November 2006

When the China Industrial and Commercial Bank (ICBC) opened for public trading at the stock exchange end of October, the bank raised a total of USD 19.1 billion to start with, achieving the largest initial public offering ever. ICBC is now the top listed bank in Asia and the fifth biggest in the world.

Despite the enthusiasm created by ICBC's listing, and the fact that international advisors such as Morgan Stanley are planning to add ICBC to its standard index soon, some analysts are still concerned about the basics and fundamentals of China's banking industry. Over a long period, loans were approved by politically motivated reasons rather than economic decisions, and on several occasions, banks previously had to be "bailed out" by the government.

History of the Banking Industry in China

In the earlier years of the People's Republic nationalization, the consolidation of the country's banks received the highest priority. Therefore the banking industry was the first sector to be socialized. In order to maintain a firm control over all financial services, including credit and money supply, the banking system was centralized under the Ministry of Finance.

In the mid 1980's, the level of banking service in China was not at the same level as in other countries. Only a few people used savings accounts and credit cards, and cooperation between banks did not exist. In 1986 the first steps were made to change this. An inter-bank borrowing and lending network was created as well as an interregional financial network. In June 1986 the first credit card the "Great Wall" was introduced. It was used for foreign exchange transactions. Another financial innovation in 1986 was the re-opening of China's stock exchange since 1949.

Since 1987 the Chinese banking system includes the following major banks:

People's Bank of China, Agricultural Bank, Bank of China, China Investment Bank, China Industrial and Commercial Bank, People's Construction Bank, Communications Bank, People's Insurance Company of China, Rural Credit Cooperatives and Urban Credit Cooperatives.

The People's Bank of China (PBC or PBOC) was the foundation of the banking system and once was the "Central Bank of China". Today the so called "Big Four" are the Agriculture Bank (ABC), the Bank of China (BOC), China Industrial and Commercial Bank (ICBC) and Peoples Construction Bank or China Constructions Bank (CCB) as it is called today. Together they still hold 55% of the Chinese credit volume.

The People's Bank of China (PBC) overlapped in function with the Ministry of Finance. After it lost many of its responsibilities, it was restored in the 1970s to its leading position. As the central bank the PBC had sole responsibility for issuing currency, controlling the money supply, served as the government treasury, the main source of credit for economic units, the clearing center for financial transactions, the holder of enterprise deposits, the national savings bank and a ubiquitous monitor of economic activities. Today the PBC is responsible for the implementation of monetary policy for safeguarding the overall financial stability and provision of financial services.

The Agriculture Bank (ABC) was created in the 1950s to faciliate financial operations in the rural areas. It provided financial support to agricultural units, issued loans, handled state appropriations for agriculture, directed the operations of the rural credit cooperatives and carried out overall supervision of rural financial affairs.

The Bank of China (BOC) handled all dealings in foreign exchange. The BOC was responsible for allocating the country's foreign exchange reserves, setting exchange rates for China's currency, issuing letters of credit, arranging foreign loans, and generally carrying out all financial transactions with foreign firms and individuals.

The China Industrial and Commercial Bank (ICBC) is the youngest one of the "Big Four". It was founded in 1984 and issued the primary bank card in 1989. It was the first Chinese bank to establish a branch outside China in 1992, and to open a branch in Europe in 1995. With the ICBC, China made the first step to a representation in the international banking arena.

The China Constructions Bank (CCB) checked the activities of loan recipients and ensured that the funds were used for their designated construction purpose. In general, the bank managed state appropriations and loans for capital construction.

In October 2005 the China Construction Bank listed successfully on the Hong Kong Stock Exchange. With a USD 9.2 billion IPO (Initial Public Offering) it was the biggest entry in the history of the Hong Kong Stock Exchange. In May 2006, the Bank of China followed with an even bigger success and as mentioned before this was topped again by ICBC in October of this year when it entered the Hong Kong and Shanghai stock market with an IPO record of USD 19.1 billion.

