China’s banking reform: Issues and prospects for the future

Restricted 1 China’s banking reform: Is s ues and pros pects for the future Alicia García He rrero * Bank o f Internatio nal Se ttle me nts Repre s e ntative Office fo r As ia and the Pac ific CASS, Be ijing June 7, 2007 *Op inions are mine and no t nece s s arily tho s e o f the BIS Restricted 2 Roadmap to the presentation 1. Why do all care for China’s financial reform? 2. An assessment of the banking reform so far A. Restructuring of SOCBs B. Financial liberalization C. Regulation and supervision 3. How are banks doing? 4. Suggestions for future steps Restricted 3 1. Why do all care for China’s financial reform?  China’s outstanding growth performance justifies optimism  And yet, such huge saving and investment ratios should yield even higher growth ► Banking system is the pillar (over 80%) but does not function properly: potential misallocation of resources ► But also a lot of self-financing key (60% ) and informal financing: risky!!  Success of ongoing bank reform key: – For China’s economic development – For the rest of the world given China’s size & interlinkages Restricted 4 2. An assessment of the reform so far a. Restructuring Organized in three waves, each of them with:  Recapitalization  Disposal of non-performing loans (NPLs)  Partial privatization  Issuance of subordinated debt Restricted 5 a. Restructuring (con’t)  Large capital injections to 3 of the 4 largest banks (state- owned commercial banks) – In three waves 20-24% of 2004 GDP injected in the banking system: • This amounts to over 110% of SOCBs capital – Not really a bail-out since • By and large only public-owned banks restructured – Howeer, different public/semi-public entities covering the costs • Distribution of costs not very transparent Restricted 6 a. Restructuring (con’t)  Even larger disposal of bad assets: NPLs transferred to Asset Management Companies (AMC): – In first wave, bilateral transfer:one AMC per bank – Disposal of assets aiming at highest recovery value and not speed: • Not much recovered: about 10% of total face value – Financing: 45% financed by PBC credit and 10 year bond issued by AMCs • Not very high yield and doubts about payment: no explicit government guarantee: • Involvement of CB could eventually constrain monetary policy although international reserves are a big cushion! • Fragmentation of government bond market Restricted 7 2. An assessment of the reform so far b. Financial liberalization 1. Introducing market practices: – Reduction in reserve requirements and in their remuneration • Steady reduction in liquid assets although still high – SOCBs given more responsibility for lending decisions • Some credit quotas removed – Private ownership: joint-stock commercial banks and city commercial banks starting 1999 – Also foreign more recently with WTO commitments Restricted 8 b. Financial liberalization (con’t) 2. Liberalizing interest rates – first money and bond market – then loans – finally deposits but not completed: • Corridor of 330 bp or higher: cannot be reduced! • Lack of competition but helps profitability Restricted 9 b. Financial liberalization (con’t) Differenc e betwee n lending and depos it rate s Restricted 10 b. Financial liberalization (con’t) 3. Opening up to foreign competition:  To greenfield investment due to WTO commitment – However difficult to grow organically in such a large country – Administrative difficulties to open affiliates can also slow down growth of foreign ownership  Sharp increase in foreign participation through strategic partnerships in 3 large state-owned banks – But still no control  Different to [...]... adequacy! – The spirit of the low probably more important than the letter of the law  Better corporate governance: Strengthened functions and accountability of board of directors  Better bank management techniques, particularly risk management  Before foreign exchange controls lifted: – Rregulations for foreign exposure need to be enhanced – Also deposit insurance scheme  Better and wider external and. .. Further capital account liberalization as a consequence of more flexibility of exchange rate regime • For the risk of capital outflows to be minized important to have completed domestic financial liberalization and the restructuring 18 Restricted 4 Conclusions (con’t) B On financial regulation and supervision  Important strides particularly in regulation but enforcement an issue – Particularly for. .. sheets and income statements 19 Restricted 4 Conclusions (con’t) So far so good, even amazingly fine but reform needs to be completed as soon as possible: why? : 1 Always better to do it in good times with high growth, strong fiscal position and international reserves – Very different from Latin America 2 Growing challenges – WTO poses challenges for Chinese banking system and also some sectors in the. .. empirically the main drivers of the improved –albeit still low - profitability of Chinese banks : – Increased capitalization – Higher bank efficiency – Lower bank concentration and market size • smaller weight of SOCBs and increased importance of JSCBs – More private ownership – High real interest rates and inflation also help 14 Restricted 4 Conclusions A On bank restructuring – Need for clear diagnosis... – For NPL stock problem: • Transfer of NPLs should be accompanied by capital injections up to the required solvency ratio to comply with Basel I and with precise timetable • Necessary for soundness but also to improve its profitability • Clarify how AMCs will pay against NPLs received and status of debt issued (only implicit guarantee) 15 Restricted 4 Conclusions (con’t) A On bank restructuring – For. .. liberalization – By the handbook in sequencing of financial liberalization but needs to be finalized! – Completion of bank restructuring important for further liberalization: • If incentive structure does not change, liberalization may not be reflected in banks’ behaviour • And if it does: reduced spread because of stronger competition: fall in profitability • Even more dangerous if real interest rates and inflation... s tandards • o fo r private banks (jo int s to c k and c ity c o mme rc ial banks ) Als • Rapid as s e t g ro wth witho ut ne w c apital • Only re c e ntly s urg e in s ubo rdinate d de bt • till in banks ’ hands thro ug h inte rbank S • o IPOs and e xpo s ure to fo re ig n rule s (HK s to c k e xc hang e ) Als • s e t quality muc h be tte r but s till po o r c o mpare d to inte rnatio nal As s tandards... restructuring • Help from financial liberalization to evaluate risk and price it properly • Need for better risk management procedures (capacity building) – Regarding privatization, only solvent and viable institutions should be privatized • Transfer control might the quickest way to improve management – Does not need to imply majority ownership • Even if the State retains control: same level playing field 16 Restricted... international standards but not a big issue  Profitability, instead, clearly low – Particularly if one considers guaranteed interest rate corridor! – Recent improvement in large state-owned banks but even worse in joint-stock and city commercial banks Quite different from Latin America, spreads even higher and also profitability 13 Restricted 3 How are banks doing? (cont’)  García-Herrero, Gavilá and Santabarbara... (con’t) 4 Steps towards capital account liberalization:  More on inflows than outflows – Although more steps taken recently for the latter mainly to stem off pressures towards exchange rate appreciation  Domestic transactions in foreign currency strongly regulated – Limited foreign exchange exposure although rapidly increasing Much faster liberalization in Latin America 11 Restricted 3 How are banks . Suggestions for future steps Restricted 3 1. Why do all care for China’s financial reform?  China’s outstanding growth performance justifies optimism  And yet,. (60% ) and informal financing: risky!!  Success of ongoing bank reform key: – For China’s economic development – For the rest of the world given China’s