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1. Introduction
1.1 The evolution of banking risk management in china
Previously, China adopted the mono-banking system where there
was virtually no need for banking risk management. During then,
every step involving the supply and utilization was predetermined
by the Chinese government. Peoples Bank of China (PBC), being the
only bank simply received instructions from the government about
the allocation of the funds.1
However, things took a change when the four specialized banks
namely the Industrial and Commercial Bank of China, the
Agricultural Bank of China, Bank of China and the China
Construction Bank were converted into state-owned commercial
banks in the late 1970s. With the transformation, commercial loans
were being made and this brings the banks to the issue on risk
management.
1.2 Credit and liquidity risk
Therefore, this term paper sets to explore on how banks in China
practices banking risk management. In light of the Central Banks
recent aggressive stance in curbing loans, this paper will highlight
on credit risk and liquidity risk. The former is an increasing concern
for the Chinese banks. It should also be noted that the Chinese1 Risk management
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economy is still operating under a relatively conservative banking
climate. The rules and regulations set by the banks are tightly linked
with the governments policies.
2.1 Time line of Chinese banks curbing loans (2004-2010)
Important Events:
2003: In order to rein in the obviously excessive credit growth, the
PBC raised the required reserve ratio by one pp on September 21,
2003. ICBC set up an industry research center in 2003 to improve its
risk control management.
2004: effective on April 25, 2004 bank reserve ratio was increasedby 0.5% to 7.5%. Chinese firms are financed by banks at a rate of
98 per cent but often fail to pay back their loans, as a result, there
are almost half of the banks assets are unpaid, caused half of the
banks insolvent. In 2004, there was US$ 45 billion used to save
Chinas second and third largest banks, the Bank of China and the
China Construction Bank. Subsequently, another US$ 100 billion
were used to save the Industrial and Commercial Bank of China and
the Agricultural Bank of China. 2
2006: On April 28, the People's Bank of China (PBOC) raised lending
rates for the first time since October 2004, boosting the one-year
benchmark rate by 27 base points to 5.85 per cent, as part of efforts
to curb the overheating in some sectors such as real estate.
2007: With effect on june 5 2007, the bank reserved ratio is to
increase by 0.5% to 11.5%. Bad-loan ratio fell again in 2007 after
tight credit monitoring.
2008:The reserve ratio was increased by 0.5% to 12% on starting
August 15,2008
Jan 2010:The central bank raised the reserve requirement ratio by
0.5% with effective day on 18 Jan 2010. It's a clear sign that it was
determined to drain excessive liquidity in the market and curb
lending.
Time Line:
Time Change in Directi Notes
2http://www.asianews.it/news-en/Inflation:-China-raises-bank-reserve-ratio-to-11-per-cent-9132.html
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reserve ratio on1987 10% to 12% Up1988 12% to 13% Up1998-03-21
13% to 8% Down
1999-11-21 8% to 6% Down
2003-09-
21
6% to 7% Up
2004-04-25
7% to 7.5% Up
2006-07-
05
7.5% to 8.0% Up
2006-08-15
8.0% to 8.5% Up
2006-11-15
8.5% to 9% Up
2007-01-15
9% to 9.5% Up
2007-02-25
9.5% to 10% Up
2007-04-16
10% to 10.5% Up
2007-05-15
10.5% to 11% Up
2007-06-05
11% to 11.5% Up
2007-08-15
11.5% to 12% Up
2007-09-25
12% to 12.5% Up
2007-10-25
12.5% to 13% Up
2007-11-26
13% to 13.5% Up
2007-12-25
13.5% to 14.5% Up
2008-01-
25
14.5% to 15% Up
2008-03-25
15% to 15.5% Up
2008-04-25
15.5% to 16% Up
2008-05-20
16% to 16.5% Up
2008-06-15
16.5% to 17% Up an increase of 1%, two stepsof operation
2008-06-25
17% to 17.5% Up an increase of 1%, two stepsof operation
2008-09-
25
17.5% to 16.5% Down reduction of some financial
institutions2008-10- 16.5% to 16.0% Down 17.5% down to 17.0% (six
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15 banks ICBC, etc.)2008-12-05
16.0% to 14.0% Down 17.0% down to 16.0% (sixbanks ICBC, etc
2008-12-25
14.0% to 13.5% Down 16.0% down to 15.5% (sixbanks ICBC, etc
2010-1-1215.5% to 16% Up rural credit cooperatives andother micro-finance institution
2010-2-25 16% to 16.5% Up rural credit cooperatives andother micro-finance institution
2.1.1. Reasons for ineffective policies
In 2004, there was inflation about 3%, highest among many years.
