Chinaâ€™s Banking Transformation: The Untold Story

China’s Banking Transformation

1

China’s Banking TransformationTHE UNTOLD STORY

James Stent

1

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Library of Congress Cataloging-in-Publication DataNames: Stent, James, author.Title: China’s banking transformation : the untold story / James Stent.Description: New York, NY : Oxford University Press, [2017]Identifiers: LCCN 2016017268 | ISBN 9780190497033 (hardcover) | ISBN 9780190497057 (epub)Subjects: LCSH: Banks and banking—China. | Financial institutions—Government policy—China. | Finance—Government policy—China.Classification: LCC HG3334.S74 2017 | DDC 332.10951—dc23 LC record available at https://lccn.loc.gov/2016017268

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Contents

Preface viiAbbreviations xv

1. China’s Hybrid Banks 1

2. Culture Matters 25

3. Leninism and Pragmatism of China’s Communist Party 39

4. Transformation: From Bursars to Bankers 64

5. Bankers 100

6. Systems 123

7. Power of the State 150

8. Financial Structure: Deep but Narrow 166

9. Coming In and Going Out 189

10. China’s Banks, Sui Generis? 204

11. Collapsing or Adapting? 222

12. Reform Directions 243

13. Conclusion 255

Works Cited 267Index 273

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Preface

In the course of my three years of service as an independent director on the board of China Minsheng Bank, and ten years at China Everbright Bank— in total thirteen years spanning 2003 through 2016— I watched China’s banks transform from damaged relics of the planned economy into modern commercial banks. Although much further development is needed in the Chinese broader financial system, the change in the qual-ity of Chinese banks that I watched over those thirteen years can only be described as a “night and day” transformation.

Yet most accounts in the media, in financial analysis, and even in much academic work give little recognition to what has been achieved in the Chinese banking sector over recent years. Indeed, much of the literature, popular and specialized, is highly skeptical of the Chinese banking sector. The widespread acceptance of this negative view has led to writing this book in order to provide a different, and more balanced, perspective than is found in the consensus negative view.

My involvement with Chinese banking began on a summer morning in 2003, when I walked into a reception room of the head office of the China Minsheng Bank for a meeting with the bank’s founder and chairman, Jing Shuping. Since its founding in 1996, Minsheng had maintained its head office in a venerable building on Zhengyi Road, just east of Tiananmen Square in the former Legation Quarter. Unlike much of Beijing, which has been extensively rebuilt, the former Legation Quarter around Zhengyi Road, including the Minsheng Bank head office, had remained architecturally intact. The well- preserved building was constructed in 1910 as the Beijing branch of the Yokohama Specie Bank. Architecturally it

viii Preface

is an Asian transplant of late nineteenth- century brick and stone Dutch architecture in vogue among Japanese at that time.1

China’s ongoing reforms had recently mandated modern corporate governance practice in listed companies such as Minsheng Bank. Under the new requirements, Minsheng’s board should include four independent directors. Jing Shuping had selected three Chinese professionals to be independent directors, but he also wanted to identify a foreigner with both banking experience and Chinese language ability to serve as the fourth independent director. Consultation with, the International Finance Corporation, a World Bank affiliate, which was advising Minsheng at that time, led to the suggestion that I might be a candidate.

An inner door of the ornate century- old reception room opened, through which walked Chairman Jing, dapper in well- tailored suit and tie, but walking slowly at the age of 83. Slight of frame and frail in appearance, he nonetheless exuded warmth, energy, charm, and a piercing intelligence. Born into a Shanghai capitalist family, he had assisted his father prior to 1949 in running the family’s manufacturing busi-ness, and was one of the capitalists who had chosen to stay in China after the civil war ended. The Cultural Revolution years were not kind to him, but he had endured and gone on to become one of the most respected and senior non- communist party figures in China during the ’80s and ’90s, serving as vice chairman of the People’s Consultative Congress and as chairman of the All- China Federation of Industry and Commerce. Through these positions, he developed a broad network of contacts in the emerging Chinese entrepreneurial world. Jing and several other leading entrepre-neurs in the All- China Federation proposed to the then- Deputy Prime Minister Zhu Rongji that a new commercial bank be established, to be owned entirely by private businessmen. Zhu backed the idea, and the Minsheng Bank was established in 1996, with Jing as chairman of the board, and shareholders who ranked among the wealthi-est of China’s new capitalists.

Our conversation ranged for half an hour across a variety of subjects, touching on cul-ture, travel, and of course banking. Chairman Jing indicated that I would be nominated as an independent director at the forthcoming annual general meeting of the bank’s shareholders, and thus began the Chinese portion of my banking career.

The circuitous path that had led me to that interview with Chairman Jing had begun in 1973, when I joined Citibank of New York as a junior officer in its Asian Division. After brief training in head office, I spent four years in Citibank’s Philippine and Hong Kong branches. In Hong Kong I transferred to Crocker National Bank of San Francisco, which assigned me first to Hong Kong, and then to Thailand, where I lived and worked from 1979 through 2002, and again from 2007 to the present time.

Those eight years during the 1970s working in American banks comprised the first stage of my banking career. It was in those two banks that I absorbed the conservative

1 Li Luke and Hu Jiezhong, eds., Beijing Gujianzhu Ditu (Beijing: Tsinghua University Press, 2009), 204– 205.

Preface ix

tenets of an earlier era of banking practice. Those were the last years of the highly regu-lated era of banking that had been the norm in America since the New Deal reforms of the 1930s. Banking was a stodgy career choice. Yet the American banking system was then relatively stable and the postwar economy was going through a golden era of prosperity.

In those days at Citibank new recruits underwent intensive training in the basics of the profession. We rotated through every department in our training. From the tellers we learned out how to pay out and receive cash and how to balance ledgers at the end of the day, from the foreign department clerks we learned the intricacies of negotiating letters of credit, and so forth. The emphasis was on controlling risk, and on doing things properly. The bank’s thick accounting and procedure manual was our bible. I was imbued with the craft of banking, with the precepts of risk control, and with a strong sense of protecting the interests of the depositors and of the bank. Most of what I know and believe to be important about banking, I learned in those early years of my career.

That was the style of banking that had stood America in good stead during the first three prosperous postwar decades. But change was afoot, the Reagan revolution started in 1981, and the rational markets theories of economics gained broad support, providing the intellectual rationale for sweeping deregulation over the next twenty years. The culture and style of Citibank of today is far different from the Citibank for which I had worked.

At just that time, when the banking world was changing, I left Crocker and American banking to join a small, privately owned Thai bank, the Bank of Asia. I was to spend eigh-teen years with Bank of Asia, during most of which time I was its only foreign employee. The youthful CEO, Yos Euarchukiati, scion of the Sino- Thai family that was the domi-nant shareholder of the bank, realized that the days of old- fashioned overseas Chinese style banking would soon be over in Thailand. The bank would need to professionalize to meet the challenges of the rapidly developing economy of Thailand. First under Yos, and then under his successor Chulakorn Singhakowin, I worked as part of a team of Thai professionals to change Bank of Asia from a traditional into a modern bank.

My stints with the two American banks had provided me with the fundamentals of the craft of banking as it had been practiced in America prior to the deregulation era. The succeeding years with the Thai bank gave me an opportunity to work inside an Asian financial institution in a developing country, tasked to introduce international best prac-tice and bring about organizational change in a local bank. One of the lessons I learned at Bank of Asia was that change must be sequenced, that “big bangs” within an Asian organization were a likely road to failure. Another lesson was the importance of change management— ensuring that all stakeholders in the organization are fully supportive of the change agenda, and that their interests have been given due respect. If all stakeholders were not “with the program,” those left out could all too easily subvert the change agenda. I learned to be patient with a pace of change that might seem unnecessarily slow, but which in the end would prove a reliable path to reaching our objectives. Those lessons in organizational change at the micro level would provide me with insights into understand-ing how the reform program worked in China at a national level.

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The years of modernizing and professionalizing the bank paid off. The Bank of Asia survived the systemic meltdown of the Thai economy during the Asian financial crisis of 1997— the bank’s sound management attracting a large capital infusion from ABN AMRO Bank of the Netherlands. From the crisis itself, and from the painful but quick recovery over the next five years, I learned not only about sustainable banking, but also about mac-roeconomic policy pitfalls in developing countries— real estate and stock exchange bub-bles, ill- advised monetary and foreign exchange policies, and the hubris that accompanies rapid economic growth, leaving a country vulnerable to unanticipated shocks.

In 2002 I retired from Bank of Asia, moved to Beijing, and worked on several projects there, including service on the board of Minsheng Bank. I developed the highest respect for Chairman Jing Shuping. Despite his advanced years, and despite having been cut off from the West for thirty years, Jing was keenly aware of international economic and financial currents, was extraordinarily progressive, and immediately grasped new con-cepts presented to him. The strong growth of the bank in those early years owed much to his leadership and vision.

Shortly after completion of my three- year term as an independent director of Minsheng Bank, I accepted an offer to be an independent director of China Everbright Bank. Both Minsheng and Everbright are listed on the Shanghai Securities Exchange, but Minsheng shares are almost entirely in the hands of private shareholders, whereas, following a recap-italization mandated by the State Council in 2007, the state, through several vehicles, is the majority shareholder of Everbright Bank.

I served two terms (the maximum allowed by governance regulations) of three years each as an independent director of Everbright Bank, starting in 2006 and finishing in 2012. During most of that period, I chaired the Board’s Audit Committee, and was also a member of the Risk, Strategy, Nominations, and Compensation Committees. The full board met at least five or six times each year. Committee meetings were held immediately prior to the full board meetings, altogether lasting two or three days. After the completion of my two terms as an independent director, I was elected one of two outside members of the bank’s board of supervisors, where I served until the completion of my term in 2016.

Widespread skepticism about Chinese bank quality prevails among both analysts and the general public. I acknowledge that my view that there has been a “night- and- day” transformation of Chinese banks since the 1990s is contrary to the impression conveyed by most foreign media accounts— which generally describe Chinese banks as fragile and inefficient, perhaps headed for crisis. This view has now become widely accepted outside of China. I find these views ill- informed, misleading, and perhaps imbued with a bias, sometimes conscious but generally unconscious, against a system that is avowedly “social-ist” at a time when adherents of neoliberalism and market capitalism are intolerant of alternative models.

I felt the need for a corrective to the prevailing gloomy and censorious view, so in 2012 I began the research and writing of this book on the banking transformation to which I had been privileged to be a front- line witness. In the wake of the financial

Preface xi

collapse of 2008, the published academic analyses and popular accounts of the failures of banks in America and the United Kingdom have been of high quality and insightful. Collected together, they would fill several bookshelves. Curiously, although journal-ists and investment analysts have written frequently on day- to- day developments and problems in Chinese banking, only a handful of books, think tank specialist surveys, consultant and rating agency publications, chapters in larger overall studies on China’s economy, and academic articles have dealt with the development and prospects of Chinese banks, and most of these are not easily accessible to the non- specialist. I hope this book fills that gap.

Unlike more academic treatments, or journalistic accounts, I have not written from the vantage point of an outside observer or researcher. This book is an account of banking told by a professional banker, with the benefit of access within banks and of input from many Chinese and foreign banking practitioners. This book is not, however, intended to be an authoritative or scholarly history of the development of Chinese banking over recent decades. Such a book is much needed, and hopefully will be written.

China is the second largest economy in the world. A banking crisis in China would have enormous impact on China’s economy, and that would rapidly turn into a global economic and financial crisis. Moreover, as China moves beyond Deng Xiaoping’s for-eign policy of “hiding its light” and asserts itself internationally, how China manages the stability of its banking system, how its banks expand overseas, how its financial system becomes more open and integrated with global systems, and what China thinks about global financial architecture take on global importance. It is therefore imperative that anyone concerned with China’s political economy should have a deeper understanding of China’s banking system than perusal of the media provides.

Development of the Chinese banking sector, lying at the heart of the nation’s economy, can serve as a case study for understanding what happens in other sectors of China’s econ-omy, even in non- economic areas. It is my hope not only that readers will take away from this book a clearer picture of Chinese banks, but also that an understanding of the bank-ing sector will provide a prism through which to understand how China as a whole works.

The introductory chapter, “China’s Hybrid Banks” sets forth the overall argument of the book that China’s banks are hybrid creatures, operating in most ways like mod-ern Western banks, but designed to serve the real economy under the guidance of the Communist Party in a market socialist political economy. The hybrid character of Chinese banks combines extensive borrowing of Western banking practice and concepts of corporate governance with traditional Chinese beliefs in how society and the political economy should be ordered. The result is a banking system that has effectively contrib-uted to national economic growth, but which has attracted a plethora of foreign criticism because it does not adhere to conventional Anglo- American concepts of how modern banking systems should run.

China’s banking transformation story would not be comprehensible to non- Chinese readers without explanation of how China’s culture and historical development have

xii Preface

influenced contemporary Chinese banking, and how Chinese banks fit into the broader political economy. Too often misunderstanding of Chinese banking practice and poli-cies stems from viewing the Chinese system through the lens of a non- Chinese, and par-ticularly Anglo- American, ideological framework that does not take sufficient account of the very different culture and political economy in which Chinese banking is embedded. Chapters 2, “Culture Matters,” and 3, “Leninism and Pragmatism: China’s Communist Party,” provide essential background on Chinese culture and political economy to make the main narrative of the banking transformation comprehensible in the broader context of how China works today. They explain how the persistence in contemporary China of Confucian views of how society should be ordered provide the rationale for strong party- state control of the banks. They also explain the “why” and “how” of the Party’s role in Chinese banks, particularly through its powerful Organization Department, which controls senior appointments in the banks.

Chapter 4, “Transformation: From Bursars to Bankers,” provides a chronological nar-rative of the development of Chinese banking over the years since Opening and Reform commenced in 1976. It relates the principal phases of development, the search for a model of banking that would suit China’s needs, and the financial turmoil of the 1990s, which led to recognition of the priority that should be given to development of a healthy bank-ing system and thus to Zhu Rongji’s dramatic reform program to transform banking into a modern system.

Having related how the transformation took place, Chapters 5 and 6 describe Chinese banking as it is today. Chapter 5, “Bankers,” discusses how Chinese banks are managed and governed, the quality of human resources, and the role of the Communist Party in banks. Chapter 6, “Systems,” is a more technical chapter discussing the credit qual-ity and risk management, internal controls and auditing, IT capabilities, strategies and nature of competition of Chinese banks. These two chapters are heavily based on my own understanding of how Chinese banks work arising out of my service on the boards of two banks, corroborated by a large number of Chinese and foreigners with sound knowl-edge of Chinese banking from various different perspectives. What I have written in these chapters has been confirmed by other foreigners and Chinese with firsthand knowledge of Chinese banks.

Chapter 7, “Power of the State,” describes how the state exercises control over the bank-ing system indirectly through its coordination of the resources of the “national balance sheet” and directly through ownership of banks and through the financial regulatory authorities.

The achievements of the government in expanding financial access broadly through society and the economy are contrasted with the underdevelopment of “direct finance”— the bond and equity markets— in Chapter 8, “Financial Structure, Deep but Narrow.” Chapter 9, “Coming In and Going Out,” describes the restricted but nonetheless impor-tant role that foreign banks play in the Chinese system, and the challenges that Chinese banks are facing as they expand overseas.

Preface xiii

Is China’s present banking system, as described in this book, entirely a creature of the present communist regime, or has it arisen out of Chinese ways of organizing the political economy that predate communist control of the country? Is the way in which banks oper-ate within the broader political economy unique to China, or does the Chinese experi-ence bear similarities with the experience of other countries? These questions are explored in Chapter 10, “China’s Banks, Sui Generis?,” through a retrospective of Chinese banking from late imperial times up to the end of the Republican era in 1949, and through looking at two of the other Asian developmental states, Japan and South Korea.

The arguments of those who believe China’s banking system remains fragile and head-ing for crisis are examined in Chapter 11, “Collapsing or Adapting?,” followed by a sketch of the principal challenges facing Chinese banks— particularly asset quality issues and the threat from nonbank digitally based competition. The likely course of future banking reform is the subject of Chapter 12, “Reform Directions.”

The concluding chapter discusses the challenges China’s banks face as the economy transitions into a lower- growth, less investment- and export- dependent economy— the New Normal. The success of the banking transformation in terms of providing the coun-try with a banking system that provides broad financial access, allocates capital efficiently, and is a sustainable and stable system is evaluated.

China’s Banking Transformation takes a generally positive view of what has happened in Chinese banking. Some have protested to me that I am ignoring the costs that China has paid in terms of environmental degradation, cultural heritage loss, increased inequal-ity, etc. There is broad agreement among Chinese and foreigners that these are immense problems, but this book is not about those issues. If I were to write a book on those subjects, it would not be a positive story. This book, however, is about banking, which is a positive story.

Others have warned me that the speed of change occurring in China will make any-thing I write about banking out of date soon after the book is published. There is some truth in that, and no doubt some things in this book will soon be dated. This book, however, is not primarily concerned with the issues faced by banks in 2016 as the book goes to press, but rather seeks to explain the longer- term role that Chinese banks play in the political economy, to explain how Chinese banks work in ways both similar to and different from Western counterparts, and to demonstrate how the nature of Chinese banking arises out of China’s culture and is conditioned by its history. I do not expect that any of these will soon change in China.

This book is based on my accumulated experience and observations over the thirteen years that I have served on the boards of two Chinese banks. To my colleagues on the boards and in the management of the two banks, I owe an immeasurable debt. Through the years they have shared with me their hopes and ideas, frustrations and worries, suc-cesses and failures, permitting me to become a “member of the team.” As the only for-eigner in both banks, I have felt honored and privileged. My position on the boards of these banks has provided me with access that has been available to only a handful of other

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foreigners. I hope that the years of experience I have accumulated over a lifetime of bank-ing and which I have shared with my Chinese colleagues has contributed in some way to the development of these banks.

Despite my privileged access, my personal experience of Chinese banking was lim-ited to what I learned from my work on the boards of two banks and, despite my best efforts, was invariably colored by my American cognitive framework. I expanded my understanding and checked the validity of my book’s themes through conducting interviews with approximately 150 people, mostly Chinese, but also foreigners, and in a few cases interviewed the same person more than once. People interviewed included banking practitioners, government officials, journalists, academics, economists in multilateral organizations, and businessmen. Interviews were conducted in Chinese and English languages, depending on the preference of my interlocutor. The people interviewed were all knowledgeable and extremely generous in sharing their views and experience with me. They asked only that I be objective in what I write in this book, pointing out both the strengths and weaknesses of the Chinese system. Those who spent time with me in interviews were too numerous to acknowledge individually here, but I want to express my deep appreciation to all of them for the time they took out of busy schedules to share their knowledge and insights with me. Without their assistance this book could not have been written.

I would like to acknowledge my debt to two people in particular. First is Hugh Peyman, who accompanied me on most of my interviews. Hugh has shared with me his great understanding of China’s contemporary economy. His critical challenges to my assump-tions and beliefs sharpened my own thinking. Michael Yang provided invaluable research support, and Michael went beyond research to also caution me when I was misunder-standing some aspect of Chinese culture or society.

I have also benefited greatly from first learning about Chinese history, language, and culture in America and Hong Kong fifty years ago, studying under great teachers who con-veyed not only their knowledge of China but also their passion for the country, its people, its language and its culture— Frederick Mote, Ch’en Ta- Tuan, Joseph Levenson, Frederick Wakeman, James Cahill, Edward Shafer, Liu Ming, and Liu Yamei, among others.

In writing in this book of my experience working within Chinese banks, I have been mindful not to disclose confidential bank and government material to which I had access.

I would like to thank Michael Aldrich, Robert Binyon, Darrell Duffie, Michael Ipson, Frank Rokers, Andy Rothman, Danny Unger, and Wei Anning for taking the time to read a draft of my manuscript in its entirety and provide me with most helpful sugges-tions, criticisms, and corrections. Several others also read and commented on sections of the text in which they had expertise: Joern Helms, Dennis McNamara, Keith Pogson, Ed Wu, Xiao Bing, Xu Jun, and Arthur Zou. Their feedback has greatly improved the final product. I am also grateful to David Shambaugh for the encouragement and guidance he gave me. Ultimately, though, I am solely responsible for everything in this book.

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Abbreviations

ABC Agricultural Bank of ChinaAMC Asset management companyBIS Bank for International SettlementsBOC Bank of ChinaCAS Chinese Accounting StandardsCBRC China Bank Regulatory CommissionCCB China Construction BankCIC China Investment CorporationCSRC China Securities Regulatory CommissionDRC Development Research CouncilGAAP Generally Accepted Accounting PrinciplesICBC Industrial and Commercial BankIFC International Finance CorporationIFRS International Financial Reporting StandardsIPO Initial Public OfferingIT Information TechnologyMIS Management information systemMOF Ministry of FinanceNDRC National Development and Reform CommissionNPL Non- performing loanOECD Organization for Economic Co- operation and Development

xvi Abbreviations

P2P People to peoplePBOC People’s Bank of ChinaPSB Postal Savings BankSME Small and Medium EnterprisesTARP Troubled Asset Recover ProgramWMP Wealth Management ProductsWTO World Trade Organization

China’s Banking Transformation

1

The economic devastation unleashed by failures of Western banks in the financial crisis of 2008 highlighted the central role played by banks in economies and the impor-tance of establishing a proper financial regulatory system. So also did the meltdown of Chinese banking in the 1990s. When they work efficiently, banking systems facilitate eco-nomic growth and stability, a happy state of affairs that prevailed in the United States in the two decades after World War II. American banks in that period did perform their role efficiently as a circulatory system keeping the blood flowing in the economy, as described by Princeton economist Alan Blinder in the quote heading this chapter. Moreover, finan-cial system development preceded and enabled general economic takeoff in what are now the advanced nations— including the Netherlands, Britain, United States, Germany, and Japan.4 The flip side, though, is that irresponsible banking sets off financial crises that bring in their wakes prolonged economic distress.

1 China’s Hybrid Banks

Some people think of the financial markets as a kind of glorified casino, with no relevance to

the real economy— where the jobs, factories and shops are. But that’s wrong. Finance is more

like the circulatory system of the economic body. And if the blood stops flowing … well, you

don’t want to think about it.Alan Blinder, 20131

If we combine a planned economy with a market economy, we shall be in a better position to

liberate the productive forces and speed up economic growth.Deng Xiaoping, 20142

We should make good use of the roles of both the market, the “invisible” hand, and the

government, the “visible” hand.Xi Jinping, 20143

1 Alan S. Blinder, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: The Penguin Press, 2013), 5– 6.

2 Xie Pingru, ed. Xiaoping Said: Build Socialism with Chinese Characteristics (Guangzhou: Guangzhou Higher Education Press, 2014), 62.

3 Xi Jinping, The Governance of China (Beijing: Foreign Languages Press, 2014), 128. 4 Charles W. Calomiris and Stephen H. Haber, Fragile by Design: The Political Origins of Banking Crises and

Scarce Credit (Princeton, NJ: Princeton University Press, 2014), 9, 23– 24.

2 China’s Banking Transformation

Everyone knows that the economic rise of China over the past four decades is unprec-edented in world history. Yet in the 1990s, just as this economic rise was accelerating and China was poised to become an economic player on the world stage, China’s banks were mired in bad debt, technically bankrupt, and backward in management and opera-tions. They were not actually commercial banks in the real sense of the word, since they operated as vestiges of the old planned economy model that China was rapidly leav-ing behind. As China dismantled its centrally planned economy and replaced it with a hybrid capitalist economy increasingly driven by market forces, it studied the workings of Western capitalist economies. It recognized that a system to effectively provide financial intermediation to channel the flow of funds from savings into investment was essential to the workings of a modern market economy. China could not achieve its economic growth objectives if its banking system remained dysfunctional.

Replacing banks of the old planned economy with banks that function well in a more market- based economy— in other words, creation of a modern banking system— became a priority national strategic objective. Achievement of that objective in little more than a decade is one of China’s major achievements. Today, the largest Chinese banks are real commercial banks, playing an important role in the nation’s economic development.

Market Socialism or Market Capitalism?

China’s modernized commercial banks are hybrid creatures— in part resembling Western counterparts, in part shaped by China’s political economy framework and by its own cultural heritage. They conform to global best practice in structure, management, and operations. As in Western banking systems, Chinese banks measure efficiency primarily by their creation of shareholder value, as reflected in return on equity (ROE). The pub-lished average ROE of the listed Chinese banks over the past few years has been consis-tently above 15%. In this focus on bottom line profitability, and in the payment of a share of profits to shareholders in the form of dividends, Chinese banks are no different from banks in the market capitalist U.S. and U.K. economies.

This market capitalist banking model is, however, only half the story of Chinese banks. The market capitalist model has been modified to accord with Chinese cultural norms, and it has been adapted to fit China’s political economy, which is directed by the Communist Party. The rationale for banking in China and the role that banks play in China’s political economy differs from what animates banking in the Anglo- American economy and to a lesser degree from most European banking systems. The rationale for Chinese banks is utilitarian— to be effective instruments for the state in fostering eco-nomic development, to serve the real economy. Chinese banks have a dual role to play, giving rise to what I term the hybrid nature of Chinese banks.

This hybrid nature follows the thinking of Deng Xiaoping and Xi Jinping in the quotes at the head of this chapter, in which they spoke of combining the market and the

China’s Hybrid Banks 3

government in the economy, resulting in market socialism (as opposed to market capi-talism). Political scientist Sujian Guo explains that if pure laissez faire market capitalist economies lie at one end of the spectrum and pure planned economies at the other end, then in between lie “mixed economies,” of which “market socialism” is an apt description of the Chinese mixed economy toward which Deng Xiaoping pointed the way when he launched Reform and Opening in 1978. Guo defines “market socialism as a type of economic system that combines the socialist principle of public ownership with the prin-ciple of the market economy, with predominant public ownership in those areas deemed critical to the implementation of socialist principles and social policy.”5 Commercial banking, of course, is one of those “critical” areas.

This hybrid role both arises out of the historical legacy of the communist planned econ-omy and is embedded in traditional Chinese thinking about the proper role of the state in the economy. Chinese banks have enthusiastically adopted and incorporated into their operations international standards of shareholder ownership and governance; systems of risk management, accounting, and internal control; listing on securities exchanges; and focus on value added to shareholders— all designed to promote the efficient manage-ment of the banks and to protect the banks from a repeat of the failures of the 1990s. Chinese bank regulatory authorities have put in place a strict supervision system mod-eled on global best practice. This capitalist packaging should not, however, obscure the reality that Chinese banks are managed not only to create shareholder value but also to play a vital role in promoting Chinese economic development. They must make money for shareholders and contribute to national economic development goals, as defined by the Communist Party. This is the essence of banking in China’s market socialism and is the fundamental difference between banks of market socialism and Anglo- American market capitalism.

In Chapter 10 I compare the Chinese banking system and the banking systems of nations that practice a form of capitalism, such as Germany, Sweden, Japan, and the Netherlands, whose capitalism is termed “cooperative capitalism” in the social science literature. In those nations, single- minded focus on shareholder value is lessened, as shareholders must cooperate with other stakeholders, including labor, the general public, and the state, thereby situating those systems somewhere between market capitalism and socialist capitalism.

Market socialist hybrid banking as it exists today is the result of the past two decades of financial reform that have brought about a “night and day” transformation in the qual-ity of China’s banks. Although there are valid criticisms that China’s banks still do not efficiently allocate capital, nonetheless it is unlikely that China’s spectacular economic growth over the period of financial transformation could have occurred if Chinese banks

5 Sujian Guo, Chinese Politics and Governance: Power, Ideology, and Organization (London: Routledge, 2013), 252– 253.


had not played a generally positive role. From shareholders’ perspective, while Western banks have been battered by a combination of bad debt and scandals since 2007, Chinese banks have thrived, growing rapidly in size, profitability, and adequacy of capital and pro-visions. They have also been responsive to national economic policy directions, thereby playing the role that the government expects of them in supporting the real economy and national infrastructure development.

The timing of China’s bank transformation was fortuitous. Bankers know that “It is easy to lend money in the good times; good bankers are the ones who get repaid in the bad times.” China’s economy was booming. Furthermore, to ensure that banks restored profitability and stability after the debacle of the 1990s, China effectively protected and subsidized banks through interest rate repression (government policy keeping interest rates at below market rates, penalizing savers and consumers, and subsidizing borrowers and investors), through implicit guarantees of state- owned enterprise (SOE) debt, and through intervention to prevent troubled industries from defaulting on their bank debt. China’s banks transformed in a short period of years that coincided with the highest sustained economic growth rates of any major economy in world history, and bank assets grew at very high rates by lending into what was a low- risk economic environment. The timing could not have been better, for both the financial sector and the real economy. The real economy could not have taken off so rapidly without a functioning banking system, and the banking system could not have performed so robustly in the absence of a booming economy.

China is now commencing a wrenching transition to what is called the New Normal, which involves structural rebalancing and a deceleration of growth. New growth targets of around 6.5% are still high compared with performance of the rest of the world, but the deceleration from successive years of growth at the rate of 10% and higher, and the accompanying structural rebalancing of the economy, are shocks to the economy, which inevitably will entail considerable adjustment on the part of businesses and perhaps a certain amount of Schumpeterian destruction. Some industries, no longer competitive, will decline, to be replaced by newly emerging industries. Some firms will no longer be profitable and will either go under or reinvent themselves in new, more competitive guise. Moreover, the government, the banks, and business enterprises of China have over the past two decades of hyper growth learned to manage under boom conditions. They lack the experience of managing in an environment of decelerating economic growth. Nonetheless, notwithstanding the complex challenges, if the competence of China’s management of the economy over the past few years is any guide, it is likely that the government will be able to guide the economic transition in ways that mitigate problems while opening new avenues for renewed vigorous economic growth.

How banks fare in this less benign economic environment will tell the tale of how robust the bank management systems put in place over the past two decades really are and how well the banks have calibrated the risk/ reward trade- off on their loan portfolios. Only in the bad times is the quality of banks truly put to the test. Furthermore, many


of the supports and protections previously provided by the government to the banks as they developed their management capabilities are now being bit by bit withdrawn. The hybrid nature of China’s banks, with strong state ownership and guidance, will to a cer-tain extent shield banks from the full brunt of the transition. Over the next few years, not only will the quality of banks be tested by adverse economic winds, but also the reforms of the financial system will be ongoing. As China’s venerable economic thinker Li Yining recently wrote, referring to the economy as a whole, and reflecting the pragmatic flexibil-ity of China’s mainstream economists:

Structural adjustment is not bounded by limits. Following the advances of science and technology, following changes in the domestic and international situations, and following the growth in management experience and rise of executives’ mana-gerial quality, today’s structural optimization only represents optimization for the present stage, and cannot represent the future ongoing structural adjustment. From this perspective, structural adjustment is relative, so structural adjustment will continue.6

As China’s economy grows and changes, new challenges will appear, and in response new development objectives will rise to the top of the agenda: greater efficiency of capital allocation, reduction of income and wealth inequality, cleaning up the natural environment, urbanization, and a host of other reform items. In each of these areas, banks will be expected to play a role. China’s modernization and the strengthening of its banking system is a major achievement, but the development of bank capabilities and evolution of the financial system, of which banks are a part, is an ongoing story. Li Yining said that in the economy “structural adjustment will continue,” so in the banking system evolution will be ongoing to meet new situations and new challenges. A few key aspects of the likely path of evolution can be discerned now with reasonable certainty: ongoing interest rate deregulation; “debanking”— reducing dependence of the economy on indirect finance through banks, increasing the funding role of direct finance through equity and bond markets; cautiously affording a greater role to the private sector in bank ownership; the rise of nonbank “fintechs” such as Alibaba to contest the banks for financial transaction settlement; and greater international expo-sure of banks.

Other aspects of the system’s evolutionary path are less certain. For example, pos-sible privatization or reduction of government shareholding in existing major state commercial banks; fostering the development of universal banking (banks offering financial services such as insurance and brokerage products); giving banks greater scope for developing derivatives business; providing a larger role for foreign banks;

6 Li Yining, Chinese Economy in Dual Transition (Hong Kong: Zhonghua Book Company, 2014), 8.


and the ultimate disposition of the nonbank financial institutions comprising today’s “shadow banking system.” However the system evolves, one can be certain that, barring major change in the political institutions of China, the government will retain more control over the financial system than in the United States and most European nations. China’s banking is unlikely over the next few years to evolve from the hybrid model of market socialism into a market capitalist form of banking. Xi Jinping has made it clear that even though the “invisible” hand of market forces have now been officially declared by the government to be “decisive,” the “visible” hand of government guidance will not be withdrawn.

As long as the national reform process maintains the dynamism of the past two decades, there are grounds for optimism about the ability of the banking system to make the necessary adjustments needed to cope with new stages of economic growth and development. Given the importance that the Chinese government accords to the financial sector, there is every reason to believe that the evolution, of which economist Li Yining writes, will be ongoing. Nonetheless, the difficulties the banking system will face in adapting to a rapidly changing economic environment, both domestically and internationally, and the challenges posed to banks by accelerating digital technology advances are formidable.

From Cashiers to Modern Banks

The extent of the banking transformation can only be fully appreciated if one recalls what Chinese banking was like from the 1950s through the 1980s. Under Mao Zedong’s leader-ship (1949– 1976), China had no need for banks. Almost all economic activity was owned, directed, and funded by the state. Within two years of the establishment of the People’s Republic of China (PRC) in 1949, all the existing banks remaining from the Republican era had been wound up, leaving only one financial institution in China— the People’s Bank of China (PBOC), which served for the next three decades as the bursar for gov-ernment allocation of funds throughout the country. The PBOC was an accounting and cashier unit that provided the funding needed to carry out the central economic plan. Bank of China continued to exist in the form of overseas branches to handle China’s for-eign trade and foreign exchange requirements in jurisdictions that recognized the PRC government, such as the United Kingdom, Hong Kong, and Singapore, but had no inde-pendent domestic existence.

In 1978 Deng Xiaoping launched “Reform and Opening”— reform of a Soviet- style planned economy that had failed China as a development model and opening to the West in search of capital, technology, ideas, and institutions needed to break out of pov-erty. Deng was a supreme pragmatist, not wedded to any particular ideology, committed only to using whatever policies and programs would provide China with the economic stability and energy to regain national “wealth and power.”


At the start of Reform and Opening, China did not know how to build a financial system or how to run banks, so it proceeded cautiously, listening to the advice of main-stream Western economic advisors such as the World Bank, the International Monetary Fund (IMF), foreign consulting firms such as Boston Consulting and A. T. Kearney, for-eign commercial banks setting up training programs in China, and international audit firms such as KPMG and Price Waterhouse, to name just a few. Chinese went on study missions to learn how banking systems in other countries worked. Thousands of young Chinese brought back with them new ideas acquired studying in universities in America, Europe, Japan, and elsewhere. As with other aspects of its national development over the past three decades, so also in the financial arena, much of China’s success can be attributed to the diligence, enthusiasm, and openness with which Chinese have studied global best practice and then applied what they had learned to building a new and stable Chinese banking system.

Step by step, the Mao- era monobanking system was broken up. Out of the PBOC and the Ministry of Finance were created four nationwide state banks: the Bank of China (BOC— as mentioned above, it had continued to exist overseas), the China Construction Bank (CCB), the Agricultural Bank of China (ABC), and the Industrial and Commercial Bank of China (ICBC). In the 1980s several joint stock banks were set up, mostly owned by one state entity or another, and a host of credit cooperatives and credit trusts were licensed. The big banks, however, still more closely resembled cashiers funding the remains of the planned economy than modern commercial banks. They dis-bursed money not based on credit analysis or efficient capital allocation, but, based on government plan, they loaned to state- owned companies, most of which were inefficient and money- losing. To compound the problem, no proper system of banking regulation yet existed.

In the mid- 1990s, China’s private sector was taking off, but China did not yet have a modern commercial banking system to support entrepreneurs. State banks loaned only to state companies. Moreover, banks did not understand how to manage the risks of lend-ing. The state companies in turn did not understand how to manage their debts. Bad debts piled up on the books of the banks, estimated to reach as much as 40– 50% of bank assets.

At that time, the extraordinary economic growth of China’s real economy was still in its early stages. The accomplishments of the twenty years after 1978 were impressive, but China’s gross domestic product (GDP) in 2000 was still only $1.2 trillion, while the United States in the same year was a $10 trillion economy.7 China was growing rapidly but was overall still a poor country.

A combination of the high level of bad debts on bank books, the collapse of some Chinese financial institutions, and the spectacle of the Asian financial crisis devastating

7 World Data Bank, http:// databank.worldbank.org/ data/ views/ reports/ tableview.aspx, accessed May 10, 2015.

http://databank.worldbank.org/data/views/reports/tableview.aspx


the banking systems and economies of Thailand, Korea, and Indonesia in 1997– 1998 con-vinced China’s leaders that its banking system had become a bottleneck that would hold back growth of the real economy. Thorough reform of the banking system was required. China’s banks would have to become modern commercial banks.

The question was: What kind of modern commercial banks? Even among Organisation for Economic Co- operation and Development (OECD countries), which provided the models of successful financial development that China studied, there were several models, reflecting the varieties of capitalism that existed in these economies. The U.S. model was the most powerful and influential at that time, but was structurally not typical of other OECD countries’ banking systems, due to the high priority given to shareholder interests in the United States, the light hand of government regulation, the high degree of independence from government, and the instability of the system over time. The U.K. system was similar to the U.S. system but was oligopolistic and had a different regulatory approach. The Japanese “coordinated capitalist system” and the German “collaborative capitalist system,” which can together be described as “coopera-tive capitalism,” offered models that saw shareholders as one among multiple stakehold-ers, emphasizing instead value for multiple stakeholders and according a strong guiding role to the state.

Creation of a modern banking sector had begun in 1992, when then Deputy Prime Minister Zhu Rongji took on the additional post of Governor of the PBOC, China’s central bank. Zhu began to lay the groundwork for banking transformation. The trans-formation, however, only really picked up speed in 1998, after the twin shocks of the Asian financial crisis and the collapse of two large Chinese credit trusts and hundreds of local credit cooperatives provided the impetus for concerted and thorough overhaul of the sector and made the task urgent. Although Zhu retired from government service in 2003, when the transformation was still in early stages, he is rightly given credit for work-ing out the strategy that was followed over the next several years.

China studied the different banking models of advanced economies, developed plans for creation of a modern Chinese banking system incorporating foreign ele-ments suited to China’s needs, and then proceeded to overhaul its banks, transform-ing bankrupt bank- cashiers into modern commercial banks. The focus was primarily on the four giant state banks: ICBC, CCB, BOC, and ABC. If they could be put on the right track, then the smaller banks would fall into place. Zhu’s transformation strategy had three elements: first, break the planned economy cultures of the banks by converting them into corporate entities, to be managed in accordance with sound corporate governance and banking practice; second, clean up their balance sheets by stripping bad loans off bank books and housing them in asset management compa-nies, paying for the exercise with government- backed bonds; and third, recapitalize the banks and list them on international stock exchanges, forcing them to submit to market discipline.


Listing on international securities exchanges was a brilliant move not only because it brought in fresh capital, but because it also effectively “outsourced” part of the job of forcing the bureaucratic state banks to improve efficiency, balance sheet quality, profit-ability, and corporate governance. To obtain approval for listing, the banks had to sat-isfy the listing requirements of the Hong Kong securities exchange, which were more stringent than those of the domestic exchanges. Additionally, foreign shareholders were demanding new stakeholders, registering their approval or disapproval every trading day by their purchases and sales of bank shares. Share prices became a preoccupation of bank boards and managers— a new way of keeping score.

By 2010, in the short space of just over a decade, the transformation, at least for the top tier banks, was basically complete. Assigning a date to the completion of the trans-formation into a modern commercial banking system is a subjective exercise. The year 2010, when the last of the four giant state banks, ABC, was listed on the Hong Kong Securities Exchange, is probably as good a cut- off point to use as any. China’s lead banks had become profitable, well capitalized, well provisioned, competently managed, and technologically advanced. The main elements of modern commercial banking had been put in place in not only the four giant state banks (by then the number had changed to five, including the Bank of Communications), but also in the twelve joint stock banks. Some of the more than 100 city banks were beginning to perform credibly as well.

The building blocks of modern banking were in place, including corporate governance, proper bank accounting, profit oriented management, risk control, internal audit, infor-mation technology (IT), and acceptable retail branch service standards. Moreover, in 2003, the bank regulatory function had been spun off from the PBOC and lodged in the newly established China Bank Regulatory Commission (CBRC), headed in its first decade by the able and visionary Liu Mingkang. By 2010, the CBRC’s capabilities were maturing; it had established its reputation as a competent, hands- on regulator, acknowl-edged by foreigners familiar with its work to be on a par in professional capability with central banks of most major countries. It differed, however, from other top- level central banks in two ways. First, it was not independent. Second, it exerted vast influence on the strategy, tactics, and daily operations of Chinese banks to an extent that would be regarded as intrusive in other banking jurisdictions.8

Since 2010, change has been more evolutionary than transformational. China’s banks were no longer government cashiers; they had become real commercial banks undertak-ing financial intermediation. But, as Li Yining stated, there is no end to the adjustment process. The banking system needs to provide broader access, capital markets need to develop further to provide financial deepening, and the financial markets need to become

8 Private communication from Frank Rokers, formerly seconded by ING to be Chief Risk Officer at Bank of Beijing.


more market driven and less administratively controlled— topics explored in later chap-ters of this book.

China’s Banking Structure Today

China’s banks today are diverse in size and type. For the purposes of this book, I have grouped the banks into three tiers. First are the seventeen tier 1 banks, which are distin-guished by their size and also by the fact that they operate nationwide networks. The CBRC officially and appropriately classifies the seventeen tier 1 banks as the “major commercial banks,” subdividing them into the five “large commercial banks” and the twelve joint stock banks. The tier 1 banks held 59% of total banking system assets at the end of 2014. Aside from size, the distinguishing feature of the five large commercial banks is that the state directly owns a majority shareholding in each of them: ICBC, CCB, BOC, ABC, and Bank of Communications. These are extremely big institutions. The largest in terms of assets is ICBC, which at the end of 2014 had total assets of $3.31 trillion, making it the largest bank by assets in the world. ICBC had 17,122 branches nationwide in China and 338 offices overseas in 41 countries on six continents. It had over 5 million corporate customers and 465 million individual customers.9

Smaller than the five giants, but still tier 1 major commercial banks, are the twelve joint stock banks, nine of which are majority owned through various mechanisms by the government, and three of which are owned by private shareholders. Of these seventeen tier 1 banks, the big five large commercial banks and eight of the twelve joint stock banks are listed on the Shanghai, Shenzhen, or Hong Kong stock exchanges. Some are listed on more than one exchange.

Tier 2 banks are the 145 city banks, which are mostly owned by provincial and local governments and generally are restricted to operating in their base areas. Only three of these are listed on domestic securities exchanges, and one on the Hong Kong exchange. Although city banks only comprised 10% of total banking system assets at the end of 2014, some of the city banks rival the tier 1 banks in quality. Others are in need of con-siderable improvement in governance, management, and operations. They tend to be more susceptible to influence from local governments than are the national banks, as local governments are often significant shareholders or can influence the banks through local power networks.

Tier 3 banks are localized and special purpose institutions that number in the thou-sands and break down into several different license categories, including rural credit cooperatives, town and village banks, small loan companies, the state- owned Postal Savings Bank, and several others. Many in number, their quality varies greatly, but alto-gether they only account for 19% of total banking system assets. Their significance lies in

9 ICBC 2014 Annual Report, Chinese version, 23– 24, 149, and 152.


the creative role that they play in deepening financial access for farmers, small businesses and consumers, especially in remote areas not well served by big bank branches.

There are three large government- owned special purpose policy banks: China Development Bank, China Agricultural Development Bank, and Export- Import Bank of China. They are state- owned, play important roles in the financial system of China, and their assets (comprising 9% of the total banking system assets) are included in official measurements of the total banking system size. They are not listed on securities exchanges and do not take deposits. They rely on bond issues and the government budget for fund-ing. Except to the extent that they play a role in China’s international financial strategy, these three special purpose banks are not covered in the discussion of commercial bank-ing in this book, as each of them represents a special situation quite different from the rest of the commercial banking sector that is the subject of this book. They are not included in this book’s classification of the three tiers of the banking system but are included for purposes of computation of the assets and liabilities of the entire banking system.

Accounting for only 2% of China’s banking assets, the foreign branches nonetheless play an important role in the overall system (described in Chapter 9).

Among major financial systems around the world, some rely for funding of the econ-omy principally on direct financing through the equity and debt markets. The United States is the exemplar of this model. Others such as Germany and Japan rely to a much greater extent on indirect finance— bank credit extension. China, however, is an outlier in its extreme reliance on bank funding, accounting for 67% of total economic funding at the end of 2011. This reflects the underdevelopment of nonbank sectors of China’s financial markets— equity markets, bond markets, venture capital, and insurance are all relatively small portions of total funding compared with other countries. Having acknowledged the underdevelopment and the need for development of direct finance, it is interesting to note that China’s reliance in 2011 on bank funding at 67% is not signifi-cantly higher than that of Germany. As in many aspects of financial system structure, the United States is as much the outlier on one side as China is on the other.10

Fragile and Facing Collapse?

For anyone following the financial press accounts of banking in China today, my assess-ment of Chinese banking as a transformed system may arouse skepticism. The consensus view from most foreign observers in the media and in the investment analysis world is that Chinese banks’ reported numbers conceal a multitude of problems that will lead to a repeat of the banking crisis of the 1990s.

10 Silvia Iorgova and Yinqiu Liu, “Structure of the Banking Sector and Implications for Financial Stability,” in China’s Road to Greater Financial Stability: Some Policy Perspectives, eds. Udaibir S. Das, Jonathan Fletchter, and Tao Sun (Washington, DC: International Monetary Fund, 2013), 124.


Many well- educated, highly motivated, and generously compensated analysts in pres-tigious Western investment and brokerage firms follow Chinese banking developments in great detail, sitting in their offices in Shanghai, Hong Kong, Singapore, New York, and elsewhere around the globe, poring through financial reports, estimating the poten-tial for bad loans that might arise from sectors of the economy that appear distressed or overleveraged. Some write of Chinese banks as compliant tools of Party bosses, lending as ordered from above, going on credit binges, lacking transparency, sclerotic in corporate culture, and grossly underreporting bad loans.

Analysts regularly forecast the coming collapse of the banking system, bringing down with it the entire economy. The first of the China banking skeptics was Gordon G. Chang, who in 2001, in The Coming Collapse of China, made dire predictions about the financial sector, oblivious to the transformation of the banks that Zhu Rongji was then getting underway. More than a decade later, in May 2012, a Bloomberg correspondent wrote that the capital of China’s big banks was overstated because bad debts had been disguised as receivables from the central government. The correspondent further maintained that not recognizing accumulating bad debts meant that “[b] y the time any big problems show up in the banks’ numbers, the jig will be up.”11

Perhaps the most well known of the banking skeptics has been Charlene Chu, for-merly of Fitch Ratings, who for years has attracted widespread attention for her fore-casts of forthcoming banking distress. In February 2014, in an interview with the United Kingdom’s The Telegraph, she explained that “[t] he banking sector has extended $14 tril-lion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China.”12 Well grounded in the numbers and in quantitative analysis, her warnings represent a plausible point of view. Over the years, subsequent events have not unfolded as she had predicted, although perhaps she would retort that the day of reckoning has simply been put off. Press reports of her carefully qualified forecasts often exaggerate them with lurid headlines predicting imminent collapse of China’s finances, leaving a more negative impression with the casual reader than Chu may have intended.

Widespread skepticism has led to low ratings of Chinese bank shares on the Shanghai and Hong Kong securities exchanges. Based on audited and published financial results, Chinese banks have been among the most profitable, best capitalized, and most well- provisioned banks in the world, but price- earnings and price- book value ratios of Chinese bank shares are among the lowest rated of major bank shares in the world. Analysts and investors do not believe the numbers reported and at different points in time expected

11 Jonathan Weill, “China’s Big Banks Look More Like Paper Tigers,” Bloomberg View, May 10, 2012, https:// www.bloomberg.com/ view/ articles/ 2012- 05- 10/ china- s- big- banks- look- more- like- paper- tigers, accessed 12 June 2016.

12 “The $15 Trillion Shadow over Chinese Banks,” The Telegraph, February 1, 2014, http:// www.telegraph.co.uk/ finance/ newsbysector/ banksandfinance/ 10611931/ The- 15- trillion- shadow- over- Chinese- banks.html, accessed 12 June 2016.

http://www.bloomberg.com/view/articles/2012-05-10/china-s-big-banks-look-more-like-paper-tigers

http://www.bloomberg.com/view/articles/2012-05-10/china-s-big-banks-look-more-like-paper-tigers

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/10611931/The-15-trillion-shadow-over-Chinese-banks.html

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/10611931/The-15-trillion-shadow-over-Chinese-banks.html


the banks to incur major losses from exposure to local government debt, to the housing sector, to the SOEs, to industries with overcapacity, or from whichever sector was the currently fashionable source of investor anxiety.

This consensus narrative is sharply at odds with what I have experienced working within two Chinese banks and with the viewpoint of many others who have had the opportunity to work closely with Chinese banks in various capacities. In this book I argue that Chinese bank quality is stronger than generally recognized, that a repeat of the banking collapse of the 1990s is unlikely, and that apprehensions concerning bank losses from exposures to various sectors, including high credit- to- GDP ratio, real estate bubbles, and shadow banking collapses, while all clearly dangers to stable and sustainable banking, are nonetheless exaggerated. How, then, could all those analysts be getting their analyses of the banking sector wrong? What are they missing?

The banks themselves must shoulder some of the blame for the skepticism with which they are viewed. Listed Chinese banks do not open themselves up to investor and analyst scrutiny as they do in the West. If not given an opportunity to enter into meaningful dialogue with the banks at board, senior management, and middle management levels, outside analysts are unlikely to trust, or indeed even to be aware of, the quality of bank internal controls, credit risk supervision, corporate governance standards, etc. The appar-ent reluctance of banks to open up to analysts only fuels suspicions of problems being covered up.

The critics, often judging China’s banks from a market capitalist perspective, seem unaware that many of what they decry as shortcomings or distortions in the Chinese banking system have actually been characteristics of some Asian capitalist, as well as a few Western, economies. Banking in the successful “developmental states” of Northeast Asia, the state’s intervention in finance in much of Asia, and even occasionally the U.S. govern-ment’s intervention in the financial system for greater societal good, are ignored by critics of the Chinese system (discussed in Chapter 10).

Outside analysts overlook three factors. First, they overlook the very real transforma-tion of how banks operate and how they are managed that has occurred since the 1990s. Second, they underestimate China’s obsession with controlling banking risk, resulting in a variety of checks and balances that have been put in place to guard against another finan-cial collapse along the lines of what happened at the end of the 1990s. Third, they analyze the banks as though they were part of an Anglo- American market capitalist economy, rather than being embedded in a market socialist economy, which is not only different in economic structure but also enables the state to intervene powerfully to affect outcomes.

Charlene Chu acknowledges the power of the state to intervene in China and there-fore anticipates that the state will be able to find short- term solutions to defaults as they occur, but she believes that over a longer period of time the state will be unable to paper over the growing severity of problems. Her analysis, however, may underestimate the abil-ity of the state in a market socialist economy to not only undertake ad hoc remedial inter-ventions to maintain market order, just as the U.S. Federal Reserve does, but also to adopt


policies to address the underlying bubbles and also guide economic growth in ways that will mitigate problems such as overcapacity. Grasping this point requires understanding the cultural, political, and economic context in which China’s banks operate.

Cultural, Political, and Economic Context

Both the hybrid features of China’s banks and the power of the state to intervene in the economy to bring about positive economic outcomes arise out of the cultural and politi-cal economy context. In social science literature, definitions of “culture” are legion. I use this definition of the word “culture”: “Culture is the shared knowledge of and schemes created by a set of people for perceiving, interpreting, expressing, and responding to the social realities around them.”13 Simply put, it is how we believe people in a society should relate to each other, both interpersonally and through their governance institutions. Out of a culture arise the structure and norms of social and political institutions, and ulti-mately economic institutions as well.

Since the collapse of the Soviet and East European communist regimes in 1989, think-ing about how to organize economies and how emerging nations should manage national development has been dominated by the view that the main features of Anglo- American market capitalism, generally called neoliberalism or the “Washington Consensus,” can be more or less universally applied around the world. This neoliberal approach is grounded in “rational expectations” theories of economics and other social sciences that have domi-nated academic discourse for the past half century.

The logic of these theoretical approaches is appealing, but for many the Wall Street financial collapse of 2008 called into question neoliberal approaches and rational expec-tations theories. Skepticism has grown as to whether or not rational expectations theory realistically reflects the way people act.

Countries will tailor and fashion economic solutions based on their own national his-torical experience, in line with their own cultural values and norms, and compatible with their own intellectual frameworks for understanding the world. As the late Douglass C. North, economic historian and leading thinker in the field of institutional economics, put it: “Ideas are adopted if and when they share a kind of cohesion that does not take them too far from the norms we possess.”14

13 J. P. Lederacin, Preparing for Peace: Conflict Transformation Across Cultures (Syracuse, NY: Syracuse University Press 1995), 9. Eric L. Jones in Cultures Emerging: A Historical and Economic Critique of Culture (Princeton, NJ: Princeton University Press, 2006), ix, states: “Culture is like class: it has no generally accepted operational definition.” Jones then states that most writers treat culture as the “pattern of beliefs, habits, and expectations, of values, ideals, and preferences, shared by groups of people, large and small.”

14 Douglass C. North, Understanding the Process of Economic Change (Princeton, NJ: Princeton University Press, 2005), 27.


This is not to argue for Chinese exceptionalism. All countries in the world regard their own cultures as to a greater or lesser degree exceptional, and indeed they are. Despite this diversity, social sciences do provide insights and tools that are of universal validity. It is in the application to an individual country’s situation at given times and stages of develop-ment that the universal must be adapted to the particular circumstances of each country. Whether one accepts this point of view or not, the fact is that it is deeply believed in China, starting with Deng Xiaoping’s “what we want to build is a socialism suited to conditions in China.”15 Senior Chinese economist and former Chief Economist of the World Bank Lin Yifu writes, “we can never be too careful when it comes to the application of a foreign theory, because with different preconditions, no matter how trivial they seem, the result can be very different”16 (italics in original).

Among market- based economies, no two countries in the world have business or bank-ing systems or practices that are exactly the same. Capitalism takes on unique features in each country, in part due to historical circumstances (what social scientists call path dependence— meaning you cannot ever fully escape your past, or, more elegantly, the choices available at any given point of time are limited by what has gone before) and in part by being adapted to national culture (what social scientists call being culturally embedded— meaning it is difficult to escape the formative cultural influences with which you grow up). Thus, the market economies of the Netherlands, France, and Britain each have uniquely Dutch, French, and British aspects, respectively, even if they are all subject to the bureaucratic homogenizing influences of European Union (EU) regulations and share many common Western European cultural antecedents. Economies reflect national cultures.17 Imposing foreign ideas, techniques, and norms on a country without appropri-ate localization can be countercultural and hence fail.

Moreover, Western approaches to banking are not static; they themselves are mutable and continually evolving, in line with national cultural and political economy norms. The present Anglo- American model is not the only way that such systems have worked in the past, or that they do or should work in today’s world. To further complicate the concept of culturally embedded systems, economic historian Eric Jones reminds us that “there is variation within culture” and that the relationship between culture and political economy flows in both directions— each influences the other in a dynamic way.18

If the differing historical paths and cultures could cause the political and economic sys-tems of northern European nations to differ amongst each other, then how much more so might China’s Asian historical path and culture give rise to a political economy, and banking system, different in many ways from Western models? Gordon Redding and

15 Deng Xiaoping, Selected Works of Deng Xiaoping, vol. 3 (Beijing: Foreign Languages Press, 1994), 256. 16 Justin Yifu Lin, Demystifying the Chinese Economy (Cambridge, UK: Cambridge University Press 2012), 66. 17 See Jones, Cultures Emerging, for discussion of the literature on this subject and for his own views on how the

extent to which cultural dependence of economies is limited by the mutability and flexibility of culture. 18 Jones, Cultures Emerging, 32, 36.


Michael A. Witt, in their book The Future of Chinese Capitalism, make the case for a cultural perspective on economic systems, maintaining that within a society, attitudes and behavior patterns are

all based in the fundamental ideas of the society about the conduct of life. Such ideas shape the institutions and become manifest in them. The rules of conduct rest on ideas about what the conduct is for. The means are shaped by the ends, and the ends come from the society’s ideals, its culture. This is what allows it to remain a society, for without that integration of accepted meanings, it loses its order and its coherence.19

Even in the most extreme market capitalist economies, the government plays a sig-nificant role. Differences between nations’ banking systems lie in the degree of govern-ment involvement. In a recent book, Fragile by Design, authors Charles W. Calomiris and Stephen H. Haber maintain that “there are no fully ‘private’ banking systems; rather, modern banking is best thought of as a partnership between the government and a group of bankers, a partnership that is shaped by the institutions that govern the distribution of power in the political system… . Banks are regulated and supervised according to tech-nical criteria, and banking contracts are enforced according to abstruse laws, but those criteria and laws are not created and enforced by robots programmed to maximize social welfare; they are the outcomes of a political process… .”20

Calomiris and Haber describe the development of the dissimilar banking systems of the United Kingdom, United States, Canada, Brazil, and Mexico to demonstrate that the banking systems of each country arise out of particularistic political circumstances. Examination of different political processes leading to very different banking outcomes in these five countries makes it clear that “universal laws” of proper banking with mini-mum government interference, as espoused by Wall Street, are actually “the outcomes of a political process.”

In its national history, the United States has experienced fourteen banking crises. Over the same period of time, its next- door neighbor, Canada, has experienced one crisis— in 1839.21 The distinctive historical development paths and cultures of the two countries, leading to different political processes, explain why the banking experience of the two countries should be so different.

Echoing the cultural economics approach of Reddy and Witt and the “outcome of a political process” argument of Calomiris and Haber, I describe in this book the opera-tions of China’s banks as generally consistent with today’s international norms of best

19 Gordon Redding and Michael A. Witt, The Future of Chinese Capitalism (Oxford: Oxford University Press, 2007), 16.

20 Calomiris and Haber, Fragile by Design, 13. 21 Calomiris and Haber, Fragile by Design, 283.


banking practice, but the economic role and rationale, the ownership structures, and the corporate cultures of Chinese banks arise out of China’s history, are embedded in a cul-tural context that traces its roots back millennia and serve the interests of the political power structure.

China’s humiliation for over a century by the West, the turbulence of civil wars and revolutions, and the role of the Communist Party in unifying and governing China all form part of the historical path out of which the present day Chinese market economy and banking system have arisen. Over the last century and a half, China has been search-ing for the right institutions and technologies of the West to graft onto China’s cultural roots to restore China to the position of “wealth and power” that it had attained in earlier centuries.

Despite three decades of Maoist attack vilifying China’s traditional culture as being “feudal,” China’s cultural legacy has deep roots in today’s China, influencing how mod-ern technology, modern management techniques, and modern economic institutions are absorbed into the society and economy. Redding and Witt write: “To understand any society today requires a coming to terms with its history, and this is especially true of China. Few societies have been so shaped by a consistent way of running a country over two millennia. … China lives with, and is shaped by, its ancient and modern history in a very compelling way.”22

The core of China’s traditional culture is the humanistic, pragmatic philosophical tradition called Confucianism, first espoused in the fifth century bc by Confucius, which then evolved through various reinterpretations over the next two millennia to be the dominant influence on how China’s government and society functioned. Confucian philosophy is most simply a formula for ensuring harmonious relationships at all levels of society, starting with cohesive, patriarchal, and hierarchical families as the fundamental units of society, and building up to a well- ordered nation. The turbulence of the past 150 years, and indeed the occasional periods of bloody political breakdown over the long stretch of Chinese history, have reinforced Chinese conviction of the importance of maintaining social harmony and order. Chinese fear chaos (luan); they accept some curtailment of personal autonomy in return for governance that keeps chaos at bay. This is not an irrational response to China’s historical experience. As Douglass C. North points out, Americans in particular and Westerners in general take for granted a degree of order in society and politics that has dulled our awareness that for most of human history, existence has been plagued by the uncertainties brought about by lack of order.23

Acceptance within the family of hierarchy and of the authoritarian figure of the pater-familias leads to acceptance of hierarchy more broadly in society and to entrusting the

22 Redding and Witt, Chinese Capitalism, 36. 23 North, Economic Change, 7.


state to manage affairs on behalf of the people. The Communist Party has taken on the mantle of traditional Chinese authoritarian rule through a bureaucracy composed of a meritocratic elite, but with a Leninist party format rather than an emperor.

This authoritarian political system enables the state to develop comprehensive national development strategy and to intervene in the banking system in a way that the American government would never seek to equal, and indeed which the American people would find unacceptable. 24 Americans, however, are wont to forget that, despite the enormous sway of America’s soft power and of its economic model, in fact the American version of banking is actually an outlier. No other major country’s banking system so emphasizes shareholder value or so little constrains the workings of the free market in the banking system as does the American system.

The role of the Communist Party and of the state in the financial system place Chinese banking as an outlier on the opposite side of the spectrum from America’s. There are, however, other banking systems which either now resemble, or have in the recent past resembled, China’s by providing a major role for the state in owning and guiding the banking system and influencing the allocation of credit. They include Japan, Korea, Singapore, and also France and the region of Taiwan.

China rarely copies exactly the models of what it borrows from overseas. It borrows selectively what it feels will best suit its needs, discards the unsuitable, then adapts the borrowing to work within its own culture and system. In the banking sphere, the result is not a clone of Western institutions, but rather a hybrid system, which is indeed an outcome of a political process, just as Calomiris and Haber argue. China’s modern political economy is based on millennia of cultural evolution along lines independent of the West; strengthened by borrowing of Western technology and institutions over the past 150 years, grafted onto the root of Chinese cultural essence; developed over the past few decades as part of the remaking of China under Communist Party governance; and dedicated to serving the national commitment to restoration of China’s wealth and power to the levels it had once attained at the height of its strength under imperial dynasties.

China’s history since the latter part of the Qing Dynasty has mostly revolved around debates over how much of the national cultural essence (ti, literally meaning “body,” but extended to mean the “essential substance”) should be retained, how much foreign methods and technology (yong, literally meaning “use,” “apply,” or “usefulness”) should be grafted onto the Chinese ti, and the form that political governance should take— the lat-ter ultimately being resolved with the ascendancy of the Communist Party (dang, mean-ing “party”). Much of my analysis of China’s banks revolves around these three concepts of ti, yong, and dang.

24 Stephen Roach, Unbalanced: The Codependency of American and China (New Haven, CT: Yale University Press 2014), 83– 101


Hybrid Banks

A foreign banker, looking at China’s market socialist banks, will see financial institutions that in most respects appear comfortably familiar and similar to the banks of market capitalist systems. The essential financial intermediation functions, organizational structure, manage-ment processes, and operations of Western banks, the broad outlines of which are generally shared among Western banking systems, are all present in Chinese banks. The similarities are to be expected, since the rebuilding of the banks after the problems of the 1990s was based on modern banking techniques learned from the West. So of course Chinese banks look much like Wall Street banks. On closer examination, however, the hybrid character of China’s banks, or in a sense their distinctive “Chineseness,” becomes apparent.

The first hybrid characteristic is the economic rationale for banking in China. Put another way, what role do Chinese banks play in the nation? Financial intermediation is the purpose of banks everywhere, but the ends of financial intermediation differ. An American or British bank is managed with the objective of maximizing shareholder value, within the constraints imposed by regulatory supervision. Government licensing facilitates government regulation to protect the public from malpractice or irresponsible management leading to bank failure. How a bank lends money, provided that it manages risk reasonably well, is its own business.

A Chinese bank is managed with twin objectives: maximize shareholder value and serve the real economy. Perhaps we might call it a financial public utility? A regulated public utility in the United States is given a franchise by the government to provide elec-tricity, water, or some other good to the public, in return for which it is allowed to earn a reasonable return on owners’ equity. A Chinese bank can be looked upon in similar fashion— given a banking license to receive the public’s money in the form of deposits, it is expected to not only use this license to earn a return for shareholders, but also to contribute to the national development strategy, to support the operations of the real economy. In fulfilling this developmental function, it must be responsive to national development strategy under the guidance of the Communist Party in ways that U.S. bank management would regard as unacceptable government interference in management and shareholder prerogatives. In the cooperative capitalist systems of Germany and, even more so, in Japan and other Asian nations, this level of government intervention would be regarded as less inappropriate or countercultural.

The second hybrid characteristic of the Chinese system follows from the first. Almost all Chinese banks are majority owned in one form or another by the government. Of the tier 1 banks, only three are majority privately owned: Minsheng, Pingan, and Zheshang.

The third hybrid characteristic is that the Organization Department of the Communist Party appoints senior management of the major banks and has a role in setting compensa-tion standards.

It should be noted that, despite lack of government ownership, the three privately owned joint stock banks are still strongly subject to Communist Party influence through guidance


given to all the banks urging support of national economic objectives, through the Party Committees of the banks, and through participating in senior personnel decisions.

These are the three features that define the hybrid character of most Chinese banks— neither wholly a creature of the market, nor wholly an agency of the state. They compete intensely for market share and profitability, do not have the bureaucratic cultures one expects to find in government organizations, and hence function much like private sector organisms. But they are viewed by the government ultimately in instrumental fashion. Banks exist to play a role in the overall economy, the financial intermediation role. They are a means to an end, not the end in itself. In creating this hybrid culture of banks, China attempts to have its cake and eat it too— realize the efficiency of market- driven, competi-tive management, while at the same time retaining ultimate control of the banking sector and guiding bank operations at the macro level in support of broad economic policy.

Hybrid characteristics of Chinese banks are not accidental. They are partially a legacy of how China has developed over the past half century, a residual of a planned economy. Notwithstanding that the hybrid features are residuals from the earlier socialist planned economy, one must ask why the transformation of Chinese banks did not result in clones of one of the various models of Western banks. After all, several East European banking systems made complete conversions, discarding their socialist roots. So have the banks of China’s immediate neighbor to the north, Mongolia, where banks are now mostly in private hands, functioning along the lines of Western banks, despite the country having been a part of the Soviet bloc until 1993. After the near collapse of its banks in the 1990s, China could have put the banks in private hands and made them independent of the Party, subject only to supervision in the public interest by the bank regulatory authorities. That did not happen.

After the 1990s, the banking transformation implanted in China’s banks the mechan-ics of a modern commercial bank, almost entirely learned from Western models. Had the Wall Street financial crisis of 2008 not occurred, perhaps Chinese banks would have gradually moved further and further in the direction of independence from the Party and government, converging with a market capitalist banking model, even though that had not been the original intention of the banking transformation launched a decade earlier by Zhu Rongji.

The Wall Street implosion of 2008 had little direct financial impact on China’s banks, but it shattered Chinese belief in the sustainability of Western models of banking. Subprime loans, millions of foreclosed mortgages, giant failed institutions requiring gov-ernment bailout, and unemployment brought about by financial crisis— this was not at all what China felt a banking system was supposed to do. Instead, China decided that further development of its banking system, while continuing to draw lessons from Western tech-nology, management, and marketing techniques, would remain one of the critical indus-tries that the government wished to own and/ or control under market socialism.

This disillusion was palpable in discussions I had in Everbright Bank in the closing months of 2008. Previously there had been cautious interest in identifying an appropriate


Western bank to become a strategic partner and shareholder of Everbright Bank, but after the crash of September 2008, within weeks that option had dropped off the agenda. It was apparent to me that the conclusion that Chinese banks would henceforth find their own way was not just a conclusion reached in my bank, but reflected the sentiments of broader discussions within the entire banking system at senior levels.

The development of China’s banking system has been shaped by the role of the Communist Party over the past half century in China, but perhaps even more by a cultural legacy that places high value on the collectivity, on the role of the state, and on the need to maintain control and order. Arising out of this historical development path, embedded in this Confucian culture, China’s banking system takes on a hybrid character that differs from the Western models from which it has heavily borrowed.

Future Directions

A period of extremely high growth of the Chinese economy, at rates exceeding 9% per annum for most of the thirty- year period ending in 2014, has come to an end. China is now transitioning into a new phase of more moderate, but still impressive, growth in the 5– 7% range, which the leadership calls the New Normal. Not only is the overall growth rate lower, but the structural complexity of the economy has greatly increased, new and more difficult economic challenges face the nation, and the country must address the problems identified in 2008 by Prime Minister Wen Jiabao of economic growth being “unstable, unbalanced, uncoordinated, and ultimately unsustainable.” Wen was particu-larly concerned with environmental destruction, widening economic inequality, persis-tence of poverty, excessive dependence on investment and exports to drive the economy, and inefficient use of resources and allocation of capital.

Whereas ensuring full employment, providing decent housing for everyone, and putting in place necessary public infrastructure were the overriding objectives of the previous three decades, now public policy focus is on greater economic efficiency, reduction of invest-ment and export dependence of the economy, a greater role for consumption and services in the composition of GDP, broader distribution of the fruits of economic development, cleaning up the environment, and restructuring the economy away from traditional, and often overcapacity, industries into innovative and more technology intensive industries.

At the same time that China is reorienting the economy and transitioning to the New Normal, it is also adjusting its foreign policy. For years after Reform and Opening began, China heeded the admonition of Deng Xiaoping to “hide its light,” focus on internal reform and strengthening, and avoid distracting international engagements. In the later years of the Hu Jintao and Wen Jiabao government (2002– 2012), foreign policy began to change. China tentatively asserted itself, at least in Asian regional affairs.

With the accession in 2012 of Xi Jinping and Li Keqiang as Party general secretary and prime minister, respectively, China, feeling confident of its newly acquired economic


strength, claimed a place in world affairs as one of the two major world powers. Finance is part of this new international assertiveness, seen in the expansion of Chinese banks outside of China, internationalization of the renminbi (rmb, China’s currency, also called “yuan”), expanded two- way flows of investment in equity markets, and the launching under Beijing’s leadership of new multilateral development banking institutions.

Internationalization of the rmb and opening of equity markets to increased foreign participation will inevitably lead to greater capital market opening. This will in turn decrease Beijing’s ability to control the flow of money into and out of China, to influence the exchange rate, and to prevent foreign economic events from destabilizing the domes-tic economy. Beijing will balance its objective of claiming a greater role in international finance against its innately cautious desire to insulate its economy from being buffeted by global economic currency flows and the impact of foreign economic problems.

These economic and foreign policy developments are paralleled by a variety of other national reform initiatives launched at the 3rd Plenum of the 18th Party Congress in November 2013 and spelled out in greater detail at the 4th Plenum in 2014. These parallel reforms include upgrading of the rule of law, environmental cleanup, and reform of certain areas of the financial sector.

Efficient Financial Intermediation?

Ultimately, though, the question must be answered: Does this largely state- owned hybrid banking system serve China well? Is it effective in performing financial intermediation? Is it a sustainable banking model that best suits China’s needs now and looking ahead? Are there aspects of China’s approach to banking that other countries might find useful? Answers to these questions must be based on a definition of financial intermediation, and a way of assessing the effectiveness of financial intermediation that will enable evaluation of the Chinese system.

Since the time that nations began to develop modern commerce and industry in the eighteenth century, they have found that some sort of banking system to provide fund-ing for investors and lubricate commercial transactions was essential. Banks today are complex institutions, but underneath the complexity, they are nothing more than finan-cial intermediaries that exist to perform two economically vital functions: intermedi-ate between savers and borrowers to efficiently allocate capital and undertake payments between parties. In the course of performing these two functions, they must assess and manage the risks involved, so as to get their money back. Banks lose money through fraud (operational risk), through loan customers defaulting on their loan principal repayment and interest payment obligations (credit risk), or misgauging market conditions (liquidity and market risks). If risk is not managed effectively, losses may wipe out a bank’s capital, or the public may lose confidence, leading to a run on the bank, causing its deposits to drain away.


To perform these two tasks of intermediating savers and borrowers and undertaking payments, banks put in place a complex set of functions, skills, and controls. Moreover, since banks are highly leveraged, and take the public’s hard- earned savings as deposits, on the understanding that they will be looked after properly and will be available for the depositor to withdraw, often at relatively short notice, the public has an interest in ensur-ing that the banks are prudently and competently managed. Therefore, governments everywhere license and regulate banks to ensure that bank operations are in good order and that banks do not engage in risky or unprofessional practices that might bring about bank failures. If a bank is not well managed and fails, then, depending on the circum-stances and on the national regulatory regime involved, the operations of the bank will be wound up and the depositors will lose their money, or the depositors will be reimbursed by deposit insurance, or the bank will be bailed out by the government.

From an economic perspective, one can judge the effectiveness of the risk assessment and credit allocation function of a banking system by looking at three criteria:

1. Access. Do businesses that need credit to grow, and consumers that need credit for housing, purchase of consumer goods, and other purposes, have broad access to credit? In technical jargon, how deep and broad is financial access? If viable businesses are unable to borrow money from formal lending institutions at rea-sonable rates, entrepreneurial energies will be blocked by lack of access to credit, reducing overall national economic growth. The extent to which banking sys-tems in different countries provide access to credit varies greatly.25

2. Efficiency. Do interest rates reflect a realistic assessment of the relative risks of different projects and borrowers? In technical jargon, how efficiently do banks allocate credit? At the micro level, how efficiently do banks deploy shareholders’ equity to yield the highest returns to shareholders? At the macro level, how effi-ciently do banks deploy credit to firms and sectors of the economy that realize the highest returns on investment?

3. Stability. Do banks have healthy balance sheets? This indicates whether or not banks are managing their loan and investment assets effectively, and whether or not they have loaned money to businesses or individuals that generate sufficient cash to repay their borrowings. In other words, are the banks stable, are their operations sustainable? Some banking systems are chronically unstable, the US one being a prominent example. Canada, Australia, and Singapore are examples of stable bank-ing systems, with low rates of bank failures and few systemic banking crises.26 In Asia, Korea has suffered through repeated banking crises over the past half century.

25 Calomiris and Haber, Fragile by Design, 7– 9. 26 Calomiris and Haber, Fragile by Design, 454.


In the 1990s most of China’s banks were technically bankrupt, continuing to func-tion only because the full faith and credit of the government was behind them.

China’s meteoric economic growth over the past two decades would suggest that the banking system has at least performed reasonably well in supporting the growth of the real economy. The restructuring and reorientation of the economy, the new assertive-ness in international relations, and the reforms in rule of law, natural environment, and financial sector all pose new challenges for the banks to adapt to in a rapidly changing environment. This book assesses how well the banking system is functioning today, dem-onstrating that it has strengths, but that increasingly weaknesses may become apparent, requiring ongoing adjustment of the banking system in future years to meet the chal-lenges of the new economic growth era that China is entering.

The narrative of this book puts forward three propositions.

1. Three elements have conditioned the nature of the banking system: China’s traditional culture (ti), China’s extensive adoption and adaptation of foreign institutions and technology (yong), and the pervasive role of the Communist Party in China’s party- state– dominated political economy (dang). This thesis is not a version of the “Asian values” argument current twenty years ago. It does not argue that China’s combination of ti, yong, and dang has been the underly-ing cause of the successful transformation of China’s banking system. The many theories of what leads to successful development and modernization attest to the difficulty of identifying their underlying causes. Rather, this book argues that ti, yong, and dang have conditioned how China’s banking transformation unfolded, and they explain the characteristics of China’s banks. It describes what happened in the transformation but does not speculate on whether or not a different set of cultural and political economy conditions might have caused the transformation to have been more or less successful.

2. The Chinese banking system has transformed since the 1990s from a technically bankrupt cashier for the government into a modern, stable, and well- managed banking system, with an ability to provide effective financial intermediation and broad financial access that has been steadily improving year by year, although further refinement and evolution of the system is needed and will continue.

3. This transformation has resulted in a hybrid banking system, neither wholly an agency of the state nor wholly a creature of the market, reflecting what Xi Jinping has called the cooperation and coordination of the “visible” hand and the “invisible” hand of a market socialism economy.

25

In the spring of 2015, an economic analyst representing a major securities firm spoke at a China investment conference, attended by people working in the field of China portfolio investment. In the course of his remarks, he predicted that within two years China would experience a financial crisis. This financial crisis would occur because the highly regarded minister of finance, Lou Jiwei, determined to ring “moral hazard” out of the system, would allow local governments to default on their bank loans. Indeed, in early 2015, many observers of China’s economy feared that China’s local governments, stretched for cash, would default.

Whether this prediction is accurate or not will be proven by events. At the time of writing this book, the outcome is not yet known, but that is not the point, for if Lou Jiwei were to do as predicted, it would be a very interesting new development, not just for banks, but for the economy as a whole, as it would be “out of character”— not the way that China, despite its bold program of “Opening and Reform” of the past three decades, has generally handled situations like this. In this chapter and the next, I discuss aspects of China’s culture, history, and political economy institutions that have explana-tory value for understanding how China’s banking system and credit markets work,

2 Culture Matters

Both the apparently moribund and the obviously vital aspects of old China’s civilization

remain relevant to an understanding of China as it is now… . The leaders of no other nation

in our century have so directly inherited the mantle— or is it the pall?— of so ancient a

cultural past… .Fredrick Mote, 19711

The role of culture in contemporary Chinese economic development cannot be reduced to

the impact of past traditions on the present, but lies at the very heart of modernization.Carsten Herrmann- Pillath, 20122

1 Frederick W. Mote, Intellectual Foundations of China (New York: Alfred A. Knopf, 1971), v– vi. 2 Carsten Herrmann-Pillath, “Making Sense of Institutional Change in China: The Cultural Dimension of

Economic Growth and Modernization,” in Masahiko Aoki, Timur Kuran, and Gerard Roland Houndmills, eds., Institutions and Comparative Economic Development (London: Palgrave Macmillan, 2012), 263.


after which I return to examine the analyst’s prediction in the light of these cultural and political norms.

The discussion of culture, history, and political economy institutions that follows is based on the extensive work done in those fields by many Chinese and foreign schol-ars. A principal argument of this book, echoing the comments of Mote and Herrmann- Pillath that head this chapter, is that the past evolution, present operational mode, and likely future development of China’s banking cannot be analyzed without an understand-ing of China’s cultural and political norms and beliefs. Hence, the prediction that Lou Jiwei will engineer a financial crisis is raised as a case study relating current policy to traditional values.

In introducing the context relevant to Chinese banking, I identify three elements on which to focus: first, China’s traditional culture; second, China’s absorption of Western technology and institutions over the past century, and especially since the start of Reform and Opening in 1978; and third, the pervasive role of the party- state in contem-porary China. As pointed out by political scientist Sujian Guo, “After the communist takeover of power, traditional Chinese culture and values including Confucianism were in fact not destroyed, but, instead, carried to the extreme in a new name— communism. Communism is not a new collective immortality for China, but the old one with a new name in the Chinese context.” 3 The party- state actually fits in quite well with the norms of Chinese political culture that prescribe how China should be governed, and the soci-ety and economy should be ordered, for the greater good.

Traditional Cultural Core

The mainstream of China’s traditional cultural heritage legacy for the past two millennia has been, and remains today, the Confucian tradition, which has provided a philosophical framework for the nation and the society to achieve harmony and stability. Reinterpreted several times over the more than two millennia since its founder, Confucius, had lived, understanding of its classic texts was the core of the education of the “mandarin” scholar gentry class that ruled China under the emperors over the course of many dynasties. This was the “Great Tradition” of China which, since the time it was instituted as orthodox state doctrine in the Han Dynasty and found its present form in the Neo- Confucian orthodoxy of the Song Dynasty, defined the governance mode of the imperial govern-ment, became the binding high culture of the elites nationwide, and established norms for conduct at all levels of society. It was also widely studied and applied in differing ways in Japan, Korea, and Vietnam, which lay within China’s sphere of cultural influence.4

3 Sujian Guo, Chinese Politics and Governance: Power, Ideology, and Organization (London: Routledge, 2013), 55. 4 Michael Schuman, Confucius and the World He Created (New York: Basic Books, 2015), is a good popularized

account of the evolution of Confucianism over the course of its history, with commentary on its present status in China and the region.

Culture Matters 27

The sponsorship of Confucianism by ruling elites in China has much to do with the fact that it offered a legitimation for authoritarian elite rule and for keeping the masses in their place. Over the early dynasties through the Song, and in today’s China, it has been reinterpreted and distorted from the original ideas held by Confucius, to suit the needs of successive governments and of the scholar official class who claimed sole authority for correct interpretation of the Confucian classics.5

Its attraction, however, certainly extended beyond this self- serving political rationale. It offers a humanistic philosophy of how to live the good life, of how to order relations between people in society that was, and is, compelling— setting a standard for good con-duct and for continuous self- improvement that was practical and relevant to both the scholar class and to ordinary people.

The discussion that follows does not attempt to describe the totality of Confucianism, for which many excellent books are available, but rather to highlight a few Confucian con-cepts that are relevant for understanding China’s banks. It does not attempt to distinguish between what might have been the original thinking of Confucius and the way in which his ideas, embodied in the Classics, have been reinterpreted over the years. The discussion is a simplified explanation of the way that Confucianism is generally understood in China today, with focus on a few core themes that have been mainstream in Chinese thinking over the past 2,000 years, even if Confucius himself, were he to reappear today, might be surprised by how some of them are understood (or misunderstood) in modern China.

The focus of Confucianism is on the group, the collectivity, rather than the individual. In the greater interest of social harmony and order, the individual takes on the identity of the community of which he or she was a part. Community started with the family and the clan, and included locality, school ties, professional ties, and ultimately the national community. Harmony was prized. Duties and obligations of the individual were more important than rights of the individual. Family is the fundamental group in Confucian thinking. Confucianism maintains that if each individual knows his place in society and behaves according to what is expected of him, starting with his place in the hierarchical structure of the family, then society will be well ordered, harmonious, and stable under the rule of the emperor. The mandarin bureaucracy, despite factions and infighting, formed a homogenous governing elite, with shared educational background, cultural val-ues, and outlook, united in service at the top of society to the emperor.6

Political scientist Sujian Guo describes life in a society in which Confucianism is the dominant ideology: “Individuals are born into and belong to a collective, and thus are subordinated to the collective. Observation of these social codes would promote col-lective social norms which constitute the foundation on which social harmony rests.”7

5 Michael Nylan, The Five Confucian Classics (New Haven, CT: Yale University Press, 2001), 13– 16. 6 James T. C. Liu and Weiming Tu, “Introduction,” in Traditional China, eds. James T. C. Liu and Weiming Tu

(Englewood Cliffs, NJ: Prentice- Hall, 1970), 18. 7 Guo, Chinese Politics, 49; also Liu and Tu, “Introduction.”


In a similar vein, Duke University scholar, the late Tianjian Shi, writes that in Chinese thinking a “person’s sense of self must arise from, and intertwine with or be embedded in certain groups, such as the family, lineage and/ or clan, community, race and nation.”8

Guo further asserts that communist rule over China, including in the time of Mao, has been rooted in Confucian concepts of state and society and of the individual’s role and obligations to state and society. Over the past few years, there has been a revival of official interest in and espousal of Confucianism, since it serves today, as it did over 2,000 years of dynastic rule, to provide a moral framework and rationale for authoritarian rule.

