The Australia-China Chamber of Commerce and Industry of New South Wales

Newsletter No. 22

23 June 2000

 

 

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CONTENTS

Removing the Threat of a Banking Crisis

Increasing the Effectiveness of the Banking System

The Effect of Financial Restructuring on the Economy

Sources of Information

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ACCCI 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 restructuring.

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 investment, and

·         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 Trade Organisation.

 

 

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REMOVING THE THREAT OF A BANKING CRISIS

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. 

Second, the 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 many years.

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 the Institute: 

http://www.iie.com/publications/publication.cfm?pub_id=23

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”.

The focus 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.

We now 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.

 

 

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INCREASING THE EFFECTIVENESS OF THE BANKING SYSTEM

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 China. 

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.

Second, Chinese 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” debtor conditions. 

Nevertheless, some 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 analysts.

 

 

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THE EFFECT OF FINANCIAL SECTOR RESTRUCTURING ON THE ECONOMY

Can China 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 cent. 

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 burden.

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.

Will the 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 strategy.

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.

 

 

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SOURCES OF INFORMATION

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.

 

Send comments on this newsletter to: j.zerby@unsw.edu.au

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