For example, food prices increased 8.1%, edible oil prices rised by
27.2%, vegetables increased 19.4% and grain up by 10.8%,
according to the National Bureau of Statistics, property investment
was up 34.9 percent in the first quarter of 2003, far outstripping
China's 8 percent GDP growth.3
Furthermore, the major banks in China were suffering from
insolvency problem. About half of the banks assets are unpaid, and
an expected amount of US$518 billion (40% of Chinas GDP) was
needed to put banks back a sound footing.
As a result, Chinese authorities are trying to contain inflationary
pressures and prevent the speculative and real estate bubble from
bursting because its effects would be devastating.
However, the increase of 1% in the bank reserve ratio has only
affected the economy to a limited extent. As shown in the Statistics
from the Beijing Construction Committee 2005, the house selling
3http://www.atimes.com/atimes/China/FA06Ad03.html
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rate in the first months of the year jumped 18 per cent to 130 per
cent compared to the same period last year.
Chinas banking sector is teetering along. Non-performing loans, a
legacy of policy lending by state-owned banks to state-owned
enterprises, are staggering. New loans to those with connections, to
cronies and to those in power have continued. It is also no secret
that publicly recorded non-performing loan figures are severely
understated and it gives one the jitters to think how much is hidden
behind the almighty Chinese state secrets. Raised reserve
requirements will not be even close to what is needed to address
banking sector dilemmas.
Regulations intended to strengthen the supervision of bank lending
and risk management took effect on Feb. 1, 2004.4
2.1.2 Methods of curbing loans: Raising interest rates v.s
increasing loan reserve requirement. (which method is the
Chinese banks using & why?)
China's economy, currently right in the transition period, is not
comparable to command or developed market economy. The
macroeconomic development poses challenges to monetary policy. In this
connection, the Chinese Government can only utilize various monetary
policy instruments in a flexible manner, in order to reach the monetary
policy targets. At present, the major monetary policy instruments include:
4
http://english.epochtimes.com/news/4-8-4/22730.html
http://english.epochtimes.com/news/4-8-4/22730.htmlhttp://english.epochtimes.com/news/4-8-4/22730.html8/9/2019 Bank Mgmt Project
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open market operation, reserve requirement, interest rate policy, re-
lending and rediscount, and credit policy.
i) Sterilize Excessive Forex Position Through Open MarketOperation While Maintaining Sufficient Liquidity in the Market
Over the past two years, China's foreign exchange reserve has
grown fast, leading to substantial increase in base money injection
as a result of Forex purchase. In line with the overall money and
credit plan, the People's Bank of China (PBC) has maintained the
stable growth of base money through open market operation.
ii) Use Reserve Requirement Policy in a Flexile Way to Lower the
Cost of Currency Withdraw and Improve the Operation of
commercial banks.
In order to rein in the obviously excessive credit growth, the PBC
raised the required reserve ratio by 1% on September 21, 2003.
Traditional Money and Banking theories regard required reserve
ratio hike as a relatively drastic measure, nevertheless the central
bank interpreted it as a mild move.
The differentiated required reserve ratio scheme is both a
transitional policy in line with China's current financial system, and
an innovation based on the original purpose of required reserve
ratio policy, i.e. to ensure the payment and settlement of
commercial banks, and to prevent over-lending by financial
institutions attracted to favorable loan terms which may undermine
their liquidity and payment capacity. The required reserve ratio
policy then gradually evolved into a monetary policy instrument,
and the deposit insurance regime combined with supervision on
capital adequacy ratio started to replace it as policy tools to impose
prompt corrective actions on financial institutions based on different
risk profiles. Given the fact that China has yet to establish deposit
insurance system, and quite a number of financial institutions failed
to reach the 8% capital adequacy ratio, the differentiated required
reserve ratio scheme is conducive to curb excessive credit
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expansion of the financial institutions with low capital adequacy
ratio and poor asset quality, and to prevent the one-size-fits-all
approach in macro financial adjustment and regulation.
iii) Utilize Other Monetary Policy Instruments
At the same time, the PBC can strengthen credit management by
curbing loans to over-invested industries, and keeping the
proportion of medium and long term loans at reasonable level. The
PBC will also endeavor to adjust loan structure, urge financial
institutions to implement credit policy, promote financial ecological
development, enhance re-lending and rediscount management,
continue to improve financial service to rural economy, and further
promote inter-bank market development.
