Chapter 11
Opening Up the Banking Sector in China: Progress, Barriers, and Further Steps

Yang Siqun

INTRODUCTION
THE FINANCIAL SECTOR IN CHINA
BARRIERS TO THE OPENING UP OF FINANCIAL SERVICES
THE ROLE OF FOREIGN FINANCIAL INSTITUTIONS
STRATEGIES OF THE FOREIGN BANKS IN CHINA
THE BENEFITS AND RISKS OF OPENING UP FINANCIAL SERVICES
OPENING UP THE BANKING SECTOR AND FINANCIAL MARKETS: A STRATEGY
SEQUENCING FINANCIAL LIBERALIZATION
CONCLUSION
References

INTRODUCTION

As a result of the Uruguay Round, members of the World Trade Organization (WTO) are committed to initiating liberalization, including the opening up of financial services, which have grown significantly in the last two decades as a result of financial deregulation, new telecommunications technology, financial innovation, and global financial integration. According to the agreements reached at the Uruguay Round, members are obliged to open up their financial services markets to foreign suppliers, in the areas of banking, insurance, portfolio management, and financial lending. However, many developing countries have been slow to open up their financial services markets. Some claim that they have comparative and competitive disadvantages in this area. Others argue that they must first reform their domestic financial sectors, as they are afraid of losing their independence with regard to financial policies. China has been hesitant to open up its financial services sector for some time. After completing agreements with the United States, the European Union, and other WTO members, China has stepped up the process of dismantling the barriers to its financial sector, especially in banking. This raises some important questions. What are the benefits and risks? What are the strategies of foreign banks once they have entered the Chinese market? Will foreign banks have a negative impact on domestic banks? Can the domestic banking sector survive in competition with foreign banks? What are suitable policies? What is the right sequence for liberalizing the financial sector?

This chapter will try to find some answers to the above questions. The conclusion is that opening up the financial services market will provide important opportunities for the domestic economy and, at the same time, will bring challenges for the banking sector as well as government policies. In general, the opening up of financial services will be beneficial for China in the long run. In the short run, however, there will be some

negative impacts, and even a crisis if the domestic sector cannot deal effectively with the problem of non-performing loans, set up sound supervision, and implement a suitable sequence of liberalization. In order to enjoy the benefits and reduce the potential costs, therefore, sound sequencing and a gradual approach are needed.

THE FINANCIAL SECTOR IN CHINA

The opening up of financial services in China began after the commencement of economic reforms. In 1979, Japan Export and Import Bank established the first representative office in Beijing. In 1982, Hong Kong Southern Commercial Bank set up the first branch of a foreign bank in Shenzhen. In 1985, the first joint-venture bank was established in Xiamen. As China continued to open up to the outside world, the liberalization of its financial services also accelerated in the 1990s. Foreign banks, property and life insurance companies, joint-venture investment banks and insurance brokers have all entered the Chinese market. By the end of December 2002, China had approved the setting up of 543 representative offices of foreign financial institutions, including 275 banks (accounting for 50.6 percent of the total number), 181 insurance companies (33.3 percent) and 58 investment banks (10.7 percent). At the same time, foreign financial institutions had established 275 operating institutions or branches in China, among which 191 were branches of 62 foreign banks, and 13 were foreign-funded headquarters or joint-equity banks. The others were insurance companies and investment banks (Figure 11.1).

Although several basic forms of financial services have been approved in China, and some of the barriers have been significantly reduced in recent years, the liberalization of financial services is quite strictly controlled. Barriers to financial services have existed for many years, and domestic and foreign suppliers are treated differently. There is also

discrimination in the services provided to domestic customers. The authorities prevent foreign financial firms from establishing branches and place various restrictions on their activities in China, such as on the number of branches they can set up and their locations, on the type of services they can provide, and on the type of customers. As far as local financial services are concerned, most foreign banks were initially not permitted to provide services involving renmimbi, and therefore were not allowed to accept savings deposits and provide services to individual customers. Thus, the basic forms of financial services were restricted.

The opening up of financial markets in China was implemented in both the coastal regions and inland areas, in financial businesses involving foreign currencies as well as renmimbi. Foreign capital investment was first promoted in the coastal areas and then introduced into inland areas. Foreign trade was concentrated in the eastern coastal areas and gradually moved to the inland cities and regions. Foreign trade and investment are playing an increasingly important role in the Chinese economy.

