China - Agricultural Bank of China Commercialization

Report No. PID5481 Project Name China-Agricultural Bank of China r(+) Commercialization Region East Asia and Pacific Sector Financial Sector Development Project ID CNPE36946 Borrower People's Republic of China Implementing Agency Agricultural Bank of China 5/F Yu Long Hotel 40 Fucheng Road Beijing, China 100046 Ms. Hua Ruoming, Chief Foreign Funds Division Telephone: 6847-5347; FAX: 68416011 Appraisal Date Spring 1998 Board Date Fall 1998 Date of this PID July 31, 1997 1. Background. Financial sector reforms have been an important component of the Government's overall reform effort since 1979 to gradually transform the Chinese economy from a centrally-planned economy to a socialist market economy. The banking sector has evolved from a monobank system to a two-tier system and the country has acquired the elements of a modern, diversified financial system. China is now entering an important phase in its transformation to a market-based system, and the authorities consider further policy reforms and institutional strengthening and modernization of the financial sector to be of paramount importance in sustaining rapid economic growth through enhancing the efficiency of resource mobilization and allocation. Both macro and institutional hurdles to creating a robust financial system are enormous, and given the linkages between fiscal, enterprise and financial sectors, a weak sector infrastructure, and paucity of banking skills, development of an market-based system will of necessity be a gradual process. 2. Until 1978, the main function of the banking system was to mobilize savings for the economic plan and investment funds mostly allocated through budgetary grants. The People's Bank of China (PBC) served as a monobank and its specialized departments were responsible for settlement of enterprises' transactions, collection of household deposits, and administration of funds for working capital and short-term investment not covered by budgetary grants. The first stage of reforms during 1979-1986 focused on breaking up the monobank system, and the formal establishment in 1984 of the People's Bank of China (PBC) as the central bank. The People's Construction Bank of China and the Bank of China, which had previously operated as departments within PBC became independent  banks specializing in the construction sector and foreign transactions, respectively. Another specialized bank, the Agricultural Bank of China (ABC), was established to take over PBC's rural banking business. Subsequently, the Industrial and Commercial Bank of China was created to take over PBC's urban operations. During this period, the number of rural credit cooperatives (RCCs), which were set up to provide small-scale rural banking services, expanded rapidly. A number of urban credit cooperatives were established to serve small individually or collectively owned enterprises. New banks were formed at the provincial level, and numerous nonbank financial institutions (NBFIs), including trust and investment companies (TICs), securities firms, finance companies, leasing companies, and insurance firms were also established. The authorities allowed limited competition as traditional barriers of specialization between banks were gradually eliminated, banks were allowed to conduct foreign transactions, nationwide banks (or universal banks) were allowed to compete with the specialized banks, and foreign banks were allowed to open branches in special economic zones to conduct foreign trade-related operations. During this period, the authorities cut budgetary support for state enterprises and allowed more control to enterprises over their after-tax profits, thereby boosting the importance of financial intermediation for enterprise operations. 3. During 1988-1991, financial development slowed as the authorities introduced a rectification program in the wake of a sharp recession and mounting inflationary pressures. Stabilization was accorded priority, and nascent instruments of macroeconomic control were supplemented with administrative measures. As a result, the share of budgetary funds in investment financing rose as the role of directed credits expanded. The flexibility in setting interest rates within specified bands was narrowed, and the specialization of the major banks was reasserted. A number of TICs were closed or merged with specialized banks. 4. A more systematic long-term strategy for the development of the financial sector was announced on the occasion of the Third Plenum of the Fourteenth Party Central Committee in November 1993. Instead of earlier partial measures, an overall sector policy framework was developed, with the focus of the reform effort shifting towards providing a legal basis and a regulatory environment for the sector, enhancing the powers of the central bank, and gradual transformation into commercial banks of the four specialized banks, the mainstay of the banking system in China. 5. In recent years, the authorities have taken measures to strengthen the commercial orientation of the banking sector. These measures have included: enactment of laws on central and commercial banking; establishment of three new policy banks to separate policy from commercial lending and reclassification of specialized banks as commercial banks with increased autonomy in lending decisions and responsibility for their profits and losses and branch management; enhancing the powers of the central bank to conduct monetary policy and prudential supervision of financial -2 -  institutions; separation of ownership links between banks and nonbanks; licensing of additional banks, including China's first non-state owned bank; merger of urban credit cooperatives in 30 cities and their conversion into city united commercial banks; permitting eight foreign banks to conduct local currency business on a pilot basis; ownership diversification of nationwide commercial banks; developing a pilot payment and clearing system, and a book-entry system for government securities trading; unification of the interbank market and conducting open market like operations; reducing the coverage of the credit plan and introduction of asset liability management norms for commercial banks; and abolishing indexed term deposits and more frequent adjustment in administered interest rates. 