The reason why Chinese government has a better interest in raising
the reserve ratio is, as mentioned earlier, easier to implement and
have less negative effect on the economy, both domestically and
globally.
2.2 Current situation in China
2.2.1 Excess liquidity and risk of overheating in China economy
i) Foreign reserve accumulation
National Bureau Statistics of China showed that there has been a boom in
Chinas reserve accumulation from the early 2000s till present, as shown
by the diagram below. This could be driven by Chinas monetary policy to
maintain an (adjustable) pegged exchange rate.5 Besides that, China has a
large amount of current account surpluses, steady inflows of foreign direct
5
Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: CapitalInflows and Monetary Policy in China.Journal of Asian Economics,20,205-224.
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investments and very large portfolio capital inflows.
Sources: National Bureau of Statistics
ii) Inflow of hot money into chinas economy
We interpret these non-FDI capital inflows, as hot money that could
potentially switch direction within a short horizon.6 All the subcomponents
of Chinas non-FDI capital inflows move in similar cyclical swing. These
swings in hot money suggest that Chinas capital inflows are sensitive to
market considerations, changes in interest rates and can be highly
speculative. This speculative capital inflow is believed to have caused
6 This interpretation is standard in the literature(Prasad &Wei,2005b).
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inflation, driven up stock prices, and helped to create a worrisome real
estate market bubble.7However, the upside to inflow of speculative funds
is that it makes the market more effervescent, stimulating the demand for
stock shares and property, which in turns drive up the prices as well. Hot
money creates enormous volatility in the financial markets due to it large
size and its short term nature of investing. Instead of moving with changes
in the financial fundamentals of companies, stock prices are moved by
liquidity shock stemmed from hot money.8According to Martin and
Morrison (2008), speculators have been using various ways to circumvent
Chinese Laws and regulations. More than 50% of speculative funds or
capital flow into China take the form of over-reported or forged FDI.
Sources: National Bureau of Statistics.
The increase in reserve accumulation could lead to several monetary
implications. The increase in liquidity may lead to economic overheating
7Zhang, G., & Fung, H. G. (2006). On the imbalance between the realestate market and the stock markets in China. The Chinese Economy, 39,
2639.8Guo, F., & Huang, Y. S., Does hot money drive China's real estate andstock markets? International
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and inflationary pressures.9 It also depends on the domestic banking
systems ability to intermediate and manage the extra liquidity.
The Chinese Government could sell Government bonds to soak up liquidity
through open market operations to soak up excess liquidity. However,
central banks must be able offer higher yields to convince domestic firms
to hold them.10 Besides that, the government could also tighten bank
reserve and lending requirements (loan limits) to decouple the link
between reserve money growth and broad money growth.11 Broad money
growth is linked to spending growth and inflation. In mid-2006, the PBC
began to rely less on bond issuance and more on reserve requirement
increase and greater window guidance to control excess liquidity and keep
9 Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: CapitalInflows and Monetary Policy in China.Journal of Asian Economics,20,205-224.10 Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: CapitalInflows and Monetary Policy in China.Journal of Asian Economics,20,205-224.11
Glick, R., & Hutchison,M., (2009) Navigating the Trilemma: CapitalInflows and Monetary Policy in China.Journal of Asian Economics,20,205-224.
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the broader money aggregates in control.
Source: National Bureau of Statistics
China has high saving rates, both household and firms, which lead to a
vast flow of liquidity into the banking system, as savers have lesser
alternative investment opportunities (until stock market reform in 2005).
12
As shown in the figure above, the increase in reserve requirements lead to
a decrease in M2-reserve requirement multiplier.
2.2.2 Exposure to Credit risk in property market
12 Prasad,E.(2007,October) Monetary policy independence, the currency
regime, and the capital account in China. Paper presented at theConference on Chinas Exchange Rate Policy. Peterson Institute ofInternational Economics.