With the strict restrictions on foreign firms, their assets and liabilities structures are quite asymmetrical to those of the domestic banks, since they cannot access domestic sources of savings. Thus, funds from parent banks or from international financial markets form a dominant part of the liabilities of foreign banks operating in China. At the end of 1999, “Vostro Accounts” plus the working capital of foreign banks accounted for about 74.36 percent of their total liabilities and equities. The loans made by foreign banks have exceeded their deposits by a substantial margin. As a result of strict controls, their total financial assets account for only a small part of their total assets. As Figure 11.2 shows, there is a big gap between loans and deposits for foreign banks. Thus, foreign banks play a relatively small role in the Chinese financial sector.

BARRIERS TO THE OPENING UP OF FINANCIAL SERVICES

The restrictions on the opening up of financial services in China have existed for a long time. The reasons are similar to those of some developed countries whose financial liberalization has also not been completed. Knowing these reasons is important for understanding the position of the developing countries with regard to the liberalization of trade and the ways of dealing with possible negative effects when barriers are removed.

First, the developed countries enjoy a comparative advantage in the service industry. Many researchers have demonstrated that countries with an abundant supply of human capital have a comparative and competitive advantage in financial services (Moshiran, 1993).¹ Thus, one response of the developing countries is to protect their financial services industry. The reason that China insisted on joining the WTO as a developing country was that it would help protect its financial markets to some extent over a fixed period of time.

Secondly, even if China can accumulate physical and human capital, this would not necessarily translate to a substantial gain in the international financial industry where, traditionally, reputation plays an important role. “Nations differ markedly in their patterns of national competitive advantage in service industries, just as they do in manufacturing. (For example, Swiss firms are strong in banking,)” (Porter, 1990). Hence, it is difficult for even efficient new entrants in the market for international financial services to compete with well-established firms, especially when a large proportion of customers are not adequately equipped to differentiate between the products supplied by new and old firms. Therefore, even if China improves its comparative advantage in financial services, a developed country will have greater comparative and competitive advantages. This enforces the argument for protecting the industry in the developing country.

The two issues above suggest that the infant-industry argument is relevant for the financial services industry in China and explains why many domestic financial firms are reluctant to open up to foreign competition. Their fear is justified because internationally traded financial services employ sophisticated technology, intensive human and physical capital, and customer-bank relations.

Thirdly, the authorities sometimes regard the financial sector as a source of cheap funding for the public sector and the national budget. According to this argument, by letting foreign firms enter the market, the government's sources of funding will be jeopardized.

Fourthly, foreign banks are sometimes accused of concentrating their activities on short-term credit and market niches, which are usually directed toward financing trade

¹ Moshiran uses a cross-sectional analysis and argues that, as with manufactured goods, financial services are subject to the same underlying factors which give the OECD (Organization for Economic Cooperation and Development) countries a competitive edge against developing countries. His results show that with the advantage of size in the banks' international assets, physical and human capital, and the amount of R&D, developed countries are the main suppliers of international financial services, and developing countries may not benefit from the removal of some market barriers and imperfections. Claessens et al. (1998) found that the foreign banks of developed countries tend to have higher interest margins, profitability, and tax payments than domestic banks in the host countries. This shows that the developed countries also have a competitive advantage in banking.

and other services. According to Germidis and Michalet (1984), they are also accused of “cream skimming.” In China, the market share of foreign banks in international trading settlement (which is considered as a profitable business) is about 30–40 percent. In addition, it is thought that when the market is liberalized domestic banks would lose their best customers and most profitable businesses, which are essential if they are to implement structural reforms.

Finally, some argue that foreign-controlled banks might organize the domestic banking business in a fundamentally different (and less desirable) way than domestic banks. That is, the allocation of resources by foreign banks will be different from that of domestic banks and this, in turn, will lead to different patterns of economic development.

It is hard to establish whether the above arguments are valid. Indeed, it is difficult for most domestic financial firms to have a comparative or competitive advantage in financial services, even in the long run. It is also unrealistic to expect foreign financial firms to play the same role as domestic ones. However, when barriers against foreign banks are to be lifted, some factors need to be considered.

