five — the Bank of China, the Industrial and Commercial Bank of China, China Construction Bank, Bank of Communications and Agricultural Bank of China — together dominate the sector with a 50% market share of total assets, according to Loechel. Under China's controlled deposit and loan rates, banks receive a guaranteed spread of about three percentage points. In turn, the banks lend at favorable terms to state-owned enterprises, often for large infrastructure investments. About 90% of Chinese companies' financing comes from bank loans, according to the World Bank.

Internal and External Pressures

Meanwhile, ordinary household savers are on the short end of the stick. Factoring in inflation, they earn negative interest rates of about 2% from their deposits. With China's bank deposits totaling 80 billion RMB last year, that negative return amounts to $1.6 trillion RMB, notes Liu. CK. Raising interest rates on household savings deposits would boost domestic consumption, drive growth and help alleviate social inequality.

Household-funded nation building can work as long as the economy is growing. But it can foment discontent when the economy starts slowing, say experts. "This kind of financial system can generate tremendously high levels of economic activity because it forces the household sector to subsidize borrowing costs very heavily," says Michael Pettis, a professor at Peking University's Guanghua School of Management, specializing in the Chinese financial system. "As long as growth rates are high and the investment is not being wasted, this system is sustainable and wealth generating, but … once we shift into a phase where investment is being misallocated, the system tends to generate unsustainable levels of debt." Adds Wharton finance professor Franklin Allen: "The economy can keep growing at 7% to 8% per year by building infrastructure in Tier II and II cities, but China probably wants to start some reforms to make sure the economy doesn't fall any further when that infrastructure development is completed."

Meanwhile, external pressures are building, too. The biggest driver is China's desire to internationalize its currency, says Allen. China must lessen its dependence on the U.S. dollar and euro, viewing both as becoming less reliable as a store of value for China's massive foreign reserves. To internationalize the RMB, "China needs to open up the capital account, and let money in and out more easily," Allen says.

To maintain a stable RMB-to-dollar exchange range so far, China has had to ensure that Chinese and U.S. interest rates do not diverge widely, to prevent higher Chinese interest rates from driving up the RMB's value. Since that makes China unable to use interest rates as a monetary policy tool, the PBOC has relied primarily on administrative controls, such as bank reserve requirements and loan growth rate targets, to control inflation. Allowing greater exchange rate flexibility will open the way for more market-based interest rates in the domestic financial system — both for inflation control by the PBOC and for more efficient, market-driven capital allocation by the banks. "If China continues to be the world's largest exporter and second-largest importer, and holds aspirations for RMB to be at least one of world's reserve currencies, they have to make these changes to the financial system over the next five to 10 years," says Wendy Dobson, a professor at the University of Toronto's Joseph L. Rotman School of Management.

Yet, some experts say true liberalization cannot occur until banks stop performing the government's fiscal functions. Yukon Huang, a former World Bank economist and now senior fellow at the Carnegie Endowment for International Peace in Washington, D.C., notes that government expenditure in Europe is 45% of GDP; in the U.S., 30% to 35%; and in China, only 28%. "How can a socialist economy have such a low share of government spending?" asks Huang. "Government spending is done through the banks." While there is nothing wrong with government spending through the banks or the budget, "as long as the money is well spent," he says, in the long run, "the broader question is how to reform the budget system. Are the country's institutions strong enough" to be able raise and collect taxes, rather than relying on household bank deposits?

But, as Wharton management professor Marshall W. Meyer notes: "China rarely institutes sweeping reforms in one stroke. Maybe now is the time to experiment seriously in banking." For now, to continue the path of financial liberalization, analysts are recommending that China take the following major steps:

Liberalize interest rates. A flexible exchange rate will bring pressures to liberalize bank interest rates. Wharton's Allen anticipates China's first step in bank reform is to lift controlson deposit and loan rates. That move could shrink the spread between the two from three to one percentage point, "challenging the business model of the big banks," says Loechel. Today, about 80% of Chinese bank revenues come from lending, compared to an international average of 50%, he says. But Chinese banks can still thrive if they follow the example of the Bank of China, which already makes 30% of its revenues from asset management. If banks double their current commission business, even while their interest spreads decline and labor costs rise, the big Chinese banks will still have a greater return on assets than their Western counterparts, he says.

Promote private-sector lending. To address the pressing need to financeprivate SMEs, China should allow private investors to invest in the banking system, says Liu. The handful of privately owned Chinese banks, including China Minsheng Bank, Ping An Bank and Zhejiang Tailong Commercial Bank, are doing well, he notes. In March, Chinese officials named Wenzhou in Zhejiang province a "special financial zone," to encourage the growth of private lending institutions. Separately, the Supreme Court overturned its earlier death penalty ruling for Wu Ying, a Zhejiang-based entrepreneur accused of illegally raising money from private investors, signaling government openness to private-sector financing.

Create other capital markets. To give banks more competition, companies an alternative source of funding and households potentially higher-yielding investment vehicles, China should set up a corporate bond market, says Dobson. In March, China Securities Regulatory Commission chief, Guo Shuqing, said China could open up a junk bond market soon to help finance private SMEs. If so, China needs to strengthen the rule of law, says Dobson. "Financial markets are transparent and run on trust and confidence, based on rules and laws that are enforced," she notes.

Strengthen bank supervision and deposit insurance. As China liberalizes its banking system, it must concurrently build bank supervisory capabilities, notes a former Morgan Stanley banker who has worked in Greater China for two decades. Widening the RMB trading band and liberalizing bank interest rates can take place relatively quickly, butdeveloping strong supervision could take at least 10 years, including the training of competent personnel, he notes. Likewise, creating a deposit insurance system will help safeguard against potential banking crises.

As China faces its next leadership transition, these reforms are an economic imperative that even conservatives in power cannot overlook, say experts. "If China cannot reform its banks and financial sector, it will have a deep negative impact on economic development and for social stability," says Loechel. But the magic elixir of these reforms may be the true test of leadership. Says Dobson: "The really hard part is you need the rule of law for a modern financial system, based on trust and transparency, to function. Whether it's Bo Xilai or Chen Guangcheng, many roads can lead to political reform. That's the great opportunity now and the great unknown."

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