1999. Consistent with the aggregate evidence from Section Il above and our firm-level evidence below, we find that bank loans are one of the most important financing sources for Hybrid Sector firms Table 2-B breaks down China' s bank loans by borrower types and loan purposes. The overwhelming amount of bank loans goes to manufacturing industries with many SOEs, while the amount of loans made to TVEs, privately- and collectively-owned firms, and joint ventures(the last 3 columns of Table 2-B), which all belong to the Hybrid Sector, is much less. According to an IFC/World Bank report( Gregory et al. 2000), which incorporates data published by the PbOC, loans made to privately owned firms(part of the Hybrid sector) from all banks is less than 1% of total loans made in 1998 with half of these loans from state-owned bank. Researchers have argued that the imbalance between loans made to the State Sector and th Hybrid Sector reflects the governments policies of wealth transfer from the Hybrid Sector to the State Sector via state-owned banks, among other channels. Brandt and Zhu(2000) argue that the employment and investment growth in the inefficient State Sector have been supported by the government in the form of cheap bank credits and money creation(or inflation taxes). With aggregate data between 1979 and 1993, they find that an average of 84% of all new credits from the state banking system is allocated to the State Sector; more than one-third of the loans were polic loans"financed by policy banks and/or the PBOC, which were generally not repaid. However, with decentralized credit allocation, even state-owned banks diverted some credit to the more productive firms from the Hybrid Sector, fueling the increasing gap in productivities and profits in these sectors. To maintain the growth of the State Sector, the government relied more on money creatio to finance the wealth transfer in late 1980s and early 1990s, which contributed to high inflation Insert Table 2-C here Table 2-C presents evidence consistent with the above arguments. Panel a) presents the changes(in percentage)in the overall Consumer Price Index(CPi) and those for urban and rural areas. High inflation was the norm in the early 1990s: for example, in 1989(1994), price levels rose by more than 15%(23%)over that of 1988( 1993); during the late 1990s the government tightened monetary supply to control inflation and as a result, deflation was observed in 1999 and 2002. Panel b)presents nominal interest rates offered by Chinese banks on savings deposits(of both households and enterprises), while rates on loans to enterprises are shown in Panel c). Both sets of rates are set Without detailed breakdowns of different types of loans made to different sectors, we cannot estimate the exact share f total loans made to the three sectors
16 1999. Consistent with the aggregate evidence from Section II above and our firm-level evidence below, we find that bank loans are one of the most important financing sources for Hybrid Sector firms. Table 2-B breaks down China’s bank loans by borrower types and loan purposes. The overwhelming amount of bank loans goes to manufacturing industries with many SOEs, while the amount of loans made to TVEs, privately- and collectively-owned firms, and joint ventures (the last 3 columns of Table 2-B), which all belong to the Hybrid Sector, is much less.7 According to an IFC/World Bank report (Gregory et al. 2000), which incorporates data published by the PBOC, loans made to privately owned firms (part of the Hybrid sector) from all banks is less than 1% of total loans made in 1998 with half of these loans from state-owned banks. Researchers have argued that the imbalance between loans made to the State Sector and the Hybrid Sector reflects the government’s policies of wealth transfer from the Hybrid Sector to the State Sector via state-owned banks, among other channels. Brandt and Zhu (2000) argue that the employment and investment growth in the inefficient State Sector have been supported by the government in the form of cheap bank credits and money creation (or inflation taxes). With aggregate data between 1979 and 1993, they find that an average of 84% of all new credits from the state banking system is allocated to the State Sector; more than one-third of the loans were “policy loans” financed by policy banks and/or the PBOC, which were generally not repaid. However, with decentralized credit allocation, even state-owned banks diverted some credit to the more productive firms from the Hybrid Sector, fueling the increasing gap in productivities and profits in these sectors. To maintain the growth of the State Sector, the government relied more on money creation to finance the wealth transfer in late 1980s and early 1990s, which contributed to high inflation. Insert Table 2-C here. Table 2-C