First are the costs and benefits. In the long run, the benefits of liberalizing financial markets are substantial. They include a more efficient system of allocating domestic and foreign savings, one of the core elements for improving the whole economy; the promotion of trade by reducing the cost of financial services; and a reduction in the government deficit in the long run (through a shift from social pension schemes to well-established insurance services). On the other hand, the loss of market share by domestic financial firms and other side-effects caused by liberalizing the financial markets should be considered together with these benefits.

Secondly, there is the need for a proper orientation and schedule for opening up the markets. The infant-industry argument may be valid where there are financial market imperfections and positive externalities from protection because of learning curve effects. However, this argument can only be valid when there is a proper orientation and schedule. Otherwise, entry barriers will not lead to competitiveness and will tend to become permanent.

Thirdly, most financial institutions with market-driven business strategies tend to establish market segments in which they have a competitive edge. Segmentation of financial markets exists not only in developing but also in developed countries. The entry of foreign banks may create new segments because of the different roles undertaken by them. The segmentation of the market based on cost competition as well as customer loyalty can be regarded as market specialization. In general, it cannot be assumed that market segmentation will have negative effects and undermine the stability of the financial system.

Finally, there is the issue of discipline. It is usually impossible for foreign banks to provide cheap funds for the government in the same way that domestic banks did in the early stages of the country's development. The competition they bring will undermine the original function of domestic banks, and thus the government, especially at the local level, will have tighter budget restrictions. However, this should not be used as a reason to

retain entry barriers since discipline and sound fiscal and monetary polices are the basis of any sustained development in an economy.

THE ROLE OF FOREIGN FINANCIAL INSTITUTIONS

Understanding the role of foreign financial institutions is very important in predicting the benefits and costs of opening up the domestic financial market. In order to get a minimum market share and to compensate for the lack of information compared with domestic competitors, foreign banks will use their management and market promotion skills in the host country to offer a different product and/or exploit cost advantages. In China's financial markets, where foreign banks are restricted to foreign currency and customer services for foreign-based enterprises and households, there is no evidence that high-tech methods have been used. However, in the most open financial businesses where competition has already been established, foreign firms are using the most advanced technology and know-how. Hence, in order to absorb the advanced technology and managerial know-how of foreign banks, opening up to competition may be a better way to proceed.

The traditional clients of foreign banks usually include multinational companies and clients in the home countries. These clients usually form their customer base since they have a strategic relationship with the service providers. This is probably one of the reasons why foreign banks enter new markets where they can tap traditional customers. As the output of foreign-funded enterprises accounts for an increasing share of China's GDP, it can be assumed that foreign banks with a sound customer base can exploit the economies of scale that these customers bring.

Foreign banks' lending activities also start with the best domestic customers, who are already experienced in international financial transactions, and whose financial accounting systems already meet international standards. They also often need advanced financial services that domestic competitors may not (yet) be able to provide. In China, lending to low-risk local customers is likely to grow when domestic funds become accessible to foreign banks, since they may have a lower cost of funding, charge lower interest rates, offer better services, and provide services (such as for international payments and foreign currency trade) that domestic banks cannot provide efficiently. This aspect of the foreign banks’ activities is controversial because they are often viewed as “stealing the best customers.” Such competition can make it very difficult for domestic banks to restructure their activities, and for this reason they often push for protection.

There are a wide range of investment activities that are virtually unheard of in the developing or transition economies. Local banks and other financial institutions have inadequate knowledge about them, or are prohibited from implementing them. Such activities include advisory services for mergers and acquisitions, for raising capital, for underwriting capital, and for money market instruments and securities markets. It can be expected that foreign banks and non-bank financial institutions will enter such activities.

Investment banking, fund management, and life insurance are underdeveloped in China because of the nascent status of China's equities market. These are China's “infant financial industries.” Some officials have argued that these markets should be protected for a period of time. However, a commitment to a gradual opening up and learning-by-doing or learning-by-competing may be a more reliable way to improve the domestic firms' competitiveness.

Apart from the customers referred to above, foreign banks are usually active in selected markets and avoid taking an active role in retail banking when they first enter a new market. The reason is that developing a network of branches is expensive and buying existing branches of domestic banks can be risky. A certain time lag will occur before information costs are reduced. During this time, the foreign banks' activities will be relatively lowkey. However, if the domestic firms fail to develop their products and services or improve their technology to provide services more efficiently, new entrants may well apply more advanced technology and managerial know-how, and if expensive branch networks are necessary, some foreign banks will develop them over the long term.²

Some government officials argue that foreign financial firms are motivated by profits in the global market and lack the commitment to local markets, especially when they are faced with obstacles in the foreign host country. Such behavior could disrupt local financial markets especially if foreign financial institutions are major players. The lack of full commitment is a legitimate problem but it may not be a serious one.

