Putting China's capital to work

By Diana Farrell and Susan Lund

China's financial system does an outstanding job of mobilizing savings. But there is considerable room for improvement in its capital allocation, and its overall efficiency.

The chief tasks of any good financial system are to attract savings and channel them to productive investments as efficiently as possible. China’s financial system does an outstanding job of mobilizing savings. But there is considerable room for improvement in its capital allocation, and its overall efficiency. Financial-system reforms could not only raise GDP by as much as 17%, or $320 billion a year, but also help spread China’s new wealth more evenly throughout the country.

China's regulators are understandably anxious that a shift in funding toward more productive borrowers could accelerate layoffs from the less productive state-owned enterprises (SOEs), and lead to more social unrest. But such a shift will stimulate job creation in the strongest areas of China’s economy and increase tax revenues to fund social programs. Speeding the move to a fully market-based financial system will relieve, rather than exacerbate, social tensions in the long run.

Financing the Most Productive
Over the past 10 years, private companies in China—whether Chinese-owned, foreign-owned, or joint ventures—have grown faster than GDP. These companies now account for half of all output and many new jobs. The share of production from wholly state-owned enterprises, meanwhile, has shrunk to barely one-quarter of GDP. Although many SOEs have been restructured and some are highly profitable, their productivity as a group is still half that of private companies, both in aggregate and by industry.

Nevertheless, SOEs (both wholly and partially state-owned) continue to absorb most of the funding from the financial system. Private enterprises have received only 27% of loan balances. Many of them resort instead to China’s large informal lending market, which has an estimated $100 billion of assets but also higher interest rates.

As well as explaining the large volume of nonperforming loans in China’s banking system, this pattern of lending also has the effect of lowering overall productivity in the economy. As a result, China is seeing its investment efficiency decline. Whereas it required $3.30 of investment to produce $1 of GDP growth in the first half of the 1990s, each $1.00 of growth since 2001 has required $4.90 of new investment—nearly 40% more than the investment required by South Korea and Japan during their high-growth periods.

Productivity would be boosted greatly if a larger share of funding went to more productive private enterprises. Less productive SOEs would have to improve their operations to continue to attract finance, or shut down. Over the next five years, this dynamic would go a long way to closing the productivity gap between state-owned and private companies, raising GDP by as much as 13%, or $259 billion annually.

Chinese households will benefit as better capital allocation creates higher returns on savings. Chinese households save a lot by international standards—on average, roughly 25% of their disposable income. But they keep 86% of their savings in low-yielding bank deposits and savings accounts. Given the low average returns and volatility of equity and bonds over the past 10 years, opting for bank deposits has been rational.

That said, poor capital allocation by banks and the comparatively high cost of financial intermediation in China mean that returns on bank deposits are also dismal. Over the past 10 years, Chinese households’ financial assets earned just 0.5% a year after inflation. In contrast, South Korean households earned 1.8% during the same period. If real returns on their savings doubled to 1%, Chinese households would gain $10 billion annually; if returns reached the level seen in South Korea, they would gain an extra $25 billion a year. With returns at these levels, Chinese households could afford to save less and consume more.

Despite the clear benefits of better capital allocation, China’s regulators have resisted making changes, presumably in order to maintain stability and preserve jobs. But developing a market-based financial system is a more attractive way to achieve and sustain higher overall employment from both an economic and social standpoint. Although jobs will be lost from SOEs that prove unable to compete for funding on a commercial basis, the burgeoning private sector will create many new ones. Net job losses are likely to be negligible even in the short to medium term. China has already experienced this effect of liberalization in its auto industry. Restructuring has caused state-owned auto enterprises to shed many jobs, but total employment in the industry has increased.

Moreover, we estimate the increase in GDP resulting from reforms that improve capital allocation will raise government tax revenues by 16%, without any increase in tax rates. The state can use these funds to support and retrain displaced workers directly, rather than distorting the financial system to achieve social goals.

Improving Financial System Efficiency
When offering warnings that the Chinese economy is booming despite—not because of—its rudimentary financial system, many economists point out a core inefficiency of the system: political pressures continue to influence lending practices. Equally detrimental to China’s financial system, however, are inefficient operations in a banking sector that towers over the system, and the underdeveloped state of the debt and equity markets. As well as skewing the allocation of capital, these problems raise the system’s operating costs. If they could match the efficiency of systems in other emerging markets, such as South Korea, Malaysia, or Chile, we estimate that financial intermediation costs could be cut by a total of $62 billion per year, while improving capital allocation as well.

