The Development of Credit Unions in China:

Past Experiences and Lessons for the Future *

Xuejin Zuo

Shanghai Academy of Social Sciences

Quite a few reform measures have been taken in China’s financial sector since early

1980s, nevertheless, the four state banks remain the dominating giants in the sector. Some

studies (e.g., Fan Gang 1999?) find that the financial sector allocates huge amount of saving

deposits into poorly managed state-owned-enterprises (SOE’s), while the more efficient and

fast-growing non-state sector, especially those small and medium sized enterprises (SME’s)

have difficulties to get funding from the sector. This situation leads to low efficiency of

investment projects, and inadequate aggregate demand in the country since 1997.

Facing China’s likely accession to WTO late this year, and the scenario of gradual

opening up of financial sector to foreign banks within five years after the accession, the

argument for lifting the entry barriers to the sector by private domestic investments is

becoming increasingly appealing. However, being concerned with the potential financial risks

related to the private banking, the People’s Bank of China (PBC) has been very cautious in

taking any moves in this direction. One of the alarming evidence is the rural and urban credit

unions, which expanded rapidly in 1980s and 1990s, but currently many are in financial

troubles and may be the sources of financial instability. In fact, there have already been

several incidence of local-level cash crises of credit unions, and by the end of 1999, for the

nation as a whole, the rural credit unions had negative net assets.

The central bank faces a dilemma in dealing with these credit unions. As pointed out by

* I would like to thank my colleagues at the Shanghai Academy of Social Sciences, Han Hanjun, Yang Xin and

Wang Tao for their research assistance.

Xie Ping (2001), at the absence of deposits insurance, bankruptcy of these credit unions

implies substantial financial losses of depositors, among them many are low-income farmers.

This seems politically infeasible. On the other hand, if these credit unions are allowed to

continue their operation, then their financial losses and the amount of non-forming loans may

grow larger, and hence nurturing even higher financial risks.

New reform and re-structuring moves for both rural and urban credit unions taken

around mid-1990s have achieved only limited progresses. Policies toward the future

development of credit unions and entry of private banks have become the important issues in

the agenda of financial sector reform. This paper will first provide an overview of the

development of rural and urban credit unions in China so far. Then the paper will discuss the

causes of their financial difficulties, and the lessons we can draw from their past experiences.

Finally, it suggests future policy alternatives toward the future development of cooperative

financial institutions and private banks.

Development of Credit Unions

Initiated in early 1950s to combat usury then prevailed in the countryside and to promote the

financial stability, rural credit unions have been the core of the rural financial system since then.

Except for the episode of the people’s commune movement in 1958, during which rural credit

unions were merged with the township-level branches of the Agricultural Bank and were placed

under the jurisdiction of the commune, in most time rural credit unions were managed by the state

banks (people’s bank or agricultural bank). In the two decades prior to their re-structuring in 1996,

rural credit unions were actually the low-level branches of the Agricultural Bank.

As part of the transition of the four state banks1 to commercial banks, rural credit unions

underwent a major reform step in 1996 to separate from the Agricultural Bank, and to restore their

nature as independent cooperative financial institutions (Huang Yanjun 2001). Nevertheless, as we

can see in the later discussions of this paper, the re-structuring practice in fact deviated from this

original goal. The development of rural credit unions as indicated by total amount of deposits and

loans are reported in Table 1.

1 Four state banks in China are: the Industrial and Commercial Bank, the Agricultural Bank, the Bank of

2

(Table 1 “Deposits and Loans of Rural Credit Unions in the Past Two Decades” about here)

After about 50 years of development, by the end of 2000 rural credit unions in China

consisted of 42000 institutions with legal person status, with total employment of 640 thousand,

total deposits of Y1.33 trillion, and total loans of Y0.92 trillion, accounting for, respectively, 12.3

percent and 10 percent of the total in the country (Zhang Gongping 2000). Nevertheless, the

expansion of the business went hand-in-hand with increasingly larger financial risks. By the end

of 1999, the total losses of rural credit unions amounted to Y86.2 billion, resulting in net assets of

negative Y8.1 billion. If bad loans were removed from the assets accounting, their financial

situation would be even worse. There are inter-regional variations in the performance of rural

credit unions. Generally speaking, the poor inland provinces do worse compared to prosperous

coastal provinces.

Reform in 1996

The national conference on financial issues held in early 1996 announced the reform of the

management system of rural credit unions as the key of rural financial reform. The primary goal of

the reform is to re-structure the rural credit union into “a cooperative financial institution owned

and democratically managed by share-holding peasant members, and operates mainly for the

members.” As specified in “the State Council’s Resolution on the Reform of Rural Financial

System” issued in August of the same year, the reform requires that all rural credit unions break

away from the jurisdiction of the Agricultural Bank, then under the new system the county

association of rural credit unions (nongcun xinyoushe xian lianshe) take over the administration of

the credit unions, and the PBC be in charge of their monitoring, the rural credit unions be

re-structured based on the principle of the cooperative financial institution.

In August 1996 the State Council’s Inter-Mnistry Coordination Group for Rural Financial

Reform was established, with its operational office set up in the headquarter of PBC. Then the

local leading groups for rural financial reform were established at three levels of the province,

Construction and the Bank of China.

3

prefecture and county. These local leading groups are usually led by the local officials in charge of

finance, and the leading group’s operational offices led by the heads of local branches of the PBC.

