By Mi Jianguo, Li Yang, Huang Jinlao

I. The Process of Opening the Service of China's Banking Industry

As an important part of its opening-up policy, China opened its door to foreign banks long time ago. In the 21 years after the opening-up initiative, foreign banks have developed rapidly in China, approximately experiencing three stages:

First stage, since 1979, foreign banks were allowed to set up representative offices in China. In 1979, China approved the opening of the first representative office of the foreign-invested bank, Export-Import Bank of Japan. By 1980, 31 foreign financial institutions had set up their representative offices in China. This was the initial stage for the opening of China’s banking industry.

Second stage, since 1981, China approved the establishment of foreign-invested operative financial institutions. In July 1981, foreign banks were approved to set up trial operative institutions in five special economic zones, including Shenzhen, to engaged in foreign exchange business. In 1982, Nanyang Commercial Bank of Hong Kong was the first to set up its branch in Shenzhen. In September 1990, Shanghai became the coastal opening city that introduced foreign-invested operative institutions after the special economic zones. From 1992, the regions allowed to introduce such institutions were expanded to Dalian and six other coastal cities. In August 1994, such regions were expanded to 11 inland central cities including Beijing. By that time, 23 cities and Hainan Province had been permitted to introduce the service of foreign banks.

During this period, in 1983 and 1985, two regulations – “Management Measures of the People’s Bank of China for Representative Offices of Overseas-invested and Foreign-invested Financial Institutions in China” and the “Regulations of the People’s Republic of China for the Management of Foreign Banks and Sino-foreign Joint Venture Banks in Special Economic Zones” – were issued respectively to put the introduction of foreign-funded financial institutions under legal control. In January 1994, the “Regulations of the People’s Republic of China for the Management of Foreign-invested Financial Institutions” was issued, further standardizing the management of such institutions.

Third stage, since 1996, foreign-banks were allowed to handle Renminbi business on a trial basis. From December 1996 to August 1998, selected foreign banks were allowed to handle Renminbi business in Shanghai’s Pudong and Shenzhen Special Economic Zone. Its business scope includes: Renminbi deposit and credit, settlement, guarantee, treasury bonds and financial bond investment. In April 1998, the central bank approved eight foreign banks handling Renminbi business in Pudong, Shanghai to enter the inter-bank lending market of China. In January 1999, the State announced that all the central cities would allow foreign banks to set up operative banking institutions. In July, the foreign banks’ business scope in Shanghai and Shenzhen were expanded, they were allowed to do business for the customers in the adjacent provinces or autonomous regions. At the same time, the central bank also adopted a series of supportive policies to the foreign banks handling Renminbi business. Firstly, when foreign-banks are short of funds, the central bank will offer large amount financing on the basis of case-by-case approval. Secondly, the foreign banks are allowed to issue significant-amount transferable deposit certificates at an appropriate time to raise funds. Thirdly, the foreign banks are allowed to join in the issuing of renminbi syndicated loans, and the insufficient part can be borrowed from the Chinese banks. Fourthly, the foreign banks are allowed to enter national Renminbi inter-bank lending market. Fifthly, the rate of total Renminbi debt to its total foreign exchange can be relaxed from 50% to 35%.

In 1997, after the Asian financial crisis broke out, especially due to the shock of event of “Guangxin”, the business expansion of foreign banks somewhat slowed down. In 1998, foreign banks’ assets shrank to 34.18 billion US dollars. In 1999, it further reduced to 31.79 US dollars. In 2000, it started to grow again. Their total assets were worth 34.6 billion US dollars.

Source: Nicholas R. Lardy, Foreign Financial Firms in Asia, April, 2001

After 20 years’ development, the number of foreign-invested financial institutions in China has been increasing, and business scope expanded. They have become an important part of China’s financial system. By the end of 1999, 87 foreign financial institutions and enterprise groups from 22 countries and regions had set up 182 operative financial institutions in China. 166 foreign banks from 38 countries and regions opened 248 representative offices. By the end of March 2001, 180 business institutions of foreign banks had been set up in China, of which, 160 were branch banks and 13 locally registered banks (including seven joint venture banks and six solely foreign-invested banks), and seven foreign financial companies. Of these banks, those from Asia accounted for 48.2% and the rest made up for 51.8%. The paid up capital was 2.68 billion U.S. dollars. The financial assets of foreign banks accounted for less than 3% of the country’s total. A total of 32 foreign banks had been approved to handle Renminbi business.