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2.2.2.1 Credit surge
Chinese banks are experiencing a credit surge as new loans extended in
2009 more than doubled from 2008. The total new loans made increased
from 4.9 trillion yuan in 2008 to a record-breaking 9.59 trillion yuan in
2009.13Figure 1 compares the volume of new loans between 2008 and
2009 for the first 5 months of the year.14
Figure 1
New loans
2008 2009 Increase
from 2008 to
2009January 804 1,600 99%February 243 1,100 352%March 286 1,900 564%April 464 591 28%May 319 665 108%
The main reason behind the credit surge is low interest rates which
promoted easy credit.
2.2.2.2 Property market boom
What is most worrying out of the credit surge is the area that the funds
are channeled into. In a speech given by Wang Zhaoxing, vice-chairman of
the China Bank Regulatory Commission, he mentioned that about 20% of
all loans made by Chinese banks are now flowing into the property
market. 15 The central bank revealed that individual mortgage loans in the
first three quarters of 2009 totaled 925 billion yuan, almost quadrupling
the amount given out in the same period in 2008. 16
13 http://www.marketwatch.com/story/china-targets-11-trillion-in-new-loans-in-2010-2010-01-1914http://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-
%E2%80%9Cgreen-shoots%E2%80%9D/15http://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9U16http://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9U
http://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-%E2%80%9Cgreen-shoots%E2%80%9D/http://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-%E2%80%9Cgreen-shoots%E2%80%9D/http://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-%E2%80%9Cgreen-shoots%E2%80%9D/http://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9Uhttp://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9Uhttp://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-%E2%80%9Cgreen-shoots%E2%80%9D/http://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-%E2%80%9Cgreen-shoots%E2%80%9D/http://mpettis.com/2009/06/china%E2%80%99s-loan-growth-isn%E2%80%99t-boosting-my-confidence-in-china%E2%80%99s-%E2%80%9Cgreen-shoots%E2%80%9D/http://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9Uhttp://www.bloomberg.com/apps/news?pid=20601089&sid=aWZU4xri7P9U8/9/2019 Bank Mgmt Project
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With record new loans extended, it has boosted property buying for home
ownership and also possibly for the less desirable purpose, property
speculation. Consequently, property sales jumped in conjunction with a
hike in property prices. It is reported that in 2009, property sales surged
by 75.5% to 4.4 trillion yuan, especially in eastern cities of Zhejiang and
Shanghai. 17 Standard Chartered Bank also calculated that land prices
have soared by 106% in 2009.18 Figure 2 shows that average property
prices (new and second hand houses) is on an increasing trend, with the
9.5% rise recorded in Jan 2010 being the highest increase in 21 months. 19
Figure 2
The housing price appreciation phenomenon is taking place in all parts of
China. Goldman Sachs reported that over the past six years, the surge in
property prices had exceeded the growth of income by 30 % point in
Shanghai and 80 % points in Beijing. In Beijing, it is estimated that on
average, a resident needs to fork out 7 months of his salary to afford per
17 http://www.bloomberg.com/apps/news?pid=20601089&sid=atGjFThc4UvM18http://www.dailyfinance.com/story/investing/chinas-call-to-cool-off-lending-
gives-investors-a-chill/19355813/?icid=sphere_blogsmith_inpage_dailyfinance19 http://www.chinadaily.com.cn/bizchina/2010-02/11/content_9462315.htm
http://www.dailyfinance.com/story/investing/chinas-call-to-cool-off-lending-gives-investors-a-chill/19355813/?icid=sphere_blogsmith_inpage_dailyfinancehttp://www.dailyfinance.com/story/investing/chinas-call-to-cool-off-lending-gives-investors-a-chill/19355813/?icid=sphere_blogsmith_inpage_dailyfinancehttp://www.dailyfinance.com/story/investing/chinas-call-to-cool-off-lending-gives-investors-a-chill/19355813/?icid=sphere_blogsmith_inpage_dailyfinancehttp://www.dailyfinance.com/story/investing/chinas-call-to-cool-off-lending-gives-investors-a-chill/19355813/?icid=sphere_blogsmith_inpage_dailyfinance8/9/2019 Bank Mgmt Project
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square meter of the house. 20 In shanghai, prices of second-hand
properties experienced an annual increase of 41%, up to 14,700 yuan per
square meter average in December. For new properties, there is a 65%
annual surge in prices to an average of 20,187 yuan per square meter inDecember.21
Similarly, property market boom is taking place even in the poor cities of
China. In the comparatively less prosperous Xinyang, property prices
appreciated by 10% over 2009 and this figure is far more than the
countrys benchmark deposit rate of 2.25.
