Far Eastern Economic Review Diana Farrell and Susan Lund May 1, 2006
The chief tasks of any good financial system are to attract savings and
channel them to productive investments as efficiently as possible. China’s
financial system does an outstanding job of mobilizing savings. But there is
considerable room for improvement in its capital allocation, and its overall
efficiency. Financial-system reforms could not only raise GDP by as much as 17%,
or $320 billion a year, but also help spread China’s new wealth more evenly
throughout the country.
China's regulators are understandably anxious that a shift in funding toward
more productive borrowers could accelerate layoffs from the less productive
state-owned enterprises (SOEs), and lead to more social unrest. But such a shift
will stimulate job creation in the strongest areas of China’s economy and
increase tax revenues to fund social programs. Speeding the move to a fully
market-based financial system will relieve, rather than exacerbate, social
tensions in the long run.
Financing the Most Productive
Over the past 10 years, private companies in China—whether Chinese-owned,
foreign-owned, or joint ventures—have grown faster than GDP. These companies now
account for half of all output and many new jobs. The share of production from
wholly state-owned enterprises, meanwhile, has shrunk to barely one-quarter of
GDP. Although many SOEs have been restructured and some are highly profitable,
their productivity as a group is still half that of private companies, both in
aggregate and by industry.
Nevertheless, SOEs (both wholly and partially state-owned) continue to absorb
most of the funding from the financial system. Private enterprises have received
only 27% of loan balances. Many of them resort instead to China’s large informal
lending market, which has an estimated $100 billion of assets but also higher
interest rates.
As well as explaining the large volume of nonperforming loans in China’s
banking system, this pattern of lending also has the effect of lowering overall
productivity in the economy. As a result, China is seeing its investment
efficiency decline. Whereas it required $3.30 of investment to produce $1 of GDP
growth in the first half of the 1990s, each $1.00 of growth since 2001 has
required $4.90 of new investment—nearly 40% more than the investment required
by South Korea and Japan during their high-growth periods.
Productivity would be boosted greatly if a larger share
of funding went to more productive private enterprises. Less productive SOEs
would have to improve their operations to continue to attract finance, or shut
down. Over the next five years, this dynamic would go a long way to closing the
productivity gap between state-owned and private companies, raising GDP by as
much as 13%, or $259 billion annually.
Chinese households will benefit as better capital allocation creates higher
returns on savings. Chinese households save a lot by international standards—on
average, roughly 25% of their disposable income. But they keep 86% of their
savings in low-yielding bank deposits and savings accounts. Given the low
average returns and volatility of equity and bonds over the past 10 years,
opting for bank deposits has been rational.
That said, poor capital allocation by banks and the comparatively high cost
of financial intermediation in China mean that returns on bank deposits are also
dismal. Over the past 10 years, Chinese households’ financial assets earned just
0.5% a year after inflation. In contrast, South Korean households earned 1.8%
during the same period. If real returns on their savings doubled to 1%, Chinese
households would gain $10 billion annually; if returns reached the level seen in
South Korea, they would gain an extra $25 billion a year. With returns at these
levels, Chinese households could afford to save less and consume more.
Despite the clear benefits of better capital allocation, China’s regulators
have resisted making changes, presumably in order to maintain stability and
preserve jobs. But developing a market-based financial system is a more
attractive way to achieve and sustain higher overall employment from both an
economic and social standpoint. Although jobs will be lost from SOEs that prove
unable to compete for funding on a commercial basis, the burgeoning private
sector will create many new ones. Net job losses are likely to be negligible
even in the short to medium term. China has already experienced this effect of
liberalization in its auto industry. Restructuring has caused state-owned auto
enterprises to shed many jobs, but total employment in the industry has
increased.
Moreover, we estimate the increase in GDP resulting from reforms that improve
capital allocation will raise government tax revenues by 16%, without any
increase in tax rates. The state can use these funds to support and retrain
displaced workers directly, rather than distorting the financial system to
achieve social goals.
Improving Financial System Efficiency
When offering warnings that the Chinese economy is booming despite—not
because of—its rudimentary financial system, many economists point out a core
inefficiency of the system: political pressures continue to influence lending
practices. Equally detrimental to China’s financial system, however, are
inefficient operations in a banking sector that towers over the system, and the
underdeveloped state of the debt and equity markets. As well as skewing the
allocation of capital, these problems raise the system’s operating costs. If
they could match the efficiency of systems in other emerging markets, such as
South Korea, Malaysia, or Chile, we estimate that financial intermediation costs
could be cut by a total of $62 billion per year, while improving capital
allocation as well.
