China's Banking Reform: An Assessment of its Evolution and Possible Impact

The Chinese banking system, characterized by massive government intervention, poor asset quality and low capitalization, has started a reform process based on the three main pillars: (i) bank restructuring, through the cleaning-up of non-performing loans (NPLs) and public capital injections, particularly in the four largest state-owned banks; (ii) financial liberalization, with the gradual flexibilization of quantity and price controls, the opening-up to foreign competition and cautious steps towards capital account liberalization and (iii) strengthened financial regulation and supervision, coupled with efforts to improve corporate governance and transparency. Although the reform is still ongoing, our preliminary assessment indicates that there has been an improvement in the soundness of the Chinese banking system. However, changes in the reform strategy are needed for it to be fully successful. Asset quality has improved, particularly in the recapitalized banks, but there is a high risk of a new build-up of NPLs. Capitalization has increased in the largest banks, as a consequence of the government capital injections, which generally remains low, as well as profitability. China's huge financing needs, to maintain high economic growth, and its commitment to fully open up its banking system to foreign competition urgently require a more comprehensive and time-bound strategy, with a long-term vision of the desired structure of the Chinese banking system. Bank recapitalization should be completed immediately, not only to ensure bank soundness, but also to increase profitability, which could be further hampered as the competition increases with full financial liberalization. Bank recapitalization, however, needs to be accompanied by a radical improvement in corporate governance, which would clearly be facilitated by a change in the property structure. (JEL classification: E44, E66, G2, G21) Copyright 2006, Oxford University Press.