China - Financial sector review : financial policies and institutional development

Report No. 841 5-CHA China Financial Sector Review: Financial Policies and Institutional Development June 29,1990 Country Operations Division Ch'na Department Asia Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CU%RENCY EQUIVALENTS Y 4.72 - US$1.00 US$1.00 . Y 0.211 FISCAL YEAR January - December ABBREVIATIONS ABC - Agricultural Bank of China BOC - Bank of China BOCOM - Bank of Communications CIB - China Investment Bank DFC - Development Finance Company FXAC - Foreign Exchange Adjustment Center GAAP - Generally Accepted Accounting Principle GITIC - Guangdong International Trust and Investment Company ICBC - Industrial and Commercial Bank of China ITIC - International Trust and Investment Company MOF - Ministry of Finance NBFI - Nonbank Financial Institution NGCO - Nongovernmental Credit Organization NGFA - Nongovernmental Financial Association PBC - People's Bank of China PCBC - People's Construction Bank of China PICC - People's Insurance Company of China RCC - Rural Credit Cooperative SITCO - Shanghai Investment Trust Company SOE - State-Owned Enterprise SPC - State Planning Commission SRC - System Reform Commission TIC - Trust and Investment Company TVE - Township and Village Enterprise UCC - Urban Credit Ccoperative  FOR OFmFCIAL USE ONLY - i - GLOSSARY OF FINANCIAL TERMS Average Cost of Funds: A weighted average of the interest cost of a bank's deposits and own funds, based on the composition of its deposits at a point in time. Bankable Risks Loans representing bankable risk are made in conformity with banks' creditworthiness standard and having an acceptable risk profile and certainty of repayment. Banks: Financial institutions that accept funds, principally in the form of deposits repayable on demand or at short notice (such as demand, time, and savings deposits). Under the general rubric 'bank" come: commercial banks, which engage only in deposit taking and short- and medium-term lending; investment banks, which handle securities trading and underwriting; housing banks, which provide housing finance; and so on. In some countries there are universal banks, which combine commercial banking with investment banking and sometimes with insurance services. Capital Market: The market in which long-term financial instruments, such as equities and bonds, are raised and traded. Commercial Bills: Short-term debt instruments that are used mainly to finance trade. Examples are promissory notes, by which debtors commit themselves to pay to creditors or to their order a stated sum at a specified date, and bills of exchange, which are drawn up by creditors and accepted by debtors. Commer- cial bills that are also accepted by banks are known as bank acceptances. Promissory notes issued by large corporations to meet their general financial needs are known as commercial paper. Contractual Savings Institutions: Occupational pension funds, national provi- dent funds, life insurance companies, and similar institutions that collect long-term savings on a contractual basis. Development Finance Institutions (DFIs): Financial intermediaries that empha- size the provision of capital (loans and equity) for development. DFIs may specialize in particular sectors--for example, industry, agriculture, or hous- ing. Although most provide only medium- and long-term capital, some, particu- larly those that specialize in agriculture, also provide short-term finance. Discount: A reduction from the face value of a financial contract. Disintermediation: Usually it refers to the removal of funds from interest- bearing time accounts in savings institutions and commercial banks for the purpose of reinvesting the funds at higher rates in market instruments. In other cases, ordinary sight and saving deposits are removed to increase the demand for durable (e.g., land, gold) or consumption goods, or to be lent directly by surplus agents (households) to enterprises, bypassing financial intermediaries. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Economic Regulation: Refers to regulation designed to achieve economic goals. Examples include reserve requirements (control of money creation), directed credit and credit allocation (lending to priority sectors in the interest of social and developmental objectives), financial transaction taxes (revenue generation for the fiscal budget). etc. Equity Finance: The provision of finance in a form that entitles its owner to share in the profits and net worth of the enterprise. Financial Distress: Usually refers to the sharp deterioration of a group of financial indicators resulting in changes in the behavior of the agent before its restructuring or bankruptcy. When such distress reaches crisis propor- tions and is widespread, it usually leads to a rush out of real or financial assets into cash. Financial Repressions Policies to maintain low interest rates and otherwise constrain financial intermediaries in ways that go beyond prudential consider- ation. Financial Savingss The portion of total wealth held in the form of financial assets. Fractional Reserve Banking: The practice by which commercial banks maintain a reserve of highly liquid assets (usually deposits in a central bank) equal to only a fraction of their deposit liabilities. Global Bankings Global banking usually refers to the combination of comner- cial banking (i.e., making loans and collecting deposits) and investment bank- ing activities (issuing, underwriting and placing securities) or other noncom- mercial banking activities (such as insurance) under one roof. Hedgings The acquisition of a financial contract designed to protect the purchaser against a future change in the price of a commodity or security in which the purchaser has an interest. Indexation: A mechanism for periodically adjusting the nominal value of con- tracts in line with movements in a specified price index. Leverage: The ratio of debt to equity or of debt to total capital employed. Liquid Liabilities: Money plus highly liquid money substitutes, such as sav- ings deposits. Marginal Cost of Funds: The interest cost of new deposits, i.e., the cost of funding the last dollar in loans. Market Capitalization: The total value of outstanding securities at present market prices. Match-Funding: Banks matching the maturity of their deposits with loans of equal maturity.  - iii- Moneys Currency and other liquid assets. Narrow definitions such as Ml refer to money used as a medium of exchange. Broader definitions such as M2 or M3 add to MI money used as a store of value. Ml: Currency outside banks plus demand deposits, excluding those held by government and banking institutions. M2: MI plus time and savings deposits (other than large certificates of deposit) at commercial banks. M3: M2 plus deposits at nonbank thrift institutions. Money Market: A market in which short-term securities such as Treasury bills, certificates of deposit, and commercial bills are traded. Money Multiplier: Links the monetary base with the money stock in a way reflecting the behavior of banks and the public. The money multiplier (m) is defined as followss m - (1 + C/D ); (C/D+r+r*) where C/D - Currency held by the Public/Deposits; r - Reserve Requirements/Deposits; and r* - Excess ReservesIDeposits. M or broad money will be the result of applying the money multiplier to the monetary base (B), defined as currency plus bank reserves. Thus, M a m . B Broad money is defined as currency plus sight and time deposits, an aggregate thought to be closely related to variations in GNP. Changes in institutional arrangements or policy parameters (reserve requirements), as well as the banks' and the public's preferences affect the size and behavior of the multiplier. Nonbank Financial Institutions (NBFIs): Financial institutions, such as building societies and insurance companies, that hold less-liquid liabilities not normally regarded as part of the money stock. Nonperforming Loans: A loan on which contractual obligations (for example, interest or amortization payments) are not being met. Open Market Operations: The purchase or sale of securities by the Central Bank to influence the supply of funds in the capital market and so interest rates and the volume of credit. The purchase of securities by the Central Bank increases the reserves of commercial banks, while sales reduces them. When reserves expand banks, banks acquire additional assets such as new loans, increasing credit and tending to depress interest rates in the economy. Reduction of reserves has the opposite effect.  - iv - Prudential Regulation: Refers to the set of laws, rules and regulations which are designed to minimize the risks banks assume and to ensure the safety and soundness of both individual institutions and the system as a whole. Examples include lending limits, minimum capital adequacy guidelines, liquidity ratios, etc. Reserve Money: Currency in circulation plus deposits (of banks and other residents but not the government) with the monetary authorities. Seianiorages The net revenue derived from money issue. Self-Dealing: Loans to a related party or oneself, not in conformity with bank policy or general prudential policies. Term Finance: Equity or medium- and long-term loan finance. Trust and Entrusted Operations: Money or property vested by an individual or group of individuals in a trust to be administered in the interest of others. Such trust can be set up in accordance with the general instructions of the initiator (trust operation), protecting it from outside interference, while leaving some discretion to the administrator. In other cases, such discretion is not granted (entrusted operations). Velocity (Income Velocity of Circulation): The rate at which money circulates through the economy in order to finance transactions. It is measures as v = (Y/M), where M is the (narrowly defined) money supply and Y is National Income or Product. In general v will be larger than 1, indicating that the quantity of money circulates more than once in a year through the economy to finance the total volume of transactions. Write-Offs: The act of removing an asset from the books of a company or bank, acknowledging and charging the loss against loan-loss provisions or capital.  CHINA FINANCIAL SECTOR REVIEWt FINANCIAL POLICIES AND INSTITUTIONAL DEVELOPMENT Acknowledgements This report is based on the findings of a mission which visited China in August-September 1989. In addition to interviews and discussions in Beijing and surrounding counties in Hebei Province, the Mission visited Shanghai. The mission consisted of Christirne Wallich (Mission Leader); Jose Silva-Lopes (consultant) and Steven Dunaway (IMF) were responsible for analy- s8's of monetary and credit policies; Diana McNaughton was responsible for work on institutional development in the financial sector; Zoubida Allaoua under- took the updating of recent developments in China's financial sector; Fernando Montes-Negret was responsible for analysis relating to the scope and mix of institutions and interest rates; Vincent Polizatto was responsible for bank supervision and regulation; and Paul Meek (consultant) was responsible for government debt operations. The mission was accompanied in Beijing by Peter Harrold. The mission was conducted in collaboration with, and accompanied in the field by, a counterpart team of Chinese officials from three agencies. Hosted by the People's Bank of China (PBC) and under the direction of Chen Yuan, Deputy Governor of PBC, the counterpart team was led by Mr. Ren Junyin, Deputy Director, Planning Department (PBC). The team also consisted of Mme. Xu Meizheng (Deputy Director, System Reform Commission)% Xie Ping (Deputy Division Chief, PBC); Luo Ping (Official, International Department, PBC); and Mr. Sun Cai Ren (Official, State Debt Management Department, MOP). The mis- sion extends its thanks to these and other officials whose insights made possible this collaborative report.  -~~~~~~~~~~ - CHINA FINANCIAL SECTOR REVIEWs FINANCIAL POLICIES AND INSTITUTIONAL DEVELOPMENT Table of Contents Page No. SUM1MARY AND CONCLUSIONS ...... .................... ..... .. i I. RECENT DEVELOPMENTS IN CHINA'S FINANCIAL SECTOR . ........ 1 Introduction........ . 1 A. Changing Role and Mix of Institutions in China's Financial Sector ......... ..... 3 Evolving Role of the Central Bank... 3 PBC's Mandate. ......... . ... ....... 3 PBC's Hierarchy... 5 PBC's Organization. . . 5 The Specialized Banks: General Characteristics. . 5 Evolution of Institutional Responsibilities . . 5 The Institutional Setting. . . 6 Organizational Structure ... 6 Financial Structure ..... . . 6 Liability Structure.. .. 6 Noncommercial Liabilities..... .... 9 PBC Credit to Specialized Banks .. . 9 Specialized Banks' Assets... . 9 Employment ............ 10 Branch Network. ........ ..... .. .. ......... 10 Market Slrares ........... . ...... * ... ... . .. 10 The Legal and Institutional Banking Environment.. 10 (i) Legal Reserve Requirements . . 10 (ii) Ta atin......................... 11 Other Banks and Depository Institutions% General Charactraistics...... .... 11 National Comprehensive Banks.... 11 Local Comprehensive Banks and Other Banks .... .... 11 RCCC............................ 12 Curb Rural Markets ....... .... ..... ..... 12 UCCs ....... ............................................. .. 12 Nonbank Financial Institutionss General Characteristics.... 13 Trust and Investment Companies (TICs.. 13 Finance Companies. .... ..... ......... 13 Financial Leasing Companies ... . .14 Security Companies. ....n....e s..... . ....... 14 People's Insurance Company of China (PICC). 14 Scope of Business of Banks and Nobanks b. . 14 B. Structure and Depth of the Financial Sector. 15 Financial Instruments and Ma.ar k. 15 Market Share of Financial Intermediaries. 15  _ ii - Page No. Financial Assets . .. . .. ......... . 17 Non-Treasury Securities' Market ....................... .. 18 Public Enterprise Bonds .................................. . 18 Enterprise Securities .... 18 Financial Institutions' Bonds . . ............... 19 Local Government-Backed Enterprise Bonds ................. . 19 Financial Markets and Their Operation . . 20 The Money Market ..... 21 The Interbank Market . . ........ ............ 21 Trade Bills, Bankers' Acceptances and CDs ................. 21 Commercial Paper . ... 21 Money Market Operation and Institutional Features . . 21 Financial Deepening and Resource Mobilization . . 22 Financial Savings ......................................... 22 Financial Deepening ....................................... 22 International Comparisons . .. 23 C. The Lending Environment and the Investment System . . 24 Interest Rates .............................................. 24 Administered Rate Structure .. 24 Dispersion of Rates .. 24 The Trend and Level of Interest Rates . . 25 Real Interest Rates .................. 25 Interest Rates on Loans .. 30 The Yield Curve .. 30 Nonadministered Interest Rates .. 30 Investment Financing, Credit Plan and Priority Lending .. 30 The State Investment System .. 30 The Credit Plan, Government-Directed and Priority Credit.. 31 Investment Financing .. 32 'New Industrial PoliciesO/Priority Credit . . 32 D. Bank Supervision .. 33 II. MONETAtd POLICY: FORMULATION AND IMPLEMENTATION . ................ 35 A. Recent Monetary Developments .................................. 35 B. Tools and Implementation of Monetary and Credit Policies ...... 37 The Credit Plan .... ... 37 The Credit Plan for NBFIs . . . 38 The Cash Plan .... 38 PBC Credit to Financial Institutions . . . 39 Reserve Requirements and "Special Deposits" . . 40 Required Reserves . ..... 40 Excess Reserves ..... 41 Special Deposits . . . 41 C. Formulation and Tmplementation of Monetary and Credit Policies: Issues and Recommendations . . . 41 The Monetary Stance ................. ..................... 41 Directed Credit .......................................... . 42 Strengthening PBC .........................EG............... 46 The Credit Plan . . ......................................... 46 Credit Ceilings . . ..... 47  - iii - Page No. PBC Credit and the Control of Reserve Money ...... 48 Control Over the Issue of Cnea ............................ 49 Reserves and 'Special Deposits ............................ 49 Excess Reserves . ...................................... * ... SO Interest Rates ...........................................SO.. so Interest Rate Structure ................................... 51 (a) Interest Rates on Deposits and Other Savings Instruments ........................................... 51 (b) Lending Rates ....................................... . . 52 Impact of Higher Rates .. 54 Interest Rate Dispersion and Risk Spreads ............. 56 III. LENDING INSTITUTIONS: INSTITUTIONAL DEVELOPMENT AND CHANGING INSTITUTIONAL ROLES ...... 57 Introduction ................................................ 57 A. Issues in Institutional Development ........................... 58 Strengthening Management Processes and Financial Performance 58 Strategic Planning ........................................ 58 Financial Management .. 58 (i) The Accounting System .. 58 (ii) Planning and Budgeting . . 60 (iii) Asset and Liability Management . . 60 (iv) Liquidity Management .............................. 60 (v) Pricing of Financial Instruments. Development of Products and Services ............................... 61 Credit Policy, Procedures, and Loan Portfolio Management.. 61 Internal Audit .. 62 Financial Performance ....................................... 63 Gross Margins .. 63 Net Margins ............................................. 