Recently, China has recorded a remarkable growth in its economy of nearly 10% per year. The bulk of this growth comes from the banking sector characterized by poor asset quality, low capitalization, and massive state intervention. For this reason, the government introduced sweeping changes to the financial sector to boost its stability. These changes included transforming the banking sector from a policy-driven, state-owned, non-performing system to a profit-driven, multi-ownership, competitive system. Although the sector has recorded marked improvements in its operation and efficiency, additional efforts is needed to deal with problems revolving around non-performing loans and shadow banking. The recurrence of financial crises has prompted the alternative use of monetary and fiscal policies, whose effects have been somewhat less effective in alleviating the crises. Coupled with a burgeoning debt problem, these instruments need careful evaluation to generate the required effects on economic indicators.
In 2005, China moved from a fixed exchange rate regime to a managed float exchange rate regime in its efforts to liberalize its financial system. The Chinese currency can fluctuate up to 30-35% of the dollar each day around a reference rate set by the government. Since the regime allows for a narrow fluctuation range around the dollar, it is classified as a managed float regime. This allowance permits monetary policy maneuver, albeit a small window of operation. The goal of monetary policy is to stabilize the exchange rate and regulate the domestic money supply and credit expansion in the overall economy.
The primary monetary policy instruments used by the People’s Bank of China (PBC), the central bank, include open market operations, reserve requirements, window guidance, interest rate policy, and real estate credit control. Open market operations involve the purchase and sale of government bonds and bills issued by the central bank. The reserve requirement ratio (RRR) refers to the percentage of deposit liabilities that banks are required to hold as assets at the central bank. This rate determines the amount of funds available within the banks for lending purposes thus affecting the growth of credit in the country. RRR has been rising steadily due to the increased influx of foreign exchange. To prevent the expansion of money supply in the domestic market and reduce the pressure for currency appreciation, the PBC often buys the foreign exchange inflows. Window guidance is a non-market approach used by the PBC to advise commercial banks on how much they can lend and to which industries or corporations they should lend. This policy is effective because most of the banks operating in the country are state-owned or have a majority state-holding. The functions of window guidance include complementing fiscal policies during financial repressions, and reinforcing industry policies such as supporting SMEs. The interest rate policy works to effect changes in the demand for bank loans and the supply of bank deposits. The PBC can either adjust the benchmark interest rates that the central bank offers such as reserve balance rate, re-discount rate, and re-loan rate or change the benchmark interest rates related to the deposits and loans of financial institutions. Lastly, the real estate credit control regulates the prices in the real estate sector by adjusting the minimum down payment ratio and the interest rate charged on mortgages.
The government instituted several expansionary monetary policies during the global financial crisis, the strategies to stimulate the economy. It lowered the benchmark interest rates. The excess reserve, requirement reserve, and re-loan rate dropped from 0.99%, 1.89% and 4.68% to 0.72%, 1.62%, and 3.33% respectively. To improve the liquidity of banks and enable them to offer more loans to support economic growth, the PBC reduced the RRR for major depository institutions and medium and small institutions from 17.5% to 15.5% and from 17.5% to 13.5% respectively. It also cut down on the issuance of bills, employed window guidance by encouraging banks to advance loans to SMEs and major infrastructure projects, and loosened its control on the real estate credit. The overall effect of these measures was the rapid expansion of credit held by the banking industry leading to a sharp rise in credit risk concerning government-held loans and real estate loans. Most of the projects initiated by the government using credit were long-term in nature and generated low return, thus increasing its risk of default. Moreover, the indiscriminate awarding of real estate loans increased the chances of default. The liquidity of banks also fell due to the huge disbursement of loans.
The Chinese fiscal policy instrument used during the global financial crisis was the injection of the bulky stimulus package into the economy for increasing infrastructural projects. The package aimed at rebalancing the Chinese economy from an export-driven path to an economy led by increased spending on investment. Most of these funds came from bank credit leading to a rise in money supply. During this period, state-owned banks mainly advanced loans to local governments to support businesses and projects that could generate employment quickly. Thus, large-scale and costly construction and infrastructure projects took priority. Local governments also spent money on pet projects with vested political influence, rather than prioritize them based on their cost-benefit ratios. As a result, the government accumulated a huge debt. The PBC tried to curb this trend by introducing contractionary monetary policies such as raising the RRR to a record 21.5% for the large financial institutions, subjecting trust companies to capital requirements, and made it compulsory for local governments and financial institutions to include high-risk off-balance sheet activities in their books. These policies aimed at tightening and reducing the burgeoning credit in the financial system. However, they failed to effect any positive change since borrowers turned to shadow banks for credit instead. The overall effect of the fiscal policy was the rise in default risk among corporations and local governments.
Established in 1912, the Bank of China served as the central bank of China, a specialized international trade bank, and the international exchange bank until 1949. After 1949, the bank was responsible for managing foreign exchange operations and supported the development of international trade and economic infrastructure. The bank became an entirely state-owned commercial bank in 1994 and was later listed in the stock market. The performance of the bank in 2015 remains relatively stable in key financial indicators. The total assets, equity, and liabilities recorded increments of 5.03%, 7.49%, and 4.83% to stand at RMB16.02 trillion, RMB1.27 trillion, and RMB14.75 trillion respectively during the first quarter of 2015. The bank also recorded an increase in the profit paid to equity holders, and the tier 1 capital adequacy ratio. Its credit expanded by 3.76% supporting the growth of the real economy while deposits rose by 6.16% to stand at RMB670.755 billion. The bank strengthened its international operations by increasing its profit before tax and total overseas assets. Besides, it reduced its credit risk by resolving RMB16.5 billion of the total non-performing loans through its domestic branches. Overall, the bank is performing better than the previous years indicated by its rising profit margins, declining credit risk, and stringer financial management.