STRATEGIES OF THE FOREIGN BANKS IN CHINA

After foreign banks were allowed to undertake business dealing in renmimbi, their operational strategy did not change much. They typically took “following the customer” as their key strategy. Their customers are mainly foreign investment companies and big domestic companies. Because of their disadvantages in terms of the operational network, inadequate information, and lack of scale economies, foreign banks seldom provide financial services, especially loan services, to small and medium-sized enterprises and households. For their typical customer, they mainly provide foreign currency accounts, international payment services, export credit letters, and foreign currency loans. Some intermediary products, such as foreign currency swaps, forwards and futures, and foreign currency interest rate swaps, with which domestic banks have less experience or expertise, are also provided by the foreign banks, although trade volumes are small.

Foreign banks have also not changed their strategy in terms of market position and business catalogues. The balance sheet of all foreign banks in the last quarter of

² U.S. life insurance companies have developed a low salary, high incentive, and high rate of layoff sales system to sell its insurance policies, which can be recognized as a kind of inexpensive retail network. Citibank is developing a retail banking presence (through automated bank technology ATMs, credit cards, etc.) without building a network of branches.

2002 shows that their total renmimbi deposits are less than 7 percent of their total assets, and the savings accounts of households, which are the main source of funds for domestic banks, only accounted for 0.11 percent of the total assets of foreign banks. Compared with newly established domestic banks of the same age which operate in the wholesale market, the scale of deposits absorbed by foreign banks is relatively small (Table 11.1).

In terms of the relationship between the foreign banks and their parent banks, the funds flowing from headquarters or parent banks form one of the most important channels of resources. Although the percentage of net funds into foreign banks has fallen continuously in recent years, these funds are still very important for the operation of the banks. The capital account has not been liberalized in China but the foreign banks have become a channel for foreign capital to flow into China. Before the consolidation of China's money market in 1997, the performance of foreign banks depended mainly on capital inflows from parent banks and international capital markets, which accounted for more than 60 percent of the total assets of foreign banks on average, and 72 percent in 1997. Since then, the net volume of capital inflow has fallen. In 2001 it was just over 16 percent, which was lower than that in 1993. It may be that the foreign banks reduced their capital inflows after the Asian financial crisis and relied more heavily on the inter-bank money market in China to fund their activities.

In 2002, the average percentage of overseas assets and liabilities to total assets and liabilities of foreign banks in China was about 33.44 percent and 54.79 percent respectively (Table 11.2). This kind of funding is not available to domestic banks whose capital accounts are supervised more strictly by the authorities. The strategy of foreign banks to use their international network to manage their portfolios in China has created a channel between China's loan market and the international fund market. However, it may also be a challenge for the Chinese authorities to manage their foreign debt since the number of foreign banks has increased substantially and most of them can use their international financial networks to bypass control measures. This capital mobility may threaten the independence of monetary policy in China, particularly if China keeps its exchange rate fixed to the U.S. dollar.

Because of the lack of operational networks and channels to absorb domestic funds, especially household deposits, which constitute the main source of funds for domestic banks, foreign banks use the interbank market as the most important means of accessing domestic currency. This stabilizes the money market interest rate and helps develop the market. Before the arrival of foreign banks, the interbank market demand for funds was dominated by non-bank financial institutions, which tended to speculate in securities and real estate. As a result, in 1995 and 1996, there was some restructuring and consolidation of non-bank institutions leading to a sharp reduction in the number of such institutions. Trade volumes in the money market consequently fell substantially compared

with the total asset liquidity of the banks. The entry of foreign banks and their ability to engage in renmimbi business has provided the market with an active demand for funds which are less risky sources of loans to bank customers.

In conformity with the Basel Accord, the Chinese monetary authority requires that the capital ratio of foreign banks should be higher than 8 percent. In 2002, the paid-up capital of foreign banks accounted for an average of 10.86 percent of assets (Table 11.2). Since there is no problem of non-performing loans, the capital adequacy ratio of foreign banks is higher than that required by international standards. However, between 1996 and 1998 and in 2001, the percentage of paid-up capital to total assets fell below 8 percent (Table 11.3). In order to reduce the possibility of moral hazard for the branches of foreign banks in China, the required 8 percent capital adequacy ratio acts as a safeguard.

