1.

Introduction

1.1 The evolution of banking risk management in china

Previously, China adopted the mono-banking system where there

was virtually no need for banking risk management. During then,

every step involving the supply and utilization was predetermined

by the Chinese government. People’s Bank of China (PBC), being the

only bank simply received instructions from the government about

the allocation of the funds.1

However, things took a change when the four specialized banks

namely the Industrial and Commercial Bank of China, the

Agricultural Bank of China, Bank of China and the China

Construction Bank were converted into state-owned commercial

banks in the late 1970s. With the transformation, commercial loans

were being made and this brings the banks to the issue on risk

management.

1.2 Credit and liquidity risk

Therefore, this term paper sets to explore on how banks in China

practices banking risk management. In light of the Central Bank’s

recent aggressive stance in curbing loans, this paper will highlight

on credit risk and liquidity risk. The former is an increasing concern

for the Chinese banks. It should also be noted that the Chinese
1
Risk management
economy is still operating under a relatively conservative banking

climate. The rules and regulations set by the banks are tightly linked

with the government’s policies.

2.1 Time line of Chinese banks curbing loans (2004-2010)

Important Events:

2003: In order to rein in the obviously excessive credit growth, the

PBC raised the required reserve ratio by one pp on September 21,
2003. ICBC set up an industry research center in 2003 to improve its
risk control management.

2004: effective on April 25, 2004 bank reserve ratio was increased
by 0.5% to 7.5%. Chinese firms are financed by banks at a rate of
98 per cent but often fail to pay back their loans, as a result, there
are almost half of the bank’s assets are unpaid, caused half of the
banks insolvent. In 2004, there was US$ 45 billion used to save
China’s second and third largest banks, the Bank of China and the
China Construction Bank. Subsequently, another US$ 100 billion
were used to save the Industrial and Commercial Bank of China and
the Agricultural Bank of China. 2

2006: On April 28, the People's Bank of China (PBOC) raised lending
rates for the first time since October 2004, boosting the one-year
benchmark rate by 27 base points to 5.85 per cent, as part of efforts
to curb the overheating in some sectors such as real estate.

2007: With effect on june 5 2007, the bank reserved ratio is to

increase by 0.5% to 11.5%. Bad-loan ratio fell again in 2007 after
tight credit monitoring.

2008: The reserve ratio was increased by 0.5% to 12% on starting

August 15,2008

Jan 2010: The central bank raised the reserve requirement ratio by
0.5% with effective day on 18 Jan 2010. It's a clear sign that it was
determined to drain excessive liquidity in the market and curb
lending.

Time Line:
Time Change in Directi Notes

2
http://www.asianews.it/news-en/Inflation:-China-raises-bank-reserve-
ratio-to-11-per-cent-9132.html
 reserve ratio on
1987 10% to 12% Up
1988 12% to 13% Up
1998-03- 13% to 8% Down
21
1999-11- 8% to 6% Down
21
2003-09- 6% to 7% Up
21

2004-04- 7% to 7.5% Up
25
2006-07- 7.5% to 8.0% Up
05

2006-08- 8.0% to 8.5% Up

15
2006-11- 8.5% to 9% Up
15
2007-01- 9% to 9.5% Up
15
2007-02- 9.5% to 10% Up
25
2007-04- 10% to 10.5% Up
16
2007-05- 10.5% to 11% Up
15
2007-06- 11% to 11.5% Up
05
2007-08- 11.5% to 12% Up
15
2007-09- 12% to 12.5% Up
25
2007-10- 12.5% to 13% Up
25
2007-11- 13% to 13.5% Up
26
2007-12- 13.5% to 14.5% Up
25
2008-01- 14.5% to 15% Up
25
2008-03- 15% to 15.5% Up
25
2008-04- 15.5% to 16% Up
25
2008-05- 16% to 16.5% Up
20
2008-06- 16.5% to 17% Up an increase of 1%, two steps
15 of operation
2008-06- 17% to 17.5% Up an increase of 1%, two steps
25 of operation
2008-09- 17.5% to 16.5% Down reduction of some financial
25 institutions
2008-10- 16.5% to 16.0% Down 17.5% down to 17.0% (six
15 banks ICBC, etc.)
2008-12- 16.0% to 14.0% Down 17.0% down to 16.0% (six
05 banks ICBC, etc
2008-12- 14.0% to 13.5% Down 16.0% down to 15.5% (six
25 banks ICBC, etc
2010-1-12 15.5% to 16% Up rural credit cooperatives and
other micro-finance institution
2010-2-25 16% to 16.5% Up rural credit cooperatives and
other micro-finance institution

2.1.1. Reasons for ineffective policies

In 2004, there was inflation about 3%, highest among many years.

