III Financial Sector Development
- Marc Quintyn, Bernard Laurens, Hassanali Mehran, and Tom Nordman
- Published Date:
- September 1996
Financial sector development has been characterized by the establishment of a two-tier banking system, followed by the significant expansion of the sector. The sector has diversified through the emergence of nonbank financial institutions (NBFIs), while banks have been allowed to despecialize. Internationalization of the banking sector has taken place only to a limited degree. More recently, the “commercialization” of the state-owned specialized banks has received a boost with the establishment of three policy lending banks and the enactment of the law on commercial banks (see Section IV).
Reforms in the financial sector can be divided into four phases, broadly coinciding with the phases mentioned in footnote 7 in Section II. The first phase covers the reestablishment of the banking system early in the reform years. The second phase starts in 1984 and includes the establishment of a genuine two-tier banking system, diversification of the financial sector, and attempts to liberalize the sector. The third phase, the rectification period (1988–91), witnessed an interruption of the liberalization and a further growth of the NBFI sector. Since 1992, in the fourth phase, several new banks have been established, policy lending banks have been introduced, and work on a legal framework for the financial sector has been undertaken in earnest.
The Role of Banks and Banking Before Economic Reform
Before 1978, the People’s Bank of China (PBC) was the dominant domestic banking institution, basically serving as a “monobank” that handled most financial transactions. Two other specialized banks, the People’s Construction Bank of China (PCBC) and the Bank of China (BOC), operated as special departments within the PBC. The function of the banking system was confined to facilitating the financing of the economic plan. Investment and construction funds, as well as a minimum working capital, were supplied to enterprises in the form of budgetary grants.
The PBC and its specialized departments acted mainly as cashiers, with their functions confined to the settlement of enterprises’ transactions, the administration of funds for working capital and short-term investment—for the part not already covered by budgetary grants—and the collection of house-hold savings. Thus, their intermediation function was limited.
Bank lending covered only transitory and unexpected financial requirements above the assigned quota. Bank loans were generally short term, mostly granted to finance the accumulation of stocks or the purchase of raw materials—in effect, substitutes for buyers’ credits and commercial bills. Interest was charged in an attempt to encourage enterprises to use funds more effectively. Lending rates, however, were low compared with both interest rates on savings deposits and administrative costs, and priority sectors continued to benefit from preferential rates.
Re-Establishment of Banking System (1978–84)
In the early years of the reform process, China’s banking system was reestablished. The PBC was restored as the country’s central bank, even though it continued to perform certain “commercial” activities and remained a department of the State Council. In order to improve the allocation of financial resources to specific sectors, the PCBC and the BOC started operating as independent specialized banks, the former to handle the financial activities of the construction sector and the latter foreign transactions. The Agricultural Bank of China (ABC) was established to take over the PBC’s rural banking business. In addition, a network of 60,000 rural credit cooperatives (RCCs) was set up under the supervision of the ABC to provide small-scale rural banking services.
Concomitantly, the first NBFIs began to appear: the China International Trust and Investment Corporation (CITIC), under the control of the State Council, and the China Investment Bank (CIB), under the control of the PCBC. The authorities also allowed the establishment of international trust and investment companies (ITICs). These institutions raise funds from foreign sources to finance foreign-funded enterprises. In this capacity, they have been the primary source for most international bond borrowing made by China during the 1980s. Many of them were established in the coastal regions—more particularly in the Special Economic Zones (SEZs)—quite often at the provincial level. Most ITICs were established and owned by the (local) authorities. During the 1980s, the number of ITICs grew to over 100, but restructuring had by the end of the 1980s brought that number down. The structure of the banking system for the period 1978–84 is illustrated in Chart 1. While the newly established specialized banks were supposed to report to and be supervised by the PBC, they—just like the PBC—were line departments under the State Council, but at a lower ranking than the PBC.