presents evidence consistent with the above arguments. Panel a) presents the changes (in percentage) in the overall Consumer Price Index (CPI) and those for urban and rural areas. High inflation was the norm in the early 1990s: for example, in 1989 (1994), price levels rose by more than 15% (23%) over that of 1988 (1993); during the late 1990s the government tightened monetary supply to control inflation and as a result, deflation was observed in 1999 and 2002. Panel b) presents nominal interest rates offered by Chinese banks on savings deposits (of both households and enterprises), while rates on loans to enterprises are shown in Panel c). Both sets of rates are set 7 Without detailed breakdowns of different types of loans made to different sectors, we cannot estimate the exact share of total loans made to the three sectors
and regulated by the PBOC, while actual rates offered by different types of financial institutions to various types of depositors and borrowers can fluctuate within boundaries set by the Pboc comparison of rates in Panels b)and c)reveals a large gap between the rates on lending(to firms) vS rates on borrowing(bank deposits), which is a source of the government's subsidization of the State Sector Despite the governments policy of"taxing"the Hybrid Sector and subsidizing the State Sector(via the state owned banking system), we find, in Section V I below, that the dominance of the Hybrid Sector over State Sector in terms of employment and investment continued in the late 1990s and into the 2000s. We conclude that alternative financing channels and governance mechanisms support the growth of the Hybrid Sector I.2 The Problem of npls and possible solutions Chinas banking sector is dominated by four large and inefficient, state-owned banks(ICBC BOC, PCBC, ABC). La Porta, Lopez, Shleifer(Lls hereafter, 2002)show that the government owns 99.45% of the 10 largest commercial banks in China in 1995(it was 100%in 1970), and this ownership level is one of the highest in their sample of 92 countries. The de ominance or the 1g Four" banks also implies the degree of competition within the banking sector is extremely low Table 2-D, based on Demirguc-Kunt and Levine(2001), compares the five-bank concentration (share of the assets of the five largest banks in total banking assets) in China, Japan, South Korea and Taiwan. At the end of 1997(and for much of 1990s), China's concentration ratio of 91% is by far the highest. However, China's concentration ratio has been falling sharply since 1997 with the entrance of many non-state banks and intermediaries Insert table 2-D here The most glaring problem for China's banking sector, and for the entire financial system in the near future, is the amount of NPLs within state-owned banks, and in particular, among the"Bi Four"banks. Reducing the amount of NPLs to normal levels is the most important task for Chinas financial system in the short term. The main obstacle when we analyze the severity and possible solutions of the NPls is the lack of comprehensive and objective data on banks' profitability (aggregate and bank-level)and NPLs. The scarcity and deficiency in bank data can be viewed as a strategic disclosure decision of the government, which fuels speculation that the problem of NPls Moreover, the llS result on the negative relationship between government ownership of banks and the growth of a countrys economy seems to apply to Chinas State Sector and the status quo of its banking sector. However, in Section V, we show that the high government ownership has not slowed down the growth of the Hybrid Sector
17 and regulated by the PBOC, while actual rates offered by different types of financial institutions to various types of depositors and borrowers can fluctuate within boundaries set by the PBOC. A comparison of rates in Panels b) and c) reveals a large gap between the rates on lending (to firms) vs. rates on borrowing (bank deposits), which is a source of the government’s subsidization of the State Sector. Despite the government’s policy of “taxing” the Hybrid Sector and subsidizing the State Sector (via the state owned banking system), we find, in Section V.1 below, that the dominance of the Hybrid Sector over State Sector in terms of employment and investment continued in the late 1990s and into the 2000s. We conclude that alternative financing channels and governance mechanisms support the growth of the Hybrid Sector. III.2 The Problem of NPLs and Possible Solutions China’s banking sector is dominated by four large and inefficient, state-owned banks (ICBC, BOC, PCBC, ABC). La Porta, Lopez, Shleifer (LLS hereafter, 2002) show that the government owns 99.45% of the 10 largest commercial banks in China in 1995 (it was 100% in 1970), and this ownership level is one of the highest in their sample of 92 countries.8 The dominance