For example, food prices increased 8.1%, edible oil prices rised by

27.2%, vegetables increased 19.4% and grain up by 10.8%,

according to the National Bureau of Statistics, property investment

was up 34.9 percent in the first quarter of 2003, far outstripping

China's 8 percent GDP growth.3

Furthermore, the major banks in China were suffering from

insolvency problem. About half of the banks’ assets are unpaid, and

an expected amount of US$518 billion (40% of China’s GDP) was

needed to put banks back a sound footing.

As a result, Chinese authorities are trying to contain inflationary

pressures and prevent the speculative and real estate bubble from

bursting because its effects would be devastating.

However, the increase of 1% in the bank reserve ratio has only

affected the economy to a limited extent. As shown in the Statistics

from the Beijing Construction Committee 2005, the house selling

3
http://www.atimes.com/atimes/China/FA06Ad03.html
rate in the first months of the year jumped 18 per cent to 130 per

cent compared to the same period last year.

China’s banking sector is teetering along. Non-performing loans, a

legacy of policy lending by state-owned banks to state-owned

enterprises, are staggering. New loans to those with connections, to

cronies and to those in power have continued. It is also no secret

that publicly recorded non-performing loan figures are severely

understated and it gives one the jitters to think how much is hidden

behind the almighty Chinese “state secrets.” Raised reserve

requirements will not be even close to what is needed to address

banking sector dilemmas.

Regulations intended to strengthen the supervision of bank lending

and risk management took effect on Feb. 1, 2004.4

2.1.2 Methods of curbing loans: Raising interest rates v.s

increasing loan reserve requirement. (which method is the

Chinese banks using & why?)

China's economy, currently right in the transition period, is not

comparable to command or developed market economy. The

macroeconomic development poses challenges to monetary policy. In this

connection, the Chinese Government can only utilize various monetary

policy instruments in a flexible manner, in order to reach the monetary

policy targets. At present, the major monetary policy instruments include:

4
http://english.epochtimes.com/news/4-8-4/22730.html
open market operation, reserve requirement, interest rate policy, re-

lending and rediscount, and credit policy.

i) Sterilize Excessive Forex Position Through Open Market

Operation While Maintaining Sufficient Liquidity in the Market

Over the past two years, China's foreign exchange reserve has
grown fast, leading to substantial increase in base money injection
as a result of Forex purchase. In line with the overall money and
credit plan, the People's Bank of China (PBC) has maintained the
stable growth of base money through open market operation.

ii) Use Reserve Requirement Policy in a Flexile Way to Lower the

Cost of Currency Withdraw and Improve the Operation of
commercial banks.

In order to rein in the obviously excessive credit growth, the PBC

raised the required reserve ratio by 1% on September 21, 2003.
Traditional Money and Banking theories regard required reserve
ratio hike as a relatively drastic measure, nevertheless the central
bank interpreted it as a mild move.

The differentiated required reserve ratio scheme is both a

transitional policy in line with China's current financial system, and
an innovation based on the original purpose of required reserve
ratio policy, i.e. to ensure the payment and settlement of
commercial banks, and to prevent over-lending by financial
institutions attracted to favorable loan terms which may undermine
their liquidity and payment capacity. The required reserve ratio
policy then gradually evolved into a monetary policy instrument,
and the deposit insurance regime combined with supervision on
capital adequacy ratio started to replace it as policy tools to impose
prompt corrective actions on financial institutions based on different
risk profiles. Given the fact that China has yet to establish deposit
insurance system, and quite a number of financial institutions failed
to reach the 8% capital adequacy ratio, the differentiated required
reserve ratio scheme is conducive to curb excessive credit
expansion of the financial institutions with low capital adequacy
ratio and poor asset quality, and to prevent the one-size-fits-all
approach in macro financial adjustment and regulation.

iii) Utilize Other Monetary Policy Instruments

At the same time, the PBC can strengthen credit management by

curbing loans to over-invested industries, and keeping the
proportion of medium and long term loans at reasonable level. The
PBC will also endeavor to adjust loan structure, urge financial
institutions to implement credit policy, promote financial ecological
development, enhance re-lending and rediscount management,
continue to improve financial service to rural economy, and further
promote inter-bank market development.

