An Assessment of China’s Banking System Reform

Abstract

China’s banking system can be seen as an enigma. It was once ­considered China’s Achilles’ heel but has now become an important part of the country’s success story. This article reviews and assesses China’s banking reforms implemented since 1998. Three key aspects of the reform are reviewed: bank restructuring, financial liberalization and bank regulation. Although improvements have been seen in asset quality and regulation, lasting government intervention and weak corporate governance by way of inadequate incentives could lead to financial stability problems. The involvement of Chinese authorities in increasing bank lending during the global financial crisis reveals that the reform process is far from complete.

The opinions expressed here are those of the authors and not necessarily those of the institutions they are affiliated with. All remaining errors are solely ours.

Appendix: Further Details on the Fourth Wave of Bank Restructuring

The first wave started in 1998 with the overall idea to allow SOCBs to operate as commercial institutions. It was implemented by a capital injection of US$33 billion in local currency (Table 6) to raise their CAR to 8% and by transferring their NPLs to several “bad banks,” the AMCs. The operation started with a reduction of the PBoC reserve requirements that freed fresh money used by SOCBs to purchase MoF bonds. Just thereafter, the government injected the funds, collected as capital, into the four SOCBs. In 2000, US$170 billion worth of NPLs belonging to the SOCBs were transferred to AMCs at face value, in exchange for bonds issued by the four AMCs (created purposely to recover the debt of each SOCB) and with PBoC loans valued at US$73 billion. At that stage, the amount transferred accounted for more than 15% of GDP and was unable to be borne by China’s weak public finances.

The second stage was aimed at allowing the two best performing SOCBs, the CCB and the BoC, to attract foreign strategic investors and to go public. On 31 December 2003, each bank employed all their pre-existing capital (US$11 billion) to write-off the NPLs while the central bank used its investment arm—Central Huijin—to inject US$22.5 billion from international reserves into each bank. As a result, Central Huijin became the main shareholder. To prevent potential pressure on the exchange rate and domestic liquidity conditions, the capital had to be maintained in foreign currency. The collateral effect of this measure was an increase in the foreign currency exposure of domestic institutions. Further along, in May and June 2004, the outstanding NPLs of the CCB and BoC were sold at 47% of their face value to the AMCs for US$16 billion and US$18 billion, respectively. Later in 2004, was an additional US$7 billion and US$17 billion, was transferred, respectively, without involving the other two AMCs, Cinda and Oriental. Moreover, the CCB and BoC increased their regulatory capital by issuing subordinate debt for a total of US$4.8 billion and US$7.3 billion, respectively. Subsequently, both banks incorporated strategic investors to improve their management and to diversify their ownership. In June 2005, the CCB selected the Bank of America as a strategic partner, which paid approximately US$2.5 billion for 9% of its capital. In August 2005, 10% of BoC capital was purchased by a consortium led by the Royal Bank of Scotland for US$3.1 billion. Afterwards both banks went public. In October 2005, the CCB raised more than US$9 billion in Hong Kong, and in May 2006, the BoC nearly US$10 billion.

The third round of restructuring focused on the ICBC in 2006. In April 2005, Central Huijin injected US$15 billion into the ICBC. Although the default rates of this bank were higher than those of the banks mentioned previously, only US$9 billion of its capital was used to write-off impaired loans. The major difference with the previous restructuring wave is that not all pre-existing capital was used to write-off NPLs, but that the MoF safeguarded a stake of US$10 billion. As a result, the MoF and PBoC each held 50% of the equity. In June 2005, the ICBC issued US$12 billion in subordinate debt. At that time, it also auctioned US$56 billion to the AMCs at 38% of its face value. Later, an additional US$30 billion was exchanged by a receivable of the MoF. In March 2006, a consortium led by Goldman Sachs, as a strategic investor, acquired 8.5% of the capital for US$3.8 billion. Like the CCB and BOC, the ICBC also went public, simultaneously in Hong Kong and Shanghai, obtaining US$19 billion—the largest IPO in the world at that time.

In October 2008, the fourth restructuring wave began targeting the ABC, the weakest systemic bank because of its focus on rural areas and its large volume of NPLs (US$120 billion). The major difference with previous restructuring waves is that the AMCs did not take part in the process and the MoF extended a higher influence in the restructuring process than previously. As a first step, approximately 80% of the NPLs were exchanged on a full book value basis via an unfounded obligation of the MoF, to be paid in 15 years. Subsequently, Central Huijin—already transferred to the sovereign investment fund (CIC)—injected US$19 billion in exchange for 50% of the capital, whereby the MoF and CIC were the only shareholders. Although the NPLs were transferred to the MoF, the ABC is in charge of their management. With regard to the inclusion of a strategic investor, for the first time the investor was domestic, the National Social Security Fund. ABC went public in July 2010 and raised US$22 billion in a dual listing in Shanghai and Hong Kong.

Table 6 Capital injections into the SOCBs