Australia-China Chamber of Commerce and Industry of New South Wales
23 June 2000
ELECTRONIC NEWSLETTER NO. 21
The focus for this issue is the Cost of Financial Reform in China. It is a continuation of E-Letter No. 21 in which we stated that
China is moving in the right direction, and at a faster pace than most observers
expected, in restructuring its financial system. In this issue, we concentrate on the fiscal costs of the
We consider the costs of financial reform with
reference to three levels:
funding needed to reduce
substantially the threat of a banking crisis,
funding needed to make the
banking sector more effective in channelling domestic savings into productive
funding needed to make
China’s banks able to compete with foreign banks following the agreed upon
liberalisation of the financial sector.
The costs are of course cumulative in the sense that
the third level can be achieved only if the other two are met. That level has received more attention
recently as a result of China’s likely entry later this year into the World
In 1985, China’s four
state-owned commercial banks were adequately supplied with paid-in capital and
other surpluses to meet generally accepted capital-adequacy ratios. Since then, however, bank deposits and
accompanying loans to state-owned enterprises increased much more rapidly
than available capital, thus lowering the ratio from more than 12 per cent in
1985 to 3.5 per cent at the end of 1998.
This gave rise to much concern.
To counter this weakness,
the People’s Bank of China lowered the reserve requirements of the four
state-owned commercial banks in 1998.
A special issue of government bonds, amounting to RMB 270 billion, was
purchased by the banks from the freed-up funds.
The government used the
proceeds of the sale to purchase subordinated debt of the banks. The latter exchange added substantially to
the capital base of the commercial banks.
The resulting increase in government debt was equivalent to about 3.4
per cent of gross domestic product (GDP) in 1998, and the exchange was
completed by August of that year.
These transactions can be
viewed in several ways. First, they
comprised a transfer of debt from state-owned banks to fiscal debt of the
central government. Improvements were
achieved in the balance sheet of the banks, but were offset by a weaker
“balance sheet” of the state.
re-capitalisation of the four commercial banks in 1998 is the result of the
lack of capital replenishments following the transfer of enterprise funding
from ministries to the banking system in the 1980s. This, in turn, could be traced to undercapitalisation of
state-owned enterprises at that time.
The exchange can therefore be viewed as a catch-up in funding.
Third, despite the
appearance of cosmetic changes, when the reallocation of debt is combined
with other changes it reflects a stronger commitment of the central
government to achieve market-tested outcomes for the four commercial
banks. The next step could be partial
privatisation of these banks.
Of greater concern was
the relatively large portion of non-performing loans held by the commercial
banks, and there is evidence that the quality of their loans deteriorated
between 1995 and 1998. Conservative
estimates put the amount at 25 per cent of all loans, while other estimates
were as high as 50 per cent in 1999.
The four asset management
companies (AMCs) that were formed in the first half of 1999 are fully owned
by the central government and were capitalised with RMB 10 billion each from
the Ministry of Finance. Cinda, the
first of these AMCs, was authorised to issue RMB 250 billion in bonds to China
Construction Bank in return for an equal amount of that bank’s non-performing
loans at face value.
China Construction Bank
will retain all normal and special loans (including loans of recent origin),
and the bank will write off assets classified as lost. The latter includes loans to state-owned
enterprises that are declared bankrupt prior to the transfer.
The three other AMCs will
follow a similar procedure with China Dongfang receiving about RMB 230
billion in non-performing loans from the Bank of China, Chang Cheng receiving
about RMB 270 billion from the Agricultural Bank of China, and Huarong
receiving about RMB 450 billion from the Industrial and Commercial Bank of
China. In addition, China Dongfang
will transfer about RMB 100 billion to the China Development Bank, which is a
non-deposit-taking policy bank.
The total amount of
allocated credit for these transfers is RMB 1.3 trillion, or about 16 per
cent of GDP in 1999.
The AMCs are expected to
take over the problem loans from their associated bank or banks, list assets,
sell the assets if possible and design debt-for-equity swaps. The World Bank reported in March of this
year that 500 state-owned enterprises applied for these swaps and 108 were
chosen for the first batch. Panda
Electronics and Shanghai Baosteel Group exchanged shares for nearly RMB 5
billion early this year.
Thus, some recovery of
the RMB 1.3 trillion in allocated credit has already occurred, and more is
expected. Chinese authorities
estimate that approximately two-thirds can be recovered, while external
rating agencies suggest that the figure is likely to be closer to
one-half. This would nevertheless
reduce the resulting fiscal debt to about 8 per cent of 1999 GDP.
Putting into place
measures to recapitalise the four state-owned commercial banks, as well as to
reduce the proportion of their non-performing loans, removed much of the
fragility of the banking sector. The
World Bank stated in its China:
Financial Sector Update (March 2000) that the prospects of a banking
crisis in China are still very low, but have not been eliminated.
