BREAKING UP BANKING MONOPOLIESS

COVER STORY

BREAKING UP BANKING MONOPOLIESS

China needs to revitalize the real economy and free up capital for small businesses By Lan Xinzhen

China is in the initial phase of a state-led financial reform, starting with its private economy powerhouse of Wenzhou in Zhejiang Province, in an effort to better support the development of the real economy.

On March 28, the State Council gave the word to establish a pilot zone for comprehensive financial reform in Wenzhou. The plan requires the city government set up a fnancial mechanism facilitating the locality’s social and economic development. It also outlines 12 tasks for Wenzhou to focus on during the reform process, such as “encouraging and supporting participation of private capital in the reform of local fnancial institutions.”

In April, Shenzhen, the original base of China’s economic reform in the late 1970s, followed suit with a guideline for financial reform. The focus of Shenzhen’s financial reform will be to serve the development of the real economy, including the introduction of pilot two-way trans-border loans between the mainland and Hong Kong, the establishment of the Shenzhen Qianhai Equity Exchange before the end of this year, and the development of the innovation bond market.

Up to now, 16 pilot zones have been set up to connect technology and fnance in cities like Tianjin and Chengdu, and they are seeking further financial innovation to offer fnancial support to scientifc and technological enterprises.

Guo Yanhong, researcher at the Research Institute of Huachuang Securities Co. Ltd., said economic readjustment is generally accompanied with opportunities for institutional improvement. In China, the recent slowdown of economic growth and the intermittent breakout and intensifcation of liquidity risks all substantiate the need for fnancial reform.

According to Guo, the old economic mechanism will face a series of challenges. To avoid economic recession, it is necessary to adopt measures to prevent the economy from shrinking. Historically, after economic crises, corresponding institutional innovations have typically followed.

“Through analysis of U.S. financial reforms, we can find that the reforms actually represented a process of financial liberalization,” said Guo.

The pilot financial reforms in Wenzhou and Shenzhen also aim at pushing forward the Chinese fnancial mechanism. Wenzhou’s reform will regulate private capital, while reform in Shenzhen will serve economic transformation and focus on incorporating capital from diversifed channels into the process.

Ending state monopoly

Days after the State Council executive meeting on March 28, Premier Wen Jiabao announced that the Central Government was determined to break the monopoly in the banking sector during a visit to Fujian Province.

“I think it has been too easy for our banks to make profts,” he said. “The reason is that a small number of large banks hold a monopoly in the sector. This is why we’ve now come to make way for private capital to enter the fnancial service sector, which ultimately requires breaking monopolies.”

The Central Government is obviously discontent with the state monopoly in the financial sector. It has already issued several documents supporting the non-public economy’s entry into the financial sector, encouraging private capital to establish banks in the country’s vast rural areas. However, because of various “glass doors,” it is diffcult for private capital to enter the fnancial system. To date, none of the government’s measures has been effective at weakening the state banks’ monopoly. The biggest ill for state monopolies in the financial sector is that bank credit is typically given to large state-owned enterprises, leaving small and medium-sized enterprises (SMEs), especially private businesses, to fend for themselves.

Most Chinese media think among the 12 tasks for the comprehensive fnancial reform set by the State Council for Wenzhou, the most important is to encourage and support private capital’s participation in reforming local financial institutions and establishing village banks, loan companies, rural fnancial cooperatives and other new-type fnancial organizations in accordance with the law.

This means that private capital can establish real “privately owned banks,” with their management personnel selected by shareholders, instead of being appointed by the government.

Pan Zhengyan, Deputy Director of the Financial Research Center of the Shanghai Academy of Social Sciences, said breaking the state’s monopoly on banks has been society’s wish for some time, and bigger strategic reform of the banking sector is unavoidable. But only fnancial reform processed with market-oriented measures will be able to break the state monopoly.

Pan said the first thing that needs to be done is to enhance competition in the fnancial market by extending market access to the fnancial sector. An important goal of the pilot project is to set up a reasonable and multiple fnancial system instead of one dominated by state-owned financial institutions. This calls for the practice of allowing private capital to fully integrate into the financial system. Incorporating private capital into the fnancial sector will not only enhance market forces, but also expand the sector’s market capacity.