THE BENEFITS AND RISKS OF OPENING UP FINANCIAL SERVICES

Benefits

Removing trade barriers allows for specialization according to comparative advantage, forcing the formerly protected producers to improve their efficiency. Thus, opening up

bank services will improve the overall function of domestic financial systems. Furthermore, as bank services generally contribute to economic growth, their liberalization will be beneficial to the whole economy.

The empirical study by Levine (1996) has shown that there is a strong link between financial development and economic growth. Three specific benefits from liberalizing the banking sector can be identified. First, there is improvement in the efficiency of financial services as the entry of foreign banks and intensive competition from foreign suppliers stimulates domestic firms to reduce transaction costs, to improve corporate governance, to innovate, and to upgrade their technology.

For most banks in China, however, owing to market segmentation and imperfect market structures, competition usually does not stimulate innovation and technology upgrading. Since these improvements are costly and can be easily imitated by other competitors, domestic banks are not eager to implement them. However, when foreign banks enter the market, it forces domestic banks to do so. By imitating the technology and quality of their services, domestic firms may catch up and narrow the competitive gap. Carter and Dickinson (1992) suggest that the acquired technical and managerial know-how can be propagated throughout the service industry. Thus, banks in developing countries can benefit from the presence of foreign banks by building up new expertise.

The domestic banks are inefficient providers of many financial services and the entry of more efficient providers is needed. The new technology and services acquired from foreign banks enable the large domestic banks to exploit economies of scale. In addition, there is a need to consolidate the many small banks in order to improve efficiency. The entry of foreign banks may speed up this consolidation process.

Whether the entry of foreign banks will have negative effects on the efficiency of domestic banks is a relevant question for policymakers and researchers, particularly if it reduces the market share of domestic banks and thus their efficiency. In this study, the Malmquist efficiency index is used to test the efficiency of domestic banks from 1997 to 2001. The domestic banks were divided into three groups in terms of their assets, ownership, and business geography, including the so-called big four state-owned banks, twelve shareholder commercial banks, and forty city commercial banks. It was found that between 1997 and 2001, the average efficiency of domestic banks increased more than 22 percent and the standard deviation fell by 13 percent, which suggests that the entry of foreign banks did not have negative effects on the efficiency and stability of the domestic banks.

A second comparative advantage that foreign banks have is their worldwide networks. These ensure their ability to satisfy changing customer service requirements, and efficient financial services are usually recognized by multinational enterprises as necessary for them to carry out foreign direct investment, especially in developing countries. Recently, empirical evidence on this has started to accumulate. Bhattacharya (1993) examined the cases of Turkey, Pakistan, and South Korea and found that foreign banks helped to make foreign capital accessible to domestic projects. Pigott (1986) surveyed the experiences of nine Pacific Basin countries and found that foreign banks rely more on foreign borrowing than domestic banks. Almost a quarter of the foreign

banks' domestic loans come from international financial markets, or their home country, or the parent group. In China, the entry of foreign banks into the market has undoubtedly helped domestic enterprises to access international capital and foreign currency loans.

The third benefit lies in the improvements to the domestic financial infrastructure when the entry of foreign banks puts pressure on the authorities to improve the financial services infrastructure. This includes prudent supervision, regulations regarding market conduct and competition, and disclosure rules. The credibility of the rules and policies is also enhanced as there is strong pressure on the authorities to minimize the risk of policy reversals and to reduce systemic risks.

Potential Risks and Costs

While most of the benefits of liberalizing financial services can be realized in the long or medium term, and are easy to identify, the potential risks and costs are less clear. There are two reasons for this. First, as opening-up and deregulation are sometimes implemented in continuous steps within a short period of time, it is difficult to identify what the short-term impacts are and to what extent these impacts result from the opening up of financial services. Secondly, the initial conditions are quite different in many developing countries so that some impacts are hard to distinguish in some countries but are easier in others.

Opening up the banking sector to foreign suppliers may mean a loss of market share for the protected domestic banks initially, because of the scarcity of capital, and their less sophisticated technology and managerial know-how, their corporate governance is weaker, and they have more non-performing loans. In the case of China, however, because of the high rates of savings and GDP growth, the financial markets are expected to grow much larger over the next few decades, and thus well-managed domestic banks will still be able to increase the scale of their businesses. Moreover, since new technology and managerial know-how can be imitated easily, domestic banks can acquire these from locally based foreign firms, thus narrowing the gap with the foreign competitors. Domestic banks will therefore be disadvantaged only in the short term.

