New Products,Same Clients

Liu Yu’e, a staff member at the Shanghai and Hong Kong-listed Ping An financial services provider, is happy to hear that some of her clients are considering moving their deposits to Ping An’s banking wing. “We offer more attractive interest rates,” she told newsChina.

Until now, Chinese depositors didn’t have much to choose from when it came to where to place their money. With interest rates set by the country’s central bank, uniform returns on deposits with similar maturities, often priced below the rate of inflation, effectively made one bank as good as another.

Flexibility

In June and July 2012, China’s central bank cut benchmark deposit and lending interest rates twice to counter the country’s economic slowdown a move few had failed to predict. What did come as a surprise, however, was the decision to allow all banks to offer depositors up to 1.1 times the benchmark interest rate, removing the rigid price ceiling that had been the hallmark of Chinese banking since the early days of economic reform.

At the same time, the central bank ap- proved new flexibility in the base lending rate, with the minimum rate lowered from 90 to 70 percent of the benchmark loan rate. The national lending rate ceiling was abolished in 2004. As China’s one-year benchmark lending rate currently stands at 6 percent, the new regulation means the lowest possible rate that a lender can secure is 4.2 percent.

Chinese banks are beginning to price their assets according to the market, rather than the whims of the sole regulator. These reforms mark one of the most sweeping changes in China’s banking sector since the inauguration of Deng Xiaoping’s Reform and Opening-up policies.

Along with these new freedoms comes greater competition. The fact that no bank has chosen to cut deposit rates shows the growing influences of market forces on China’s financial sector. Now, banks will have to work harder to maintain and increase their market share as customers are offered a greater range of choice than ever before.

It is hoped that the relaxation of regulations will motivate banks to diversify their clientele and business structures, thus allowing more productive sectors greater access to credit and expanding into more sophisticated non-credit-based business. In this way, they hope to revive both China’s banking sector and the country’s flagging economic growth. A recent report by Standard and Poor’s was titled “China’s small step to relax its bank deposit rate ceiling is a giant leap for financial sector reforms.”

From Turkey to Phoenix

The global impact of these changes to China’s banking sector is likely to be vast. In 2011, China’s banks accounted for one-third of the profits of the world banking sector. In fact, the world’s three most profitable banks are Chinese State giants, according to a survey released on July 3 by the British magazine The Banker. Just nine years ago, China’s banks were struggling with a bad-performing loan ratio averaging 18 percent. Since then, however, these vast institutions have enjoyed almost uninterrupted 30 to 40 percent annual profit growth.

In a recent speech, Guo Shuqing, chairman of the China Securities Regulatory Commission, claimed that the country’s banking sector provided some 80 percent of China’s corporate financing, with Chinese banks collectively holding 90 percent of the national financial system’s total assets. The message was clear: China’s banks had underwritten the greater part of the country’s economic miracle.

This means that the signs of weakness that have recently begun to emerge in the sector are keeping Beijing’s economic planners awake at night. Badly performing bank stocks have been a drain on the profitability of China’s stock market as they comprise 20 percent of the market’s total tradable shares. Market confidence in the sector is so low that even the Party’s mouthpiece the People’s Daily has resorted to reassuring investors that the market is “unnecessarily preoccupied with negative factors in the banking sector.” Unfortunately for the People’s Daily, editorializing has had little effect on China’s pragmatic investors.

One of the “negative factors” clearly referred to in the above editorial and analysis by financial media is the profit model of China’s banks. With a government-mandated deposit rate ceiling and base lending rate, only a minimal profit margin can be secured by any one bank. As a result, banks are only interested in doing business with large, typically State-owned enterprises and projects implicitly or explicitly backed by governments, and are becoming reliant on granting cheap loans to government monopolies, who in turn guarantee large, if low-value, returns.

This has allowed the national banking center to grow almost perfectly in sync with the country’s State-owned enterprise (SOE)-driven economy. Nearly 80 percent of their profits have been drawn from the differential rates between deposit and lending.

Public anger at the country’s banks is already growing, with accusations of favorable treatment of SOEs, with continued snubs to the private sector a particular bugbear to those in favor of greater economic liberalization. The concentration of risk in the spending sprees of often inefficient local governments seen as the Achilles heel that could potentially derail growth and reverse the eco- nomic gains of the past two decades.