The regulation system used by the Bank of China emphasizes stability, rationality, and prudence in dealing with risk. Its risk management objective aims at maximizing the interests of shareholders within risk tolerance set by the bank, and on the compliance with banking regulations. The risk management structure comprises several participants such as the Board of Directors, Internal Control Committee, and the Asset Disposal Committee among others. To manage its credit risk, the bank maintains centralized credit approval criteria, uses a sophisticated examiner system to classify risk, enhances the disposal and recovery of non-performing loans, and engages in post-loan management. The bank limits its market risk by monitoring its credit limit. Apart from risk management, the Bank of China also uses internal controls to regulate its operations. First, all institutions, management departments, and staff shoulder the internal control responsibility. This first line of defense aims at instilling self-evaluation and self-rectification. Second, the Business Line Department and the Legal Compliance Department are responsible for establishing the internal control system to evaluate the first line defense. Third, an Audit Department evaluates the effectiveness of all the internal controls implemented by the bank. Besides, it follows the rules prescribed by domestic financial regulators such as the PBC and consistently improves its corporate governance initiatives.
The Chinese banking system has expanded significantly compared to the size of the economy. The four dominant state-owned banks in the sector include the Agricultural Bank of China, the Bank of China, the China Construction Bank, and Industrial and Commercial Bank of China. The state transformed these banks from specialized to commercial entities to create an efficient financial system. Since the government owns a controlling share in these banks, their board of directors report to the State Council. Joint stock commercial banks, a postal savings bank, policy banks, city commercial banks, and rural financial institutions and credit co-operations also make up the banking system. The non-bank financial intermediary sector is small but fast-growing and includes trust companies and finance companies. Foreign-owned banks make up a small part of the banking system due to excessive government restriction.
The operations of the banking sector are under the control of the central bank (PBC) and the regulatory commission called the CBRC (China Banking Regulatory Commission). These institutions control banking activities by formulating and implementing monetary policies during times of financial crises or economic boom to maintain economic stability. Furthermore, they oversee the licensing of banks and ensure their compliance with the Basel II requirements. All commercial banks are subject to capital adequacy requirements to maintain their liquidity and solvency. These conditions determine the amount they should deposit with the central bank and the amount they should hold as liquid funds in their accounts to facilitate day to day operations. Prudential ratios such as the assets to liquid liabilities ratios and the loan to deposit ratios introduced by the regulatory bodies play a crucial role in determining the financial health of banks and the banking industry as a whole. The regulators also launched a five-tier loan classification system to reduce the level of non-performing loans by extending loans on the basis of the credit record of debtors. These classifications include loss, doubtful, substandard, special-mention, and pass. These regulatory are productive and healthy given the drop in the number of non-performing loans, and stability in its performance.
The debt held by China has been growing rapidly over the years. However, much of this growth stems from the 2008 stimulus package that instigated uncontrolled borrowing without consideration to the credit rating of their debtors. According to the Standard and Poor’s (S&P) report released in 2014, the corporate sector debt held by non-financial companies stood at $14.2 trillion. This amount is the highest globally, and even exceeds the debt held by the United States (i.e. biggest lender in the world). A significant portion of the Chinese corporate debt accrues to the shadow banking sector. Shadow banking refers to those credits or lending that are not included in the balance sheet. In 2014, the volume of global shadow banking increased by US$1.6 trillion, with a large proportion of this growth attributed Chinese trusts and money market funds. In 2012, the total debt of China was approximately $18.5 trillion, about 215.7% of the GDP. Total debt includes debt held by the government, financial institutions, non-financial institutions, and households. If this trend continues, China could potentially suffer a banking crisis. With the majority of the funds of banks tied up in credit, their strained liquidity may inhibit normal banking operations such as paying interest on deposits or meeting RRRs. The corporate debt is likely to worsen in the near future due to a decline in corporate profits because of a slowing down in economic growth. If profits fall, corporations will be unable to service their debts leading to defaults. While most economists spell doom for the country, some argue that China could avoid a financial crisis for several reasons. First, its total debt to GDP ratio is modest compared to that of other developed economies. Hence, the debt situation is not dire enough to cripple the whole financial system. Second, the primary issuers of the corporate debt are domestic-based since the country limits the participations of foreign investors. Therefore, domestic lenders can always raise money from the high national savings rate.
The banking system in China is characterized by extensive involvement of the state. The government has the majority ownership in the dominant banks in the country. Thus, it has sway over their deposit and lending activities. The state also owns the three existing policy banks. It also has controlling stakes in many of the smaller commercial banks. The Bank of China is no different. Being a state-owned commercial bank, much of its activities are directed by the government through the ministry of finance or its other holdings. Being the majority shareholder in this bank, the government appoints its senior management team, making it prone to political interference and weak corporate governance. The bank is accountable only to the state through the ministry of finance leading to less transparency in its operations. The bulk of the credit advanced by the bank goes to infrastructure projects and other state-owned enterprises since the state can easily control the lending decisions of the bank.
In conclusion, the Chinese banking system has undergone several adjustments over the years to become more competitive in the global market. Its major transformation is its shift from a strict state-controlled system to a more liberal system that allows some room for market operations. Other changes such as the restructuring of non-performing loans and increased supervision and transparency have contributed to the higher efficiency and competitiveness of the Chinese banking system. Similar to other countries, China uses monetary and fiscal policy instruments to rectify economic downturns such as interest rates, reserve requirement ratios, and deficit spending among others. However, the effects of monetary policy are constrained by the huge state intervention in the banking system. Thus, the country relies more on fiscal policies such as deficit spending that push the country towards a looming debt crisis. Therefore, much effort is necessary to prevent a looming debt crisis in China, regulate shadow banking activities, and encourage more participation from the private sector.
References
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