Written Testimony of David Hale;
Zurich Financial Services

Before the U.S. China Economic and Security Review Commission
January 18, 2002 Public Hearings on

WTO Compliance and Sectoral Issues

Opportunities for Financial Service Companies in China

China’s membership of the WTO will set the stage for an international opening of China’s economy and financial service industry on a scale without precedent in the country’s long history as a nation state.

The opening of China’s economy will create tremendous opportunities for foreign companies in many sectors. But it is important to understand that China’s goal in pursuing trade liberalization is to transform its domestic economy. China’s leaders believe foreign competition is essential to encouraging economic rationalization and faster productivity growth. As a result, they will be very sensitive to the impact of foreign competition on China’s domestic firms, employment stability and social conditions in general. If it becomes apparent that the economic shocks resulting from trade liberalization are much greater than expected, China could attempt to impose either explicit or informal regulatory barriers on foreign competition.

The good news for foreign companies is that China has already experienced a massive foreign direct investment boom which has made the economy far more open today than were other Asian economies, such as Korea and Japan, as recently as five years ago. The cumulative level of FDI in China since the late 1980’s has been almost $400 billion. As a result, China has a stock of FDI surpassed only by the United States and the United Kingdom. In 1999, the stock of FDI in Britain was $394 billion compared to $225 billion in German, $164 billion in Brazil, $79 billion in Singapore, $65 billion in Indonesia and $48 billion in Malaysia. In Japan and Korea, by contrast, total FDI during 1999 was only $39 billion and $28 billion. Much of this FDI also resulted from the East Asian financial crisis. Before 1995, the stock of FDI in Korea was only $9 billion.

Most of the FDI in China has focused on the manufacturing and commercial sectors. Foreign financial services firms, by contrast, have faced significant barriers to penetrating the Chinese market. Only a few insurance companies have been licensed to sell products in China and they are primarily confined to the Shanghai area. Foreign banks have only a 1% market share in China and are constrained by geographic barriers to expansion. Securities companies and fund management companies are allowed to enter China only through joint ventures.

During the negotiation of the WTO treaty, China was very reluctant to permit easy access to its financial service market because of concern about how rapid liberalization might destabilize the macro-economy. Chinese officials pointed to the recent East Asian financial crisis as an example of how rapid financial liberalization could encourage excessive growth of leverage and speculative capital flows destructive of economic stability.

As a result of the East Asian financial crisis, China will be as sensitive to how the entry of foreign financial service firms might affect its macroeconomic situation as it will be to the increased competition from foreign manufacturing firms. As Mr. Stephen Harner explained in a recent monograph about the Chinese financial service industry, the Chinese view of financial service development will be driven by strategic considerations, not just adherence to liberal economic values. As he noted,

“When it comes to its financial sector and financial services, China explicitly rejects the concept of ‘international division of labor’ based on comparative advantage. It does not matter at all to China that other countries have more efficient and stronger financial institutions and companies which, if allowed to do so, could immediately raise the standards and lower the costs of financial services in the Chinese market. Viewing its financial system as the lynchpin of its economy, China’s priority is to develop a strong and stable financial system based on strong and stable indigenous financial institutions that are subject to the control of the Chinese government.”

“Given this situation, it is critical for foreign financial companies approaching China to form clear views on two questions: What will be the primary determinant of what type of and how much business my firm will be able to conduct in China? And: What is likely to be the most effective strategy for exploiting the available opportunities?”

“In our view, the key determinant of what will be possible for foreign firms will be the rate at which the domestic industry develops and becomes competitive. In other words, foreign companies will be allowed to participate and develop in the Chinese marketplace to the extent and and at the pace at which Chinese authorities determine that the operations will be beneficial – rather than detrimental – and will contribute to the development of China’s financial sector.”

Chinese policy makers are likely to be most concerned about the stability of their banking sector because it still plays a dominant role in providing financial intermediation services within the Chinese economy. As the tables below indicate, the banks still provide over 82% of corporate funding while four large state owned banks account for 66% of all lending. They are also massive organizations with 25,000 branches and 1.6 million employees.


Table 1: Capital Sources of China Enterprises

Table 2: Market Share of Financial Institutions in China

The existing banks enjoy several advantages over potential foreign competitors. They have vast retail networks which provide them with low cost liquidity. They know existing corporate customers in both the state owned and private sectors. They will be protected from competition in consumer lending for five more years at a time when mortgage lending is one of the most rapidly growing sectors. Housing loans, for example, are now nearly 400 billion RMB compared to only 19 billion at year-end 1997. But the big four state owned banks also have serious problems. They have a stock of non-performing loans equal to 30-40% of their total assets. They have limited experience in lending money to private companies. The government relies heavily on the banks to fund its capital spending and thus discourages them from playing as active a role in the private sector as might now be appropriate.

