«Finance for Urban Centers Patrick Honohan A major characteristic of China’s economic transformation is urbanization on an unprecedented scale. The ...»
Finance for Urban Centers
A major characteristic of China’s economic transformation is urbanization
on an unprecedented scale. The construction and real estate sectors now
account for nearly 20 percent of GDP; investment in housing, the bulk of
it in urban areas, grew almost 19 percent a year between 2000 and 2004.
Gross investment in urban infrastructure by Shanghai alone amounted to
almost $300 billion between 1990 and 2004 (Yusuf, Nabeshima, and
Perkins 2006). Financing the infrastructure, housing, and working and fixed capital needs of an increasingly diverse set of enterprises—industrial and service—presents a huge challenge, in terms of both the volume and efficient allocation of resources.
Thanks to China’s deep banking system and high level of household and corporate savings, funds are available in the aggregate, but the financial sector has succeeded only partially in guiding these funds to where they are needed for greatest economic efficiency. This problem is becoming a matter of greater concern as urbanization increases the flow of resources into very long-lived assets.
By far the largest component of China’s financial system is banking, a sector whose structure has been evolving rapidly over the past few years. Four enormous state-controlled commercial banks represent the The author is indebted to extensive contributions and suggestions by Genevieve Boyreau- Debray, Loic Chiquier, Bob Cull, Mansoor Dailami, Yongbeom Kim, Kaoru Nabeshima, David Scott, and Shahid Yusuf. Research assistance was provided by Hanqing Shi.
105 106 China Urbanizes: Consequences, Strategies, and Policies core of the system; together they control assets equivalent to about 100 percent of GDP. While in practice each bank still retains a degree of the sectoral specialization implied by its names (agriculture, con- struction, industry and commerce, and foreign trade), all four now offer commercial banking services on a nationwide basis. In the past, these banks were tasked with supporting state-owned enterprises (SOEs). They paid little attention to the ability of those enterprises to repay. As a result of the proliferation of the resulting nonperforming assets, public funds on the order of $400 billion have been applied to recapitalizing the banks ahead of their partial privatization to strategic foreign investors and the investing public on the Hong Kong and Shanghai exchanges (“China to Open” 2006).1 While the four banks still account for some 60 percent of deposits (and a somewhat smaller percentage of loans, following the sale of a siz- able chunk of their nonperforming loans), other banks are making steady inroads into the urban financial market. Some have national licenses, although they concentrate on the largest cities; 113 cities also have city commercial banks.2 The China Development Bank, funded largely by bonds sold to other intermediaries, is the most important player in credit and investment banking at the longer-term end of the market.
At first glance, China’s banks, stock exchanges, and large insurance companies and the impressive physical presence of financial firms in Shanghai, Beijing, and other centers might suggest that the country’s cities have the main elements of a financial system that can provide credit and risk capital. But a closer look reveals important shortcomings in the functioning of these institutions—shortcomings that can be traced to continued ambiguity over the role of the government in finance.
Not enough bank credit seems to be going to the cities and provinces where it is most needed, in part, no doubt, because locally owned private banking has faced significant regulatory obstacles and has hardly begun to be established. As for the securities markets, more than 1,430 equities are listed on the Shanghai and Shenzhen markets, most of them representing subsidiaries carved out of the more-saleable assets owned by a larger state- or collectively owned group. Typically, only about a third of the subsidiary’s shares were sold on the market. In effect, the 1 At the time of writing, only the Agricultural Bank had not yet been partially privatized.
2 Thirteen banks have national licenses. All but one is majority controlled by the government or government-owned enterprises, though several also have foreign equity stakeholders. Foreign banks also operate in China, although they remain small, especially in the local currency market, where they accounted for less than one percent of loans in yuan in 2006 (“Not Too Big” 2007).
Finance for Urban Centers 107 stock exchange is still dominated by government-controlled enterprises;
it does not primarily provide a channel through which entrepreneurs can tap China’s ample savings. This will change in the future, because firms that account for 93 percent of market capitalization have abolished the nontradable share categories and the government has lifted the ban on new listings (“China: Stock Market” 2006).
The growing housing finance market is also subject to constraints, in part because of the persistence of efforts to plan and manage the functioning of the market. Meanwhile, though urban infrastructure is being built, it is being done so without the full benefit of modern techniques of infrastructure finance that could harness a spectrum of maturities and instruments and reassign costs and risks so that they are transparently borne by those who can best absorb them.
Allocating Financing Efficiently across Provinces Ample though its savings are, China cannot afford to misallocate them.
Despite the enormous investment needs of the urban explosion, banks have not been performing their classic function—familiar from numerous historic episodes of urbanization around the world—of channeling investable funds from mature surplus regions to dynamic urban economies. Indeed, it is far from clear that credit is flowing smoothly to the right borrowers in the right cities. Recent research reveals the limited interprovincial capital mobility in China and the fact that the net banking flows that do occur do not flow to the provinces—and presumably by extension to the cities—with the most-rapid growth prospects.
Conditions in China would seem to be ideal for an integrated financial market. Not only are the main banks in each city and province the same, but the two organized securities markets seem open to enterprises from all provinces. The legal and regulatory system is common across provinces, and language problems are of relatively minor importance. Given these favorable conditions, why are funds not flowing to the places where they are needed to promote the development of China’s most promising cities?
One reason relates to the governance of the state-owned commercial banks. Although each is apparently a single legal entity, these banks have operated in a highly decentralized way, and their regional management has been strongly influenced by provincial and local governments (Yi 2003).