The reason why Chinese government has a better interest in raising

the reserve ratio is, as mentioned earlier, easier to implement and
have less negative effect on the economy, both domestically and
globally.

2.2 Current situation in China

2.2.1 Excess liquidity and risk of overheating in China economy

i) Foreign reserve accumulation

National Bureau Statistics of China showed that there has been a boom in

China’s reserve accumulation from the early 2000s till present, as shown

by the diagram below. This could be driven by China’s monetary policy to

maintain an (adjustable) pegged exchange rate.5 Besides that, China has a

large amount of current account surpluses, steady inflows of foreign direct

5
Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: Capital
Inflows and Monetary Policy in China. Journal of Asian Economics,20,205-
224.
investments and very large portfolio capital inflows.

Sources: National Bureau of Statistics

ii) Inflow of ‘hot money’ into china’s economy

We interpret these non-FDI capital inflows, as “hot money” that could

potentially switch direction within a short horizon.6 All the subcomponents

of China’s non-FDI capital inflows move in similar cyclical swing. These

swings in “hot money” suggest that China’s capital inflows are sensitive to

market considerations, changes in interest rates and can be highly

speculative. This speculative capital inflow is believed to have caused

6
This interpretation is standard in the literature(Prasad &Wei,2005b).
inflation, driven up stock prices, and helped to create a worrisome real

estate market bubble.7However, the upside to inflow of speculative funds

is that it makes the market more effervescent, stimulating the demand for

stock shares and property, which in turns drive up the prices as well. Hot

money creates enormous volatility in the financial markets due to it large

size and its short term nature of investing. Instead of moving with changes

in the financial fundamentals of companies, stock prices are moved by

liquidity shock stemmed from hot money. 8 According to Martin and

Morrison (2008), speculators have been using various ways to circumvent

Chinese Laws and regulations. More than 50% of speculative funds or

capital flow into China take the form of over-reported or forged FDI.

Sources: National Bureau of Statistics.

The increase in reserve accumulation could lead to several monetary

implications. The increase in liquidity may lead to economic overheating

7
Zhang, G., & Fung, H. G. (2006). On the imbalance between the real
estate market and the stock markets in China. The Chinese Economy, 39,
26−39.
8
Guo, F., & Huang, Y. S., Does “hot money” drive China's real estate and
stock markets? International
and inflationary pressures.9 It also depends on the domestic banking

system’s ability to intermediate and manage the extra liquidity.

The Chinese Government could sell Government bonds to soak up liquidity

through open market operations to soak up excess liquidity. However,

central banks must be able offer higher yields to convince domestic firms

to hold them.10 Besides that, the government could also tighten bank

reserve and lending requirements (loan limits) to decouple the link

between reserve money growth and broad money growth.11 Broad money

growth is linked to spending growth and inflation. In mid-2006, the PBC

began to rely less on bond issuance and more on reserve requirement

increase and greater window guidance to control excess liquidity and keep

9
Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: Capital
Inflows and Monetary Policy in China. Journal of Asian Economics,20,205-
224.
10
Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: Capital
Inflows and Monetary Policy in China. Journal of Asian Economics,20,205-
224.
11
Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: Capital
Inflows and Monetary Policy in China. Journal of Asian Economics,20,205-
224.
the broader money aggregates in control.

Source: National Bureau of Statistics

China has high saving rates, both household and firms, which lead to a

vast flow of liquidity into the banking system, as savers have lesser

alternative investment opportunities (until stock market reform in 2005).12

As shown in the figure above, the increase in reserve requirements lead to

a decrease in M2-reserve requirement multiplier.

