Making haste slowly

Small enterprises face new squeeze from big banks as pressure grows for reforms

China's small and medium-sized enterprises may be facing a new credit crunch as the country's big five state-owned banks come under further financial pressure. All reported sharply rising bad loans as they reported their quarterly financial results over the past fortnight.

Revenues of China's listed banks suffered as the economy slowed and fell 15 percent year-on-year in the third quarter.

Some expressed concern it would become increasingly difficult to lend to SMEs because of the risk of further deteriorating their loan books, which could lead many enterprises starved of funds.

Businesses may resort to borrowing expensively through ever-burgeoning "shadow" banks, whose practices some fear could undermine China's financial system.

The recent data coming from the banks has put increasing pressure on the Government to accelerate its banking reform program, aimed partly at widening access to funding.

Wu Xiaoling, standing committee member and vice-chairwoman of the financial and economics affairs committee of the National People's Congress, told a recent conference in Beijing it was vital to create more market freedom in the banking system.

"Although this issue is not new, it continues to remain a severe problem," she said.

The severity she referred to was the relative rigidity in the setting of interest rates in China and the need for further liberalization.

The current fixed ceiling on the deposit rate makes it very difficult for China's mainly state-owned banks to price risk and so when it comes to lending money they play safe.

Instead of lending to China's cash-hungry SMEs, they prefer to lend to China's state-owned enterprise behemoths, knowing they will at least get their money back.

Wu, who was addressing the 8th Annual China Bankers Forum at the CEIBS (China Europe International Business School) campus in Beijing, said there remained a fundamental misallocation of capital in the economy.

"State-owned enterprises can get relatively cheap capital from the banks but others such as SMEs cannot get capital when they need it or only at an expensive price. If we cannot reflect the real supply and demand of the market, we cannot improve the efficiency of the market," she said.

Banking reform in China has come a long way since the 1980s when there was just one centrally set interest rate for the whole economy.

The late 1990s saw another key step when all the major state-owned banks sold stakes through IPOs.

It is liberalizing interest rates that is key, however. Zhou Xiaochuan, governor of the People's Bank of China, said earlier this year this process could be completed within two years.

Some progress has already been made. The floor on lending rates has been removed but what would represent true liberalization would be the freeing up of the deposit rate.

At present, banks cannot pay more than 3.3 percent, or 1.1 times the 3 percent benchmark deposit rate.

This stifles any competition for deposits but keeps the costs of China's banks low so they can lend at relatively low rates to SOEs and still make a decent profit maintaining, according to some, a cozy arrangement - one that some vested interests may not want to dismantle too quickly.

There is little risk-reward incentive to lend to SMEs under the existing model since they make a sufficient margin already on low risk lending.

Yang Wensheng, vice-president of China Construction Bank, said at the CEIBS conference that lending and providing financial services to the SME sector was still seen as a major opportunity by some Chinese banks, although he admitted the framework was not yet there.

"It is actually something of a blue ocean for us. If we can actually find the rules for providing financial services to SMEs it can be of great potential for the growth of the banking economy," he said.

Timothy Beardson, a leading Asian banking expert and author of Stumbling Giant: The Threats to China's Future, believes banks should possibly be forced to operate under a quota system to increase small business lending. Currently only one in five loans go to SMEs.

"This means the banks should receive instructions to deliberately lend more to private companies, perhaps through quotas," he argues.

"Private companies should not be charged higher interest rates than state-owned enterprises. Let's tell the banks it is their job to fund China's future, not its past."

One of the problems for policymakers is that reform is having to be implemented at a time when the Chinese economy is also slowing, which is creating other pressures on the system. Third quarter GDP growth of 7.3 percent was the lowest for 66 months.

The PBOC announced on Sept 19 it was injecting 500 billion yuan (64 billion euros, $81 billion) for a three-month period to create extra liquidity.

Junheng Li, founder and head of research J.L. Warren Capital, the New York-based equity research firm specializing in China, regards the move as significant.

"This liquidity operation is to bridge the potential liquidity stress at smaller banks with funding gaps," she says.

Some of the real pressures in the system still reside in the so-called shadow banking system, which is now of an enormous scale in China.

Much of the focus has been on informal lending by private individuals to small businesses in such places as Wenzhou, the Zhejiang province city on China's eastern seaboard famous for its entrepreneurs. This led to a funding crisis at the beginning of 2011 when a number of small business owners fled the country and some committed suicide.

But what often goes unreported is that by far the major part of shadow banking has been conducted by the established banks themselves.

They have set up arm's-length trust or wealth management products in which their customers invest money. These have secured high returns for investors by lending money to small businesses at high rates of interest.

One such product, China Credit Equals Gold #1 that offered a return of 10 percent, had to be bailed out recently by Huarong, a government vehicle that was originally set up to mop up some of the non-performing loans in China's 1990s mini banking crisis.

The product was sold by Industrial and Commercial Bank of China through its branch network, although it had no direct ownership. Investors, despite supposedly risking their money, will get most of it back because of the bailout.

May Yan, head of Asia ex-Japan Banking Research at Barclays, based in Hong Kong, says there have been worries in the market about a trust product default all year, which might send a shudder through the entire China banking system.

