Problems with the Old Mammoths and Growth of the New Tigers

The Negative Impact of State Ownership on the Corporate Governance of Banks

While PRC experienced its unique economic miracle, featuring average annual growth rates of about 9% over some 25 years, not all sectors progressed at the same pace, possibly providing bottlenecks for future growth. Progress has been slowest in the service sector (Dutta, 2005). And within the service sector advancement has been most sluggish in the financial sector. Much of the issue hinges on the link between SOBs and SOEs has received much attention and this raises the important question of the negative impact of state ownership on the corporate governance of banks.

Various papers by La Porta et al. (La Porta et al., 1997, 1998) analyze the nexus between institutional setup and the functioning and development of financial markets. In general, they find that the degree of investor protection is crucial in this respect: the degree of investor protection is at a minimum in countries with French origin law, while it is at a maximum in countries in the tradition of the common law, principally the UK and the US. Obviously this introduces also the role of the state, as the state itself is always the key actor in drawing up market rules, from which investor protection derives. Indeed, the authors show that, comparing countries, as state ownership increases investor protection and financial market development decrease.

Further according to Pagano and Volpin (2002) the degree of investor protection is negatively correlated with the degree of protection in the labor market. They show that “corporatist” economies (especially with coalition governments) deliver low investor protection in exchange for high labor protection while, on the contrary, in “non-corporatist” economies they find high investor protection and low labor protection. Finally, the more widespread is shareholding, the higher is the level of investor protection chosen by the government, that is there is a “”lock-in” effect of privatizations (Perotti and van Oijen, 1999). According to Rajan and Zingales (2001) choices by “interest groups” hinder financial market development, while ruling governments may oppose financial market development since, by raising competition this limits their discretion and their power. They predict that government opposition to financial market development is lower if the economy is open to trade and to capital flows.

What is more relevant here is that in a later paper, La Porta, et al. (2002) directly addresses the issue of government ownership of banks. The authors maintain this is a very special case to verify the “political” theories of the distortions induced by state intervention in financial markets. Their main finding is that, again comparing countries, after state ownership of banks increases, the growth of financial markets, of per capita income and of productivity are all lowered. Thus, the general consensus in the literature is that state ownership of banks is detrimental to bank efficiency, to the development of financial markets and, through these channels, also to economic growth.

In the context of PRC various authors have shed light on the negative impact of state ownership on bank performance. We cite just a few of them. Using city-level data over the early period of 1989-1991, Wei and Wang (1997) find evidence that PRC’s bank loans favored state-owned industrial enterprises and argued that such lending bias diminished the effectiveness of other measures designed to promote the growth of non-state sectors or to induce SOEs to restructure.

In line with this, Brandt and Li (2003) find that as a result of discrimination, private firms resort to more expensive trade credits. Using provincial data from 1991 to 1997, Park and Sehrt (2001) show that the financial reforms of the mid-1990s were ineffective at lowering policy lending by SOBs, thus negatively impinging on these banks’ performance, while SOB lending did not respond to economic fundamentals. Moreno (2002) points out that banks in PRC traditionally met government policy goals by financing the operations of SOEs, regardless of their profitability or risk, and that while bank exposure to SOEs has tended to decline over time, SOEs still accounted for over one-half of outstanding bank credit in 2000 and that exposure to poor-performing SOEs has had a major impact on bank performance. Chang (2003) argues that PRC's (mostly unprofitable) SOEs have been kept afloat with loans from the SOBs, while SOBs cannot force SOEs to pay back their loans without causing their collapse and the inevitable political crisis that would ensue, hence SOBs have continued to lend to SOEs. This fact is confirmed by a survey performed by the People’s Bank of China (PBOC) in 2003, finding that of the total non-performing loans (NPLs) of SOBs, 30% was due to intervention by the central and local governments, 30% resulted from mandatory credit support to SOEs, 10% arose from the poor legal environment and weak law enforcement in some regions, and 10% stemmed from industrial restructuring in some enterprises, thus leaving only 20% that originated from the operational decisions of the SOBs themselves (Zhou, 2004a). Cull and Xu (2000) detect signs of SOB loans going increasingly to unproductive SOEs during the 1990s, when these banks increasingly assumed bailout responsibility (Cull and Xu, 2003). A less alarmist view is held by Gordon (2003), who argues a banking crisis might materialize in PRC only with free private capital movements.