We receive numerous queries from Australian
companies about how to set up a business in China. Though we have offered advice and suggestions when the business
plans are specific and reasonably well formed, we lack the resources to provide
a comprehensive, first-step approach to formulating those plans.
A book published last year by the Institute for
International Economics in Washington, D.C. includes many of the introductory
elements needed for the initial planning effort. It is entitled: Behind the Open Door: Foreign Enterprises in the Chinese Marketplace. The
author is Daniel Rosen, who studied foreign direct investment in Asia for
The chapters in the book include: “Gauging the New Chinese
Marketplace”, “Foreign Enterprises and Human Resources”, “Running a
Productive Plant” and “Of Laws and Privileges”. The book sells for US$25 in paperback.
Chapters can be downloaded from the Internet site of
Note, however, that the downloaded pages
“self-destruct” after one day and cannot be printed.
We would like to gauge the amount of interest in
this type of publication and would welcome comments on it. We can also offer to set up an information
exchange by e-mail on “getting behind the open door”.
for this issue is the China's Financial Sector. The Chamber issued a note
on 10 December 1998 under the title: "Will China's Financial Sector
Crash?" (available at http://www.library.unsw.edu.au/~jazerby/china.finance.htm).
We examined some of the dire predictions that emerged at the height of the
East Asian crisis and concluded that many of them were overstated, especially
with reference to China.
examine some of the support measures that were put into effect since July
1997. Not only has China moved in the right direction, but also the speed has
been more rapid than most people thought possible. The institutional
strengthening is not yet over, however.
Under the terms of the
U.S.-China WTO accession agreement, foreign banks may conduct local currency
business with Chinese enterprises beginning two years after accession. Beginning five years after accession,
foreign banks may conduct local currency business of any kind throughout
Timing is therefore an
important element in achieving profitability for the Big 4 banks, as well as
for a large share of the second-tier banks.
Urban and rural co-operatives are not likely to have their market positions
eroded by foreign banks, but both the national and city commercial banks will
need to show a better market performance to retain depositors with a more
liberalised financial sector.
The two-year period
before the beginning of foreign bank lending to Chinese enterprises requires
a relative fast pace for the restructuring process. If the entire RMB 1.75 trillion (minimum credit allocation) in
expected transfers is to be concluded in that period, and if a large portion
of that requires bonds to be issued to the banks, then government finances
will be heavily strained.
There is reason to
believe, however, that not all of the allocated credit mentioned above will
be conveyed through bond issues.
First, some of the transfers to the AMCs have been recorded by the
associated banks as “payment pending”.
This must of course be cleared eventually, but settlement could wait
until the banks need the proceeds.
The average Chinese
household has nearly RMB 59,000 in financial assets, of which 80 per cent is
invested in savings deposits. For
most of the past decade, banks in China had more funds than they can
profitably deploy, which is an additional reason for the increased proportion
of non-performing loans. A large
amount of additional liquidity would not be helpful at the present time.
authorities have agreed that the purchase by foreigners of a portion of the
non-performing assets may be necessary for the successful resolution of the
non-performing loan problem. This is
due to China’s limited resources in dealing with the large and complex
problem of loan restructuring.
Several funds have
already been established with foreign contributors, the purpose of which is
to participate in the debt-for-equity swaps.
The external funds therefore comprise a form of foreign direct
investment and will allow some of the debt recovery to be achieved without
incurring interest payments.
Third, with an increased
amount of debt-for-equity swapping, the AMCs will gain additional liquidity
so that a portion of the payments to the associated banks can be made with
cash. Similarly, as a larger number
of state-owned enterprises become recapitalised through the swaps, their
capacity to retool and restructure will be substantially improved. This will allow some to return to “normal”
increase in bond issues will be needed to meet the liberalisation
schedule. This will increase the
fiscal burden of interest payments and could comprise a sizeable increase in
percentage terms. It is the size of
the percentage increase that captured the attention of a number of Western
afford additional public debt?
The public debt associated
with China’s financial sector is not newly acquired debt. It was always there in the form of
implicit financial obligations of the state to its fully owned
enterprises. The need to make these
obligations explicit became apparent only recently, partly as a result of the
East Asian financial crisis.
The ratio of China’s
public debt to GDP has been relatively low (less than 20 per cent compared to
an average of more than 60 per cent for industrialised countries). As China continues its transition from
state ownership to private ownership, the financial obligations within the
state sector must be accounted for and funded in some way. Much of this, but hopefully not all of it,
must be taken over by the state. The
conventional ratio of China’s public debt to GDP will therefore increase.
With no new spending
programs by the government, the speed at which the public debt rises in the
next few years could be viewed as an indication of the speed of the
transition away from state ownership (and state control over implicit
financial obligations). It would
therefore be a positive sign in relation to China’s development objectives.