“Harmonious society” was the slogan encapsulating national objectives under the leadership of President Hu Jintao when he was head of state from 2003 through 2013. Social harmony of course serves the interests of an authoritarian Communist Party by defining political dissent and unrest as “unharmonious behavior.” Redding and Witt, in their study of contemporary Chinese capitalism, point out that for “centuries the mandarinate’s control over society was based on society’s dependence on the mandarin interpretation of the Confucian- inspired laws. A remarkably small elite could control a remarkably large country that way.”9 Just as it does today.

Confucianism’s core value is “benevolence” (ren). Good governance was characterized by benevolence and was the responsibility of wise officials, selected based on educational attainments. This was “rule of men,” which took the form of the meritocratic mandari-nate that staffed the bureaucracies of successive Chinese dynasties for over 2,000 years of rule.

In Confucianism, it is benevolence that counterpoises authoritarian government. The people should obey, and the emperor and the Mandarinate in return should deliver benevolent rule to the people, resulting in a “peaceful nation and secure people” (guotai minan). In modern political science terms this was regime legitimation by performance, which in essence is how the present communist government derives legitimacy, and how its power is accepted by the majority of the population. In practice, however, this perfor-mance legitimation is self- defining. “How do you know the emperor has the mandate of heaven? Because he is the emperor. How do you know the mandate has passed to a rebel? Because the rebel is sitting on the throne and the emperor is hanging from a tree.”10

Historically and culturally, China has not drawn sharp jurisdictional divisions between public and private in the way that the West has. As a result of the emphasis on the impor-tance of the collectivity, the state in China has played a decisive role in ordering eco-nomic relationships in society. Gordon Reddy states that in China the “state has a duty

8 Tianjian Shi, The Cultural Logic of Politics in Mainland China and Taiwan (Cambridge, UK: Cambridge University Press, 2014), 48.

9 Gordon Redding and Michael A.Witt, The Future of Chinese Capitalism: Choices and Chances (Oxford: Oxford University Press 2007), 86.

10 I am indebted for this observation to Michael Aldrich in a private communication in 2015.

Culture Matters 29

to control. That has always been the first principle of Chinese statecraft. Loss of control over order is deeply threatening.”11

While the Chinese draw less distinction between the public and private spheres than do Westerners, they have always drawn a line between what is in the public domain and what is restricted to the official domain, which explains the obsession with preservation of what is deemed to be “state secrets.” Transparency suffers in the process, but the power of the state to control is enhanced.

Applied to the economic sphere, this duty to control, to ensure order, provides the rationale for the state to intervene in various ways for the collective good, for the pres-ervation of stability in the economy. The collective good would include avoidance of boom/ bust cycles, provision of full employment, raising overall standards of living, and perhaps intervening to forestall a securities market freefall— as it did to great Western criticism in 2015. (Most Americans living in the 1950s or 1960s, prior to the triumph of neoclassical economics and the Reagan revolution, and with memories of the mass unemployment and suffering of the Great Depression still fresh in memories, would not have quarreled with this concept of appropriate government action to bring about collec-tive social good.) In today’s China the state is not reluctant to use its power to the fullest to advance the national development agenda and to preserve order in the economy and society, as discussed in Chapter 7. By and large, so long as they perceive the state as per-forming effectively and having a positive impact on their lives, Chinese people acquiesce in the state’s use of power.

In mainstream Anglo- American thinking, through the “magic of the market,” indi-viduals pursuing self- interest bring about the greatest societal good through the “invis-ible hand.” Historically, this has not been a feature of Chinese thinking about economic relations. Indeed, the Chinese language contains ancient expressions still in common use, such as weili shitu (“be intent on nothing but profit”), that disparage the pursuit of profit as a goal in and of itself. In traditional China, the status in society of people pursu-ing business careers was low. The ideal was the junzi, or gentleman- scholar, who devoted himself to education, self- cultivation, living a life of virtue, and practicing benevolence in relations with others. Today, however, in the words of Deng Xiaoping, “to get rich is glorious,” businessmen are encouraged to join the Communist Party, and tycoons such as Jack Ma have become role models in society. Market forces have been defined as the “decisive factor” that will drive the economy, but in the Chinese view, the market does not occupy the sacrosanct space that it does in Anglo- American thinking. The market is a means to an end, not an end in itself. The end is the good of the nation, of the people as a whole.

The gentleman scholar should live in accordance with the concept of zhongyong, which is perhaps best defined as “moderation in all things,” avoiding extremes, achieving

11 Reddy and Witt, The Future of Chinese Capitalism, 52.


harmony and unity through diversity. Zhongyong in political practice leads to prag-matism, avoidance of dogmatism, flexibility in policy, openness to new concepts— the antithesis of doctrinaire Soviet- style communist governance, but also antithetical to the rigid screed of free market dogmatism.

Three other philosophical traditions— Legalism, Taoism, and Buddhism— have coex-isted with Confucianism, with varying levels of influence at different periods of time. Sharply contrasting with the idealism of the Confucians, the ruthlessly practical Legalist tradition held that an orderly society could best be maintained by severe enforcement of laws by the ruler. The Legalist school was started in the third century bc by Han Feizi and was embraced by the Qin Dynasty autocrat as the government’s official ideology— the only time that an imperial dynasty did not ensconce Confucianism as the official ideol-ogy. The results were not happy, essentially because rule was not exercised with “benevo-lence,” thereby lacking moral legitimacy. Generally reviled as lacking in moral legitimacy (by Confucian scholars who perhaps exaggerated the excesses of Qin rule in their histori-cal accounts in order to discredit a competing school of political philosophy), the Qin Dynasty model of governance based on Legalist doctrines was in fact a part— the practi-cal administrative part— of how Chinese imperial government worked.12 The Confucian ideal was rule through moral sway, but when that did not work, harsh Legalist methods were readily resorted to. As Professor Yi Zhongtian puts it, “Confucianism was the vis-ible ruling party, Legalism was the hidden ruling party.”13

Today China remains a land of “rule of men”— the Party is above the law, great power and discretion is placed in the hands of officials, and much effort is expended by the Party to “rectify Party style,” to inspire proper behavior in the ranks of officialdom through a series of educational campaigns, reminiscent of the Confucian emphasis on the “self- cultivation” and education of the wise scholar official. This accounts for the fer-vor with which the anti- corruption campaign, launched by Xi Jinping in 2013, is being prosecuted— a very Confucian campaign to purify the “rule of men,” but employing some rather Legalist methods, all packaged under the banner of Communist Party discipline, which will be explored in the next chapter.

Daoism, at the opposite extreme from the collectivism of Confucianism, espoused oneness with nature and leading a life untrammeled by social hierarchy and behavioral discipline. To the extent that Daoism would have any relevance to contemporary eco-nomics and finance, it would be through espousal of “inaction” (wuwei) as behavior that would be most in harmony with nature and lead to the best results. This in turn led Daoists to advocate “governance by inaction” (wu wei er zhi). As a political philosophy, this has not attracted much notice in today’s China where the state is highly activist.

12 E. A. Kracke, Jr., “The Chinese and the Art of Governance,” in The Legacy of China, ed. Raymond Dawson (New York: Oxford University Press, 1964), 310– 315.

13 Yi Zhongtian, Zhongguo Zhihui (Shanghai: Wenyi Publishing House, 2011), 49.

Culture Matters 31

Daoism might, however, resonate with those Americans today who espouse a libertarian political philosophy, advocate deregulation, and feel that “government is the problem.”

To this philosophical mix was added a foreign import, the Buddhist religion, brought to China from India. Buddhism preached compassion, restraint, and enlightenment through faith, meditation, and following the path of the Lord Buddha. The growing interest that Buddhism is attracting in China today, including among many successful businessmen, is not begrudged by the government, as it is a guide for personal happiness and salvation, offers no political alternative to Confucianism, and operates in a different realm from and subordinate to the state. When, however, a Buddhist sect, or religious sect of any other sort, appears to in any way challenge the state, as did the fa lun gong sect a few years ago, the state will crush it as a potential source of disorder and competitor to the Party for loyalty.

While Legalism, Taoism, and Buddhism were also important components of tradi-tional Chinese culture and still have deep roots in the popular cultural consciousness of Chinese today, for most of China’s imperial history, Confucianism was, in the words of Mote, “the great way of the whole civilization, the mainstream of intellectual life, the dominant mode of social and political existence.”14 Chinese are pragmatic people in thought and action who handle ambiguity, contradiction, and the yin- yang unity of opposites well, so they have seen value in each of the non- Confucian traditions, much though they may differ from each other. They apply the approaches of each tradition selectively to the different situations they confront at different points in their lives. Mote explains that “the real value of Taoism (Daoism) is that it has served as a balance wheel on Confucianism. Whenever Confucians tended to go too far, to rigidify and petrify life with their standards and forms, to become overzealous in their ethical programs, Taoism helped to restore balance.”15

Confucianism comprised the core of China’s “Great Tradition,” to use the terminol-ogy developed by the American anthropologist Robert Redfield in his studies of peas-ant society in Central America. In Redfield’s model, the Great Tradition, comprising the philosophies, values, and fine arts of the elites, has in traditional societies coexisted with localized “Little Traditions.” The two coexist and are interdependent at the level of the village.

China is a vast nation with a single Great Tradition based primarily in the ideals of Confucianism but in practice supplemented with a dose of Legalism. The immense dif-ferences between regions— geographic, climatic, ecological, agricultural, linguistic, and ethnic— made it inevitable that China’s culture would also encompass “little traditions.” Throughout its history, the vast majority of people lived in peasant communities, where communication and transportation were often inconvenient, and very few living off the land were literate. As a result, localities developed “little traditions” coexisting with the

14 Mote, Intellectual Foundations, 67. 15 Mote, Intellectual Foundations, 84.


Confucian “Great Tradition.” Little traditions included customs and ways of life, folk-lore, folk art, and local forms of worship, but also indigenous ways of settling disputes, arranging commerce, and of relating to central government rule. The persistence of these “little traditions” in the face of all the efforts at nationwide standardization of the central government is an important feature of today’s China, as it has been throughout Chinese dynastic history. Chinese people’s loyalties to their native locality are strong, second only in strength to their loyalty to the family.

Language demonstrates how the Great Tradition and little traditions in China relate to each other. The formal, written Chinese language has always consisted of a unified set of characters, vocabulary, and pronunciation (the national or common language— mandarin spoken by the educated elite across the nation); each locality would have its own spoken dialect, often not intelligible in the neighboring district.

This coexistence of great and little traditions could also be seen in the workings of the government throughout Chinese history from the Qin Dynasty more than 2,000 years ago up to the present day. A centralized authoritarian government, with the emperor (or now politburo) at the apex determined national policies, appointed officials, and issued decrees or enacted laws which were to be applied in standardized form throughout the realm. The Chinese proverb “Heaven is high; the emperor is far away” sums up the real-ity on the ground. The ranks of the imperial civil service numbered only around 10,000, which meant that the local magistrate dispatched by the emperor had to govern with a light hand and to rely heavily on assistance and cooperation from the inhabitants of the local communities that he looked after. The historian R. Keith Schoppa writes of Qing Dynasty rule that this “model of minimal and indirect governance by its very practice in the vastness of the country created (and was continually fraught with) tension between the poles of center and local… .”16

The contemporary Chinese government’s bureaucratic control extends much more deeply into grassroots levels of society than it did in the Qing model described by Schoppa. Nonetheless, there remains in today’s China great scope for permitting local deviation from central government dictates, for interpretation to suit local conditions, for experimentation with ideas and policies outside of central orthodoxy. China’s gov-ernment is not a federal structure, such as the United States has, but it does allow for much decentralization. Local governments have huge responsibilities for governance and development in their provinces and districts. The level of indebtedness incurred by local governments in recent years, and the reform efforts underway now to give greater fis-cal powers to local governments reinforce the importance of local governments as actors in Chinese finance, just as local governments are in the United States. The structure of China’s banking system, with tier 1 nationwide banks and localized tier 2 and tier 3 insti-tutions, also shows the persistence of the great and little traditions.

16 R. Keith Schoppa, “The Political Creativity of Late Imperial China,” in China’s Rise in Historical Perspective, ed. Brantly Womack (Lanham, MD: Rowman & Littlefield, 2010), 207.

Culture Matters 33

Tension between central and local governments remains in the Reform and Opening era of China. Alternation between centralization and decentralization has characterized Chinese banking, credit policy, and monetary policy over the past forty years and is asso-ciated with intermittent bouts of inflation, followed by credit and monetary tightening. Localities pursue expansive fiscal policies, and the center reigns them in.17

Partially because it suits the government’s purposes to inculcate traditional Chinese concepts of social order and harmony in order to quell “disruptive” elements threaten-ing social stability, but also because China increasingly wishes to assert its independence from Western influences and to ground its politics, society, and moral fabric in indig-enous traditions, Confucian thinking is being promoted in education and in popular culture. Its value as a source of political legitimacy to the Party is also recognized.

Xi Jinping’s March 2013 speech to the Party School indicates current Party thinking on traditional culture. After emphasizing that leadership cadre must diligently study economics, politics, history, culture, society, military affairs, foreign affairs, etc., Xi said that they

should also study history and culture, especially traditional Chinese culture. China’s traditional culture is both extensive and profound, and to acquire the essence of various thoughts is beneficial to the formation of a correct world view, outlook on life, and sense of values… . Leading officials should also study litera-ture. They should refine their tastes and develop uplifting interests through appre-ciation of works of literature and art. Many revolutionaries of the older generation had a profound literary background and were well versed in poetry. In short his-tory helps us understand the failures and successes of the past, and learn lessons from the rise and fall of states. Poetry stimulates us, sends our dreams skywards and makes us witty.18

Xi makes a point of liberally interspersing classical allusions and references to sto-ries from ancient history in his speeches. This has not escaped the attention of the Chinese public. In 2014, the Party School published a book with the folksy title Reading History with the General Secretary, containing some of Xi’s allusions and historical ref-erences, followed by edifying explanations on their significance in guiding the life and work- style of officials today. The Introduction to the book states: “China’s traditions and its modernization really do not exist in opposition to each other. Tradition is the

17 Victor Shih, Factions and Finance in China: Elite Conflict and Inflation (New York: Cambridge University Press, 2008). The entire book is an excellent account of the back and forth between local expansive financial policies, countered by contractionary policies of the central economic institutions of the center. Shih’s use of these cycles to explain China’s elites as dividing into two broad factions, “generalists,” who have provincial power bases, and “technocrats,” who have provincial power bases, may, in my opinion, be an oversimplification.

18 Xi Jinping, The Governance of China (Beijing: Foreign Languages Press, 2014), 453– 454.


foundation and source of modernization. If we lose tradition, we would have nothing to depend on.”19

The president of China exhorts government officials to study history, poetry, and eth-ics? The Party School publishes a book extolling the value of traditional culture? This would have been impossible only thirty- five years ago when China was in the midst of a “criticize Confucius” campaign, directed against “feudal traditions” that were seen as impeding China’s modernization. It would also have received less emphasis only twenty years ago, when the government was absorbed in borrowing Western institutions and technologies to jump- start economic development. China has now moved on, become more selective in what it takes from the West, more interested in integrating foreign borrowings with indigenous traditions than uncritically adopting them wholesale. As a result, Chinese intellectual traditions, always important just under the surface even in the most extreme periods of Mao’s rule, again play a vital role in the Chinese political economy and society— and in the world of banking.

The interest in Chinese traditional culture and frequent allusions to the Chinese clas-sics on the part of Everbright Bank’s Chairman, Tang Shuangning, in his discussions of banking issues is evidence that Xi’s words reflect an important strain in how Chinese Party members think about the world in which they live and work. Tang not only pub-lishes articles on current banking issues, he also writes essays on Tang Dynasty poetry and prides himself on the quality of his calligraphy.

American Contrasts

In the United States, rooted in the creed of individualism, laissez- faire philosophy has underpinned much economic thinking. In the mainstream American view, the pursuit of personal economic interests will, through the invisible hand of the marketplace, result in the greatest good for the nation as a whole. If the workings of the invisible hand include cyclical unemployment and periodic turbulence, so be it— those are all tribulations that must be endured for the marketplace to work its magic and for Schumpeterian “creative destruction” to drive technological and economic progress. The economic historian Daniel R. Fusfeld explained that Adam Smith maintained that “self- interest in a free society would also lead to the most rapid progress and growth a nation was capable of achieving.”20 (Devotees of laissez- faire conveniently overlook that Adam Smith also saw the value of regulation by the state for the greater good of society.)

Modern Western economic history is replete with examples of how this rigorous adher-ence to laissez- faire has played out in application of doctrinaire policy. As the United States began its descent into the Great Depression of the 1930s, Senator Thomas P. Gore

19 Lu Dahu, Gen Zongshuji Du Lishi (Beijing: The Central Party School Publishing House, 2014), 1. 20 Daniel R. Fusfeld, The Age of the Economist (Glenview, IL: Scott Foresman, 1972), 31.

Culture Matters 35

of Oklahoma declaimed that depressions were “an economic disease. You might just as well try to prevent the human race from having a disease as to prevent economic grief of this sort.”21 This thinking was shared by Treasury Secretary Mellon, who felt that the government should not in any way intervene with the natural workings of the economy as it spiraled down into the depths of depression. The practical results of this application of economic dogmatism were massive unemployment and widespread suffering, causing even conservative Republican President Hoover to adopt interventionist economic poli-cies, and then leading to the election of Franklin D. Roosevelt and the New Deal.

Decades later, Federal Reserve Chairman Alan Greenspan, steeped in laissez- faire economic doctrine of both conservative economists and the novelist Ayn Rand, was the most prominent advocate of allowing the financial markets to self- regulate and self- adjust. The practical result of this dogmatism was the financial crisis of 2008, which led to reassertion of a more prominent role for government in the economy and stricter regula-tion of the financial markets.

Neither traditional Confucian thought about the position of individuals within the greater society nor the collectivist ideas that underlie modern Chinese thinking about the role of the state support limiting government economic and political policy to provi-sion of certain public goods. Nor do they support the idea that prosperity can be created entirely based on individual initiative. For Chinese, the wealth of the nation and the wealth of its citizenry are intertwined.

Another major contrast between the intellectual traditions of Confucianism and of the West is that Confucianism is little concerned with the cosmological and epistemo-logical issues that are prominent subjects of Western philosophical and religious interest. The concerns of Chinese philosophy are with human life and society22— essentially how to live harmoniously with society (Confucian and legalist) or how to live harmoniously with nature (Daoist). Mote explains that “all schools of Chinese thought have looked with great suspicion upon the concern with any purely speculative theory of knowledge disputatiously maintained. . . .” Furthermore, for Confucians, “order and practical social good were more important in any philosophy than a search for abstract truth.”23

This attitude is manifest in the lack of interest that most contemporary leading Chinese economists evince in strictly theoretical economic debates— their academic interests revolve around how to apply economic concepts to practical policymaking. There are a large number of very fine minds in the economics profession in China today, but most are not attracted to the sort of mathematically based research that leads to Nobel Prizes among Western economists, nor are they attracted to theoretical models that do not reflect the complex realities of real economic behavior; in the tradition of Confucius advising the kings of ancient China, today’s economists compete to make their advice

21 Quoted in David M. Kennedy, Freedom from Fear (New York: Oxford University Press, 2005), 51. 22 Donald J. Munro, The Concept of Man in Early China (Stanford, CA: Stanford University Press, 1969), ix. 23 Mote, Intellectual Foundations, 107– 108.


on how to run the country’s economy heard by China’s leaders. Confucius himself, and other literati of the time, traveled between the capital cities of the different Chinese king-doms of the Yellow River Valley, seeking to find kings who would engage them to advise on matters of statecraft and governance. In later dynasties, the Chinese scholar- official ideal was an intellectual who was also a practical man of action.

The whole purpose of Confucius’s philosophy was ultimately social— how to order society in such a way that it would be orderly, peaceful, and prosperous. Political economy enters into Confucianism as a means to order society harmoniously, for which practical measures were needed. One scholar of Chinese classics, Michael Nylan, maintains that “economic justice” is an essential requisite in Confucius’s conception of the moral and well- ordered society. “The just state must therefore assure its people economic opportu-nities and a social safety net… .”24

This same legacy of intellectual pragmatism inherited from two millennia of Confucian thought also shapes the characteristic pragmatism of China’s Communist Party. Xi Jinping, in his landmark speech to the Party School on March 1, 2013, on the occasion of its 80th anniversary, exhorted leading Party members to dedicate themselves to study, but said that “The purpose of study lies in practice. The ultimate goal of leading officials who dedicate greater effort to their studies lies in honing their capability in work and in solving problems.”25

If one is an economist in China, neither the cultural nor philosophical approaches to life and thought with which one has grown up nor the career paths that one can pursue would encourage focus on the sort of mathematically based economic theorizing that has dominated Anglo- American economic thinking and research over recent decades. The economics profession, whether in government service or in academia, is focused on developing economic solutions for the pressing development problems that China faces.

Using Modern Methods

The Opium War of 1839– 1842 shocked China, impelling China’s long search for a way to restore China’s place in the world. For centuries past, China had been the largest and most prosperous economy in the world. China had felt itself to have been the center of the world, as signified by the name that China calls itself, zhongguo literally meaning “Middle Kingdom.” Its emperor was accustomed to receiving tribute from the “barbar-ian” weaker and less civilized countries on its peripheries. With the arrival of foreign warships, China was forced at gunpoint to heed the demands of European barbarians. This was China’s shame, as over the succeeding decades it lost battle after battle against the foreigners and had to cede foreigners extraterritorial privileges on its own territory.

24 Nylan, Five Confucian Classics, p. 358. 25 Xi Jinping’s “Address to the Party School” on March 1, 2013, in Xi, 454.

Culture Matters 37

The study of Western civilization and gradual incorporation of aspects of the West into Chinese civilization began. Over the century after the Opium War, China searched for the formula, for the mix of ingredients that had enabled Western people, whom Chinese regarded as barbarians, to surpass and humiliate China’s ancient civilization. The proper weight to be accorded to modernization on the one hand and to upholding the legacy of cultural heritage on the other, or to combining the two, has been the dominant theme underlying China’s turbulent history over the past century and a half.

In the second half of the nineteenth century, the mantra ti yong (“strengthen Chinese core with foreign methods”) encapsulated the search for the ideal balance between the Confucian culture and modernizing reform. As the decades passed, with China becom-ing weaker and suffering more humiliations, different protagonists sought to make the mantra work for China. Zeng Guofan and Li Hongzhang, leading Qing officials, focused on Western science, technology, and revamping the military, while later on Kang Youwei and Liang Qichao, as intellectual leaders, focused on education and political reform to provide the dynastic government with new vitality and legitimacy.

The intellectuals of the May 4th Movement of 1919 and of the New Culture Movement of the Nationalist period in the 1920s through the 1940s moved beyond seeking tech-nical solutions to the problem. They saw the suffocating influence of China’s ancient Confucian culture as the source of its contemporary backwardness and embraced an array of new ideas, often radical, for rebuilding Chinese culture and society. More recently the radical social engineering of the Communist government culminated in the disastrous Cultural Revolution.26 None of these attempts over the course of a more than a century was successful in finding the way for China to regain wealth and power, although Mao’s successful revolution culminated in 1949 with unification of the nation and abrogation of quasi- colonial agreements imposed by foreigners. That was at least the first step toward restoration of Chinese national pride.

In 1978 Deng Xiaoping’s bold initiative, Reform and Opening, finally provided a for-mula for balancing ti and yong and for regaining China’s wealth and power. The results of this new strategy are well known— unprecedented economic growth averaging over 9 percent over the thirty years 1980 through 2010, lifting millions out of poverty, put-ting in place nationwide transportation infrastructure, converting the economy from a planned system based on state owned enterprises to a market- driven system with the pri-vate sector as the growth driver, and building a modern banking sector.

This chapter has introduced key aspects of Chinese traditional culture and history that have shaped the modern Chinese nation, still profoundly affecting thought and behavior norms of today’s Chinese, the nature of China’s governance, and the way that its banking system is managed and operates. It has sketched how China’s quest to regain wealth and

26 Rana Mitter, A Bitter Revolution: China’s Struggle with the Modern World (Oxford: Oxford University Press, 2004) and Orville Schell and John Delury, Wealth and Power (London: Little Brown, 2013) are excellent sources of information on China’s search for modernity over the past 150 years.


power has led to extensive borrowing of foreign technology, institutions, and commer-cial and financial best practice, which are all grafted onto China’s ancient cultural core. My description of China’s current banking system as a hybrid can be understood as an application of the concept of tiyong (“Chinese core, foreign methods”). The next chapter completes the introduction of the context of Chinese banking, describing the political institutions, political values, and key features of public policy formulation that character-ize China’s governance approach and form the political environment in which banking has developed in China. In today’s China, the Party, or Dang, governs and shapes the political environment. As explained in Chapter 1, ti, yong, and dang are the elements that define China’s hybrid banking.

39

The Communist Party has ruled China since 1949. Today the role of the Party in Chinese banks is one of the distinguishing features of the Chinese banking system. The Party permeates the political and economic life of China. Under Mao, the Party per-meated private life in China as well, but the reforms of Deng took the Party out of the personal sphere, leaving people free to get on with their lives as they choose, and thus converted China from a totalitarian regime to an authoritarian regime. Built on Leninist principles, honed through twenty years of epic struggle in China’s civil war with the Nationalists, the Party was legitimated by its success in 1949 in unifying China and driv-ing out all foreign intruders, thus ending China’s “century of humiliation.”

The Party makes no pretense of being democratic in any way that a Westerner would recognize, yet neither is it a clone of the Communist Parties of the former Soviet- style regimes. It follows the tradition of China’s imperial Mandarinate, governing in authori-tarian fashion, claiming a mandate based on performance in raising the people’s liveli-hood and restoring China’s national pride and influence on the world stage. It is far and away the most successful of the “authoritarian capitalist” states, which today include Russia, Vietnam, and Laos.

3 Leninism and Pragmatism of China’s Communist Party

Without the leadership of the Communist Party, there could be no building of socialism.Deng Xiaoping 1

1 Xie Pinru, ed. Xiaoping Said: Build Socialism with Chinese Characteristics (Guangzhou: Guangzhou Higher Education Press, 2014), 81.


As already discussed, tolerance for an intrusive and authoritarian state is culturally higher in China than it is in the West.2 China’s authoritarian governance fits the pat-tern of what Tianjian Shi refers to as “guardianship democracy,” which is legitimized less by process (such as elections) than by delivering results. The state is the guardian of the people’s interests and is therefore less concerned with popular participation than are lib-eral democracies.3

Political scientist Bruce Gilley places China’s political economy within the framework of what he calls the “Asian Governance Model,” covering fourteen East and Southeast Asian nations in which he discerns a common heritage of political values with deep roots in pre- colonial governance traditions. The key elements of this Asian Governance Model are a dominant state “that enjoys above- average levels of legitimacy, compliance, capacity, effectiveness and resilience and a correspondingly above- average set of obliga-tions to behave morally, seek social feedback, and remain internally accountable, reform-ist, meritorious and rational.”4 Gilley writes that in the “Asian Governance Model,” “the state will deliver economic and social advancement, state and territorial sovereignty, and national and cultural renewal, in return for which society will accord it legitimacy and authority.”5 This model describes China’s politics over the past forty years of Reform and Opening reasonably well, allowing an authoritarian China to fit within the same Asian Governance Model as a more participatory polity such as Korea, and other Asian nations, such as Singapore, Indonesia, Thailand, and Malaysia, that are in various stages of transitioning between authoritarian and participatory systems.

Party- State

The Party, not the government, is the ultimate source of power in China. The Party controls the government. This “party- state” governance is similar to the model that was followed for decades by the Kuomintang, both during the Republican period in the mainland and subsequently in Taiwan through the 1980s, when it initiated political lib-eralization and Taiwan became a pluralistic political system, with independent parties competing in open elections.

Parallel to and subordinate to this party apparatus is the structure of the organs of gov-ernment, which in most ways looks not dissimilar from government structures of other countries. However, the policies of the nation are determined at the highest level by the

2 Tianjin Shi, The Cultural Logic of Politics in Mainland China and Taiwan (Cambridge, UK: Cambridge University Press, 2014) and Gordon Redding and Michael A. Witt, The Future of Chinese Capitalism: Choices and Chances (Oxford: Oxford University Press, 2007).

3 Tianjin Shi, The Cultural Logic of Politics, 197– 201. 4 Bruce Gilley, The Nature of Asian Politics (New York: Cambridge University Press 2014), 16– 17. 5 Gilley, Nature of Asian Politics, 16.

Leninism and Pragmatism 41

Party and are only then carried out by the government; key appointments to government and all major government- owned business organizations are made by the Party.

This parallel structure of party and government is the Leninist model that China adopted from the Soviet Union in the 1920s and refined after it unified China under its rule in 1949. The Party is still in name communist, but there is little that Marx, Lenin, or Stalin would recognize as communist economics left in the policies the Party pursues today, notwithstanding the tortured attempts of Party ideologues to trace the present doctrine of the Party back through successive theoretical adaptations by Jiang Zemin, Deng Xiaoping, and Mao Zedong to the original ideas of Karl Marx. It is not just in China that Marxist orthodoxy has been fundamentally reinterpreted. Lenin radically reinterpreted Marx to explain how a backward pastoral nation like Mongolia could become a communist nation in 1924.

The Party is a foreign import, but it was not difficult to graft it onto traditional Chinese concepts of governance, which have always been authoritarian, elitist, and more about “rule of men” than “rule of law.” Political scientist Zheng Yongnian, born and raised in China, educated at Peking University and Princeton, and now heading the East Asia Institute in Singapore, expressed the continuity of political culture succinctly: “. . . politi-cal parties in China are simply an organized form of the ‘power of the emperor.’ You must understand this organized form of the ‘power of the emperor’ from the cultural perspec-tive. This situation actually started with Sun Yat- sen.”6 The Communist Party cadres staff-ing the ranks of government fill the role that in previous centuries had been carried out by the Mandarinate. Both the imperial system and the contemporary system assume that the nation and the people well be best off under rule by a meritocracy.

Although the Party no longer espouses communist economics, the Party remains true to its origins in two areas. First, the Party retains its political rationale as the “vanguard of the people,”7 in which capacity it continues to exercise unquestioned authority in all mat-ters of national ideology, policy, and governance, and it retains its Leninist organizational structure and mode of operations. In these ways the Party has not departed from either its Leninist origins or the model established by Mao Zedong and then carried forward successively by Deng Xiaoping, Jiang Zemin, Hu Jintao, and now Xi Jinping, each adding his own gloss to Party dogma, but none straying far from the original mold.

The sole source of political power in the country, the Party is secretive in deliberations, highly structured and disciplined, demands total loyalty of its members, and occupies all the important authorized political space in the country. This results in a phrase used in China that strikes foreigners as odd— “Market Leninism.” The phrase would seem to be internally contradictory, yet it does convey the sense of a political economy that

6 Zheng Yongnian, Zhongguo Gaige Sanbuzhou (China’s Reform: A Roadmap) (Beijing: The Oriental Press, 2012), 118– 119.

7 As defined by Jiang Zemin’s theory “The Three Represents,” which expanded the party’s scope of representation from the proletariat and peasantry to include all the people.


combines authoritarian governance with an economy run for the most part on market principles, albeit with a strong guiding role for the state. The market is to be the decisive factor in the workings of the economy, while the Leninist Party controls the politics of the country and reserves to itself the power to intervene in the market economy when it sees fit.

In practice, the Party exercises its absolute authority in three principal areas:

1. National Policy: At the top of the Party, the Standing Committee of the Politburo sets general policy at the strategic level. Policy directions are given to the State Council for elaboration in bureaucratic regulatory form, but are at the same time transmitted down through Party channels to Party units in every organization of the country. Directors and managers of state- owned banks will be fully aware of Party policy in relevant areas and will be expected to be supportive of national policy in setting strategy and guiding the operations of the banks.

2. Senior Appointments: The Central Organization Department of the Party is responsible for vetting and appointing all top officials, perhaps numbering in the tens of thousands, including senior appointments in SOEs, and for guiding the training and career development of senior party members. The Party appoints the top few managers of each state- owned bank. Through this mechanism the Party controls the significant institutions of the country that are not privately owned. In addition, Party cells exist in organizations all over the country, to which employees who are Party members will belong.

3. Propaganda and Discipline: The Party exercises control over not only its own members (who number over 80 million), but over all citizens through a com-bination of censorship of media it regards as undesirable, or in some way not conducive to social harmony, and through the enormous and pervasive security apparatus.

Aside from these three areas, the implementation of policy and administration of the country is carried out by the state.

Both the Party and the government control and influence commercial banks, but in different ways and through different channels. The role of the Party in the management of the banking system parallels the role of the Party at the national level: policy, person-nel management, and discipline. Senior bank executives are almost all Party members, appointed to their positions by the Party, based on professional competence, but with political reliability an essential qualification. Many have served stints in the national financial regulatory agencies, or other financial positions in the state prior to be being assigned to commercial banks. Their career development is in the hands of the Party. Understandably, they will be responsive to national policies that are transmitted down from the Politburo. If they commit transgressions, their cases will be handled first through Party disciplinary channels prior to being handed over to the courts.


The second area in which the Party remains true to its origins lies in what I shall call, for lack of a better term, Party values. Just as the Party’s authoritarian governance mode carries on much of the governance philosophy and methods of imperial dynastic govern-ing institutions, so also the Party’s governing values and norms are not inconsistent with values that have been generally characteristic of Confucian China throughout its history. While there are no doubt many such characteristic behavior patterns, this discussion is limited to three that directly bear on how China formulates and implements policy in the economic and financial area: pragmatism, strategy, and stability.

First, I discuss how Party policy formulation, personnel management, and discipline shape China’s banks. Later, I explain how Party values permeate policy in the financial sector at both macro and micro levels.

Policy Formulation: Politburo

National policy is debated and decided upon at the apex of the Party hierarchy, the Politburo, and, more particularly, at the Standing Committee of the Politburo. Most of the twenty- five Politburo members also concurrently hold positions in the government, generally at the level of State Council, which is the equivalent of the cabinet for the gov-ernment. Real power, however, is concentrated in the seven members of the Standing Committee of the Politburo, where major national policy issues are decided.

Within the Politburo there are several “Leading Groups,” each looking after a particu-lar area of policy. The leader and core members of the leading groups are Politburo mem-bers, but other senior government officers who are not members of the Politburo will be invited to join based on their responsibilities in the government. Despite the extraordi-nary importance of these Leading Groups in defining policy directions, the workings of these Leading Groups are not well understood outside of senior Party and government ranks, and even the membership of the Leading Groups, while known, is often not offi-cially promulgated.

The Leading Group for Finance and Economics has handled policy for the develop-ment of the banking system, and hence has been the key body thinking about and plan-ning the transformation of the banking system. This Leading Group was established as early as 1957, when it was headed by Chen Yun, highly respected within the Party for his economic capability. In the subsequent years it was headed successively by Zhao Ziyang, Jiang Zemin, Zhu Rongji, and Wen Jiaobao. President Xi Jinping presently heads the Leading Group for Finance and Economics, which has a total membership of more than twenty persons, consisting of some Politburo members, some from the State Council, and other non- Politburo members including, among others, the minister of finance, the gov-ernor of the People’s Bank of China (PBOC), the head of the CBRC, and the Director of the National Development and Reform Commission (NDRC), which is the presti-gious and powerful government agency handling overall planning for the government.


Of great importance is the position of the Secretary to this Leading Group, currently Liu He, who is also Deputy Director of the NDRC. Liu He received a Master of Public Administration degree from the Kennedy School at Harvard University in 1995 and is generally thought to be the chief economic advisor to Xi Jinping.

After succeeding Hu Jintao as General Secretary of the Party, Xi Jinping made changes to the Leading Group system, establishing new leading groups and personally heading several. Most importantly, he has established the new and very powerful Leading Group for Comprehensively Deepening Reform, which he heads. This is a large Leading Group, with over twenty members, of whom only one, the governor of the PBOC, would seem to have direct economic responsibilities. Members are drawn from a broad spectrum of government areas covering military, legal, ethical, and other issues, indicating that its thrust will not be overlapping with the Leading Group for Finance and Economics and that its reform focus will be on non- economic areas.

As all state power is ultimately in the hands of the Party, and all strategic policy deci-sions are made by the Standing Committee of the Politburo, the power and responsibility of this small group is awesome. There is a legislative organ of the government, and there is a judicial branch of the government, but ultimately they are subservient to the Party, represented at the highest level by the Politburo Standing Committee. Therefore, under-standing the priorities of the people who occupy positions on the Politburo reveals much about what drives strategic decisions.

Bruce Gilley, surveying the fourteen nations of his “Asian Governance Model” para-digm, finds that in almost all of them, executive branch leadership in policy formulation is the norm, with weak legislative and judicial functions. Leadership by the executive in setting policy, centered in the Politburo, is in line with China’s historical traditions and with what one would expect to find in an Asian country.8

In a country with hierarchical cultural norms, as China has, delegation is often a problem, both at the level of the firm and at high levels of government. The level of detail that the State Council delves into in its meeting agenda is amazing.9 An extraor-dinary number of decisions must be made by the State Council. Anything that would have strategic implications must also first pass through the Politburo, or one of its Leading Groups.

First and foremost, the Politburo Standing Committee is dedicated to ensuring that the Party stays in power. Since the legitimacy of the party- state is in good part based on performance, which thus far has been largely defined in China as raising the livelihood of the people, the Standing Committee is driven to produce economic growth, a task at which it has over the past thirty years excelled, with average and relatively consistent per annum GDP growth over 9%. For years the leadership felt that its credibility was at stake

8 Gilley, Nature of Asian Politics, 130– 134. 9 Based on my interviews with people who have made presentations on policies and issues to the State Council.


if it did not “bao ba” (maintain an 8% real growth rate). The commitment to 8% or higher growth was impelled by the need to provide full employment to soak up surplus labor, mostly in the countryside. High economic growth levels ensured that new jobs were cre-ated in sufficient number to soak up the excess labor that was coming of age. Over the past two or three years, China’s demographic profile has reached a turning point; hence-forth, China will begin to experience labor deficit, so that the priority is shifting from providing employment to boosting labor productivity.

Not only has the pressure to provide employment abated, but after three decades of average 10% growth, the “convergence effect” is beginning to appear. As developing nations move up the economic ladder, their GDP growth rates are very high, as they only need to copy and reproduce foreign technologies and institutions and put to gainful employment their plentiful cheap labor. These are the “low- hanging fruits.” After a few years of high growth rates, these economies begin to converge on the advanced nations in economic level and in economic sophistication, at which time their growth rates decel-erate; the low- hanging fruits that are easily gathered through copying technology and employing cheap labor have already been realized.10

In 2014, after extensive prior warning, the government reduced the growth rate target to 7.5%, and then to 7% in 2015, with further decline likely, in recognition of the inevitable deceleration of growth as China begins to converge with the economic front runners. Now that the obsession with high growth rates and full employment is abating, the Politburo is, in the interests of maintaining the Party’s power, broadening its attention span to include issues such as corruption, rule of law, the environment, inequality, and others that are increasingly important for performance legitimation of the regime.

Performance means not only hitting targets, but minimizing risk and mistakes, main-taining control and avoiding surprises. Stability and predictability are prized. This gov-erning style combines commitment to challenging and far- reaching goals, including major reforms, with a cautious, step- by- step approach. Policy is exhaustively debated. The debate is vigorous and open, argued in print and digital media, debated in academic seminars, and brought to the highest levels of the Party. There policy is ultimately set by the Politburo, to be carried out by the State Council and the organs of the Chinese government.

Different points of view contest for a hearing in today’s China. The economic debates are vigorous. Some of China’s most high- profile economists argue in the media that China’s reform must move faster to open up the economy to unfettered market forces, following the tenets of Western economists like Hayek and Friedman. Others, occupy-ing the middle ground, and generally less visible in the media but more influential in

10 Dwight H. Perkins, East Asian Development: Foundations and Strategies (Cambridge, MA: Harvard University Press, 2013), 51.


the government, promote a more prominent role for state capitalism and state regula-tion within a market economy. On the other wing, there are the neo- Marxists, who point to the environmental destruction, massive corruption, and enormous wealth and income disparity that has resulted from the reforms of the past three decades. They argue for a more controlled development program hewing more closely to the Party’s founding ideals.

Decisions are consensual. Gone are the days when Mao alone decided the course of the nation. Even the “Paramount Leader” Deng did not always get his way in policy formulation, having to debate policy with the generally more cautious faction of Chen Yun. Input is now provided from many sources, policy initiatives are floated and then passed up and down the relevant ministerial bureaucracies for comment, on the basis of which they are revised. This goes on until finally a consensus is reached, the opposition of vested interests has either been accommodated or overridden, and there is sufficient “buy- in” to launch the new policy.

It is at the level of the Politburo Standing Committee and the Leading Group on Finance and Economics that the broad strategic directions of the nation’s bank-ing system are debated and set. These broad strategic directions are then transmitted to the highest organ of the government itself, the State Council (Politburo Standing Committee members mostly sit on the State Council as well, so there is considerable overlap, but the functional roles of the two bodies are differentiated).

In any political system, the actual way in which policy proceeds from incubation of an idea to promulgation of a policy or law is enshrined partially in constitutional and procedural arrangements and partially in unwritten political practice. In China, the path from first surfacing a new policy idea to final promulgation of an implementing directive by the State Council is long and winding, reflecting the innate caution of the leadership. The national leaders will involve both relevant departments and bureaus of the government bureaucracy and a variety of think tanks, belonging to the govern-ment and to academia, in researching the issues involved. Points of view are debated Gradually a consensus emerges and a policy is drafted. This draft is sent down through all affected government units for comment. In the course of the review process, the draft policy is modified. When the State Council finally approves the policy, it will have been thoroughly considered by all relevant areas of the government, and a considerable degree of bureaucratic “buy- in” will have been secured, making implementation easier.

The cultural continuity from ancient imperial China’s political system is fascinating. Historian E. A. Kracke, Jr. describes Tang and Song Dynasty practice:

The highest direction of policy was confided to a Council of State, whose members were heads of several agencies. The Council’s views were scrutinized by separate organs of criticism. During the later T’ang and the Song, the emperor could consult also academies of distinguished scholars appointed to provide still another source of advice. To maintain the effectiveness of these structural checks and balances, it


was imperative to guard vigilantly against domination of the several policy bodies by any faction of too like- minded a group.11

With a change in the institutional names, these same sentences could describe the policy formulation process today.

Personnel Management: Organization Department

Of the seventeen tier 1 commercial banks, almost all the chairmen and CEOs are at the time of writing members of the Communist Party. There have, in the past, been excep-tions. The founder and Chairman of the China Minsheng Bank, Jing Shuping, was not a Party member. Jing’s family background in pre- 1949 Shanghai business circles and his position as Chairman of the All- China Federation of Industry and Commerce, com-bined with his political position as Vice Chairman of the Chinese People’s Political Consultative Committee, suited him to found Minsheng Bank, China’s first privately owned bank, with the approval of Zhu Rongji, in 1996. Later, Eddie Wang, the CEO of Minsheng from 2006 to 2009, was a Canadian citizen of Hong Kong origins, a veteran of HSCB Bank, and not a Party member. Today, the CEO of the Guang Fa Bank is a Taiwanese, appointed to the position by major shareholder Citibank. The overwhelm-ing majority of senior managers and members of the Boards of Directors and Boards of Supervisors are, however, members of the Communist Party. Whether the candidate for the board or for management is a Party member or not, the appointment will be vetted by the Organization Department of the Communist Party, operating through the CBRC.

The Organization Department of the Party not only functions as the human resources (HR) department of the Party and the state but also handles all senior positions in com-mercial enterprises in which the government has a stake. Richard McGregor, in The Party: The Secret World of China’s Communist Rulers, describes the extensive power and influence of the Organization Department:

The Department is accurately, if blandly, described as the human resources arm of the Party, but this does not do justice to its extraordinary brief and the way it is empowered to penetrate every state body, and even some nominally private ones, throughout the country… . The Department maintains files on top- level officials in the public sector, to keep tabs on their political reliability and past job per-formance, making it indispensable to the Party’s control of the country and the nation’s vast public sector.12

11 E. A. Kracke, Jr., “The Chinese and the Art of Governance,” in The Legacy of China, ed. Raymond Dawson (New York: Oxford University Press, 1964), 318.

12 Richard McGregor, The Party: The Secret World of China’s Communist Rulers (UK: Allen Lane, 2010), 72– 73.


In Western banking systems, the CEOs of banks will be confirmed in their positions only after the regulatory authority has ascertained that they meet the prescribed quali-fications for being CEO, but in addition, in China’s state- owned banks, they must be approved, and probably also selected, by the Organization Department. When I was on the board of the Minsheng Bank in 2003– 2006, even though the state held no shares in the bank, board and senior management positions were blessed by the Organization Department. As a result, “poaching” of senior executives between banks only occurs if blessed by the Party through the CBRC in each individual case.

How does this work? The Organization Department appoints the CEOs of all the tier 1 banks that have controlling state ownership, appraises their performance (and politi-cal reliability), and is involved in setting salaries and bonuses. Their long- term career paths are determined not by the boards of the banks they run, but by the Organization Department, with a view not only to the banks’ needs, but also to individual develop-ment needs and broader national goals. Guo Shuqing, who had been Director of the State Administration of Foreign Exchange, became Chairman of Construction Bank, after which he was moved to chair the China Securities Regulatory Commission, with a mandate to reform and develop the securities business. Clearly destined for higher posi-tions due to superior performance, the Organization Department transferred him to be Governor and Deputy Party Secretary of Shandong Province. Guo’s career development lies with the Communist Party, which evaluates his performance and prospects for pro-motion into more senior and responsible positions.

More typically rotation by the Party will not be to totally different fields but will be within the financial sector. Liu Mingkang, after a few years serving in various positions within the government of Fujian Province and of the PBOC, served as Chairman of China Everbright Bank from 1999 to 2000, then Chairman of Bank of China for the next three years, after which he was appointed to head up the newly established CBRC, a position that he held with distinction from 2003 until his retirement in 2011. Given his expertise, Liu was one of the small number of members of the Party’s Leading Group for Finance and Economics. Tang Shuangning started his career in 1982 with the China Construction Bank, moved in 1989 to the PBOC, then served as one of the Deputy Directors of the CBRC from its founding in 2003 until 2007, when he was transferred to serve as Chairman of the Everbright Group of companies. He is also concurrently Chairman of the China Everbright Bank, a member of the Everbright Group.

A somewhat analogous situation of rotating between public and commercial sec-tors in America would be the frequent movement back and forth of senior personnel between Wall Street, top universities, and Washington, of which examples are numerous. Prominent recent examples include Larry Summers, Hank Paulson, and Robert Rubin.13

13 Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Pantheon Books, 2010), 93– 94.


In France, the staffing of the leadership of the financial sector, both the powerful Treasury and the commercial banks, with graduates of France’s elite grande ecoles has many simi-larities with the way in which leaders of the Chinese financial system are selected from within a carefully groomed and selected Party elite.

For a Western equivalent, think perhaps of a career military officer, being posted to different locations, gradually rising through the ranks depending on performance evalu-ation. Or think of a huge diversified multinational corporation, in which the executive will be given development assignments that will provide exposure to different functional areas or lines of business, and perhaps to different international markets as well. Of course, the difference is that the Western executive can, and increasingly does, jump ship, attracted by a better offer from another corporation. In China, there is only one Party, although expansion of the private sector of the economy will in the future offer opportu-nities outside the Party.

As senior members of the Communist Party, the CEOs of the state- owned banks hold rank in the government hierarchy. The exact numbers are not publicly known, but it is believed that hundreds of people in China hold the rank equivalent of Minister, and perhaps thousands hold the equivalent of Vice Minister. The chairmen and CEOS of the state- owned and joint stock banks hold ministerial rank and vice- ministerial ranks.

The top dozen or so senior managers of the state- owned tier 1 banks are also almost all Party members and appointees. Their careers will be supervised by the Party, through the bank’s HR department working with the Party chapter of the bank. This is where the pro-cess gets complicated, and opaque to outsiders. In the past, one heard stories of Western companies in business with Chinese partners who worked hard at developing good rela-tionships with line management, only to discover that real decision- making power in the joint venture lay with a Party official who appeared to be a person of not much stature on the line management organization chart.

Whether or not this is actually common today in other enterprises, it is not true of the tier 1 banks, in which the party and line organization hierarchies have been streamlined. Generally either the Chairman or the CEO concurrently serves as the Party Secretary.

The Party chapter of each bank meets behind closed doors to discuss government poli-cies, personnel issues, and conduct “party education.” From accounts of people who have attended these Party meetings in banks, the meetings are conducted in much the same fashion as any other bank meeting would be. Provided with an understanding of the party line, management is able to run the bank with due consideration of how to reflect higher level goals and policies.

With the exception of personnel issues, at the tier 1 bank level, Party guidance on policies is generally directional rather than specific. Direct instructions to a bank, as in Western countries, come from the appropriate government supervising agencies, most especially the CBRC. To the extent that higher level approval is needed, it will be granted by the State Council, not the Party.


The Human Resources departments of the banks are a key center of Party control over the banks. According to Board charters, the Compensation Committee of the Board is responsible for considering annual performance appraisals, promotions, and salary adjustments of senior management. In fact, since the dozen or so members of senior man-agement are Party members, the salary of these senior managers is controlled in a general range by the Party. As the information of listed banks is publicly available, the Party is concerned that the remuneration of these bank senior managers should not be excessive at a time when wealth disparity is a sensitive issue with political overtones.

In addition to providing competent leadership for the regulatory authorities and banks, the Organization Department’s control over the careers of senior management of these economically core institutions ensures that they will be supportive of Party policy.

The Organization Department of the Party arguably does a good job as HR manager of the major banks of the country. It is not likely that the banking system could have developed as it has over the past decade if the CEOs were just “Party hacks,” as sometimes alleged. In fact the CEOs of the banks are a well- qualified group of people, who could stand up against their peers running major banks in other parts of the world.

Discipline: Central Discipline and Inspection Committee

Discipline is the third aspect of the Party’s role in banks. If an employee who is not a party member is suspected of malfeasance, the case is investigated by the audit depart-ment and appropriate disciplinary action is then taken by the personnel department. If the employee is a Party member, the case is considered a breach of Party discipline; after the Audit Department completes the investigation, the matter will be turned over to the Party’s Central Commission for Discipline Inspection.

Control over the appointments and career development of chairmen and boards of banks gives the Party enormous influence over the banks. Appointment power is accom-panied by the power to discipline. Ten years ago, two successive seemingly successful and well- regarded CEOs of Construction Bank were sacked for corruption. The first, Wang Xuebing, was described by Bloomberg Businessweek at the time “as one of the brightest stars in the often dark sky of the Chinese financial world.”14 He was sacked in January 2002 and then arrested on charges of improperly arranging for a massively undercollat-eralized $23 million loan involving his wife while he had been in his previous posting at Bank of China. This loan was subsequently repaid not by his wife, but by transfer of funds out of the Bank of China’s New York office. The New York aspect of the case led to investigation by U.S. authorities, resulting in Bank of China reaching an agreement with the U.S. Comptroller of the Currency to pay a $10 million fine.15

14 Bloomberg Businessweek Magazine, January 27, 2002, accessed November 22, 2014. 15 Alex Frew McMillan, “Bank of China Wins U.S. Case,” CNN.com, July 16, 2002, http:// edition.cnn.com/

2002/ BUSINESS/ asia/ 07/ 15/ hk.boc/ index.html, accessed November 22, 2014.

http://edition.cnn.com/2002/BUSINESS/asia/07/15/hk.boc/index.html

http://edition.cnn.com/2002/BUSINESS/asia/07/15/hk.boc/index.html


Xinhua’s reporting on the sentencing of Wang to 12 years in jail at the end of the fol-lowing year did not mince words:

Wang was expelled last year from the Communist Party of China (CPC) on charges of taking bribes, leading a decadent life and breaking financial rules. He was an alternate member of the 15th Central Committee of the CPC.

Wang had embezzled and accepted bribes and expensive gifts to the tune of millions of yuan, led a decadent life, and broken financial rules with severe conse-quence when he was general manager of the New York branch of the Bank of China and president of the Bank of China, CPC sources said.16

In 2005 Wang’s successor at the helm of Construction Bank, Zhang Enzhao, was also arrested on charges of accepting bribes in return for authorizing loans. He was sentenced to fifteen years in jail.

If one bank is lagging in its profitability, control of risk, or growth compared with its peers, the Party will most likely change management of the poorly performing bank. There are no golden parachutes for those fired for unsatisfactory performance in China, and alternative employment opportunities in banking outside the control of the Organization Department of the Party would be hard to find. When the failed CEO of a major American bank is fired, dismissal may trigger a “golden parachute” in the employment contract. The $161.5 million awarded to Stan O’Neill of Merrill Lynch and $12.5 million compensations to Chuck Prince of Citibank, when they were fired in 2007 for presiding over the near- bankruptcy of their companies, are not available to failed CEOs of Chinese banks.

The lack of such employment contract clauses in China no doubt exerts a certain disci-pline on senior Chinese bankers. On the other hand, the impression I have gained from observing personnel movements within the Chinese banking system is that officers who have performed adequately, but have perhaps reached their maximum potential, will be found appropriate and honorable, but less critical and demanding, posts where they can make a contribution during the remaining years until their retirements. Bankers who have dropped off the “fast track” will be taken care of properly, provided that they have not committed any transgressions. In this way, their loyalty and enthusiasm is retained for the system, and their abilities are utilized effectively in the appropriate positions and levels.

Party Values: Pragmatism

How the Party exerts control and influence over the banking system through the three mechanisms just described is conditioned by what I term Party values. Party values refers

16 China View, “Former Banker Wang Xuebing Sentenced to 12 Years in Prison,” China View, October 12, 2010, http:// news.xinhuanet.com/ english/ 2003- 12/ 10/ content_ 1224226.htm, accessed August 12, 2014.


to the way that the Party thinks about and deals with challenges and issues, the way that the Party goes about formulating and implementing policy. Party values incorporates many elements, three of which are key to understanding the evolution of banking in modern China and to understanding how China’s banks behave: pragmatism, stability, and strategy.

These three values are consistent with traditional Chinese ways of thinking about gov-ernance, and in fact may properly be considered to lie in the realm of traditional cultural values. They have stood China in good stead in its development efforts over the past thirty years, but they often slow the speed of reform to the frustration of critics who feel that greater speed and sense of urgency is needed. The almost two decades of turbulence from the Great Leap Forward in 1958 to Mao’s demise in 1975 would appear to contradict the claim that pragmatism, stability, and strategy have been consistent characteristics of the Party. Prior to the late 1950s, and especially during the civil war period, Mao him-self was a master of pragmatism and strategy. Stability during those war years was not a value, as mounting a revolution is of course antithetical to stability. But from the late 1950s onward, not only stability but also pragmatism and strategy were subordinated to Mao’s disastrous and quixotic quest for total revolution. As the exception that proves the rule, the very thoroughness with which Deng and his successors reinstated pragmatism, stability, and strategy as defining values of the Party demonstrates the extent to which the excesses of the Mao period were viewed by his successors as aberrations, to the impor-tance these three elements hold for the Party, and to the extent that they are consistent with Chinese cultural norms. The feeling then and now was “We must never again let this happen to China.”

With the end of the Mao era, pragmatism in Party policymaking became the order of the day, enshrined in the phrase: “Seek truth from facts” (shishiqiushi). This aphorism, derived from the 2,000- year- old classical history text Han Shu, was later chosen to be the motto of the Central Party School in Yanan during World War II. In a speech in Yanan in 1942 Mao said, “Only if those with book knowledge develop in practical spheres will it be possible for them to go beyond their books. Only then will it be possible for them to avoid the error of dogmatism.”17

Given the ideological extremism that Mao imposed on the country during the twenty- seven years that he led the government after unifying the country in 1949, it is ironic that this pragmatic approach should have been sanctified by him. Perhaps Mao’s distaste for dogma might have stemmed from his abiding distrust of intellectuals. It was the earthy practical wisdom of rural farmers that he saw as the force that could remake China. More important than that though, as explained by Schell and Delury, “doctrinaire and unyielding as Mao could sometimes be, the side of his personality that had allowed him to become such a good guerilla fighter— infinitely able to adjust to the kaleidoscope

17 Orville Schell and John Delury, Wealth and Power (London: Little Brown, 2013), 221.


of ever- changing challenges and danger to ensure survival— created a new tradition of exceptional tactical flexibility.”18

The most well- known example of Mao’s tactical flexibility was his willingness to work together with the Nationalists against the Japanese during World War II. Undeterred by either the bitter hatred between the Red Army and Chiang Kai- shek’s forces or the divergent national development visions of the Communists and the Nationalists, Mao saw the tactical advantages of joining forces with his archenemy to achieve the immediate goal of repelling the Japanese invaders, after which he would promptly revert to his earlier strategy of annihilating the Nationalist armies and driving Chiang out of the mainland.

Deng also expressed the concept in his pithy quote: “It does not matter whether a cat is black or white, as long as it catches mice.” This is the opposite of the ideological rigid-ity and fervor that had characterized Marxist- Leninist parties in other countries, and in particular the Soviet Union.

Indeed, as recounted by David Shambaugh in China’s Communist Party: Atrophy and Adaptation, what has saved the Party from the fate of the Soviet and Eastern European Communist Parties is precisely this pragmatism, combined with a willingness to research and study, then apply the lessons learned and adapt to new realities as conditions change. Shambaugh describes how the disintegration of the Soviet Union and the Tiananmen incident that both occurred in 1989 shocked the Party, stimulating at the same time intro-spection and a multi- year intensive study of what worked and did not work in other national political economies.

This study led to an intensification of the Reform and Opening that Deng started in 1978 and to an all- out commitment to economic development based heavily on market forces. It was abundantly apparent that the political economies of the Soviet Union and Eastern bloc countries had failed, while the capitalist nations of the West, Japan, and several other Asian neighbors were thriving. With pragmatism and intellectual rigor, the Party set about understanding the sources of the wealth and power of the capitalist nations and proceeded to import and adapt them to China.

It is not only in the area of doctrine that pragmatism is a dominant motif in Party gov-ernance. Pragmatism can also be seen in the adaptation of policy to varying local condi-tions around the country. Herrmann- Pillath writes how government “in modern China manifests an amazing coexistence of domains where central control is established with sometimes draconian means down to the grassroots level (for example, population poli-cies) whereas in other areas local autonomy is often substantial, and even against central interests.”19

18 Schell and Delury, Wealth and Power, 255. 19 Carsten Herrmann- Pillath, “Making Sense of Institutional Change in China: The Cultural Dimension of

Economic Growth and Modernization,” in Institutions and Comparative Economic Development, ed. Masahiko Aoki, Timur Kuran, and Gerard Roland Houndmills (London: Palgrave MacMillan, 2012), 266.


At bank board meetings, theoretical concerns do not distract discussions from focus on practical issues, obtaining results, and achieving targets. Arguments are supported with practical evidence, not with theoretical justifications.

Party Values: Stability

Throughout Chinese history, political and social stability has been a supreme, albeit not always achieved, goal. Recall from the previous chapter that Confucius was a very conser-vative thinker, whose philosophy was built around maintaining proper social order and performing correctly various rites designed to ensure social harmony (for which in the modern West we might substitute the analogous word “stability”). During the long years of the Civil War, instability rather than stability would provide the crucible for revolu-tionary success. Post- Mao, the Party wants to stay in power, for which purpose a stable economy, society, and polity are required. Now that the Party is the dynasty in power, stability serves its purposes, just as it did the emperors of centuries past.

The historical experience of the previous two millennia taught that when there was turbulence, when society was chaotic and the state was weak, then the ruling dynasty would fall, the people would suffer, and either China would be invaded by barbarians from without or insurrection would spring up from within. Chinese therefore fear “luan” (disorder), and they approve of a government and a system that can keep chaos at bay.

From the first half of the nineteenth century through the latter part of the twentieth century, China was internally turbulent and externally humiliated. The Opium War was followed by the Taiping Rebellion, a millennial cult that at its height controlled a signifi-cant part of central and southern China, and in which an estimated 16 million died. That was followed by the Boxer Rebellion, the warlord years of the 1920s, the Civil War, and the Japanese invasion. Finally, memories of those over the age of 70 of the famine of the Great Leap Forward period of the 1950s are still fresh, while those over 60 remember the chaos and mindless brutality unleashed by the Cultural Revolution.

Concern with economic stability focuses the government on pursuing a consistent level of growth, with no surprises, and in ensuring a high level of employment. Many have criticized the large Keynesian 4 trillion yuan stimulus delivered to the economy through the banking system at the end of 2008 and early 2009, but aside from the fact that most of the criticism was misdirected,20 the critics failed to understand the sensitivity of the Chinese government to the looming unemployment of up to 20 million people who would be laid off their jobs in factories hit by declining orders from overseas as a result of the Great Recession sweeping the West. China’s leaders do not share the fatalistic view

20 See Nicholas Lardy, Sustaining China’s Economic Growth after the Global Financial Crisis (Washington, DC: Peterson Institute Press, 2012), for a discussion of the stimulus and explanation of why it was a largely successful policy.


(see Chapter 2) of Senator Gore in the 1930s that depressions were “an economic disease” that must be allowed to run its course. The Chinese approach is to prevent the disease and, failing that, administer a cure. Full employment is key to economic and social stabil-ity and therefore is of highest priority for the Chinese government. From the Chinese point of view, keeping those 20 million workers employed by bank funding of new proj-ects was necessary to ensure social stability, even if debt problems would later have to be dealt with.

Party Values: Strategy

Part of the success of China’s economic development over the past three decades can be attributed to a clear vision and the formulation of sound strategy to implement the vision. Since Reform and Opening, China’s vision has been spelled out in variations on a theme over the past thirty years. The vision in its present version is packaged as the “China Dream.” To fulfill the vision, the government’s strategy encompasses all aspects of the economic, social, and political spheres. It embodies this in the national five- year plans. The fact that the plans are indicative rather than Soviet- style administrative plan-ning documents does not diminish their importance as road maps that the state uses to develop the nation. Study and discussion among experts to draft the next five- year plan begins generally at least two years ahead of adoption of the new plan. The options put forward by the experts are then discussed and adopted by the Party at the Politburo level and given to the government to implement. Under the five- year plans, people and resources are aligned to implement the strategy.

After much study and debate, the strategy that has been embodied in the current five- year plan is almost always implemented, albeit sometimes with tactical delays or modifications necessitated by changing circumstances or new insights gained in the implementation process. This accounts for the continuity of strategy from the 3rd Plenum of 1993 through the 3rd Plenum of 2013. Looking forward, China has published in collaboration with the World Bank a 400- page document, China 2030, which delin-eates the strategy through 2030.

A key aspect of strategy is sequencing and setting of priorities. A good strategy takes into account available resources and absorptive capacity. It does not try to do everything at once. An initiative will be launched when conditions are ripe, or when postponement would not be possible. One can question the prioritization and sequencing, as in the slowness with which environmental cleanup has been tackled over the past two decades, but the leadership had made a decision that economic growth would take precedence over environmental quality. Now that China has become a middle- income country and popular discontent over polluted air, contaminated water, and toxic soil is rising, not to speak of the associated health costs, environmental cleanup is moving up rapidly in the priority accorded to it in the national strategy.


At Everbright Bank, sequencing is as important in strategy formulation as it is at the national level. When I joined the board, it was evident to one and all that the bank still had manifold weaknesses that would need to be addressed, but it was equally evi-dent that the bank was constrained in its absorptive capacity. Problems would have to be prioritized and tackled one by one over the succeeding years. There was at board and management level awareness of how much could be accomplished in any given year; it would be fruitless to try to address a problem that the bank was not yet ready to take on effectively.

From the time I first attended a board meeting in 2006, I repeatedly pointed out the dire need for upgrading retail bank service standard, which, by my own experience trans-acting business at the bank’s branches, was deplorable (this was true of almost all Chinese banks at that time). Finally, in 2009, the CEO told me that the time had come to deal with this issue— management announced to the board that that was to be the year for launching the all- out “Sunshine Service Campaign.” I protested that a campaign was not what was needed, but rather that we needed a carefully worked out long term program to re- engineer service standards. My protests were silenced with the explanation that mass mobilization of retail staff over the continuous period of a full year, with slogans, training, drives, rewards, model workers, etc., would be the way this would be handled. It worked, Chinese style. After the first year of the campaign was finished, standards of retail service in most of the branches were up to international standards— and stayed that way.

A hallmark of strategic formulation and implementation in China is the use of pilot projects. In the early years of Reform and Opening, Chinese leaders spoke of “crossing the river by feeling the stones.” Before jumping from a concept to nationwide implemen-tation, a new approach or new way of doing things will first be tried out on a limited basis for a time. Based on the feedback from this pilot, the approach will be refined and improved— or even abandoned— and then rolled out nationwide. An early example of piloting was the establishment of the Special Economic Zones such as Shenzhen, in which foreign investment was welcomed, without immediately letting foreign invest-ment into the rest of the nation until the results of the experiment had been observed and evaluated. A similar pilot is underway today in the Shanghai Free Trade Zone. One imagines that President Obama may wish that he had been able to do a localized pilot on the Affordable Care rollout so that the bugs could have been dealt with before it went live nationwide.

A corollary of the use of pilots is that China does not like “big bangs.” The risks are too high, the threat of instability too great. During the Maoist years from 1949 to 1976, the country was wracked by a series of mass movements launched by Mao with the objective of totally remaking Chinese society and culture. The most devastating of these move-ments were the Great Leap Forward of 1959– 1962 and the Great Cultural Revolution of 1966– 1976. Memories of the chaos and destruction of these movements is embedded in the psyches of China’s leaders. As a result, a very important aspect of the decision- making style of the Party since Mao’s death has been an aversion to “big bang” solutions.


The aversion to “big bangs,” however, goes back much further in Chinese history than Mao’s attempts at total social re- engineering. Historians James Liu and Tu Weiming write that the Confucian officials’ penchant was for improvement in conditions, not radical change. “The search for improvement … precluded radical departures on the ground that they carried the risk of much disruption… . The slow, cautious, and piecemeal style of change was regarded as the best means for the system to correct and reinforce itself.”21 The pace of change in today’s world, the pressures on the leadership to perform, and the boldness of China’s vision for wealth and power, do not permit the sort of Confucian scholar- official “piecemeal style of change,” but nonetheless the old mandarin aversion to “radical departures,” the fear of “disruption,” and the bias for caution can still be seen in today’s aversion to “big bangs.”

The Chinese government may announce a major aggressive strategy, but often very little happens for a while. This is partly because the grip of the central government in Beijing over implementation of policies is not as tight as one might expect in an authori-tarian system. The country is simply too big, the degree of decentralization too great. Typically, the implications of the new strategy must be absorbed by all who will be involved, which may involve training or cajoling. Vested interests that oppose the new strategy must be dealt with. Then pilot projects are undertaken, feedback from them is evaluated, and adjustments are made. Finally, often several years later, the strategy is fully implemented. This very cautious approach can take a frustratingly long time, but it lowers the risk of failure, is less disruptive, and is ultimately more successful than the “big bang” approach. Many of the countries that emerged out of the former Soviet bloc engaged in some sort of “big bang” conversion from socialist to capitalist systems, but only a few of them have made the transition out of socialist planned economies as successfully as has China with its more cautious approach. In any event, those East European transition economies were much smaller than China, and their histories and cultures may have made it easier for them to handle the total jump of a big bang to full capitalist and democratic systems.

Interest rate liberalization exemplifies this cautious approach to strategy and imple-mentation. Interest rate controls were designed to facilitate savings mobilization and direct it into investment, penalizing the individual saver, favoring the large state corpo-rations hungry for funds for their investment projects. As time passed, the economic benefits of this policy were increasingly overshadowed by the costs of misallocation of capital, excessive investment, and constrained consumption, resulting in the unbalanced economy of which Wen Jiabao warned in his remarks in 2007. The government has been aware that economic theory clearly points out the advantages of market determined interest rates, but it has been slow in relaxing the ceilings. The general government policy

21 James T. C. Liu and Weiming Tu, “Introduction,” in Traditional China, eds. James T. C. Liu and Weiming Tu (Englewood Cliffs NJ: Prentice- Hall 1970), 18– 19.


direction to free up interest rates was announced in 2012, but implementation through PBOC administrative regulations has been painfully slow.

A new policy initiative may be bold in conception and scope, but the Party’s bias toward pragmatism, stability, and strategy will result in a cautious approach to actual implementation. Pragmatism means that the theory is accepted, but how it will be applied depends on perceptions of the likely real world impact. Economic theory calling for market- determined interest rates to ensure efficient capital application is well under-stood and accepted, but a multitude of potential unintended consequences must be con-sidered before the theory is put to work. Stability means that the government does not want turbulence in the financial sector marketplace or in the real economy. For example, how will the weaker banks, and especially the smaller locally based banks, compete to attract deposits in a world of interest rate liberalization without offering higher rates that will squeeze profit margins and in the long run impair the growth and capital adequacy of these smaller banks? Strategy means that the overall policy decision will be implemented in a modulated fashion, carefully orchestrated at the level of the State Council to take into account unintended consequences and not disrupt stability, and coordinated with other parts of the national strategy of which it is a part.

The reform agenda of Xi Jinping is bold in concept and scope. His reform agenda may transform China as comprehensively as did the reform agenda of Deng Xiaoping three decades earlier. Many Western observers, initially excited by Xi’s reform vision, began to question its substance a few months after it was announced at the 3rd Plenum in November of 2013. In fact, the rollout of Xi’s reforms has proceeded, but tested with pilots, con-strained by pragmatic considerations to minimize risk and disruption, concern to avoid destabilization, and need to prioritize, sequence, and coordinate components of strategy. And no doubt the need to overcome resistance of influential vested interests is taking time.

The Paradoxes: Scale and Speed

Following this discussion of the importance of stability and pilot testing, the reader may be thinking, “What about those gigantic projects that China has done? What about the hell- bent rush to build the economy at the cost of massive environmental destruction and major loss of built architectural heritage?” These are paradoxical themes that run together with the Party’s emphasis on pragmatism, stability, and strategy. China lives with ambivalence, tolerates inconsistency, and handles contradictions well. The flip side of pilot projects and experimental approach is massive scale and speed.

A state penchant for large projects is evident from earliest imperial history. The Great Wall and the Grand Canal were enormous engineering feats that required mobilization of hundreds of thousands of laborers and decades to complete. The grandness of their conception and scope are echoed in the Three Gorges Dam, the Great Hall of the People, the massive Beijing Capital Airport, the vastness of Tiananmen Square, and the building


of huge new cities on empty land. Projects on a massive scale have always appealed to China’s rulers, and the present government is no exception. More rationally, perhaps for some purposes, in a country as huge and populous as China, with such enormous demands pressing on its infrastructure, there may be no alternative to “thinking big.” Anything less would not address the needs.

A travel guide in Yunnan Province, who had studied Chinese literature in university, once remarked to me that the most dangerous word in the Chinese language was ji, which means “urgent” or “in a hurry.” In total contrast to the cautious, deliberate, and experi-mental approach that is the dominant style in policy formulation in China, some things are done with unseemly haste. This generally seems to be a local, or sectoral problem, rather than a characteristic of national- level policy formulation. Haste in bulldozing heri-tage areas of cities to build rows of featureless apartment houses, haste in building facto-ries that do not meet minimal environmental standards, haste in building cities without adequate planning for those who would live in them or what infrastructure would be needed to support the inhabitants— these are all examples of haste that have, to borrow the English adage, “made waste.”

Building too big and building too fast coexist in China with the emphasis on pragma-tism, stability, and strategy that generally characterize China’s policy formulation process. Using a traditional Chinese analogy, one might say that massive scale and great haste are the aggressive yang forces that counterpoise the nurturing yin forces. China is indeed a nation in a hurry, and it wants to play an outsized role on the world stage, so as a nation it has become accustomed to thinking big and to development that is fast. Where a pre-dilection for pragmatism, stability, and strategy are great strengths of China’s develop-ment approach, the liking for large scale and great speed, while sometimes serving China well, also often either backfires or has major negative side effects. For the most part, in the development of the banking and financial sector in China, the cautious virtues have prevailed. When there have been unintended side effects, or things have gone wrong, it is generally because the desire for scale or speed has trumped the Chinese government’s bet-ter instincts. Deng Xiaoping admitted the problem, saying: “The mistakes we have made since the founding of the People’s Republic were all due to over eagerness; disregarding China’s realities, we set excessively high targets, with the result that progress was slowed.”22 Perhaps the problems of China’s stock markets in the summer of 2015 stemmed from ji— excessive haste in trying to stimulate growth in the hitherto laggard equity markets?

The Missing Value: Institutionalized Trust

If China’s cultural legacy and political institutions have provided the country with certain advantages at the macro level in coordinating the economy and dealing with problems,

22 Xie Pinru, Xiaoping Said, 17.


they have also bequeathed the country certain disadvantages that are likely to become obstacles to China’s overall economic development and the ability of the banking sec-tor to deal with the growing complexity of the nation’s economic challenges. Foremost among these is the absence of institutionalized trust.

Redding and Witt23 point out that trust is an essential ingredient for firms to deal with each other and for a marketplace to work. Without a basis for trust, how can suppliers trust that they will be paid by downstream customers, and how can customers trust in the quality and timeliness of goods delivered? There are two types of trust in an econ-omy: personalized and institutionalized. The United States, United Kingdom, Japan, and Germany have institutionalized trust. They have clear and precise laws that are enforced, courts that are independent and impartial, a well- developed legal profession, police and bureaucrats that are honest and objective, accounting standards that are adhered to con-sistently and are professionally audited, and systems for collating credit information. These are the institutions of a modern society that provide a reliable framework for deal-ing with strangers on the basis of trust and reliable channels for seeking redress in the event that the trust is broken.

The other kind of trust, which prevails in more traditional societies, is personalized trust. In the absence of institutionalized trust, how does one develop trust in business counterparties sufficient to keep the wheels of commerce turning? The answer is that one trusts first family, then clan, friends, and networks that one builds up and knows well. It is with these people that one does business.

Frederick Mote wrote that traditionally “Everything in the Confucian world resists legalistically codified and objectified norms; for binding legal codes it substitutes basic principles which wise and humane men, considering all the particular circumstances of each case, can humanely apply.”24 The situation has not changed much in today’s China. Enforcement of laws is all too often spotty, the courts are not independent and the legal profession is fledgling; the accounting and auditing professions, while vastly improved compared with only a few years ago, still require much development; and nationwide credit bureaus are in early stages of development. Traditionally, just as the emperor relied on his mandarins to keep order in the empire, so today the government still relies on its Party member bureaucrats to adjudicate disputes.

Mote explained that in the Confucian tradition “government is of men, not of laws. There is strong distrust of laws as something inviting people to be tricky, bringing out the worst in them; whereas, good governors, exerting the personal influence of their moral force bring out the best in men.” From this wariness of laws emerges a legal system that is based less on either the “letter of the law” or the “spirit of the law,” and more on the practical results of individual cases of adjudication of the law, to ensure that the legal

23 This discussion on trust is heavily indebted to Redding and Witt, The Future of Chinese Capitalism, particularly 221– 231.

24 Frederick W. Mote, Intellectual Foundations of China (New York: Alfred A. Knopf, 1971), 44.


decision results in a fair and just solution to the problem. In an ideal world of benevolent and wise rulers and officials, this would work well. In the real world, the downside of this results- oriented approach is that it lacks the consistency of precedent- based jurispru-dence and can result in arbitrary application of the law and corruption of the process. Moreover, not all of the governors and officials embodied the “moral force” of which Mote wrote.

The practical implications of this are enormous for the private sector of the economy and for banks that are lending increasing amounts of money to the private sector. Lending to SOEs and local governments can be made based on implicit state guarantees of repay-ment, supplemented by calling on the personalized trust that exists between Party mem-bers if problems need to be worked out at the level of seniors from the bank and seniors from the SOE or local government organizations. On the other hand, in the absence of effective rule of law and reliable audited accounts, assessment of risk in making loans to the private sector, based only on personalized trust and personal reputation, cannot rely on modern credit analysis techniques, enforcement of contracts, and workout of bad loans through the court system based on institutional norms. This should lead to caution in lending to the private sector, or it will lead to difficulty recovering on private sector loans that go bad.

For developing economies that have attained middle income levels, as China has today, one of the constraints on breaking out of the dreaded “middle- income trap” into the ranks of the high- income countries is insufficient development of institutional trust. The major high- income countries, such as Western European nations, the United States, Canada, Australia, and Japan, all have high levels of institutional trust. Presumably to address this very issue, the major reform launched by Xi Jinping at the 4th Plenum in November 2014 was “rule of law.” Foreign pundits disparaged this reform because the Party would still remain above the law. They miss the point. What Xi is attempting to do is not to fundamentally change the political framework of China, but to introduce the legal basis for institutional trust between people and firms in the conduct of their lives and businesses. This is a task that will take years to accomplish, beginning with the overhaul of the court system and professionalization of judges that is getting underway. Concrete steps have been taken already, including a 40% increase in judges’ compensa-tion, so as to attract more qualified people into the profession. The implications of this for stable commercial banking, expansion of credit access, and ability of banks to collect on delinquent debt are entirely favorable.

Now to return to the analyst’s prediction, mentioned at the start of Chapter 2, that minister of finance Lou Jiwei, in order to wring moral hazard out of the system, would permit default on the part of local governments of their debt owed to banks. The predic-tion appears plausible, but whether or not it comes to pass is not the point. In fact, there have been a handful of temporary defaults by remote local governments over the past sev-eral years, but cash has quickly been found to ensure that obligations are met. Evaluating the plausibility in the light of the key aspects of Chinese culture and political governance


that have been introduced in these two chapters demonstrates the relevance of these fac-tors to understanding banking and credit markets in China.

Following is a list of some of the values and norms, associated with traditional Chinese culture and with the Party, that have been taken up in Chapters 2 and 3. Only those values and norms likely to be relevant to the question of local government defaults are included.

Collectivity and groupOrder and harmony, state’s duty to control to prevent disorderDecision- making by consensusStabilityPragmatismAvoiding risk and failureCautionHolistic strategy and strategic sequencingAvoidance of big bangs and associated disruption

How would the decision be made? Would the Minister of Finance have the authority on his own to do this? Most likely the decision would go up to top levels for consensual decision, as the implications both domestically and internationally of defaults by local governments would be major. Senior people from the various key financial and economic stakeholders would have to be convinced that the cost of local government defaults would be worth the benefits to be gained.

The minister would have to overcome his colleagues’ reluctance to do anything disruptive when reform of debt must be weighed against the goals of maintaining reasonable economic growth rates at a delicate time of transitioning into the New Normal economy. The worthy objective of “wringing out moral hazard” from the local governments, on which presumably everyone would agree, would have to be weighed against the need to preserve confidence in the banking system when non- performing loans (NPLs) are rising and to not discredit the local governments at a time when measures are being prepared to enable them to issue longer- term bonds on their own. In view of those objectives, where does the priority lie? Is this the right time to deliver such a lesson, or could it be deferred for a few years until a proper bond market is up and running that the local government could access? For local governments that really cannot make their payments to banks, can they not be pressured to raise cash through sale of shares in corporate assets they own or transfer of funds from other budget areas to service debt? Should not this issue be considered within the context of the larger strategy of reforming the entire fiscal system of local governments, which is on the agenda, and the related strategy of developing bond markets to take the pressure off of banks? Not to mention the priority on developing the Western and poorer regions of the country, which is precisely where the local governments would be most likely to


default. Or the priority on urbanization, which must be supported by massive infra-structure investments by the local governments.

One can see the difficulty that would be encountered in explaining the need at this point in time to deliver lessons on fiscal responsibility. Perhaps one might let one or two inconsequential districts default as examples to discipline the rest— what the Chinese call “killing a chicken to scare the monkeys.” If, on the other hand, the decision were made to induce a financial crisis in order to wring moral hazard out of the system, then that would signal that the government felt the need to employ more drastic measures than it typically has over recent decades— a significant change in the pace and style of management of reform in the financial system.

In Chapter 8 I explore further the issue of local government debt owed to the banks. It is in fact an enormous issue, but the way that it is thus far being handled by the govern-ment is consistent with what we would expect based on the values and norms that I have set forth in this and the previous chapter. Readers well versed in recent Chinese history may point to the massive SOE closures and resulting unemployment of millions of work-ers that occurred in the 1990s and the swift closure of GITIC at roughly the same time, both during the time that Zhu Rongji was directing the economy, as counterexamples. Policies on these were indeed undertaken with speed and decisiveness different from the policy behavior I have sketched in this chapter. They were, perhaps, the exceptions that prove the rule, and will be discussed in the next chapter.

64

The previous two chapters have outlined aspects of China’s cultural heritage and its political economy that have caused China’s banking system to resemble banking systems in the West in many ways but to have also developed with distinctly Chinese features. Subsequent chapters describe how today’s modern banking system in China is embedded in Chinese ways of thinking about the state, the economy, and society, and how the bank-ing system is part of a market socialist economy rather than a market capitalist economy.

This is the path dependence of Chinese banking— the set of factors that have led to the Chinese banking system as it has developed today. Outcomes are conditioned by what came before and by established habits of thinking, but path dependence is not predesti-nation. There are forks on the road, alternatives between which to choose, major events (which social scientists call contingencies) that change paths, and strong individuals who have their own personal visions that they bring to bear on the policy process.

China’s banking system is conditioned by China’s cultural background and political economy, but it is also conditioned by what went on in the rest of the world over the past thirty years, by the extraordinary success of China’s Opening and Reform program that has exceeded what anyone expected when it was launched four decades ago, and by

4 Transformation: From Bursars to Bankers

Banks need to be levers of economic development and technological upgrading. We must

make banks become real banks.Deng Xiaoping, 19791

. . . in enterprises and financial institutions, the concept of credit is weak, there is a lack of

consciousness of financial risk, and in particular in some places and in some departments the

officials have inadequate understanding of finance, do not understand, or even have not seen

financial laws and regulations, repeatedly interfering with the normal operations of financial

institutions.

State Council, 19972

1 Quoted in Liu Mingkang, ed., Zhongguo Yinhangye Gaige Kaifang 30 Nian: 1978– 2008 (China Banking Industry: 30 Years of Reform and Opening 1978– 2008) (Beijing: China Financial Press, 2009), 5.

2 Quoted in Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 72.

Transformation: From Bursars to Bankers 65

the beliefs of strong national leaders, in particular Deng Xiaoping and Zhu Rongji, and financial sector leaders like Zhou Xiaochuan and Liu Mingkang, who were able to guide development of the system in directions they thought best for the country.

This chapter sketches the development of banking in China from the monobanking system that was still in place when Reform and Opening was launched after Mao’s death, up through the present day. In this history, certain watershed events and decisions deter-mined the road forward that was chosen.

