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Wen Jiabao Has the Wrong Solution for China’s Banks

by | April 4th, 2012 | 03:39 pm
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Criticism of bank profits has now reached the highest levels of the Chinese political system. In a national radio address this week, Premier Wen Jiabao stated that China’s large banks were excessively profitable. Wen’s solution was to open the system up to private capital and smash the monopoly of the large banks. He even referred to expanding the financial liberalization experiment in Wenzhou as a way to achieve this (Chinese language).

When Premier Wen refers to large banks in China he is talking about the “big four” commercial banks, ICBC, Bank of China, China Construction Bank and Agricultural Bank of China. These banks, despite public listings, are still primarily state-owned and account for around 40 to 50 percent of total bank assets. Private banks do exist in China, but the largest financial institutions remain state-controlled.

Wen addresses the right problem, excessive bank profits, but has the wrong diagnosis and therefore the wrong solution. It only takes a few competitors with the right incentives to do away with a monopoly. This is one element a lot of observers seem to miss when bemoaning the continued influence of state-owned enterprises in China. Take mobile phone services. The market is dominated by three state-owned firms, China Mobile, China Unicom, and China Telecom. Despite all being owned by the government, these firms compete fiercely amongst each other for customers. This has lowered the cost of service and led to a high level of mobile phone penetration and better service than in most developing countries.

The same potential for competition exists in the financial sector. The big four commercial banks compete with each other intensely for deposits; the rapid growth of wealth management products that they offer is evidence of this.

The central bank sets a ceiling on the deposit rate and a floor on the lending rate, thereby guaranteeing the banks a profitable interest rate spread and stifling competition. Competition cannot occur when prices are fixed and for banks the key prices are interest rates. Wen explicitly called for interest rate liberalization during his 2009 National People’s Congress speech, but powerful vested interests have managed to prevent the reform from progressing.

Deposit rates are set at such a low rate that real returns have been on average negative for the last decade. This represents a huge tax on households and a giveaway to the banks. This is the primary reason why banking profits are so high. Until the systematic underpricing of capital is changed, banks will stay profitable regardless of whether the big four state-owned commercial banks are broken up or not.

Once interest rates become market determined, there actually will be an opportunity for all banks to compete. When a bank’s success becomes determined by the appropriate pricing of risk and efficient commercial operations, better managed banks will begin to take market share away from their inefficient competitors.

Wen’s reference to the Wenzhou financial liberalization pilot program is a hopeful sign for reform. The State Council has approved a revised version of a plan submitted by the Wenzhou Government last year. Some of the actions outlined in the plan are quite old, encouraging banks to lend more to small and medium enterprises and allowing small loan companies to become village banks. Other proposals are newer, such as encouraging private funds to establish themselves as private equity and venture capital companies.

The newest proposal, and the one that has received the most attention, is to establish more direct channels for Wenzhou residents to invest abroad. Residents in Wenzhou would be permitted to invest up to $200 million dollars abroad with a maximum of $3 million per person.

If this represents an opening in the capital account, it is only a slight crack. The aggregate amount that will be allowed to flow out of the country represents less than 1 percent of deposits in Wenzhou. The only way this will represent a true shift in the financial system is if the program is scaled up across the country as Premier Wen is now calling for.