of the “Big Four” banks also implies the degree of competition within the banking sector is extremely low. Table 2-D, based on Demirgüç-Kunt and Levine (2001), compares the five-bank concentration (share of the assets of the five largest banks in total banking assets) in China, Japan, South Korea, and Taiwan. At the end of 1997 (and for much of 1990s), China’s concentration ratio of 91% is by far the highest. However, China’s concentration ratio has been falling sharply since 1997 with the entrance of many non-state banks and intermediaries. Insert Table 2-D here. The most glaring problem for China’s banking sector, and for the entire financial system in the near future, is the amount of NPLs within state-owned banks, and in particular, among the “Big Four” banks. Reducing the amount of NPLs to normal levels is the most important task for China’s financial system in the short term. The main obstacle when we analyze the severity and possible solutions of the NPLs is the lack of comprehensive and objective data on banks’ profitability (aggregate and bank-level) and NPLs. The scarcity and deficiency in bank data can be viewed as a strategic disclosure decision of the government, which fuels speculation that the problem of NPLs 8 Moreover, the LLS result on the negative relationship between government ownership of banks and the growth of a country’s economy seems to apply to China’s State Sector and the status quo of its banking sector. However, in Section V, we show that the high government ownership has not slowed down the growth of the Hybrid Sector
must be severe. Our main data source is the Asian Banker(an international organization) database on banking systems(including state-owned and non-state owned banks)in major Asian economies, which is based on government and official records. We also include data from non-government sources, including case studies from a particular region or bank. Some of this data paints a much gloomier picture of the NPLs and Chinas state-owned banks than the official data suggests. Since without objective and accurate bank-level data we cannot determine the exact amount of NPLs or evaluate the feasibility and effectiveness of different solutions, we present both an optimistic view and a pessimistic view when discussing these issues nsert Tables 3-A.3-B and 3-C here Tables 3-A and 3-B, based on the Asian Banker database, compare NPLs and banking system profitability in China and other major Asian economies in recent years. First, NPLS, either as a fraction of total new loans made by all banks(including all non-state banks)or as a fraction of GDP in a given year, are the highest in China from 2000-02 (Table 3-A). Notice that the official information on China's NPls first became available in 1998 but the figures in 1998 and 1999 in Table 3-a probably significantly under-estimate the actual size of NPLs in those years. The comparison includes the period during which Asian countries recovered from the 1997 financial crisis, and the period during which the Japanese banking system was disturbed by the prolonged NPL problem. Second, the profitability of China's banking system, measured by the return to equity or assets, is also among the lowest in the same group of countries ( Table 3-B) As bad as the numbers in Tables 3-A and 3-B appear, they may still significantly underestimate the amount of NPls according to the pessimistic view. For example Qiu et al (2000)estimate that the ratio of loan interest paid to state-owned banks over loan interest owed is on average less than 50% in 1999, suggesting that the actual ratio of NPLs over total loans made can be higher than 50% in 1999. The December 1998 issue of Guoyou zichan guanli(Management of State Assets, p 38)states that, as of year-end 1997, bad loans within the entire banking izations(including non-state banks)of Hubei Province amounted to rmb84.5 billion, or 43.69%of all bank loans. These two pieces of evidence suggest that the amount of NPLs(in terms of fraction of GDP or total new loans made)can be twice as large as the figures in the period 1999 2002 reported in Table 3-A. Consistent with this view, Lardy(1998)argues that, if using international standards on bad loans, the existing NPLs within China's state-owned banks as of mid- 1990s would make these banks' total net worth negative. so that the entire network of state banks
