Chinese Financial System: The Role of Public Sector Firms

While, in most of the large and matured economies, the private sector financial institutes had dominated the mind and market shares, China remained an exception. The Chinese financial sector had been historically dominated by the state controlled enterprises. Despite of government directive lending, high degree of corruption and lack of professionalism, the business strategies adopted by those financial institutes have been quite successful. The underlying economic characteristics have surely helped them in this regard. Moreover, these firms were also the maximum benefactors of the economic and financial reform of China that started in 1978. Restructuring, liberalization, improved regulations & supervision were the three main pillars of Chinese banking reform Restructuring: This included reduction of the NPLs, recapitalization, merger and closure of the loss making organizations. Restructuring resulted in a huge decrease in the NPL ratio. In 2005, CCB, BOC and ICBC recorded a very low percentage of NPL with respect to the total asset base The government set up four Asset Management Companies (AMCs) for each of the four major banks to reduce their NPL level. These AMCs took on the NPLs and sold off or auctioned off some of the distressed assets. Till the second quarter of 2005, the AMCs disposed around RMB3.8 trillion of distressed assets By 2005, the government recapitalized the Big Four banks roughly with $250 billion. To reduce NPL, the Big Four were exempted from providing loans to the state council approved projects and were permitted to carry out commercial banking activities. This encouraged them to provide loans as per the repayment capabilities of the borrowers. Three of the Big Four CCB, BOC, and ICBC, made remarkable improvement in the asset quality. Financial liberalization: The liberalization policies of the Chinese authorities started in 1997. It improved the functioning of the banking sector in the following ways: A number of credit quotas were removed for SOCBs. Interest rates were flexibly set in the wholesale market. Interbank market was unified and the ceiling on interbank rates was lifted. Foreign banks were allowed to open their branches with a capital base of RMB 500 billion (proposed RMB 400 billion). Foreign banks opening their branches through joint venture with the other banks were required to have a capital base of only RMB 300 billion (proposed RMB 200 billion). From the beginning of 2003, foreign banks were permitted to operate with the domestic currency in the wholesale market, but were subjected to strict geographical limits. These restrictions were gradually removed after December 11, 2006, and the banks were allowed to operate in the retail domestic currency market without any geographic or business restrictions An important financial reform that started from June 2005 was public listing. CCB, ICBC, BoC, Merchant bank and Bank of Communication raised around $47 billion through IPO. ICBC alone raised around $21 billion, which recorded worlds highest ever public issue. Improved regulations: It included introduction of a more cautious approach towards risk, improved corporate governance, adoption of Basel norms, etc. One of the main objectives of strengthening regulation and supervision was risk management. Banks had to look forward towards improving the loan-reserve ratio. Improved regulations were implemented for strengthening corporate governance. In order to improve the efficiency in the banking system, Basel II norms were implemented. Reserve requirements were reduced from 20% to 6% in November 1999. The ceiling of the total foreign ownership in a single domestic bank was fixed at 25%. An individual foreign investor was allowed a maximum of 20% stake in a single domestic bank.

 As a regulatory measure, CBRC planned to issue quarterly NPL data for the banking sector. This will lead to the accountability and more transparency of the banking records. Until 1979, The Peoples Bank of China (PBC) was the only bank in China and therefore, was in charge of a large number of issues in the entire financial system, such as the conduct of exchange rates, monetary policy, foreign reserve management, project financing, commercial lending and deposit-taking activities. The first restructuring in Chinese banking sector took place in 1979, with the introduction of a two-tier banking system, that comprised primarily a central bank and three government owned specialized banks - Agricultural Bank of China (ABC), Bank of China (BOC) and China Construction Bank (CCB). Later another specialized bank, Industrial and Commercial Bank of China (ICBC) was spun off in 1984. Thus, PBC assumed the role of Chinas central bank. The Agricultural Bank of China was established to take over PBCs rural banking business and to supervise over a network of 60,000 rural credit cooperatives that had been providing small-scale rural banking. The Bank of China was delegated to take over foreign currency transactions, while the China Construction Bank focused on the construction sector. Accumulated Disposal of NPAs by AMCs
Period (in trillion yuan) Great Huarong Wall Orient Cinda

