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Monday, March 11, 2013

International Banking Risks in China

Back in 1970s, the implementation of various economic reforms was the focus of China. These reforms in turn resulted to a number of effects not only to the country itself but to other foreign countries as well. Before these reforms were implemented, China originally practices the command-type of economy where a significant portion of the Chinese economic outputs are regulated and distributed by the administration. The Chinese government used to be in charge of controlling market prices, establishing production objectives and allocating resources as well. While implementing this economic approach, China encountered several problems especially when the industrial period arrived. In order to cope with this period’s challenges, the country allocated large scale investments on its human and physical resources. Due to this movement, majority of the country’s industrial production was operated by state-owned enterprises (SOE); this however, prevented foreign investors and other private companies to operate in China. The purpose of letting the state own most of the economic resources is to prevent China from depending from foreign support, making the country self-sufficient. International trade was then limited to the importation of goods that was not available or produced in the country.

The constrictive Chinese policies however led to economic inactivity and inefficiency; there were limited profit incentives derived from both business and agricultural sectors. In addition, with this type of economic system, no competition was observed. As a result, progress was unattainable. This system also made the living standards in the country lower than other developing nations. The outcome of the traditional economic system then encouraged the Chinese government to come up with effective reforms that will augment the people’s living standards and the overall economic state. With the implementation of reforms, China’s major economic sectors naturally went through significant changes and development. While the reforms could have resulted to positive outcomes, certain risks are still likely to affect it and its neighboring countries. In this research, focus will be placed on the country’s financial sector, particularly on its foreign banking opportunities. The different risks involved in establishing foreign banks in the country as well as the ways on how to address them will also be highlighted in this discussion.

The Chinese Financial Sector
It was during the early 1980s when China first implemented reforms on its banking sector. This reform was focused mainly on the creation of four specialized banks separate from its central bank. The banks worked under monopolistic operations, concentrating the competition on acquiring more depositors. Eventually, bad loans started to affect the system, which resulted to quality deterioration of assets, excessive risk-taking and inflationary credit expansion (Cheng & Cheng, 1998). China then implemented new banking reforms in 1993. This time, the focus is on asset quality improvement, reestablishment of public confidence and development of genuine commercial banks. Though several analysts noted that the current Chinese banking status and general financial sector are still underdeveloped, the reforms had given the country several benefits like increased GDP and foreign direct investment. With these changes, international countries are very mush interested in putting up businesses like foreign banks in China. In addition, the country’s entry to the World Trade Organization (WTO) further increases the opportunity of foreign countries in accessing the large Chinese market. Nonetheless, analysts warn foreign investors of the different risks involved in establishing banks in the country.

Operational Risks
Among other types of risks, the operational aspect is perhaps the most complex as several factors (e.g. management, political, governance) are involved. One of the main operational risks that foreign investors can encounter in putting up banks in China is the problem on extensive administrative influence as well as the instability of regulations. As claimed by various foreign investors, the success of firms in China appears to be connected to government relations rather than to the market forces. Moreover, due to inadequate rules and regulation, problems such as investment misallocation, financial speculation as well as corruption had been rampant. International firms, particularly those in the west, usually encounter difficulty in operating in China due to lack of consistent laws. The improper enforcement of the contract as well as the lack of protection granted for intellectual properties are typical concerns as well (Morrison, 2005).
While banking entrepreneurs become attracted to the Chinese market economy, they must prepare themselves to various legal risks and issues. As pointed out earlier, the Chinese government has a significant authority over the country’s businesses. Policies and regulations applied in the Chinese business industry are subject to changes; hence, foreign entrepreneurs must be prepared to adjust. Considering that the country’s economic regulations and bureaucratic framework are still developing, changes are then inevitable (Humberg, 2003). The legal and regulatory aspects of the Chinese banking business are relatively unstable despite the reforms and developments conducted (Hu & Hope, 2005). Some legal practices in China are also different from the other common international practices. The issuance of a contract for instance, is a final matter in western cultures. However, contracts can change unexpectedly in China (Overby, 2000).

According to Hu and Hope (2005), the internal operations of Chinese banks are also problematic. The corporate governance of the country’s banks for example, is not very conducive for checks and balance systems. This problem is mainly rooted on the inadequacy of effective board members and independent directors. The banks’ culture on full disclosure should also be developed based on best and effective standards. This problem can greatly affect foreign bank operations since it is likely that its main workforce will be derived from the Chinese workforce pool, considering that it is less costly this way. If this will be done, employees and the board will expect usual corporate governance practices. Though foreign entrepreneurs can do some changes on its own banking governance once they start operating in China; the problem is whether these changes will be allowed or tolerated.