In order to upgrade the qualification of the county association of rural credit unions for their

new duties in the administration of rural credit unions, the county associations themselves were

re-organized and staffed based on the PBC’s requirement Most county associations appointed their

new leadership, set up divisions for new functions, and hired new staff. More than 10 thousand

workers transferred from the local branches of the Agricultural Bank to the country associations,

swelling their total employment to about 40 thousand in the whole country.

Based on the accounting records at the end of October 1996, and approved by the

headquarters of PBC and Agricultural Bank, and the State Council’s Leading Group of Rural

Financial Reform, a total fund of Y187.84 billion were transferred form the Agricultural Bank to

the PBC. In the meantime, the PBC lend the same amount of special loans to the Agricultural

Bank.

By the end of 1999, more than 50 thousand rural credit unions and over 2400 county-level

and above-county-level associations of rural credit unions had been re-structured during the

reform. A case study of the reform is used below to provide some details of the reform.

A Case of the Reform

The research team of the Rui’an Branch of the PBC (2001) published a report based on its

investigation on the reform of rural credit unions in the City. In 1997 and the following years, the

rural credit unions of the Rui’an City undertook reform measures based on the “Specifications for

the Management of Rural Credit Unions” issued by the PBC.

The registered capital of rural credit unions came from the sale of shares to their members

and the accumulation of their retained profits. The shares can only be purchased with cash, total

shares held by any individual member can not exceed 2 percent of the total registered capital.

Each share was priced at Y10. The minimum holding of shares were one share for each individual

member, 100 shares for each collective member, and 100 shares for each employee member of the

credit unions. For the very first time enterprises were allowed to hold shares. Based on the study

of the Li’ao rural credit union, after the reform nearly three-quarters of the credit union’s equities

were owned by its employees, whereas only 9 percent owned by other rural households, and 16.7

4

percent owned by enterprises.

After the merge of rural foundations and rural financial services collectives with the credit

unions, both the deposits and loans of the credit unions as percentage of the total grew with time,

so did the ratio of non-performing loans in the total lending. This trend of increase was

accompanied by trend of decline in their profitability.

Performance after the Reform

The reform is not very successful to the extent that it failed to achieve the official goal of

restoring the cooperative nature of rural credit unions. The emphasis on the top-down external

monitoring while neglecting the internal governance, the bureaucratic and inefficient management

system adopted during the reform, and the strong government intervention into business decisions,

are in direct contradiction to the principle of the cooperative financial institution. As a cooperative

financial institution, rural credit unions should be relatively simple and small, and characterized

by more transparent information, democratic management and efficient internal monitoring by all

members of the union, and primarily member- oriented lending. Unfortunately, the real

performance of the rural credit unions deviated from these definitional features.

Increase in NPL

For a long time prior to the reform in 1996, the rural credit union was operating in the

shadow of the Agricultural Bank, protected it from direct exposure to financial risks. Separation

from the Agricultural Bank made the credit unions more vulnerable to financial risks. By the end

of 1996, the non-performing loans amounted to Y238.4 billion, accounting for 38 percent of the

total loans, an increase of 7.5 percentage point compared to the figure in 1995. There were 26

thousand, or 53 percent of the total credit unions, losing money. By the end of 1996, the total

losses accumulated to Y35 billion; with Y14.7 billion occurred in that year.

In 1998, the PBC intended in its document “the guideline for the comprehensive

re-structuring of the rural credit unions with negative worth” to resolve the negative worth

problem among one-third of such credit unions, and by the end of 2000 to generally resolve the

negative worth problem for all rural credit unions. Measures were taken to improve the

governance and management of the credit unions, to reduce the staff, and provide special funds to

5

aid the credit unions in financial difficulties. Nevertheless, by 1999, the financial situation of rural

credit unions was even worse, with further increase in their debts.

There are some associations between the performance of rural credit unions and the

development of the area where they are located. Generally speaking, the credit unions in the

less-developed inland provinces have more financial troubles. This can be illustrated by a case

study in a prefecture of the poor northwestern Gansu Provice.

Based on a study conducted by the PBC Longnan Branch research team (2000), among the

248 credit unions in the Longnan Prefecture of Gansu Province, 150 are losing money, while only

98 are profitable. In some counties, 80 percent of the rural credit unions suffered from losses. For

the prefecture as a whole, the net losses (losses minus profits) totaled Y5.24 million, averaging

Y22,000 per credit union. Nearly a quarter of the credit unions were in such a poor shape that their

accumulated losses surpassed the sum of their shareholders’ value and total deposits. After

separation from the Agricultural Bank, over half of the credit unions could continue to operate

only with the support of the external financial aids, one-third of them had a negative net worth,

over 28 percent could not make cash payment to withdrawers. Some for years had not been able to

make any lending from their shrinking saving deposits, and hence were in fact not functioning.

The primary cause for such financial difficulties is high percentage of NPL in their total loans.

Among these 248 credit unions, NPL accounted for almost half of the total loans, about 30

percentage higher than the allowed maximum. For some credit unions, this figure was even higher

than 90 percent.

Decrease in the Lending-Deposit Ratio for Rural Households and Agriculture

In spite of the PBC’s repetitive calls emphasizing the financial support to peasants,

agriculture and the development of the countryside (nongmin, nongye and nongcun, or sannong)

as the most important task of rural credit unions, in reality it is very difficult for rural households

and agricultural production to borrow from even rural credit unions.

After the four state commercial banks withdrew from the below-county level administrative

units (townships/villages) to reduce their operational losses, rural credit unions became the

monopolistic financial services providers in rural areas. In some poor rural townships, as the credit

union is in fact paralyzed, simply no such services are available at all.

