China - China Construction Bank Transformation (formerly known as Financial Sector Development Project)

Report No. PIC615 Project Name China-Construction Bank Transformation (Seel/) (@+) Region East Asia and Pacific Sector Financial Sector Development Project ID CNPE3605 Borrower People's Republic of China Implementing Agency China Construction Bank (See 2/) 12 (C) Fuxing Road Beijing, China 100810 Mr. Xi Deyan, Director, Policy Research Telephone: 68570730; FAX: 68570692 Appraisal Date March 17, 1997 Board Date August 1997 Date of this PID April 24, 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. But the piecemeal nature of reforms often has accentuated macroeconomic stability and, in general, the financial sector reforms lagged behind those in other areas of the economy. China is now entering an important phase in its transformation to a market-based system, and the Government considers 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 safe and sound financial system are enormous, and given the linkages between the fiscal, enterprise and financial sectors, a weak sector infrastructure, and paucity of banking skills, development of an market-based financial system will of necessity be a gradual process. 2. 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 four --Agricultural Bank of China, Bank of China, Industrial and Commercial Bank of China, and the People's Construction Bank of China--were chartered and/or rechartered as specialized banks. During 1987-1993, the authorities allowed some diversification and limited competition as traditional barriers of specialization between banks were gradually eliminated, the Bank of Communications was recreated, and new commercial, regional and savings banks established along with urban credit cooperatives. Non-bank financial institutions proliferated, two stock exchanges established, and the range of financial instruments broadened. A number of foreign banks were allowed to open branches with limited business scope. During this period, bank lending began to replace  budgetary financing for investment. Rapid growth of output, together with low interest rates and the absence of hard budget constraints on poorly capitalized state enterprises, fueled the demand for credit. 3. 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 to conduct monetary policy, and gradual transformation into commercial banks of the four specialized banks, the mainstay of the banking system in China. 4. The authorities have since then accelerated the pace of reforms and implemented a wide range of measures, including: (a) the promulgation of important financial legislation such as the Central Bank Law and the Commercial Banking Law; (b) strengthened the powers of the central bank to conduct monetary policy and prudential supervision of financial institutions, and prohibition on the central bank from extending overdrafts and direct lending to the government; (c) creation of three new policy banks to separate policy from commercial lending, and reclassification of specialized banks as commercial banks with increased autonomy in their lending decisions; (d) separation of ownership links between banks and nonbanks to prevent risky financial activity by nonbanks from transmitting large systemic shocks to the banking system; (e) elimination of preferential sector lending rates, increasing the frequency of interest rate adjustment and abolishing indexed term deposits; (f) initiation of open market operations; (g) development of a modern payment and clearing system and a book-entry system for government securities trading; (h) introduction of asset-liability ratio management for all banks, other than the formerly specialized banks; (i) increased competition by the licensing of China's first nonstate owned bank, ownership diversification of nationwide commercial banks, creation of a large number of City United Commercial Banks through the merger of urban credit cooperatives, and licensing of selected foreign banks to undertake local currency business on a pilot basis. 5. Despite the acceleration of financial sector reforms in the last two years and progress made to date, further policy reforms and institutional strengthening are necessary in order to enhance the efficiency of resource mobilization and allocation. Development of an efficient financial system would require an effective monetary policy that relies on indirect control instruments; further strengthening of the legal, prudential and infrastructure framework; successful transformation of the formerly specialized banks; further reforms in the state-owned enterprise sector and in the investment regime and public finances; enhanced competition; and further liberalization of interest rates. It would also require a new corporate governance and incentive system for state banks and, above all, it would require converting human resources into - 2 -  human capital to enable banks to manage commercially their assets and liabilities. The existence of strong linkages between fiscal, enterprise and banking sectors, and organizational changes needed to transform the existing institutions into market-based institutions will take time. 6. 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 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 reform issues through economic and sector work and dissemination of findings in various workshops and seminars; (ii) assistance in the establishment of appropriate banking sector infrastructure-legal, prudential, accounting and payment system-under the ongoing Financial Sector Technical Assistance project; (iii) assistance in the transformation of the formerly specialized banks into commercial banks; and (iv) training of the staff of PBC, commercial banks and other institutions in the financial sector. 7. Project Objectives. The main objective of the proposed China Construction Bank Transformation (CCBT) project is to assist in the transformation into a commercial bank of the China Construction Bank (CCB). CCB is one of the four 100 percent state-owned large banks in China. All four banks are ranked by asset category as among the largest 100 banks in the world. CCB (and the other specialized banks) face a number of external and internal constraints to full commercialization. The external constraints refer to constraints--credit plan, administered interest rates, non-performing loans of state-owned enterprises, personnel and compensation policies, inadequate loan loss provisioning policies and high income and other taxes--on which the banks has little or no control. The internal constraints are equally binding in view of specialized banks' past role as fiscal agents of the government, and where all decisions about credit allocation and pricing were centralized, with little distinction between public finance and enterprise finance as the state played the role of owner, regulator and borrower. Transformation into a full fledged commercial bank is expected to be gradual and take a number of years. 8. 