Economic historians divide the Reform and Opening era into two phases. The first phase, from 1978 through around 1993, was a tentative and experimental period of grad-ual introduction of market forces into the economy while retaining the legacy of a state- planned and - controlled economy in which the growing private sector was seen as an adjunct to the state’s control of the “commanding heights” of the economy. The strategy for economic development was more or less made up based on what did and did not yield good results.

In the second phase, starting in 1993, associated in its early years with Prime Minister Zhu Rongji, a clearer strategy emerged— the abandonment of the planned economy, the state ceding a much larger role to the private sector, and acceleration of the opening of the economy to foreign investment as China. As the second reform phase gathered speed after the turn of the century, the party- state moved from tolerating entrepreneurs to embracing them.3 The “market socialism” hybrid economy that has emerged out of this reform process has been aptly described as “Competitive state- coordinated capital-ism” by scholar Christopher A. McNally4 (but in this book I stick with the term that the Chinese themselves officially use— “market socialism”).

Looking at the banking sector alone, I divide the history of post- 1949 Chinese banking into five phases:

• A transition period from 1949 to 1951, during which the new communist govern-ment was reshaping the economy according to its socialist vision.

• From 1952 through 1979 was the “monobanking system period,” with only a sin-gle bank, the PBOC, functioning as a bursar for the government and remittances house, based on the central planning model of the Soviet Union.

• An “experimental period,” 1978 through 1994, during which Reform and Opening got underway and commercial banking was reestablished. The PBOC monobank was divided into a central bank and four large state commercial banks. A number of new banks were also opened. During this second period banks still operated as part of a state- directed planned economy.

3 Christopher A. McNally, “China’s Emergent Capitalism,” in Varieties of Capitalism, Types of Democracy and Globalization, ed. Masanobu Ido (London: Routledge, 2012), 169– 192.

4 McNally, “China’s Emergent Capitalism,” 169– 192.


• Fourth, the “transformational period” of reform, starting in 1994 and lasting to 2010, during which time the banking system was fundamentally re- engineered, modernized, and stabilized.

• Since 2010 banking has been in an “evolutionary period.” Developments have not been transformational, but have strengthened and developed the banks to meet changing needs and the challenges of the economy as it transitions from high investment, export- oriented, surplus labor to the New Normal; financial repression (artificial suppression of interest rates below market rates) is relaxed, private investment to establish new banks is permitted, policy emphasis shifts toward improving financial accessibility and financial broadening (or less ele-gantly, “debanking”), and rapidly advancing information technology capabilities change the way that people and firms manage their financial affairs.

Mao and Monobanking

When the Communist Party took power in 1949, China’s economy was reeling from the effects of years of fighting the Japanese and the civil war that followed. Most of the Republican era (1911– 1949) banking system was effectively bankrupt, and many people were unable to withdraw their deposits. One of the first priority tasks of the new gov-ernment was to restore some sort of order and credibility to the banking system it had inherited from the Nationalists.

The victorious Communists, however, already had almost two decades of experience of their own socialist banking, established in the zones that the Red Army was able to control. In the early years of organizing peasant resistance to the Nationalists, a major slogan used to mobilize support was “Reduce rent, reduce interest,” which was a power-ful slogan in view of the 30% interest rate charged on rural loans at that time. In the early Soviet setup in “liberated areas” of Jiangxi Province, the Party prohibited local lending institutions from charging high interest rates and closely supervised their operations. It issued its own currency, which circulated interchangeably in the liberated zone with Nationalist notes, opened a mint for silver coins, and established its own banks as well. The first Central Bank (guokia yinhang) of the Communists was established in 1932 in Jiangxi Province. Mao Zemin, younger brother of Mao Zedong, was appointed president of this central bank.

When the Party and the Red Army were encircled by the Nationalist Army in 1934, they abandoned the Jiangxi Soviet and commenced the Long March that was to lead the Party to its new base area in Yanan in Northwest China. Mao Zemin and thirteen other bank staff, with a guard detachment and 100 porters, carried the Party’s silver and currency— the Party’s entire treasury— for the length of the march, providing the finan-cial support for the Red Army until it reached its destination. Afterwards, settled in the


Northwest of China, the Party set up banks in the zone they controlled. Mao Zemin was seized and executed in Xinjiang Province by a warlord in 1943.5

In anticipation of impending victory in the civil war, the PBOC was established as the new central bank and main commercial bank of the Party in Hebei Province in December of 1948 through merger of several of the local Communist banks. The PBOC moved from Hebei into Beijing in early 1949 after the city had been secured.

In 1951, the governor of the PBOC, Nan Hanchen, undertook the dissolution of the Guomindang banking system and incorporation of banking system assets into the PBOC, which became the only bank operating in the country. A total of seventy- two domes-tic banks had survived the civil war between the Communists and the Guomindang. Nan Hanchen oversaw an appraisal process under which those banks with a negative net worth were closed down without compensating shareholders, while the operations of banks with positive net worth were folded into the PBOC. The shareholders of the latter were treated as “national capitalists,” whose assistance and cooperation was needed during the early years of the transition to socialism, and so were allowed to convert their shares in the private banks into fixed interest obligations of the government, payable over a period of years.6

Radical policies and the attendant chaos of the later Maoist years interrupted redemp-tion of those bonds. In a small irony of history, Nan Hanchen’s grandson, Nan Jingming, as a junior employee in the PBOC after Reform and Opening started, was assigned to the team investigating the status of payment on those bonds and arranging that the original owners did finally receive their compensation, based on the appraisals of his grandfather almost thirty years before.

During the early 1950s, as China changed from a capitalist to a socialist mode of pro-duction, all businesses were nationalized, and a Western- style banking system was no lon-ger needed. The financial system became a centralized financial arm of the government, tasked with handling all the financial needs of the new economic system of production and distribution. The economy and society were organized around production units (danwei), which produced everything needed and provided a total living environment for its employees. The limited excess savings of people could be deposited in branches of the PBOC, but there was no longer any need for loans, either commercial or household, as the government provided for everything through the centrally planned fiscal system, which appropriated funding to production units to meet their production expenses.

The CBRC’s official history of financial reform, Thirty Years of Opening and Reform of the Chinese Banking System, published in 2009 in Chinese, describes the role of the

5 Bowuguanli Shuo Geming Jinrong (Museum Tells the Story of Revolutionary Finance) (Beijing: Capital University of Economics and Business Press, 2014), 31– 54; Harrison Salisbury, The Long March: The Untold Story (New York: McGraw- Hill, 1985), 34, 49– 50.

6 Zhaojin Ji, A History of Modern Banking: The Rise and Decline of China’s Finance Capitalism (Armonk, NY: M. E. Sharpe, 2003), 253– 254.


PBOC under the centralized planning of those years: “The PBOC became the entire nation’s credit center, payments settlement center, and financial cashier. It almost monop-olized all financial business of the entire nation, carrying out the functions of a central bank, and all the functions of commercial banks.”7

In 1969, when the Cultural Revolution was still in full swing, the PBOC lost its insti-tutional independence and was downgraded to a bureau under the Ministry of Finance, where it became nothing more than the Ministry of Finance’s bookkeeper and cashier, housed in Ministry offices around the nation. Not until 1978, with the start of normal-ization under the leadership of Deng Xiaoping, was the PBOC restored to a position independent of the Ministry of Finance.

1979– 1994: Experimental Reform

Reform and Opening was officially launched at the 3rd Plenum of the 11th Party Congress in December 1978, and the financial system entered a new phase, this time to keep pace step by step with the transition from the pure socialist regime of Mao to a nascent “mar-ket socialism.” After the dramatic resolutions of the 1978 3rd Plenum, pointing China down a new direction of rapid economic development in which private agricultural production would be again permitted in rural areas, incentives and retention of profits were permitted for urban production units, and the economy was remonetized. These new economic developments led to an increase in payments transactions and volume of deposits, as both households and enterprises once again saved surplus cash, and bank credit was again needed for businesses.

The importance of banking to underpin Reform and Opening was not lost on China’s senior leadership. In October 1979, Deng Xiaoping stated, “. . . now banks are just book-keepers and cashiers. They are not genuinely undertaking banking functions.” Later he stated, “Banks need to be levers of economic development and technological upgrading. We must make banks become real banks.”8

Few people remained who were proficient in the commercial banking and accounting skills that were needed to meet the economy’s evolving needs. The bankers of prelibera-tion Shanghai had mostly been relocated in the 1950s to Xinjiang to assist in the develop-ment of that remote frontier area or had fled to Taiwan, Hong Kong, or elsewhere as the civil war came to an end. Those who remained in the major cities were mostly old and retired or had experienced difficulties in the Cultural Revolution due to their politically suspect backgrounds. A quarter century of radical social restructuring under Mao had left the country short of the human resources needed to put the country back on its feet

7 Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 4. 8 Quoted in Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 5.


economically. Those working in the PBOC had no special qualifications, as banking had now lost any sense of being a profession that would require specialized expertise.

Shortage of qualified human resources, and of technical skills and knowledge, was the legacy Maoism had bequeathed to Deng as he rebuilt the economy. That same Maoist legacy, however, also left a clean slate on which Deng could reconstruct the nation. Schell and Delury recount that “Mao’s revolution did help free Deng, the deracinated Leninist, to deal pragmatically with the present. Rather than having to dwell on the past in an end-less joust with Confucius and sons, or dreaming unrealistic dreams about pie- in- the- sky communism, Deng was freed to focus on making China more prosperous.”9

Most of the leaders who have piloted the development of the financial system over the past fifteen years were of the generation that came of age in the final years of Mao and in the first years of the Reform and Opening period of Deng. Denied a normal education in their youth, many of them were “sent down” to work in the countryside as young men and women— an experience which left an indelible mark on them. As my colleague on the Board of Directors of Minsheng Bank, Wang Yugui, related,

In the early 1980s I was fortunate to be able to leave China to study in a graduate program in insurance in New York City for two years, receiving a degree there. I then returned to China and went to work here. Very few of my contemporaries who were privileged like me to study overseas at that time wanted to return to China, which at that time was still so desperately poor. Why did I return? Because the only way that I could give meaning to my years of suffering and privation in the Cultural Revolution was to return to join in the task of building a better nation.10

Those who became leaders of financial reform, whether in the banks or in policymak-ing positions in the government, were mostly of that generation, including Xi Jinping, now President of China, who had spent several years of his youth in an impoverished cor-ner of Shaanxi Province. A few years later, as a young official on an observation mission to the United States, he must have compared his bitter years in Shaanxi with the comforts of the Iowa farm family with whom he spent a night.

These people were the first to attend Chinese universities when they re- opened in 1978. Some were able to study abroad for degrees in the 1980s and then returned as Wang Yugui had. Like Wang, their youthful experiences of working in very difficult circumstances in rural areas in remote parts of the countryside made a profound impression on them. The contrast with what they encountered when they went abroad, either for a study trip or to embark on degree programs, inspired them to participate in the development of their own country.

These experiences motivated the generation that has spearheaded the transformation of the financial system in support of China’s Reform and Opening over the past decade.

9 Orville Schell and John Delury, Wealth and Power (London: Little Brown, 2013), 323. 10 Personal conversation with Wang Yugui, April 2014.


Westerners who trained this generation of young bankers in the 1980s speak of their intellectual curiosity, of their eagerness to learn and to put knowledge to good use in the building of their country. Some of this generation have become top- level finance officials and executives, some have worked equally hard in the middle ranks of the PBOC, the CBRC, or the commercial banks, but all have expressed in their own ways the hopes and dreams that they had for developing a strong banking system as their part of the national search for wealth and power. It is this generation of men and women whose stories do not emerge in the dry rendition of facts and figures about the transformation of China’s banking system, but it is they who have in the years since 1979, and especially in the years since 1994, brought about the transformation. Many have shared their stories with me in the course of researching this book.

The 1980s were a period of great intellectual ferment in China. Not only were portions of the economy gradually released from state control, starting with agriculture and then proceeding to industry, but now that China had turned its back on Maoist radicalism, there was a sense of unlimited possibilities for building wealth and power for China. This extended into the political, literary, social, and artistic areas as well. There was an explosion of creativity, ranging from the earliest entrepreneurs starting small businesses to artists and writers testing the boundaries of what would be acceptable in post- Maoist China. The 1980s was a heady decade of searching for the way forward, on both indi-vidual and national levels, a time when the government permitted experimentation of all sorts, albeit always closely supervised, to take place. Change was in the air, coming so fast that no one knew how far it would go, where it would lead China.

National leaders debated how much socialism and state domination of the economy should be retained and to what extent private enterprise and the free market should be given free rein. Leaders, bureaucrats, and academics were all learning how nonsocialist systems work. They thought about what would best suit China’s development needs moving forward. Despite the heady atmosphere, economic reform was gradual and step by step. Reflecting the pragmatism and experimentation favored by Deng, the outcome of the debates was a mixed market socialist economy, with a gradually expanding role for the private sector. In the 1980s, the private sector was seen as a supplement to a still dominant state sector.

Economist Barry Naughton has described the period in which Deng led Reform and Opening as a period in which there were many “veto players” and decision- making power was fragmented at the top of the government, with several revolutionary- generation Party elders holding different viewpoints and able to make their voices heard. Political fragmentation among the leadership elite, combined with Chinese cultural skepticism of big bang solutions and a genuine lack of clarity as to precisely how the economy should be reformed, limited the speed at which Reform and Opening could proceed. The debates between those who supported more cautious or more rapid reform opening held the two camps in check but permitted an experimental approach that in the end served China much better than the big bang approach that was taken in Russia after the dissolution of the Soviet Union.


After Jiang Zemin took over the position of General Secretary of the Communist Party in 1989 and then President of China in 1993, the elder generation of Party leader-ship began to fade from the scene. Economic decision- making power in the next genera-tion of leaders became more concentrated, permitting reform to move into its next, more aggressive phase in 1993.11

Reflecting these broader economic debates, within the PBOC the years 1978 through 1993 were a period of wrestling with the question of what kind of banking system China needed in order to support the reform and development of the economy. PBOC plan-ners worked closely on this question with the reform- oriented research institutes spon-sored by Prime Minister (and then General Secretary [1988– 1989]) Zhao Ziyang, until his fall from power in June of 1989.

The first step in financial reform, undertaken between 1979 and 1984, was the sepa-ration of the central banking and commercial banking functions of the PBOC. One after another, the agricultural, international banking, and general commercial bank-ing functions of the PBOC were hived off into newly chartered specialist banks, while the infrastructure construction funding function was carved out of the Ministry of Finance, in which it had resided: Agricultural Bank of China (1979), Bank of China (1979), Construction Bank (1979), and finally Industrial and Commercial Bank (1984). During this first reform period, these four state banks operated as bureaus reporting directly to the State Council. As the first banks chartered to operate in the Opening and Reform period and inheriting the massive branch network of the PBOC, they had first mover advantage, claiming a dominant position in the banking market that they retain to this day.

The next set of financial reforms occurred in the period 1984 through 1994. The four state- owned banks (BOC, CCB, ICBC, and ABC) ceased to be specialist banks and quickly developed overlapping portfolios, each serving all sectors and regions of the economy. The Bank of China lost its monopoly on foreign trade and foreign exchange. Joint stock banks, including China Minsheng Bank and China Everbright Bank, were licensed as corporations. These joint stock banks, less constrained by government credit quotas, were intended to introduce additional competition into the system.

Reflecting the experimental spirit of that period, “crossing the river by feeling the stones” in the famous phrase of Deng Xiaoping, there was no one single model for the establishment of these joint stock banks. Most were owned in one way or another by the state. The giant state- owned Capital Steel Company established Hua Xia Bank. The Fujian Provincial government set up Industrial Bank.12 Some initially operated on a nationwide basis, such as China Everbright Bank, while others, such as Industrial Bank,

11 Barry Naughton, “A Political Economy of China’s Economic Transformation,” in China’s Great Economic Transformation, eds. Loren Brandt and Thomas G. Rawski (Cambridge, UK: Cambridge University Press, 2008), 101– 103.

12 Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 18.


initially operated only within one province. Today, the twelve joint stock banks have nationwide branch systems, compete directly with the five large commercial banks (the original four plus the Bank of Communications), and together with the five large com-mercial banks, constitute the seventeen tier 1 major commercial banks.

Three of these joint stock banks were established with significant or majority private sector shareholding. The Shenzhen Development Bank (now Pingan Bank) was estab-lished in 1987 with a total of 11 institutional shareholders and 7,276 individual sharehold-ers. SOEs held 51% of the shares, private sector companies 17%, and individuals 32%.13 Everbright Bank was originally set up in 1992 as part of the state holding company, Everbright Group, but in 1996 the shareholding structure was reorganized to include 130 leading entrepreneurial enterprises. Later, in 2007, it was further reorganized dur-ing a major capital increase to give a majority shareholding to the Ministry of Finance’s Central Hui Jin Company, thereby putting it back under state control.

China Minsheng Bank was a joint stock bank completely under private sector owner-ship and management throughout its history. The brainchild of prominent entrepreneur Liu Yonghao, who had risen in a short number of years from a farm family in Sichuan Province to become one of China’s major businessmen, and several other leading private businessmen who were active in the All- China Federation of Industry and Commerce, they worked with Federation Chairman Jing Shuping (mentioned in the preface to this book) to prepare a proposal for establishing the bank to submit to Zhu Rongji for con-sideration. Zhu saw the value in experimenting with establishment of a private bank and approved the proposal, appointing Jing Shuping to lead the bank as its founder and chairman.

In 1995, Minsheng Bank was opened, with all of the shares subscribed to by private entrepreneurs. Ownership was distributed among a large number of businessmen, with no one given more than 10%. Many shareholders rank among China’s largest business conglomerates. The largest shareholders sat on the board, later joined by independent directors (including myself ) not related to shareholders. Minsheng Bank has thrived and to this day remains privately owned.

Until 1994, state banks were required to lend based on an annual National Credit Plan, laid down centrally for the entire nation on a province- by- province basis. The Credit Plan was the financial counterpart to the physical production plan of the planned economy. Under this quota system, most lending was to the state sector. Loren Brandt and Xiaodong Zhu see the “central government’s use of the banking system to support the state sector” as reflecting “the Chinese government and the Communist Party’s deep commitment to workers and job growth in the largely urban state sector … necessitated by declining fiscal resources at the government’s disposal.”14 Brandt and

13 Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 19. 14 Loren Brandt and Xiaodong Zhu, “China’s Banking Sector and Economic Growth” in China’s Financial

Transition at a Crossroads, ed. Charles W. Calomiris (New York: Columbia University Press, 2007), 97.


Xiaodong Zhu estimate that in “most years, 80 to 85% of all credit extended through the state- owned banks went to state- owned firms… . A slightly lower percentage of credit through the entire financial system went to the state sector. On an annual basis, the flow of resources through the financial system making its way to the state sector was as much as 15 to 20% of GNP.”15

Since credit allocation was set under a national Credit Plan in support of economic policies largely revolving around SOEs, there was little need for exercise of independent credit judgment by the banks. During that period, state banks knew next to nothing about cash flow analysis, risk mitigation, loan recovery, or any of the other credit- related skills that are taken for granted in a modern commercial bank in a market economy. At the same time, the clients, who were almost all SOEs, often did not understand the dif-ference between a loan and an appropriation, nor did they realize that they were obliged to repay loans.

Supervision of implementation of the annual National Credit Plan was the duty of the provincial branches of the PBOC. Therein lay a major problem. Both the provincial branches of the PBOC and the provincial branches of the state banks were under the influence of provincial governors and party secretaries, which pressured them to sup-port local projects and local SOEs, whether or not they were viable. The combination of directed lending under the Credit Plan, the inability to resist the influence of local politi-cal authorities, and the poor risk- management capability of the state banks themselves taken together was a recipe for mounting NPLs. Scholar Victor Shih points out that the banks during this period, taking advantage of support from central leaders favoring rapid economic expansion, were at times able to thwart the control mechanisms of the tech-nocrats in Beijing who were attempting to keep credit growth and monetary expansion within reasonable bounds.16

The corporate cultures of the state banks retained characteristics from the prereform era. As a hangover from the prereform planned economy, they were constrained exter-nally by the National Credit Plan to play their roles in fulfillment of the national develop-ment plan. Internally they focused on the welfare of their employees. Until very recently these organizations had been responsible for comprehensively providing for the needs of their employees. Memories of this responsibility still influenced how state banks were run. The mission of the state banks, as understood by management, was to lend as Party officials instructed and to look after their employees.

At the same time that the state banks were closely controlled by the credit quota plan and were lending predominantly to the state- controlled sector, nonbank financial insti-tutions were established. Citic, founded at the behest of Deng Xiaoping in October 1979, and which was later to evolve into today’s giant Citic Group and Citic Bank, was the

15 Brandt and Zhu, “China’s Banking Sector and Economic Growth,” 95– 96. 16 Victor Shih, Factions and Finance in China: Elite Conflict and Inflation (New York: Cambridge University

Press, 2008), 86– 160.


model on which the State Council authorized credit trusts in 1980. Initially, the credit trusts prospered and proliferated— by 1982, the government had licensed an astound-ing 620 credit trusts. The credit trust industry over the next thirty years was to have a checkered history, requiring several reorganizations, finally emerging as the credit trusts which today play a major role as nonbank financial institutions.17 In addition, small- scale rural cooperatives and urban cooperatives were set up around the country. Much less constrained by the national credit plan than the state banks, these nonbank financial institutions became significant sources of credit for the non- state sector during these first two decades of Opening and Reform.18

During these years of reform in the second half of the 1980s and extending into the early 1990s, Deng Xiaoping, Zhao Ziyang, Hu Yaobang, and the next level of national leaders were cautiously receptive to financial reform proposals. The reform concepts worked out by the technocrats at the PBOC were favorably received at the State Council level, even though the leaders had limited understanding of the economics of the proposals being put forward— they simply encouraged adoption of creative ideas proposed by the tech-nocrats based on study of what had worked in advanced economies and from what had been suggested by the delegations of economic advisors assembled by the World Bank.19

The 1980s and 1990s were years of experimentation and high growth, with as- yet inad-equate grasp of the policy levers, resulting in macroeconomic instability. High invest-ment fueled high growth, but the accompanying bouts of inflation led to restrictive government policy to bring inflation under control. The success of the inflation- fighting policies then sharply reduced growth rates. Peaks in levels of investment closely corre-lated with peaks in GDP growth rates during those years.20

Within the top levels of the Communist Party, keen debate was going on as to how the economy should be structured and what should be the speed and nature of the reforms. Deng Xiaoping, supported by Hu Yaobang, Zhao Ziyang, and others, advocated moving quickly and pragmatically, relying heavily on what they were learning from their foreign advisors. Chen Yun was the leading voice in the government calling for caution, warning against the dangers of unleashing inflation and skepticism of some of the reforms.

Whenever inflation picked up, the voices of restraint gained the upper hand in poli-cymaking for a period of time. The oscillations between strong momentum for reform and contractionary caution exacerbated the fluctuations between high investment/ high growth and lower investment/ lower growth, particularly in the period 1988– 1993. In mid- 1988, with inflationary pressures already building up, and acting against the advice

17 Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 10– 11. 18 Brandt and Zhu, “China’s Banking Sector and Economic Growth,” 88– 89. 19 Ezra F. Vogel, Deng Xiaoping and the Transformation of China (Cambridge, MA: Harvard University Press,

2011), 454– 457. See also Schell and Delury, Wealth and Power, 290. 20 Lee Branstetter, “China’s Financial Markets: An Overview,” in China’s Financial Transition at a Crossroads, ed.

Charles W. Calomiris (New York: Columbia University Press, 2007), 25– 26.


of the more cautious leaders, Deng pushed forward rapid and full decontrol of prices. This “big bang” approach toward reform, seldom seen in China’s Reform and Opening, resulted in chaotic retail market conditions, an inflation rate that hit 26% in the second half of 1988, and popular unrest. It was a poorly conceived reform move, from which Deng, and his prime minister, Zhao, had to back down.

This provided an opening over the next three years for the more conservative and cau-tious Prime Minister Li Peng, backed by Chen Yun, to reassert balance in economic man-agement. Li replaced Zhao as prime minister in 1988, and as general secretary in 1989. After that, prices were again brought under control, investments were curtailed, and lending was restricted. The impact of these moves on the GDP growth rate was striking, as growth declined from 11.3% in 1988 to 4.1% in 1989, and then further to 3.8% in 1990.21

Within the financial system, restraint meant that support by the state banks for the nonbank financial institutions, which were the principal sources of credit for the dynamic non- SOE portion of the economy, was sharply reduced, which had an immedi-ate impact on investment and growth rates. State bank support for the SOEs, however, was largely unaffected by the credit restraints.

1993– 2010: Transformational Reform

Deng had by then retired from positions in the government but was distressed by the wavering in commitment to reform. Relying on his unrivaled prestige and network of Party connections, Deng launched his counterattack. He traveled around China, speak-ing out in favor of pushing reform forward. In January of 1991, in a visit to Shanghai, which had been the prewar center of Chinese banking, he declared, “Finance is very important, because it is the core of the modern economy. Handling financial affairs well is the key to success in this sphere.”22 Deng’s biographer, Ezra Vogel, notes how Deng was careful, as a communist, to use the word “finance” rather than the word “capital.”23

In 1992, after considerable intra- elite maneuvering, Deng settled the debate over whether to push reform forward aggressively or not when he made his now legendary “Southern Tour,” proclaiming “To get rich is glorious.” General Secretary Jiang Zemin was then able to consolidate his grip on the levers of power; controls on bank lending and SOE investment were relaxed, and the economic boom of the 1980s was reignited, with GDP growing at over 13% per annum in the two years after Deng’s Southern Tour.

Despite the clear reform agenda that had been set, the Jiang- Zhu government had to deal with one immediate problem, a high rate of inflation, and two major structural problems, SOE reform and bank reform, that could no longer be put off. SOEs still

21 Vogel, Deng Xiaoping, 469– 473. 22 Selected Works of Deng Xiaoping, Vol. 3, 237. 23 Vogel, Deng Xiaoping, 668.


dominated the economy. Most of them were inefficient, resistant to change, and losing money. They were kept in business by a steady flow of loans from the state banks, directed by the National Credit Plan. Banks were mandated to assist the government in maintain-ing social stability through propping up these enterprises, which still employed a signifi-cant portion of the population.

With the promoters of rapid growth and economic experimentation back in the lead-ership, and the economy again on full throttle, the technocrats who were methodically studying how to modernize the financial system were overwhelmed by the sheer speed and vigor of the forces driving the economy forward. The financial system could not cope with the growing economic size and complexity.

Scholars Brandt and Zhu (no relation to the former prime minister) make clear how inefficient this misallocation of capital between the state and private sectors was, point-ing out that “Between 1978 and 1994 . . . the non- state sectors’ share of the gross value of industrial output increased from only 22% to 63%. Put slightly differently, the contribu-tion of the SOEs to annual growth in industry fell from nearly 90% in 1978 to only 12% in 1994.” Further, they state that total factor productivity in the private sector was estimated to be at least double that in the state sector.24

Second, the state banks were drowning under NPLs. Estimates of the level of NPLs range as high as 40– 50%, but whatever the precise number,25 the banking system was technically insolvent, and a huge amount of national financial resources was being mis-allocated through misdirected political interference in the credit allocation process. A massive bailout could not be avoided.

By the mid- 1990s China was transitioning rapidly from a planned economy to a hybrid market economy, but the banking system lagged behind, mired in the ways of the old planned economy and awash in bad debts. Zhu Rongji and his leading economic thinkers realized that they could not create a modern, efficient Chinese economy if China lacked a robust, modern financial system. They recognized that over the previous decade they had put in place some of the outward forms of a modern financial system, but that this was only a shell sheltering a relic of the old planned economy. The banking system still oper-ated as a fiscal agent of the government, as a bursar for disbursement of government funds.

What was the modern, efficient financial system that China needed for its develop-ment? If it were not to be a fiscal agent, if it were not to be a bursar giving out loans at the command of the government, then what should it be, how should it operate, and how should it be governed? A multitude of questions presented themselves for which no one in China knew the answers. The government sought answers in the same way that it was seeking answers for the other challenges it was encountering in developing the

24 Brandt and Zhu, “China’s Banking Sector and Economic Growth,” 95. 25 Brandt and Zhu, “China’s Banking Sector and Economic Growth,” 86; Dwight H. Perkins, East Asian

Development: Foundations and Strategies (Cambridge, MA: Harvard University Press, 2013), 133– 135.


economy— listening to teams of foreign experts and sending delegations out to study best practice in other countries.

In particular, they looked to the United States and the United Kingdom, but also to Japan and several other countries. Teams were sent out from China to study how for-eign commercial banks and regulatory regimes worked. At the same time, the World Bank, Price Waterhouse, and other multinational organizations sent teams to advise the Chinese.

A basic decision had been made that the banking system would be transformed and that on the wreckage of the old system would be constructed a new banking system that would perform credit allocation and payment functions efficiently in the service of the real sectors of the economy. This transformed banking system would manage risk pru-dently so that never again would a government bailout of the entire system be necessary. The people charged with studying how to reconfigure the banking system proved to be fast learners.

Summarizing the problems that had arisen over the previous fourteen years, the offi-cial history of the Reform and Opening of the Chinese banking sector, Thirty Years of Opening and Reform of the Chinese Banking System, related that, despite the major devel-opment of the financial system that had occurred, it was still “unable to escape the grip of planned economy ways of thinking,” leading to three fundamental problems that had to be resolved: (1) loans were still granted under a planned economy model; (2) the roles of the PBOC and the four state banks had not been clarified or clearly separated, so that commercial banks were not real commercial banks; and (3) macroeconomic manage-ment and market mechanisms had not been properly established, so that the economy careened back and forth from expansion to contraction.26

The Ministry of Finance did not wish to take action on the problem of NPLs, as the central government in the mid- 1990s derived around one- sixth of total central govern-ment revenues from taxing banks. It was therefore reluctant to permit banks to stop accruing income on bad loans until the loans had been in default for three years, as that would have further weakened the government’s already shaky fiscal position. Thus, there was a conflict of interest within the Ministry of Finance between its need for tax revenues and its responsibility to ensure a stable and efficient financial system.27

After Deng’s Southern Tour, the new reform agenda was set forth in 1993 at the 3rd Plenum of the 14th Party Congress, which determined that China was to transition from a planned economy along Soviet lines to a socialist market economy. This followed Deng’s comments on his Southern Tour that “[a] planned economy is not socialism, capi-talism also has planning; a market economy is not capitalism, socialism also has markets” and “[p]lanning and markets are both economic tools.” 28 Prior to this, official policy

26 Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 40. 27 Branstetter, “China’s Financial Markets: An Overview,” 34. 28 Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 39– 40.


assigned the private sector a secondary role of supplementing the state- owned sector. From 1993 that changed, as it was acknowledged that the private sector should play a leading role in the economy.

Over the next twenty years, until the 3rd Plenum of the 18th Party Congress in November 2013, China’s economic reform and growth agenda clarified. The experi-mental stage of reform and the reform politics of multiple veto- players had ended. Implementation unfolded step by step over subsequent years, with modulations in pace and nuance and occasional setbacks, but never going significantly off the track that had been set in the 3rd Plenum of 1993. From this point forward, China’s aptitude for strategy (discussed in Chapter 3) became a major factor in the success of reform efforts.

One of the strengths of economic policymaking in China is that planning is undertaken on a holistic basis, looking at the entire economy and the interrelationships between pol-icy initiatives, rather than on a piecemeal basis. The resolutions of the 3rd Plenum of 1993 set the stage for a coordinated set of reforms, of which SOE reform was one and financial sector reform was another. These two reforms were inextricably linked to each other, as banking reform could not succeed without reform of its clients, the SOEs. At the same time, the success of these two reforms in turn depended on pushing forward fiscal reform, housing reform, and other key reforms. The reform initiatives that were pursued from 1993 onward succeeded in good measure not only because each reform was of itself well conceived, but also because taken together they formed an integrated package. The whole added up to more than the sum of the parts.

Although the resolutions of the 3rd Plenum in 1993 set the stage for the transforma-tion of the banking system, progress from 1993 through 1998 was slow. Zhu Rongji’s attention in 1994 and 1995 was focused as much on restabilizing the economy and bring-ing inflation under control as on reform. Full transformation of the banking system from the old planned economy mode to a market- driven mode had to await comple-mentary reforms getting under way and also twin shocks, one foreign and one domestic, that occurred in 1997– 1998, galvanizing action. Meanwhile, bad debts on the books of the state banks further accumulated, and local governments went on a spree of opening small financial institutions to support local development projects and stimulate local investment. All too many of these local financial institutions operated at the direction of local government planners, without strong management or any sense of risk assessment and control.

After bringing inflation under control, the next priority was SOE downsizing, which unfolded over the course of about ten years, followed by several years of consolidation. SOEs in twenty- two out of thirty- eight industrial sectors were losing money in 1996, their continued operations sustained only by a steady infusion of credit from the state banks, little of which could be paid back. The solution engineered by the Jiang- Zhu team was twofold. First, the government closed and divested of SOEs that lay outside of areas that were defined as core strategic industries. That was a bold move, which dislocated the lives of millions of people, but it was essentially a one- time event.


The second approach, adopted for the core strategic industries, such as banking, oil, electricity, and defense, which remained under government ownership, was corporatiza-tion of the SOEs— a different process from divestiture or privatization. During the previ-ous decade, enamored of Japanese theories of managerial efficiency, the government had tried to foster SOE efficiency through increasing the effectiveness of SOE management. The results of this effort were unsatisfactory. The problem lay in lack of a responsible owner. SOEs were owned by ministries and departments of the government, which exer-cised ownership rights through their bureaucrats— in other words, bureaucrats supervis-ing bureaucrats— a sure recipe for sluggish performance.

Scholar Wang Yingyao describes the “changing notions of public sector management that occurred among the Chinese policy elites” between the 1980s and the 1990s.29 It was recognized that to be effective, management needed to be embedded in a frame-work of corporate shareholder value, copied from the market economies of the West, but orchestrated by the state. This was the beginning of the process of financialization of state ownership of the economy. Wang states that “financial entrepreneurship” by the state “embedded market competition in political and bureaucratic processes which caused the conflation of state and market in unexpected fashion”30 and to what she calls “the forma-tion of the ‘shareholding state’,” in which corporate governance was used to motivate and discipline management and to establish “depoliticized shareholding.”31 The pressure of market forces and the shareholder corporate structures of the West are thus used by the state to impart dynamism into the SOEs. From the Party’s point of view, this approach permitted the state to retain control over industries at the “commanding heights of the economy” through the state becoming a value- seeking shareholder. When these corpo-ratized SOEs were then listed on the securities exchanges, there was the added benefit that the excess funds of the general public could be mobilized in support of the growth of these SOEs through public share subscriptions. The SOEs could then be weaned off of dependence on budgetary allocations from their “owner” ministries.

The creation of the “shareholder state” was completed when organizations had been created “to ‘personify’ shareholders and exercise shareholders’ rights.”32 This was done through the establishment of government- owned supervision agencies and financial holding companies. For the non- financial SOEs, the State- owned Assets Supervision and Administration Commission (SASAC) was charged with looking after “sharehold-ers’ interests” and exercising “shareholders’ rights on behalf of the state.” In the finan-cial arena, it was accomplished through establishment of China Central Huijin, which became the majority shareholder in several state banks (including China Everbright

29 Wang Wingyao, “The Rise of the ‘Shareholding State’: The Financialization of Economic Management in China,” unpublished paper, 12.

30 Wang Yingyao, “The Rise of the ‘Shareholding State,’ ” 4. 31 Wang Yingyao, “The Rise of the ‘Shareholding State.’ ” 9, 14. 32 Wang Yingyao, “The Rise of the ‘Shareholding State,’ ” 17.


Bank), put its representatives on the bank boards, and monitored the banks’ financial performance.33 Huijin was initially established and owned by the PBOC, making the PBOC both the owner and the regulator of the major state banks. In 2007 the Ministry of Finance (MOF) established the China Investment Corporation (CIC) as the national sovereign wealth fund to manage and invest a portion of China’s burgeoning foreign exchange reserves. One of the first acts of CIC after its establishment was to arrange for the transfer of Huijin from under the PBOC to become a subsidiary of CIC, thus mak-ing the MOF indirectly the principal owner of several of the largest state banks.

The State Council’s “Resolution on Financial Sector Reform” of December 1993 out-lined financial reforms to be undertaken over the next five years. The first Commercial Banking Law followed in 1995. In 1996, China joined the Bank for International Settlements (BIS), and in 1997 committed to full compliance with bank supervision principles set forth by BIS’s affiliated organization, the Basel Committee on Banking Supervision. Taken together with accession to World Trade Organization (WTO) in 2001, China’s commitment to the Basel Principles signaled that the Chinese banking sys-tem would move in the direction of global best practice. Progress in meeting full compli-ance has required several years of improvement of banking operations and regulation, and has proceeded more slowly than many outside observers would have wished, but China has not wavered from achieving this goal.

Complementing the SOE and financial sector reforms were a series of other reform measures, foremost among which was the fiscal reform of 1994, which centralized the receipt of tax revenue in the national government, leaving less in the hands of the pro-vincial governments. This reduced the dependence of the Ministry of Finance on tax-ing bank revenues, making possible the imposition of regulations barring the accrual of revenue on NPLs. (As an unintended consequence, in solving one problem it gave rise to another, which has come back to haunt China today— the fiscal deficits and resultant high debt levels of provincial and local governments).

Divestment and closure of SOEs that were unprofitable or were no longer defined as being strategic resulted in millions losing jobs and for the first time being without an employer that provided housing and welfare. To cushion the shock, it was imperative that people who suddenly found themselves without free housing should be provided with affordable places to live. As a result, China embarked on a massive housing program, involving the sale of units formerly belonging to SOEs at attractive prices, development of widely available mortgage finance, and encouragement of private sector real estate development, supplemented by public sector real estate development for lower- income people. In just two decades, China went from almost no one owning their own dwelling to 90% of the population owning their own residence today34 (compared with 66% in

33 Wang Yingyao, “The Rise of the ‘Shareholding State,’ ” 17– 18. 34 Andy Rothman, “China’s Property Is Slowing, Not Crashing,” Financial Times, September 30, 2014, https://

next.ft.com/ content/ 849c8e90- f28b- 3a16- bd69- d8092bf2daa0, accessed June 12, 2016.

http://next.ft.com/content/849c8e90-f28b-3a16-bd69-d8092bf2daa0

http://next.ft.com/content/849c8e90-f28b-3a16-bd69-d8092bf2daa0


the United States, despite the Community Revitalization Act of 1977, which encouraged bank lending to low- income neighborhoods but had the unintended consequence of giv-ing rise to the subprime mortgage lending that was to take such a toll on the financial system in 2007– 2009.) This provision of almost universal home ownership ranks as one of China’s greatest, but often overlooked, achievements.

The massive shock of SOE downsizing was accompanied by making it clear to SOE managers that henceforward positive cash flow, profitability, and servicing of loans to banks was part of their job. Maintaining positive cash flow was essential if state banks were to continue supporting the SOEs that had been deemed strategically important, and hence would remain under state control. This behavioral change in SOE manage-ment was brought about in two ways. First, provincial and local influence over state banks to lend in support of local state enterprises was curtailed. Tier 1 banks, with nationwide networks, were restructured to bring local branches more tightly under control of head office, largely, but not entirely, insulating them from pressure brought to bear on them by local party officials, to whom they had previously reported. Higher levels of credit extension approval authority were withdrawn from provincial branches and concentrated in head office risk departments. At the same time, the organizational structure of the PBOC (which prior to the establishment of the CBRC in 2003 was the regulator of the banks) was changed from provincial offices to regional offices in charge of geographical areas that did not correspond to the administrative structure of the rest of the government. This allowed PBOC inspectors to get on with their supervision of the banks, much less impeded by interference from local officials. These measures greatly increased the external financial discipline under which SOEs had to operate.

More discipline was imposed on the SOEs by Zhu Rongji’s master stroke of obtaining admission for China to the WTO, which obligated China to adhere to market disci-pline and open to international competition. SOEs were no longer just operating in a monopolistic or oligopolistic protected domestic market, but were now disciplined by global competition. Dwight Perkins, who has followed China’s development for half a century from his base at Harvard, explains that “[b] y signing a treaty with the world eco-nomic system, China was tying its own hands when it came to protecting its industries and financial institutions.”35

Edward Steinfeld, in his aptly named Playing Our Game, argues that, once it had cho-sen to invite foreign investment to develop export manufacturing industry as the core of its economic development strategy (and the degree of foreign investment in China’s export industries exceeds that of other developing nations at comparable stages of growth), China realized it had no choice but to adopt these norms of global capitalist practice: “. . . participation in global production— particularly to the degree experienced

35 Perkins, East Asian Development, 133– 135.


by China— requires harmonization of certain core domestic practices with prevailing global norms.”36

Elaborating on this, Steinfeld goes on to say that the ineluctable logic of the foreign investment led to

“integration with global production and if integration was going to be achieved through foreign- led, supply- chain focused restructuring efforts, then certain kinds of institutions would be needed. Many of these— commercial codes, labor laws, and currency conversion mechanisms, among others— would evolve in fits and starts and would function erratically all along. Nonetheless … their very existence rep-resented a start departure from China’s prior mode of revolutionary governance, and an equally stark convergence toward practices found throughout the advanced industrial world.37

While the overall impact of China’s accession to the WTO and adoption of many of the instrumentalities of modern, open economies did, as scholars Perkins and Steinfeld state, bring China more in line with international practice, nonetheless Western business-men and lawyers, working on the ground, have experience of the ability of the Chinese bureaucracy and legal system to sometimes tilt the playing field against foreign competi-tors. This is done without overtly violating the letter of the law or of China’s international obligations.

A modern banking system, operating according to the best practices of global banking, was one of the “certain kinds of institutions” of which Steinfeld writes. So the transfor-mation of the banking system into a modern system that would mesh with other modern banking systems around the world was no longer an option; it had become a necessary support for the export focus of China’s development policy. The way forward for devel-opment of a modern banking system was, by the mid- 1990s, much clearer to China’s financial authorities and planners than it had been a decade earlier.

The Crises of 1997– 1998

Two related shocks precipitated real restructuring of the state banks during the next five- year period, 1998– 2003. First, the Southeast Asian financial crisis of 1997– 1998, while having only limited impact on China, was nonetheless observed closely by China’s lead-ers, who learned from the experiences of Thailand, Korea, and Indonesia that a rickety and overextended financial sector could plunge an entire economy into depression. China

36 Edward S. Steinfeld, Playing Our Game: Why China’s Rise Doesn’t Threaten the West (Oxford: Oxford University Press, 2010), 121.

37 Steinfeld, Playing Our Game, 125.


was spared the full force of this financial crisis largely due to its relatively closed capital account, which insulated it from the precipitate withdrawal of foreign loans and portfo-lio investment that had rocked the financial systems of Thailand, Korea, and Indonesia. Nonetheless, China’s economy was indirectly affected by the reduction in demand for export products of industries located along its southern coast.

The second shock was the collapse of banks in south coastal Hainan and Guangdong in 1998. Problems in coastal export industries set the stage for collapse of the overheated real estate sector and other sectors in which there had been speculation and overinvest-ment. This led to the closing in 1998 by the government of two large financial institu-tions, the Guangdong International Trust and Investment Corporation (GITIC) and the Hainan Development Bank, plus several hundred other trust companies and small- scale urban and rural cooperative financial institutions.

The GITIC collapse was highly visible internationally. Next to Citic it was the most high profile of the international trusts, borrowing heavily from abroad in foreign cur-rency, including a $150 million bond issue placed in the United States, which received a credit rating from Moody’s at the same level as the Ministry of Finance— in other words, the same level as sovereign risk. Heavily exposed to collapsing real estate and infrastruc-ture projects, it defaulted on foreign obligations. Beijing promptly closed it down.38

Hainan Development Bank closed in the same year, only three years after being estab-lished. This is the only case of a joint stock bank being shut down, but it did not attract the international attention that the closure of GITIC had, as it had not borrowed over-seas and so was a purely domestic problem.

Likewise, the several hundred small local financial institutions that were closed down in the same period went largely unnoticed outside of China but had a major impact on the government’s thinking of how to handle the problems of insolvent financial institu-tions. Heretofore, China had largely been following the American model in develop-ing its bank regulatory and supervision regime. America’s financial history is a record of repeated bank crises and instability over the past 200 years. Even in years of relative financial stability, there are generally a certain number of small banks that run into dif-ficulty and are closed down. The American regulatory approach for dealing with these systemically unimportant banks is to close them down immediately and then arrange for the depositors to be made whole and the operations of the closed bank taken over or merged with another bank (except, of course, if they were “too big to fail”).

This American approach had been applied by Beijing with the many local institutions that had gotten into trouble. These closures were a sudden shock to local economies, stalling their development and leading to unemployment. Observing these unintended consequences, the financial reform planning team reconsidered the appropriateness

38 Carl Walter and Fraser Howie, Red Capitalism: The Fragile Foundations of China’s Extraordinary Rise, 2nd ed. (Singapore: Wiley & Sons, 2012), 39– 41.


of using the American regulatory model. In their study tours abroad, the reform plan-ners had been impressed with the gentler English model, which dealt with failed finan-cial institutions quietly without closing them down. It is this gentler regulatory model that has prevailed in China’s subsequent regulatory style and which has underlain the approach toward financial system transformation, despite the possibility that it could lead to “moral hazard” and can be criticized for avoiding taking decisive action to con-front problems in financial institutions.

The twin shocks of the Asian financial crisis abroad and the GITIC crisis led to clear direction from the State Council empowering the PBOC to finally push through the reforms that had first been contemplated in the 3rd Plenum of 1993 but had not yet been implemented in full. Accession to the WTO further strengthened the reformers’ hand. The State Council in December 1997 announced a program for dealing with accumu-lated bad assets and building an efficient, modern banking system. Runs on banks that had occurred in Guangdong and Hainan had conjured up images of the financial chaos of the declining years of Guomindang rule and shocked the State Council into realizing the urgency of putting the nation’s banking system on a professional footing, with strong bal-ance sheets, strict risk management, and proper accounting in place.39 The State Council’s announcement emphasized risk- management controls, noting that “in enterprises and financial institutions, the concept of credit is weak, there is a lack of consciousness of financial risk, and in particular in some places and in some departments the officials’ have inadequate understanding of finance, do not understand, or even have not seen financial laws and regulations, repeatedly interfering with the normal operations of financial insti-tutions.”40 The State Council’s diagnosis of the problem was not an exaggeration.

Stripping and Listing

Prime Minister Zhu Rongji led the implementation of the reforms prescribed by the State Council. People who worked under Zhu during those crucial years say that actually his understanding of the workings of market economies was not deep. How could it be otherwise, given that he had been educated during the years when China was cut off from the market economies and the only economics being taught was socialist? Zhu, however, from his years working in the State Planning Commission, and later the State Economic Commission, had a thorough understanding of the workings of China’s planned socialist economy. He knew its weaknesses and inefficiencies. Most importantly, he had an insatia-ble intellectual curiosity and was a fast learner. His team of bright assistants studied how finance in developed countries worked, then briefed Zhu on their findings. Relying on what had been learned and advice he received, Zhu astutely figured out how to revamp

39 Private conversation with a retired senior finance official, September 2014. 40 Liu Mingkang, Zhongguo Yinhangye Gaige Kaifang, 72.


Chinese banking. He also had the political clout, steely determination, and courage of his convictions to lead his team in translating ideas into reality.

Zhu’s banking reform program had two principal elements: first, cleaning up the balance sheets of the tier 1 banks so that they could be listed on the Shanghai and Hong Kong stock markets, and, second, at the same time introducing modern management, accounting, internal control, auditing, and corporate governance into the banks.

Zhu Rongji intended that listing of the state banks on the Hong Kong stock exchange, with underwritings handled by the major Western investment banks, would force the state banks to bring their corporate governance and accounting systems up to global stan-dards, passing muster with international auditors and the scrutiny of foreign securities exchange examiners. This task posed major challenges, since if banks recognized all the bad loans they were carrying, they would have sizable negative equity. In other words, recognition of the massive bad loan losses would make them technically bankrupt. Shares of banks in such condition could not be sold to skeptical foreign investors. Therefore, in preparing the banks for listing, the government had to strip the enormous burden of uncollectible NPLs out of the banks.

A decade earlier the United States had resolved its savings and loan debacle by strip-ping the bad assets out of defunct savings and loan institutions and placing them in a special purpose Resolution Trust Corporation. The Resolution Trust was what bankers call a “bad bank”— institutions set up for the sole purpose of housing and resolving bad loans, allowing for the loan originating institution to either be wound up or resume oper-ations with a balance sheet that now contained no bad assets and had positive equity. The Resolution Trust Corporation provided a model of how China could solve its bad debt problem, although the scale was quite different: In the United States the total cost to the government of the bailout of the savings and loan debacle had been $150 billion, or 2% of GDP. The Congressional Budget Office estimated that the full cost to the American economy of the savings and loan collapse, if the waste of misallocated resources due to bad lending decisions were added to the direct bailout costs to the taxpayer, approached $500 billion, or more than 6% of GDP at that time.41 In China, Naughton estimates that the total amount that the government would have injected just into the four largest banks to clean up their balance sheets would total 2.4 trillion yuan.42 This was done over sev-eral years, so it is difficult to calculate a percentage of GDP comparable to the American number. If we use China’s GDP in 2003 of 13.6 trillion yuan, then the bailout over several years added up to 17% of 2003 GDP— a staggering burden for a country at the level of China’s development at that time.

41 Gary H. Stern and Ron J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts (Washington, DC: Brookings, 2004), 23– 24. In John Cassidy, How Markets Fail: The Logic of Economic Calamities (New York: Farrar, Straus and Giroux, 2009), 162, the author puts the direct cost to the government at “about 125 billion.”

42 Barry Naughton, The Chinese Economy: Transitions and Growth (Cambridge, MA: MIT Press, 2007), 464.


China in 1999 set up four asset management companies, one for each of the four state banks. Each asset management company purchased NPLs from its related bank at face value, paid for by issuing ten year bonds, to be carried as receivables on the asset side of the balance sheets of the four banks over the course of the next ten years, with inter-est paid regularly and principal repaid in a single lump sum at the end of the ten- year period.

In both the United States and China, stripping assets off and placing them in “bad banks” was successful, but the goals of the programs and the context in the two countries were different. In the United States the savings and loans formed only a part of the total financial system. In China, the four big commercial banks were the core of and the major portion of the financial system.

The United States sequestered the bad loans in the Resolution Trust Corporation, which was directly funded by the U.S. government, and over a period of six years, out of a total of more than 4,000 savings and loan institutions, closed down 747 of them. It sold the bad assets out of these companies into the market through various mechanisms.

In China, the objective was to make it possible to radically transform, rather than close down, the four state banks through corporatization, followed by listing on international securities exchanges. Through listing, the banks would be recapitalized with foreign funds, providing them with the international “seal of good housekeeping” that came with due diligence examinations by global investment banks underwriting the listings. Listing would also compel the four banks to become efficient and stable institutions capable of effectively providing financial intermediation to support the future growth of the real economy.

Listing of these huge state banks could only be accomplished with the assistance of international auditors and international investment banks. International auditors would certify to the credibility of the cleaned- up balance sheets, and international investment banks would advise the state banks on how to package their new international capital issues so that they could be sold to sophisticated international investors. In the meantime, working with the international audit firms and the investment banks, the Chinese bank staff benefited enormously from transfer of professional banking knowledge and skills.

The Chinese program was highly successful. Within a few years, the state banks reported asset quality, profitability, and provisioning against loss that ranked them among the highest in the world, particularly when compared with what happened to many Western banks in the wake of the 2008 financial crisis. And they were soon among the largest ten banks in the world, whether measured in terms of total asset size or in terms of market capitalization.43

43 Walter and Howie, Red Capitalism, 42– 44, have taken issue with the high global ranking of Chinese banks, stating that it is not appropriate to compare the Chinese state- owned banks, which have only a minority inter-est actively traded on the stock market, with the major Western banks, almost the entirety of whose shares are at least potentially tradable. Their point is that trading in the shares of an ICBC is very thin, and hence the market capitalization that is derived from multiplying market share price by the total outstanding shares of the


Part of the success of the program must be attributed to fortunate timing. During the years 2003 through 2008, when the listings of the four state banks occurred, there was not yet the massive market skepticism about the quality of Chinese bank management and reporting that pervaded the market later on. The listings generated considerable excitement in the market and were well received by investors. With the successful listing of the last of the big four banks, the Agricultural Bank of China in 2010, the transforma-tion of the banking system from a command economy bursar to commercial banks oper-ating in a market economy had been accomplished. Dating the transformation from the 3rd Plenum resolution of 1993, the transformation took seventeen years to accomplish. More realistically, dating from the 1998 State Council resolution to reform the banks, at which time the transformation got underway in earnest, the transformation had taken twelve years.

The results of the transformation were clearly reflected in the banks’ financial state-ments over the next four years from the end of 2010 through the end of 2014. During that period net after tax profits of the tier 1 banks increased by 86%. For all commercial banks in the system, ROE reached a peak of 20.4% in 2011, gradually declining each year thereafter as NPLs increased and margins narrowed, but still registered 17.6% at the end of 2014— a return to shareholders that would be the envy of other banks around the world. Also at the end of 2014, capitalization of the commercial banks was strong— core capital ratio of 10.8% and total capital ratio of 13.2%.

In viewing these enviable financial results though, it is worth re- emphasizing two points. First, these results were partially due to supportive, and one could say oligarchic, policies of the government during the period— particularly restriction of private sector entry into banking and financial repression. Second, these results were achieved in a time of extraordinary economic growth when loan demand was extremely high and defaults were rare. As protective government policies are removed and the economy enters the New Normal, the banks will be more challenged.

Asset Management Companies: Accounting Legerdemain?

The program of stripping out bad loans and placing them with asset management com-panies has been strongly criticized by some Western media and analysts and unfavorably compared with the U.S. resolution trust program, which was considered to be more trans-parent. It is worth quoting at some length the comments in May of 2012 of a Bloomberg analyst as a clear statement of the skeptical point of view:

bank overstates the true market capitalization. This might be a more powerful argument were the share prices of the traded minority overpriced. But with price:earnings and price:book ratios of the share prices of the state banks heavily discounted in the Hong Kong and Shanghai markets, Chinese banks, even with high market capitalization by global standards, are among the cheapest bank shares in the world.


a look at the receivables at ICBC and other large Chinese banks provides insights into what passes for normal in the country’s banking system. Everything is a big circle.

The largest receivable at ICBC is a 313 billion- yuan asset called “Huarong bonds.” The footnotes to ICBC’s latest annual report say they were issued to ICBC starting in 2000 by China Huarong Asset Management Corp., an asset management com-pany established by China’s finance ministry. The bonds’ book value hasn’t changed over the years. After ICBC bought the bonds, Huarong used the cash to buy non- performing loans from ICBC at full face value, cleansing ICBC’s books. In short, ICBC swapped bad loans for bonds backed by the loans’ new owner. The old loans didn’t really go away. Perhaps not surprisingly, ICBC wasn’t repaid its principal when the Huarong bonds began to come due 10 years later in 2010. Instead, ICBC received a notice from the finance ministry saying the maturity dates had been extended by another 10 years. ICBC has said the ministry ‘will provide support for the repayment’ if Huarong can’t make good, citing a separate 2005 notice. Such a notice isn’t the same as a guarantee… .44

In this point of view, the asset management companies had not really relieved the state banks of the burden of their bad loans. The bad loans had been swapped for receivables from asset management companies, which were supported but not guaranteed by the Ministry of Finance. Had those bond receivables been shown on the balance sheets of the state banks discounted to the expected true value of the loan portfolios of the asset- management companies (AMCs), then they would have properly reflected the economic reality of the program. This is what happened in the United States with the Resolution Trust Corporation. The assets were stripped out of the savings and loans at prices dis-counting the likely recovery value of the loans, and the difference from the book value was taken as losses by the savings and loans, which were then bankrupted, and depositors were made whole by taxpayer financed bailout. But in China they had been stripped out at face value, the banks remained in existence, and depositors were unaffected. Since on average the recovery rate of the asset management firms on the bad loans was running around 20%, and these bad loans were the only assets of the asset management compa-nies, ergo the bonds of the asset management companies were carried on the balance sheets of the banks at hugely inflated values.

Critics reasoned that the only thing that had changed in the state banks’ balance sheets was that instead of carrying distressed loans to SOEs at inflated values, they now carried bonds of state- owned asset management companies at equally inflated values. In either case, the state banks should still show negative equity. The state- owned banks had simply swapped loans valued at full for bonds also valued at full, when in fact both loans and

44 Jonathan Weill, “China’s Big Banks Look more like Paper Tigers,” Bloomberg View, May 11, 2012.


bonds probably should have been valued at 20 cents on the dollar, which would have wiped out bank equity. If that had in fact happened, of course then foreign investors would not have been interested in paying dollars for the shares of the Chinese banks, and it would have been left to the state to recapitalize the four banks it owned with yuan appropriated from the national budget.

At the time of listing, investors either did not recognize this problem, which could be seen as a sort of “accounting legerdemain,”45 or they chose to ignore it, as the time for reck-oning would not arrive until the ten year bonds came due a decade later. Besides, inves-tors might also hope that one way or another the Chinese government would find a way to service these bonds, which is in fact what has been happening over subsequent years.

This story of loan stripping and of bond receivables carried on the balance sheets of the state banks is a story well known to many analysts and financial journalists following Chinese banking and is a key reason for suspicion of Chinese banks on the part of some investors. The “accounting legerdemain” aspects of it would have been fully understood by the Chinese government technocrats who developed the program (and of course, by the Western investment banks that sold the bank securities to international investors who trusted in the due diligence process, but I won’t go into that).

Why then did the Chinese government go this route? The answer is twofold. First, China needed a robust, fully functioning banking system if it was to take advantage of the extraordinary opportunities for growing the real economy that presented themselves after accession to WTO. In an increasingly market- oriented economy, there was simply no alternative to the banks as a way to channel the nation’s savings into funding commer-cial enterprises and public investment. Given the absence of robust capital markets, the banking system could not become the bottleneck that would retard economic growth, on which the continued survival of the Communist Party depended. Since the banks needed to be restructured anyway, better to recapitalize using the ample funds available from eager investors in the international capital markets.

Second, the mechanism of purchasing the loans at full face value was deferral of a problem that one could not reasonably expect to resolve in the short term. When the bonds fell due after ten years of economic growth of over 9% per year, the total value of the bonds would have shrunk to a more manageable portion of GDP, and the govern-ment could then deal with them more easily.

For the first few years the asset management companies focused on recovering the bad loans that they had received from the state banks. A portion of these they dealt with themselves, and a portion they sold off to investors specializing in management of trou-bled assets, most of them foreign. Presumably the advantage in selling to foreign firms was the knowledge and experience in asset recovery that foreigners brought with them

45 Walter and Howie, Red Capitalism, 53– 76, provides a detailed and clear exposition of the skeptical point of view toward the accounting of the entire bank restructuring.


from other markets, which would permit them to bid for the distressed assets at a higher price than the Chinese asset management company could get on its own, but also because it might be easier for a foreign firm to “play tough” in collecting than it would be for a Chinese government entity, which might be subject to local Party pressure to be lenient. How these asset management companies handled assets that they retained on their own books is not clear, but anecdotal evidence from foreign asset management companies that purchased troubled assets from the Chinese asset management companies gives a glimpse of how the recovery process worked.

Several large international players, such as Goldman Sachs, Morgan Stanley, Citicorp, Cargill, and others, were interested in purchasing distressed assets, provided that the price was right. The Chinese asset management companies managed the sale of these assets to the foreign companies astutely, getting generally quite good prices. They did this despite the fact that they were under pressure from above to dispose of distressed assets quickly so as to generate cash. As a result, most of the foreign investors made a reasonable return on their investment, but not outsized profits.

The CEO of one of the foreign asset management companies described to me how he sat out the first fifteen auctions conducted by Huarong, the asset management company that had taken over ICBC’s distressed assets. Only when foreign competitors had won enough auctions to fill their portfolios was he able to win an auction at his target price. For loans with security, his firm paid 30 cents on the dollar; for unsecured it paid 1– 5 cents on the dollar.

Some of the more difficult provincial portfolios he divided into subportfolios, sell-ing them off to local Chinese investors who were prepared to either use connections or unorthodox methods that the foreign investor could not use easily. The remainder he and his team dealt with themselves. Assuming negotiations with the debtor were not fruitful, then the foreign investor went to court. The relevant laws were adequate for enforcement, but the key to success lay in convincing the judge, who would orchestrate the workout, to cooperate in enforcing creditor’s rights— an example of “rule of men” trumping “rule of law,” discussed in Chapter 3.

The judge was in a complicated position, with several Party and government report-ing lines to satisfy. He was appointed by the Provincial People’s Congress, paid by the Ministry of Finance, supervised by the Party’s legal advisory committee, and if there was any criminal aspect to the case, then the Party’s Commission for Discipline Inspection would get involved. Local governments, whose asset was most likely the collateral for the distressed loan, would invariably oppose the creditor collecting anything. The judge then gauged the political winds from various sources to determine how best to settle the case. He would try to establish what the foreign investor had paid for the asset as a way of determining how much should be paid by the debtor, but he was generally unable to obtain this information, and so would mediate between the parties to come up with what he felt was a reasonable settlement, a reasonable compromise between all the par-ties involved. This generally would not mean bringing the full weight of the law on the


debtor to squeeze maximum payment, but at any rate, in the case of my informant, this process overall yielded a satisfactory result on the total investment in purchasing the portfolio.46

The Chinese AMCs did their jobs as “bad banks” well. They disposed of most of the distressed assets. Nonetheless, they had a problem: they had acquired these assets from the state banks at face value and paid for them with bonds that were supposed to pay interest and be retired in ten years. Since they could only sell their portfolios or collect on loans at massive discounts to face value, they generated insufficient cash to service and retire the bonds. When the bonds came due, the State Council simply passed a resolution rolling them over for another ten years.

The U.S. Resolution Trust Corporation was wound up after it had served its purpose of liquidating the distressed assets of the savings and loan companies, leaving the taxpayer to make the depositors whole. The Chinese AMCs, however, could not be liquidated, as that would entail defaulting on the bonds that the state banks hold, ultimately forcing the state banks to indirectly write off the bad debts of the ’90s, or would require using taxpayer money to make up the deficiency.

When it established the four AMCs, the Chinese government was deferring the prob-lem assets of the state banks for final resolution at a later date. More than a decade has now passed. It appears, now that most of the original distressed assets have been disposed of at enormous discounts, that the four AMCs have “refashioned themselves into financial holding and investment firms.”47 Some of the SOE loans they acquired from banks they converted into equity in the borrower SOEs. In subsequent years, as those SOEs returned to profitability, many listed on securities exchanges, resulting in large profits for the AMCs. As a result of their good performance, and presumably to provide profits covering remain-ing loan disposal losses, the AMCs were permitted to diversify into several other financially related businesses including leasing, fund management, insurance, and others.48

One of them, Cinda, listed in 2013 on the Hong Kong stock exchange in a $2.8 bil-lion initial public offering (IPO). Another, China Huarong Investment Management Company, listed in 2015 in a $2 billion IPO. Prior to the IPO, Huarong had privately placed $2.4 billion of shares with eight investors “including COFCO, Goldman Sachs Group and Warburg Pincus.” Co- sponsors for the Huarong listing are Citi, Goldman Sachs, HSBC, and ICBC International (a subsidiary of ICBC). Huarong reported prof-its in the first half of 2015.49

46 Private conversation with one of the foreign investors, April 2014. 47 Wang Yingyao, “The Rise of the ‘Shareholding State,’ ” 24. 48 Bloomberg News, “Turning Toxic Debt to Gold in China: Companies Set Up to Dispose of Bad Loans are

Throwing Off Profits” http:// www.bloomberg.com/ bw/ articles/ 2013- 10- 10/ bad- loans- turn- to- profits- for- chinas- asset- managers, accessed October 6, 2015.

49 Jing Song, “China Huarong Kicks Off Hong Kong IPO,” Finance Asia, January 14, 2015. http:// www.financeasia.com/ News/ 393523,china- huarong- kicks- off- hong- kong- ipo.aspx, accessed October 6, 2015.

http://www.bloomberg.com/bw/articles/2013-10-10/bad-loans-turn-to-profits-for-chinas-asset-managers

http://www.bloomberg.com/bw/articles/2013-10-10/bad-loans-turn-to-profits-for-chinas-asset-managers

http://www.financeasia.com/News/393523,china-huarong-kicks-off-hong-kong-ipo.aspx

http://www.financeasia.com/News/393523,china-huarong-kicks-off-hong-kong-ipo.aspx


China Huarong Asset Management Company can be used as an example of how ulti-mately the obligations of these asset management companies are being resolved. In 2010, Huarong’s outstanding bond was rolled over for another ten years. In 2012 the bond lia-bility was removed from Huarong’s balance sheet and placed in a fund established by the Ministry of Finance. Interest due was paid directly by the Ministry of Finance, while the fund was capitalized with tax paid by ICBC, holder of the bond, and Huarong. Between 2012 and 2015, the principle of the bond was paid down from 175 billion yuan to 112 bil-lion yuan. Meanwhile Huarong has invested in a variety of profitable financially related businesses, generating revenue on which it pays the taxes that are used to retire the princi-pal of the bond. This illustrates the power of the state to intervene to affect outcomes— a phenomenon of China’s market socialist economy too often underestimated by critics, and which is discussed further in later chapters. Considering that the AMCs became profitable and were able ultimately to take care of their obligations, the indignation about the bonds of these AMCs seems overwrought.

With hindsight, how should we evaluate the program of cleaning up the balance sheets of the state banks? First, it achieved its immediate objective— getting the banks listed on international exchanges and recapitalized with foreign funds. That was a requisite for the subsequent upgrading of the banks that occurred. Second, it did succeed in “kicking the can down the road.” As China’s GDP has grown, these distressed assets have gradually been reduced to a footnote in the national balance sheet of China.

Another question is why the international auditing firms and the underwriting invest-ment banks would have certified the accounts of the state banks, accepting the face value of the asset management companies’ bonds. One assumes that the obligations of the state banks and AMCs were viewed as ultimately being obligations of the Ministry of Finance— in other words, sovereign risk.

Should the Chinese government have been more scrupulous in how it accounted for this program, taking the discount as a write- off front- end from the banks’ balance sheets? If it had, it would not have been able to list or recapitalize the banks, unless it had recapi-talized them with taxpayer money, which would have diverted scarce financial resources from other more pressing development needs. Notwithstanding the strong criticisms of some Western observers, China’s bold move in rehabilitating the state banks through relieving them of their distressed assets permitted them to shake off the legacy of the planned economy and to rebuild them as modern banking institutions.

After Jiang Zemin and Zhu Rongji retired in 2003, they were succeeded by Hu Jintao and Wen Jiabao as general secretary of the Party and prime minister, respectively. Hu and Wen have been criticized by both Chinese and foreigners, who feel that under their leadership the government’s commitment to economic reform lost the momentum it had established under Jiang and Zhu. In particular, Hu and Wen are criticized for backsliding on reducing the role of SOEs, and for not pushing financial sector reform forward. In their highly critical book, Red Capitalism, Carl Walter and Fraser Howie look back on Zhu’s time as prime minister as the time when China was moving in the right direction,


but state that “in 2003, the new Fourth Generation leaders were ushered in and things began to change… . The new leadership’s political predisposition, combined with a weak grasp of finance and economics, has led to change through incremental political compro-mise that has pushed economic reform far from its original path.”50

It is certainly true that, especially in Hu- Wen’s second term in office (2008– 2013), there were no spectacular financial reforms to compare with the closing down of GITIC and Hainan Development Bank, accession to the WTO, establishment of CBRC, setting up asset management companies, and the listing and recapitalization of the large banks. What the critics miss, however, is that the earlier major reforms established a radically new framework for Chinese banks and that a period of consolidation was now needed for the banks to realize the potential of those reforms, build up professional capacity, and develop the needed operational systems. In addition, the financial crisis of 2008 that was sweeping through Western banking systems during Hu- Wen’s second term suggested it was a time to focus on protecting the Chinese system from infection from abroad and for assessing the lessons to be learned from the Western financial debacle, rather than boldly moving forward on new reforms.

Building Professional Banking Capabilities

Zhu’s vision was bold, but in and of itself stripping of bad loans, listing of banks on for-eign stock exchanges, and putting in place boards of directors did little to improve the actual operations of the banks. Banks had to learn risk management, internal control, modern accounting and auditing, and general management skills; IT systems had to be put in place; operational efficiency had to be raised; the concept of customer- centric ser-vice, with all that entails, had to be adopted as a core element of strategy. Boards of direc-tors had to figure out how to supervise management. There was little knowledge of any of this in place in 2003 when I joined the Minsheng Bank board.

At Minsheng Bank, and subsequently at Everbright Bank, I had the opportunity to see firsthand the acquisition of professional skills and the increase in professional operational quality of these two banks during those Hu- Wen years of consolidating the transforma-tion. Having boldly launched the transformation, Zhu left it to his successors to follow up with the mundane but absolutely necessary day- to- day work of building capacity. That takes a few years to accomplish.

When I joined the Everbright Bank Board in 2006 and chaired the Board’s Audit Committee, the internal audit system was only in the early stages of development. This and many other systems had to be built, people trained to manage them and to carry out their tasks, and senior managers made accountable for the results. A few years later, the Everbright Bank Audit Department had become an effective control department.

50 Walter and Howie, Red Capitalism, 4.


In a remarkably short period of time, competence in most of these functions was in fact acquired at all the tier 1 banks, and to a considerable extent at the tier 2 and tier 3 banks as well. The government recognized that a tremendous amount of institutional capacity had to be acquired. Bright and competent people were sent into the banks to carry out the development. The CBRC played a constructive role by putting pressure to upgrade their competencies, steadily ratcheting up the pressure on the banks through inspections and audits that increased in strictness as standards of banking rose.

In addition, the government opened up the banking sector to foreign banks to invest as “strategic partners,” taking from as little as a few percent to a maximum for any one foreign bank of 20% stakes in tier 1 banks, and also in selected tier 2 banks. There was a rush of enthusiasm on the part of foreign investors. Among the institutions that took stakes in Chinese banks between 2004 and 2006 were Bank of America, HSBC, ING, Standard Chartered, Citibank, and RBS. They contributed in varying degrees to the development process in the investee Chinese banks, transferring skills and knowledge that was of great value.

China’s banks had the good fortune to be developing their professional capabilities and competencies under extraordinarily favorable economic conditions. The linking of China into the world’s supply chains occurred at a time when economies around the world were booming and ready to purchase the flood of consumer and electronic goods cheaply produced in China. Globalization of manufacturing was enabled through the IT revolution and the search of multinational corporations and overseas Chinese businesses for low- cost labor production facilities. China was the perfect manufacturing platform, both for foreign assembly operations and for small and medium- sized Chinese firms producing components in global supply chains. Accession to the WTO in 2002 helped China to take advantage of this globalization.

China’s growth in those years was in part based on exports, but also on massive invest-ment in housing and infrastructure on a scale never before seen in the world. This pro-duced a networking effect, where housing construction drove a large number of related industries, at its height accounting directly and indirectly for 35% of total GDP.51 Investments in transportation, electric power production, telecommunications, and other key building blocks of the economy had synergistic impact, raising the productivity of the economy, especially along the eastern seashore, as large portions of the population were brought into the networks of the modern economy.52

During the first decade of the century, Chinese economic growth was in excess of 10% most of the time. Demand for credit was insatiable. With interest rates regulated by the government, net interest income was high. Credit risk was minimal in a booming econ-omy. Banks were, as a matter of policy, operating in a highly protected environment. The

51 Rosealea Yao, “Housing & Construction Review,” GavekalDragonomics (October 2015): 5. 52 Ricardo Hausmann, “The Economics of Inclusion,” Project Syndicate, November 7, 2015.


CBRC knew that these conditions would not last forever, and so took pains to ensure that banks, recovering from the debacle of the ’90s, would be highly profitable, but at the same time forced them to use the profits to steadily increase capitalization and reserves against bad debts. This would put them in a strong financial position when the economy grew less rapidly, profits declined, and the inevitable loan losses appeared.

Investment by foreign strategic partners came to an abrupt end in 2008. China’s wel-come mat for foreign banks investing in Chinese banks had been based on Western bank-ing being the model for the modern banking system to which China aspired. With the crash on Wall Street, China’s financial sector leaders, at the government policy level and at the bank management level, reappraised the attractiveness of the Wall Street model. As one famous American, British, and European banking name after another fell into dif-ficulties, Chinese banks became wary of inviting foreign institutions into Chinese banks. The brand of foreign banks was tainted. By that time, however, Chinese bank skill lev-els were improving rapidly. There was confidence that Chinese banks could continue to strengthen without relying on introduction of foreign partners as shareholders.

The 4 Trillion Stimulus

Wall Street’s crash in 2008 had another consequence for Chinese banks. Watching the impending financial crash from a distance, China’s top leaders were concerned that it would spread to China. China has immense foreign currency reserves and little foreign currency debt, so balance of payments pressure was not an issue. Nor was the Chinese banking system exposed to the toxic derivative products that would have to be written off of American and European bank balance sheets; Chinese banks had invested very little in them. The fear was that demand for China’s exports would dry up as Western economies went into recession. China’s growth model was based on exports and domestic invest-ment. If one of those weakened, GDP growth rate might plummet and millions become unemployed.

Something had to be done immediately to provide alternative growth stimulus and employment. The well- known 4 trillion yuan stimulus was launched in the autumn of 2008. It was pure Keynes, except that instead of the government spending the money directly, most of the funds were released in the form of bank credit extension. This proved to be fast and efficient in getting the money out the door— probably faster than could have been done through central government expenditure programs.

Critics of this stimulus speak of the “government ordering banks to lend money.” That is true, but it is misleading. China’s GDP growth rate had been extremely high, there were opportunities for lending money everywhere, and banks were competing vigorously to put loans on the books to preserve market share in a booming economy. The growth in bank lending in 2007 had been too high. The PBOC, concerned about excesses in the economy, had placed ceilings on bank credit expansion. Banks were not permitted


to lend in excess of their ceilings. (These credit ceilings are not to be confused with the National Credit Plans of the 1980s, which were instructions to banks on where to allo-cate credit in the waning days of the planned economy. The ceilings of 2007 were crude quantitative tools for controlling monetary expansion that the government used in lieu of more sophisticated market based tools that were not yet available.) At the same time, provincial and local governments all had a backlog of infrastructure projects awaiting approval by the National Development and Reform Commission (NDRC: a powerful body that, among other duties, approves major projects). The NDRC had been going slow in releasing approvals for projects to proceed. Thus, on the supply side, the PBOC was sitting on the banks, while on the demand side the NDRC was sitting on the local governments.

To release a flood of money into the economy in the form of bank loans, all that was needed was for the State Council to instruct the NDRC to expedite project approvals the PBOC to suspend credit ceilings. Economic stimulus would follow naturally. Since local governments run chronic fiscal deficits, when their projects were unexpectedly approved, they lacked funds. Banks, freed of PBOC restrictions, provided the funding solutions for the local governments. In a few months, huge amounts of bank loans were approved and went out the bank doors to borrowers throughout the country.

No bank refrained from joining the feeding frenzy. Whether or not through Party channels they were explicitly ordered to loan, the incentive structure for CEOs ensured cooperation. A bank that did not take advantage of the opportunity to lend to local gov-ernment infrastructure projects, which were at least implicitly sovereign risk, would lose market share to competitors. Moreover, as a Party member running a state owned bank, a CEO would see it as his job to support government policy and would certainly not wish to stand out as the CEO whose bank did not participate in supporting the stimulus.

This stimulus is easy to criticize at both a national and a bank level. At the national level it can be argued that it was not worked out with sufficient safeguards to ensure that money was responsibly loaned out and that the projects funded were viable. The loans were indeed made in a great rush with little time for sober analysis. As a result, proj-ects for roads, railways, airports, etc., all of which have long term payoff periods, and in any event may never themselves generate sufficient cash to retire their debt, were funded mostly with three- year bank loans, when in the United States they would have been funded with long- term bond money.

How much of this stimulus money may end up as bad debt on the books of the lend-ing banks remains to be seen. From a macroeconomic perspective, however, the “credit binge” achieved its objective. China’s economic growth in the years 2009 and 2010 was 10%, and China’s cumulative growth from 2008 to 2014 has been 78%, compared to 8% for the United States for the same period, and lower still for European nations. A cer-tain amount of bad debt to be cleaned up a few years later did not seem a high price to pay for maintaining high economic growth rate and avoiding putting millions onto the unemployment rolls.


It should also be noted that not all of the 2009– 2010 high growth rate can be attrib-uted to state infrastructure expenditures. Nick Lardy points out that SOE investment, private corporate investment, and residential property purchases all grew at a high rate in this period.53 Some of this investment would of course also have been supported through bank lending, so not all of the growth of bank assets during this period was to local governments.

One consequence of the Wall Street crash of 2008 and China’s stimulus was that leader-ship of China became preoccupied with maintaining 8% growth almost to the exclusion of pursuing other economic goals. Financial sector reforms such as interest rate liberaliza-tion that might otherwise have moved forward faster were put on the back burner while all attention was focused on maintaining economic growth through stimulus policies.

Recent Reform Directions

When the last of the state- owned banks, the Agricultural Bank of China, was recapital-ized and listed in 2010, the transformation of the Chinese banking system from a bur-sar of the Ministry of Finance into a modern financial intermediary generally adhering to international norms of governance, capitalization, and accounting, was completed. Financial intermediation functions were working basically as they do in other market economies, corporate governance structures were in place, risk management and audit functioned well, technology was up to and sometimes ahead of international norms, and customer service at both corporate and retail levels rivaled what was offered in advanced markets.

This is not to say that everything worked as well as it could. In all areas there was room for improvement, and there were significant quality differences between the leading tier 1 banks compared with some of the more remote tier 2 and tier 3 banks. But the financial intermediation model based on international norms was firmly in place. The ongoing work for Chinese banks would no longer be transformational; it would be evolutionary improvement in quality, refinements in strategy, adaptation to new technology, reactions to changing market needs and opportunities, and further expansion into lesser served areas of the Chinese economy and overseas. This is the same financial sector development process that has been going on in other developing countries such as Thailand, Mongolia, and Indonesia, each of which is steadily strengthening its banking capabilities.

With the exception of possible privatization of Chinese bank ownership and moving forward with interest rate liberalization, it is noteworthy that when the IMF, the World Bank, and the Chinese government now speak of “financial reform” needed over the next few years, their focus is not on the banks, but instead on broadening the financial system

53 Nick Lardy, Markets over Mao: The Rise of Private Business in China (Washington, DC: Peterson Institute for International Economics, 2014), 5– 6.


through developing alternative sources of financial intermediation to supplement and complement the banks— capital market development, insurance industry development, opening of the capital accounts, etc.

Similarly, in the reform agenda passed by the 3rd Plenum of the Central Committee of the 18th Party Congress, held in October of 2013, the first year that Xi Jinping and Li Keqiang were leading the country, of the sixty reform areas (almost a laundry list of all desired future reforms), only one area, section 12, related to finance, and it made no mention of the banks themselves. Banks have now reached a state of development at which, despite need for ongoing improvement, they are no longer on the front burner for reform. The reforms launched by Zhu Rongji in 1998 and implemented over the next twelve years were transformational.

The most important developments since 2010 have been interest rate liberalization, deposit insurance, shadow banking, the rise of nonbank fintechs, and opening for new private bank licenses. Interest rate liberalization will have an enormous impact on the banks but is a systemic economic issue endogenous to the banks. In common with a number of other developing countries, China for many years as a matter of policy kept controls on interest rates for both deposits and loans. The technical term for controlling interest rates is “financial repression.” Governments in developing countries have often used financial repression as a policy tool— effectively a distortion by government fiat of market pricing of interest rates— generally with the objective of mobilizing savings from the general public to be lent on at cheap prices to sectors of the economy favored under the government’s development strategy.

As I shall discuss in Chapter 7, a sound argument can be made for financial repression at certain stages of the development process. In China, the principal effect of financial repression was to mobilize savings at artificially low rates of interest and transfer them through the banks to the SOE sector, also at low interest rates— a subsidy of govern-ment corporations. While this may be a valid policy tool at a certain stage in a country’s economic development, the benefits gained from it must be weighed against the very real costs in terms of distorted pricing resulting in suboptimal resource allocation. Firms or projects that have very low returns on capital invested are subsidized. Were interest rates determined by the market at a higher rate, then those firms or projects would be unable to afford the cost of borrowing, making the money available to others which had higher rates of return on investment.

Interest rate liberalization has been discussed at policy levels for years, and small steps in this direction began as early as 1996, but it was only in 2012 that the PBOC accelerated the step- by- step process of interest liberalization. Even since then, interest rate liberaliza-tion has been a painfully slow process. I would argue that both the economy as a whole and the banking system would have been better off had financial repression ended much earlier.

The other two major new recent developments in the banking sector have been the establishment of a deposit insurance program, a major step toward imposing greater


market discipline on the banks, as the state will be able to gradually step back from its implied guarantee of the banks, and the licensing of five new private banks on a limited basis.

This financial sector transformation has been one part of the pragmatic approach to development that China has adopted since the inception of Reform and Opening in 1978. The style and approach used in the banking transformation were set forth in the guidance provided by Deng Xiaoping from 1978 through his final public appearances in 1994. The core concepts underlying the transformation, all pointed to by Deng, are prag-matism and aversion to ideological fixations, use of pilot projects and “Crossing the river by feeling the stones” rather than “big bangs,” commitment to learning from global best practice and openness to foreign trade and investment, development of policy through seeking consensus finding a middle road between extreme positions, and combining market economy with a strong ownership and guidance role for the government. These are key to understanding how the financial system has succeeded in supporting China’s extraordinary economic growth.

Of course, the development of the system remains a work in progress, many areas of further improvement are required, and the next stage of economic reforms that was announced at the 3rd Plenum in November of 2013 by the Xi Jinping leadership poses new challenges for the banks. How successful Chinese banks will be in further building their capabilities and meeting new challenges in forthcoming years remains to be seen, but certainly the record of accomplishment of the past decade gives grounds for consid-erable optimism. The next chapters examine how the system works today, suggest the challenges that lie ahead, and take a deeper look at reform directions.

100

Adjacent to where the old city walls had stood on the western side of “Old Beijing”— the historical Ming and Qing Dynasty city of Beijing— is an area which, until not so many years ago, was accessed through hutongs, the narrow lanes that crisscrossed the residential areas of the old city, brimming with life— old folks sunning themselves in the winter while playing chess, vendors hawking their wares, bicyclists weaving in and out among the locals. On both sides of the hutongs, behind gray brick walls, stood the one- story courtyard houses that are as iconic of Beijing as are the Forbidden City and the Temple of Heaven.