2.2.2.3 Possible growth of asset bubble
The question now remains whether an asset bubble is forming in the
property market or has it already been developed. Excessive property
speculation has fuelled the property boom. To make things worse, large
portion offunds lent to industries like manufacturing have been indirectly
channelled into the property market.It will be disastrous if China follows
Americas footsteps in the subprime mortgage crisis. If Chinas property
market is indeed experiencing a bubble, its burst will deflate housing
prices greatly and hurt the banks with unpaid loans. Therefore, it is
imperative for the Chinese banks to manage the high credit risk
associated with the lending binge.
2.2.3 Exposure to Credit risk in stocks market
2.2.3.1 Commodity speculation
Apart from the property sector, the credit surge is taking effect in Chinas
commodity market. With easy credit, speculative investments are
undertaken in the commodities market. Since March 2009, commodities
20 http://news.xinhuanet.com/english/2009-12/27/content_12711265.htm21 http://www.china.org.cn/business/2010-02/03/content_19360939.htm
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prices have surged and the Reuters-Jefferies CRB Index has increased by
nearly one-third
When extending loans for commodity purchases, it is the practice of
Chinese banks to permit the usage of underlying commodities collateral.
Similar to property lending, the loans are structured like mortgages. Since
commodity prices are much more unstable than housing prices, the
increase in speculative commodity trading exposes the banks to high
credit risks. 22
2.2.4 Exposure to liquidity risk
With the surge in lending, the banks may be sowing seeds for future
liquidity risks. High volume of funds is being channeled out of the banks
and hence, there may be insufficient funds left to respond to payment of
debs due. Furthermore, the house and commodity mortgage loans have
poor liquidity. Liquidity risk management is especially pertinent in the face
of the current global financial crisis.
2.2.5 Non-Performing Loans (NPLs) in China
2.2.5.1 Overall outlook on NPLs
The lending spree coupled with the slowing of global economy may have
set a hotbed for the increase in NPLs. Plunging enterprise profits may lead
corporate firms to default on their loans. 23 It is estimated that for every 1
% point slow down in annual economic expansion, the banks NPL ratio
could increase by 0.99 point. 24
22 http://english.caijing.com.cn/2009-06-19/110186641.html23
http://www.domain-b.com/finance/banks/20090522_chinese_banks.html24http://uk.reuters.com/article/idUKPEK22500020081205?pageNumber=1&virtualBrandChannel=0
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Despite so, the China Banking Regulatory Commission (CBRC) reported
that the NPL of Chinese commercial banks dipped by 62.89 billion yuan to
497.33 yuan in 2009. The NPL ratio also decreased by 0.84 % point to
reach 1.58 % point. 25 However, these figures may not necessarily indicate
an improvement of the banks balance sheet as new loans are used to
displace delinquent commitments.
Moreover, Chinese banks are now conducting off balance sheet activities
like repackaging of loans to hide bad loans off their balance sheets. 26 The
issue of NPLs may also not be evident yet as fresh loans havent gone bad.
The prevalence of bullet-oriented payment structure also indicates that
any default with new lending will not surface until the loan is due.
Therefore, the lending spree may have sown seeds for future NPLs which
are not yet visible.
2.2.5.2 NPL in property market
In particular, there is increasing risk of NPL associated with property loans
in Shanghai. In a statement released, Yan Qingmin, head of the Shanghai
Bureau of the China Banking Regulatory Commission expressed the
concern that the unsettled amount of bad loans on commercial property in
Shanghai escalated in 2009.27 In 2009, banks in Shanghai have offered
163 billion yuan of new loans to the property sector, including mortgages
and loans to developers. 28 This figure does not reflect the total risk
exposure of Shanghai banks to real estate debt as loans extended to some
state-owned companies as industrial lending may have been channelled
25http://www.reuters.com/article/idUSTRE60E3192010011526 http://www.huffingtonpost.com/james-jubak/chinas-banks-copy-citigro_b_402398.html27 http://www.china.org.cn/business/2010-02/03/content_19360939.htm28
http://www.thefreelibrary.com/China+:+Shanghai+Bad-Loan+Ratio+Would+Triple+With+10%25+Home+Price+Drop.-a0218430467
http://www.reuters.com/article/idUSTRE60E31920100115http://www.reuters.com/article/idUSTRE60E319201001158/9/2019 Bank Mgmt Project
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into the property market. Moreover, Chinese bank regulators have
calculated that if housing prices fall by 10% in Shanghai, it will multiply
the ratio of delinquent mortgages by three times and a 30% drop will
result in a five-fold increase. 29
In Beijing, empty office buildings are sprouting across the capital of China.