63 Provisioning Policy ....................................... 67 Write-Offs ...... 67 B. Recommendations for Institutional and Management Strengthening 68 Credit Risk Management ..................................... 68 Interim Steps in Credit Risk Management . . 68 (i) Portfolio Segregation for Directed Lending ............ 70 (ii) Portfolio Tracking ..................... .. 71 (iii) The Free Limit . . . 71 Internal Audit ... 71 Strengthening the Accounting Framework . . . 72 Financial Management in State-Owned Banks . .. 72 The Legal Framework for Collateral and Debt Recovery .. 73 Strategies for Recapitalization . . . 74 Strengthening Basic Management Functions . . . 76 Planning .................................................. 76 Management Information Systems ........................... . 76 Human Resource Management and Training .................. . 77 C. Developing a More Competitive Financial System: Sectoral and Structural Issues and Recommendations ......................... 77 Changing Scope of Business .................................. 78 Structural Separation of Banking and Nonbanking Activities 78  - iv - Page No. Administrative Distortions and Intra-Industry Barriers.... 79 (a) Limits to Deposit Taking ............................ . . 79 (b) Limits to Lending Activities ..,,,.. ......... 79 (c) Limits on Access to Financial Services . . 81 Limited Term Transformation and Need for Long-Term Finance 81 Unsatisfied Credit Demands ................................ 82 Nonprice Competition and Administered Interest Rates... 83 Improving the Mix of Financial Institutions: Some Options.. 83 Entry into Financial Services,,,,,,,,,... . . 84 Role of NBFIs and Term Lenders ............................ 84 Comm ercialvs.Global Banking .......................... 84 Institutional Options ..................... , , .... 85 Other Institutions ............................. . 85 IV. BANK SUPERVISION AND REGULATION . . . 87 A. Present Arrangements and Emerging Supervisory Challenges 87 Objectives of Bank Supervision .... 87 Developmental Goals vs. Prudential Concerns .... 87 Avoiding Accumulation of Losses and "Financial Distress' 88 Strengthening the Legal Basis for Bank Supervision . .88 Strengthening the Bank Supervision Process.... 90 Organization of Functions .n.c....i o.. . ......... 4...... 90 Strengthening Supervisory Methods .......................... . 90 on-Site Inspections ..... 90 Off-Site Supervision . . ................................ 91 Evaluating Loan Quality .... 92 Communicating Examination Results .... 92 Use of Examination Results and PBC*s Management Information .............. . . ................ 93 Licensing .........,,,,,. . . ............... 93 B. Recommendations for Strengthening Supervision. . 94 Establishing an Appropriate Legal Framework . . . 94 Licensing Entry and Exit. . .. . .... , 95 New Branches and Banks ........................ , .. 95 Licensing Authority ,,.,.,,.,,. . .. ......... 96 Capital ...................................... , 96 Dissolving Problem Banks . . .............................. 96 Prudential Controls and Limits . . ........................... , 96 Sanctions and Penalties,.. .......... . ... . . ..... 98 Implementing a Strengthened Bank Supervision Framework 98 Focus on Prudential Concerns .... 98 Move from Audit to Appraisal .... 100 Examine the Consolidated Institution and Target Scarce Resources .... 100 Examine Using a "Top-Down" Approach . . .,.,.. 100 Emphasize the Development of Banks' Own Management Systems 101 Redistribute Supervisory Personnel ........................ 101 Training ................................ 101 Developing New Examination Methodologies .................. 101 Develop an Off-Site Surveillance and Early Warning Function 101 Near-Term Initiatives Towards Long-Term Objectives ......... . 102  Page No. V. GOVERNMENT DEBT MANAGEMENT AND MONETARY POLICY ................... 103 A. Government Domestic Debt Management in China .................. 103 Government Securities . ............................ . 103 The Treasury Securities Market ................ 103 Government Securities: General Characterist ics ........... 103 The Government Debt Management Process ...................... 105 Issue Procedures ............... 105 Agency Responsibilities ...... 106 B. Government Debts The Placement Challenge and Other Issues.... 106 Treasury Bondss Growing Volumes ............... 106 Quasi-Government Bonds/"Agency Securities" ................ 107 Ownership ........................... 108 Coupon Rates . ....... ............................................... . 108 Maturity Structure .............................. .......... . 108 C. Recommendations .......... . .. .......... ....... .......... 109 The Framework for Debt Managementt The Medium Term ......... 109 The Integration of Monetary Policy and Debt Management .... 109 PBC's Role in Debt Management ................. 110 Financing the Government in the Sbort Term . .1........ il Encouraging a Short-Term Market in Enterprise-Held MOF Securities ......................... 112 Trading Bonds Held by Enterprises ......................... 112 Developing a Long-Term Debt Management Strategy . ........ 113 Mandatory vs. Competitive Sales ................ 113 Developing the Wholesale Market for Government Debt ...... 114 Maturity Structure ................... . ........... 115 Market Development: Short-Term Bills ..................... iS Market Development: Treasury Bonds ..................... 116 Reorienting MOF Sales to Individuals: Retail Operations.. 116 Open Market Operations: Initiating PBC Operations ...... 116 VI. POSTCRIPT: DEVELOPMENTS TO THE FIRST QUARTER, 1990 ........ ........ 118 The Decline in Inflation and the Monetary Policy Stance Since the Last Quarter of 1989 ............................ 118 Recent Changes in Nominal Interest Rates . ........... 119 Lending Rates .. . .......... 119 Deposit Rates ................ . 119 PBC Rates ................................................. 120 Directed Bank Credit ...................... 121 Financial Sector Developments . ......... 122 Trust and Investment Companies (TICs) ..................... 122 Further Proposals to Develop China's Financial Markets .... 122 The Mandatory Rollover of SOE-Held Maturing MOF Bonds ....... 122 Concluding Remarks ....... ............... . 123  _vi - Page No. LIST OF TABLES IN TEXT Table 1.1: Structure of the Financial System (1988) ................ 3 Table 1.2s Specialized and Comprehensive Bankst Domestic Assets and Liabilities ......... ............ .. 8 Table 1.3: Scope of Business of China's Financial Institutions ..... 16 Table 1.4: China: Financial Assets: 1985-89 ..................... . 17 Table 1.5s Relative Size of Financial Markets ....... . 23 Table 1.6: Financing of Domestic Fixed Investment .................. 32 Table 2.1: China: Monetary and Velocity Developments, 1985-89..... 36 Table 2.2s Estimated Impact of Higher Interest Rates on State-Owned Enterprises ......... ..............$ ...... 55 Table 3.1: Financing of Investment - 1987 . ...................... 82 Table 4.1: Supervisory and Internal Auditing Tasks Carried Out by PBC's Organizational Units .................. .. ....... 91 Table 5.l1 Sources of Government Financing...................... 107 Table 6.1: Interest Rates on Loans and Deposits................... 119 Table 6.2: PBC Interest Rates ............ . .... . 120 Table 6.3t Interest Rates on Special Loans at Preferential Rates... 120 LIST OF BOXES IN TEXT Box 1.1: PBC: Past and Present . . 4 Box 1.2: The Specialized Banks anks.......... . ..... 7 Box 1.3: Interest Rates. . . .......... .... . ....... *. . .-. 26 Box 1.4s Interest Rate Policy and Banks' Lending Spreads 28 Box 2.1: Interest Rate and Credit Policy in Japan and Korea 43 Box 2.2: Indexed Interest Rates ..............53 Box 3.1: Accounting in China. ........... 0. .. . .......... 59 Box 3.2: Financial Performance Simulation Model . .64 Box 3.3: Credit Policy olicy............. 69 Box 3.4: Financial Performance Indicators: Objectives and Use 74 Box 3.5: Universal vs. Commercial Banking: Pros and Cons of Suppressing Product-Line Barriers in the Financial Sector .................0# ...... s Box 4.1s Costs of Financial Crisis ............ ... ...... 89 Box 4.2: Restructuring Problem Banks: Options and Costs......... 97 Box 4.3s Problem Banks and the Camel Rating System......... *.*.. 99  - vii - Page No. LIST OF FIGURES IN TEXT Figure 1.1t Nominal and Real Interest Rates ................... 29 Figure 5.1: Governhent Debt Maturings 1989-95 . ............... 109 STATISTICAL ANNEX ........................................................... 