Financial Reforms in China and India

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Institute for International Business

Working Paper Series

IIB Paper No. 9May 2007

Financial reforms in China and India: A comparative

analysis

Wendy Dobson

Director, Institute for International Business

Rotman School of Management

University of Toronto


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Financial reforms in China and India: A comparative analysis*

Wendy DobsonRotman School of Management, University of Toronto

Abstract:

This paper surveys financial reforms in the worlds two most populous and rapidly-growing economies. The contribution of financial systems to long term growth throughthe efficient mobilization and allocation of scarce capital is well documented in theliterature. Indias financial system is popularly perceived to be better developed thanChinas, yet they share two significant weaknesses: under-developed corporate bondmarkets and bank-dominated financial systems. High levels of state ownership of banksare associated with misdirected lending and high costs of intermediation. The paper

examines the institutional frameworks that determine incentives in these sectors andmarshals empirical evidence that historical decisions and insufficient market reformsuggest performance problems persist. These problems will become more evident whengrowth slows; indeed a crisis may be necessary to force change since prevailing higheconomic growth rates in spite of the weaknesses undermine the case for deeper reforms.

* This paper also draws on Dobson and Kashyap, The contradiction in Chinasgradualist banking reforms, forthcoming inBrookings Papers on Economic Activity2006:2. Both papers are available athttp://www.rotman.utoronto.ca/Dobson.

JEL classification numbers: P 51; O16; G20.

Key words: comparative analysis; financial systems; China and India.

Acknowledgements: This paper has benefited from discussion and comments at aseminar in Pudong organized by IFPRI, CES and SUFE.
http://www.rotman.utoronto.ca/Dobsonhttp://www.rotman.utoronto.ca/Dobsonhttp://www.rotman.utoronto.ca/Dobsonhttp://www.rotman.utoronto.ca/Dobson


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1. Introduction

Chinas financial system is often called the Achilles heel of its long-term growthprospects while Indias has generated enthusiasm as a source of strength. Although Chinahas more money circulating in its financial system (in 2004 Chinas financial assets were

200 percent of GDP while Indias were 160 percent

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) the freer play of market forces anddiversity of financial institutions make Indias system more efficient in allocating capital.Government ownership of banks is common to both economies: at between 90 and 100percent, these levels are the worlds highest (OECD 2005:140). Banks also dominate thedomestic financial systems: in 2004 they accounted for 72 percent of total financial assetsin China and 43 percent in India.2

The purpose of this paper is to compare financial reforms in the two countries andevaluate their potential impacts on growth and development. The finance-growthliterature emphasizes that domestic financial systems influence a countrys economicdevelopment and growth through the roles they play in both the accumulation and

allocation of capital.

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International evidence shows that over time public sector banksperform poorly by the usual market metrics on efficiency and soundness: returns onequity are low, expenses are high and they are dogged by non-performing loans.

The analysis begins with a comparative evolution of the two financial systems inthe next section with particular attention to incentive structures including prudentialoversight, legal systems, ownership and corporate governance, and market monitoring.The third section examines banking and capital market performance and the fourthdiscusses prospects for achieving further reforms to promote soundness and efficiency.As both economies become more complex and integrated into the world economy theirfinancial systems will be tested on their efficiency and their ability to withstand economicshocks.

The final section concludes that further reforms are required. Efficiency asmeasured by the allocation of capital is improving but weaknesses in capital markets andgovernment involvement in both directed lending and asset allocation by banks continueto create distortions in both countries.

2. Financial systems in China and India

When they took power in the late 1940s governments in both countries sought tomobilize domestic savings and channel them into industrial development. Governmentownership and intervention was the means to that end. Chinas planners abolished privateproperty and institutions after the 1949 revolution when the state took over the financialsystem. Since the late 1970s, recreating financial markets and market-based institutionshas been a work in progress. Indias leaders chose a mixed economy after independencefrom Britain in 1947. Markets continued to function alongside public institutions, butwith ever-increasing bureaucratic oversight and regulation. Banks were mostlynationalized by the late 1960s but capital markets were permitted. Today, Indiasfinancial system is the most-developed in the emerging market economies.


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2.1Banks

Both countries financial systems are bank-dominated. Chinas assiduous savershave no alternative to the formal banking system (OECD 2005). Many Indians, on the

other hand, mistrust banks and prefer to accumulate gold and real assets instead. Bothgovernments require banks to serve social objectives but the Indian government is moretransparent about the social outcomes being worth the price. Banks, whether public orprivate, must meet targets for rural access to banking services and lending to prioritysectors and must allocate a required share of their investments to public sector bonds. TheChinese governments political priorities are to ensure gradual controlled liberalization ofpublicly-owned producers and economic growth sufficient to absorb millions of laborforce entrants, migrants and laid off workers each year. Bank lending is still enlisted tofinance much of this growth even as banks are modernized to meet new foreigncompetition.

Historically, governments have owned banks as vehicles to finance industrialdevelopment.4

The underlying rationale was that market failures exist in developingeconomies because private banks respond only to private returns and fail to financesocially desirable projects or borrowers (usually small borrowers and sometimes verylarge projects). State-owned banks dominate the banking sectors in a majority ofdeveloping countries despite international evidence that countries with a large state bankpresence have slower financial and economic development than countries that do not(Hanson 2004). For example, cross-country empirical studies by La Porta et al (2002)have found that state ownership of banks in a country in 1970 was associated with lessfinancial development and lower growth and productivity through time. These effectswere more pronounced in lower-income countries. The positive growth effects ofincreased private ownership of banks were also found to be statistically significant andeconomically meaningful.

Indias banking system, which dates to the eighteenth century, is a mixture ofpublic, private and foreign ownership. The rationale for nationalization in the late 1960swas ostensibly to increase banks support foreconomic growth using governmentownership to reduce their vulnerability to connected lending, to force rural branching toencourage small savers, and to contribute to planned growth and equitable distribution ofcredit, particularly to small scale industry and farmers.

