Financial Sector Openness and China’s Post WTO Experience

Dr. Yan WangSenior Economist, World Bank

Prepared for the Workshop on “Vietnam’s WTO Accession: Remaining Policy and Legal Issues”

HCM city, VietnamDecember 19-20, 2005

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Outline• Service sectors in developing countries

are usually underdeveloped and inefficient --- hurting growth

• GATS- scope, definitions and major issues

• Opening service trade brings large gains• Banking sector openness: issues and cross

country analysis • China’s pre- and post- WTO reforms• Summary

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I. Why services matter?• Services account for more than 50 percent of

output and employment. These ratios are higher for industrial countries (see charts)

• Some services are low-skilled labor intensive such as tourism and personal services. Thus the expansion of these services are conducive to job creation and poverty reduction.

• Producer and distributive services are crucial for the competitiveness of the goods-export sector, as well as for the economic growth in general.

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A Historic Trend: Service Sector Employment has been rising rapidly in Industrial Countries

Service sector employment as a % of total in Industrial Countries, 1890-1998

0

10

20

30

40

50

60

70

80

1890 1950 1960 1970 1980 1992 1998

France

Germany

Japan

UnitedKingdomUnitedStates

Source: Wang et al (2003)

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Some Services are Labor Intensive and Thus Contribute to Job Creation

Source: Wang et al. 2003

Service Sector Employment in 1999

Kenya MoroccoPanamaRussia

EstoniaCosta Rica

Slovenia

Portugal

Korea, Rep.

AzerbaijanBulgaria

RomaniaThailand

UzbekistanArgentina

Pakistan

Mongolia

IrelandJapan

ItalySpain

Mauritius

Peru

Singapore UK

Puerto Rico

Hong Kong, China

Switzerland

Norway US

Macau,ChinaNew Zealand

Turkey

Philippines

Croatia

Czech RepSlovenia

ColumbiaBarbados

Israel Canada

Honduras

AustraliaFranceSweden

Malaysia

China

Germany Austria

Hungary

Finland

Jamaica

10

20

30

40

50

60

70

80

0 5000 10000 15000 20000 25000 30000

GDP per capita, PPP (current international $)

Empl

oym

ent i

n Se

rvic

es (

% o

f tot

al e

mpl

oym

ent)

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Developing Countries: services inefficient- hurting growth

• Underdeveloped and inefficient: in China, Services accounted for 34% of GDP in 2004 (which was adjusted upward to 40.7% by NBS), lagging behind other industrial and developing countries. Why?

1. Under-reporting /data issue2. It is a part of “Imbalances” existing in the Economy

– Inadequate education and health services in rural areas– Inadequate access to financial services by SMEs

Overinvestment in physical capital and underinvestment in human and natural capital

3. State monopoly, lack of competition in some sectors;• How to correct this imbalance?

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CountryGDP per capita,

PPP (current international $)

Vietnam 38.22 * 2704India 52.15 3115Indonesia 37.56 3583Syrian Arab Republic 47.40 3945Egypt, Arab Rep. 52.44 4103Morocco 53.49 4160Sri Lanka 57.64 4173Azerbaijan 32.22 4175Philippines 53.79 4558Jordan 72.58 4571China 34.50 5495Ukraine 46.28 6317* Year 2003, all others figures are year 2004.

Service Sector: Vietnam, China and Countries with Similar GDP per capita

Services, etc., value added (%

of GDP)

Source: Global Development Fianance and World Development Indicators (August 2005)

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Sectoral Share of Services in Total Employment in OECD Countries1988 1998 Change

Wholesale, retail trade, restaurants and hotels (1) 19.2 20.1 0.9Transportation, storage, and communication（2） 6.4 6.4 0Finance，insurance, real estate and business services（3） 9.4 11 1.6Public administration and defense (4) 10.6 10.8 0.2Education, health care, social assistance and others（5） 18 19.3 1.3Total 63.6 67.6Notes: Total employment (all activities) = 100.Source：Services: Statistics on Value Added and Employment, OECD, Paris, 2000.