6

Urban Bias in the Development of Rural Credit Unions

Some studies find strong urban-bias even in the development of rural credit unions, as

reflected in the spatial allocation of the operation sites, the destination of lending and the

distribution of the unions’ employees by rural-urban residence. This is in fact the transfer of rural

saving to the better-off urban areas, and hence accentuating the already significant income

disparity between urban and rural areas.

Based on his investigation in a primarily agricultural city,2 the Huaihua City of Hunan

Province, Shen Yongwei (2001) illustrates this bias through a series of statistical data. Huaihua

City is among the less-developed inland areas. Although over 60 percent of the deposits came

from the countryside, about one half of the business offices/posts of rural credit unions in the City

were located in urban areas, and about one half of the unions employees, fixed assets, and

outstanding loans, NPL, and operational losses came from urban areas. The study called this

urban-biased development of rural credit unions. It was argued that in the prosperous coastal

provinces, where level of urbanization is high, it maybe inevitable to see the increased importance

of urban components in the operation of rural credit unions. However, such trend in a less

developed, primarily agricultural area could only be seen as an alienation of rural credit unions.

Furthermore, if judged by amount of deposits and profitability, the performance of urban

components was worse than rural components of the credit unions. From the perspective of

economics, it is not rational to transfer rural savings to urban places. To a large extent, it is a

reflection of urban-biased policy practice and behavior of urban-prevailing local governments.

Before some further discussion of the rural credit unions, let us have an overview over the

development of urban credit unions.

An Overview on the Development of Urban Credit Unions

Urban credit unions started later as compared with their rural counterparts. After the

establishment of the first urban credit union in Zhumadian City of Henan Province in 1979, urban

2 “City” sounds like an urban place. However, in China’s administrative system, the boundary of city tends to

cover the surrounding counties, or in another word, these counties are under the jurisdiction of cities, and hence are regarded as part of the “city.” In 1980s and 1990s, many prefectures were renamed to “cities.”

7

credit unions as a new form of financial institution in urban areas experienced a fast growth in

1980s and early 1990s. By the end of 1989, there were over 3400 urban credit unions, with total

deposits of Y22.1 billion. By the end of 1994, before the restructure of urban credit unions into

city cooperative banks, there were more than 5200 urban credit unions operating with registered

capital of Y11.1 billion, total deposits of Y235.4 billion and outstanding loans of Y132.4 billion.

The trend of deposits and loans of urban credit unions are reported in Table 2.

(Table 2, deposits and loans of urban credit unions, about here)

The administration and supervision of urban credit unions evolved with time. In the early

stage of development, urban credit unions were under the jurisdiction of the Industrial and

Commercial Bank of China (ICB). The Bank also provided financial support and services to the

unions.3

In 1986 and 1988, the PBC issued, respectively, “Temporary Stipulation on the

Administration of Urban Credit Unions” and “Stipulations on the Administration of Urban Credit

Unions,” defining urban credit unions as collective financial institution, directly under

administration and supervision of the PBC.

With the expansion of their operational scale and the number of financial products provided,

urban credit unions shown increasingly the characteristics of commercial banks. In the meantime,

the inherited weakness in their governance and the agent problems, with the absence of effective

monitoring by the PBC, the development of urban credit unions was accompanied by the

increased financial risks related to their operation. Since mid-1990s, there were occasions of panic

withdraw from some urban credit unions. The government was forced to come to rescue. Starting

from 1995, the central bank decided to restructure/merge urban credit unions into city cooperative

banks (renamed to city commercial banks in 1998) as one critical measure to prevent and reduce

financial risks related to urban credit unions.

Restructure of Urban Credit Unions into Urban Cooperative Banks

3 The ICB set up Service Division for Individual Business, in chare of the administration and supervision of urban

credit unions.

8

In contrast to the 1996 rural credit unions reform that aimed at restoring the cooperative

nature of rural credit unions, the 1995 restructure of urban credit unions was intended to merge

them into commercial banks.

With the issuance of the “Circular for the Organization of Urban Cooperative Banks” by the

State Council in 1995, the move to restructure of urban credit unions into commercial banks

started in large and medium-sized cities. By the official definition, city cooperative banks are

joint-equity financial institutions between the old urban credit unions, and the new investments

from urban enterprises, households, self-employed small business, and local government. As a city

cooperative bank has the legal person status, all the urban credit unions merged into it become

subordinating branches of the bank, and hence they will lose their old status as independent legal

persons. The city cooperative banks will coexist with those urban credit unions that do not merge

into a bank. Both are under the administration and supervision of the PBC.

The pilot experiments were conducted in 16 cities in 1995, extending to 95 cities in 1996. By

the end of 1996, 18 city cooperative banks were set up, and this number increased to 71 by 1997,

containing 1625 former urban credit unions operating as their branches.

In 1997, the PBC decreed the “Stipulation on the Administration of City Cooperative Banks.”

Not long after than, the State Council approved the re-orientation of city cooperative banks to city

commercial banks. It is required that the city commercial banks follow the model of joint equity

banks in the share holding, financial management and business operation. They are not longer

treated as cooperative financial institution with regard to their administration and business

operation.

By 1998, there were 88 city commercial banks operating in China, with total assets of Y494.2

billion and total liability Y471.0 billion. Among the city commercial banks, four had assets

exceeding Y20 billion, located in Shanghai, Beijing, Guangzhou and Tianjin.

