Chinese Reform Picks Up Speed

Beijing is making smart moves, but bad loans are still a big problem

Something extraordinary appears to be happening inside the Chinese government. While Beijing has long paid lip service to the notion of cleaning up its banks and stock markets, until recently the central authorities have been too busy fixing state-owned companies and unshackling private enterprise to turn their attention to the financial sector. Now, the regime seems poised to overhaul the financial system -- the faster the better. Need evidence? Just consider the initiatives announced in the past month:

On Feb. 4, the all-powerful State Council called for broad changes, from trading state-held shares in companies to liberating investment rules for pension funds. A week later, the central bank renewed talk of a partial revaluation of the yuan. Then Britain's HSBC Holdings PLC (HBC ) got permission to underwrite domestic bond issues -- the first foreign bank allowed in the market. On Feb. 20, China Construction Bank announced plans to peddle $506 million in assets seized as collateral from deadbeat borrowers. At month's end, Hong Kong banks got the green light to accept deposits in yuan, a key step in making China's currency convertible.

Whew. "This is a really fast pace of reform," says Nicole Yuen, head of China equities at Swiss bank UBS in Hong Kong and the only non-mainlander to sit on the China Securities Regulatory Commission. And February's flurry is just part of the program. January was also chock-a-block with ambitious announcements, and financial reform is likely to top the agenda at the annual National People's Congress, opening Mar. 5 in Beijing.

The big question: Why have the Chinese suddenly decided to put the pedal to the metal? The answer is part comforting, part scary. The comforting part: Authorities seem genuinely determined to create a real financial system, one that raises capital efficiently and directs it to the best companies. The scary part: The renewed focus on finance is an indication that Beijing believes the country's problems with dud loans and ballooning credit are getting out of control -- and is frantically trying to fix things before it's too late.

One big hint of the rising level of concern: On Feb. 10, Premier Wen Jiabao told top financial officials at an annual conclave that "there are many problems and pitfalls in the finance system" that need correcting. Sure, everyone who follows China knows that its banks have long been used as macro-piggybanks for any project authorities wanted. The point, says China watcher Nicholas R. Lardy of the Institute for International Economics in Washington, is that Wen is finally confronting the problem after a year of concentrating on other issues, such as the SARS epidemic. "Finally we have seen a sea change," Lardy says.

A SURGE OF DUBIOUS LENDING. With the leadership otherwise occupied, banks kept piling up new loans. Lending last year hit $350 billion -- up 21% from 2002. And the money supply grew almost 20% in 2003, when the target growth rate was 16%. The result has been a surge in economic activity -- much of it investment in projects of dubious value. Some observers fear that many of those new loans will go bad, and that's the last thing Beijing needs. After years of state-directed lending, China is buried in a mountain of bad debt. Standard & Poor's estimates that China's bum loans already total $860 billion.

At the same time, China's booming trade surplus has flooded the country with cash. In mature economies, central banks typically mop up such excess liquidity by selling bonds to banks; money spent on state bonds can't be loaned to enterprises. But China's bond market is still underdeveloped. And since interest rates in China aren't set by the market, the central bank has only "blunt tools" to use, says Ping Chew, director of sovereign ratings at S&P in Singapore.

Wen & Co. have clearly decided it's time to accelerate those reforms. Officials late last year started to clamp down on credits to hot-growth industries such as steel, autos, and real estate to prevent overinvestment. This recalls the tried-and-true methods of earlier regimes: Cut them off, and they won't grow. But longer term, the country's mandarins realize they need a system that can sort out on its own who deserves capital. And this should happen before 2006, when World Trade Organization rules mandate that China grant foreign banks full privileges. "The government is really feeling the pressure to get things going in the runup to 2006," says Joan Zheng, China economist at J.P. Morgan Chase & Co. (JPM ) in Hong Kong. Also, the current system overemphasizes bank finance, and companies need access to funding options such as stock and bond offerings.

TOUGHER FLOATING. This requires a massive overhaul, and that's why Beijing is suddenly moving on all fronts. CCB and Bank of China, for instance, are being prepared for global listings. When those stocks are traded, the government hopes, investors will pressure banks to clean up their tattered loan books and improve lending practices. Allowing foreign investors greater access to China's stock markets is also expected to force tougher standards on Chinese companies that want to float their shares. The state will also release its massive reserve of shares in hundreds of companies and allow them to be traded -- a key step in getting the government out of business.

Finally, a gradual rise in the value of the yuan should boost export costs and stem the flow of money into the country. That would dry up one source of speculative capital. On the other side of the ledger, an eventual move to convertibility of the yuan would make it possible for Chinese to invest in securities abroad -- and reduce the likelihood that those funds will be thrown at questionable investments at home.

The outlines of the plan are getting clearer every day. Execution, obviously, is another matter. UBS' Yuen points out that China's labyrinthine bureaucracy is certain to slow things down. For instance, one proposed reform -- expanding the range of investments that insurers can make -- requires approval from several different regulatory bodies. "This is still China, after all," she says.

The problem of the banks' bad debts is an even bigger challenge. In December, Huarong Asset Management Co., the outfit that holds the nonperforming assets of Industrial & Commercial Bank of China, held an auction -- and only 3 of 22 bundles of loans on offer were purchased. "The assets were lousy," says a distressed-debt dealer at a foreign investment bank. "It's fair to say that everybody is frustrated with the pace."

It's also fair to say that Beijing is picking up the pace. Complete reform of the financial system? Unlikely. Still, important things could get done as Wen brings all the power of the government to bear.

By Frederik Balfour in Hong Kong

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