According to Pan, to thoroughly break the state monopoly in the fnancial sector, the government should also change the rules of market competition. Non-market formation of interest rates is a special mechanism in the Chinese banking sector. That is to say, prices of bank capital (interest rates) are decided by the “authority,” instead of the market. The price mechanism does not play a decisive role to either the suppliers (banks) or the buyers (enterprises). It is diffcult for privately owned SMEs to get loans at reasonable prices.

Hence there is conflict in the Chinese financial industry: On the one hand, SMEs, particularly privately owned ones, can only depend on financing means with high interest rates and high risk such as usurious loans or illegal fnancing, with interest rates higher than the social average. On the other hand, under the protection of a special pricing mechanism, banks of various sizes are enjoying bonus from policies and gaining profits from actual “negative interest rates” caused by infation. Such a price formation mechanism for bank capital is beneficial to the banking sector and directly leads to monopoly profts in the banking sector and actual monopoly in the fnancial industry.

“The key point to change the unreasonable allocation of social resources is to change the present market rules. Otherwise, it is hard to realize justice and rationality in competition of the financial industry and to really break the monopoly in the banking sector,” Pan said.

Legalizing private lending

Liu Yuanchun, Deputy Director of the School of Economics of Renmin University of China, said an important part of the fnancial reform scheme in Wenzhou is to regulate private lending and facilitate private capital entry into the fnancial sector.

Private lending, especially in large sums, is illegal in China. In Zhejiang Province, where the private economy is more developed than in other regions, many people have already been sued for private lending. Figures showed that in 2008 there were nearly 200 cases involving illegal deposits and more than 40 cases involving fundraising fraud. The recent Wu Ying case has aroused wide public condemnation against ruling private lending as illegal.

Wu Ying, 31, former legal representative of Zhejiang Bense Holding Group, was detained by the public security bureau for her involvement in illegal fundraising on March 16, 2007. Jinhua Intermediate People’s Court of Zhejiang Province sentenced Wu to death for fraud on December 18, 2009. Zhejiang Higher People’s Court affrmed the death sentence on January 18, 2012.

This death sentence aroused public debate on whether the businesswoman should be executed for her crime. Online, most people sympathize with Wu and think her crime doesn’t warrant a death sentence. Others believed Wu and other cases are institutional tragedies.

Probably due to public pressure, the Supreme People’s Court decided on April 20 to reject the death sentence for Wu and sent the case back to Zhejiang Higher People’s Court for retrial. The death sentence will probably be reversed.

“The financial reform experiment in Wenzhou will open a window for private fnance to enter the banking sector,” said Yi Xianrong, a researcher at the Institute of Finance and Banking of the Chinese Academy of Social Sciences. “Its significance should not be underestimated in pushing forward China’s reform of the fnancial market, particularly the reform of the complete fnancial system.”

According to Yi, where private lending is active, local economies are usually more developed. Most of the funds from private lending have gone to the real estate market, and most of the funds used for private lending ultimately come from the banking sector. If private lending collapses, it will not only damage the economy in China’s most prosperous east coastal areas, but also seriously affect China’s real estate market and the banking system as a whole. At present, the scale of private lending in China totals 4 trillion yuan ($634.92 billion), and the amount of capital lent “under” Wenzhou has surpassed 120 billion yuan ($19.05 billion).

“Problems of Chinese private lending are the result of strict control over the legal fnancial system. The most important thing for the experiment to be carried out in Wenzhou should be tolegalize present private lending and then regulate private lending in China. It is important for China’s fnancial reform,” Yi said.

LENDING TO YOU: Huafon Small-Sum Loan Co. Ltd. is the frst micro-credit company in Wenzhou, Zhejiang Province, where micro-credit companies are being supported by the ongoing fnancial reform

In the detailed plan for financial reform, Wenzhou proposes to establish micro-credit companies based on private capital and make them cover all the townships. This year, the city is to set up 30 micro-credit companies with net assets of 20 billion yuan ($3.17 billion). By the end of 2013 the number of micro-credit companies in Wenzhou will reach 100, with net assets totaling 40 billion yuan ($6.35 billion).

