The start of reform of the PRC’s mono-banking system coincided with major upheavals in international finance. These included the collapse of the Bretton Woods system in 1973, an increase in competition from non-bank financial institutions and the
3 Hui Jin was initialy a subsidiary of the State Administration for Foreign Exchange (SAFE), the administrative agency of the PBC responsible for foreign exchange management. In 2007, the MoF aquired all shares in Hui Jin from the PBC, whoch was compensated with specially issued treasury bonds. The MoF then injected the shares in Hui Jin into China Investment Corporation (CIC), the PRC’s new sovereign wealth fund which was created the same year. Hui Jin has been a wholly owned subsidiary of CIC since. Hui Jin’s shareholder rights are exercised by the State Council.
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emergence of global money center banks. The backdrop of these events meant that as early as the 1980s, the PRC leadership had developed an intricate understanding of the relationship between large banks and financial stability. That said, official and independent scholarly accounts give relatively scant attention to the early role of banks in the PRC’s economic take-off (Goodstadt, 2012). Many studies have focused on the role of informal finance in sustaining the growth of the non-state sector (Allen, Qian and Qian, 2005). Lardy (2002: 128–29) argued that the adjustment of the PRC’s financial system was not inhibited by tariff rates or other protections; rather by the ability of money losing state-owned firms to continue to avoid their losses. Against this background, this section examines why after almost two decades of reorganization and institutional reform of the financial system – which arguably did not really begin until the early 2000s following the non-performing loans (NPL) crisis –, the PRC’s state-banks rank among the largest in the world, while at the same time the ability of loss making SOEs to sustain their position appears unchecked.
Figure 4: Stages of Reforms in the Banking Sector
PRC = People’s Republic of China.
Source: Compiled by the authors, drawing partly on Okazaki (2017: 305).
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Figure 4 provides a summary of major reforms in the PRC’s financial system since 1978. These have to a large extent attempted to mirror developments in international banking. Large state banks have structured themselves along these lines of modern corporations, launched initial public offerings (IPOs), appointed non-executive directors, and sold minority shareholding to foreign banks (Sun and Tobin, 2005).
Significantly this approach was not new to the PRC, and its origins can be traced to the period 1911–1935 where semi-private and private banks were formed with limited liability and shareholders (Cheng, 2003). These banks mirrored their international counterparts in that they not only enjoyed limited liability, but also had long-serving high profile chief executives known as the Jiangzhe Caifa. These financial magnates enjoyed strong relationships with both Shanghai’s capitalists and the government. The period also saw the emergence of grassroots financial institutions, the qianzhuang and diandang, which share similarities with contemporary informal lending institutions (He et al., 2017).
This train of development was interrupted by civil war and the subsequent foundation of the PRC in 1949. In 1950, a decree effectively signaled the communist takeover of the government shares in the semi-private banks and was followed by the establishment of a CCP appointed board of directors and supervisory board (Cheng, 1954). The Agricultural Bank of China was reformed in 1963 (having been abolished in 1957) with the objective of coordinating the finances of collectives and the rural credit cooperatives at the local level.4 The PRC maintained a link with the international financial system via the overseas branches of the Bank of China which had the objective of maximizing foreign exchange earnings to fund socialist construction (Tobin, 2016). In 1979, following the launch of the “open door” policies, the PRC established or re-opened three state-owned commercial banks (SOCBs): the Agricultural Bank of China, the Bank of China and the Construction Bank of China. In 1984 a fourth SOCB, the Industrial and Commercial Bank of China, was established. By the mid-1990s these large specialized SOCBs – often referred to as the “big four” – accounted for over 60%
of the PRC’s banking assets.
The first joint stock banks were formed in the early 1980s, when banks such as South Sea Bank (a private bank prior to 1949) and the Bank of Communications were launched.5 This was followed in 1994, by the establishment of three specialized “policy”
banks, the Agricultural Development Bank of China, the China Development Bank, and the Export-Import Bank of China. Whereas joint stock banks were characterized by smaller state shareholding and faced a greater risk of bankruptcy, the specific objective of the three policy banks was to reduce the commercial banks’ role in financing development projects (Lin and Zhang, 2009). Accountability to shareholders and depositors provided joint stock banks with a greater incentive than SOCBs to engage in prudent lending (Jia, 2009). They also enjoyed significant policy support in growing their loan books, especially after 2013 when the large SOCBs began to reduce their loan growth. Their growth also highlighted a funding constraint as smaller joint stock and city commercial banks do not enjoy the nationwide deposit raising networks of the larger SOCBs. As a result they became increasingly reliant on inter-bank funding (BIS, 2016). Another notable feature has been the reorganization and restructuring of the China Post and Savings Bank. This has allowed it to engage in commercial lending since 2007, a move that saw it become the country’s fifth largest banking organization
4 A full account of financial restructuring during this period can be found in Donnithorne (1967).
5 Previously these banks were nearly all subsumed within the PBC though they remained as institutions – e.g., South Sea, Po Sang, Young Brothers and Yieh Yieh all retained overseas branches in Hong Kong, China, but they were for all intents and purposes part of the PRC mono banking system.
