China’s microcredit scene is beginning to stir interest among foreign investors. HSBC, for example, opened its first rural bank in Hubei on December 13, and international private equity firms are rumored to be looking at the sector.


At the International Workshop on Rural Finance Reform and Establishing a New Socialist Countryside in China, which took place on December 8-9 in Beijing, academics, policymakers, microfinance practitioners and banking officials provided a useful primer on the microfinance industry in China while revisiting some old problems: How should China reform a microfinance system rooted in inefficient, state-directed lending? How can it create commercially viable institutions while meeting the needs of the poor? The annual conference, sponsored by the Ford Foundation, the research department of the People’s Bank of China and Central SAFE Investment Ltd. (an investment outfit owned by Central Investment Corporation), also highlighted significant new developments in rural finance, and what they might mean for China’s credit-starved country dwellers.


Policy vs. Sustainable Finance

Chinese policymakers have been late converts to the cause of microfinance. Much of the discussion at the conference revolved around the problems that China has faced in establishing an effective microcredit infrastructure for the countryside, which many critics blame on state-directed lending that has led to market inefficiencies and has caused lending institutions to run up massive volumes of bad debt. This issue remains at the heart of the policy debate over future microfinance reform in China.


According to Wang Jun, senior research fellow at the China Center of Economic Research, Qinghua University, there is still no clear demarcation between commercially oriented and policy-driven finance. Even in today’s policy environment, explained Wang, who is also on the staff of the World Bank, it remains politically problematic for banks to place commercial objectives ahead of supporting poverty-relief policy objectives. “Nobody wants to stand up and say, ‘My strategy is based at the county level and below, but I must make a profit,’” he said. “’I will provide financial services and products. But I’m sorry, I will not provide services for every farmer, or take every farmer as my customer. I have to select those who are willing to pay me back.’” Since banks then will be forced to fund rural schemes out of their own budgets, he added, they may be tempted to try to recoup cost from the government. A clear demarcation between policy and commercial finance is called for, Wang argued.


Liberalization of interest rates is one of the main battlegrounds in the debate over policy-oriented vs. commercially led lending, Wang noted. Consensus is elusive. “We’ve been talking about this for years,” he said. “But the problem is still there.” The rate has been liberalized as an incentive for recently launched pilot schemes designed to bring in private investment: Village banks, which may charge twice the central bank base rate, and fledgling microcredit companies (MCCs) may charge up to four times the base rate. However, those arguing for further liberalization believe that added incentives are required to bring in private investors and make lending commercially viable.


“We should abolish the four-times cap that we put on the private lenders,” Wang argued, noting that in Laos, for example, private lenders’ interest rates may be up to 10% per month, or 120% per year, but borrowers’ real rates of return are higher than the interest they must pay. “Unless we liberalize the interest rate in the countryside, many other problems cannot be solved,” he warned. The excess liquidity at the macro-level in China has been a great cause of concern, he noted, but the rural market is begging for more credit. Other speakers concurred that if some of the excess cash could be directed to the countryside, the excess liquidity problem could be alleviated.


RCC Reform

The Rural Credit Cooperatives (RCCs), which have traditionally borne a significant share of providing financial services in the countryside, embody much that those in favor of a more market-oriented approach decry. They are afflicted by massive non-performing loans, which critics blame on their policy-oriented lending and other corporate governance problems.


Despite their vast branch network, the RCCs have multiple problems, observed Thorsten Giehler, program director of financial sector development in China for GTZ (an enterprise owned by the German government that promotes sustainable development worldwide). These include “poor service quality,” their “historical burden,” and governance issues, he said.


Following unsuccessful efforts to reform the RCCs in the past, the China Banking Regulatory Commission (CBRC) is now ready to roll out its pilot project. “The reform of the RCCs is once again at the crossroads,” said Qinghua’s Wang. Though it will be difficult, he recommends severing RCCs’ ties to local governments, which have in the past been investors in RCCs. Allowing private investors in, or even allowing unsuccessful RCCs to go bankrupt, would be a better solution, he argued, than local government bailouts. (However, as proper market exit mechanisms do not yet exist, several officials at the conference argued that establishing such procedures is another future challenge.) Wang also noted that despite the efforts at interest rate liberalization, RCCs are still only able to lend up to 130% of the central bank base rate. Already, he said, “the landscape above the township or county level has become very competitive, but below the village or township level, they are not being covered by anybody.”