18 must be severe. Our main data source is the Asian Banker (an international organization) database on banking systems (including state-owned and non-state owned banks) in major Asian economies, which is based on government and official records. We also include data from non-government sources, including case studies from a particular region or bank. Some of this data paints a much gloomier picture of the NPLs and China’s state-owned banks than the official data suggests. Since without objective and accurate bank-level data we cannot determine the exact amount of NPLs or evaluate the feasibility and effectiveness of different solutions, we present both an optimistic view and a pessimistic view when discussing these issues. Insert Tables 3-A, 3-B, and 3-C here. Tables 3-A and 3-B, based on the Asian Banker database, compare NPLs and banking system profitability in China and other major Asian economies in recent years. First, NPLs, either as a fraction of total new loans made by all banks (including all non-state banks) or as a fraction of GDP in a given year, are the highest in China from 2000-02 (Table 3-A). Notice that the official information on China’s NPLs first became available in 1998, but the figures in 1998 and 1999 in Table 3-A probably significantly under-estimate the actual size of NPLs in those years. The comparison includes the period during which Asian countries recovered from the 1997 financial crisis, and the period during which the Japanese banking system was disturbed by the prolonged NPL problem. Second, the profitability of China’s banking system, measured by the return to equity or assets, is also among the lowest in the same group of countries (Table 3-B). As bad as the numbers in Tables 3-A and 3-B appear, they may still significantly underestimate the amount of NPLs according to the pessimistic view. For example, Qiu et al. (2000) estimate that the ratio of loan interest paid to state-owned banks over loan interest owed is on average less than 50% in 1999, suggesting that the actual ratio of NPLs over total loans made can be higher than 50% in 1999. The December 1998 issue of Guoyou zichan guanli (Management of State Assets, p. 38) states that, “as of year-end 1997, bad loans within the entire banking organizations (including non-state banks) of Hubei Province amounted to RMB84.5 billion, or 43.69% of all bank loans.” These two pieces of evidence suggest that the amount of NPLs (in terms of fraction of GDP or total new loans made) can be twice as large as the figures in the period 1999- 2002 reported in Table 3-A. Consistent with this view, Lardy (1998) argues that, if using international standards on bad loans, the existing NPLs within China’s state-owned banks as of mid- 1990s would make these banks’ total net worth negative, so that the entire network of state banks
would be insolvent In recent years, the Chinese government has taken active measures to reduce the npls and improve the efficiency of the banking sector. First, four state-owned asset management companies (AMCs)were formed with the goal of assuming the NPls(and offering debt-for-equity swaps to the banks)accumulated in each of the" Big Four" state banks and liquidating them. The liquidation process includes asset sales, tranching, securitization, and resale of loans to investors. Table 3-C shows that cash recovery on the bad loans processed of these companies ranges from 7% to 35%in 2001 and 2002, while the asset recovery rate ranges from 12% to 75%. A critical issue that affects the effectiveness of the liquidation process is the relationship among AMCs, banks, and distressed or bankrupt firms: Since both the AMCs and the banks are state-owned, it is not likely that the AMCs would force the banks to cut off (credit) ties with defaulted borrowers (SOEs or former SOEs)as a privately owned bank would do(e.g, Bonin and Huang 2001). Thus, as the old NPls are liquidated, new NPLs from the same borrowers continue to surface Second, state-owned banks have diversified and improved their loan structure by increasing loans made to individual lenders while being more active in risk management and monitoring of loans made to SOEs. For example, the ratio of consumer lending to total loans made for the four state-owned banks increased from 1% in 1998 to 10% in 2002; by end of 2004, 10% of all outstanding bank loans(RMB 2 trillion or $242 billion) was extended to consumers. Mortgages which account for 90% of consumer credit, grew at an annual rate of 115% between 1998 and 2004 (Economist, 04/21/2005). One problem with the massive expansion of consumer credit is that China lacks a national consumer-credit database to spot overstretching debtors, although a pilot system linking seven cities was set up in late 2004. The deficiency in the knowledge and training of credit risk and diligence of loan officers from state-owned banks is another significant factor in credit expansion, which can lead to high default rates and large amount of new NPLs if the growth of the economy and personal income slows down. Accompanying the rapidly expanding automobile industry, the other fast growing category of individual-based loans is car loans, most of which are For example, the Basle Committee for Bank Supervision classifies a loan as"doubtful"or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step is not taken until principal payment is delayed beyond the loan maturity date or the extended due date, and in many cases, until the borrower has declared bankruptcy and/or has gone through liquidation One of the four AMCs, Huarong Asset Management Co., sold tranches of securitized NPLs to a consortium of US investment banks led by Morgan Stanley(and including Lehman Brothers and Salomon Smith Barney) and to a joint venture forged between Goldman Sachs and Rongsheng Asset Management Co. in 2002. These deals were approved by the Chinese government in early 2003(Financial Times, 05/2003)