Priority lending required by government meant 40 percent of net bank credithad to be directed to small scale industry, with 18 percent of this total directed toagriculture and 10 percent to weaker sections.5 Targets for banks to serve un-bankedlocations led to a rapid expansion of the banking sector but with most depositsconcentrated in the public sector banks (PSBs). By 1990-91 PSBs accounted for 90percent of total deposits and advances. PSBs retained their corporate structures butsubstituted government for independent directors. Specialized state-ownedintermediaries that included the National Bank for Rural Development (NABARD), theSmall Industries Development Bank of India (SIDBI) and various state finance


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corporations also promoted the social objectives of finance (Patel 2004).

Indias 1991 balance of payments crisis was a catalyst for liberalizing bankownership and regulation. RBI reforms aimed to make the banking system more resilientto market shocks and to introduce arms length regulation to replace its hands-on

approach (something that still over-shadows the banking system). PSBs were alsopermitted to access capital markets for up to 49 percent of their equity. In 1994 six newprivate banks were launched by government-owned financial institutions and threeforeign banks entered the market. Two of the private banks, HDFC and ICICI, havesince grown quickly and are noted for sophisticated management and technology andstrong customer focus.6 Limited foreign entry was also permitted.7 In March 2006, Indiahad 218 scheduled commercial banks, also known as SCBs (Table 1) that included morethan one hundred regional rural banks.

In China, after the 1949 revolution Chinas central bank, the Peoples Bank ofChina (PBOC), became a mono-bank responsible both for conducting monetary policy

and for collecting savings at branches throughout the country. In 1984, PBOC depositand lending functions were turned over to four state-owned policy banks whose loanssupplied the countrys thousands of state-owned enterprises (SOEs) with their workingcapital requirements. Initially SOE losses were financed with public bonds. As the lossesmounted, the central government moved in the mid-1990s to reduce the resource drain byforcing the SOEs to finance their needs with bank loans.

Bank reforms began in earnest in 1995 when institutions and regulations werechanged to transform them into commercial banks. Prudential norms for lending wereintroduced, banking, securities and insurance regulators created and regulatory standardstightened. Three policy banks were created to carry on policy lending functions andPBOC created regional heads supposedly with sufficient seniority to force bank lendingon creditworthiness criteria.

Chinas domestic banking system now consists of a large number of institutionsalmost all of which are owned by various levels of government (Table 1). The Big Fourstate-owned commercial banks dominate the system, accounting for more than half ofbanking assets, thousands of branches and hundreds of thousands of employees locatedthroughout the country. Smaller but more numerous banking institutions are alsogovernment owned but are geographically concentrated.

2.2 Capital markets

Direct finance through equity and debt markets provides a wider range of debtmaturities and lower-cost capital to businesses and more choice for savers than isavailable from banks. Capital markets encourage efficient capital allocation throughinstitutions that continuously monitor the performance of issuers through movements inshare prices and threats of takeovers. Non-bank debt markets, however, are under-developed in both countries.


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Indias capital markets are better developed than Chinas and play a more

significant role in the economy. India has two national stock exchanges (Bombay StockExchange (BSE) and the National Stock Exchange) with the former established in 1875.Both have electronic trading platforms and as much as 70 percent of BSE marketcapitalization is accounted for by private firms and joint ventures (Farrell and Lund

2005). India also has futures markets and a venture capital market. Bond marketinfrastructure includes the Clearing Corporation of India (CCIL), established in 1999 tohandle clearing and settlement. The government bond market is large because of fiscalfunding requirements but because banks are required to hold government bonds the yieldcurve fails to play its full role as the market benchmark. The corporate bond market isunder-developed, accounting for only one percent of total financial assets (thecomparable figure for China is 5 percent) because of stringent regulations on registrationand disclosure and high transactions costs for issuers (Farrell and Key 2005).

Chinas capital markets are among the smallest in the world. There are two stockexchanges, established in 1990 in Shenzhen and Shanghai.8 Most of the available listings

are those of the public shares of Chinas largest SOEs. High levels of governmentownership in these companies and segmentation of the market have limited marketliquidity. Two kinds of shares are available, one restricted to domestic investors and theother available only to foreign investors. Recent innovations to resolve these problemsinclude the Qualified Foreign Institutional Investor (QFII) program, administered by theChina Securities Regulatory Commission (CSRC) and the State Administration ofForeign Exchange (SAFE), which allows foreign investors to trade in the domesticmarket subject to restrictions that include a ten percent equity stake in any domesticcompany and prohibitions on acquisitions of non-tradable state-owned shares.

Chinas bond market is in even earlier stages of development, serving mainly as achannel for government finance due to a highly restrictive regime facing corporateissuers. Although both the central bank and the securities regulatory commission are theregulators, the National Development Research Council, secretariat to the policy makingState Council, must approve quota allocations and the issuance of corporate bonds. Bankscontinue to supply most debt finance. By September 2006, corporate bonds accounted for3 percent of outstanding bonds compared to the 68 percent combined shares ofgovernment and central bank bonds.

9Corporate issuers, especially those listed on the

Hong Kong Stock Exchange, are tapping into overseas debt markets instead.

2.3 Financial oversight

Supervisory structures in China are still quite new and therefore evolving, whileIndias are well-established, even entrenched. Both have flaws including uncertain andoverlapping jurisdictions that affect banks in particular.

In India, the Reserve Bank of India (RBI) carries out a number of roles that reflectits history. Not only is it the central bank, it is also the bank regulator, manager of thepublic debt and majority owner of the State Bank of India, Indias largest commercialbank. Mor et al (2006) argue that Indias banking oversight focuses on bank processes


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rather than on credit quality and risk and that the reforms of the past decade have failed torectify this problem. A central bank with multiple roles is often found in developingcountries, but as an economy becomes more complex and makes more demands on thefinancial system, conflicts of interest are bound to arise, for example between monetarypolicy or debt management objectives and bank soundness and efficiency. We return to

this issue below.