Sectoral Composition in OECD

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Why open the service sector• The service sector has the ability to absorb more labor,

as some subsectors are labor intensive and can employ more low- or high-skilled workers.

• Services as engine of growth: since deeper division of labor and specialization contribute to competitiveness and higher productivity

• Liberalization in service may generate sizable gains– A) Standard gains from trade and specialization;– B) Services as intermediate input—new services

will appear and better services for the goods sector; – C) Gains from FDI as a means for trade --learning-

by-doing.

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II. GATS: Scope and definition• General Agreement on Trade in Services (GATS),

negotiated during the Uruguay Round (1986-94)

• Services is defined as – Any services in ay sector except services supplied in the

exercise of government authority

• Trade is defined as (four modes of trade)1. Cross border supply2. Consumption abroad3. Commercial presence or local establishment4. Temporary entry of natural persons

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GATS: Scope and Definition• GATS has several advantages:

Negotiate reciprocal market accessStrengthen credibility of domestic policiesPre-commit to future reformsRegulatory cooperation

• GATS list of service sectors includes:

• Business services• Communication services• Construction services• Distribution services• Educational services• Environmental services

• Financial services• Health-related services• Tourism services• Recreational & cultural serv.• Transport services• Other services

• Including 150+ sub-sectors

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GATS: requirements• General GATS disciplines:

• Transparency of policy regime (Article III)• Most-favored nation treatment (non-

discrimination between trading partners) (Article II)

• Economic integration (Article V)• Mutual recognition Agreement (Article VII)

• Country specific commitments:Four modes of deliveryTwo types of measures: limitations on market access and national treatment

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Commitment by other countries:Example of GATS schedule

NoneOnly senior managerial personnel, specialists and technical assistants with the approval of the Insurance Commissioner

(4) Movement of natural persons

None(a) Foreign equity participation limited to 25 per cent of registered share capital.

(b) New establishment is subject to license approved by the Minister with the consent of the Cabinet.

(3) Commercial presence

Life insurance premium is tax deductible up to a certain amount for holders of policies issued by local companies

None(2) Consumption abroad

NoneNone(1) Cross-border supply

Limitations on National Treatment

Limitations on Market Access

Thailand: life insurance

Source: Fink, Mattoo, Rathindran (2002)

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Commitments by China & others

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

DC LDCAC CHN DC LDCAC CHN DC LDCAC CHN DC LDCAC CHN

Mode 1Cross-border supply

Mode 2Consumption abroad

Mode 3Commercial presence

Mode 4Movement of natural

personsSource: Mattoo 2002, based on WTO data.

DC = developed country; LDC = developing country; AC = acceding countries; CHN = China

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Comments on China’s commitments in opening its service sector

• China committed to opening in 57% of sectors and modes vs 38% in other large developing countries & 47% in rich countries– “The most radical services liberalization ever

negotiated in the WTO” (Mattoo 2002)Aaditya Matto (2002) analyzed the pro and cons:• Initial restrictions could encourage further agglomeration

in certain regions which is unlikely to be reversed later• Restrictions on foreign ownership may dampen the

incentives of foreign investors to improve firm performance.

• Improved prudential regulation and measures to deal with NPLs are necessary to deliver the benefits of liberalization in financial services.

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Cost of not opening• Lack of competition led to inefficiency in many

service sectors. In banking, market access was not allowed to the domestic private sector, nor to foreign banks.

• Making commitment to WTO with a fixed schedule is a good way to fight domestic interest groups, and lock in reforms.