Q1, 2004 Q2, 2004 Q3, 2004 Q4, 2004 Q1, 2005 Q2, 2005

0.15 0.17 0.18 0.21 0.21 0.22

0.17 0.18 0.18 0.21 0.21 0.23

0.09 0.09 0.10 0.11 0.11 0.11

0.12 0.13 0.13 0.15 0.15 0.16

The SOCBs had been the primary source of finance for the large state-owned enterprises (SOEs), in which the allocation of funds were made on the basis of government-mandated quotas, rather than on profitability analysis and credit evaluations. This resulted in large amount of NPLs, as high as 25% in 1997. In 1998, a $33 billion government equity capital injection into the four SOCBs reduced the NPL ratio to 10%, but it again rose to 25% in 1999. As majority of such loans were held by state owned firms, government had to intervene to recover the NPLs.

SOCBs and the China Development Bank were allowed to transfer $170 billion to the NPLs, in book value, to the four newly created Asset Management Companies (AMC); Huarong, Great Wall, Orient and Cinda. But, all these hardly affected the overall NPL ratio of SOCBs. The NPL ratio did not increase further only due to the growth of the new credit, which might become non-performing in the future. In fact, the total amount of NPLs had actually increased, if the whole financial system was considered, which also included the NPLs, which were transferred to the AMCs. The AMCs had hardly disposed the NPLs, due to the poor legal framework and absence of proper market, and thus had been relying mainly on the debt-equity swaps or sales of collateral assts. An additional problem was that only the best assets had been sold, which raised doubts about the recovery capacity of AMCs in the long run. After Chinas entry into WTO, more emphasis was given to the management of NPLs, which included the recapitalization of the SOCBs and the disposal of NPLs, which in 2003, stood at RMB1.9 trillion, or a fifth of their outstanding loans. In 2004 and 2005, $45 billion was injected into BoC and CCB and $15 billion into ICBC. At the same time, ICBCs balance sheet was boosted even more by the disposal of an additional $85 billion NPLs to the AMCs and elsewhere.
10 % 8% 6% 4% 2% 0% SOCBs JSCBs City Rural commercial commercial banks banks Foreign banks 9%

NPL as a % of Total Loans

7%

7%

3%

1%

By 2005, government capital spending on both NPL reduction and capital infusion into the Big Four banks reached roughly to $250 billion. The three strongest of the Big Four (CCB, BOC and ICBC) made a dramatic improvement in their asset quality. Also, when the government permitted foreign investments, under which, a foreign investor might hold a stake of up to 20% in any financial institution, the public sector

enterprises were able to attract the maximum investments. Foreign investments flew in large volume, starting with Bank of America (BoA) holding a 9.9% stake of CCB for $3 billion. As part of its agreement with BoA, CCB brought in 50 BoA experts to help upgrade CCB operations in risk management, global treasury services and in information technology-areas where BoA had strong expertise. The BoA experts also developed new products, such as wealth management and credit cards. Changes to the PRC Commercial Banking Law also freed the public sector enterprises from providing loans to the State Council-approved projects and permitted them to carry out commercial banking activities, such as trading in government bonds, dealing in foreign exchange and offering credit card services. By 2004, several public banks also made foray into electronic banking, when the Law on Electronic Signatures was passed in August 2004. The public sector financial institutions also launched some of the worlds largest IPOs. Chinese financial system also was benefited from the undervalued Renmibi, as that resulted into huge foreign currency inflow into the Chinese financial system. The public enterprises also dominated the life insurance market in China. China Life had dominated the Chinese market for over 30 years and had a market share of 44%. It was followed by two more public enterprises, Ping An Insurance and China Pacific Insurance company (CPIC). The Chinese insurance companies also introduced a new valuation concept, namely Embedded Value (EV), which was a better estimator of intrinsic worth of a financial institution. These public sector enterprises also adapted several innovative strategies to sustain its EV. One of the major successes of Chinese public sector enterprises perhaps lied in remaining least affected by the global sub prime meltdown, despite of having low quality of assets in their balance sheets. Chinese banks were hardly affected by the sub prime crisis due to the efficient management of interest rates and government back-up in the form of capital injections and debt equity swaps. In US, mortgage problem got magnified because of the securitization of the mortgage loans, but in China, the securitizing of mortgages was not widespread. Even if there was mortgage crisis arising out of the sub-prime lending in China, the Chinese public sector enterprises would get the support from the Chinese government through capital injections and debt equity swaps. But with the expected implementation of Basel II accord, it was to be seen how far the Chinese government would be able to protect the Chinese firms and whether or not the Sub-prime Cataclysmal would be followed in China? Objective Questions: Define the following terms: 1. Functions of finance 2. Payback period 3. Net present value 4. Liquidity-profitability trade-off 5. Financing of long term funds 6. Implicit cost of capital 7. Public deposits 8. Episodic financing 9. Investment decision 10. Factors affecting Capital Structure

