The Agricultural Bank of China’s showcase microfinance project — its only such project — is based in a small but tidy office in a dry mountain region in the country’s far west. Founded in the early 1990s with Australian development money, the program — which doles out small loans of less than $250 each — is directed at three of the poorest counties in China. It has been a boon to local farmers who have used the money to buy chickens and seeds, and  even open small stores that sell everyday items.


But is it profitable? Not really, acknowledges Liang Fuxian, the director of the program, which is based in Qinghai Province. He says that in recent years, the interest has barely covered expenses. “Costs are high,” he notes, adding that because the handful of loan officers the bank employs must trek to the most remote parts of the area to collect payments, the debts are often not repaid.


Until recently, China has not worried about break-even or even money-losing banking projects. Rural finance was considered to have more of a social-welfare, poverty-alleviation mission than a business one.


However, as the Agricultural Bank of China prepares for its initial public offering sometime next year, there’s a worry that its new shareholders will not be as benevolent as the Chinese government. While people often grumble that the Agricultural Bank does not provide enough credit to individual borrowers as it is, an IPO may well wipe out the little credit it does provide. Investors are interested in profits and that puts in jeopardy the future of credit for the hundreds of millions of rural residents who are its clients.


Others are speculating that some or all of the Agricultural Bank’s operations may be peeled off and recast as a pure policy bank. This rumor seems to have been repudiated by the officials in charge of the Agricultural Bank’s restructuring, who have publicly insisted that the listing will proceed as planned, without spinning off or breaking up the bank’s operations.


Moreover, there has never been such an entity as a listed policy bank. If the Agricultural Bank withdraws from the rural market, observers wonder what will take its place. There are many ideas about how to fix the rural economy, but most of them seem to avoid market principles. The financial regulators who manage China’s banking system, observers say, will need to balance profitability and social welfare — goals that may inherently conflict.


Beijing‘s Renewed Focus


The situation presents a dilemma for China’s leadership, which in recent years has dedicated itself to improving the plight of a rural population that is missing out on many of the benefits of blistering, double-digit economic growth. In a 2006 speech to the National People’s Congress, President Hu Jintao said that China’s industrial economy should begin to “repay its debt to the countryside,” a slogan which has been gaining momentum over the last year.


The fate of rural lending is critical to the economy as a whole. While opportunities in cities have led to the out migration of millions of workers from the countryside, some 750 million people — or about two thirds of China’s vast population — live in rural areas. Although these rural residents save slightly more than their urban counterparts, they have limited access to credit. This, according to widely quoted statements by State Council researcher Chen Jianbo, has led to a systemic imbalance: Rural savings are financing industrial development.


Outside factors have also contributed to Beijing’s renewed focus on China’s rural finance problems. In 2006, Muhammad Yunus, founder of the Grameen Bank in Bangladesh, was awarded the Nobel Peace Prize for his work in microfinance. Yunus’s Nobel Prize seems to have had a powerful effect on Chinese regulators, helped along by some judicious lobbying on the part of China’s microfinance industry. Yunus was awarded the Nobel Prize shortly before a previously scheduled conference on microfinance in Beijing.


Bai Chengyu, the Secretary General of the China Association of Microfinance, an industry association, says that “we took advantage of this opportunity to invite many media organizations to report on microfinance and arranged meetings between professor Yunus and the government.” Yunus met with ministers and other high-level officials from the People’s Bank of China, the China Banking Regulatory Commission, the Ministry of Commerce and the Foreign Ministry. “This has led to some advantageous changes,” says Bai.


The Chinese government has been tinkering with microcredit and other innovative rural finance programs for more than a decade without much success, but the next year will be a critical one for China’s rural financial system. There is a lot of momentum building behind rural finance, and this year is likely to see some substantial changes, although on a small scale. Some changes that have already happened are a relaxation of restrictions on village banks, village mutual funds and microcredit companies. Another major factor that will shake up China’s rural finance sector is reform of existing institutions, including the Agricultural Bank’s planned IPO and continuing efforts to reform the organization and management of China’s Rural Credit Cooperatives.


China’s banking regulators for the first time are taking tentative steps towards promoting market-oriented rural financial institutions.


There’s talk that the Agricultural Bank will focus even more on lending to large state-owned enterprises or on corporate customers. At the extreme, some observers think that the Agricultural Bank, which was spun off from the central bank in 1979 with a mandate to serve China’s rural economy, may no longer remain an agricultural bank per se and may even pull out of the difficult rural market altogether.


Changes and Reforms


To understand today’s problems with rural lending, one need only look at China’s recent history. Years of policy-driven lending have left the country’s two primary rural lenders — the Agricultural Bank of China, the world’s largest bank in terms of branches, and the Rural Credit Cooperatives, a network of collectively-owned rural savings and loan cooperatives managed by local governments — saddled with massive levels of non-performing loans (NPLs).


China has started several pilot projects to try to meet the financial needs of the country’s rural population, but many of these experiments have failed to develop into models that can be replicated on a commercial basis.