• Underdevelopment of many service sectors: such as logistics, distribution, telecom, internet services, insurance and banking, has constrained the economic growth and competitiveness. Openness would facilitate the growth of new sectors, new services and new products

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III. Key Issues in Financial Services• Why open the financial services?• Financial services include:

– Banking services– Insurance and insurance related services– Other –securities, asset management, foreign exchange services, etc

• Does GATS compromise the ability of governments taking measures for prudential reasons? No. Opening financial services does not mean opening capital account.

• Gains from opening foreign bank entry: cross country analysis

• Competition first: The case of China• How to ensure the access to credit by the poor?

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Why Open? International experience

• Financial development contributes significantly to growth, through efficient allocation of resources (King and Levine 1993, and Leving and Zervos 1998)

• Financial markets reduce the information cost of borrowing and lending and help allocate risks

• Financial assets (with attractive returns) encourage saving in financial form

• Financial institutions, banks, mutual/pension funds and others, play important roles in efficient resource allocation

• An efficient banking system requires a contestable system—one that is open to entry and exit

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Foreign bank presence has sharply increased in the developing countries (percent)

Source:World Bank staff estimates in Global Development Finance 2002; Bankscope

05

1015202530354045

Number of ForeignBanks in % of Total

Foreign Bank Assetsin % of total assets

19952000

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Benefit of banking sector openness: The presence of foreign banks

• is associated with higher efficiency of banking system, which would improve the allocation of resource and is growth-enhancing.

• It may reduce financial intermediation costs as reflected in domestic banks’ lower net margins, non interest income and lower overhead costs.

• It reduces domestic banks’ pre-tax profitability in high-foreign-entry market

• It helps enhance the capacity of domestic banks by training staff that then move to domestic banks.

• Source: Claessens and Lee 2001, Claessens, Demirguc-Kunt and Huizinga 1998, World Bank, GDF (2002), and Wang (2004).

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Empirical evidence from cross country analysis

Using data from 30 countries from 1994-2003, we found that• Foreign banks’ are relatively more efficient as their profitability

is higher and their overhead cost lower. • Countries with a higher foreign bank share tend to have more

competitive domestic banks - cost and profit indicators are lower. • Degree of openness to foreign bank entry varies a lot among

countries. The asset share of foreign banks ranges from 0.2 percent in China to 61.6 percent in Hong Kong, China.

• Among industrial countries, foreign bank shares also vary significantly, from 34 percent in the United Kingdom- the highest share, to only 1.7 –2 percent in Sweden and Japan. (see Annex table 1)

Source: Bayraktar and Wang, 2004.

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Regression Results: openness and efficiency

• Banking sector would become more competitive with a higher share of foreign banks. Foreign bank share is a negative related to overhead cost, interest rate margins, and non-interest income, indicating higher efficiency.

• Other economy-wide factors matter as well: Bank performance is positively related to GDP growth rate, and negatively related to the inflation rate, and the real interest rate.

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IV. China’s commitment is strong in opening its banking sector

China has committed to open its banking sector to foreign banks after joining WTO:

• Immediately open foreign currency business to foreign banks without limit;

• In the 2nd year, open RMB business to firms, and open four cities each year; and

• In the 5th year (2006), open RMB business to all residents in all regions with no geographic limit.

• Geographical restrictions: open 14 coastal cities first, and 4 more cities each year until 2006.

See Annex 9 of China’s WTO agreement.

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Pre-WTO: Cost of not open Monopoly and Inefficiency

• Pre-WTO, market access in banking was not allowed to the domestic private sector. The sector has been dominated by four State-owned banks (the big four), and a dozen shareholding banks.

• “The Big Four” have extensive branch networks and employ 1.7 million people. [1.3 million in 2004]

• But they were actually bankrupt in 2002. The total amount of Non-performing loans were estimated at 25.4% (Dai, 2002) to 40% of their total assets in 2002.

• Four AMCs were established to restructure the NPLs. Fiscal revenues were injected to recapitalize the banks.