10X2=20

Subjective Questions 5 X 6 = 30 1. Discuss the role of China Banking Regulatory Commission as supervisory authority for the banking sector in China. What measures did it implement to improve the functioning of this sector?

2. 3. 4. 5.

Highlight the factors that led to the deregulation of the banking sector in China. Highlight the major reform measures taken by the Chinese government. What potential challenges are faced by the Chinese banking sector? How big is the Big Four? Discuss the role of the Big Four in the overall development of Chinese banking sector.

FUNCION OF FINANCE The five basic corporate finance functions are described as those functions related to: Raising capital to support company operations and investments (aka, financing functions) Selecting those projects based on risk and expected return that are the best use of a company's resources (aka, capital budgeting functions) Management of company cash flow and balancing the ratio of debt and equity financing to maximize company value (aka, financial management function) Developing a company governance structure to encourage ethical behavior and actions that serve the best interests of its stockholders (corporate governance function) Management of risk exposure to maintain optimum risk-return trade-off that maximizes shareholder value (aka, risk management function) PAY BACK PERIOD One of the oldest and most widely used method to evaluate a capital investment proposal is the Payback Period, as the name implies it refers to the time required to recover the initial investment or the initial cash outlay as it is called in financial terms NET PRESENT VALUE Net present value or wealth of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and, therefore is desirable. A financial action resulting in negative NPV should be rejected since it would destroy shareholders, wealth. Between mutually exclusive projects the one with the highest NPV should be adopted. INVESTMENT DECISION It refers to allocation of capital funds to long term asset that would benefit (cash flows) in the future. Two aspect of investment decision are Evaluation of profitability of new investment The measurement of cut off rate against the prospective return of new investment LIQUIDITY-PROFITABILITY TRADE-OFF The profitability liquidity trade off require that the financial manager should develop sound technique of managing currents assets. He/She should estimate firms need for current assest and make sure that funds would be made available when needed FINANCING OF LONG TERM FUNDS Long terms funds are required for fixed assets out of long term funds. Long term funds have to pay after 10 or 20 years. So, we can easily repay this fund out of our profit. If we will finance fixed assets out of short term fund, it may be risky because if we will not pay this fund on its maturity, we can not carry our business long and we can not also sell our fixed asset in very short time. The result may come in the form of insolvency of business. So, we never take any solvency risk and try to understand the importance of financial management. PUBLIC DEPOSITS Public deposit is the source of fund for private and non-banking companies. It means accepting fund from the public in the form of deposit. The interest on these deposits is more than interest given by banks and post offices.

FACTORS AFFECTING CAPITAL STRUCTURE Capital structure may be defined as the mixture of capital resources which include equity share capital, pref. shares capital and long term debts. It is the duty of finance manager to make finance structure of company and provide the fund for completing the need of company in short period and in long period. Appropriate proportion of capital sources will depend upon: Risk of insolvency or bankruptcy The cost of capital: company should try to collect fund from that resource whose cost is least Optimum mix of resources so that control must be in same hand for consistency in the decisions of company