Banking sector China’s banks have a number of operational weaknesses. They
gather only sketchy information on borrowers’ credit histories and financial
performance, and the coverage of independent credit rating agencies, such as
Moody’s or Standard & Poor’s, is limited. Loan officers in many bank
branches have rudimentary loan pricing and risk management skills, despite
recent efforts to improve. To such risk-averse lenders, the scale and government
ownership of even poorly performing soes can make them more attractive loan
prospects than smaller private companies, because of their seemingly low risk.
There may also be local political pressure to lend to what are still the largest
local employers in many regions.
Poor capital allocation by banks is amplified by the dominance of the banking
sector in China’s financial system. In market economies, the share of bank
deposits in the financial system’s total assets typically ranges from under 20%
in developed economies to about half in emerging markets. But as the graphic
nearby shows, in China, banks intermediate nearly 75% of the capital in the
economy. Bank deposits and savings accounts, roughly half of them from
households, now total $2.6 trillion.
Banks’ inefficiencies result in higher than necessary operating costs. The
main source of banks’ revenue, particularly in China where fee-based income is
low, is the spread between their average borrowing and lending rates. China’s
largest banks will need a total of $215 billion from the government to
recapitalize their balance sheets. Around $105 billion has already been injected
since the 1990s. Adding these funds to their net interest margin raises the true
cost of intermediation in China’s banking sector to 4.5%, compared to 3.1% in
our benchmark countries. Raising the efficiency of China’s banking operations to
the benchmark would reduce their costs by $25 billion annually, given their
volume of lending. More efficient banks would also be able to lend successfully
to smaller, private businesses, saving these firms the premium they now pay to
borrow on the informal market, worth an additional $2 billion a year.
Payments system China is currently in the process of building a modern
payments infrastructure. For wholesale payments, the China National Automatic
Payment System (CNAPS) has been put in place in many cities and offers
functionalities comparable to systems in more developed economies, namely gross
settlement of high-value payments and net end-of-day settlement of smaller value
ones. But many local banks are resisting the significant capital investment
necessary to connect to the system, preferring instead to use the old
“Electronic Interbank System,” which has far higher transaction costs. Most
retail payments are still made in cash, since credit and debt cards are not
widespread among the population, and most small retailers have not wanted to
make the investment necessary to install the equipment to accept cards. Speeding
the spread of electronic retail and wholesale payments would result in $20
billion of savings each year, and benefit the government by reducing tax evasion
(since the gray market operates in cash). The size of this prize justifies
introducing some form of incentive to retailers, consumers and banks to pay
electronically.
Debt and equity markets China’s equity and bond markets are among the
smallest in the world. Equity market capitalization, excluding nontradable
“legal person” shares owned by the state, is equivalent to just 17% of GDP,
compared with 60% or more in other emerging markets. The corporate bond market,
meanwhile, is just 1% of GDP, compared with an average of 50% in other emerging
markets. It is held back by a mass of regulations that lengthen issuance time to
a year or more, limit the interest rates that corporate bonds can pay, and leave
the government with discretion over which companies list.
Moreover, China’s small capital markets are used almost exclusively by SOEs.
Until a few years ago, state regulators selected companies for equity offerings
in line with industrial policies, and still do for bond issues. Equity listing
criteria have since become more independent, but here again, government
regulators maintain discretion over which companies can list. So far, almost
none have had a majority of private ownership at the time they initially listed
shares, although some were privatized after listing.
Chinese companies need more fully developed equity and bond markets to
provide competition to banks and give them a better choice of funding vehicles.
In our benchmark countries, companies get roughly 60% of their debt from bond
markets and 40% from bank loans. If they could match this mix of financing
vehicles, Chinese companies would lower their funding costs by $14 billion
annually. Efficiency improvements in China’s equity markets would reduce the
costs to issuing companies by an additional $1.5 billion. Chinese households
would benefit because flourishing bond and equity markets would underpin the
development of more attractive financial products, such as mutual funds,
pensions funds, and insurance, than bank deposits.
