Dong Fu

English

Research Papers in Economics

guarantee on deposits. Aside from the
applicability of this guarantee to any bank,
the four SCBs are perhaps even less
likely to be closed, owing to a dictum
common in many countries. That is, some
banks are viewed as “too big to fail.”
There is, however, another less dis-
cussed reason why Chinese banks have
not faced runs by depositors. The reason
is capital controls. These controls largely
prohibit Chinese citizens from investing
overseas. With China’s high domestic
savings rate (as much as 40 percent by
some estimates) and the relative scarce-
ness of alternative financial vehicles such
as stocks and bonds, opportunities for
purchasing financial assets other than
bank deposits are highly limited. 
Financial Liberalization Puts
Increasing Pressure on 
Capital Controls
In line with its World Trade Organi-
zation (WTO) commitment, China has
gradually opened its domestic banking
and financial sector to foreigners.
2 By
October 2004, 62 foreign banks were
operating in China. These institutions
account for only 1.8 percent of total
banking assets. However, with an aver-
27.1 percent of GDP. China’s banking
sector is dominated by just four state-
owned commercial banks (SCBs) that
account for 54 percent of China’s total
bank assets and liabilities (Chart 1).
In terms of total assets, all four SCBs
rank among the world’s 40 largest.
Quantity, however, does not mean qual-
ity. These banks have proved inefficient
in allocating funds to China’s economy.
All four have low profitability. Moreover,
the size of their bad-loan portfolios has
been among the world’s largest. 
Capital Controls Are Crucial 
to Banking Stability
Although appearances and reality
can differ sometimes in Chinese bank-
ing, even the appearances look prob-
lematic. The latest official data show the
average ratio of nonperforming loans to
total loans for China’s big four banks as
15 percent in first quarter 2005, down
from 20 percent at the end of 2003 (Table
1).
1 While these ratios are well above
those in most countries, private estimates
have placed total Chinese impaired loans
(including those already taken over by
the government in trade for bonds) in
the range of 50 percent of bank assets. 
There are questions about the ade-
quacy of the capitalization of the four
big banks. The China Banking Regulatory
Commission requires all banks to meet
the minimum capital adequacy ratio of 8
percent, consistent with the Basel I inter-
national standard, by January 2007. At
the end of 2003, the average capital ade-
quacy ratio was only 4.6 percent for the
four SCBs. This ratio was calculated with
the knowledge that existing nonperform-
ing loans were not provisioned for suffi-
ciently. 
Although they are technically bank-
rupt, none of China’s state-owned banks
has ever faced a bank run or closure. An
often cited reason is that even though
China has no official deposit insurance
system, there is an implicit government
Beyond the Border
ntil very recently, the two
salient features of China’s for-
eign exchange regime had
been capital controls and the de facto
peg to the U.S. dollar. On July 21,
China’s central bank—the People’s Bank
of China—changed the dollar peg to a
basket peg based on a number of undis-
closed foreign currencies. It also allowed
a simultaneous 2 percent appreciation of
the Chinese currency against the U.S.
dollar, from 8.28 yuan to 8.11 yuan per
dollar.
Meanwhile, despite gradual loosen-
ing, capital controls are still largely in
effect. These features of the Chinese for-
eign exchange regime carry important
implications for government efforts to
resolve China’s ongoing banking prob-
lems and to maintain the nation’s finan-
cial stability. 
Banks Play the Central Role in
Financial Intermediation in China
At the end of 2004, total bank
deposits stood at 185.5 percent of
GDP—with total bank loans at 138.1
percent. In comparison, the combined
market capitalization of the Shanghai
and Shenzhen stock exchanges was only
U
Foreign Exchange Policy and Banking Reform in China
Chinese Banking Sector in Terms
of Assets
(Percent, 2004 data)
Chart 1
SOURCE: China Banking Regulatory Commission.
26% 
Urban
commercial
banks 
Joint-stock
commercial
banks 
53.7% 
14.9%
5.4%
Four
state-owned