125  CHINA FINANCIAL SECTOR REVIEW: FINANCIAL POLICIES AND INSTITUTIONAL DEVELOPMENT Summary and Conclusions introduction 1. In 1979, China embarked on an ambitious program of reforms in enter- prise management, rural development, financial intermediation and public fina.ace. Financial sector reform began in the early 19808 with the separation of China's monobank system into commercial and central banking functions, as described in the earlier Finance and Investment Report. Beginning in 1986, various investment banks (TICs) were established, and in the nonbank financial sector more generally, reforms meant a growing number of financial intermedia- ries, such as leasing companies, local TICs licensed by provincial govern- ments, as well as pension funds, insurance companies and foreign banks. Reforms in the financial sector were intended to underpin economic growth and efficiency, foster competition, reduce costs of intermediation, and facilitate a more efficient allocation of credit. A. Major Issues: Financial Reform and System Reform 2. The steps taken in the 1979-89 period helped the emergence of a broader financial market providing alternative financing sources for govern- ment, enterprises, households, and financial institutions. Taken together, the reforms helped to provide alternatives, first, to budgetary financing of enterprises and, second, to the reliance of enterprises on the specialized banking system. However ten years of reforms and deepening have been less than fully successful in changing the bank-only structure of the financial system, in fostering price competition between financial institutions, and in allowing a meaningful role to the financial sector--distinct from that of the budget--in allocating credit. Additional fundamental reforms are needed in the financial sector for banks to become true intermediaries rather than chan- nelers of funds following government priorities, and to achieve a more com- plete separation of fiscal and monetary functions. 3. Financial reform has given the economy greater dynamism and raised new challenges. The rapid growth in financial intermediaries outside the specialized banking system has given rise to new concerns relating to entry into financial services, their institutional adequacy, and capitalization. Supervision and regulation of these institutions are essential ingredients of reforms, to be addressed by strengthened capacity in the central bank. Major issues have also arisen with respect to their autonomy in intermediating and allocating financial savings. In essence, the role of the banks and of the plan/budget in resource allocation--distinct processes for intermediation in most countries with developed financial systems--remain blurred in China. An objective of reform should be to separate these financial and fiscal functions more clearly.  - ii - 4. In this area and others, the authorities must now develop policies which reconcile short-term economic effectiveness with longer-term objectives of growth and efficiency. Reliance on administrative mechanisms has been the thrust of recent policies, although some indirect instruments such as interest rates began to play a marginal role. To an extent, this can be justified by invoking the imperatives of dealing with an exceptional inflationary situation while the financial system was still evolving. However, the authorities need to assess carefully whether the choice of policies has been such as to impose longer-run damage to the financial system, one that would be more difficult to reverse once the emphasis shifts to reform. Recent anti-inflation policy is an example of this challenge. While China remains committed to the increased use of "indirect levers" of monetary control, their limited effectiveness has led the authorities to make use of direct credit ceilings and administrative price controls. These measures should, however, be temporary and with reli- ance as soon as practicable on indirect controls such as more flexible inter- est rates and control of reserve money. 5. In the area of banking reform, the challenge lies in the fact that while there is a stated commitment to financial diversification, autonomy and self-responsibility of banks, financial liberalization has given rise to an allocation of credit which differs from that desired by the Plan. The result- ing credit structure, often referred to in China as "twisted,' combined with the authorities, desire to ensure continued financing to "key' projects, has led to the imposition of new controls on all intermediaries, to redirect their lending to the priority areas determined by the Plan. Such priority also carry low interest rates which may impair profitability. 6. Concern over such potential misallocation of credit through decen- tralized decision-making by banks has its roots in the price system and the system of enterprise subsidies. Therefore, financial, enterprise and price reforms must be addressed together, and a successful financial reform cannot, in the long run, succeed without changes in the prevailing price system (as banks will lend on the basis of "wrong' price signals) while enterprise reform (a hard budget constraint) is required for enterprises to become responsive to market signals. However, while it is best that reforms be coordinated in all three areas, delays in completing price and enterprise reform should not be seen as justifying delays in the initiation of financial reform. 7. In the meantime, administrative controls on banks are not the pre- ferred way to address concerns about the credit structure. There are two 'contradictions' implicit in the authorities' directed credit policy: (a) first, administrative 'guidance' may be inconsistent with making banks autonomous; (b) second, priority loans at low interest rates could conflict with the objective of making banks accountable for profits. 8. Moreover, the present approach of subsidizing interest rates to pri- ority sectors has a disadvantage of giving all enterprises in a designated sector access to subsidized credit, subsidizing the enterprise sector gener- ally at the expense of the banks and MOF. Greater targeting of interest sub- sidies would be more efficient and far less costly. Another option would be to fully eliminate priority lending rates and to subsidize those enterprises requiring support directly through budgetary subsidies. This would further serve the objective of making the granting of subsidies more transparent.  9. The change in 1981 in the system of financing key projects from grants to loans, and the increased role of the banking system in financing investment, was a key step forward in making borrowers more accountable. How- ever, some infrastructure sectors and projects, characterized by long gesta- tion periods, do not generate sufficient returns to be good candidates for bank financing. The same is true of projects which have 'public good' charac- teristics (roads and major infrastructure projects) where imposing user charges is difficult. There is a risk of large losses if low-yielding "unbankablen investments become a large share of banks' total loans. 10. The desire to relieve budgetary pressures by having banks finance low-yielding public investments is acknowledged, but as a strategy, it is self-defeating. To the extent that budgetary resources are constrained in China, a reallocation of resources within the budget in favor of infrastruc- ture may be advisable, given that enterprise subsidies currently take a very large share. This would prevent further impairment of bank profitability, while adequately financing infrastructure. For many types of infrastructure investment, the budget remains the preferred financing vehicle. 11. The more general point is that further fiscal reform may be needed for the budget to play an appropriate role in financing infrastructure. Reforms since 1979, giving greater decision-making responsibility to enter- prises and local governments, have changed the role and size of the government budget, and its role in financing expenditures. Fiscal reforms linked with decentralization (among them 'tax contracting' and 'provincial contracting") have also introduced rigidities into the revenue-generation system. The con- sequent constraints on revenue growth and difficulties in funding major expen- diture programs directly via the budget, appear to be a major factor in the government's decision to encourage banks to finance key projects. The move from budgetary financing to reliance on the financial system may have placed responsibilities on the banks which are incompatible with their financial viability and growth. The use of the banks to finance fiscal investments reflects the ongoing confusion over the respective spheres of the fiscal and the financial systems, and the misuse of the banking system to finance hidden budgetary deficits. 