Chart 1.Structure of Financial Sector in 1978–84
Following a 1979 directive of the State Council, the allocation of investment funds was to shift gradually from budgetary grants to bank loans, subject to interest rates and repayment of principal. Both the PBC and the specialized banks were authorized to grant medium-term and even long-term (five-ten years) loans for the purchase and improvement of equipment and other approved investment projects. As a consequence, the composition of funds allocated to industrial enterprises changed rapidly from 70 percent in the form of budgetary grants in 1978 to 80 percent in the form of bank lending in 1982.
Despite these changes, the banking system continued primarily to serve the limited purpose of providing the credit needed by enterprises to implement the plan for physical output within the framework of central planning. Neither the project’s profitability nor the borrower’s repayment ability was taken into consideration in the monitoring process.
Diversification and Innovation (1984–88)
Starting in October 1984, budgetary funds for state enterprises were further cut and replaced by bank lending. The tax reforms, which gave state enterprises full responsibility for the use of their aftertax profits, changed the destination and size of enterprise deposits: enterprises could now use their funds not only to settle approved goods transactions but also to pay wages and bonuses, as well as to finance working capital and short-term investment. In addition, the investment system was reformed to encourage enterprises to borrow from the banking system to finance projects, rather than to rely on direct grants from the state budget as in the past.
A directive of the State Council in September 1983 formally established the PBC as the country’s central bank by removing its urban commercial banking activities. A fourth specialized bank, the Industrial and Commercial Bank of China (ICBC), was formed to conduct henceforth those activities. This development formally ended the transition toward a full-fledged two-tier banking system, as China became the first socialist country with a centrally planned economy to set up a two-tier banking system.
The PBC’s new mandate was embodied in provisional regulations on banking that were enacted in 1986. According to those regulations, the PBC was responsible for the conduct of monetary policy and the regulation and supervision of the entire financial system, as well as of money and capital markets. The PBC became functionally equivalent to a line ministry under the State Council, which implied that all economic and financial decisions of the PBC Council—its policymaking body—needed approval by the State Council.8
The new mandate shifted the PBC’s main objective from that of passively supplying cash and credit under the cash and credit plan to fulfilling the traditional functions of a central bank. To that end, the PBC began reorganizing itself and developing new instruments and working methods. However, the predominance of the credit plan and associated policy lending greatly reduced the PBC’s ability to perform traditional central banking functions. The PBC’s branch structure, like that of the specialized banks, is based on the administrative structure and hierarchy of the country, with branches at the level of the province, the prefecture and municipality, and the county. The city level takes a special position, as it is not subordinated to the provincial level and has independent planning status.
The financial sector diversified further after 1984. The establishment of the ICBC was followed in 1986 by the opening of some 1,200 urban credit cooperatives (UCCs) under ICBC supervision. Following the example and successful experience of the RCCs, the UCCs were created to serve small individually or collectively owned enterprises.
In the subsequent years, many of the measures taken in 1984 were expanded. New banks were established at the provincial level, and all banks were allowed to engage in foreign transactions in 1986. Two “universal” or “comprehensive” banks—the Bank of Communications (BOCOM), which had merged with the PBC in 1949 but remained in operation in Hong Kong, and the CITIC Industrial Bank, a wholly owned subsidiary of CITIC—were permitted to compete with the state-owned specialized banks in all forms of business.
Greater competition in the banking system was sought by reducing restrictions on the activities of the state-owned specialized banks—they were permitted to engage in lending outside their traditional domain—and increasing the banks’ responsibility for their financial results. In practice, however, the operations of the specialized banks remained concentrated in their particular sector of origin. A limited number of foreign banks were allowed to open branches in the SEZs. Their business scope remained limited to foreign-trade-related operations, and they were not permitted to engage in renminbidenominated activities.