Zhou Dewen, Vice Chairman of the China Association of Small and Medium-Sized Enterprises, said encouraging private investment through financial reform not only can consolidate the development of the Chinese private economy, but also further promote the private economy to make bigger contributions to China’s economic development.

He also said to regulate private lending and promote private investment, the government should formulate game rules on private investment. Now the most important thing is, when legalizing private lending, China needs to make laws on private investment and fnancing to regulate and protect these activities.

Benefiting SMEs

Cao Fengqi, Director of the Research Center of Finance and Securities of Peking University, said fnancial reform will signifcantly infuence the fnancing for SMEs. “To legalize private lending will be beneficial to SMEs and can solve their fnancing diffculties to some extent,” he said.

Today, SMEs make up more than 90 percent of all enterprises in China. SMEs also contribute more than 60 percent of the GDP, 80 percent for urban job opportunities and 50 percent of the country’s tax revenues. Furthermore, 65 percent of the country’s invention patents and 80 percent of the research and development of new products are from SMEs.

Development of SMEs needs financial support, but financing difficulties have long been an unsolved problem. According to a report on the development of Chinese SMEs released by the All-China Federation of Industry and Commerce in 2011, more than 90 percent of the surveyed owners of privately owned SMEs said they could not get loans from banks.

According to the report, the real reason is that monopolies by the four biggest state-owned commercial banks have gradually reduced the fnancial resources that small and medium-sized banks can get, restricting their capability to serve SMEs. To seek profits and avoid risk, the four biggest state-owned commercial banks are reluctant to offer loans to SMEs. Difficulty in acquiring loans from legal financial institutions has led SMEs to turn to private lending, which has no legal status in the fnancial legal system. Due to unsound financial laws, legal private lending activities are not clearly defined against crimes of illegal fundraising or fundraising fraud. Many enterprises don’t dare to borrow private capital and are forced into bankruptcy. The fnancial reform this time will legalize private lending, which could rescue these SMEs. The financial reform in Shenzhen proposes two important policies in supporting SMEs: offering favorable loans to emerging strategic industries as well as micro and small enterprises, and nurturing a multi-market and multi-level fnancial system.

Grassroots appeals

The 12 tasks for the fnancial reform in Wenzhou were designed by the China Banking Regulatory Commission and the Central Government. The Wenzhou government and market participants such as private lenders and borrowers were excluded from the process, leading to doubt on the thoroughness of the reform.

A report of the Guangzhou-basedSouthern Weekendsaid, “An anonymous investor in Wenzhou has found the intention from the 12 tasks that ‘no one in the decision-making level really wants to break monopolies.’ He said only if real privately owned banks are created ‘can the financial monopoly be broken by setting up some micro-credit companies in Wenzhou.’”

Hence Zhou thought there are arguments on whether the financial reform should be designed by the Central Government or local governments.

The financial reform Zhou wants should be designed from the ground up because this will better cater to the wants and needs of market participants.

Ma Guangyuan, researcher at the Institute of Risk Investment of Peking University, also expressed discontent with the fnancial reform designed by the top level. He said in his blog that the scheme of Wenzhou’s financial reform is still far behind market expectations.

Ma said there are many problems in China’s financial sector that need to be solved, such as breaking the financial monopoly, introducing market-oriented reform of interest rates and legalizing private lending. These are all urgent, particularly the market-oriented reform of interest rate. But regrettably, the fnancial reform scheme approved this time gives no response to the most urgent topics in the reform.

Ma warned that in terms of the timing of reform, now is the best window of opportunity to push for significant financial reform. Conditions are ready to legalize private lending, allow private capital to enter state-owned fnancial institutions and adopt market-oriented formation of interest rate. If this chance is allowed to pass by without change, it will be more and more diffcult for future reforms.

lanxinzhen@bjreview.com