In addition, Indias numerous state, urban and district cooperative banks and

nonbank finance companies are subject to multiple overseers including the StateRegistrar of Cooperative Societies, Ministry and Finance and RBI, which weakensoversight and creates opportunities for regulatory arbitrage. Other government agenciesincluding the comptroller and auditor general, Central Vigilance Commission (CVC) andCentral Bureau of Investigation are also involved in bank oversight, particularly audits.Students of Indias banking system highlight this pervasive government involvement beyond what might be justified to prevent systemic riskas creating disincentives forefficient capital allocation.10

Capital market oversight is more efficient. Indias stock exchanges are theresponsibility of the Securities and Exchange Board of India (SEBI). The insurancesector has been regulated since 2000 by the Insurance Regulatory and DevelopmentAuthority (IRDA) which protects premium holders and ensures orderly growth of theindustry. Recent international surveys have given Indias disclosure, accounting andboard room standards and practices consistently high marks. 11

Chinas financial institutions are regulated by three main agents, all created since2000: the China Banking Regulatory Commission (CBRC), the China SecuritiesRegulatory Commission (CSRC) and the China Insurance Regulatory Commission. ThePBOC shares responsibility for oversight and the rationale for the division of laborresponsibilities and authority among them remain somewhat unclear.12 The CBRC isresponsible for oversight of retail and wholesale banks but not investment banks which,along with securities houses are the responsibility of the CSRC. The PBOC isresponsible for the safety and soundness of the financial system. The decisions of eachagency are subject to approval by the State Council which reflects the political concernsof the party leadership.

3. Comparative performance of banks and capital markets

3.1 BanksSince the 1980s both governments have reformed and modernized the banking

sectors but public ownership and social objectives have retained their importance andcontribute to continuing distortions. China has retained near-universal governmentownership at the same time that the central government has tightened prudentialstandards and oversight and modernized the incentive structures for bank managers. Indiaalso has tightened prudential standards and oversight but permitted more diverseownership.


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Despite public ownership of the banks in both countries the relationship betweenthe state banks and state enterprises differs. In China, governments initially owned boththe banks and the capital-intensive industrial SOEs who were their major borrowers. Asthe SOEs were transformed, however, they continued to rely on bank financing in largepart because of government priorities to maintain sufficiently rapid economic growth to

absorb layoffs. Indias banks, in contrast, have not been used to fund the SOEs directly;the SOEs are financed by the public treasury (but banks are required by RBI to invest aproportion of their assets in public sector bonds).

Enterprise ownership is becoming less transparent in China as corporate entitiesevolve into a mix of state and non-state forms.13Bank managers take the heat for thebad loans to loss-making firms. In contrast, Indian banks bad loans are concentrated inthe government-mandated priority sectors. The cost of SOE financing is thus moretransparent to the Indian taxpayer as subsidies and financial support appear in the publicaccounts and it is implicitly assumed that government will not default on these bonds.The burden of this practice falls on individual and corporate borrowers; as interest rates

fell in recent years, bond prices rose attracting banks to the potential profits from thoseinvestments and crowding out lending and private investment (Farrell and Lund 2005).More recently, buoyant credit growth has led to interest rate rises and the sale of bonds asa windfall source of funds available for, among other things, removing bad loans as theyappear on bank balance sheets.

Indian reforms and bank efficiency

Indias banking reforms in the early 1990s re-introduced market forces and beganto reduce government ownership. Bank efficiency, measured by declining NPA ratios hasimproved. The dominance of publicly owned banks, however, penalizes more productiveborrowers but it has motivated innovation by non-PSBs in priority lending where effortsare underway to create profitable business models (Mor et al 2006).

NPA ratios have declined steadily since 2000 (Table 2) and banks have not beenrecapitalized since the late 1990s.14 Legislation passed since 2002 creates a framework tospeed up the liquidation of defaulted loans.15 Creditor rights have been strengthened.Lenders are allowed to settle with borrowers out of court and to sell blocks of bad loansto investors. NPAs tend to be concentrated in PSB loans to the priority sector whichaccounts for between 40 and 50 percent of their NPAs (RBI website). Requirements forcommercial bank presence in the rural areas has led to 71 percent of their brancheslocated there, producing 33 percent of their deposits and accounting for 21 percent oftheir total loans (Patel 2004). On the positive side, small and medium-sized privatecompanies account for 45 percent of all corporate loans and generate 23 percent of bankrevenues (Farrell and Lund 2005).

The relationship between ownership and bank efficiency in India is the subject ofconsiderable enquiry and debate. Several studies using aggregate data provide someevidence of greater efficiency of non-PSBs while the findings from micro studies ofspecific banks reinforce these findings. Using aggregate data, Sarkar, Sarkar and


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Bhaumik (SSB 1998), found only weak differences in ownership effects between privateover public sector banks with little evidence of a differential in operating efficiency. Alater study of cost efficiency found private banks superior to PSBs, but the impact ofderegulation in the early 1990s showed no significant differences between the two groups(Kumbhakar and Sarkar 2003). Further, the time trend in cost efficiency shows both

groups making progress. But SSB (1998) found moral hazard in PSBs where mangerswere less careful in managing risk than were private or foreign banks.

Indepth study of a single PSB concludes that Indias financial system under-lendsand denies access to credit for many potentially profitable firms. A major reason is thatpriority lending is perceived to be risky relative to investment in government bonds.Loan officers fear being exposed to charges of corruption if loans go bad; they also lackexpertise to evaluate potential profitability of such customers (Banerjee, Cole and Duflo2006). A further investigation into the role of bank ownership in under-lending, findsprivate banks to be no less responsive to government-mandated lending priorities thanthe public banks, with the exception of agricultural lending. A comparison of the

intermediary roles of public and private banks confirmed that PSBs are less aggressivethan private banks as lenders, attractors of deposits and in setting up new branches.(Banerjee, Cole and Duflo 2005).

