Fan Jianjun

Research Report No 036, 2004

The central bank injected 45 billion U.S. dollars in capital into the Bank of China and the China Construction Bank in early 2004, thus formally launching the process of reforming the four major state-owned commercial banks. As a ripple effect, the academic circle immediately saw a drastically heating debate on how to reform the banking industry. But there is one very important issue that has not been touched upon. That is about the path of the reform of the four major state-owned commercial banks: how to undo the historical fast knot of the four major commercial banks and eventually realize their rebirth? On this issue, there is a series of questions we need to answer. Why have the four major state-owned banks been selected as the starting point of the reform of China’s banking industry? Why have the stockholding system and public listing been selected to push forward the reform of the state-owned banks? In what direction will the state-owned banks develop after they are listed? What will China’s banking industry look like in the future? And etc.

I. Why Have the Four Major Banks Been Able to Operate

Smoothly Although the four major state-owned commercial banks have accumulated large amounts of non-performing assets, one noticeable phenomenon is that these banks have had no liquidity problems and instead can continue to make profits. This is somewhat puzzling. But a careful examination will reveal that the main reason behind this phenomenon is the government control over the banking industry.

First of all, as the financial authorities still control the interest rates of deposits and loans (especially those of deposits) of the banks, other commercial banks cannot vie for the market shares of deposits and loans with the four major banks through price (interest rate) competition. At present, the profits of China’s commercial banks depend very much on the control of the interest-rate (especially the control over the interest rates of deposits) (the base interest rate of loans is 5.31 percent, the base interest rate of deposits is 1.98 percent, and the base interest-rate differential is as high as 3.33 percentage points). As the scale of the non-performing assets of the joint-stock commercial banks is relatively small, they can reap excess returns that are even higher than what the four major commercial banks achieve. But what will happen if the control over interest rates is lifted? What is certain is that the joint-stock banks, whose asset quality is better and whose corporate governance system is sounder, will inevitably nipple up the market shares of deposits and loans from the four major commercial banks by raising deposit interest rates and (or) reducing loan interest rates. If so, two things will happen. One is that the four major commercial banks will try every possible means to retain their market shares and enter into a senseless competition with the joint-stock banks, even at the cost of incurring heavy losses. This is because the interest-rate margin that can enable the four major commercial banks to make profits is far smaller than that for the joint-stock commercial banks. When the interest-rate margin between deposits and loans is fully compressed, the joint-stock commercial banks can manage to stay at the profit-loss equilibrium point, but the four major commercial banks will incur heavy losses. The other is that the four major banks will maintain their profitable interest-rate differentials, but at the cost of losing large market shares of deposits and loans. In the long run, the four major state-owned banks will encounter a liquidity crisis no matter in what case. In the first scenario, the liquidity crisis will be caused by a continuous shrinking of their capital; in the second, the liquidity crisis will eventually be caused by the fact that a continuous drop in their newly added deposits will make them unable to cover up the losses arising from their bad accounts.

Secondly, as the threshold of the banking industry is strictly controlled by the government, large amounts of private capital and foreign capital are screened out of the banking industry, thus making intra-industry competition insufficient. In this case, the four major banks may well be able to cover up the losses arising from their bad accounts by attracting large amounts of newly added deposits so as to ensure their liquidity.

Then why are the depositors willing to place their deposits endlessly in the four major commercial banks whose asset quality is not so good? To answer this question, we need to have an in-depth analysis of the motives of the depositors. In fact, when the depositors select their opening banks, they mainly consider three factors: one is whether their deposits will be safe, which is the primary concern; two is whether they can acquire maximum earnings as long as their deposits are secure; three is whether the service is good and whether the transactions are convenient.

We can see that the primary concern of the depositors is not whether the asset quality of the opening banks is good. Their primary concern is whether their deposits are safe, namely whether their opening banks will go bankrupt. We can be sure that right now the ordinary people have formed a relatively solid expectation for the four major commercial banks: even if the four state-owned banks are in a negative asset-liability ratio, the government will unlikely force them to declare bankrupt. This means that in the mind of the depositors, their deposits in the four major banks will not have any security problem.

Now let us look at the side of returns. China’s reform to marketize interest rates has already taken off. The interest rates of foreign exchange loans and the interest rates at the inter-bank money market have been largely liberalized. The floating scope for the interest rates of Renminbi loans was also raised to 1.7 times from 1.3 times the base interest rates at the highest. But the control of the People’s Bank over the interest rates of deposits remains as monolithic as in the past, leaving no room for fluctuation. Although the deposit products provided by various commercial banks are slightly different in terms of time structure and deposit terms, they have no difference whatsoever as far as prices are concerned. So the rate of returns has no significant impact on the account opening decisions of the depositors.

Therefore, the only competition tool that can currently be used by commercial banks to attract deposits is the convenience of transactions and the quality of services. In general, we should say that the four major commercial banks are not in a disadvantageous position in this regard. Compared with some other banks, they even have significant advantages. In particular, when it comes to the distribution of business outlets, they are far better than foreign-invested banks, joint-stock banks, or city commercial banks. So when there are not so many investment options, the public is more willing to place their surplus funds into the four commercial banks that are noted for large numbers of business outlets and for more convenience in deposit and withdrawing.

It is precisely because the four major state-owned banks are strictly protected by the government through a series of control measures, they still enjoy powerful advantages in attracting deposits and offering loans, especially in loan attraction. Although their capital has been seriously eroded by large amounts of non-performing assets and some of their capital has even become negative, their newly added deposits each year can entirely cover up these losses. As a result, the four major banks have not had too big problems with their liquidity (the newly added deposits at all financial institutions in 2003 totaled 3.71 trillion yuan, of which 1.7 trillion yuan was the net increase of personal savings deposits). This is the primary reason why the four major banks can still operate smoothly and can make profits even though their hidden risks are very high.

What is predictable is that as long as the four major state-owned banks encounter no liquidity problems, the depositors will unlikely go for panic withdrawing and the hidden risks of these banks will unlikely be exposed too soon. And what is equally predictable is that once the four major banks encounter liquidity problems because of the changes in market conditions (for example, liberalization of interest-rate control or market access restrictions), panic withdrawing will happen immediately and will spread rapidly (even if the government still undertakes not to conduct bankruptcy liquidation against the four major banks). This scenario should be similar to the securities companies, which are encountering panic withdrawing due to their liquidity difficulty.

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