15 September 2007

Phantom Menace of Chinese Banking

Remy Piwowarski looks at the messy Chinese banking system and ponders whether the financial crisis is looming.

Many fans of Star Wars hate it, but I love the first episode. And I actually don’t know why? Sure, Jar-Jar and all those Gungans are the quintessence of childishness, but the mood of the movie is really interesting: the Republic seems to be rather peaceful - there are of course some mysterious dangers on the horizon and not everybody knows about them, but the general picture is not as violent as in further episodes. There is peace, but a misleading one with dangers clear and present though largely invisible. My intuition tells me that the world economy is now in a similar situation. Where does the danger come from? China.

The problem with the fastest growing economy in history is that it has a bank-centred financial system. The Chinese banking system is the main source of capital in China, the main venue of people’s savings and the main instrument of investment policies. Therefore, the banking system plays a crucial role in the Chinese economy and as such its state is irreversibly linked to the world economy. Unfortunately, to put it euphemistically, the system itself is in a bad shape and the threat of a financial crisis is clear and present.

Looking into the past

As Berger et al (2005) write, before the 1978 the Chinese banking system was modeled after the Soviet one with a single bank, the People’s Bank of China, responsible for all major banking operations. The situation came to a change in 1978 when from the People’s Bank of China four big quasi - commercial banks were separated: China Construction Bank, Agricultural Bank of China, Industrial and Commercial Bank of China and the Bank of China. Today, these banks still dominate the China’s banking industry and are commonly referred as the Big Four.

In the 1980s, the aforementioned banks served mainly as policy-banks, financing government projects and providing loans to state-owned companies (SOEs). Furthermore, till 1985 their operations were legally constrained to their respective areas (agriculture, construction etc.), which hampered competition. In 1994, a major overhaul of the Chinese banking system took place when it turned out the banks amassed large amounts of non-performing loans (NPLs). The Chinese government recapitalised the banking system by creating state-owned asset-management companies and later established two policy-oriented investment banks.

The growth of the private banking was rather limited in the 1990s. The first private Chinese bank China Minsheng Banking Corporation was created in 1998 and, in 1990s, entrepreneurs in China established 12 private banks in total. The entry of western banks was slow. In 1979, US and European banks were allowed to open their representatives offices in special economic zones (SEZ) and since 1982 they have been permitted to open operational branches. The regulations expanded in the 1990s and in 1999, 25 foreign banks had permission to operate all over the country. Some of the foreign banks bought also minority stakes in the Big Four.

Nevertheless, despite all these reforms, the Chinese banking system is facing tremendous problems.


What’s the main problem with the Chinese banking? To put it shortly: Chinese bankers make many loans not because of the profitability of ventures, but because some mighty regional rulers want them to finance state-owned companies. And since state-owned enterprises are running losses (why? mainly because they are state-owned and because they know the banks will lend to them!), the amount of non-performing loans is soaring.

Is this path sustainable? Have recent reforms improved the situation? Economists take two positions on these issues.

Kashyap and Dobson (2005) from the University of Chicago take a more skeptical attitude in their newest paper. The authors point out huge and persistent inefficiencies in the Chinese banking system. Bad lending practices are still continuing, despite a government bailout in 1994 and reforms, e.g. introducing new risk assessment
techniques, creating a supervisory institution, limited liberalisation, or entry of foreign

The previous wave of bad loans was caused by the government’s willingness to keep state-owned enterprises (SOEs) operating. The privatisation of SOEs did not take place, since many of them would not have been able to survive market competition, which would create unemployment and possibly social unrest. Direct subsidies would mean, in turn, a huge stress on government’s budget. Hence, the Big Four banks were ordered to provide loans to SOEs. Furthermore, since loans to SOEs were backed by the state, the banks did not implement credible methods of risk assessment and moral hazard came into place.