Two other significant costs of public sector ownershipmodernization of skillsand technologies -- are not as well documented in the literature. PSBs are inflexible inhuman resource practices because of public sector rules and regulations on salaries andpersonnel that make personnel restructuring difficult despite a willingness to pay thecosts. PSBs also face difficulties attracting new staff and modern skills that are essentialto adopting the latest risk management and credit evaluation systems because they are notpermitted to compete with the higher financial rewards offered in the private sector.Lacking the necessary skills and technology, PSBs have been slow to introduce nation-wide automated banking services and new products; they are therefore losing marketshare to private and foreign banks.16

In summary, the impact of continued high levels of state ownership andconservative regulation make the PSBs that dominate Indias banking system operate likenarrow banks: they take deposits but channel a significant proportion of theirinvestments into low risk government bonds. In 2005 government securities stillaccounted for 31 percent of bank assets and corporate loans for around 50 percent (IMF2006b).

But the picture is changing. As Indias economic growth has accelerated demandfor and returns to bank lending have also improved. The stocks of government securitiesheld by banks dropped in 2006 to the mandatory 25 percent level as banks responded torobust credit demand in retail products like mortgages. In addition, experiments withmodels designed to turn priority sector lending into profitable businesses have begun toshow success. Rural branches have largely failed to deliver finance to the poor for theobvious reason that such lending is high risk and high cost business when borrowers lackcollateral and credit histories (Basu and Srivastava 2006).


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Efforts by NGOs and micro-finance institutions have successfully restructuredborrower profiles in some parts of the country. These groups help savers (mainlywomen) to pool their savings and make small loans to members using peer pressure toenhance loan repayment probabilities. Some commercial banks are now experimenting

with linkages through which the groups savings are deposited and borrowing facilitatedby group guarantees posted as collateral. ICICI Bank is pioneering the securitization ofmicro loan portfolios using local entities as the administrators (Mor et al 2006). Theseefforts are in their early stages, but show some promise in addressing the transactionscost and risk problems inherent in the business. Of course, the test of such approacheswill be whether credit quality is maintained in the next economic downturn.

Chinas banks and efficiency

Chinas challenge differs in that the banks to be transformed into commercialbanks were originally policy banks, lending according to government priorities. Since

1998 China has followed a three-step strategy to introduce market-based incentivestructures into the four largest state owned commercial banks (SOCBs). The test of thesereforms lies in banks ability to allocate credit efficiently and manage risks successfully.

This section explains why, by these criteria, the reforms are still insufficient.

The first step in the three-step strategy was to inject capital to strengthen thecapital bases of the banks to meet BIS standards. Since 1999, the banks have both writtenoff NPLs and transferred them to four state-owned asset management companies (AMCs)which issued government-guaranteed bonds in return. The second step was to attractstrategic foreign investors willing to purchase equity stakes in the banks (restricted to 20percent for any single investor and 25 percent total), to contribute directors to the boardsand assign foreign managers to the banks. The third step was to offer small amounts ofequity to institutional and other investors through IPOs on the Hong Kong and ShanghaiStock Exchanges. The purpose of this step was primarily to force bank managers toincrease the transparency of their reporting and to expose them to market evaluations bybank analysts.17

At the end of 2006 this process was near completion in three of the four SOCBs.As they cleared their balance sheets of legacy bad loans, they generated optimism thatthey had put their problems behind them. NPL ratios for three of the largest banks haddeclined to single digit levels in 2005 (Table 3). Estimates of the cost of removing thebad loans vary, depending on assumptions, but the government found the necessaryfunds, from the treasury and foreign exchange reserves.

Looking to the future, the central issue is whether modern bank incentivestructures have made Chinas misdirected lending (mainly to SOEs) a thing of the past.There are several reasons to argue that more needs to be done.

First, government influence is still pervasive because of political priorities tomaintain economic growth, job creation and social stability. Chinas growth is being


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driven primarily by rapid rates of investment which grew at unsustainable rates of 34percent in 2004, 16 percent in 2005 and continued into 2006. The banks mainstayborrowers are firms, many of them government-owned or -controlled. By the large banksown published financial statements corporate customers still account for between 70 and80 percent of their loans.18

Second, in 2005, more than 40 percent of the industrial SOEs were losing moneyand current data indicate the losses at government-controlled firms continue to mount.19While the largest SOEs are reporting burgeoning profits and financing new investmentsthemselves, revenues and profits are concentrated among the large: in 2005 the ten largestaccounted for over 53 percent of total revenues and the 165 SOEs owned by the centralgovernment accounted for more than 70 percent of SOE profits.20 Yet China still has120,000 SOEs. The implication is that banks exposures are likely to be greater to the

tens of thousands government owned or controlled firms whose profits appear to be muchless certain.

Third, the governments approach to unsustainable growth is to try to slow it byadministrative guidance to the banks on the sectoral allocation of loans; but suchguidance is a very blunt instrument that distorts credit decisions emphasizing sectoralrestrictions rather than decisions based on the risk and productivity indicators ofborrowers and projects. For example, a productive and profitable borrower in a restrictedsector will be denied credit while a less productive borrower in a permitted sector willhave accessjust the opposite outcome from that predicted by market forces. Smallentrepreneurial borrowers also have difficulties accessing bank credit because ofregulations requiring the banks to demand high levels of collateral.21

Micro level and anecdotal evidence adds to concerns about bank inefficiency andinability to price their loans to reflect credit risk. One study of the determinants ofbanksloan growth rates during the 1997-2004 period found that corporate profitability of thebanks commercial customers had no effect on loan growth and that the large state ownedbanks were losing market share to other financial institutions more quickly in theprovinces with more profitable customers. Data on loan pricing patterns at the bankssince 2004 show that interest rates charged borrowers are very compressed around thebenchmark rate, suggesting little ability or preference to price for risk (Podpiera 2006).

Finally, governance in Chinas majority government-owned banks is a work inprogress that affects incentive frameworks. While steps have been taken to increaserepresentation by independent directors on boards, the involvement of Communist partyofficials, while declining, continues to be pervasive. Bank heads are members of theCentral Committee (Naughton 2003); the CEO is often also the party secretary; bankperformance is discussed at party meetings.22

These ownership and governance weaknesses contribute to attitudes amonginvestors, depositors and customers that Chinas government-owned banks are too big tofail. The Big Four are more subject to external monitoring than they were, but capitalinjections and continued government involvement in their governance undermine


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efficiency. Depositors believe they have blanket protection of their deposits even if therate of return is low. Deposit insurance is one way to remove blanket protection, but nodate has been set for such an innovation. Moreover, even if the formal rules change itremains to be seen whether depositors would actually be forced to bear losses should abank fail.