China should be one of the countries that open banking industry fast in the world. Many developed countries joined the WTO and signed service trade agreement, but they still shut their door of home currency business to foreign banks and also place regional restriction over foreign banks. Some new emerging market countries have also long banned the entry of the capital of foreign banks. Mexico adopted this policy for 57 years until October 1994, but resumed it after the financial crisis in 1995. It took 40 years for foreign banks to acquire the same treatment with local bank in Chinese Taiwan (See note 1).

The degree of penetration of foreign banking into China’s banking service market – assets of foreign banks/total assets of the banking industry – is lower than that of the new emerging economies, still at the primary level, but is quite similar to quite a few number of developed countries. In 1995, the assets of foreign banks accounted for nearly 2% of the total assets of Chinese banking industry, lower than that of most new emerging economies. But in the same period, the foreign banks’ assets in the US only account for 3% of the total, Australia and Belgium 5%, Canada 7%, France 8%, South Africa 2%, Italy, Switzerland and Norway 1%, while Denmark, the Netherlands and Sweden are 0%. Only UK (19%), Germany (25%), Spain (31) and New Zealand (91) have a higher percentage.

Source: Stijin Claessens, etc. How does foreign entry affect the domestic banking market? Working Papers by World Bank, May 1998.

II. The Distribution of the Shares of China’s Financial Service Market by Foreign Banks

After their entry into China, foreign banks develop their business rapidly. At present, foreign banks have taken up quite a large market share in the foreign exchange loans and international settlement. They have an even larger market share in Shanghai and Shenzhen where such banks are concentrated.

In foreign exchange credit, by the end of 2000, the total foreign exchange loans of foreign banks accounted for 22.7% of the total foreign exchange loans made by all the financial institutions. In Shanghai, the market share of this business of foreign banks has been by far higher than that of Chinese banks. In 1997, the foreign banks’ share in foreign exchange loan market in Shanghai reached 69%. In Beijing, which opened later than Shanghai, the share was 28%.

In international settlement, the total settlement volume of foreign banks in July, August and September of 1999 were 21.919 billion US dollars, a rise of more than 10% over the same period of previous year. Foreign banks have taken up more than 35% of the market. At present, as their main customers – foreign-invested enterprises – gradually increased their share in the country’s total import and export (49% in 1998), they will further raise their proportion in international settlement business.

In foreign exchange deposit, by the end of September 1999, the total foreign exchange deposit of foreign banks accounted for 4.54% of the total deposit volume of all financial institutions. In Shanghai, the foreign exchange deposit of foreign banks was also much higher than the average level of the country. At the end of 1998, it was 17%. At the end of June 1999, it was 15%. Generally speaking, the total foreign exchange deposit of foreign banks still takes up a small market share (See note 2).

In Renminbi service, due to more limitations on foreign banks, their Renminbi service still takes up a small market share. But since 1997, with the increase of foreign banks dealing with Renminbi business, relaxation of regional limitation and the permission of foreign banks borrowing Renminbi, their Renminbi business will keep a momentum of fast growth. By the end of 2000, foreign banks’ Renminbi assets had reached 29.3 billion yuan. But at the end of 1999, it was only 6.493 billion yuan.

Since 1981 when China introduced the first foreign bank, foreign banks have kept a trend of healthy development. Before 1999, they all achieved substantial profits. In terms of loans arranged for industrial and commercial customers, they have a high demand for their credibility. So their assets have been of high quality. In international settlement, foreign banks seldom make advance money. Usually, foreign banks will gain profit in two or three years after opening. Their asset-income ratio will be much higher than that of the Chinese banks. Their income from handling charges takes up a large proportion in the total income. In 1998, they earned a profit of 215 million US dollars. ROA was 0.63%. Till the first half of 1999, foreign banks were still profitable. The average return on assets (pre-tax profit/average asset volume) of the foreign banks in Shanghai was 0.28% and the average profit rate was 3.49%. The ratio of net margin to income from handling charges was about 4:1.

In 1999, foreign banks reported an industrial loss of 156 million US dollars. That was due to the deterioration of credit quality of some domestic trust and investment companies (including Guangxin and Yuehai) and the drastic rise of bad loans. The concerned loans in that year accounted for 12.19% and bad loans 13.12%. At the end of 1998, five of the top ten borrowers of Hong Kong and Shanghai Banking Corporation were the large enterprises supported by the governments of Guangdong at various levels (their loans accounted for 30% of the total). After the “Guangxin” and “Yuehai” events took place, the quality of such loans were obviously declining, which led to the lowering of this bank’s asset quality. As the bad accounts increased, bad debts reserve will increase by big margin, thus causing losses.

