For companies doing business in China, the implications of official China’s strategy are mixed, but the situation is broadly positive. It is crucial for corporate leaders to figure out how the government’s outlook will translate into policy and attitudes within individual industries and sectors, particularly those where the government is pursuing reform but also maintaining strong oversight.
China’s banking sector, which is clearly a strategic industry, exemplifies many of the issues that the government faces, and the direction it is likely to take. Since China was admitted to the World Trade Organization in 2001, there has been an ongoing process of restricted liberalization. Under the oversight of the China Banking Regulatory
I 104 |
Commission, the sector’s main architect, China has developed an increasingly strong and sophisticated banking system. Competition has been permitted, but subject to strict control, especially when foreign banks had a major advantage. This partial liberalization has allowed foreign banks to introduce modern banking practices, particularly at domestic banks in which they have purchased stakes. And there has been some integration with the global financial system.
China’s banking system is built around the four big state-owned banks (Agricultural Bank of China, Bank of China, China Construction Bank, and Industrial and Commercial Bank of China) and supported by a series of smaller national and regional banks. The commission has allowed competition where it believes this will strengthen performance, but also maintained protection where necessary. Although it has eased some measures, such as the requirement that a nearly $50 million deposit be paid before a branch is opened, it has also held the expansion plans of foreign banks subject to its approval. Thus, although China’s banking sector has been liberalized in theory, it remains one with high barriers to entry and multiple obstacles to growth.
Since late 2006, foreign banks can offer the same range of services and products as Chinese banks. Ownership restrictions have also eased: a foreign institution can now own up to 20 percent of any Chinese bank, as long as the total stake held by foreign institutions in a Chinese bank does not exceed 25 percent. Foreign banks can operate under their own names, but to build out a national branch network, they must incorporate in China and then negotiate a tough and expensive approvals system that leaves most of the control over particular products and practices with the government’s officials. For various products, foreign banks are not allowed to operate on their own: credit cards, for example, can only be offered via a joint venture with a Chinese bank. And it would be very unlikely to see a foreign bank permitted to introduce an investment innovation before its Chinese counterparts.
Many international banks have established a presence in China, but only two have attempted to establish branch networks of any scale. The
I 105 |
UK’s HSBC (which was founded in the 1860s in Hong Kong) has branches in twenty cities, and it has also taken a stake in Bank of Communications, China’s fifth-largest bank, and Bank of Shanghai, one of the country’s largest regional banks. 6 Citigroup has branches in eight cities, plus stakes in two city-level commercial banks: Shanghai Pudong Development Bank and Guangdong Development Bank.
Despite their clear commitment to China, the progress of both banks was slow, even before the global financial crisis. Official approval for Citigroup’s purchase of a stake in Guangdong Development Bank took more than a year, and plans to increase its network to thirty branches by 2008 never came close to being realized. As for HSBC, its hopes of being allowed to expand its stake in Bank of Communications beyond the 20 percent limit have receded since it paid $1.75 billion to buy into the bank in 2004.
Other foreign banks have tried to establish a presence by buying stakes in Chinese banks. The largest deals involved the four largest Chinese banks with international stock market listings. These include the $3 billion spent by Bank of America for 9 percent of China Construction Bank in 2005, the $2.6 billion paid by Goldman Sachs for 5.75 percent of Industrial and Commercial Bank of China in 2006, and the $1.5 billion paid by Royal Bank of Scotland (RBS) for 4.3 percent of Bank of China in 2004. In addition, a host of banks from around the world have taken stakes in second-tier and regional banks, usually paying several tens or hundreds of millions of dollars.
But after the global financial crisis of 2008 and 2009, most of the givens that appeared to be shaping China’s banking liberalization appeared to be rethought. Chinese officials have tightened regulatory procedures and clearly no longer see the Western financial system as an attractive model for their own system. Various stakes taken by foreign banks have been sold back, often by Western banks that needed to bolster their balance sheets. In January 2009, RBS sold its stake in Bank of China for $2.4 billion; a nice profit, but little more than a drop in the ocean of RBS’s losses. The same month, Bank of America sold part of
I 106 |
its Chinese holdings for $2.8 billion. It is likely that other troubled foreign banks will follow suit as the lock-in periods on their stakes in Chinese banks expire.
Aside from the financial straits in which many foreign banks find themselves, there are other reasons why inbound investment in China’s banks may slow down. The dearth of stock market listings since 2008 means that there is less money to be made from IPO (initial public offering) fees. For retail banks, the prospects of establishing a branch network of any scale look as daunting as ever. And there is no indication—rather the opposite, in fact—that officials will consider easing the limits on foreign stakes in Chinese banks.