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Challenges to China’s inefficient banking sector

Banks Tier-1 capital $mn

Returns on assets %

Profit/ employee ($)

Citi-Group 74,415 1.63 84,260

HSBC 67,259 1.38 72,360

ICBC 20,170 0.05 940

AgriBC 16,670 0.19 1600

Bank of China 27,602 0.81 22,970

ChinaConB 23,530 1.29 19,550

Source: The Banker, no. 7, 2005.

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Post-WTO Implementation1. Banking sector

• Opening further to foreign bank entry.– Dec ’03, ceiling on foreign ownership in local banks raised

from 15% to 20% for a single bank and 25% overall– RMB business has been opened in 25 cities by the end of

2005, and geographic restrictions will be eliminated by the end of 2006

• By the end of Oct. 2005, 22 foreign investor invested over $16.5 billion in 17 domestic banks, accounting for 15% of these banks’ capital.

• 71 foreign banks from 20 countries have set up 238 operational entities in 23 cities in China. 138 of them are allowed to engage in RMB business. Though they still account for a small 2%($84.5bil) of total banking asset. (see table)

• Strengthening supervision and regulation—legal reform, CBRC.

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Openness and restructuring reinforcing each other: “one stone, two birds”

• Banking sector openness can help the re-structuring process, improve governance and efficiency.– Bank of America holds 9% of China Construction Bank [$3

billion]– A consortium led by Royal Bank of Scotland invests in Bank of

China($3.1bn, 10%)– Swiss bank UBS invests $500mn in Bank of China– Credit Suisse First Boston invests in ICBC– Bank of Communications’ IPO raised $1.9bn in HongKong and– HSBC took 20% share in Bank of Communications for $1.75bn.

• Ideally, these will help the ownership restructuring and transform State Owned banks into shareholding ones; and promote growth. But it also depends on corporate governance issues….

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Foreign Ownership in China’s Local Banks: Important Role in Restructuring

10*/10*/1.68*/0.2*

Royal Bank of Scotland- Li Ka-shing - Merrill Lynch/ Temasek Holding/UBS/ADB

Bank of China

9.1**/5.1**Bank of America/Temasek HoldingChina Construction Bank

19.9**Standard Chartered BankBohai Bank (Pivate- Tianjin)

11**Commonwealth Bank of AustraliaJinan City Commercial Bank

10SHK Financial GroupDalian City Commercial Bank

12.5 / 12.4IFC/ Scotia BankXi’An City Commercial Bank

50 / 50HSBC/Ping An Insurance GroupFujian Asia Bank(a joint venture bank)

15IFCNanjing City Commercial Bank

8 / 7 / 3HSBC/IFC/Shanghai Commercial BankBank of Shanghai

20.1 / 3China Everbright Group (Hong Kong) /ADBChina Everbright Bank

16 / 5 / 4Hang-Seng Bank/ Tetrad Ventures/IFC Industrial Bank Co.(Fujian)

5** /1.6Temasek Holding*/IFCChina Minsheng Banking Corp.

4.6Citi BankShanghai Pudong Development Bank

17.89New Bridge Capital Shenzhen Development Bank

19.9**HSBC (Shanghai)Bank of Communications

% of SharesInvesting Foreign BanksLocal Banks

Source: Bayraktar and Wang 2004. *to be completed **These deals were completed after Aug 2004 .

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Domestic Restructuring: • State-owned Banks are being restructured and

commercialized.– $60billion capital injection to re-capitalize 3 of 4 big state banks in the

past two years; – Set up Asset Management Companies to dispose over $170billion bad

assets received from the State Banks. – Eased interest rate restriction, banks were allowed into new business (e.g.

fund management companies, etc.)– “Big four” are engaging in restructuring, and preparing for public listing.

• China Construction Bank launched its IPO in Hong Kong on Oct 27, 2005, raised $9.2 billion –the world's largest IPO in the last four years.