19 would be insolvent.9 In recent years, the Chinese government has taken active measures to reduce the NPLs and improve the efficiency of the banking sector. First, four state-owned asset management companies (AMCs) were formed with the goal of assuming the NPLs (and offering debt-for-equity swaps to the banks) accumulated in each of the “Big Four” state banks and liquidating them. The liquidation process includes asset sales, tranching, securitization, and resale of loans to investors.10 Table 3-C shows that cash recovery on the bad loans processed of these companies ranges from 7% to 35% in 2001 and 2002, while the asset recovery rate ranges from 12% to 75%. A critical issue that affects the effectiveness of the liquidation process is the relationship among AMCs, banks, and distressed or bankrupt firms: Since both the AMCs and the banks are state-owned, it is not likely that the AMCs would force the banks to cut off (credit) ties with defaulted borrowers (SOEs or former SOEs) as a privately owned bank would do (e.g., Bonin and Huang 2001). Thus, as the old NPLs are liquidated, new NPLs from the same borrowers continue to surface. Second, state-owned banks have diversified and improved their loan structure by increasing loans made to individual lenders while being more active in risk management and monitoring of loans made to SOEs. For example, the ratio of consumer lending to total loans made for the four state-owned banks increased from 1% in 1998 to 10% in 2002; by end of 2004, 10% of all outstanding bank loans (RMB 2 trillion or $242 billion) was extended to consumers. Mortgages, which account for 90% of consumer credit, grew at an annual rate of 115% between 1998 and 2004 (Economist, 04/21/2005). One problem with the massive expansion of consumer credit is that China lacks a national consumer-credit database to spot overstretching debtors, although a pilot system linking seven cities was set up in late 2004. The deficiency in the knowledge and training of credit risk and diligence of loan officers from state-owned banks is another significant factor in credit expansion, which can lead to high default rates and large amount of new NPLs if the growth of the economy and personal income slows down. Accompanying the rapidly expanding automobile industry, the other fast growing category of individual-based loans is car loans, most of which are 9 For example, the Basle Committee for Bank Supervision classifies a loan as “doubtful” or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step is not taken until principal payment is delayed beyond the loan maturity date or the extended due date, and in many cases, until the borrower has declared bankruptcy and/or has gone through liquidation. 10 One of the four AMCs, Huarong Asset Management Co., sold tranches of securitized NPLs to a consortium of US investment banks led by Morgan Stanley (and including Lehman Brothers and Salomon Smith Barney) and to a joint venture forged between Goldman Sachs and Rongsheng Asset Management Co. in 2002. These deals were approved by the Chinese government in early 2003 (Financial Times, 05/2003)
made by state-owned banks. The total balance of all China's individual car loans rocketed from RMB 400 million(US$48.4 million)in 1998 to RMB 200 billion(US$24.2 billion) at end of 2003 and as much as 30% of all car sales were financed by car loans during this period( Financial Times, 05/25/2005). However, the growth in both car sales and loans has slowed down significantly since 2004 in part due to the high default rates. As many as 50% of debtors defaulted on car loans in Shanghai and Beijing, where the largest number of cars is sold and loans are made. There are examples in which loan applications were approved based solely on applicants'description of their personal income without any auditing Barron's, 12/06/2004) The above examples on car loans and consumer credit illustrate the importance of reforming state-owned banks in solving the problems of NPLs and improving the entire banking sector central question in reforming the state-owned banks is the ongoing privatization process. There are two imminent issues. First, more competition in the banking and intermediation sector, including the