How much and how long will domestic banks incur losses, or how much potential risk and costs there will be, depends on whether they can implement institutional and structural reform efficiently. If China's domestic banks can be reformed and improved quickly, the risks and costs may not be very serious. The empirical evidence validates this point. For example, Claessens et al. (1998) found that the number of foreign banks in domestic markets is negatively correlated with the latter's profitability and overhead expenses. Leightner and Lovell (1998), using Malmquist growth and productivity indices for Thai banks during the period 1989–1994, found that total factor productivity had declined for local banks but increased for foreign banks in Thailand. Terell (1986), using aggregate accounting data for fourteen countries, found that those countries which allowed foreign banks to enter had lower gross interest margins, before-tax

profits, and operating costs (all scaled by the volume of business). There have also been some studies on the impact of financial market liberalization on regional barriers in the United States' banking industry. Bauer et al. (1993) found changes in productivity rates ranging between–3.55 percent and 0.16 percent from 1977 to 1988, the period when inter-state and inter-country restrictions were lifted, which is very similar to opening up local markets to cross-border suppliers. Using similar data and the same period of time, Humphrey (1993) found that productivity rates changed between–1.4 percent and–0.8 percent. Berg et al. (1992) found that productivity in Norwegian banks initially declined when liberalization took place but was followed by productivity growth during the period 1980–1989.

The possibility of losing monetary independence is one of the major problems developing countries face when they decide to open up their financial services to foreign financial institutions, especially the multinational banks of developed countries. This kind of hesitation is sometimes depicted as similar to eighteenth-century mercantilism. It presupposes that the foreign bank will base its business operations on a specified set of home country interests rather than follow a profit-maximizing strategy that will be in the best interest of the host country.

There is no empirical evidence to show that foreign entrants have adverse effects on a government's monetary policy. Claessens and Glaessner (1997) have argued that “most developed and some developing countries allow for free entry of financial service producers without any adverse effects on the conduct of monetary policy or soundness of the financial system.” They suggest that “at the opposite, in many countries, especially developing countries, foreign banks have proven to be a source of stable funding in the face of adverse shocks. In Argentina especially (where 22 percent of all bank assets are held by foreign banks) but also in Mexico in late 1994 and early 1995, the (then few) foreign banks were able to maintain access to offshore funding while domestic banks experienced strains.”

However, there are other aspects of financial market opening that need to be considered. First, opening financial markets is an important step in the integration with the world's financial markets, especially when a country has a large market share held by foreign banks and its currency can be exchanged freely. In this situation, the government usually does not have much room to carry out independent monetary and fiscal policies, even in the short run, since the reaction of foreign institutions may not be a favorable one. When a country has an asymmetric economic growth rate, or economic cycle, and irregular interest rate fluctuations with its main business partners, an adjustment in monetary and fiscal policies may cause unexpected reactions from foreign financial firms since they may have more flexibility to implement their strategies. It may be unreasonable to assume that the behavior of domestic banks is more acceptable. However, the multinational foreign banks, which pursue maximum profit and allocate assets globally, may take different decisions from those of domestic financial institutions, which target profit maximization in the domestic market. It is difficult to test this empirically, not only because there is not enough data, but also because there is no suitable methodology to judge whether domestic firms behave more favorably in respect of government policies.

OPENING UP THE BANKING SECTOR AND FINANCIAL MARKETS: A STRATEGY

Before 1999 there were no clear plans for opening up China's banking sector and financial markets. Yet, when China and the United States reached agreement on the former's entry into the WTO, China had an implicit strategy that would protect the domestic sector and open up its financial services gradually, beginning with a segmented market (segmented by business, region, and customers). The basic strategy has not changed although there is a subtle difference. The key aim now is to follow a clear schedule to open up the market and to reduce protection, putting pressure on the domestic sector to improve its performance and then to open up according to WTO commitments. If this strategy is successful and domestic firms improve their performance within the given time-frame (about five years), domestic firms will not lose much market share. Clearly, this way of reasoning is based on the learning curve theory. The learning curve effect can only be valid when the domestic sector is assured that protection will be eliminated within a given period, and the effects of liberalization can only be realized when domestic firms do their best to improve their performance within the time allowed. The technology and managerial know-how of the financial sector can be improved quickly by “learning by doing” or “learning by competing.” However, the domestic banking sector needs to solve the burden of accumulated non-performing loans and, more importantly, to stop these loans from increasing.

