McKinsey Global Institute Putting China s Capital to Work The Value of Financial System Reform Susan Lund, Senior Fellow McKinsey Global Institute October 25, 2006
KEY MESSAGES China has made steady advances in modernizing its financial system and in mobilizing savings, reflected in the doubling of China s stock of financial assets relative to GDP over the past ten years. China s banking sector plays an unusually large role in its financial system. Capital allocation in the system is poor: wholly and partially state-owned companies continue to absorb most of the funding from the financial system, while private enterprise, the engine of China s growth, receives a disproportionately small share. As a result, China s investment efficiency is declining. The dominant bank sector, though improving, remains highly inefficient and potentially vulnerable to a sharp reduction in liquidity. Reforms that enable a larger share of funding to go to the most productive companies and improved the operating efficiency of China s financial system could raise GDP by $321 billion annually, or 17 percent. Financial system reforms are also necessary to enable China to reach its goal of increasing domestic consumption and rebalancing growth. 1
CHINA S FINANCIAL SYSTEM DEPTH IS HIGH GIVEN ITS GDP PER CAPITA Position in 2004 1994-2004 evolution for select countries Stock of bank deposits, bonds and equity, 2004 Percent of GDP 500 Mature 450 Japan Malaysia United States 400 United Kingdom Singapore 350 South Africa Australia 300 Emerging Sweden Canada 250 Chile South Taiwan Nascent Thailand Korea Finland 200 India China Saudi Arabia Brazil Norway New Zealand 150 Turkey Philippines Egypt Hungary Czech Republic Mexico 100 Indonesia Russian Federation Tunisia 50 Vietnam United Arab Emirates Ukraine 0 1,000 10,000 100,000 GDP per capita (at purchasing power parity), 2004 Dollars, logarithmic scale Source: WDI; McKinsey Global Institute Global Financial Stock Database 2
CHINA S FINANCIAL SYSTEM IS DOMINATED BY THE BANKING SECTOR Financial system capital, 2004 Percent, $ Billions Equity Corporate debt Government debt Bank deposits and currency 100% = 4,291 247 350 1,105 130 675 19,627 1,602 1,428 396 471 214 47,729 15 8 5 30 33 35 4 11 21 11 1 22 19 25 27 7 12 43 40 34 9 60 55 21 34 30 35 29 13 19 35 72 11 6 11 11 14 1 11 46 45 12 43 37 36 35 33 33 32 30 21 19 China Indonesia Thailand India Philippines Mexico Japan South Korea Hong Kong Singapore Malaysia Chile U.S. Note: Numbers may not add to 100 percent due to rounding Source: McKinsey Global Institute Global Financial Stock Database 3
A DISPROPORTIONATE SHARE OF BANK LOANS GO TO STATE-OWNED ENTERPRISES AND COLLECTIVES Comparison of GDP and corporate bank loans outstanding, 2003 Percent State-owned enterprises Shareholding enterprises 1 Collective enterprises 2 Private and foreign enterprises 3 23 19 6 52 35 27 11 27 GDP 4 Corporate loans outstanding 1 Most of the shareholding enterprises are partly state owned. Some are state controlled, some are not. 2 Collective enterprises are owned by the population. Many are run like private enterprises, but some are controlled by local political groups. 3 Fully private enterprises include local privately owned enterprises, foreign joint ventures, and wholly owned foreign enterprises. 4 Breakdown of industrial value added by ownership type, 2003, as determined by the Organisation for Economic Co-operation and Development. Source: OECD; PBOC; McKinsey Global Institute analysis 4
BUT THE PRODUCTIVITY OF STATE-OWNED FIRMS IS HALF THAT OF PRIVATE COMPANIES Average Total Factor Productivity (TFP) of large industrial firms Direct state control led firms = 100 State controlled and collectives (48% of companies) Privately controlled (52% of companies) Direct state control Indirect state control, LP* >50% Indirect state control, other Collective >50% Private, LP* >50% Private, individual >50% Private, nonmainland >50% 100 x2 146 170 216 221 208 192 Private, other 200 * Legal person. Source: OECD; McKinsey Global Institute analysis 5