Chinese concern to preserve its national “Chineseness” does not much extend to the conservation of traditional urban and village residential space. Palaces and temples are a source of great national pride and are well preserved, but the surrounding low- rise resi-dential neighborhoods, built in the Ming, Qing, and Republican eras, have generally been regarded by city governments as something of an embarrassment and as an inefficient way of organizing urban space in a modern city. The imaginative proposal in the early 1950s of the famous architect, Liang Sicheng, to build the new capital city of China on the west side of the city walls, allowing for the conservation of the historical city as a great

5 Bankers

Effective corporate governance is critical to the proper functioning of the banking sector and

the economy as a whole.Bank for International Settlements, July 2015.1

1 “Corporate Governance Principles for Banks,” Bank for International Settlements, July 2015, http:// www.bis.org/ bcbs/ publ/ d328.htm, accessed June 11, 2016.

http://www.bis.org/bcbs/publ/d328.htm

http://www.bis.org/bcbs/publ/d328.htm

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monument of Chinese culture, was tragically not adopted. Nonetheless, the layout and appearance of the old city remained more or less undisturbed through the Maoist years.

With the beginning of reforms, the fabric of the city began to change. Great swathes of the old city were razed, replaced by tall office buildings, shopping malls, hotels, and apart-ment blocks. The newly prosperous face of China should have modern cities, with gleam-ing glass wall buildings copied from Hong Kong and Los Angeles, as physical symbols of China regaining wealth and power. In 1993, destruction of the old hutongs and courtyard houses in a portion of the area north of Changan Avenue on the west side of the city got underway, despite the protests of residents and cries of heritage conservationists. Year by year, a new financial district slowly arose, broad avenues replacing quaint hutongs, gleam-ing office towers of commercial banks replacing the old courtyard houses— the emblem-atic architecture of old Beijing giving way to the latest in international office block styles as a physical symbol in glass and concrete of the transformation of the banking sector that was underway. Only a few neighborhood temples remained untouched as a reminder of what had stood here before.

The head office of China Everbright Bank, where I served as a director and a supervi-sor, lies within this new financial district. The bank’s attractive modern building is laid out in the shape of an “H,” with two office towers as the verticals of the “H,” and the high atrium lobby as the crossbar linking the two towers. Walking into the bank, I approach this atrium through a garden, where magnolia trees bloom in the spring time. Entering the spacious reception lobby, with white marble floors and enormous clear glass walls, I walk around a long traditional screen of frosted glass, on which a poem has been etched in bold cao (“grass”) calligraphic style of the bank’s chairman, Tang Shuangning. Entering a traditional courtyard house of old Beijing, one encounters a screen, placed according to Chinese traditional rules of fengshui to block the entrance of unwanted spirits and pernicious energy; in the lobby of Everbright Bank, this screen is not only a dramatic decorative element but also serves a traditional geomantic function. With the help of a Chinese colleague, I can decipher the characters artistically etched on the screen— it is a poem by Mao Zedong.

Further into the lobby, there is an almost imperceptible depression in the marble floor, out of the center of which gurgles water, flowing to the edge of the depression and then recycling back into the floor. Water is an auspicious element in Chinese belief. Placed strategically in the right spot in the atrium, this flowing water is not just an attractive decorative feature, but is a potent fengshui source of nurturing energy for the bank. The Chairman’s powerful calligraphic display of Mao’s poem provides yang energy, the flow-ing water counterpoises yin energy.

Taking in the whole lobby, what am I seeing? The legacy of traditional heritage and val-ues embodied in the fengshui and calligraphic elements; a bright and attractive modern building, displaying China’s mastery of the latest in international construction technol-ogy and architectural design; and the institutional presence of the Communist Party, represented by the poem of Mao Zedong. The sturdy physical structure of the building,


constructed in accordance with global best practice, is infused with the energy (qi) of China. Traditional culture (ti), modern technology (yong), and the Party (dang)— the three elements that define how transformed banks work in today’s China— are displayed in this lobby, and the entire building itself is emblematic of the wealth and power that China is now attaining.

China Everbright Bank ranks 11th in asset size among the seventeen commercial banks that comprise China’s tier 1 banks. It is dwarfed in size by the five state- owned large commercial banks, but in style of management, quality and scope of operations, and profitability, Everbright differs not much from those five banking behemoths, or from the other eleven joint stock banks. Ultimately the state is the majority owner of all but three of the tier 1 banks. The Party appoints, or at least approves, members of the Board and of senior management. All the banks offer much the same products, services, and nationwide branch network. Tier 1 banks in 2014 in total comprised 59% of the assets of the total banking system. Describing the tier 1 banks is therefore the focus in this and the next chapter, as they are the dominant players in the banking system, which in turn accounts for most of the funding of the economy.

Two factors determine the quality of a bank: people and systems. Without good sys-tems, banks cannot perform efficiently. Good systems are of little benefit if competent professionals are not in place in all areas of the bank, from top levels of corporate gov-ernance to the clerks, loan officers, customer service officers, programmers, and tellers at working levels. In this chapter we look at the people who make Chinese banks work and how people in the banks are managed, starting with corporate governance.

Corporate Governance

When I started my banking career in Citibank in 1973, corporate governance was not something one heard about. From the 1990s onwards, crises of various sorts pushed the issue of corporate governance to the fore. Academics, regulators, and corporate boards began to pay a great deal of attention to the issue. Spectacular collapses such as Enron in 2002 and Lehman Brothers in 2008 led to increasing concern with how corporations were managed. All over the world corporate governance regulations were tightened, and the pressures on boards of directors and management to ensure proper corporate gover-nance in their companies increased.

Forms of corporate governance vary between countries. The Anglo- American corpo-rate governance model revolves around a unitary board of directors, mostly comprised of outside non- executive directors, whose duty it is to represent the interests of the principal stakeholder, the shareholder, in supervising the management team that it appoints to manage the affairs of the company. This gives rise to the “principal- agent” problem much discussed among academics. The principal is the shareholder; the agent is the “hired gun” who is supposed to work to serve the best interests of the shareholders. A problem arises

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in that the agent may not work in the best interests of the shareholders. The board of directors is supposed to resolve this problem through supervision, reserving major corpo-rate decisions for its approval, and putting in place the appropriate incentive schemes and codes of ethics to induce responsible behavior on the part of management.

The German- Dutch model of corporate governance, arising out of those two countries’ cooperative (or coordinated) capitalist traditions, embodies more collectivist approaches to political economy. This model represents the interests of a range of stakeholders, of which shareholders are only one. Under this corporate governance model, at the top of the firm is a dual board structure— the supervisory board, under which is the board of directors. Among European countries, several have dual board structures, while others follow the Anglo- American model of a unitary board, and some have a combination of the two. In theory, the dual structure should be superior in constraining management from acting as an independent agent. The theory does not always work in practice; a recent spectacular example of failure of dual board corporate governance was the failure of the supervisory board of ABN AMRO Bank to rein in the excessive ambitions of Rijkman Groenink, the man it had appointed as CEO of the bank in 2000. Groenink took over the helm of a well- run and highly respected institution that was a Dutch icon, but within five years under his stewardship, the bank had to be broken into three parts and sold off to foreign buyers. Dutch people wonder what the supervisory board was doing while this was happening. Most members of the ABN AMRO supervisory board were retired CEOs of the bank’s major corporate customers, with limited knowledge of banking.

Developing good corporate governance at companies listed on the securities exchanges in China is a national development priority, arising out of the 1990s drive to corporatize the SOEs and to convert state control over these corporate assets to financial control exer-cised through the state’s position as shareholder— in the case of the large banks, largely through Central Huijin, which was charged, in the words of Wang Yingyao, with “mod-ernizing state ownership and aligning it with shareholder value.”2 Corporate governance standards and requirements are based on foreign models, which have been extensively studied by China and judged beneficial as a means of making use of the market to pre-serve the value of state assets.3 In applying Western models to Chinese corporate gover-nance, China has taken some pieces from the Anglo- American model, and some from the German- Dutch model. How corporate governance standards are applied, however, as in all China’s borrowings from the West, bears “Chinese characteristics” and is a hybrid. In the Everbright Bank lobby, we are reminded of Chinese cultural tradition through callig-raphy and fengshui, the framework of global best practice through the engineering of the

2 Wang Yingyao, “The Rise of the ‘Shareholding State’: The Financialization of Economic Management in China,” unpublished paper, 14.

3 Wang Yingyao, “The Rise of the ‘Shareholding State,’ ” 14.


building, and of the role of the Party by Mao’s poem. Likewise, in corporate governance of Chinese banks we find the framework of global standards of corporate governance in place, adapted in practice to Chinese culture, guided by the presence of the Party.

One anecdote recounted to me more than once by people who were present at the time demonstrates how Chinese bank governance is a hybrid. In international practice, meetings of the boards of directors of listed companies are held privately, with no atten-dance on the part of outsiders. The story goes that at a meeting of the board of directors of Bank of China, shortly after foreign strategic investors purchased shares in the bank and put foreign representatives on the board, a foreign shareholder director inquired at a board meeting about an attendee of the meeting who did not appear to be a bank employee. The employee in question was a representative of the CBRC, sent to observe the meeting on behalf of the regulatory authority. To the foreign director, accustomed to different procedures, and to sharp drawing of jurisdictional boundaries in the West, this attendance by a representative of the government was a violation of proper governance, an improper intrusion on the part of the government into the proceedings of a commer-cial bank meeting. The Chinese attending did not see that CBRC attending was in any way improper.

CBRC officers routinely observe the proceedings of bank board meetings in banks. Their presence is generally felt to be positive for both CBRC and for the commercial bank, as it facilitates mutual understanding and communication. As a result, on the occa-sions when I would, as an independent director, visit the relevant supervisory depart-ment of the CBRC, I found CBRC officers extremely well informed about Everbright Bank and aware of the positions I had taken on various issues. This is one of the ways in which Chinese regulatory supervision is more intrusive and controlling than in the West, but also a practice that is culturally acceptable in the Chinese banking context in a way that it is not for a Westerner.

This anecdote is an example of the adaptation of global governance standards to China’s guoqing (national situation). Chinese are eager to learn global best practice, but how they will ultimately apply it is a decision they will make based on what they deem will work best in the Chinese context at any particular time— and what will work best may evolve as the situation changes.

As an independent director of Everbright Bank, I attended the three- day corporate governance course required of all independent directors of listed companies. The course is given periodically at the Shanghai National Accounting Institute. Academics conduct full- day programs of lectures on Chinese governance standards, at the end of which all participants sit for a Chinese language written examination to demonstrate understand-ing of the governance material and qualify as independent directors (I passed.)

As in many policy areas in China (environmental quality and food quality come immediately to mind), vigorous central government espousal and passage of strong laws and regulations does not equate to effective implementation. Most Chinese with whom I have spoken believe that China’s corporate governance quality is at best spotty, which of

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course is one reason why the government pays so much attention to it. If China’s equity markets are to be taken seriously not only internationally, but also by Chinese investors, whose losses in prior years have made many cynical about investing in listed shares, then corporate governance must improve. This requires raising standards of public disclosure, protection of minority rights, prevention of insider trading, control of fraud and other operational risk, compliance with legal and regulatory requirements, and accounting and audit. In sum, allowing an outside investor buying shares in a listed company to have reasonable confidence that the financial condition and operations of that company are more or less as disclosed, and that the board of directors of that company ensures that the business is being managed in good order, with good risk controls, accountability and internal controls, and compliance with legal and accounting requirements.

Recent scandals of NASDAQ- listed Chinese companies, periodic public scandals involving listed companies, and memories of the disastrous condition of Chinese banks in the 1990s led to widespread skepticism concerning corporate governance of Chinese banks, the quality of their publicly reported financial accounts, and the value of exter-nal auditors’ certification of accounts. Many Western observers are dismissive of Chinese bank governance standards and heavily discount the reported bank bottom lines as they believe that potential bad debts are much higher than those reported.

Based on anecdotal evidence from people serving on corporate boards, this skepti-cism may be justified with regard to at least some of the non- financial corporations listed on the exchanges. In my experience, however, it is not substantiated by the corporate governance standards that I have seen practiced in tier 1 banks. My experience has been corroborated by conversations with friends, Chinese and foreign, who have served on the boards of other tier 1 banks, and of some tier 2 banks as well. More than a decade of work by the Ministry of Finance, PBOC, CSRC, CBRC, and by the boards and man-agements of the banks themselves has resulted in extraordinary improvement in corpo-rate governance of banks. Admittedly, corporate governance in Chinese banks remains a work in progress. That, however, is also true of corporate governance in banks in Europe, America, and Japan as well.

In fairness to the skeptics, Chinese banks fall very short in openness and transpar-ency. Disclosures comply with detailed regulatory requirements that for the most part conform to global standards, but that is as far as it goes. Analysts and journalists do not enjoy the access to bank management that is taken for granted in American, European, or Southeast Asian financial institutions. Inquiries and requests for indepth interviews are mostly handled at the level of the banks’ investor relations departments. This inaccessibil-ity is counterproductive, fueling the suspicions of foreign journalists and analysts that the banks are hiding problems.

Lack of openness is a “Chinese characteristic,” stemming from a combination of the traditional aloofness inherited from the imperial Chinese Mandarinate, and also from the Party’s own traditions of secrecy. This characteristic does not work to the advantage of the banks, banking regulation, or the country, but may not be easy to change in the


short term. Old habits and ways of thinking die hard. Furthermore, given the collec-tivist orientation of Chinese society, and the internal discipline of the Party, it is not easy for any one bank CEO to take the lead in increasing the transparency of his bank, although some banks have taken tentative steps in this direction, especially in meeting with shareholders and the media in Hong Kong at the time of release of quarterly state-ments. Guidance from on high will probably be needed to increase accessibility of bank management and boards to the shareholding public and to the media.

Notwithstanding this general aversion to open dialogue with the shareholding public and the media, the Annual General Meeting (AGM) of the shareholders does provide shareholders an opportunity to raise whatever questions they wish. In my experience, they receive answers at the meeting from members of management, with directors and supervisors also present. Since, however, most of the banks are majority owned by government- related entities, the chances of shareholder activism gaining traction in these banks is almost nil. At this time there is no Chinese equivalent of CalPERS (California Public Employees’ Retirement System) and other activist American pension and hedge funds to use their shareholdings to press for change in bank policies or management. Recently, however, foreign shareholders of banks listed on the Hong Kong exchange have begun to exercise their rights. In October 2015, institutional investors mustered 42% of total shareholder votes, enough to block China Merchants Bank management’s proposal for revision of its employee share ownership program.4 Whether or not such shareholder rebellion will spread to mainland shareholders remains to be seen.

Supervisors and Directors

Corporate governance in China starts with the board of supervisors and the board of directors. In their research in the 1990s on global best practice of corporate gover-nance, the Chinese studied the Anglo- American model of a single tier board of direc-tors primarily composed of outside board members. They were also impressed by the German- Dutch two- tier model of a supervisory board principally composed of outsiders, but also including rank- and- file employee representation, beneath which is a board of directors composed of senior executives responsible for actual management of the bank. The Chinese saw the benefits of both systems, and so incorporated both of them in the Chinese governance model.

The result is a bit of a top heavy mishmash. At the top there is a board of supervi-sors, composed of external supervisors, shareholder representatives, and rank- and- file employee representatives. The English language website of ICBC sets forth the role and composition of its board of supervisors:

4 Peter Thai Larsen, “Signs of Spring,” Breakingviews, October 5, 2015, http:// www.breakingviews.com/ overseas- investors- fire- warning- at- china- inc/ 21218964.article, accessed October 6, 2015.

http://www.breakingviews.com/overseas-investors-fire-warning-at-china-inc/21218964.article

http://www.breakingviews.com/overseas-investors-fire-warning-at-china-inc/21218964.article

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The Board of Supervisors of Industrial and Commercial Bank of China Limited is the supervision organ of the Bank and responsible to the Shareholders’ General Meeting. It supervises the financial activity, risk management and risk control of the Bank as well as the fulfillment of duties by the Board of Directors, the Senior Management and their members. The Board of Supervisors comprises six members, including two shareholder supervisors, two external supervisors and two employee supervisors.5

The board of supervisors annually undertakes a performance review of the board of direc-tors as a whole, and of the individual directors.

At Everbright Bank, the board of supervisors, in addition to a chairman who works full- time at the bank, had two “external supervisors” (I served as one of the two in my last four years at the bank) whose role is analogous to, but not the same as, independent directors on the board of directors, plus three supervisors representing shareholders, and four supervisors chosen from among the staff of the bank. After my departure from the bank, the number of external supervisors was increased from two to three.

On paper, the board of supervisors seems rather powerless. But it can inquire into, investigate, and comment on any area of the bank’s management in which it is inter-ested. Supervisors participate in discussions of the board and its committees, but do not vote in board meetings. In my service as external supervisor at Everbright, I have looked at various areas of both risk management and business development of the bank, with the encouragement of the other supervisors and support of executive management. For example, as a supervisor, I spent a week traveling to branches of Everbright Bank in dif-ferent parts of the country— five branches in five days— speaking with corporate account managers and bad loan workout managers on the management of their clients, looking at the credit files, and discussing my observations with the branch risk supervisors, in an effort to get a grassroots understanding of our bank’s credit assessment and management strengths and weaknesses.

Based on investigations and subsequent discussions at the supervisory board meetings, resolutions are passed and forwarded to the board of directors and management— a sort of “advice and counsel.” Care is taken to ensure that the advice and counsel is construc-tive, well founded, couched in respectful language, and not micro- managing. From what I could see, any such communications from the board of supervisors were taken seriously by management and accepted in the constructive spirit in which they were offered.

Additionally, the chairman of the board of supervisors occupies a special position in the bank, parallel in visibility with the Chairman of the board of directors, and gener-ally seated next to him in shareholders meetings. He is generally involved full- time in

5 ICBC website, http:// www.icbcltd.com/ ICBCLtd/ Corporate%20Governance/ Board%20of%20Supervisors/ Board%20of%20Supervisors/ , accessed September 3, 2014.

http://www.icbc-ltd.com/ICBCLtd/Corporate%20Governance/Board%20of%20Supervisors/Board%20of%20Supervisors/

http://www.icbc-ltd.com/ICBCLtd/Corporate%20Governance/Board%20of%20Supervisors/Board%20of%20Supervisors/


the affairs of the bank and in some banks has a brief to handle certain areas of the bank’s affairs.

The formal duties and powers of the board of supervisors have been spelled out clearly in the corporate governance documents of the securities exchange and in the bylaws of the banks. As is sometimes the case in China, the prescriptions of the written regula-tions do not necessarily equate to what happens in practice. What really is the intention behind the establishment of this peculiar institution of Chinese corporate governance, the board of supervisors? It adds one level of oversight and review by experienced (and presumably politically reliable) senior people to all the other checks and balances on bank management. One Chinese informant suggested that it is the final source of assur-ance for the Ministry of Finance that state assets will not be lost through irresponsible management. In other words, if all the other checks and balances failed, then the board of supervisors should blow the whistle. If this is indeed the case, then this mechanism would work behind the scenes through the Party rather than through overt resolutions. Whether or not this has been tested in practice, I do not know.

Boards of directors are composed of around fifteen people, including shareholder rep-resentatives, independent directors, and a small number of executive directors. The boards meet at least quarterly and consider matters that would be standard in an American or European bank. For the most part, the real work of the board takes place in board com-mittees: Audit, Risk, Strategy, Nominations, Compensation, and Related Parties (the latter looks into bank transactions that might contain conflict of interest due to being conducted with shareholders and not at arms’ length).

Aside from matters formally requiring board- level approval according to government regulation or corporate bylaws, most of the board’s attention is focused, at both full board and at committee level, on the control of risk and on the bank’s financial budget and financial performance. Less attention has been accorded to matters of strategy, human resources, or technology. During the decade prior to 2013, bank assets and profitability soared, so boards felt little pressure to think through issues of strategy. Directors lacked expertise in technology and marketing, and left these issues largely up to management to deal with. Directors were keenly aware that they had an implied mandate from their government shareholders to limit risk, prevent losses, and deliver satisfactory returns on shareholders’ funds.

The board of directors is formally appointed by the shareholders at the annual gen-eral shareholders meeting. Nominations for the board are in theory vetted by the board’s nominations committee, but this standard provision of best practice corporate gover-nance runs smack up against the special role of the Communist Party in looking after human resources. Personnel- related requirements of corporate governance are uncom-fortably grafted onto a Chinese system in which the Party is heavily involved in making the key appointments. Although obviously the Party will not nominate or approve for directorship anyone who is regarded as unsuitable from the Party’s point of view (mean-ing politically unreliable), nonetheless a look at the qualifications of the members of the

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boards of the tier 1 banks shows that almost all of the directors on both the supervisory boards and the boards of directors of Chinese banks have backgrounds in finance or eco-nomics, some still actively working in other organizations, and some retired. It is well understood within the Organization Department of the Party that solid expertise and a record of performance are needed for the key positions within the banks. With the exception of Minsheng Bank, there are fewer representatives of the corporate world. The average age of most directors is between 45 and 65, with few over 70 and fewer still under 40 years of age. Among the total of around 260 directors in the 17 tier 1 banks in 2014, there were 13 foreigners, plus 7 Hong Kong citizens, serving as directors, a few as inde-pendent directors, but most as representatives of foreign shareholders. Foreigners who are not fluent in Chinese language will be at some disadvantage, as board proceedings and papers are in Chinese language.

That members of the boards of directors of the tier 1 banks overwhelmingly have finance, accounting, and economics backgrounds, and that they are predominantly recruited from among retired banking professionals, retired bureaucrats from the finan-cial sphere, or academics, is both a strength and a weakness. They understand finance and have long experience in the field, enabling them to discuss banking issues in board meetings knowledgeably. No doubt this has played a positive role in the transformation of Chinese banks over the past decade.

The disadvantage is that board composition lacks diversity of professional background and of age. Chinese banks’ exposure to the private sector of the economy grows year by year. The competitive strength of each bank increasingly lies with the robustness of its technology, responsiveness to ever- more demanding tech- savvy customers, and market-ing prowess. With the exception of the three privately owned banks, the boards of most tier 1 banks lack meaningful representation from private entrepreneurs, and also from the technology, telecommunications, and marketing sectors. Although Chinese over the age of 50 are remarkably up to date in their use of technology in their lives, nonetheless there is still a generation gap between board members and the more youthful cohort of customers, who, even more than their counterparts in Europe and America, expect the technology embedded in their smart phones to play a major role in their day- to- day lives, including their banking transactions. Paul Schulte, who follows events in the Chinese economy closely, writes in his recent book The Next Revolution in Our Credit Driven Economy about this issue, referring not just to Chinese banks, but to banks around the world, “that investors should only buy banks that have IT specialists under the age of 40 years on their boards of directors.”6

It is likely that the capability of Chinese bank boards to effectively guide management would be enhanced if they each contained at least one or two representatives of the pri-vate corporate sector, one or two who work in the technology and telecommunications

6 Paul Schulte, The Next Revolution in Our Credit- Driven Economy: The Advent of Financial Technology (Singapore: Wiley & Sons, 2015), 176.


areas, and someone with marketing expertise, particularly understanding of Chinese con-sumers and how to go about successful branding. That this diversity is still lacking reflects the overriding concern of the government that the boards of directors should be able to control risk and prevent losses. Bank boards of directors have been successful in this, but less successful in effective branding, understanding of their customers, and innovative product development, thereby providing an opening for the non- banks such as Alibaba and Tencent to invade their territory.

A debate has proceeded in China for decades over the need for “red” versus “expert.” In other words, what is the importance of political reliability versus the need for pro-fessional competence? Political reliability is a less important factor today than it would have been a decade ago, but it still cannot be underestimated in the selection process. When the resume of a candidate for the board or for senior management is circulated for consideration, it begins with a comment on whether or not the candidate is a Party member. This occasioned an outburst in a nominations committee meeting at Minsheng Bank that I attended a decade ago in which one of the committee members, a self- made entrepreneur, took exception to this presentation of the resume, saying “It is embarrass-ing that we still begin resumes with Party credentials, when we should be focusing on the individual’s professional suitability for the position.” Today, however, it is probably true to say that Party membership is seen only as an indication of trustworthiness, and that someone who appeared reliable and responsible would be considered for a board seat even if he or she were not a Party member.

Notwithstanding that most members of the board and management of banks are Party members in good standing, it is rare in the banking sector that political standing would be sufficient to gain a senior position in bank management or board. Young Chinese not in the banking sector have remarked to me that they feel banking is one state- dominated area of the economy in which professionalism trumps Party connections in opening opportunities for advancement, and that a non- Party member will not be disadvantaged, at least up through middle management.

How are board directors selected? As generally happens elsewhere in the world, the nominations committee of the board screens candidates and forwards them to the annual general meeting of the shareholders for election. Aside from one or two executive direc-tors from the management team (always including the CEO), the other directors fall into two categories. First, large shareholders have the right to be represented on the board in numbers proportional to their shareholding. As a matter of courtesy, the nominees of shareholders are confirmed by the board, and then elected by the AGM. I have, however, personally seen one example of a shareholder nominee being rejected by the nominations committee of the board after making an unfavorable impression in interview. This was a matter of some awkwardness, as it required telling the shareholder (a government com-pany) that the candidate it had put forward simply was not qualified to sit on the board, but it shows that the screening process is not pro forma, and that there are acknowledged standards that must be met. In addition, after being elected, the eligibility of the director

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must be confirmed by the CBRC prior to taking the director’s position. The CBRC has not been reluctant to veto candidates who in one way or another did not meet its criteria.

Second, the independent directors are nominated by shareholders holding 1% or more of total shares of the bank. Chinese practice seems to be in line with practice in European countries such as the Netherlands that empower smaller shareholders. By contrast, American companies give less scope to shareholders to nominate directors. Citibank and Bank of America now permit shareholders holding 3% of shares to nominate directors, but they are the still the exception, with most companies only allowing nomination by larger shareholders.7 (That may change under new U.S. SEC regulations being consid-ered, which mandate “3% access.”8)

Given how banks work in China, the nomination and election process for indepen-dent directors just described occurs at the final stages of the entire process to comply with legal requirements. The real selection occurs privately well in advance of the public pro-cess. As the need to replace an independent director is foreseen due to normal rotation requirements, or the resignation of an independent director, then key shareholders con-fer with the secretary to the board to suggest names of candidates qualified for a board seat. The secretary to the board vets the names, consults informally with the CBRC, and finally selection is made by the chairman in consultation with all stakeholders.

By the very fact that they are nominated by a shareholder, they are almost by defini-tion not going to be completely independent. The independent director concept under Chinese law relies on the integrity of the individual director to act in the best interests of the bank. It is the director, not the nominating shareholder, who is required to be inde-pendent. The extent to which an independent director is able to resist pressure from a large and strong shareholder by whom he or she was nominated can be problematic. This is not a problem unique to Chinese banks. It is a worldwide problem.

Throughout my service on the boards of two banks in China, I have been impressed by the high quality of discussion among directors at meetings, the frank exchange of views, and careful attention paid to the written and oral presentations by bank management, with no reluctance to criticize areas of weakness. The level of management attention to and follow- up on directors’ resolutions and suggestions is high.

Considering the level of probing into operations and risk standards by directors, it is less likely that Chinese banks would find themselves in the position of American and British banks in recent years, with massive problems of dimly understood derivatives and securitized portfolios taking directors unaware. Hard questions are asked, and answers are provided. If Chinese banks get into difficulty, it is not likely that directors will have been unaware of what was going on. Thus, potential loan portfolio problems that have been widely discussed in the international press, such as loans to local government lending

7 “Shareholder Season: It’s Time to Hear from the Directors,” Gretchen Morgenson, International New York Times, March 30, 2015, 17.

8 Private communication with Darrell Duffie.


vehicles, overcapacity industries, and shadow banks, are extensively reviewed in board level committees and in board discussions with external auditors.

Contrast this with the story of Robert Rubin, Chairman of the Executive Board of the Board of Directors of Citibank from 1999 until he resigned in 2009, described by the Wall Street Journal as “former Treasury secretary in the awkward position of hav-ing to justify $115 million in pay since 1999, excluding stock options, while explaining Citigroup’s $20 billion in losses over the past year and a government bailout of at least $45 billion.”9 Or Stuart Gulliver, CEO of HSCB Bank in February 2015, responding to questions about a tax evasion scandal in one of its Swiss subsidiaries, who said, “Can I know what every one of 257,000 people is doing? Clearly I can’t. If you want to ask the question could it ever happen again— that is not reasonable.”10

Neither of these situations is likely to occur in a Chinese bank. Such a high salary would not have been paid to a Chinese Rubin in the first place. Moreover, once the gov-ernment had to rescue the bank, a Chinese Rubin would have faced some degree of per-sonal responsibility for the damage to the economy and burden to taxpayers (although in the end the U.S. government made money out of its bailout of Citibank). Gulliver’s plaintive evasion of responsibility for knowing what was going on in the bank would not have been accepted by the CBRC, which expects management to be putting in place systems to ensure bank employees do not need to be individually supervised from a cen-tral authority. Only in this decentralized way, with authority delegated to the appropri-ate levels, can a large banking organization function anywhere in the world. What the employees do is prescribed by job descriptions, authority delegation, workflow processes, and corporate values.

This does not mean that problems do not arise. Chinese banks are developing rap-idly, new situations arise, new risks must be managed. The PBOC and CBRC play an active and paternalistic role in spotting potential risks, then guiding banks in how to cope with them. The liquidity problems that arose in 2013 were a learning process for the banks. They had not heeded repeated admonitions to develop strong liquidity risk protection, so the authorities focused their attention in the form of a painful, but short, slap on the wrist.

Management and Staff

The CEOs of the tier 1 Chinese banks are key people in China. In 2014, all held uni-versity degrees, of which six were master degrees and seven PhD degrees, most of them

9 Ken Brown and David Enrich, “Rubin, Under Fire, Defends his Role at Citi,” Wall Street Journal, November 29, 2008, http:// www.wsj.com/ articles/ SB122791795940965645, accessed April 3, 2015.

10 Martin Arnold and George Parker, “Bankers Held to Higher Standards than Bishops, Claims HSBC Chief,” Financial Times, February 23, 2015, http:// www.ft.com/ intl/ cms/ s/ 0/ 5fe45a84- bb81- 11e4- b95c- 00144feab7de.html#axzz3WF4csVmV, accessed April 3, 2015.

http://www.wsj.com/articles/SB122791795940965645

http://www.ft.com/intl/cms/s/0/5fe45a84-bb81-11e4-b95c-00144feab7de.html#axzz3WF4csVmV

http://www.ft.com/intl/cms/s/0/5fe45a84-bb81-11e4-b95c-00144feab7de.html#axzz3WF4csVmV

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in relevant fields of study. Several have significant overseas experience, either academic or professional. Their qualifications stand up against those of their peers running large banks in OECD institutions.

Top members of bank senior management are generally similarly well qualified. A prominent example well known in Western financial circles is Zhu Min. Zhu Min obtained his Master of Public Affairs degree from the Woodrow Wilson School at Princeton University and a PhD from Johns Hopkins University, after which he worked at the World Bank for several years. From 1998 through 2009 he worked in the Bank of China, rising to be Executive Vice President, in charge of finance and treasury, risk man-agement, internal control, legal and compliance, and strategy and research. In 2009 he was appointed Deputy Governor of the PBOC, and then returned to Washington in the capacity of Deputy Managing Director of the IMF, in which position, by all accounts, he has acquitted himself exceedingly well.

Senior managers of Chinese banks are adequately compensated by Chinese salary standards, but their compensation pales by contrast with Wall Street counterparts, and is significantly lower than counterparts in the United Kingdom and most continental European countries. In 2014, the highest compensated Chinese bank CEO was the CEO of Pingan Bank, who took home 8.3 million rmb, followed by the CEO of Minsheng Bank, who earned 4.5 million rmb. Both of these are banks in the private sector, with more freedom to set market- based salaries. Nonetheless, these salaries are not large by standards of Western banks of equivalent size.

The largest Chinese bank by asset size, the Industrial and Commercial Bank (ICBC), which also happens to be the largest bank by asset size in the world, is a good example of how bank executive compensation is determined in banks that are directly owned by the state. In 2013, when ICBC earned 21.9% return on equity and showed 10.2% year- on- year growth in bottom line profitability, the CEO total compensation was just over one mil-lion rmb, including all benefits. Young partners on Wall Street made more than that in those years, not to speak of the halcyon years before the 2008 crisis.

The State Council is sensitive to the image projected if the CEOs of huge banks are perceived to be “fat cats,” compensated at rates that are multiples of what the average citizen earns. This sensitivity has intensified since Xi Jinping came to office at the end of 2012. The Xi government has launched campaigns to reduce special privileges of high ranking party members and to address China’s massive problem of income and wealth disparity. In August 2012, the State Council passed a resolution mandating sweeping reductions in the pay of senior management of SOEs, starting with the banks. This was followed in 2015 by a resolution limiting the compensation of SOE chairmen and CEOs to no more than rmb 600,000 per annum. It should be remembered, however, that only the big five banks, plus China Everbright Bank among the joint stock banks, are covered by this regulatory limitation. The other joint stock banks, while majority government owned through various vehicles, are indirectly rather than directly owned by the state, and thus are not subject to this constraint; they are, however, not deaf to indirect moral


suasion brought by the Party and the government to keep senior salaries from being unseemly.

Aside from the top few people in these banks that are subject to salary limitations, other members of middle management are compensated at market rates. Some depart-ment heads and branch managers are thus compensated at higher rates than the top man-agers of those banks, as they are not subject to Party Organization Department control. Of course, there are other perks as well— the fancy offices, vehicles and drivers, expense accounts, etc., that the Chinese CEOs enjoy, but altogether they do not amount to a great deal. And in any event, since Xi Jinping in 2013 launched the campaign to end the extrav-agant lifestyles that had been carried on at state expense by some Party members and senior managers of SOEs, these perks have been considerably reduced. Expense account dining is not beneficial to one’s career in Xi’s China. There are as yet no stock option programs, although they are being studied. Bank senior managers reap none of the equity capital gains and dividends that a successful entrepreneur enjoys, despite the fact that their workloads and level of stress are not less than those of their Western counterparts. Actually, perhaps more. If they do not do well in their jobs, that will be the end of their careers. The Party that assigned them to their CEO positions will probably not be giving them a second chance.

In China, CEOs and senior executives are compensated by salaries and benefits that enable them to live good lives and by reasonable bonuses for good performance. Recall, however, that except for the three private banks, the ultimate employer of CEOs is as much the Organization Department of the Party as the bank by which they are employed at any particular time. CEOs respond to how the Party appraises performance. What is the mandate given to these bank CEOs by the Party, on the basis of which they will be appraised, and their career prospects determined? (Of course, as in any bureaucratic sys-tem in the world, the strictly meritocratic basis for career advancement will to a greater or lesser extent be supplemented by having a powerful benefactor, or sponsor, looking after one’s advancement.) The inner workings of Party Organization appraisal are opaque to outsiders, but doubtless appraisal criteria would include achievement of growth and profitability goals, avoidance of risks and losses, and implementation of national and Party policy guidelines, economic and non- economic, and, of course, adherence to Party discipline.

Some Western fund managers have questioned how they can rely on senior Chinese bank management to aggressively pursue profit on the bottom line if they do not have adequate financial incentive— in other words if they are not motivated by the same level of massive performance reward as motivates Wall Street senior executives. Yet Chinese managers do seem to be highly driven.

In both the Anglo- American and the Chinese systems, means have been found to incentivize managers, but as Joseph Stiglitz discusses in his book Freefall, the incentives that have been developed in the Anglo- American model to motivate senior executives of financial institutions have been perverse and disastrous in their economic and social

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consequences. Senior managers are rewarded for profits but not penalized for losses; the losses are socialized through bailouts by taxpayers, while gains are privatized by the man-agers. As a result, social and private returns are misaligned.11 Thus far, these problems have been avoided in China.

Beneath senior management are tens of thousands of staff. Tier 1 banks in China, par-ticularly the top five, are huge. The biggest, ICBC, in 2014 had 462,282 total staff and 2,962 outlets. That is after about 125,000 staff were laid off from ICBC in the restructur-ing of the 1990s. At its peak, ICBC employed 554,900 people.

Managing and transforming these enormous institutions is not made easier by a rigid organizational structure, split between head offices and the branch networks, that does not face off against the marketplace. The major business departments, such as Consumer Banking, Corporate Banking, Capital Markets, IT, etc. report directly to the CEO, as do the branch regions. Taking ICBC as an example, the vast branch system reports to what is labeled on the bank’s organization chart as “senior management,” presumably meaning the CEO and his immediate deputies. Then a group of head office depart-ments, including “marketing management departments” such as Corporate Banking, Personal Banking, and E- banking, together with all the central administration and staff support departments, also all report to senior management. The problem with this form of organization is that the head of Personal Banking becomes a staff person, without direct ability to control the personal banking business of the branches, which report separately to the top.

This is a structure based on geography and legal registration of branches, rather than on the market. Most Western banks moved away from this sort of structure into matrix management structures thirty years ago. In a matrix organization, market seg-ments face off against the customers. Outlets are just points for delivery of services and products to customers in different market segments, equivalent to storefronts. In this digital age, more and more product delivery is via electronic channels rather than physical outlets, rendering a branch- based organizational structure outmoded. It is puzzling that Chinese banks, which have transformed in many areas and eagerly embraced new technology, have clung to this out of date organizational structure that does not align the energies of the institution against the marketplace. The only tier 1 bank to have broken the mold is, predictably, the private sector Minsheng Bank, which has gone part way towards adoption of a Western- style matrix manage-ment structure. Bank of Communications (one of the five large banks, and the bank in which HSBC has a shareholding) and Ping An Bank (the other private sector bank) are now reported also to be moving to a more market- oriented organizational structure.

11 Joseph Stiglitz, Freefall: America, Free Markets and the Sinking of the Global Economy (New York: W. W. Norton, 2010), 114, 151– 153.


How well does the Chinese corporate governance model handle the “principal- agent” problem discussed above? Experience with corporations and corporate governance in China is still too brief to reach conclusions on this question, but one can see that the nature of the problem in state- owned banks is different from the problem in Wall Street banks with dispersed small shareholders. In a Chinese state- owned bank, the fact that the shareholder is a state agency, and that the regulators, supervisors, directors, and man-agement are all Party members, would seem to more effectively align the interests of the principal and the agent than would happen in a bank in a market capitalist system. From a prudential control point of view, this may be advantageous, but from a market efficiency point of view, critics would say that it simply results in “Party hacks” in management doing the bidding of the Party, stifling initiative, innovation, and exercise of independent judgment. The Party is not unaware of these trade- offs, and presumably has accepted the costs in return for stability and control. The reforms announced in 2013 will, if effectively implemented, provide SOEs with more incentives for efficiency.

Corporate Culture

Corporate governance, discussed earlier in this chapter, begins at the board level. Strategy, standards, policies, and overall control are the responsibility of the board. As an indepen-dent director, I have therefore over the years been in a good position to evaluate the effectiveness of corporate governance.

My access to the more elusive area of corporate culture has been more limited, as cor-porate culture is something that must be experienced in the day- to- day workplace of a bank to be understood. Moreover, corporate culture is not just a matter of the corpora-tion itself, but also reflects the wider society’s culture. As an independent director, and a foreigner, I have been somewhat removed from directly experiencing corporate culture.

Senior and middle- level managers, as in banks anywhere in the world, set the tone for the corporate culture and working style. In discussions over the years with middle- level staff of the banks in which I have served, I have found a strong work ethic. Long hours are worked, dedication is high. Senior provincial branch officers are typically in their thirties and forties, although some are older. They are highly motivated, well informed on bank policy and strategy, and have offered to me articulate, constructive, and unre-strained comments, suggestions, and criticisms during my visits to branches around the country. These talented middle managers are evidence that not only are the top levels of management smart and capable, but also the next generation of bank leadership will be of equal quality when it takes their place.

An older American, who had been spending a year working in the securities affiliate of one of the joint stock banks without any prior experience of China, commented to me that one of the surprises for him in the course of the year was to discover how similar the tastes, aspirations, work habits, and values of young professional Chinese staff with

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whom he had been working resembled their counterparts of the same age and position in comparable Wall Street firms.

Chinese bank culture is a learning culture. People are eager to learn. Keith Pogson, man-aging partner for financial services of Asia Pacific of Ernst and Young, reflecting on his years working to develop the audit capabilities of Chinese banks, commented: “Chinese audit staff a decade ago had limited understanding of modern audit techniques. The international audit firms all worked hard with their Chinese clients to transfer knowl-edge of international best practice in audit. The Chinese were eager to learn, and rapidly adopted whatever we transferred.”12

As emphasized throughout this book, the borrowing of international best practice (yong) is one of three factors that define today’s Chinese banks. This eagerness to learn from abroad described by Pogson is one part of the corporate culture, but equally impor-tant is Chinese tradition (ti) and the role of the Party (dang).

In his study of the economic culture of Overseas Chinese business in Southeast Asia, S. Gordon Redding writes of insecurity, paternalism, and personalism in explaining the organizational behavior of Chinese businessmen. While insecurity may persist among private sector Chinese entrepreneurs in mainland China today, it can probably be dis-counted as a factor in the large banks, which are securely embedded in the fabric of the national political economy.

It is interesting, however, to consider the likely persistence of paternalism and per-sonalism in Chinese bank corporate culture. Since tier 1 Chinese banks are not family concerns, the family, still so important in many aspects of Chinese culture and society, is not the origin of whatever paternalism we may find in Chinese bank corporate culture. It is worth quoting Redding at some length on what he means by paternalistic and person-alistic hierarchical values in a Southeast Asian Chinese business organization:

The leader or manager … can look to his workforce and to his immediate sub-ordinates also for a degree of deference unusual when compared to that found in other cultures… . The hidden key to the workings of this stable pattern is that the subservience implied is in fact sought. Chinese hierarchies are perhaps better understood from the perspective of followership than of leadership.

Such subservience is also the outcome of a highly personalized relationship, as such bonding cannot occur in a depersonalized system. The Chinese are loyal to people, less so to principles or ideas. It is people who can most easily give them what they want in exchange for the highly focused form of loyalty which they are pre-pared to offer in exchange. Given a “fixing” on a father- figure boss, and given that his authority is exercised with a civilized benevolence, the conformity to his will offered by the subordinates is of a kind likely to transcend any formal definition of

12 Private conversation with Keith Pogson.


its limits. The organization chart and the formal job description become irrelevant as reflections of the power relationship, and redundant as guides to action, except in the crudest sense.13

Chinese working in banks have told me that these paternalistic and personalistic, hierarchical and collectivist traditional Chinese values, found by Redding to endure in powerful form in overseas Chinese organizations, also are present in today’s state- owned banks. This gives rise to the concern to constrain the power of branch managers in prov-inces, who seem to hold more power than their Western counterparts would.

Chinese returning from working overseas for a long period, or Hong Kong Chinese accustomed to working in multinational organizations, do not find it easy to fit into the corporate cultures of Chinese banks. One easy way to quickly acquire international best practice is to recruit Chinese who have worked for ten or twenty years in American or European banks, since they will bring with them those banks’ expertise in areas such as risk management, capital markets, etc. They do indeed transfer skills into the Chinese organizations they join, but they encounter some difficulty accustoming themselves to the hierarchical cultures of the banks. Additionally, if they are middle- or upper- level managers in the banks, they are disadvantaged by probably not being not being members of the Party, and thus not involved in the human resources (HR) decisions that are made by the Party, often covering their own subordinates.

Despite the resemblances to Wall Street counterparts commented on above, these middle- level Chinese professional staff still work within an institutional framework and culture that owes as much to the legacy of Chinese heritage as it does to Western organi-zational models. This accounts for the “culture shock” encountered by returning Chinese expatriates as they re- integrate into a Chinese corporate culture.

One senior bank manager close to retirement age (whose entire career had been in China) frankly told me that, in his opinion, among management there is insufficient willingness of subordinates to challenge their superiors, to the detriment of the bank’s performance. Added to the traditional deference of juniors to their seniors and the desire to avoid overt conflict, both of which are hallmarks not only of Chinese culture, but of Asian culture in general, there is in addition the discipline that is imposed within the Party over employees who are members (and that of course includes almost all senior managers) to adhere to the Party line.

Related to these issues of hierarchical culture is the tension that has always existed in Chinese culture between “rule of men” and “rule of law.” I have in Chapter 3 examined this at the philosophical and political levels— the alternative governing philosophies of Confucianism, stressing benevolence, moral leadership, and the perfectibility of man, on the one hand, and Legalism, with its stress on draconian laws and punishments, on

13 S. Gordon Redding, The Spirit of Chinese Capitalism (New York, Berlin: Walter de Gruyter, 1993), 130.

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the other. At the level of the bank, this tension plays out in the form of the authority of individual managers, who are accustomed to exercise of judgment in making decisions on a flexible basis, and the requirements of a strict internal control system that limits discretionary authority. Given the size and complexity of China’s banks, the only practi-cal solution is imposition and enforcement of strict internal controls, carefully defining what can and cannot be done. This is, however, countercultural, as it restricts the various personal accommodations based on guanxi that are an important aspect of how China has always worked.

These issues of enduring Chinese values of paternalism and personalism are, however, only evident to me through anecdotal evidence. It is difficult at this point in time in China to conduct the sort of systematic research into economic culture that Redding conducted twenty- five years ago among the overseas Chinese business communities of Southeast Asia. Nonetheless, despite the absence of systematic research on this subject, it is most certainly true that the traditional Confucian values of playing one’s role properly in society, of valuing the collectivity over the individual, and of fostering social harmony are important parts of Chinese bank corporate culture. The impact this will have in the future on Chinese bank performance, innovation, and stability in China’s increasingly complex economy and society, and comparison of this with Western and Japanese coun-terparts, is worthy of detailed study.

Integrity is an essential aspect of any bank culture. In my years working in a bank in Thailand prior to moving to China, I was aware that banks had to constantly be on guard against corruption, generally in the form of “under- the- table” payments made to lend-ing officers, or collection officers, by loan customers in return for favors in obtaining approval for loans, or side- streaming proceeds from bad loan collection and collateral foreclosure into personal pockets. This has been a problem over the years in banking in other countries of Southeast Asia, not just Thailand. I have been curious as to the extent that it is a prevalent problem in Chinese banking as well. Among the thousands of defi-ciencies noted by internal auditors and government examiners, incidents of bribing of staff were rarely noted. Discussing this with colleagues, the general opinion seems to be that it occurs, but not to such a significant extent that would make it a systemic problem. I think that if it were a major problem, I would have heard about it in general bank dis-cussions, just as I did in my years working in a Thai bank. I never heard the issue raised in my time in Chinese banks, except when I raised it myself. It will be interesting to find out, as the anti- corruption investigations examine the commercial banks, whether or not incidents of bribery are surfaced.

There have in the past been serious problems of defalcation in Chinese banks, often of enormous sums of money, or granting loans with conflict of interest, but those problems now seem to have been largely brought under control as internal controls have improved.

The past two years of the intense anti- corruption campaign has snared thousands of cadre in its net since Xi Jinping launched the campaign at the end of 2012, both in gov-ernment administrative positions and also among executives of SOEs, with focus thus


far principally in the energy, airline, and entertainment sectors. At the time of writing, only four arrests have come to public attention in the commercial banking sector (there have also been some middle- level arrests in the CBRC, and senior executives have been snagged in certain securities companies). A former senior officer of Agricultural Bank of China, Yang Kun, was sentenced to prison in early 2015 for accepting 30 million rmb in bribes. Li Ruohong, former chairman of Guangfa Bank, was investigated for cor-ruption in September 2014. A shareholder- appointed director of Bank of Beijing, Lu Haijun, was arrested “for suspected serious violations of discipline,” which is the code for crimes of corruption. Apparently Lu’s “violations” were not in connection with the bank, but instead stemmed from his senior position in Beijing Energy Investment Holding. The energy sector had been the fiefdom of the disgraced former security czar, Zhou Yongkang, whose fall brought down many senior people in the sector with him. Lu had sat on the board of Bank of Beijing as a shareholder director representing Beijing Energy Investment Holding, a shareholder of the bank.14

Another prominent banker to be arrested in early 2015 was Mao Xiaofeng, the youth-ful CEO of China Minsheng Bank. It appears that his arrest, while based on infractions at the bank he managed, was ultimately due to his close ties with Ling Jihua, the personal secretary to former President Hu Jintao and Chief of the Party’s General Office. Ling had been arrested earlier, and those perceived to be part of his clique have also been investi-gated. This appears to be the underlying reason for Mao’s fall, upon which the accusations against him regarding employment of Ling’s wife and mistress were based. Mao it would seem was caught in the sort of tension described above— to accommodate his political patron, Ling Jihua, or to adhere strictly to regulations and refuse to hire Ling’s wife and mistress. This put Mao in the unenviable position of having to choose between two alter-natives, both with potentially career- destroying consequences for Mao.

As repeatedly stressed in this book, management of tier 1 banks is risk averse. Avoidance of risk is the mandate for CEOs. This sets the tone for the entire organization. It is bet-ter to miss an opportunity than to risk losses. This leads to a level of behavioral cau-tion that works against innovativeness. Promotions will go to those who are dependable and have not made mistakes, rather than to those who demonstrate great creativity, or who have achieved breakthroughs in their work. This harks back to the safe but boring world of commercial banking in the United States and the United Kingdom in the 1950s and 1960s. It avoids the privatization of gains from taking big risks, while socializing losses, of which Stiglitz and others have criticized Wall Street and the U.K. banks. The Chinese have gone to the opposite extreme. In this respect, critics may be justified in call-ing Chinese banks “staid,” perhaps in the same way that American banks were staid half a century ago. Of course, in recent years no one would call the banks of Wall Street staid.

14 Gabriel Wildau, “China’s Anti- corruption Probe Broadens into Finance Sector,” Financial Times, February 3, 2015, http:// www.ft.com/ intl/ cms/ s/ 0/ e50b1036- ab73- 11e4- 8070- 00144feab7de.html#axzz3WEUJWvWl, accessed April 3, 2015.

http://www.ft.com/intl/cms/s/0/e50b1036-ab73-11e4-8070-00144feab7de.html#axzz3WEUJWvWl

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Perhaps this fear of trying something different, which might not succeed, accounts for the failure of the banks to change their organizational structure to a more modern model. Organizational structure changes are wrenching transformations, fraught with anxiety and risk. Why take the risk when the consequences of failure would be so high? Anyway, a CEO probably would not be allowed to experiment with such bold organizational change without approval from a higher level, at least from CBRC and the Organization Department of the Party, and perhaps even from the State Council. If approval were given, it would then probably be approval to undertake the restructuring as a pilot. If the pilot worked, then it would be rapidly applied across the board to all banks so that all would benefit. There would be no obvious competitive advantage gained.

With the exception of the three private sector banks— Minsheng, Pingan, and Zheshang— tier 1 banks move as a herd. There are some differences in style and business focus. For example, Industrial Bank is known for its focus on interbank market products and for its promotion of environmentally sound lending. China Everbright Bank was the pioneer in wealth management product creation. China Merchants Bank made its reputation by being the first bank in China to aggressively deliver a quality credit card product and to upgrade the quality of its banking hall services. But by and large the dif-ferences between the banks are small by comparison with the similarities.

Another weakness of Chinese bank corporate culture is lack of internal collaboration. At the top of the bank, there is regular rotation of management between functional areas, but in the middle and lower levels people tend to work within their respective functional areas, giving rise to silos. The sort of cross- functional teamwork collaborating on projects, which is a hallmark of well- run Western organizations, is limited.

Lastly, corporate culture in a Chinese bank cannot be discussed without mention of the importance of the Confucian concept of li, which roughly translates as “good man-ners” and “decorous conduct.” At the level of the board and its committee meetings, it is rare that the lively debate is not conducted in a courteous and respectful tone. An atmosphere of friendliness, good humor, and sensitivity to others is expected of board members. Brash behavior is frowned on. Confucius would presumably approve of the extent to which li remains part of how Chinese banking is conducted.

The managerial and governance aspects of Chinese banks have changed to an extraor-dinary degree over the past two decades. In 1992, when Everbright Bank was established, the mixture of tradition, modernity, and Party that made up the bank was tilted much more heavily in the direction of the Party and tradition, with modern concepts and tech-niques of banking just beginning to change the nature of banking in China.

Today, Chinese banks have embraced Western banking practice, and thereby trans-formed the banking system. This transformation was pushed by government policies and support, as related in the previous chapter, but ultimately the transformation was implemented not only by government leaders, but by the people working in the banks— members of the boards of supervisors and boards of directors, senior and middle manag-ers, and the rank- and- file employees who acquired the skills of modern banking operations


and service in a short period of years and have acquired a high level of professionalism. At the same time they are conscious of, accept, and take pride in the Chinese cultural world in which they operate, and the fact that all Chinese banking institutions, state- or privately owned, are part of a national development project led by the Communist Party, of which many are members.

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In the previous chapter on the people who manage banks, I have explained that the forms of corporate governance and management of Chinese banks are similar to those of modern banks anywhere in the world, but that foreign governance and management practices are adapted to comport with the Chinese cultural heritage and political econ-omy in which the banks are embedded. Turning now to examination of the systems used in management and operation of banks, “Chinese characteristics” are less evident, except in the area of state intervention in direction and allocation of credit and mitigation of credit risk.

The efficient allocation of credit is one of the two core functions of banks (the other being the making of payments between parties). Credit allocation requires management of risk, something that was not understood in China prior to the banking reforms of the 1990s, resulting in failure to recognize or deal with bad debt.

Reading reports of foreign observers in recent years, it is apparent that many of them do not believe that any lessons were learned from that banking disaster, and so one reads of “a repeat of the experience of the 1990s.” In fact, the lessons had been learned very

6 Systems

Guarding against risk is the abiding theme of reform and development of banking and of

banking supervision.Shang Fulin, Chairman of China Bank Regulatory Commission, 2015.1

1 Shang Fulin, “CBRC Chairman Shang Fulin’s Address to the 2015 Country- wide Annual Meeting of city banks,” September 23, 2015, http:// mp.weixin.qq.com/ s?_ _ biz=MzA4MDM3NDMxNQ==&mid=214703167&idx=1&sn=4563bbc6e521b3cd7e6ab10b81a31a1f&scene=5&srcid=0923DzW7x2VHzVcVkmCDPsPo#rd, accessed October 28, 2015, and translated by the author.

http://mp.weixin.qq.com/s?__biz=MzA4MDM3NDMxNQ==&mid=214703167&idx=1&sn=4563bbc6e521b3cd7e6ab10b81a31a1f&scene=5&srcid=0923DzW7x2VHzVcVkmCDPsPo#rd




well, starting at the Politburo and State Council levels, which resolved to ensure that the banking system would be stable in the future. How otherwise can one explain the priority given by the State Council to reconstituting the banking system, expending vast sums on bailouts and recapitalizations of the banks, and appointing the “best and the brightest” to run banks? China’s government well understands that the economy will not develop without a healthy financial system, and that a healthy financial system requires control of risks in the banking sector. This understanding propelled teams of Chinese bank planners and regulators to study in depth the workings of Western banking systems, and then to bring back and apply to the Chinese situation what they had learned overseas.

Of course, studying and understanding is one thing; successfully applying what has been learned is another. The same diligent approach was applied by China to study of international best practice in other fields such as environmental control, but the applica-tion of theory has been deficient, and results on the ground have not been impressive. Worthy goals were set and enlightened regulations were adopted, yet the environmental situation in China has further deteriorated. For every alternative energy facility launched, for every polluting factory cleaned up or closed down, a new coal- based power plant is built, thousands more vehicles go on the roads, more than undoing the positive steps taken, not to speak of the blatant infraction of anti- pollution requirements by countless factories. Why should we believe it would be any different with credit allocation and risk management in the banks? Why should we believe that the lessons learned from study-ing international best practice in lending money should have been applied in practice in Chinese banks?

As discussed in Chapter 3, the Chinese leadership is pragmatic in its approach to managing economic development, and it is conscious that timing, sequencing, and set-ting priorities are key to success. With few exceptions, once a goal has been designated high priority, it gets done. Other areas are not neglected, but if they have not been identified as priority, they will not be focused on to the same extent until a later date. One can disagree with the priorities that are set, but one cannot deny that the leader-ship is consistent in pursuing them. For the past fifteen years, the overriding priorities were to grow GDP at the fastest possible rate, to restore China’s rightful place in the world, to create a prosperous and contented middle class, and to provide full employ-ment for the nation’s massive population. The leadership has been single- minded in achieving these goals, at the expense of a more balanced growth model under which natural environment, cultural heritage, industrial safety, social equality, etc. might have fared better.

Being relegated to secondary priority, however, cannot entirely explain the failure to carry through on commitments to areas such as environmental quality. Vested interests, crony capitalism, and corruption have also been culprits, obstructing attempts of the gov-ernment to move forward in these areas. Perhaps one of the motivations of Xi Jinping’s fierce anti- corruption campaign is to smash the power of these vested interests, cracking resistance to the government’s agenda.

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What has that meant for the relative priorities of financial reform and environmen-tal cleanup? Environmental cleanup has been accorded a lower priority, while financial reform was at the front of the line. Environmental problems are fully acknowledged by the leadership. There are no climate- warming doubters in the State Council, and no free- market ideologues who object in principle to environmental regulation, although there are plenty of vested interests and recalcitrant local governments subverting environmen-tal guidelines. Environmental cleanup will be attended to but is only now moving to a priority position in the planning time frame of China.

Meanwhile, reflecting the high priority accorded to development of the financial sector, the best and the brightest go into financial institutions, supported by bright economists working in academia and think tanks on issues of monetary policy, banking policy, and related areas of accounting and audit. Hence the excellent credentials of most Chinese board members, CEOs and senior managers, and of the regulators.

And within the broad area of financial reform, what have been the priorities? Priority has not been given to development of the equity markets, as they have not been seen as the most important source of funding for Chinese development at this stage, although they will surely be upgraded in importance at a later stage. As the bulk of funding of China’s economy has been provided by the banks, that is where the priority has lain thus far. The leadership, taking on board what it had learned from the collapse of the 1990s and its studies of overseas best practice, wanted an aggressive, well- run, and competitive banking system that would provide the real economy with the funding that it needed to maintain an 8% plus growth rate, but which would at the same time manage risk so that never again would government money have to be used to recapitalize the system.

To ensure a competitive banking system that aggressively lends to the real economy, several tier 1 banks’ shares were listed on the Shanghai Exchange, and in some cases also on the Hong Kong exchange. Just as in any other market economy, boards and manage-ment of banks pursued high profits to give shareholders good returns on equity, thereby maintaining share prices, which in turn would permit banks to return to the market for new capital issues to support further growth. The competitive pressures that come with being listed and publicly traded shares ensured that national goals of banks providing funding would be achieved. It was, however, recognized that banks pursuing profit with-out an eye to risks would sooner or later run into difficulties as loans turn sour.

Credit Quality

Therefore, understanding of how to control risk, and implementation of effective inter-nal control systems received equal priority with pursuit of profit, not only from regula-tors, but also from bank boards and management. In my years on the board of Everbright, I found that at the level of the board and its committees, the main focus was on close follow- up of risk areas, and much less on developing competitive advantage, or developing


the customer base— in fact too little time was spent at board level thinking about revenue generation and profitability enhancement. Partly I attribute this to the fact that over the past decade the whole banking system has been favored by the government to ensure high levels of bank profitability.

Among directors and management there is an unspoken awareness that their man-date is to avoid problems. In other words, reflecting the value China places on stability, banks were to conduct their operations in a way that would not put the stability of the banking system in jeopardy. The government has more or less ensured over the past few years that each national bank, provided that it kept up with market innovations, would generate good net revenue. As Xiao Gang, Chairman of Bank of China, said on August 26, 2010: “In China, because of the non- liberalized interest rate, net interest margins on yuan loans are almost double that of margin on foreign currency loans in the interna-tional market. In such an environment, which bank would not want to increase its lend-ing? The more banks (sic) lending, the more profits they earn. Simple.”2 The government could structure the system so as to facilitate banks making money, but it could not ensure against losses; control of risk would have to be the banks’ own responsibility, and there-fore was the preoccupation of boards and senior management.

This risk control focus prevailed in Everbright Bank in the years starting in 2006 when I joined the board. As best I can detect, it has equally been the focus at the other state- owned tier 1 banks. My experience from 2003 to 2006 at private Minsheng Bank was somewhat different. Minsheng, it will be recalled, was the earliest privately established bank in China. Its shareholder directors were entrepreneurs, keen to receive a high return on their investment in the bank. Minsheng had just been established during the crisis of SOE bad debts of the 1990s, so a legacy of NPLs was not part of the bank’s institutional memory. Minsheng’s shareholder directors had not studied issues of risk management, and, most importantly, they represented their own personal shareholder interests, not the government’s. They had built their own businesses through taking enormous risks that had paid off handsomely. They were not the cautious bureaucratic type.

Not surprisingly, the Minsheng Board was therefore more focused on building revenue than on guarding against risks. These entrepreneurial directors wanted profits and divi-dends. Some balance, however, was achieved on the board by the more cautious voices of the five independent directors (of whom I was one), who came from non- entrepreneurial backgrounds. To date, the more aggressive style of Minsheng has served it well, allow-ing it to grow in size, market share and profitability slightly faster than the state- owned banks during a time of rapid economic growth. Whether or not in the new environment of slower growth and overcapacity industries Minsheng will maintain portfolio quality, avoiding NPLs, will be interesting to watch over the next few years.

The first step in control of risk in a bank is aligning incentives that motivate senior management to act in line with the strategic objectives of the bank. Since the 2008

2 Roubini Global Economics, http:// www.relooney.info/ 0_ New_ 11869.pdf, accessed August 9, 2014.

http://www.relooney.info/0_New_11869.pdf

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financial debacle in the West, the compensation and incentive structure of bank execu-tives in the United States, the United Kingdom, and Europe has been the subject of much debate. The big Wall Street investment houses had, until not many years ago, been private partnerships, in which the partners were personally on the line for the losses of their firms. After many of these firms went public, the senior executives and traders made a lot of money in the good times, while the shareholders and taxpayers bore the brunt when the firms’ bets turned sour. Those who had made huge bonuses in prior good years did not have to return those huge bonuses when taxpayers bailed out the firms in a bad year. Public outrage has since spurred regulators and legislators to begin to rein in excessive compensation of senior management, although it is unclear how successful this effort will be.

The risk management and internal control systems built up by Chinese banks are mod-eled directly on those of the Western models that they had studied and observed, with considerable assistance from audit firms, from consulting firms, from the World Bank, IFC and the Asian Development Bank, and from strategic partner banks. Bank of China went so far as to bring in a seasoned American credit officer, Lonnie Dunn, from HSBC to head the risk management function of Bank of China in late 2004. This was a bold experiment, but it lasted less than two years, despite high hopes and best efforts on both sides. Perhaps because Dunn did not speak Chinese, perhaps because of difficulty fitting into Chinese corporate culture, or perhaps because of unrealistic expectations, the experi-ment was unsuccessful and a frustrated Dunn only stayed with the bank for two years.

Efforts of the Chinese banks to strengthen their risk- management systems were spurred not only by knowledge transfers, but also by constant pressure from CBRC, whose regulations were becoming more demanding and risk inspections more thorough with each passing year.

When commercial banks began their transformation, each provincial branch was more or less a little kingdom within the bank. The branch manager had high loan approval authority and had strong relationships with local government and Party authorities, who were able to influence, or even dictate, lending decisions. Until 1998 they were also required to meet lending quotas set by the PBOC each year. Risk management depart-ments did not yet exist, internal audit departments had not been established, and recog-nition of NPLs was inconsistent, if they were recognized at all. After the transformation was launched, the whole process of loan approvals and loan monitoring changed to be in line with global best practice. Loan approval authority for large loans and for restructur-ing of problem loans was centralized in head offices, thus cutting the cozy links between provincial officials and branch managers, making it much more difficult for local govern-ments to use the tier 1 banks as their ATM machines.

Another major reform of the risk management process was establishment of risk management departments in parallel with customer management departments. In each branch, all credit approvals must be jointly approved by the front line account manager with direct client management responsibility, and by the back office risk- management


department, responsible for double- checking that credit standards were maintained, and to guard against collusion between the account manager and the client. In the event that the client defaulted, both the account manager and the risk manager would be held responsible.

This removal of large credit authority from the branches to head office, and the assign-ing of dual responsibility for credit approvals, has stood the banks in good stead over the decade since it was imposed. It of course made the whole credit approval process more cumbersome and time consuming. Construction Bank and Minsheng Bank are under-stood to be relaxing the requirements for dual track approval in order to increase market-ing responsiveness.

NPLs: Hidden Losses?

Outside observers nonetheless remain highly dubious of the published NPL numbers of the banks. To a certain extent they may have a point. It is human nature to be “in denial” about problems, and there are probably few banking systems in the world that do not indulge in this to a certain extent. After all, the classification of borrowers, and predic-tions of which ones might go bad at some future date is a matter of judgment based on many imprecise assumptions. It is not an exact science. So one can concede that there is a certain amount of “denial” and “fudging” on Chinese balance sheets, without discredit-ing the integrity of the financial numbers as a whole. Nonetheless, China may actually be less “in denial” than outside observers believe, for four reasons.

First, many different people are involved in setting the NPL numbers. At the front- line account manager level, the account relationship managers and the branch risk depart-ments anticipate problems by putting customers judged likely to encounter cash flow difficulties on a watch list. From my inspections of the credit management process at Everbright Bank branches, I can affirm that customers are actually put on watch list for special attention prior to becoming delinquent in their payments. When customers become overdue for longer than the number of days specified by the CBRC, the account-ing system automatically records these clients as NPL, and places them in one of sev-eral categories of negative classification, which trigger requirements for establishment of reserves against loss, the percentage depending on the severity of the negative classifica-tion. After the fact, the recognition of delinquencies is checked by internal audit, then external auditors, and finally by CBRC auditors, and all of these are reviewed at board of directors and board of supervisors levels as well.

Second, if money has already been set aside from bank profits to deal with loan losses, then if and when those losses occur, there will be no impact on bank profits. The bank has set up prudential reserves for likely losses in advance of the losses materializing. The CBRC has in recent years steadily ratcheted up the provisioning requirements for

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Chinese banks. In other jurisdictions it is considered acceptable for provisions to cover only identified NPLs or negatively classified loans, or often only a portion of them. The reason for not covering 100% of identified NPLs is that rarely will loans be written off in their entirety, as collateral foreclosure, calling on guarantees, or the proceeds from bank-ruptcy proceedings will enable at least a portion of the exposure to be repaid.

By contrast, over several years of strong economic growth, during which time NPLs of Chinese banks were all trending down, CBRC steadily increased the requirements for provisioning for bad debt to a level of 150% of NPLs. This is in line with current Basel Committee on Banking Supervision recommendations that provisions should be higher in the good times, so that they can be charged against when they are needed as economic conditions deteriorate. The CBRC recognized that China was going through an extraordinary period of rapid economic growth in which loan defaults would be small in number but that these favorable circumstances would not last. The CBRC’s insistence on putting away some of banks’ high profits for a “rainy day,” when NPLs would start to trend upward again, was cautious— and wise. NPLs did in fact start to trend upwards at the end of 2011.

Of course, a multiple of a small number is still a small number. At their lowest level, NPLs were less than 1% of total loans, so that provisioning at even the high level of 300% of NPLs, attained by some banks for a period of time, added up to less than 3% of total loan book. In a cyclical economic downturn, it is quite normal for NPLs to reach 3% and higher. Nonetheless, as mentioned, it is unlikely that more than a portion of NPLs will end up as bad debt that cannot be collected, either through restructuring of the borrower or through realizing the proceeds of foreclosure and sale of collateral. The present levels of provisioning of Chinese banks thus provide considerable scope for further deteriora-tion of economic conditions and bank portfolio quality without causing losses on the banks’ bottom lines and eating into capital.

Third, outside observers without experience in bank lending have been assuming that when they hear of a loan being restructured in China, then it must be a “cover- up,” an unwillingness to acknowledge a bad debt situation. Four years ago a financial journalist confidently told me that banks were covering up bad loans in the steel industry. Steel manufacturers (not steel traders, which is another story) had confirmed to her that they could still get their loans rolled over by banks. Since these steel companies were experi-encing cash flow difficulties, the journalist concluded that the banks should have been putting these loans into default. This is an erroneous understanding of good banking practice. When a corporate customer in a cyclical industry such as steel gets into cash flow difficulties, the bank must ascertain whether or not the problem is fatal, or merely a short- term cash flow problem that can be dealt with through rescheduling maturi-ties, increasing capital, or other form of restructuring, giving the customer breathing room to await cyclical turnaround. Often it is the latter, and the bank will work with the customer to restructure the customer’s obligations. Putting a corporate customer into bankruptcy is not undertaken lightly by a bank. If the market sees it to have been


unnecessary, then the bank will suffer reputational damage.3 Who would wish to borrow from such a bank?

Now, four years later, the U.S. government maintains in discussions with the Chinese government that this prolonged cyclical downturn in the steel industry is actually caused by massive Chinese overproduction of steel. Chinese steel overproduction is acknowl-edged by the Chinese government. In the Chinese system, though, it has not been banks that have taken the lead in winnowing down the unprofitable steel producers. The prob-lem of Chinese overcapacity is being dealt with through government industrial policy, with less efficient producers being closed or merged through managed macroeconomic industrial policy. It remains to be seen how much of the ultimate losses entailed by the restructuring of the steel industry will be borne by the banks.

Fourth, outside observers often generalize from problems specific to a particular indus-try or locality. For example, as the Chinese economic growth rate started to slow, I heard concerns on the part of Hong Kong analysts about exporters running into difficulties in Zhejiang and Jiangsu, which are centers of export manufacturing. The analysts had traveled in those provinces and found that many of the exporters dependent on cheap labor were going out of business, some facing lack of demand in their depressed Western markets, some no longer competitive because of rising labor costs. The analysts said that those problems would be leading to bad loans, which should be significantly driving up the published bank NPLs, yet they saw only slight NPL growth on bank balance sheets. Clearly the banks were hiding problems.

NPLs of the Zhejiang and Jiangsu branches had indeed gone up. But in the context of the entire nationwide portfolio, the impact on total bank NPLs was small. Moreover, many of those companies that Hong Kong analysts found were going out of business had wrapped up their affairs satisfactorily and proceeded to start up new factories, install-ing more technology- based production lines, producing products that were less labor intensive. They were reacting creatively to Schumpeterian destruction. Another group of clients simply had never been able to access bank credit, and so had financed them-selves in the informal credit market, perhaps contributing to the blow- up of the informal Wenzhou money market that occurred at that time.

Even in the best of times though, some loans default due to bad management, a disas-ter of some sort, or just bad luck. Some portion of a portfolio is bound to go bad. When a Chinese corporate borrower defaults, and there appear to be no reasonable prospects for restructuring, then the loan is immediately transferred to the loan collection depart-ment. No longer does the hapless client meet with those polite, smart, and eager young

3 The Hong Kong Institute of Bankers, Bank Lending (Singapore, Wiley & Sons 2012), 203, states “This requires the ability to differentiate between problem loans that can still be fixed and those that can no longer be fixed.” The manual then advises that one of the courses of action to be considered will be “Renegotiate loans terms and conditions, including requiring additional collateral. The loan can also be restructured to give the borrower breathing space, such as lengthening the loan period, and forgiving part of the penalties.”

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university graduates who extended and monitored the loan when the banking relation-ship began. Now he meets the workout guys, older seasoned people who have over the years learned how to see the foreclosure process successfully through the local courts. Unless the client has some special influence, the loan workout managers will drag the client through bankruptcy proceedings in a matter of months, seize the collateral, and sell it on the market. The head of KPMG’s China financial services audit practice, Simon Gleaves, observed to me that Chinese bank workout teams are merciless and efficient.4 It nonetheless also remains true that greater efficiency and transparency is needed in the collateral collection process5— something that hopefully will come in the next few years as part of the government’s overall legal reform.

In sum, Chinese banks have over the past decade been risk averse, and they have become skilled at handling credit risk associated with the predominantly SOE and large corporate loans that they had been extending. Concerns about repeating the enormous loan losses of the 1990s are not therefore warranted by banks’ exposure to those corpo-rate credits. I, however, have concerns about new credit risks building up in the system, related to the rapid expansion of lending to the private sector, and especially of the pri-vate small and medium enterprises (SME) portfolios, in recent years.

Lending to SMEs: Trouble Looming?

Banks are now aggressively increasing lending to the private sector. Anywhere in the world, SME credit is the most risky portion of bank portfolios; it is especially risky in immature, emerging markets such as China. If private sector risk is to be managed, experi-enced loan officers and credit reviewers are needed. Chinese banks are rapidly expanding their SME portfolios, for sound commercial reasons as well as in response to govern-ment suasion, but they lack experience and training in lending to small and medium sized enterprises. If Chinese banks do not sharpen their skills in this area, then in the course of time NPLs will rise. If the pricing of SME risk is done properly, a moderately higher level of NPLs can be sustained without problem, offset by the commensurately higher returns. If the risk is not managed properly, then SME loans may become a significant source of net credit loss.

It is questionable whether Chinese banks are adequately prepared to analyze and monitor the risks of private sector lending and to price loans reflecting risk. Several of the standard concepts taught in basic credit training in Western banks, such as character and manage-ment capability of owners and managers and cash flow forecasting, were not relevant when the bulk of credit extension was to SOEs. Previously, character was not a factor in lending. After all, the owner was the state, and if management was not performing, the Organization

4 Private conversation with Simon Gleaves. 5 PWC, Banking and Finance in China: The Outlook for 2015, January 2015, 19.


Department of the Party would replace them. As for cash flow, there has in the past been an implicit guarantee of the availability of funds from the government. This, however, may now begin to change, as the government may wish to use the banking system to put performance pressure on the state enterprises, and it is not inconceivable that SOEs would be allowed to default in the future. That would change the nature of corporate lending in China. And assessment of character and cash flow analysis are of course crucial inputs for assessment of private sector credit risk. Whether Chinese banks will master these analytical skills in time to prevent major problems in their private sector loan portfolios remains to be seen.

With only a few years of experience in lending to the SME segment, China remains far behind the United States in mastering the requisite skills. SME lending has been a core business for U.S. banks for decades, pushed into this high- risk sector because major corporations, previously the mainstay of bank profits, disintermediated banks by bor-rowing directly from financial markets through bond issues and commercial paper, thus reducing the attractiveness of the corporate segment as a source of profitability for banks. According to the U.S. Census Bureau, in 2010, the United States had a total of 28 million registered businesses, of which 95% had annual sales of under $2 million, and 4% sales in the range of $2– 20 million. This 99% segment of medium and small businesses has thus been an important market for U.S. banks to get right.

It is worth digressing to quickly look at how the major U.S. banks handle SME lending. Each large U.S. bank develops its own internal data base, containing tens of thousands of credit histories of its own clients fed in over the course of years, yielding a rich mine of raw material for a cadre of the banks’ math whizzes to analyze as the basis of risk models for use in lending to the SME sector. Xiao Bing, Senior Vice President of Wells Fargo Bank in San Francisco, explains that at Wells Fargo the model for handling business clients with less than $2 million is similar to the model used for consumer clients. Relationship managers are generally not assigned to these clients. Scoring programs play an important role in lending to this customer segment. These programs not only capture the financial condition of the customer’s business, but also capture at least five or six “trade lines” (individual credit lines such as a credit card or a home mortgage) from the business owner’s personal credit his-tory as a substitute for the traditional banker’s face- to- face assessment of the “character” of the borrower. With these smaller credits, it is inefficient for large U.S. banks to use human interface to make credit assessments, so the risk models rely on the business owner’s personal credit history to account for some of the subjective considerations that should be part of a credit assessment.6

The United States, however, also has thousands of small community banks, which are important suppliers of credit to SMEs. Given their much smaller scale, and their knowl-edge of local conditions and local businessmen’s reputation, they tend to still rely to a much greater extent on human interface with SMEs as a basis for analysis. This is similar

6 Conversation with Xiao Bing, October 2014.

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to the approach successfully used by two Chinese city banks, Bank of Taizhou and Tailong Bank, whose lending models are considered in Chapter 8. Those two banks, however, operate in the special economic environment of Zhejiang Province, making it questionable whether or not their models have wider applicability in China.

China’s large banks still have much development work to catch up to best practice in risk modeling for this SME segment. Not only do Chinese banks not yet have sufficient historical credit data to create the vast internal data bases needed to fully rely on the credit scoring approach of the U.S. banks, but the public credit bureau still does not capture all relevant institutions (missing ecommerce- based lending and micro- finance companies as well as others). Partially because of these gaps, Chinese banks do not feel comfortable relying on publicly available sources of credit history data. In addition, Chinese banks lack senior risk and lending officers with years of experience in lending to the private sec-tor through good times and bad— in the fifteen years since the restructuring of Chinese banks began, China’s GDP growth rate has hovered around 10%. A bank’s skill at control-ling lending risk is only really tested in economic slowdowns. An economic slowdown has now started in China. SME loan portfolios will merit close attention as China transi-tions to the New Normal.

U.S. banks have become proficient at tapping into e- commerce cash flows to service loan payments. The bank obtains customer permission to claim a specified amount of credit card payments to the customer each day to service the loan. After making the speci-fied deduction from credit card receipts, then the remaining receipts go to the customer. In this way, the bank taps the customer’s cash flow before the cash goes into the custom-er’s account, which greatly mitigates the bank’s risk of not being repaid.

Over the past few years of developing SME lending, Chinese banks have used a differ-ent approach, the shang quan or supply chain approach. The shang quan approach may have been inspired by China’s traditional informal curbside lending market, exemplified by the money lenders of Wenzhou, a coastal trading city in Zhejiang Province in which the local merchants have been renowned for their ability to lend money outside of the banking system based on kinship ties, trade associations, and social connections. The knowledge and trust gained by Wenzhou money lenders through these ties have resulted in an outstanding debt repayment record with few defaults— at least up until some spec-tacular defaults in 2011. The shang quan approach is designed as an alternative model for efficient lending that compensates for the lack of reliable internal and external data, for the lack of institutionalized trust (discussed in Chapter 3), and for the lack of experience in SME lending. How viable this approach will be as the economy modernizes remains to be seen.

Risk/ reward relationship is a fundamental aspect of getting SME lending right. In U.S. banks, the difference in lending rate charged for customers of different risk levels can be as high as 7– 8%. In China, the biggest driver in pricing differentiation is still the products rather than the perceived risk of the customer. Loan pricing to reflect risk is still not properly in place, but full compliance with the requirements of the Basel III


agreement, starting in 2017, will probably compel more attention by the banks to this issue of risk- reward balance.

SME lending in Thailand is illustrative of the difficulty banks experience lending to SMEs. SMEs, largely owned and managed by Sino- Thais, have been the foundation of Thailand’s economic growth over the past half century. Their business modus operandi is very similar to that of their counterparts in China and therefore makes for an interesting comparison. The Thai government has long had an active policy of promoting SME lend-ing, and Thai banks have decades of experience and strong capabilities in SME lending. Thailand’s banking sector is mostly composed of private sector banks (which themselves tend to be managed by Sino- Thais), but there are a few state- owned banks as well, among which is one large listed, majority state- owned commercial bank, the Krung Thai Bank, and one special- purpose wholly government policy bank, the SME Bank, the business objectives of which are obvious from its name. As of mid- 2014 the NPLs of the SME Bank were believed to be close to 40%.7 In July 2015, facing declining economic condi-tions, the Thai government considered a measure to subsidize commercial banks with funds carrying 1% interest rate for on- lending to SMEs at 5%. The Bangkok Post reported that the “idea comes amid a rising number of cash- strapped SMEs struggling from lower sales cramped by the economic slowdown, declining exports and high household debt, with commercial banks reluctant to lend for fear of more loans turning sour.”8 This illus-trates the risks in emerging markets of lending into the SME sector.

Given the growing importance of SME lending in Chinese bank portfolios, and the high risk associated with it, developing reliable and comprehensive credit history data-bases is an area deserving priority attention from Chinese banks and from the regulatory authorities.

Operational and Liquidity Risk

Thus far, the discussion of risk management has focused only on credit risk, which gener-ally poses the largest threat to a bank, and hence was the first focus of reform as banks began their transformation. There are, however, other forms of risk that must be subject to tight internal controls as well. Of these, perhaps the most important are operational risk and liquidity risk.

It was only a few years ago that enormous cases of fraud and defalcation periodically came to public attention, well publicized in the media. A particularly notorious example was the defalcation of almost 3 billion yuan (around $350 million at the exchange rate of that time) from a branch of Bank of China in Harbin in northeastern China. The branch manager, Gao Shan, in coordination with two local businessmen, the Li brothers,

7 Wichit Chantanusornsiri, “Transparency Key in Reshaping State Enterprises,” Bangkok Post, July 23, 2015. 8 Wichit Chantanusornsiti, “SME Lending Scheme for Wary Banks,” Bangkok Post, July 27, 2015.

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between 2000 and 2004 siphoned the money from deposits of corporate customers of the branch, undetected by internal audit (internal audit functions of Chinese banks were embryonic at that time). On December 30, 2004, the three of them fled to Vancouver. They were later arrested by Canadian police and returned to China for trial.9

Writing about the case in 2012, when Gao returned to face the court in Harbin eight years after fleeing, Canada’s National Post commented, “As many as 4,000 Chinese fraudsters have fled overseas in recent years, taking with them as much as $50- billion in ill- gotten funds, according to estimates by Chinese media. ‘Most of them are still living the high life in foreign countries,’ wrote the Shanghai Daily on Tuesday.”10

Bloomberg Businessweek Magazine, in January 2002, reported on the widespread cor-ruption in the major state- owned banks:

The PBOC said early this month that it was censuring all of the Big Four banks, which control two- thirds of the country’s banking assets, and punishing 686 mem-bers of their staffs. The move is part of a seemingly never- ending effort to root out bank corruption by conducting sweeping investigations and crackdowns. The cen-tral bank said it found “a serious breach of rules” at more than 100 bank branches. It also closed 1,585 post- office bank branches for various infractions.11

Meanwhile, in September 2000, Cheng Kejie, a powerful provincial politician and a vice chairman of the Standing Committee of the National People’s Congress, was executed for taking $5 million in bribes to help arrange loans from Bank of China and China Construction Bank. Another official in charge of Bank of China foreign- exchange opera-tions committed suicide in May 2000.12

In its reporting in 2006 on the sentencing of the CEO of Construction Bank to fifteen years in jail, China Daily commented: “The banking regulator said in October that the financial sector had been hit by 724 cases of bank fraud in the first nine months of the year, of which 194 involved at least 1 million yuan.”13

This was not only financially unacceptable for the banks, but reflected badly on the reputation of the banks for competence. Something had to be done. Great efforts were then made to tighten internal controls and to strengthen audit procedures. The incidence of major fraud has since declined drastically. What Bloomberg in 2002 had characterized

9 Caixin Online: http:// english.caixin.com/ 2013- 09- 30/ 100588206.html, accessed August 9, 2014. 10 Tristin Hopper, “China’s Gao Shan Heads Home to Face Charges on $130M Fraud Ring after Eight Years

Hiding in Vancouver,” National Post, August 13, 2012, http:// news.nationalpost.com/ 2012/ 08/ 13/ chinas- gao- shan- heads- home- to- face- charges- on- 130m- fraud- ring- after- eight- years- hiding- in- vancouver/ , accessed June 12, 2016.

11 “China’s Banks Under a Cloud,” Bloomberg Buinessweek Magazine, January 27, 2002, http:// www.business-week.com/ stories/ 2002- 01- 27/ chinas- banks- under- a- cloud, accessed August 12, 2014.