Interest, Credit and Liquidity Risks
China is relatively weak in terms of its credit or loan systems, considering its observed poor performance. The banking sector of the country is neither appropriately regulated nor properly managed. For instance, greater than 22% of the loans held by the state commercial banks are bad; young stock markets are also suffering the same state (Wu, 1998). Due to the poor state of China’s banking sector, Chinese reformers became even more hesitant to offer its banking sector to foreigners. In banking and loans, political connection is an important element; this in turn worsens the corruption within the country’s banking system. In addition, this practice widens the economic inefficiency of China as savings in general are not allocated based on the possibility of returns (Morrison, 2005). If no improvements will be done for China’s financial sector, instability is a possibility.

In order to resolve its problem on bad loans, China had decided to implement a new loan system (five-classification loan-grading system) that is based on international standards. Initially, China practices the four-classification system, which gravely defective. With this old system, endless speculations had been raised primarily on non-performing asset levels and inadequate provision of loans. While the new loaning system may benefit the country and resolve some of its financial issues, the effect of which is yet to be observed and evaluated. The possible success of this new approach is largely dependent on how Chinese regulators can effectively administer its execution (Hu & Hope, 2005). For new entrepreneurs, new systems that are not yet fully tested and guaranteed can be risky. It is then difficult to believe on the efficacy of this alternative unless concrete outcomes have already been obtained.

In terms of interest rate, regulations tightly control this banking aspect for foreign banks, making them less attractive for the market. In addition, the People’s Bank of China, the country’s central bank, is greatly protecting local banks particularly the four major banks developed during the initial reform for the financial sector. This then allows the country to cover about ninety-percent of the total lending activity (The Banker, 2001). The risk for liquidity is also a matter of concern for entrepreneurs planning on investing a banking business in China. Considering that the country had just gone through a major financial crisis during the latter part of the 1990s, liquidity in the country was greatly reduced, along with the decreasing GDP, falling export rate, declining retail price index and the slowing down supply of currency.

Market Risks
The market risks involved in foreign bank establishment in China is mainly caused by the country’s entry to the WTO. Before China joined the WTO, foreign banks that have renminbi (yuan) licenses were only supposed to lend renminbi from their deposits; access of these banks to interbank market was also prohibited, which greatly affects their capability to make loans. However, when China entered the WTO, the right to lend renminbi became limited to foreign banks that had been allowed to do this type of business. The provision of the licenses however, was only given to few selected banks. This in turn, makes the access of foreign banks to the Chinese market very restricted (The Banker, 2001).

The access to market is also greatly affected by China’s protection to its domestic firms. Local companies, including banks, had been complaining to the Chinese government and claimed that the policies implemented by the administration greatly favor foreign firms. For example, if a major foreign bank operates in China, most of the local companies offering similar financial services have no option but to close down. Eventually, as more foreign investors enter the country and operate within its banking industry, majority of the players will be foreigners. The Chinese administration is then concerned that if this will continue, more domestic industries will suffer (Chen, 1998). Hence, the government decided to control the entrance of the foreign firms in the country.

This in turn led the government to reduce the policies in favor of the foreign enterprises. In 1996 for example, the Chinese administration decided to cut down the value-added tax refund among foreign companies for exported goods from 17% to 9%. China has even planned to take out the privileges granted to foreign investors for importing capital equipment tax. This clearly implies that the country’s government has been more selective in accommodating foreign firms, which greatly limits foreign banks’ access to market (Chen, 1998).

Banking Risks in other Nations
Establishing a bank in other parts of the world such as those belonging in the European Union may be more advisable for some entrepreneurs. There are many reasons for this judgment. One of which is the fact that the European Union is a vast region of countries whose level of development varies. This means that EU offers business areas that are less developed than the other, giving better opportunities for foreign banks. Rules and regulations are likely to be more stabilized in some European regions as compared to the Chinese business setting. Tariffs or barriers to entry like taxes may also be lower in other European countries, making foreign entry less difficult. Most importantly, market diversity in EU is far larger than in China, making access to opportunities and market growth easier.

