At the end of 2005, the People’s Bank of China (China’s central bank) launched a pilot initiative to create new, privately invested lending institutions in some of China’s poorest areas. A year later, the China Banking Regulatory Commission announced measures to stimulate new “village banks” and financial cooperatives, and on the last day of 2006 it also licensed the Post Office Savings Bank to enter the rural credit market. Rural finance experts have welcomed the new measures. But, Nick Young reports, many earlier efforts to encourage rural credit have faltered and it may be some time yet before financial services trickle down to the poor.

Tang Min (汤敏), Deputy Representative of the Asia Development Bank in China, sees the new measures as “a major breakthrough, not only in rural finance but also in the general financial system” because they “finally recognise the private sector demand for investment.” Allowing new financial institutions to form, Tang says, may signal “large scale opening up of the financial market to the private sector” after decades of state-run banking that failed to deliver credit to the most productive areas of the economy.

Wang Jun (王君), Senior Finance Sector Specialist at the World Bank office in Beijing, believes that new financial institutions will exert useful, competitive pressure on China’s national network of Rural Credit Cooperatives (RCCs), which are a legacy from the days of Maoist collectivisation but “cooperative” only in name. “If they [RCCs] don’t get their act together they may be wiped out altogether, not right away, but in the longer term,” Wang says.

Chinese Academy of Social Sciences professor, Du Xiaoshan (杜小山)—known to some as “the father of microfinance in China” because of his ten-year effort to pilot Grameen-style lending to the poor—also welcomes the new measures as broadly constructive. He perceives a government effort to create a three-tier financial system in China, such that “big enterprises have one kind of financial service [from the big state banks], little enterprises have little banks [currently springing up at city level, and beginning, like the state banks, to sell stakes to private investors,] and poor people have access to their own financial services.”

But a more sceptical note is sounded by Peter Situ, a consultant to the UN’s International Fund for Agricultural Development. “Sure, there is potential there,” he says. “But something is wrong if you look at it commercially. RCCs have been there [in rural areas], the ABC [Agricultural Bank of China] has been there—but they are always withdrawing because of the low market efficiency.”

Another well-informed foreign expert says the village bank idea “came out of the blue.” According to this source, “The China Banking Regulatory Commission was under so much political pressure, they had to come up with something, but instead of consulting, they went ahead and did something that was absolutely not harmonised. Now the whole [rural finance] community is trying to analyse what it means.”

What’s going on?

As with many of its “pillar industries,” China has been trying for over a decade to commercialise its banking sector in ways that introduce market forces without relinquishing state control. To some observers, this is socialism with market characteristics. To others, it is simply a contradiction in terms. Either way, the pledge to open up financial services to foreign players, made at the time of WTO entry five years ago, has added pressure to get China’s own financial institutions into more competitive shape.

Notoriously, the state banks were “politically directed” in the past, with lending policy based more on the dictates of government and Communist Party bosses than on commercial considerations. Finance flowed freely to local government real estate and industrial projects. Some of those were highly profitable, but others were hare-brained schemes that temporarily boosted GDP and made local leaders look good but at high environmental cost and with few sustainable benefits. During the 1990s the banks also repeatedly lent to ailing state owned enterprises and cash-strapped local governments whose leaders, especially in poorer areas of western China, feared mass unemployment and unrest if full play were given to market forces.

History may yet judge this an example of Chinese “gradualist” managerialism, easing the pain of economic restructuring. But there have been three, adverse consequences.

Firstly, there is a chronic shortage of credit for the private sector. “There is a huge untapped market of people without credit,” according Thorsten Giehler, lead financial sector specialist in China for the German government aid implementing agency, GTZ. The People’s Bank of China (PBC), he says, estimates that there is an “underground portfolio” of USD 300 billion circulating informally—that is, illegally—in loans to families and private businesses. This amounts to about 20% of all lending in China and “the informal [financial] sector is still growing in areas where there is no formal alternative.” This makes it extremely hard for central policymakers to set monetary policy and manage the market.

Secondly, the state banks accumulated huge “non performing loans” made to government entities that couldn’t or wouldn’t repay. The state picked up the bill, refinancing the banks and passing their debts over to asset management companies charged with recouping whatever they could. These wholesale debt managers sold “distressed assets” at bargain basement prices to debt recovery agents, including foreign banks. An agent for one international merchant bank told China Development Brief that he resigned from the job after recouping a multi-million dollar debt from a county government, because he found that the money had been paid out of the county’s environment protection budget.