SEQUENCING FINANCIAL LIBERALIZATION

Internal and External Financial Liberalization

Financial liberalization comprises two main parts: internal and external. For most developing countries, both parts of the financial system need to be reformed. The objectives are to improve efficiency and competitiveness. Sometimes, internal and external liberalization can be implemented reciprocally; however, in some situations liberalization which is not carefully thought out on one side, especially the external side, may be harmful to the other. There are many examples where ill-prepared liberalization has led to instability and crises. The lessons from Latin America in the 1970s and 1980s and from Southeast Asia in recent years indicate that financial liberalization needs to be carefully sequenced.

China's opening-up policies are based on external liberalization, but without internal liberalization, foreign competitors may find it difficult to exploit their competitive advantage in technology and managerial know-how. Ill-prepared or ill-timed internal liberalization may wipe out the benefits and enlarge the costs. For example, in a highly segmented market with interest rate and credit ceilings, foreign banks may not be able to use their advanced technology to full advantage. Furthermore, if China proceeds with

external liberalization within a short time-span by opening up the capital market and shifting to a convertible currency without implementing a sound supervisory and regulatory framework, the financial system may be thrown into chaos. This will be a loss-loss situation for both domestic and foreign banks.

For many developing countries, the scope and the cost of the 1997–1998 financial crisis have been enormous. Honohan (1996) has found that the poorer countries tend to bear higher costs from the crises as a share of GDP. Caprio and Klingebiel (1996), Honohan (1996), and Goldstein and Turner (1996), have also showed that the banking crises in developing or emerging market economies have incurred high fiscal costs, often 10–20 percent of GDP. Although many factors, especially internal ones, can cause financial crises in developing countries and there are no strong links between financial crises and external financial liberalization, the experiences of Latin American and Southeast Asian countries show that unrestrained external liberalization without planned or synchronized internal liberalization may have damaging consequences for the whole financial sector, and even the entire economy.

Sequencing Financial Liberalization

The vast literature on the sequencing of financial liberalization does not offer a single prescription for China. Yet, following the lessons of the Asian financial crisis, it is widely accepted that the domestic financial sector should be liberalized only after the domestic real sector is reformed, and that controls on capital movements should be maintained until domestic financial institutions have been liberalized.³ Wahba and Mohieldin (1998) investigated the experience of developing countries and suggest that the optimal liberalization process is a sequence starting with domestic real sector liberalization, followed by trade liberalization, then financial liberalization, and finally capital account liberalization. In practice, developing countries have followed many different sequences. As the initial conditions under which they open their financial markets are quite different, perhaps it is not always necessary to follow the optimal sequence strictly. However, two proposals are strongly recommended for China. First, the capital account should be the last in the sequence, and secondly, it would be better to carry out internal liberalization a little earlier than the opening of financial markets. One reason is that if capital controls were removed before internal financial liberalization, capital flight would be inevitable and its consequences could be very costly. Furthermore, if capital flows into a developing country that lacks an efficient and liberalized financial system, the foreign capital may be inefficiently allocated and systemic risk may arise, as it did during the Asian financial crisis.

Implementing internal liberalization before opening up financial services is the best choice for Chinese financial firms. In this way, China's WTO commitments pertaining

³ Greenaway and Morrisey (1993), Gibson and Tsakalotos (1994), Hanson (1994), and Williamson (1993), share the same idea.

to financial liberalization would be acceptable for all sides. Internal liberalization may improve the productivity of domestic financial firms in the medium term, reduce distortions, and improve the efficiency of the financial system. It may also push the domestic financial supply curve a little to the right so that there is less cost or risk from opening up.

