Newly Established Maquiladora Companies Transfer Pricing

By Dong Fu
Federal reserve Bank of Dallas

Banks Play the Central Role in Financial Intermediation in China
At the end of 2004, total bank deposits stood at 185.5 percent of GDP-with total bank loans at 138.1 percent. In comparison, the combined market capitalization of the Shanghai and Shenzhen stock exchanges was only 27.1 percent of GDP. China's banking sector is dominated by just four stateowned commercial banks (SCBs) that account for 54 percent of China's total bank assets and liabilities (Chart 1).

In terms of total assets, all four SCBs rank among the world's 40 largest. Quantity, however, does not mean quality. These banks have proved inefficient in allocating funds to China's economy. All four have low profitability. Moreover, the size of their bad-loan portfolios has been among the world's largest.

Capital Controls Are Crucial to Banking Stability
Although appearances and reality can differ sometimes in Chinese banking, even the appearances look problematic. The latest official data show the average ratio of nonperforming loans to total loans for China's big four banks as

15 percent in first quarter 2005, down from 20 percent at the end of 2003 (Table 1)
1 While these ratios are well above those in most countries, private estimates have placed total Chinese impaired loans (including those already taken over by the government in trade for bonds) in the range of 50 percent of bank assets.

There are questions about the adequacy of the capitalization of the four big banks. The China Banking Regulatory Commission requires all banks to meet the minimum capital adequacy ratio of 8 percent, consistent with the Basel I international standard, by January 2007. At the end of 2003, the average capital adequacy ratio was only 4.6 percent for the four SCBs. This ratio was calculated with the knowledge that existing nonperforming loans were not provisioned for sufficiently.

Although they are technically bankrupt, none of China's state-owned banks has ever faced a bank run or closure. An often cited reason is that even though China has no official deposit insurance system, there is an implicit government guarantee on deposits. Aside from the applicability of this guarantee to any bank, the four SCBs are perhaps even less likely to be closed, owing to a dictum common in many countries. That is, some banks are viewed as "too big to fail."

There is, however, another less discussed reason why Chinese banks have not faced runs by depositors. The reason is capital controls. These controls largely prohibit Chinese citizens from investing overseas. With China's high domestic savings rate (as much as 40 percent by some estimates) and the relative scarceness of alternative financial vehicles such as stocks and bonds, opportunities for purchasing financial assets other than bank deposits are highly limited.

Financial Liberalization Puts Increasing Pressure on Capital Controls
In line with its World Trade Organization (WTO) commitment, China has gradually opened its domestic banking and financial sector to foreigners.2 By October 2004, 62 foreign banks were operating in China. These institutions account for only 1.8 percent of total banking assets. However, with an average nonperforming loan ratio of only 1.3 percent, they are substantially more solvent than China's four SCBs.

Foreign banks differ markedly from Chinese banks in other ways as well. Government rules for Chinese banks largely restrict them to the most traditional functions of commercial banking. In contrast, many of the foreign institutions are so-called universal banks. These foreign institutions not only carry on the traditional functions conducted by China's state-owned banks, but also engage in investment banking, securities and insurance operations. The foreign institutions have global opportunities for funding. China's fragmented financial regulatory system, which includes completely separate organizations for banking, securities and insurance, is poorly equipped to deal with universal banks.

Moreover, despite China's WTO-linked openings to foreign financial institutions, the Chinese government still makes efforts to control capital flows. In 2004, the Chinese government announced a new rule under which foreign banks have to apply in advance for quotas for offshore borrowing.

Notes:
1.- There are widespread disputes on the actual figure for nonperforming loans. Historically, Chinese banks used a four-tier loan classification system, which tended to underreport nonperforming loans. In 2002, they started to migrate to a five-tier classification system, which is more in line with the international standard.

2.- Foreign banks can now engage in foreign currency transactions with all clients and with no geographical restriction. By July 2004, their share of foreign currency loans rose to 17.8 percent. So far, foreign banks have conducted business in Chinese currency with Chinese companies in 18 cities. At the end of 2006, foreign banks will be able to operate freely in China.