THE EFFICIENCY OF CHINA S INVESTMENT IS DECLINING Years Incremental capital-output ratio ** Investment ratio Percent of GDP Annual GDP growth Percent China India Japan 1991-1995 1996-2000 2001-2003 1995-2004 * 1961-1970 3.3 4.6 4.9 4.1 3.5 40.0 37.8 41.2 21.2 36.2 12.0 8.3 8.4 5.6 10.5 South Korea 1981-1990 3.7 32.0 8.7 * Fiscal years, finishing in March of the following year. ** Measures the investment required to produce $1 of additional GDP Source: World Bank 2004 World Development Indicators; PBOC, Reserve Bank of India, McKinsey Global Institute analysis 6
THE COST OF BANK DEBT IS VERY LOW FOR CHINESE SOE s China United States Average interest rate on debt for listed companies, 2004 Percent per year Average annual revenue $ Billions per year Utilities Consumer cyclical Diversified Communications Basic materials Energy Consumer noncyclical Industrial Technology 3.8 6.3 4.0 5.7 4.1 6.1 4.4 6.1 4.6 6.1 5.0 6.2 5.8 5.0 6.1 5.7 4.6 8.6 0.3 0.5 0.1 1.9 1.4 0.6 0.2 0.3 0.3 6.7 15.6 8.7 8.5 7.0 12.2 10.5 9.5 9.3 Despite smaller average size and riskier business environment, Chinese companies benefit from a lower interest rate than U.S. companies The interest rate paid by a large number of companies in China appears to be lower than the minimum level allowed by the central bank Minimum corporate interest rate allowed by China s central bank: 5.02% Note: Based on balance sheet analysis of the 10 largest listed companies in each sector; interest rate is obtained using the ratio of interest expense over bank debt Source: Bloomberg; McKinsey Global Institute analysis 7
60 PERCENT OF CHINA S NPL REDUCTION IS DUE TO THE TRANSFER OF BAD LOANS TO ASSET- MANAGEMENT COMPANIES Source of NPL reduction for large state-owned commercial banks, 2001 2005 Percent of loan balance 31.1 NPLs at the end of 2001 12.4 NPLs transferred to assetmanagement companies * 8.6 10.1 NPL resolution and dilution end of 2005** NPLs at the due to growth * A total of $150 million was transferred between 2001 and 2005, which represents 12.4 percent of the 2005 loan balance ** End of 3Q Source:CBRC; PBOC; McKinsey Global Institute analysis 8
CONSUMER WEALTH IS HIGHLY CONCENTRATED. Cumulative percent of liquid financial assets, 2003 100% = $1,937 billion 100 90 80 70 60 50 40 30 20 10 < 2% of total households account for more than 60% of total wealth 0 0.09 1.86 100 Cumulative percent of households 100% = $160 million Note: In the United States, top 12% of the households own 83% of total liquid financial assets; in Hong Kong, top 11% of the household own 78% of total liquid financial assets; in the United Kingdom, top 5% of the households own 71% of total liquid financial assets. Source: Datamonitor; BCG Global Wealth Report 2003; McKinsey Global Institute analysis 9
LEAVING BANKS DEPENDENT ON RELATIVELY FEW AFFLUENT CUSTOMERS Breakdown of clientele segments in a provincial branch Affluent Mass affluent Middle income Mass retail 2 Number of customers by segments 1 Percent 2 18 25 55 Proportion of total branch profitability Percent -11 8 48 55 Large banks profitability would be significantly affected if affluent and mass-affluent customers were to migrate to smaller local banks or to foreign banks following their entry into RMB-denominated products (end of 2006) 1 Segmented by customer deposits in 2003. 2 50% of all customers are loss making. Source: Disguised client data; McKinsey analysis 10
WEAK BANK PERFORMANCE IN CHINA CREATES VULNERABILITIES Causes of weak performance Key vulnerabilities Weak governance and lack of commercial mindset Operational weaknesses in lending and risk management Decentralized structure with local autonomy Corporate lending to hyper-competitive sectors with thin margins Renewed NPL build-up Sharp reductions in liquidity and profitability, due to concentration of profits, from: Foreign bank entry and loss of affluent, profitable customers Corporate bond market development Real estate exposure 11
