Reduced government influence should be the cornerstone of China's banking reform

The most remarkable feature of China's banking system since 1994 has been its rapid transformation from a monopoly of State banks to a system with a wider range of non-State banking institutions. As a result of this the State-owned commercial banks, or SOCBs, and their non-State counterparts have now become more responsive to market signals and discipline.

Considerable headway has been made in implementing key reforms in the banking sector, as evidenced by the improved balance sheets, enhanced corporate governance, and compliance with international best practice. The public listing of the four SOCBs represented a milestone in ownership reform in China's banking sector. This move exposed the State banks further to the market forces and competition.

However, if the mission of China's banking reform is to develop a full-fledged market-based banking sector and thereby sustain the country's long-term economic growth and development, a further retreat of State influence is of vital importance.

To illustrate, when the central government initiated the 4 trillion yuan ($634 billion, 492 billion euros) stimulus package in 2008, SOCBs were pressured by local governments to extend loans to key projects to maintain economic growth.

A significant number of these projects finally turned out to be unmatched by effective demand, which intensified the problem of overcapacity. More importantly, it causes recurrence and accumulation of non-performing loans in the banking sector. These loans rose by 18.2 billion yuan in the second quarter of this year to 456.4 billion yuan, which marked the third straight quarterly increase. The rise in such loans for three consecutive quarters was the first such instance in the past eight years.

The remaining agenda for China's banking reform hinges on the difficulties facing the lenders to resist the practice of lending based on government pressure - both from the central and local levels.

The majority shares of the four SOCBs are still held by the People's Bank of China, the Ministry of Finance and other government entities. Without an overhaul of the ownership structure of the SOCBs, lending decisions based on commercial principles will be less conceivable.

It is likely that central leaders will now become more cautious while relaxing controls in the banking sector, much in line with the doctrine of a socialist market economy endorsed in 1993. The notion of socialist market economy recognized an enlarged role of market and privatization in the course of economic reform, but the State-owned sector would remain the mainstay of the economy.

Expanding market liberalization of China's banking sector may weaken central government's macroeconomic control, though market reforms have brought substantial benefits to Chinese SOCBs.

China will continue to strike a balance between liberalization and State control in banking. Due to the global financial crisis of 2008 and its repercussions, policymakers will continue to focus more on financial stability and not pursue any further ownership reform in the near future.

Apart from the ownership issue, from a wider perspective a well-functioning banking system should be able to serve the whole economy in a more balanced way.

After three decades of reform, rural financial reforms are still lagging, thus creating the risk of slowing down further rural development. Without an efficient financial market, investment in rural industries and agricultural production will be inhibited, and the effects of any further effort to enhance rural income will be very marginal. As the average size of each loan application in rural areas remains small and more risky, this lowers the cost-effectiveness of processing each loan application.

Lending to rural areas has so far recorded relatively higher non-performing loan ratios than those for other economic sectors. Further, the lack of collateral from farmers increases the default risks of these loans. Lower profitability and higher risks deter the banks from taking bold steps to tap into the rural business, particularly in poor regions.

The lack of access to credit by farmers and rural enterprises cannot be resolved merely by market solutions. Government policy initiatives, such as tax exemption, concessionary land rents and further liberalization of interest rates, are needed to provide local and foreign banks with incentives to invest in rural areas. This is especially important in remote regions.

Without addressing the credit problems in the countryside, a stable and sustainable income increase can hardly be achieved. The consumption level of rural households will probably continue to lag their urban counterparts, which puts further impediments to bridge the rural-urban gap.

China's accomplishments in banking reform have been staggering, particularly in terms of reducing non-performing loans, lifting capital adequacy ratios, and enhancing internal corporate governance. This can be attributable to the central government's financial support and the competitive pressure exerted by China's WTO accession.

However, the State influence, either direct or indirect, on banks' operation and loan decisions is prevalent. The success of China's banking reform thus relies on whether banks can truly operate according to market principles such as profitability and repayability, which in turn rest on the extent of State influence on loan decisions.

Last but not least, China's banking reform would be far from complete without addressing the issues of the under-development of rural finance.

The author is associate professor of economics at The Open University of Hong Kong. The views expressed here are not necessarily those of China Daily.

(China Daily 10/05/2012 page7)