3.2 Capital market development

Chinas corporate bond market is a work-in-progress for several reasons. Issuersface numerous regulatory restrictions; bankruptcy laws have only recently been adopted;default procedures are not yet based on market principles; investors lack the transparencyafforded by a credit rating system, modern accounting standards and transparency byissuers; market discipline has not been established and investor education is insufficient(Zhou 2005). Nevertheless, the stock exchanges are quickly assuming their intended rolesas liquidity and credibility problems ease following such innovations to increase demandfrom foreign institutions as the QFII program and supply side developments including a

recent spate of new share offerings by SOEs and several large state-owned banks.

Indias under-developed corporate bond market shows few signs of revival.Stringent government regulations continue to make it costly and difficult to issuedomestic bonds; infrastructure is inadequate: legal recourse is complicated andbankruptcy laws are ineffectual (Jadhav 2005). Another factor is the willingness of banksto issue 5-year credits that reduce the incentives for corporations to dis-intermediate thebanks. And foreign issues have helped to satisfy Indian companies appetite for long termfinance. Companies are permitted to issue foreign currency convertible bonds (FCCBs)and private placements to international institutional investors, a channel that avoids thecosts and obstacles facing issuers of domestic instruments.

Further capital market development is clearly needed in both countries. China hasthe larger task of developing the institutions and instruments of direct finance by creatingappropriate institutional and regulatory frameworks that facilitate market forces andpromote market discipline.

4. Prospects for further reforms to promote efficiency and soundness

Momentum for reform exists in both countries within the constraints of continuedstate ownershipof banks. Bank regulators have tightened prudential standards. TheIndian government has also strengthened creditor rights following the 2002 Sarfaesi Actlegislation; ownership reforms dating back to the early 1990s are bearing fruit as privatebanks create more competition for PSBs. While PSB efficiency has increased, however,they are still not allowed to consolidate or be acquired by private banks (Economist2006). Declining central government fiscal requirements

23and recent buoyant growth

have also reduced banks investment in government bonds to the statutory minimum. InChina, three of the Big Four state owned banks now have relatively clean balance sheets.But the economic and credit booms in 2002-04 have tested their ability to evaluate andmonitor new loans; bank loans have soared (reducing NPL ratios) in response to robust


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demand in expanding industries.

Of course the most potent stimulus to greater efficiency in financial institutions ismore competition, modern management technologies and incentives to manage risks andrewards. In this section we assess the prospects for more competition, new knowledge

and skills and better allocation of capital, particularly in the banks.

One source of new knowledge and skills is foreign entrants and here the policiesdiffer. As theoretical and empirical analysis suggests, foreign entrants improve financialsector efficiency by stimulating competition and injecting new products, skills andtechnologies.24Chinas bold rationale for foreign entry was embedded as a pre-commitment in WTO accession talks. Foreign entrants are restricted to 25 percent totalequity stakes but are expected to help change banks incentive systems by bringing

modern skills and institutional structures to their domestic partners, an approach used inthe industrial sector. State-owned banks have also been permitted to list on the HongKong Stock Exchange, primarily to encourage transparency and responsiveness to

modern market evaluations of their profitability and efficiency.

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In comparison, RBIs road map for foreign entry26 laid out in its 2005 AnnualReport is cautious. Foreign investors are restricted to 24 percent of the equity in a smallnumber of private banks that the RBI wishes to see restructured. Larger equity stakes arepermitted up to 49 percent ifa banks board and shareholders approve. Wholly ownedsubsidiaries of foreign banks are accorded national treatment. In 2009 permitted activitieswill extend to other private sector banks but stakes in such banks will be limited to 74percent. There is no explicit plan to reduce the public share of the PSBs or to allow non-state stakes in those entities.

A second stimulus to competition comes from ownership changes. Performancecomparisons by ownership are difficult, but current market indicators are available forsome of the largest banks (including private banks in India) in both countries (Tables 4and 5). Chinas banks are much larger than Indias as measured by market capitalization,assets and loans. The State Bank of India is the only bank that comes close in size. ChinaConstruction Bank, which listed on the Hong Kong Stock Exchange in 2005, is notChinas largest bank (rather it is the Industrial and Commercial Bank of China whichlisted in Hong Kong and Shanghai in late 2006) but its deposit share is much larger thanthose of the next two largest banks for which public information is available (Table 4).What do we learn about the relative efficiency of the state-owned banks? First, Indiasprivate bank (HDFC) is the leader on most performance indicators (Table 5); Indian bankaverages for net profits, ROA and ROE are higher than the Chinese averages. Net interestmargins are high in both countries, reflecting the continued administration of interestrates and the opportunity afforded banks to cover their costs by maintaining largespreads. This indicator is a sobering one because it also reflects banks favored positions,lack of competition and low productivity, the costs of which are borne by borrowers andsavers.

The other main indicator of future prospects for the banking systems is the


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potential size of future loan losses and uncertainty about the necessity of yet morebailouts. Reasons for skepticism that China has put its problems behind it were laid out insection 3. Future loan losses are not perceived to be a problem in India, although someanalysts have noted persistent regulatory forebearance and non-transparent subsidies ofsome troubled state-owned financial institutions (Patel 2004). But Indias buoyant growth

since 2003 has fueled rapid credit growth which suggests little room for complacency.

Two potential triggers of future problems in China are perceived to be stiffercompetition from foreign entrants and slower growth. Foreign competition is the lesslikely source since foreign entrants perceive Chinese customers as underserved andinterested in new products that domestic banks will later learn to produce. Somecustomers might migrate to foreign banks but as in most other countries, domesticcustomers tend to stay with the brands they know unless things go wrong.