12 Ibid. 13 “Former CCB Head Jailed for 15 Years,” chinadaily.com.cn, November 3, 2006, http:// www.chinadaily.com.

cn/ china/ 2006- 11/ 03/ content_ 724071.htm, accessed August 12, 2014.

http://english.caixin.com/2013-09-30/100588206.html

http://news.nationalpost.com/2012/08/13/chinas-gao-shan-heads-home-to-face-charges-on-130m-fraud-ring-after-eight-years-hiding-in-vancouver/

http://news.nationalpost.com/2012/08/13/chinas-gao-shan-heads-home-to-face-charges-on-130m-fraud-ring-after-eight-years-hiding-in-vancouver/

http://www.businessweek.com/stories/2002-01-27/chinas-banks-under-a-cloud

http://www.businessweek.com/stories/2002-01-27/chinas-banks-under-a-cloud

http://www.chinadaily.com.cn/china/2006-11/03/content_724071.htm

http://www.chinadaily.com.cn/china/2006-11/03/content_724071.htm


as a “seemingly never- ending effort to root out corruption” seemed a decade later to have finally borne fruit. Today, the quality of internal controls in most Chinese banks is high.

Nonetheless, operational risk still remains a significant issue, especially for some of the banks in which development of professional standards lags. Among the five large banks, the laggard is the Agricultural Bank of China (ABC). In early 2015 two employees devised a scheme to remove vast amounts of cash from ABC, invest it in the then- rising stock market, but lost the money when the market crashed later in the year. Total losses to the bank were $578 million. The two employees have been arrested. Effectiveness of internal controls over operational risk varies between banks and will remain an ongoing struggle. Nonetheless, tremendous overall progress has been made in this area.

While great progress has been made in coming to grips with operational risk, under-standing of liquidity risk is just beginning. Liquidity risk is the risk that a bank’s treasury may not manage the maturities and types of the bank’s assets and liabilities so that each day the bank has enough liquid funds available to repay obligations as they fall due or repay demand obligations when the other party demands payment. Not only a bank, but any firm, may be solvent, meaning its assets exceed its liabilities, but face a liquidity problem if there is not enough cash or cash equivalent to meet day- to- day obligations. This is particularly important for a bank, as the sustainability of a bank’s operations rests on public confidence. If ever a bank is unable to meet a legitimate request for payment of an obligation that is due, be it a cash withdrawal from a savings account by a depositor or an interbank demand payment, then rumors spread that the bank has difficulties, leading to a public “run” on the bank, or refusal of other banks to lend it money in the interbank market.

It is generally liquidity problems rather than solvency problems that lead directly to the failure of banks, although the two conditions can be present at the same time. Thus, the immediate cause of the overnight collapses of Bear Stearns in 2007 and Lehman Brothers in 2008 was a liquidity shortfall— they could not come up with the cash to meet repay-ment demands. Once that situation becomes known in the market, then everyone wants their money back immediately, a panic results, and the game is over for that bank within hours. Nonetheless, it is also often, but not always, true that liquidity crises are sparked by concern over underlying solvency.

In the case of China’s banks in the 1990s, technically several of them were insolvent, as their heavy burden of unrecoverable debt reduced their assets to less than their liabilities, meaning that their capital was wiped out. But they did not go under, because the public knew that the state was the owner of the bank and would not let them go under, hence the insolvent banks did not face a liquidity problem. In more recent times, by ensuring that cash is one way or another is made available to a liquidity- stressed bank, the govern-ment has reduced the risk that liquidity problems will bring down banks.

Due to very cautious regulatory policies of the CBRC, Chinese banks are both solvent and liquid. The official loan:deposit ratio requirements of the CBRC had not (until May 2015, when the ceiling was lifted) permitted Chinese banks to lend more than 75% of

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their deposit bases— a restriction that is conservative compared with standards in other nations, and which leaves banks with a large number of assets that are easily exchangeable for cash in a crisis.

Nonetheless, the CBRC is gradually preparing the banking industry for a future that will be less closely regulated, and in particular a liberalized interest rate environment, which will necessitate sharper liquidity management skills and more management atten-tion paid to funding strategy and to the asset– liability mix. In the summer of 2013, it abruptly intervened in the money market to sharply tighten liquidity and raise interest rates for a few days, catching one or two banks off guard at the end of one afternoon. Many observers misconstrued what was going on as a real liquidity shortage, whereas it was a lesson delivered sharply, but with no permanent cost, to banks to pay more atten-tion to possible unanticipated events in the money market, to hone their liquidity man-agement capabilities. In the subsequent months, reflecting the risk control orientation of Chinese banks, attention has been focused on the issue to ensure that proper liquidity management mechanisms and policies are in place so that the embarrassment of being caught short would not be repeated. The regulatory authorities are well aware of where the vulnerabilities in the system lie, leading to preemptive action by the authorities to force banks to address these weaknesses.

Audits, External and Internal

As part of the transformation of Chinese banks, all tier 1 banks appointed one or another of the major international audit firms as their external auditors. Initially, the push to list the big banks on New York and foreign exchanges probably was a decisive factor in choosing international audit firms. Once the large banks had chosen international firms, the other tier 1 banks had to follow suit, otherwise their financial reports would not be credible. Despite the development of domestic audit capabilities, up until today the com-plexities of bank operations have deterred tier 1 bank boards from appointing local firms as their auditors.

The high profiles and international visibility of Chinese banks mean that they are clients of highest priority for the major accounting firms— important for the audit fees they earn, but also because of their international visibility. If major accounting problems emerge that had not been flagged by the Big Four audit firms, the reputation damage for the audit firms would be serious. The senior partners of the China practices of the Big Four firms give much thought to the issues that arise in auditing these enormous banks. These partners, most of them English and American, are well aware of the skepticism that the investing public and foreign media have of Chinese bank accounting standards, but they have strongly vouched for the quality of their audit examinations and for their unqualified audit opinions (that’s audit language meaning there are no material aspects of the accounts that do not meet accepted accounting standards).


Keith Pogson, who now serves as Managing Partner for Financial Services of Asia Pacific of Ernst and Young, has long and deep experience of Chinese banking. He has worked with Chinese banks in various capacities since 2002, including disposal of dis-tressed assets in the cleanup from the 1990s, advising foreign banks on strategic invest-ments in Chinese banks, training, and auditing. He credits the international audit firms with devoting extraordinary effort to upgrading the accounting skills and standards of their Chinese bank clients, but at the same time credits the Chinese banks with enthu-siasm for learning and upgrading skills. Thousands of Chinese bank staff have passed through the training programs of the Big Four.

One of the major issues for an auditor in China is whether to classify accounts as prob-lem loans based on forward- looking projected cash flows, known as the expected loss approach, as is normal practice in most countries, or based on impairment— meaning that the borrower must actually be in default on payment of interest or principal. Impairment is the normal basis for classification in China. The issue is complicated in China because of the large role of the state, discussed in the next chapter, which means that cash resources available to the borrower itself, and collateral, are not the whole story on the likelihood of a loan to be repaid.

The case of China Everbright Bank is interesting. The Bank had racked up large NPLs on its books in the 1990s, but the government did not approve a recapitalization of the bank until 2007. The external auditors, first Price Waterhouse and then KPMG, refused to issue unqualified opinions on the books of the bank until the accounts were cleaned up in the year 2008. Thereafter, though, the bank has received unqualified audit opinions.

In terms of governance responsibility, the Audit Committee is first on the line if the accounts turn out to have been misstated. The external auditor is the Audit Committee’s best friend, its main source of assurance that the management of the bank has not been concealing problems from the board. The function of the external auditor is, however, limited in scope of coverage to matters that might in any way impact on the integrity and accuracy of the financial reports.

External audits are only part of the auditing that takes place. In most Chinese banks internal audit departments had been in existence for years, but it was only in 2006, with the promulgation of internal auditing guidelines by the CBRC, that they began to play a significant role. At first the effectiveness of the internal audit departments was limited, but, as in other areas in which China has had to come up the learning curve, banks mas-tered internal auditing skills quickly. With the publication of the CBRC guidelines in 2006, the position of chief auditor of the bank was created and all internal audit depart-ments had to report to the board rather than to the CEO (this was already in place in some banks by that time).

Internal audit departments have now become effective in alerting management to internal control weaknesses, and they have become a major tool of the board’s audit committee in monitoring adherence to internal control and other policies within

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the bank. Anywhere in the world, whether or not a bank’s internal audit function is effective depends on how well it can balance the delicate matter of an indepen-dent reporting line directly to the board, while at the same time being respected by management for the value it contributes to the bottom line through calling atten-tion to potential losses. Unlike the external auditor, the internal auditor can and does look into risk areas that may not be related directly to the accuracy of the financial reports. Thus it considers operational risks, market risk, liquidity risk, strategic risk, and reputation risk.

The audit committee which I chaired at Everbright Bank from time to time instructed that certain additional audits be performed on areas of concern to the com-mittee members. I had regular private meetings with the bank’s senior audit officers, during which we had wide- ranging exchanges of views. The audit committee also spent considerable time each quarter with our external auditor, Price Waterhouse, probing to ensure that all questionable items had been looked into thoroughly, that the exter-nal auditor was satisfied that it had full access to all relevant information concerning the accounts of the bank, and that it was not being impeded in the conduct of its audit.

In addition to external and internal audits, there is also the regular examination of the banks performed by the CBRC. Thus, a bank receives three sets of audits— internal, external, and regulatory. Any one of them can blow the whistle on problems in a bank.

Media regularly publishes concerns over deterioration of bank asset quality and suspi-cions that problem loans are understated, leading to overstated profits and capital posi-tions. If bank risk management is effective, and the triple audits described above are doing their jobs, then why is this supposed asset deterioration not showing up in the published numbers? The conclusion of the markets can only be that regulators, bank accounting departments, bank loan officers, bank risk officers, internal auditors, bank boards, and international audit firms are all collaborating to cover up the true state of affairs in the banks. In other words, a conspiracy of massive proportion goes on despite the glare of full media and stock analysts’ persistent skepticism. If one believes in such a conspiracy, then it is no wonder that prices of Chinese bank shares command low valuations.

A more sophisticated skepticism about the validity of NPL numbers holds that while the loans are not yet impaired, many will become impaired in the future due to declin-ing overall economic growth rate, overcapacity, weak exports, etc., which will show up as NPLs in future years. Reasonable people can come to different conclusions on the prob-ability of this happening.

Technology

At the end of the 1970s Chinese banks started to use computers in their operations. The systems installed at that time were branch- based and decentralized, unable to aggregate


data across an entire bank. Each province had its own core banking application. In the 1990s the four large state banks established national data centers. The smaller banks did not start their IT operations until the 1990s, and so were able to build centralized, inte-grated systems from the start, avoiding the transition task that the large banks faced at that time.

Progress over the subsequent three decades has been rapid. The average Chinese con-sumer is more “tech- savvy” than the average American or European consumer. Chinese consumers are hooked on e- commerce. Alibaba and JD Commerce have made enormous inroads into traditional retail storefront shopping. Indigenous social media is ubiqui-tous. As a result, bank clients are increasingly reluctant to visit bank branches and are demanding— and getting— all the bank services they want on the Internet and cell phones.

Simon Gleaves, longtime partner at KPMG in Beijing, which has run scores of tests on IT in Chinese banks, comments that “Chinese banks are committed to updating their IT to accommodate new products” and therefore are updating their core systems approxi-mately every ten years. By contrast, he says, the core systems of Japanese and Western banks are dated. The IT human resources of the major Chinese banks are second to none in the world. Their disaster recovery systems meet KPMG’s IT audit standards.14

Peter Nolan, Professor of Chinese Development at the University of Cambridge and also a director of Bank of Communications, writing in 2012 in Is China Buying the World?, states that “China’s top banks now compare favorably with their global peers in terms of the sophistication of their IT systems.”15 Progress in IT in the banks has prob-ably accelerated since Professor Nolan wrote that.

Fan Bin of IBM in Beijing concurs. He is in a position to know. IBM supplies the mainframes for all of the tier 1 banks and 60% of the tier 2 banks and has helped with the software development in several of them. Fan told me that Chinese banks now rank equally with U.S. and U.K. banks in sophistication of IT functionality.16

The Chinese banking system as a whole processes the largest number of banking trans-actions per day of any country in the world. Among Chinese banks, ICBC processes the most (not surprisingly, as it is also the largest Chinese bank by asset size) and is generally regarded as the most capable of the Chinese banks in terms of software development capabilities. U.S. and U.K. banks’ IT systems face two problems. First, most were installed many years ago and have been adapted and upgraded repeatedly to accommodate devel-opments in IT itself, bank product development, and more demanding information and data analysis capabilities. The result is never as satisfactory as installing totally new soft-ware. Second, repeated mergers of U S. and U.K. banks often result in patching together different systems, which also does not deliver satisfactory results. Chinese banks have

14 Private conversation with Simon Gleaves, April 1, 2014. 15 Peter Nolan, Is China Buying the World? (Cambridge, UK: Polity Press, 2012), 117– 118. 16 Private conversation with Fan Bin, 2013.

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been much less burdened by these legacy systems and, having started computerized oper-ations at a later date, have had the advantage of working with much newer systems.

It might seem too obvious to ask, but why is IT important to banks? Basically, for three reasons. First, it enables the delivery of digital products to customers, both cor-porate and consumer. Second, it allows for automation of back office transaction pro-cessing. Without computers, the processing of each bank’s enormous daily transactions volume and production of the daily accounting information would require armies of people. Third, IT provides the management information needed to control the bank. How do Chinese banks stack up against their counterparts in the United States, Europe, and Japan in each of these three areas of IT?

In the first area, digital products, bank clients are tech- savvy and demanding. The younger generation of Chinese expect to be able to do all their banking through their cell phones. And with Chinese banks, they can in fact do all normal transactions through cell phones. Chinese banks’ cell phone and interbank applications are the equal of and per-haps ahead of most Western countries in functionality and ease of use. Development of these products has been driven by fierce competition for customer deposit accounts and by the likes of Alibaba and Tencent competing for payments and deposit business from outside the banking system. China Construction Bank reports that 86% of its customer transactions are now conducted through digital and self- service channels.17

In electronic processing, Chinese banks do not do as well. Improvements have been enormous, but branches still have some staff working in branch back offices doing tasks that in leading Western banks have been automated and centralized. Perhaps this is due to the fact that in the past few years in which banks were able to earn high revenues, con-trol of expenses did not seem a priority strategic issue. In the next few years, as revenues trend downwards and real wages in the service sector rise, Chinese banks will have to pay more attention to the control of operating expenses. IT can make a significant con-tribution to this effort, particularly if used in conjunction with process re- engineering, something that Chinese banks have not yet seriously undertaken.

In the development of management information systems (MIS) measuring finan-cial performance and providing customer information, Chinese banks also lag behind Western banks and need to improve. They have yet to develop a 360- degree view of the customer and are unable to seamlessly link together all of a customer’s points of interface with the bank in one customer overview. (Indications are that by mid- 2015, a few of the banks were close to accomplishing this. Once they have this capability in place, the next challenge will be to make it a part of day- to- day bank management culture, favorably impacting revenues and profits.) As spreads narrow and fees and commissions become more important components of overall customer profitability, this lack of comprehen-sive and integrated customer data will be a disadvantage for Chinese banks. Similarly,

17 China Construction Bank, 2014 Annual Report, 10.


financial MIS does not yet effectively reach down to the customer level, reflecting both weakness of IT development in this area and also the branch- rather than customer- centric organization of the banks that was mentioned earlier. Moreover, they are not yet able to build the sort of databases and mathematical credit scoring models for SME lend-ing that institutions like Wells Fargo have in the West.

For the most part, the major Chinese banks are developing their own software, par-ticularly at the Big Five. The size of their IT development staffs is enormous— in ICBC, 3,000 personnel; in Bank of China, 2,000. But these numbers are dwarfed by the size of the IT development staffs at Alibaba and other nonbank IT- based companies. These companies use development methodologies totally different from the mainframe computer– based formal development approaches used by the banks. In racing to put out some new application, sometimes these companies will give the same assignment to sev-eral different development teams under one roof, allowing the teams to compete among themselves in house to come up with the best solution in the shortest amount of time.

As Nolan points out, Chinese banks have achieved this degree of IT sophistication by importing foreign IT technology from the IT giants of the Western world, principally IBM and HP. There are now indications that in future development of bank IT, China as a matter of national policy will seek to reduce its dependence on foreign, and particularly U.S., technology. This policy is driven by two factors: first, a legitimate concern with the security of its financial systems when they are designed by foreign vendors; second, China has made development of high- technology capabilities a strategic economic prior-ity. Certainly the ability to equip its banks with domestically developed IT systems, and then export those systems to banks abroad, would be appealing.

How successfully and how quickly China will be able to wean itself from dependence on foreign IT is not clear. Not only must the IT capabilities be developed, but also new systems will have to be installed in the banks to replace the legacy systems— a very expen-sive and complicated exercise. This process may take many years.

Strategy, Competition, and Branding

People and systems are the two fundamental building blocks of banks. People and sys-tems are, however, necessary but not sufficient to build a strong bank. People and systems must be put to good use in competing for business in the marketplace. The more vigorous the competitive environment, the more banks will be compelled to upgrade services to meet customer expectations, all the while controlling risk and delivering a profit to the shareholders. How a bank does this is laid out in a bank’s strategy.

Within any one national market, the quality of retail service and nature of con-sumer banking products generally differ little between banks. In the United States, there are a small number of nationwide, or at least regional, behemoths, and there are several thousand much smaller banks serving communities. The small- scale banks

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may lack some of the product range of the nationwide banks, but their services and products are much the same and they may present a more local, friendly face to the customer. Essentially consumer banking is a commodity business, with limited pos-sibility of proprietorial products or services. ATM machines, credit cards, mortgage products, trade finance, and deposit products of different banks are all more or less the same.

This is even more true in the Chinese market, where banks move with herd- like behav-ior, and share knowledge and techniques with each other. Prior to 2008, the retail branch service of almost all Chinese banks was, simply put, terrible. By 2010, the situation was dramatically turning around in most banks. Chinese bankers woke up to the importance of quality of branch service. Within two years they had brought most retail branch con-sumer services up to international standards, albeit perhaps more so in the medium- sized joint stock banks than in the five large national banks. This branch consumer service improvement was soon followed by quality telephone banking, Internet banking, and cell phone banking. With seventeen nationwide banks to choose among, plus each local-ity with its own city bank, and probably a rural bank of one sort or another as well, the Chinese consumer has a surfeit of banks between which to choose. The major consumer products of the large banks migrated with surprising speed to even rural cooperative banks, many of which now offer credit cards, cell phone banking, etc., without which they would lose deposits.

In the early years of Reform and Opening, bank strategy was the responsibility of the central planning authorities. Banks loaned according to plan quotas within sectors for which they were responsible. They were bursars of the government. Bursars do not need business strategies as they are nothing more than instrumentalities of strategy. If a bank did no more than loan to meet quota and passively carry out money transfer functions, with no other more complicated performance goals, then what need was there for strat-egy? Moreover, in the dying days of the planned economy, banks were bureaucratic enti-ties, with no meaningful competition between them.

When the transformation of banks commenced, the question arose of how to make state- owned bureaucratic entities into dynamic enterprises that pursued a set of demand-ing performance goals? The answer that Zhu Rongji and his team decided on was to make them corporations, driven by competition, seeking profits in the marketplace, just as in capitalist systems. To ensure that they did compete with each other for profits, they were listed on securities exchanges, domestic and foreign, with a portion of state shareholding divested to public investors. Instead of the state demanding performance through the bureaucracy, it outsourced that task to the market— including the foreign market via the Hong Kong securities exchange.

Zhu’s strategy worked. Management teams of banks either adapted or were replaced, and they quickly began to behave in much the same way as their counterparts in pri-vately owned banks elsewhere in the world. They became intensely competitive, with an eye toward share prices, earnings per share, return on equity, NPL ratios, reserve ratios,


capital adequacy, etc.— in other words, the whole panoply of ratios and figures that taken together measure bank quality in the capitalist system.

This competitive behavior developed in spite of the fact that bank CEOs and senior management all ultimately worked for the same employer— the Central Organization Department of the Party. Ultimately the state in one form or another was the majority owner of all but three of the tier 1 banks. The Organization Department had to learn to use performance ratios as a major scorecard when evaluating individual manager per-formance, with results not dissimilar to shareholder and brokerage analyst evaluation of bank management performance in the banks of Wall Street. In China, however, while boards of directors are entrusted with day- to- day oversight of the banks and have formal authority over hiring and dismissing management, it is the Organization Department rather than shareholders and the board that ultimately makes decisions with regard to management. Neither the managers themselves nor the Organization Department had any prior experience with these concepts of managing a profit- making organization. It was a sudden awakening to a new world.

It was a new world that the Chinese bankers took to with alacrity. Younger Chinese involved in learning the new concepts and skills reminisce about studying foreign bank models at the time of listing of their banks. They wondered if their banks could achieve ROEs at the 10% plus levels attained by the big international players. It was quite beyond their dreams that Chinese banks before long would be achieving ROEs in excess of 20%, making them among the most profitable banks in the world.

Competitive behavior developed soon among the banks after they were reconsti-tuted. One would have assumed that capability for formulating bank business strategies would immediately have been developed to provide these managers with competitive advantages. For the first few years, however, banks had no real strategies. Several factors accounted for this.

First, as discussed in Chapter 3, the formulation and execution of strategy is one of the core strengths of the Chinese party- state. Starting from the time of the planned economy, China’s leaders have made long- term strategy and planning key tools in their governance of the country. Although the planned economy has long since been abandoned, the Chinese government runs on strategies— the five- year plans, the reform strategies agreed upon in the annual plenary meetings of the Party Central Committee, and a host of sectoral plans and strategies at all levels of the government. From the commencement of Reform and Opening, the strategies have been well conceived and have created an envi-ronment for entrepreneurs to make money.

While strategy- setting was one of the most important functions of the government, ironically the rapid growth of the economy meant that entrepreneurs did not really need strategies to develop their businesses. SOEs just followed the relevant portions of the state plan as their strategy. Entrepreneurs spotted emerging market demands and copied known technologies of the advanced countries, adapting them for efficient use in China. Businessmen could capture low- lying fruit, seize opportunities, and make money. In this

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unsophisticated environment, strategies at the firm level were unnecessary. Business strat-egy formulation was not part of the skill set of entrepreneurs, nor was it part of the busi-ness culture of those years. The Chinese business world was not developing a body of knowledge about strategic planning from which the banks could benefit.

Second, for bank managers, the priority was to develop the rudiments of professional banking organizations— risk management, IT, internal audit, and all the other functions that had not previously existed in Chinese banks but which were now necessary. Strategy could come later.

Third, to the extent there was an implicit strategy, it did not take much time to figure out that the highest profits and lowest risks came from dealing with the SOEs. They were assumed to carry with them an implicit government guarantee of repayment, the SOEs was where the loan demand was, and anyway this was in line with national development objectives. No sophisticated corporate strategy was needed for that. Just align lending with national economic development objectives, and lend to the sectors that were sup-ported by the government.

As competition intensified, banks became more sophisticated. As it became clear that the days of easy profits would draw to a close, managers began to pay attention to the need to develop proper business strategies, review them at the board of directors level, and then communicate them to all levels of management.

In 2005, after two years as an independent director of Minsheng Bank, I was concerned that the bank lacked a business strategy and was convinced that this weakness would con-strain the bank’s competitive capability in the more challenging years ahead. There was in name a board- level strategy committee, but that committee only considered specific “strategic” issues, such as stock market listing and introduction of a strategic partner from abroad. Despite its name, the committee did not concern itself with bank- wide strategy. The board was largely composed of the bank’s major shareholders. These men and women were successful entrepreneurs who had built their businesses in the first wave of business growth in the 1980s and 1990s. They often came from relatively humble backgrounds and had for one reason or another in the early stages of Reform and Opening chosen to, in the phrase current at the time, “jump into the sea” (xia hai). Strategy formulation of the type that an MBA learns in business school was not part of their toolkit, and they would with good reason have seen such a tool as not very useful for the challenges they faced. But the chairman, octogenarian Jing Shuping, already introduced in the Preface, was a far- sighted visionary whom I was confident would be responsive to suggestions of the need for a bank business strategy.

One afternoon I visited Jing Shuping in his office. Gaunt and frail, suffering from a pulmonary ailment that was to take him away two years later, he listened intently to me expound ideas on how the bank should develop a proper strategy, not interrupting but completely grasping the ideas. After fifteen minutes I had finished. Chairman Jing’s reac-tion was immediate and decisive, instructing that the principal shareholder directors should meet as soon as possible to hear me give a more formal rendition of the proposal


for developing a bank strategy. That meeting, held a few days later, resulted in the forma-tion of a small team of bright middle managers to work under the direction of the deputy president, Hong Qi (who subsequently became CEO and then Chairman of Minsheng), and me for a few months to investigate strategic options and put together a full strategy, assisted by a foreign independent consultant, Nicholas Krasno, engaged to advise and facilitate in the project.

This strategic planning exercise at Minsheng Bank, started in 2005 and completed in 2006, illustrates Chinese ability to absorb concepts from foreign models and then appropriate them for their own use within a Chinese context. If I had pushed the idea at an earlier date, the bank would not yet have been ready for it. Whether in macro or micro contexts, Chinese excel at sequencing. Don’t do everything at once— start with the basics, with the low- hanging fruit, then move up the ladder, gradually adding on the more complex, the more difficult tasks, as they become relevant to the needs of each stage of development.

In 2005 the timing was right. Minsheng responded with alacrity, the right people were put on the task, and work on the strategy proceeded on schedule. The last stage of the exercise was to spend three days visiting KBank (Kasikorn Bank, formerly known as Thai Farmers Bank) in Bangkok. KBank is one of the leading banks of Thailand. After recon-stituting its business in the wake of the 1997 financial crisis, it had developed expertise in banking to the SME sector. At KBank the Minsheng strategy team learned how another Asian bank, which was then perhaps a decade ahead of Minsheng in development, had formulated and implemented a strategy in a neighboring Asian market. At the conclu-sion of the visit, Hong Qi said, “I have long had a dream of creating a bank in China that could meet international standards. But I never thought that this dream would be within reach at this time. Now that I have seen KBank’s success, I know that if the Thais can do this, then we Chinese can realize this dream as well.” Once the strategy had been adopted, Minsheng was on its way to the leadership position among Chinese banks in SME lend-ing that it occupies now.

This visit to Bangkok led over the course of the next year to adoption of a strategy that was inspired by what K- Bank had done, and also to an informal partnership with K- Bank developing SME business on a pilot basis in the Pearl River Delta region, but without K- Bank taking an equity stake in Minsheng. At the same time, Temasek of Singapore was taking a 5% equity stake in Minsheng (which it sold in 2009). Since Temasek had a stable of ex- Citibankers skilled in SME lending from other Asian countries, Minsheng worked with Temasek to develop SME lending business in the Yangtze River delta of Central China around Shanghai. Thus, knowledge transfer was arranged from two differ-ent foreign financial institutions with extensive experience in Asian SME lending outside of China. The resulting alternative models were then adapted to Minsheng’s needs in the Chinese context and internalized.

How robust the Minsheng SME lending model will prove to be when tested by a slow-ing economy remains to be seen, but the systematic way in which Minsheng arranged

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knowledge transfer in the area of SME lending practice is typical of the willingness of Chinese banks to look abroad for exemplars of best practice and then use it in build-ing its business. Today, in terms of market reputation, lending to the SME sector as a proportion of total loan book, and quality of SME products, Minsheng leads among the tier 1 commercial banks. Its leadership position was established by learning how to do the business from foreign institutional mentors earlier than its competitors. Within an industry sector in China, state- owned firms are competitive not only with private and foreign competitors, but also among themselves. The principal private bank among the national banks, Minsheng, is regarded as the most aggressive in the banking sector. This strength is generally ascribed to its highly competitive compensation and bonus system, to the exacting performance standards it sets for its employees, and to its aggressive and entrepreneurial corporate culture, which has developed in response to the urgings of its entrepreneur- dominated shareholder structure and board composition.

Between the state- owned banks the competitive impulse is keen as well. The govern-ment encourages oligarchic competition between these state- owned banks as a means of spurring efficiency in the banking system. In other words, the government is using market competition as a tool to ensure these government- owned entities do not lapse into bureaucratic complacency that often characterizes state- owned companies around the world. The corporate cultures of these Chinese state- owned institutions focus on bottom- line profits in a way that a Wall Street manager would find familiar.

Journalists often use the term “behemoths” to describe the large state- owned Chinese banks. But if we compare the sizes and degree of market concentration in the American and Chinese systems, the differences are not pronounced. Consider that at the end of 2014, Forbes reported that approximately 44% of the assets of the U.S. banking system were in the hands of the top five U.S. commercial banks. The comparable figure for the top four in China was 51%.18

State ownership of banks, and Party control of senior management appointments, give rise to an interesting attribute of Chinese bank competition— there is little proprietorial ownership of unique products and systems. Knowledge that would be considered highly confidential within American institutions is widely shared and copied between Chinese banks, both directly between the staffs of different institutions, who are linked across institutions by a rich network of contacts, or through the CBRC, which is eager to see that best practice and innovations are made widely available within the system, to the benefit of all.

18 Steve Shaefer, “Five Biggest U.S. Banks Control Nearly Half Industry’s $15 Trillion in Assets,” http:// www.forbes.com/ sites/ steveschaefer/ 2014/ 12/ 03/ five- biggest- banks- trillion- jpmorgan- citi- bankamerica/ , accessed June 12, 2016, and China Banking Regulatory Commission, 2014 Annual Report (Chinese edition), 152. In cal-culating this ratio, I have included only those institutions that are commercial banks, excluding tier 3 nonbank lending institutions and also the three policy banks, as none of these excluded institutions compete directly with the commercial banks.

http://www.forbes.com/sites/steveschaefer/2014/12/03/five-biggest-banks-trillion-jpmorgan-citi-bankamerica/

http://www.forbes.com/sites/steveschaefer/2014/12/03/five-biggest-banks-trillion-jpmorgan-citi-bankamerica/


The result of this is that Chinese banks, while highly competitive, are relatively undif-ferentiated. Occasionally one bank gains a “first mover” advantage, as China Merchants Bank did by being a pioneer in aggressively selling credit cards, and Minsheng did in being the first bank to really focus on SME lending, resulting in each of them develop-ing a reputation for specialized expertise in these areas and identifiable market niches. They are the exceptions. The other banks are little differentiated in product offerings. What one initiates, the rest soon follow. Partially this herd behavior is due to the shar-ing of information and ideas between banks, and partially it may have to do with senior managers being appointed by the Party and tending to take their leads from Party and state direction.

As described earlier, bank management does have a mandate to control risk, to not lose money. Does this inhibit innovation, breaking away from the herd, establishing a unique niche? To a certain extent it does. Bank CEOs need to establish a balance between inno-vation in search of competitive advantage and avoiding failed or money- losing products, which will have a highly negative impact on their career prospects.

A major aspect of any successful strategy for a business organization is the establish-ment of a powerful and unique brand. Just as Chinese enterprises were slow to develop capabilities for strategic planning, so most of them have proven even slower to develop modern branding. China as a nation has proven that it can indeed develop powerful brands— the 2008 Beijing Olympics and the high- speed rail system both had power-ful brands developed by government agencies, and in the private sector firms like the traditional Chinese medicine firm Tong Ren Tang, the electronics firm Hua Wei, and the tech companies Alibaba, Baidu, and Tencent have been adept at branding. By and large, however, Chinese businesses have either not seen the importance of branding as a competitive weapon or have not known how to develop strong brands. Industries that have clear brand leaders in other countries lack brand leaders in China. Just look at air-lines, hotel chains, retail chains, and banks, among others. None of these industries has a strong brand identity in China that can compare with the brands of Singapore Airlines or Cathay Pacific, Hilton or Hyatt, Walmart or Tesco, Standard Chartered Bank or Charles Schwab. No Chinese banks can yet claim a strong brand identity, with the possible excep-tions of China Merchants Bank and Minsheng Bank.

Lack of consciousness of branding means that few Chinese banks have memorable logos, slogans, branch designs, or distinctive advertising that the average consumer immediately identifies with a particular bank. In this area, Chinese banks lag behind the sleek packaging of the branches of Standard Chartered, HSBC, and Citibank in China. Similarly, when they go abroad, the images of the big Chinese banks in their overseas operations tend to be nondescript.

Concluding this examination of the people and systems of Chinese banks, competent management is in place, corporate governance is providing strict supervision of man-agement, and the core bank systems are working for the most part up to international standards, with certain areas still requiring improvement. All over the world, however,

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banks are being challenged by digital disintermediation and uncertain economic condi-tions. Chinese banks are facing these same challenges, plus additional challenges posed by government reforms designed to reduce the economy’s reliance on bank funding and reforms increasing the role of the market in the financial intermediation process in order to increase efficiency of credit allocation. These strategic challenges, even if successfully met by the banks, will decrease bank profitability and inevitably make the banking busi-ness riskier. These issues will be examined in Chapter 11, but first the next three chapters describe the role of the state in banking control and supervision, the role of nonbank sector financial institutions, foreign banks coming into China, and Chinese banks ven-turing overseas.

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Briefly recapitulating the argument that I have presented in this book thus far, China’s banking system today reflects three influences: traditional cultural heritage (ti), adoption of much from the West (yong), and the pervasive role of the Communist Party (dang) in ordering politics and economics. Chapter 2 outlined the principal attitudes, beliefs, and behavioral norms that remain so powerful in China today and explained how the search to recover wealth and power led China to selectively and yet eclectically graft much of value from the West onto this core Chinese culture. Chapter 3 explained how the party- state has controlled and guided the development of China since 1949, playing a major role in the Chinese banking system. Chapter 4 related how the development path of China’s modern yet hybrid banking system incorporated these three influences of cultural heritage, foreign borrowing, and strong Party rule. Chapters 5 and 6 brought the narration down to the level of the banks themselves, examining their operational strengths and weaknesses, identifying which hybrid components resemble best practice of banking in the rest of the world, and which exhibit strong “Chinese characteristics”

7 Power of the State

China has placed an unmistakable emphasis on strategy and stability for the past thirty- five

years. The results have been extraordinary, but they grew out of a blended model of resource

allocation guided by the heavy hand of the state . . .Stephen Roach, 20141

I hold China’s financial regulatory system in very high regard. I think they understand the

problems, and they have learned lessons from the mistakes that were made in the West.George Soros, 20132

1 Stephen Roach, Unbalanced: The Codependency of American and China (New Haven, CT: Yale University Press, 2014), 41.

2 George Soros, quoted in Wang Xiaoni and Zhao Jingjing, “Interview: Outlook for China’s Economic Transformation is Hopeful: Soros,” Xinhuanet, April 7, 2013, http:// news.xinhuanet.com/ english/ indepth/ 2013- 04/ 07/ c_ 132290258.htm, accessed June 18, 2015.

http://news.xinhuanet.com/english/indepth/2013-04/07/c_132290258.htm

http://news.xinhuanet.com/english/indepth/2013-04/07/c_132290258.htm

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arising out of China’s own worldview and beliefs and animated by the drive for national resurgence.

In this chapter I look at the high degree of state control over the entire banking edifice and over the economy of which the banks are a part. The state primarily exercises this con-trol in three ways— different from the three channels through which the Party permeates the banks, discussed in Chapters 3 and 4. State control is seen in what I term the “national balance sheet”, in majority state ownership of most banks, and in the bank supervisory agencies. Despite the transformation of the banking system that has occurred, despite steadily growing marketization of the banking system, the state ultimately retains a strong influence over the banking system and is not reluctant to use that influence in support of national economic policy. Conversely, it also intervenes in the economy to affect out-comes in the banking system.

State control over the banking system contrasts with declining state involvement in much of the real economy, including several sectors of manufacturing, real estate, and some services, in which sectors the state’s role has receded. Leading economist Professor Huang Yiping of Peking University writes:

In my view, the unique policy that contributed to China’s extraordinary eco-nomic performance was its asymmetric approach to market liberalization during the reform period— in other words, the almost complete liberalization of product markets, but the maintenance of heavily distorted factor markets. Free markets for products ensure that production decisions are based on demand and supply condi-tions in the economy, and resources are allocated efficiently. Distortions in factor markets are a way of providing incentives for economic entities and, sometimes, for overcoming market failures.3

The party- state liberalized the market for producing goods and services at a relatively fast pace, allowing great scope for private sector initiative in manufacturing, construction, and commerce, but was much slower to relinquish control over key factors of production, in particular capital. Hence the banking system has remained predominantly in govern-ment hands, as have the key components of the financial markets.

National Strategy and State Balance Sheet

Chapter 3 explained how the mammoth Communist Party organization occupies all political space and is able through policy setting, human resources direction, and disci-plinary powers, to control what happens in China’s banks. Of equal importance to the

3 Yiping Huang, “Introduction,” in China’s New Role in the World Economy, ed. Yiping Huang and Miaojie Yu (London: Routledge, 2013), 3.


operating environment of the banks is the ability of the party- state to effectively coordi-nate the entire economy through mobilization of resources and through manipulation of what, for want of a better name, is the “national balance sheet”, or perhaps “state balance sheet.” The state is not just an economic regulator, it is the most important economic actor as well.

As a foreigner working in China, occasionally I would hear or see something that provided me a flash of insight into how China works. One such moment occurred at Everbright Bank in November 2008. Under discussion was the prospects for the Chinese economy in the following year. My head was full of the dire forecasts of dramatic eco-nomic slowdown in China that were currently appearing in the Western media. The foreign commentariat was debating whether China’s growth would decline by half or more in view of the precipitous drop in exports as Western markets tipped into recession, yet my Chinese colleagues were without hesitation maintaining that GDP growth for 2009 would be 8%— the figure put out by the government in its projections. I protested that 8% growth projections were unrealistic given the global economic environment. My colleagues advised me to not challenge this growth assumption— the government had already developed the plans for the Keynesian stimulus that would maintain the 8% growth goal. My colleagues were right— actual 2009 growth turned out to be 9% and the following year higher.

Why was I so wrong in my expectations for economic growth, and why, when the rest of the world was slipping into recession, did China’s economy, after stumbling briefly, resume performing so well? Evidently, the State Council had been as pessimistic about the impact of the external economic environment on China as I was. The reaction of the United Kingdom and Europe to deteriorating economic conditions was to go into auster-ity mode, prolonging the hardship for several years;4 in China, an alarmed State Council, confronted by the looming specter of massive unemployment and plummeting economic growth rates, went into crisis mode. The result was classic Keynesian stimulus, using all the controls available to the party- state to channel money through the state owned bank-ing system to local governments for them to get moving on “shovel ready” investment projects. This required rapid policy decision at the State Council level, presumably with intensive consultation and input from the various economic think tanks at the service of the State Council; instructing the PBOC to relax lending quotas restraining commercial bank credit extension, and relaying this on to the commercial banks through “window guidance”; instructing the NDRC to expedite approval of pending infrastructure proj-ect approvals; and then get dozens of banks and hundreds of local government agencies around the country to agree on terms and conditions of funding, release of the funds, and initiation of the projects. All this happened within about half a year, which is remarkable

4 For excellent explanation of the impact of austerity on U.K. economic growth post 2008, see Robert Skidelski, https:// www.project- syndicate.org/ commentary/ niall- ferguson- british- austerity- by- robert- skidelsky- 2015- 05, accessed June 1, 2015.

http://www.project-syndicate.org/commentary/niall-ferguson-british-austerity-by-robert-skidelsky-2015-05


for a country the size of China. It could happen because of the ability of the party- state, once it had decided on a Keynesian stimulus, to mobilize all the thousands of necessary actors to set the stimulus in motion.

After that, I never again underestimated the power of the party- state in China to effect outcomes in the economy. Several years later, in the 2014 CLSA annual China investors’ conference held in Beijing, I noted that over the course of the three- day event, a recurring theme in the presentations of Chinese academics and businessmen was to stress that the key to how events would play out over the next two to three years lay with state policies and the role of the state as an economic actor.

The question arises: How solvent is the national balance sheet? The Chinese Academy of Social Sciences has put together a national balance sheet, released by the Academy in Chinese, and subsequently published by the IMF in a compendium on China’s financial system in 2013. In 2015, the consultant Oliver Wyman collaborated with the Fung Institute of Hong Kong to analyze the numbers, based on the Chinese Academy’s research.5 The numbers are mostly from 2011, but those numbers are still generally valid at the time of writing this book. The broad conclusion of these researchers is that both the sovereign balance sheet of China and the national balance sheet have substantially positive net assets.

In China’s party- state, the meritocratic and technocratic elite is obsessed with staying in power, which in turn means being legitimated in the eyes of the population through performance. Although other performance measures, such as environmental quality, international power and prestige, a harmonious and just society now receive increasing emphasis, in 2008 maintaining social order and delivering rapid economic development were the principal sources of performance legitimation. Maintaining a high rate of eco-nomic growth depends on clear- headed and objective recognition of economic realities. Self- delusion and policy rigidity would be a rapid route to self- destruction for the party- state— which China believes was the cause of the downfall of the Communist Party in the Soviet Union.

The party- state uses market mechanisms increasingly as a means of ordering the econ-omy for the practical reason that they are perceived to be effective, but it does not rely on the market to solve all problems or on the genius of the market to bring about economic growth on its own. The party- state believes it has a responsibility well beyond regulat-ing the market. It is highly interventionist in developing a strategy for guiding the mar-ket and for coordinating the actors in the market. Economist Stephen Roach comments

5 Yang Li and Xiaojing Zhang, “China’s Sovereign Balance Sheet Risks and Implications for Financial Stability,” in China’s Road to Greater Financial Stability: Some Policy Perspectives, eds. Udaibir S. Das, Jonathan Fletchter, and Tao Sun (Washington, DC: International Monetary Fund, 2013), 63– 78; also Oliver Wyman and Fung Global Institute “Bringing Light upon the Shadow: A Review of the Chinese Banking Sector,” 2015, http:// www.oliverwyman.com/ content/ dam/ oliverwyman/ global/ en/ 2015/ feb/ Bringing- Light- Upon- The- Shadow.pdf, accessed June 12, 2016.

http://www.oliverwyman.com/content/dam/oliver-wyman/global/en/2015/feb/Bringing-Light-Upon-The-Shadow.pdf




that since “the days of Deng Xiaoping, one of modern China’s greatest strengths has been strategy— especially when it comes to economic policy and macromanagement.”6 Extensive debate occurs prior to adoption of the strategy (except in crisis situations such as the 2008 stimulus), often delaying final strategy formulation for several years, but once the strategy has been agreed upon by all stakeholders, then dissension within the gov-ernment is not tolerated. Everyone is expected to “get on board,” starting with the State Council, which, despite whatever disagreement may have been voiced along the way, will in the end speak with a unified voice. Once a strategy has been set, then the party- state uses all the tools available to it, ranging from the entire state bureaucracy, state- controlled media, state- controlled banks and other giant state enterprises in critical sectors, plus unified elite level support for the strategy.

Roach compares this with America, which has historically been resistant to national strategizing— a reflection of American suspicion of “big government,” starting from the American Revolution against the “tyranny of the king.” Writing of America’s current eco-nomic imbalances and manifest infrastructure weaknesses, Roach comments: “America doesn’t seem to get it. Strategy doesn’t come easy for a nation whose economy sits on the bedrock of the Invisible Hand.”7

One senior Chinese executive of a foreign bank branch in China observed to me that in a market capitalist system, “money flees problems,” whereas in China, due to the state’s role, money is drawn to a problem to resolve it. The state will decide whether or not the market should be left to its own devices or the state should aggressively intervene, changing the market outcome. Naturally, the state has no ideological hang- ups about using Keynesian policies to stimulate the economy when needed. This has major positive implications for banks if they are facing problems with their loans to certain economic sectors or to major projects in a troubled economic environment.

The party- state’s capability to concentrate resources and coordinate work to achieve a priority objective is a real advantage for China. There are, however, three caveats to this advantage. First, if China gets a strategy wrong, then the consequences will be enor-mously negative due to the amount of resources that have been committed. Second, if in China “money is drawn to a problem,” that may lead not to problem resolution but to cover- up of a problem, or “good money after bad.” Third, while China can concentrate enormous resources and be very decisive in dealing with problems, it is also true that China is one of the world’s few continental- sized economies, and the ability of the center to keep all the provinces marching in the same direction in support of policies laid down at the center is limited, except in matters that receive highest priority, such as the 2008 stimulus, in which case the center can more or less keep all the provinces (and banks) marching in the same direction to the same tune.

6 Roach, Unbalanced, XII. 7 Roach, Unbalanced, XIII.


Although the most dynamic portions of the economy are in the hands of private entre-preneurs and the household sector’s assets in the form of private ownership of residential property are huge, nonetheless the state directly and indirectly controls a major share of total Chinese national assets. It owns a majority of most financial institutions and the many giant SOEs, plus it owns vast tracts of land and other assets. Only a portion of total debt is owed in foreign currency to foreign creditors (estimated in 2015 at $1 trillion, or less than a third of China’s international reserves at that time). This gives the state enor-mous control over financial flows.

A large part of China’s total debt is owed by state entities to other state entities. In China’s market socialism, or “competitive state- guided capitalism” in McNally’s phras-ing, the state is trying to use market competition to increase efficiency of operations of state entities, but ultimately they are just different manifestations of the same state. This is what is meant by the term “the state balance sheet.” The Chinese executive of a foreign bank mentioned above further observed that his bank has few worries for the present about the solvency of all these state entities because of the center’s ability to coordinate resources and move them around the “state balance sheet.” This, of course, at some point ceases to work if either total debt becomes too great or the debt is deployed to fund proj-ects and activities with subpar return. Whether or not China’s debt burden has reached such a level is much debated around the world, and will be considered in Chapter 11.

Bank Ownership

The government in one form or another is the major shareholder in most of China’s banks. Behind the faceless exterior of government entities that own the banks, individu-als make shareholder decisions that are relayed to the banks. These are the people whose jobs are to maximize the benefits to the government organization for which they work. And the different government entities for which these individuals work in turn have their own institutional values and objectives, which can lead to conflict between them and require reconciliation from the center. At the level of MOF and Huijin, investing in tier 1 banks, the overriding benefit sought is financial return for the government as the “share-holder state.”8 At second and third tier banks, shareholding organizations representing provincial and local authorities may seek not only financial return as shareholders, but also bank support for priority development projects. To the extent that this occurs, it obviously has implications on efficiency of bank intermediation.

The free market and private ownership of enterprises are articles of faith among neo-liberal practitioners and theorists of development economics. In this view, state- owned enterprises are inefficient, market- distorting, reactive, subject to political influence,

8 Wang Yingyao, “The Rise of the ‘Shareholding State’: The Financialization of Economic Management in China,” unpublished paper, 9– 17.


purveyors of favoritism, corrupt, and bureaucratic. Privatization unlocks latent energy in developing economies that have been stifled by unwieldy state- owned bureaucratic enter-prises. The poor record of SOE performance in all too many developing countries gives grounds for believing in the ability of privatization to enhance economic growth rates, improve efficiency, and reduce market distortions, although arguments can be made that privatization can be pushed too far, resulting in privatization of sectors that are best left to public sector organizations.

From the early 1950s through 1978, the private sector did not exist in the Chinese econ-omy. Thereafter, private sector entrepreneurs were first tolerated as a supplement to the mainstream SOEs and later actively encouraged in most areas of the economy that were not reserved for state control. In the 1990s, privatization of many SOEs occurred, result-ing in both massive unemployment and a large boost to Chinese economic efficiency and growth rates. Today sectors such as technology are for the most part under private owner-ship and management, resulting in successful Chinese companies like Alibaba, Tencent, Huawei, and Baidu that have made fortunes for their owners. Sectors such as real estate are partially government- owned and partially privately owned, although the middle and higher ends of the market are mostly the province of private companies. Aside from these huge private sector companies, there are millions of small and micro private enterprises.

With a few exceptions, ownership of the banking sector has been retained in govern-ment hands. Of the seventeen tier 1 banks, fourteen (except for Minsheng, Ping An, and Zheshang), plus the three policy banks, are majority- owned by the national government in one way or another. The tier 2 city banks are mostly owned by lower level government bodies, and at the third tier, the remaining institutions are owned by local governments, or by some form of cooperative ownership. Most tier 1 banks and a few tier 2 banks are listed on securities exchanges, both domestic and overseas, but majority ownership and control of fifteen of the listed banks, except for the three private ones mentioned, rests firmly in the hands of the state. On closer inspection of shareholder lists, one discovers that many of the shares that are not directly owned by government agencies are in the hands of large SOEs, which are in turn government owned and controlled. Moreover, the state is not without strong influence over the three privately owned banks as well through the Party mechanisms that have been described earlier.

One reads of “state- owned banks” in China. But how exactly does the state own banks as part of its financialization of state ownership of its assets? The present ownership struc-ture is the outcome of jockeying between the PBOC and the MOF during the period 2000– 2007, when the banks were being recapitalized. PBOC had established Hui Jin as a holding company to undertake recapitalization of China Construction Bank and Bank of China, but in 2007 the MOF, when it established the sovereign wealth fund China Investment Corporation (CIC), arranged for the transfer of Huijin from PBOC to be a subsidiary under CIC, and thus under MOF control. Prior to that, the PBOC had con-trolled two of the large four banks, and MOF had controlled two. Now, either through direct shareholding, or through Hui Jin, the MOF is the majority owner of all four of the


largest state banks. Direct and indirect MOF holdings in these four banks are as follows, based on annual reports of the banks as of 31 December 20149:

percentage of total outstanding shares directly or indirectly held by the mof

Banks MOF Huijin Total MOF HoldingsICBC 34.9 35.1 70Construction Bank 57 57Bank of China 65 65

Agricultural Bank 39 40 79

Source: 2014 annual reports of the banks

The only other tier 1 bank in which Huijin has invested is China Everbright Bank, in which it holds a controlling interest both directly and indirectly through its investment in Everbright Bank’s holding company, the China Everbright Group Limited. The 2014 Annual Report of Everbright Bank describes the “development strategy” of Huijin as being “an investor in major state- owned financial enterprises, on behalf of the State in light of the applicable laws to achieve the goal of preserving and increasing the value of state- owned financial assets.” The report goes on to say that Huijin does not “intervene in the day- to- day business operation of the major state- owned enterprises in which it has a controlling equity interest.”10

Huijin does, however, exercise its shareholder rights actively, principally through appointment of representatives to the board. For example, in Everbright Bank, out of eighteen directors, six directly represent Huijin. These six people are of course share-holder directors, but they are more aware of what goes on in the bank than other share-holder directors, as they spend considerable time in the bank as “shareholder watchdogs,” yet are not members of the bank’s management team and have no line responsibilities. In 2015, four of the six had Ministry of Finance backgrounds of one sort or another, and the other two had strong working experience in financial institutions. Provided offices within the bank, most are assigned full time to the bank to observe and understand bank opera-tions and report back to Huijin. Their intimate knowledge of what is going on in the bank obviously enhances their abilities to exercise their directors’ duties. Despite being embedded in the bank, they have no executive duties or powers and do not overtly share in management decision- making. In view of their active monitoring of the bank, and the proactive involvement of the professional directors at the board committee levels, the statement that Huijin “does not intervene in the day to day business operation,” while technically correct from an institutional point of view, masks the reality.

9 As reported in the annual reports of each of the banks. 10 China Everbright Bank Company Limited, 2014 Annual Report, 71.


The roles of Huijin directors in the four big banks are analogous to their roles in Everbright Bank. In working with these Huijin directors on the board and in commit-tees, I have found them of course advocates for the interests and point of view of Huijin, but also committed to professional development of the bank, open to my ideas as a for-eign colleague, and also sensitive that they should act as directors, not as members of the management team. I have also found working with them to be collegial and not strained by the special circumstances of their inner/ outer role.

Other banks at all tier levels, with the exception of the handful of privately owned banks, are owned by the state principally through SOEs and provincial and local govern-ment agencies. For example, 54% of the shares of Bank of Shanghai, a city bank with assets of almost a trillion yuan, was owned by a number of shareholders in one way or another related to the government of the city of Shanghai. The largest of these, Shanghai Alliance Investment, controlling 19% of the shares, is a venture capital and private equity firm of the Shanghai government. Recalling that China does not have a federal system of government, and that the Party permeates the economy at all levels, ultimately it is the same state that has control over these lower- level banks as well. Moreover, some of the directors of Bank of Shanghai have professional backgrounds in national- level organiza-tions such as Construction Bank, thereby enabling cross- fertilization between the bank-ing giants and the provincial banks.

The World Bank, most of the western press, and a significant number of leading Chinese academic economists urge further privatization of the Chinese banking system. Zhang Weiying, China’s most well- known and widely published disciple of Chicago school of economics, in 2012 wrote: “Whether or not China will be able to realize its future growth potential, the first thing is to do a major reduction in in the scope of government entities. Now government entities occupy 35– 40% of the economy, but they absorb 70– 80% of resources. If in the next 10– 20 years, the government share can be reduced to less than 10%, I feel that then China’s potential can be better realized.”11 And in principle, Chinese policymakers appear to subscribe to this point of view, up to a point. The 3rd Plenum of 2013, proclaiming that the free market will be the principal guiding force of development of the Chinese economy in the future, calls for opening up the financial sector, including commercial banking, to private participation.

Implementation of the policies on bank ownership of the banking system resolved in the 3rd Plenum began in 2014 with the decision to license the establishment of five new privately owned banks, with five more in the pipeline. These licenses are, however, issued on an experimental basis, with conditions and restrictions for their start- up stages.

As of today, the ownership and management of the commercial banking system in China remains firmly in the hands of the government. The likely speed of implementation

11 Zhang Weiying, Shenme Gaibian Zhongguo: Zhongguo Gaibiande Qianjing he Lujing (What Changes China: The Landscape and Paths of China’s Reform) (Beijing: Citic Publishing Group, 2012), 20.


of the reforms launched by the 3rd Plenum is not known, but it is reasonable to expect that for some years to come, at least the five large commercial banks will remain under majority government ownership control. Perhaps, as advocated by some in the World Bank, one of the five might be privatized as an experiment, but most observers believe that the government will be reluctant to give up a substantial portion of its control over these “commanding heights of the economy.” Aside from licensing new private banks, privatization of existing state- owned banks will likely start with the lower tiers of the system, not with the large state banks.

The spectacle of enormous, out- of- control banks in New York and London causing damage to their national economies and requiring taxpayer bailouts over the past few years is unlikely to persuade Beijing policymakers of the wisdom of wholesale adoption of privatization for the largest Chinese banks.

Financial Authorities

The Party sets economic policy and oversees the state balance sheet, the Party- controlled state apparatus owns most of the banks, the Party through the Organization Department appoints the senior management of most banks, and the Party appoints the governor of the central bank and the head of the regulatory authorities. Owner, manager, and regula-tor are all the same— the Party. In such a system, how can there be effective supervision of the financial system and of bank operations?

Developing a “regulatory state” has indeed been problematic in China, with many regulatory agencies subordinated to the political or economic objectives of the indus-tries that they are supposed to regulate— regulatory capture. The various problems in recent years in food safety, coal mine safety, toy safety, enforcement of environmental standards, etc. shows the weakness in China of the regulatory state. Yet China’s central bank and banking regulator have both established over the past decade reputations for competency, and, although they certainly are not de jure independent, they have not become “subordinated regulators”. They have acquired a significant amount of de facto independent authority in their work. The authority that they have acquired stems from the specialized expertise they possess, the importance that the financial industry has for the success of China’s overall economic development, and the quality of the people who have been attracted to work in them.

The two principal state bodies responsible for overseeing the banking system are the People’s Bank of China (PBOC), with a macroeconomic management role, and the China Bank Regulatory Commission (CBRC), which split off as a separate organization from the PBOC in 2003 to perform bank regulatory functions.

The governor of the PBOC holds ministerial rank and reports to the State Council directly. The PBOC was established in 1948 and functioned as China’s monobank during the first three decades after establishment of the PRC. Only in 1983 did it legally assume


a new role as a central bank, with commercial banking operations split off into other banks. Its central bank functions were then codified by the Central Bank Law of 1995, revised in 2003.

The Central Bank Law mandated fourteen functions for the PBOC to perform, the five most important of which are:

• Formulating and implementing monetary policy in accordance with law• Issuing the Renminbi and administering its circulation• Regulating financial markets, including the interbank lending market, the inter-

bank bond market, foreign exchange market and gold market• Preventing and mitigating systemic financial risks to safeguard financial stability• Maintaining the Renminbi exchange rate at adaptive and equilibrium level, and

holding and managing the state foreign exchange and gold reserves.12

Today the PBOC is widely viewed, both domestically and internationally, as a competent central bank that has over the years built up expertise and authority in the area of mon-etary management. This was not true in the ’80s, when the PBOC was feeling its way in the transition from being a government cashier in the planned economy to the market socialist economy, in which it must proactively and effectively control the monetary and foreign exchange operations of the country.

In their study, The Rise of the People’s Bank of China: The Politics of Institutional Change, Stephen Bell and Hui Feng have analyzed the development over three decades of the PBOC’s institutional authority and the respect that it now enjoys. In their view, the development of the PBOC’s power stemmed from three factors: first, the shock of infla-tion crises, which clearly required the services of a competent central bank to handle; sec-ond, with increasing economic and financial complexity, leadership’s recognition of the importance of the specialized expertise of the central bank to support smooth economic growth; and third, the skill with which senior management of the PBOC over the years took advantage of opportunities to increase bureaucratic power, employing techniques of “bargained gradualism” and developing strong informal relations of mutual trust and dependence with the top leaders of the country.13

In the late 1970s, as China was commencing Reform and Opening, there was a spurt of inflation— something that had not been a problem under the command economy. This paved the way for the establishment of the PBOC as the central bank in 1983. But during

12 People’s Bank of China website, http:// www.PBOC.gov.cn/ publish/ english/ 952/ index.html, accessed June 4, 2015.

13 Stephen Bell and Hui Feng, The Rise of the People’s Bank of China: The Politics of Institutional Change (Cambridge, MA: Harvard University Press, 2013). This is a sound, well- researched and comprehensive study on which I have relied extensively in discussion of the PBOC. Chapter 11 of their book, which discusses the banking system, is an area in which Bell and Feng seem to have done less personal research and so reach some

http://www.PBOC.gov.cn/publish/english/952/index.html


the 1980s, in the words of Bell and Feng, monetary “policy innovation and the develop-ment of the PBOC were constrained by the policy legacies of the past such as centralized credit controls, by the gradualist dynamics of the transition economy, by China’s imma-ture financial markets and its managed exchange system, and by its hierarchical politi-cal and administrative order.”14 The PBOC’s authority developed only slowly during the 1980s, in part because its importance was not yet fully grasped, and in part because of the fragmented political power structure that I have noted existed during those early years of Opening and Reform.

The next two inflation shocks came in the late ’80s and early ’90s. These shocks made clear the importance of the central bank to the economic management of the country, and indeed to the power of the Communist Party. Inflation is believed to have been one of the factors underlying the student disturbances in the first half of 1989. Additionally, Party leaders had memories of the hyperinflation of the late 1940s, which was one of the causes of the downfall of the Nationalist Government. The appointment of top Shanghai technocrat Zhu Rongji to the position of governor of the PBOC, in addition to the posi-tion of deputy prime minister, which he held at that time, showed the importance that the State Council now accorded to the PBOC, for this was the first time that a really senior Party leader had been appointed to this office. Zhu Rongji moved on to become prime minister before long, but his successors as governors of the PBOC, Dai Xianglong (served 1995– 2002) and then Zhou Xiaochuan (served 2002– present), were protégées of Zhu and were trusted by Wen Jiabao as well. Recognition of the need for financial stability led to the Central Bank Act of 1995, the commencement of banking reform over the next few years, and expansion of the scope of authority of the PBOC, enabled by the more unified power structure that came into being with the Jiang- Zhu government.

Moreover, the PBOC was attracting top talent into its ranks, many with higher degrees in economics and finance from overseas universities and English language flu-ency. These bright technocrats steadily developed their understanding of the economic framework for effective monetary policy and foreign exchange management. All over the world, politicians rely on the arcane specialist knowledge of central bank experts in mon-etary policy— it is rare that political leaders possess the specialist knowledge to handle these issues with competence and confidence themselves. This dependence of Party lead-ers on PBOC technocrats led to close lines of communication with the political leaders of China. The PBOC leveraged these connections to increase the authority and influence of the PBOC as a key player in economic policy formulation and implementation.

The governor’s term is for five years. By 2012, when Hu and Wen passed the leadership of the Party and the nation to new leaders, it was widely speculated that Zhou Xiaochuan, who by then was over retirement age of 60, would be replaced by a new governor chosen

conventional but, in my opinion, unsupported conclusions. Shortcomings of Chapter 11 should not, however, detract from the value of the rest of the book.

14 Bell and Feng, The Rise of the People’s Bank of China, 35.


by the new leadership. This did not happen. Evidently Zhou’s performance, his relation-ships with other stakeholders, and his international image, have made him for the time being indispensable, resulting in appointment to a third term as governor.

Unlike central banks of many other countries, and in contrast to current global ortho-doxy, the PBOC is not independent of political control. Despite the broad sweep of its responsibilities under the Central Bank Law, important decisions concerning monetary policy must be approved at the level of the State Council. Nonetheless, Bell and Feng point out that the command of the arcane expertise underlying monetary policy and exchange rate movements give the “PBOC the initiative in setting the policy agenda by proposing policy. . . .”15

Among the various responsibilities with which the PBOC is tasked, price stability and hence fighting inflation and managing the foreign exchange rate are the priority tasks. The technocratic managers of the PBOC, many with Western degrees, have been lib-eral in their thinking, favoring opening the banking system to foreign investment, giving greater scope to market forces, and moving toward a more open capital account. This would not only open up China’s financial sector to broader market forces but would also provide the PBOC with more tools for effective exercise of price- based management of monetary policy. In advocating these policies, however, the PBOC’s technocrats have often come up against other stakeholders who favor a monetary and foreign exchange regime more closely controlled by the government, either to maintain an undervalued exchange rate in support of exports or to keep fixed interest rates low in support of cheap funding of SOEs and local projects. The PBOC has therefore learned to take a gradualist approach, bit by bit advancing its policy agenda in debates with other stakeholders.

The Ministry of Finance (MOF) is another stakeholder in the banking sector, albeit with much less direct supervisory influence. According to the State Council’s website:

The Ministry of Finance of the People’s Republic of China is the national executive agency of the Central People’s Government which administers macroeconomic policies and the national annual budget. It also handles fiscal policy, economic reg-ulations and government expenditure for the state… . The Ministry of Finance’s remit is smaller than its counterparts in many other countries.16

Not a word about banks in its remit, but, as noted above, it is a direct shareholder in two of the large banks, and in all four, plus Everbright Bank, MOF- controlled Hui Jin has a shareholding.

Some scholars have described an ongoing struggle for policy influence and control over the banking system between the PBOC and the MOF. Through its shareholdings in the

15 Bell and Feng, The Rise of the People’s Bank of China, 54. 16 State Council website, http:// english.gov.cn/ state_ council/ 2014/ 09/ 09/ content_ 281474986284115.htm,

accessed June 5, 2015.

http://english.gov.cn/state_council/2014/09/09/content_281474986284115.htm


banks, the MOF formerly had influence in the banking sphere. In 1998, the first govern-ment bailout of large banks was undertaken by the MOF using budget funds. When this bailout did not resolve the problems of the banks, the PBOC was allowed to undertake the second, and much more thorough bailout, using funds from the foreign exchange reserves under its management. This bailout succeeded and in the process heavily diluted MOF holdings in the banks. The MOF lost influence. The PBOC then proceeded to introduce reforms in the banks, impose market discipline, and bring in foreign strategic investors, as described earlier in this book.

A reaction against the PBOC’s initiative gained strength in 2005– 2006, particularly from the conservative wing of the Party, and from some in the intellectual community who accused the PBOC of selling out national assets to foreigners at cheap prices. The Hu- Wen government then attempted to preserve balance among conflicting stakeholders and restore to the MOF some power over the banking sector. Whether or not this shift-ing of power and influence over the banking system has impacted the speed of financial reform or not, as is maintained by Walter and Howie, and to a certain extent subscribed to as well by Bell and Feng, does not seem to me to be clearly supported by the evidence. At any rate, at the present time, with Lou Jiwei heading the MOF and Zhou Xiaochuan still heading the PBOC, both organizations are led by pro- change reformers.

While the PBOC is in charge of looking after stability of the financial system through the monetary and other policies under its remit, three organizations are involved in regu-lation of financial institutions themselves: The China Securities Regulatory Commission, established in 1992, the China Insurance Regulatory Commission, established in 1998, and the CBRC, last to be established. All three report directly to the State Council. The CBRC is responsible for supervision of all lending institutions in China and for ensuring that banks have adequate corporate governance, sufficient capital, competent manage-ment, and proper risk controls. As China’s strategic priority for financial sector devel-opment has been heavily skewed toward banks, with the equity and insurance sectors lagging behind significantly in scope and development, the CBRC has played the domi-nant role in regulating financial intermediation in China.

Discussion is now underway to combine the three regulatory agencies under one roof in order to achieve more effective and comprehensive coordination of the entire financial system and all its parts. With the emergence of new digital forms of intermediation, such as P2P (peer to peer) lending, areas of the financial system are growing rapidly with no government body taking regulatory ownership. This is potentially quite dangerous and needs to be addressed in any reconfiguration of financial regulation.

Memories of the turmoil in the banking system in the 1990s and of the enormous financial burden that the government assumed in reconstituting the system through bail-out and recapitalization are fresh, ensuring the CBRC’s influence and power as a priority agency of the government, a lynchpin in economic development strategy. Its mandate has been to guide the development of a modern banking sector and to ensure that never again would there be a meltdown of the banking system such as had occurred in the


1990s. In addition, CBRC guides banks in conducting their operations so as to support broad financial development objectives, such as increasing financial depth, support of SMEs, etc.

Leadership and staff of CBRC was recruited from the “best and the brightest,” start-ing with the Chairman, Liu Mingkang, who headed CBRC for its first ten years until his retirement in 2012. A career banker, he started his financial career with the PBOC in 1979, first in China, and then from 1984– 1987 at the London branch of the PBOC. While working in London, he at the same time earned his MBA at the City University of London. Returning from abroad, he served five more years in the PBOC in his native Fujian Province, before being appointed vice- governor of the province. He then rotated between postings with the PBOC, the China Development Bank, and the provincial government. From 1999 to 2000 he was Chairman of China Everbright Bank, then became Chairman and Party Secretary of the much larger Bank of China. From Bank of China, he became the first chairman of the newly created CBRC. Liu was superbly well qualified through international and domestic professional experience in a variety of posi-tions, mostly related to finance, to be the first head of the CBRC.

Under Liu’s dynamic leadership, in the short space of one decade, the CBRC has become a powerful and competent regulatory agency, with a strong record of keeping banks out of trouble through relentless pressure on raising standards of corporate gov-ernance, capitalization, internal controls, and risk supervision. In 2010, his achievements were recognized by the Global Association of Risk Professionals, which jointly awarded CBRC and Liu personally its Risk Manager of the Year award for the work they had done in 2009.

Where Western bank regulators stipulate what banks should avoid doing in the inter-ests of stability, the CBRC has gone much further, not only prohibiting certain activities regarded as too risky, but directing the banks in what they should be doing. He Wei Ping, who has written a carefully documented study entitled Banking Regulation in China, aptly comments that Chinese “regulatory authorities tend to have a sense of ownership of banks which is reflected in their approach to regulating them.”17

As a result, the CBRC is sometimes criticized by Chinese bankers for excessive cau-tion, for stifling financial innovation, for exercising too much “parental guidance,” and for interfering with the competitive forces of the market economy. The IMF has recently published a study of conflict between financial development and financial regulation, not with respect to this debate in China, but on a worldwide basis. It concluded that “there is very little or no conflict between promoting financial stability and regulatory frameworks as financial development proceeds.”18 While this is not a judgment on the

17 He Wei Ping, Banking Regulation in China: The Role of Public and Private Sectors (New York, NY: Palgrave MacMillan, 2014), 3.

18 “Rethinking Financial Deepening: Stability and Growth in Emerging Markets,” IMF Staff Discussion Note, May 2015.


particular Chinese situation, in the IMF’s view, surveying the situation in countries around the world, there is no inherent conflict between innovation and regulation in the financial sector.

Whatever the merit of criticisms of the CBRC for excessive zeal, the banking system has flourished under CBRC guidance, with vastly improved financial intermediation ser-vices for the economy and the average Chinese citizen compared with just ten years ago. The CBRC’s caution reflects the mandate that it has from the government to ensure that the system does not get derailed again by banks assuming excessive risk. It also reflects China’s view of the financial system as being an instrument of economic growth, not as an end in and of itself.

This brief overview of how the Party and the government control and supervise the banking system shows the pervasive reach of the party- state into the process of finan-cial intermediation in China, even in the case of the three privately owned tier 1 banks, Minsheng, Pingan, and Zheshang. Five new private licenses for banks have now been issued, and the banks are being established. We should not imagine that these private banks will operate with the same independence from the state as would their counter-parts in the West. They will be able to maneuver and innovate more than would their state- owned competitors, in the expectation that this freedom will enable them to spur the entire system to higher levels of efficiency and performance. That indeed is why they are being licensed. But that freedom will be circumscribed whenever the state and its agencies feel reining them in to be in the general interest.

166

Returning to a basic concept of finance discussed earlier in this book, banks exist to support the economy by channeling, or intermediating, the flow of money from savers to borrowers and by providing a mechanism for payments. Up to this point, the narrative has revolved around the tier 1 banks, as they have been and remain the dominant play-ers in financial intermediation in China. Aside from the tier 1 banks, however, several other bank and nonbank financial institutions also perform financial intermediation. Additionally, savers can channel their savings to productive purposes through the finan-cial markets— direct funding of final users of funds, not flowing indirectly through inter-mediaries to ultimate users. Finally, the effective provision of both indirect and direct funding must be underpinned by a supporting infrastructure including legal framework, law firms, accountants and auditors, credit rating agencies, and others.

This chapter briefly surveys the financial structure of China beyond the giant tier 1 banks that have been the focus of this book thus far. The objective of this chapter is to demonstrate that, given the transformation of China’s tier 1 banks, further development of China’s financial structure will depend less on improvement of the capabilities of the tier 1 banks, and more on development of lower tiers of banking, on development of financial markets, and on upgrading of the financial infrastructure, all in line with the

8 Financial Structure: Deep but Narrow

The democratization of finance is a route to the good society, and the democratization of

banking is a trend— admittedly slow and long term— that should play an important role in

that process.

Robert J. Shiller, 20121

1 Robert J. Shiller, Finance and the Good Society (Princeton, NJ: Princeton University Press 2012), 44.

Financial Structure: Deep but Narrow 167

recommendations of countless scholars and practitioners, both Chinese and foreign, and set forth in the resolutions of the 3rd Plenum of 2013.

Economist Huang Yiping of Peking University concisely summarizes what finan-cial reform (of the entire financial system, not just the banks) had accomplished by 2012: “Chinese financial reform was relatively strong on building frameworks and expanding sizes of the financial system, but relatively weak on improving quality and liberalizing the markets.”2 In other words, almost the entire edifice of a total financial system has been put in place, recognizable to someone familiar with the financial systems of Western countries, but the quality of the components of the financial system varies, and the entire financial system remains heavily under government control, as discussed in the previous chapter. The financial system has not been liberalized to the same extent as some other areas of the economy— the “asymmetric liberalization of product and factor markets.”

The extent and quality of development of China’s financial system can be broken down into four areas: financial deepening, financial inclusiveness, financial broadening, and financial infrastructure quality. Each of these perspectives will be considered in turn in the sections that follow. (Referring to Huang Yiping’s comments, it should be noted that these financial areas can be developed with either more or less state involvement— a con-troversial issue further considered in Chapter 11.)

Financial Deepening and Financial Inclusiveness

Financial depth describes the extent to which provision of financial services penetrates the economy, generally measured by the ratio of financial assets to GDP. A proxy for this is the ratio of broad money supply M2 to GDP. Compared to other countries in its pres-ent phase of economic development, China has achieved a high level of financial depth. Huang Yiping points out that by 2010, the M2:GDP ratio had reached 180%, exceeding the comparable ratio in the United States.3

Related to financial depth is financial inclusiveness, also called financial access, which is a measure of the availability and ease of access of financial services, particularly credit, to all sectors of society and of the economy. Financial systems providing access to lower income rungs of society and smaller enterprises are believed to contribute to poverty reduction and narrowing of income inequality and to stimulate overall economic growth by generating employment and mobilizing more of society in productive economic work. Although financial access in China still needs to be increased, expanding provision of financial services to lower- income groups has been a major achievement of China’s

2 Yiping Huang and Xun Wang, “Financial Development and Economic Development in China,” in China’s New Role in the World Economy, eds. Yiping Huang and Miaojie Yu (London: Routledge, 2013), 124.

3 Yiping Huang and Xun Wang, “Financial Development and Economic Development in China,” 123.


financial development over the past few years; China’s level of financial access compares favorably with that of other nations at comparable levels of development. How effective this financial access expansion has been in accomplishing broader policy goals of poverty reduction has not yet been clearly demonstrated by rigorous statistical analysis.4

In recent years, analysts and media have criticized banks’ disproportionate lending to SOEs and large private companies, restricting access by SMEs and micro- businesses to credit. How valid is this criticism? In earlier years the criticism was justified. Banks had little appetite for lending to the private sector, and especially to smaller private sector firms. The risks were considered high, and the rewards limited when it was so easy to lend money to the state- owned sector with implied state guarantee.

The government, however, has in recent years understood that providing inadequate credit to the private sector, and especially to the enormous number of smaller enter-prises that are the most dynamic players in the economy, was a constraint on growth. Government moral suasion through the PBOC and the CBRC was brought to bear on banks to increase SME lending. As mentioned earlier, this coincided with recognition on the part of bank managements, starting with Minsheng Bank, that lending to SMEs rep-resented a significant opportunity for new business and profit. Government policy and suasion and commercial insight therefore combined to spur bank lending to the SME sector, and ultimately into the micro- business sector as well. In addition to encouraging tier 1 banks to increase exposure to SMEs, the government has licensed several kinds of local financial institutions throughout the country, specifically targeted to serve small businesses and farming, most particularly village and township bank and small loan companies.

Definitions of SMEs and micro- enterprises, and of maximum micro- credit loan size, vary around the world, depending on economic conditions and policy objectives in dif-ferent countries. Exploration and comparisons of these definitions quickly becomes very confusing, and not very productive, except for the specialist. For purposes of this analysis, I assume that definitions reasonably reflect the policy environments of different coun-tries, and that the Chinese definitions can be taken as defined by consensus among sev-eral Chinese government agencies in 2011. The trends over time in broadening access are the key factor. As of the end of 2014, the CBRC, which now reports “small and micro” lending not including “medium,” reported that small and micro loans totaled 20.7 tril-lion yuan, accounting for 23.9% of total financial institution credit extension. This was an increase in loan volume of 17.5% over the prior year— 4.2% faster than the average increase in total credit extension. Financial institutions had a total of 11.1 million small and micro business loan accounts, an increase in the customer base of 9.4% over the prior year.5 Critics who harp on lack of access of small businesses to credit have failed to note

4 Personal communication from Ed Wu, formerly Director of the China Program of Planet Finance, October 27, 2015.

5 China Banking Regulatory Commission, 2014 Annual Report (Chinese version) (Beijing: China Financial Press, 2015), 58.


these numbers steadily increasing over the past six years. Moreover, these numbers do not capture the use of credit cards by SMEs as a form of short- term credit for their businesses, which, if included, would increase the figures for SME access.

Strong competition amongst the banks to develop portfolios in this sector has increased SME access to bank funding. But SMEs have a high failure rate, so SME lending, par-ticularly in an immature and rapidly evolving market such as China, is the riskiest part of banks’ portfolios. There is a presumption among non- bankers that all deserving SMEs, or entrepreneurs in general, should have access to bank credit. This presumption also seems to be shared by many economists in the government whose economic expertise does not extend to banking. Related to this misunderstanding is the idea that the high interest rates charged in the informal credit markets are unjustified. In fact, those high interest rates are generally a shrewd calculation based on experience of the risk- adjusted returns.

The return to bankers on their loans is a few percentage points spread (profit) over banks’ cost of funds. On a well- secured loan to a stable business, this is an adequate risk- adjusted return, including provision for a few bad loans in the portfolio. It is not an ade-quate return for a loan not well backed with collateral, or to an entrepreneur starting a new business, or to a small company struggling to grow. Such enterprises are not good candidates for bank loans— the spread on the good loans will not cover the write- offs of the bad loans. Joseph Stiglitz and Bruce Greenwald explain that “in the initial period it cannot be ascertained who is a good entrepreneur and will repay the loan and who is a bad one and will not. The bank loses money on the bad entrepreneurs, but may not be able to be adequately compensated by ‘excess’ returns from the good entrepreneurs.”6

Pressuring banks to lend to SMEs can lead to a wave of write- offs, unless the banks have developed means to ascertain SME risk with a high degree of confidence. I have earlier discussed how in the developed U.S. market, with accurate sources of credit infor-mation and generally transparent financial reporting, Wells Fargo Bank has developed the mathematical models for loan extension and pricing to this market. China’s market has probably not matured to the point that the Wells approach could be effectively used (although it may be possible in a few more years).

If Chinese banks are generally not equipped to provide credit to unsecured and very small companies, then other approaches are needed. Non- bank locally based special-ist lenders can play a major role in providing SME credit, which is already happening successfully in China. Even these types of lenders may, however, not be equipped to handle entrepreneurial start- ups. The uncertainties and risks are simply too great. The venture capital industry, which has expertise in securing an equity holder’s, rather than a banker’s, return on capital at risk can fund some start- ups, but in both China and inter-nationally, venture capital primarily concentrates on funding start- ups in leading edge

6 Joseph Stiglitz and Bruce C. Greenwald, Creating a Learning Society: A New Approach to Growth, Development and Social Progress (New York: Columbia University Press, 2014), 77.


technology- type ventures, as this is where the returns for the winners are greatest. For small start- ups in other areas, the view in the micro- finance community is that self- funding from family and friends is probably most appropriate.7

The government could also introduce small business loan guarantee schemes. For example, Thailand has a state- owned Thai Credit Guarantee Corporation, which guar-antees commercial banks extending loans to small and medium enterprises for up to 30% loss on each loan. Thailand also offers special tax incentives for SMEs as well. The Thai government is also encouraging the development of joint public– private venture capi-tal firms supporting SMEs.8 Such schemes might be useful in China not for nationwide use, but instead, in line with the Xi Jinping government’s policy emphasis on eliminating poverty, for targeting pockets of severe hardship, which still exist in China, particularly in more remote inland areas such as Shaanxi and Guizhou.

Starting with the Hu- Wen government, alleviation of rural poverty and narrowing income and wealth inequality has been an economic priority. One tool for accomplish-ing poverty reduction is to extend financial services, and particularly access to affordable credit to poor people, assisting them to develop micro businesses and supporting small farmers. A bewildering variety of financial institutions have been involved in this effort, with success varying by type of institution and region of the country.

At the highest level, almost all of the tier 1 banks have over the past few years aggres-sively launched micro- lending operations, relying principally on mutual guarantee through supply chains. With the exception of the Agricultural Bank of China (ABC) and the Postal Savings Bank (PSB), however, their outreach has been mostly limited to urban areas.

In earlier years, ABC and PSB were collecting deposits in rural areas, but then lend-ing out in urban areas, in effect syphoning funds from needy rural communities into the booming urban areas or, in the case of PSB, placing their funds with the central bank in the form of deposits and buying government bonds. More recently both banks have become more active in lending out funds in rural communities as loans to both small and micro businesses. Compared with the smaller institutions whose rural lending operations are described below, ABC and PSB have superior personnel, IT, and risk management and are considered to now be contributing effectively to rural financial inclusiveness.

Beneath the first tier banks are the city banks, which comprise tier 2 of the system. City banks are generally majority owned directly or indirectly by local governments, but some are privately owned. A few have foreign strategic shareholders, for example, ING of the Netherlands in Bank of Beijing and Scotiabank in Bank of Xian. Quality of city banks varies from first rate to still shaky, which is understandable as they are under control of local shareholders, rather than of national level shareholders.

7 Ed Wu, October 27, 2015. 8 Wicht Chantanusornsiri, “SME Scheme to Add NPL Guaranatees,” Bangkok Post, July 7, 2015.


Supervision by CBRC has strengthened their capabilities, but some still require much improvement, lacking capability to upgrade their IT, meet Basel 3 requirements, and to effectively make use of outside consulting assistance in developing their manage-ment and operations.

Two of the city banks are interesting from the point of view of extending financial inclusiveness: Bank of Taizhou and Tailong Bank are both located in the coastal city of Taizhou in southern Zhejiang Province (Taizhou, a medium- sized city by Chinese stan-dards, is the only city in China to have three city banks). Both banks grew over the course of more than twenty years through the amalgamation of credit cooperatives founded by local entrepreneurs, who have a deep understanding of the needs and ways of local busi-nesses. The prosperity of Zhejiang Province for centuries has been based on small traders and merchants, and today the province is home to a vast number of small manufacturing concerns, located in rural villages, that are nimble in responding to market signals. The southern part of the province in which Taizhou City is located is rocky, hilly land inter-spersed with valleys in which the population congregates in small villages. Agriculture has been difficult, as a result of which Zhejiang people have become adept at small scale manufacturing and trading.

Bank of Taizhou was established as a city bank in 2002 through the merger of eight local credit unions that between them had NPLs amounting to 13% of loan book, at the same time that other credit unions throughout the country were being merged and reconstituted as city banks in order to deal with their high levels of bad debts. At that time Bank of Taizhou had a loan book of around 4 billion yuan. As of the end of 2014 it had grown by more than sixteen times, with total loans of 67 billion yuan. The bank has adhered to its original mission statement to “Change China’s financial system by giving small businesses access to top quality financial services.”

Bank of Taizhou is 95% owned by local private interests, with a 5% share owned by a local district government that does not exert influence. In addition to private compa-nies owned by local interests, the bank’s shareholder roster includes China Merchants Bank with a 14% shareholding, Pingan Group with 10% holding, and Geely Group (automotive) with 10%. The bank’s head office is in the city of Taizhou of Zhejiang Province, but its network of 127 outlets serves several other cities in the province includ-ing the economically important city of Hangzhou. Return on equity has been high even by Chinese bank standards— 25%, with return on assets over 2%. NPLs have remained under 1% for many years. Informal discussion with one of the CBRC officers who for-merly audited the bank confirms that Bank of Taizhou indeed has a remarkably high quality of assets.

The key to the success of the bank has been a clearly defined business model, excellent local credit knowledge, adherence to a successful niche strategy that is adapted to the special economic and social conditions of Zhejiang Province, and intensive training. For centuries Zhejiang has been a prosperous part of China, with major ports along the coast and a strong trading tradition.