REFORMING CHINA S FINANCIAL SYSTEM COULD BOOST GDP BY UP TO $321 BILLION ANNUALLY Potential benefits of financial reforms in China $ Billions Direct impact on costs 25 Increased bank efficiency 20 Migration of more payments to electronic platforms 14 Shift to more bond market funding 2 1 Replacing informal lending with formal banks Increased equity trading efficiency 62 Direct savings from financial system reform Indirect impact on GDP 259 Increased productivity due to better capital allocation Percent of GDP 1.3 1.0 0.7 0.1 0.1 3.2 13.4 Source: McKinsey Global Institute analysis 12
REFORMS COULD ALSO ENABLE HOUSEHOLDS TO EARN UP TO $25 BILLION MORE ANNUALLY ON THEIR FINANCIAL ASSETS Percent China South Korea U.S. Distribution Real return * Distribution Real return * Distribution Real return * Other Mutual funds Equity Fixed income Pensions and life insurance Bank deposits and cash 1 7 4 2 86 0 1.0 2.5 1.6 1.6 0.3 Other Mutual funds Equity Fixed income Pensions and life insurance Bank deposits and cash 6 10 5 2 18 59 n/a 1.7 3.4 2.9 3.1 1.2 Other Mutual funds Equity Fixed income Pensions and life insurance 9 12 18 7 35 n/a 1.9 3.4 4.9 4.5 Bank deposits and cash 19 0.3 Weighted average real return: 0.5% Weighted average real return: 1.8% Weighted average real return: 3.1% * 1995-2005; some numbers are estimates. Source: U.S. Federal Reserve; PBOC; RBI; Bank of Korea; McKinsey Global Institute analysis 13
FINANCIAL SYSTEM REFORM WILL SUPPORT THE EMERGENCE OF MIDDLE CLASS CONSUMERS URBAN CHINA Share of real urban disposable income by income class Billions RMB, 2000, Percent 100% = 523 0 1,687 4,819 11,559 1 1 0 0 2 4 5 3 5 11 10 7 97 91 44 51 22,605 16 11 61 Global (over 200k) Affluent (100k-200k) Upper aspirants (40k-100k) 36 21 10 8 4 Lower aspirants (25k-40k) Poor (under 25k) 1985 1995 2005E 2015F 2025F Source: MGI China Consumer Demand Model, v2.0 14
THIS IS AN IMPORTANT PRECURSOR TO RE-BALANCING THE CHINESE ECONOMY TOWARD CONSUMPTION Share of real GDP Billions RMB, 2000, Percent Contributions to growth of real GDP GDP growth, percent contribution 100% Government consumption Investment Private consumption 15,684.8 33,276.1 60,281.8 14 14 14 42 42 41 37 41 45 100% Government consumption Investment Private consumption 10.2 6.6 6.0 11 14 13 38 38 51 19 48 52 Net trade 7 2005 3 2015 1 2025 Net trade 19 2005 0 2015-2 2025 Source: Global Insight; National Bureau of Statistics of China; MGI China Consumer Demand Model, v2.0 15
URBAN MIDDLE CLASS WILL EMERGE AS THE MOST IMPORTANT DRIVER OF CONSUMER SPENDING URBAN CHINA Urban consumption expenditure by income class RMB Billions, 2000 13,474 1,388 1,036 2,371 2,079 9,318 12,235 573 790 6,011 8,229 296 370 4,877 3,704 1,709 370 148 143 1,672 2,548 2,100 1,897 1,678 1,371 1,087 979 924 838 2005E 2010F 2015F 2020F 19,201 2025F Global (>200K) Affluent (100K-200K) Upper aspirants (40K-100K) Lower aspirants (25K-40K) Poor (<25K) Source: MGI China Consumer Demand Model, v2.0 16
A COORDINATED APPROACH TO FINANCIAL SYSTEM REFORMS IS NEEDED Reforms to improve capital allocation Reforms to balance the financial system Reforms to improve system efficiency Increase competition in the banking sector and improve governance Change collateral requirements for small businesses to improve credit Improve the information and data available to make good lending decisions Deregulate the corporate bond market Deregulate bank interest rates ahead of current schedule Spur growth of domestic institutional investors through deregulation Change equity IPO process to allow private companies and SMEs to compete for funds Decide role of HKSE vs. mainland equity markets Accelerate improvements in the payments system Further liberalize the capital account Source: McKinsey Global Institute 17
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PUTTING CHINA S CAPITAL TO WORK THE VALUE OF FINANCIAL SYSTEM REFORM To get the full report, please see www.mckinsey.com/mgi/publications/china_capital/index.asp 19