Finally, China’s maintenance of a nonconvertible currency remains the largest single barrier to the integration of Chinese banks into the global financial system. Economists may argue the macroeconomic benefits of an international currency, but after witnessing the events of Asia’s financial crisis and now the global financial meltdown, official China is wary of the problems that might occur if the government was to loosen its control over the renminbi (Rmb).
The internationalization of China’s banking system, therefore, is far more likely to come from outbound investments made by Chinese banks in foreign banks. So far, there have been only a handful of small foreign purchases, the exception being the £1.5 billion stake that China Development Bank (one of the country’s “policy” banks and, so, more a government arm than a bank in any normal usage of the word) bought in Britain’s Barclays Bank in 2007. Another example would be the 20 percent stake in Standard Bank, Africa’s largest bank bought by the Industrial and Commercial Bank of China (ICBC) in 2007 for $5.6 billion.
Going forward, however, Chinese banks, especially the larger ones, are likely to expand outbound investment in foreign financial institutions. This will happen gradually at first, and with due attention to the shortcomings exposed in the world financial system since the start of the sub-prime mortgage crisis, but their investments will grow in size as they become more confident in their abilities to manage their purchases.
I 107 |
When all of these small, gradual, and incremental changes are considered together, it’s clear that China’s banking system has been transformed beyond recognition. In the next decade, there will be further progress with increasing competition, liberalized ownership and product rules, and global integration. But this will only occur with strict official oversight. Indeed, it is quite likely that China’s financial system will become both more liberal and more subject to central control— with greater competition allowed among banks and more government direction over their lending and credit policies.
Other industries will follow a similar path: liberalization for the benefits it brings, subjected to oversight and, ultimately, control by the government and Communist Party. Official China has a series of goals in almost every industry. If foreign companies seem ready to help realize these goals, then they will be allowed to participate, especially if they can bring expertise and technology that will help raise standards in the short to medium term and allow Chinese companies to establish themselves in the longer term. China’s leaders are prepared to offer immediate, albeit controlled, access to the country’s markets, partly for the short-term benefits—jobs, faster growth, and a wider range of goods—that contribute to social stability and satisfaction with the government, and even more so for the longer-term strategic gains they bring to China’s aspiration of becoming a powerful country with a modern economy. Companies that do not understand this reality— and that fail to recognize the importance of officials’ belief that ultimately everything in China must come under their direction—run the risk of seeing potential but never realizing it.
Recent developments in worker’s rights and tax reform highlight official China’s strategic direction. The Labor Contract Law, brought into force in 2008, significantly strengthened the rights of staff and workers. It stipulates that all employees are entitled to a written employment contract and makes it much harder to lay off and fire them. Although many companies have complained that the new law will add significantly to their costs, in official China’s view, it is fully in line with
the ideal of a “harmonious society.” In the rush to expand manufacturing capacity, workers had often seen their interests come second to those of factory owners; redressing this imbalance was clearly important, especially for a government that claims a particular affinity with working people.
More than this, the new legislation enables official China to extend its power by rule of law as opposed to direct governmental edict. Previously, the government commanded that something be done and enforced compliance with sanctions. In developing a legal infrastructure, the state can devolve its powers, retaining oversight, but allowing those involved to police themselves. Written employment contracts, for example, allow employees to monitor their rights themselves. Providing that they can depend on the state for enforcement, such a system will enhance both official China’s legitimacy and its control.
China’s political leaders are also using tax reform to strengthen their governance abilities. China began building a Western-style tax system to meet the needs of its market economy in the mid-1990s. While development has been rapid, unsurprisingly, many loopholes remain. As a result, for much of the past two decades, many companies, both Chinese and foreign, have had a relatively free ride in terms of taxes.
This is ending as the government improves and modernizes its revenue-raising abilities. Transfer pricing provides a notable example of the changes under way. Until recently, tax officials had a very limited ability to track how companies priced goods they moved from one subsidiary to another. This enabled many firms to spirit exports out of China tax free and save themselves billions of dollars in the process. (This explains, in part, why foreign-invested enterprises, especially those from Hong Kong and Taiwan, have long reported lower profit levels than other companies in China.)
Since the mid-2000s, however, the State Administration of Taxation has devoted increasing attention to this issue. It is training inspectors to conduct transfer-pricing audits, and promulgating several sets of regulations and procedures. So far, its capacity to audit companies
I 109 |
remains minute; fewer than one hundred companies are scrutinized each year. But official China plans to bring nearly three decades of loose tax regulation and enforcement to an end. Within a few years, and quite likely far sooner than most companies expect, China will have a well-developed capacity for handling transfer pricing as well as other taxation issues. Companies should prepare themselves for compliance.
As with workers’ rights, this control is being imposed without the arbitrary intervention of officials in the direct operations of companies. And in both instances, the net outcome is the tightening of the Communist Party’s hold on China’s economy.