6. Despite the reform measures and progress made to date, further policy reforms and institutional strengthening are necessary to enhance the efficiency of resource allocation. Development of an efficient financial system would require an effective monetary policy that relies on indirect control instruments and reduction in the role of the credit plan; further strengthening of the sector infrastructure framework, including legal, prudential, accounting, and payments system; further reforms in the state enterprise sector, including a resolution to their bad debt problem; enhanced competition; further liberalization of interest rates; and converting human resources into human capital to enable banks to manage commercially their assets and liabilities. 7. Macroeconomic and structural reforms continue to be central to the Bank's assistance strategy in China. Incomplete reforms of the financial sector, state-owned enterprises and public finances constrains development of strong macroeconomic management tools and threatens sustained rapid economic growth. The Bank is following a multiprong approach in the banking sector consisting of the following main elements: (i) policy dialogue with the authorities on financial sector and state enterprise issues through economic and sector work and dissemination of findings and experience of other countries in various workshops and seminars; (ii) assistance in the establishment and strengthening of sector infrastructure- legal, prudential, accounting, and payments system-under the ongoing Financial Sector Technical Assistance Project, and skill upgrading of the staff of the central bank, commercial banks, policy banks and other institutions in the financial sector under various grants and loans and a multi-year training program managed by the Bank's Economic Development Institute; (iii) enhancing the role of smaller Chinese commercial banks through institutional development programs, participation as financial intermediaries under Bank's lines of credits, and closer relationship with IFC, including possible equity participation; and (iv) assistance in the gradual transformation of the formerly specialized banks into commercial banks. 8. Project Objectives. The main objective of the proposed Agricultural Bank of China Commercialization Project is to assist in the transformation into a commercial bank of the Agricultural Bank of China (ABC). The ABC is one of the four 100 percent state- - 3-  owned large banks in China. All four are ranked by asset category as among the largest 100 banks in the world. The ABC dominates rural banking, with total assets of approximately $150 billion, over 50,000 branches and subbranches and a staff of over 500,000. It has traditionally focused on short-term financing, with loans for working capital and grain procurement accounting for about 80 percent of its portfolio. The non-state sector has typically accounted for about 55 percent of ABC's loans, primarily collectives, township and village enterprises (TVEs), and households. The remaining 45 percent of the loan portfolio has largely been with state supply and marketing cooperatives and state farms. 9. ABC's mandate and focus, however, have been changing in response to the gradual deregulation of financial sector in recent years. First, the share of TVE lending has significantly increased and the share of state lending has declined in response to ABC's increased emphasis on market-based credit decisions and new focus on profitability. Second, ABC's non-commercial functions, including financing of government staple crop purchases, official grain storage, agricultural development programs, and poverty alleviation programs, have largely been transferred to the new policy bank, the Agricultural Development Bank (ADB). The ABC also successfully transferred the stock of its non-commercial portfolio to ADB, which amounted to about 20 percent of ABC's portfolio and included some of its most problematic investments. Third, ABC's oversight functions and the holding of reserves for RCCs has been transferred to PBC. While this has adversely affected ABC in the short-term (RCCs accounted for some 25 percent of ABC's total deposits), it has freed management to pursue its own commercialization goals. 10. The ABC (and the other formerly specialized banks) face a number of external and internal constraints to full commercialization. The external constraints refer to constraints-- centrally-mandated credit allocations, administered interest rates, non-performing loans under the government's directed credit programs, personnel and compensation policies, inadequate loan loss provisioning policies and high income and other taxes--on which the bank has little or no control. The internal constraints are equally binding in view of the specialized banks' past role as fiscal agents of the government. While recent reforms have enhanced the prospects of improved ABC financial performance, substantial challenges remain for its transformation into a full fledged commercial bank. These challenges include conflicting mandates, lack of a coherent strategy and business plan, inadequately trained staff and weak personnel management systems, operating procedures based on administrative and not commercial principles, an incomplete and out-dated information technology (IT) system, and an excessively large and inefficient network of local offices. Similarly, ABC needs to diversify its savings and deposit bases to make up for the loss of the RCC business and the increasing competition from other banks and financial institutions in rural areas. This will require carefully planned expansion into targeted urban markets and the broadening of ABC services and markets. Finally, ABC has inadequate resources to meet the growing demand - 4 -  for investment funds in its priority market, the non-state sector, reflecting a mismatch between shorter-term deposits and longer-term credit demand. 