2.2.2 Exposure to Credit risk in property market

12
Prasad,E.(2007,October) Monetary policy independence, the currency
regime, and the capital account in China. Paper presented at the
Conference on China’s Exchange Rate Policy. Peterson Institute of
International Economics.
2.2.2.1 Credit surge

Chinese banks are experiencing a credit surge as new loans extended in

2009 more than doubled from 2008. The total new loans made increased

from 4.9 trillion yuan in 2008 to a record-breaking 9.59 trillion yuan in

2009.13 Figure 1 compares the volume of new loans between 2008 and

2009 for the first 5 months of the year.14

Figure 1
2008 2009 Increase
New loans from 2008 to
2009
January 804 1,600 99%
February 243 1,100 352%
March 286 1,900 564%
April 464 591 28%
May 319 665 108%

The main reason behind the credit surge is low interest rates which

promoted easy credit.

2.2.2.2 Property market boom

What is most worrying out of the credit surge is the area that the funds

are channeled into. In a speech given by Wang Zhaoxing, vice-chairman of

the China Bank Regulatory Commission, he mentioned that about 20% of

all loans made by Chinese banks are now flowing into the property
15
market. The central bank revealed that individual mortgage loans in the

first three quarters of 2009 totaled 925 billion yuan, almost quadrupling

the amount given out in the same period in 2008. 16

13
http://www.marketwatch.com/story/china-targets-11-trillion-in-new-
loans-in-2010-2010-01-19
14
http://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn
%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-
%E2%80%9Cgreen-shoots%E2%80%9D/
15
http://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9U
16
http://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9U
With record new loans extended, it has boosted property buying for home

ownership and also possibly for the less desirable purpose, property

speculation. Consequently, property sales jumped in conjunction with a

hike in property prices. It is reported that in 2009, property sales surged

by 75.5% to 4.4 trillion yuan, especially in eastern cities of Zhejiang and

17
Shanghai. Standard Chartered Bank also calculated that land prices

have soared by 106% in 2009.18 Figure 2 shows that average property

prices (new and second hand houses) is on an increasing trend, with the
19
9.5% rise recorded in Jan 2010 being the highest increase in 21 months.

Figure 2

The housing price appreciation phenomenon is taking place in all parts of

China. Goldman Sachs reported that over the past six years, the surge in
property prices had exceeded the growth of income by 30 % point in
Shanghai and 80 % points in Beijing. In Beijing, it is estimated that on
average, a resident needs to fork out 7 months of his salary to afford per

17
http://www.bloomberg.com/apps/news?
pid=20601089&sid=atGjFThc4UvM
18
http://www.dailyfinance.com/story/investing/chinas-call-to-cool-off-lending-
gives-investors-a-chill/19355813/?icid=sphere_blogsmith_inpage_dailyfinance
19
http://www.chinadaily.com.cn/bizchina/2010-
02/11/content_9462315.htm
 20
square meter of the house. In shanghai, prices of second-hand
properties experienced an annual increase of 41%, up to 14,700 yuan per
square meter average in December. For new properties, there is a 65%
annual surge in prices to an average of 20,187 yuan per square meter in
December.21

Similarly, property market boom is taking place even in the poor cities of

China. In the comparatively less prosperous Xinyang, property prices

appreciated by 10% over 2009 and this figure is far more than the

country’s benchmark deposit rate of 2.25.

2.2.2.3 Possible growth of asset bubble

The question now remains whether an asset bubble is forming in the

property market or has it already been developed. Excessive property

speculation has fuelled the property boom. To make things worse, large

portion of funds lent to industries like manufacturing have been indirectly

channelled into the property market. It will be disastrous if China follows

America’s footsteps in the subprime mortgage crisis. If China’s property

market is indeed experiencing a bubble, its burst will deflate housing

prices greatly and hurt the banks with unpaid loans. Therefore, it is

imperative for the Chinese banks to manage the high credit risk

associated with the lending binge.

2.2.3 Exposure to Credit risk in stocks market

2.2.3.1 Commodity speculation

Apart from the property sector, the credit surge is taking effect in China’s

commodity market. With easy credit, speculative investments are

undertaken in the commodities market. Since March 2009, commodities

20
http://news.xinhuanet.com/english/2009-12/27/content_12711265.htm
21
http://www.china.org.cn/business/2010-02/03/content_19360939.htm
prices have surged and the Reuters-Jefferies CRB Index has increased by

nearly one-third

When extending loans for commodity purchases, it is the practice of

Chinese banks to permit the usage of underlying commodities collateral.

Similar to property lending, the loans are structured like mortgages. Since

commodity prices are much more unstable than housing prices, the

increase in speculative commodity trading exposes the banks to high

22
credit risks.