Quite a few urban credit unions with financial difficulties have been closed or merged with

other ones since 1997. The PBC fixed in Hainan Province 34 city credit unions, among which five

were closed, 28 were merged into the Hainan Development Bank, and one was retained. In 1998,

the PBC closed 16 urban credit unions, consisting of 13 in Guangxi Province, 2 in Guangdong

Province, and 1 in Qinghai Province. In 1999, the PBC suspended the operation of 150 urban

credit unions in Guangdong, 7 in Yiyang of Hunan, and 2 in E’zhou of Hubei as they had

9

difficulties to pay withdraws. To handle the risks caused by the financial difficulties of urban

credit unions, the PBC lend them Y16.2 billion special loans.

In 2000, the PBC mandated that all urban credit banks choose among three alternatives: to be

acquired by city commercial banks, to be acquired by joint equity commercial banks, and to merge

with rural credit unions. Therefore, there will be no rooms for the existence of cooperative

financial institutions (only if in nominal terms) in urban areas.

Although financial risks were reduced after the restructure of urban credit unions into city

commercial banks, the problems of corporate governance and government interference continue to

exist in commercial banks. Moreover, the informal sector continues to have difficult access to

bank credits.

Causes of the Past Failures and Lessons to Be Learned

The development of urban and rural credit unions in the past two decades is one of the

products of the reform. On the one hand, they filled in the bland space of financial services left by

the state commercial banks. On the other hand, they created huge amount of bad loans and hence

potential financial risks. Many factors may have contributed to the failure of urban credit unions;

some are common to developing countries, while some are unique for China’s transitional

economy. It is necessary to make a careful analysis of these causes and lessons to be withdrawn.

Causes Regarding Governance and Management

Ambiguity of property rights, and deviation from the nature of cooperative financial

institution As cirted by Xie Ping (2001), the International Labor Organization (ILO) defined in

1994 a cooperative is a voluntary and democratic organization, an association with a common goal.

All members fund, take risks and benefit from, and actively participate in, its activities. The 1997

“Stipulations for the administration of rural credit unions” defined rural credit unions as “consist

of share holding members, implement democratic management by all members, and provide

financial services mainly to members.”4

4 In the 1998 State Council’s Circular to issue the PBC’s “Stipulations about furthering reform and rectification of

the management of rural credit unions,” the cooperative principle is explained as “voluntary holding of shares, democratic management and service provision mainly to the members.”

10

However, by the above-stated standard, China’s urban and rural credit unions have never

been de facto cooperative financial institutions. From the very beginning, the creation of rural

credit unions was the product of government mandatory instructions. The memberships are more

mandated than voluntary. The members have no freedom to withdraw. Apparently, the involuntary

members are not the owner of the unions, the so-called “democratic management by all members”

is nothing but an empty word. Prior to the reform in 1996, rural credit unions were under the

jurisdiction of state banks, and in fact became their grass-roots level branches.

The 1996 rural credit union reform announced it target as to restructure rural credit unions to

cooperative financial institutions that “consist of share holding members, implement democratic

management by all members, and provide financial services mainly to members.” However, the

implementation of the reform completely deviated from this original target. The reform only

handed the control over rural credit unions from the Agricultural Bank to the county association of

rural credit unions. Although both rural credit unions and county association of rural credit unions

have independent legal person status, the associations have the decision-making power with

regard to the appointment of the head of credit unions and business operation, leaving rural credit

unions actually not an autonomous entity but subordinate part of the association. Moreover, the

association itself is completely controlled by the local government. As members have no chance to

participate into the decision making of the unions, they have no incentives to care for the

performance of rural credit unions.

A case study of the 1996 reform of rural credit unions in Rui’an City reported by the research

team of the PBC Rui’an City branch can be used to illustrate the details of the reform. As required

by the PBC regulation, every rural credit union in the city set up a board of directors (lishi hui)

and a board of supervisors (jianshi hui). The board of directors is in charge of personnel, financial

plan including the budget, distribution of profits and financing of possible losses. The board of

supervisors monitors the compliance to the laws and regulations, government policy, and the

management of the union. The chairman of the board of directors and the chairman of the board of

supervisors can be concurrently held by, respective, the head and the deputy head of the union.

But the case study found that most board of directors and board of supervisors were only a matter

of formality, but actually not functioning.

The city association of rural credit unions controls the personnel, labor and compensation,

11

lending and other business operation; it also provides services to unions under its jurisdiction

regarding such as inter-union borrowing, account settlement, and etc. In fact, the relation between

the city association and subordinating unions are more like the relation between the headquarter of

commercial bank’s and its non-legal-person branches than the relation between two independent

institutions.

Another case study can be used to describe how the local government interferes the operation

of rural credit unions. The study conducted by the research team of the PBC Wuzhou City Branch

(2001) found that rural credit unions have little autonomy over their business operation. It is a

common practice for the local government to direct the lending for the sake of their own interests,

most of all, their political achievements (zhengji). In Wuzhou City, such interferences can be

classified into three categories. The first category is the “policy lending” to finance the investment

in the poorly managed township and village enterprises (TVEs), quite often the investment

decisions were made with no feasibility studies. For instance, Rural Credit Unions in Guangchang

County were forced to lend to the TVE’s in the county. As 90 percent of the TVE’s in the county

were closed, this lending practice led to more than Y10 million bad loans, leaving the creditors in

big financial troubles. The second category is the policy lending to support the premature projects

for structural re-adjustment of agriculture, based on only official’s will. In 1996, local officials in

Nanfeng County forced rural credit unions in the county to provide rural households with Y120

million for their new project of raising soft-shelled turtles (jiayu). However, the unexpected

changes in the market made the project a money losing business, and more than Y60 million of the

loans had not been repaid. The third category is the mandated credit given to the township

government to make up the unfulfilled task of tax and fee submission to the county government.