All these factors played an important role in the 1990s and, as said earlier, the same factors seem to be at work today. The authors notice that banks are lending to previous NPL clients. Furthermore, the data show that there is absolutely no correlation between the regional profitability of SOEs and the amount of lending. In addition, huge banks discriminate against small and medium enterprises and the range of interest rates is small, which denotes poor skills of assessing clients’ creditworthiness.

The anecdotal evidence shows, in turn, that the boards of major banks are not populated by technocrats, but by party officials. As a result, politically-motivated managers favour lending to SOEs. In addition, according to the authors, the impact of minority foreign shareholders is small mainly due to the very fact that they are minority shareholders.

As we can see, the picture is rather gloomy, but it is not the only one.

Are optimists right?

A more optimistic perspective is provided by Yusuf et al. (2006) in their
book about the condition of SOEs. Yusuf et al (2006) write: “The current growth
momentum, the small size of the official public sector debt […] the size of the foreign
exchange reserves (over $660 billions in March 2005) [which act us a back-up for shortterm savings according to Guidotti – Greenspan principle – R.P.], and the sheer volume of domestic savings (47% of GDP in 2003) provide a cushion sufficient to offset for 9 several years the excess resource consumed by inefficient SOEs (…)” (Yusuf et al (2006) p. 19-20). Furthermore the authors point to the fact that past callings for a substantial overhaul of the SOEs and banks have been largely misplaced: nothing like a financial crisis or the slowing-down of the economic growth took place (an example of a past call for reforms is 1998 paper by Dornbusch and Giavazzi or a paper by Lardy from the same year). The only risk that the Chinese economy is facing comes from the globalisation and the increasing need for competivness in international markets. Hence, although the authors devote their book to SOEs, the implication is clear: there is no need for a substantive overhaul of the banking sector due to the aforementioned factors.

For a non-economist, the argumentation of the authors might seem convincing, but I would like to make an important points.

It is true that slowing down the market reforms may be a sound strategy because of social concerns. Nevertheless, such an argumentation may be a good excuse to do nothing to revamp the banking system and the economy at large. The point is that the reforms will have to be conducted finally and the Chinese policymakers should be aware of that. A parallel (though quite distant) can be built with the policies of the current Polish or Hungarian governments: high levels of growth may make the government irresponsible in regards to budgetary policies or structural reforms. Similarly,
repeating the mantra about the need to create jobs for village inhabitants may
contribute to the lack of responsibility.

On the other hand, we have to do justice to the authors’ claims that the fundamentals of the Chinese economy (low budget deficit, high levels of foreign reserves) are strong and comprehensive schemes to deal with social issues need time to be devised and implemented. Perhaps, a good solution is privatisation and liberalisation together with offsetting social problems by an increase in spending on welfare and healthcare, proposed also by Eichengreen and Park (2006) as a measure to solve global imbalance problem.

Financial Crisis?

Non-economic readers may be wondering? What does the problem with Chinese banking has to do with the world economy? The answer is: a lot. If the Chinese financial system collapses (i.e. a financial crisis takes place), the Chinese economy will slow down. I don’t think that I need to explain potential repercussions. But is the crisis really likely?

Probably the most comprehensive analysis of the likelihood of a deep financial crisis is provided by Allen et al (2005). The authors state that in China three types of crises may occur: a financial crisis, a currency crisis, and a twin crisis.

The outburst of a real estate bubble may cause a financial crisis, similarly to the case of Thailand in 1998. In such a situation, many banks (including the Big Four) may become insolvent and the inflow of foreign funds and credits into the Chinese financial system may end abruptly. The primary reason for the crisis will be the agency problem – the lack of control from international investors over the way Chinese banks allocate their money.

The financial crisis may also take place in the event of a slowdown in the Chinese economy, or the persistence of NPLs. The authors point out that a small government budget deficit and high amounts of foreign reserves should enable the Chinese authorities to “prevent the situation from getting out of control” (p. 61). On the other hand, the Shanghai real estate market experienced many bubble outbursts in the past and the next one may have dire consequences.

