By Linda Yueh
China has been phenomenally successful in transitioning from a centrally planned economy into a more market-oriented one. China's strong push for economic growth since reforms began in 1979 has catapulted it into a trillion dollar economy that is also the world's third largest exporter and importer in the span of a couple of decades. China's success, however, is not inconsistent with a significant degree of structural problems in its economy.
The core problems stem from the close relationship between three main state-sector players from the command period that continues through the reform period: state-owned enterprises (SOEs), the government and state-owned commercial banks (SCBs). These problems are also a result of China's gradualist transition path. By gradually introducing market forces into the economy, the most difficult problems in the reform path remain unresolved. China's remaining difficulties are further highlighted by its accession to the World Trade Organization (WTO), which requires significant liberalization in trade and financial services.
Accession woes
Although there have been many benefits from WTO membership, accession has also contributed to the reduction in competitiveness of SOEs and exposed the lack of market forces governing lending by SCBs. The decline of SOEs has further drained the government of its traditional source of revenues and instead increased the amount of subsidies, including loans from SCBs.
The transfers from SCBs to loss-making SOEs and the lack of credit assessments in lending have generated significant amounts of non-performing loans (NPLs). The culmination of policy loans, ‘soft' budget constraints for state-owned enterprises, and the decentralization of local state-owned commercial banks have resulted in a significant stock of NPLs that is estimated at Rmb2 trillion. As a proportion of GDP, NPLs are in the region of 20% of total national income. Other estimates put the figure higher.
The root of the NPL problem, however, cannot be addressed without attending to the inefficiency of SOEs, which has accordingly generated substantial urban unemployment for the first time in the reform period. This set of problems constitutes one of the most significant challenges confronting China at present. In terms of economic stability, it may be the most serious issue.
Basel changes
China's WTO commitments will require it to increase the degree of integration of its banking and financial sectors with the world's financial system. To that end, the recently established regulatory authority, China's Banking and Regulatory Commission (CBRC), is looking to undertake reforms in accordance with the Basel core principles. China's system at present is not well integrated with world markets, particularly as it still retains substantial capital controls and limited currency convertibility.
Recent moves to allow Chinese companies to hold in foreign currencies and the agreement to permit Hong Kong to deal in Rmb-denominated financial instruments are in response to both the pressures on the renminbi and global capital mobility as China becomes increasingly open to world markets. From 1990 to 2000, China's degree of openness measured as exports to GDP doubled from 15% to 30%. China is also one of the top three leading destinations for FDI and increasingly for short-term capital flows. Its successful integration will depend on banking sector reforms and resolution of the NPL issue in its financial system.
Recapitalizing
Excess cash holdings estimated at Rmb1 trillion and a savings rate of 40% of GDP make China an attractive market with vast potential, but numerous reforms of the banking sector are needed. The Chinese authorities have undertaken a series of measures intended to recapitalize the four big state-owned commercial banks, including an infusion of $45 billion into two – Bank of China and China Construction Bank – from China's vast foreign exchange reserves. The transfer was clearly intended to increase their capital adequacy ratios to bring them closer to internationally accepted standards.
This move accompanies other measures such as the sale of minority equity stakes in China's smaller commercial banks, namely the joint stock banks. In addition, there have been sales of NPLs to foreign investors by the four Asset Management Companies, which were created in 1999 to shoulder NPLs from the SCBs. However, the SCBs are still wrought with problems of under-capitalization and significant holdings of NPLs.
Dangers
The major risk in China's banking sector will be the inability of the banks to stem the inflow and rid themselves of the NPLs within the next few years. There is also a danger of excess lending that was seen earlier this year when the economy was thought to be growing too quickly in certain sectors, such as construction and real estate. Finally, there are signs that the amount of NPLs are falling as officially reported, and the CBRC has made strides in improving the governance, capitalization and transparency of the banking sector.
China's reforms are largely on track in beginning to address the structural imbalances and demands of the global market. The progress of the latter in areas such as banking and financial services will depend critically on the former. China has begun to tackle its NPLs and establish regulatory authorities to manage its WTO mandated financial liberalization. But China must not neglect the institutional foundations of the market economy, such as transparent laws. Finally, success will also depend on China's progess in balancing growth and staving off unrest.
Linda Yueh is a fellow in economics at Oxford University and the London School of Economics.