12. Similar challenges arise in the area of regulation and supervision. While the rapid development of new financial institutions and activities will enhance the financial sector's ability to intermediate funds to high value investments, (assuming pari passu a reduction in price distortions), further steps need to be taken to address regulatory and supervisory deficiencies so that banks channel these funds in a safe and sound manner. The demand for new intermediary services is large and the 'market response' to them strong. 13. Since many intermediaries fulfill these legitimate demands in a responsible manner, curtailing these intermediaries or activities may not be feasible. Moreover, many countries have found that administrative controls on financial intermediation (known as 'financial repression') only drives such activities underground, making them harder still to supervise. Thus, the Report recommends these new forms of intermediation be integrated where appro- priate into the formal sector, thus ensuring that they are governed by a more adequate legal, accounting and supervisory framework.  - iv - 14. With respect to deficit financing and the development of government securities markets, important strides have been made in treasury bond manage- ment, allowing individuals to trade bonds and introducing indexed government bonds. However, the government's near term financing requirements are large and the current mandatory allocation system for government bonds, if contin- ued, will place large burdens on enterprises. At the same time, MOF recourse to borrowing at the central bank would be undesirable. MOF should take steps now to develop a more market-oriented financing program. This means develop- ing broader government securities markets and increasing the general attrac- tiveness of government bonds by raising their yields and by allowing enter- prises to trade them. B. Essential Steps in Future Sectoral Development 15. A Framework for Financial Sector Developments The Banking Law. A comprehensive framework for financial sector development, codified in a Bank- ing Law, is needed. This Banking Law would define the operations of all institutions in China's financial sector, including the central bank, special- ized and other banks, TICs and other intermediaries. It would define their scope of business, guide their development, and the development of the mix of institutions, and the rules under which they operate, as described below. 16. (i) Strengthening PBC. An important aspect of the Banking Law would be to further define and strengthen PBC within the overall national macroeco- nomic framework agreed for desirable price and income growth. PBC should be given primary responsibility for determining the monetary expansion implied by the credit plan and should be the chief monetary policy-making body. The authority of PBC to implement agreed monetary policy must also be strength- ened, and those operations of PBC that have an impact on monetary and credit policies should remain under the strict control of PBC's head office. Among the areas codified in a banking law should be strengthened powers of PBC with respect to: (i) PBC's responsibilities for developing the credit plan consis- tent with national stabilization objectives; (ii) increased autonomy and clear limits to PBc's financing of government deficits; (iii) development of PBC's central banking role, moving away from its functions of development bank; (iv) strengthening PBC's powers in the area of bank supervision and regula- tion; (v) increased powers to organize the credit and capital markets; and (vi) PBC's responsibility for overseeing and managing the payments system. 17. (ii) Prudential Framework for Bank Operations, The law would focus on prudential regulations to ensure the safety, soundness, and stability of the financial system, and would also provide for PBC to supervise the finan- cial activities (including the securities business) of all financial institu- tions. The law should also require banks to make bad debt provisions related directly to portfolio quality. Under this approach, MOF would no longer be directly responsible for determining provisions or write-offs since these would be based on portfolio quality. MOF could determine the extent to which provisions are tax deductible; however, as a general principle in most coun- tries, debt provisions are fully deductible. Finally, there should be one bank law for all institutions rather than the separate regulations which now exist.  l 18. The law should establish strict prudential lending limits and con- trols on the banks, even if the banks cannot at the present time comply with such limits. A phase-in period would allow for compliance over a reasonable period. Detailed regulations are outlined later in this summary and in Chap- ter IV. 19. (iii) Framework for Institutional Development and Structure. The Banking Law would also define the rules governing the mix of institutions. To promote further competition in the sector requires establishing new financial institutions and expanding those in operation, while also ensuring their safety and soundness. However, there is an important question of how further liberalization should proceed in the presence of serious price distortions, which lead to what the authorities believe is an undesirable allocation of resources away from basic sectors and industries. 20. These questions go beyond purely technical or sectoral considerations and relate to the will to give more room to market forces, and to allow, pari passu with other reforms, the financial system more autonomy to allocate resources. For this reason, it is almost impossible to recommend an "optimal' financial structure to be codified in the Banking Law which also offers the flexibility which the transition will require. However, some general consid- erations relating to new institutions (entry), scope of business and competi- tion between institutions (the level playing field), each of which should be defined in the Banking Law, are outlined in para. 26 below. 21. Strengthening Bank Management. Strengthening the state-owned banks is the second major challenge. While profitability and a sound loan portfolio are overriding objectives for many financial institutions, in many cases banks also must respond to the economic and social imperatives of government credit policy which sometimes conflict with institutional viability. Clearly defined financial objectives, linked to performance contracts, could provide the framework for the strengthening of bank management in China. Therefore, poli- cies towards state-owned banks should give priority to maintaining banks' financial viability, and institutional development should focus on the further strengthetiing of credit risk and financial management. 22. Banks also need greater autonomy over lending decisions and greater flexibility in setting interest rates on loans and deposits if they are to develop into viable, efficient and financially sound institutions. Autonomy is essential for further financial sector development, but this must be accompanied by a hard budgetary constraint. 23. Competition and the Mix of Financial Institutions. Competition is the third crucial ingredient. Competition can be enhanced by entry into financial services. However, excessive expansion of banks and NBFIs, without sufficient prudential regulation and supervision, is typically not consistent with the development of the financial industry in a safe and sound manner. A strong regulatory framework is therefore essential. Equally, it is important that the financial sector continue to expand. China is a large country with a high savings rate and plenty of room for new, properly capitalized and super- vised intermediaries. Specifically, the report recommends that provisions be made for smaller credit institutions such as UCCs and RCCs to upgrade their status to banks, when they meet minimum entry requirements. As long as entry  - vi - is carefully scrutinized and adequate capitalization and banks' earnings are ensured (the objective of these requirements is not to restrict entry but to have sounder banks), entry into financial services is desirable. 