A major innovation was the proliferation, starting in 1986, of trust and investment companies (TICs), as well as of securities houses. TICs receive government and enterprise trust deposits or entrusted deposits9 and, particularly the larger ones, also underwrite and broker securities. Most TICs were established by the four state-owned specialized banks, while other banks, the Ministry of Finance (through its bureaus of finance), and some municipalities also own TICs. Banks initially established these TICs as vehicles to circumvent the credit quotas, but most TICs increasingly engaged in banking business, taking household deposits and granting working capital loans. In the late 1980s, the number of TICs operating throughout China peaked at 365.
The securities companies are owned, jointly or individually, by provincial governments, banks, and TICs. A small number of securities companies have been established by the Ministry of Finance and deal exclusively in government securities. Finally, other types of NBFIs proliferated in China’s financial markets, such as leasing companies, insurance companies, and finance companies. The latter were formed by enterprise groups primarily to recycle intragroup funds among large industrial and commercial enterprises. The structure of the financial system in effect after the 1984 reforms is illustrated in Chart 2.
Chart 2.Structure of Financial Sector in 1984–88
Rectification and Recentralization (1988–91)
The pace of reform in the financial sector slowed appreciably during 1988–91 because of the effects of the rectification program.10 Considerable recentralization took place; the role of directed credit regained significance (the share of the government budget in investment financing went up again); there was more uniformity in interest rates as the flexibility given the banks to set rates within prespecified margins was reduced; the specialization of the major banks was reasserted; and the authorities reverted to the previous practice of limiting enterprises’ banking business to one bank only.
The same forces were felt in the NBFI sector. A reorganization of the TIC subsector became necessary in 1988 because the banks increasingly channeled part of their lending activities through their TICs, which were thus considered one of the channels through which inflation was fueled. In addition, the large number of TICs made adequate supervision by the PBC nearly impossible. The number of TICs was significantly reduced by closing or merging with the specialized banks those TICs that were established at the levels below national, provincial, and city.
Despite the rectification measures, this period was also characterized by progress in the introduction of new financial instruments and markets (see the discussion in Section V on financial markets).
Box 3.Policy Lending and Policy Lending Banks
The separation of policy lending from commercial lending has become a critical issue. The leading idea behind the establishment in 1994 of three policy lending banks is to channel the flow of new policy lending through these newly created institutions. This is a significant step in the commercialization of the state-owned banks. In addition, the clear separation of commercial lending from policy lending will facilitate the implementation of indirect monetary policy, that is, liquidity management at the level of the system, rather than liquidity management at the level of individual banks or liquidity management simply to meet credit plan targets, or both.
However, the provisions of Article 41 of the Law of the People’s Republic of China on Commercial Banks (1995), which stipulate that “commercial banks wholly owned by the State shall provide loans for projects approved by the State Council,” seem to indicate that policy lending might not be confined to the policy lending banks (see Section IV, “Legal Underpinning for a Market-Based Financial System”). In addition, the specialized banks are still burdened by a stock of nonperforming loans generated by past policy lending, which, according to PBC estimates, amount to as much as 15 percent of their portfolio. This is an issue that the authorities will have to address in the near future.
Cleaning up the loan portfolios of the state-owned banks implies the need to define policy lending properly. Although there is no uniform definition of policy-based lending, the following five categories of policy-based loans can be identified:
- power and transport infrastructure investment loans, which can be sound financially but are generally large and have long-term repayment periods;
- fixed-asset loans designed to enhance the technology of state-owned enterprises (SOEs) included in the five-year plan, regardless of their financial health;
- loans for the development of rural areas, including the alleviation of poverty;
- working capital loans to priority SOEs, including structurally loss-making enterprises of significant national or regional political impact; and
- loans for subsidized sectors, such as education and health.
Because policy loans are meant to support the priority sectors identified in the Government’s economic policies, they are mandatory. Therefore, the projects to be financed with these loans might not meet commercial banks’ criteria for lending.
The outstanding stock of policy lending at the beginning of the 1990s reached about one third of the total outstanding loans extended by the banking system.