Reforms Before the WTO Entry

When China was preparing for entering the World Trade Organization (WTO), China's banking system was not on an internationally appropriate level. In order to be more competitive with other countries, and to fulfill the WTO requirements, the structure of the banking organization was modified over the course of time repeatedly, to suit changing conditions and new polices.

Before joining the WTO in 2001, the reforms of China's financial system could be divided into 5 phases:

In the first phase from 1979 to 1981, China opened the finance market for banks with overseas capital. In 1979 China allowed 31 foreign financial institutions to open a Representative Office in China and in 1981 foreign financial institutions were allowed to set up their commercial subsidiaries only in the special economic zones.

In the second phase from 1981 to 1989 the constitutional administration of the foreign financial institution was created step by step. From 1983 to 1985 China published the People's Bank of China's determination about the administration of the constant substitution of foreign representations and foreign Chinese financial institutions in China. In addition the determination about the administration of banks with foreign capital and Joint Ventures with an interest of foreign Chinese capital in the special economic zones was also announced. This was an official sign for the opening of the Chinese banking business.

In the third phase from 1990 - 1993 foreigners were allowed to settle down in the Lujiazui area in Pudong, Shanghai, in order to establish a new financial center. Because of the development of the Pudong New Zone in August 1990, Shanghai, as an outward costal city, was allowed to admit foreign commercial financial institutions and in 1992 the cities Ningbo, Nanjing, Guangzhou, Fuzhou, Dalian, Tianjin and Qingdao followed. At the same time, China allowed an American insurance company (AIG) to establish in China in order to demonstrate considerations of opening the Chinese insurance market to foreigners.

In the forth phase from 1994 to 1996 China opened non-costal cities for foreign banks and set up supra-regional financial institutions. The implementation of the regulation over the administration of foreign financial institution on the 1st of April in 1994 marked the standardization of the administration for these institutions. In August 1994 the Chinese state council allowed 11 additional cities including Beijing to set up commercial financial institution with foreign capital. At this point, China was negotiating to join the GATT (General Agreement of Tariff and Trade, predecessor to the WTO) and they needed to speed up the opening of the banking market for foreign companies.

In the fifth and last phase before joining the WTO China opened the renminbi business for banks with foreign capital. In December 1996 the People's Bank of China announced that foreign financial institutions, which can provide the right conditions, are allowed to do local currency business in Lujiazui Pudong New Zone. In August 1998 five banks with foreign capital received permission from the Chinese state council to do local currency business in the special economical zone of Shenzhen. In July 1999 the People's Bank of China expanded the local currency business to the foreign banks in Shanghai und Shenzhen.

Agreements and Reforms after Joining the WTO

When China joined the WTO, the organization demanded China to comply with special obligations concerning the bank business in the country. China had to agree to open their bank sector completely to foreign banks within five years after joining the WTO from 2001 - 2006. China specifically agreed, that it would allow foreign banks to accomplish foreign currency business without any market access or national treatment limitations, and to conduct foreign currency business with foreign-invested companies and foreign individuals, subject to certain geographic restrictions.

Two years after joining the WTO, foreign banks should have been able to conduct domestic currency business with Chinese companies subject to special geographic limitations, and within five years China agreed to lift all geographic restrictions. China also agreed that foreign banks are allowed to provide financial leasing services at the same time as their Chinese counterparts.

However, China was slow in implementing the agreements. In 2002 the People's Bank of China issued regulations governing foreign-funded banks along with rules to keep pace with the WTO commitments but the PBOC was extremely cautious in opening their bank sector. This situation made it difficult for foreign banks to enter the market and expand their presence. To give an example, the PBOC allowed foreign-funded banks only to open one branch every 12 months.

Of course this resulted in pressure from countries such as the USA, Australia, Canada Japan and several European countries. Therefore the PBOC announced in December 2003 that foreign banks were permitted to conduct domestic currency business with Chinese companies and the working capital requirements for foreign banks were reduced.