Thirdly, the central government’s repeated refinancing of the state banks (and RCCs) has inhibited the development of commercial banking practices. Even now, a great deal of lending is based on guanxi (关系; relationships, connections) rather than on sound commercial criteria, according to Thorsten Giehler. In particular, he emphasises, despite the efforts of international development agencies to encourage microfinance experiments in China, there is still a deficit of “microcredit technology” for smaller borrowers.

Money drains from the countryside

Nevertheless, pressure has grown on the big state banks, which are beginning to list on stock exchanges and sell shares to foreign banks, to commercialise their operations. This has tended to push capital towards the booming cities and coastal regions. For money goes where more money can be made; and that isn’t in China’s poor rural areas.

“The ‘big four’ banks are reducing their presence in rural areas,” says Giehler. “During the last five years about 30,000 ‘big four’ branches have closed.”

Although they have difficulty accessing credit, China’s better-off rural people do have significant household savings. According to the China Statistical Yearbook (2006), rural deposits in 2004 totalled CNY 2.07 trillion, mainly deposited in Rural Credit Cooperatives, China Post Office savings accounts or the Agricultural Bank of China. But the great majority of these deposits are used to finance loans in more developed, eastern and coastal areas that bring higher returns.

Some observers blame the financial outflow partly on interest rate policy. In 2004 interest rates were liberalised for banks, but Rural Credit Cooperatives can still only lend at up to 130% of the base rate (currently around 6%) set by the PBC. This ceiling—imposed because of the lingering belief that charging commercial interest rates to rural people amounts to usury—makes it hard for RCCs to achieve financial sustainability. According to Tang Min, most RCCs lend at 9-10% interest, and this is simply not profitable.

Furthermore, as Wang Jun points out, Chinese law requires fixed assets to be used as loan collateral. Farmers’ “inventory”—such as livestock—does not qualify as collateral and farmers do not own the land they work so cannot put that up as collateral either. This places them, as small customers with no guarantees, at the end of the queue for credit.

However, Wang adds, “Competition in urban markets is fierce, banks simply cannot increase their lending rate, whereas financial institutions lending to micro-borrowers can have decent profit margins, although delivery of financial services tends to be difficult.” Easing those difficulties, Wang believes, would require, at the very least, “improved information about borrowers, such as records of their credit history, to reduce the bank’s risks and serve as a deterrent to defaulters.”

But few observers believe that the RCCs—the only lending institutions with extensive reach in the countryside—are up to this task. About a third of them are seriously indebted, another third are in precarious shape, and those reporting profits are not, in the main, lending to farmers or small borrowers. “Many RCCs do have a surplus of capital overall,” according to the Sun Yinhong (孙印洪), Sub-Regional Officer for the International Fund for Agriculture Development. But, he says, “Despite the huge unmet demand [for rural credit] they lend instead to parent institutions or invest in real estate projects, so the finance goes out of the county to prefectures and above.”

Tang Min agress that many RCCs “feel that the rural area is quite risky, because there is no collateral, so they feel it is better to lend to the Central Bank [PBC] and get the money back. So they absorb more than they lend out, and they deposit it in Central Bank.”

Recent policy has been to encourage the more profitable RCCs to re-establish themselves as commercial banks and, according to Peter Situ, “in well-developed areas of the east and south, conversion to commercial banks is very clear.”

Yet it would be politically difficult to close down the lame RCCs altogether—given that they are, at least in name, the only extensive and officially recognised provider of financial services in rural areas—without creating some alternative. Therefore, the People’s Bank of China, tired of bailing out the debt-ridden RCCs, is hoping to foster a new kind of rural financial institution that can offer services and create competition.

New “credit only” companies

It was in this context that, in November, 2005, the PBC agreed to allow the formation of “credit-only” lending companies in one county each of five provinces. These companies are not allowed to take savings deposits, but only to lend from their own equity, raised from private investors. The minimum equity threshold was set at around CNY 100 million—much less than China’s regulations require for establishing commercial banks or cooperative financial institutions (CNY 1 billion and CNY 150-200 million respectively). The first of the new credit companies opened in January 2006 in Pingyao, Shanxi (the original centre of China’s banking industry, which is credited with the invention of paper money, and thus a symbolic choice). Now there are seven companies in business and ten are expected to be operating by the end of this year.

GTZ has been providing policy advice and technical assistance to the PBC in the development of this pilot, and the Asian Development Bank has assisted in designing a bidding process for licences for the new companies in Guizhou and Inner Mongolia.