With respect to the policy lending banks, the State Development Bank will be responsible for financing key construction and infrastructure projects and strategic industries. Its coverage is quite broad as it could finance (i) highways, ports, power, and railways; (ii) basic industries, such as the steel and the chemical industries, and raw materials; (iii) emerging industries, such as the automobile and electronics industries; and (iv) other priority state projects in other sectors, including forestry and agriculture. The Import-Export Credit Bank has a narrower scope; it will provide buyers and sellers credits in support of import and export activities. The Agricultural Development Bank will become a purely policy-based lending institution, whose activities will include financing the state’s procurement of agricultural products and agricultural development.
Since policy lending is a quasi-fiscal activity, the funding of the policy banks is becoming a critical issue. Heavy reliance of policy lending on central bank funding and difficulties in ascertaining the proper use of funds contributed in the past to expansionary monetary policies. Moreover, the development of interbank transactions and the commercialization of the state banks render the monitoring of specialized banks’ policy-lending activities increasingly difficult. The State Development Bank is to be financed with capital provided by the Ministry of Finance and from existing funds for key construction projects, bonds issued to the public, and a portion of deposits from the PCBC. The Import-Export Credit Bank will be financed with capital from the Ministry of Finance. The Agricultural Development Bank will be financed through bonds issued to financial institutions.
Commercialization and Expansion (1992-Present)
In early 1992, the authorities declared an end to the rectification program and announced their intention to accelerate the process of reforming and opening the economy. The period since 1992 has witnessed an expansion of the banking sector and, in 1994, the establishment of three policy lending banks, designated to be the main vehicles for policy-based lending in the future (see Box 3). Policy lending can be defined as that part of bank lending that is made at the request of (or strongly encouraged by) the government to promote its economic, industrial, and sectoral policies and to assure funding for priority activities (see Box 3). Such lending may or may not be made at subsidized interest rates. The establishment of these policy lending banks was intended to pave the way to a further commercialization of the state-owned specialized banks, henceforth to be called state commercial banks.11 Two of the newly licensed banks are “nationwide commercial banks,” the new name for what were formerly called universal banks. In addition, six other commercial banks, most of them of regional significance, have been licensed, together with two “housing savings banks.” Some of these regional banks, particularly those established in fast-growing areas such as Guangdong Province, Shenzhen, and Shanghai, are quickly gaining importance. In the near future, the authorities plan to transform the state commercial banks into competitive, autonomous, and self-accountable commercial entities, whose operations would be supported by an appropriate legal framework. Plans also exist to transform the UCCs into commercial banks, which, as smaller entities, would become driving forces behind local urban development plans.
Growth in the number of TICs and securities houses has remained limited in the period since 1992. In the NBFI sector in general, the authorities contemplate the promotion of institutions providing medium- and long-term funding for investment purposes. A main goal for the authorities is to impose strict border lines between banking and other activities. For the moment, several TICs conduct banking and trust operations, and they will have to choose between becoming banks or remaining TICs (which do not conduct banking operations). Chart 3 depicts the basic structure of the financial sector in China in 1995.
Chart 3.Structure of Financial Sector in 1994
After approximately 15 years of reform, the four state-owned specialized banks still dominate the financial sector. Chart 4 indicates that through the third quarter of 1994 the four state-owned specialized banks and four universal banks still held almost 73 percent of total deposits (down from 83 percent in 1985) and 80 percent of total lending (down from 94 percent at the end of 1985). The RCCs, with about 58,000 locations, held 15 percent and 10 percent of deposits and loans, respectively. TICs as a group had a market share of almost 6 percent of both lending and deposits, while the UCCs, with approximately 3,500 locations, accounted for about 6 percent of deposits and 3 percent of total sector lending. The share of TICs and RCCs in total deposits has remained roughly constant since 1991, while the UCCs have expanded their deposit share to the detriment of the large banks. Tendencies on the lending side are slightly different because the shrinking share of the large banks has been taken in roughly equal proportions by the other types of institutions.