commercial
banks
Other
Table 1
Recent Changes in
Nonperforming Loan
Condition in the Four SCBs
Nonperforming Nonperforming
loan ratio loans
(percent) (billion yuan)
2003:Q4 20.0 —   
2004:Q1 19.2 1,889.8
2004:Q2 15.6 1,523.1
2004:Q3 15.7 1,559.6
2004:Q4 15.6 1,575.1
2005:Q1 15.0 1,567.1
SOURCE: China Banking Regulatory Commission.
FEDERAL RESERVE BANK OF DALLAS   SOUTHWEST ECONOMY   JULY/AUGUST 2005 16Even though Chinese
banks’ nonperforming
loan ratios have fallen 
as a result of government
intervention and the 
two newly restructured
state-owned banks’
financial footings have
strengthened significantly,
China’s domestic banks
have far to go before they
are viable.
age nonperforming loan ratio of only 1.3
percent, they are substantially more sol-
vent than China’s four SCBs. 
Foreign banks differ markedly from
Chinese banks in other ways as well.
Government rules for Chinese banks
largely restrict them to the most tradi-
tional functions of commercial banking.
In contrast, many of the foreign institu-
tions are so-called universal banks.
These foreign institutions not only carry
on the traditional functions conducted
by China’s state-owned banks, but also
engage in investment banking, securities
and insurance operations. The foreign
institutions have global opportunities for
funding. China’s fragmented financial
regulatory system, which includes com-
pletely separate organizations for bank-
ing, securities and insurance, is poorly
equipped to deal with universal banks. 
Moreover, despite China’s WTO-
linked openings to foreign financial insti-
tutions, the Chinese government still
makes efforts to control capital flows. In
2004, the Chinese government announced
a new rule under which foreign banks
have to apply in advance for quotas for
offshore borrowing. 
What If China Removed
Capital Controls Completely?
China has recently adopted mea-
sures to permit more flexible capital
flows in response to increasing pressures
on its currency. But there is much evi-
dence that China continues to be con-
cerned not only about capital inflows
but also about capital outflows. Creating
opportunities for Chinese citizens to
invest abroad could lead to outflows of
deposits from China’s already troubled
commercial banks.
A few days before China’s central
bank  announced its new exchange rate
regime, the government announced that
Chinese multinationals would be permit-
ted to acquire more foreign currency and
lend the foreign currency to their sub-
sidiaries. The new rules still limit the
ability of Chinese to place their money
abroad. However, if large outflows were
to take place, Chinese banks that now
rely on the government to preserve their
captive deposit markets would have
much more difficulty in stanching fund
outflows that would erode the balance
between assets and liabilities.
China’s Policy Priority Lies 
in Bank Recapitalization 
and Privatization 
On Dec. 31, 2003, the Chinese gov-
ernment conducted the third large-scale
bank bailout in six years. The two previ-
ous bailouts had involved procedures
that are standard across the world—the
injection of domestic-currency-denomi-
nated capital and an exchange with the
government of bad assets (impaired
loans) for good assets (government secu-
rities).
3
As part of the third bailout, however,
the government injected $45 billion of
foreign-currency-denominated reserve
assets (dollar- and other currency-
denominated bonds) to two SCBs—the
Bank of China and China Construction
Bank.
4 The two banks have since been
restructured into joint-stock companies,
and they are planning an initial public
offering both domestically and overseas
in an effort to diversify ownership and
privatize, at least partially.
Even though Chinese banks’ non-
performing loan ratios have fallen as a re-
sult of government intervention and the
two newly restructured state-owned
banks’ financial footings have strength-
ened significantly, China’s domestic banks
have far to go before they are viable.
Thus, the government’s motivations to use
capital controls to preserve a captive
domestic deposit base remain strong.
China’s Exchange Rate Question
The majority of recent disputes over
China’s foreign exchange rate have
involved China’s trade balance. Although
China’s overall current account surplus is