EPISODIC FINANCING IMPLICIT COST OF CAPITAL

Discuss the role of China Banking Regulatory Commission as supervisory authority for the banking sector in China. What measures did it implement to improve the functioning of this sector? Chinas banking regulatory body, the China Banking Regulatory Commission (CBRC), was established in Beijing. The roles of CBRC as a supervisory authority are as follows: (1) To stipulate regulations and provisions for banking supervision; draft laws, and administrative regulations and make proposals for their drafts and amendments; (2) To approve the establishment, amendment, termination and business scope of banking institutions and their subsidiaries; (3) To supervise banking institutions on and off the spot, and punish those of unlawful behaviors according to law; (4) To examine the qualifications of senior managers of banking institutions; (5) To compile statistics and reports of banking institutions in the whole country, copy to the Peoples Bank of China and publish them in accordance with government regulations; (6) To offer opinions and proposals together with the Ministry of Finance and the Peoples Bank of China, with regard to how to deal with emergency risks of deposit banking institutions; (7) To be responsible for the routine management of supervisory boards of major state-owned banking institutions. Following were the measures implemented by CBRC for the functioning of the sector: a. Promote the financial stability and facilitate financial innovation at the same time; b. Enhance the international competitiveness of the Chinese banking sector; c. Set appropriate supervisory and regulatory boundaries and refrain from unnecessary controls; d. Encourage fair and orderly competition; e. Clearly define the accountability of both the supervisor and the supervised institutions; and f. Employ supervisory resources in an efficient and cost-effective manner Highlight the factors that led to the deregulation of the banking sector in China. Deregulation of the banking sector in China took place due to the following reasons: 1. Loans were issued to the large state-owned enterprises based on government directives, rather than on credit evaluation and profitability analysis. This created the problem of high amount of NPLs. Deregulation could lead to lending, based on the profitability and repayment capability of the enterprise rather than on government mandated quotas.

2. Foreign participation in the banking sector was not allowed. Due to this reason, foreign banks could not acquire the stakes of the local banks. After Chinas entry into the WTO, deregulation was needed in the banking sector to facilitate foreign investments. 3. Restrictions were imposed on the Chinese banks to operate in the countrys capital market. In order to raise huge amount of money through IPO, the banks were required to be deregulated. 4. Briefly discuss the major structural changes in Chinese banking sector. 5. What potential challenges are faced by the Chinese banking sector? 6. How big is the Big Four? Discuss the role of the Big Four in the overall development of Chinese banking sector. 7. Which way is the Chinese banking sector moving towards? Will foreign entry be able to enhance the performance of domestic banks? Highlight the major reform measures taken by the Chinese government. From the inception of the Chinese banking industry, banks used to operate in a protected economy. The Peoples Bank of China (PBC) was the only bank, which operated in China before 1979. Its main functions included conduct of exchange rates, monetary policy, project financing, deposit-taking activities, etc. Introduction of the two-tier banking system: The two-tier banking system comprised of the Central Bank and the Commercial banks. The role of the Central Bank was adapted by PBC and the roles of the Commercial Banks were adapted by - Agricultural Bank of China (ABC), Bank of China (BOC), and China Construction Bank (CCB). In the year 1984, Industrial and Commercial Bank of China (ICBC) was added to the list. Previously, PBC was in charge of the entire banking system and transactions. But with the adaptation of the two-tier banking system, the banking operations became decentralized and responsibilities were distributed between the central and commercial banks. Introduction of Joint Stock Commercial Banks (JSCBs): After 1980, some JSCBs like China Investment Bank, Jointstock Bank of Communications, CITIC Industrial Bank (owned by China Investment and Trust Corporation), etc. were established. Introduction of Urban Credit Co-operatives (UCCs): UCCs were established in the urban areas in 1980s. They were the main financiers for the non-state enterprises. International trust and investment companies: The provincial and municipal governments set up international trust and investment companies for raising funds from the foreign sources. Formation of Central Bank: From 1986, PBC was made responsible for the supervision of the monetary policy, financial system and capital markets. Previously, entire banking system was dependent on PBC. But, after the first phase of reform, though the functions were distributed among the state-owned commercial banks, PBC continued to supervise the above areas. This reform measure was taken with the objective of controlling inflation. PBC took responsibility of formulating the credit plans and set an aggregate credit ceiling on each PBC branch. NPL management: During the first phase of the reform, the problem of the NPL was detected and the banks were given authority to write off their NPLs up to RMB 0.5 billion. What challenges does the Chinese banking sector face? Chinas entry into the WTO led to a remarkable improvement in the banking sector of the country. The banking sector was opened up to the foreign participants. However, in competing with the global economy, the banking sector faced some hard challenges. After adopting several reforms, the banks were unable to write off a considerable portion of their NPLs. In the future, the banks may face difficulty in

