Five persistent myths about China's banking system.

• Author: Anderson, Jonathan

Of all the various topics and issues facing observers of the Chinese economy, it is safe to say that none arouses more spirited debate than the role of the financial system, and in particular the state of Chinese banks. Is the mainland on the verge of a financial crisis? Has the recent economic overheating created a new flood of bad loans? Do banks know how to allocate capital, or are they simply quasi-fiscal agencies acting at the mercy of the government? And does the rapidly opening financial system represent a gold mine or a "black hole" for foreign investors?

The answers to these questions are not always straightforward, but in our experience the truth lies very much away from the extremes so often presented in the financial press. Chinese banks are by no means "out of the woods," first and foremost because they remain state-owned institutions, but they are now well advanced from their situation only a decade ago. This means that the economy is protected from the risk of a financial crisis--but, on the other hand, the banking sector is more a sunset industry than an exciting growth sector.

There are a number of myths about banks and the financial system in China but the following are the most important and most persistent: (1) China's cost of capital is far too low; (2) Mainland banks are unreconstructed quasi-fiscal agencies; (3) Bank recapitalization is a sham; (4) Banks are already "out of the woods"; and (5) The Chinese banking system is an exciting growth industry. Let us now examine these five myths.

Myth 1: China's Cost of Capital Is Far Too Low

Until 2004, bank lending and deposit interest rates were rigidly fixed in China, at roughly 6 percent on average for loans and 2 percent for deposits. Even today, the regime for deposit rates has not changed, although banks have been given some leeway in raising lending rates. As a result, the common perception is that capital is "far too cheap," and that low capital costs are the main explanation for China's rapid growth over the past few decades.

In fact, the level of real lending and deposit rates are pretty much what we would expect from an economy with a gross domestic savings rate above 40 percent of GDP. The historical average for China over the past two decades is almost exactly the same as in the four Asian "tigers" during their high-growth period, and higher than that for Japan.

Indeed, a closer look at financial markets suggests that if anything, the capital cost to Chinese firms using the banking system is still too high, in the sense that full financial market liberalization would almost certainly result in lower lending rates. Market-determined long bond yields are currently only half the level of long-term bank loan rates, a reflection of the enormous amount of liquidity in the system. And although banks have taken advantage of the recent removal of the ceiling on lending rates to gradually bring the average up, the median lending rate is still firmly stuck at the mandated floor. Smaller financial institutions, in particular, are well known for their willingness to offer "under-the-table" incentives in order to bid effective deposit rates up--and effective loan rates down.

Myth 2: Mainland Banks Are Unreconstructed Quasi-Fiscal Agencies

The view that Chinese commercial banks are still little more than subsidy vehicles, propping up loss-making state-owned enterprises (SOEs) or blindly promoting government development goals, is so pervasive among outside observers as to be almost universal. However, this view turns out to be misguided on two counts. First, much has changed within the banking system itself, in terms of internal controls and incentives. And second, even more has changed among banks' borrowers.

Looking at commercial banks' internal structures, China has made significant progress in most areas. Whether state banks actually use these tools or not is a separate issue (and one that we take up further below), but over the past decade they have formally adopted modern risk controls, external auditors, centralized loan committees, and new corporate management structures. More important still, banks have seen...