Structural adjustments unfold in Chinese financial system

Since China Construction Bank launched its mega IPO in Hong Kong in late 2005, the banking sector quickly emerged as one of the greatest pillars in both the mainland and Hong Kong equity markets, with all the "Big Four" state-owned commercial banks sitting on the "top Ten" list in terms of market capitalization as well as many other barometers. However, many investors have found their glory fading away a bit in recent years.

The changing operational environment for Chinese banks is an inevitable result of the nation's economic transition, meaning that major commercial banks face a long and bumpy road ahead. I will try to present the complicated case in three parts.

First, let us take a quick look at the relationship between China's economic development and its financial system. For many years, China's economy has revolved around government leadership, exports and investment as core elements. Segregated operations and strict regulatory oversight have also helped to form the current bank-led and non-fully competitive financial system. Despite the rapid development of non-banking financial operations such as securities, insurance products, trusts and funds over the past 20 years, banks remain dominant in the financial system. By end-2011, the banking industry's total assets amounted to 113.3 trillion yuan, while those in the insurance, trust, securities and fund industries amounted to only 14.4 trillion yuan in aggregate. The proportion of non-bank financial institutions within China's financial system is far smaller than that in developed countries such as the US and Japan. Correspondingly, the majority of social financing in China is indirect financing. Based on People's Bank of China (PBOC) data, social financing amounted to 12.8 trillion yuan in 2011, of which new bank loans made up 58.3 percent while direct financing such as stocks and bonds accounted for only 10.6 percent and 3.4 percent, respectively.

In the formation of the financial system, a portion was leftover from the days of economic planning, but even more was a result of the close correlation to the economic growth model over the years. In the past decade, massive inflow of foreign capital stemming from trade surplus plus yuan appreciation caused banks' balance sheets to expand rapidly. Meanwhile, the government provided support for loan growth in order to meet financing need of infrastructure projects.

Under the compulsory settlement system, the sustained inflow of forex caused fundamental changes in yuan base money and monetary growth models, and forex reserves became the main supplier of base money. The ratio of forex assets to reserve currency liabilities on the PBOC's balance sheet went from less than 50 percent in 2002 to 80 percent in 2004.

Apart from exports, investment has been another economic growth driver. In face of the export slump after 2008 following the US subprime crisis, Beijing unleashed a 4 trillion yuan stimulus program. Correspondingly, the contribution of investment to GDP soared from 48 percent in 2008 to 96 percent in 2009. Within the 4 trillion package, central fiscal investment amounted to only 1.8 trillion yuan, and basic infrastructure projects needed to seek funding from external sources. Encouraged by regulators, new bank loans reached 9.6 trillion yuan, driving the overall loan balance growth to 31.7 percent Year-on-Year (YoY) and overall bank assets to climb 26.3 percent YoY in 2009. Although the stellar loan growth began to subside somewhat after that, it still came in high at 19.9 percent YoY for 2010 and 15.8 percent YoY in 2011 in order to ensure the smooth operations at projects under construction.

However, time has changed. Impacted by the EU debt crisis and the correction in the domestic property market, China's economic growth has slowed significantly since late 2011 and forex has continued to flow out since late 2011, signalling that expectations of yuan appreciation have entered a stage of stability. With the development of China's economy and the external changes, China's growth momentum in the existing mode is nearing depletion and a transformation of growth model is imperative. More importantly, such transformation will require structural adjustments of the current financial system.

The author is Executive Director at BOCI Securities). The opinions expressed here are entirely his own.