Another possibility is a currency crisis. High amounts of capital in China is speculative in character and allocated there in order to reap gains from the future revaluations of the Chinese currency. If the revaluation actually takes place, or if it is determined that no revaluation takes place, speculators will withdraw their capital from China in a very abrupt manner. In the event it happens, the role of the Chinese government will be crucial: if it allows the currency to float, a devaluation will take place quickly, which will limit further outflows of capital; if the government decides to keep the peg, a currency crisis will ensue, leading to a banking crisis through a rapid bankrun. This will be the instance of a twin (financial and currency) crisis.

So, in general, it seems that the likelihood of a financial crisis in China is not predicated that much on the shape of the Chinese banking system. A more important factor is the level of Chinese foreign reserves. The economists give different opinions on the question of whether reserve accumulation may prevent a financial, or a twin (financial and currency) crisis. As regards the risk of a financial crisis, Grifith-Jones and Gottschalk (2005) state that the Chinese foreign reserves are well above the levels needed for a successful management of a financial crisis and in the event of a major financial disruption, only a certain fraction of them would have to be used. Hence, possible slowdown in the Chinese economy, or the crash in the Shanghai real estate market may be manageable.

Prasad and Wei (2005) state that the levels of the Chinese reserves should be sufficient to counter the negative effects of a financial shock, but they do not make any definite forecasts on whether this will turn out to be true in the future.

According to Wyplosz (2004), in the situation of an abrupt speculative withdrawal of funds, the build-up of foreign reserves may not be sufficient to manage the crisis. As Wyplosz (2004) writes in his paper: “Large reserves of foreign currency, such as those which have been accumulated since the 1997-8 crisis, are open to the same limit: when a crisis is in full swing, it soon overpowers any limited stock of ammunition”.

Where do we go from here?

Clearly, the Chinese banking system is in a bad shape. Nevertheless, as we said, the Chinese economy has something peculiar: 1,602 bln USD of foreign reserves (as of April 2007) that could be used to fight the crisis. Are they sufficient to fight a financial crisis? Are they sufficient to fight all possible threats to the Chinese economy? What is the past experience? Clearly, the opinions presented so far do not provide much evidence nor argumentation on that. In my next article, I will try to answer these questions and present my own model of estimating losses.


Allen Franklin, Jun “QJ” Qian, Meijun Qian(2004) “China’s Financial System: Past,
Present, and Future”. Last Revised: April 4, 2006

Berger Allen L., Iftekhar Hasan, Mingming Zhou (2006). Bank Ownership and
Efficiency in China: What Will Happen in the World’s Largest Nation?

Eichengreen, Barry and Yung Chul Park (2006). “Global Imbalances: Implications for
Emerging Asia and Latin America”.

Griffith-Jones s., R Gottschalk . Financial Vulnerability in Asia.
- IDS Bulletin, 2006 - asia2015conference.org

Kashyap, Anil K and Wendy Dobson. “The contradiction in China’s gradualist banking
reforms.” National Bureau of Economic Research. October 2006

Lardy, Nicholas R. and Morris Goldstein (2004)
“What Kind of Landing for the Chinese Economy?”Institute of International Economics. Policy Briefs. www.iie.com/publications/pb/pb04-7.pdf

Prasad, Eswar and Shang-Jin Wei (2005). “The Chinese Approach to Capital Inflows:
Patterns and Possible Explanations”. IMF Working Paper.

Wyplosz, Charles. (2004) “Regional Exchange Rate Arrangements: Lessons from Europe
for East Asia”. Graduate Institute for International Studies, Geneva and CEPR
First draft: February 2002

Yusuf (2006) Shahid, Dwight H. Perkins, and Kaoru Nabeshima. “Under New
Ownership Privatizing China’s State-Owned Enterprises”. In: Palo Alto. Stanford
University Press.

1 comment:

Anonymous said...

Nice try but your analysis is way off-base. China, unlike Thailand, Korea, ... during the Asian financial crisis, is not a net foreign borrwer and thus is not subject to a financial crisis. You should also remember that there is foreign exchange control.