Studying PRC’s experience with the asset management corporations (AMCs) introduced to address SOBs’ NPL problem, Ma and Fung (2002) conclude that, while posing significant quasi-fiscal liabilities, their contribution to the resolution of the NPL problem was only limited. In agreement Bonin and Huang (2001) also criticize the design of these AMCs. Less unfavorable views are held by Zhou (2004b) and also by IMF (2004).

Foreign Banks Cannot be the Whole Answer: a Home Solution is Needed for Better Banking

Can foreign banks help bring better banking to PRC? Answers are generally positive, but the next issue is to what extent foreign banks can help PRC. The economic literature holds that the entry of foreign banks benefits emerging economies mostly because foreign banks are likely to be more efficient (and more independent) than domestic banks and, thus, they foster virtuous competition for the recipient banking systems (Claessens, et al., 2001; Focarelli and Pozzolo, 2001; Hawkins and Milhaljek, 2001). Furthermore, it is often argued that the retail entry by foreign banks is more desirable than their wholesale entry, which might even channel to the country “hot money” and favor pro-cyclical swings in capital inflows. Foreign bank penetration may also facilitate FDI inflows.

In relation to PRC Liu (2004) argues that the sequencing in terms of entry of foreign banks adopted by PRC has been able to avoid some of the problems observed in other countries, where a rapid entry of foreign banks has been associated with excessively rapid growth in overall bank lending fuelling speculative excesses. Ma and McCauley (2004) show that, in spite of the fact that PRC’s capital account is still closed, interest rate differentials seem to affect the monthly variation in the fraction of foreign currency bank deposits. In their interpretation, this suggests that, behind the official ban on capital outflows, PRC’s capital account is already integrated to some extent. They also stress that the non-negligible holding of US dollar deposits by Chinese nationals indicates a more internationalized banking system than conventionally thought. Studying inward FDI to two regions of PRC, He and Gray (2001) find that FDI to each region by non-financial corporations increases sharply following FDI to that region by commercial banks. They argue that this evidence is consistent with two explanations. First, that the newly available expertise in the international financial system allows multinational firms to invest with the assurance that they will have a sophisticated capability to hedge risks. Second, that, since the financial sector is a sensitive sector, permission for multinational banks to enter is a sign of a commitment to a policy of open development by that region.

Foreign banks in PRC were initially limited to doing business only in a few cities and to providing foreign currency transactions to foreign companies operating in the country. Since April 2002 some foreign banks were allowed to offer foreign currency transactions to Chinese nationals and firms. From December 2003, the government allowed foreign banks to provide intermediation services in yuan to Chinese firms in 13 cities, extended to four further cities at the end of 2004. Presently, only 84 of the 191 foreign banks operating in PRC hold a license to do business in yuan, but their local business is disadvantaged by the lack of cheap retail deposit funding and by the limits to inter-bank funding (Huang, 2002). According to the WTO agreement, only by 2007 will foreign banks be fully allowed to do business in yuan. However, red tape to obtain licenses and other remaining obstacles may significantly limit the ability of foreign banks to develop retail branching. For instance, foreign banks are required to have had a representative office for three years before they can open a branch, long times are required for them to expand branch networks and they face capital requirement levels that are high by international standards.

In practice, foreign bank entry to PRC is still too recent and limited to make it possible to assess its effects. For instance, it is clearly the case that the few Chinese banks where foreign banks have an ownership share are among the best performing, but it is not clear whether we can draw a causal link. In other words, have these banks significantly improved their performance after the advent of foreign participation or were they high performers already?

Furthermore, the extent to which foreign banks can play a role toward better banking in PRC may be limited by two additional considerations. As argued by Bonin and Huang (2002), foreign bank competition could mainly be in the form of taking wealthy and profitable clients away from local banks, while foreign banks might shy away from building matching networks in the short-term. In addition, as shown in Ferri (2003), the extent of foreign bank penetration is smaller in larger-sized countries. Arguably, this depends on the fact that even the largest banks find it unpalatable to concentrate their risks too much, which could happen should they take a high share in a very big country.

These considerations suggest that the potential for foreign bank penetration in PRC should not be exaggerated. Thus, though it is reasonable to expect that foreign banks’ role will be key in various respect (from risk management, to competition, to investment banking), better banking in PRC has to be found at home. In this sense, considering that by the side of the problematic “Old Mammoths” (the SOBs), a breed of dynamic “New Tigers” is growing quickly , it is important to focus on the latter.