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(Tobin, 2012). Its rural branch network has to some extent compensated for the decline of rural credit cooperatives and branch consolidation of the large SOCBs.
A distinguishing feature of the PRC’s banking reforms is the low presence of foreign banks. This contrasts sharply with the experience of other transitional economies such as Hungary and Poland where foreign banking assets accounted for more than half of total banking assets after a decade of reform (Bonin et al., 2010: 856). After the relaxation of geographical restrictions on their operations after 2006, the market share of foreign banks grew to 2.1% in 2008 (Table 1). From 2007, foreign banks were allowed transform their mainland branches into locally incorporated banks. By 2015, some 37 solely funded foreign banks with 306 branches and subsidiaries were locally incorporated. As part of this they were required to allocate RMB 100 million (around US$ 16 million) in freely convertible currencies transferred from the parent bank.
Capital injections were also treated as foreign direct investments, effectively increasing the complexity of the approval process. Consequently, the presence of foreign banks remains low at just 1.3% of assets in 2015. To reverse this decline, the requirement to allocate a certain amount of freely convertible currency was relaxed in 2015 (Xinhua, 2014).
Table 1: Market Share (by Assets) of Major Banking Institutions (2003–2015)
2003 2005 2008 2010 2013 2015
SOCBs 57.9 56.1 51.6 49.2 43.3 39.2
Joint stock banks 10.7 11.9 14.0 15.6 17.8 18.5
City commercial banks 5.3 5.4 6.5 8.2 10.0 11.4
Rural commercial banks 2.9 5.6 7.6
Rural credit coops 9.6 8.4 8.3 6.7 5.7 4.3
Foreign banks 1.5 1.9 2.1 1.8 1.7 1.3
Postal savings bank 3.2 3.7 3.5 3.7 4.1 4.2
Source: CSRC Annual Report 2015.
While foreign banks have had a relatively low domestic presence, PRC banks have been increasing their international activities, becoming an increasingly important source of international credit. By the end of 2015, their cross-border assets accounted for some US$ 722 billion, making them the tenth largest creditor in the international banking system and a significant supplier of US dollar credit (BIS, 2016: 7). However, unlike other larger international creditors like the UK, Japan and Germany, the PRC is a net debtor in the international financial system. This is partly to do with the unique role of Hong Kong, China; where PRC banks have listed subsidiaries on the Hong Kong Stock Exchange and operate the market in renminbi deposit accounts and bonds (Tobin, 2016). Consequently, the cross-border liabilities of Mainland banks amounted to US$ 944 billion at the end of 2015, a significant proportion (US$ 320 billion) of which related to the market value of the banks’ traded equity in Hong Kong, China (BIS, 2016).
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3.1 Non-performing Loans, Stock Market Listings and Deferred Structural Reforms
The PRC’s revival of commercial banking has not been trouble free. A combination of poor lending practices and a lack of experience in managing risk left the banks in a poor financial position. The well-known consequence of this was a rapid growth in the level of NPLs. Official estimates put the NPL ratio at 33% in 2000 while an S&P (2004) estimate which included impaired loans and off-balance sheet loan guarantees put the ratio closer to 50%. The PRC responded by launching a bank bailout amounting to 3.1% of GDP in 1998. It also established four state-owned asset management companies (AMCs) to absorb almost RMB 1.4 trillion in bad loans.6 In February 2004, the Law on Bank Regulation and Supervision was amended to give greater power to the CBRC as a prudential regulator of banking standards. This was followed by the international listing of three of the four large SOCBs between 2005 and 2006. The fourth bank, the Agricultural Bank of China, was listed in 2010. By the end of 2017, 39 banks were listed on the stock markets, usually in Shanghai and Hong Kong, China (Table 2). This approach, which involved integrating international best-practices where appropriate and equity investments from international banks and institutions has been described as an incremental transactional model in the sense that it did not seek to immediately replicate international banking models (Pistor, 2009).