This is a result of oversupply of skyscrapers due to the easy credit
extended to land developers.30 Therefore, the banks in Beijing are also
facing a high risk of bad loans. If the property market plunges, it will be
accompanied with an escalation of NPLs.
2.3 Impact of policy
On Jan 20 Chinese banking authorities have asked some main banks to
curb their lending for the rest of the . Meanwhile, for nonstate-owned
lenders like Citi Bank and Everbright Bank, the Central Bank asked them
to increase their reserve requirement ratio by half a percentage point. It is
the first time of China's central bank to raise bank reserve requirements
since June 2008.
The direct cause of this action is the surge of new lending. Chinese banks
doled out a record 9.6 trillion yuan ($1.4 trillion) in new loans last year.
The lending surge, combined with Beijing's 4 trillion yuan stimulus plan
helped kick-start the economy after a late 2008 slump, but aroused fears
of overheating.31 Also, consumer inflation has accelerated significantly in
December. All this has triggered a series of intensifying policy by Central
29 http://www.123jump.com/market-update/China-Regulators-Worry-Bad-Debts;-Lenovo-Profit/36412/30 http://www.bloomberg.com/apps/news?
pid=20601109&sid=a6i2PSZD.Jr4&pos=1131 http://www.asiaone.com/Business/News/Story/A1Story20100120-193196.html
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Bank to rid the financial system of excess cash that can fuel inflation and
asset bubbles.
Regulators, worried about potential inflation, asset bubbles and bad loans,
feel they must set limits on total credit growth, but by doing so they
create incentives for banks to churn out loans quickly to gain as much of
the industry quota as possible.
2.3.1 Positive impacts
China's banking system is healthy despite last year's explosive growth in
credit. So the authorities controlled the growth in credit with the
instruction of curbing loans.
Regulators were paying special attention to loans for local government
projects and real estate. All banks have been ordered to "heighten their
vigilance against an impossible, embedded credit risk," Liu said. New
leverage and liquidity restrictions would be imposed, he added.
This action has not changed the government's stance of a tight credit but
a loose monetary policy, nor has it changed the prospects or the expected
the timing of hikes of the central bank's benchmark deposit and lending
rates. It helps the Central bank continue to control the pace and amount of
credit supply.
And the decision to raise the proportion of deposits that banks must hold
in reserve is a small first step toward reducing the massive stimulus
provided to its economy. The Chinese authorities were acting
preemptively to handle with the increasing risk of a bubble in the property
market and inflation.
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Just last week, China raised its capital reserve requirement for banks for
the first time since June 2008 in an effort to drain excess cash from the
financial system. Earlier in the month, the central bank raised the interest
rate on its three-month bills for the first time since August 13 and has
been jacking up the rates on short-term bills to absorb liquidity.
The reality is that liquidity remains very ample in the Chinese banking
system; and credit has to remain strong in China this year to finish the on-
going projects.32 By moving now to tighten loose lending and deal with
other negative side effects of an aggressive fiscal and monetary policy
adopted during the global crisis, the central bank has achieved the goal of
control the problem with inflation and property bubble.
2.3.2 Negative consequences
With the announcement of curbing lending, China stocks drop 2-3 percent,
led by bank shares. Worries over the impact of lending curbs knocked
Shanghai's benchmark index .SSEC down 2.7 percent, weighed on the rest
of Asia-Pacific and hurt the Australian dollar.