"At the beginning of the year everyone believed that a trust product would default in a large way but that hasn't happened," she says.

Yan says that in some ways it would be healthy for the system if there was such a default since those putting their money in WMPs think they cannot go wrong.

"This implicit guarantee on financial products is very bad because people just think they are risk free, even if they are getting a 10 percent return. It doesn't make sense. The government is always worried about the risk of a default," she says.

The government, however, is intent on introducing more competition into the banking system as part of its overall reforms.

Foreign banks were allowed into China after the country joined the World Trade Organization in 2001 but although HSBC, Standard Chartered and others have a presence in the country their combined market share is just 2 percent. They tend to operate at the margins, providing specialist services that the Chinese banks do not have the capability to provide.

The government announced in March it was launching a pilot to establish five banks run by private operators such as electrical goods retailer Suning and Tencent, which operates China's popular instant messaging service WeChat. These would operate in selected cities.

China's leading existing private bank is Minsheng Bank, which was launched in 1996, and has more than 200 branches around China, although it is seen to have government involvement.

Zhu Ning, deputy director and professor of finance at the Shanghai Advanced Institute of Finance, believes the pilot move is "highly symbolic".

"I think it is a good start but it remains unclear as to what they will and won't be able to do," he says.

"It is where China needs to be in the medium to long term. We are a very long way from that at the moment, given how long it will take them to clear the regulatory hurdles."

Some have concerns that new entrants might be lured into the banking market because they think there are rich profits to be made.

The 17 China banks that made it onto the Forbes Top 500 Chinese Enterprises accounted for 51 percent of the whole list's net profits.

A consequence of further banking reform, however, will be in the profitability of the sector, particularly if they have to compete for deposits by offering higher rates and inevitably increasing their cost base as result.

Dorris Chen, head of China Financials Research at Standard Chartered in Hong Kong, thinks this is a particular risk.

"There is a danger of new entrants seeing banking as some sort of monopoly business. They are very misguided if they do."

She says it is easy for them to underestimate how saturated the Chinese banking market is with the state banks having virtually every high street covered.

"It is not like it is an underserved market which is something the foreign banks have already found, even though they have discovered their own little niches," she says.

"People think the Internet companies like Alibaba and Tencent with their hundreds of millions of captive customers will be able to transfer to become banks but you can't just move these to become banking customers because of all the banking regulations."

Andrew Sheng, president of the Hong Kong-based independent think tank Fung Global Institute, who is a close observer of the Chinese banking sector, says there is a danger of creating excessive competition.

"Competition can raise standards and improve product and service choice but there is also a danger of creating a race to the bottom. That sort of competition is not good," he says.

With the size and complexity of the Chinese economy, there are those who argue that too much responsibility is being placed on the banks to be the main catalyst of economic reform, particularly in funding the business sector.

Wu of the financial and economics affairs committee of the NPC believes there needs to be a greater role for direct funding in the form of private equity and venture capital in order to ease some of the strain.

"China is a country where most of the market risks are taken by the banks. This is not the same in other countries. In the US, direct financing is very strong and so the risks are shouldered not just by the banks," she says.

"We need to reduce the reliance on financing by the banks and develop sources of direct finance."

There can be no doubt that banking reform is a central part of economic reform overall.

Those in the financial liberalization sequencing school of development believe that banking reform needs to be completed before China opens up internationally and allows money to freely flow in and out of the country. At present, that is tightly controlled.

The danger is that money would flow in to China's unreformed banks and create a financial crisis like that in Latin America in the 1980s or in Asia in the late 1990s. China largely escaped the Asian financial crisis because it was a closed economy.

Sheng at Fung Global Institute says such a sequential approach is too idealistic and does not fit the real world.

"Reform is actually about a thousand tweaks. It is exactly like conducting an orchestra. You cannot just have the brass playing or the wind instruments or the strings but you have to carefully orchestrate everything," he says.

"You are dealing with a fourth of all mankind here. It is a very complicated system and sequencing everything is actually an art."

Yan at Barclays agrees it is a delicate process.

"Certainly opening up the capital market needs to be the last thing you do when you do financial reform but I don't think you can't wait until banking reform has been completely finished to do this. Many things have to move forward together.

"If you look at the other economies in the region that have gone through this process such as South Korea and Taiwan it takes between six and 16 years. My estimate is that China is halfway through at present."

One of the problems facing China's banking reformers is that Western banks are not such a great role model they once where after the financial crisis when many of them faced collapse.

As Xu Nuojin, a senior adviser at the financial survey and statistics department of the PBOC, told the CEIBS banking conference that China has to somehow find its own way.

"I think subconsciously we have the assumption that moving toward the US and Western banking systems is the right reforming direction for us," he says.

"The problem is that it might follow a course that is at odds with our specific situation. We might actually as a result drop what is good about our banks and pick up other aspects which we cannot easily absorb and are not that relevant to us."

Contact the writers at andrewmoody@chinadaily.com.cn and huhaiyan@chinadaily.com.cn

(China Daily Africa Weekly 11/14/2014 page16)