Nonetheless, it should also be considered that certain risks can also hinder the development of a foreign bank within EU. For instance, the presence of higher competition level is likely, considering that multiple local and foreign banks will be operating within the region. Moreover, though laws and regulations may be stable, differences in banking policies, operational practices and other relevant factors may make market access not as easy. From this standpoint, it becomes clear that establishing a bank in any foreign country has its advantages and downsides. This suggests that foreign entrepreneurs must be skilled in handling this possible business risks.

Means of Addressing the Risks
China and its banking sector have a lot to offer for foreign investors; however, the country and its administration must improve some of its banking aspects not only to make China more appealing to entrepreneurs but also to prevent business issues. One of this means would be the stabilization of its business laws and banking legislations. The country must have a definite ruling for both domestic and foreign banks in such a way that both will benefit from. While the Chinese government is protecting its local banking sector, it must also employ means that will make foreign bank investors less cautious. The restrictions should also be implemented at a reasonable level (Chen, 1998).

China has in fact, conducted several changes so as to be more open for foreign banks. For instance, it has attempted to improve its corporate governance by requiring and encouraging banks to introduce governing boards. Moreover, approved accounting firms are now used for auditing. Operational risks are also being handled by strengthening balance sheets; financial statement definitions are also slowly being accomplished based on international standards (Moreno, 2002).

The foreign investors themselves can apply certain means to safeguard their businesses from these recognized risks. One of the important strategies that firms should consider is to operate alongside a local business partner (Overby, 2000). This will help the firm adapt easily to the Chinese business environment. A local partner can also assist in learning the Chinese culture, practices, regulations and means of interaction. More importantly, a Chinese business partner can also help in achieving progress faster. Training the staff becomes even more important in foreign business ventures. The workforce must be supported fully particularly in adapting the business’ new concepts, standards and technologies. The management should ensure that the local staff is also well-adjusted to the new system so as to encourage them to contribute more for the business (Humberg, 2003).

In general, the investors can start off by analyzing the business environment they wish to invest on. It is important that business entrepreneurs are aware of the distinct features of each foreign setting; in this way, the investors will know how to address in the most effective way. If for example the foreign bank entrepreneur is from the West, establishing a bank in China will naturally make western and eastern difference apparent. As discussed by Ambler and Witzel (2003), Western and Chinese origins have distinct differences on various aspects like politics, philosophy, society and history. Hence, it is imperative that entrepreneurs understand their foreign prospects well. From this aspect, learning and adaptation are perhaps the two most important factors that should be present.

China is very appealing for entrepreneurs particularly because it offers low labor costs and a large market; similar factors have also encourages foreign banks to operate and establish branches in the country. Nonetheless, operational, credit, liquidity, interest and market risks are present, which can greatly affect foreign investors’ business goals. If banks will be established to other regions, the type and degree of risks may be different; however, risks in the banking business, irregardless of the environment, are omnipresent. For this reason, the foreign countries open to international trade as well as the investors themselves should have the appropriate qualities that will promote harmonious business relations. In conclusion, successful foreign business operations are not solely dependent on capital, connections and people but on the ability to learn, change and adapt as well.

‘Knock Knock’, 2001, The Banker, May 1, viewed 4, January, 2006, .

Ambler, T & Witzel, M, 2003, Doing Business in China, Routledge, London.

Chen, R, 1998, ‘An analysis of China's economic development policies and prospects’, Business Economics, July, pp. 29-34.

Cheng, E & Cheng, Y, 1998, ‘Banking Reform and the Separation of Policy and Commercial Loans in China’, MOCT-MOST, no. 8, pp.5-21.

Hu, F & Hope, N, 2005, 'Can Foreign Entry Transform China’s Banking System?', SIEPR Policy Brief, November.

Humberg, C, 2003, ‘Successfully Moving In and Setting up Business in China’, TUV Rheinland World News, pp. 4-5, viewed 4, January, 2006, .

Moreno, R, 2002, ‘Reforming China’s Banking System’, FRBSF Economic Letter, no. 200-17, May 31.

Morrison, W, 2005, ‘China's Economic Conditions’, CRS Issue Brief for Congress, July 1.

Overby, S, 2000, ‘Taming the Dragon’,, viewed 4, January, 2006 .

Wu, R, 1998, ‘Which Way for the Chinese Economy?’, World and I, vol. 13, no. 10, pp. 40+.

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