Table 2: People’s Republic of China Listed Banks
Year 5 large commercial banks
Industrial and Commercial Bank of
China (ICBC) 1984 2006 25,764,798 14.67 1.57 461,749 17,200
China Construction Bank (CCB) 1954/1979 2005 22,053,943 14.67 1.51 362,482 14,985 Agricultural Bank of China (ABC) 1951/1955/
1979 2010 20,923,117 13.40 2.19 496,698 23,692
Bank of China (BOC) 1912/1979 2006 19,422,438 13.87 1.38 310,042 11,556
Bank of Communications (BOCOM) 1908/1987 2005 8,935,790 13.87 1.51 92,556 3,350 Postal savings bank
Postal Savings Bank of China
(PSBC) 2007 2016 8,764,955 12.73 0.82 169,735 40,000
6 One AMC was created for each of the big four commercial state-owned banks: China Great Wall Asset Management for the Agricultural Bank of China, China Orient Asset Management for the Bank of China, China Huarong Asset Management for the Industrial and Commercial Bank of China, and China Cinda Asset Management for the China Construction Bank.
10 16 city commercial banks
Bank of Beijing (BOB) 1996 2007 2,275,226 11.44 1.18 14,534 503
Sources: Compiled by authors with data from KPMG (2017), PWC (2017a), Bloomberg and banks’ financial statements.
The drawback of this approach was that it left intact the Leninist type control structures.
While these were conducive to centralized regulation, and ensured that there were limited personal connections or crossing of career paths between bank and industrial CEOs, they ultimately failed to improve the allocation of capital (Heilman, 2005; Lin, 2016). A lack of structural reforms in the financial sector also contributed to the build-up of macroeconomic imbalances (Ito and Volz, 2013).
The costs of deferring structural reforms became especially apparent following the 2008–2009 fiscal stimulus. This was not strictly a “fiscal” stimulus, since most of it consisted of bank loans and local government investment rather than central government expenditure. State-owned banks were instructed to lend to fund the bulk of the state’s stimulus package. Bank managers had little autonomy to resist government lending priorities, and they knew that based on experience, they would be rescued (Goodstadt, 2012). Much of this lending went to local government “financing platforms”.
These were technically prohibited as they involved, albeit indirectly, local government borrowing (Figure 5). The overriding policy goal of the stimulus meant that bank loans to these platforms were implicitly tolerated. By the end of 2010, there were 6,576 of
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these platforms, a majority of which operated at the county level, and their debt balances accounted for 46.4% of local government debt (NAO, 2011). Their connection to the banking system meant that local government debt became a source of risk for bank balance sheets. Bank finance is the main source of debt funding for local government, accounting for some 78% of loans in 2012 (NAO, 2013). Some local governments have also turned to more expensive trust loans, while trusts have also invested capital in financing platforms.
Figure 5: Typical Structure of a Local Government Funding Platform
Source: Compiled by authors based on IMF (2013: 4).
3.2 The Emergence and Growth of Shadow Banking
While the 2008–09 fiscal stimulus brought to the fore the stability issues surrounding off-balance sheet financing, trust and investment companies first played a role in responding to the pressing need to finance local development in the early 1980s. In 1986, state banks were required to shift their trust business to separate companies, which were thereafter subject to stricter regulations (Lardy, 1998: 73). However their asset base continued to expand rapidly until the mid-1990s, before the PBC started to exercise closer control over their operations. The unprecedented decision of the PBC in 1994 to restrict lending to the MoF for the budget deficit was also a factor in driving the increase in the proportion of off-balance sheet finance (Lardy, 1998). In this way shadow banking emerged in the PRC to capture the off-balance sheet business of formal banks. The term came to represent a pejorative film for all non-bank financial intermediation after 2008, thus obscuring the true nature of risk and usefulness as a source of non-bank funding for small firms (Tsai, 2016).
The PBC’s acknowledgement that state-owned banks had participated in creating large amounts of off-balance sheet liquidity drew increasing attention to the visibility of risk on their balance sheets (PBC, 2011). The PBC sought to deal with this by adjusting the reserve requirement ratios of banks so that their capital ratios would more adequately reflect the level of off balance sheet lending. It led the PBC to adopting a wider monetary aggregate – namely total social financing (Table 3). This reflected the fact that between 2002 and 2010, the average annual growth of the all system aggregate was 27.8%, while the average annual growth of bank loans was 18.4% (PBC, 2011).
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Table 3: The Components of Total Social Financing
On Balance Sheet Off Balance Sheet
Renminbi loans by financial institutions Entrusted loans (in which the bank acts as a loan intermediary)
Foreign currency denominated loans Trust loans (involving the repackaging and sale of loans as wealth management products) Stock markets and net financing of
corporate bonds Undiscounted bankers’ acceptances (a form of off-balance sheet bank draft guaranteed by the bank) Others: e.g., micro financing
Source: Compiled by authors.