11. Project Description: The proposed project should be placed in the context of needed reforms in China, and should be perceived as simply the first of a series of operations in support of ABC's commercialization. The main focus of the proposed project is on setting up modern commercial banking practices and policies and procedures to provide senior managers with reliable information to base future decisions. The project design is based on the priorities and sequencing of internal reforms identified by ABC management, based on a number of PHRD-financed studies undertaken by international experts for the project as well as studies financed under an ADB grant. The PHRD financed studies focused on two provincial branches and reviewed operating procedures related to financial accounting and reporting, portfolio classification, risk management and asset and liability management, and preparation of five year business plan based on branch's competitive advantage in various segments of the local market. An Information Technology (IT) diagnostic study is under preparation. The ADB-financed studies focused on project lending, management information systems and accounting system improvements. 12. The proposed project will have the following components: (a) a technical assistance component, whereby the services of commercial banking experts would be provided to assist ABC in its modernization program; (b) a training component, whereby a core commercial banking curriculum would be developed and ABC's in-house training capabilities will be strengthened; (c) procurement of priority IT hardware and software; and (d) a line of credit component for onlending to eligible subborrowers. All components would have as their main objective the institutional development of ABC. About 10-15 percent of the IBRD loan of $300 million would finance the services of commercial banking experts, high priority hardware and software as identified by the ongoing IT study, and training. The main emphasis will be on strengthening ABC Head Office and two-three selected provincial branches on a pilot basis. 13. The technical assistance component will be divided into a number of modules, including: (i) governance and organizational reform, including a new charter in accordance with the requirements of the new commercial banking law and company law; (ii) strategic and business planning in line with ABC's long-term mission and competitive advantage; (iii) financial management to address a number of key areas, including the integrity of the accounting system, financial reporting system, and establishment of and/or strengthening of key functions such as asset liability management, treasury and market risk; (iv) internal audit function, including an internal audit structure, a new set of audit standards, internal audit manual, and effective operations monitoring; (v) credit management, including establishment and/or strengthening of a credit control committee, credit policy and procedures and manual, mandates of branch level credit committees, project appraisal manual, improved approach to loan exposure, valuation of - 5 -  collateral, loan classification system, and a work out unit to monitor and address issues related to nonperforming loans; (vi) human resource management, including reforming the current personnel management policies and processes, compensation and reward system, and establishing a comprehensive organization-wide human resource data base; and (vii) information technology, including developing robust and integrated strategies and operational arrangements to implement specific components of the new five year IT plan, model branch technical architectures, standardization strategy for consistent and cost effective application. The training component will include upgrading of 1-2 existing training facilities, training materials, training equipment, training of trainers and overseas training of selected core staff. 14. The line of credit (85-90 percent of the total loan amount) would also support ABC's institution building. ABC's credit functions will be revamped and its capacity to manage credit risk, interest rate risk, market risk, foreign exchange risk and liquidity risk will be strengthened under the modernization component. In addition, loan approval procedures would be standardized, loan monitoring and reporting process improved, and provision made for training and enhancing staff skills in credit management. Under this component, ABC would finance subprojects strictly in accordance with commercial criteria and an appraisal methodology that is acceptable to the Bank. Unlike previous Bank lines of credit to ABC, the proposed line of credit would not be directed to specific subsectors or regions, i.e., there will be no real sector objectives. Eligibility criteria for subprojects and subborrowers will include: all subborrowers will be from the non- state sector, i.e., collectives, TVEs, cooperatives, individuals and joint ventures; project sponsors should be able to finance at least 30 percent of the subprojects total investment cost; subborrowers will submit financial statements to ABC that are audited by independent auditors; subborrowers who are not current on their past debt obligations to ABC will not be eligible for loans; a minimum economic rate of return and financial rate of return of 12 percent; all subprojects must meet government's environmental standards and have the written approval of the relevant environmental protection bureaus. In addition, all subprojects should conform with ABC's overall operational strategy as set out in the new business plan. 15. Project Financing: The proposed Bank loan of $300 million would finance about 50 percent of the total cost of the project estimated at about $600 million. The balance will be financed by subborrowers equity contribution (30 percent) and by ABC (20 percent). 16. Project Implementation: ABC would be responsible for the overall implementation of the project. An Interdepartmental Group chaired by ABC's executive Vice President and co-headed by the Deputy General Managers of International Department and Development Department have been entrusted with the task of providing direction and coordination for ABC's commercialization effort. The Group is composed of representatives of Development, Funds Planning, - 6 -  Industrial and Commercial Loan, Financial Accounting, Information and Computer, Auditing, Legal Affairs, Personnel and Education, and International Departments. The Development Department will be responsible for guiding the work under the proposed project and the International Department will be in charge of coordination and liaison. 