2.2.4 Exposure to liquidity risk

With the surge in lending, the banks may be sowing seeds for future

liquidity risks. High volume of funds is being channeled out of the banks

and hence, there may be insufficient funds left to respond to payment of

debs due. Furthermore, the house and commodity mortgage loans have

poor liquidity. Liquidity risk management is especially pertinent in the face

of the current global financial crisis.

2.2.5 Non-Performing Loans (NPLs) in China

2.2.5.1 Overall outlook on NPLs

The lending spree coupled with the slowing of global economy may have

set a hotbed for the increase in NPLs. Plunging enterprise profits may lead
23
corporate firms to default on their loans. It is estimated that for every 1

% point slow down in annual economic expansion, the banks’ NPL ratio
24
could increase by 0.99 point.

22
http://english.caijing.com.cn/2009-06-19/110186641.html
23
http://www.domain-b.com/finance/banks/20090522_chinese_banks.html
24
http://uk.reuters.com/article/idUKPEK22500020081205?
pageNumber=1&virtualBrandChannel=0
Despite so, the China Banking Regulatory Commission (CBRC) reported

that the NPL of Chinese commercial banks dipped by 62.89 billion yuan to

497.33 yuan in 2009. The NPL ratio also decreased by 0.84 % point to
25
reach 1.58 % point. However, these figures may not necessarily indicate

an improvement of the bank’s balance sheet as new loans are used to

displace delinquent commitments.

Moreover, Chinese banks are now conducting off balance sheet activities
26
like repackaging of loans to hide bad loans off their balance sheets. The

issue of NPLs may also not be evident yet as fresh loans haven’t gone bad.

The prevalence of bullet-oriented payment structure also indicates that

any default with new lending will not surface until the loan is due.

Therefore, the lending spree may have sown seeds for future NPLs which

are not yet visible.

2.2.5.2 NPL in property market

In particular, there is increasing risk of NPL associated with property loans

in Shanghai. In a statement released, Yan Qingmin, head of the Shanghai

Bureau of the China Banking Regulatory Commission expressed the

concern that the unsettled amount of bad loans on commercial property in

Shanghai escalated in 2009.27 In 2009, banks in Shanghai have offered

163 billion yuan of new loans to the property sector, including mortgages
28
and loans to developers. This figure does not reflect the total risk

exposure of Shanghai banks to real estate debt as loans extended to some

state-owned companies as industrial lending may have been channelled

25
http://www.reuters.com/article/idUSTRE60E31920100115
26
http://www.huffingtonpost.com/james-jubak/chinas-banks-copy-
citigro_b_402398.html
27
http://www.china.org.cn/business/2010-02/03/content_19360939.htm
28
http://www.thefreelibrary.com/China+:+Shanghai+Bad-
Loan+Ratio+Would+Triple+With+10%25+Home+Price+Drop.-
a0218430467
into the property market. Moreover, Chinese bank regulators have

calculated that if housing prices fall by 10% in Shanghai, it will multiply

the ratio of delinquent mortgages by three times and a 30% drop will
29
result in a five-fold increase.

In Beijing, empty office buildings are sprouting across the capital of China.

This is a result of oversupply of skyscrapers due to the easy credit

extended to land developers.30 Therefore, the banks in Beijing are also

facing a high risk of bad loans. If the property market plunges, it will be

accompanied with an escalation of NPLs.

2.3 Impact of policy

On Jan 20 Chinese banking authorities have asked some main banks to

curb their lending for the rest of the . Meanwhile, for nonstate-owned

lenders like Citi Bank and Everbright Bank, the Central Bank asked them

to increase their reserve requirement ratio by half a percentage point. It is

the first time of China's central bank to raise bank reserve requirements

since June 2008.

The direct cause of this action is the surge of new lending. Chinese banks

doled out a record 9.6 trillion yuan ($1.4 trillion) in new loans last year.

