The Contradiction in China's Gradualist Banking Reforms

During china's two and a half decades of economic reform, it has often been observed that the bank-dominated financial system is the economy's Achilles' heel. Since 2003, China's central government has reformed the largest state-owned commercial banks to improve their competitiveness before opening the banking industry to foreign competitors, as mandated as part of the country's accession to the World Trade Organization (WTO). Reform of these banks has markedly improved their performance, but the process has been gradual, and underlying problems remain.

One can assess these developments in two contrasting ways. The first is optimistic: the Chinese authorities can afford to reform the state-owned banks gradually because of the economy's growth momentum, the small public sector debt-to-GDP ratio, the size of China's foreign exchange reserves, and the large volume of domestic savings.¹ A complementary perspective by Jonathan Anderson notes that the removal of nonperforming loans (NPLs) from bank balance sheets has substantially reduced their financial risk, even if those NPLs have not all been resolved.²

The alternative assessment is more skeptical, highlighting the depth of reforms and bank restructuring that remain. Nicholas Lardy has emphasized, as have others more recently,³ that, in China as elsewhere, an efficient banking system is essential to the efficient allocation of capital and the transmission of monetary policy, and it is closely tied to capital account convertibility and other economic objectives. The gradual pace of reform in China, particularly of the government's involvement in bank ownership and decisionmaking, postpones the day when such a system arrives. This choice of continued public sector involvement reflects a basic trade-off between, on the one hand, greater efficiency in state-owned institutions, of which the banks are an important part, and, on the other, stable employment growth and, more recently, rural-urban and regional equality.

The Chinese authorities seek rapid economic growth and employment creation sufficient to absorb the country's surplus labor force, which consists of new entrants, rural-urban migrants, and those laid off from money-losing state-owned enterprises (SOEs). In the past two decades, the banks have been enlisted to support the SOEs as well as to finance infrastructure investments and export platforms through policy lending (lending based on policy objectives or political criteria and connections rather than creditworthiness). Addressing the growing rural-urban and regional inequality is the centerpiece of China's 11th Five Year Program, approved by the National People's Congress in early 2006. The program seeks more balanced urban and rural development by improving public services in the rural areas and by increasing urbanization.

We are skeptics on the issue of gradual banking reform. It is not uncommon for former command economies to undertake reform gradually in order to prevent widespread unemployment. As this paper will show, however, the dependence of China's government-affiliated firms on the state-owned banks for their working capital means that the banks are forced to satisfy contradictory objectives: financing employment and social stability while transforming themselves into commercially viable corporate entities. Further, we argue, the Chinese government is proceeding in a way that ignores this contradiction.

The impact of continued government ownership of the banks is apparent in current institutional arrangements. Just as China's high average growth rates conceal large disparities between the three large coastal urban agglomerations—around Beijing, the Yangtze River Delta (Shanghai), and the Pearl River Delta (Hong Kong, Guangdong, Shenzen)—and the rest of the country, the banking system remains fragmented and often dominated by still-independent local branches and decisionmakers, whose objectives may differ from those of the Beijing headquarters.⁴ We provide aggregate data and bank-level statistical evidence showing that inefficiencies persist in lending by China's largest banks.

The available evidence persuades us that government influences, intentional and unintentional, will continue to constrain bank reform, with all the performance weaknesses that such influence implies. Eight years ago, Lardy described many of these weaknesses and proposed corrective measures: remove the NPLs (he suggested using a swap of government bonds for...