Recent steps to centralize management control, notably through the appointment process for managers, have reportedly not yet fully eliminated the divided loyalties of regional management. And by all accounts, it would be a mistake to assume that the arrival of technical support and 108 China Urbanizes: Consequences, Strategies, and Policies board representation from foreign strategic shareholders will have solved all of these problems.
One apparent consequence of this governance structure can be detected from the pattern of financial flows. The evidence suggests that a part of the savings of Chinese households has been wasted by being invested in the wrong geographical areas. If the allocation of loanable funds across provinces is wasteful, it would not be surprising if the pattern of allocation within provinces (between urban and rural areas, between different cities and different borrowers) is also prone to waste. While this conjecture must be qualified by the finding of Cull and Xu (2003) that access of enterprises to bank lending is correlated on a firm-by-firm basis with the enterprise’s profitability, productivity, and employment growth, Cull and Xu (2000) also find that this relation has weakened over time.
One indication of the inefficiency of the banking sector comes from banking statistics and the allocation of bank loans across provinces. In international comparisons, deeper national financial systems are systematically associated with more rapid growth.3 In China, however, provincial banking depth and provincial output growth are inversely related (Boyreau-Debray 2003), and provincial enterprise profitability is negatively associated with lending growth (Podpiera 2006). A perverse relation is also apparent in the market valuation of tradable shares in companies listed on the Shanghai or Shenzhen stock exchanges compared with estimates of provincial capital productivity. These anomalous patterns strongly suggest that the flow of investable funds from China’s formal financial system4 is not governed solely by the logic of the market.5 3 For a summary of this literature, see Honohan (2004). Most of the cross-country studies do not include China, apparently because of difficulty in matching the authors’ preferred concepts of financial depth. China’s exceptionally deep financial system and rapid economic growth at first sight suggest that its experience is fully consistent with the global correlation. However, more complex econometric models that take account of additional dimensions of financial sector development reduce China’s ranking in this regard.
4 This is not necessarily true of investment funds from nonbanking sources, which are becoming increasingly important in China. Boyreau-Debray and Wei (2004) show that, in contrast to bank- or government-financed funds, self-financed corporate investment is higher in areas in which the marginal productivity of capital is higher. For a perspective on the institutional background that could ensure that nonstate and nonbank finance in China is more effectively channeled, see Allen, Qian, and Qian (2002).
5 The interprovincial pattern of some alternative indicators of financial development, such as greater diversity in sources of finance, is correlated with growth, as predicted by conventional theory (Boyreau-Debray 2003). These points are foreshadowed by Lardy (1998). The idea of a dividing line between coastal and noncoastal provinces should not be taken too simplistically, however, given the findings of Cull, Shen, and Xu (2003) on Sichuan Province.
Finance for Urban Centers 109 One possible explanation for the peculiar pattern of investment is that the allocation of financial resources across provinces reflects the desire to ensure that adequate credit is available in poorer regions. However, the data do not support this view. Indeed, regression analysis fails to detect any significant correlation between mean provincial output per capita and bank credit.6 Credit is thus not being systematically channeled to poor regions.7 The concentration of SOEs, rather than income, appears to be the most important determinant of net banking inflows. Lending is not going to where it achieves the best pay off in terms of economic growth but instead to where the state-owned banks’ traditional clients are found.
Presumably, the progressive commercialization of the state-owned commercial banks will eventually weaken this link, but while it persists, a price is being paid in terms of provincial growth. Poor provinces with good growth potential but relatively few state enterprises are receiving a suboptimal supply of funds. It is likely that even in provinces that are net recipients of funds, many enterprises with promising growth prospects are also being starved of funds. The empirical evidence points not only to problems in the geographic distribution of the volume of funds but to deeper contrasts between how financial intermediation has been functioning in China and how market finance is supposed to function. The most obvious structural difference that might explain this contrast is the continuing predominance of state ownership in banking in China, especially in noncoastal provinces.
It has been argued that foreign direct investment (FDI) partially offsets the distortion of banking flows, by favoring some of China’s more dynamic cities.8 This offset is only partial, however.
Analysis of interprovincial patterns of finance suggests unexploited potential for better credit allocation. One of the main barriers to exploitation of this potential has been the de facto local government control or 6 Dayal-Gulati and Husain (2002) make a similar finding, showing that more bank credit actually slowed the speed of interprovincial income convergence. The credit data they use refer only to state-owned commercial banks, however, not to the system as a whole.
7 Such a policy goal would be difficult to rationalize. Less-prosperous provinces might need support or subsidy from the rest of the country because of their poverty and hence their inability to generate the necessary tax revenues to cover the cost of essential public services, including income support of needy households. But such resource transfers should be on a grant basis, through mostly fiscal channels, if they are to redress the poverty imbalance.
8 See Huang and Di (2004) for an argument that FDI differentially substitutes for financial market deficiencies in different Chinese provinces.
110 China Urbanizes: Consequences, Strategies, and Policies influence over the allocation of credit. This control does not come solely through exercise of ownership rights. Instead, it derives from the influence of regional governments and elites on the behavior and decisions of regional bank managers, especially managers of state-owned banks but also managers of other banks, many if not most of which are largely controlled by regional governments or owned by SOEs. By capturing the allocation of credit in this way, these government and quasigovernment bodies may have thought that they were advancing the public interest. In fact, they are retarding the long-term growth and full convergence of Chinese productivity and per capita output with levels of advanced economies.
The authorities have wisely acted to alter the lines of responsibility in the banks, centralizing decisions and appointment processes with a view to weakening the influence of local governments on banking policy (Yi 2003; Zhou 2004). They have sold strategic stakes in three of the large banks to foreign investors and launched initial public offerings.