The New Tigers Grow Intensely and Outperform the Old Mammoths

The New Tigers are growing very rapidly.³ Even though truly private commercial banks have been absent from PRC, and in spite of belonging to different institutional categories, the New Tigers share a common trait distinguishing them from the SOBs. Contrary to the situation of the SOBs, which have the state as the single shareholder, the New Tigers have a plurality of shareholders. Some of these shareholders may be themselves public sector shareholders, being part either of the public administration or of the SOE system, but none of them is in the position of a single shareholder in any of the New Tigers. As argued elsewhere,⁴ the plurality of shareholders may be important in reducing political interference in a bank’s business , thus delivering better corporate governance and better performance.

This conjecture is consistent with what is observed over the years. Namely, the New Tigers are reducing more and more the SOBs’ market share, and also the former visibly outperform the latter by conventional indicators. Between 1998 and 2003 the average annual rate of growth of total assets was 11.2% for the SOBs and 23.8% for the New Tigers and the gap became larger between the first sub-period 1997-2000 (12.3 against 20.4%) and the second one 2000-2003 (10.0 against 27.2%; Figure 1 [ PDF 93.5KB | 1 page ]). This gap produced a significant erosion in SOBs’ market share: over this period they lost 10.5% of the market, whilst the share of the New Tigers almost doubled from 12.8 to 23.3% (Figure 2 [ PDF 94.3KB | 1 page ]).⁵

Even more importantly, the New Tigers made such significant gains of market share while achieving much higher returns than the Old Mammoths. Indeed, between 1997 and 2003 the ROA (Return on Assets) of the SOBs halved from the poor 0.15% to 0.077%, while the New Tigers, though suffering a reduction, managed to keep their ROA at about 0.50%, a level which is comparable to that observed for the banking systems of developed countries (Figure 3 [ PDF 93.8KB | 1 page ]). A similar indication may be derived looking at the New Tigers’ ability to generate remuneration on their own capital: between 1997 and 2003, in spite of their low capitalization, SOBs’ ROE (Return on Equity) dropped from 4.3 to 1.6% while, though reducing over time as well, in 2003 the ROE for the New Tigers stood at about 8%, a level not far from that typical of developed countries.

Do the New Tigers offer PRC a “Growing Out” Option?

In light of their growing market share coupled with better performance, it seems reasonable to ask whether the New Tigers are effectively supplanting the Old Mammoths. And more broadly, do the New Tigers offer PRC a “growing out” option to overcome the difficulties in restructuring its Old Mammoths⁶ and, through this, bring better banking to PRC?

There are two answers to this question. The first answer, somewhat mechanical and unsophisticated, may be derived through a simple forecasting exercise. In Figure 4 [ PDF 110.3KB | 1 page ]we report the forecast market share of the New Tigers up to 2010 assuming that they keep growing at the rate experienced on average over 2000-2003 (27.2%), while the SOBs continue expanding at the much lower average rate they achieved over the same period (10.0%). This forecasting exercise is naïve in that it merely projects past trends to the future.⁷ It emerges that, under these hypotheses, the New Tigers could reach a market share above 45% by 2010 (Figure 4 [ PDF 110.3KB | 1 page ]). Should this come about, then one could deem that PRC’s banking problem would be greatly reduced (if not half solved) in just five years from now.

However, even though the scenario presented is not unrealistic from a macroeconomic perspective, there is no guarantee that it is also based on solid economic reasoning. To be sure, the continuation of the astonishing growth they experienced over the last few years postulates that the New Tigers really enjoy a competitive edge across the board vis-a-vis SOBs. But is this really the case? One way to address this issue is assessing whether the better performance of the New Tigers is fully attributable to their better corporate governance. It is exactly at this juncture that we notice a second trait distinguishing the New Tigers from the Old Mammoths. The New Tigers concentrate their business in the most developed part of PRC, its vibrant Eastern Belt, while on the contrary, the SOBs operate throughout the whole of the country.. As a result, it is not clear whether the New Tigers’ better performance is owed entirely to their better corporate governance or whether geography also gives these banks a great help.. For instance, according to Huang (2002), the SOBs generate 95% of their profits from about half a dozen of the coastal cities, including Shenzhen, Guangzhou, Xiamen, Shanghai, Tianjin, and Beijing. If this is true, then doubts are cast on the possibility that the growth of the New Tigers can provide an effective solution to the banking problem out of the affluent Eastern Belt. As a consequence, to gauge how much of a solution the New Tigers may offer, we need to consider in more depth how far geography (that is favorable bank location) lies behind their strong performance. This is the main task for the rest of the paper.

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