The more likely trigger for problems will be slower domestic growth or a negativeexternal shock. High domestic growth rates have been fueled by rising investment funded

partly by bank loans. At the same time, state companies have not been required to paydividends, allowing them funds to fuel even more investment whether or not it has apositive real rate of return. Such misallocation of capital, as the Bank for InternationalSettlements has noted will eventually manifest itself as falling profits and this will

feed back on the banking system, the fiscal authorities and the prospects for growth moregenerally.

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Another bailout will probably be required, but by most calculations it will beaffordable. One way to estimate future loan losses is to age the Special Mention loans

publicly reported by three of the Big Four into loan losses in 2007 or 2008. Assuming theSpecial Mention loans become non-performing in 2007, an estimated RMB 1.5 trillionnew bad loans would appear from lending during the current boom (around US$ 200billion) and about 7.2 percent of 2007 GDP (Dobson and Kashyap 2006).

Lardy (2004) uses an alternative method examining the impact on fiscalsustainability of the implied added burden of interest obligations of AMCs to the banksand the increase in NPLs resulting from loans made during the credit boom in the 2002-04 period. In the event of a growth slowdown, these liabilities would negatively affectfiscal sustainability. In two alternative scenarios, where 20 percent and 40 percent of thenew loans become non-performing, he finds that the debt-to-GDP ratio rises at first, butthen declines through the period to 2013. In other words, fiscal sustainability is preservedduring this period.

Indias buoyant growth has brought a credit boom which causes similar concerns

about the consequences of a future growth slowdown. Since 2004, credit has grown by30 percent (IMF 2006b), partly because of the wider use of bank credit with financialdeepening and partly because of misdirected credit. The sectoral breakdown of creditgrowth in Table 6 suggests other reasons to be concerned. Overall credit growth wasnearly 28 percent, far in excess of the governments 23 percent target. The prioritysectors accounted for 40 percent of this growth (IMF 2006b:57).


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Sudden rapid credit growth often foreshadows deteriorating loan quality that willchallenge risk management at the banks and raise questions about weaknesses inprudential standards and supervision. RBI data show that the PSBs had a higher NPAratio in 2005-06 (3.7 percent) than the private banks (2.4 percent) and foreign banks (2.1

percent). The same data also show that the priority sector share of PSB non-performingadvances had risen to 54.1 percent of total PSB NPAs from 48.1 percent the previousyear. The PSBs dominate the surge in lending to priority sectors. IMF (2006b) performedstress tests to assess the vulnerability of the banking system to loan quality deteriorationand concluded that most banks are able to maintain their capital adequacy ratios close to9 percent and are therefore unlikely to cause systemic risk. 28

This discussion underlines the costs of distortions associated with high levels ofgovernment ownership. In China, this supports the assumption that government will dowhatever is necessary to maintain soundness. In India, the PSBs dominate the concernsabout a new crop of bad loans, suggesting that they are responding to public sector

economic development priorities rather than risk-based lending practices. Publicresources may be adequate to fix problems, but further bailouts only continue to distortincentives and divert public funds, for example, from Chinas current 5-year Programpriorities to enhance public services in rural areas and speed urbanization.

5. Conclusion

The financial systems in both India and China are developing but somewhatslowly relative to the speed with which their economies are increasing in size andcomplexity. Their banking systems are increasingly sound; they are also more efficientbut they are still agents of capital accumulation rather than of innovation and technicalchange. The Indian government directs banks to finance government deficits and socialprojects at the expense of non-priority borrowers. Chinas huge bank-dominated state-owned financial system persists in lending to entities associated with the state regardlessof their productivity.

Banks in both countries are under-lending to the agents of economic change andjob creation: small, entrepreneurial entities that lack political connections, governmentownership, or government contracts and guarantees. Formal finance, despite officialefforts in India, reaches a small proportion of entrepreneursbut a larger share than inChina. Instead those entities must rely on retained earnings and informal finance at muchhigher cost of capital which suggests that the high growth rates are financed less by banksthan by retained earnings and informal financial institutions in China and by Indiascapital market institutions. This in turn suggests that governments believe growth to beadequate to support the cost of using banks to pursue political objectives. Theimplication is that both countries could have grown even faster if they had more efficientfinancial sectors. But as these economies become more complex the distortions inevaluating credits and managing risk will exacerbate vulnerabilities to shocks andindustrial setbacks as well as uncertainty about governments future fiscal liabilities.


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The analysis in this paper implies that more reform would be desirable to improvecapital allocation by increasing competition and spurring development of capital marketsin China. As discussed in the previous section there are ways to do this through moredomestic competition (and consolidation of small entities) and more foreign participation.China has made better use of this channel than India, using foreign entrants to introduce

modern skills, products and new technologies, encourage greater transparency, and fanthe winds of domestic competition. Privatization (or at least more widely-held localownership) is another channel and here India has the better record. Chinas success withgaizhi in the industrial sector (transformation of industrial SOEs by grasping the largeand letting go the small, maintaining state ownership of selected large entities whilerestructuring and privatizing legions of smaller ones), should also be considered in thebanking sector.29

Competition in Indias banking system could be increased though consolidation ofthe smaller PSBs (and indeed allowing takeovers by the more efficient and fast growingprivate banks). Market forces could also be allowed to influence how banks meet priority

lending targets by making obligations tradable as Basu and Srivastava (2006) suggest.Increased competition for the banks from a better developed corporate bond marketwould stimulate efficiency. More competition for capital will also raise interest rates andthe cost of servicing the public debt. In turn, Indian governments and public enterpriseswould have to reduce their dependence on bond finance by cutting their fiscal deficits.

Greater clarity is needed about the future role of Chinas largest state ownedbanks. If majority government ownership continues, serious consideration should begiven to changing the banks structures to segregate risk on the lending side orto alignlending mandates with the inadequate incentives and capacity of these banks to evaluatecredit risk accurately. There are at least two ways to segregate risk. One is to restructurethe banking sector more clearly into policy banks, leaving the commercial banks asnarrow banks that take deposits and invest them in low risk assets (a lesson to belearned from Indias experience). Another alternative is to divide the banks into good

and bad banks, with the bad assets and deadbeat customers moved into the bad banksand the good banks freed to operate strictly on market criteria (Dobson and Kashyap2006).