entrance of more non-state( domestic and foreign) banks and intermediaries, is good for improving the efficiency of both the"Big Four"banks and the entire banking sector. For example Park et al. (2003) find that competition among banks and intermediaries leads to better effort of the banks(especially state-owned banks)and better loan decisions in China s rural areas. Another issue is the governments dual role as regulator and as majority owner. These potentially conflicting roles diminish the effectiveness in each of the two roles that the government intends to carry out. In Section IV below, we argue that the non-tradable government shares in all listed companies should be gradually sold off to ensure that the privatization process is complete. The same procedure should be applied to the privatization process of state- owned banks Only after these banks are (majority)owned by non-government entities and individuals can they unconditionally implement all profit-and efficiency-enhancing measures Third, there has been a boom in the entry and growth of non-state financial intermediaries and this trend is expected to continue with more foreign banks entering the domestic credit markets as a result of China's entrance into the WTO. In Section Ill. 3 below, we provide more evidence on the growth of both non-bank and non-state financial institutions. Fourth, the government has been directly involved in reducing NPLs among state-owned banks by injecting cash into these banks. A large fraction of the NPLs among state-owned banks resulted from poor lending decisions made for SOES, some of which were due to political or other non-economic reasons; thus, it makes sense for A few foreign lenders(e.g, GM and Ford) were recently approved to enter the car loan market by forming joint ventures with Chinese automakers(Financial Times, 05/27/2005)
20 made by state-owned banks.11 The total balance of all China’s individual car loans rocketed from RMB 400 million (US$48.4 million) in 1998 to RMB 200 billion (US$24.2 billion) at end of 2003 and as much as 30% of all car sales were financed by car loans during this period (Financial Times, 05/25/2005). However, the growth in both car sales and loans has slowed down significantly since 2004 in part due to the high default rates. As many as 50% of debtors defaulted on car loans in Shanghai and Beijing, where the largest number of cars is sold and loans are made. There are examples in which loan applications were approved based solely on applicants’ description of their personal income without any auditing (Barron’s, 12/06/2004). The above examples on car loans and consumer credit illustrate the importance of reforming state-owned banks in solving the problems of NPLs and improving the entire banking sector. A central question in reforming the state-owned banks is the ongoing privatization process. There are two imminent issues. First, more competition in the banking and intermediation sector, including the entrance of more non-state (domestic and foreign) banks and intermediaries, is good for improving the efficiency of both the “Big Four” banks and the entire banking sector. For example, Park et al. (2003) find that competition among banks and intermediaries leads to better effort of the banks (especially state-owned banks) and better loan decisions in China’s rural areas. Another issue is the government’s dual role as regulator and as majority owner. These potentially conflicting roles diminish the effectiveness in each of the two roles that the government intends to carry out. In Section IV below, we argue that the non-tradable government shares in all listed companies should be gradually sold off to ensure that the privatization process is complete. The same procedure should be applied to the privatization process of state-owned banks. Only after these banks are (majority) owned by non-government entities and individuals can they unconditionally implement all profit- and efficiency-enhancing measures. Third, there has been a boom in the entry and growth of non-state financial intermediaries, and this trend is expected to continue with more foreign banks entering the domestic credit markets as a result of China’s entrance into the WTO. In Section III.3 below, we provide more evidence on the growth of both non-bank and non-state financial institutions. Fourth, the government has been directly involved in reducing NPLs among state-owned banks by injecting cash into these banks. A large fraction of the NPLs among state-owned banks resulted from poor lending decisions made for SOEs, some of which were due to political or other non-economic reasons; thus, it makes sense for 11 A few foreign lenders (e.g., GM and Ford) were recently approved to enter the car loan market by forming joint ventures with Chinese automakers (Financial Times, 05/27/2005)