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Twenty years ago, China’s banking system was simply a funnel for the Communist Party to fund often unprofitable growth by diverting deposits to state-owned enterprises. Some pundits argue that this is still the case. They may be forgiven their skepticism, but it is perhaps too cynical a view. Much has changed in the Chinese banking system and authorities continue to press ahead with reforms even now. In its latest move, China has planned an initial public offering (IPO) of the Agricultural Bank of China (ABC), designed to raise US$20 to $25 billion. In today’s somewhat uncertain market environment, it has been characterized as a test of the markets’ faith in China’s reforms.

Bank loans account for the vast majority of capital raised by China’s non-financial sector. The corporate bond market is still extremely undeveloped—at the end of last year, the size of China’s corporate bond market was about 3.3% of China’s GDP. An efficiently run banking system is therefore important for China’s growth. My colleague, Richard Gao, once worked in the loan department of a major bank in Guangdong. He recalls, “My job was to roll over existing loans.” Banks at that time had very few commercial incentives. As state banks, they were ascribed one sector of the economy and expected to support it. There was one each for manufacturing, infrastructure, trade and rural lending. This lack of commercialization bred inefficiency and risk. By the late 1990s, non-performing loans were, by China’s own estimates, at about 40% of GDP. Many state-owned enterprises were faltering and, as the chief financial support for such institutions, the banking system was weakened too.

China reacted by launching an ambitious program to transform the banking system. As a first step, growth of non-state owned commercial banks was encouraged. Most of these banks were established in the 1980s and 1990s, although one has a history preceding the Communist revolution. China set up three separate “policy” banks in 1994, explicitly to do the state’s bidding in terms of directed lending and foreign exchange transactions. In 1995, China introduced a law to commercialize the financial system and change the operations of its four largest state-owned banks, “the Big Four.” On a broad level, this law was part of the ongoing legalization of the Chinese economy and encouraged market discipline. In 1998, the Ministry of Finance issued US$40 billion in special debt to replenish the capital base of the Big Four. The government set up four asset management companies in 1999, which have taken over about US$205 billion in non-performing loans (NPLs). Thus, China has sought to retain some control in lending. At the same time it seeks to bring more commercial practices to the banking sector, including consumer and mortgage lending. It has also been preparing to open its financial sector to foreign competition to comply with World Trade Organization agreement terms set in 2002. In addition to these reforms, China has gradually been liberalizing its interest rates. Since 1996, the ability for China's banks to set interest rates has been progressively, but also only partially, liberalized.

The next step in reform was to list the major banks on exchanges. The Hong Kong entities of mainland Chinese banks had listed as early as 2002 as did private Chinese commercial banks. However, the first Big Four bank listed in 2005. Two of the remaining three followed the next year. After going public, the banks received strategic foreign investors, and operations have gradually improved. The size of the latest planned listing of ABC may seem daunting given the current market atmosphere. With 23,624 branches, ABC has more branches than any other bank in the world. It employs approximately 441,000 full-time staff and ranks third, in terms of assets, among China’s Big Four banks.

Over the past two decades, asset quality in the country's banking system seems to have improved—older NPLs have been taken off the books, and the NPL ratio for loans extended since 2000 has been much lower than it was before the reforms. Profitability of China’s major banks has also improved and the newer banks have increased market share. Clearly, China’s financial system has much more development to undergo. A full-fledged market system is not yet in place, and the pace of reform will be important for China’s future growth. This pace may even impact the government's willingness to liberalize its currency. At the very least ABC's proposed IPO is a sign that China is ready to push ahead with reform and commercialization of the banking sector, even as the financial systems of the West falter and faith in markets has been undermined. As such, the proposed listing of ABC is not so much a test of the markets' faith in China as it is an expression of China's faith in markets.

Robert Horrocks, PhD

Chief Investment Officer
Matthews International Capital Management, LLC

(c) Matthews Asia

www.matthewsasia.com

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