In an example of the regional variations and adaptation to local conditions of China’s approach to economic development, Zhejiang has pursued a model different from other provinces— the “Zhejiang Model,” also called the “Wenzhou Model” after one of the important cities in the province, relying on developing privately owned micro and small- scale manufacturing feeding into export supply chains, operating out of the rural villages of the area and resulting in dispersed rural industrialization. Success of these small enter-prises has depended on rapid adaptation to changing export market requirements and innovative production technology to remain cost competitive in global markets. As a result, Zhejiang in 2014 was ranked second after neighboring Jiangsu Province in per capita income among Chinese provinces (not including the cities of Tianjin, Beijing, and Shanghai, which have the highest per capita incomes, but are cities not under the jurisdiction of provinces).

Bank of Taizhou’s business model supports this small- scale dispersed and privately owned rural manufacturing, and the bank’s account management and risk management is built around the village- based nature of Zhejiang’s economy. The average age of the bank’s 7,000 bank staff is 27. Out of total staff, an incredible 4,000 are account managers, indicating that only a minority of staff are in support functions not involved in directly generating revenue through extension of loans. When a new staff member is recruited, he or she first undergoes three months of general bank training. If headed for an account manager position, this basic training is followed by three months of credit and risk man-agement training. In urban areas, one account manager handles 100 clients, but in rural areas the account manager handles a portfolio of 300 clients. Staff are recruited from the locales in which they will work. They understand the local dialect and customs, so are easily accepted by the communities into which they are lending.

The bank restricts itself to business lending, with very little consumer credit. Of the bank’s total loan assets, 80% are composed of loans of rmb 5 million or less, and 99% of the total number of loan accounts are loans under rmb 5 million. Average loan size is rmb 500,000. The basis of credit extension is “knowing the client,” which means under-standing his business, but more important knowing his reputation in the neighborhood, whether urban or village. To accomplish this, the bank integrates itself into neighbor-hoods, sponsoring many community activities. Of total loans, 92% are guaranteed by colleagues, friends, or neighbors who vouch for borrowers’ reliability and ability to repay. Credit scoring systems are not used. This traditional style of grassroots credit evaluation has worked extremely well, as evidenced by the bank’s very low loan default rate. It has also resulted in very good credit access for small and micro entrepreneurs.

In sharp contrast to the tier 1 banks, and many of the other city commercial banks, the Communist Party and the local governments seem to not get involved with Bank of Taizhou. The bank is genuinely under private control, including its personnel decisions. Perhaps this is a reflection of the understanding that official interference in a bank so well attuned to the Zhejiang private enterprise model of economic development would be counterproductive, so the bank is left to get on with its business.


This particular model of lending may, however, be best suited to the special circum-stances of the Zhejiang model of economy, which has not been replicated elsewhere in China. Experimental branches that Bank of Taizhou established in other parts of China, particularly in the outskirts of big cities like Beijing, have not fared as well as the Zhejiang branches. The nature of economic activity elsewhere is different, and so Bank of Taizhou’s lending approach works less well outside of its native area.

Even in its base area of Zhejiang Province, it is not clear whether or not Bank of Taizhou’s model is long- term sustainable. It is highly people intensive. With rising wages, will it be possible to continue to invest the time in tracking the credit reputations of customers on such a close basis? And will Zhejiang’s village- based small manufactur-ing economy itself evolve into more sophisticated and larger scale enterprises, for which larger- scale and more complex financing will be required and can be cost justified? In future years it will be fascinating to watch how the economy of Zhejiang evolves, as China moves away from export- oriented manufacturing of low- value products and moves up the value chain, while at the same time relying less on exports and more on domestic demand to drive national economic growth. How will Bank of Taizhou itself keep pace with the changing requirements of its customer base?

For the meantime, however, the business model of Bank of Taizhou and of its competi-tor Tailong Bank have been outstandingly successful in supporting the real economy of the region, meeting the financial needs of their predominately village- based customer base, and in maintaining high bank profitability and strong balance sheets. Bank of Taizhou and Tailong Bank are among only a handful of privately owned Chinese banks. They have delivered a high return to shareholders while increasing financial inclusion in an economically vital area of the country. In recognition of their success, Tailong Bank was honored by a visit by Prime Minister Wen Jiabao, interested to learn how its business model worked.

Ed Wu, who has been involved for several years in micro- credit work in various parts of China, reports that “there are at least another 30 or so second and third tier financial institutions in various areas of China that have succeeded in providing credit to small and micro businesses.”9 That is a very small number of institutions in the totality of Chinese finance, but perhaps over the next few years, to support the national drive to eradicate poverty, their example will be taken up by others on a broader scale.

Financial Broadening: Bond Markets

Financial broadening is the provision of nonbank financial institutions and of channels of direct finance through financial markets to supplement indirect financing through banks and other intermediaries. As Huang Yiping points out, China’s financial framework is in

9 Ed Wu, October 27, 2015.


place; almost all the important financial markets and financial institutions exist in China and have existed for some years: equity markets, bond markets, venture capital firms, and insurance companies, etc. Aside from first tier banks, however, these nonbank institu-tions are not yet functioning as effectively as they should. China depends excessively on tier 1 banks for funding of the economy.

Economist and Nobel laureate Robert J. Shiller explains that this phenomenon is not confined to China. Provision of indirect finance through banking works “especially well, relative to direct borrowing from the public, in less- developed countries, where there are fewer analysts, rating agencies, and newspapers and magazines to provide evaluation of investments. Hence banking plays an even bigger role in the economies of less- developed countries.”10 Calomiris and Haber corroborate this view: “No financial system has devel-oped bonds and stock markets without first developing a banking system.”11

The brief description that follows does not purport to be a comprehensive survey of China’s financial markets. It simply sketches how development of non- banking financial markets will impact banks. Financial markets affect banks in various ways. The policy to reduce dependence on bank funding requires efficient, deep, and mature capital markets as alternative sources of funding for businesses and alternative savings outlets for deposi-tors. Bubbles in the stock market can rebound on banks through interconnections of banks and financial markets— principally margin lending and exposure directly or indi-rectly to the financial markets by bank clients. In the United States, the “crash of 1929” is the classic example. In 2008, the opposite occurred; U.S. banks got into trouble, which worked its way into the securities markets.

I have noted that the Anglo- American model is an outlier at one end of a spectrum of different models of finance. In the United States and United Kingdom, the equity and bond markets play a more important role in total economic funding than in most other major economic systems. Although the United States and United Kingdom are outliers on the spectrum of providing direct funding through capital markets compared with German, Japanese, and other models in which indirect finance through bank inter-mediation is more important, nonetheless, the long established history, the openness to international investors and listing companies, the robust supporting infrastructure, the independence from government intervention, and the sheer size and depth of the New York and London financial centers gives prominence and visibility to the Anglo- American model. In Germany and Japan, although both have large equity markets, bank lending remains the dominant source of funding for the economy.

In the first thirty years of Reform and Opening, China has been an outlier on the opposite end of the spectrum from the Anglo- American model. Banks have funded around 80% of China’s economic growth over thirty years. In no major economy in the

10 Shiller, Finance and the Good Society, 42. 11 Charles W. Calomiris, and Stephen H. Haber, Fragile by Design: The Political Origins of Banking Crises and

Scarce Credit (Princeton, NJ: Princeton University Press, 2014), 23.


world are banks more significant in the economy than they are in China. Over the past decade it has become apparent to policymakers and experts in finance and economics that China’s reliance on indirect finance, while it served the country well for many years, is no longer desirable. The country should “debank,” increasing direct channels of fund-ing for the real economy. This means giving a greater role to the equity markets and bond markets, and to a lesser extent to venture capital.

How far China should move along the indirect- direct funding spectrum, and at what speed, are undetermined, but the direction of movement is clearly stated in the reform resolution of the 3rd Plenum in 2013, which states “We will improve the multi- layer capi-tal market system, promote reform toward a registration- based stock issuing system, pro-mote equity financing through diverse channels, develop and regulate the bond market, and increase the portion of direct financing.”12

Although they have grown significantly in the past few years, bond markets remain the most underdeveloped portion of China’s overall financial structure, both in size and in efficiency. The different development trajectories of financial markets in different countries generally have historical origins. With its long historical memories, China is no exception. Zhiwu Chen of Yale and Tsinghua Universities explains that traditionally China’s financial strategy was to foster fiscal surpluses and savings. During the latter half of the nineteenth century, under the impact of domestic rebellions and foreign aggres-sion, the fiscal surplus dried up. The fiscal surplus and savings- oriented tradition “had prevented China from developing a domestic bond market, and hence limited late Qing China’s debt capacity. Without well- developed debt markets, especially without a long bond market, the Qing government did not have the means to smooth the impact of a large fiscal shock and spread the lump- sum war reparation over many years.”13 The only issuance of domestic government bonds occurred in 1853 to finance suppression of the Taiping Rebellion, which devastated central China over several years, resulting in enor-mous loss of life. Local gentry were induced to subscribe to these bond issues. The Qing government later reneged on these bonds, which made it impossible thereafter for the government to again raise money in the domestic market.14

As a result, in order to pay reparations to foreign powers after the Sino- Japanese War and then the Boxer Rebellion at the end of the nineteenth century, China had to resort to issuing foreign bonds to be subscribed by the very nations levying the reparations. This resulted in handing over control of large portions of national tax revenue to for-eign investors as security. Later the government of the Republic of China defaulted on several domestic government bonds. Today these painful memories from the Qing Dynasty and the Republican period suggest caution in permitting governmental units

12 “Decision of the Central Committee . . . ,” 10. 13 Zhuwu Chen, “Financial Strategies for Nation Building,” in Capitalizing China, ed. Joseph H. P. Fan and

Randall Morck (Chicago: The University of Chicago Press, 2013), 321– 322. 14 Zhiwu Chen, “Financial Strategies for Nation Building,” 327– 328.


and corporations to issue bonds, since they have in the past resulted in loss of sovereign control.

Another factor that has dampened official interest in encouraging lively and free trad-ing in an open bond market is that it would lead to a market- determined risk- free interest rate. In the interest of the policy of financial repression, the government has wished to keep setting of interest rates firmly within its own control through the central bank and the state- owned banking system. If independent traders in the bond market were to set the interest rate on bonds through market pricing, then the interest rate set through the banking system would no longer be the sole interest rate in the market.15

Chinese bonds are broadly divided into three categories: government bonds and cen-tral bank notes, financial bonds, and corporate bonds. Bonds are traded in two exchanges, the Interbank Bond Market, regulated by the PBOC and previously accounting for 95% of all trading, and the much smaller Exchange Bond Market, regulated by the CSRC, which is now starting to grow at a rapid rate as CSRC approves more and more corporate bond issues.16 Investors in bonds are almost entirely institutions, principally commer-cial banks, which hold 70% of bonds, and insurance companies, non- financial compa-nies, and other institutions accounting for the remainder. Individuals do not hold bonds directly, although they now hold them indirectly through purchase of commercial banks’ wealth management products, some of which are invested in portfolios of government and other bonds.17

Government bonds are under the purview of the PBOC. For many years government bonds have basically meant Ministry of Finance and PBOC instruments, as local gov-ernments were, with a few exceptions, prohibited from issuing bonds, due to fear that irresponsible issuances of bonds by local governments would compromise national fiscal integrity. Local governments were limited in funding to distribution of tax revenues from the center and to miscellaneous local sources of revenue, such as land sales. Were local governments able to issue their own bonds, then it was feared that the central govern-ment’s ability to exercise financial discipline over local governments would have been weakened.

In one of the more important reform measures being undertaken by the Xi govern-ment, local governments are being allowed to issue their own bonds. Beijing recognizes that local governments need more control over their finances if they are to undertake major investments in support of the government’s urbanization program. Moreover, the previous prohibition on local governments borrowing or issuing bonds simply resulted in local governments establishing corporations to act as “lending platforms” to take on

15 Carl Walter and Fraser Howie, Red Capitalism: The Fragile Foundations of China’s Extraordinary Rise, 2nd ed. (Singapore: Wiley & Sons, 2012), 98– 118.

16 Private communication with Xu Jun, October 30, 2015. 17 Goldman Sachs, “FAQ: China’s Bond Market,” http:// www.goldmansachs.com/ gsam/ glm/ insights/ market-

insights/ china- bond- market/ china- bond- market.pdf, accessed July 11, 2015.

http://www.goldmansachs.com/gsam/glm/insights/market-insights/china-bond-market/china-bond-market.pdf

http://www.goldmansachs.com/gsam/glm/insights/market-insights/china-bond-market/china-bond-market.pdf


debt. That debt then did not transparently show on local government books or in their budgets, leading to control problems. Additionally, the stimulus of 2008– 2009, largely funded through bank loans to local governments, has left the banks with an overhang of relatively short- term loans to local governments that cannot be serviced within the stipulated loan time frames by the cash flows generated from the projects in which the local governments invested. Part of the solution to this maturity mismatch will be to issue longer- term local government bonds to repay the bank loans. According to central gov-ernment audit, at the end of 2014, local government debt totaled 18 trillion yuan, which was one quarter of that year’s GDP.

The problem of local government debt has been recognized ever since the stimulus was unleashed in 2008– 2009. The cautious and deliberate manner in which the govern-ment has gone about resolving the problem reflects what I have identified as trademark Chinese government caution. Within months of the loans being granted, the CBRC, concerned with deterioration of bank loan quality, began demanding special reporting from the commercial banks on a periodic basis of all local government loan extensions and analysis of potential problems. It was only after the Xi government took office that steps were actually taken to deal with the problem. The first step was to spend the year 2014 establishing the full extent and the details of local government debt throughout the country. Only when the parameters of the problem were understood did the government begin to replace bank loans with bonds.

In accordance with Chinese preference for piloting major new initiatives, in 2014 a select few provinces and cities, including Beijing, were permitted to issue up to a total of 100 billion yuan in bonds. Upon the conclusion of those pilots, in 2015, the central gov-ernment expanded the scope of local government bond issuance to 1 trillion yuan, imple-mented in the form of swaps for bank loans. In other words, banks substituted bonds for loans on their books. This market can be expected to steadily expand over the next few years, with local governments issuing bonds at a small premium over the rate charged for central government obligations.

One difficult issue being worked on is how to avoid moral hazard in local government bond issues. China does not have a federal system of government, such as the United States has. In the United States, the cities Fresno, Stockton, and Detroit independently default on bonds and go bankrupt without impact on state and national- level govern-ments. But local government bodies in China do not have independent existences— they are all parts of the sovereign national government. Default by a local government is in effect a default by China. As of the time of writing of this book, the legal framework for providing for local government bankruptcy was still being worked on.

Financial bonds are a large but particular category: bonds of the three special pol-icy banks, and most particularly of the China Development Bank, which, in the 1990s, began to issue an enormous number of bonds, then on- lend the proceeds to local govern-ments to finance infrastructure projects, and to foreign countries in support of Chinese government foreign policy (particularly to countries such as Venezuela and Ethiopia).


The government’s objective in establishing the policy banks is to remove the burden of supporting long- term infrastructure projects from commercial banks. With the princi-pal exception of bank lending under the 2008 stimulus, banks have been able to avoid supporting infrastructure that is properly the responsibility of the policy banks, but the banks are still indirectly exposed, as China Development Bank cannot take deposits, and hence is funded by issuance of bonds, most of which are held on the books of the com-mercial banks.18

Corporate bonds got off to a bad start in the 1990s, when a number of locally owned SOEs were free to issue corporate bonds. In an undisciplined environment, a number of these defaulted, resulting in the central government stopping corporate bond issuance for a number of years. Corporations have subsequently resumed issuing bonds of two types: corporate bonds issued by listed companies, approved and regulated by CSRC; and enterprise bonds, issued by large SOEs, approved by the NDRC.

Outstanding corporate bonds have grown from rmb 6 trillion in 2005 to rmb 35 tril-lion ($4.2 trillion) in December 2014, with rapid growth over the past year, especially in the Exchange Bond Market as CSRC encourages corporations to issue bonds. Despite this rapid growth of bond volumes in recent years, bonds remain a much smaller portion of total funding of the economy than equity or bank loans and make a smaller contribu-tion to total economic funding than in other major countries. China’s bond market is now the third largest in the world, ahead of France, Italy, and Germany, but dwarfed by the enormous bond markets of Japan and the United States.

The principal obstacles to the development of a more sophisticated and dynamic bond market are the absence of a risk- free rate off of which bonds can be priced in the primary and secondary markets and the absence of a larger pool of investors. Large SOEs, issuing enterprise bonds, have in the past found it easier and no more expensive to simply take out loans from the commercial banks instead of issuing bonds. That situation may now be changing as the government bit by bit removes the implicit guarantee behind SOE bor-rowings, which will cause banks to become more discriminating in credit extension and pricing to SOE clients. SOEs may then find the bond markets more attractive as sources of funding, lowering their reliance on bank loans.

Other problems include the existence of two exchanges for trading, low trading volumes, multiple approving agencies, weak credit rating system, and lack of clarity in the corporate bankruptcy process. Two factors will spur the government to fur-ther develop the bond market. First, the government needs an active bond market to absorb issues of local government bonds as their volume grows in coming years. Second, internationalization of rmb will require a liquid and internationally open bond market where foreign holders of rmb could place their rmb holdings. Eventually there is no doubt that bond markets will play a much bigger role in Chinese finance

18 Walter and Howie, Red Capitalism, 126– 131.


than they do today, and bonds will be held much more widely, including by foreigners, than they are today.

Financial Broadening: Equity Markets

Aside from the bond market, the other major capital market is the equity market. Curiously, the government has been more supportive of equity market development than bond development, seeing it as a good way to tap national savings to provide equity capital for SOEs, and later for private companies as well. Nonetheless, the generally high quality of development and oversight of the first tier banks described in this book is much less in evidence in the equity markets. For a government that prizes stability, the boom and bust of the Shanghai market over the period 2014– 2015 must be disappointing.

China’s two main equity exchanges, Shanghai and Shenzhen, were established in 1990 and 1991, respectively, and the China Securities Regulatory Commission (CSRC) was carved out of the PBOC and established as a separate regulator in 1992, a full ten years prior to the establishment of its sister organization the CBRC. The markets were estab-lished after careful study of the Hong Kong, European, American, and other markets. The regulatory frameworks of those markets were largely copied in establishing the Chinese markets. International best practice was incorporated in the regulations, but implemen-tation of the regulations has been deficient.19 In their first twenty years, China’s equity markets were characterized by high trading volatility, with short periods of boom (2001 and 2008) in share prices followed by sharp drops and then lengthy periods of sluggish trading and depressed share prices. After the market collapse in 2009, share prices traded for several years in a limited range until the boom of 2014– 2015.

The most significant exchange is the Shanghai exchange, where Chinese companies’ shares are called “A shares,” as opposed to Chinese companies’ shares on the Hong Kong exchange, which are called “H shares.” The Shenzhen exchange is much smaller, but it also contains the ChiNext Board, which was set up in 2009 to provide listings for smaller, more speculative private companies, largely in the technology sector. Last, there is an over the countermarket, called the New Third Board, on which many young companies are traded. The listing process on the New Third Board is simple compared with the bureaucratic approval process for the two major exchanges, as a result of which the num-ber of listings on this over the counter exchange has been growing quickly.

In 2006, economist Xiao Geng wrote that the equity markets required a “complete reform package. In setting and implementing policies, the government should not be overly concerned with market prices, but instead should emphasize the competitive

19 Xiao Geng “Development of China’s Capital Markets” (first published January 14, 2006, in the periodical Zhengquan shichang zhoukan), in Xiao Geng, Zhongguo Jing jide Xiandaihua (Modernization of China’s Economy) (Nanjing: Phoenix Publishing and Media Group, 2012), 121– 122.


market mechanisms and the government’s management of risk that underlie controlling market volatility.”20 He suggested that the problems of the market could be traced to financial repression, leading to “cheap capital” that provided inadequate return on inves-tors’ capital, and to lack of enforcement of regulatory framework.21 More specifically, Xiao Geng wrote that development of the Chinese exchanges requires overcoming chal-lenges related to the four functions of a securities market: allocation of capital; assess-ment of risk, price discovery, and valuation of companies; corporate governance; and risk management. He added that market structure is heavily weighted toward SOEs and suf-fers from price distortions, government interference, and the weak corporate governance that is typical of emerging markets.22 (As mentioned earlier, the generally good corporate governance of the listed banks is not yet the norm across the non- financial listed firms.)

The problems and needs were clear, but attempts to address them with suitable reform measures ran into strong resistance from exchange “insiders” and vested interests who found the existing state of affairs to be in their interest. In its 2011 Financial Stability Report (the latest IMF financial stability report on China), the IMF devoted only six lines out of total text of forty- nine pages of text to the equity markets, laconically noting that “Further development in equity markets hinges on addressing legacy issues and bet-ter servicing the needs of SMEs.”23 The brevity of this six lines may indicate the low vis-ibility of the equity markets at that time on the reform agenda and that the government was not yet prepared to take on resolving equity market problems.

In addition to listing on these two domestic markets, many Chinese companies have listed on the Hong Kong and, to a lesser extent, New York securities exchanges. As recounted in Chapter 4, overseas listings raised enormous amounts of money for the four largest state- owned banks, enabling them to deal with the accumulated bad debts of earlier years, recapitalize, and restructure management and governance. Not only did the banks access enormous amounts of foreign capital through overseas listings, but major non- financial SOEs also raised equity in overseas exchanges, making them among the largest corporations in the world. Most foreign exposure to Chinese companies’ shares is through the Hong Kong exchange.

Echoing Xiao Geng’s criticism identifying the weaknesses of the domestic exchanges, but written five years later in 2011, Walter and Howie allege that “despite the infrastruc-ture, the data, and all the money raised, China’s stock markets are a triumph of form over substance. They give the country’s economy the look of modernity, but like the debt

20 Xiao Geng, Zhongguo Jing jide Xiandaihua, 113. 21 Xiao Geng, Zhongguo Jing jide Xiandaihua, 122. 22 Xiao Geng, Zhongguo Jing jide Xiandaihua, 117– 119. Similar arguments are advanced by Walter and Howie,

Red Capitalism, 166– 167. 23 IMF, People’s Republic of China: Financial System Stability Assessment (Washington DC: International

Monetary Fund, 2011), 47.


capital markets, the reality is that they have failed to develop as a genuine market for the ownership of companies.”24

The inadequacies of China’s securities exchanges are apparent. In truth, almost all coun-tries exhibit some of the same problems in early stages of their development, when the mentality of investors is geared toward speculation rather than investment, information asymmetries contribute to insider trading, regulations are inadequate, and regulators lack experience. After going through one or more boom– bust cycles, often accompanied by contagion into the banking system through default on margin loans and into the econ-omy as a whole through negative wealth effect, the experience in other emerging markets is that investors gradually replace speculators, regulation becomes more effective, and exchange trading becomes more efficient and more transparent.

Despite the problems, the securities exchanges have contributed to China’s economic growth over the years. Even though most of the major listed companies have been SOEs, equity markets have provided an alternative mechanism for channeling savings, both personal and institutional, into funding the growth of state- owned companies, and they have provided an alternative in a financially repressed system to placing savings in low- yielding bank deposits. Perhaps most important, they have fostered improved corporate governance and disclosure on the part of listed companies. There are ongoing deficiencies in corporate governance and work that remains to be done to make Chinese banks truly transparent to investors, but nonetheless as originally intended by Zhu Rongji, listing on securities exchanges, first internationally and then domestically, has forced banks, to raise corporate governance toward international standards. As financial institutions, the banks are supervised by the CBRC and, as listed companies, by the CSRC. Most likely many non- financial companies listed on the exchanges fall short of the targeted quality of corporate governance, but this can be improved over time.

China’s equity markets do, however, differ from most other equity markets in certain respects:

1. SOEs dominate total market capitalization. State shares of these listed compa-nies rarely trade, eliminating the risk of a huge overhang of shares that might be dumped on the market, depressing share prices. In almost all cases, only a minor-ity of shares are traded actively, and among the SOEs, many of these tradable shares are actually held by other SOEs, meaning that only a small portion of total shares in those SOEs are actually in private hands and potentially tradable.

2. This state majority ownership gives rise to a principal/ agent problem for non- state shareholders. The investing public, in its position as a principal, has little effective influence over the agent— the management installed by the majority state shareholder. This dilutes the meaning of the ownership rights that accrue



to the general investing public, as the management and governance of the listed SOEs is firmly in the hands of the state through various ownership channels.25 One likes to believe that in the New York Stock Exchange, ultimately investors at large have some voice over the future of the companies that they own, as shown by increasing shareholder activism in U.S.- listed companies. The Chinese situa-tion may, however, be somewhat analogous to the securities exchanges of some other countries in which shareholder value and the concept of shareholder as the main stakeholder in companies is less well enshrined. For example, in Japan, how much potential voice do small investors from the general public have over the affairs of the large listed conglomerates they own? Or, for that matter, how much influence do they in fact have in the United States over the agent, management?

3. Despite some opening of the markets to foreign institutional investment, which began on a selective basis in 2002, only 3% of tradable shares are in foreign hands.

4. Chinese investors in the A share (onshore) market are 80% retail, with two thirds of those investing less than $15,000.26 Institutional investors, due to underdevel-opment of pension fund, insurance company, and other institutional sources of investment money that could be directed into the equity market, do not play the stabilizing role that they do in more mature markets.

5. Government intervention in the equity markets is frequent and often decisive in its impact on share prices. Operating through the IPO approval process of the CSRC, the government regulates the flow of new securities onto the exchange with the objective of stabilizing price levels, preventing an excess of new offer-ings from depressing prices on the exchange (precisely what Xiao Geng has criti-cized as a principal weakness of the market). The number of companies applying for listing, and meeting all listing requirements and criteria, often exceeds the number of new offerings that the government has targeted, resulting in a long queue of companies awaiting their turn in line to be listed. This differs from standard practice in most other equity markets, in which the role of the regula-tor is simply to ensure that the applicant company meets all the criteria of a listed company, without regard to the impact of listing that company on the overall trading volumes or number of listed companies.

It has been puzzling that the government had not accorded higher priority to devel-opment of mature equity markets. The constructive roles played by equity markets in other Asian countries, such as Thailand, Malaysia, Singapore, and the Philippines, had not stimulated China to give its equity markets greater prominence in overall

25 Douglas J. Elliott, “China Will Struggle with Its Stock Markets Until It Completes Reforms,” Brookings, August 12, 2015, http:// www.brookings.edu/ research/ opinions/ 2015/ 08/ 12- china- stock- market- reform- elliott, accessed August 15, 2015.

26 Andy Rothman, Matthews Asia Weekly, July 10, 2015.

http://www.brookings.edu/research/opinions/2015/08/12-china-stock-market-reform-elliott

http://www.brookings.edu/research/opinions/2015/08/12-china-stock-market-reform-elliott


financial development, particularly when compared with the prominence accorded to banking reform over the years. Perhaps this is due to the fact that, once the banks had begun their transformation, through sheer size and nationwide coverage, they were able to provide most of the savings mobilization and investment funding require-ments that the government felt was required at the time, so there was no urgency to develop equity markets.

Or perhaps the busts of the Chinese equity markets in 2001 and 2009, and the exam-ples in the West of the dot- com crash of 2000 and the Wall Street implosion of 2008, made the government prefer the easily controlled and low- risk banking sector over the volatility of stock markets. The Party values control, stability, and harmony. The bank-ing system as it has developed fits those Party predilections. Stock market booms and busts, despite the government’s obtrusive intervention in the markets, are out of control, destabilizing, and, through causing financial loss to investors, not conducive to social harmony. A heavily controlled stock market that did raise some money for firms, and that did contribute to improved corporate governance and performance efficiency of SOEs, was all that the government seemed to expect from the exchanges. Low valuations of listed firms seemed a small problem.

This attitude, however, changed after the accession of the Xi government in 2013. The reform resolution of the 3rd Plenum of November 2013 called for boosting the importance of the equity markets. Subsequent to the general guidelines set forth in the 3rd Plenum, several specific measures have been implemented, designed to increase attractiveness of the equity markets, most particularly the opening of a two- way link for investments between the Shanghai and Hong Kong equity markets.

In addition, the government encouraged Chinese investors to put money into the equity markets. Why the government did this has not been made clear, but most likely, with declining growth rate, and reluctance to undertake another fiscal stimulus, the government hoped to create a “wealth effect,” in which consumers would feel rich and spend more. At the same time, a rising market would provide an opportunity for SOEs to issue more equity, retiring some of their excessive debt, and a more active equity market would facilitate funding of new technology start- ups, which the government would like to encourage as part of the ongoing transformation of the economy.

Taking their cue from the government, Chinese investors believed that market indi-ces would rise. Previously, the only outlets for individual savings were low- yielding bank deposits, higher- yielding but riskier wealth- management products, and real estate. Real estate had for several years been a bonanza, but with oversupply of real estate, the government had intervened to discourage speculative purchase of real estate and cool down real estate price rises. What was a Chinese to do with his money? The wealthy Shanxi coal mining magnate or Hebei industrialist who already owned five Beijing luxury apartments, all paid for with cash, saw that further real estate invest-ment would be unlikely to yield the high returns of prior years, and might even be an illiquid asset that declined in value, so he was inclined to consider diverting funds to


the stock market if the government was signaling “buy.” And the small guy earning a corporate salary saw an opportunity to increase his wealth.

As word spread of the easy money to be made in the stock market, too many people piled in— not just Shanxi coal magnates and the like, but stories spread of salary work-ers giving up their jobs and students using their tuition funds to play the market. They all piled in. The Shanghai Stock Exchange Composite Index rose rapidly, climbing from just over 2,000 in early June of 2014 to a peak of 5,178 in early June of 2015, at which point the Shanghai market was ranked second in total market capitalization globally. Such is the power of the state, as described in Chapter 7, to influence eco-nomic outcomes, that investors felt the stock market rise would continue, somehow supported by the government. Experienced market analysts warned of an obvious market bubble, as obscure shares rocketed up in speculative trading, reaching a level that was described as the “price- to- dream” ratio. Rapid increase over the months in margin lending for stock speculation introduced a degree of leverage into the market that had not previously existed. The government became alarmed that the bubble was irrational and out of control. To forestall the markets going even higher, it intervened.

The problem with the intervention is that the key government agencies involved in setting securities market policies lacked experience and understanding of how to intervene in a leveraged market in a way that would dampen speculation without set-ting off a panic. The government correctly saw that margin lending was getting out of hand. Clamping down suddenly on margin lending precipitated panic, followed by mutual fund withdrawals. To meet redemptions, mutual funds had to sell the good with the speculative out of their portfolios. Soon many shares had only sellers, no buyers. Orders went unfilled. The markets had seized up.

The peak in mid- June was followed by a 30% fall in the indices. The “price- to- dream ratio” shares collapsed by much, much more. Panic selling threatened to create a generalized liquidity crisis, perhaps threatening the banks themselves. Mindful of what had happened in 2008 in New York, the government decided to use a variety of measures to restore orderly markets. Panic selling was gradually offset by a series of heavy- handed government measures designed to restore confidence and stabilize the markets: quantitative easing “with Chinese characteristics,” encouragement of govern-ment institutions to buy shares and forbidding them to sell, talking up the markets through the media, loosened restrictions on margin trading, suspension of new IPOs, restricted short selling, and several other administrative measures.

By the time that this book goes to press, this market slump will be history. Markets rise and fall throughout the world. The point in describing it here is not because in the longer term of Chinese financial development it will be of any great importance, but to demonstrate the challenges China faces in promoting equity markets. As the government employed all the weapons in its arsenal to staunch the losses and restore stability to the markets, foreign pundits proclaimed that the government’s bumbling attempts to combat market forces would fail. The pundits were not entirely correct.


Even using bumbling methods, the government did succeed in restoring some order to the markets, gradually arresting the decline of the index, and averting a more general-ized liquidity crisis.

Given all the 3rd Plenum rhetoric about market forces being “decisive,” there has been concern as to whether or not this market intervention represents a reversal of reform efforts, a backtracking on commitments to let market forces be “decisive.” To answer this question, let us recall some of the basic characteristics of Chinese governance set forth earlier:

• China is pragmatic, not ideological. The market meltdown indicated things had gone badly awry, so the government took whatever measures were necessary to get the situation under control.

• China values harmony and stability. Estimates put the number of investors at around 10 million, not all of whom are active. This is only a fraction of China’s urban population, but nonetheless this number of Chinese having suffered losses in a market that rose on the back of government encouragement was of concern to the Party.

• The Party likes control. Market meltdowns are out of control. The Party’s instinc-tive reaction is to try to assert control.

• China does not do “big bangs.” China does incremental reform. But once an unequivocal commitment to a strategic direction is made, the government will stay the course, albeit with a certain amount of backing and filling along the way. No doubt there will be considerable reflection on the mistakes that have been made, but it is unlikely that this equity market set back will derail market reforms.

Reform in the direction of greater role for market forces will continue. But I suspect the Party will reflect on where the balance between government and market best lies at the present stage of development of the economy and will study what needs to be done to provide the market with more innate stability so that it is not subject to volatile swings.

Probably the banking system is more amenable to centralized control than is the equity market, in which there are too many generally anonymous and autonomous players mak-ing pricing decisions every minute of the trading day, influenced by government policy in their buy and sell decisions, but difficult for the government to actually control. The government will have to learn that the equity markets cannot be controlled, but that they do need to be well regulated.

The latest run- up to an equity bubble, with apparent government encouragement, indicates that adequate preparatory work has not yet been done for the equity markets to become more active. In Chapter 3, it was pointed out that the government sometimes (and generally with bad results) abandons its usual cautious, experimental approach, and does something too fast (ji) or too big (da). In encouraging Chinese to pile into the equity market, it committed both sins— too fast and too big. The subsequent interven-tion to stabilize the market and prevent losses to investors and spillover into the real


economy was, on the other hand, entirely in line with characteristic governance style of the Party set forth in Chapter 3.

On the first page of the introduction to this book Xi Jinping is quoted: “We should make use of the roles of both the market, the ‘invisible’ hand, and the government, the ‘visible’ hand.” In this view, the government’s mistake was not the fact that it intervened to stop the market rout, but that the functioning of both the “visible” and the “invisible” hands in the securities exchanges still require much improvement. This will take time. The transformation of the commercial banks took a decade. The transformation of the equity markets into mature, professional, well- regulated markets has just begun.

Accounting and Auditing: The Parallel Story

Improving the quality of accounting and auditing in China are “works in progress.” Analysts studying the disclosed financial performance of listed Chinese firms are skep-tical of the integrity and methodology underlying many firms’ reported numbers. It is therefore worth digressing briefly to look into how far development of modern account-ing and auditing has come in China since the beginning of Reform and Opening.

Reliable accounting and auditing are fundamental to efficient banking in two ways: first, to ensure that the accounts of the banks themselves are in good order and can be relied to inform bank management strategy and decisions, but also for sound bank regulation, assessment of credit- worthiness for extension of interbank credit lines between banks, credit rating agency analysis, and, in the case of the listed firms, invest-ment analysis; second, banks rely on commercial and corporate clients’ accounting state-ments in making credit decisions.

Prior to the reorganization of the economy along socialist lines in the early 1950s, Chinese banks and firms had used the standard accounting system of capitalist econo-mies. Introduced to China in the nineteenth century by foreign firms and banks, account-ing as practiced in the West is based on double- entry bookkeeping, balancing assets and liabilities and reckoning profit and loss. In the Western system, the accounts prepared by an enterprise’s accountants will be checked for accuracy by licensed outside auditors— specialists trained in ensuring that the accounts prepared by an enterprise conform with generally accepted accounting principles, contain no material omissions or misrepresen-tations, and accurately represent the financial outcomes of a firm’s operations. In lending to any enterprise, banks rely on analysis of the enterprise’s financial statements prepared by accountants and certified for accuracy, integrity, and reliability by licensed external auditors.

This Western accounting system was not used in socialist economies. After the change to a socialist planned economy, Western accounting was abandoned, replaced by the socialist accounting system then in use in the Soviet Union and Eastern European coun-tries. As all Chinese enterprises were now owned and managed by the state, and banks


were no longer lending to the enterprises, after 1956 there was no further need for audi-tors to certify the correctness of the accounts. The body of knowledge and principles used in the accounting profession radically changed, and the entire profession of auditing simply disappeared.

With the beginning of Reform and Opening in 1978, the re- introduction of the mar-ket to China’s economy, the process of three decades earlier had to be reversed. Now that socialist accounting was becoming irrelevant to the evolving needs of the economy, international norms of accounting and auditing were re- introduced. Under China’s Accounting Law, the Ministry of Finance is the principle Chinese agency responsible for setting standards for accounting in China. Starting in 1993, the MOF has been develop-ing Chinese Accounting Standards (CAS).27 In the 1990s, as Chinese companies pre-pared to list on the two new securities exchanges that had been established in Shanghai and Shenzhen in 1990 and 1991, respectively, they had to implement modern Western- style accounting, although not yet full international Generally Accepting Accounting Principles (GAAP).

Adoption of international GAAP first occurred in joint ventures between Chinese and foreign shareholders. These joint ventures led the way in applying international accounting standards. Over the years CAS has increasingly converged with international standards. The next stage in raising accounting standards in China came in the years around 2000, when Chinese banks and firms began listing in overseas securities exchanges, particularly Hong Kong and New York, and China was preparing to join WTO. To be admitted to WTO, China needed to demonstrate that it was a market economy, one aspect of which is the use of accounting that conforms to international standards. The pace of change accelerated. By 2007, China’s national accounting standards had largely converged with international standards. Banks, large SOEs, and listed companies essentially conformed to international standards, as embodied in International Financial Reporting Standards (IFRS), otherwise known as International GAAP. According to the IFRS Foundation, in a report dated August 22, 2014, “China has adopted national accounting standards that are substantially converged with IFRS.” 28

China has been active in international forums working on global financial reporting issues, as there are certain areas in which the hybrid nature of China’s market socialism requires a different approach from the approach used in market capitalist economies. For example, the rules for “transactions between related parties” that are applied in the United States become meaningless in China, due to ultimate ownership of most banks and large companies directly or indirectly by the state. If the previous rules for disclosure

27 Lehman Brown website, http:// www.lehmanbrown.com/ Newsletters/ PTO/ LB13.htm, accessed October 16, 2014.

28 “IFRS Application Around the World: Jurisdictional Profile: People’s Republic of China,” IFRS Foundation, August 22, 2014, http:// www.ifrs.org/ Use- around- the- world/ Documents/ Jurisdiction- profiles/ China- IFRS- Profile.pdf, 1.

http://www.lehmanbrown.com/Newsletters/PTO/LB13.htm

http://www.ifrs.org/Use-around-the-world/Documents/Jurisdiction-profiles/China-IFRS-Profile.pdf

http://www.ifrs.org/Use-around-the-world/Documents/Jurisdiction-profiles/China-IFRS-Profile.pdf


of related party transactions were applied in China, an enormous portion of the assets of Chinese banks would have been “related transactions,” which clearly was not in the spirit of the original thinking underlying requirements for disclosure of related party transac-tions in capitalist economies. Moreover, it would have given rise to corporate governance inefficiencies in the banks, as loans to related parties require approval from a committee of the board of directors that exists specifically to scrutinize such transactions. Common sense prevailed, and the rules for related party transactions were modified globally to accommodate the Chinese situation.

The auditing profession in China was resurrected in the early 1980s. No standards existed for the practice of auditing. The profession had to be reestablished. Retired audi-tors with experience of auditing prior to 1949 returned to service to pass their knowledge to the new generation of aspiring auditors. During the period 1992– 1993, the “Big Six” (now reduced to “Big Four”) auditing firms set up offices in China, serving multinational clients that had operations in China. These firms played a major role in the development of the auditing profession and auditing standards in China, as they assisted the MOF in formulating principles and also recruited and trained large local Chinese staffs, many of whom later went on to build up local Chinese audit firms.

Those local Chinese auditing firms are steadily growing in capability and credibility. To date, however, no tier 1 Chinese bank yet uses local audit firms. Local audit firms have bid for the business of some of these tier 1 banks, but the boards of those banks have not yet felt confident that the local firms would have the competence to undertake the complex task of auditing such enormous financial organizations, and probably also have believed that both nationally and internationally, audit by an international firm conveys greater credibility.

The government fully recognizes the importance of improving accounting and audit-ing to meet internationally expected levels of quality and reliability. This has largely been accomplished in the area of defining Chinese accounting and auditing standards that conform to international norms. The application of these standards and practices has also largely now occurred in the tier 1 banks, and probably in most of the tier 2 and 3 banks as well. Practice in large listed SOEs may still require improvement, and certainly practice in most of the smaller, local state enterprises and private firms still requires several years of concerted effort to bring up to standard.

189

One might imagine that a large commercial bank that had done well over the years in its home market could without too much difficulty expand its operations to markets in other countries. Leading a bank into international markets has a certain allure for bank boards and management teams. The temptation to open offices in exotic locales with fast growing economies around the world can be hard to resist. On paper the expansion strategies and feasibility studies are attractive.

From the 1960s through the 1980s, many of the larger Western banks expanded their international operations, geographically increasing their branch networks, supporting the aggressive expansion of multinational corporations of their own countries into emerging markets, conducting traditional correspondent banking with local banks, undertaking sovereign lending to governments, and introducing consumer lending and investment banking throughout Asia, Latin America, Africa, and the Middle East. Names like Wells Fargo, Deutsche Bank, and Security Pacific Bank became increasingly visible in the developing world, with branch presences, joint ventures, or offshore lending arranged by their representative offices. The markets were growing rapidly, local competition was unsophisticated, and profits were high. Everyone wanted to get into the game.

9 Coming In and Going Out

We should open our country to the outside world to obtain such aid as foreign investment

capital and technology.Deng Xiaoping 1

1 Xie Pingru, ed. Xiaoping Said: Build Socialism with Chinese Characteristics (Guangzhou: Guangzhou Higher Education Press, 2014), 51.


But then came the Latin American debt crisis, the Asian Financial Crisis of 1997, and the Russian default, which dampened enthusiasm for international expansion by all but the most committed of the international banks, while at the same time local banks everywhere were upgrading their skills, product range, and service offerings, pro-viding stiffer competition for international banks. Newcomers to the game discovered that their overseas expansion strategies were more difficult to implement than they had expected, and that the complexities of handling risk, compliance, and human resources in a variety of different jurisdictions and cultures was not worth the effort and resources required. Banks in America and Europe that had been keen on opening branches abroad and acquiring foreign subsidiaries scaled back their overseas operations. Many withdrew from the markets, leaving really only a handful of European, American, and Japanese banks maintaining full international networks. Banks like Wells Fargo have refocused on their profitable domestic markets, concentrating international operations in corre-spondent banking, capital markets, and supporting their multinational clients’ overseas financial needs, much of which can be done without maintaining expensive overseas networks.

By the early years of the twenty- first century, only a handful of Western banks retained extensive global networks serving local markets. These were the truly global banks that had accumulated a century of experience in foreign banking, whose corporate cultures included a deep knowledge base of how to operate in foreign environments and had a cadre of both mobile expatriates and highly qualified local managers to staff the far- flung operations.

Even these big global international banks that have maintained international net-works for decades have retreated from the retail markets in some countries, unable to sustain profitability or develop sufficient scale of operations to justify the effort. Between 2012 and October of 2014, Citigroup cut its retail presence in twenty- four countries. HSBC has in recent years ended its consumer operations in twenty coun-tries. Reporting on this retrenchment, Martin Arnold and Camilla Hall wrote in the Financial Times of London that for the most part the global banks retain wholesale banking presences in these countries, but that for individual banking, “International banks are competing for the ideal client, who is wealthy and wants to shift money around the world seamlessly.”2

In this chapter I first look at the experience of foreign banks establishing presences in China, then at Chinese banks as they venture into overseas markets. While the large foreign banks with China operations have decades of international experience, most Chinese banks, except for Bank of China, have only just completed their first decade of foreign expansion and are in the early stages of developing international business.

2 Martin Arnold and Camilla Hall, “Big Banks Giving up on their Global Ambitions,” FT.com, October 19, 2014.

Coming In and Going Out 191

Foreign Banks Come to China

Prior to 1949, foreign banks had established major presences on the Bund in Shanghai and also in other treaty port cities such as Tianjin, Xiamen, and Guangzhou. After the change of regime in 1949, foreign branches were taken over by the Chinese govern-ment, with the principal exceptions of HSBC, Bank of East Asia, OCBC, and Standard Chartered Bank, which were permitted to retain skeleton presences in Shanghai from 1949 through the Opening and Reform period.

After Reform and Opening started, China realized that to achieve its goal of devel-oping modern banking in a reasonable period of time, it should start by learning from foreign banks. In the 1980s, foreign bankers, still in their expansive overseas strategy mode and viewing China as long term potentially the largest and most profitable over-seas market not yet exploited, nurtured relationships with Chinese banks by spending time training Chinese counterparts in the minutiae of modern banking— trade finance, risk management, treasury operations, etc. In 1981 China authorized foreign banks to open branches in Shenzhen and four other Special Economic Zones, but only to deal in foreign currency. Bit by bit over the next decade, the restrictions on foreign bank branch locations and activities were relaxed, and a large number of foreign banks opened branch operations in China.3

The major breakthrough for foreign banks came with China’s accession to WTO in 2001, under the terms of which China agreed to open up the Chinese market for for-eign banks to conduct local currency operations and other banking business without geographic restriction and on equal regulatory terms with domestic banks by the end of 2006. At that time, the Chinese banks worried that foreign banks would put Chinese banks at a severe competitive disadvantage, as Chinese banks were still weak. They need not have been so concerned. In almost all banking markets around the world, the ability of foreign banks to make major market inroads, especially when they go below the high net worth and local blue chip corporate levels, is limited. Most people like to deal with domestic banks

In 2007, China permitted foreign banks meeting certain criteria to locally incorpo-rate wholly owned subsidiaries, licensed to conduct local currency operations. According to the United States Trade Representative’s 2014 Report to Congress on China’s WTO Compliance, since 2006 China has continually improved its WTO compliance by provid-ing a more level playing field to foreign banks, but there are still “some instances in which China does not seem to have fully implemented particular commitments.”4 The major areas of alleged non- compliance appear to be limiting foreign participation in Chinese banks’ equity to less than 25%, and various conditions imposed on foreign banks applying

3 Liu Mingkang, ed., Zhongguo Yinhangye Gaige Kaifang 30 Nian: 1978– 2008 (China Banking Industry: 30 Years of Reform and Opening 1978– 2008) (Beijing: China Financial Press, 2009), 12– 13, 24– 28.

4 United States Trade Representative, 2014 Report to Congress on China’s WTO Compliance, 128.


to do local lending or participate in bond markets. According to the report, though, most areas of non- compliance have been dealt with by the Chinese government one by one over the years. Foreign bankers have told me that since 2013 the pace of liberalization of regulations governing foreign banks has accelerated and the regulatory environment has become more favorable to foreign banks. This reflects not only China’s concern with WTO compliance, but also an increasingly relaxed attitude toward the potential com-petitive threat posed by expanding foreign banks to the domestic banking system.

In arranging China’s accession to the WTO, Zhu Rongji believed that foreign com-petition would be a healthy tonic for Chinese SOEs, including the banks. But there was never any intention of allowing foreigners to take a major share of the Chinese banking system— recall the importance that the Chinese government gives to banking as part of the commanding heights of the economy. In any event, over the years, the Chinese banks did strengthen, and foreign banks now have less than a 2% share in the market. The fears of being outcompeted by foreign banks have not come to pass, except in certain special-ized and sophisticated areas of finance where foreign bank expertise and experience can-not yet be equaled by local competitors.

As of the end of 2014, 38 foreign banks from 15 countries had established locally incorporated subsidiaries with 296 outlets in China. Another 66 foreign banks from 26 countries had established 97 branches in China, and 158 foreign banks had established representative offices. While there was of course a heavy concentration of foreign banks in Beijing and Shanghai, a few foreign banks established more extensive branch net-works. Foreign banks can now be found in 69 cities with reasonably broad geographic distribution around the country. Despite the large number of foreign banks licensed in one form or another in China, and the breadth of their coverage of major cities, foreign banks’ total assets of 2.8 trillion yuan at the end of 2014 accounted for only 1.62% of total Chinese commercial banking assets, down from a peak in 2011 of 1.93%.5 Foreign bank profits in 2014 were only 0.8% of total China banking industry profits, and foreign banks’ return on assets of 0.6% was less than half the average for Chinese banks.6

Now only Standard Chartered, HSBC, Bank of East Asia, DBS, and Citibank are actively expanding their branch networks and aggressively seeking local Chinese busi-ness. Others maintain single branches in Shanghai or Beijing for wholesale banking pur-poses, or for serving their multinational clients. Wholly owned foreign branches are for the most part invisible to the average Chinese, except in the financial and commercial districts of Beijing, Shanghai, and a few other large cities. In asset size, branch networks, and market penetration, they are dwarfed by the big five Chinese banks, and the total

5 China Banking Regulatory Commission, 2014 Annual Report (Chinese version) (Beijing: China Financial Press, 2015), 45– 46.

6 Gabriel Wildau “HSBC Faces Uphill Battle to Bolster China Business,” Financial Times, June 10, 2015, http:// www.ft.com/ intl/ cms/ s/ 0/ c1a7ac2e- 0f3e- 11e5- 897e- 00144feabdc0.html#axzz3fwKs47sS, accessed July 15, 2015.

http://www.ft.com/intl/cms/s/0/c1a7ac2e-0f3e-11e5-897e-00144feabdc0.html#axzz3fwKs47sS

http://www.ft.com/intl/cms/s/0/c1a7ac2e-0f3e-11e5-897e-00144feabdc0.html#axzz3fwKs47sS


assets of all the foreign banks are approximately equal to one medium- sized joint stock bank’s assets, such as China Everbright Bank.

Foreign commentators, foreign embassies, and some of the foreign banks complain that foreign banks are, despite commitments under WTO agreement, restrained by the Chinese government from expanding as they would wish to in the Chinese market. The principal complaints relate to slow regulatory approval for opening of branches and launching of new products. In its survey Foreign Banks in China 2013, published in early 2014, the accounting firm PWC reported that foreign banks “have long endured limited ability to innovate, in practical terms, due to strict regulatory licensing requirements, lengthy approval processes and stringent capital requirements”7 and that therefore many foreign banks are comfortable maintaining a non- aggressive strategy in China.8 In June 2015, The Financial Times reported that “Today, foreign banks still need permission from regulators for each new branch they open. Foreign bankers complain that the approval process often takes months or years. Regulators have also forced foreign banks to set up businesses in underserved areas as a condition of approving new branches in developed regions.”9 What is not mentioned is that Chinese banks are subject to similar conditions in their applications to open new branches in underserved regions. Moreover, these con-ditions reflect the fundamental difference between the Western and Chinese banking systems highlighted in this book— the Chinese banking system exists not only to provide a return to shareholders, but also to “serve the real economy,” one aspect of which is to support development of the less economically advanced parts of the country. That applies to foreign banks as much as to domestic institutions.

Granted that the rules cover both foreign and domestic banks, nonetheless it is no doubt often true that in practice the bureaucratic process for approval of foreign bank applications for business expansion may proceed less smoothly than it does for Chinese banking institutions. This is probably particularly true of foreign banks that lack the deep knowledge of China, strong local staff, and excellent access to the authorities at a senior level that a bank such as HSBC enjoys.

Another complaint of foreign banks is that they are not given sufficient scope by the CBRC to take advantage of their strengths in innovative areas such as derivatives creation and trading. This, however, is an area in which the CBRC is moving cautiously, not in order to hold back foreign banks, but to ensure that whatever derivatives are introduced to the market have genuine value added for corporate clients. The authorities are con-cerned that derivatives should not just be exotic instruments that will make money for the banks, and they worry that derivatives may exceed the present capacity of Chinese corporate treasurers and boards to fully understand and use properly.

7 PWC, Foreign Banks in China 2013, 6. 8 PWC, Foreign Banks, 6. 9 Wildau, “HSBC Faces Uphill Battle,” June 10, 2015.


The major problem for foreign banks now is not regulatory restriction, but rather the difficulty that banks in any foreign market face competing with the local connections, knowledge, and loyalties of domestic banks. In China, foreign banks are important ser-vice providers in China for multinational investors, are active in the foreign exchange and capital markets, attract high- net- worth private clients, and provide services out-side of China to Chinese corporations “going out,” but they have not gained significant market share in the broader corporate or retail banking markets. In my years serving at Everbright, in discussions of competitive strategy, foreign banks scarcely figured in analy-sis of competition, indicating that foreign banks are niche players.

Judging from the recent retrenchments of some international banks from retail pres-ences in many markets, how successful would foreign banks actually be in broadening market share were they allowed to freely expand? Asked about where foreign banks have a comparative advantage, officers of the major foreign banks, academic observers, and customers with whom I spoke cited to me only a few areas in which Chinese banks still lag behind their foreign competitors in services and products. Certainly foreign exchange dealing, especially in some of the more exotic currencies, such as African currencies, is one area in which Citi and HSBC have the lead, but whether that advantage will be retained in future years as Chinese banks establish presences in Africa is unclear. Capital markets and derivative products are also areas of competitive advantage for foreign banks. A senior Chinese treasury officer of one of the leading foreign banks, in discussions with me, expressed his belief that it will only be a few years before the major Chinese banks will also have caught up in these areas with the foreign banks. Nonetheless, the PWC foreign bankers survey noted that “the expertise that foreign banks possess across their global networks in product development, clearing through central counterparties (CCPs) and developing an effective infrastructure for more sophisticated client service and opera-tions, could provide foreign banks with opportunities to improve earnings quality rela-tive to their peers.”10

In consumer products, the credit cards, deposit accounts, Internet banking, mort-gages, and other basic banking facilities offered by foreign banks do not seem to the Chinese consumer clearly superior to the offerings of Chinese banks. As mentioned in Chapter 6, branding is an area of weakness for Chinese banks, and indeed that is an area in which the large foreign banks with Chinese branch networks have performed better than Chinese banks.

Among the foreign banks that have locally incorporated, only the major ones are able to source sufficient local currency deposits. Locally incorporated foreign banks that do not have adequate yuan deposit bases are encountering difficulty and may be forced to retrench or even give up their local bank licenses to revert to foreign branch status.

10 PWC, Foreign Banks, 6.


Chinese bankers working in foreign banks felt that a certain type of Chinese will be attracted to work in foreign banks, and will then be unlikely to seek employment in a Chinese bank, as he or she will have become accustomed to the corporate culture and career paths of foreign institutions. They claimed that for middle- and senior- level man-agers, Chinese banks were entirely competitive with foreign banks in compensation, and that often the incentive schemes available for upper level Chinese managers were more attractive in Chinese banks than in foreign banks’ Chinese operations.

The Success of HSBC in China

HSBC is the largest of the foreign banks, with approximately one quarter of total for-eign bank assets in China. A senior former HSBC banker involved in the expansion of the bank’s China business during the crucial years of 2005– 2010, explained to me how HSBC achieved its strength among foreign banks in the China market.11 In 2004 the bank was optimistic that it could build a strong business in China, provided that it realis-tically analyzed where its opportunities and competitive strengths lay. The bank’s higher cost structure would prevent it from being competitive in the mass market, it had no particular advantage over Chinese banks in IT- based banking, and it did not have a range of products in the China market that would stand up against the Chinese banks.

What HSBC did have was a strong brand, deep roots in the Chinese communities all over Asia, strengths in commercial and trade finance products for businesses, and strong customer loyalty acquired outside of China from Hong Kong– based and multinational clients. Last, it could attract big Chinese enterprises to use its international trade and FX capabilities. Funding its China asset base would be the crucial constraint. It there-fore capitalized on its brand and image strength to target “aspirational” upper- middle- class Chinese clients with its range of “premier brand” consumer products. It succeeded in attracting these clients, providing it with reasonably priced and stable deposits. Once it gained a position in this market segment, its lead position was self- reinforcing. HSBC became the bank with which “aspirational Chinese” would wish to be identified, as they felt association with HSBC gave them a certain social cache. Fortunately, it became the brand leader among foreign banks for the target high- net- worth Chinese market quickly, because after the 2008 financial crisis in the United States, foreign banks lost their brand advantage.

HSBC’s loan portfolio in China was about two thirds Hong Kong and global mul-tinational corporations and one third local Chinese firms, of which the majority were SOEs. Chinese companies were attracted to bank with HSBC because of its expertise in international trade and FX.

11 Information on HSBC in China was obtained in interviews with HSBC officers conducted in 2013– 2014.


Key to HSBC’s success in China were two intangible factors. First was strong support from HSBC Chairman John Bond in London. Bond set the tone for the bank in its operations in China, emphasizing “We are guests there.” He sponsored the training in London of many young Chinese from both the regulators and the banks. Bond made it a point to personally meet with all of these Chinese trainees while they were in London. Now retired from HSBC, Bond has for the last several years served as a member of the CBRC’s International Advisory Board, which meets once a year.

Second, HSBC established close working relations with PBOC and CBRC. Every move that it planned to make was first discussed with the regulators, ensuring that HSBC’s strategy was in line with what the government felt was the appropriate role and contribution of a major foreign bank. In the HSBC officers’ experience, contrary to the complaints of foreign bankers reported above by PWC, China’s regulators understood that foreign banks could contribute in their own way to development of the economy, but that they faced a multitude of obstacles arising out of market conditions and the entrenched positions of local banks. The regulators therefore provided foreign banks with exemptions from several restrictions that applied to local banks in order to assist foreign banks to get off the ground in a difficult competitive environment. For example, recognizing that foreign banks would need time to build up a local deposit base, CBRC relaxed the strict Chinese loan:deposit ratio for the first five years of a locally incorpo-rated foreign bank. The CBRC was described as “incredibly rational.” Reflecting on HSBC’s success, an expatriate former HSBC executive remarked, “In China, you get out in proportion to what you put in.”

When foreign banks were given the opportunity to do local currency business by locally incorporating in 2007, HSBC was the one of the first foreign banks to do so. In addition to the wholly owned local subsidiary HSBC (China), the bank also maintains in Shanghai one wholesale branch of the global bank and has invested in 19% of the equity of Bank of Communications, the smallest of the five large commercial banks. In Bank of Communications, it participates actively in senior management and transfers knowledge and technology to the bank. HSBC’s Hong Kong subsidiary, Hang Seng Bank, also has fifty branches of its own in China, and holds a 20% share of Yantai Bank, a city bank in Shandong Province. Finally, HSBC has invested in twelve rural banks in China. In one way or another, the HSBC group thus has not only its own foreign presence throughout China, but also through investments it has a presence in tier 1, tier 2, and tier 3 banks.

Foreign Banks as Strategic Partners

In addition to opening their own operations in China, foreign banks have taken minor-ity positions in Chinese banks, mostly investing during the period 2004– 2007, and pre-dominantly in the tier 1 banks, although some have also invested in the better quality tier 2 banks, and a few have taken shares in tier 3 banks as well (e.g., HSBC’s investment in


twelve rural banks). The impetus behind inviting foreign banks to invest in China’s large banks was to provide Chinese banks with “strategic investors,” who would take minor-ity stakes of no more than 20% per single foreign investor and no more than 25% in aggregate foreign shareholding. Strategic partners would transfer skills and technology to Chinese banks and through participation at board level improve the quality of corpo-rate governance.

In most other countries, foreign banks investing in local banks have insisted on owning 100% of a local operation, or at least a controlling interest, and have generally demanded management control. Foreign banks normally are unwilling to take minority stakes, as they feel that in the event the local bank runs into difficulty, in order to protect their reputation, the foreign shareholding bank will end up responsible for honoring 100% of the liabilities, while only taking a portion of the profits in the good times.

Only one foreign bank has ended up with major management influence in a Chinese bank. Citibank, with a 20% shareholding in the joint stock Guangfa Bank, has, as the largest shareholder, appointed one of its own people as CEO. In all other cases, foreign strategic partner involvement in management has been below the CEO level, or non- existent. Foreign banks have been willing to accept this minority, non- controlling situa-tion in China, which they rarely do in other countries, because of the size and potential profitability of the China market.

The first phase of foreign equity participation in Chinese banks was 1996– 2001, during which period only a few isolated investments occurred, mostly by multilateral institutions such as the International Finance Corporation (IFC). The second phase, 2001– 2004, saw foreign banks investing in joint stock and city banks, as the weak balance sheets of the unreformed large commercial banks discouraged foreign interest. In the third phase, commencing in 2004, with Zhu Rongji’s transformation of the large commercial banks underway and their balance sheets cleaned up, foreign banks invested in four of the five large commercial banks (only Agricultural Bank of China, late to undertake reform, did not take in a foreign strategic investor). HSBC was the first, taking a 19.9% stake in Bank of Communications in 2005. Shortly thereafter Royal Bank of Scotland led a consortium investing in Bank of China, and Goldman Sachs led a group investing in ICBC. The tim-ing of these investments was important, as they strengthened the image of the Chinese banks prior to launching their IPOs.

Transmission of skills and technology took place from the foreign strategic sharehold-ers directly into Chinese banks, but also it took place through establishment of joint ven-tures between the partners in areas like credit card business. These joint ventures allowed for more innovative collaboration than working through the mammoth bureaucracies of the Chinese banks themselves. Overall, the amount of knowledge, technology, and expertise that was transferred through these strategic partnerships varied considerably from bank to bank.

Certain Chinese banks were more open to change than others and probably did lever-age their partners’ knowledge, while at the same time certain of the foreign strategic


shareholders were more effective in finding ways of transferring their skills than others. In particular, Bank of America made a commitment to its partnership in the China market with Construction Bank, effectively ending its direct involvement in China and channel-ing most China business through its Chinese partner. Bank of America also dedicated an enormous number of people to working with Construction Bank, some in China, and some remotely from the United States. When I was a director of Minsheng Bank, I recall that Minsheng was aggressive in seeking out the SME product knowledge that its Singapore partner Tamasek could bring to the table through its stable of experienced Taiwanese ex- Citibankers. The Dutch financial conglomerate ING invested in a top city bank, Bank of Beijing, and has made a major commitment to assisting Bank of Beijing management in its risk- management business, seconding two experienced bankers for several years in key positions of management in the bank. The strategic partnership has thrived, Bank of Beijing enjoys a top reputation for asset quality in China, and ING has expanded its areas of assistance to Bank of Beijing to include SME banking, direct bank-ing, and financial markets.

On the other hand, in some of the other Chinese banks, it is not clear what contribu-tion other than equity capital the strategic shareholder has brought. In fairness to both the Chinese and foreign banks, however, it is not easy to reap the fruits of strategic part-nerships to the extent that is contemplated in the original partnership agreements. China Everbright Bank discussed strategic partnership with several foreign suitors but never reached an agreement. I do not recall that at the board level we felt that Everbright Bank was disadvantaged due to lack of a foreign partner. Moreover, given that the Organization Department shifts executives between banks on a regular basis, whatever knowledge that is learned by a bank from its strategic partner will eventually find its way over to other banks when executives are shuffled between banks.

In any event, after 2008, the wave of foreign strategic investments in Chinese banks declined dramatically. Chinese banks were shocked by the Wall Street crash. Bank of America had no choice but to sell (at handsome profit) its holding in Construction Bank in order to repair its capital base in the wake of massive losses in the home market. There was growing domestic Chinese criticism against permitting strategic partners to buy into Chinese banks at what were perceived to be low valuations— in effect selling national financial assets to foreigners cheaply, permitting the foreigners to then make large gains from sales into the stock market. Dubious though these accusations were, they did cause Chinese banks and regulators to become very cautious thereafter in bringing in foreign investors.

The Chinese economy and the banking market is too large for any foreign bank with even limited international aspirations to ignore. In future years, as the economy grows larger, as the internationalization of the rmb continues, and Chinese capital markets become increasingly internationally open, some presence in China will be ever- more important for international banks. Most foreign banks, however, will limit themselves to wholesale, capital markets, and foreign currency products, not requiring an extensive


retail branch network. Only a small number will have the capacity and desire to venture more broadly into China’s local corporate and consumer retail markets, either through an extensive branch network or through digitally based products. Assuming the trend of increased WTO compliance and liberalization of regulations pertaining to foreign banks continues, it will be up to each foreign bank to work out a strategy that suits its own capabilities and global strategy— universal banking at one end of the strategic spectrum, specialized wholesale lending to particular market segments or capital and FX market trading at the other end.

Despite the small market share occupied by foreign banks, they have contributed above their weight to the transformation of China’s banking sector. Training by foreign bankers started in the 1980s and continues to this day in various forms. Foreign banks have transferred knowledge, technology, and corporate governance standards as strategic partners in joint ventures, albeit perhaps not as much as had originally been hoped and with uneven results. The very presence of huge global banks invested in the large Chinese commercial banks contributed to the receptivity of foreign investors to their IPOs over-seas. By the businesses they do in China, and by the example of their management and marketing, foreign branches and subsidiaries contribute to development of FX trading, credit card technology, branch design and branding, private wealth management, sophis-ticated corporate finance, and a host of other areas. These contributions are clearly recog-nized and appreciated by the CBRC and PBOC, but they have, in keeping with Chinese regulatory and governance style, used the same cautious approach to liberalization of regulations governing foreign banks that they have used in other areas of development of banking.

Chinese Banks Going Out

Prime Minister Zhu Rongji announced China’s “Going Out” strategy in 2001.12 Under this strategy, the government encouraged Chinese firms to expand overseas, by setting up their own operations in other countries and by buying foreign companies, stakes in foreign companies, or divisions of foreign companies. The three principal drivers of this strategy are the need to acquire secure sources of raw materials on which the Chinese economy is dependent, to learn new technologies and skills through acquisitions of successful foreign companies, and to earn higher returns on China’s enormous foreign exchange reserves, which are otherwise invested in low- yielding foreign bonds, particu-larly U.S. treasury bills. Notable examples of “going out” have been Lenovo’s acquisition of the PC division of IBM and Geely Motors’ acquisition of Swedish automaker Volvo.

Starting with three of the five large commercial banks, the state- owned banks have been expected to also “go out,” partially in support of the overseas expansion of China’s

12 David Shambaugh, China Goes Global: The Partial Power (New York: Oxford University Press, 2013), 175.


manufacturing firms, but also as part of a strategy for China to play a much larger role in the global financial markets and to establish a financial presence all over the world. The IMF reports that between 2009 and 2013, the portion of overseas loans to total loans of Chinese banks rose from 6.1% to 9.2%— a rather cautious rate of growth, until one considers the rapid overall growth of total Chinese banking assets during that period, making the growth rate of overseas loans a large number in absolute terms.13 Between 2006 and 2012, U S., Japanese, and Euro area banks registered very low rates of expansion of overseas assets. Chinese banks, during that same period, expanded the number of their international offices tenfold, and increased their overseas assets from $227 billion in 2006 to over a trillion dollars by the end of 2012.14 It should, however, be noted that lending to Hong Kong, Macao, and Taiwan is counted as international assets by the Chinese banks, and those three areas may account for as much as half of the international assets portfolio.

Throughout the years of Maoist monobanking, Bank of China, even though domesti-cally merged into the PBOC, retained its name on its branches and subsidiaries in a small number of key financial centers to handle China’s foreign exchange and foreign trade needs. After Reform and Opening, Bank of China steadily opened branches all over the world. Today branches remain its principal form of overseas presence. In 2014, Bank of China reported that 77% of its net profits before income tax derived from operations in China, 17% from Hong Kong, Taiwan, and Macao, and 6% from operations in other countries.

ICBC expanded internationally much later, for the most part through purchasing all or portions of local banks, or through establishing subsidiaries rather than overseas branches. Construction Bank is now also expanding overseas. Presumably the presence of Wim Kok, formerly prime minister of the Netherlands and a leading elder statesman of Europe, on Construction Bank’s board is indicative of a long- term strategy to use informed advice in navigating the complexities of investing in European banking. Among the big four banks, only China Agricultural Bank has thus far shown little interest in overseas expansion. Some of the joint stock banks were in 2014 also signaled to begin on a small scale to set up overseas presences.

With the possible exception of Bank of China, which has built up expertise in its over-seas branch operations over the course of many years and is a leader in the commercial banking aspects of rmb internationalization, all the other Chinese banks face substantial challenges as they look to overseas expansion. As mentioned earlier in this chapter in

13 “Japanese Banks Outmuscle Chinese on Growth Abroad, IMF says,” Bloomberg, http:// www.bloomberg.com/ news/ articles/ 2015- 04- 08/ japan- banks- outmuscle- chinese- on- growth- abroad- imf- says, accessed August 1, 2015.

14 “International Expansion of Chinese Banks,” International Institute of Finance, March 27, 2014, https:// www.iif.com/ publication/ research- note/ international- expansion- chinese- banks?destination=node/ 8697&ct=d36fdd63a63fa2319552eca0a222a5e9172a85ba85d46dd3462c41b7493537e4a786ef2165b73d3d281436f8d6b093a7d90c6ba5d2d26eb9a32f4240220e4b59, accessed August 1, 2015.

http://www.bloomberg.com/news/articles/2015-04-08/japan-banks-outmuscle-chinese-on-growth-abroad-imf-says

http://www.bloomberg.com/news/articles/2015-04-08/japan-banks-outmuscle-chinese-on-growth-abroad-imf-says

http://www.iif.com/publication/research-note/international-expansion-chinese-banks?destination=node/8697&ct=d36fdd63a63fa2319552eca0a222a5e9172a85ba85d46dd3462c41b7493537e4a786ef2165b73d3d281436f8d6b093a7d90c6ba5d2d26eb9a32f4240220e4b59





discussing the international expansion of Western banks over the past half century, oper-ating overseas in different markets and jurisdictions requires mobile expatriate staff with the requisite cultural sensitivity and language skills, the ability to adapt to the differing commercial practices and customer habits of a variety of marketplaces, compliance with different regulatory regimes, the ability to penetrate into markets that may be wary of foreign banks, a head office senior management and support cadre able to coordinate the challenges of a multiplicity of foreign businesses, and a host of other challenges.

Chinese banks are enormous, qualified in terms of sheer size to launch overseas opera-tions. They have the advantages that in many target markets they will have a captive cus-tomer base of Chinese corporate and individual clients to serve, and that the growing internationalization of the rmb will give them an advantage in offshore rmb clearing and trading. Nonetheless, they have not built up the international cadre of expatriate manag-ers to staff their expansion, they lack experience in adaptation to local markets that are completely different from China, and they face considerable skepticism in most markets as financial standard- bearers of the Chinese government. They also lack the currency, debt instrument and derivatives trading expertise, and experienced personnel to compete effectively with the trading desks of the established big Western financial institutions in the major money centers. Perhaps most importantly, their head office cultures are entirely oriented toward the domestic market and operations in a market socialist economy. At the board and senior management levels, it will take time to build up an understanding of how to run a global network of foreign operations.

Thus far, Chinese banks seem to be aware of the magnitude of these challenges and to be proceeding, in true Chinese style, step by step. All of the characteristics of how China sets and implements policy can be seen in the approach that banks have been taking to international expansion. The strategic goal is clear— to serve the real economy, which in this case is the expansion overseas of Chinese commercial activity, and to provide a finan-cial dimension to China’s assertion of its place in world affairs as a major power. Rapid returns on financial investment seem secondary; avoidance of risk is primary in expan-sion plans. Thus, when the Chinese sovereign wealth fund, CIC, invested with exqui-sitely bad timing in Blackstone and Morgan Stanley in 2007 and then took a large book loss when the market crashed the following year, it was subjected to indignant public criticism for squandering state assets, even though in both cases those investments have since recovered and provide China long term with valuable insider positions in major American financial firms.

The lesson that China has drawn from such early investments overseas is that the risks of investing in overseas markets are different from what they are used to handling in the domestic China market. Officers of the planning department of one huge state manufac-turing company in 2009 discussed with me its thinking on investing in production plat-forms in Southeast Asia and confided that it finds the risks in Southeast Asian markets to be daunting. They said that in China, when they contemplate expanding production to a new province, they know exactly what to expect— everything will be clearly sorted out


with all relevant provincial authorities, bank support will be secure, compliance issues and civil society concerns will be minimal, and so planning is relatively straightforward. Not so in the Southeast Asian countries, where they were faced with a host of political, regulatory, civil society, and market variables that could not be precisely predicted. They were therefore inclined to caution— and indeed up to the time of writing, that company has yet to make a manufacturing investment in Southeast Asia.

Chinese banks have therefore been moving carefully in overseas expansion. Senior Chinese bankers with whom I have spoken acknowledge the challenges and seem anx-ious to avoid risk. In June 2015, Jiang Jianqing, Chairman of ICBC, set forth in an essay a clear view of both the logic and the perils of the overseas expansion of Chinese bank-ing. After summarizing the failures encountered by many Western banks in their inter-national expansion over the past century, he listed the management, cultural adaptation, risk control, and regulatory compliance obstacles facing Chinese banks as they go over-seas. In his view, the keys to Chinese success overseas will be ensuring that Chinese banks overseas are serving the globalization of the Chinese economy, that they localize their operations with cultural inclusiveness, that they establish “a world class product line,” that “corporation management and risk management should be the priority,” and that the international operations are integrated into the overall banking group’s management.15 In Chairman Jiang’s remarks, the themes recounted earlier in this book on domestic Chinese banking reappear in the context of China’s international expansion: “serving the real economy” comes at the top of Jiang’s list, risk management is paramount, and the need to bring Chinese operations up to global best practice echoes the borrowing from global best practice that China has been doing domestically in its banks over the past three decades.

It remains to be seen whether or not the Chinese government will wish the state banks to adopt a more aggressive strategy of international expansion in support of the more active projection of China’s geostrategic power internationally that is now occurring. Long term, a major Chinese presence in the money centers of the world will become rou-tine, as will branch networks of Chinese banks in countries of strategic interest to China, particularly in central and Southeast Asia, but that will require many years to build up.

Discussion of Chinese banks “going out” would not be complete without mention of two of the three policy banks, China Development Bank and the Import- Export Bank of China. Neither of these establishes presences outside of China (other than Hong Kong and a few representative offices elsewhere), but they have both been active in extend-ing loans to foreign governments in support of major infrastructure projects, particu-larly if the projects are undertaken by China. Sometimes loan repayment is secured with committed exports of commodities, such as oil, that China needs. Unlike the caution

15 “ICBC Chairman on the Overseas Expansion of China’s Banking Industry,” Central Banking.com, IFF China Report, http:// www.centralbanking.com/ centralbanking/ feature/ 2412016/ overseas- expansion- of- china- s- banking- industry, accessed August 1, 2015.

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http://www.centralbanking.com/central-banking/feature/2412016/overseas-expansion-of-china-s-banking-industry


exercised by the major commercial banks in going overseas, China Development Bank has not been reluctant to lend on a large scale into emerging markets with low credit rat-ings, such as Venezuela and Ethiopia, in support of Chinese national economic interests. Unless oil prices markedly recover from their 2015– 2016 lows, repayment of these loans is likely to become problematic.

One Western consultant who has been involved in advising the players on both sides of the table in negotiations of financial arrangements between Chinese banks and foreign clients commented to me on the difference in approach to such negotiations taken by Chinese banks compared with Western banks. Western banks will go into great detail concerning the adequacy of the legal framework for debt collection, the nature of the bankruptcy laws, and other technical issues in the countries into which they are lending. Chinese banks express little interest in those aspects of negotiating their loan contracts. They take a very long term view, see the loans as part of China’s overall economic relation-ship with the countries into which the loans are being made, and see the loans as simply enabling a larger commercial program for the countries.

Two other factors that will no doubt play a role in Chinese banks’ international expan-sion in future years will be internationalization of the rmb and the establishment of new multilateral development lending institutions led by China. Despite the optimistic fore-casts of some observers, it will probably be many years, if not decades, before the rmb begins to rival the role of the U.S. dollar as a global reserve currency, but it is steadily grow-ing in importance as a currency of settlement in international trade, now ranking second, but still far behind the U.S. dollar. At the same time, some central banks are beginning to hold a portion of their international reserves in rmb assets, and an increasing number of Chinese bonds are being floated offshore denominated in rmb. London, Frankfurt, and several other financial centers around the world have been designated as clearing centers for settlement of rmb transactions. HSBC, capitalizing on its strong position as the lead-ing foreign bank in China and the dominant bank in Hong Kong, is positioning itself as the major non- Chinese dealer in rmb. Nonetheless, the major beneficiaries of increased use of the rmb internationally will most likely be the Chinese banks themselves. Further exploration of these topics, however, lies outside the scope of this book.

204

This book described the role the state plays controlling and directing the banking sector, influencing financial outcomes through intervention in the banking system and in the economy as a whole. I explained the commitment of today’s Chinese banks not only to build shareholder value, but also to contribute to the real economy and support national economic development strategy. Supporting the thesis of Calomiris and Haber in Fragile by Design that development of national banking systems is conditioned by spe-cific national cultures and historical circumstances, I have argued that China’s banking system is shaped not only by emulation of international banking practice and by socialist ideas, but also by the legacy of Chinese history and culture.

If my argument that this dual role of banks is not only due to Communist Party policy, but also arises out of centuries of Chinese political and social culture, then we should be able to find antecedents for the dual role in the banking system that existed in China prior to the Communist Party victory in 1949. A brief survey of Chinese bank-ing in imperial times and in the Republic (1911– 1949) demonstrates that this is indeed the case.

10 China’s Banks, Sui Generis?

Banking is the Business of serving our state and society.Xu Jiqing, Chairman of National Commercial Bank, ca. 1925– 19301

1 Linsun Cheng, Banking in Modern China (Cambridge, UK: Cambridge University Press, 2003), 230.

China’s Banks, Sui Generis? 205

Historical Retrospective: Chinese Banking Before 1949

China’s experience with finance goes back more than 2,000 years. Currency in the form of bronze coins began to be used in the Warring States Period (475– 221 bc) and was stan-dardized under the first unitary Chinese state, the Qin (221– 207 bc). Coinage continued to be minted by the government and widely circulated in the Han Dynasty (206 bc– 220 ad), with copper being the main metal used in the mints. Silver displaced copper as the main material for coinage in the Ming Dynasty. Coins were used in partial payment of salaries, taxes, commutation of corvee labor obligations, and trade.2

After some decline in monetization of the economy during the four centuries of dis-unity that followed the fall of the Han, the Tang Dynasty (618– 907) saw a resurgence of monetization and the beginning of the use of bills of exchange for commerce and official use. During the latter part of the Tang, bills of exchange, called feiqian or “flying cash,” were used privately to reduce the cost, inconvenience, and risk of settling interprovincial trade payables through the physical transport of bulky strings of copper coins. Sometime around the tenth century, these bills of exchange evolved into the first paper money, which the government of the Song Dynasty (960– 1279) printed. Paper money coexisted with copper coins, silver ingots, bolts of silk, and other means of payment. Historian Frederick Mote stated that “Everybody in Song society used money.”3 The Mongol Yuan Dynasty (1271– 1368) continued to support the widespread use of paper currency. Credit extended for production and for receivables also became widespread during the Song and Yuan.4

This brief account of the development of currency, payments, and credit over the cen-turies between the Qin Dynasty up through the end of the Yuan Dynasty attests to the antiquity of Chinese banking. Economic historian Linsun Cheng writes that during the Song Dynasty “Chinese financial institutions were already conducting all major bank-ing functions, including the acceptance of deposits, the making of loans, issuing notes, money exchange, and long- distance remittance of money.”5 Strangely, the use of paper currency lapsed under the succeeding Ming and Qing Dynasties. The use of paper cur-rency was not revived in China until close to the twentieth century, when it was reintro-duced by foreign banks.

The story of banking in China picks up again in the mid Qing Dynasty with the estab-lishment of qianzhuang, sometimes called “native banks” but literally meaning “money

2 Mark Edward Lewis, The Early Chinese Empires: Qin and Han (Cambridge, MA: Harvard University Press, 2007), 54– 55, 64– 65; also Mark Elvin, The Pattern of the Chinese Past (Stanford, CA: Stanford University Press, 1973), 146, and Michael Loewe, Imperial China, (New York: Praeger, 1969), 194– 196.

3 Fredrick W. Mote, Imperial China 900– 1800 (Cambridge, MA: Harvard University Press, 1999), 363– 364, and Loewe, 195– 196.

4 Mark Elvin, The Pattern of the Chinese Past (Stanford, CA: Stanford University Press, 1973), 161– 163. 5 Cheng, Banking in Modern China, 11.


shops,” in Zhejiang and Jiangsu Provinces, centering on the cities of Shanghai, Ningbo, and Shaoxing. This delta area of the Yangzi River Basin area had long been the most eco-nomically vibrant area of China (and is the area in which the Bank of Taizhou and the Tailong Bank, described in Chapter 8, are domiciled). As commerce flourished there in the nineteenth century, the qianzhuang functioned as local commercial banks, exchang-ing and discounting commercial notes for businesses. They extended credit based on reputation and personal trust, with no security. The qianzhuang were well managed. They were self- regulated through the Shanghai Native Bankers Guild, under which a clearing system for qianzhuang was established which operated successfully up through the 1930s. Although qianzhuang banking was concentrated in the greater Shanghai area, native banks also opened in other areas of China. Scholar Ji Zhaojin, who has studied the workings of these native banks, concludes that through these native banks a “very sound financial institution was built upon a high degree of self- regulation. . . .“6

A bit later, a second type of financial firm, called piaohao (draft shops), emerged in the northern province of Shanxi. Shanxi merchants had for centuries engaged in long- distance trade to other parts of China. In the first half of the nineteenth century, these merchants set up piaohao primarily to remit funds in facilitation of trade, but in the course of this remittance business, they also accepted deposits and made loans, and even-tually issued drafts that could be cashed at other branches of the piaohao. The Qing gov-ernment, lacking any means of transferring funds around the country, also utilized the services of the piaohao for official payments. Gradually the piaohao assumed more and more official financial functions on behalf of local government treasuries. By the end of the nineteenth century, there were 32 piaohao with 475 branches scattered through all the provinces of China.7 By specializing in nationwide remittances, opening nationwide branches, and serving the credit needs of government officials, they complemented rather than competed with the services of the localized and private sector oriented native banks.

Later in the nineteenth century, a third variety of financial firm appeared in China— foreign banks, centered on Shanghai and the other foreign treaty ports. International trade was entirely handled by foreign trading firms. The native banks were not equipped to handle the financing needs of foreign trade, so this niche was occupied by foreign banks. As foreign trading firms were limited in penetration of the domestic trading net-works of China,8 this left the native banks with control of domestic trade finance. It was in Shanghai that the two types of financial institutions, one Chinese and one foreign, met with each other in a mutually beneficial relationship.

Foreign banks thrived under the protection of the extraterritorial rights they enjoyed in the treaty ports, free of Qing government control. They not only financed international

6 Zhaojin Ji, A History of Modern Banking: The Rise and Decline of China’s Finance Capitalism (Armonk, NY: Me. E. Sharpe, 2003), 11– 12.