In July 2004 capital requirements for foreign banks in other categories were reduced and the China Banking Regulatory Commission (CBRC) issued the Implementation Rules for the Administrative Regulations on Foreign-Invested Financial Institutions, which removed among other things the restriction to open only one branch every 12 months. In December 2004 the CBRC allowed foreign banks to opened branches in an additional five cities for and to process local currency business, including Xian and Shenyang. This allowed them to be ahead in the commitments towards the WTO. Foreign banks were now allowed to conduct local currency business in 18 Chinese cities.

Up to the end of May 2006, 71 foreign banks established 197 branches in China. Currently they are allowed to conduct local currency business in 25 Chinese cities.

After a slow start, China has only until the 11th of December 2006 to fulfill the WTO agreements at which point China will have to open the banking sector for all foreign banks in every region of the country.

As it stands however, any foreign bank looking to gain a foothold in a city must open a representative office, which can offer only advisory, non-profit making services, in the city and maintain it for two years.

Only then can it apply to open a branch office and actually start doing business. While the representative office rule has been lifted in western China to encourage investment and the government has indicated this could soon extend nationwide, branches have experienced further delays when applying for local currency trading licenses. A minimum capital requirement of USD 62 million must also be met to open a full service branch.

Advantages for Foreign Banks

Once China opens the banking market to foreign banks, those already established on the market have an advantage. This can also be seen with the large number of representative offices that have been opened in the last few years by foreign banks.

Retail Banking

It is said that the best way for foreign banks to enter the China market is through retail banking, as the local Chinese banks are generally weaker in this sector. In addition, it is expected that much of the future growth and profitability will come from retail, small-business lending and fee-based businesses. Generally speaking, foreign banks have better skills and are more experienced in this area than Chinese banks, which concentrate more in the traditional areas of banking such as deposits and lending. Many of the Chinese banks do not invest time and manpower in their customer relations. Considering 1.3 billion Chinese people have approximately a total of USD1.65 trillion on saving accounts, this is a key mistake. Many local banks do not know their affluent clients and this presents a chance for foreign banks who have an immediate advantage with their experience.

Because affluent customers are highly concentrated geographically, foreign banks only have to provide a small number of branches in the big cities to target these customers. Surveys show that the demand for better services is very high, and customers are unsatisfied with the services of local Chinese banks. Therefore customers would rather go to a foreign bank even if they have to pay higher fees or interest rates.

Credit Card

A hot sector in the bank market is the credit card market. It is expected that banks will get soon the permission to issue their own credit cards, which will give them access to a market, which is worth USD 40 billion. Credit cards are more and more in demand in the Chinese culture, but local banks lack of experience. In addition, with credit cards from local banks, customers are only able to pay in renminbi and no other currencies.

But what is the best way to access the market? The best and easiest way for foreign banks to enter this sector is by joining a partnership with a local Chinese bank. On one hand, Chinese customers prefer the service of a foreign bank but on the other hand, 66 percent of card holders choose to pay their bills cash at bank branches or pay them at the automated teller machines. Chinese banks have an existing network of branches spread over the country with the technical facilities. Figures show, that the most effective way to acquire new customers for credit cards is to visit companies and provide incentives for staff. Almost half of all credit card holders sign up if a bank representative visits their workplace and if there is an already established corporate relationship; larger local Chinese banks have an additional advantage in this area.

It is therefore easier for foreign banks to become a partner of a local bank and to benefit from the existing network. Currently, foreign investors are only allowed to have a stake up to 20 percent in a local bank, however if more than one foreign bank or investor is involved, a total of 25 percent can not be exceeded. This regulation is expected to change with ongoing reforms.

Outlook for the Future

In general, China's banking system does have a prosperous outlook. With the WTO pushing for the opening up of the banking industry, China is implementing regulations for foreign banks to access slowly all areas. This means for local banks in order to stay competitive, they have to "clean up" their long term problems as many are heavily loaded with non-performing loans. Recognising the problem China already decreased slowly the loans since opening their bank sector step by step. Local banks are getting better and better in setting their risk management, and already are becoming more competitive.

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All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.