17. Project Sustainability: ABC's competitiveness and financial position would be supported by: (a) introduction and/or strengthening of new operating procedures designed to enhance ABC efficiency, improve risk management, and reduce transaction costs, particularly in the areas of financial management, credit management and market risk management; (b) on-lending terms to sub- borrowers that provide an appropriate margin to cover ABC's risk, operating cost, and profit requirements; and (c) emphasis on institutional development program, and the large investment in human resource development and information technology. The non- state enterprises, the main beneficiaries under the line of credit, operate under a less distorted incentive regime and have been the main engine of growth in China. In the last two years, ABC has undertaken a number of initiatives towards its transformation, and senior management is fully committed to the main objectives of the proposed project. 18. Lessons for Project Design: The proposed project incorporates lessons of experience from the four previous rural credit operations with ABC as well as banking sector projects in the transition economies of Central and Eastern Europe. There are however major differences in banks, financial systems and in the expected role of the State and private sector in China compared to banks, financial systems and economic organizations in other economies. The formerly specialized banks in China are very large in terms of assets, branches and workforce, even by international standards. More important, the Chinese authorities have adopted a policy of gradualism in its deregulation and reform program and large scale privatization is now not in the cards. Experience has shown that economies in transition lack good management information, and this is true of China also. The institutional development program proposed under the project is based on comprehensive diagnostic studies of the financial position, operating procedures, organizational structure, and needs assessment in the areas of commercial banking skills and information technology. These diagnostic studies have mostly been managed by ABC, and the proposed scope and design of the institutional development program takes into account ABC's implementation and absorptive capacity. 19. Environmental and Social Aspects: The subprojects to be financed under the line of credit would be identified only during project implementation. The project has a Category B rating, as the line of credit might finance some subprojects with potentially adverse social and environmental impacts. Under the policy and administrative requirements for environmental assessment of development projects in China, EIAs, EAPs and EAs are carried out by project sponsors. Financial institutions are prohibited from extending loans for projects that do not have the approval -7 -  certificate from the relevant level environmental protection bureaus. To date financial institutions have played mostly an administrative role limited to verifying that all necessary environmental approvals are in place for a given project. ABC plans to take a more pro-active management of environmentally related risks. In line with the recommendations of an Asian Development Bank financed study, ABC is preparing an environmental due diligence policy that would be integrated with the project lending process. An interactive environmental due diligence training module will be developed to enable ABC credit officers to efficiently conduct environmental due diligence as a routine part of the project lending process. In view of the size and complexity of its organizational structure, ABC plans to establish environmental risk assessment capability at the HO and, initially on a trial basis, in two provinces. 20. During project preparation, it would be agreed with ABC that the subprojects will try to avoid the need for resettlement. However, in the event that resettlement is required, a separate Resettlement Action Plan (RAP) will be prepared for each of such subprojects. ABC will prepare a Resettlement and Rehabilitation policy framework, acceptable to the Bank, reconciling national laws with Bank policies on social impact, and specifying the instruments and processes to deal with resettlement and adverse social impacts that may be identified during the appraisal of subprojects. The policy framework would specify standards and cutoff point beyond which preparation of a full-scale RAP will be necessary. 21. Program Objectives Categories: The project relates to the economic management program objective, through the commercialization and institutional strengthening of ABC, and the private sector development program objective, through the provision of investment funds for TVEs. 22. Date the Initial PID Prepared: NA 1/ Previously named Rural Banking Commercialization Project Contact Point: Surinder Malik, Task Manager The World Bank 1818 H Street N.W. Washington, D.C. 20433 Telephone No.: (202) 458-2506 Fax No.: (202) 522-1556 Note: This is information on an evolving project. Certain components may not necessarily be included in the final project. - 8 -  Processed by the Public Information Center week ending August 15, 1997. -9-  Annex Environmental The subprojects to be financed under the line of credit would be identified only during project implementation. The project has a Category B rating, as the line of credit might finance some subprojects with potentially adverse environmental impacts. Under the policy and administrative requirements for environmental assessment of development projects in China, environmental impact assessments are carried out by project sponsors and submitted to relevant level environmental protection bureaus. Financial institutions are prohibited from extending loans for projects that do not have the approval certificate. In order to take a more pro- active management of environmentally related risks, ABC, with the assistance of international experts, is preparing an environmental due diligence policy that would be integrated with the project lending process. An interactive environmental due diligence training module will be developed to enable ABC credit officers to efficiently conduct environmental due diligence as a routine part of the project lending process. ABC will be required to ensure that the recommendations, including mitigation measures, of the approved EAs have been adequately incorporated into the subproject feasibility studies and investment approval and loan documentation. Qualified environmental consultants would carry out annual environmental quality assurance checks of selected sample of subprojects financed under the project to assess the implementation from an environmental standpoint. - 10 -