7 Cheng, Banking in Modern China, 11– 14. 8 Dwight H. Perkins, “China’s Prereform Economy in World Perspective,” in China’s Rise in Historical Perspective,

ed. Brantly Womack (Lanham, MD: Rowman & Littlefield, 2010), 112.


trade and handled international remittances, they also loaned to the native banks, issued bank notes for circulation within China, and financed Qing government indemnity payments owed to foreign governments. While both the Chinese and foreign institu-tions conducted banking functions, their customer bases, credit risk controls, and scale were very different. The Chinese called the native banks qianzhuang and came up with a new name for the foreign banks— yinhang, literally “silver firm,” thus distinguishing between the two types of institutions. According to Linsun Cheng, the term yinhang first appeared in a Chinese– English dictionary in the 1860s to describe a modern, Western- style commercial bank, but actually it was already in use by 1854, when it appeared in a Hong Kong– based Chinese language missionary magazine. Between the 1850s and 1900, a number of different words for ‘bank” contended in Chinese usage— four translitera-tions and twelve translations. The transliterations gradually dropped away, and ultimately the word yinhang won out over contenders such as chaoshang. It is surmised that the acceptance of yinhang may have been influenced by the Japanese adoption at that time of the Japanese word ginko, which is the Japanese pronunciation of the characters for yinhang.9

In the latter part of the nineteenth century, China, weak and battered by the incur-sions of Western powers at its doorstep, was searching for ways to restore national wealth and power. The government realized the need for development of industry, but, reel-ing under the weight of paying indemnities to foreign powers after the Boxer Rebellion, it lacked funding to start industries. The piaohao and the native banks were small- scale private enterprises; they lacked the capital resources needed to fund large undertakings. Moreover, they were conservative, content to lend based on personal knowledge of the customers with whom they had been dealing for years, financing self- liquidating trade transactions. The foreign banks served foreign trade and the foreign business community in the treaty ports and would not take on the risks of what would today be called “devel-opment” finance. Progressive Qing officials realized that China needed modern banks of its own in order to pursue their dreams of developing Chinese industry.10

After considerable debate between the conservative and progressive factions of the Qing government, the first modern Chinese commercial bank, the Imperial Bank of China (zhongguo tongshang yinhang), was established in 1897 by a senior Qing official, Sheng Xuanhuai, with offices in Shanghai. It was set up by imperial edict as a joint stock company, with capital subscribed by both the government and private interests. Sheng announced that “All business methods pursued by the IBC will entirely follow the regu-lations of the Hong Kong and Shanghai Banking Corporation.”11 To ensure that this in fact happened, he hired a British banker, A. M. Maitland, to run the operation, with the assistance of several other foreign professionals. Unfortunately, the bank did not garner

9 Personal communication from Endymion Wilkinson, October 1, 2015. 10 Cheng, Banking in Modern China, 83– 97. 11 Quoted in Cheng, Banking in Modern China, 25.


deposits, suffered losses from the Boxer Rebellion, could not wrest the remittance busi-ness from the piaohao, and so was unable to grow and provide funding for the develop-ment of Chinese industry, for which purpose it had been established.

The next attempt at establishing a modern Chinese commercial bank was the opening in 1906 by the Board of Households (hubu) of a bank, initially called the Hubu Bank, and then in 1909 renamed the Da Qing Bank. The Da Qing Bank was set up to be a central bank, with exclusive right to handle all official transfers, the right to issue notes, and the right to run the state treasury. This severely diminished the remittance business of the piaohao, beginning a process of gradual shrinking and ultimate disappearance from the financial scene of the piaohao. The government now understood the importance of developing indigenous modern banks. It established the Bank of Communications in 1908, and a total of seventeen banks, some official, some official– private joint ventures, and three private banks were opened in the twilight years of the Qing Dynasty.12

At the end of the Qing Dynasty, Chinese banking consisted of the traditional piao-hao firms specializing in nationwide remittances, the qianzhuang financing domestic commerce based on credit standing and reputation of the clients, embryonic Chinese national central bank and modern private sector Chinese commercial banks, and, most powerful among the four, foreign banks in Shanghai and other treaty ports, with their lock on all international funding and payments. Additionally, the non- formal traditional credit systems that had long existed in towns and rural areas to provide local financing continued to play a role.

In addition to the banking system, in the late Qing Dynasty, the government at both the national and the local levels began to borrow money from foreign lenders through issuance of bonds. These bonds were secured by the foreign lenders having a lien on cus-toms revenue, or on taxes such as the salt tax— an aspect of the extraterritoriality that existed in China at that time. To ensure the availability of these revenues to service these bonds, the foreign lenders took control of collection of the taxes themselves. Over the course of years, with increasing bond issues by the Qing government, national and local fiscal revenues were steadily eroded as foreign creditors claimed them for payment of bond obligations. Scholars Huang Haizhou and Zhu Ning believe that the precarious financial position of the government, with an overload of foreign debts, may have been one of the reasons for the ultimate overthrow of the Qing government in 1911.13 (Lest we think that such an invasion of the sovereign rights of a nation to control its own domestic finances could only occur in a bygone imperialist era, we have only to look at the unfor-tunate situation in which the Greek government finds itself in the second decade of the twenty- first century to realize that there are modern- day equivalents.)

12 Cheng, Banking in Modern China, 30– 32. 13 Haizhou Huang and Ning Zhu, “The Chinese Bond Market: Historical Lessons, Present Challenges, and

Future Prospects,” in China’s Emerging Financial Markets: Challenges and Opportunities, eds. James R. Barth, John A. Tatom, Glenn Yago (New York: Springer, 2009), 526– 530.


Almost no bonds were issued domestically to local borrowers, partly because China’s legal system did not inspire trust on the part of investors that they would be able to claim their rights as bond- holders, but also because the imperial government felt that it would be demeaning to ask for loans from its own subjects. As a result, in the declining years of the Qing Dynasty, issuance of foreign bonds was associated with national humiliation at the hands of foreign powers, yet no domestic bond market existed to serve as an alterna-tive long term source of funds.14

After the overthrow of the Qing government and establishment of the republic in the xinhai revolution of 1911, to guarantee the continued servicing of the debts of the deposed Qing government to the foreign banks, China’s customs duties, salt tax, and railway receipts were deposited with the foreign banks first; after debt was serviced, the residual was passed on to the Republican government. Despite this burden, the Chinese banking system developed rapidly on the foundations laid down at the end of the impe-rial era. The period 1911 through 1927, known as the Beiyang government period, was a time of political instability, clashing war lords, and weak central government in Beijing. Nonetheless, a total of 266 new banks were established during the Beiyang period, approximately half of which had failed by 1927. The Beiyang government supported the establishment of modern banking. Minister of Finance Chen Jintao in the early years after the revolution stated that “the wealth of a country relies on its industry, and the life-blood of industry relies on finance. We will take it as our obligation to promote modern banks.”15 Although many banks established during this period were small and unstable, three leading banks did emerge in Shanghai, and four in the north, centered on Tianjin.

Meanwhile, the Da Qing Bank was reorganized in 1912 under dominant government control as the Bank of China, operating as both the central bank and the principal dealer in foreign exchange transactions. The present- day Bank of China traces its lineage back to this Bank of China of the early Republican period. Feeling that the bank could not function properly under government control, the then CEO of the bank arranged for substantial share subscriptions in BOC from various Shanghai banking groups, so that by 1918 the bank was under dominant private ownership.

In 1927, Chiang Kai- shek ( Jiang Jieshi) led the Guomindang army, based in the south of China, on the Northern Expedition, the victorious conclusion of which ended the Beiyang government in Beijing and enabled establishment of a new government with its capital in Nanjing. Despite the beginning of the civil war with the communist guerilla forces and the continued quasi autonomy of some warlord forces, China again had a sem-blance of unity, tariff autonomy was regained, and a new national currency was put in place. The first independent bank supervisory body, the Bureau of Financial Supervision, was established in 1927, but was largely ineffective due to extreme shortage of staff.

14 Huang and Zhu, “The Chinese Bond Market,” 527. 15 Cheng, Banking in Modern China, 39.


During that ten- year period ending in 1937, however, Chinese banking flourished— the “Golden Age of modern Chinese banks.” The old piaohao, unable to compete with the modern banks, withered away, and the qianzhuang, while still having their niche in financing domestic commerce, lost overall market share to the modern banking sector, which was expanding both in size and in quality of management. Just prior to the com-mencement of the Golden Age, total banking system capitalization consisted of modern national commercial banks 40%, foreign banks 37%, and qianzhuang 23%, indicating that national commercial banks had dislodged foreign banks as the strongest players in the banking sector. While still cautious and principally focused on lending to the com-mercial sector, the national commercial banks were also lending to industry, as Sheng Xuanhuai had hoped thirty years earlier when he advocated the establishment of modern banks under the Qing.

Both Linsun Cheng and Ji Zhaojin, in their studies of Chinese banking development, emphasize the extent to which the leaders of the fledgling national commercial banks were influenced by patriotism and adherence to Confucian philosophy. Bank sharehold-ers and executives saw building modern banks as part of the process of reasserting national sovereignty in the face of foreign encroachment— the regaining of “wealth and power” described in Chapter 2. Ji writes that bankers were politically involved and “dreamed of establishing a national capitalist society with democratic politics and a prosperous economy.”16 They therefore saw financial support of Chiang’s Northern Expedition in 1927 as part of their patriotic responsibility. Later, disillusioned with the corruption and incompetence of the Nanjing government, they resisted the demands of the government for funding.

Patriotism was combined with Confucian ideals, leading to a strong sense of service to society and to the country. Linsun Cheng writes: “While involved in profit- making busi-nesses, these Chinese bankers believed that they were assuming their responsibility to serve society and their success would be a possible means of salvation… .” The Shanghai Bank set “serving society” (fuwu shehui) as the bank’s motto, and the Chairman of the National Commercial Bank, Xu Jiqing, in a statement typical of the spirit of the times among Shanghai bankers, said “What is most important for a bank’s leader is to keep the bank’s credit so that it can serve society better. A bank’s job is not to make fortunes for its shareholders, nor for the bank’s staff, but to serve society.”17 In the Bank of China, monthly staff meetings were held to inculcate a traditional sense of ethics among the staff.18

It was not, however, just patriotism and Confucianism that drove the growth of these banks. Senior management, imbued as they were in that age with a traditional classical Chinese education, were also mostly trained at the university level overseas, especially in

16 Ji, A History of Modern Banking, 164. 17 Cheng, Banking in Modern China, 230. 18 Cheng, Banking in Modern China, 229– 230.


the United States, and so had a good understanding of modern Western business man-agement and international banking.

Banks during the Nanjing “Golden Decade” were primarily under private sector own-ership and were market driven, despite the Nanjing government’s ever- more insistent demands for financing from the banks, backed up by strong- arm tactics. Not only was there tension with the government over funding of the chronically empty treasury, but also there was policy conflict over ownership. Sun Yat- sen, as father of the republic, had articulated some rather ill- formed ideas of socialist origin that China’s “financial insti-tutions, major communications lines, heavy and basic industries, and other economic sectors that were vital to public welfare ought to be under government control, either through state ownership or state management.”19 This evolved under Chiang’s leader-ship into “national capitalism,” which in effect meant that the major financial institutions should be under the control of Chiang’s allies in the government— a system that has been described as bureaucratic monopoly.20

The Nanjing “Golden Decade” was brought to an end by a combination of China’s international currency crisis that occurred in 1935, by the government’s intention to implement “national capitalism,” by the evacuation of banks from Shanghai when the Japanese surrounded the city, and by the financial exigencies of total mobilization to fight the Japanese invasion. By the end of 1938, the government had seized control over all the major banks. That year it decreed that all foreign exchange transactions must go through the Central Bank of China, thus starting government control over foreign exchange movements that has continued to the present day.

After the 1911 Revolution, the republican government assumed all the foreign bond obligations of the former imperial government, and in addition began to issue bonds domestically, primarily to retail investors. Government finances were chronically mis-managed, and by the 1920s the government had defaulted on both domestic and for-eign bonds, leading to restructuring. It defaulted again in 1935, and then during the war resorted to massive bond issuances, most of which were subscribed to by Chinese banks under duress.21

After the war ended in 1945, the Nationalist government further expanded its con-trol of private banks at the same time that it lost control of the economy and national finances, with hyperinflation and bank runs. The banking situation that the communists inherited upon taking over the government in 1949 was shambolic— a sad collapse from the growing and prosperous banks of the “Golden Decade.”

Inflation, however, solved the government’s problems of servicing bonds, as it could meet payments with devalued currency. The result, however, as Huang and Zhu point out, was that “the domestic bond market damaged the image of the bond market in

19 Cheng, Banking in Modern China, 89. 20 Ji, A History of Modern Banking, 165. 21 Huang and Zhu, “The Chinese Bond Market,” 531.


China, and domestic investors became very suspicious of bond financing after suffering steep personal losses.”22

In this brief rendition of China’s pre- 1949 banking history, what do we find in the banking system that presages Chinese banks of today? Several common themes stand out:

1. Banks serve the real economy. Whether Sheng Xuanhuai’s advocacy of establish-ment of a national commercial bank to fund growth of industry in late Qing China, or Beiyang Minister of Finance Chen Jintao’s support for the establish-ment of banks to foster industrial development, or the fervent Confucian patrio-tism of Shanghai’s commercial bankers hoping that their banks could be a means of strengthening the nation and reasserting national sovereignty, the sentiments are no different from Chinese commercial bank annual reports today that high-light bank support of national economic development plans. For example, the BOC’s Annual Report 2014 states: “The bank proactively served the nation’s strategy and explored new approaches and models in an effort to enhance its ability to support the real economy. Credit resources were mainly allocated to key social and economic areas and weak points so as to facilitate the sound and steady development of the real economy.”23 China’s bankers were then and are now highly nationalistic and see their banking institutions as contributing to national development.

2. Confucian and foreign models for banks. In the spirit of ti and yong (essence and technique), the Shanghai commercial bankers were imbued with traditional Chinese worldview but were thoroughly conversant with foreign management and financial techniques, just as China’s banking leaders are today. Then, as now, much was learned from the practice of foreign banks. A Hong Kong and Shanghai Bank officer was employed to be the first general manager of a Chinese bank; a century later, HSBC (the later name for the former Hong Kong and Shanghai Bank) is invited to invest in Bank of Communications, to second staff to its management team, and to transfer technology. Many Chinese bankers have studied finance and economics in Western institutions, just as their predecessors in Shanghai had eighty years before.

3. The Chinese banking system has been a hybrid of state and private banks. The first Chinese banks at the end of the Qing Dynasty, the Imperial Bank of China, the Da Qing Bank, and the Bank of Communications, were all state sponsored. The Bank of China over the course of its century of history has bounced back and forth between government and private control.

22 Huang and Zhu, “The Chinese Bond Market,” 532. 23 Bank of China, Annual Report 2014, 86.


4. Large modern banks coexist with smaller, more local nonbank institutions that are less regulated. Just as the self- regulating qianzhuang played an indispensable role in keeping credit flowing to small businesses a century ago, so the “shadow banking” institutions, the city banks, and the smaller tier 3 institutions today play a role in supplementing the credit granted by the banks, relying more on local knowledge and charging higher spreads commensurate with higher risk.

5. Risk avoidance characterized the national commercial banks of the Republican period, just as it does the state and joint stock banks today. Chinese bankers have been conservative in venturing into areas where they felt they could not control the credit risk.

6. Chinese banks have always sought professional managers. When the Imperial Bank of China was established, China had no banking expertise, so foreigners were employed to manage the bank. When banking reforms got under way in the 1980s, 1990s, and first decade of the twenty- first century, foreign advisors and consultants were employed and secondment of management was sought from foreign bank shareholders.

Well before the Communist Party came to power in 1949, key characteristics of con-temporary Chinese banking were very much present in the early years of development of banks at the end of the Qing Dynasty and during the Republican years. Calomoris and Haber’s thesis in Fragile by Design— that national culture conditions national banking systems— is well supported by the history of banking in China.

State Led Models

Does this path dependence, this historical continuity, then imply that Chinese banking is sui generis? That it is in a class by itself ? In many ways China’s state- led approach to economic development and its hybrid banking system are sui generis. China’s approach to development has incorporated political elements from its own historical background into the Soviet party- state approach, resulting in a political economy that seems thus far to have worked well on Chinese soil, avoiding the fate of the Leninist party- state in the former Soviet Union. The combination of a pervasive and highly evolved bureau-cratic party- state that intervenes heavily in a thriving market socialist economy is with-out parallel, with the possible exception of Vietnam, which in any event differs from China in being a much smaller nation and thus far lagging behind China in economic development.

Much writing critical of China’s banking implies that a transition from the pres-ent market socialism system of banking to a more market- conforming banking system approximating the Anglo- American system would be the most desirable outcome. If one accepts the argument of Walter and Howie in Red Capitalism, then perhaps China would


have been better off if reform in the direction of a fully market capitalist form of banking had proceeded rapidly over the past decade.

These critics, however, ignore the experience of countries, Asian and Western, that have prospered not in spite of, but arguably because of, governments that have been highly interventionist in their economies, defying the doctrines of neoclassical economics and not adopting the practice of fully market capitalist economies. In their recent book, Creating a Learning Society, Joseph Stiglitz and Bruce Greenwald state: “Governments can help infant economies grow. In most of the countries that have been successful in making the transition from less developed to more developed, from a stagnant economy to a dynamic economy, governments have done so.”24

Stephen Roach makes the same case more emphatically: “Japan and Europe have long favored state subsidies, state ownership, and other measures to support key industries, as have most developing countries. Apparently economic development is far too important to be left to the markets.”25

Recall economist Li Yining’s dictum, quoted early in the book, that what constitutes good economic policy is not immutable but evolves depending on the situation and on the stage of development. Rejecting ideology that dictates one optimal solution for all cases, a country should consider policies that suit its own institutional heritage and value systems and that evolve with the pace of development of its economy. A banking system that is suited to the needs of a country that is still at a low income level of development may be different from what is needed at higher levels of development.

Several countries have adopted successful development strategies in which the state has played a leading role, not just as regulator, but also as major economic actor, intervening heavily in the market in various ways, through a prominent role for state bureaucracies to undertake industrial policy and overall economic planning, through state ownership of key industries, and through purposely distorting market prices in order to guide eco-nomic behavior and activity in the directions that will best accomplish state development goals. China, as described in earlier chapters, is guilty of all these deviations from neoliberal orthodoxy.

Several social scientists in the 1990s dubbed these state- led economic approaches as “developmental state” strategies. Japan during the first decades of its postwar reconstruc-tion and development, Korea and the region of Taiwan from the 1960s through the 1980s are held up as having followed developmental state strategies. Singapore and France have also been described as having followed developmental state paths, and more recently, for a period of time, so has Ireland, until its economy was devastated by excesses in its banking and real estate sectors. In recent years, with the turn- of- the- century triumph of neoclassical


25 Stephen Roach, Unbalanced: The Codependency of America and China (New Haven, CT: Yale University Press), 123.


economics, the concept of “developmental states” has become distinctly unfashionable. Some economists and political scientists have pointed out that earlier all- encompassing developmental state interpretations of some state- led economic success stories have been overly simplistic, missing the complex reality that more finely textured historical analysis is now revealing.26

There is a body of economic literature that provides theoretical underpinnings for developmental state policies. The developmental state model traces its intellectual roots back to a mid- nineteenth- century German economist, Friedrich List (1789– 1846), who was himself inspired by the great philosopher Georg Hegel (1770– 1831) and the first American secretary of the treasury, Alexander Hamilton. Studying the works of Adam Smith and the other classical economists, Hegel accepted the role of markets in national development, but, observing the immiserating effect of industrialization on England’s working class, he wrote about the need for government to intervene in the market to ensure that all members of society benefited from economic development.27

List and other members of the German economic school of “historicism” proceeded from Hegel’s concerns to develop policy recommendations for countries entering into industrialization. List’s thought was a reaction against the static analysis of the British classical economic theories that dominated economic thinking at the time. He believed that classical economic theory could only be useful in a fully developed economy. At that time, compared with Britain, Germany was an industrial late developer. List believed that German development would not be well served by application of classical economic theories, which erred in assuming universal validity for all stages of histori-cal development and for all countries. He introduced historical stages of development into economic thinking (note the similarity with Li Yining) and therefore favored trade protectionism during the development convergence stage for countries that needed to develop their backward industries (in line with Stiglitz and Greenwald’s thinking two centuries later). List’s ideas on the role of the nation- state in economic development, as opposed to a pure laissez- faire approach, were most likely influenced by the thinking of Alexander Hamilton, first secretary of the treasury in the United States, with whose ideas List became familiar during a lengthy sojourn in the United States.28

Economic historians treat List’s thinking as heterodox, and certainly he is not in the mainstream of the great classical and neoclassical economists Adam Smith, John Stuart Mill, Alfred Marshall, and others. Few people know of or study List today. Yet he had a

26 In particular, the excellent essays in Byung- Kook Kim and Ezra F. Vogel, eds., The Park Chung Hee Era: The Transformation of South Korea (Cambridge, MA: Harvard University Press, 2011).

27 Gerhard Lehmbruch, “The Institutional Embedding of Market Economies,” in Origins of Nonliberal Capitalism: Germany and Japan in Comparison, ed. Wolfgang Streeck and Kozo Yamamura (Ithaca, NY: Cornell University Press, 2001), 53– 54; and Robert B. EkelundJr. and Robert F. Hebert, A History of Economic Theory and Method, 6th ed. (Long Grove: Waveland Press, 2014), 284.

28 Ekelund and Hebert, A History of Economic Theory and Method, 265– 267.


profound influence after his death on the development of the German national economy later in the nineteenth century and also on the development of the Japanese economy at the same period. List and other German advocates of a strong role for the state in direc-tion of the economy were studied and taken up by leading Japanese economic thinkers during the Meiji Restoration.

The “developmental state” school of economics calls for a strong controlling role for the state in directing investment, often intentionally distorting prices to induce invest-ment in particular strategic areas that would have been neglected had the market been left to its own devices. The state worked closely with entrepreneurs and bankers to exe-cute development policy. Japan and Korea, after they had succeeded in join ing the very small number of developing nations that have risen to upper income status, then at least partially dropped much of developmental state policies, although in both countries the state still plays a strong interventionist role in the economy today.

With the triumph of neoclassical approaches to economic development (Washington consensus) in the ’90s and through the early part of this century, developmental state economics fell thoroughly out of favor for a period of time. Today, widespread question-ing of neoclassical economics’ claims of universal validity is reviving interest in aspects of developmental state economics, updated to suit the new environment of twenty- first- century globalization and the digital age.29

Developmental state theory is used to describe the post– World War II reconstruc-tion of the Japanese economy, but it also fits nineteenth- century Meiji era Japan in many respects as well. William Lockwood, in his comprehensive The Economic Development of Japan, emphasized the role of the Meiji state in guiding the development of the economy. At the end of the nineteenth century, Japan had a central bank, a few state- controlled banks, five large private banks connected with the great zaibatsu, and hundreds of smaller private banks. The government did not actually invest in the state- controlled banks, leav-ing capital subscription to the private sector, but, as Lockwood explained, “the govern-ment appointed or approved the principal officers and directors. Under their statutes and bylaws, policies were also subject to continuous scrutiny and control by the Ministry of Finance… . Through its relationship to these institutions, as well as its participation in various ‘national policy companies’ like the South Manchuria Railway and Oriental Development Company, the State was in a position to exert a large influence over the investment of private funds when it chose to do so.”30 During the mobilization for war in the 1930s, and during the war, the Japanese government effectively took over planning and managing the economy in close coordination with large business groups.

29 In particular, see Peter Evans, “The Developmental State: Divergent Responses to Modern Economic Theory and the Twenty- First- Century Economy,” in The End of the Developmental State?, ed. Michelle Williams (New York, NY: Routledge, 2014), 220–240.

30 William W. Lockwood, The Economic Development of Japan, 2nd ed. (Princeton, NJ: Princeton University Press, 1970), 515.


After the war ended, the political institutions of Japan evolved as the country became a democracy, but the bureaucracy remained largely in place, and with it many of the war-time ways of thinking about directing the economy and institutions of state guidance.31 Writing of the rapid Japanese economic growth of the 1960s, Lockwood commented, “The hand of government is everywhere in evidence, despite its limited statutory powers. The ministries engage in an extraordinary amount of consultation, advice, persuasion, and threat. The industrial bureaus of MITI proliferate sectoral targets and plans; they confer, they tinker, they exhort. This is the ‘economics by admonition’ to a degree incon-ceivable in Washington or London.”32 Moreover, the state played a large role in fund-ing postwar investment, both public and private. Lockwood noted that during the early 1960s, the state in Japan controlled one third of total investment spending, an amount only exceeded by West Germany’s 40%.33 Lockwood’s view of the role of the state in Japan is supported more recently by Dwight Perkins, who in 2011 wrote “it was Japan that pioneered an approach to industrial development in which government institutions played a central role… .”34

Korea’s economic takeoff commenced about a decade after Japan’s got underway, and more than a decade prior to the commencement of Reform and Opening in China. Korea’s political economy and approach to economic development owe much to having imported and fully incorporated into its own culture the Confucian orthodoxies of China centuries ago, but equally much to influences from Japan during the half century that it had been a colony under Japanese rule through the end of the Second World War. Korea’s development under President Park Chung Hee’s leadership (in power 1962– 1976), was driven by powerful state direction, with a strong role for the bureaucracy, distortion of factor prices, including financial repression, and other key characteristics of a “develop-mental state” model. Park had been educated in Japan when Korea was a colony of Japan, he had served in the Japanese army, and he was impressed with how Japan had mobilized the economy both for war production and in the postwar reconstruction effort, so it was natural that Japanese ideas influenced Park’s economic approach.

Orthodox development economic approaches at the time held that Korea should have featured its comparative advantage in agriculture as the core of its growth strategy. Park realized that to do so would have condemned Korea to being at best a middle- income economy based on farmers. That was not his vision. Instead he focused not on “static comparative advantage” of the moment, but on “dynamic comparative advantage” that involved taking enormous investment risks, but which resulted in the creation of an advanced industrial economy. To achieve this, Park flaunted conventional neoclassical

31 Lehmbruch, “The Institutional Embedding of Market Economies,” 74– 76, 87– 91. 32 Lockwood, The Economic Development of Japan, 649. 33 Lockwood, The Economic Development of Japan, 613. 34 Dwight H. Perkins, East Asian Development: Foundations and Strategies (Cambridge, MA: Harvard University

Press, 2013), 67.


economic theories not only of comparative advantage, but of market- determined pricing and private sector leadership of growth.35 He funded his industrial policy, in which the government picked winners, with a tightly controlled banking system and extreme finan-cial repression of not only negative real interest rates, but for a brief period lending rates below deposit rates as well.

Korea was not, however, a clone of Japan, whose economic takeoff had preceded, and in many ways inspired, Korea’s. Nor was China, which was to follow, simply copying what had succeeded in Korea. There were important aspects of Korean development that were distinctly Korean. Moreover, as mentioned above, several different factors accounted for the success of the particular Korean model of development, so that a simplistic “devel-opmental state model” cannot fully explain the Korean hypergrowth story. The most notable characteristic of Korean developmental strategy that distinguishes it from Japan and China’s experience is that Korea was unable to mobilize sufficient domestic savings to support its industrial investment and high rate of growth, despite the financial repres-sion it implemented and which was to later be so effective in mobilizing domestic savings when employed as a strategy in China. Korea therefore relied on both its industrial con-glomerates borrowing in foreign currency from abroad and Korean banks supplementing their inadequate domestic deposits with overseas borrowings. The result was not one, but four financial crises brought about by inability to repay excessive foreign borrowing, most spectacularly in 1997, when the financial crisis in Thailand and Indonesia spread to Korea. Sudden recall of short- term foreign loans by international borrowers plunged many of the industrial conglomerates and banks into bankruptcy.

Nonetheless, in contrast with the role of the state in the Anglo- American capitalist model, the Park authoritarian government, in the words of political scientists Chung- in Moon and Byung- joon Jun, “emulated the ideal of an institutionalized organic state corporatism, and embodied Park’s conservative nationalist vision of single- mindedly pursuing economic growth.”36 In this state- led, collectivist approach and single- minded pursuit of economic growth, Park’s Korea and China under Reform and Opening have much in common, including using the banking system and financial repression to allo-cate national savings into economic sectors that had been designated as priority under national industrial policy. In China, however, financial repression was successful in mobi-lizing domestic savings, so that China did not need to rely on foreign borrowings.

In four East Asian nations— Japan, Korea, China and Singapore— it is believed that the state should play an important guiding role in economic development. Other coun-tries around the world have also subscribed to this approach, although few have achieved the success of that East Asian quartet. The developmental state approach is at odds with the neoclassical approach to development, espoused by adherents of the neoliberal

35 Stigltiz and Greenwald, Creating a Learning Society, 25– 27, 338– 340. 36 Chung- in Moon and Byung- joon Jun, “Modernization Strategy: Ideas and Influences,” in ed. Byung- Kook

Kim and Ezra F. Vogel.


Washington Consensus, upholding the Anglo- American model of market capitalism as the sole road to successful economic development.

The neoliberal approach does not take into account the experiences over the past half century of the East Asian developmental states, nor the diversity of models that exist within advanced Western capitalist economies. China’s banking system shares elements with a few advanced nations that do not follow the Anglo- American shareholder- focused market capitalism model of banking. The German economy, variously described as social market capitalism and cooperative market capitalism, is an example of a success-ful alternative to the Anglo- American model. In Anglo- American market capitalism, the shareholder is the key stakeholder for whose benefit the economy functions; in German capitalism multiple stakeholders, including employees, the public at large, and the state, as well as shareholders have a claim on the fruits of corporate enterprise.

Based on ownership, the German banking system is composed of “three pillars”: private nationwide banks (36% of total banking assets in 2010), public banks (Landesbanken), and cooperative banks (Sparkassen). These public and cooperative banks have served the German economy well since World War II, funding the reconstruction of the German economy and infrastructure from the rubble of the war and supporting Germany’s rise to become the most powerful economy of Europe. The German economy is heavily based on small and medium- sized manufacturing businesses (mittelstand), who derive their major financial backing from the public and cooperative banks.37

In the crisis of 2008, the large German private banks were hit hard, as were some of the regional public banks, due to their exposure to toxic Wall Street assets and speculation in derivatives, but the smaller savings banks, having avoided exposure to Wall Street, weath-ered the storm. The German government had to undertake a massive bailout of some of its banks at public expense. Moreover, since 2001, the EU has been pushing German publicly owned banks to detach themselves from state support. This has resulted in the German banking system evolving into something more reminiscent of other banking systems.

The point of this discussion of the Japanese, Korean, and German banking systems is neither to recommend them as models, nor to compare them with the Chinese banking system, but simply to point out that even in very advanced and successful economies, there exist divergent paths to economic development and a range of hybrid market econ-omies and banking systems in which the state plays a much more prominent role than it does in U.S. and U.K. banking, and which do not conform to the neoclassical orthodoxy of the Washington consensus over the past three decades.

37 Ellen Brown, The Public Bank Solution (Baton Rouge, LA: Third Millennium Press, 2013), 206– 207; also Fabian Hassan, “A View from Germany I— How the Three- Pillared German Banking System Has Gotten Through the Crisis,” Finance Watch, March 20, 2014, http:// www.finance- watch.org/ hot- topics/ blog/ 851- view- from- germany- 1, accessed August 10, 2015.

http://www.finance-watch.org/hot-topics/blog/851-view-from-germany-1

http://www.finance-watch.org/hot-topics/blog/851-view-from-germany-1


Actually there is no need for Americans to look abroad for examples of alternative mod-els of a strong role for the state in banking and as an economic actor. The Hamiltonian approach to governance, inherited in subsequent years by Henry Clay, Abraham Lincoln, Theodore Roosevelt, and Dwight Eisenhower, has always been a major political force in America, coexisting with the more libertarian stream of Jefferson and Jackson, now in an extreme incarnation as the philosophy of the Tea Party, which follows Reagan’s famous cry that “government is the problem.” Throughout the history of the republic, the U.S. government has played a role in development of transportation and communi-cations. The Erie Canal was constructed between 1817 and 1825 by the New York State government with a budget of $7 million, which was an enormous sum of money at that time. The Transcontinental Railroad, constructed from 1863 to 1869, was authorized by an act of Congress and carried out by private companies subsidized by federal govern-ment bond issues and land grants. And more recently the federal government was heavily involved in the development of the Internet.38 The U.S. government also directly extends credit through the Export Import Bank and the Small Business Administration. The lat-ter has special categories for various small businesses that further certain objectives that the government wishes to support, such as implementing pollution controls.39

The U.S. government also intervenes in situations where market failure appears to threaten the financial system and economic stability. The Troubled Asset Relief Program to prop the “too big to fail” banks in 2008 is well known. Now largely forgotten is Alan Greenspan’s intervention in October 1987 when there was a dramatic overnight collapse in New York Stock Exchange share prices. Panic ensued and the market started to seize up. Washington considered a variety of contingency plans to stop the crash in share prices, including closing down the exchange for a few days. Journalist Bob Woodward describes how Fed Chairman Greenspan, the arch- conservative believer in the ability of markets to take care of themselves, rejected closing the exchange but “was prepared to go further over the line. The Fed might loan money, but only if those institutions [the banks] agreed to do what the Fed wanted them to do. He was prepared to make deals. It wasn’t legal, but he was willing to do it, if necessary. There was that much at stake. At that moment, his job was to do almost anything to keep the system righted, even the previously inconceivable… .”40 Greenspan indicated to the markets that the Fed was prepared to extend whatever credit was needed to stop the decline. Woodward concludes that Greenspan’s intervention succeeded, preventing the stock market crash from becom-ing a wider economic collapse. “In the end, money talked— or at least the Fed’s openly stated willingness to provide it.”41

38 Stiglitz and Greenwald, Creating a Learning Society, 388. 39 SBA website https:// www.sba.gov/ category/ navigation- structure/ loans- grants/ small- business- loans/ sba-

loan- programs/ 7a- loan- program/ special- purpose- loans- program, accessed August 14, 2015. 40 Bob Woodward, Maestro: Greenspan’s Fed and the American Boom (New York: Simon & Schuster, 2000), 42. 41 Woodward, Maestro, 46.

http://www.sba.gov/category/navigation-structure/loans-grants/small-business-loans/sba-loan-programs/7a-loan-program/special-purpose-loans-program

http://www.sba.gov/category/navigation-structure/loans-grants/small-business-loans/sba-loan-programs/7a-loan-program/special-purpose-loans-program


In this 1987 crisis, we see the U.S. government’s determination to restore order to the securities market and to prevent a collapse in share prices from precipitating a broader financial crisis. The U.S. government was prepared to use the “visible” hand of the gov-ernment to back up the “invisible hand” in a case of market failure. The concerns of the U.S. government in 1987 were similar to the concerns of the Chinese government in the summer of 2015 when panic overtook the Shanghai securities market. The difference between the two situations does not lie in whether or not the government intervened to restore orderly markets, but in the vastly more sophisticated American investment com-munity, more developed regulatory mechanisms, and experience and expertise on the part of the government in how to deftly employ the “visible hand,” unlike the heavy- handed approach of the Chinese government in rescuing the Shanghai exchange.

222

This book has presented the story of Chinese banking’s successful transformation over the past fifteen years from a technically bankrupt vestige of the planned economy into a proper commercial banking system that is now competently managed and strictly supervised. There is, however, another viewpoint stating that the high profits and spec-tacular growth have been covering up a host of problems. Even if one does not accept that negative viewpoint, it is also true that the banking industry now faces a host of new challenges. In this chapter I review the principal critiques that have been made of China’s banking development over the past fifteen years and then look at the concerns analysts are raising about the future development of the banks.

The Collapse Narrative

The alternative viewpoint sees the development of Chinese banking in recent years very differently from the point of view put forward in this book. That alternative nar-rative maintains that financial reform has, since 2005, failed to fulfill the promise of the initiatives that got underway between 1998 and 2004, and it denies that genuine

11 Collapsing or Adapting?

China cannot, and should not, be assessed in the same way that America sees itself. The optics

of the two economies, as well as the lens by which they should be viewed, are very different.

So much of Washington’s China fixation misses that key point.Stephen Roach, 20141

1 Stephen Roach, Unbalanced: The Codependency of America and China (New Haven: Yale University Press, 2014), 252.

Collapsing or Adapting? 223

transformation of the banks has in fact occurred. In that narrative, the financial system is fragile, is a house of cards that cannot be sustained— a view that has achieved wide cur-rency among foreigners, and is perhaps most forcefully set forth by Carl Walter and Fraser Howie in their widely read and highly praised Red Capitalism: The Fragile Foundations of China’s Extraordinary Rise (2012). The same alternative viewpoint can also be seen in the repeated warnings of impending financial distress issued by Charlene Chu of the Beijing office of Fitch Ratings throughout the period from 2006 until her resignation from Fitch in 2014, and now resumed after she joined Autonomous Research as a senior partner.2 Gordon Chang, whose The Coming Collapse of China, written in 2001, predicted that the entire Chinese economy would come crashing down because of the NPLs of the banking system, was the earliest of the Cassandras.

Walter and Howie both have impressive credentials and deep experience of China. Red Capitalism marshals an array of facts and statistics to back up the passion that comes out clearly in their narrative. They do not mince words:

China’s banks look strong, but are fragile; in this, they are emblematic of the coun-try itself. The Chinese are masters of the surface and excel at burying the telling detail in the passage of time… . China’s financial system … has become increas-ingly complex; this complexity has begun to erode the effectiveness of the Party’s traditional problem- solving approach of simply shifting money from one pocket to another and letting time and fading memory do the rest.3

One focus of Walter and Howie’s critique of the banks is the issue of the bonds that the big four banks purchased from the AMCs. As discussed in Chapter 4, the accounting logic of this criticism is clear, but a rigid accounting approach overlooks the economic logic of China’s treatment of this problem and ignores the enormous benefits that arose not only to the banks, but to the entire economy as a result. They state that the PBOC’s “complex funding arrangements for NPL disposals, although practical given the govern-ment’s limitations, had never been a good solution.”4 They admit that it was a practi-cal solution, which, as I have emphasized repeatedly, is a hallmark of Chinese economic policy. Perhaps it was not a “good solution,” but was there any better solution? Sometimes the second- best solution is the only realistic option. Reading Walter and Howie, I assume that they would have preferred for China to immediately write down the debt by 80%, making impossible the listing and accompanying reform of the banks, and impacting the entire economic growth of the country just after China had joined the WTO. This was

2 Linette Lopez, “The World’s Top China Analyst Has a Doomsday Scenario,” Business Insider, August 18, 2015, http:// www.businessinsider.com/ charlene- chu- doomsday- scenario- 2015– 8, accessed October 12, 2015.

3 Carl Walter and Fraser Howie, Red Capitalism: The Fragile Foundations of China’s Extraordinary Rise, 2nd edi-tion (Singapore: Wiley & Sons, 2012), 29.


http://www.businessinsider.com/charlene-chu-doomsday-scenario-2015-8


not an option likely to appeal to China’s leadership— certainly not a practical solution. If the Chinese had gone that route, the transformation of the banks would have been much delayed, and I probably never would have become a member of the board of two Chinese banks, nor would I have written this book.

Another point Walter and Howie raise is that China’s banks “operate a business model that requires large chunks of new capital at regular intervals,” resulting from the need to fund the rapidly growing economy principally with bank lending. As bank assets grow faster than profit can sustain capital- lending ratios, banks need to go back to their shareholders for more capital. Granted, if dividend payments had been canceled, then there would not have been so pressing a need for repeated capital increases. But so what? A booming economy requires bank loans, which necessitate capital increases in banks that are earning high ROEs. That seems like a reasonable business proposition.

The weakness of the overall assessment by Fraser and Howie is that, while raising many valid issues, they project their Western cognitive framework onto a Chinese environment that does not fit the paradigms of Westerners— a mistake made by many foreign critics. In this regard, it is worth digressing to quote one American academic, Stephen Roach, and two German academics, Sebastian Heilmann and Dirk H. Schmidt.

Stephen Roach has closely followed China’s economic development over many years, both as a practitioner and an academic. As a practitioner he was chief economist of Morgan Stanley and then chairman of Morgan Stanley China, in which position he had extraordinary access to elite levels in China. As an academic he now teaches at the Jackson Institute at Yale University. Roach writes in his recent book Unbalanced: The Co- dependency of America and China, that it is “virtually impossible for nations like the United States to get out of their own skin in assessing ever- changing developments in China.” He goes on to maintain that “China cannot, and should not, be assessed in the same way that America sees itself. The optics of the two economies, as well as the lens by which they should be viewed, are very different. So much of Washington’s China fixation misses that key point.”5

Heilmann and Schmidt, in the introduction to China’s Foreign Political and Economic Relations: An Unconventional Global Power, an academic treatise about China’s foreign policy, write:

Both American and European depictions often characterize China’s rise to power in terms derived from the Western historical experience… . These catchwords express moral outrage or political condemnation. Furthermore, they often serve to boost a superficial sense of self- assurance among Western societies in the face of the growing competition from China. Yet sweeping denunciations of China hide many

5 Roach, Unbalanced, 251– 252.


particularly challenging aspects of Chinese expansion by subjecting novel develop-ments and experiences to old and outdated Western patterns of perception.6

The comments of Roach and Heilmann and Schmidt, applied to the financial sphere, point to the need to understand China’s banking system as something in many ways fundamentally different from Western paradigms, something that marches to a different tune from those with which Westerners are comfortable.

Walter and Howie compile a list of real problems that could threaten the stability of the system. Thus far, though, they have been wide of the mark in their conclusions, and as wrong in their predictions of how banking problems would damage China’s economy as Gordon Chang had been almost a decade earlier. Their conclusions would be reasonable if the banking system operated within an American cultural and political economy con-text. However, as suggested by Heilmann and Schmidt, they have left out of their analyses the entirely different Chinese context in which these problems arise and are addressed.

The fact that the system has not collapsed has not caused these skeptics to reflect on what they might have been missing. The skeptics simply say that the problems are being papered over, and the ultimate collapse will be all the deadlier. Only time will tell whether or not they are right.

One of China’s most senior economists remarked to me, “Western critics are not wrong in pointing out these problems. What they don’t realize is that by the time that they have identified a problem, we are already working on coming up with the solution.” An excess of confidence is dangerous, but given the magnitude of China’s banking transformation over the past fifteen years, and China’s record of success in dealing with financial sector problems, perhaps the economist can be pardoned the hubris and self- satisfaction in his statement.

The Chinese government and the Chinese banks themselves are the first to acknowl-edge that there is still much in Chinese banking that requires improvement and that there are manifold challenges ahead for bankers. Nonetheless, the system over the past decade has functioned reasonably well. The banks themselves have healthy balance sheets and have put in place the framework of good governance (but with “Chinese character-istics”), have provided around three quarters of the overall financing of China’s super-charged growth, have provided mortgage facilities for Chinese people to attain high rates of home ownership, have provided efficient modern digital banking services for consum-ers and firms, and most recently have turned serious attention to funding the SME sector, which is the real growth engine of the Chinese economy.

China makes no pretensions that it offers to other countries a “Beijing model” of how to run banking systems. It acknowledges that the Chinese banking system is rooted in

6 Sebastian Heilmann and Dirk H. Schmidt, China’s Foreign Political and Economic Relations: An Unconventional Global Power (Lanham, MD: Rowman & Littlefield, 2014), xv, xvi.


Chinese ways of governance and economic development, suited to China’s needs at its present stage of development, but perhaps not to other nations with different traditions and different development trajectories.

Critical Barrage

The argument of this book is at odds with the generally much less positive, and often alarmist or harshly critical, commentary on Chinese banking and finance found almost every day on the pages of the press and in the reports of investment analysts. Illustrating the differences between the point of view taken in this book and the negative consen-sus are two articles written by people who are presumably well equipped to comment on China’s economy: an article by Joe Zhang, published in the Financial Times in July 2014, and a column by Nobel laureate Paul Krugman, published in the New York Times in July 2015.

Having previously worked in the PBOC, author and economic observer Joe Zhang understands the workings of the Chinese government, showing that skepticism concern-ing China’s ability to cope with an increasingly challenging economic policy environ-ment is not restricted to foreigners. Nonetheless, the reasoning underlying the proposal in his article that the government should “starve the banks of new capital”7 ignores fac-tors of which he should be aware. Zhang states that a credit bubble is in the making, proceeding from the fact that the “Chinese economy, under the influence of fiscal and monetary stimulus for the past 36 years, is saddled with industrial overcapacity and weak corporate profitability.” The implication is that Chinese fiscal and monetary policy has been wrong ever since Reform and Opening began. If that is indeed the case, then China’s growth over that period of time in the face of bad government policy all along is nothing short of miraculous.

Zhang asks rhetorically “whether China should create some ‘bad banks’ to handle the vast amounts of bad debt in the banking industry.” (His comment, like that of many other observers, simply assumes that “vast amounts of bad debt” exists in the banking indus-try, without citing specifics.) His answer to the rhetorical question about “bad banks” is “absolutely not. The last time China did this in 2000– 2001, the bad banks proved to be the origin of today’s credit bubble. With a blanket deposit insurance regime, China’s banks are merely an extension of the government apparatus.” This ignores the fact that bank lending fueled the sustained economic growth of the intervening fourteen years, and enabled China to ward off the economic recession that hit Western countries in 2008.

Zhang goes on to suggest that “China’s banks should be forced to distribute most, if not all, of their net profits each year as dividends. Their existing lending capacity should be sufficient to support the economy for many years.” Finally, he concludes the article

7 Joe Zhang, “Stop Indulging China’s Banks or Risk Another Crisis,” FT.com, July 10, 2014.


by stating “there has been a backlash across the world against the austerity measures pre-scribed by the International Monetary Fund. However, China is the notable example where austerity is sorely needed.”

If Zhang were correct in maintaining that there is a credit bubble in China today, it would seem most imprudent for the government to choke off strengthening of the capital base of the banks. The government has many levers, which have been described in this book, for controlling the volume and direction of credit extension. Starving banks of cap-ital would seem to be the least desirable option. While such a policy prescription might seem sensible to some readers of the Financial Times, applying to China the austerity policies that have been applied in Europe is likely to induce the sort of financial stagna-tion that has plagued southern Europe over the past few years. British economist George Cooper describes what would happen were that policy to be implemented: “Allowing an economy to free fall into recession from a point of extreme over indebtedness is extremely dangerous, risking a self- reinforcing economic collapse along the lines of that which hap-pened in the Great Depression.”8 Zhang’s proposal is not a formula that would appeal to the economic leadership of China.

Equally critical of China’s financial management, renowned Nobel laureate Paul Krugman, commenting in his syndicated column in the New York Times, wrote of the Chinese government’s intervention to prop up the slumping Chinese security exchange during the month of July 2015 that “China’s remarkable success over the past 25 years notwithstanding, the nation’s rulers have no idea what they’re doing.” He goes on to say that “Every time you think the authorities have done everything possible to destroy their credibility, they top themselves… . The big news here isn’t about the Chinese economy: it’s about China’s leaders. Forget everything you’ve heard about their bril-liance and foresightedness. Judging by their current flailing, they have no clue what they’re doing.”9

Krugman is right in a sense. China’s top leaders for the most part did not and do not claim economic expertise. How many leaders of countries do have economic expertise? Over the course of his authoritarian eighteen years in power in Korea, Park Chung Hee is alleged to have become his own best economics advisor, but he would be the excep-tion. Clinton, Bush, and Obama— none of them have claimed proficiency in economics. They relied on the advice of the advisors they picked. Their choice of advisors reflected their basic predilections and political instincts of how the economy should work and the directions in which they wished to move. Advisors then formulated for them the pro-grams and policies that would be in accord with their overall visions.

8 George Cooper, The Origin of Financial Crises (New York: Vintage Books, 2008), 88. 9 Paul Krugman, “China’s Naked Emperors,” New York Times, July 31, 2015, http:// www.nytimes.com/ 2015/ 07/

31/ opinion/ paul- krugman- chinas- naked- emperors.html?rref=collection%2Fcolumn%2Fpaul- krugman&action=click&contentCollection=opinion&region=stream&module=stream_ unit&contentPlacement=4&pgtype=collection&_ r=0, accessed August 10, 2015.

http://www.nytimes.com/2015/07/31/opinion/paul-krugman-chinas-naked-emperors.html?rref=collection%2Fcolumn%2Fpaul-krugman&action=click&contentCollection=opinion&region=stream&module=stream_unit&contentPlacement=4&pgtype=collection&_r=0





Deng Xiaoping did not understand at any level of sophistication how market econo-mies worked. He did, however, have a fundamental insight that was correct: market economies were doing much better than China had fared under Maoist economic poli-cies. So he brought in Western advisors to set China on a new course. Krugman may be right that Deng did not know what he was doing— a problem that Deng solved by “crossing the river by feeling the stones.” Bound by neither ideology nor the dictums of either Mao Zedong or Milton Friedman, Deng relied on a number of different advisors, and on what his own economic team learned in their studies of other economies, to tell him what to do next. If it worked, he continued. If it did not, he made a tactical retreat. The results certainly vindicate his approach.

Westerners credit Zhu Rongji with great understanding of how markets worked. People who have worked with him have told me that actually he did not understand in great depth, as his professional background was in the workings of the planned econ-omy. Saying this in no way diminishes the man or his contributions to the development of China. He relied on a cast of bright Chinese to educate him and formulate policies which he then pushed forward. He was a fast learner, and he put into practice what he learned. As described in this book, Chinese leaders surround themselves with bright advisors to propose policies. Sometimes these policies did not work. Deng and Prime Minister Zhao pushed certain liberalization and decentralization policies too fast, resulting in highly destabilizing inflation, which required countering with contraction-ary policies. But the government was led by smart and pragmatic people. When they saw a policy was not working well, they changed it.

Overall, despite some policy setbacks and wrong decisions, China’s leaders have made the right calls on the big issues, and they have learned from their mistakes, enabling them to pragmatically adjust and get back on track. Since, as Krugman admits, the stock market slump is not of great long- term consequence, lashing out at China’s leaders for “not having a clue” seems a rather large leap in logic based on one supposedly bungled stock market intervention. It smacks of the Western peevishness at Chinese state inter-vention in the economy exceeding what the Washington Consensus feels is appropri-ate (and this despite the evidence, cited in the previous section concerning Greenspan, that the U.S. government has been prepared to do whatever it takes, in defiance of free market dictums, to prevent stock market meltdown). That as prominent and liberal an economist as Krugman would depart from his usual evidence- based economic analy-sis to add his voice to the negative consensus of “China bashers” shows the pervasive-ness and persuasive power of that negative consensus. Krugman’s criticism is the sort of “sweeping denunciation of China” of which Heilmann and Schmidt wrote.

The negative consensus view advanced by all these critics needs to be examined. China’s economy is the second largest in the world. Four of its banks rank among the top ten largest banks in the world. If the economy and the banking system are as badly managed as the negative viewpoint would suggest, then we should all be very concerned, as China’s problems have become the world’s problems.


What accounts for the degree of censure, indeed ire and hostility, that China’s eco-nomic policies and its entire economic system elicit from Western pundits? Sometimes one detects a sort of Schadenfreude whenever China experiences an economic setback, a gloating over reports of “ghost cities” or excess industry capacity. Other times perhaps it is a case of what Alan Blinder calls “Armageddonists.” Blinder writes that the “conse-quences of adverse economic events are typically exaggerated by the Armaggedonists— a sensation- seeking herd of pundits, seers, and journalists who make a living by predicting the worst.”10 Most of all, one senses a bit of American missionary zeal. In the late nine-teenth century and first half of the twentieth century, America sent missionaries to labor for years on end converting Chinese heathen to the way of the Gospel. Now America channels its missionary zeal toward getting everyone to agree with the secular gospel, the Washington Consensus.

The alarm on the part of the West at the challenge China’s success poses to the postwar global governance system dominated by the United States may also subconsciously be a factor. This defensiveness manifested itself clearly in the pique with which Washington reacted to the Asian Infrastructure Investment Bank set up by China. Or, in more sophis-ticated formulation, there is alarm that China has succeeded in becoming the second- largest economy in the world under a political economy framework that adopts some Western institutional norms (as in joining the WTO, meeting international accounting standards, and being an active participant in the Basel Committee setting standards for global banking), but does so within a political economy framework very different from Western liberal democracy and neoclassical market capitalism. To some in the West, this is threatening. A banking system that is controlled by the state simply has to be wrong and cannot work properly, even if it seems to have served China quite well over the past fifteen years, and even if state- dominated banking systems have worked well in several other countries over the past half century.

There are, of course, some significant exceptions to the negative consensus. A number of journalists and analysts and many academics publish objective critiques of China’s eco-nomic and financial performance, offering insight into what animates the Chinese politi-cal economy and accounts for its success. Over the years their balanced coverage has been validated by unfolding events.

Understanding the causes of the prevailing negative consensus should be the subject of a separate book. I would simply suggest that analyses heavily informed by faith in the universal correctness of the market solutions of the Anglo- American market capital-ist model, and not informed with a sound foundation in Chinese history and political economy, are unlikely to aid in understanding unfolding events in the Chinese banking system— or any other aspect of China either for that matter. Joseph Stiglitz and Bruce

10 Alan S. Blinder, After the Music Stopped: The Financial Crisis, the Response and the Work Ahead (New York: The Penguin Press, 2013), 119.


Greenwald make this point most clearly— not with regard to China specifically, but with regard to developing countries in general: “Washington Consensus policies which pushed capital and financial market liberalization did not take into account the impor-tance of local knowledge.”11

It must be added, however, that China has need for great improvement in how it explains itself to the outside world. The generally suspicious attitude that it adopts toward foreign press, and its reluctance to open up its banking institutions to outside scrutiny, do not help in getting across its story, or in persuading the rest of the world that its financial system is not on the brink of collapse. Its occasional attempts at public rela-tions, such as the full- page advertorial placed by Xinhua News Agency in the New York Times on March 14, 2016, are ineffective. In style, contents, and graphics these public rela-tions efforts are clumsy and out of touch with the international audience. If China wants its banks to be better regarded internationally, it will have to make them accessible and comprehensible to the journalists, investment analysts, and economic pundits who mold the consensus view. Otherwise the critical barrage will continue.

Is the Total Debt Burden Sustainable?

What are the main areas of concern now about the banking system that might lead to a financial crisis? The following paragraphs briefly introduce the asset quality problems fac-ing the banks at time of writing. These asset problems stem from larger macroeconomic and economic sector concerns, analysis of which in detail is beyond the scope of this book, and would in any event quickly be outdated by events. My introduction to these problem areas is not intended as a complete treatment of the subject. Readers interested in delving further into each problem area can follow the footnote references to sources that offer balanced analyses in some detail. In what follows, I simply offer thoughts from a banking perspective to put the problems in some context.

The first major concern is the rapid accumulation of debt that has occurred over the past few years and the resultant total debt/ GDP ratio of 282% in 2014. According to McKinsey Global Institute’s report on China’s debt, this increased dramatically both in absolute numbers and in proportion of GDP from its level of $7.4 trillion and 158% of GDP in 2007 (just prior to the 2008 stimulus package). Compared with advanced countries’ total debt level, China’s debt position was high, but not remarkable: in the same year South Korea was at 286%, Australia 274%, the United States 269%, Germany 258%, and Canada 247%. Compared with other developing nations, however, China’s total debt level is high.12


12 McKinsey Global Institute, “Debt and (not much) Deleveraging”, February 2015 prepared by Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva, 15–36 and 75–92.


Where China stands out is in its level of non- financial corporate debt, which in 2014 stood at 125% of GDP, higher than Korea’s 105%, and much higher than Australia, the United States, Germany, and Canada, which were in the range of 50– 70%. McKinsey states that this is “one of the highest levels of corporate debt in the world.” Half of China’s non- financial debt is directly or indirectly (including construction sector) related to real estate.13 At 55% of GDP, China’s governmental debt is not unduly high.

Summarizing all China’s assets and liabilities, public and private, domestic currency and foreign currency, a report put out by Wyman and Fung states that “the Chinese economy in total is not overly indebted, that the government retains capacity to absorb losses, and that any emerging debt problem is of a domestic nature only.”14 They base this conclusion on four factors:

1. The positive net asset position, including central and local government assets and liabilities, of the sovereign balance sheet of RMB 87 TN, or 184% of GDP in 2011.

2. Low household debt compared with household assets, especially real estate. Household debt in 2014 was only 38% of GDP, much lower than Korea’s 81% or the United States’ 77%.15

3. Net corporate debt is much lower than gross corporate debt, as much is offset by deposits placed with banks.

4. China is a net lender to the rest of the world, so will not be threatened by calling of foreign currency debt obligations owed to lenders overseas.16

In an article in Caijing magazine in August 2014, Andrew Sheng, a member of the International Advisory Council of the CBRC, points out certain characteristics of China’s national balance sheet, particularly when contrasted with that of the United States, which in many ways has a national balance sheet that is the mirror image of the Chinese national balance sheet. First, 50% of China’s net assets are with the household sector, 25% with the government, and 25% with the corporate sector, whereas in the United States 90% are in the household sector, as the federal government is a net debtor. Second, China’s asset strength lies in real estate assets, whereas in the United States it lies in financial assets. Sheng places U.S. net financial assets at 95% of GDP, while China’s net financial assets he reckons are only 34% of GDP, reflecting the much greater extent of financialization of the U.S. economy.17

13 McKinsey Global Institute, “China’s Debt: Three Risks to Watch,” August 15, 2015, http:// financial- news.blog.jp/ archives/ 1037072068.html, 75– 78.

14 Andrew Sheng, Christian Edelmann, Cliff Sheng, and Jodie Hu, Bringing Light Upon the Shadow: A Review of the Chinese Shadow Banking Sector (Oliver Wyman and Fung Global Institute, 2015), 7.

15 McKinsey Global Institute, 75. 16 Sheng, “Bringing Light Upon the Shadow” 4. 17 Andrew Sheng (Sheng Liantao), “Pandian Zhongguo Zichan Fuzhai,” Caijing, August 25, 2014, 49.

http://financial-news.blog.jp/archives/1037072068.html

http://financial-news.blog.jp/archives/1037072068.html


Writing almost two years later in a posting on Project Syndicate in May of 2016, Sheng and his colleague Xiao Geng noted that the combined debt/ deposit ratio of Chinese government and non- financial corporate sector was 97.6%; deposits exceed borrowings, putting them in a comfortable position to service their debt. Sheng further points out that within the corporate sector, there is a great diversity in ability to handle debt bur-den. Over- capacity industries may have difficulty, but other industry sectors that are fast- growing and efficient will have little problem.18

Economist Nicholas Lardy follows China’s finances closely at the Peterson Institute in Washington. Writing in June of 2016, he downplayed fears of a banking crisis in China, pointing out that China’s high rate of savings make it able to sustain without much prob-lem high levels of debt. The fact that little of the debt is owed to foreign lenders also makes the debt burden easier to handle. He argues that “it is likely that China is years away from a potential banking crisis, providing it with a window to slow the growth of credit to a sustainable level.”19 Lardy’s conclusion is in line with my analysis of China’s debt burden advanced in this chapter.

China’s leaders have made it clear that they understand that the country cannot increase its overall indebtedness from present levels. The government is undertaking measures to reduce indebtedness in certain key sectors, for example, by developing equity markets as an alternative to debt financing by corporations and discouraging lending to and growth of the real estate development and construction industries. These measures will only bear fruit over time. Provided that the government continues to exercise caution in its fiscal policies, maintains growth rates of at least 5%, and implements the fiscal reforms it has announced, present overall debt ratios should gradually decrease.

Shadow Banking: Disaster Looming?

The shadow banking system, which has developed rapidly over the past few years, is the subject of much media and some analyst concern. Perhaps the most shadowy aspect of shadow banking is its definition, of which there are several. The size of a country’s shadow banking system changes, depending on the definition chosen. I follow the definition of the Financial Stability Board: “credit intermediation involving entities and activities out-side the regular banking system.”20 Perhaps the more neutral “nonbank credit interme-diation” would be a better term than the slightly sinister- sounding “shadow banking.”

18 Andrew Sheng and Xiao Geng, “Moving From Debt to Equity in China,” Project Syndicate, May 31, 2016, https:// www.project- syndicate.org/ commentary/ china- moving- from- debt- to- equity- by- andrew- sheng- and- xiao- geng- 2016- 05?utm_ source=project- syndicate.org&utm_ medium=email&utm_ campaign=authnote, accessed June 11, 2016.

19 Nicholas Lardy, “No Need to Panic, China’s Banks Are in Pretty Good Shape,” Financial Times, June 1, 2016, https:// next.ft.com/ content/ 5bfb049a- 2287- 11e6- 9d4d- c11776a5124d accessed June 11, 2016.

20 Douglas Elliott, Arthur Kroeber, and Yu Qiao, “Shadow Banking in China: A Primer,” Broookings Institute, March 2015, 4 (quoting FSB 2013).

http://www.project-syndicate.org/commentary/china-moving-from-debt-to-equity-by-andrew-sheng-and-xiao-geng-2016-05?utm_source=project-syndicate.org&utm_medium=email%26utm_campaign=authnote

http://www.project-syndicate.org/commentary/china-moving-from-debt-to-equity-by-andrew-sheng-and-xiao-geng-2016-05?utm_source=project-syndicate.org&utm_medium=email%26utm_campaign=authnote

https://next.ft.com/content/5bfb049a-2287-11e6-9d4d-c11776a5124d


Shadow banking covers a variety of different products, institutions, and forms of credit intermediation packaging in China, prominently including wealth- management prod-ucts (WMPs), bankers’ acceptances, entrusted loans, and pawnshops and the curb mar-ket. Details on these and other forms of shadow banking can be found in a number of excellent reports that have been done on the subject, but perhaps one of the clearest and most accessible is “Shadow Banking in China: A Primer,” published by the Brookings Institute in March 2015 and available on its website. The remarks that follow rely heavily on that report and on the Financial Stability Board’s August 2015 Peer Review on China.

Shadow banking arises in any financial system to serve customers who are not being adequately served by the commercial banks. It can provide healthy competition to com-mercial banks, making credit cheaper and more widely accessible, but also providing higher returns for savers. In a tightly regulated system, it can foster financial innovation. It can thus be beneficial for development of the financial system and the economy. The trade- off is that shadow banking tends to accept higher risk, hence can be financially destabilizing. This puts pressure on the authorities to regulate shadow banking activities neither too closely nor too loosely, striking the right balance between promoting the ben-efits that shadow banking can provide and the risks and losses that it may entail. Effective monitoring of shadow banking is key to getting that balance right.

Subprime lending, uncontrolled derivative trading, and badly underwritten credit risk insurance in the United States in the years leading up to 2008 is an example of shadow banking out of control, with any possible benefits that it might have brought wiped out many times over by the financial distress that resulted. Market participants and regulators failed spectacularly to recognize and mitigate the risks.

What has spurred the rapid growth of shadow banking in China, how have the regu-lators responded to this growth, and what are the risks it represents? Shadow banking on the credit extension side grew up to meet demand for loans from sectors that the commercial banks were either reluctant to lend to because of the risks involved, or were constrained by the regulators from lending to, by both quantitative limits such as restric-tion (until May 2015, when it was lifted) of loan deposit ratio to not exceed 75%, high central bank reserve requirements that froze 20% of deposits, and absolute quotas on total bank lending, and also by restricting banks from increasing their loan exposure to local governments and the real estate sector. Starved of credit, there needed to be a safety valve. Local governments and real estate companies that could not get loans rolled over from the banks were forced to go to the shadow banking system for credit, generally at high interest rates that would be provided by trust companies and other nonbank lend-ers. SMEs that could not, despite government encouragement of banks to lend to smaller private sector enterprises, obtain credit from the banks would seek credit from micro- credit companies and other non- banks at higher rates.

On the liabilities side, shadow banking emerged because of interest rate repression that has been described earlier in this book. Interest rate liberalization is proceeding step by step, but rates on standard bank deposits remain comparatively low. As a result, many


bank customers have moved their savings from bank deposit instruments offering 3– 4% to wealth management products offering 5% to as high as 10% returns, with the higher end of the spectrum more commonly being offered by tier 2 and tier 3 institutions, espe-cially trust companies.

As a result of these constraints on and limitations of the commercial banks, shadow banking began expanding rapidly in around 2010. It should be seen as a diversified, market- driven, response to China’s need for a broader financial sector that provides debt financing alternatives to the commercial banks. In a financially repressed system, in which I have argued interest rate liberalization has proceeded too slowly, one can look at the intermediation of shadow banking as interest rate liberalization by stealth— neither offi-cially sanctioned, nor officially prohibited. This is a fascinating aspect of China’s hybrid banking system, in which the “invisible hand” is allowed to assert itself for a period of time by the “visible hand” of the regulators.

The conclusion of analysts who have carefully studied the composition and risks of shadow banking is that there are substantial risks, particularly in the present environment of declining economic growth rate, with exposure to certain industries such as real estate and steel that suffer from overcapacity. The regulatory authorities as a result have steadily increased the strictness and scope of their regulation of shadow banking.21

Despite the increased monitoring and regulation, during 2014 and 2015 the total amount of WMP outstanding has continued to rise. Over the past few years, I myself have been somewhat puzzled that the authorities had not intervened more forcibly to contain the risks in shadow banking, particularly given the anti- risk bias of the author-ities and their lack of hesitation to intervene in the commercial banking sector when needed. The area of greatest concern is the substantial portion of WMPs which banks sell that are off balance sheet and not transparent.

Nonetheless, I would not disagree with the conclusion of Elliot, Kroeber, and Yu in the Brookings report: “… the authorities have more than enough fiscal capacity to deal with even a large shadow banking crisis given quite low central government debt to GDP ratios… . China’s shadow banking is not especially large by international standards, is relatively simple (with low levels of instruments such as securitized assets and deriva-tives), and is overseen by regulators who have so far shown themselves alive to the most important risks (namely funding risks and lack of transparency) and have taken prudent steps to minimize these risks.”22

What is the future of shadow banking in China? Now that the interest rate system of China has been liberalized, some of the need for shadow banking will disappear. Commercial banks will be able to compete fully for depositors’ savings in a free market-place, with no artificial government restrictions. On the lending side, the commercial

21 See FSB 2015 for details on regulatory steps that have been taken. 22 Elliott, Kroeber, and Yu, “Shadow Banking in China,” 2.


banks will need to sharpen their ability to price loans commensurate with risk. Even with complete interest rate liberalization, there will still be portions of the market and types of borrowers whom commercial banks are not prepared to serve, generally due to either risks or high operating costs involved. For these borrowers, shadow institutions will still provide an important function, but with removal of artificial interest rate controls, their products will become increasingly transparent— out of the shadows and fully disclosed. In line with the regulatory authorities focusing more now on lower levels of the financial system, it is also likely that the various shadow banking intermediaries will be increas-ingly well regulated, and at the same time their management quality and risk recognition capabilities will rise.

Real Estate “Bubble”

Another major area of concern about the banking system is banks’ exposure to real estate, which is seen as being in the throes of a “bubble.” Real estate is important not only because real estate assets are such a large component of the national balance sheet, but also because investment in real estate has been one of the key drivers of Chinese growth over the past two decades. Real estate investment rose from 4% of GDP in 1997, when private housing began to take off in China, to 15% of GDP in 2014, by which time almost 90% of Chinese owned their own housing. Lending to the real estate sector now accounts for about 20% of outstanding loans. Substantial portions of the economy have become dependent on real estate, directly or indirectly: the construction industry, cement, steel, and machinery, which provide inputs to housing and commercial buildings and also to the infrastructure that is built around new real estate development. Moreover, land sales by cities to real estate developers have been an important source of cash for local govern-ments to fund their own budget shortfalls, and property is often used as collateral for loans.23

A good part of the slowdown in GDP growth over the past two years has been due to the first decline in real estate construction that China has experienced since 1997. This has occurred because of a build- up in unsold housing inventory. During the real estate boom years of 1997– 2010, the average amount of unsold real estate inventories was twenty- two months, which is slightly more than the twenty months that developers will normally carry real estate from the time of start of construction to the time of comple-tion. Dragonomics’ analyst Rosealea Yao estimated that at the end of 2014, the stock of unsold housing stood at thirty- four months, but that, by the end of 2015, it would have declined to twenty- nine months. On this basis housing inventory would normalize by the end of 2016, resulting in a recovery of the construction industry in 2017, thereby taking

23 Mali Chivakul, W. Raphael Lam, Xiaoguang Liu, Wojciech Maliszewski, and Alfred Schipke, “Understanding Residential Real Estate in China,” IMF Working Paper, International Monetary Fund, April 2015, 3.


the downward pressure off of not only the real estate industry, but also GDP growth rates. Depending on government policy on support of supply and demand for housing, the adjustment of unsold housing stock might occur faster, with sharper pain in the short term, or later if government intervention reduces the pain in the short term by stimulat-ing demand or promoting more housing starts.24 This projection may prove to have been too optimistic, but it indicates the magnitude of the numbers to show that excesses can be worked off within a reasonable period of time, albeit not without considerable pain in the real estate industry, and some pressure on bank’s portfolio of real estate loans.

Excess housing inventory is a problem nationwide, but the aggregate numbers conceal a complex situation. There is variation in the supply– demand equation between prov-inces, and also between large cities such as Beijing and Shanghai, and smaller cities and towns, where problems of oversupply are more acute. There are also differences between the real estate development companies, which total 89,000, of which only a handful are large and nationwide. The large companies tend to have higher margins and more secure financial backing.

Excess housing inventory conceals another anomaly in the aggregate numbers— millions of Chinese still live in substandard urban housing. Rosealea Yao estimated that 35– 40 million urban housing units were substandard in 2014 and would need to be replaced. Providing housing for these low- income households is not commercially viable for private sector developers, so the government undertakes on its own social housing projects and in some cases has simply bought excess housing inventories off of private sector developers to convert into low- income housing.25

There is also the well- publicized problem of “ghost cities”— cities planned and built on the wild dreams of local governments, but which attract neither businesses nor resi-dents after they are completed. Perhaps the most notorious of these is Ordos, in Inner Mongolia, the subject of several journalists’ exposés. Indeed, shortly after being built, the serried ranks of apartment buildings in ghost cities do stand empty for a while. But journalists rarely make a follow- up trip a year or two later to write the sequel to their exposés. If they did, they would find them filling up (and, to their credit, a few journalists do report on cities that, after some delay, do fill up).

A well- known example of a “ghost city” that was the subject of some ridicule is Pudong, the vast business district that was constructed in the 1990s on the vacant land on the unoccupied east bank of the river running through Shanghai. Visiting Shanghai in 1998, famed free market economist Milton Friedman gazed at the collection of office towers with only 30% occupancy and declared them to be a “a statist monument for a

24 Rosalea Yao, “When Will Construction Rebound?” Dragonomics, October16, 2015, http:// research.gavekal.com/ content.php/ 11419- China- When- Will- Construction- Rebound- â€”- by- Rosealea- Yao, accessed October 22, 2015.

25 Rosealea Yao, “The Slums Are Still With Us,” Dragonomics, September 8, 2014.

http://research.gavekal.com/content.php/11419-China-When-Will-Construction-Rebound

http://research.gavekal.com/content.php/11419-China-When-Will-Construction-Rebound


dead pharaoh on the level of the pyramids.”26 Shanghai city authorities pressured a num-ber of SOEs to move to the new area and persuaded lenders to forebear on overdue loans. Today it is the thriving financial center of Shanghai, where Citibank, HSBC, and a host of other major financial institutions have their offices in landmark skyscrapers, and it is home to over 5 million residents. Friedman underestimated the power of the state in China to implement its plans and make them work.

More recently, in 2011 the new city of Zhengzhou was considered a ghost city. Designed to relieve congestion in the nearby Zhengzhou old city, the new city stagnated for a while, attracting much media attention internationally. By 2013 it had 1 million resi-dents, 23,000 registered businesses, and was a thriving commercial and residential center of central China.27 For some of the smaller cities below provincial level, wishful thinking on the part of the local governments when they launched their grandiose plans may not work themselves out so quickly, but they do not represent a very significant portion of overall urban construction in China.

Provincial and Local Debt

The fourth area of concern is banks’ exposure to provincial and local debt. The mea-sures that are being introduced to extend the maturities of local government debt and to convert them from bank loans to bond issues have been mentioned in Chapter 8. Here it is worth adding that the Chinese government reports that one third of local govern-ment debt is funded through the shadow banking system, showing the interrelationship between economic challenges and the need for holistic and systemic, rather than piece-meal solutions.

A large portion of taxes raised by local governments is required to be turned over to the central government. Given the importance of local government debt, the room for major rationalization of local government revenues and debt structure, and the possibil-ity that some of the poorer provinces or projects with weak cash flows may be subsidized, it is likely that defaults of local government debt will not extend beyond a containable number of individual cases. As noted above, total government debt at 55% of GDP is not high, so the government as a whole has the ability to move cash around to support individual local governments unable to meet their obligations. This, combined with the local government fiscal reforms, should be sufficient to gradually resolve local govern-ment debt problems.

26 James T. Areddy, “Shanghai’s Pudong, Once Soulless, Rises Up,” The Wall Street Journal, December 21, 2011, http:// www.wsj.com/ articles/ SB10001424052970204770404577080491863427170, accessed October 12, 2015.

27 Tom Miller, “Ghostbusting China’s Cities,” Dragonomics, October 24, 2013, http:// research.gavekal.com/ content.php/ 9188- DG- Ghostbusting- China- s- Cities- by- Tom- Miller, accessed October 23, 2015.

http://www.wsj.com/articles/SB10001424052970204770404577080491863427170

http://research.gavekal.com/content.php/9188-DG-Ghostbusting-China-s-Cities-by-Tom-Miller

http://research.gavekal.com/content.php/9188-DG-Ghostbusting-China-s-Cities-by-Tom-Miller


All of these problems are real, and not easy to solve, particularly in an environment of global economic weakness and decelerating economic growth. Nonetheless, with the enormous power of the state to undertake “macro- adjustment policies,” to marshal resources, and to coordinate responses, reasonable policy solutions to each of these problems do exist. The path to a soft landing from each of them can be charted. Success depends on the competence of the economic teams developing and implementing the policies and on the political will and economic clarity at the top to see them through. Based on the government’s track record, there are reasonable grounds for believing that appropriate government policies and the “tincture of time” will mitigate the threat posed by these problems to destabilize the banks.

Challenge of the New Normal

More daunting than the already daunting challenges enumerated above is the change in the economic environment facing Chinese banks in the latter years of the second decade of the century— the New Normal is less benign for banks than the highly favorable envi-ronment of only fifteen years earlier. At the turn of the century, as the banking transfor-mation got underway, China faced an almost perfect set of conditions, both domestically and internationally, that were supportive of the banking transformation and the rapid growth of the economy as a whole.

Domestically, China enjoyed a demographic dividend of surplus labor, particularly rural labor that migrated to work in the urban factories and provided the cheap labor for China to become the “workplace of the world.” World trade was expanding rapidly, pro-viding receptive markets for China’s exports, which anyway were boosted by an under-valued yuan. The current phase of globalization facilitated the movement of production platforms from high- cost developing countries to China. China was growing from a low base, which allowed for rapid growth simply through learning from foreign technologies and adapting them for use in China. Investment in construction of sorely needed physi-cal infrastructure spurred economic growth. The newly built infrastructure provided a more efficient platform for economic activity, reducing logistical costs throughout the country. Housing construction was a major source of growth as China needed to upgrade and expand its urban housing stock. Unlike Korea and many other developing countries, domestic savings was available in adequate amount to support the historically unprec-edented levels of investment, with little need for the foreign borrowing that was so finan-cially destabilizing for Korea. A more benign scenario to support Opening and Reform as it got into high gear would be hard to imagine.

After more than a decade of uninterrupted super high growth, the environment has turned distinctly less favorable. Most of the world has been plunged into recession since the financial crisis of 2008, reducing demand in China’s export markets. The yuan is now probably fully valued, and will rise and decline in a broad range around the level at which


it has settled. Investment in infrastructure and in many industry sectors now yields ever- lower returns. China has been converging on the advanced countries’ economic levels, meaning that the low- hanging fruits of technology adoption from abroad have already been plucked; further upgrading of productivity will require more indigenous innova-tion, research, and development. The demographic dividend is now history, and China’s labor costs are rising steadily, making some of its low- value manufactures no longer com-petitive. This is China’s New Normal.

Arguably the conditions for making easy money and for hypergrowth had begun to disappear by the end of the first decade of the century. The government skillfully kept the music playing for the next five or six years through investment stimulus. The results show up in the network of high- speed rail lines, new highways, industrial parks, airports, subway lines, and other useful urban infrastructure. Fortunately, the government is fully aware of the changed economic conditions. It is adopting new policies and pushing new reforms to adapt to the New Normal. Whether or not these reforms and policies, which appear pointed in the right directions, are being implemented with sufficient speed and thoroughness to meet the challenges the country faces in sufficient time is a subject of debate among those tracking China’s economy. In any event, it will be up to the banks to recognize these new realities and to adjust risk policies and industry sector portfolio allocations accordingly.

The Chinese government, Chinese and foreign economists, and multilateral institu-tions all concur that the growth model that has propelled China’s hypergrowth of the past fifteen years is unsustainable and has resulted in an unbalanced economy. Continuation of the existing growth model is not a viable way forward. If the growth strategy is not changed, China will run into huge problems, growth rates will decline rapidly, and the country will join the legion of other developing countries that developed rapidly for a period of several years, but then stalled, caught in the “middle- income trap”— and China is today an “upper- middle- income country” by World Bank classification.

Slowing of growth is not only necessary, but also desirable. The hypergrowth of recent years can no longer be sustained environmentally by either China or the world. Slower growth and rebalancing of the economy will, however, hurt some industries— overcapacity and “sunset” industries— while new growth industries emerge.

In recent years, returns on investment in the economy have been declining. Increased efficiency in use of the factors of production must underpin the next stages of economic growth. Banks must become more efficient in allocating credit to projects and enterprises that promise high returns at a time of increasing labor costs, otherwise it will fail in its function of providing efficient credit intermediation in the service of the real economy.

To the strictly economic problems must be added the costs of rapid development over the past three decades— environmental destruction, cultural heritage degradation, inequality and social instability, all of which will have to be addressed quickly if they are not to lead to political instability. For the past two decades, certain factors that have been conducive to rapid economic growth— demographic dividend, enormous need


for housing construction, release of low- productivity excess rural labor into higher- productivity urban employment, and undervalued exchange rate— have disappeared. Moreover, the global economic environment, which was highly favorable to China’s export- led growth only a decade ago, has turned unfavorable, as once insatiable demand for Chinese products in the rest of the world now falters.

But there is also good news. First, unlike several large developing countries, China does not have to deal with inflation or deflation, international payments deficits, high unemployment, or foreign debt payment worries. It has room to maneuver. Second, the government of China is keenly aware of the imbalances of the economy. It is not in denial mode. Third, its party- state government has teams of bright technocrats and academic advisors working on strategies to rebalance the economy on a new basis, with weight shifted to consumption, services, and moving up the value chain in manufactur-ing products. Moreover, the party- state has demonstrated capacity for developing and implementing integrated strategies. Indeed, the shift to services is beginning to show up in economic statistics, but the payoffs from these strategies will take time.

New Challenges for Banks

Aside from these macroeconomic issues pressuring bank asset quality, banks also face new internal problems and competitive challenges: lack of experience and capability in analyzing private sector credit; disintermediation as corporate clients move from indirect funding through the banking system to direct funding from the capital markets; and the rise of new forms of digital disintermediation.

The first challenge— low capabilities in private sector credit analysis— was discussed in Chapter 6, but is worth re- emphasizing. Now that China is entering the New Normal, many firms will encounter cash flow problems, and many will find that their management capabilities are inadequate to cope with new realities. China’s front- line lending officers have never experienced economic slowdown and tight credit conditions. Moreover, they have only in the past five years or so aggressively expanded lending to private sector firms. In lending to SOEs and local governments, banks could assume that one way or another the state would make available the cash flow needed to meet obligations. Soon the state may be withdrawing its implied guarantee and financial support for SOEs that are not efficiently run or are no longer commercially viable. Now lending officers will need to use credit analysis skills to deal not only with private sector companies but with SOEs as well.

Private sector firms are on their own. The state may undertake policies to alleviate distress in industries, thus indirectly helping private sector firms that find themselves in trouble, but the state will not come to the rescue of individual private firms, except in unusual circumstances when there is a strong economic rationale for doing so— typically safeguarding employment of local people in the area of the enterprise.


Disintermediation challenges banks in two ways— classical and digital. Classical disin-termediation will follow the path of disintermediation in developed economies, bearing in mind that the paths of developed countries differ in the extent to which direct financing has replaced indirect financing, with the United States as one outlier and Germany as the other. After many years of desultory development, the Chinese government has finally made developing and regulating equity and bond markets a priority. As SOEs and local governments, which were core customers of Chinese banks, wean themselves from bank financing, and as the implicit government guarantees are bit by bit withdrawn, Chinese banks will need to find alternative uses for their vast pool of deposits. Consumer lending and SME lending will become more important to the banks in order to compensate for the loss of the corporate and local government loans that will have been disintermediated. This will be in line with government economic policy to encourage consumption and also to support the most vital growth area of the economy, the SME private sector. Chinese banks will, however, need to further develop their underwriting skills if they are to prevent a wave of bad loans in the future. To overcome this challenge, Chinese banks must invest much more in credit training than they have thus far. Unfortunately, they may not realize this until they have been shocked by significant increases in private sector NPLs.

While the outlines of how classical disintermediation will likely unfold are clear, digital intermediation is occurring for the first time all over the world. There is not yet any over-seas model for how this will proceed. Given how readily Chinese take to digital media, China will not lag behind developed countries in this area and may move in paths that reflect the particular evolution of China’s own digital culture, with the enormous pres-ence of companies like Alibaba, Tencent, Baidu, Xiaomi, and others. At time of writing, despite all the media hype, the deposits taken from banks by these digital giants is actu-ally small— around 1%, but the potential threat to steal both deposit and lending business from the banks may be large. The large “fintechs” possess extraordinary databases, which they can mine for both financial selling and also for risk analysis purposes. The fintechs at this point have not yet learned to combine data mining on their vast customer bases with sophisticated risk management in the way that Wells Fargo has in the United States. This will take them some time, but it will inevitably occur. There is no room for complacency on the part of the banks.

Aside from the potential of these fintech behemoths, crowdfunding and P2P lend-ing are new alternatives to borrowing from the established banks. These new digital net-working financial channels are taking off rapidly in China, but in the initial unregulated phases there have been abuses and considerable bad debt. It will take time for them to mature, and they must be regulated.

The response to these threats will be in two forms. First, the banks themselves are mov-ing as rapidly as possible to develop their own Internet and cell phone banking platforms to retain customers. Second, on the one hand the financial authorities will welcome pri-vate sector nonbank innovation to stimulate greater financial efficiency and spur the banks to greater competitive efforts, but on the other hand the government is unlikely to


permit digital disintermediation to proceed too fast, causing significant loss of business to the banks in which the state itself holds majority ownership stakes. Besides which, the state controls banks directly, whereas control of the giant digital companies will have to be more indirect. In June 2015, reflecting on the need for regulation in the United States, Robert Pozen, former chairman of the U.S. mutual fund company MFS Investment Management, warned that “The big risk is selling to relatively unsophisticated investors over the internet who probably do not know what they are getting into. There is a real possibility of loss here.”28 The Chinese regulatory authorities must keep abreast of digital finance developments so as to protect the investing public and to guard against threats to financial stability. In August 2015, the CSRC issued regulations governing crowdfund-ing. More regulation of digital forms of finance will follow.