Both of these international agencies are enthusiastic about the progress of the pilot companies. Tang Min of the ADB reports that “When we designed the bidding for Guizhou, we thought no-one will want to go for it, but we were surprised because there were so many people wanting to bid. In Inner Mongolia, another very poor area, there were also lots of people wanting to bid. The financial sector was so controlled by the state, but they’ve opened this little window and many people want to come in.” Indeed, one of the PBC’s purposes, Thorsten Giehler believes, was “to use all of the energy and creativity of the entrepreneurs and to put it into the banking sector.”

According to Giehler, most of the new companies have now lent out nearly all of their start-up capital and, because they cannot take savings, are facing the problem of how to raise more loan funds. “They have people with deep pockets behind them but in the long run they have to establish a commercial relationship with a bank,” enabling them to borrow and retail bank deposits, he says. However, the status of the credit companies remains ambiguous: they are not banks, and so not formally recognised by the China Banking Regulatory Commission, and this makes it difficult for them to enter the inter-bank market.

Nevertheless, Giehler is confident that the companies are significantly expanding the availability of credit to small and medium entrepreneurs who previously borrowed in the informal sector. The loans, he says, are larger than “micro” (which is generally defined as a maximum loan size of no more than 70% of an area’s GDP per capita). But, Giehler stresses, effective microfinance delivery requires good, well-trained credit officers who are able to analyse the creditworthiness of clients, based on assessments of character and the credibility of business plans rather than on collateral. The new credit companies have not yet received this kind of training input, but this year GTZ will be working closely with two of them to develop these skills, as well as good information systems, institutional discipline and marketing of loan products.

Still, there is not yet enough competition in marketplace to satisfy the World Bank’s Wang Jun. “It is not enough just to create a crop [of credit companies] and let it go,” he says. “It’s like a franchise, creating a new kind of monopoly, so the incumbents have no incentive to continuously improve their products and efficiency.”

New socialist banking

Meanwhile, 2006 saw China’s central government promise to create a “new socialist countryside” while, on the global stage, a Nobel Prize was conferred upon Mohammed Yunnus, celebrated founder of Bangladesh’s Grameen Bank, who visited Beijing in October.

These developments seem to have spurred the China Banking Regulatory Commission (CBRC) to issue, on December 22 2006, “Proposals on Adjusting and Relaxing Market-Entry Policies for Banking Institutions in Rural Areas to Support the Construction of the New Socialist Countryside.”

These encourage private investments in rural banks and set low registered capital thresholds: CNY 3 million for establishing county-level banks, and CNY 1 million for establishing banks at township (乡) and rural town (镇) level. The proposals also
allow credit cooperatives to be set up at township/town level with registered capital of CNY 300,000, and credit cooperatives to be set up at administrative village level with registered capital of CNY 100,000.

In February, the CBRC announced that the new rules would be piloted in 33 counties spread across six provinces. Before the month’s end the first “village bank,” the Yilong Huimin County Bank, opened for business in Yilong County, Sichuan. According to a China Daily report (February 28), this is “the smallest bank in China, with only 10 staff and two counters,” at which “Farmers can get loans of up to 20,000 yuan without guarantee, while small enterprises or farmers engaged in special areas can obtain loans of up to 100,000 yuan.”

Yet this is not yet quite the wide, financial opening that it might appear. Under the new rules, established banks must hold at least a 20% stake in the new “village banks,” and each private investor is limited to a maximum stake of 10%. (The Nanchong City Commercial Bank has a 50% stake in Yilong County’s new “village bank” and five private investors hold 10% each.)

There seems to be no shortage of private investors willing to enter the market. Wang Jun reports that he has already had numerous enquiries from Chinese entrepreneurs who sense “a once in a lifetime chance to become bankers.”

But most experts question whether commercial banks that have shown little prior interest in the rural finance market will now regard this as an opportunity. Yet, Tang Min points out, “The government is concerned that if anyone is allowed to go in [to village banking] there may be incompetence—so for risk management, they want some experts in there.” This, he believes, is why the CBRC is insisting on the involvement of existing financial institutions.

Du Xiaoshan questions whether the CBRC will itself be able to take on the burden of supervising a new batch of institutions. “Each county office has only three staff, how can they oversee many institutions? This is a fairly serious problem,” he says.

Peter Situ wonders whether the new banks will be able to flourish in markets that are limited to a single township or county. “It might be fine just for basic village banking needs,” he says, but points out that much of China’s rural population is now mobile, and so would find it more useful to bank with an institution that has outlets and can offer services outside of their home area. “I can’t imagine villagers wanting it [‘village banks’] unless the CBRC integrates [the new institutions] into a network.” The rural banks, he suggests, would be more viable if they were able to operate at least at prefectural level, covering several counties.