solving the NPL problem independently. They had always solved the problem of NPL by virtue of the state capital injections. According to the International Monetary Fund, the Big Four did not adjust the loan rates on the basis of the borrowers' credit risk. If the Chinese banks did not further improve their credit culture, risk assessment methods, lending practices and product mixes, they may repeat their past mistakes of giving loans to the old corporate customers, who do not have the repayment capability. This might lead to the accumulation of the new NPLs. The corporate culture of the Big Four still lacked a developed profit motive. Some old lending practices persisted, such as focusing on the market share, rather than profitability and providing loans, based on the direct orders from the government, rather than ability to repay. Due to majority control by the PRC government, shareholder accountability was also lacking. The Big Four's senior management team still consisted of the PRC government officials, whose loyalties were divided between the government and the stockholders. Who were the Big Four? Discuss their role in the development of Chinese banking sector. The four SOCBs, known as the Big four, are the Agricultural Bank of China (ABC), the Bank of China (BoC), the China Construction Bank (CCB) and the Industrial and Commercial Bank of China (ICBC). These banks were established after the economic reform started in China. Until 1979, China had only one bank, Peoples bank of China (PBC), which was controlling a number of issues in the Chinese market, such as the conduct of exchange rates, monetary policy, foreign reserve management, etc. With the introduction of the two-tier banking system, the Big four were established. ABC was set up with the objective of taking over PBCs rural banking business and to supervise a network of 60,000 rural credit cooperatives. BoC was established to take over the foreign currency transaction and CCB focussed on the construction sector of the country. The role of ICBC was to give credit to the industrial sector of the country. The Big four concentrated in the development of the country, taking the charge of the specified sectors. Agricultural Bank of China Agricultural Bank of China (ABC) was founded in 1979 and was mainly involved in rural financing. It provided services to the agricultural, industrial, commercial and transportation enterprises in the rural areas. ABC offered its customers a number of innovative deposit products, bankcard and fiduciary and insurance agency products, which significantly increased the bank's competitive strength. The bank was a leader in the area of bankcards and recorded a huge volume in interbank transactions. Bank of China Bank of Chinas (BoC) business was broadly divided into commercial banking and treasury business. Commercial banking constituted majority (83% of total operating profit) of Bank of China's business, which comprised of corporate banking, retail banking and banking with financial institutions. Corporate banking was built on credit products to meet the needs of its corporate clients and provide them with individual financial services. Retail banking served the financial needs of the individual customers, focusing on savings deposit, consumer credit bankcard and wealth management business. Financial institutions banking was aimed at banks, securities firms and insurance companies worldwide with services, such as funds transfer, clearing, inter-bank lending and custody. Treasury business included domestic and foreign-currency trading and investment, fund management, wealth management, valuesecured debt business, domestic and overseas financing and other fund operation and management services China Construction Bank

China Construction Bank (CCB) had a large customer base and it had established banking relationships with many strategically relevant business groups and leading companies. In addition, the bank also had joint-venture subsidiaries in China, overseas branches in Hong Kong, Singapore, Frankfurt, Johannesburg and Seoul; and representative offices in New York and London. Headquartered in Beijing, China Construction banks business consisted of three principal business segments, corporate banking, personal banking and treasury operations. CCB derived maximum business from commercial banking, which contributed 53% of both total assets and operating income. Industrial and Commercial Bank of China ICBC went public in 2006 through a record-setting IPO. It managed more than 18,000 domestic branches and more than 100 overseas branches and offices. ICBC had substantially improved its capital management and its capital adequacy. During that period, the bank was able to cut down its cost to income ratio hugely from 63% to 41%, but it still stood at a higher level. The most significant improvement was the reduction of NPL from 30% in 2001 to 4.7% in 2005. Better credit risk management and tighter control entailed the bank with a high quality of newly added loans. Moreover, ICBC divested bad debts of RMB 635 billion through financial restructuring in 2005. Chinese economy is set to become worlds largest by 2050. The Big Four, with a huge asset base of $2.9 trillion in 2006, has enough resources to be explored in the years to come. These banks will have to concentrate more on professional lending and social sector development in order to sustain high economic growth in China.