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 CCB's transformation. The main focus of the proposed project is on setting up modern banking practices and policies and procedures, and to gradually know more about the true financial position of CCB in order to provide managers, owners and regulators with reliable information to base future decisions. The project design is based on the priorities and sequencing of internal reforms identified in the detailed diagnostic studies undertaken for the project. These diagnostic studies covered CCB's organization and management, financial position and performance, information technology, and - 3 -  human resource development. The project will have two components: (a) transformation component and (b) line of credit component. Both components would have as their main objective the institutional development of CCB. 9. The transformation component ($30 million) would finance the services of commercial banking experts, limited hardware and office equipment, and training, including upgrading training facilities, training materials, training equipment, training of trainers and overseas training of selected core staff. The transformation component will be divided into a number of modules, including: (i) financial management to address a number of key areas, including a new basic accounting system, redesigned chart of accounts, new financial reporting system, redesigned accounting procedures and manual, and establishment of key functions such as ALM, treasury and market risk; (ii) internal audit, including an internal audit structure, a new set of audit standards, internal audit manual, and effective operations monitoring, including an early warning system; (iii) credit management, including strengthening of credit functions, new credit policies and procedures and manual, a revised project appraisal manual, improved monitoring and reporting system, and a workout unit to monitor nonperforming loans; (iv) corporate governance, including a draft charter and corporate governance structure, HO-branch relationship, and an internal operating charter; (v) strategic and business planning, including establishment of a strategic planning function, market research function, preparation of a guiding document on CCB's priorities in the next five years, and three-year rolling business plans; (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 management system; (vii) information technology, including a computerized management information and control system, a new information technology strategy and organization, and revised standards and methods; and (viii) training, including upgrading training facilities, training materials and equipment, training of trainers, a core commercial banking curriculum, training of core staff and management. 10. The line of credit ($200 million) would also support CCB's institution building. CCB's credit functions will be restructured and its capacity to select economic/profitable projects strengthened under the transformation 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 the credit component, CCB would finance subprojects in manufacturing and infrastructure sectors, and appraise subprojects strictly in accordance with commercial criteria and an appraisal methodology that is acceptable to the Bank. Eligibility criteria for subprojects and subborrowers will include, a minimum economic rate of return and financial rate of return of 12 percent, project sponsors should be able to finance at least 30 percent of the subprojects total investment cost, the subproject must meet government's environmental standards and have the written approval - 4 -  of the relevant environmental protection bureaus. In addition, CCB will not extend loans to enterprises that are not current on their past debt obligations to CCB. Subborrowers will submit financial statements to CCB that are audited by independent auditors. 11. Project Financing. The total project cost is estimated at $1,250 million. The proposed Bank loan of $230 million will finance less than 20 percent of the total project cost. Self-financing will constitute about one-third of total cost, and other borrowings including from CCB and commercial and other banks will provide the rest of financing. The subborrowers will bear the risks associated with foreign exchange and interest rate variations. The maximum subloan size will be $20 million. CCB will provide about $25 million for the transformation component from its own resources. 12. Project Implementation. CCB would be responsible for the overall implementation of the project. A Project Management Office has been in place since the start of the diagnostic studies. To provide unified coordination and management of the transformation component during project implementation, CCB will establish a joint management team, consisting of key CCB operational staff under the Director, Policy Research, and staff of the international commercial bank (or consulting firm or a consortium of banks and consulting firms) selected to provide expert banking services. The line of credit will be the responsibility of the project appraisal department, credit management department and banking department. 13. Project Sustainability. CCB was selected as the first large Chinese bank to be transformed into a commercial bank, mostly due to the keen interest and enthusiasm shown by its senior management. The current President is a reformer, has been associated in the past with rural sector reforms in China, and also served as Deputy Governor of PBC. CCB was the first bank to free itself from policy lending, establish an ALM committee and credit committee, merged various credit departments and foreign and Renminbi lending, and agreed to undergo detailed diagnostic studies by an international consulting firm. A number of working groups were established to participate in the diagnostics and detail and prioritize technical assistance needs. CCB management and senior staff have full ownership of the project. In the last two years or so, CCB has undertaken a number of initiatives towards its commercialization, including closure and/or merger of unprofitable branches, centralization of treasury functions, streamlining of credit functions, branches' credit approval authorization limits, a new staff contract system, and training of staff and management. 14. Lessons for Project Design. The proposed project is the first of its kind in China. It incorporates lessons of experience from similar projects elsewhere, especially projects in the transition economies of Central and Eastern Europe. There are however major differences in banks, in financial systems and in the expected roles of the State and private sector in China compared to banks, financial systems and economic organizations in other economies. The banks in China are very large in terms of assets, branches and workforce, even by international standards. More important, the - 5-  Chinese authorities have adopted a policy of gradualism in its deregulation and reform program and large scale privatization is now not in the cards. The delivery mechanism used for the provision of banking expertise for banks in some of the transition economies will be used in the context of the proposed project. 15. 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. These are submitted to relevant level environmental protection bureaus for review and approval. Financial institutions are prohibited from extending loans for projects that do not have the approval certificate of the EPBs. CCB's guidelines for appraisal of fixed asset investment effective since March 1996 require the inclusion of environmental protection programs and remedies approved by the environmental protection authorities. CCB 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. 16. During appraisal, it was agreed that the candidate 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 enterprises. CCB has prepared 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 specifies standards and the cutoff point beyond which preparation of a full-scale RAP will be necessary. 17. Program Objectives Categories. The project relates to the economic management program objective, through the transformation and institutional strengthening of CCB. 18. Date the Initial PID Prepared. March 1994. 1/ Previously named Financial Sector Development Project. 2/ Previously named the People's Construction Bank of China. Contact Point: Surinder Malik, Task Manager The World Bank - 6-  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. Processed by the Public Information Center week ending August 22, 1997. - 7 -  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 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 certificate of the relevant level environmental protection bureaus. CCB's guidelines for appraisal of fixed asset investment effective March 1996 require the inclusion of environmental protection programs and remedies approved by the environmental protection authorities. CCB 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. -8-