Finally, certain regulatory changes can be envisaged that would modernize banksincentive systems. Best practice deposit insurance would create incentives for monitoringby depositors. Indias deposit insurance system, however, may not be the model as it isconsidered to be overly liberal and contribute to, rather than reduce, moral hazard (Patel2004). More independent financial regulators (eg, freeing bank regulators from thecentral banks) would allow them the freedom to focus more effectively on soundness andefficiency. At present Chinas CBRC must satisfy both PBOC and the State Councilbefore it can implement regulations. Indias plethora of oversight agencies includes RBI,the National Housing Bureau, as well as overseers of cooperatives, insurance andsecurities. RBIs multiple roles can conflict with bank soundness and efficiency despiteRBI officials statements to the contrary. For example, its ownership position in the StateBank of India means that its views dominate those of minority shareholders in


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commercial decisions. RBI responsibilities for debt management will influence its viewson commercial banks investment requirements and its concerns with bank soundnessmay conflict with monetary policy decisions. Balasubramanian et al (2005)puts forward athoughtful position, recommending the creation of a single Financial Services Agency-type regulator, with RBI playing a coordinating role among the existing regulators during

a phased transition to the single agency. In the end, RBI would focus only on monetarypolicy.

In conclusion, this survey of the financial systems in China and India indicatesthat reforms to date have reduced the risks of systemic banking crises but capital is stillbeing misallocated by banks, corporate bond markets and related infrastructure are stillunderdeveloped. Both banking systems, with high levels of government ownership, arevulnerable to future growth downturns. Both financial systems lag behind the increasingcomplexity of the domestic economies and are likely to slow integration into worldcapital markets that comes with full capital account convertibility. Ironically, without acrisis, India which has all the components of a modern financial system seems unlikely to

remove the political constraints on its full development. Similarly, in the absence ofslower economic growth and a further bank bailout, China is unlikely to resolve thetensions between the political goal of gradual controlled change and an efficientcommercial banking sector.


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Table 1. Structure of the Banking Industry, China (2005) and India (2003-04)

A. The Chinese Banking Industry, 2005(CNY billion)

Number ofinstitutions

Assets(CNY)

Marketshare,%

Liabilities(CNY)

Marketshare,%

All banks 34,045 374.697 100 358.070 100

Big Fourcommercialbanks

4 196.580 52.5 187.729 52.4

Joint stockbanks

12 58.125 15.5 56.044 15.7

Citycommercialbanks

112 20.367 5.4 19.540 5.5

Other 33,917 99.625 26.6 94.757 26.5

Source: CBRC website, accessed June 2006.

Notes: 1) All banks include policy banks, state-owned commercial banks, joint stock commercial banks,

city commercial banks, rural commercial banks, urban credit cooperatives, rural credit cooperatives, postalsavings, foreign banks and non-bank financial institutions.

2) Big Four commercial banks include the Industrial and Commercial Bank of China (ICBC), AgriculturalBank of China (ABC), Bank of China (BOC), and the China Construction Bank (CCB).

3) Joint stock banks include Bank of Communications, CITIC Industrial Bank, Everbright Bank of China,Huaxia Bank, Guangdong Development Bank, Shenzhen Development Bank, China Merchants Bank,Shanghai Pudong Development Bank, Industrial Bank, China Minsheng banking Co. and Evergreen Bank.

4) Other consists of rural commercial banks and rural credit cooperatives, policy banks, the postal savingsbureau, finance companies, trust and investment companies and financial leasing companies.

B. The Indian Banking Industry, 2006*

(Rupees billion)

Number ofinstitutions

Deposits(Rupees)

Market share,%

Loans*(Rupees) Marketshare, %

Public SectorBanks (PSBs)

28 16,225 75 11,347 73.2

Private banks 28 4,282 19.7 3,168 20.2

Foreign banks 28 1,137 5.3 989 6.4

Total 218 21,644 100 15,504 100

Source: RBI A Profile of Banks, 2005-06; Statistical Tables Relating to Banks in India, Tables 3.1, 7.1and 7.2. Accessed at www.rbi.org in December 2006.Notes: * This date refers to 2005 fiscal year which ended on March 31, 2006.

These aggregate statistics refer to Indias Scheduled Commercial Banks (SCBs). They do not includeregional rural banks, a number of cooperatives and development finance institutions.
http://www.rbi.org.in/http://www.rbi.org.in/


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Table 2. NPAs in Indian banks, 2000-05

(Rupees billion)

NPAs Total Advances NPAs / Total

Advances,%

2000 608 4,758 12.8

2001 640 5,587 11.4

2002 710 6,809 10.4

2003 703 7,765 9.1

2004 649 9,020 7.2

2005 575 11,712 4.9

2006 519 15,504 3.3

Source: RBI. Statistical Tables Relating to Banks of India, Table 7.1 Bank Group-

wise Classification of Loan Assets of SCBs, 2000-05. Accessed atwww.rbi.org.in.

Table 3. Reported NPLs in Chinas Big Four banks, 2000 and 2005

(RMB billions; NPL% = % total loans)

Loans (2000) NPL% Loans (2005) NPL%AgriculturalBank of China(ABC)

1484.3 na ABC 2829.3 26.2

ChinaConstructionBank (CCB)

1386.4 20.3 CCB 2458.4 3.8

Industrial andCommercialBank of China(ICBC)

2413.6 34.4 ICBC 3289.6 4.7

Bank of China

(BOC)*

1505.8 27.2 BOC 1800.1 5.5

Total 6,790.1 28.7** 10377.4 10.5

Loans/GDP 76.0 55.9

* reported for domestic loans only; **loans and NPLs for only 3 reporting banks

The ratio of NPLs is based on the BIS five-category loan classifications

Sources: Bank annual reports; BOC 2006 IPO Memorandum; CEIC data
http://www.rbi.org.in/http://www.rbi.org.in/http://www.rbi.org.in/


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Table 4. Market indicators, Chinese and India banks, 2004-2005 (US$ million)

Marketcap.

