Few would deny the need to overhaul China’s financial system. The difficulty of gaining access to capital, the plague of non-performing loans, and the sluggishness of securities markets all point to the failings of the status quo. But exactly how and when financial reforms should occur — and how to manage them most efficiently — is anything but a foregone conclusion. Balancing the needs of the state with the needs of the business community is a delicate dance, especially in a country where governmental control is firmly entrenched. In a panel on financial reform at the recent Wharton China Business Forum, experts noted the challenges of transforming the nation’s financial culture but were optimistic about the government’s commitment to change.

Clarence Kwan, national managing partner at Deloitte, noted that financial reform was now part of the government’s stated policy. “Reform has now become the government’s priority. Chinese premier Wen Jiabao talked about that in the [recent session of the] 10th National People’s Congress,” he said. “But it’s important for the government to balance growth with stability. They are interrelated factors, and priorities change over time.”

According to Kwan, Jiabao mentioned five key areas during the session: restructuring of state-owned enterprises, rural development, financial sector reform, Social Security and government administration. “The idea is to create a more service-oriented organization,” said Kwan. “Once you improve stability, each of these factors will lead to growth.”

Kwan noted that Jiabao also talked about accelerating reforms of the state-owned banks as the country prepares two of the big four (Bank of China and China Construction Bank) for overseas listings. “Is the best way to break them all up and let them compete? I like that idea,” said Kwan. “There are no differences among the four banks right now, so it would be very interesting to see what happens if they are broken up.”

Panelist Vicky Marklew, vice president and senior international economist at Northern Trust, a Chicago-based global asset management firm, noted that China had become the most difficult country for assigning risk ratings. “It’s so easy to point out the negatives — incomplete transition to a market economy, lack of transparency, patchy rule of law, corruption,” she said. “But there are positives, too. China has a significant level of foreign exchange reserves, very little external debt, a commitment to the World Trade Organization’s accession timetable, and a gradual liberalization of capital accounts. The potential of China is what companies can’t afford to ignore.”

Adding to that potential, said Marklew, is the vast household savings pool in China. “The individual income savings rate is about 40%. At the moment it’s either sitting in a bank or under a mattress doing nothing. When the people get more access to financial instruments, that will be interesting to companies like ours.”

Putting Stock in Markets

Not only is it important to improve the capital markets, said Kwan, but it is also imperative to increase the caliber of the listed companies. “Some have issues with quality. That has a lot to do with how and why the company became listed and how the stock market is set up.”

“Initially, the stock market in China was established as a new way of channeling capital to favorite state-owned enterprises,” explained Marklew. “Even now, who gets to list is largely controlled by the state, and barely a third of the shares are freely traded. Very few companies have a true private sector background, and even those are probably still controlled by government agencies at the provincial levels.”

Last year, she added, “there was a marked increase in short-term overseas borrowing, and most of the new external debt taken out by Chinese companies is for less than a year. These are indications that the stock market is still not working.”

According to Kwan, even though many new companies have been listed, the total market value of the stocks traded in China is more or less the same as it was in 2000. “It hasn’t grown in line with global markets.” Corporate oversight is also a problem, he said. “There should be independent directors to improve the listed companies. But who is qualified to be an independent director? Can he or she influence the overall independence of the board, and, even if so, will the board be efficient?”

Finding the Funds

Since reforms won’t happen overnight, many Chinese companies have been going abroad to seek capital. “U.S. and Hong Kong initial public offerings of Chinese companies are on the rise,” noted Kwan. “In 2004, more Chinese companies listed on overseas markets than the domestic exchange, and raised more capital there.”

The trust law that China issued a few years ago, Kwan added, is being used now to create new financial instruments. “Companies are using it to pool funding from individuals. A collection of trust assets is being used to build stores in China for Wal-Mart,” Kwan said.

Marklew noted that China is gradually allowing an increasing number of domestic institutions access to international markets. “For instance, last year the country permitted domestic insurers to buy overseas debt,” she said. “China will have potentially the same impact on financial markets over the next decade as it has had on trade markets over the last 10 years.”

Kwan pointed to the recent IBM-Lenovo deal as an example of how Chinese corporations are making a major push to become global players. “Overseas merger and acquisition activity is on the rise. To fund such globalization, companies will need to find new ways of financing deals, such as private equity funds. Domestic capital accessibility is an issue, but right now companies can find ready funding from overseas sources.”

Freedom to Lend

Panelist Xiao Feng, vice chairman and CEO of Boshi Fund Management in Shenzhen, China, said that often government policy dictated exactly where banks could invest, thereby causing distrust on the part of the companies. “One quarter the government will say, ‘Invest in electricity,’ and then three quarters later it doesn’t want banks to invest in that sector anymore. That’s a problem.”

Such centrally directed lending imperatives (known as “policy lending”) are still rampant, especially at lower levels, noted Marklew: “At the end of next year, the banking sector has to be open to foreign regulation according to the WTO. Something like 60% of all lending is funneled through the big four state banks in China, and there are thousands of branches in each one. So at the provincial levels, policy lending is still going on, even if it’s not happening as much anymore in Beijing. If the provincial leader likes the business you are in, you get easy access to capital.”

At that level, Marklew added, there is little understanding of the true credit culture, particularly in the context of a government that’s encouraging big firms to go global. “If, as a company, you have been functioning in an essentially policy-directed lending system, it’s a big change when you arrive on the international scene.”

Much of the problem stems from the repercussions of lending to anyone not approved by the government, said Kwan. “If a bank officer makes a loan based on an evaluation of an individual or entrepreneur, and it turns bad, that officer’s job may be in danger. People will ask, ‘Why did you lend to that person?’ even though the whole credit decision was made on an up-and-up basis. Until China moves away from this mentality and allows the system to make risk-based loans, it will be difficult. It’s not that they don’t know how; it’s that the system doesn’t provide any incentive to do it.”