Chart 4.Deposit Money Banks, 1985:IV-1994:III
Source: People’s Bank of China.
Despite the significant progress made in developing a banking system and the contribution made by China’s banking system to the financial deepening of the country, banks in China—and, in particular, the four state-owned specialized banks—cannot be characterized as modern, efficient banking institutions. This situation is mainly due to the uneven path of past reforms, the Government’s views regarding the role of banks in the reform process, and political and administrative considerations. More specifically, four major impediments to the modernization process can be distinguished.
First, during most of the period since 1978, bank supervision and prudential control have remained geared toward ensuring compliance with economic regulations, in particular, the fulfillment of the credit plan. Criteria and regulations that prevail in a market-oriented environment, such as bank soundness and safety and, ultimately, stability of the financial system, have not yet been integrated into the supervisory and regulatory framework by the authorities. This in part reflects the lack of a broad legal operating framework for banks during most of the reform period. At a more specific level, proper loan classification and adequate provisioning for bad loans (see below) have not yet been applied. Eliminating this regulatory and supervisory gap looms as one of the big challenges in the commercialization process of the four major banks. A lack of market-oriented supervision has also led to a situation wherein the four state-owned specialized banks de facto have become universal banks, with all the risks that this entails in an inadequately regulated environment.
Second, the four state-owned specialized banks never experienced an arm’s-length relationship with the Government, a situation that has had several repercussions. For most of the time since their establishment, this close relationship has meant that the specialized banks had to follow conflicting mandates. Banks have increasingly been stimulated to become profit oriented, while at the same time they have had to operate under government instructions, mostly in the form of policy lending. Given the vagueness surrounding the definition offered in Box 3, it is difficult to make an accurate estimate of the share of policy loans in the banks’ loan portfolio. A World Bank (1995) estimate puts policy lending in 1991 at about 67 percent of the BOC’s lending, 58 percent of the PCBC’s, 51 percent of the ABC’s, and 18 percent of the ICBC’s.
One of the main consequences of the dominance of policy lending in the banks’ lending activities is the low quality of their loan portfolio. Faced with the pressure of policy lending, the state-owned specialized banks have failed to adopt modern management techniques such as asset/liability management, loan risk assessment, and loan monitoring. Some estimates put the aggregate amount of nonperforming loans of the state-owned specialized banks at roughly 15 percent of their total outstanding loans.
Third, the accounting and management information systems are still largely designed to ensure compliance with administrative guidelines under the credit plan, rather than to deliver a picture of the banks’ financial position or information relevant for making management decisions. The lack of modern accounting techniques delays the introduction of modern asset-liability management techniques, as well as of macroeconomic liquidity management by the PBC (see Section VII). The delay in the introduction is also related to the fourth impediment to modernization, as the present structure of the banks is not conducive to integrated management.
Fourth, the high degree of decentralization of the branch structure is another impediment to adopting modern bank management techniques. The status of the bank branches in China has always been an interesting issue. Branches in China enjoy such a high level of autonomy that they do not fit the definition of a branch as understood in industrialized countries. At the origin of the branches’ unique position is the way in which the PBC and the four state-owned specialized banks were formed. At the separation of their functions (in the early 1980s), the PBC received the lion’s share of the total “headquarters” institution, leaving each of the four specialized banks the task of building a headquarters unit. This job has proven to be difficult because the branches were well established and well rooted in the local political structures. In addition, the early reform years were marked by a mood of economic decentralization that made the establishment of strong headquarters tantamount to going against the reform tide. It is now difficult to bring the branches under the headquarters’ direction and control, and, as a consequence, it is not an easy task to introduce principles such as liquidity management and asset/liability management in supersized banks with between 28,000 (PCBC) and 56,000 (ABC) branches. For its part, the lack of integrated liquidity management delays the introduction of indirect monetary policy, which, by definition, is based on monitoring and guiding aggregate liquidity developments in the financial system.