Banking sector China’s banks have a number of operational weaknesses. They gather only sketchy information on borrowers’ credit histories and financial performance, and the coverage of independent credit rating agencies, such as Moody’s or Standard & Poor’s, is limited. Loan officers in many bank branches have rudimentary loan pricing and risk management skills, despite recent efforts to improve. To such risk-averse lenders, the scale and government ownership of even poorly performing soes can make them more attractive loan prospects than smaller private companies, because of their seemingly low risk. There may also be local political pressure to lend to what are still the largest local employers in many regions.

Poor capital allocation by banks is amplified by the dominance of the banking sector in China’s financial system. In market economies, the share of bank deposits in the financial system’s total assets typically ranges from under 20% in developed economies to about half in emerging markets. But as the graphic nearby shows, in China, banks intermediate nearly 75% of the capital in the economy. Bank deposits and savings accounts, roughly half of them from households, now total $2.6 trillion.

Banks’ inefficiencies result in higher than necessary operating costs. The main source of banks’ revenue, particularly in China where fee-based income is low, is the spread between their average borrowing and lending rates. China’s largest banks will need a total of $215 billion from the government to recapitalize their balance sheets. Around $105 billion has already been injected since the 1990s. Adding these funds to their net interest margin raises the true cost of intermediation in China’s banking sector to 4.5%, compared to 3.1% in our benchmark countries. Raising the efficiency of China’s banking operations to the benchmark would reduce their costs by $25 billion annually, given their volume of lending. More efficient banks would also be able to lend successfully to smaller, private businesses, saving these firms the premium they now pay to borrow on the informal market, worth an additional $2 billion a year.

Payments system China is currently in the process of building a modern payments infrastructure. For wholesale payments, the China National Automatic Payment System (CNAPS) has been put in place in many cities and offers functionalities comparable to systems in more developed economies, namely gross settlement of high-value payments and net end-of-day settlement of smaller value ones. But many local banks are resisting the significant capital investment necessary to connect to the system, preferring instead to use the old “Electronic Interbank System,” which has far higher transaction costs. Most retail payments are still made in cash, since credit and debt cards are not widespread among the population, and most small retailers have not wanted to make the investment necessary to install the equipment to accept cards. Speeding the spread of electronic retail and wholesale payments would result in $20 billion of savings each year, and benefit the government by reducing tax evasion (since the gray market operates in cash). The size of this prize justifies introducing some form of incentive to retailers, consumers and banks to pay electronically.

Debt and equity markets China’s equity and bond markets are among the smallest in the world. Equity market capitalization, excluding nontradable “legal person” shares owned by the state, is equivalent to just 17% of GDP, compared with 60% or more in other emerging markets. The corporate bond market, meanwhile, is just 1% of GDP, compared with an average of 50% in other emerging markets. It is held back by a mass of regulations that lengthen issuance time to a year or more, limit the interest rates that corporate bonds can pay, and leave the government with discretion over which companies list.

Moreover, China’s small capital markets are used almost exclusively by SOEs. Until a few years ago, state regulators selected companies for equity offerings in line with industrial policies, and still do for bond issues. Equity listing criteria have since become more independent, but here again, government regulators maintain discretion over which companies can list. So far, almost none have had a majority of private ownership at the time they initially listed shares, although some were privatized after listing.

Chinese companies need more fully developed equity and bond markets to provide competition to banks and give them a better choice of funding vehicles. In our benchmark countries, companies get roughly 60% of their debt from bond markets and 40% from bank loans. If they could match this mix of financing vehicles, Chinese companies would lower their funding costs by $14 billion annually. Efficiency improvements in China’s equity markets would reduce the costs to issuing companies by an additional $1.5 billion. Chinese households would benefit because flourishing bond and equity markets would underpin the development of more attractive financial products, such as mutual funds, pensions funds, and insurance, than bank deposits.