small by Asian standards, its large surplus
with the United States and other indus-
trialized countries has ignited complaints
that an undervalued Chinese currency
bestows an unfair advantage on Chinese
exporters. China’s latest move to let its
currency appreciate 2 percent against the
U.S. dollar and the simultaneous change
from a dollar peg to a basket peg are 
at least partly aimed at addressing the
trade problem. Decisions about China’s
exchange rate regime are driven by fac-
tors other than the trade balance, in par-
ticular, the health of the banking system. 
China’s still-fragile banking condi-
tions are likely to continue to motivate
exchange rate intervention even under
FEDERAL RESERVE BANK OF DALLAS   SOUTHWEST ECONOMY   JULY/AUGUST 2005 17the new basket peg system. So far, three
of China’s big four banks have received
bailouts involving the exchange of bad
loans for dollar- and other foreign-cur-
rency-denominated bonds.
5 The Chinese
currency’s appreciation means a reduc-
tion in the value of these foreign-cur-
rency-denominated assets relative to the
banks’ Chinese-currency-denominated
liabilities and an accompanying move
back in the direction of insolvency. The
2 percent appreciation on July 21 may
not have a severe impact immediately in
this regard. However, if it leads to further
appreciation, there would be a more sig-
nificant impact on the current bank
reform plan.  
Conclusion 
The current debate on the Chinese
currency involves two related but sepa-
rate issues that have often been con-
fused. One is capital controls, and the
other is the exchange rate at which the
Chinese currency is pegged, whether to
the dollar or to a basket of foreign cur-
rencies.
The debate has largely focused on
trade effects. Banking conditions and
bank reform in China provide an alter-
native perspective in analyzing the coun-
try’s foreign exchange policy. China’s lat-
est move from a de facto dollar peg to a
basket peg, together with a simultaneous
2 percent appreciation of its currency
against the U.S. dollar, represents a
major step toward a more flexible for-
eign exchange policy.
Meanwhile, combined with the loos-
ening of capital controls, this new basket
peg adds an increasing urgency for
China to resolve its banking problem. In
fact, the quicker the banking problem is
resolved, the sooner a more flexible for-
eign exchange policy can truly material-
ize in China.
—Dong Fu
Fu is an assistant economist in the
Research Department of the Federal
Reserve Bank of Dallas.
Notes
The author would like to thank Bill Gruben for helpful discussions and
suggestions.
1 There are widespread disputes on the actual figure for nonperforming
loans. Historically, Chinese banks used a four-tier loan classification
system, which tended to underreport nonperforming loans. In 2002,
they started to migrate to a five-tier classification system, which is
more in line with the international standard.  
2 Foreign banks can now engage in foreign currency transactions with
all clients and with no geographical restriction. By July 2004, their
share of foreign currency loans rose to 17.8 percent. So far, foreign
banks have conducted business in Chinese currency with Chinese
companies in 18 cities. At the end of 2006, foreign banks will be able
to operate freely in China.
3 In 1998, the four SCBs received a capital injection of 270 billion yuan.
In 1999–2000, four asset-management companies were set up and
purchased 1.4 trillion yuan of nonperforming loans at book value from
the four SCBs and one government policy bank.
4 However, for the time being, the banks are not allowed to sell the for-
eign reserve assets. 
5 In April 2005, the Industrial and Commercial Bank of China—the
largest of the four SCBs—received a $15 billion capital injection of
foreign reserve assets.
FEDERAL RESERVE BANK OF DALLAS   SOUTHWEST ECONOMY   JULY/AUGUST 2005 18
Combined with 
the loosening of 
capital controls,
this new basket
peg adds an
increasing urgency 
for China to resolve 
its banking problem.

Foreign exchange policy and banking reform in China

http://dallasfed.org/assets/documents/research/swe/2005/swe0504d.pdf

Foreign exchange policy and banking reform in China

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics