China's legislators outlined a sweeping government reorganization plan last week, in which the central bank's banking supervisory functions are carved out to create a separate banking regulatory commission.

The move ended months of speculation surrounding the possible establishment of a China Banking Regulatory Commission (CBRC). Authorities have pinned high hopes on the separation, hoping the new body will provide tighter supervision over domestic banks weighed down by non-performing loans (NPLs), speed up reform and reduce financial risks, offer a more efficient monetary policy to stabilize China's currency and support overall economic growth.

The reform is being heralded as a significant step towards achieving those goals. What is more pivotal, according to comments by economists and banks, is how such a framework is fleshed out in the midst of an ongoing reshuffle and how related reforms proceed.

Separation

The paramount benefit of the reform is that it draws a line between monetary policy and bank supervision. Long-standing confusion surrounding the functions of the two has already eroded the efficiency of both, economists said.

"On the one hand, monetary policy should rely more on market-orientated tools like open market operations instead of loosening or tightening bank supervision," said Wei Jianing, a senior researcher with the Development Research Centre (DRC) under the State Council, the Chinese cabinet.

The excessive money supply and lending that took place in 1992 and during the first half of 1993, a result of the then slack financial supervision, caused widespread fever to grip the economy, leading to financial chaos. When the government took measures in late 1993 to straighten out the disorder, one tactic was to readjust money supply by tightening bank supervision.

"On the other hand, when things go wrong in banking supervision, we shouldn't plug the holes by stuffing money into them," said Wei, noted as one of the earliest advocates for divorcing bank supervision from monetary policy.

A considerable slab of the NPLs at China's commercial banks and rural credit co-operatives over the years was simply written off with increases in the central bank's relending, he said.

Acknowledging that the separation could improve the efficiency in bank supervision and monetary policy making, Wang Songqi, a senior researcher with the Chinese Academy of Social Sciences (CASS), still expressed concern about possible costs.

"The costs are too expensive," he said. Merely establishing branches for the ministerial-level CBRC in some 320 cities where the central bank has a prefectural office, Wang estimates, could easily cost tens of billions of yuan in expenditure for things like housing, personnel and equipment.

It also makes co-ordination between the central bank and the CBRC, now an inter-ministerial effort, far more difficult in situations such as a bank's insolvency, he said.

Economists say there is no clear global trend as to whether bank supervision should be independent from monetary policy. Currently, three quarters of member economies of the Organization for Economic Co-operation and Development have their monetary policy and bank regulatory functions handled by the same entity.

Bank supervision

"We expect that the CBRC will fulfil its role of preventing and dissolving banking risks by reinforcing bank supervision, brushing up on levels of regulatory expertise and fostering a greater pool of first-class regulatory personnel," said DRC's Wei.

The new commission is expected to be based on the central People's Bank of China's (PBOC) bank supervision department, but it is still unclear how its supervisory methodology will differ from the existing set up.

Government officials and analysts have said the central bank's efforts to supervise its banks have been effective. The ratio of non-performing assets at China's financial institutions dropped to 19.8 per cent last year from a high of 26 per cent five years ago, according to Qiu Xiaohua, deputy director of the National Bureau of Statistics.

"That means overall bank supervision has been effective," he said. "It not only supported a fairly fast economic growth, but also effectively prevented and dissolved financial risks."

But there are also weaknesses, economists say. "There's a high personal behaviour factor (in supervisory activities), and their methods and approaches lag behind (supervisory needs)," said a senior official with the Agricultural Bank of China.

"The CBRC should increase staff scrutiny, and focus more attention on discerning risks and expelling irregularities," he said.

Underlying reasons for regulatory difficulties, the banker said, include a lack in clear orientation for the four State-owned commercial banks. "Should they be profit seekers, engines for economic growth, or the government's tools?" he asked.

Andy Xie, executive director of Morgan Stanley, Asia, said inadequate disclosure of information on Chinese banks' irregularities makes it difficult to evaluate regulatory efficiency.

What is left unanswered in the reform, analysts say, is who will be supervising China's emerging financial holding companies that operate different subsidiaries to circumvent legal barriers separating banking, insurance and securities. The CBRC is designed to oversee banks, asset management companies, trust companies and other depository financial institutions.

"A regulatory vacuum was created," said Wang.

Monetary policy

It is unclear how the slimmer PBOC will approach its monetary policy objectives in the future, but economists said the separation was already taking effect.

Fears of inflation had prevented the central bank from scaling up money supply to support growth. It raised its yearly money supply growth targets twice last year partly as a result of rapid increases in loans. This year, the PBOC has set a 16 per cent growth target, similar to last year's real growth.

"The central bank is already showing signs of an attitude change in daring to loosen up (money supply)," said Yuan Gangming, a senior CASS economist.

"Risk prevention should not be a goal of monetary policy," he said. "The result of monetary policy shouldering that responsibility was inadequate money supply. And the problem remains unsolved."

China's consumer price index remained on a downward spiral for virtually all of last year, stirring worries about deflation.

Still, most economists acknowledged the monetary policy's effectiveness over past years.

"We were faced with fairly complicated circumstances over the past few years, but the financial picture kept improving year by year," said a senior PBOC adviser. "The monetary policy, I should say, was effective."

The creation of the CBRC theoretically wiped the central bank from partaking in bank supervision objectives, but analysts are calling for the reform to be used as an opportunity to grant the central bank a higher level of independence, in an effort to insulate it from political considerations. The PBOC falls under the administration of the State Council.

It has become a global trend to reinforce the independence of the central bank in recent years, said Wei. Relatively conservative countries like Britain, Japan and South Korea all took such measures after financial crises or other monetary turmoil erupted.

Strengthening central bank independence can help China resist external pressure to appreciate its renminbi, Wei said, citing the example of Japan, which was forced by other countries in the 1980s to raise the yen's exchange rate sharply only to pummel its exports and produce economic bubbles.

Some Western economists, along with the Japanese Government, have been pressuring China to raise the renminbi's exchange rate, which they claim is undervalued and harms other economies.

"If our central bank becomes directly responsible to the National People's Congress, if the monetary policy committee can be elevated from an advisory board to a decision-making body and make decisions by voting, it will help alleviate external political pressure on the renminbi's exchange rate," Wei said.

But the PBOC adviser said it is unlikely that the central bank's monetary policy committee can become a decision maker soon, as the central bank law needs to be revised first to exclude bank supervision from its responsibilities.

Currently, the PBOC formulates monetary policy initiatives on the basis of the monetary policy committee's suggestions with the final decision resting with the State Council, analysts explained.