III. The Competition Advantages and Strategy of Foreign Banks

Starting from January 1, 2007, foreign financial institutions will be no different from Chinese financial institutions in terms of regions and service targets. In trade liberalization and opening of domestic markets, China has made important commitments in following the international practice. Its far-reaching significance has gone beyond people’s expectation.

(1) Competition advantages

1. Advantages in management

Chinese banks, especially state-owned commercial banks, have many shortcomings in bank governance structure. Many banks do not have the board of supervisors or board of directors. So they are short of a scientific, efficient and transparent decision-making mechanism. The ownership, decision-making and operation have not been effectively separated. They lack independence and autonomy. At the same time, they do not have a flexible operation mechanism, strong internal control or complete business rules and operation procedures. Foreign banks usually have a sound management system, scientific decision-making mechanism and flexible operation mechanism. They are also mature in organization structure, human resource development, limit of agency authority and stimulus and restraining systems. So foreign banks have a stronger business exploration and risk resolving ability.

2. Advantages in scale

Foreign banks are large and have strong capital strength and quality assets. Take the First National City Bank of New York for example. Its total assets are as much as 700 billion U.S. dollars, about twice as much as that of the Industrial and Commercial Bank of China. The average bad assets ratio of US commercial banks in 1998 was 0.67% while the ratio of Chinese commercial banks was 40 times as much, no matter with whatever calculating methods. The massive capital scale of foreign banks is real. The Chinese state-owned banks’ scale is actually much smaller after the 30% of the bad assets have been deducted.

3. Advantages in system

Foreign banks follow international practice in its operation. They are basically free from government interference. So they bear less extra burdens. But the Chinese commercial banks will not be able to be free from the administrative interference for quite a long time and the long-standing historical burdens. And their internal guarantee system has not been thoroughly reformed. Their non-business costs are still huge, which has become one of the main disadvantages of Chinese banks in their competition.

Most foreign banks adopt a multiple-operation system. For instance, the First National City Bank of New York and the Travelers Group Corporation were merged into a large banking group involving commercial bank, investment bank and securities and insurance business. According to the “Regulations for the Management of Foreign-invested Financial Institutions in China”, foreign banks are also allowed to deal foreign exchange investment business. So they will exploit their advantages in multiple-business operation. When the multi-business operation of foreign banks competes with separate-business operation (See note 3), the difference in competitiveness is that the multi-business operation can provide more complete services to customers and conduct effective combination of various financial services, thus greatly reducing the costs.

In the mid-term, Renminbi cannot be converted freely under capital account, and there is a strict separation between home currency and foreign exchanges. But foreign-invested enterprises and banks can easily do low-cost financing on the international financial market. For instance, they can do it on the Japanese market, due to very low interest rate, even plus swap rate and risk premium, the costs will be lower than the domestic interest rate. After China’s entry into WTO, foreign banks’ services will extend to Chinese-invested enterprises, many Chinese-invested enterprises will turn to foreign banks for financing.

4. Advantages in product structure

Major transnational banks have transferred from handling traditional banking business to modern banking operation. The low-risk, low-cost and high-profit off-the-statement profit has become the main source of profit. Statistics show that the profit of transnational banks from off-the-statement profit accounts for 40% or even two-thirds of the total profit. Take the Deutsche Bank AG for example, its five sectors can offer more than 100 items of financial products and services such as bonds, futures and option rights, projects and assets transaction, property right trading and fund management, mergers and acquisitions, reorganization, stock listing, project financing, foreign exchange current account, international settlement, collection, circulating capital financing, trade financing, custody and brokers’ clearance, etc.. The commercial banks of the developed countries have already finished the transformation from passive loan granting to active service. They help the enterprises analyze the development prospects, current status of assets, financial structure and realize the optimum combination of assets before making financing suggestions. In this process, credit business only makes up a small part.
The Chinese banks will for a fairly long time mainly deal traditional banking business. They can hardly provide the value-adding services or intermediate services. At present, they mainly deal some traditional off-the-statement businesses (such as acceptance of bill, letter of guarantee and documentary letter of credit). These low-grade services are open to a small number of customers and yield low gains. The credit card business has been booming, but due to small trade volume, the credit card payment can only be used as an auxiliary payment means. The businesses of treasury bond futures, foreign exchange futures and stock index futures were stopped because of excessive speculation and non-standardized trading. Only the Bank of China is dealing forward foreign exchange trading business. The trust business, an intermediate service, is not conducted by commercial banks, but managed by the trust and investment companies.

