Proposed regulations could hinder foreign expansion into the retail banking sector

----By Brian Schwarz

According to China's WTO accession agreement in 2001, Beijing agreed to open its banking sector to full foreign competition starting on December 11, 2006. But recent state media reports say Chinese authorities are formulating new regulations that could hamper the efforts of overseas banks to attract retail customers. Some banking analysts speculate that Beijing has drafted the new rules in a bid to contain the influence of foreign banks in China, according to the International Herald Tribune.

Chinese financial regulators plan to impose tighter restrictions on foreign banks trying to get a slice of the country's huge pile of local currency deposits, worth an estimated US$2 trillion. For the more than 70 foreign banks that operate about 230 branches in the country, the new regulations could limit future expansion plans into smaller second- and third-tier cities.

Foreign banks are eyeing entering the potentially lucrative consumer banking market where they could seek yuan-denominated deposits, issue credit cards, and offer home loans. The proposed rules would call for foreign banks to incorporate in China with a minimum of RMB1 billion, or US$123.3 million, in capital before they could compete with domestic banks for retail customers, China Daily reported in August.

Even more worrisome for foreign banks eyeing China's vast market, Beijing plans to stipulate that they accept only fixed deposits of more than RMB1 million from individual local customers, a sum far beyond the reach of most middle class savers.

Despite these concerns, WTO Chief Pascal Lamy gave China high marks for its implementation of the global body's trading rules during the past five years. "The overall appreciation is a positive one," Lamy said in a speech in Shanghai that reviewed China's WTO performance.

"Even if there are still areas that need some improvements, the political commitments and determination shown by the Chinese government are serious and responsible," Agence France-Presse quoted Lamy as saying.

Local banks making progress

Some bank analysts downplay the importance of Beijing's recent moves. The new regulation requiring foreign banks to incorporate locally is nothing new, according to Emmanuel Daniel, president of The Asian Banker, a banking intelligence company in the Asia Pacific region.

Several other countries, such as Australia, have such regulations and almost always, the capitalisation requirement is commensurate with the size of the potential depositor base, Daniel points out.

At the same time, many local players like China Merchants Bank, CITIC Bank and China Minsheng Bank have made notable progress in developing strong delivery capabilities sometimes up to international standards, Daniel goes on to explain.

China's banking system is dominated by the so-called Big Four national banks, which control about 60 percent of the nation's banking assets. The Bank of China, China Construction Bank, Industrial & Commercial Bank of China (ICBC) and Agricultural Bank of China have come under intense pressure to clean up their act in recent years.

Daniel argues the big four banks are so large and dominant in their branch network that no foreign bank will be able to match their size. With their knowledge of the local market and political influence, these "natural barriers" will help keep the foreign banks out.

Since the end of 2001, Beijing has been digging these big banks out of a mountain of debt from nonperforming loans (NPLs). The final bill for Chinese taxpayers will be an estimated US$215 billion, and possibly far more, according to a July report by McKinsey Global Institute. At the end of 2003, Standard & Poor's pegged NPLs within the entire Chinese banking sector at 40 percent of all banking assets.

By May of 2005, S&P said, the total was down to 31 percent, or some US$700 billion.

Therefore, for the year 2006, Moody's Global Credit Research holds a stable to positive outlook on the fundamentals of China's banking system. However, the average bank financial strength rating of E+ for Chinese banks remains one of the lowest on Moody's global scale, according to analyst May Yan.

Beijing has tried for some time to clean up their balance sheets before the sector opens up fully to foreign competition. In doing so, it has lightened the burden of non-performing loans, accrued through years of government-directed lending to state-owned enterprises and poor internal controls.

Moody's predicts the impact of the WTO-mandated opening of the sector will be gradual and will not cause an immediate system collapse. Foreign banks are likely to target high-end retail and multinational clients in the affluent coastal regions. Mr Daniel suggests that foreign banks should view the China market not as one whole, but as a collection of distinctive provinces, each with their own set of economic conditions and cultural characteristics. Because of these regional differences, each province could be practically viewed as a separate country.

Showing concern

At the end of August, representatives of about 30 foreign banks reportedly opened talks with the China Banking Regulatory Commission (CBRC) on the proposed regulations. Most foreign banks have refused to discuss the proposed regulations while negotiations continue with the Chinese authorities, according to the International Herald Tribune.

Despite the regulatory risks, some banks are moving ahead with investment plans. London-based Standard Chartered, for instance, already has 11 branches and 1,700 workers in China and is expected to be at the forefront of the foreign expansion into the consumer market.

Foreign investors are also making headlines by pouring huge sums of money into China's largest banks. In June of 2005, for instance, Bank of America paid US$3 billion for a nine percent stake in China Construction Bank.

While the Big Four have grabbed most of the recent headlines, with the Bank of China's successful initial public offering in Hong Kong, many potential investors are viewing the smaller banks as a local partner. The Chinese banking sector can be thought of as a three-layered hierarchy, with the Big Four state banks at the top, followed by the 13 joint stock commercial banks, and the 117 city commercial banks (CCBs) at the bottom.

Even though the CCBs accounted for just five percent, or US$247 billion, of the country's banking sector at the end of 2005, they are an attractive target for foreign investors given their smaller size.

"These banks are more manageable in terms of restructuring and implementing better controls," John Wadle, co-head of Asian banking research at UBS, was recently quoted as saying in the China Economic Review. "You can also pick a bank with sufficient market share to achieve a critical mass of customers."

High stakes

China's national saving rate is close to 50 percent and its household sector saves about 30 percent out of current income, according to Morgan Stanley's Stephen Roach. Yet the combination of poor capital allocation by banks and the comparatively high cost of financial intermediation means the returns on bank deposits for the average Chinese saver have been dismal.

In a second McKinsey report entitled, "Putting China's Capital to Work: The Value of Financial System Reform," researchers calculated Chinese households have earned just 0.5 percent a year on their savings after inflation. By comparison, households in South Korea earned 1.8 percent on their financial assets during the same period. If real returns on savings in China doubled to 1 percent, households would gain US$10 billion annually - and at South Korea's current level of returns they would gain US$25 billion annually, the consulting firm concludes.

In this way, Chinese households could afford to save less and consume more. Overall, the banking system's inefficiency put a huge drag on the nation's economy. Because of the country's poor capital allocation, which sustains inefficient companies at the expense of more productive ones, McKinsey calculates that solving this shortcoming would raise China's GDP by US$259 billion, or 13 percent.

Greater regulatory barriers

Foreigners are facing growing regulatory hurdles across the financial sector. In September, international firms were denied the opportunity to acquire domestic brokerages. The China Securities Regulatory Commission announced it would stop issuing licenses to foreigners to open new branches in an effort to give domestic players more time to improve profitability.

The ban appears to alter plans by Beijing to draw on foreign investors' capital and management expertise to help clean up a sector plagued for years by poor management and heavy losses. Under its WTO commitments, China must allow foreign investors to hold stakes of as much as 49 percent in local brokerages by December 2006. The current ceiling is 33 percent.

While some regulatory barriers still restrict foreign expansion in certain sectors of the economy, Chinese regulators are generally moving in the right direction. According to the World Bank's annual "Doing Business" report, which recently ranked 175 economies in terms of regulations that enhance or constrain business, China was praised for establishing a credit information registry for consumer loans. The report noted that 340 million Chinese citizens now have credit histories.

While Singapore was rated number one overall, China came in 93rd place, which was an impressive improvement from 108th in the same rankings in 2005. The World Bank concluded China's climb reflected the rapid pace of reforms being carried out and making the Middle Kingdom one of the top ten economies in the area of simplifying business procedures.