Banking reform will have long-term implications for Chinese economy

During the banking reform in the past decade, State-owned banks have achieved the short-term goal of "stability" through restructuring and the introduction of strategic investors. However, it is hard to say how much they have achieved in terms of the long-term goal of "efficiency".

Banking reform in China over the past decade has had three main features:

First, the primary goal of the reform is to maintain stability rather than to improve efficiency.

Second, the opening-up policy is so far viable only to State-owned banks and not to the entire banking sector.

Third, the institutional mechanism for progress is not consolidated and the reverse is likely to occur.

China's commitments to the World Trade Organization mean that it needs to open up the banking sector further, allowing foreign banks to compete domestically with State-owned banks. However, State-owned banks would feel the heat from increased competition, and would need to take steps to reduce leakage of market share to their foreign competitors.

Before China entered the WTO, I had remarked in an article that the opening-up of the banking sector and the reform of State-owned commercial banks should go hand in hand. If reforms lag the opening-up process, it would lead to higher systemic risks for the banking industry. The reform of State-owned commercial banks is not just about their own future, but is also linked to the overall economic and social stability.

At that time, speeding up banking reform had become a "consensus". If you look at the details of that consensus, you will find some differences with the need to balance the short-term and the long-term goals the main focus of discussions. Improving efficiency and better supporting economic growth in the long run and reducing financial risks in the short term were other objectives.

A perfect reform program should in theory be able to handle both these factors, but for the decision-makers at that time it was not that easy a task to achieve. All they could do was to take one decision and ditch the other. The result was short-term "stability" got the upper hand over long-term "efficiency".

The thought process at that time was that as long as there was no financial crisis in the short term, there was always a chance to solve the long-standing problems. On the contrary, if a financial crisis breaks out, the long-term scenario is even more uncertain, and the opportunity for reform may be lost altogether. And how short can the "short-term" be?

The opening-up process was supposed to be a three-phased process with significant developments during WTO entry, two years after entry and five years after entry.

The shareholding system reform of State-owned commercial banks was conducted under the auspices of the banks' head office. Under this program, senior executives of the banks tried to find their own buyers. This approach was not reasonable, but that is essentially what happens in urgent situations. As a result of the bargain between domestic and foreign bankers a creative win-win situation was created by which the Chinese side maintained financial stability, while foreign investors made profits.

The trick behind the process was that the State-owned banks opened up creatively by transforming their major foreign competitors into their own shareholders, thereby interlinking their interests. Thus a showdown was avoided.

Many do not understand why "strategic investors" still profit a lot out of our State-owned banks when their competitiveness is low. The answers are two-fold: One is that the massive stripping of bad assets before the restructuring of State-owned banks helped them gain huge one-time subsidies.

Second, after the restructuring, the banking structure remained unchanged. The State-owned banks still maintained or even strengthened their monopoly position.

But the progress on the State-owned banking system has not been consolidated; it is easy to go backward and may occur at any time. When State-owned shareholders are dominant, foreign banks as strategic investors in fact cannot much influence the direction of bank strategies. Therefore the equity rope on foreign banks cannot keep them tight, the underweight will take place sooner or later. In terms of macroeconomic policy, the objectives and tools of monetary policy have been forced into a comprehensive regression since 2008 to adapt to the stalled reform of commercial banks.

Based on my observations, there are two lines of thought:

Although long-term interests are the sum total of short-term interests, even if the maximization of short-term interests is sustained and successfully achieved, it does not automatically lead to the maximization of long-term interests; on the contrary, it is possible to deviate from the goal.

The same applies to overall and partial interests. Which means the results of bank reform during the past decade need to be further assessed to see if they are achieved at the expense of long-term, overall interests.

The author is a researcher at the Development Research Center of the State Council. The views expressed here are not necessarily those of China Daily.

(China Daily 10/05/2012 page7)