• Bank of China, ICBC are being restructured to share-holding companies.• By the end of 2004, 30 Chinese banks met the requirement of 8%

capital adequacy ratio. Asset quality improved slightly (see table), although more than 100 other commercial banks and credit cooperatives still have problems of NPLs and under-capitalization.

• State Banks consolidation--cutting branches in rural areas represents a new problem—Poor people’s access to credit is a big concern

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Non-performing loans and capital adequacy of banks

....6.1..City commercial banks

....7.47.6 2Joint stock banks

5.45.26.76.8 1State owned commercial banks

Capital adequacy ratio

Memorandum:

Per cent

....15.0 214.1 1City commercial banks

..11.97.94.9Joint stock banks

3126.120.415.6State owned commercial banks

Non-performing loans ratio (NPL)

Per cent

Old classificationFive part classification

2001200220032004

1. End-June. 2. End-September.

Source: OECD Economic Survey: China.

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2. Securities Market• Significant steps to open its stock market: Qualified

Foreign Institutional Investors (QFII) implemented in 2003 to allow market access by high quality firms. By mid 2004, 15 QFIIs have entered China’s securities market, and had received a cumulative quota of USD$1.875 billion dollars.

• Joint-venture securities companies emerged. (e.g. China-Euro Securities Limited, and Changjiang BNP Paribas Peregrine Securities both have 33% foreign shares.)

• The ceiling on foreign investment was raised from $4 billion to $10billion in 2005.

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3. Insurance • Implementing WTO commitment: By the end of

2004, China’s Insurance regulator CIRC announced further easing of restrictions on foreign participation in the insurance sector, including:– Cancellation of geographical restrictions on foreign

insurers, who were previously confined to 15 cities,– Opening up of health insurance, group insurance and

annuity sectors (foreign insurers had been limited to selling individual life policies)

– Abolition of compulsory reinsurance requirements; and– Raising the cap on foreign insurance brokers’ ownership

share from 50% to 51%.

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Insurance• Strong growth of the insurance market

– In the first 10 months of 2004, total insurance assets rose to $138.6 billion, a 37.8% increase from the same period in 2003

– Total life insurance premium revenue for the first ten months of 2004 was $29.1billion, 8.8% higher than in the same period in 2003

– Non-life insurance revenue – of which around 60% is in the auto sector—reached 12.2 billion dollars in 2004 (to Nov 20), a rise of 28% year-on-year

• By the end of 2004, more than 100 foreign insurers established offices in China, of which 32 have business licenses. Of these, 19 are life-insurance joint ventures and 13 have licenses that apply to property and casual insurance. International companies hold a market share of about 2.5% in the life insurance market.

• Domestic insurance giants still hold 86% of the life insurance sector in 2003. However, PICC and China life saw their market shares fall by 2-3% respectively.

• Total assets of foreign insurers rose by 3.5% between 1999 and 2003. They reported a 2.7-fold increase in premiums. Foreign insurers account for more than 10% of market share in Shanghai and Guangzhou

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SummaryThe service sector is crucial for export competitiveness, growthand job creation. Trade in services brings large gains from competition, new and better service provision, lower prices, and learning by doing. Making commitment in WTO negotiations is a good way to lock-in reforms. Indeed, WTO accession and competition became the new propellers of financial sector reforms in China.Openness and restructuring may reinforce each other. Attracting foreign bank entry improves banking sector efficiency and is conducive to bank sector restructuring. However, the jury is outon final results (corporate governance is at issue). China’s commitment to first open coastal cities to foreign financial service providers may contribute to agglomeration of financial servicesEnsuring access to credit by the poor is still a big challenge that China is facing. More pro-poor policies are needed to support the rural workers

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Annex Table: Number of Banks and Ranking of Countries According to the Share of Foreign Banks, 1994-2003