The PSBC: New Kid on the Block

Against this backdrop, much of the participants’ discussion centered on alternatives to the RCCs, of which there are a growing list. Recent years have seen the launch of initiatives allowing the establishment of microcredit programs, village banks and village mutual funds. However, in giving an overview of the players, GTZ’s Giehler noted that in reality, none yet has emerged as a big rural credit provider.


Giehler explained the advantages and disadvantages of each of the alternatives. Village banks have the advantage of only requiring a low minimum equity. However, their ownership structure is a “big disadvantage,” as it limits each private investor to a 10% stake, he said. “This is not a big incentive, specifically for private investors, to become owners of a village bank,” he said. MCCs, meanwhile, are not allowed to take deposits, meaning that they have problems with refinancing, though Giehler said there were “promising rumors” that guidelines may be in the works to resolve this problem.


City commercial banks, meanwhile, stand out for their “professionalism as financial institutions,” but in terms of their potential to provide microfinance in rural areas, they face the disadvantage of being very much urban based, Giehler said. And NGOs, while the “forerunners” in microfinance in China and in working with the very poor, have governance issues of their own: “It’s actually unclear who owns them,” he said. This is not their only shortcoming: “Their size is a problem. Most of them are really tiny institutions.”


But a new candidate has brought hope to the microcredit field. In one of the most talked-about developments in recent times, the China Banking Regulatory Commission last year granted permission for the Postal Savings Bank of China (PSBC) to provide credit. “I think it will be one of the most important players in microfinance in China,” Giehler noted.


Nonetheless, he acknowledges that it is going to be a “huge task” to turn the PSBC, which began micro-lending operations in March 2007, into a credit-providing institution. As the bank has been fashioned out of the Postal Savings and Remittance Bureau into a subsidiary of China Post, it faces the challenge of transformation. The new entity will need to build everything from new IT systems to a new culture on top of developing a new range of banking functions, specifically with regard to microfinance.


It also needs to learn to handle risk, he added. Prior to its restructuring, it had no experience providing credit. Indeed, even its clients’ deposits were kept by China’s central bank. Qinghua’s Wang Jun pointed out that the PBSC could be vulnerable to corporate governance problems, given that the state remains its largest shareholder. One participant suggested that, due to its inexperience and resulting high risks, the PSBC’s move into microcredit may be cautious and gradual.


Retraining staff will be another important priority. “You have to change the whole mindset of the people,” Giehler said. “You have to train them how to extend credit, how to assess creditworthiness, to manage risks.”


On a more optimistic note, Wang Jun noted that, in contrast to the RCCs, the Postal Savings Bank has no historical legacy and no record of financial scandals. According to Giehler, the PSBC has a “multiple advantages” over its potential competitors, and it has a significant advantage over the RCCs: its unified, nation-wide structure. The PSBC has a wide network of about 30,000 branches providing financial services, in addition to access to 30,000 branches of China Post, which could act as agents for some services, he noted. Some studies suggest that a significant portion of remittances sent back home by migrant workers (of whom there are typically estimated to be 100 million in China) are actually achieved by depositing cash in one part of China, and then simply making a withdrawal in their home town thanks to the bank’s unified structure. The range of the PSBC’s services, and the fact that it is allowed to take deposits, also distinguishes it from the MCCs.


The fact that the bank has a pre-existing client base in the region of 250 million also promises to give a significant boost to its efforts to build credit services. “The most crucial part of banking is information,” said Giehler. “If you have information about 250 million clients — this is one-fifth of the Chinese population — then of course you have a big advantage in comparison to many other institutions.” And in terms of both average income level of its retail banking clients and its product range, it lies in the middle of the spectrum of the RCC alternatives, and is therefore well positioned to do things that they, with opportunities to widen the range of its services. Giehler believes they have the option to extend their range to small and medium sized enterprises or expand their activities in the retail market.


