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The Yin & Yang of U.S. Bank Interest in China
BY CHRIS SKINNER
U.S. banks drawn to the opportunities of the opening of China will find an antiquated, fragile system ? and a technological prowess that could ultimately advance retail banking in the U.S.
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SYNOPSIS | China is opening up its banking markets to foreign investors as a requirement of its membership in the World Trade Organization. The largest U.S. banks, in particular, are poised to pursue the opportunities in 2007, when ownership rules become more liberalized. Risks include the antiquated condition of China?s banking system, which today survives only with government support. Over time, China?s technological prowess is expected to positively influence U.S. bank growth and development, specifically in next-generation computing and telecommunications.
The opening up of China?s financial markets to foreign investors in 2007 offers overseas banks an opportunity to market to a nation of 1.3 billion consumers in an economy that?s growing faster than any other in the world.
It?s a no-brainer that U.S. banks, in particular, would be drawn to the deposit-gathering and lending possibilities of a nation with a $9.9 trillion spending power, based upon the economic measure of Gross Domestic Product (GDP) Purchasing Power Parity, which grew 9.9% in 2005 alone. China, in turn, needs the United States? help to renovate its aging, over-staffed, under-invested and fragile banking system.
The result is that Chinese and U.S. financial institution executives are working together to achieve mutually beneficial objectives. America’s largest banks are exporting skills and competencies to create China’s future investment markets and retail bank operations while China’s banks are giving American bankers the opportunity to test new channels, products and services on a highly technology-literate Chinese society.
It’s a scenario peppered with both opportunity and risk.
The WTO Imperative
China is being forced to open up its banking markets to foreign investors as a condition of membership in the World Trade Organization (WTO). China joined the WTO in December 2001 to gain the benefits of that organization’s liberalized, less protectionist trading rules. China’s participation in the WTO has helped fuel much of its recent growth by removing many quotas and barriers to trade.
Initially, the liberalization rules applied to foreign exchange and insurance. But the opening of China?s banking to foreign ownership since 2003 has encouraged many overseas investors and owners.
When China implements unrestricted financial market operations in 2007, the current limitations of ownership will be removed. These limitations hold foreign companies to a maximum stake of 25% of a Chinese bank?s shares, with an individual bank limited to a 19.9% stake. When those limitations are removed next year, Citigroup Inc., Bank of America Corp. and Merrill Lynch are all likely to join in a free-for-all as Chinese banks become hot property. Throughout the period from 2007-2010, analysts expect Chinese banks to become predatory targets for full acquisition by their foreign partners.
But China has some problems, not the least of which is competing on the world stage with archaic financial markets. By comparison to America’s markets, China’s are still in the Dark Ages. While half of GDP is represented by the corporate bond market in most emerging economies, China’s corporate bond market languishes at just 13% of GDP. The equities markets capitalize on 17% of GDP (deducting for the effect of State-Owned Enterprises, or SOEs), compared to 60% in most other emerging markets.
Other issues to be resolved, with the help of U.S. and other foreign investors, include introducing a customer focus culture, developing credit risk management skills and assessments, moving from government lending to commercial lending, creating equities and bond markets, etc. McKinsey & Co. research estimates that China’s markets will gain around $320 billion a year in efficiency improvements through financial reform, possibly driving a further 17% increase in GDP.
In the meantime, businesses operating in China need to tread warily, according to a 22-page November 2005 analysis by the Federal Deposit Insurance Corp. (see www.fdic.gov/bank/analytical/banking/2005nov/article1.html). “Although the exploding Chinese economy may be the envy of the world,” writes Valentine V. Craig, a chartered financial analyst in the FDIC’s division of Insurance and Research, the risks include an “overheating economy, rising protectionism in countries that buy China’s products, growing economic inequality in a non-democratic society and problems associated with a rapidly aging population.”
Archaic Banking System
Until the late 1990s, Chinese banks primarily existed to serve the government. The banks were 100% state-owned and were used to generate funds for SOEs and other state-run projects. Hence, all deposits were used to funnel monies from citizens to government operations and all loans were made to SOEs with no analysis of risk or return.
This meant that a culture of customer antipathy was rife. Branch operations were run as queuing systems, where passbooks were stamped and customers were shuttled in and out with no view toward speed or service. The concept of relationship management was much more centered on relations with the People’s Republic of China than with the people of China.