Shares of Bank of China and China Construction Bank traded in Hong Kong
tumbled 4 percent. 33
Lending in the first 10 days of 2010 was strong, after domestic media said
that banks dished out 600 billion yuan ($87.9 billion) in new loans in the
first week of the year alone. Some economists estimate banks have
already lent over 1 trillion yuan so far this year. Worries that the Chinese
economic growth engine is about to slow markedly because of tighter
32 http://www.theglobeandmail.com/report-on-business/china-move-forces-
banks-to-curb-lending/article1428847/33 http://www.asiaone.com/Business/News/Story/A1Story20100120-193196.html
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monetary policy sent shudders through global stock, commodity and
currency markets. The currencies most linked to commodities trade the
Canadian, Australian and New Zealand dollars all took an immediate hit,
as oil, gold and copper fell. And stocks suffered losses, as fears mounted
that the 10-month rally could come unglued. U.S. Treasuries climbed,
thanks to their appeal as a safe haven.
Losses were heaviest in Hong Kong and mainland China while benchmarks
in other markets fell about 1.5 percent or less. Oil dropped to near $80 a
barrel while the dollar was slightly higher against the yen and a tad lower
versus the euro.
Regulators announced this month an increase in the share of deposits
banks must hold on reserve, but most of the latest measures haven't been
publicly disclosed, and they bear little resemblance to how monetary
policy typically is conducted in other economies. Shanghai's benchmark
stock index has fallen 9% so far this year, and concerns about credit policy
have roiled markets from Hong Kong to New York.
The news pushed the dollar higher, and oil and gold lower. That in turn hit
the euro, which was already under pressure from controversy surrounding
deficits and public finances in Greece, and a report on Tuesday showing a
bigger-than-expected decline in German investor sentiment.
2.3.3. Access to credit for SOEs and SMEs
China's state-owned banks have never been the best allocators of
credit. As an extension of the state, these banks favor loans for
state-owned enterprises (SOEs) over small and medium enterprises
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Limiting loans for SOEs and SMEs, however, may also force the less
productive SOEs to improve their operations to continue to attract finance,
or else they will have to face the risk of shutting down. Financial analysts
and economists of China believed that over the next five years, this
dynamic would go a long way to closing the productivity gap between
SOEs and SMEs, raising GDP by as much as 13%, or $259 billion
annually.36
While controlling lending to both SMEs and SOEs also forces the central
bank of China to maintain a reasonable and balanced pace. For example,
more restrictions has been applied to industries with overcapacity and
high pollution, ICBC said it would continue to offer finance to ongoing
government-backed projects, environmentally, friendly emerging
industries, small- and medium-sized enterprises, and for consumer
spending. 37
2.4. Curbing loans policy in the 1990s
Chinas banking sector is dominated by four large multi-purposes,
extensively branched, state-owned banks (SOBs) that account for more
36Wei Gu, Rebalance Chinas two financing legs,Reuters,The Great Debate,JULY30,2009.HTTP://BLOGS.REUTERS.COM/GREAT-DEBATE/2009/07/30/REBALANCE-CHINAS-TWO-FINANCING-LEGS/
37ICBC to curb property loans, China Economic Net,2010-02-09 08:30,http://en.ce.cn/subject/chinamarkets/marketpic/201002/09/t20100209_20943553.shtml
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than 70% of both credits to enterprises and household deposits. From the
late 1970s to the late 1990s, the financing responsibility for large SOEs
shifted from the fiscal budget to these SOBs. During this period, fiscal
revenues to GDP fell from 30% to 12% while bank loans to GDP increased
from 50% to 120%. 38
2.4.1. The Problem of Un-performing Loans (UPLs)
Between 1980 and 1994, enterprise expenditures on social welfare
increased by six times and, in the mid-1990s, it was roughly half of the
SOEs total wage bill (Huang et al 1999). Consequently, the profitability of
SOEs fell sharply and, from 1996, the consolidated state sector became a
net loss-maker. As a result, SOBs were often forced to extend new loans to
illiquid SOEs.
However, the overly optimistic expansion of credit that China experienced
in the early 1990s was an additional source of NPLs. It overheated the
economy and created runaway inflation. Domestic credit grew at the rate
of 30% per year between 1991 and 1995, a rate significantly higher than
the average growth rate of 21.3% in the 1980s. 39During that same period
of time, real estate lending increased rapidly and fueled property
development that was far beyond the limits of the country's demands.
Many of the problem loans that now plague China's banks were created by
the credit boom in the 1990s and by subsequent asset price NPLs are the
survivors of loans to, and assets of, failed SOEs.