Affected by the interest rate marketization and industrial competition, the margin between the traditional deposit and credit businesses will be definitely narrowed. Now the regional difference in this margin in China’s banking industry is very obvious. The quotation for the short-term loan in Shanghai is generally LIBOR plus 50-80 while the quotation in Qingdao is as high as LIBOR plus 200-300 points. Shanghai has 57 foreign banks operating there. But Qingdao has only three. It is the competition that causes the narrowing of margin.

5. Advantages in international network

Foreign banks in China are mostly transnational banks, whose business networks are distributed worldwide. They have extensive business outlets and experiences in international business. But the commercial banks in China have less overseas outlets, and the international settlement is usually done through their head office. Multiple links and low speed have caused low efficiency and increased interest rate risk for the customers. Foreign banks can operate both on the international and domestic markets. They can better meet the need of customers, especially transnational customers. So they have a sharper competition edge in vying for quality customers with Chinese banks.

6. Advantages in financial strength

Table 3 indicates the sharp difference between Chinese and foreign banks in financial strength.

Note: (1) The ranking refers to a company’s ranking in the world’s top 1,000 and its own country. For instance, 10/1 means that it is ranked 10th in the world and first in its own country. (2) Except for Agricultural Bank of China (December 1998) and Bank of Tokyo-Mitsubishi (March 2000), all the banks’ data are up to December 1999.
Source: The Banker, July 2000, Top 1,000 World Banks

(2) Competition strategy

With their solid competition strength, foreign banks’ business is booming in China in spite of the limitations. After China’s entry into WTO, their development strategies could be divided into three categories:

Firstly, major international banks will adopt an overall business strategy. It is predicted that after China’s entry into WTO, such banks will expand their various financial services faster in China and compete with Chinese banks in almost all the financial spheres, such as credit, settlement, asset management, financial consulting management and financial derivatives. In fact, these banks are already developing extensively on a considerably large scale now.

Secondly, other major international banks will place emphasis on the services with their professional advantages. At present, they usually set the goal on more profits, not particularly on market share. They will make use of their own advantages in operation, management and customer relations and adopt a strategy that emphasizes certain sectors to gain immediate profits. These banks will compete for quality customers and high value-added businesses.

Thirdly, the medium and small foreign banks usually serve the customers from their own countries or areas. They are engaged in some traditional businesses, such as credit, settlement and trade financing. But due to their large number and their influential and extensive networks in their own countries, they are very competitive in serving their customers with investments in China and related international trade services. They will deal a major shock to the domestic financial institutions.

In general, foreign banks expand their financial business in China through the following four ways: (1) Setting up branch organs. But due to the limitations in time and costs as well as the trend of network development, they will not open many branches in China in a short period of time. The expansion will not be so fast. (2) Expanding the market through modern technologies, such as increasing ATMs, computer terminals, and services through Internet, e-commerce and mobile phones. This will be the main way of competition for the foreign banks. (3) Cooperating with domestic financial institutions, especially banks, to conduct joint operation. (4) Purchasing domestic banking institutions to expand their business rapidly.

IV. The Upcoming Shock from Foreign Banks

China’s banking service market will not be opened completely and immediately. Foreign banks will not make all the preparation for entering this market in a short period of time. Therefore, the current threat is from foreign banks that will start a fierce competition with Chinese banks in some key areas. From international experience and the practice of the foreign banks in China, we believe the following six aspects will be the focus of competition.

(1) High quality customers

Foreign banks have the business advantages in offering comprehensive services. At the same time, with solid strength and good market image, they will certainly try to grab the quality customers from China’s commercial banks. Generally speaking, 80% of the profit of a bank comes from 20% of the quality customers. But now, only 60% of the Chinese banks’ profit come from 10% of the quality customers. The fierce competition will lead to the drains of Chinese commercial banks’ customers and deal a great blow to their profitability.

Specifically, transnational enterprises, enterprises of sole foreign investment, joint venture and cooperative, export-oriented enterprises and large enterprise groups of China and high-tech enterprises will become the focus of competition. At present, more than 160 foreign banks’ main customers are enterprises with foreign investment, mainly the enterprises and transnational corporations from the same countries or regions of the banks, which account for 50-60% of the total customers. Chinese enterprises only make up 10-20% of their customers. Some foreign-invested enterprises, especially Japanese enterprises have made the statement in their regulations of the board of directors that all the foreign exchange business must be handled by the banks from their own country. After China’s entry into WTO, foreign banks naturally have an advantage in customer relations.

	Very unimportant (%)	Not important (%)	So-so (%)	Important (%)	Very important (%)	Banks that give no answer
Foreign-invested enterprises	-	4.0	16.0	16.0	64.0	2
State-owned enterprises	-	7.7	23.1	38.5	30.8	1
Collective or township enterprises	15.4	11.5" P Economy