The same argument for rural credit unions holds for urban credit unions. Urban credit unions

are not really cooperative financial institution, nor are really small commercial banking operating

by commercial standard. In most cases, urban credit unions are subordinated to local branches of

state banks or local government, often operating as their low-level branches. They are regarded as

the “tertiary sector” (sanchan) of local branches of the state banks and local government, with the

function of supporting the related enterprises, or providing jobs to their family members and other

relatives. Under this institutional setting, it is natural that these credit unions were poorly managed,

and vulnerable to financial risks and bank runs.

12

Frequently people see the failure of urban and rural credit unions as the failure of cooperative

financial institution. Nevertheless, from the above discussion it is clear that the urban and rural

credit unions are in fact not cooperative financial institutions by nature. As so far rural and urban

credit unions have been subject to interferences and direct management of local governments or

local branches of the state banks, their failure should be firstly regarded as the failure of these

interferences. Unfortunately, this obvious fact tends to be neglected. Careful studies on the lessons

to be learned from the past failure of rural and urban credit unions will be of great importance for

formulating prudent but active policies regarding the future development of cooperative financial

institutions and small and medium-sized private banks.

Moral Hazard Problems Caused by the Absence of Bankruptcy and Government

Interferences Since the bankruptcy of rural credit unions would cause substantial financial losses

to rural depositors, especially the low-income rural households, it is politically difficult, if possible

at all. As pointed out by Xie Ping (2001), the lack of exit mechanism and the local government

interferences generated moral hazard problems at three different levels. Firstly, local governments

realized that the state would not let rural credit unions to go bankrupt due to political concerns

over stability, and hence tend to take advantage from rural credit unions. In addition to mandatory

lending, the local governments also charge high taxes and fees on rural credit unions. Secondly,

the managerial staff of rural credit unions realized that the state would not close their unions, and

hence they do not care to improve the unions’ performance through more effective management.

Thirdly, the borrowers, especially the TVE’s, know that rural credit unions would not go bankrupt,

and hence they tried to make every effort to postpone their repayment for the loans.

Moral hazard problems are not limited to only lending and borrowing decisions. The

ambiguous property right of rural credit unions and the absence of the real owner made the agent

problem very serious. The rent-seeking space available within rural credit unions invited

corruption. Many rural credit unions suffered from heavy losses continued to buy luxury cars,

hiring and to upgrade office buildings. This is called, by Chinese saying, rich monks in poor

temples.

Inadequacy of capital and shortage in trained personnel Generally speaking, rural credit

unions tend to be small with inadequate capital. This is more evident in the less-developed western

provinces. Based on the survey of 248 rural credit unions in Longnan Prefecture of Gansu

13

Province conducted by the research team of PBC Longnan Branch (2000), by the end-1996, the

average shareholder’s capital were Y58.6 thousand per union, and 15 percent of the unions had

shareholder’s capital below Y10000. One of the unions had only Y400. The undercapitalization

and too small scale make these credit unions very vulnerable to any financial risks. Even one

withdrawal or a small legal dispute could push the union into insolvency.

Shortage in trained personnel was a serious problem too. In the Longnan Prefecture, among

the 1049 employees working in the area’s rural credit unions, 40 percent had only junior high

school or lower level education, while only below 10 percent had senior high school or higher

education. Given this situation, it was difficult to find a qualified head or accountant for the credit

union. Among the credit unions surveyed, nearly 80 percent had accountant who were not capable

of making accurate and complete accounting record in a timely manner. Some head of the credit

unions were illiterate.

Ineffective External Supervision

As a legacy of the past planning system, the central bank’s efforts to control financial risks

were focused on the approval of entry into the business, while neglecting the prudential regulation

and supervision of the financial institutions. Therefore, once a credit union was approved, there

was no effective supervision over its operation. This can be clearly seen from the

above-mentioned case studies.

The importance of prudential regulation and supervision was widely recognized in China in

recent years, especially after the Asian financial crisis. One thing we have to do is to build up the

supervision capacity of the central bank. This may take longer time to achieve than merely

conceptual changes in supervision of financial institutions.

However, as in the case of rural and urban credit unions, an effective supervision will be

possible only if the past role of local governments is re-oriented. The direct intervention and

involvement of local governments and even the local branches of the central bank in the

management of credit unions had turned themselves from outsiders into insiders. Let de facto

insiders to exercise outsiders’ function of supervision, is parallel to the situation where a game

player is in the meantime the referee. This practice has no doubt shaken the foundation of external

supervision.

14

Therefore, to strengthen the prudential regulation and supervision of credit unions and other

financial institutions, local governments have to delink their function from direct intervention and

management of business operation of the unions.

As credit unions tend to be less “formal” compared to commercial banking, the more

effective supervision and oversight should first come from their members, rather than outsiders.

Improved internal governance and management would lay solid foundation for any effective

external supervision.

Lack of Market Constraint

A competitive market setting can also play an important role in promoting efficient allocation

of funds and control of risks in the banking system. It is easier for a well-managed bank to get

funding from investors, creditors, depositors and other business partners at more favorable prices

and conditions. On the other hand, banks with high financial risks have to pay for higher risk

premium, additional guarantee and etc. Therefore, this market reward or penalty can push banks to

maintain capital adequacy and to support the more effective functioning of the supervisory

authority. Unfortunately, the market competition in the financial sector has been generally

suppressed, and hence market constraint can hardly play a role in this regard.

This is more apparent for rural credit unions. After the state commercial banks withdrew from

their operation posts at below-county-level rural areas, rural credit unions became the only

financial institution in the area. This monopolistic position immunizes them from market

competition pressure, and on the other hand, preventing the market constraint from functioning.

