China: Setting the Pace
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FROM BUREAUCRATS TO BUSINESSPEOPLE
China’s reforms of 1999 were intended to give the banks a fresh start with fresh capital. But when the banks continued to lose money, the country’s leaders realized they had to make fundamental changes in the way the banks did business. That meant reorganizing management and moving ineffective managers out. The banks brought in foreign consultants and focused their energies on reducing bad loans.
The government continued to push banks to discipline themselves with the goal of making them attractive to investors as quickly as possible. Still, as recently as five years ago, the very concept of “book value” could not apply to Chinese banks, and most foreign investors would not have bought them at any price.
In 2003, the government stepped in to recapitalize the two biggest banks. This coincided with a massive reform program, led by the government, encompassing almost every aspect of the banks’ operations, management and governance. These reforms included installing experienced, foreign regulators over the industry; substantial spending on technology and systems; adoption of modern risk management techniques and controls; and reduction of redundant staff and excess branches—perhaps the most politically painful step.
Two years later, the government allowed the first bank shares to be floated on the Hong Kong stock market, attracting a flurry of foreign institutions as investors, notably U.S., British and Hong Kong Banks. Since then, there have multiple bank IPOs in China, and some bank stocks currently trade in excess of two times book value. Investors have poured an estimated $25 billion into China’s banks. Another IPO is scheduled soon; if it is executed as hoped, it will be the largest IPO in the history of the world. These listings serve as a testament to the rapid progress that China has made in reforming its banking system.
Market deregulation and privatization have compelled banks to become innovative to compete and survive. In 2005, Chinese authorities took another step towards open markets, relaxing constraints on the capital account and allowing qualified parties to transfer some capital to overseas banks. Though limited in scope, this move sent a signal to Chinese banks that in the future they would compete for depositors, which might mean offering higher interest rates, improving solvency, and boosting performance. If Chinese banks fail to reform in light of these changes, consequences could become dire—depositors are likely to enjoy increasing freedom about where their savings are banked.
Source: Merrill Lynch
TRIMMING FAT: China’s banks have embarked on a massive reform program, including the politically difficult steps of reducing redundant staff and downsizing excessive branch networks.
In contrast to its mainland banking system, China inherited one of the best-working banking systems in the world with the handover of Hong Kong in 1997. The “Special Administrative Region” is home to 131 licensed banks and host to 62 of the world’s top 100 banks. The government has interfered very little in its functioning, and its integration with the mainland system has been gradual. It was just in 2004, for example, that Hong Kong banks could start taking deposits in China’s currency, the renminbi or RMB, also called yuan. Hong Kong’s success as a banking center should serve as a model for China to emulate as its system evolves.
Conditions set forth by the World Trade Organization (WTO) are another major driver of change. Under WTO accession guidelines, China will be required to allow foreign banks to enter its markets and take deposits in yuan. Seen by some as a near-term threat to China’s banks, the WTO agreement could have the effect of spurring more competitive practices.
As in the rest of Asia, though, the biggest driver of change is growing consumer affluence and market demand. Branches have been redesigned to better accommodate retail customers, and banks are moving quickly to expand electronic banking capabilities. Consumer banking is widely viewed as the leading factor in the growth and profitability of China’s banks. By some projections, China’s total banking assets could double by 2010 compared to 2004. At the end of 2005, 40 million credit cards had been issued in China—a country that only a decade prior denied its citizens the right to own property. Consumer credit is viewed by some observers as having the potential to transform Chinese society fundamentally.
Source: Merrill Lynch
OPENING DOORS: Consumer loans have grown rapidly from nearly non-existent ten years ago, now representing nearly 10% of the Chinese banking system’s assets.
A major caution sign on the banks’ horizon is the expected development of capital markets in China, which will enable investors to put more money in stocks and bonds and provide corporate borrowers with an alternative source of capital. While that may sap some strength from the banks, it should also add more vigor to the economy. The emerging Chinese banking system will be tested by these challenges. Cleaning up an officially acknowledged $225 billion in non-performing loans, mainly through securitization and sale to NPL investors at steep discounts, is also a critical priority.
Nonetheless, China’s experience illustrates how quickly a banking system can change from primitive to modern, given the political will, economic motivation and necessity of forging ties with the rest of the world.