Even so, this did not deter the Chinese people from putting their hard-earned money into their bank accounts, with consumers generally saving 20% to 25% of their disposable income. That is why 86% of bank assets in China comprise deposits and cash. Savings are then serviced at a measly 0.5% interest rate, even though China has one of the highest savings rates in the world — a Gross National Savings rate of 47.6% of GDP in 2004.
On the other side of the balance sheet, loans were offered to government-backed projects and SOEs without regard to financial viability. As long as the Politburo Standing Committee of the Communist Party supported the project, the money was provided. This explains analysts’ estimates that 95% of all bank lending is to SOEs and over 40% are non-performing loans (NPLs), with little likelihood of ever receiving a payback.
The result has been a fragile banking system that survives only through the government’s support and reinvestment. For example, Ernst & Young estimates that China has $911 billion of NPLs in its financial system, five times more than the official estimates. (The official estimates play down the levels of NPLs, as over half of them are to SOEs.)
Chinese banks would be bankrupt by now if it were not for the support of the government. For example, Chinese banks have recapitalized their balance sheets by over $215 billion in government money since the late 1990s. As a result, according to McKinsey Research, Chinese banks must earn $25 billion more in revenues every year than banks in other countries to carry out the same levels of lending.
Just as the Chinese government needs Chinese banks to achieve its goals, Chinese banks need the government to survive. This cozy closed loop of collecting money from citizens for zero interest to fund government projects is about to change, however. The opening up of China to deregulated markets and foreign investment introduces new dangers to the fragile system as the new overseas managers will not tolerate dangerous borrowing and reckless capitalization. This may mean that loans will no longer be provided or serviced to SOEs, raising the specter of many SOEs closing down, causing massive labor and structural problems.
Manufacturing Giant
In spite of their backward financial system, the Chinese do know how to make stuff. And, as China benefits from what others know about banking, this will be the reform that China will bring to banking worldwide: How to use next-generation technologies to grow business. The technology advantages to be gained by U.S. bank investors in China promise to have a ricochet effect — ultimately impacting how U.S. retail banks are run.
China is now the fourth largest economy and third largest trading nation in the world. It’s on track to become the second largest economy by 2025. The first signs of this growth may have been when we saw our clothes being imported cheaply under the “Made in China” label. Later, we may have noticed that our computer drive or Intel chip was “Made in China.” More recently came the news that IBM’s PC Division was sold to Chinese manufacturer Lenovo for $1.7 billion in 2004 and that Britain’s flagship auto maker MG Rover was acquired by Nanjing Automotive of China in 2006.
With the deregulation of Chinese banking imminent, China’s leadership has focused on modernizing the financial system. The government has recapitalized the balance sheets of the major Chinese banking institutions to the tune of $215 billion since the late 1990s. It has also refreshed core systems for the Central Bank RTGS (Real Time Gross Settlement) system and the China National Advanced Payment System.
China may have missed the Internet revolution, but its leaders want to lead the information revolution. This comment from Houlin Zhao, director of the International Telecommunication Union of Geneva, Switzerland, at a technology summit in Beijing in April 2005 sums it up well: “Twenty-six Chinese share one Internet address whilst each American possesses six IP addresses. This is the quandary facing China in the (last Internet) era.”
Consequently, China has been working hard to create the next generation of technologies, which include new Internet and wireless standards, such as IPv6, Internet2, WiMAX and 4G. With 400 million mobile telephone users and over 100 million Internet users, 60% of whom are on high-speed broadband, China is already creating new ways of doing banking business. In 2006 alone:
- China Minsheng Bank Corporation (CMBC) launched a totally new payment system called SmartPay, allowing merchants across China to process payments through a cell phone or PHS (Personal Handyphone System) network. The effort has quickly been emulated by other banks, such as China Merchants Bank.
- The Industrial and Commercial Bank of China (ICBC) has started a phone-based payments service for the Internet with Chinese firm 99Bill, an e-payments service that even allows P2P (peer-to-peer) payments for Chinese bloggers.
- YeePay, an e-payment service that allows Chinese users to make real-time payments over the telephone, mobile or online, was launched in 2005 and within five months was transacting over $1.2 million a month. Since then, YeePay has initiated strategic partnerships with leading commercial banks in China, including ICBC, China Merchant Bank, China Construction Bank and CMBC.
