The Development of Credit Unions in China: Past Experiences and Lessons for the Future *

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1 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 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.

2 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 banks 1 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

3 (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 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

4 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 Y 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

5 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 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

6 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

7 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

8 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

9 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 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 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

10 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

11 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

12 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

13 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

14 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 Y 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

15 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

16 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

17 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

18 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

19 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

20 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

21 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