Elite Chinese Politics and Political Economy

Dear Readers, I am in China now and find that my blog is no longer blocked by the Chinese government. Someone somewhere apparently thought that my discussion is too trivial to be blocked. Whoever did this, thank you (not that I care that much about it.....). Anyway, much more about my trip to China when I return to the US, which might get this site blocked again! In the mean time, here is my new piece at Far Eastern Economic Review:


FEER
China's Uphill Battle
For Stronger Banks

By VICTOR SHIH
November 21, 2005


While the road to hell is paved with good intentions, China's road to financial reform is paved with political ambition and bureaucratic rivalry. A case in point is the China Banking Regulatory Commission, which is having positive effects on financial regulation and the monitoring of nonperforming-loan ratios. Although the CBRC continues to struggle under the shadow of its increasingly powerful elder brother, the People's Bank of China, it now seems that the decision at the end of 2002 to create a separate agency to monitor China's banks was crucially important because it created a bureaucratic voice in favor of constraining NPLs in China.

The formation of the CBRC was based as much on political considerations as economic ones. In 2002, researchers at the now-abolished Central Finance Work Committee and the State Council Development and Research Center called for the establishment of an independent agency to regulate the banking sector. The main rationale was the need for specialized regulation of an increasingly complex financial system that is soon to be enlarged by an influx of foreign financial institutions. The stock market and the insurance industry already had their own watchdog organizations by 2002, but the banking sector was still overseen by the central bank.

Although the PBOC had the organizational capacity and human capital to fulfill this mission, its incentives were not aligned with the goals of financial regulation. As one of the proponents of an independent agency, CFWC researcher Qian Xiaoan, hinted in an article at that time, financial monitoring lacked "authoritativeness" and "independence," meaning that financial regulation had to struggle for attention among the PBOC's multiple agendas.

For much of the reform era, the PBOC's missions included inflation prevention, growth maintenance, bailing out illiquid financial institutions and finally regulating depository institutions. Time and again, the last task took a back seat to inflation prevention and growth promotion.

By contrast, an independent regulatory agency could single-mindedly carry out regulatory functions and-perhaps more importantly-lobby the central leadership on the importance of regulating financial institutions. With a clear mission, this agency would also defend banks' rights to resist political pressure to provide loans and lobby on their behalf in the central government. In some ways, the most important contribution of an independent ministerial-level financial regulator is the creation of a powerful political lobby for financial prudence.

Although the birth of the CBRC was colored by bureaucratic politics and quite possibly elite politics, the CBRC has taken a much more hard-line stance with respect to lowering banks' NPL ratios. The newly appointed head of the CBRC, Liu Mingkang, had a reputation of being a strong proponent of banking commercialization.

Perhaps more importantly, the new agency no longer had a mixed mission. Its mission was clear: lower the NPL ratios of Chinese banks. If Mr. Liu failed to do so, his career would suffer. This kind of transparent assignment of responsibility has been the key to the CCP's ability to achieve momentous outcomes in the past, and it once again served the regime.

In classic central-planning fashion, the first thing that Mr. Liu did as the head of the CBRC was to impose a hard NPL reduction target on the Big Four banks, in addition to liquidity and capital adequacy targets on all banks. Although these targets were imposed via administrative decrees, they did have the effect of changing bankers' incentives.

Nearly three years after the agency's creation, the NPL ratio in China has dropped to just above 10% from more than 25%. Although the lowering of the NPL ratio is due primarily to recapitalization from the foreign-exchange reserves and the off-loading of NPLs to the asset management companies, the fact that NPL creation did not speed up to a significant degree in the midst of an investment boom probably had something to do with the CBRC's vigilance.

Whereas the PBOC had been ambivalent about banks bending to local political pressure to lend, the CBRC unambiguously chastised local politicians for intervening in bank decisions. From CBRC head Mr. Liu down to the local CBRC chiefs, if the NPL ratio rises, their jobs will be jeopardized.

Despite a focused mission and improved incentives to regulate banks, the CBRC's regulatory capacity suffers from both internal problems and external intervention. Internally, the hard targets imposed by Mr. Liu on banks and on CBRC branches forced many bankers and local CBRC officials to submit false NPL figures to the headquarters. This is a perennial problem of the command economy, and the CBRC is no exception. Externally, although the CBRC in theory takes the helm in banking regulation, in reality it contends with a host of agencies for regulatory supremacy in the banking sector.

The CBRC's regulatory authority is further diluted by the existence of disciplinary committees and supervision committees in all major financial institutions. Because these institutions are either wholly or partially state-owned, they have Communist Party committees with propaganda, organization, and discipline and inspection sub-committees.

To make matters worse for the CBRC, the PBOC under Zhou Xiaochuan by no means gave up the fight to regain regulatory power from the CBRC. After taking the helm at the central bank, Mr. Zhou successfully argued that money laundering and counterfeiting are monetary phenomena that should fall under PBOC supervision. This is significant because the antimoney-laundering portfolio affords the PBOC and the State Administration of Foreign Exchange great latitude with which to examine the books in all financial institutions, not just in banks.

Finally, the CBRC's regulatory power has been threatened by the PBOC's assertion of its role as "investor" in an increasing number of financial institutions through the Central Huijin Company. By serving as an investor, the Huijin board of directors-dominated by PBOC officials- has a large say in the appointment of senior bankers, and Huijin has exercised that power a few times since its formation.

Thus the prospects for a truly independent financial regulator in China remain dim. The Party is unlikely to relinquish its hold on vital financial and regulatory institutions. And the central leadership repeatedly has found ways to bail out China's ailing financial sector instead of fixing it. The problem with easy fixes is that they give agencies with access to ample funding, including the PBOC, MOF and NDRC, more power over cash-deprived regulatory bodies. Despite its well-aligned incentive structure, the CBRC faces an uphill battle to create a more robust financial system.

Mr. Shih is an assistant professor of political science at Northwestern University. Excerpted from the November issue of the Far Eastern Economic Review. Futher information is available at www.feer.com