- The non-bank payment card in Hong Kong, Octopus, is one of the largest payments transactors with almost 10 million daily transactions valued at HK$69 million (US$9 million) a day.
- China Merchants Bank launched what they claim to be the world’s first dual-currency credit card, where the user decides at the merchant’s terminal which currency he wants to use: Chinese Remnimbi or Hong Kong Dollars.
- Taishin Bank in Taiwan launched the world’s first credit card enabling the user to decide at the merchant’s terminal whether to pay by debit, credit or revolving credit by transaction.
All of these new products and services are driven by a massive market of under-served consumers, alongside completely overhauled systems and architectures driven by the latest technologies.
Investing in the Infrastructure
In 2005, the Wall Street Journal reported that Chinese “financial institutions are spending hundreds of millions of dollars to upgrade their computer systems and to train thousands of bankers and bureaucrats in international financial practices.” How much? About $23 billion a year, and growing fast, according to Needham, Mass.-based TowerGroup Inc.
Such spending is necessary as Chinese bank front and back office systems don’t exist. I remember visiting with the CEO of the Bank of Beijing in 1997 when I worked for NCR. The executive took great delight in telling me that the bank’s head office had 30,000 staffers, more than the total number of employees working for NCR at the time. The central bank, the People’s Bank of China, employs about five times the number of employees as the U.S. Federal Reserve, while the regulator, the China Banking Regulatory Commission, has another 20,000 workers. These numbers are phenomenal. With so many employees available to perform every processing task imaginable, is it any wonder that Chinese banks did not use technology?
Now China wants to be as competitive and therefore as automated as the U.S. and rest of the world. A recent TowerGroup report estimates that bank information technology spending in China increased 32% annually from 2004 to 2007, from $10.1 billion to $23.2 billion, which is faster than anywhere else in the world.
And where is that $23 billion going? Mainly on core systems using software services from U.S. and European software firms. This is because, for retail bank-specific systems, U.S. and European sources can provide proven and reliable platforms. On the other hand, for next-generation hardware technologies, China is the place. This is because China is investing heavily in next-generation systems.
Already, Cisco and Dell are being challenged by Huawei and Lenovo. Microsoft was extremely concerned as to whether China would select Linux rather than its own operating systems as the next generation platform. China has favored Linux as an open and transparent system, which is why Microsoft has invested so heavily in building relationships in China, as have Google, Intel and others.
One of the biggest lessons American banks will learn from China is in technology, as China invests in developing the platforms and systems that we will all be using after 2010.
The U.S. owns today’s Internet because America made it happen. But that was the Internet of today, based upon a system called IPv4 (Internet Protocol version 4). China, however, is investing heavily in IPv6 (Internet Protocol Version 6), the standard for the next generation of Internet. By way of example, the Chinese government invested over $175 million in a one-year project started in 2002 called the China Next Generation Internet, which built China’s next generation Internet on IPv6. Similar projects are building leadership in wireless systems, such as WiMAX, and telecommunications services, such as fourth generation cell phone standards.
And the relevance to banking? China’s banks are already creating new ways of thinking about technology differentiation and service. Consider, for example, Chinatrust Commercial Bank’s soccer promotion of Swatch-style watches last summer. The watch was given away to promote the World Cup in Germany and incorporated a contactless MasterCard PayPass chip, or RFID (Radio Frequency Identification Chip) for payments. The idea being that when it comes to payments, you just flash the watch over the payment reader and the product was yours.
Although other banks are implementing RFID chip programs, this Chinese approach is different because the chips are being given away in non-card based products as “fashion” items. This is a great way to build new consumer segment loyalties, and a totally different approach to anything Western European or American banks are doing with the RFID chips so far.
China ’s banks are implementing similarly radical consumer programs in mobile, wireless and Internet. For example, Derek Sulger, chief financial officer for mobile payments firm SmartPay — the firm that launched the new m-payments service with CMBC this year — believes the Chinese will have created a mobile payments market from virtually nothing in 2004 to almost 40 million customers by the end of 2006. Such rapid creation of new markets is why firms such as SmartPay are receiving millions of dollars of investment from venture capitalists, including many U.S.-based firms.
In effect, the next generation of U.S. retail banking is being created today in Beijing, Shanghai, Dongguan, Guangzhou, Xian, Guilin, Hangzhou, Ningbo, Shenzheng ... in China.
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