Why China's Banking Sector Isn't as Weak as It

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					Why China's Banking Sector Isn't as Weak as It Might Look -- and Other Myths

China's transformation from a stagnant, government-controlled economy marked by
corruption and stagnation to a more international free market system has been
accelerated by banking and other financial reforms, according to speakers at a
conference on China sponsored by the Global Interdependence Center, a non-profit
organization based at the University of Pennsylvania and focused on increasing global
trade. The change, these speakers add, is being directed by Chinese leaders
who feel pressure to continue to deliver economic growth.

Banking reform in China is being bolstered by stronger regulation as well as the
upcoming privatization of leading banks, although the system remains weighed down by
large non-performing loan portfolios, said Jeffrey R. Williams, president of Shenzhen
Development Bank (SDB) and the first foreign president of a Chinese bank. "It's my
belief that historians will look back on the 21 st century and say that China's entry into
the global economy was the defining theme" of that era, he noted.

Williams, an American who has spent his entire career in China, Taiwan and Hong Kong,
recalled his first trip to China in 1979 to teach at Peking University, where he earned the
equivalent of $100 a month. A colleague lived with her husband and two children in one
room in a flat shared with another family. In the winter, teachers and students kept
their coats on in the classroom because there was little heat. "It was peaceful and idyllic,
but life was extremely tough," he said.

Since then, he added, the change that China has experienced "has been breathtaking in
its rapidity and reach." Indeed, the common Western view of China's banking system as
crippled by corruption and bad loans, overstates the problems. "The real story is not
nearly so gloomy. As China has changed, so has banking."

According to Williams, China is not in danger of a crisis like those that hit Southeastern
Asia in 1997 because it has little external debt. Most of China's banking obligations are
local. In addition, China has vast foreign reserves and -- unlike Japanese officials who
were reluctant to clean up bad bank debt and prolonged the country's decade-long
economic slump -- Chinese leaders are taking a strong role in pushing bank reform. "In
Japan, a culture of inertia has defeated the central bank and its ability to drive growth.
China's leaders are intensely aware that they need to maintain stable growth to meet
the needs and aspirations of their people."

Expertise, Not Money

Williams pointed to three main elements of Chinese banking reform. First, he noted, the
government has announced a firm timetable of 2007 for the banks to meet World Trade
Organization standards for capitalization and limits on non-performing loans. "It has
[established] a no-turning-back mindset," said Williams, although he added that it is not
clear now whether all of China's banks will be able to meet the deadline.

Second, China has increased the powers of its banking regulation body, the Chinese
Banking Regulatory Commission (CBRC). In the past two years, he said, the CBRC,
which was once a division of The People's Bank of China, has gained new independence
and raised its profile. The CBRC recently issued 127 new regulations geared toward
bringing international standards of risk management to Chinese banks.
Finally, Chinese regulators have decided to seek foreign financial investments in order to
gain banking expertise. Williams noted that the Chinese Construction Bank, which went
public in October, listed on the Hong Kong exchange rather than domestic stock
markets. PetroChina used a similar tactic with its 2000 initial public offering on the New
York Stock Exchange. A foreign listing, Williams said, provides Chinese companies with a
kind of international stamp of approval on their governance standards. "China does not
need the money. What is important is that Chinese leaders are looking for expertise and
change." He cited an old Chinese saying: "For reading scripture, a monk from outside is
best."

Williams' own bank, SDB, is one of 12 "joint-stock commercial banks" operating in the
country. The bank was founded 18 years ago by the government of the city of
Shenzhen. At that time, it was the center of China's special economic zone, just over the
border from Hong Kong where Chinese leaders first began to experiment with capitalism
in the late 1970s. Shenzhen City, originally a small fishing village, is now a major
financial center with a population of 10 million. SDB, which has branches in 18 cities,
was the first company to trade shares on the Shenzhen stock exchange. In late 2004,
after Newbridge Capital, a U.S. private equity firm, acquired a nearly 18% share of the
bank from entities controlled by Shenzhen City government, Williams was appointed
president.

Direct Lines of Reporting

Like most Chinese banks, SDB had problems, including a large portfolio of non-
performing loans. Williams said the bank has set out to make changes.

In the past, for example, branch officers had great autonomy over loan approvals, a
system which encouraged lending and, in turn, drove up bonuses. The branches also
used an incentive system similar to an agricultural reform introduced in China in the
1980s, known as the household responsibility system, whereby a business was required
to return a set amount of money to the state, but could keep anything it generated over
that amount. "It's a great way to motivate people, but it also leads to a lot of short-term
behavior," said Williams.

To rein in risk, he set up direct lines of reporting from headquarters to the credit officers
in each branch. A week after this change was announced, regulators sent out a circular
urging other banks to adopt a similar system. Williams also improved the bank's human
relations department, strengthened internal auditing and published a new code of
conduct. SDB is still working on new accounting and information systems and recently
signed a deal with General Electric Capital, which will invest $100 million in the bank and
help develop new consumer banking products.

