The countdown begins

A top level financial meeting was convened last month focusing on the reform of China's commercial banking sector. The meeting, which called for improved corporate governance in banks and more diversified ownership, was the latest attempt to accelerate the pace of reform in the sector.

Three years ago, China's banks were warned that they must change the way they conduct business. In outline, three problems were identified: government interference, putting policy objectives ahead of commercial rationale on lending; dauntingly high debt weighing on technically insolvent banks; and low management, operational and commercial capabilities.

Reform has been slow over the past decade but the prospect of World Trade Organisation membership has instilled some urgency. Once it was formally accepted into the WTO in December, a timetable for market opening locked in. As far as China's most important trade and investment partners are concerned, the deadlines agreed for the financial sector are set in stone.

From 2004, foreign banks will be permitted to conduct business in local currency with Chinese companies. Three years later, they will be able to compete with domestic institutions in retail banking, serving both enterprises and individuals. At the same time, geographical restrictions will be lifted, allowing foreign banks to roll out their operations elsewhere in China. The regulatory and operational environment should then be equal for domestic and overseas institutions alike.

Foreign toehold in the market
Currently, foreign financial institutions have only a toehold in China. By the end of last year a total of 31 banks with branches in Shanghai and Shenzhen were conducting small volumes of yuan business with foreign-invested enterprises. They bought in local currency at a cost because they were not allowed to take deposits. According to official sources, their combined net profits were just US$134m in the first half of last year.

Accession to the WTO means much improved prospects for foreign banks. HSBC is applying to offer foreign-currency businesses in four cities and Standard Chartered and Citibank are also preparing applications. Perhaps more than any other foreign retail banks, these three have the ambition and resources in the region to compete with the local competition head on.

However, taking market share from domestic banks is unlikely to be straightforward. The experience of many other sectors over the past decade shows how adept the Chinese government is at protecting its state-owned enterprises. Being limited to opening just one new branch a year means that foreign banks will remain dwarfed by the Chinese banks.

Some foreign bankers believe that new barriers will be raised as quickly as the old ones come down. Regulations announced last month stipulating that foreign bank branches conducting foreign currency business must have operating capital of at least Yn600m have done little to quell these fears.

The doors are opened China's financial institutions will come under enormous pressure as the doors open wider. The major multinational names have considerable expertise in international markets and leverage from substantial global operations. The 160 or so foreign banks in China can be expected to raise their exposure well above almost US$40bn-50bn in assets they already hold there.

Many foreign financial corporations surpass China's home-grown banks in the provision of fee-based services, where Chinese institutions are particularly weak. Domestic banks are ill matched in product and service range and sophistication, risk assessment and credit pricing, cash handling, marketing and in a host of other areas. They lack profitability and lag in market segmentation capabilities. Chinese banks remain over-staffed despite recent branch closures. Foreign banks are leaner, with higher management and operating expertise, and they have invested heavily in technology. Their foreign exchange capabilities are global, whereas the major Mainland banks, with the exception of Bank of China, are still highly localised within the domestic economy.

As new areas grow, Mainland banks will find themselves on a steep learning curve compared with their foreign rivals. Fundamentally they lack experience in making commercial loans, for example to private enterprises or to individuals buying homes and big-ticket items such as cars. These businesses, which are in their infancy in China, offer perhaps the greatest potential to foreign bankers. It is no coincidence that Minsheng Bank, China's only private bank that lends primarily to the private sector, enjoyed a 60 percent rise in pre-tax profits last year. A proposed joint venture between China Construction Bank and Germany's Bausparkasse Schwaebisch Hall, likely to be the first of its kind in China, will be engaged mainly in the mortgage business.

Non-performing loans
Market opening threatens the viability of China's tens of thousands of financial institutions. At the top of the banking hierarchy are the big four state commercial banks – Bank of China, the Industrial and Commercial Bank of China (ICBC), China Construction Bank and the Agricultural Bank of China (ABC). They are the only banks with nationwide branches and they account for 70 percent of financial transactions in China. Collectively, they have well over 100,000 branches at home and a few overseas.

Despite the separate existence of three state policy banks established in 1994, the big four lend to central and local government priorities far more than is healthy, which has led to the problem of excessive corporate debt and non-performing loans (NPLs). Four asset management companies (AMCs), set up in 1999, have taken Yn1,400bn in nonperforming assets off the banks' books as part of the drive to rebalance their accounts. It remains unclear how much is left; Chinese accounting falls short of international norms and books may not give an accurate picture. NPLs are probably still accumulating fast as bank lending continues to be influenced by government instruction. There is strong reluctance to recover debt from defaulting state-owned enterprises (SOEs), for example, through bankruptcy proceedings. State industry takes about four-fifths of all loans.

There is only a limited advantage to be gained by transferring the problem to AMCs. They were only able to repackage and offload a small proportion of their holdings to domestic and foreign investors in November and December last year. They cannot stand as a permanent sink for domestic bank bad debt. Furthermore, contingent liabilities in the financial system are high, not least where the state has recapitalised the top banks by hundreds of billions of yuan in recent years. The problem of NPLs goes to the heart of the credibility of the domestic banking system.

