January 24, 2002
PERSPECTIVE
Scandal and reform in China
Measures to strengthen supervision and provide policy support for banks in China may not be enough, writes James Kynge When China bewitches visiting chief executives, the spell is usually concocted from at least three elements: the size of the potential market, the sight of Shanghai's glitzy skyscrapers and dinners with sophisticated businessmen who speak excellent English and betray not a trace of their Communist past. Wang Xuebing, the former head of the Bank of China who is now the focus of investigations into China's biggest banking scandal since the 1949 revolution, was one such businessman. A former head of the bank's New York office, Mr Wang was a dining partner or golfing acquaintance of many of the world's leading bankers and chief executives. The shock at his downfall, therefore, has been palpable. The shock will dissipate over time. But there may be more lasting implications from the Wang Xuebing scandal. First, foreign financial groups currently scouring China for potential equity, or joint venture partners following Beijing's admission into the World Trade Organisation, may become more circumspect. Second, the incident may influence policy. Beijing is preparing for a Financial Work Conference early next month that is expected to set a five-year reform agenda. Chinese officials say initiatives to deregulate crucial aspects of the country's financial environment may slip further. The Bank of China scandal illustrates the divide between those who say Beijing should focus on strengthening supervision and those who believe that only the discipline of the market will root out corruption and build a strong financial system. The strongest argument - now greatly reinforced - of those who favour a delay in liberalisation is that the "big four" banks, which control more than 70 per cent of the country's banking assets, would be unable to survive fully competitive conditions on a level playing field. It has been known for some time that the big four, all of which are wholly owned by the finance ministry, are technically insolvent. What was largely unclear until this month was how badly managed Chinese state banks can be. The Bank of China has agreed to pay $20 million in fines to US and Chinese regulators to settle charges of loan fraud and other misconduct during Mr Wang's time. He left the bank in February 2000. According to US Treasury investigators the problem in the US appears to have focused on: improper loans from the bank's New York branch to people close to the branch's former managers; the facilitation of a fraudulent letter of credit scheme; a loan fraud scheme; and the unauthorised release of collateral. Within China, a portrait of systemic corruption is emerging. The national audit office has uncovered 22 cases of serious fraud involving Rmb2.7 billion ($326 million) in its regular review of the Bank of China's books. The nature of Mr Wang's connection to the cases remains under investigation. Adding to the disarray is the audit office's revelation this month that it has also uncovered Rmb160 billion in misused funds from January to November last year in 107,000 businesses and government agencies. Unanswered questions abound. There has been no follow-up to an announcement in 1999 that the audit office found Rmb400 billion in "misused funds" at 4,600 branches of the Industrial and Commercial Bank of China and 1,700 branches of the China Construction Bank - two others among the "big four" banks. Neither has the government seen fit to launch a public inquiry into what happened to billions of "missing" foreign exchange reserves. In 1998, the combined total of foreign direct investment and the trade surplus was $89 billion. But the foreign exchange reserves grew by only $5.1 billion. In 1999, the reserves grew by $9.72 billion on a combined investment and trade surplus of $76 billion. Abuses are common in other areas of the financial system. Recent cases have included listed companies falsifying their earnings reports, brokerage houses engaging in insider trading and helping investors to manipulate stock prices, and fund management companies exceeding limits on their subscriptions to share offerings. With this background, it is not surprising that the task of boosting supervision is expected to be the overarching theme of the Financial Work Conference. Officials say one initiative will be to encourage foreign auditors to examine Chinese banks and allow independent directors - including foreigners - on to the boards of state banks. But analysts believe that nothing less than systemic overhaul is required. The problem, analysts believe, is that China's Communist system - in which party directives override those of government agencies - does not lend itself to the establishment of an independent, arm's-length regulator. Bankers such as Mr Wang, who are also senior party officials, could in theory overrule mere functionaries in a government regulator. In the absence of any clear programme to reform the Communist party, some observers doubt that measures to strengthen supervision and provide policy support for the banks will be enough to create a strong, market-based financial system by 2007 - the date by which China has promised to allow foreign banks to compete on a level playing field. But the People's Bank of China, the central bank, has backed away from a 1999 promise to liberalise interest rates within three years. Analysts say perhaps the most crucial point of next month's conference will be whether a new timetable is announced. Free rates would help to impose market discipline on banks, brokerages and insurance companies. Without them, and the determination to let losers fail, China's state banks may regard round after round of policy assistance as a series of "free lunches". In 1998, the ministry of finance issued special bonds worth Rmb270 billion to recapitalise the big four. In 2000, the banks were allowed to transfer Rmb1,400 billion in bad loans to four asset management companies. There is no guarantee that the latest initiatives of allowing them to issue long-term bonds to retail investors or to list on domestic stock markets will meet with much more success, analysts say. The worry for foreign institutions is that if the banks remain too weak to face competition, the opening scheduled under the WTO agreement could be delayed, or new restrictions announced on foreign competition.
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