The transfer of implicit
financial obligations to more formal debt instruments nevertheless entails a
commitment by the state to carry the interest burden. In China, government revenue (and
government expenditure) has been relatively small in relation to GDP (about
10 per cent in 1997 and 1998, compared to more than 20 per cent for most
industrialised countries). More
importantly, the percentage declined in recent years, as government revenue
failed to keep up with GDP.
Does this mean
that China will not be able carry the new interest burden?
Government revenue must
obviously increase, and this is already happening. During the first four months of this year, tax revenue from the
industrial sector rose by 13.8 percent, on an annual basis, to RMB 144.9
billion. Of this total, SOEs
accounted for RMB 105.3 billion, with an annual increase of 12.2 per
Rather than increasing
tax rates, Chinese authorities are apparently relying upon growth in the
economy to provide enough revenue to cover the larger interest payments. Some analysts consider this to be risky,
since a drop in the growth rate could send the process off the tracks. Additional government spending to restore
the growth rate, as occurred from the second half of 1998 to the fourth
quarter of 1999, adds substantially to government debt and to the interest
Nevertheless, the reliance
upon economic growth seems to be working so far. A total of RMB 210 billion in Treasury bonds were issued in
1999, about RMB 160 billion of which were classified as a “special issue”. This year an additional RMB 212 billion
have been issued which is slightly less than half of the planned amount. A new batch issued in June carries a
five-year term and a fixed interest rate of 3 per cent per annum. All of this occurred without noticeable
strain in the financial market.
financial restructuring pose problems for social welfare funding and for
other development programs?
Most Western analysts
express varying degrees of frustration over the lack of announced plans for
the various reforms that are occurring simultaneously in China. Justification for classifying China’s
economic reforms as “piecemeal” could be easily found with the early reforms
in the 1980s. Many of these policies
and programs were subsequently changed, and often changed again.
Similar justification is
less easily found after Zhu Rongji took over China’s economic
management. It is difficult to
believe that the large number of reforms that were put into effect during the
past three years emerged coincidentally.
We mentioned some of these in E-Letter No. 21, and greater detail can
be obtained from the World Bank’s March Update.
The reforms comprise a
comprehensive set, and this suggests that the problems were appreciated even
if they were not fully articulated.
Similarly, some form of medium-term strategy seems to be implicit in
the announced timeframe. Such an
implicit strategy has an advantage in allowing changes to be made, to suit
changing conditions, without the need to rewrite and re-explain the entire
Since financial sector
reform depends upon the commercial viability of a large portion of SOEs, it
is of fundamental importance to the other areas for which continuing reform
is needed. Perhaps we can use the
currently popular expression and state that the problems of the financial
sector are being “addressed”. There
is also reason to believe, at the present time, that China can afford the
cost of the “stamps” to “post” them.
We cannot yet be certain, however, whether there are sufficient
implementation resources to “deliver” the solutions.
Nicholas Lardy was one of the first analysts to look at China’s
financial sector in detail. This
research was published as China’s Unfinished Economic Revolution by
Brookings Institution Press in 1998. The
data pertain mainly to 1997 and earlier.
A subsequent article by
Lardy in the Asian Wall Street Journal
(30 September 1998) entitled “China Chooses Growth Today, Reckoning Tomorrow”
updates it to some extent. The
article is reprinted by Brookings Institution at: http://www.brook.edu/views/op-ed/lardy/19980930.htm.
A paper by Lardy entitled
“The Challenge of Bank Restructuring in China” was presented at a conference
co-sponsored by the Bank of
International Settlements and the
People’s Bank of China on 1-2
March 1999. It is collected in Policy
Paper No. 7, Strengthening the Banking System in China: Issues and
Experience: http://www.bis.org/publ/index.htm. Other articles in that collection
(especially one by Lawrence Lau)
are also useful.
A fourth article by Lardy
is entitled ”Fiscal Sustainability: Between a Rock and a Hard Place”. It appeared in China Economic Quarterly and was reprinted by ChinaOnline on 16 June 2000 at http://www.chinaonline.com/commentary_analysis/economics/currentnews/secure/c00061641.asp.
More recent information
is available from the World Bank
(China Update, March 2000) at: http://www.worldbank.org/.
Select “China” in “Regions and Countries” and download “Quarterly Economic
Update” (in PDF).
Another current and
informed commentary appeared in ChinaOnline
on 20 June 2000 by John L. Walker of Simon Thacher &
Bartlett. It is entitled “Financial
Reform in China” at: http://www.chinaonline.com/commentary_analysis/instreform/currentnews/secure/c00061345.asp.
Some of the sources
listed in E-Letter No. 21 were also used.
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