Totalassets

Loans Deposits Shareholdersequity

Depositmarket

share,%China (2005)

Bank ofCommunications

25,988 170,130 95,204 148,955 9,611 4.0

China ConstructionBank (CCB)

86,921 554,679 305,036 482,578 35,926 13.1

China MerchantsBank

9,786 89,519 57,281 78,345 3,180 2.1

India (2004)

State Bank of India(SBI)

10,770 100,302 44,138 80,054 5,250 21.5

HDFC Bank 5,271 11,217 5,576 7,929 986 2.1Punjab NationalBank

3,259 27,534 13,176 22,501 1,712 6.0

Source: Ramos et al (2006)

Table 5. Indicators of Bank Performance, China and India, 2005

Netinterest

margin,%

Priceearning

ratio

Net profit

(% average

assets)

ROA,% ROE, %

China (2005) 2.8 18.96 0.6 0.6 15.3

Bank ofCommunications

2.7 22.6 0.7 0.7 13.3

CCB 2.9 13.8 1.1 1.1 19.0

China MerchantsBank

3.0 21.0 0.6 0.6 17.2

India (2005) 3.2 11.1 1.5 1.6 17.1

State Bank of

India

3.2 11.2 0.9 1.0 16.1

HDFC Bank 4.4 25.6 1.5 1.4 18.1

Punjab NationalBank

3.6 9.0 1.2 1.2 17.7

Hong Kong 2.4 13.9 1.2 na 13.7

Source: Ramos et al (2006)


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Table 7. Credit growth by sector, 2003-04 and 2004-05

(yoy, percentage change)

Sector 2003-04 2004-05

Priority sectors 24.7 31.0Agriculture 23.2 35.2

Small-scale industry 9.0 15.6

Others 38.3 37.0

Industry (medium and large) 5.1 17.4

Petroleum -16.8 19.2

Infrastructure 41.6 52.3

Autos -5.8 20.9

Cement -11.5 7.4

Housing 42.1 44.6Nonbank financialcompanies

18.9 10.8

Wholesale trade 10.1 36.0

Export credit 17.2 14.3

Gross (nonfood) bank credit 17.5 27.9

Source: IMF 2006b, Table V3.


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Endnotes

1 Farrell et al 2006.2 Farrell et al 2006. Corporate debt accounted for 35 percent and equity for 34 percent of total financialassets in the United States that year.
http://www.rbi.org.in/http://www.bis.org/http://www.bis.org/http://www.rbi.org.in/


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3 See for example, Levine (1997); Allen and Gale (2001); Beck (2006).4 Gerschenkron (1962) was one of the first to make the case that in a weak institutional environment,private banks are unable to overcome deficiencies in information and contracting. Lewis (1950) advocatedgovernment ownership of banks to develop strategic industries.5 Priority sector lending is monitored by the Ministry of Finance and reported regularly. See

www.indiabudget.nic.in.6 ICICI was founded as a state development bank in 1955; it formed a commercial banking subsidiary in1994 which merged with the parent in 2002 as a single publicly-listed company. HDFC Bank was alsocreated in 1994 by a state-owned mortgage company.7 For example, ING bought 20 percent of Vysya Bank and Chase Capital acquired 15 percent of HDFCBank (Madgavkar et al 2001).8 In 1990 ten companies had listed on these exchanges; by the end of 2006, the number had grown to 1500.9 UBS (2006).10 See Battacharya and Patel (2003); Patel (2004); and Banerjee et al (2006).11See LaPorta et al (2003).12 The single regulatory model typified by the Financial Supervisory Agency in the UK has been studied; aregulatory merger is a future possibility.13 For example, reported corporate entities in bank annual reports include state, collective and shareholdingforms of ownership as well as private, foreign and other.14 By 2002 capital injections had cumulated to Rs. 225 billion (Patel 2004), or roughly 10 percent ofnominal 2002-03 GDP, a number that does not include a number of indirect bailouts of troubled publicsector financial institutions, such as temporary tax exemptions and government guarantees.15 This legislation is known as the Securitization and Reconstruction of financial Assets and Enforcementof Security Interest (Sarfaesi) Act of 2002.16Authors interviews, Mumbai, November 2006.17 Dobson and Kashyap (2006) make a conservative estimate at 10.8 percent of 2005 GDP for the big fourbanks, while Ma (2006) estimates 19.4 percent as the cost for the entire banking system.18 The China Construction Bank, which breaks out its loans by the legal form of borrower, reports thatloans to SOEs grew by nearly 9 percent in the first six months of 2006. Another large bank reports the 10largest borrowers; half are SOEs (see Dobson and Kashyap, 2006: 9).19 See Dobson and Kashyap (2006).20 See Embassy of PRC (2006).21 OECD (2005).22 It is worth noting that the pervasive role of the party does not appear in the IPO memorandums of any ofthe three banks that went public in 2005-06.23IMF (2005) reports Chinas overall budget balance as a deficit of 2.1 percent of GDP while IMF (2006a)reports Indias central government balance in 2005-06 as a deficit of 4.3% of GDP and the generalgovernment balance as a deficit of 7.7 %.24 See Dobson and Jacquet (1998) for a review of the literature and evidence on market entry by foreignbanks.25 Even so, this part of the modernization strategy has drawn criticism that banking assets should not besold to foreigners and that the price on what has been sold has been too low.26RBI (2005:137) Box V.2 Road Map for Presence of Foreign Banks. 27 Bank for International Settlements (2006).28One exception is four old private banks accounting for 12 percent of bank assets whose capital bases

would erode to dangerous levels.29 Recent listings by Bank of China and Industrial and Commercial Bank of China on both the Hong Kongand Shanghai Stock Exchanges are moves in this direction.

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Financial Reforms in China and India

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