Planting seeds

Fish farmer Liu Huaxin would like a loan to grow his business. The extra money would allow Liu to expand his production capacity as well as move into speciality fish products which could help to increase his profits and ultimately improve his standard of living. That is easier said than done in his home of Qiaozui, a village near Wuhan.

"Right now, banks in our district have bad debt and many non-performing loans. Bad creditors have damaged good creditors’ [reputations] because they did not pay their loans," he said.

Liu is one of those good creditors, having repaid in full and on time a RMB10,000 (US$1,460) micro-credit loan he received in 2007. But despite his history, and although Beijing is encouraging lending to individuals and companies under its US$586 billion stimulus package, he has found it hard to get a loan.

In the past, farmers like Liu had few alternatives if they were turned down by a bank. Liu’s local rural credit cooperative (RCC) came through with a micro-credit loan in the end, but had it not, he doesn’t know what he would have done.

Now, Liu has somewhere else to go. HSBC, Standard Chartered and Citi have opened rural institutions, taking advantage of a regulation introduced by the China Banking Regulatory Commission (CBRC) in 2006 to invite banks to set up township banks or lending companies in rural areas. These banks bring with them international risk management principles and focus on smaller loan amounts.

Global expertise

"When the CBRC invited us it also hoped we could bring in international standards for corporate governance and risk management," said Elton W.K. Lee, executive vice president and head of rural banking for HSBC.

HSBC, which started opening rural banks in 2006, currently has the largest rural network with five outlets – in Hubei, Chongqing, Fujian, Beijing and Guangdong. Citi China opened two lending companies in Hubei province in 2008 and 2009, and will open a third branch near Dalian in Liaoning province in the near future. Standard Chartered has one branch in Inner Mongolia that opened last year.

Zhang Kai, director of franchise development for Citi China, said that Citi chose the rural lending company model, where the company offers credit and loans to local businesses but does not take deposits, because this was the best way to serve the local market. "[We] wanted to expand our business to less-developed regions of China by introducing a commercially viable model," she said.

Each of the banks stressed that commercial rationale, not corporate social responsibility, was their primary reason for entering the rural areas. But given this approach appears so at odds with the core of these lenders’ China strategy – doing business with high-value clients in urban areas – some market watchers don’t take the claims at face value.

"They’re being good corporate citizens," said Peter Tebbutt, senior director of financial institutions for Fitch Ratings. "But there’s learning to do to understand what’s going on in rural China. [This is a good idea] just for their understanding of China and a broader understanding of Chinese banking markets."

Qiang Liao, director of financial institutions for Standard & Poor’s, is more skeptical, suggesting the foreign banks are playing politics as much as being do-gooders. "I think they might get soft rewards in other areas such as getting more favorable responses in their applications for new branches in coastal cities or new business licenses," he said.

Qiang added that the banks may have a second, longer-term goal. Many export-related manufacturers are moving to central and western China both to cut costs and to meet the needs of increasingly affluent local customers. Foreign banks that lay down roots in these areas now may find themselves well positioned to take advantage of strong loan demand in five to 10 years’ time.

Foreign banks may also have an advantage in trade finance, as they can provide larger and stronger international networks than many of their Chinese competitors. HSBC has already begun to roll out trade financing at its rural banks, starting in Suizhou, Hubei province in April of this year. Lee said Suizhou was chosen as the pilot location because the area’s businesses are all export-oriented.

But setting up advanced services not offered by domestic counterparts in rural areas does not mean much if customers cannot access them. With a small number of branches spread over a wide geographical area, it’s difficult for customers to take advantage of these services. Consequently, banks may struggle to make their rural operations profitable.

"We need to reach a critical mass in order to achieve profitability," Lee said. "If you just open one or two branches, the costs… will be out of proportion."

Small base, big ideas

The banks have tried some unique ideas to expand their reach without increasing the number of branches. Citi and HSBC both offer unsecured loans. Borrowers must pass credit checks to qualify for these loans and, if they are using HSBC, provide references and an individual guarantor. HSBC also provides what it calls supply-chain financing loans through the major agribusinesses in the areas where it has rural branches. These companies then extend small loans to the farmers who supply their raw materials.

Standard Chartered, meanwhile, has several micro finance initiatives underway. It runs a program with Esquel, a major Hong Kong apparel manufacturer, to provide cotton farmers in Xinjiang with micro-finance loans as well as educational seminars about debt management for farmers. It has also pledged US$2.93 million to the China Foundation for Poverty Alleviation (CFPA) for micro loans to small businesses in seven provinces.

The banks told CHINA ECONOMIC REVIEW that they are looking into ways to provide mobile banking to help reach customers in remote areas. Though it may help the banks to reach more customers, mobile banking is more of a stop-gap than a permanent solution.

"If they’re seriously interested in rural finance they should adopt the same strategy that they are doing in urban centers," said Qian Ying, principal economist (financial sector) in the East Asia department of the Asian Development Bank (ADB). "They should look at how to build their networks."

Buyout option

If the banks feel they are unable to do this, Qian suggests that they buy existing networks. He admits this won’t be easy. Most service providers in rural areas are RCCs – there are no guidelines for these to be purchased by foreign or domestic players and, even if there were, suitable candidates would be few and far between.

Rabobank dipped its toe in the water in 2006, acquiring a 10% stake in the United Rural Cooperative Bank of Hangzhou along with the International Financial Corporation, which took 5%. The purchase was part of a CBRC pilot program to allow foreign banks to invest in RCCs. A year earlier, the ADB invited Rabobank to invest in an RCC in Inner Mongolia, but the deal fell through.

The ADB is currently looking to purchase a bank in central or western China, but Qian isn’t optimistic. "Their balance sheets are weak and there’s lots of connected lending [to related parties] so it’s not so straightforward," he said.

Foreign banks face additional barriers to expansion. They are obliged to set up each rural bank as a separate entity from one another and from their locally incorporated commercial banking entity, a rule meant to ensure that each bank stays focused on serving its local community.

It is a hurdle, but one Lee says HSBC is determined to overcome. The regulator’s willingess to allow expansion is one issue; another is economics.

"We need to assess the economic potential of an area… we need to see if it’s commercially viable," Lee said.