38Michael Geiger , Monetary Policy in China (1994-2004): Targets, Instruments and their Effectiveness,WrzburgEconomic Papers No. 68, April 2006, Universitt Wrzburghttp://www.wifak.uni-wuerzburg.de/wilan/wifak/vwl/vwl1/wepdownload/wep68.pdf
39
Non-performing loan resolution in China. (Journal of Real Estate Portfolio Management).Real Estate Issues,22-SEP-02 ,http://goliath.ecnext.com/coms2/gi_0199-2771962/Non-performing-loan-resolution-in.html
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By the mid-1990s, over one-half of SOEs were making losses and about
three-quarters of the loans on the books of these banks were to SOEs.
Many of these loans were classified as non-performing. By 1999, three of
these SOBs would be insolvent, if assets were marked to market, although
all four remain highly liquid because of their dominant share of household
deposits in an economy with a high savings rate and few competing assets
for household portfolios.
2.4.2. The 1990s Reform
In the mid-1990s, the Chinese authorities engaged in a series of reforms
to deal with the bad loans problem culminating in the creation of four
asset management companies (AMCs), one for each bank, to take on
these bad loans.
In 1999, the Chinese authorities established four AMCs as temporary
institutions to deal with bad loans originated before 1996 that totaled 19%
of 1999 GDP. AMCs are charged with both the disposal of assets and the
restructuring of SOEs, with the latter facilitated by debt-equity swaps
approved by State Economic and Trade Commission (SETC). They are
responsible to three government agencies; in addition to the SETC, these
are the Ministry of Finance and the Peoples Bank of China (PBC), the
central bank.
In an effort control lending practices, the PBC introduced a credit policy,
which more directly based credit and lending policies on the government's
overall macroeconomic planning. Thus, Chinese lending practices were
driven by, and entwined throughout, the central Chinese governments
political goals and objectives.
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The PBC introduced minimum reserve requirements in the year 1984 in
order to control the financial sectors liquidity. At first, the officials set
different reserve obligations for the different deposits with regard to their
origin and the institution actual holding the reserves. In 1985 the PBC
combined all different reserve requirements and set one minimum reserve
requirement at 10 per cent. But only since 1998 the instrument of the
reserve requirement was more active and in a more westernized sense
used. That year also marks the time when the PBC shift its monetary
policy from direct control to more indirect control and made open market
operations (OMO) the main instrument of its monetary policy.
Since then, the reserve requirement ratio has undergone four major
changes. In March 1998 the ratio was cut from 13 to 8 percent, in
September 1999 it was decreased from 8 to 6 percent and in September
21, 2003 the ratio was adjusted to 7 percent for all financial institutions
except the rural and urban credit cooperatives, which were still subject to
6 percent reserve requirement (cf. Wei, 1999: 145 f.; PBC, 2000; and PBC,
2003c).
The Chinese reserve requirement regime has two particular features: First,
minimum and excess reserves are interest bearing. According to
Schlotthauer (2003), during the 1990s the interest paid on the reserves
was so high that there have been years where the dominant strategy of a
commercial bank was to hold reserves at the central bank instead of
granting a risky loan to an enterprise (Schlotthauer, 2003: 212).
Targeted and real values for domestic loan increases in China, 1998-
2004
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Year Target growth (%) Actual growth (%)
1998 12.7 15.51999 15.7 8.32000 11.7 6.02001 13.1 13.02002 11.6 16.9
2003 13.7 21.12004 16.4 11.6
Source: Own calculations, based on data from PBC, 2001; PBC, 2003b; PBC, 2004a; PBC StatisticsDatabase Online; and Xie, 2004a: 2.
Note: Target values are usually published in billion RMB. Using the data of total domestic loanincreases the target is converted into a percentage growth target.
Although the 1990s saw many reform efforts, mechanisms to control risk
have not yet been created since the central bank's 'window guidance'
continues to be the major reason behind lending institutions' decisions.
There continues to be political pressure from the PBC to expand loans
during stagnant economic conditions. These growth-oriented lending
practices create poor performing loans.40
40Miriam (Penny) Milsom, Monetary Policy in China, January 13, 2003,
http://www.sixsmart.com/SSPapers/pmw8.htm
http://www.pbc.gov.cn/english/http://www.pbc.gov.cn/english/