The jury is still out, meanwhile, on the CBRC’s decision, on December 31, 2006, to license the China Post Office Bank.

With a national network of some 36,000 branches—two thirds of them at county level or below—and with experience in dealing with rural depositors, the Post Office is theoretically well-placed to begin delivering credit. But, given the difficulties of profitably serving rural populations, will it want to? The political call to serve rural people may stimulate it to try—for this is, after all, another state owned bank. But it has no experience as a lender and it will be a momentous task to develop the skills necessary to lend successfully on a significant scale.

“Now everything is possible”

Nevertheless, expert opinion is broadly positive about the new experiments in rural finance.

They are, after all, pilots, that it should be possible to learn from and adapt. Moreover, they show a general willingness to liberalise and diversify rural financial markets; a recognition, as Tang Min says, that “We cannot put all the eggs in one basket; more institutions and greater competition will be helpful.”

Moreover, Thorsten Giehler points out, the CBRC move implicitly endorses the experiment in “credit only” companies, suggesting a more open minded policy atmosphere in which “now everything is possible.”

Also drawing some comfort from the new initiatives are a few dozen proto microfinance institutions that have grown out of projects sponsored by UN agencies, NGOs and Chinese agencies such as the Womens Federation and China Foundation for Poverty Alleviation.

Du Xiaoshan, whose “Funding the Poor Cooperative” is a prominent example, sheltering under the Chinese Academy of Social Sciences’ Rural Development Institute, says there are now around 100 of these proto-institutions, many of which are now members of a China Microfinance Association established in 2003. They typically target the poor, especially women, and have been important in introducing international microfinance concepts to China—even though many observers believe that “Grameen style” lending is not practicable in China’s remote, rural areas, which differ so much from Bangladesh.

The Chinese mircofinanciers have grown up in a legal limbo, unrecognised by the CBRC, which regards them as non-banking institutions and therefore outside the regulator’s jurisdiction. They are not allowed to accept deposits or to borrow from banks, so invariably face problems of replenishing loan capital, and struggle to achieve financial sustainability in the small and diffuse markets they serve.

Despite these adverse conditions, Du says, about ten per cent of the proto institutions have grown modestly, while the majority have managed to survive without significant growth. He believes that most would be able to flourish if they had more access to capital.

For Du, the good news is that the CBRC “hasn’t told us to close our doors.” He reads this as permission to continue the “experiments” and is hopeful that a more pro-rural policy environment will lead to more policy support—notably, regulations to give a legal identity to non-profit microfinanciers and enable them to access funds from “wholesalers” of capital.

Du would also like to see a lower registered capital threshold for farmers’ credit cooperatives to form, and permission for them to create county-level associations of cooperatives, in order to share knowledge and training resources and also to access finance wholesalers.

Germany’s KFW is meanwhile supporting the China Development Dank to develop a microfinance wholesale facility, with two commercial city banks acting as retailers who will develop microcredit portfolios in urban areas. The China Development Bank has also committed 100 million RMB to China Foundation for Poverty Alleviation.

If government is “joined up”

But in this more open, experimental atmosphere the possibilities may include more muddle.

Tang Min points out that “China has had no lack of failure in financial reform before.” He cites earlier efforts to stimulate urban credit cooperatives and “rural financial foundations,” concluding that “In the end there were a lot of problems. The rural financial foundations—a big failure. So caution is very necessary.”

So too are harmonisation of policy initiatives and reconciliation of institutional interests—areas which China often finds hard to achieve.

The China Banking Regulatory Commission was established in 2003, in a move to separate the functions of financial regulator and central bank, both of which had previously been carried by the Peoples Bank of China.

Anomalously, the CBRC at that time also took over responsibility for the RCCs, and some observers suggest that this created a disincentive for measures to introduce rural competitors. It was the PBC, therefore, which took the lead in creating the “credit only” companies.

It is clearly essential that the PBC and CBRC work together, along with other key government agencies, in shaping future policy for rural finance. The future of RCCs, for example, remains a critically important issue. Will they simply wither away as they are steadily displaced by institutions—whether for-profit, non-profit, or genuinely cooperative—that have more effective reach, and the will to reach, to unserved constituencies? Or should a concerted effort be made to restructure some of them? Concerted—or, one might say, “harmonious”—policy responses are needed here.