Priorities for Financial Reform
The current shortcomings of China’s financial system are rooted in
relationships between the system’s component parts—banks, bond markets, equity
markets, the payments system and institutional investors.
For instance, China needs a healthy corporate-bond market to provide funding
to large companies and infrastructure projects, and to spur banks to lend more
to smaller companies and consumers instead. The bond market, however, is
unlikely to flourish until banks develop more accurate risk-based loan pricing
and stop the flow of cheap loans to large companies. Speeding growth of domestic
institutional investors is also essential, because few retail investors in any
country buy corporate bonds directly. Yet all these relationships work both
ways. Financial intermediaries, capital markets and banking have to evolve in
tandem.
China’s four financial system regulatory bodies thus need to implement a
coordinated, system-wide program of reforms. Measures to increase competition in
the banking sector will be critical to prompt banks to upgrade their lending
skills, management and it systems, and governance. China’s regulators have taken
steps in this direction to prepare for competition from foreign banks, which
will enter the local currency market in December 2006. But these banks have
relatively few branches today and opening more will take time, limiting their
immediate impact on competition. Regulators should therefore also allow more
private domestic banks to enter the market, and relax limits on foreign
ownership in banks ahead of the currently planned schedule—particularly for the
smaller city and regional banks badly in need of the banking skills and
technology that foreign investors bring. They should also raise the requirements
for bank governance by making boards more independent and offering training
programs for directors, and should strengthen financial reporting and auditing
requirements to make bank performance more transparent.
In a more competitive environment, banks will likely lose their largest
corporate customers to the capital markets, obliging them to turn to private
companies, SMEs, and consumers instead. But to lend successfully to these
segments, banks must be able to assess the credit quality of borrowers and price
their risks accurately. To this end, banks need the services of independent
consumer credit bureaus. To speed their development, regulators should provide
incentives for lenders and utilities to report the payment histories of
borrowers.
To help creditworthy SMEs to borrow, regulators should also ease the strict
collateral rules on banks. Today, real estate and some forms of equipment are
accepted as collateral. But unclear property rights in many parts of China
deprive small businesses of needed collateral. Moreover, Chinese real-estate
prices are soaring, so using this asset as the main collateral for loans may be
risky. The regulators should therefore allow banks to accept more types of
equipment and accounts receivable as loan collateral, and the government should
consider expanding the program of loan guarantees to SMEs. Since banks have had
trouble taking possession of collateral in the past, particularly when it was
not a fixed asset, it is also imperative that China further develop its legal
system in this regard.
The corporate bond market in China has been slow to develop largely because
of inappropriate regulations. To speed its expansion, regulators should abolish
preferential access to the market for policy banks to allow more private
companies to issue bonds, and shorten the issue approval process to something
nearer the maximum of a week it takes in most other Southeast Asian countries
from the 14 months to 17 months it takes today, and abolish limits on interest
rates payable on corporate bonds. They should also encourage the expansion of
sophisticated corporate-rating agencies, such as Moody’s and S&P, which
today have limited coverage, or build up Chinese rating agencies.
Excessive regulation is also holding back growth among institutional
investors. Regulators should therefore consider relaxing restrictions on the
types of investments domestic intermediaries can make, and making taxes on these
investments more favorable. They should also allow domestic intermediaries to
invest some portion of their assets abroad to improve the returns they can offer
to households. In addition, Chinese households need education in investment and
financial services planning. This could be encouraged through tax rebates or
subsidies to households, and by tax incentives to private companies that offer
them.
To enable more private companies and SMEs to choose equity capital as a
source of finance, regulations should be changed to let more private firms that
technically qualify for an IPO actually list on each of the stock exchanges, and
to allow more IPOs and foreign investors on the small-cap exchange in Shenzhen.
To further the joint progress of all three exchanges in China, regulators should
also encourage the more strategic relationship that is developing between the
Hong Kong Stock Exchange and the mainland exchanges in order to improve mainland
equity market operation.
Lastly, strict capital controls prevent China’s residents today from
investing in foreign financial markets or securities, where they might earn
higher returns than from domestic savings vehicles. This policy also protects
China’s banks and capital markets from competition that they need in order to
develop. As a first step toward capital-account convertibility, regulators
should gradually allow domestic intermediaries to invest some assets in Hong
Kong.
Ms. Farrell is director of the McKinsey Global Institute, McKinsey’s
economics think tank where Ms. Lund is a senior fellow.
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