24. In light of the need to promote competition, it is recommended that entry into banking and nonbanking activities should continue; however, because of the regulatory constraints in the system, the two types of activity should perhaps not be mixed at this stage. That is, decisions to merge nonbanking activities (such as insurance, underwriting and issuing of securities, securi- ties dealership and entrusted business) with more traditional banking func- tions (such as lending, deposit-taking and leasing) through "global financial supermarkets" should proceed with caution. Relaxing barriers between differ- ent segments of the financial services industry (i.e., minter-industry' bar- riers) and allowing banks to diversify into nonbanking products, and vice versa, is not advised at this stage because prudential regulation remains weak. 25. Institutional Options. These considerations suggest two possible options for the evolution of China's major financial institutions. If the separation of banking and nonbanking activities is accepted, one might envis- age the following developments for the banks and TICs over the medium term. 26. (a) TICs could be reorganized to redefine their scope of business to transform them into investment banks able to assume greater risks than would be appropriate to deposit-taking institutions. This would limit their opera- tions to long-term lending and their deposit-taking to entrusted deposits only. Their general trust business will be reassumed by the specialized banks. The medium-term objective could be to steer TICs back in the direction of investment banking, which was their original intent. 27. (b) Alternatively, other TICs might apply for a banking license, in which case they will be limited to basic deposit taking and lending opera- tions. Their securities and trust operations would be spun off to the TICs which wanted to remain TICs, or would be independently managed, or merged with others. 28. (c) Banks, under this approach, would retain their commercial bank- ing business, including leasing and possibly housing and consumer finance. Local bank branches, thus, would give up their securities and entrusted busi- ness, which would be spun off to the TICs and regulated by PBC. As banks, they would compete with those TICs and other institutions (for example, UCCs and RCCs which wish to upgrade themselves to the status of banks) which decided to go the banking route. 29. If the separation of these activities is not accepted, then it is important that product-line barriers within different segments of the finan- cial industry (such as restrictions on deposit-taking and differential mone- tary controls, credit ceilings, PBC credit and interest rate policies) be eliminated. This would allow banks (with their TIC business) and TICs (with their banking business) to compete on the same level playing field. If the principle of global banking is chosen to govern the financial sector struc- ture, capitalizing each financial activity separately is advisable. China may  - vii - also want to consider setting limits on the proportion of nonbanking activi- ties in global banks' total activities. Whatever solution is chosen, capital- ization requirements should be increased from their present levels to provide greater risk cushioning and induce mergers of suboptimally sized banks. C. Summary of Recommendations: Reforming China's Financial System Monetary, Credit, and Interest Rate Policies 30. Monetary Policy Objectives and Tools. PBC's tighter monetary policy has played an important part in stabilizing the economy, and pressures to ease credit excessively should be resisted. It is also recommended that selective credit interventions be reduced. Monetary policy is not an efficient tool for promoting the development of specific economic sectors or regions. Countries that have successfully used them (Korea and Japan) have provided very selec- tive and temporary support (based on "infant industry" arguments), usually to sunrise or high-tech industries. More generally, monetary policy is better used to foster sustained output growth and price-level stability. China has already begun to use indirect instruments more effectively, beginning with the 1989 interest rate changes. Its tools could be further strengthened as follows. 31. (i) The Credit Plan. The scope of the credit plan should be broad- ened to include the credit demands of all sectors of the economy and recon- ciled with China's objectives for economic growth, inflation, and the balance of payments. Second, national economic objectives--sustainable growth and low inflation--should provide the basis for the overall credit ceiling in the plan. In particular, it is important that the government's financing require- ments are considered explicitly, with an expansion ir, credit to the government offset by a reduction in credit to the rest of the economy if both cannot be accommodated within the ceiling. PBC should be given primary responsibility for proposing the credit/monetary expansion implicit in the credit plan, sub- ject to approval by the State Council. 32. (ii) Credit Ceilings. Over time, credit ceilings should be replaced by further reliance on indirect methods. Direct controls create distortions that reduce the efficiency of resource allocation, reduce competition among financial institutions and encourage practices designed to evade the ceilings. Priority should be given therefore to replacing credit ceilings with other monetary policy tools, such as higher effective reserve requirements and higher interest rates on PBC rediscount and refinarncing facilities, if neces- sary, while initiating open market operations on an experimental basis. 33. (iii) Control of Reserve Money, Currency Issue and PBC Lending. PBC should acquire further experience in the control of reserve money and adopt explicit targets for the stock of reserve money, even under a system of credit ceilings. Speciflcally, PBC should adopt at least quarterly targets for the stock of reserve money, based on: (a) a broad money supply target; and (b) the estimated reserve money multiplier. The quarterly target for reserve money would then provide the basis for calculating the credit granted by PBC Headquarters through its branches to the banks and, more broadly, PBC's net domestic credit. To target reserve money, the authorities should also modify  - viii - their present policy of controlling currency through the Cash Plan. Currency is only one part of overall base money management. 34. (iv) Interest Rates. Many priority interest rates are still low, administered adjustments occur with lags and interest rates remain very dif- ferentiated. Immediate replacement of the existing system of controlled interest rates by a system based on market forces may not be feasible; how- ever, the Report recommends sustained progress in improving the level and structure of interest rates. Administered interest rates should be guided by the objectives of: ti) mobilizing financial resources; (ii) controlling aggregate domestic demand; (iii) improving the allocation of financial resources; (iv) providing adequate margins to financial institutions; (v) ensuring fair competition between financial institutions; and (vi) reduc- ing the costs of priority credit and interest rate subsidies to the budget. Such discretionary actions need to be replaced by market-determined interest rates at an early stage. 35. Deposit Rates. While the introduction of indexation helped in restoring confidence, even with the 1989 rate adjustments, interest rates on certain financial assets are negative in real terms. More generally, rates are inflexible and should be adjusted more automatically and regularly, on the basis of the inflationary outlook and expectations to ensure that as inflation rises and declines, interest rates also adjust. Over the longer term, a greater role for market forces should be allowed some play. (a) Interest rates should fully protect the purchasing power of individ- uals' and entities' financial savings. (b) Enterprises should be allowed to make indexed time deposits (and hold indexed government bonds) similar to those permitted individuals. (c) The present deposit indexation formula should be modified to reflect the annual compound inflation rates during the entire life of the deposit. We also recommend offering savers a positive, not zero, spread or real rate of interest. 36. Lending Rates. The Report makes three recommendations with respect to lending rates: (a) Lending rates must provide adequate spreads over banks' cost of funds. These currently appear insufficient for banks to generate the income necessary for adequate provisions and capital growth, and are negative at the margin for some maturities, and for banks taking a large volume of indexed deposits. (b) The existing large differences among interest rates on loans produce substantial distortions. Interest rate differentials which favor certain institutions should be significantly narrowed or eliminated. (c) Maintaining an adequate spread and the recommended automatic adjust- ments in deposit rates implies corresponding adjustments in lending rates.  - ix - 37. Eliminating the tax-deductibility of principal payments (a recommen- dation made in earlier World Bank reports and the basis presently of experi- ments in Chongqing) would also serve to improve investment efficiency. 