In light of his observations, Giehler gave several recommendations for the bank’s future direction. While marketing new microloan products to new customers is one option, he said, that is a strategy that its competitors will also be following. The PSBC, however, has the opportunity to attract microfinance clients by offering new products to its pre-existing customer base. “First, you offer an overdraft on the savings and current account,” he proposed. “And then later on, you can customize this kind of credit progress.” Credit cards are a further option for the PSBC to consider. It is also possible to link microinsurance to microcredit, he noted.


An ABC Comeback?

It is possible that the PSBC may find competition from a source that has been discounted by many. Like the RCCs, the Agricultural Bank of China (ABC), another traditionally significant player in rural finance, has found profits hard to come by in the rural market, and in the process became saddled with large non-performing loans. In recent years, the ABC has followed the big commercial banks and began focusing on urban areas, pulling back from rural areas. Indeed, there has even been speculation that the bank might withdraw from the rural credit market altogether in advance of an expected IPO in 2008.


However, taken at face value, remarks made at the conference by a high-ranking ABC official appeared to quash these rumors. The official noted that the central government has directed the bank to focus on “agriculture, farmers and rural development.” Targeting the countryside, instead of attempting to do battle with big commercial banks in big cities, is “fully justified,” he said, observing that the international giant HSBC is moving in the same direction. Nevertheless, he warned that the bank cannot simply transfer urban business models to the countryside: Innovative offerings matched to farmers’ needs will be key. To this effect, the bank will be launching a microcredit credit card which will provide for Rmb 8,000-10,000 in credit. The official added that, following the reduction of its rural presence in recent years, recruitment and training at rural branches will be another priority. The bank is also planning to add an additional 6,000 ATMs at the county level by 2010, while making other improvements to its rural services.


Tsinghua’s Wang Jun welcomed the bank’s strategy statement, adding that the bank’s urban drift has not played to its traditional strength in rural areas. Nevertheless, he said that obstacles remained for the bank’s return in force to the rural market, partly due to the poor demarcation of policy-oriented and commercially oriented lending, as noted above.


Demanding Problems

In addition to these supply-side complications, the conference delegates discussed problems on the other side of the supply-and-demand equation, in particular the trickiness of measuring exactly how much demand for microcredit there is in the countryside.


A central bank official explained how the inefficiencies of the existing system make measuring demand a conundrum. Due to artificially low interest rates, microcredit demand among the poorest farmers may not reflect actual productive demand, said the offical, but rather demand for poverty relief. This is especially the case in western China, she noted, where incomes are lowest. In addtion, other speakers suggested that in many cases rural residents use loans for non-productive purposes, like healthcare, education, residential construction or even weddings. Furthermore, as interest rates for microcredit are not yet liberalized, excessively low interest rates may lead to artificial demand. Several speakers also pointed to the necessity of providing collateral for loans as a complicating factor that exacerbates the difficulty of measuring demand.


Indeed, Giehler pointed out, as most small loans continue to be extended against collateral, microfinance in China cannot yet be said to exist in the narrowest definition of the term. The collateral requirement has led to situation where the lion’s share of small loans is extended not to poorer farmers, but to those in the middle-income bracket, who have greater assets or collateral, said Cheng Enjiang, China liason and vice president at Accion International. (Accion is a non-profit microlender.) According to Cheng’s report on a survey — “The Demand for Microcredit as a Determinant for Microfinance Outreach – Evidence from China” — as income increases, so does the demand for small loans from the RCCs. Those borrowing from RCCs tend to have a higher income, and the poor tend to borrow from private lenders. “Our initial policy design for microcredit is not working,” Cheng said. “The low-income farmers are primarily relying on the private lenders or informal financial institutions. So the challenge is how to extend microcredit beyond these farmers with middle income and above.”

Based on his findings, Cheng argued that measures need to be taken to stimulate demand for microfinance, and microfinance institutions need to be encouraged to reach out to the poorer communities and households with “pro-poor microfinance products.” “Microfinance plus” schemes address the specific needs of the poor by providing not just loans, but also support such as farm business training and infrastructure work in order to improve the environment in which microloans can be set to work. A number of speakers also emphasized the need to direct more fiscal resources to support the most vulnerable of the poor, who may not necessarily benefit from microloans.