After the big four come about 10 national commercial banks and 90 city commercial banks. They share many of the problems of the top four. Credit co-operatives also play a crucial role in capital intermediation, but are troubled. China's 42,000 or more rural credit co-operatives are the only port of call for farmers unable to offer collateral or guarantees required by the banks. The ABC, once a major provider of financial services to rural China, has withdrawn from lending to farmers because of poor risk. There are also about 3,000 credit co-operatives in the towns and cities. Credit co-operatives lend into a high risk, low return environment, but one of crucial political importance for the government. The rural economy remains the country's largest employer at a time of mounting unemployment.

Meeting the challenge
The slow move towards profitability may be too little too late for China's banks, which need to make far greater use of the Yn14,400bn in savings sitting in their reserves in 2001. Positive headline figures for 2001 – Yn26.6bn in profits at the big four for 2001, compared with Yn14.7bn in 2000 – are deceptive. For example, the ICBC's pretax profits of Yn5.9bn are to be judged against actual profits of Yn34bn. It set Yn17.5bn aside for bad loans and it wrote off Yn10.6bn for earlier losses. The profitability of BOC's core activities declined in 2001, only partly accounted for by the global economic slowdown. While its Mainland branches raised profits 4.7 percent to Yn2.3bn, overseas operations witnessed a fall of 9.9 percent to Yn8.6bn equivalent.

Claims that NPL ratios are coming down at the top banks, for both old and new lending, are unreliable for lack of transparency. Outstanding loans at China's banks were posted at Yn11,200bn for 2001, a rise of 11.6 percent on 2000. The quality of these loans is questionable. For example, lending to agriculture, one of the slowest growing sectors of the economy, has been high.

Since 2000, China's banks have come under closer scrutiny as they open themselves to National Audit Office (NAO) and foreign auditing. Tens of BOC employees have been netted along with former bank head Wang Xuebing for serious irregularities at branches in China and New York, where the bank is being heavily punished by the US authorities for misdemeanours throughout the 1990s. The NAO spotlight moves to the CCB this year, while Ernst & Young is to audit ICBC branches in Shanghai and Zhejiang province. Further revelations at China's banks would jeopardise listing plans, which are key to their continuing recapitalisation. They would also raise doubts in the minds of prospective foreign partners, which are key to domestic banks' long-term strategies for modernisation and survival.

The cost of restructuring and modernisation will be heavy. BOC's books took a major one-off hit when the bank restructured its Hong Kong operations last year. BOC has just 25 overseas branches, well short of an HSBC or a Citibank's global reach. Other Mainland banks lag the BOC in rolling out abroad to become global players.

China's banks know what they must do, but they do not have much time. They can be expected to remain focused on internal reform and restructuring, improving corporate governance, expanding operations and services, targeting new clients (especially foreign enterprises), raising profitability, reducing substandard loans, upgrading technology, and retrenchment. Adding to earlier cuts, the BOC alone intends shedding 5,000 staff in 2002 when it shuts 88 branches. The big four banks employ around 2m people, an enduring legacy from the days of the centrally planned state.

Unfortunately, many of the people who will go will be the ones they can least afford to lose. Low rates of pay mean that top staff are vulnerable to being poached by foreign-funded banks. Three economists quoted by China Business Times last month predicted that the top four banks could be expected to lose about a third of their most qualified staff. Alliances will remain a core strategy, as encouraged by government. Bank of Shanghai (BOS) has sold minority stakes to the HSBC, Hong Kong's Shanghai Commercial Bank and the World Bank's International Finance Corporation. BOS is now 18 percent foreign-owned. The Bank of Communications, China's fifth largest commercial bank, has been scouting for foreign partners. Other banks can be expected to tighten collaboration with foreign banks. All 10 shareholding banks are looking for sell stakes to overseas institutions.

Foreign banks will not find everything in their favour now that China is in the WTO. Few state-owned enterprises make for an attractive lending proposition, so market penetration is likely to be well short of the 15 percent share predicted by the central bank for 2006. Nicholas Lardy, a senior fellow and China specialist at the Brookings Institution in the US, is cautious about the prospects for foreign banks. He predicts their market share will only grow from about 1.5 percent today to 3-4 percent by 2005.

Domestic banks will compete aggressively in developing new markets and for private sector and foreign clients. Already, a number of leading banks have signalled their intention to tackle the foreign multinationals on their own turf. Chinese banks are known to be active in offering direct loans to foreign corporations operating in China. ICBC says it has already made large direct loans to Sony and Kodak.

The big four domestic banks and four second- tier banks are all backing a foreign-denominated US$1.8bn loan facility for BP. With large US dollar deposits at their disposal, the Chinese banks were able to offer more competitive rates than most foreign lenders wanting to take part in the consortium.