Chinese bank report card: the reform road is still bumpy, so forget full RMB convertibility anytime soon.

• Author: Lo, Chi
• Position: Changes in China banking system

China's banking system has gone through some profound changes, though reform is far from complete. Financial liberalization has yet to fully unleash banking's potential to fulfill asset demand, and China's mortgage and personal finance markets remain in infancy.

It will take a few more years than expected for banking reform to be completed, despite the World Trade Organization requirements for China to fully open its banking sector to competition by the end of 2006. The banking system is unlikely to collapse, however, despite the slow pace of reform and the inherent banking woes. But Beijing must take bold steps to push reform forward.

These include making asset management companies more effective by reforming the institutional and legal framework, creating a truly commercial banking culture, and ceding public control of the banking system by allowing eventual full private ownership.

Given China's reform momentum, its banking reform outlook remains benign. But full capital account (and hence RMB) convertibility will be delayed until banking reform is completed because the Chinese banking system cannot handle volatile international capital flows before sound banking practices and regulations are in place.

BANKING REFORM PROGRESS

China has made some material progress in reforming its ailing banks. Non-performing loans have fallen steadily, as a share of total assets, GDR and new loans (see Figures 1 and 2). Private analysts estimated that China's non-performing loans amounted to more than 50 percent of GDP in the early 1990s. But official estimates put them now at less than 10 percent. Even if the true bad debt levels were three times higher, this still represents a sharp improvement. Nevertheless, some are still worried that the bulk of the nonperforming loan decline in recent years resulted from bank loan expansion, especially between 2002 and 2004 when bank lending grew by an average of 18 percent per year.

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Fundamentally, China's banking sector has undergone some serious reform since 1998, when financial liberalization and banking clean-up efforts were launched. The process started with fresh capital injections, nonperforming loans carve-outs, and organizational restructuring for the Big Four state banks, which still account for 53 percent of the system's assets and liabilities.

Beijing issued RMB270 billion (US$32.6 billion) of special-purpose bonds to recapitalize the Big Four in 1998, and set up four asset management companies to buy RMB1.4 trillion (US$170 billion) of bad debts from them between 1999 and 2000. Then at the end of 2003, Beijing used the country's huge foreign reserves to inject US$45 billion into the Bank of China and the China Construction Bank. The cash injection allowed the two banks to boost their capital adequacy ratios to over 8 percent and cut nonperforming loans to less than 10 percent.

These efforts cost Beijing US$260 billion since 1998, about twice the amount South Korea spent on restructuring its banks alter the Asian crisis and about the same amount the United States spent on cleaning up its savings and loan industry in the 1980s.

Chinese banks have also improved their technical ability since 1998 by raising accounting and regulatory standards. The People's Bank of China's decision in October 2004 to lilt the commercial lending rate ceiling has, in principle, allowed banks to price loans according to credit risk. Crucially, the China Banking Regulatory Commission was created in late 2002 as an independent bank regulator, focusing on cutting...