During China’s Reforming and Opening-up efforts to gradually transform its economy into a quasi market economy, its financial system has been subject to constant modifications. China has set the ground rules to develop its financial system, from the creation of regulatory authorities and the modernization of state-owned banks to setting the framework for the participation of foreign banks.  As China has become the world’s second largest economy, it is clear that it needs a more sophisticated financial system to correspond with its increasing importance in the global economy.

In the next few years, China faces the complex and gradual evolution from an export- and investment-oriented economy into a consumer-led economy. Today, exports and fixed investment make up almost 80% of the country’s GDP, while services account for around 35%, the smallest share when compared to that of any major economy in the world. Boosting consumption and increasing the share of services in the economy will perhaps translate into a smaller GDP growth rate but increases in both employment and wages. Even though the Communist Party is well aware of the pressing need to reform its current economic model and maintain social stability by creating more jobs, one fundamental aspect of this major change is the role of the banking sector and particularly the role of foreign banks in the Chinese economy to boost competition for credit allotment and help fund privately-owned, labor-intensive companies.

With the liberalization of the banking industry (including ownership requirements, foreign investments and the liberalization of interest rates and currency convertibility,) the Chinese economy will benefit from the increase in competition and available credit. Foreign banks will introduce new financial products that will allow savers to invest in more profitable instruments and the increased inflows of capital will result in greater liquidity for both consumers and producers. By allocating credit to private companies and not just state owned enterprises (SOEs), the government’s goal of procuring job creation and maintaining social harmony will be closer to reach.

The Central Bank
The People’s Bank of China (PBOC) does not enjoy as much independence as the Federal Reserve (Fed). At PBOC, the policy committee reports to the state council and other ministries, and collectively set out the monetary policy; at the Fed, the board dictates policy, without the responsibility of reporting to other parties.  Additionally, since the PBOC has several mandates other than keeping inflation low, there can be many opposing interests when dictating policy. The PBOC also oversees the exchange rate controls, and the sterilization of incoming capital flows is necessary to controlling the exchange rate and the levels of inflation.

Commercial Banks
The Chinese banking system is heavily regulated and there seems to be continuous reminders by both the authorities and the leaders of the largest commercial banks that their role is to develop the real economy, rather than to speculate in the capital markets with securities and other financial instruments. The recent financial crisis that has shaken not only the most prominent banks in the US and Europe but also the banking systems of many a developed country has been a crude reminder of the true purpose of banks as the engine of an economy.

Additionally, the government has a massive influence and active presence in the banking system. Today, the banking industry is heavily dominated by the “Big Four”: a series of commercial, largely state-owned (and heavily regulated) specialized banks. Together, the Industrial & Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC), and the Agricultural Bank of China (ABC) represent almost 50% of the total market share by assets. In addition, several other policy banks and other smaller, government-controlled banks make up the rest of the market, with only a feeble 2% in the hands of foreign banks. All in all, China boasts more than 200 local banks, led by ICBC, the world’s largest bank by market capitalization, amount of assets, and number of outlets (over 16,000). The other three big Chinese banks rank amongst the ten largest banks in the world too. Although the central bank stopped operating the big commercial banks during the 1980’s to focus exclusively on regulation and the designing of monetary policy, PBOC still retains full control on the interest rates at which commercial banks lend money and attract savings, effectively creating a superficial credit market.  Additionally, the main function of commercial banks is to support SOEs and lend to companies which have been selected by the government, especially after the recent lending boom that was designed to mitigate the effects of the global financial crisis. This crowding out effect limits the private sector’s access to credit within the formal commercial banking system, forcing it to fund itself through private investors or through shadow banking at above market rates.

Foreign banks are also subject to a good deal of regulation that greatly limits their activities. It was only until recently that some foreign banks were licensed to issue credit cards and underwrite securities (through JV’s), and opening new branches is considerably difficult. HSBC, the largest foreign bank in China, boasts less than 120 outlets. Foreign banks in China cannot compete with Chinese commercial banks: as long as interest rates are not liberalized, banks will continue doing phenomenally well as they have an attractive net margin. Therefore, while local banks focus on gargantuan credits to develop the massive expansion of infrastructure and to fund regional governments, foreign banks are becoming active players in both currency transactions and as advisors to their Chinese clients.

The Continuous Need for Reforms and Changes in Regulation
China’s rule by the Communist Party has, ironically enough, proven to be a determining factor in the country’s march towards a market economy. Contrary to many democracies, a strong centralized government with no clear balance of power and virtually no political opposition has the ability to make arduous economic reforms that reap huge benefits in the long run. Although China has gone a long way in executing these reforms, it seems that the current political timing (with China having chosen a new leadership recently) has signaled a standstill in terms of passing new reforms, a stalemate that will likely continue into 2013. Amongst the most awaited reforms are the free convertibility of the RMB, the liberalization of interest rates, and a tax reform.According to PricewaterhouseCoopers’ annual survey of China’s foreign banking sector, CEOs of foreign banks view regulation as their biggest challenge in doing business in China. Additionally, the report mentions that foreign banks support Shanghai’s plans to become a global financial center by 2020, but believe that it can only be achieved through interest rate liberalization and free convertibility of the RMB. With the liberalization of interest rates, banks would need to compete for deposits and credit allocation by offering more attractive rates.  Freer convertibility of the RMB would allow foreign banks to leverage on their global footprint and offer holistic solutions to their customers around the globe.

The Role of Foreign Banks in the Next China
In describing the current state of affairs of China’s banking and financial system, it is easy to see that it is a vibrant yet continuously developing industry. China has to adapt its banking and financial system to the changing times and to its increasing role as one of the world’s leading financial and economic powers. Whether it is because the Chinese leadership wants to establish the RMB as a global currency or because it is actively rebalancing the Chinese economy and shifting its growth model from an export- and investment-led economy to a consumer-led one, the Chinese banking system has to be modernized and modified accordingly to adapt to China’s new position in the world.

China enjoys one of the world’s highest savings rates as well as enormous inflows of capital, both from foreign direct investments and from its exports. These excess liquidity and huge reserves could be used to bolster the services sector by allocating credits to small- and medium-sized service companies that have no other viable means of funding. By liberalizing interest rates and allowing more competition from foreign banks, Chinese people and businesses will enjoy access to a wider array of financial products and capital will be allocated more efficiently.

Although reforms seemed to have stalled during the past few months due to the change in leadership, the new Chinese leadership will surely address these problems. The world is watching: China needs to adapt to its new role as a global leader.

Manuel Martinez is a second year MBA candidate from the Yale School of Management, focusing on finance. He is a member of SOM’s Honor Committee and will work for Citi’s Investment Banking Division in New York City upon graduation. Contact him atmanuel.martinez@yale.edu.

This article appears in the March 2013 issue of China Hands.