SDB's capital ratio has improved from 2.3% to 3.3%; when it hits 4% the bank will be
able to sell subordinated debt, which could bring the ratio up to 6%, said Williams. This
is still short of the 8% required by 2007, but, he noted, "we are breathing easier."

Finding the Key

In addition to banking and other reforms, China is also looking to foreigners for new
ideas that will allow the country to continue its astonishing economic growth, according
to Ted Chu, senior manager of economic and industry analysis at General Motors and a
conference speaker.
Chu, who was raised in Shanghai and earned graduate economics degrees at
Georgetown University, was a macroeconomist at the World Bank. He cautioned that his
remarks do not necessarily reflect the opinion or policies of General Motors. "Please
allow these personal observations, not as a professional economist or a representative of
a car company, but as one who has been raised in China and is now a citizen of the U.S.
and has some understanding of both societies."

Chu noted that change has been remarkably fast in China where per capita GDP has
grown 10-fold since 1970, the fastest in the world. China passed Germany in motor
vehicle sales in 2002 and is expected to pass Japan next year with sales of over six
million vehicles. Such growth has implications for the global economy, Chu said. For
example, 60% of Chinese GDP is now linked to global trade and Chinese reserves of
over $700 billion help finance the U.S. trade deficit. "Chinese exports to the U.S. are
rising dramatically and exports from the U.S. to China are also rising dramatically. There
is a lot of potential ahead."

Western analysts have attempted to explain what is going on in China with broad
strokes, according to Chu. He pointed to rapid economic growth, urbanization, a high
savings rate, cheap labor, strong foreign direct investment, inequality, environmental
pollution and over-investment as some of the generalizations about China that are
frequently made. Discussions of these issues usually focus on "China today and its
short-term growth, but do not provide insights into the future," said Chu. He compared
the practice of basing opinions about China's future on the current situation to looking
for a lost key at night only under a streetlight.

At the beginning of the 20th century, he noted, economists forecast that Argentina would
develop a stronger economy than the United States. A similar bet might have been
made on Japan in the 1980s. "Looking at Japan's numbers and statistics gave the
impression that Japan was going to take over the world. Today, we are very relaxed
about Japan."

Now the attention is on China, said Chu, who went on to discuss some of the common
perceptions about China. First, many people believe China's key economic advantage is
its vast supply of cheap labor. Chu challenged that idea. "I would like to suggest that
cheap labor is not China's advantage, but its problem."

China's biggest economic challenge today is how to stimulate domestic demand,
especially private consumption. Chinese workers are not paid well and therefore lack the
purchasing power to consume, according to Chu. He said that looking around the world,
cheap labor does not necessarily mean a country is competitive. He pointed to the
African nations as an example. Other countries have high wages but are not competitive,
such as Germany, Italy and Japan. Still other countries, he said, pay high labor rates but
remain competitive. The United States, United Kingdom and South Korea fall into this
category.

That leaves a handful of nations, including China, Thailand, India, the Czech Republic
and Russia, as examples of countries that are inexpensive and competitive. "China
becomes the manufacturing floor of the world, not because of cheap labor, but because
China has the most open and flexible market," said Chu, adding that productivity
improvements and structural reform of economic systems have driven down
manufacturing employment in China from 54 million jobs in 1994 to 30 million in 2004.
As China faces higher costs of production inputs, such as energy, the country is under
pressure to increase productivity and innovation. "This leads to a two-way Gold Rush.
On the one side, Chinese firms are spending a lot on research and development to go up
the value chain. On the other side, foreign firms are rushing into China to take
advantage of low costs."

Chu downplayed concerns that China's growth will be cut short by projected shortages of
resources. "The most reliable signpost for the future is not with statistics but with
ideas," he said, noting that China has been importing ideas on a scale that is
unprecedented since the Meiji Restoration in Japan in the mid-19th century.

For example, China is studying international accounting standards and looks to Britain,
the United States and Hong Kong for securities laws. China is borrowing ideas about
military systems from France, developing a Central Bank along the lines of the United
States Federal Reserve system and looking to Singapore for exchange-rate policies.
Japan's economic power was short-lived because its leaders never promoted fair trade
and economic openness, Chu added. "In global developments these days, we tend to
worry about things like the spread of bird flu, but the biggest problem is national and
political barriers to the spread of the best ideas."

Chu is often asked whether China's political system represents an ideological conflict
with the West that would require investors and businesses to consider a big risk
premium when it comes to China. Chinese leaders are indeed trying to remain in power,
he said. But he went on to say that in a true dictatorship, government retains control
through brutality and terror, and ultimately is doomed to fail if it tries to maintain a
closed society and does not have the psychological support of the population.

Chu finds it ironic that many countries considered to be operating under a capitalist
system actually have more examples of socialism than China. "It is the Communist party
that is trying all it can do to adopt capitalist reforms," he said. "The Communist party is
not promoting this on the basis of ideology, but only because it works."

There is no denying there are large differences between the economic and political
systems of China and the United States, he added, citing differences in the forms of
democracy practiced by England in the eighteenth century and its breakaway colony
across the Atlantic. "American and British democracies have gone a long way. China has
just begun its socioeconomic-political journey."
Published: December 14, 2005

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