The growth in off-balance sheet lending coincided with a reduction in the role of FDI in capital formation. This fell from a pre-financial crisis of 6.8% for the years 2005–07 to 3.0% for the years 2011–2016 (UNCTAD, 2017). PRC banks had long benefited from a surplus of deposits over loans as the PBC purchased foreign exchange from banks (Sun, 2015). The declining role of FDI has placed pressure on domestic sources of bank funding forcing banks to turn to off-balance sheet wealth management products (WMPs) to fund their activities. WMPs are financial products that offer higher returns than conventional equity or deposit accounts. Large SOCBs can purchase WMPs from smaller banks in return for funding. SOCBs can also issue their own WMPs to fund inter-bank lending to smaller banks. While most do not carry an explicit guarantee, their systematic importance in the financial system has earned them a level of public confidence. This is illustrated in data from the BIS, which indicated that approximately 40% of WMP asset portfolios were invested in bond markets with a further 16%
invested in money market instruments (BIS, 2017: 13). This has led to concern regarding the emerging inter linkages between the different components of the financial system. In addition, here are numerous opportunities to hide off-balance sheet assets in the calculation of risk-weighted capital, making meaningful cross-county comparison of acceptable levels of off-balance sheet risk extremely difficult (IMF, 2011).
A second consequence of the growth in shadow banking has been the emergence of a discrepancy between bank lending and liquidity growth. From 2008 onwards, bank lending started to outpace the growth in the broad money supply (Figure 6). In 2011, the PBC acknowledged that bank lending was no longer particularly useful in explaining the growth in M2 and that “all system” or total social financing now played a more important role in supporting economic growth (PBC, MPR, Q1 2011). A further change in this relationship occurred in 2016 and 2017 as the growth in the broad money supply and lending to non-financial began to slow in response to government policy, while total social financing continued to expand faster (Figure 7). This indicated the continuing channeling of funds off-balance sheet into poorly performing state enterprises and funding platforms.
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Figure 6: Growth in Broad Money Supply vs Bank Credit (%)
Source: Compiled by authors using the PBC’s Monetary Statistics.
Figure 7: Year on Year Growth (%) in Credit to non-financial Corporations (NFCs), Total Social Financing (TSF) and M2
Source: Compiled by authors using the PBC’s Monetary Statistics.
3.3 Interest Rate Reforms, Deposit Insurance and the Moral Hazard Problem
The removal of the lending interest rate cap in July 2013 therefore represented a new chapter in the PRC’s financial reforms. It also necessitated a more complex monetary framework. In 2013 the PBC introduced a Standing Lending Facility to meet large scale demand for long term liquidity and Short-Term Liquidity Operations to facilitate repurchase operations with shorter term maturities (Sun, 2015). The reforms, which began with a widening of interest rate margins in the 1990s, sought to give banks
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greater flexibility in the pricing of risk, but limit competition by retaining control over deposit rates. This involved a progressive widening of bank lending rates (albeit around a narrow range) and the eventual removal of the upper rate in 2004 for all banks (except for rural credit cooperatives). On the deposit side, banks were required to match the official deposit rate until 2004, when the lower limit was removed.
In July 2014 the CBRC relaxed its stance on the components used to calculate banks’
loan to deposit ratios, a move that effectively allowed banks to expand liquidity. To protect against competition leading to a greater frequency of bank failures, the next stage, namely the removal of the deposit rate cap, required a system of managed bank resolution and deposit insurance. In May 2015, a scheme was implemented which stipulated depositors could receive up to RRMB 500,000 in compensation if a bank were to collapse. Finally, in October 2015 it was announced that the deposit rate cap would be lifted, effectively allowing deposit-taking institutions to compete for deposit funds.
The liberalization of the interest rate and the introduction of a system of deposit insurance offered an appealing solution to the pervasive moral hazard problem caused by state-ownership of the financial system. Moral hazard has long permeated all levels of the PRC’s financial system. SOCBs were willing to lend to large state enterprises and local governments on the understanding that were these loans to go bad, they would ultimately be bailed out. The moral hazard issue highlights the danger that the welfare and efficiency-enhancing benefits of interest rate liberalization – namely an extension of credit to private firms and greater financial diversity – may be squandered if deposit insurance is not accompanied by wider financial reforms. The latter point is important as in theory, smaller joint stock commercial and city banks and potential new private banks should be the main beneficiaries of deposit insurance.
3.4 Consolidation and Policy-driven Diversity
A consequence of the moral hazard problem in banking, and one which interest rate
A consequence of the moral hazard problem in banking, and one which interest rate