38. The adjustments in lending rates which might result from a more market-determined structure could create difficulties for some enterprises. However, judging from the lending taking place at rates outside the adminis- tered structure, many enterprises can apparently bear higher interest costs. Enterprises with low profitability should be allowed to adjust their prices; alternatively, distressed but viable enterprises should be helped to restruc- ture, or, if necessary, giveni direct budget subsidies. This is preferable to subsidizing all enterprises with low interest rates. 39. While changes in interest rates which a more market-determined struc- ture might give rise to would increase the interest cost of government bonds, government reversue will also increase from sources such as the increased prof- itability of banks. Any net increase in budgetary costs could be met by reducing government expenditure (for example, by a reduction of subsidies to enterprises) or by raising additional revenues via taxation. Financial Institutions 40. Financial Management and Organization. The Report identifies several areas in financial management and policy environment of the specialized banks which should be further strengthened. First, there appears to be an erosion of the gross interest margin (the difference between interest earnings and interest expense) on banks' commercial business as a result of indexed depos- its and the practice of lncreasing administered deposit rates more rapidly than lending rates. 41. Second, although bank profits are still rising in absolute terms, there appears to be a declining trend in bank profitability as a result of increased arrears and enterprise losses. Bank borrowing from PBC suggests possible liquidity problems. Continued increases in uncollected interest and growing noninterest costs (due to the rapid expansion of bank offices which may cost more to operate than they contribute in earnings) will further narrow net interest margins and profits. 42. Finally, recent trends in delayed payments to banks and losses in state-owned enterprises suggest possible financial distress in the banks which may rnt be reflected in their financial accounts under present methods of presentation. The apparent paradox of rising profits, combined with possible portfolio problems and a high proportion of uncollected interest, results in part from the large subsidies banks receive from PBC in the form of PBC credit at low interest rates amounting to one-third of their total funds, and the practice of limited provisioning. Based on the Report's findings and PBC's statements about loan quality, present loan loss provisions fall short of meeting the likely levels of loan losses in bank portfolios. Price reform is likely to have a further impact on bank loan portfolios, intensifying the urgency for the development of a strategy to handle problem loan portfolios. 43. The illiquidity of banks and their arrears may not reflect a solvency problem. Illiquidity may be due to (i) slow deposit growth relative to loan  - x - growth; (ii) an overextension of loans to priority borrowers, with no presump- tion that these loans are substandard, (iii) a mismatched asset and liability structure; or (iv) the impact of the current credit squeeze, in which enter- prises delay repayment because they fear being unable to get new loans. With- out a full-scale, independent professional portfolio audit, it is difficult to assess the true condition of China's banks. However, many indicators suggest there is cause for concern. Developing a methodology to deal with problem portfolios and other financial issues is therefore pressing. Recommendations for Strengthening Banks 44. (i) Credit Risk Management. To establish the basis for high-quality portfolios in the future, specialized banks should further strengthen their "credit risk management". This means improving their selection of borrowers, policies on guarantees, and administration of the loan portfolio, including debt recovery, identification of problem loans, provisioning for loan losses, and writing off unrecoverable loans. 45. Improving techniques alone will not ensure high performing portfo- lios. Banks should be allowed more leeway to choose borrowers based on cri- teria of creditworthiness and profitability, pari passu as other reforms permit. While the planned allocation of credit is likely to remain a key com- ponent of China's economic system, this conflicts with increasing their accountability. One option might be to give the specialized banks freedom in selecting credits within a prescribed "free limit" without government inter- vention and with full responsibility for the profits and losses on these credits. This 'free limit" should rise over time. Ultimately, a "Development Fund" could take over the remaining directed loans. 46. In the near term, another option is segregating banks' own commercial lending and lending to support state policy in order to explicitly identify the risks, profits and costs of each lending activity. Under the segregated portfolio approach, two financial statements would be prepared: one for directed loans, another for commercial loans made under the banks' "free limitg. Broadly, the category "directed loans, should include all loans not made in conformity with the defined criteria of creditworthiness (laid out in Chapter III), and those made in support of priority lending objectives. 47. (ii) Accounting. China's existing accounting framework is designed for use in a centrally planned economy, and as China integrates further with the global financial community, accounting standards that are internationally accepted and that support prudent financial management will become important. Specifically: (a) China's banking system requires a " uniform chart of accounts' con- sistent with international "Generally Accepted Accounting Princi;lesl (GAAP), prepared on a timely basis, and having a financial orienta- tion. (b) Bar'ks should also undergo full external audits in accordance with international accounting practices.  . xi - (c) Definitions of what constitutes arrears, an "overdue" or sticky loan. a 'nonperforming loan," and a "bad debt" should be modified and made consistent with GAAP. (d) Adequate reserves for loan losses should be introduced, based on potential or actual loss experience and analysis of portfolio qual- ity. 48. (iii) Financial Management. State-owned banks present a rl'ique set of management challenges because of the complexity and conflict inherent in their role. Clearly defined financial objectives should provide the framework for strengthening bank management; introducing key financial performance indi- cators should have top priority. These indicators (outlined in Chapter III) would cover profitability, debt recovery, balance sheet structure and expense control and could be integrated into China's "contract system" currently under implementation in some of the specialized banks. The Report also recommends that a financial "simulation model" be developed to analyze the financial impact of different policy measures (such as changing deposit and loan rates, higher reserve levels, shifts in the composition of loans and deposits) on banks. 49. (iv) Recapitalization. An erosion of bank capital has taken place as a result of bank portfolio losses, and these losses should be formally recog- nized. Inevitably, there will be fiscal costs involved in the replenishment of banks' capital. One way to reduce the fiscal burden is for banks to raise lending rates (and thereby margins and income) so that retained earnings can build capital. This approach has the advantage that it needs no budgetary funds; the higher interest costs it implies are consistent with the recommen- dation to establish adequate spreads for banks. A second option is for the government to provide new capital. Since this would be costly to HOF and/or to the provincial Finance Bureaus--the banks' owners--consideration needs to be given at the soonest opportunity to devising recapitalization strategies. 50. Competition. China's financial reforms have promoted greater compe- tition in the banking sector by broadening the scope of operations of the spe- cialized banks and by creating new comprehensive banks and NBFIs. However, the reluctance to allow price competition and the continued administrative fixing of intcrest rates has encouraged financial institutions to substitute nonprice competition, including overbrarching and a tendency for financial institutions to look for lucrative sideline businesses, activities now possi- ble os a result of progressively liberalizing legislation. More price compe- titioi. would alleviate this tendency to substitute inefficient nonprice compe- tition. At the same time, price competition, if not bridled by a hard budget, or profitability, constraint on banks--and banks are not at present fully accountable for their profits and losses--could lead banks to use loss-leading price competition to pursue market share at the ex)ense of profitability and prudence. Examination and Supervision of Financial Institutions 51. In most market economies, the goals of regulation are "prudential," i.e., to prevent financial instability to contain risks that banks take.  - xii - However, in China, as in most socialist countries, emphasis is more 'eco- nomic," i.e., regulation is designed to ensure that banks meet social and developmental goals of channeling directed credit to priority sectors. This "economic" orientation often conflicts with prudential concerns for the safety of the financial system, since judgments about an enterprise's ability to repay are frequently ignored. 52. It is often argued that in socialist countries it does not matter that bank loans cannot be repaid since banks owned by the state cannot fail. However, damaging financial crises are not confined to market economies but have also occurred in socialist countries (such as Yugoslavia) where the bank- ing system has been used as a charnel to meet social and developmental objec- tives. The accumulation of nonperforming loans can be disguised temporarily, but when arrears reach the point where banks' income is insufficient to meet expenses and other liabilities, a liquidity crisis typically follows. At this stage, the budget or central bank must provide funds to keep the banks afloat. This carries an obvious cost in the form of possible inflation or widening budget deficits that must be financed. 53. Establishing Supervisory Laws and Regulations. A comprehensive Bank- ing Law, discussed earlier, with prudential regulations is necessary. This would establish the legal framework within which banks operate and set pruden- tial limits, controls and supervision. Among such prudential limits are: (a) Lending or exposure limits to a borrower, group of borrowers, and economic subsectors designed to ensure diversification of risks. A ratio of lOZ to 15Z of capital is considered prudent. (b) Minimum capital in relation to bank assets and off-balance sheet risks. A ratio of 8Z is considered prudent. 54. The Banking Law should also address entry. Given the rapid growth in new financial institutions. it is recommended that licensing criteria (and branching) be relatively tight and that only PBC headquarters be authorized to issue licenses. Existing institutions should raise their capital to a higher minimum entry level within a reasonable period. 55. Refocusing Bank Supervision to Broaden its ScoPe and Effectiveness. Bank supervision activities In China focus more on compliance with the credit plan and audit than prudential supervision. In spite of the progress already made, it will not be easy to further transform bank supervision because of the basic conflict between enforcing compliance with the Plan (instructing banks to make loans to important projects) and appraising portfolio quality (criti- cizing those same loans for not being creditworthy). Actions to extend the scope, coverage, and effectiveness of bank supervision activities would strengthen China's system of supervision: (a) Refocusing the examination procedures and the "examination handbook' towards prudential concerns. (b) Redistributing bank supervisors to cities with more financial activ- ity (Shanghai, China's most important financial center needs more than the 20 examiners presently assigned to that city).  - xiii - (c) Focusing on the loan portfolio's quality is essential. In China, as in most countries, the assessment of asset quality is a critical step since hidden losses in the loan portfolio are most likely to bring about the bank's problems. Developing a Strategy for the Government's Domestic Debt 56. Meeting 1990's Financing Needs. Much progress has been made in developing government bond markets in China. In the short term, the major issue is refinancing the increased volume of maturing debt and raising new funds to cover the budget deficit in 1990. Based on mission estimates, MOF will need to sell bonds worth about Y 65 billion, more than twice the amount scheduled for sale in 1989. 57. In dealing with the debt overhang, two requirements are key: first, maturing debt must be paid in full and on time to establish beyond doubt the sanctity of the contract between the Government and its bond holders. Sec- ondly, the sale of MOF debt in 1990 and beyond must because of its size, tap as wide a market as possible. Permitting tradlng in enterprise-held bonds on an experimental basis would help support the development of this wider market by increasing the attractiveness of government bonds. 58. Among the options the government could consider in the short term is the sale of negotiable short-term market-rate Treasury bills on a voluntary basis to financial institutions. Over time, this would establish the basis for PEC open market operations. Liquid asset holdings such as these are via- ble only if the Treasury bill holdings of financial institutions are brought under the credit ceilings to avoid excessive credit growth. If market finan- cing is not pursued, financing could also be obtained by a direct line of credit from the PBC to MOF. (Such net credit expansion should also be included in the credit plan.) PBC's lending to MOF should be at market interest rates and on the basis of a negotiable instrument which PBC could later sell. Unplanned MOF borrowing from PBC should be avoided. Financing the deficit by forced borrowing from households and enterprises is probably not feasible over the longer run if volumes continue to grow. 59. Planning for the Future. In planning for the future, the first step is to reduce the budget deficit. Whatever the deficit, it should be financed with MOF securities offered at market rates so that individuals and entities will purchase them voluntarily. The offering of indexed bonds is a very posi- tive development in th_s regard. While the sale of indexed bonds has raised financing costs, if the government's tight credit policy succeeds in reducing inflation, confidence may be restored and fixed-rate MOF debt may again be saleable. Indeed, inflation control offers the best hope of getting MOF's interest costs under control. 60. The longer-term program for future debt management recommended in the Report has several components. First, it should aim at mobilizing savings through the sale of bonds to individuals on a voluntary basis. Over-the- counter retail sales through banks, UCCs, RCCs, and post offices should be added to the present mandatory payroll deduction system for individuals. The shift from a quota-oriented sales effort to one that competes for savings on a  - xiv - voluntary basis will require new distribution channels and retraining staff to sell new products. 61. Second, MOF must tap the retail market more broadly, as MOF financing already exceeds what can be raised at below market interest rates. The pres- ent sale of indexed bonds is a positive step in the development of a competi- tive instrument. MOF however needs other retail instrurants paying a rate competitive with bank deposits. Such instruments could be available for investment at all times through convenient sales outlets, or be offered for subscription during a single month each year. 62. MOF must also offer issues designed for sale in the wholesale market --that is, to financial institutions, institutional investors, foundations, enterprises and others that may have sizable funds to invest. MOP should seek to meet the maturity needs and other preferences of different investor groups, selling Treasury bills as well as longer-term (one, two, three and five-year) Treasury bonds. The goal would be to achieve a balanced maturity structure which reduces burdensome bunching of maturities. Developing a viable whole- sale market requires fostering an active secondary market in fully negotiable securities so that holders of MOF issues can sell them before maturity if they have unexpected cash needs. It also involves moving to market interest rates on MOF's own offerings. A good secondary market will enhance the appeal of MOF issues and in time enable MOF to borrow at interest rates that reflect the prime quality of the Government's debt. 63. A wholesale secondary market for Government issues would enable PBC under the State Council to pursue a more flexible and effective monetary pol- icy than is possible with the present annual credit plan. Now it is difficult to adjust t;:e credit plan quickly in response to an overheating economy or one in which unwanted slack is appearing. With a good secondary market PBC Head Office would be able to add or withdraw reserves from the financial system on its own initiative to encourage or restrain credit growth in the nation as a whole. Finally, the trading of MOF securities at market interest rates will provide a benchmark for pricing other securities in the market--for example, the short- and longer-term offerings of enterprise