China’s banks now appear to be in the process of reforming along neoliberal lines by tentatively relaxing interest rate controls. This also means ceding control of China’s financial industry to the markets, in turn reducing the power of the central bank. Banks will need to learn how to price money on the basis of supply and demand, with the central bank only providing a reference point, rather than simply giving orders. Instead of offering potential customers what regulators call “stealth interest rate hikes” such as store coupons, gifts or oneoff cash payments with a new account, banks will have to compete through their respective deposit and lending rates.

One thing seems certain this marks the beginning of the end of China’s time-honored fixed-rate profit model.

New Deal

The cost to Chinese banks could be huge. Standard and Poor’s estimates that rate cuts and liberalization could hit the banking sector’s return on average assets by 30-35 base points in 2013, with Chinese banks’ ability to correctly price risks “put to the test.” In its annual report released in early July, the China Banking Association stated that partly because of the narrowing discrepancy between the country’s deposit and lending rates, profit growth in the banking sector will fall to 16 percent in 2012 from 39 percent in 2011.

Tighter regulation and increased competition is coming at a bad time for China’s State banks, already struggling with the country’s economic slowdown. “Even without rate liberalization, China’s banking sector has to prioritize changing its development pattern,”said Jeoffrey Choi, banking and capital markets leader for Ernst & Young Greater China.

China’s financial pundits seem to believe that the country’s banks should put up and shut up. Shang Fulin, Chairman of the CBRC, recently urged banks to “adapt to interest rate liberalization by offering better services for depositors and lenders, and exploring other business not based on interest rate income.”

In its recent report, Standard & Poor’s stated that the new policies could “encourage banks to provide more loans to small and midsize enterprises (SMEs) and individuals.”Many Chinese analysts echoed this stance. With such businesses now taking center stage as the State sector reaches capacity, financial reform is coming at exactly the right time.

Domestic analysts have warned that perceiving these rate liberalizations as a fanfare heralding a new era of private sector dominance is wishful thinking. Chinese banks, big or small, have barely any room to negotiate with their biggest clients, all of whom are likely to be either SOEs or local governments. “Their orders are much safer and larger,” said Mr He, manager of a mid-sized Beijing-based bank. With national economic policy still heavily geared in favor of the government, banks will likely continue to play hardball with SMEs while rolling over for State monopolies.

“With profit margins already squeezed, we can’t afford even one default in 100 loans, which we think will be more likely to come from SMEs, particularly in the current economic downturn,” one bank manager, speaking on condition of anonymity, told NewsChina. His bank has stepped up efforts in diversifying into more sophisticated financial services, such as consultancy and wealth management products. Their targeted clients, however, were almost exclusively SOEs.

Lopsided

Indeed, many observers believe that the new rate liberalization will simply derail growth. “[Liberalization] will deprive the central bank of a very direct, effective monetary policy tool which other national banks don’t have,” said Yin Jianfeng, vice director of the Finance and Banking Institute of the Chinese Academy of Social Sciences.

“With China’s financial system so heavily reliant on the banking sector, any move undermining banks’ most important profit source could trigger systematic market risk,”he added. Yin believes that the government should instead try to develop the domestic stock and bond markets, providing more financing and investment opportunities to a more diverse range of businesses. This kind of competition, he believes, will give greater incentives to banks in attracting individual depositors and SMEs. Diluting the immense financial risk inherent in the country’s allimportant banking center, he added, would make future interest rate liberalization “natural and quiet.”

Corporate bonds and shares are still subjected to rigorous government approval procedures, leaving these markets both underdeveloped and segmented. Chinese companies issue three kinds of bonds approved by three different agencies and traded in two different markets. Treasury bills are also traded in two separate markets. Only vast, asset-rich companies, the majority of which are likely to be SOEs and State banks, can operate in such an environment. Even for them, the capital flow is severely restricted among different markets.

Choi at Ernst & Young welcomes the rate reform, but also argues that it should go side by side with relaxation of other financial restrictions as central bank rates, inter-bank rates and bond yield curves combine to affect financial pricing. In China, government controls systematically hinder the possibility of financial players to diversify their services and product ranges by imposing too many artificial restrictions, undermining the ability of banks to adapt to market conditions, in turn stifling economic rebalancing.

When State monopolies continue to receive privileged access to the market, it makes financial sense for banks to neglect other sectors, regardless of the long-term effects on the rest of the economy. When investment opportunities are limited, depositors may as well pick their bank out of a hat. When government agencies prefer to tilt the rules of the game entirely in their favor despite snowballing risk, even market-based interest rates have little real impact.

While everyone seems to agree that only diversification can prevent China’s economy and banking sector from stagnation and potential collapse, the people with the power to change the status quo are also those who stand to lose the most.