China's Trapped Transition_ The Limits of Developmental Autocracy - Minxin Pei [70]
Another consequence of maintaining the state’s dominance in the banking sector and of defending the SCBs’ privileged market positions has been an unbalanced structure in China’s capital markets. With the SCBs maintaining a near monopoly on financial intermediation during most of the reform era, bank loans—direct financing—have been the primary source of capital. Indirect financing, through the issuance of stocks and bonds on the capital markets, grew very slowly. Equity issuance started in China in 1987, but did not raise any significant amount of capital until 1993, when proceeds from IPOs reached 37 billion yuan, and peaked in 1997, with IPOs raising 129 billion yuan.95 Between 1995 and 1998, bank loans contributed more than 80 percent of the increase in the capital stocks of firms, equity investment accounted for only 5 percent, and bonds less than 2 percent. The ratio of direct financing in China (less than 10 percent) was much lower than in Japam and other East Asian countries (about 30 percent).96 A financial system dominated by bank lending has concentrated risks in the banking sector. But such a system has served the government well. As a study by the State Planning Commission stated, “Because of the government’s direct control of the financial system, the country’s capital is concentrated in the state-owned banking system. Such capital, through implementation of the government’s credit plans, flows to key projects and SOEs that fit with the government’s plan.”97
Finally, China’s banking reform has failed the third test—financial performance. The dominant SCBs, which are among the largest financial institutions in the world, have also been the worst performers by international standards, with returns on assets in the 1990s ranging from 0.3 to 0.9 percent.98 Measured by capital and loan loss reserves, the SCBs had fragile balance sheets. During the 1990s, their capital adequacy ratio was significantly below the 8-percent level recommended by the Basel guidelines.99 In 2001, the average capital adequacy ratio of the four SCBs was only 4.95 percent, about half the level recommended by the Basel guidelines for banks in emerging markets.100
However, the most serious weakness of the SCBs—and of the Chinese banking system—is the huge amount of NPLs. Although the Chinese government spent more than $200 billion to recapitalize the SCBs and reduce their NPLs from 1998 to 2001, the impaired asset ratio in the banking system has remained stubbornly high, mainly because the recapitalization of banks has not been accompanied by more systemic reforms, and new NPLs have been generated in large volumes. For example, the official NPL ratio in 1999 was 25 percent. But in 2002, after the transfer of 1.4 trillion yuan of NPLs was completed and the asset base of the four SCBs increased considerably, their NPL ratio was still 25 percent, implying a rise of NPLs in absolute terms.101 Indeed, from 1998 to 2002, 1.7 trillion yuan in new bad loans were created in the four SCBs.102 Official data released in 2003 showed that, as of September 2003, the NPL ratio was 21.38 percent for the four SCBs and 18.74 percent for all major financial institutions (based on the five-category classification). But Standard & Poor’s estimated in 2003 that the real NPL ratio in China’s banking system was about 45 percent, more than double the official Chinese figure. The rate of recovcry on NPLs was estimated to be only 20 percent. The U.S. rating agency deemed the Chinese banking sector technically insolvent. It would take at least fifteen years to bring the NPL ratio in the banking sector to 5 percent.103
Poor Governance and Corruption
In addition to politically directed lending, poor governance and weak management have also contributed to the deteriorating performance of China’s banks. By international standards, Chinese banks have woefully weak internal control. For example,