Priorities for Financial Reform
The current shortcomings of China’s financial system are rooted in relationships between the system’s component parts—banks, bond markets, equity markets, the payments system and institutional investors.

For instance, China needs a healthy corporate-bond market to provide funding to large companies and infrastructure projects, and to spur banks to lend more to smaller companies and consumers instead. The bond market, however, is unlikely to flourish until banks develop more accurate risk-based loan pricing and stop the flow of cheap loans to large companies. Speeding growth of domestic institutional investors is also essential, because few retail investors in any country buy corporate bonds directly. Yet all these relationships work both ways. Financial intermediaries, capital markets and banking have to evolve in tandem.

China’s four financial system regulatory bodies thus need to implement a coordinated, system-wide program of reforms. Measures to increase competition in the banking sector will be critical to prompt banks to upgrade their lending skills, management and it systems, and governance. China’s regulators have taken steps in this direction to prepare for competition from foreign banks, which will enter the local currency market in December 2006. But these banks have relatively few branches today and opening more will take time, limiting their immediate impact on competition. Regulators should therefore also allow more private domestic banks to enter the market, and relax limits on foreign ownership in banks ahead of the currently planned schedule—particularly for the smaller city and regional banks badly in need of the banking skills and technology that foreign investors bring. They should also raise the requirements for bank governance by making boards more independent and offering training programs for directors, and should strengthen financial reporting and auditing requirements to make bank performance more transparent.

In a more competitive environment, banks will likely lose their largest corporate customers to the capital markets, obliging them to turn to private companies, SMEs, and consumers instead. But to lend successfully to these segments, banks must be able to assess the credit quality of borrowers and price their risks accurately. To this end, banks need the services of independent consumer credit bureaus. To speed their development, regulators should provide incentives for lenders and utilities to report the payment histories of borrowers.

To help creditworthy SMEs to borrow, regulators should also ease the strict collateral rules on banks. Today, real estate and some forms of equipment are accepted as collateral. But unclear property rights in many parts of China deprive small businesses of needed collateral. Moreover, Chinese real-estate prices are soaring, so using this asset as the main collateral for loans may be risky. The regulators should therefore allow banks to accept more types of equipment and accounts receivable as loan collateral, and the government should consider expanding the program of loan guarantees to SMEs. Since banks have had trouble taking possession of collateral in the past, particularly when it was not a fixed asset, it is also imperative that China further develop its legal system in this regard.

The corporate bond market in China has been slow to develop largely because of inappropriate regulations. To speed its expansion, regulators should abolish preferential access to the market for policy banks to allow more private companies to issue bonds, and shorten the issue approval process to something nearer the maximum of a week it takes in most other Southeast Asian countries from the 14 months to 17 months it takes today, and abolish limits on interest rates payable on corporate bonds. They should also encourage the expansion of sophisticated corporate-rating agencies, such as Moody’s and S&P, which today have limited coverage, or build up Chinese rating agencies.

Excessive regulation is also holding back growth among institutional investors. Regulators should therefore consider relaxing restrictions on the types of investments domestic intermediaries can make, and making taxes on these investments more favorable. They should also allow domestic intermediaries to invest some portion of their assets abroad to improve the returns they can offer to households. In addition, Chinese households need education in investment and financial services planning. This could be encouraged through tax rebates or subsidies to households, and by tax incentives to private companies that offer them.

To enable more private companies and SMEs to choose equity capital as a source of finance, regulations should be changed to let more private firms that technically qualify for an IPO actually list on each of the stock exchanges, and to allow more IPOs and foreign investors on the small-cap exchange in Shenzhen. To further the joint progress of all three exchanges in China, regulators should also encourage the more strategic relationship that is developing between the Hong Kong Stock Exchange and the mainland exchanges in order to improve mainland equity market operation.

Lastly, strict capital controls prevent China’s residents today from investing in foreign financial markets or securities, where they might earn higher returns than from domestic savings vehicles. This policy also protects China’s banks and capital markets from competition that they need in order to develop. As a first step toward capital-account convertibility, regulators should gradually allow domestic intermediaries to invest some assets in Hong Kong.

Ms. Farrell is director of the McKinsey Global Institute, McKinsey’s economics think tank where Ms. Lund is a senior fellow.

This article originally ran in Far Eastern Economic Review.

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