In addition, the government’s policy toward the informal financial institutions spontaneously

developed in the countryside, may have also prevent the market constraint from full functioning.

The government has made all informal financial institutions illegal. However, as demand of the

growing and diversified rural economy for financing could not be satisfied by the formal financial

system, informal financial institutions appeared and played an important role in rural financial

market. For instance, as early as in 1993, informal financial intermediation accounted for about 40

percent of the total circulation of money in Wenzhou of Zhejiang Province. By comparison, the

self-raised funds by business owners accounted for another 40 percent, while the state banks and

credit unions accounted for only 20 percent (Zhang Shuguan 1999). The alternative to illegalize

15

and to eliminate these informal financial institutions is to legalize these informal institutions and

place them under the supervision of the central bank. In this way, the informal financial

institutions can be competitive and complementary forces to the formal banking, and hence

strengthen the market constraint in the healthy development of the financial sector.

One important question related to the future development of credit unions and private banks

is about the general judgment on the structure of China’s financial sector: is the sector suffering

from financial risks arising from “excessive competition” or suppressed competition? It seems that

the past experiences of rural and urban credit unions do not support the argument for “excessive

competition.” Rather, it indicates the severe problem of government direct intervention, and the

suppressed market competition in the financial sector led to inefficient allocation of savings to

investors, and prevented the market constraint from full functioning.

Generally speaking, the major strategies adopted in the 1995 and 1996 reform of urban and

rural credit unions are: Firstly, strengthen the supervision of credit unions by local governments

and local branches of the central bank. Unfortunately, it ended up with the government direct

interferences into the business operation, and invited severe rent-seeking practice and moral

hazard problems. Secondly, increase the operational scale of credit unions through associating

rural credit unions in the same county under the leadership of the county association, and merging

urban credit unions into city cooperative banks. The second strategy, based on the believe that

larger institutions will be less vulnerable to financial risks, would lead to the termination of urban

credit unions in cities, and the further deviation of rural credit unions from the nature of

cooperative organizations.

Alternative Policies for the Future Development

Facing the gradual opening up of the financial sector to the foreign banks and non-bank

financial institutions after China’s accession to WTO, what policies should be adopted regarding

the future development of urban and rural credit unions? In the following discussions, I would like

to focus on two questions: 1) should we allow the development of real credit unions in China? 2)

should we liberalize the entry to banking system by small private banks? In order to prepare for

16

the discussions on these two questions, let us first digress on the characteristics of rural economy,

and how the financial sector can better sever the need of the economic development.

“Informal” Nature of the Rural Economy

The “informal” nature of the rural economy can be illustrated by its employment structure.

Among the roughly 700 million total employment in China, about 70 percent are rural, and just

over half are agricultural. TVEs create job opportunities for about one quarter of the rural labor

force. TVE employment, after dramatic growth in 1980s, however, stagnated and even declined

since the mid-1990s. Therefore, majority of rural laborers, including those migrated to cities, are

engaged in family farming and traditional services and other informal activities. There demand for

financing can hardly be met by the formal banking system consist of state banks, joint-equity

banks, city commercial banks and rural and urban credit unions. As illustrated in our earlier

discussion, the development of informal financial institutions to a certain extent served the need of

the informal sector. Nevertheless, these informal institutions were not recognized by the central

bank, and tended to be the target of the financial rectification.

Lin and Li (2001) argued that large state banks are not suitable to the task of serving the

financial needs of small and medium-sized enterprises (SME’s), from the perspective of

organizational structure and cost of information collection. They further argued that small banks

could do better do serve the need of SMEs. As the SMEs are the major sources of growth in the

past two decades, the present financial sector prevailed by the four state banks should be

re-structured to allow the development of more small private banks to promote the more efficient

and sustainable growth.

I would like to follow their reasoning to argue that the present financial system is “too

formal” to server the need of the development of informal sector. In reality, many townships

became the forgotten corner of financial services, and hence representing a difficult problem in

their development. In spite of the Center’s repetitive calls for the credit unions to serve the rural

households, agriculture and rural society, the problem remain unresolved.

The Increased Diversity of China’s Rural and Urban Economies

When the reform started in late 1970s, China’s economy was much more uniform compared

17

to the situation today: rural economy was primarily agricultural, and urban economy dominated by

manufacturing of SOE’s. Empirical data recorded a substantial growth of non-agricultural sector

in the countryside, faster growth of service sector in urban areas, and the diversified ownership

structure of both urban and rural economies. The inter-regional and urban-rural income disparities,

increased. Even the demand structure is much more diversified.

The more diversified economy needs for more diversified organizational and ownership

structure of financial sector. As the spectrum of rural economy ranges from family farming and

other off-farming activities, small enterprises in manufacturing and services, to large-scale

manufacturers equipped with modern technology, the needs a comprehensive financial system to

serve the diversified needs of the various components of the economy. The system should include

“real” cooperative credit unions, small private banks and other joint-equity commercial banks, and

possibly the emerging Internet banking. However, as in most cases rural households and small

business have more difficulties in access to credit, the importance of the low end of the financial

system, namely, credit unions and small private banks, should be emphasized.

Alternative Policies for the Future of Rural Credit Unions

The future of credit unions, first of all, rural credit unions, and the policies to deal with them

have becomes a controversial issue. For instance, Xie Ping (2001) in his influential paper

suggested two alternative polices for the future of rural credit unions: to continue their existence

as a “nominal” cooperative institution but de facto doing the business of commercial banking; or

to restructure rural credit unions to commercial banks so that their title can be consistent with the

nature of their business. Notably, he ruled out any possibilities of the future development of real

credit unions in China.