Key Issues and the Sub-sequencing of Internal Reforms

There has been much discussion about how the domestic financial sector should deal with China's commitments to the WTO. There are some who think that domestic banks should be transformed from deposit banks to universal banks within a few years in order to compete with the foreign banks. This view may be based on a misunderstanding. Accordingly, foreign banks should follow the basic laws and regulations of their host countries. Thus, they cannot offer comprehensive services in China regardless of whether they are universal banks or simple deposit banks in their home countries. In fact, to transform domestic banks into those offering comprehensive services in the short term is a dangerous strategy for internal financial reform, since it will open almost all financial services to foreign banks, and this in turn would mean less time for the domestic banks to improve their efficiency. Hence, it may be better not to dismantle the “fire-proof wall” between banks, securities companies, insurance companies, and other financial firms, at least in the short term. A suitable policy may be to allow the different kinds of financial firms to cooperate to some extent, such as letting insurance companies sell their policies within the banks' networks, but not to allow them to offer comprehensive products themselves.

The raising of the capital adequacy ratio of domestic banks in recent years may be one key reform that can be continued. Claessens, Demirguc-Kunt, and Huizinga (1998) argue that the more capitalized the domestic banks are the better they are able to cope when financial markets open up. In recent years, the Chinese authorities have tried to increase the capital adequacy ratio by issuing special treasury bonds.⁴ However, since banking assets increase together with liabilities, it is impossible to keep track of the ratio this way. The realistic way for the state-owned banks to maintain capital adequacy may be to list the bank, or part of the bank, in domestic or foreign capital markets. This not only solves the capital adequacy problem, but may also improve the transparency and corporate governance of the bank.

As mentioned above, the increase in non-performing loans may be the biggest obstacle preventing domestic banks from competing with foreign financial institutions. If domestic financial firms can solve this problem, it would be a major step forward.

One of the important reasons why domestic banks can attract huge savings from households is that the government has a 100 percent deposit insurance scheme. This scheme is essential for the domestic banks, especially the big-four state-owned banks

⁴ In 1998, the government issued about RMB270 billion worth of treasury bonds to increase the capital of the “big four” state-owned banks.

to exploit their advantage in the retail banking network and to attract enough funds to restructure their assets. Hence, in the short run, it may be better to keep this scheme, at least for the big-four banks. Once the systemic risk arising from increasing non- performing loans has been eliminated, the deposit insurance scheme can be reconsidered.

Based on the experience of other developing countries and taking into account the issues discussed above, when China opens up its markets, a more detailed sequence may be needed, beginning with domestic real sector liberalization, followed by the first steps of trade liberalization, and reduction of tariff and non-tariff barriers. This can be followed by further steps in trade liberalization, with a convertible current account, internal financial liberalization to upgrade the legal and regulatory framework, elimination of credit controls, development of a security market, and improvement in corporate governance. Later, or at the same time, a clear schedule may be drawn to open up financial services and to increase the pressures for internal reforms. Subsequently, further internal financial reforms can take place, such as capitalization of state-owned banks, improvement in supervision, a reduction of non-performing loans, and a more flexible interest rate. Finally, financial services could be opened up in line with WTO commitments, followed by the harmonization of financial regulations, more flexibility in the exchange rate, and then capital account liberalization.

CONCLUSION

Although foreign financial firms have been allowed to engage in several basic financial services to varying degrees in China, discrimination against them has existed for a long time. Most foreign banks face constraints on the number of branches they can set up, their locations, and the customers they can supply. In general, the process of opening up the financial markets in China has been a gradual one, using the strategy of “following the customer.” As a result of strict controls on foreign banks, their total financial assets account for only a small portion of the total assets of banks in China. Moreover, foreign banks play an unimportant role in China's financial sector.

As it is the case in many other developing countries, foreign banks have similar characteristics: they have advanced technology and managerial know-how in their target markets; they provide financial services to traditional clients, lend to the best domestic customers, but at first have less interest in the retail network. Foreign financial firms entering China's financial markets will benefit the country in three ways: by improving the efficiency of financial services through competition; by making foreign capital and international financial markets more accessible; and by upgrading and improving the domestic financial infrastructure.

However, if the opening up of the financial markets is carried out too quickly and local conditions are not ready, there may be a high price to pay. Not only will local firms lose a substantial market share, but the entire economy may be destabilized as a result. Hence, it is essential to have a suitable strategy and sequencing of internal financial reforms before

opening up the market. Since China's current financial regime is imperfect in terms of technology innovation, internal control and supervision, and corporate governance, and since the problem of non-performing loans has not been solved, radical liberalization would endanger the domestic sector and the stability of the economy. Thus, it would be better for China to implement internal financial reforms before opening up the market and to have a well-prepared internal reform sequence, as suggested above.

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