The lending surge, combined with Beijing's 4 trillion yuan stimulus plan

helped kick-start the economy after a late 2008 slump, but aroused fears

of overheating.31 Also, consumer inflation has accelerated significantly in

December. All this has triggered a series of intensifying policy by Central

29
http://www.123jump.com/market-update/China-Regulators-Worry-Bad-
Debts;-Lenovo-Profit/36412/
30
http://www.bloomberg.com/apps/news?
pid=20601109&sid=a6i2PSZD.Jr4&pos=11
31
http://www.asiaone.com/Business/News/Story/A1Story20100120-
193196.html
Bank to rid the financial system of excess cash that can fuel inflation and

asset bubbles.

Regulators, worried about potential inflation, asset bubbles and bad loans,

feel they must set limits on total credit growth, but by doing so they

create incentives for banks to churn out loans quickly to gain as much of

the industry quota as possible.

2.3.1 Positive impacts

China's banking system is healthy despite last year's explosive growth in

credit. So the authorities controlled the growth in credit with the

instruction of curbing loans.

Regulators were paying special attention to loans for local government

projects and real estate. All banks have been ordered to "heighten their

vigilance against an impossible, embedded credit risk," Liu said. New

leverage and liquidity restrictions would be imposed, he added.

This action has not changed the government's stance of a tight credit but

a loose monetary policy, nor has it changed the prospects or the expected

the timing of hikes of the central bank's benchmark deposit and lending

rates. It helps the Central bank continue to control the pace and amount of

credit supply.

And the decision to raise the proportion of deposits that banks must hold

in reserve is a small first step toward reducing the massive stimulus

provided to its economy. The Chinese authorities were acting

preemptively to handle with the increasing risk of a bubble in the property

market and inflation.

Just last week, China raised its capital reserve requirement for banks for

the first time since June 2008 in an effort to drain excess cash from the

financial system. Earlier in the month, the central bank raised the interest

rate on its three-month bills for the first time since August 13 and has

been jacking up the rates on short-term bills to absorb liquidity.

The reality is that liquidity remains very ample in the Chinese banking

system; and credit has to remain strong in China this year to finish the on-

going projects.32 By moving now to tighten loose lending and deal with

other negative side effects of an aggressive fiscal and monetary policy

adopted during the global crisis, the central bank has achieved the goal of

control the problem with inflation and property bubble.

2.3.2 Negative consequences

With the announcement of curbing lending, China stocks drop 2-3 percent,

led by bank shares. Worries over the impact of lending curbs knocked

Shanghai's benchmark index .SSEC down 2.7 percent, weighed on the rest

of Asia-Pacific and hurt the Australian dollar.

Shares of Bank of China and China Construction Bank traded in Hong Kong
33
tumbled 4 percent.

Lending in the first 10 days of 2010 was strong, after domestic media said

that banks dished out 600 billion yuan ($87.9 billion) in new loans in the

first week of the year alone. Some economists estimate banks have

already lent over 1 trillion yuan so far this year. Worries that the Chinese

economic growth engine is about to slow markedly because of tighter

32
http://www.theglobeandmail.com/report-on-business/china-move-forces-
banks-to-curb-lending/article1428847/
33
http://www.asiaone.com/Business/News/Story/A1Story20100120-
193196.html
monetary policy sent shudders through global stock, commodity and

currency markets. The currencies most linked to commodities trade – the

Canadian, Australian and New Zealand dollars – all took an immediate hit,

as oil, gold and copper fell. And stocks suffered losses, as fears mounted

that the 10-month rally could come unglued. U.S. Treasuries climbed,

thanks to their appeal as a safe haven.

Losses were heaviest in Hong Kong and mainland China while benchmarks

in other markets fell about 1.5 percent or less. Oil dropped to near $80 a

barrel while the dollar was slightly higher against the yen and a tad lower

versus the euro.

Regulators announced this month an increase in the share of deposits

banks must hold on reserve, but most of the latest measures haven't been

publicly disclosed, and they bear little resemblance to how monetary

policy typically is conducted in other economies. Shanghai's benchmark

stock index has fallen 9% so far this year, and concerns about credit policy

have roiled markets from Hong Kong to New York.

The news pushed the dollar higher, and oil and gold lower. That in turn hit

the euro, which was already under pressure from controversy surrounding

deficits and public finances in Greece, and a report on Tuesday showing a

bigger-than-expected decline in German investor sentiment.