However, when we discuss the future development of rural credit unions, we should noticed

that two different category of credit unions are involved in the discussion. One is the credit unions

that has been existing in China for several decades, and as we revealed earlier in this paper, they

are only named cooperative credit unions, but not really cooperative by nature (let us call them

notional credit unions thereafter for simplicity). These notional credit unions have become the

policy tools of local governments, many of them are in financial troubles, and for the country as a

whole have a negative net worth. Given the political difficulties for them to go bankrupt, it is

18

apparently an unpleasant job to deal with these notional credit unions and the huge debts they

made.

The other category is the credit unions organized really based on the principle of cooperatives

(let us thereafter call them “real credit unions”). They have never existed, at least in large scale, in

the country. In our discussion of the future of credit unions, we should not confuse the notional

credit unions with the real ones. The 1996 reform of rural credit unions once set its goal as to

restore the cooperative nature of the unions. Only this attempted goal was not achieved in the

implementation of the reform. The failed attempt to picture a tiger presents a cat at the end.

Clearly, one simply fact is, the real cooperative credit unions were once intended as the goal of the

reform. The question is, whether we can real cooperative credit unions under the present

institutional arrangement in China, and whether such real credit unions would cause new financial

risks. The following text will discuss, respectively, alternative policies for the future of notional

and real credit unions.

Alternative Policies for the Future of Notional Credit Unions There have been many

discussions regarding the future of the present tens of thousands notional credit unions. In addition

to the above-mentioned suggestions by Xie Ping, some argued (e.g., Ma Zhongfu 2001, Huang

Yanjun 2001) that we should not consider only one model for the future development of rural

credit unions; in contrast, various models should be considered to reflect variations in local level

of development. In the more developed and urbanized region, rural credit unions can be merged

into rural cooperative banks, which are the hybrid of traditional cooperative and commercial

banking. Legislations about cooperatives and cooperative banking should be made so that the

future cooperative banks could have a legal framework to follow. On the other hand, in poor

regions, the major task of rural credit unions is poverty alleviation, and hence functioning as

policy banking. Therefore, there the present rural credit unions can be transformed to be the local

branches/posts of the Agricultural Development Bank, one of the policy banks in China. In other

areas, the present rural credit unions can take various forms; for instance, the county association of

rural credit unions may take over all credit unions under its jurisdiction to become one single and

larger cooperative entity, or several credit unions can merge into one union, or on single credit

union retains its position as independent legal person, and etc.

19

Although I agree that development level may play an important role in shaping the structure

of financial intermediation in different localities, it should not be over-emphasized. In poor area,

there my emerge some successful private enterprises, that would like to borrow from commercial

banks; yet in developed coastal province like Zhejiang, small business operations still may have

difficulties in access to bank loans, and hence seeking for more means of financing. This is

evidenced in the dominance of private lending among relatives and neighboring households in

some prosperous areas, despite that the interest rate for such borrowing tends to be much higher

than the official rate.

We should admit, that given the poor financial conditions of the present notional rural credit

unions, it is not an easy task to restructure them into whatever entities suggested, since huge costs

will be involved in the process. Here I want to emphasize that any restructuring of the present

rural credit unions, no matter whether its target is real cooperative financial institutions,

commercial banks or the hybrid of both, should aim at establishing an institution of independent

legal status, with clearly defined property rights, and protected from direct intervention and

management by the government.

For those credit unions with some market value, we should use market approach to facilitate

the restructuring. That is, these credit unions can be restructured into a commercial bank, can be

acquired by, or merged with, other commercial banks, or can be sold to collective to become a real

cooperative. For those have no market value, and cannot take the market approach, the

government should help settle their insolvency, at least partially, with fiscal funds, and then close

them down. The notional cooperatives should come to a complete end, and the new ones should

have a completely new start. We should avoid the practice to transfer the heavy losses of the

notional credit unions to the new real credit unions.

Alternative Policies for the Future of Credit Unions Based on the poor performance of the

present notional credit unions, Xie Ping and some others (e.g., He Wentao and Jiang Hai 2001) in

their studies preclude the future development of cooperative financial institutions. However, their

argument are not very convincing, since policy measures to deal with the present notional credit

unions should not be confused with the policies regarding the future development of real credit

unions, and the past failure of notional credit unions can not be used to infer the future of real

credit unions.

20

The informal nature and the emerging diversity of the rural economy represent the need for a

more comprehensive and efficient financial system. Real cooperative credit unions should be one

component of such system, and hence should have more policy rooms for future development.

Although a few new, real credit unions may come from the old, notional credit unions through

restructuring, most new unions do not necessarily come from the old ones. Instead, they can be

new born institution based on the principle of cooperative organizations, or nurtured from the

existing informal financial institutions, but legalized and placed under the regulation and

supervision of the central bank.

Some argue that the present unions are too small and too weak to compete with large banks,

therefore, one way to overcome this weakness is to unite local credit unions into a large national

group, which can mobilize deposits nationwide and hence reduce the risks caused by runs of

depositors (e.g., Yang Ziqiang 2000). Although a certain scale is necessary for the proper

operation of credit unions, mere size is not the path leading to success. In contrast, the particular

advantage of real cooperatives relies on the relatively small and limited operation scale, so that the

organizational structure can be simple and efficient to avoid the agent problem; information

among members is naturally more transparent, and hence to minimize the problem of asymmetric

information between the creditor and the borrower. As credit unions lend primarily to its members,

who are in the same time the owners of the union, the externalities and the resulting moral hazard

problems commonly observed in commercial banking can also be minimized.