How digital disintermediation will play out over the next few years will be one of the most interesting aspects of Chinese financial development to watch. Will there be major problems? Will the digital giants step in to replace banks in some of their intermedia-tion functions? Will the Chinese government develop regulatory mechanisms for digital finance that will be looked at as best practice by the rest of the world?

Looking at these two sets of issues challenging banks— macroeconomic pressures on bank asset quality and disintermediation by direct finance or by new nonbank financial players, particularly fintechs— if the government can make the economic transition to a more balanced and sustainable growth path successfully, then banks will be able to deal with the problems that presently absorb the attention of the “worriers”— shadow bank-ing, local government debt, excess housing, etc. The external pressures on bank asset qual-ity will abate. The challenge to bank franchises posed by disintermediation will be the more difficult one for banks to deal with, particularly as the government will be less pro-tective of the banks and will be encouraging disintermediation as a way of “debanking” the economy, of creating a more diverse, sophisticated, and responsive financial system.

In confronting these new competitive challenges, the banks must take their own futures in hand in the face of disintermediation, the end of the era of lending to “risk- free” SOEs, and the transition to the New Normal economy. Over the next few years, Chinese banks will have to undertake a new transformation, equipping themselves to adapt to a new economic environment. The challenges are immense, but the banks’ capacity to meet the challenges should not be underestimated.

28 Quoted in “Huge Growth in China’s Money Funds Poses Risk,” Financial Times, June 14, 2015, http:// www.ft.com/ intl/ cms/ s/ 0/ fa4b774e- 0df5- 11e5- 9a65- 00144feabdc0.html?o=clippings/ list#axzz3cw8f5K6e, accessed June 14, 2015.

http://www.ft.com/intl/cms/s/0/fa4b774e-0df5-11e5-9a65-00144feabdc0.html?o=clippings/list#axzz3cw8f5K6e

http://www.ft.com/intl/cms/s/0/fa4b774e-0df5-11e5-9a65-00144feabdc0.html?o=clippings/list#axzz3cw8f5K6e

243

One reads much about the need for financial reform in China. What exactly do people mean when they speak of financial reform? At the risk of oversimplification, there are two broad approaches to medium- and long- term financial reform in China: the mar-ket capitalist approach and the market socialist approach. On capital markets, financial infrastructure, insurance industry development, asset management business, and other aspects of financial reform that do not relate to the state’s role in the banking system, the two approaches are in broad agreement. It is in the area of banking and in the role of the state in the entire system that the differences between the two approaches emerge. As Joseph Stiglitz notes, “The big question of the twenty- first century global economy is, what should be the role of the state?”

The Market Capitalist Approach

The market capitalist approach, promoted by the World Bank, subscribed to by the major-ity of foreign commentators and analysts, and supported by some Chinese economists,

12 Reform Directions

There is certainly no “one size fits all” approach to sequencing financial sector liberalization,

especially in an economy as sophisticated and complex as China’s.Nigel Chaulk and Murtaza Syed, International Monetary Fund, 20131

The big question of the twenty- first century global economy is, what should be the role of

the state?Joseph Stiglitz, 20102

1 Nigel Chaulk and Murtaza Syed, “The Next Big Bang: A Road Map for Financial Reform in China,” in China’s Economy in Transition: From External to Internal Rebalancing (International Monetary Fund, 2013), 253.

2 Joseph Stiglitz, Freefall: America, Free Markets and the Sinking of the Global Economy (New York: W. W. Norton, 2010), 196.


advocates privatization of banks to make the banking system more commercially ori-ented, and proposes other changes in the overall management and supervision of bank-ing. The World Bank approach, aimed at moving the banking sector towards a market capitalist banking model, is based on neoliberal economic ideas.

The market socialist approach advocates improving the efficiency and competitive-ness of banks while retaining dominant state ownership. It aims for rationalization rather than radical revision of the role of the state in the financial system. This is the mainstream Chinese approach, embodied in the reform resolutions of the 3rd Plenum of November 2013.

The first approach— the market capitalist approach— to financial reform is cogently presented in the finance sections of a document entitled China 2030: Building a Modern Harmonious, and Creative Society.3 Running to over 400 pages, this report was put together over the period 2010– 2012, during the last years of the Hu- Wen government, by teams from the World Bank and the Development Research Center of the State Council (DRC), which is one of China’s most important and well- regarded think tanks. Jointly signed by the president of the World Bank and the head of the DRC, it puts forward the World Bank’s approach to development, modified to a certain extent by input from DRC to reflect China’s policy preferences and constraints. It provides a broad blue-print for reform and liberalization of the Chinese economy by 2030. In the forward, the report sets forth six overall “strategic directions for China’s new development strategy.” The first of these is “rethinking the role of the state and the private sector to encourage increased competition in the economy.”4 This first strategic direction is broadly agreed upon between the Chinese government and the World Bank. Indeed, the role of the state and the role of the private sector are major concerns in the 3rd Plenum of 2013’s reform platform. It is in the specifics of how to redefine state and private sector roles that the two approaches differ.

In my conversations with World Bank officers in Beijing and Washington, the prefer-ence of the World Bank for privatization of the banks as a key aspect of financial reform was clear. China 2030, however, perhaps reflecting the joint World Bank— Chinese authorship of the report, recognizes that this is not likely to occur, and therefore recom-mends that “state ownership functions need to be strengthened. To be effective, state- ownership agencies need to act in ways similar to private owners.” 5 It goes on to state that “mere organizational changes can fail to achieve the intended results if they are not accompanied by fundamental changes in incentives and institutions.”6

3 China 2030: Building a Modern, Harmonious, and Creative Society, The World Bank and Development Research Center of the State Council, Washington: 2013.

4 China 2030, XIV. 5 China 2030, 118. 6 China 2030, p. 119.

Reform Directions 245

In the section covering the financial sector, China 2030 sets forth five sets of recom-mendations that are not doctrinally controversial, as they are needed whether China’s financial sector becomes market capitalist or remains characterized by market socialism:7

• Further liberalize interest rates• Deepen capital markets• Upgrade financial infrastructure and legal framework• Strengthen the regulatory and supervision framework• Build a financial safety net and develop crisis management and insolvency

schemes

Some of the detailed recommendations primarily concern banks, for example, liberal-izing interest rates. Others relate more to the non- banking sectors of the financial system. All have been touched upon earlier in this book in one place or another as areas in which improvement of the system is indeed needed.

Two of the sets of recommendations, however, are more controversial:

• Full commercialization and rationalization of the of the financial system• Recasting the rights and responsibilities of government

The recommendations of China 2030 are based on an analysis that “the Chinese finan-cial system remains repressed, unbalanced, costly to maintain, and potentially unstable.”8 “Unbalanced” refers to the heavy dependence of the economy on bank funding. This is a point on which there is widespread agreement between the Chinese government and the World Bank. China 2030 uses the word “repressed” in a much broader sense than the classi-cal sense of “financial repression” that has been used in this book, i.e., suppression of inter-est rates below market level. Repression in China 2030 means “pervasive controls remain in key areas.”9 “Costly to maintain” is another way of promoting the World Bank’s clear pref-erence for privatization of the system. The report disagrees with government’s direct use of the banking system as an instrument to promote macroeconomic and sectoral economic development goals, adducing the NPLs of the 1990s and the subsequent bank recapital-izations as the costs of this approach. The report then assumes that banks are now incur-ring major new losses, implying that another bailout and recapitalization will be required. This underestimates the “night- and- day” transformation of Chinese banks recounted in this book. China 2030 presents no evidence to demonstrate that another bailout will be required. The “costly to maintain” thesis essentially buys into the assumption popular in the media that the system is “awash” with bad loans, mostly arising out of the state sector.

7 China 2030, pages 118– 123. Each bullet point is a bold- faced section head in the book. 8 China 2030, 115– 117. 9 China 2030, 115.


The report does not mention one of the major concerns of this book— the need for improving credit analysis skills for lending to the private sector. Lack of these private sector lending skills is a problem in emerging market banks whether state- owned or privately owned.

Perhaps China 2030 was prepared primarily by economists and other social scientists, with little input from people with practical banking experience. The World Bank’s affili-ate, the IFC, has extensive experience as a shareholder and a consultant in several Chinese banks, mostly state- owned. Representatives of IFC sit on the boards of several Chinese banks and are witness to the transformation that has occurred since the 1990s. They could have provided guidance as to where the real risks and weaknesses of the system lie.

“Potentially unstable” maintains that the system is “fragile and vulnerable to potential instability for several reasons.” Among these are the emergence of shadow banking and the lack of a deposit insurance program, both of which the government has subsequently been addressing. But the gist of this potentially unstable critique comes back to aversion to China’s state ownership of banks and to its control of the banking system to advance the government’s economic development agenda.

Many of China 2030’s specific recommendations are clearly to the point, and are for the most part being implemented at this time by the government, albeit perhaps not with the speed that would be preferred by the World Bank. The area in which there is major diver-gence between the recommendations of China 2030 and the thinking and likely course of reform of the Chinese government lies in the role of the state in the financial system. The market capitalist point of view arises out of neoliberal doctrine, in which market capital-ism is the preferred system, in which markets and private ownership dominate, with the state having a more hands- off guiding and regulatory role. This neoliberal viewpoint also assumes that market capitalism, as it has evolved in recent years in the West, has universal applicability and will benefit any country that chooses to adopt it.

The World Bank’s thinking on privatization is more explicit in its China Economic Update— June 2015, and especially in Section 3 of that report, entitled “Special Topic: Reform Priorities in China’s Financial Sector.” Shortly after that report was issued, Section 3 was withdrawn by the World Bank and no longer appears on the redacted ver-sion of the report available on the Web, ostensibly because it had not gone through the World Bank’s internal review and clearance process, but more likely because some of its recommendations are sharply at variance with the thinking on financial reform of the Chinese government.

In my conversations with World Bank staff in Beijing and Washington, I was struck by two recurring themes: first, a high degree of skepticism concerning the workings of Chinese banks today; second, a deep belief in the ability of privatization to bring real benefits to the Chinese banking system. These skeptics make it clear that they feel that the corporate governance of Chinese banks is ineffective. They did not produce evidence for this skepticism, nor did they indicate that they have spent time with people who serve on the boards of Chinese banks to understand in some detail how they actually work.


This skeptical assumption is “confirmation bias”: Chinese banks are state- owned and run by bureaucrats, ergo their corporate governance could not be good.

There are thoughtful Chinese, in government positions, in academia, and in the pri-vate sector, who share China 2030’s enthusiasm for reducing the state’s role in the econ-omy and the banking system. Prominent among these advocates of a greater role for the market and lesser role for the state is Professor Zhang Weiying, a respected liberal econ-omist at Peking University whose books and articles are widely read in China. Where these Chinese adherents of neoliberal approaches differ from the World Bank viewpoint is that they are well informed about the transformation of the banking system that has occurred over the past decade. Zhang Weiying has been an independent director of one of the joint stock banks and has expressed to me in conversation that he has no quarrel with the quality of corporate governance in the board of that bank. Professor Zhang and others are, however, convinced that overweening state interference with the workings of the economy is counterproductive.

One Chinese academic pointed out to me that the government could reduce its own-ership stake in Chinese banks to less than 50%, diversifying ownership among a large number of smaller shareholders, while still retaining control as the largest, albeit no lon-ger majority, shareholder. This would not address the World Bank’s concern, as the state would still be in control, but the economist’s point to me was that this would free up state financial resources for other purposes.

To the extent that the recommendations for policy liberalization in China 2030 will increase the efficient functioning of the market within the market socialist economy, they will be given favorable consideration and most likely adopted in one form or another. For example, there is no contradiction between market socialism and reforms enhanc-ing competition between banks, establishing a deposit insurance scheme, improving the accounting and legal infrastructure, freeing up interest rates, developing the asset man-agement business, promoting venture capital, upgrading the payments and clearance system— these sorts of recommendations are equally sensible for market capitalist and market socialist systems, and are in fact included in the government’s financial reform plans. The World Bank’s withdrawn Section 3 actually contains many sound technical recommendations, but when its recommendations imply dismantling some of the “social-ist” aspects of China’s market socialism, it challenges fundamental Chinese government concepts of how China’s political economy should work.

Recommendations of China 2030 for privatization of banks, for better clarifying the role of state- owned financial institutions, and related recommendations to reduce the role of the state in the financial system, to the extent that they are not congruent with the mar-ket socialist orientation of China’s leaders, are unlikely to gain much traction over the next few years. They run counter to deeply held beliefs of China’s leaders that control of major banks is the key to control of the economy and that control of the economy is essential to maintain social and political stability. Private capital is being allowed to open new finan-cial institutions on a pilot basis, but they will for a long time to come be small in scale and


supplementary in function to the mainstream state- owned enterprises. In the critique of the state as “promoter” in the financial system, the World Bank runs counter to China’s belief that banks should play both a commercial and an economic development role.

The Market Socialist Approach

The market socialist approach towards financial reform is laid out in three short para-graphs in Section 12, “improving the financial market,” of the sixty sections of the reform decision of the 3rd Plenum of the 18th Central Committee of the Party, adopted November 12, 2013. If one wishes to understand the policy of the Chinese government in the area of financial reform, one must carefully read these three dense paragraphs:

We will open the financial industry wider, and allow qualified non- governmental cap-ital to set up, in accordance with law, financial institutions such as small or medium- sized banks on the precondition that this comes under stronger oversight. We will push ahead with reform of policy financial institutions. We will improve the multi- layer capital market system, promote reform toward a registration- based stock- issuing system, promote equity financing through diverse channels, develop and regulate the bond market, and increase the proportion of direct financing. We will improve the compensation mechanism for the insurance industry, and establish an insurance sys-tem for catastrophe risks. We will develop inclusive finance. We will encourage finan-cial innovations, and enrich the financial market with more levels and more products.

We will improve the mechanism for market- based Renminbi exchange rate formation, accelerate interest- rate liberalization, and improve the national debt yield curve that reflects the relationship between market supply and demand. We will promote the opening of the capital market in both directions, raise the convert-ibility of cross- border capital and financial transactions in an orderly way, estab-lish and improve a management system of foreign debt and capital flow within the framework of macromanagement, and accelerate the realization of Renminbi capi-tal account convertibility.

We will carry out reform measures and stability standards for financial oversight, improve the mechanism for oversight and coordination in the financial sector, and define the oversight functions and risk management responsibilities at both the central and local levels. We will build a deposit insurance system, and improve the market- based exit mechanism for financial institutions. We will strengthen finan-cial infrastructure construction to ensure that the financial market operates in a safe, efficient and stable way.10

10 “Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening the Reform,” chinaorg.com, January 16, 2014, 10– 11.


Reading through this terse recitation of intended reform measures, one notes that it includes many of the reforms proposed by the World Bank to strengthen markets, but only contemplates a larger role for the private sector in small and medium- sized banks, and even then “on the precondition that this comes under stronger oversight.” Not a word is to be found about privatization of existing major financial institutions. It is evi-dent that the government sees the principal reform needs of the financial system as being in the nonbank sectors and overall is satisfied with the existing ownership, regulation, and management of the banks— or at least does not see major reforms in this area as hav-ing the strategic importance that comes through in China 2030.

Indeed, the needs for financial reform in equity markets, bond markets, venture capi-tal, asset management business, and financial infrastructure are enormous. Another major area of financial reform, lying outside of the scope of this book, is further cautious opening of the capital account, internationalization of the rmb, and giving the market a greater role in determining the value of the rmb.

Role of the Market

Many observers were quite excited by a section of the reform decision of the 3rd Plenum of 2013 that stated that the “underlying issue is how to strike a balance between the role of the government and that of the market, and let the market play the decisive role in allo-cating resources and let the government play its functions better. It is a general rule of the market economy that the market decides the allocation of resources. We have to follow this rule when we improve the socialist market economy. We should work hard to address the problems of market imperfection, too much government interference and poor over-sight.”11 This is indeed a reform statement of highest significance, defining government orthodoxy with regard to the importance of markets in the economy. It was, however, read by many in ways that fit with their own predilections for a fundamental change in the system away from market socialism towards market capitalism. Careful reading of the words indicates this was not what the government intended.

As a result, by 2015, many were concerned that the pace of reform in the private sector had slowed down, that commitment to real reform was lagging. Typical of these senti-ments was an article that appeared in the International New York Times on October 20, 2015, headlined “China sends a muddled message on its economy.” The article stated that “China is now sending a muddled message to the world, with disparate signals that are broadly raising doubts about the direction of the country’s economy.” After discussing the “bungled handling of its stock market bailout,” it goes on to “a highly anticipated package of overhauls to the nation’s sprawling state- owned companies, announced last month, came as a crushing rebuke to some investors’ hopes that China would seek to

11 “Decision of the Central Committee,” 4.


privatize such businesses.”12 The Financial Times of London’s reporting was equally scath-ing: “China’s release of a long awaited plan to overhaul the country’s bloated state- owned enterprises (SOEs) has proved another triumph for entrenched interests over the broader economy.”13

This initial elation and later disappointment is again “confirmation bias” at work— or to use a less formal term, it is “wishful thinking.” The assumption of Westerners is that reform means dismantling the socialist aspects of China’s economy to achieve the efficien-cies of a market capitalist economy. They assume that “decisive role for the market” means reduced state involvement in the economy, and ultimately movement toward some form of capitalism, be it market capitalism or cooperative capitalism. In this line of thinking, SOE reform would mean privatization of SOEs, which happened in Eastern Europe after the breakup of the Soviet Union. Of course, these people reasoned, privatization should include the banks. People therefore read into the 3rd Plenum’s program what they wished would happen, not what the text clearly states the leaders of China intend to do.

In fact, in China the market is to be given a more prominent role within a market socialist economy. China’s leaders believe that the role of market forces is to make the market socialist economy more efficient— one in which SOEs play a major role. Reading further along in the 3rd Plenum reform document, one reads that public ownership is to play the dominant role, that the public and non- public sectors are both “key components of the socialist market economy, and are important bases for the economic and social development of China. We must unswervingly consolidate and develop the public econ-omy, persist in the dominant position of public ownership, give full play to the leading role of the state- owned sector, and continuously increase its vitality, controlling force and influence. We must unwaveringly encourage, support and guide the development of the non- public sector, and stimulate its dynamism and creativity.”14 The prose of such docu-ments can be mind- numbing, especially in translation, but that should not obscure the fact that every word in it has been carefully crafted and expresses official policy, distilling into short sentences the conclusions of months, and sometimes years, of extensive policy debates, in keeping with the vital role the Party places on strategic planning.

Further on in the reform document, the resolutions set forth the strategy to improve the efficiency and contribution to the economy of SOEs:

We will improve the state- owned assets management system, strengthen state- owned assets oversight with capital management at the core, reform the authorized operation mechanism for state- owned capital, establish a number of state- owned

12 Neil Gough, “China Sends a Muddled Message on Its Economy,” International New York Times, October 20, 2015, 1, 17.

13 Gabriel Wildau, FT, September 14, 2015, http:// www.ft.com/ intl/ cms/ s/ 0/ 5eeeb84a- 5aaa- 11e5- 97e9- 7f0bf5e7177b.html#axzz3pYt1Vb8A, accessed October 25, 2015.

14 “Decision of the Central Committee,” 6.

http://www.ft.com/intl/cms/s/0/5eeeb84a-5aaa-11e5-97e9-7f0bf5e7177b.html#axzz3pYt1Vb8A

http://www.ft.com/intl/cms/s/0/5eeeb84a-5aaa-11e5-97e9-7f0bf5e7177b.html#axzz3pYt1Vb8A


capital operating companies, support qualified SOEs to reorganize themselves into state- owned capital investment companies. State- owned capital investment opera-tions must serve the strategic goals of the state, invest more in key industries and areas that are vital to national security and are the lifeblood of the economy. …

Owned by the whole people, SOEs are an important force for advancing national modernization and protecting the common interests of the people. Although SOEs generally have assimilated themselves into the market economy, they must adapt to new trends of marketization and internationalization, and further deepen their reform by aiming the focus at regular decision making over operation, maintaining and appreciating the value of state assets, participation in competition on an equal footing, raising production efficiency, strengthening enterprise vitality, and bearing due social obligations.15

On the corporate governance of SOEs, the recommendations state that “We will estab-lish a system of professional managers, and give better play to the role of entrepreneurs. We will deepen reform of systems concerning the promotion and demotion of manage-ment personnel, hiring and firing of employees, and salary increase and decrease.”16 Based on this, one might expect that there will be changes in the compensation and incen-tive systems of senior management in state- owned banks, making them more flexible and competitive with private sector than the present system that has been described in Chapter 5.

The recommendations then make clear to what purpose the market is to “play the deci-sive role in allocating resources,” explaining that “Establishing a unified, open, competi-tive and orderly market system is the basis for the market to play a decisive role in the allocation of resources.”17 In the view embodied in this set of recommendations, “enter-prises,” both public and private, are to be subject to market forces.

In matters of strategy and policy, the Chinese government is not opaque. What goes into a reform strategy document, such as the 3rd Plenum decision, has been vetted and negotiated between stakeholders and is pretty much what the government will do over the next few years— not always, but most of the time; perhaps not quickly, but eventually. Therefore, in forecasting what China will do, close attention to the leadership’s often dry and terse long- term policy statements amply repays the effort.

In the banking sector, starting in 2003, China moved not toward privatization but toward corporatization. The state controls almost all the major banks, even if they are listed on securities exchanges and have private sector shareholders, both Chinese and foreign. What gives a “Chinese characteristic” to this state ownership is that the state ownership is predominantly not directly from the government, but through holding

15 “Decision of the Central Committee,” 7. 16 “Decision of the Central Committee,” 8. 17 “Decision of the Central Committee,” 9.


companies such as Central Huijin, similar to Singapore government ownership of enter-prises through Tamasek. The 3rd Plenum SOE reforms will expand the corporatization of SOE ownership and corporate governance, as an improvement on the present steward-ship by SASAC.

The recent announcement of the direction of SOE reforms was greeted overseas with dismay. Critics attacked the reforms as inadequate, since they involved changing to sev-eral different corporate ownership mechanisms, all ultimately still controlled by the state, and no privatization. One analyst argues that the SOE reform that is needed is “to return to the strategy followed from roughly 1997– 2003, when the government closed or privatized many of the underperforming SOEs.” The analyst terms the reform proposal that has been announced to be a “mishmash” that does not impose “a single, clear vision of SOE reform,” but instead accommodates a variety of points of view from within the bureaucracy.18

It may or may not be correct that a bold privatization program along the lines of what Zhu Rongji did fifteen years ago would be more effective. In line with the analysis of how the Chinese political economy works, however, there are no grounds for being surprised that the government did not follow the privatization route. Looking at the 3rd Plenum reform document outlining the reforms to be implemented, there was no hint of priva-tization of major SOEs. In 2015, a mere two years after the 3rd Plenum, we should not expect the government to put forward a bold privatization program not envisaged in what had been agreed upon by the Central Committee. That would not be the way the Chinese government works.

That the reform program for SOEs would reflect compromise between different bureaucratic points of view accords with the description of the policymaking process set forth in Chapter 3. All stakeholders had a say in how to implement the broad policy outlined in the 3rd Plenum document. Since there was no clear consensus on the best approach, more than one approach is to be tried at the same time. This may be confusing to foreign analysts and investors, who presumably might prefer one bold strategy that would capture the imagination, but perhaps not to China’s leaders, who will be watching which approach works best. In discussing bank policy in Everbright Bank, Chinese col-leagues often spoke of the need to avoid “one knife cuts everything” (yidao qie) policies. The same principle perhaps applies in the SOE reforms?

The Chinese government approach to SOE reform will of course be resisted by many within the SOE community. Their comfortable lives and careers will be unsettled by these reforms. Reform of SOEs will therefore not proceed smoothly, as it encounters resistance from vested interests, especially at the local level. That, however, is the nature of the reform process in China.

18 Andrew Batson, “The Flailing State of Enterprise Reform,” GavekalDragonomics, September 15, 2015, 1– 2.


One additional consideration in considering SOE reform is that China has changed since the 1990s. The closing and privatizing SOEs of the 1990s delivered enormous benefits to the national economy, but there was a cost— millions lost their jobs, many remained unemployed for long periods of time. That generation accepted these costs as a necessary strategy for national rejuvenation at a time when China was still impoverished. Could a similar program be launched in today’s China, at a time of declining growth rates, without unleashing social unrest? If privatization is pushed today, it would need to be accompanied by provision of a safety net for those affected.

The position of the IMF with regard to financial reforms in China is interesting to compare with that of the World Bank. The impression conveyed to me by conversations with IMF officials in Beijing and Washington is that, while recognizing the need for ongoing reform of the financial system, these officers feel reasonably comfortable with China’s macroeconomic management. They seem persuaded by China’s prior reform success and effective financial management policies that the government is on the right track, and therefore confine themselves to offering constructive suggestions on the reform directions that will work best.

This balanced approach comes through clearly in an essay by Chaulk and Syed con-tained in an IMF compendium of articles entitled China’s Economy in Transition, pub-lished in 2013. Chaulk and Syed both served in senior positions in the IMF office in Beijing. They set forth suggestions for a five- year road map for financial reform that focuses on issues that foster more efficient financial intermediation and financial system stability, emphasizing that the reforms must be carefully sequenced so as not to be desta-bilizing, and that with financial liberalization the imperative for tight prudential regula-tion to “prevent unsafe practices” will be greater. The state relinquishing any of its role as promoter or owner in the finance industry is not mentioned.19

In an essay in another IMF compendium, China’s Road to Greater Financial Stability, published in 2015, Joseph Yam, CEO of the Hong Kong Monetary Authority from 1993 to 2009, writes of the need for China to be wary of trends that may be widespread and popular in market capitalist economies, but which in reality are an expression of the political power of vested financial interests to push policies that are not in the public interest and do not contribute to the real economy, only serving to increase the prof-its and compensation packages of the finance industry. He quoted approvingly former Prime Minister Wen Jiabao’s slogan of “gradualism, controllability and the ability to take the initiative.”20 Yam’s comment is interesting, coming as it does from a retired senior civil servant of the market capitalist bastion of Hong Kong.

19 Chaulk and Syed, “The Next Big Bang,” 258. 20 Joseph Yam, “Delivering Financial Stability in China,” in China’s Road to Greater Financial Stability: Some

Policy Perspectives, eds. Udaibir S. Das, Jonathan Fletchter, and Tao Sun (Washington, DC: International Monetary Fund, 2013), 185– 189.


The difference in substance and style between the financial reform prescriptions of the World Bank and the approach contained in the compendiums published by the IMF are clear. The World Bank calls for a drastic reform of China’s financial system. The contribu-tors to the IMF publications, seeing no imminent crises, suggest ways of improving the existing system over a five- year period of time.

Whether or not the financial reforms outlined in the 3rd Plenum will be successfully implemented or not will become clear in the course of the next few years. One can judge them adequate or inadequate, but a message of this book is that in analyzing events in China, one should not allow one’s hopes and policy preferences to obstruct an under-standing of what China is doing, and why it is doing it. If we understand the interrela-tionships in China between banking, political economy, and culture, then we will not be surprised at policies that China adopts. We should only be surprised if policies on banking are adopted that are inconsistent with its cultural and political economy norms and with previously announced reform directions. There is no indication that will hap-pen over the next few years. Instead, we should expect gradual, incremental, cautious, but nonetheless steady, rollout of reforms that have been announced. Investors who are described in the October 2015 International New York Times article as having their hopes for bolder reforms in a market capitalist direction quashed would do well to read care-fully the details contained in the reform resolution of the 3rd Plenum.

255

The Chinese economy now faces new pressures and challenges. Hypergrowth must slow to more normal levels gradually and without excessive disruption. Slowing of growth is inevitable— to grow at 10% from a low base is possible, but as China’s econ-omy converges on high- income economies, sustaining growth levels of even 7% or 8% is impossible. In the New Normal, unrelenting focus on high growth numbers must yield to more sustainable and balanced development approaches: private entrepreneurs will play a more prominent role; the services sector will become a main growth driver; wealth and income inequality must diminish; environmental quality, health and safety, caring for an aging population, and other issues must move to the top of the policy agenda. This is the environment in which Chinese banks must find their way forward over the next few years.

13 Conclusion

. . . an economy that continues to experience such rapid growth is neither realistic nor

sustainable and China shouldn’t aim for such growth… . I firmly believe that for the future,

the advantages of a slowdown in China’s economic prospects far outweigh the disadvantages.

China’s economic development is no longer in need of increasing its numbers, but of

increasing its quality.Jack Ma, 20151

Economics is not the kind of science in which there could ever be one true model that works

best in all contexts.Dani Rodrik, Professor of International Political Economy, Harvard University, 20152

1 Jack Ma, “Letter from Executive Chairman,” 2016, http:// ar.alibabagroup.com/ 2015/ letter.html, accessed October 16, 2015.

2 Dani Rodrik, “Economists vs. Economics,” Project Syndicate, September 10, 2015, https:// www.project- syndicate.org/ commentary/ economists- versus- economics- by- dani- rodrik- 2015- 09?utm_ source=Project+Syndicate+Newsletter&utm_ campaign=be2a176f93- Sept_ 13_ 20159_ 5_ 2015&utm_ medium=email&utm_ term=0_ 73bad5b7d8- be2a176f93- 93726721, accessed October 12, 2015.

http://ar.alibabagroup.com/2015/letter.html

http://www.project-syndicate.org/commentary/economists-versus-economics-by-dani-rodrik-2015-09?utm_source=Project+Syndicate+Newsletter&utm_campaign=be2a176f93-Sept_13_20159_5_2015&utm_medium=email&utm_term=0_73bad5b7d8-be2a176f93-93726721





Coping with the New Normal

The outcome of the effort to rebalance the economy, adjust to a slower rate of growth, and cope with the New Normal will not be clear for some time. In March 2014, econo-mist and Financial Times columnist Martin Wolf put the odds more on success than failure when he wrote after attending the annual China Development Forum in Beijing that “Worriers are paying particular attention to excessive capacity, investment and debt. I share the view that making the transition to slower and more balanced growth is an extraordinarily hard challenge even by the standards of those China has already met. Yet betting against the success of Chinese policy makers has been a foolish wager. When a superb horse meets a new obstacle, the odds must be on the horse. But even the best horse may fall.”3

Is the banking system now strong enough to withstand the pressures of the difficult years that lie ahead? With GDP growth decelerating, heavy industrial and construction sectors stagnating, and the investment and export drivers of the economy faltering, will loan portfolio quality be heavily damaged, destroying bank profitability and eroding bal-ance sheets? Or will the strengths of the banks, the government’s demonstrated ability to pragmatically deal with problems, and the financial resources available in the “national balance sheet” to resolve problems, contain the inevitable loan problems within levels that the system can deal with, avoiding a financial crisis?

No matter how robust a banking system may be, in times of severe economic stress (the so- called “hard landing”) even the best banks have to deal with spiraling bad loans— a systemic crisis rising out of broader economic problems rather than weaknesses of the banking system itself. In a situation of milder economic stress (“soft landing), such as China is experiencing at the present time, NPLs will rise, but generally not rise to a level that will precipitate a financial crisis.

Even if a “soft landing” into the New Normal is smoothly engineered, the sustainability and robustness of the transformation of the banking system will still be tested. Concepts put forward earlier in this book will be the factors determining the future of the economy and the fate of the banks.

First, what parts of bank loan portfolios are likely to turn sour? Given the “national balance sheet,” it is likely that restructuring will avert default of SOE and local govern-ment debt and put state enterprises and local governments on a sounder financial footing. Conservative loan to collateral valuations will minimize losses from the consumer mort-gage portfolios, just as happened in Thailand during the economic meltdown of 1998. Consumer credit card receivables could be problematic but are unlikely to severely dam-age balance sheet quality. The weakest link in the tier 1 banks is exposure to private sector

3 Martin Wolf, “China’s Struggle for a New Economy,” Financial Times, March 25, 2014, http:// www.ft.com/ intl/ cms/ s/ 0/ 1e4472ae- b348- 11e3- b09d- 00144feabdc0.html?o=clippings/ list#axzz3cw8f5K6e, accessed June 14, June 2015.

http://www.ft.com/intl/cms/s/0/1e4472ae-b348-11e3-b09d-00144feabdc0.html?o=clippings/list#axzz3cw8f5K6e

http://www.ft.com/intl/cms/s/0/1e4472ae-b348-11e3-b09d-00144feabdc0.html?o=clippings/list#axzz3cw8f5K6e

Conclusion 257

business borrowers, constituting one quarter to one third of tier 1 bank loan portfolios. Rebalancing of the economy from investment to services and consumption, declining export demand at a time of rising wage pressures, and the recessionary conditions that are beginning to appear in some of the heavy industry provinces, will stress the cash flows of private sector enterprises that are unable to cope with the rapidly changing environment. This will be the principal cause of losses for the tier 1 banks.

Problems will also arise in tier 2 and tier 3 institutions, but the pattern will be different. Tier 1 banks, due to broadly similar portfolios and nationwide exposure, will most likely all be impacted to a similar extent by the changing economic conditions. The experience of tier 2 and tier 3 institutions will vary, as those banks differ widely in capacity of man-agement and in degree of independence from local government pressures, and most of their loans are extended to borrowers in the province or locality of each bank’s domicile. The decisive factors for tier 2 and tier 3 institutions therefore will be the quality of each individual bank’s governance and the local economic situations of the areas in which they operate.

In the economic slowdown that is occurring, new lessons will be learned, particularly the need to strengthen private sector credit analysis. There may be a year or two in which NPLs rise sharply, necessitating allocation of some or all of profits to loan loss reserves, but this is within the normal experience of banking systems in unfavorable economic conditions anywhere in the world. There is no particular sector of bank portfolios or operations that will give rise to sudden massive losses due to reckless lending, as hap-pened with Korean credit card portfolios in the 1990’s, or with American derivatives and subprime loans in the past decade.

Aside from the inherent strengths that have been built in the banks over the past fif-teen years, the nature of the Chinese political economy and the relationship of the finan-cial system to the government will provide a measure of protection to the banks from the impact of declining economic growth and overcapacity industries. Some media accounts and financial analysts’ reports maintain that potential but unrecognized NPLs are actu-ally in the range of 10% or higher (although they generally, but not always, recognize that ultimate losses on these loans will be less).4 What these analyses do not consider is the factors that have been discussed in Chapter 7— the power of the state and the national balance sheet to influence outcomes.

All governments now intervene in economies and financial systems to mitigate the impact of economic problems to some extent. The extent of the intervention varies between nations and over time. In the United States, initially the government’s response to the Great Depression was a very “hands off ” attitude— let nature run its course. Subsequently, the Roosevelt government was much more active in fostering recovery

4 For a recent example, see Bloomberg’s article on the forecast of hedge fund manager, Kyle Bass, that the Chinese banking system might lose “10% of its assets because of non- performing loans,” Katia Porzecanski, Bangkok Post, Asia Focus section, February 15, 2016, 5.


from the Depression. In 2008, the Bush government’s TARP program and compulsory assistance to the thirteen largest banks was highly interventionist— an intervention con-tinued by the Obama government. The U.S. government’s interventions occurred despite the fact that the United States generally lies at the end of the spectrum of market capital-ist systems that accords the smallest role to the state in the economy.

The Chinese market socialist economy lies at the other end of that spectrum. The Chinese government, in accordance not only with its contemporary political economy model, but also in keeping with the nation’s Confucian tradition, believes that it is the duty of the state to intervene in the workings of the economy for the greater good. The health of the hybrid banking system, running in accordance with market principles, but in the service of national goals, has been a priority of the government for the past fifteen years. Over the next few years, unless there is a fundamental change in the leadership’s vision of the Chinese political economy, that will remain a top strategic priority. Hence the extraordinary lengths to which the government went in 2008 to prevent a growth recession, and more recent active interventions to maintain 7% growth, although that goal is being realistically adjusted to something lower.

The most likely outcome of the present slowing of growth will be a “soft landing”— albeit not as soft as the government might wish for. There have already been bumps along the way, thus far mostly patched over, and there will be more in the future, with perhaps not all of them amenable to patching over. But recall that in the rest of the world “money flees problems,” whereas in China “money moves towards problems.” Starting in 2012, I have been forecasting that NPLs will peak at no higher than 5%. In early 2016, as I complete writing this book, I see little reason to revise that forecast. Out of total NPLs, not all will result in losses for the banks. And a portion of the losses that do occur can be written off against loan loss reserves already established. Even if NPLs do rise somewhat above 5%, the result will be diminution of profits for a year or two, not a financial crisis requiring major bank recapitalizations. This does not mean that there will not be loans in excess of the 5% level requiring some form of restructuring, loan- bond swap, or loan conversion into equity. As part of the restructuring of SOEs now underway, the government will lower SOE debt:equity ratios. Banks may be given a choice between accepting an NPL or converting to equity in a company that will be restructured to improve efficiency. When that happens, the payoff, as in the case a decade earlier with exchange of bad loans for bonds in AMCs, may take several years, but it will be within the capacity of the government to restructure SOEs into more effi-cient and profitable organizations that will provide a reasonable return on the equity conversion.

If, however, as China makes its economic transition to the New Normal, it does not experience a “soft landing,” but instead there is a “hard landing,” then the potential level of NPLs is impossible to predict. A “hard landing” for China would throw the entire global economy into a major downturn, so all projections would have to be thrown out. Even among “China bears” such a scenario is not given a high probability.

Conclusion 259

Evaluating the Transformation

The ethos of Chinese banking is hybrid, part Western and part Chinese. China’s banks have borrowed banking practice, governance, and technology from the West and incor-porated it into their banks. But in China’s banks the “invisible hand” is guided by the “vis-ible hand” of the party-state in performing the financial intermediation function. This is in accordance with not only how the Party has designed the political economy, but it is also in character with the more collectivist cultural attitudes that have prevailed for centuries in China, and it puts the banks in the service of the national effort to restore China’s wealth and power.

In the introductory chapter, I posed three criteria for evaluating the effectiveness of the risk assessment and credit allocation function of a banking system: access, efficiency, and stability. Subsequent chapters have given a sense of how China’s banking system now performs against these three criteria.

For most of the recent past, the banking system was focused intentionally as a matter of government policy on mobilizing savings from the general public and lending it at low rates under conditions of financial repression to state- owned enterprises and major private enterprises. Access to credit was limited to favored borrowers, and interest rates were administratively determined, not determined by the market. Not only was this in line with government policy, it also made sound commercial sense to the banks, as the risks were negligible. In neoliberal thinking, this rigging of interest rates and providing of implicit state guarantees is inefficient, as capital has been underpriced and then made available to certain favored borrowers. It was, however, in line with “developmental eco-nomic” concepts that had been successfully used in Japan, Korea, and Taiwan. In China, this scheme of credit allocation resulted in banks successfully funding the phenomenal growth of the economy, but it also played a key role in creating the “unbalanced and unstable economy” that the government is presently adjusting to become more balanced and more sustainable.

Over the past few years, as part of the shifting of the economy onto a more secure long- term basis, financial repression is being terminated, the financial system is being “debanked” by building up the capital markets as alternative sources of funding, SOE’s are being reformed and no longer are risk- free borrowers, and banks are encouraged by national policy to focus on expanding financial access, especially to SMEs, micro- consumers, and the rural and poor segments of society. Just as in prior years, banks are serving national economic development objectives, but now the objectives have changed, and banks are responding— because of their Party connections, because of pressure from a very activist official regulatory body, and because it makes commercial sense in the new environment. Banks are proving responsive and are succeeding in supporting the new objectives, assisting in making the transition to the New Normal. Interest rates are now almost entirely market determined, and financial access is being deepened steadily by both banks and non- banking institutions. SMEs, contrary to popular thinking, now have


reasonably good access to institutional credit— at least those SMEs that are by any rea-sonable definition bankable. As of time of writing, the banking system scores well in both financial access and financial efficiency compared to banking systems in other emerging countries of the world.

New financial technology, only in its initial stages of being introduced to the mar-ket, is capturing the imagination of the public and holds promise of disrupting both the credit intermediation and payments businesses of banks. This is happening all over the world, but faster in China than elsewhere. How effectively banks will respond to this new development, and how it will alter the financial landscape, will not be decided by the “invisible hand” of the market alone. The challenge to the state- dominated banking sys-tem is being mounted by private sector technology companies such as Alibaba, Tencent, Baidu, and others. The “visible hand” of the party-state will play a role in determining the outcome— where banks and private “fintechs” end up as the process unfolds, and what the new financial architecture looks like. The party-state will look upon development of the fintechs’ business favorably to the extent they improve efficiency of financial interme-diation and depth of financial access, reducing financial transactions costs and improving financial access for dynamic small businesses and for poorer communities. But it will rein them in if they take on too much risk that could be destabilizing to the economy, or pres-ent a threat to the interests of the Party or to social harmony.

China has always placed a premium on stability, on harmony. Confucian zhongyong (the “middle way” discussed in Chapter 2) counsels avoiding extremes. Since the bail-outs of the early 2000s, avoidance of risk, a strict and activist regulatory regime, strong governance, healthy bank balance sheets, and good returns to shareholders have been the priorities in development of the banks. China’s banking system over the past fifteen years has achieved a high degree of stability, even in the crisis of 2008 when banking roiled in the rest of the world. I have argued that the various issues that obsess some observers and analysts will be satisfactorily resolved, causing no more distress to bank balance sheets than is normal for banks during periods of economic difficulty— maximum of 5% NPLs. The intervention of a strong state utilizing the “national balance sheet” will contain prob-lems. The exceptions will occur among some tier 2 and tier 3 banks, and perhaps in some portions of the shadow banking system, but those institutions experiencing severe dif-ficulties will not be of systemic importance and the damage they cause will be contained. Compared with the experience of several major Western financial systems over the past decade, the Chinese have developed and managed a stable banking system (a few Western banking systems, especially Canada’s and Australia’s, have been more stable than China’s).

I would also argue that the rise of fintechs to challenge and supplement the banking system will be generally positive for the economy as a whole, and that the state will inter-vene as needed to guide the development of fintech business in such a way as to maxi-mize the contributions from their innovations, while limiting their destabilization of the financial system. In the near term, the state may be slow in reacting to the fast developing sector, so that there are some failures of fintechs, causing losses to unwary depositors who

Conclusion 261

trusted in their extravagant claims. Longer term, however, the state will develop policies for digital finance and bring this new area within its regulatory ambit. The state simply has too much at stake to allow private sector fintechs to become seriously destabilizing.

Transformation of China’s banks over the past fifteen years is a reality— a “night- and- day” difference in quality of financial access, efficiency, and stability. The two essentials of a well- run bank, good people and good systems, are in place in tier 1 banks, and in many lower- tier banks as well. On these foundations, over the past several years the banking system has registered high profits and strong balance sheets, with sufficient capital and reserves. Putting in place the foundations of efficient financial intermediation and earn-ing strong profits has enabled banks to effectively fund the economy during the last fif-teen years of boom— a major achievement. Undertaken at a time of favorable economic conditions, successful restructuring and transformation of the banking system did not lead to complacency; China used the profits of the good times to build strength for the slowdown that inevitably follows a boom.

Indubitably a confluence of fortunate factors contributed to the success of the banking transformation. For the first decade of the century, world economic conditions favored extraordinary growth of China’s export sector, which was one of the three drivers of its hypergrowth. Provision of improved housing for the population and government invest-ment in infrastructure were the other two drivers. Housing and infrastructure drove the boom in the construction industry, which in turn drove expansion of steel furnaces, machinery manufacturing, and other heavy industry. A virtuous cycle pushed overall GDP growth to over 10% in some years. In this boom environment, demand for bank credit was high. Due to widespread prosperity domestically and generally strong demand overseas for China’s exports, few businesses encountered cash flow problems. How could banks not prosper in this favorable environment? So a portion of the growth and profit-ability of Chinese banks over the past fifteen years can be attributed to a favorable eco-nomic environment.

That, however, is only part of the story. Lessons had been learned from the 1990s within China, from 1997 in Southeast Asia and Korea, and from the Wall Street prob-lems of 2008. The top level of government made a strategic commitment to building a strong banking sector. The PBOC, the CBRC, the Ministry of Finance, and the banks themselves were mandated and empowered to make that happen. Despite the achieve-ments and the enormous profits recorded over the next few years, no one involved in the banking transformation effort was complacent. Competition was fostered between the banks, and the PBOC and CBRC continually prodded the banks to strengthen cor-porate governance, to tighten risk management, to upgrade internal controls and audit functions, to increase prudential reserves “for a rainy day.” The right people were put in the banks at all levels from board through management to general staff, and they went to work. The result was the “night- and- day” transformation.

If over the next few years the government can make the economic transition to a more balanced and sustainable growth path successfully, then it will be able to deal with the


problems that presently absorb the attention of the “worriers”— shadow banking, local government debt, excess housing, etc. Moreover, with the economy transitioning into the New Normal, development of capital markets as alternative sources of funding, the decisiveness of the market in determining economic outcomes increasing, and the new world of digital finance emerging, banks will have to rethink their strategies to remain relevant in a rapidly changing world. SOE restructuring is a priority of the government, and, as providers of finance, banks will be expected to play a role in the restructuring program.

Only the banks themselves can determine their own futures in the face of disinterme-diation, the end of the era of lending to “risk free” SOEs, and the transition to the New Normal Economy. They need to embark on a second “transformation,” but this time in a less favorable economic environment, with reduced government support in the form of financial repression and other policy measures, and confronted by the specter of disrup-tive technologies.

Diversity of Culture and Political Economy

Banks are at the heart of the Chinese financial system that has fueled the hypergrowth of the economy. In the words of Alan Blinder, quoted at the beginning of Chapter 1, “Finance is more like the circulatory system of the economic body. And if the blood stops flowing … well, you don’t want to think about it.” Part of the success of China’s economic development over the past fifteen years must be attributed to China’s leaders thinking about how money was circulating in the system, to defining a strategy to ensure sustainable circulation, and to the consistent implementation of that strategy.

I have made the case that banks have in recent years performed their intermediation function reasonably effectively, but that the system works differently from the way it works in market capitalist economies. The development of the system is still going on, so it is at least premature, and possibly impossible, to reach a judgment about whether or not the Chinese hybrid system functions as effectively as do systems in market capital-ist or cooperative capitalist economies. This book instead argues that the institutional arrangements of Chinese banking have been designed to fit into China’s collectivist market socialist economy and have consciously or unconsciously reflected an inherited Confucian way of thinking about how the polity and society should work and relate to each other.

The Chinese do not maintain that the banking systems of other countries would work better if a Chinese banking model were imposed on them. Deng’s vision was that China should build institutions modelled after successful Western systems, but modified to meet Chinese conditions— hence having “Chinese characteristics.” China believes that systems that have “Chinese characteristics,” using the “visible hand” of the market econ-omy and the “invisible hand” of the government, will work best in China. By emphasizing

Conclusion 263

“Chinese characteristics,” China is also saying that the system that it has designed is for use in China, and not for use as a universal model around the world. The idea that there is a “Beijing Consensus” or “China model” for other countries has never gained currency in China.

Many Western observers, including economists, media commentators, and multilateral institutions, criticize China’s lack of adherence to the established orthodoxies of market capitalism, especially as defined in the neoliberal “Washington consensus.” The Western assumption all too often is that the market capitalist way of running an economy has universal applicability. There are three flaws in this assumption.

First, it ignores the differences among market capitalist economies themselves, and even more so the differences between market capitalist and cooperative capitalist econo-mies. There are substantial differences between them, arising out of their different his-torical development conditions, different cultures, and different preferences for the role of the state in economies.

Second, it ignores the sound advice of economist Li Yining, quoted in the Chapter 1, that “today’s structural optimization only represents optimization for the present stage, and cannot represent the future ongoing structural adjustment. From this perspective, structural adjustment is relative, so structural adjustment will continue.” The principles by which China’s economy run are in a constant state of refinement and evolution— evolution based on changing economic realities, not in transitory fashions of economic theory.

Third, the Western assumption does not give credit to the “night- and- day” transfor-mation of its banking system, or to China’s achievement of historically unprecedented success in economic development, which has not only given China the second largest GDP in the world, but has also lifted hundreds of millions of Chinese out of poverty.

No one is more qualified to expose the danger of the Western critique of China’s econ-omy and financial system than Stephen Roach, who was for years senior economist in Morgan Stanley in the heart of Wall Street, and then served in Hong Kong as chairman of Morgan Stanley Asia. In the sentences quoted in the heading of Chapter 11, Roach in 2014 wrote that “China cannot, and should not, be assessed in the same way that America sees itself. The optics of the two economies, as well as the lens by which they should be viewed, are very different. So much of Washington’s China fixation misses that key point.”5

Voices are being raised to challenge complacent assumptions that the market capitalist approach is the only approach, and that it should be adopted wholesale elsewhere. One such voice is that of Harvard’s Dani Rodrik, quoted in the heading to this chapter, who declares that economists should

5 Stephen Roach, Unbalanced: The Codependency of America and China (New Haven: Yale University Press, 2014), 252


figure out which model applies best in a given setting. And doing that will always remain a craft, not a science, especially when the choice has to be made in real time.

The social world differs from the physical world because it is man- made and hence almost infinitely malleable. So, unlike the natural sciences, economics advances sci-entifically not by replacing old models with better ones, but by expanding its library of models, with each shedding light on a different social contingency.

He goes on to urge awareness “that different circumstances call for different models.”6 Is this not what Li Yining is also saying?

Geopolitical tensions are increasing between China and the United States There are several reasons for the growing frictions, but one clearly is misunderstanding. Many Chinese with whom I have worked understand the United States and other capitalist economies well, through studying and working in the West, and through their readings and interactions with Western advisors.

A much smaller number of Westerners have an equivalent level of familiarity with China, and only a minority of those really understand how the country works and thinks. For the most part, however, the assumptions of capitalism all too often cause Western analysts of the Chinese economy to misconstrue what is happening and to make forecasts about Chinese economic performance that are shown by subsequent events to have been ill- founded. Perhaps more importantly, they do not acknowledge that China may work quite well, but differently from the West. They do not acknowledge the different lenses of which Roach writes.

One of my intentions in writing about the banking system is to use it as a case study of how China’s political economy works. China’s hybrid banking system only makes sense in the context of its own political economy and cultural values. An understanding of the banking system in turn assists in understanding how the broader political economy works.

Assuming that the frictions between the West and China can be restrained by wise leadership and cool heads on both sides, constructive cooperation between the two superpowers in resolving global problems can coexist with healthy competition in the economic sphere. The West will be successful in neither the cooperative efforts nor the competition if it complacently assumes that “our way” is superior and that the Chinese will ultimately have to manage their affairs “our way.” Perhaps over the long course of time, there will be convergence between the two systems, reducing misunderstanding, but it should not be assumed that in that convergence, the only one to move will be China. Perhaps there are aspects of the Chinese approach to banking that the West may find more sustainable, that will present alternatives to the present chronic instabil-ity of the financial systems of the capitalist economies. The wave of reregulation in the United States and Europe that followed the crisis in 2008 is recognition that perhaps the

6 Rodrik, “Economists vs. Economics.”

Conclusion 265

pendulum in the West had swung too far in the direction of leaving the market to its own devices with minimal state guidance and control.

For the past thirty years the United States and Europe have been dogmatic in their defi-nitions of how their capitalist economies should run, and on keeping the state at as much distance as possible from the workings of the all- powerful market. If Western nations were to once again be less dogmatic, then perhaps they will accept the value of China’s more experimental and pragmatic ongoing evolution of its economic mechanisms, and also see value in the Chinese view that banks are not an end in and of themselves, existing for the sole purpose of adding shareholder value, but that they also can legitimately be viewed as a sort of public utility, yielding return to shareholders but, more importantly, contributing to economic growth and providing sustainable financial access.

Whatever the course of development of Chinese market socialist and Western capi-talist banking systems over the next decades, professionalism of Chinese banking and sophistication of the financial system will steadily increase. The size and international influence of China’s banking system will continue to grow along with the rising assertive-ness of a newly confident China. The West will only be able to engage the Chinese bank-ing system effectively if it understands how it works, recognizing both the similarities and the differences with Western banking systems.

The banking system is a microcosm of China as a whole. Understanding of how China’s banking system works leads to insight into China’s very different political econ-omy model. It is a model that has worked well for China over the past thirty years and continues to work well today as the country transitions to the New Normal. China’s political economy model will evolve over the longer course of time. No matter how it evolves, China’s political economy and financial system will evolve predominantly on China’s terms, which may or may not please capitalist critics. If the West and China are to engage with each other constructively, it is imperative that the West understand China on its own terms, not through a Western lens.

267

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273

Asian Development Bank (ADB), 127Asian Financial Crisis, x, 7– 8, 82, 84, 218, 256Asian Governance Model, 40, 44asset management companies, 86– 93Audit Committee, 93, 138– 139audit, development of the profession in China,

60, 137, 186– 188; external audit, 85– 86, 92, 105, 112, 128, 137– 138; internal audit, 9, 50, 85, 93, 97, 117, 119, 127– 128, 135, 138– 139, 145, 261

Australia, 23, 61, 230– 231, 260

bad bank, 85– 86, 91, 226bad debt: in 1990s, 2, 7, 76, 78, 91, 123, 126,

171, 180; present level of, 96, 129, 226, 241; provisioning against, 95, 129; understatement of, 12, 105, 129; Western bank, 4, 85. See also NPL

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3rd Plenum: of 11th Congress (in 1978), 68; of 14th Party Congress (in 1993), 55, 77; of 18th Party Congress (in 2013), 13, 22, 55, 58, 78, 84, 87, 98– 99, 124, 158– 159, 167, 175, 183, 185, 244, 248, 249– 252, 254

4 trillion yuan stimulus. See stimulus4th Plenum, 22, 61

A Shares, 179A. T. Kearney, 7ABC. See Agricultural Bank of ChinaABN AMRO Bank, x, 103accounting, 3, 9, 60, 68, 84– 85, 93, 97, 105,

125, 137– 139, 229, 247; accounting for bank restructuring under Zhu Rongji, 89, 223; modernization of Chinese accounting, 186– 188

Agricultural Bank of China (ABC), 7– 10, 71, 136, 170

Agricultural Development Bank, 11Alibaba, 5, 110, 140– 142, 148, 156, 241, 260All- China Federation of Industry and

Commerce, viii, 47, 72Anglo- American model: corporate governance,

102– 103, 106; economic, 2– 3, 13– 15, 29, 36, 114, 174, 213, 218– 219, 229

Index

274 Index

Bank of Communications, 10, 115, 140Bank of East Asia, 191Bank of Shanghai, 158Bank of Taizhou, 133, 171– 173, 206Bank of Xian, 170banking reform, 78, 85, 123, 161, 183, 213Basel Committee on Banking Supervision,

80, 129Beijing Model, 225Bell, Stephen, and Hui Feng, 160,

160n14– 161n14benevolence, 28– 30, 117– 118big bang, ix, 56– 57, 62, 70, 75, 99, 185Blinder, Alan, 1, 229, 262Bloomberg, 12, 87, 135board of directors, 102– 108; review of NPLs,

128; review of related party transactions, 188; review of strategy, 145

Board of Supervisors, in China, 106– 108, 128; in ABN- AMRO Bank, 103

BOC. See Bank of Chinabond markets, 11, 62, 160, 173– 179, 192, 208,

212, 241, 248– 249Bond, John, 196Boston Consulting, 7brand, 95, 110, 142, 148, 194– 195, 199Brandt, Loren, and Xiaodong Zhu, 72, 76Brazil, 16Bureau of Financial Supervision, 209

Calomiris, Charles, and Stephen H. Haber, Fragile by Design, 16, 18, 72, 174, 204

Canada, 16, 23, 61, 230– 231, 260capital account, 83, 98, 162, 248– 249capital allocation, 5, 7capital market: bond market, 175– 179; Chinese

overseas experience in; 118; disintermediating banks, 98, 174, 240, 259, 262; equity market, 179– 186; foreign banks in, 190, 194; need for reform of, 9, 175, 243, 245, 248; open to foreign participation in, 22, 198; weaknesses of, 89. See also equity markets and bond markets

Capital Steel Company, 71CBRC. See China Bank Regulatory CommissionCCB. See China Construction Bankcentral bank, 159– 162; control of interest rates,

176; early history of, 66– 68, 208–211; Japanese central bank, 216; split from commercial banking, 65, 71. See also People’s Bank of China

Central Commission for Discipline Inspection, 50, 90

Central Huijin, 72, 156–158, 162Chang, Gordon G., The Coming Collapse of

China, 12, 223Chaos, 17, 54, 56, 67, 84Charlene Chu, 12– 13, 223Chaulk, Nigel and Murtaza Syed, 243Chen Jintao, 209, 212Chen Yun, 43, 46, 74– 75Chen, Zhiwu, 175Cheng Kejie, 135Cheng, Linsun, 205, 207, 210Chiang Kai- shek ( Jiang Jieshi), 53, 209– 211China 2030, 55, 244– 247, 249China Bank Regulatory Commission (CBRC),

163– 165, 261; appointment of senior bankers, 47– 48, 111; concern with loan quality after stimulus, 177; establishment of, 9, 81, 93, 179; and foreign banks, 193, 196, 199; International Advisory Board of, 196, 231; member of Leading Group for Finance and Economy, 43; professional reputation, 9, 164; supervision of banks, 49, 94– 95, 104–105, 112, 121, 127– 129, 136– 139, 147, 168, 171, 181

China Construction Bank (CCB), 7– 8, 10, 48, 71, 135, 141, 156

China Development Bank, 11, 164, 177– 178, 203– 203

China Dream, 55China Everbright Bank: board of supervisors of,

107; chairman of, 34, 48, 164; establishment of, 71– 72; external audit of, 138; head office of, 101– 103; Hui Jin as shareholder, 157– 158, 162; internal audit, 93, 139; professionalism, 93; risk focus, 126, 128; strategic partner, 20– 21, 198; strategy formulation, 156; wealth management products, 121

China Huarong Asset Management Corp., 88, 90– 92

China Insurance Regulatory Commission, 163China Investment Corporation (CIC), 80,

156, 201China Merchants Bank, 106, 121, 148, 171China Minsheng Bank: brand, 148; CEO arrested,

120; CEO compensation, 113; chairman of, 47; establishment of, 47, 71– 72; matrix

Index 275

management, 115; private ownership, 72; professionalism, 93; risk approach, 126, 128; senior appointments, 48; SMEs, 168, 198; strategy formulation, 145– 148

Chinese Accounting Standards (CAS), 187Chinese characteristics, 103, 105, 123, 150, 184,

251, 262– 263ChiNext Board, 179CIC. See China Investment CorporationCinda, 91Citibank, 47, 51, 94, 111, 148, 192, 197, 237Citic, 73, 83city banks, 9– 10, 133, 156, 170, 171,

197, 213collaborative capitalist system, 8, 113. See also

cooperative capitalist systemcollectivist, 35, 103, 106, 118, 218, 259, 262.

See also collectivitycollectivity, 21, 27– 28, 62, 119. See also

collectivistCommercial Banking Law, 80Communist Party, 2– 3, 17– 21, 24, 28– 30, 36,

39– 63, 72, 101, 108, 150– 151, 172community banks, 132competitive state guided capitalism, 65, 155Confucianism, 17, 26– 31, 33, 35– 37, 54, 57,

260; banking embedded in, 21, 119, 262; Korean, 217; patriotism and, 210– 212; rule of men vs. rule of law, 60– 61, 118; state intervention, 258

Confucius. See Confucianismconvergence effect, 45cooperative capitalism. See cooperative capitalist

systemcooperative capitalist system, 3, 8, 19, 250,

262– 263coordinated capitalist system, 8. See also

cooperative capitalist systemcore banking application, 140core strategic industries, 78– 79corporate bonds, 176, 178corporate culture, 12, 17, 73, 116– 122, 127,

147, 190, 195corporate governance, 8– 9, 13, 79, 85, 97, 100,

102– 108, 116, 123, 148, 163– 164, 180–183, 188, 197, 199

corporatization, 79, 86, 251– 252corruption, 30, 45– 46, 50, 61, 119– 120, 124,

135– 136, 210

credit allocation, 23, 73, 76– 77, 123– 124, 149, 259

credit cooperatives, 7– 8, 10, 171credit risk, 13, 22, 94, 123, 131– 132, 207, 213;

in U. S., 233credit trusts, 7– 8, 74culture, corporate, 17, 20, 73, 116– 121,

127, 141, 147, 201; of international banks, 190, 195

culture, national, 14– 16; culturally embedded, 15, 21, 24, 25, 204, 213, 254, 263; definition of, 14, 14n13, 15n17; Korean, 217; 254; modernization and, 56; political culture, 41; traditional Chinese, 17, 26– 34, 37, 62, 102

Da Qing Bank, 208– 209, 212Dai Xianglong, 161Dang, 18, 24, 38, 102, 117, 150Daoism, 30– 31DBS, 192debanking, 5, 66, 175, 242, 259defalcation, 119, 134demographic dividend, 238– 239Deng Xiaoping: banking reform, 64, 68, 73– 74,

99; Chinese characteristics of socialism, 15; and the Party, 39, 41, 59; planned and market economy, 1– 3; Reform and Opening, 6, 21, 29, 37, 73– 75, 189, 228

deposit insurance, 23, 98, 226, 246– 248derivatives, 5, 111, 193, 201, 219,

234, 257Development Research Center, 244developmental states, 13, 18, 214– 219digital technology, 6direct finance, 5, 11, 166, 173– 175, 240, 242direct funding. See direct financedisintermediation, 149, 240– 242, 262Douglass C. North, 14, 17

East Europe, 14, 20, 57equity markets, 5, 11, 22, 59, 105, 125,

174–175, 179– 186, 232, 249Ethiopia, 177, 203European Union, 15Everbright Bank. See China Everbright BankEverbright Group of Companies, 48, 72, 157Exchange Bond Market, 176expected loss approach, 138Export- Import Bank of China, 11

276 Index

financial access, 11, 23– 24, 66, 167– 168, 170–173, 259– 261, 265

financial crisis of 2008, 1, 20, 35, 93, 238financial depth, 164, 167financial inclusion. See financial accessfinancial innovation, 164, 233, 248financial intermediation, 2, 9, 19– 20, 22– 24, 86,

97– 98, 149, 163, 165, 166, 253, 259– 261financial public utility, 19financial reform: 1976– 2004 period, 3, 67, 69,

71, 74, 80, 83, 125, 167; future directions, 97, 124, 243– 254; slowing during 2005– 2012 period, 93, 163, 222

financial repression, 4, 66, 87, 98, 176, 180, 217– 218, 233, 245, 255, 262

Financial Stability Board, 232fintechs, 5, 241– 242, 260– 261Fitch Ratings, 12, 223foreign banks, 5, 94– 95, 138, 149, 190– 199,

2011, 205– 212France, 15, 18, 49, 178, 214

Gao Shan, 134– 135Generally Accepted Accounting Principles

(GAAP), 187Germany, 1, 11, 60, 174, 178, 241; coordinated

capitalism, 3, 19, 215, 217, 219; levels of debt, 230– 231

ghost cities, 229, 236Gilley, Bruce, 40, 44GITIC. See Guangdong International Trust and

Investment CompanyGleaves, Simon, 131, 140going out, 194, 199– 203Golden Decade, 211Great Tradition, 26, 31– 33Greenspan, Alan, 35, 220, 228Greenwald, Bruce. See Stiglitz, JosephGuangdong International Trust and Investment

Company (GITIC), 63, 83– 84, 93Guangfa Bank, 47, 120, 197guardianship democracy, 40Gulliver, Stuart, 112Guo Shuqing, 48Guo, Sujian, Chinese Politics and Governance, 3,

26– 27

H Shares, 179Hamilton, Alexander, 215, 220

Hang Seng Bank, 196harmony, 17, 26– 28, 30, 33, 42, 54, 62, 119,

183, 185, 260He Weiping, 164Hegel, Georg, 215Herrmann- Pillath, Carsten, “Making Sense of

Institutional Change in China,” 25– 26, 53Hong Kong, 6, 12, 68, 101, 106, 109, 118, 130,

195, 200, 202, 203, 207Hong Kong and Shanghai Banking Corporation,

207, 212. See also HSBCHong Kong Monetary Authority, 253Hong Kong Securities Exchange, 9, 10, 12, 85,

87, 91, 106, 125, 143, 179– 180, 183, 187Hong Kong Stock Market. See Hong Kong

Securities ExchangeHong Qi, 146Hoover, Herbert, 35HSBC, 91, 94, 115, 148, 190– 197, 203, 212,

237. See also Hong Kong and Shanghai Banking Corporation

Hu Jintao, 21, 28, 41, 44, 92, 120Hu Yaobang, 74Hua Xia Bank, 71Huang Haizhou and Zhu Ning, 208Huang Yiping, 151, 167, 173Huarong. See China Huarong Asset

Management Corp.Huawei, 156Hubu Bank, 208hybrid banks, 2– 6, 13– 24, 150, 213, 234,

258, 264

IBM, 140, 142, 199ICBC. See Industrial and Commercial Bank of

ChinaIFC. See International Finance CorporationIMF. See International Monetary Fundimpairment of loans, 138Imperial Bank of China, 207indirect finance, 5, 11, 173, 240, 242individual (opposite of collectivity), 27– 29, 34,

35, 119individualism. See individualIndonesia, 8, 40, 82– 83, 97, 218Industrial and Commercial Bank of China,

7– 8, 10; board of supervisors, 107; CEO compensation, 113; establishment of, 71; foreign investors in, 197; Huarong bond

Index 277

receivable, 88, 90– 92; international expansion, 200, 202; IT, 140, 142; market capitalization, 86n; MOF ownership, 157; organizational structure, 115; staff employed, 115

Industrial Bank, 71, 121information technology (IT), 9, 66ING, 94institutional economics, 14institutionalized trust, 60– 133insurance, 11, 23, 69, 91, 98, 163, 174, 176, 182,

243, 248integrity: as a character trait, 111, 119; of

financial reporting, 128, 138, 176, 186Interbank Bond Market, 176interest rate deregulation, 5, 214. See also interest

rate liberalizationinterest rate liberalization, 57– 58, 97– 98,

233– 235, 245, 248. See also interest rate deregulation

interest rate repression. See financial repressioninternal audit, 9, 93, 119, 127– 128, 135,

138–139, 145internal control, 3, 13, 85, 93, 105, 113, 119,

125, 127, 134– 138, 164, 261. See also risk control

International Finance Corporation (IFC), viii, 127, 197

International Financial Reporting Standards (IFRS), 187

International Monetary Fund (IMF), 7, 97, 113, 153, 164– 165, 180, 200, 253– 254

internationalization of the rmb, 22, 178invisible hand, 1, 6, 24, 29, 34, 154, 186, 221,

234, 259– 262Ireland, 214IT. See information technology

Jack Ma, 29, 255Japan, 1, 7, 11, 26, 53, 60– 61, 77, 105, 141, 173,

178, 182, 190, 200; as cooperative capitalist economy, 3, 8, 19; as developmental state, 18, 214, 216– 219, 259

Ji Zhaojin, 206, 210Jiang Jianqing, 202Jiang Jieshi. See Chiang Kai- shekJiang Zemin, 41, 43, 71, 75, 92Jing Shuping, vii– viii, x, 47, 72, 145joint stock banks, 7, 9– 10, 19, 49, 71– 72, 113,

116, 143, 200, 213, 247

K Bank, 146Keynes, 54, 95, 152– 154Kok, Wim, 200Korea, 8, 18, 23, 26, 40, 82– 83, 214, 216– 219,

227, 230– 231, 238, 257, 259, 261Krasno, Nicholas, 146Krugman, Paul, 226– 228Krung Thai Bank, 134

Laos, 39Lardy, Nick, 54n, 97, 232large commercial banks, 10, 72, 102, 159, 197, 199Leading Groups, 43– 44, 46, 48Legalism, 30– 31, 118lending platform, 176Leninist party, 18, 42, 213Li Keqiang, 21, 98Li Peng, 75Li Ruohong, 120Li Yining, 5– 6, 9, 214– 215, 263– 264Liang Sicheng, 100Lin Yifu, 15liquidity risk, 22, 112, 134, 139List, Friedrich, 215little tradition, 31– 31Liu He, 44Liu Mingkang, 9, 48, 65, 164Liu Yonghao, 72Liu, James and Tu Weiming, Traditional

China, 57loan loss reserves, 257– 258. See also provisioningloan losses, 85, 95, 128, 131loan:deposit ratio, 136, 196local government debt, 13, 63, 177, 237, 242,

256, 262Lockwood, William, The Economic Development

of Japan, 216– 217Lonnie Dunn, 127Lou Jiwei, 25– 26, 31, 61, 163Lu Haijun, 120

Ma, Jack, 29, 255Maitland, A. M., 207major commercial banks, 10, 72, 203. See also

Tier 1 banksMalaysia, 40, 182management information system (MIS), 141Mao Xiaofeng, 120Mao Zedong, 6, 41, 66, 101, 228

278 Index

Mao Zemin, 66– 67market capitalism, x, 2– 3, 14, 229; China’s lack

of adherence to, 262– 263; in developmental states, 219; and financial reform, 247– 254; governmental intervention in, 258; universal applicability, 246, 263

market concentration, 147Market Leninism, 41market risk, 22, 139market socialism, 3, 6, 20, 24, 65, 68, 187, 213,

245, 247, 249McNally, Christopher A., “China’s Emergent

Capitalism”, 65, 155Mexico, 16micro- credit, 168, 170, 173micro- lending. See micro- creditmiddle income trap, 61, 239Ministry of Finance, 68, 71– 72, 77, 80, 83, 88,

90, 92, 97, 105, 108, 155– 156, 162– 163, 176, 187, 261

Minsheng Bank. See China Minsheng BankMIS. See management information systemMongolia, 20, 97monobanking, 7, 65– 68, 200Moon, Chung- in, Byung- joon Jun, 218Mote, Frederick W., Intellectual Foundations of

China, 25– 26, 31, 60– 61mutual fund, 184

Nan Hanchen, 67Nan Jingming, 67NASDAQ, 105national balance sheet, 92, 151– 153, 155, 159,

231, 235, 256– 257, 260national capitalism, 211National Development and Reform

Commission (NDRC), 43– 44, 96, 152, 178native banks. See qianzhuangNaughton, Barry, 70NDRC. See National Development and Reform

CommissionNeo- Confucian, 26neoliberal, 14, 263, 155, 214, 246– 247. See also

Washington Consensusneoliberalism. See neoliberalNetherlands, 1, 3, 15, 111New Normal, 4, 21, 62, 238– 240, 255– 258,

265; challenge for banks, 66, 87, 133, 242, 259, 262

New Third Board, 179New York Stock Exchange, 180, 182, 220Nolan, Peter, 140non- performing loans. See NPLNPL: of 1990s, 62, 73, 76– 77, 80, 126, 143, 171,

223, 245; present level, 128– 131, 134, 139, 223, 241, 256– 258, 260. See also bad debt

OCBC, 191OECD. See Organization for Economic

Co- operation and DevelopmentOpening and Reform, 25, 64, 71, 74, 161,

191, 238operational risk, 22, 105, 134, 136, 139Ordos, 236Organization Department (of the Communist

Party), 42, 47; and banks, 19, 48– 51, 109, 114, 121, 144, 159, 198

Organization for Economic Co- operation and Development (OECD), 8, 113

P2P. See people to people lendingPark Chung Hee, 217, 227Party Committee (in banks), 20Party values, 43, 51– 58, 183path dependence, 15, 64, 213PBOC. See People’s Bank of Chinapeople to people lending (P2P), 163, 241People’s Bank of China (PBOC), 159– 165; in

1978– 1979 period, 7, 65, 71, 73, 77, 127; bond supervision, 176; establishment, 67; in Leading Groups, 43– 44; interest rate deregulation, 58, 98; under Monobanking, 6, 65, 69, 200; owns Huijin, 80, 156; reform of banking system, 84, 105, 112, 135, 223, 261; relations with foreign banks, 196, 199; reorganization of, 81; stimulus of 2008, 95–96; in The Rise of the People’s Bank of China, 160; Zhu Rongji as governor, 8, 161

People’s Consultative Congress, viiiPerkins, Dwight, East Asian Development,

81– 82, 217Philippines, 182Piaohao, 206– 208, 210pilot projects, 56– 58, 99Pingan Bank, 19, 72, 113, 121, 156, 165, 171planned economy: abandonment of, 65, 76– 78,

92, 144; accounting in, 186; banks in, 2– 3, 7– 8, 20, 65, 73, 76– 77, 143, 222; combined

Index 279

with market economy, 1, 77; credit plan in, 72– 73; PBOC in, 160; reforms of, 6; Zhu Rongji experience in, 228

Pogson, Keith, 117, 138policy banks, 11, 147n, 156, 177– 178, 202Politburo, 32, 42– 46, 55, 124; Standing

Committee, 42– 44, 183Postal Savings Bank, 10, 170power of the state, 13, 14, 92, 150– 165, 184,

237, 238, 257Pozen, Robert, 242Pragmatism, 30, 36, 43, 51– 53, 58– 59, 70, 99Price Waterhouse, 7, 77, 138– 139principal- agent problem, 102, 116private banks, 16, 67, 98– 99, 109, 114, 147, 156,

158– 159, 165; German, 219; Japanese, 216; in pre- 1949 China, 208, 211, 212

privatization, 5, 79, 97, 120, 156, 158, 159, 244–247, 249– 253

provisioning, 86, 128– 129. See also loan loss reserves

Pudong, 236

qianzhuang, 206– 210, 213

rational expectations, 14RBS, 94real estate bubble, 13, 235– 237Redding, Gordon and Michael A. Witt, The

Future of Chinese Capitalism, 15– 17, 28, 60Redding, S. Gordon, The Spirit of Chinese

Capitalism, 117– 119Reform and Opening, 3, 6– 7, 21, 26, 33, 37, 53,

65, 68– 70, 77, 174, 187, 218regulation: Basel implementation, 80; digital

finance, 242; EU, 15, 164; financial (in China), 7, 64, 80, 84, 127, 163, 179, 181, 249, 253; foreign banks, 192, 199; implementation, 104– 105, 108, 120, 124–125; 179; proponents of, 46, 164– 165; shadow banking, 234; value of, 19, 34

regulatory state, 159Resolution Trust Corporation, 85– 86, 88, 91resource allocation, 98– 150restructuring of debt, 127, 129– 130, 211,

256, 258retail branch, 9, 143, 199risk: audit of risks, 139; aversion to, ix,

13, 45, 56– 58, 62, 120– 121, 148, 165,

201–202, 213, 260; liquidity risk, 136– 137; management and assessment of risk, 3– 4, 9, 13, 19, 22– 23, 51, 61, 64, 73, 77– 78, 84, 93, 97, 105, 107– 112, 118, 123– 131, 145, 160, 163– 164, 190– 191, 198, 239, 241, 248, 259, 261; operational risk, 134– 136; risk- free, 4, 92, 96, 145, 168, 242, 259, 262; shadow bank risk, 233– 235, 242, 260; SME risks, 131–134, 169; systemic risk, 246

risk control, 9, 105, 107, 126, 137, 163, 202, 207. See also internal control

risk- free rate, 178Rodrik, Dani, 255, 263Roosevelt, Franklin D., 35, 257Roosevelt, Theodore, 220Rubin, Robert, 112rule of law, 22, 24, 41, 45, 61rule of men, 30, 28, 41, 90, 118rural credit cooperatives, 10Russia, 39, 70, 190

SASAC. See State- owned Assets Supervision and Administration Commission

savings, 2, 23, 57, 67, 89, 98, 166, 175, 179, 181– 183, 218, 232, 234, 238, 259

savings and loan crisis. See United StatesSchulte, Paul, The Next Revolution in Our

Credit- Driven Economy, 109Scotiabank, 170Shambaugh, David, China’s Communist Party, 53Shanghai Alliance Investment, 158Shanghai Exchange. See Shanghai Securities

ExchangeShanghai Free Trade Zone, 56Shanghai National Accounting Institute, 104Shanghai Native Bankers Guild, 206Shanghai Securities Exchange, x, 125, 179, 221shareholder state, 79, 155shareholder value, 2– 3, 18– 19, 79, 103, 182,

204, 265Sheng Xuanhuai, 207, 210, 212Sheng, Andrew, 231Shenzhen, 56, 191Shenzhen Development Bank, 72Shenzhen Securities Exchange, 10, 179, 187Shih, Victor, Factions and Finance in China,

33n17Shiller, Robert J., Finance and the Good Society,

166, 174

280 Index

Singapore, 6, 18, 23, 40, 146, 182, 198, 214, 218, 252

small loan companies, 10, 168SOE. See state- owned enterpriseSOE reform, 75, 78, 250, 252– 253Soros, George, 150Soviet (in Jiangxi Province), 66Soviet Union, 6, 14, 20, 30, 39, 41, 53, 55, 57,

65, 70, 77, 153, 186, 213, 250Special Economic Zone, 56, 191stability: as a cultural value, 26, 29, 52; of

financial system, 1, 23, 126, 163, 164, 185, 220, 225, 242, 253, 260– 261; as a Party value, 43, 54– 56, 58, 247, 260

Standard Chartered, 94, 148, 191– 192state balance sheet. See national balance sheetState Council, x, 244, 42– 46, 49, 58, 64, 71, 74,

80, 84, 87, 91, 96, 113, 121, 124– 125, 152, 154, 159, 161– 163

State Economic Commission, 84state ownership, 5, 48, 79, 103, 147, 151, 156,

211, 214, 244, 246, 251State Planning Commission, 84State- owned Assets Supervision and Administration

Commission (SASAC), 79, 252state- owned companies. See state- owned

enterprisesstate- owned enterprise (SOE), 4, 7, 147,

155–157, 181, 249, 237, 240– 242, 250– 253, 256– 260, 262

Steinfeld, Edward, 81– 82Stiglitz, Joseph, Freefall, 243, 114, 120, and

Bruce Greenwald, Creating a Learning Society, 214– 215, 229, 169

stimulus (of 2008), 54, 95– 97, 152– 154, 177, 183, 226, 230, 239

strategic investor. See strategic partnerstrategic partner, 21, 94– 95, 127, 145,

196– 199strategy: of banks, 142– 148; as a Party value, 43,

52, 55– 60, 78, 144, 150, 153– 154subprime loans, 20, 257Sun Yat- sen, 41, 211supply chain, China’s links to world, 82, 94, 172,

in bank lending, 133, 170sustainable banking, x, 13, 22

Tailong Bank, 171, 173, 206Taiwan, 18, 40, 60, 200, 214, 216, 259

Tang Shuangning, 34, 48, 101Temasek, 146, 198, 252Tencent, 110, 141, 148, 156, 241, 260Thai Credit Guarantee Corporation, 170Thailand, 40, 134; corruption in banks, 119;

equity markets, 182; financial crisis, 8, 82–83, 218, 256; financial sector development, 97; KBank, 146; SME lending, 134, 170; transitional polity, 40

Thirty Years of Opening and Reform of the Chinese Banking System, 67, 77

Ti. See TiyongTianjin, 172, 199, 209Tier 1 banks, 17, 32, 72, 102, 166, 174; auditors

of, 137, 188; centralization of authority, 81, 127; corporate governance, 105– 111; government ownership, 155, 157; herd behavior, 121; IT, 140; lending to SMEs, 168– 170; listing on exchanges, 125, 156; management and staff, 111– 115; Party guidance, 47– 49, 172; private sector lending, 256– 257; privately- owned, 19, 102, 144, 156, 165; quality compared with tier 2 and 3, 97; reform program of Zhu Rongji, 85– 87, 93–94, 137; risk averse, 120, 126 (see also risk); strategic partners, 94, 196; transformation of, 261

Tier 2 banks. See City BanksTier 3 banks, 10, 94, 97, 196, 260Tiyong, 18, 24, 37– 38, 102, 117, 150, 212town and village banks, 10Troubled Asset Relief Program, 220, 258trust companies, 83, 233– 234

U. S. See United StatesUnited Kingdom: austerity policy, 152;

banking system, 16, 120; capital markets, 174; China learning from, 77; compensation of bankers, 113, 127; direct funding, 174; institutionalized trust, 60

United States (U. S.): activist role of government, 13, 220, 221, 228, 258; bank crises, 16, 23, 174, 208; bank IT, 140, 142; China learning from U. S., 8, 77, 211; dominance in global governance, 229; financial system, 1, 6, 8, 13, 19, 120, 127, 142, 147; Great Depression, 34–35, 174, 241; institutionalized trust in, 60– 61; laissez- faire, 34; local government, 177; market capitalism of, 2, 265; national debt, 230– 231;

Index 281

reliance on direct funding, 11, 174, 241; savings and loan crisis, 85–87, 88, 91; shadow banking in, 233; SME lending, 132– 133; tensions with China, 264; Trade Representative report on China, 191; Xi Jinping’s visit, 69

universal banking, 5, 199

Venezuela, 177, 203venture capital, 11, 169– 170, 249Vietnam, 26, 39, 213visible hand, 1, 6, 24, 186, 221, 234, 259– 262Vogel, Ezra, 75

Walter, Carl and Fraser Howie, Red Capitalism, 86n43

Wang Xuebing, 50– 51Wang Yingyao, 79, 103Wang Yugui, 69Wang, Eddie, 47Washington Consensus, 14, 216, 219,

228– 230, 263wealth and power, 6, 17– 18, 37, 53, 57, 70,

101–102, 150, 207, 210, 259Wells Fargo, 132, 142, 169, 189– 190, 241Wen Jiabao, 21, 57, 92, 161, 173, 253Wenzhou, 130, 133, 171World Bank, 7, 55, 74, 77, 97, 127, 158– 159,

243– 249, 253– 254World Trade Organization, 80– 84, 89, 93– 94,

187, 191, 193, 199, 223, 229WTO. See World Trade OrganizationWyman and Fung, 231

Xi Jinping, 1, 6, 21, 24, 30, 33, 36, 41, 43– 44, 58, 61, 69, 98– 99, 113– 114, 119, 124, 170, 186

Xiao Bing, 132Xiao Gang, 126Xiao Geng, Modernization of China’s Economy,

179– 180–182, 232Xu Jiqing, 204, 210

Yam, Joseph, 253Yanan, 52, 66Yang Kun, 120Yantai Bank, 196Yinhang, 207Yong. See Tiyong

Zhang Enzhao, 51Zhang Weiying, What Changes China, 158, 247Zhang, Joe, 226Zhao Ziyang, 43, 71, 74Zheng Yongnian, China’s Reform, 41Zhengzhou, 237Zheshang Bank, 19, 121, 156, 165Zhongyong, 29– 30, 260Zhou Xiaochuan, 65, 161, 163Zhu Min, 113Zhu Rongji: approves founding of Minsheng

Bank, viii, 47, 72; “going out” policy, 199; governor of PBOC, 8, 161; leader of reform, 65, 78, 84– 85, 228– 252; Leading Group on Finance and Economics, 43; retires, 92; transforms banks, 12, 20, 76, 85, 98, 143, 181, 192, 197

Chinaâ€™s Banking Transformation: The Untold Story

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