2.3.3. Access to credit for SOEs and SMEs

China's state-owned banks have never been the best allocators of

credit. As an extension of the state, these banks favor loans for

state-owned enterprises (SOEs) over small and medium enterprises

(SMEs). In the first half of 2009, China’s state-owned banks have

granted SOEs 84 percent of total bank loans, even though they only

contribute 45 percent of GDP and employ merely 25 percent of the

labour force.34 By funding more overcapacity, banks are throwing

good money after bad — large industrial enterprises in China

already have an average debt ratio of as much as 60 percent.

Large firms are so flush with credit that they have started punting on

stocks and properties, while China’s small enterprises are so short of

credit that they pay double the legal lending rate for unofficial loans which

are usually obtained from the underground lenders.

In late November 2007, the People’s Bank of China (PBC), which is the

central bank, orally requested all banks with RMB licences to curb their

RMB lending over the long term to cool the economy and control inflation.

These measures unnecessarily damage economic activities and have a

disproportionate effect on SMEs because they do not rely on a large pool

of liquid assets and thus, their short term solvency largely depends on

bank loans. Moreover, the tightening of lending restrictions in 2010 may

likely have more impact on the credit liquidity of SMEs. The new loan

curbing policy has capped a monthly ceiling of 900 billion yuan, although

the total credit supply is still believed to be sufficient, loans flowing to the

private sector may reduce and private enterprises could be the first to feel

the pinch.35

34
Wei Gu, Rebalance China’s two financing legs,Reuters,The Great Debate, JULY30,2009.
HTTP://BLOGS.REUTERS.COM/GREAT-DEBATE/2009/07/30/REBALANCE-CHINAS-TWO-
FINANCING-LEGS/
35
By Mao Lijun and Wang Bo (China Daily),Lending caps to reduce liquidity,2010-01-21
09:14

http://www.chinadaily.com.cn/bizchina/2010-01/21/content_9354045.htm
Limiting loans for SOEs and SMEs, however, may also force the less

productive SOEs to improve their operations to continue to attract finance,

or else they will have to face the risk of shutting down. Financial analysts

and economists of China believed that over the next five years, this

dynamic would go a long way to closing the productivity gap between

SOEs and SMEs, raising GDP by as much as 13%, or $259 billion

annually.36

While controlling lending to both SMEs and SOEs also forces the central

bank of China to maintain a reasonable and balanced pace. For example,

more restrictions has been applied to industries with overcapacity and

high pollution, ICBC said it would continue to offer finance to ongoing

government-backed projects, environmentally, friendly emerging

industries, small- and medium-sized enterprises, and for consumer

37
spending.

2.4. Curbing loans policy in the 1990s

China’s banking sector is dominated by four large multi-purposes,

extensively branched, state-owned banks (SOBs) that account for more

36
Wei Gu, Rebalance China’s two financing legs,Reuters,The Great Debate, JULY30,2009.
HTTP://BLOGS.REUTERS.COM/GREAT-DEBATE/2009/07/30/REBALANCE-CHINAS-TWO-
FINANCING-LEGS/

37
ICBC to curb property loans, China Economic Net,2010-02-09 08:30,
http://en.ce.cn/subject/chinamarkets/marketpic/201002/09/t20100209_20943553.shtml
than 70% of both credits to enterprises and household deposits. From the

late 1970s to the late 1990s, the financing responsibility for large SOEs

shifted from the fiscal budget to these SOBs. During this period, fiscal

revenues to GDP fell from 30% to 12% while bank loans to GDP increased
38
from 50% to 120%.

2.4.1. The Problem of Un-performing Loans (UPLs)

Between 1980 and 1994, enterprise expenditures on social welfare

increased by six times and, in the mid-1990s, it was roughly half of the

SOEs’ total wage bill (Huang et al 1999). Consequently, the profitability of

SOEs fell sharply and, from 1996, the consolidated state sector became a

net loss-maker. As a result, SOBs were often forced to extend new loans to

illiquid SOEs.

However, the overly optimistic expansion of credit that China experienced

in the early 1990s was an additional source of NPLs. It overheated the

economy and created runaway inflation. Domestic credit grew at the rate

of 30% per year between 1991 and 1995, a rate significantly higher than
39
the average growth rate of 21.3% in the 1980s. During that same period

of time, real estate lending increased rapidly and fueled property

development that was far beyond the limits of the country's demands.

Many of the problem loans that now plague China's banks were created by

the credit boom in the 1990s and by subsequent asset price NPLs are the

survivors of loans to, and assets of, failed SOEs.