Therefore, rural credit unions, at least in the early stage of their development, should be

limited to a certain administrative boundary, say, township or county. Each credit union should be

small but with independent legal person status. A large and hierarchical organization of rural credit

union will deprive of all their above-mentioned advantages, placing them in direct confrontation

with the giant state commercial banks. The key to the vitality and competitiveness of rural credit

unions do not rely on their size, rather, on their advantageous governance, democratic

management, information transparency, and free from government intervention to their business

operation. Rural credit unions can also be integrated with poverty alleviation programs??.

Credit unions can also be developed in cities to meet the need of growing informal sector.

Both the establishment and development of rural and urban credit unions can start with pilot

experiments??.

21

Alternative Policies for the Future of Private Banks

Although hundreds of joint-equity banks and city commercial banks have already been

established so far, the dominance of local governments or state units in their ownership structure,

and the government appointment of their high-level management indicate the degree of

government intervention. Therefore, we can say that the entry barriers to private banking have not

been lifted yet.

Facing the scenario of China’s accession to WTO in near future, and its opening RMB

corporate banking business to foreign bans within 2 years, and opening RMB retail banking within

5 years after the accession, actually the question is not “whether” China should open banking to

domestic private investments, but “when”. After the complete opening of banking to foreign banks,

it would be politically and legally embarrassing or even infeasible to continue to ban entry into

domestic private banking. Moreover, we have even more economic reasons to favor early

liberalization of private banking. The deepening of the reform would require that the financial

sector reform catch up with the real sector reform, the former has been far lagging behind; and the

competition between the state banks and private banks would impose competition pressure on the

inefficient state banks, at least at the local level. To a certain extent, this would best prepare

domestic banks to face the coming competition from the foreign bank.

Of course the central bank has good reason to consider the financial risks involved in the

process, given the past failures of urban and rural credit unions. In fact, the same reasoning we

used for the future development of cooperative credit unions applies to private banking. The major

causes of the past failure of credit unions are the lack of autonomy given the ambiguity of their

property rights, and the policy loans forced by government intervention leading to huge amount of

bad loans and financial vulnerability. This failure is not the failure of private banking, but rather

the government intervention.

For the future private banks, what lessons we can learn from the past failure of credit unions?

First, high priority should be given to the corporate governance of private banks themselves. The

equity of the bank should be properly diversified to avoid dominance of few big shareholders.

Institution of independent directors in the board may help. Second, measures should be taken to

prevent local government intervention to the lending practice and other operation, to ensure the

22

operation be based on only commercial standard, and to strengthen risk management. Third, the

prudential supervision should be effectively exercised. Such supervision should include the

minimum capital requirement, the external supervision over capital adequacy and through market

constraint.

To ensure the financial stability, private banking can be first experimented in several

locations of different level of development. The operational scope of these experimental banks can

be limited to certain administrative areas, and with their potential primarily targeted to SMEs. The

experiment of several small private banks should not be a risky venture to the financial sector. Of

course, risks always exist, this is true even for the four giants of state banks.

23

Table 1 Deposits and Loans of Rural Credit Unions� 1978-99

(Ybillion)

Year Deporsits Loans Year Deporsits Loans1978 16.60 4.51 1989 166.95 109.491979 21.59 4.75 1990 214.49 141.301980 27.23 8.16 1991 270.94 180.861981 31.96 9.64 1992 347.77 245.391982 38.99 12.12 1993 429.73 314.391983 48.74 16.37 1994 568.12 416.861984 62.49 35.45 1995 717.29 517.581985 72.49 40.00 1996 879.36 628.981986 96.23 56.85 1997 1055.58 727.321987 122.52 77.14 1998 1219.15 834.021988 139.98 90.86 1999 1335.81 922.56

Table 2. deposits and loans of urban credit unions

Year Deposits Loans D/L Ratio1986 2.95 1.95 0.661987 7.56 6.34 0.841988 15.71 13.39 0.85

1989 23.56 20.15 0.861990 29.68 na 1991 41.67 30.33 0.731992 78.65 45.00 0.57

1993 na na na

1994 201.99 124.32 0.621995 335.74 192.90 0.571996 304.43 196.37 0.65

1997 na na na

1998 na na na 1999 770.00 523.30 0.68

24

References

Huang Yanjun, “Institutional Changes and Innovation in Rural Finance, ” Finance and Insurance,

No. 2, 2001.

1.

Research Team of Longnan Prefecture Branch of PBC, Study of Rural Credit Unions in Longnan

Prefecture, ?? 2001.

Research Team of Ruian City Branch of PBC, “Investigations and Some Thoughts on the System

Reform of Rural Credit Unions in Ruian County,” Working paper of the Ruian City Branch

of PBC, 200

Research Team of Wuzhou City Branch of PBC, “Several Issues about the Development of Rural

Credit Unions under the Informal Institutional Arrangement and Techonlogical Constraints,”

Financial Studies, No. 1, 2001.

Sheng Yongwei, “Urban or Rural: the Business Characteristics and Rational Choices for the

Reform of Rural Credit Unions,” Financial Studies, No. 5, 2001.

Xu Dianqing and et al., Two Hundred Questions about Private Banking in China, forthcoming.

Zhang Gongping, “Promote the reform and the development of rural credit unions,” Fiance in

China, No. 8 2000.

Zhang Shuguang (ed), Case Studies of China’s Institutional Changes, Vol 2. China’s Financial and

Economic Press, 1999.

25