Since the Asian financial crisis of the late 1990s, banking reform in China has focused on developing the ability of the state to supervise and regulate banks, as well as fostering good governance practices within banks. This column suggests lessons for other countries seeking to promote financial stability in support of sustainable economic development.
A stable and effective domestic banking sector is a prerequisite for sustainable economic development. Financial instability and financial crises can disrupt economic development for years or even decades. They can also create political and social instability.
Since the 1970s, the scale and severity of financial crises has been unprecedented, with developing countries that chose to liberalize and deregulate their financial systems being the worst affected. Much blame has been placed on these countries, usually for not going far enough with their reforms. The World Bank and the International Monetary Fund (IMF) continue to promote open financial systems as well as increased foreign ownership of domestic banking sectors.
Given the widespread occurrence of financial crises, this policy consensus should be called into question. The most significant was the global financial crisis, which originated in the United States in 2007, and was transmitted around the world through global financial conglomerates.
Since the global financial crisis, China has emerged as an important counter-example to the policy consensus on banking reform. Around ten years earlier, in 1997, the country’s banking system was so weak that George Soros suggested it only survived the Asian financial crisis because its banking sector was not open to external capital flows. China’s state-owned banks were technically insolvent and depended on financial support from the state.
Despite a massive bailout in 1999, which was equivalent to 4% of China’s GDP, the banks remained insolvent. It was widely believed that the sector (and China’s economy) was in such a mess that it would not survive without deregulation to allow for privatization and the entry of foreign banks, which would in turn provide ‘much-needed market discipline’.
At this crucial point of the reform process, with the additional pressure of entry into the World Trade Organization, China’s officials made a decision that would change the destiny of the country’s banking sector and its economy.
These officials had grown up in the days of China’s cultural revolution and were in their first years of devising policies for a market economy. Despite this, they ignored the advice of international experts and chose to list banks as whole entities and retain majority state-ownership.
After this reform, China’s banking sector finally became profitable and the country is now home to the four largest commercial banks in the world. Foreign banking assets in China remain less than 2% of total banking assets.
China’s approach to banking reform is often portrayed as anti-market or obstructionist, but this could not be further from the truth. Since Deng Xiaoping, the architect of China’s economic reforms, its leaders have all had a strong belief in the power of the market to transform the economy. But they view the market as a ‘double-edged sword’, which can promote economic instability or even a crisis if it is poorly regulated.
As such, the emphasis of banking reform has been on constantly developing the ability of the state to supervise and regulate banks, as well as fostering good governance practices within banks. This has been achieved through extensive engagement with international experts, pro-active adoption of international regulatory standards, and the transfer of ideas about risk management from international banks.
China’s first head banking regulator sums up the country’s approach as ‘risk-based and consolidated supervision with strong control and great transparency’, reliant on ‘a set of simple, useful and effective ratios, limits and targets, modeling those used by some developed markets in the past and were later abandoned by themselves during the frenzy [of] innovation and deregulation’.
Under this approach, China’s regulators were able to reduce non-performing loans from 17.9% in 2003 to 1.58% in 2009. According to Chairman Liu Mingkang, over the same time period, the proportion of banks in compliance with capital adequacy requirements increased from 0.6% to 99.9%, and loan provisioning coverage increased from 19.7% to 155%. These improvements provided the banking sector with the necessary resilience to cope with the risks posed by the global financial crisis.
There is no doubt that currently there are real risks in China’s banking system, such as the level of non-financial sector debt. But these should not be viewed as caused by a ‘lending binge’ by the state, as some suggest. As former World Bank President Robert Zoellick recently said, ‘China’s huge stimulus offered a critical boost to a tumbling world economy…’, and ‘Beijing’s high level of debt today reflects the cost of that course of action’.
In its most recent assessment, the IMF praised the wide range of actions taken by China’s regulators to reduce risk. Its report noted that the ratio of corporate debt to GDP, which had risen rapidly since the crisis, had finally stabilized. China’s banks are far from insolvent. The non-performing loan rate remains below 2% and China’s largest banks hold more capital than required by international standards.
China has chosen a different path in its banking reform. Its officials have developed systems of regulation and governance that reflect the view that the state should play a more active role in ensuring financial stability. China’s ability to weather both the Asian and global financial crises, while developing a profitable and resilient banking system, suggests that it is an important counter-example to the current policy consensus on banking reform.
Guy Williams is the author of the book ‘The Evolution of China’s Banking System, 1993-2017’ (Routledge, 2018).