Total number of banks

Total number of foreign banks

Asset share of foreign banks (in % of total

assets)Argentina 156 41 China 0.2Brazil 213 39 Sweden 1.7Canada 81 22 Japan 2.1Chile 39 8 Taiwan, China 4.6China 61 5 Italy 5.1Colombia 64 8 Korea, Rep. 5.3Denmark 125 12 Germany 5.4Finland 23 3 Thailand 6.1France 372 69 Spain 6.8Germany 447 33 Brazil 6.9Hong Kong, China 155 59 United States 8.5Indonesia 111 26 Turkey 11.0Ireland 79 48 Philippines 13.2Italy 429 27 France 13.9Japan 322 5 Canada 14.9Korea, Rep. 66 3 Indonesia 17.9Malaysia 95 14 Denmark 18.5Mexico 68 14 Malaysia 18.6Norway 65 9 Finland 19.0Peru 29 9 Colombia 20.7Philippines 51 12 Argentina 20.7Portugal 61 17 Norway 23.9Spain 192 25 Ireland 28.0Sweden 50 5 Venezuela 29.8Taiwan, China 66 2 Portugal 30.7Thailand 49 9 Chile 30.9Turkey 75 11 United Kingdom 33.9United Kingdom 357 143 Peru 53.1United States 451 54 Mexico 54.2Venezuela 85 8 Hong Kong, China 61.6

Source: Authors' calculations using data from BANKSCOPE.Source: Bayraktarand Wang 2004

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Change in net

margin/ta

Change in Non-

interest income/ta

Change in before tax profits/ta

Change in overhead/ta

Change in loan loss

provision/taForeign bank asset share

Total -0.002*** -0.009*** -0.007*** -0.003*** 0.001(-2.793) (-4.963) (-2.711) (-3.951) (0.885)

Stock market liberalized first 0.000 -0.001 -0.004*** -0.002*** 0.001***(-1.092) (-1.502) (-4.580) (-5.281) (3.962)

Domestic financial markets liberalized first 0.015*** 0.016*** 0.001 0.021*** 0.013***(2.820) (3.767) (0.141) (6.646) (3.526)

Capital account liberalized first 0.002 -0.002 -0.008** -0.001 -0.005***(1.284) (-0.853) (-2.347) (-0.318) (-2.642)

(domestic banks)(Weighted Least Squares estimation with country and year dummies, heteroskedasticity corrected standard errors)

Table 7: Summary Table - Foreign Bank Share as a Determinant of Performance Indicators

DEPENDENT VARIABLES

Source: The first two lines of the estimated coefficients of the foreign bank share are taken from Tables 5 and 6. The estimated coefficients of the foreign bank share in the last two lines are obtained by running an exact set of regression equations as in Table 5 and 6 but including only countries which liberalized their domestic financial first in the first set and then including countries which liberalized their capital account first in the second set.

Note: t-statistics are reported below estimated coefficient values. *,**, and *** indicate 10 percent, 5 percent, and 1 percent significance levels successively.

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References:• Bayraktar and Wang, Yan, 2004. “Foreign Bank Entry, Performance of

Domestic Banks and the Sequence of Financial Liberalization” World Bank Policy Working paper #3416.Bhattasali, D., Li, Shantong and Will Martin. 2004. eds. China and the WTO: Accession, Policy Reform and Poverty Reduction, Oxford University Press and the World Bank.Matto, Aaditya, 2002.”China’s Accession To The WTO: The Services Dimension,” World BankWang, Yan, and Fan Zhai, “Impact of liberalizing trade in services: a CGE analysis for China.” Working paper. Wang, Yan and Yudong Yao. 2003. "Sources of China's Economic Growth 1952-1999: Incorporating Human Capital Accumulation", China Economic Review 14(1, 2003) 32-52.Wang and Husain. 1996. “China’s FDI and Economic Growth”, Revue d’Economie du Development. 1-2.World Bank, 2003. Promoting Growth with Equity, Country EconomicMemorandum.World Bank. 2000. The Quality of Growth.See http://www.worldbank.org/trade/China-WTO .