In Qinghai, Liang’s department has lent about 12 million yuan ($1.6 million) to small farmers over the past decade. Although inflation-adjusted interest rates average around 12%, much higher than the Agricultural Bank’s usual lending rates, “The program serves poor mountain villages that are extremely remote,” he says, and administrative costs can easily cancel out the benefits of higher interest rates.


While microfinance programs are currently permitted to set interest rates higher than ordinary bank loan rates, there is still an upper limit intended to prevent small farmers from usurious lending practices.


Wang Jun, coordinator of the China Financial Sector Program of the World Bank, argues that even higher interest rates are necessary to make rural lending profitable, at least in areas such as animal husbandry that have high rates of return. “Why shouldn’t the borrower be willing to accept interest rates around 20% to 30% per year if his profit margin is 100% or 200%?” Wang asks.


Likewise, the Rural Credit Cooperatives, the primary lender in small villages throughout China, have also faced challenges with profitability. These collectively owned rural savings and loan cooperatives were until recently managed by the local governments and operated as independent units at the village level. Because lending decisions were controlled by local governments concerned more with building local relationships than avoiding credit risk, the RCCs had notoriously low repayment rates. In an attempt to solve this problem, the central government in 2003 consolidated the management of RCCs at the local and provincial levels. Jiao Jinpu, deputy director of the Research Institute of the People’s Bank of China, recently stated publicly that these measures have led to even fewer loans to small borrowers as the cooperatives pool their resources to lend to corporations and state-owned companies.


For a long time, Rural Credit Cooperatives have been the only financial institution in Chinese villages, and they have a tendency to defend their turf. Li Yiqing, a researcher at the China Academy of Social Sciences who also manages microfinance programs at the Funding the Poor Cooperative — one of China’s longest-running microfinance initiatives — says that local RCC offices have in the past competed to undercut microfinance programs with advertising and lower interest rates. “Sometimes they act as if the village is their territory. We will go in to do a project, and then signs appear advertising a new ‘model microcredit program'” offered by the local RCC. But unlike most microfinance programs, many RCCs receive state subsidies and do not expect to turn a profit.


As public debate over farmers’ limited access to credit has picked up, regulators in China have introduced a number of significant changes in the last year, including an overhaul of the Postal Savings Bank and a loosening of restrictions governing the establishment of small-scale rural financial institutions.


Formerly barred from issuing loans, the Postal Savings and Remittance Bureau, a department of the national postal service, was given permission to establish a bank offering small deposit-backed loans to urban and rural depositors. The lending subsidiary, known as the China Postal Savings Bank, was officially established on March 20, 2007. Other changes include pilot programs allowing the establishment of microcredit programs, village mutual funds and village banks in rural areas in six provinces.


While these measures are a step in the right direction, they currently exist only on a pilot basis and at this point do not have the backing of China’s large state-owned banks.


Most of the investment in the new village banks has come from small city commercial banks. But investment in these banks “is just symbolic,” according to Liao Qiang, a banking analyst at Standard & Poor’s in Beijing. “I don’t think it’s a viable business for the larger City Commercial Banks, mainly because that kind of financing is relationship-based. I don’t know if this business can grow to a viable or a profitable one for those banks, but for the time being I don’t think it’s meaningful for their business strategy or assets.”


Hope on the Horizon


Competition from Rural Credit Cooperatives and other state-subsidized programs is likely to be a major stumbling block for these market-oriented rural finance programs. According to the World Bank’s Wang Jun, “There are still many people who hold the view that rural and microfinance cannot be commercially sustainable. They believe that farmers are a vulnerable group of society, they have limited means of production  and opportunities, and deserve government support. Most of these people demand subsidized interest rates, which is problematic.”


Wang argues that policymakers in Beijing need to draw a clear distinction between those parts of the rural population that need subsidized lending and those that do not. “In the vast area of rural finance, you cannot mix financing with policy resources,” Wang says.


What are the other keys to microfinance in China? Persistence is crucial, says Li. When the Funding the Poor Cooperative issued its first round of loans a decade ago, the repayment rate was very low. Li’s team sent out teams of loan officers and researchers to confront the families that were not paying back, returning every day until the loans were repaid.


Staffing is another important consideration. Li says that it is common for loan officers to take advantage of rural lending programs, and that nepotism and other conflicts of interest run rampant at the local level. Based on his own experience managing several microfinance projects, Li stresses the importance of hiring qualified staff with appropriate training. Microcredit programs typically lack the budget to hire loan officers from commercial banks, but the best loan officers often have at least a basic bookkeeping background.


In recent months, there has been some hope on the horizon for rural finance. Muhammad Yunus has suggested that China consider establishing a small credit market open to private investors, and the bank is rumored to have plans to establish three microcredit companies in China. The bank has already invested in several microfinance programs in China, including the Funding the Poor Cooperative. The China Development Bank, China’s largest policy lender, signed an agreement at the end of last year to provide 100 million yuan ($12.8 million) to fund microfinance programs run by the China Poverty Alleviation Fund.

And while the big state banks have shown little interest in investing in the new village-level financial institutions, smaller city commercial banks have been actively investigating this opportunity. So far they have been the main backers of the handful of village banks that are currently being run on a pilot basis. Even HSBC, the London-based global banking giant, has announced plans to invest in a village bank.