38
Michael Geiger , Monetary Policy in China (1994-2004): Targets, Instruments and their Effectiveness,
WürzburgEconomic Papers No. 68, April 2006, Universität Würzburg
http://www.wifak.uni-wuerzburg.de/wilan/wifak/vwl/vwl1/wepdownload/wep68.pdf
39
Non-performing loan resolution in China. (Journal of Real Estate Portfolio Management).
Real Estate Issues,22-SEP-02 , http://goliath.ecnext.com/coms2/gi_0199-2771962/Non-
performing-loan-resolution-in.html
By the mid-1990s, over one-half of SOEs were making losses and about

three-quarters of the loans on the books of these banks were to SOEs.

Many of these loans were classified as non-performing. By 1999, three of

these SOBs would be insolvent, if assets were marked to market, although

all four remain highly liquid because of their dominant share of household

deposits in an economy with a high savings rate and few competing assets

for household portfolios.

2.4.2. The 1990s Reform

In the mid-1990s, the Chinese authorities engaged in a series of reforms

to deal with the bad loans problem culminating in the creation of four

asset management companies (AMCs), one for each bank, to take on

these bad loans.

In 1999, the Chinese authorities established four AMCs as temporary

institutions to deal with bad loans originated before 1996 that totaled 19%

of 1999 GDP. AMCs are charged with both the disposal of assets and the

restructuring of SOEs, with the latter facilitated by debt-equity swaps

approved by State Economic and Trade Commission (SETC). They are

responsible to three government agencies; in addition to the SETC, these

are the Ministry of Finance and the People’s Bank of China (PBC), the

central bank.

In an effort control lending practices, the PBC introduced a credit policy,

which more directly based credit and lending policies on the government's

overall macroeconomic planning. Thus, Chinese lending practices were

driven by, and entwined throughout, the central Chinese government’s

political goals and objectives.

The PBC introduced minimum reserve requirements in the year 1984 in

order to control the financial sectors liquidity. At first, the officials set

different reserve obligations for the different deposits with regard to their

origin and the institution actual holding the reserves. In 1985 the PBC

combined all different reserve requirements and set one minimum reserve

requirement at 10 per cent. But only since 1998 the instrument of the

reserve requirement was more active and in a more westernized sense

used. That year also marks the time when the PBC shift its monetary

policy from direct control to more indirect control and made open market

operations (OMO) the main instrument of its monetary policy.

Since then, the reserve requirement ratio has undergone four major

changes. In March 1998 the ratio was cut from 13 to 8 percent, in

September 1999 it was decreased from 8 to 6 percent and in September

21, 2003 the ratio was adjusted to 7 percent for all financial institutions

except the rural and urban credit cooperatives, which were still subject to

6 percent reserve requirement (cf. Wei, 1999: 145 f.; PBC, 2000; and PBC,

2003c).

The Chinese reserve requirement regime has two particular features: First,

minimum and excess reserves are interest bearing. According to

Schlotthauer (2003), during the 1990s the interest paid on the reserves

was so high that there have been years where the dominant strategy of a

commercial bank was to hold reserves at the central bank instead of

granting a risky loan to an enterprise (Schlotthauer, 2003: 212).

Targeted and real values for domestic loan increases in China, 1998-

2004
 Year Target growth (%) Actual growth (%)
1998 12.7 15.5
1999 15.7 8.3
2000 11.7 6.0
2001 13.1 13.0
2002 11.6 16.9
2003 13.7 21.1
2004 16.4 11.6
Source: Own calculations, based on data from PBC, 2001; PBC, 2003b; PBC, 2004a; PBC Statistics
Database Online; and Xie, 2004a: 2.
Note: Target values are usually published in billion RMB. Using the data of total domestic loan
increases the target is converted into a percentage growth target.

Although the 1990s saw many reform efforts, mechanisms to control risk

have not yet been created since the central bank's 'window guidance'

continues to be the major reason behind lending institutions' decisions.

There continues to be political pressure from the PBC to expand loans

during stagnant economic conditions. These growth-oriented lending

practices create poor performing loans.40

40
Miriam (Penny) Milsom, Monetary Policy in China, January 13, 2003,

http://www.sixsmart.com/SSPapers/pmw8.htm