At the end of 1999, there were 155 foreign bank branches in China. Of these, 25 had obtained licenses to conduct business in the Chinese currency within severe limits. The banks were allowed to lend only to foreign invested enterprises and to keep RMB liabilities within 50% of the total. At the end of 1999, total foreign loan volume was only $18.3 billion compared to a peak of $27.5 billion in 1997.

As a result of the WTO agreement, there is likely to be a significant expansion of foreign banking activity in China during the next five years. Under the new rules, foreign banks can now make foreign currency loans to both Chinese companies and individuals. Within two years, they will be able to make local currency loans to Chinese companies. Within five years, they will be able to make local currency loans to Chinese individuals as well as expand anywhere in the nation. Enterprises now account for 35% of China’s bank deposits while households represent another 52%. Foreign banks will focus on enterprises during the next few years and then widen their focus to retail business after 2005.

The major new concern of foreign banks is the cost of foreign currency deposits raised within China. In December, the foreign banks were being forced to pay a premium of 1.5% over the cost of funding (2.57%) in the local foreign currency inter-bank lending market. This funding cost is of great concern to the foreign banks because they now control 20% of all foreign currency lending in China compared to a total market share of only 2%. It appears that the foreign banks have been funding themselves with money from overseas because of barriers to using the local market. If China imposes regulatory barriers to the foreign banks utilizing the domestic foreign currency inter-bank lending market, it could slow the expansion of foreign banks compared to their perceptions of the opportunities offered by the WTO Treaty.

China has also introduced policies to require foreign banks to add significantly to their capital as they expand in the country. Under the new rules, banks will have to provide capital of 200 million RMB per branch if it does foreign currency lending and 300 million RMB if it does both domestic and foreign currency lending. In five years the capital requirement will rise to 600 million RMB. These capital requirements will depress the profitability of Chinese branches during the early years and thus make foreign banks more cautious about the speed at which they will expand beyond the traditional financial centers. Hong Kong stock analysts, for example believe that the new capital rules will reduce the return on equity of existing China branches of Bank of East Asia from 30% to 15%.

The Insurance Sector

China is also opening up its insurance sector to widespread foreign participation for the first time since before the 1948 revolution.

There were many foreign insurance firms in China during the early decades of the 20th century. The big American firm, AIG, actually began in Shanghai about the time of the First World War.

The foreign firms were nationalized by the communist government after the revolution. The government then shut the whole industry down during the 1950’s and 1960’s except for cargo insurance. The government began recreating an insurance industry in 1985 by establishing the People’s Insurance Company of China.

During the past quarter century, the insurance industry has grown rapidly . Insurance premiums have mushroomed from 300 million RMB in the early 1980’s to 159.6 billion RMB in 2000. In 1991, 76.8% of insurance premiums were for non-life products and only 4 billion RMB (23.2%) went for life insurance. In 2000, the situation reversed. The life insurance share of premiums rose to 62.5% while the non-life share shrank to 37%. The change reflected the fact that life premiums grew twenty five fold after 1991 while non-life premiums grew 4.5 times.

In 1999, China’s insurance market was slightly larger than Sweden’s but still smaller than Taiwan, Switzerland and Canada. In 1999, China’s insurance premiums were $17 billion compared to $16 billion for Sweden, $20 billion for Taiwan, $11 billion for Brazil and $8 billion for Mexico. Industry observers expect that the Chinese market will expand to $34 billion by 2005 and $60 billion by 2010. Such growth would make the Chinese market nearly as large as Italy today ($67 billion) but still much smaller than France ($123 billion) or Germany ($139 billion).

Despite the long history of state domination, China’s insurance market has become more competitive during recent years. China Life, the traditional state owned company, still controls about 70% of the national market. But a highly aggressive new player, Ping An, has captured about 20.5% of the market while a third player, China Pacific, has about 7.5%. In the big urban markets, Ping An has actually displaced China Life from top place. In Shanghai, Ping An Life Insurance has a market share of 44% compared to 29% for China Life and 10% for China Pacific. In Beijing, Ping An has a market share of 40% compared to 21% for China Life and 18.4% for another new independent company, New China Life.

Foreign firms have so far been confined to the Shanghai market, except for AIG. In 2000, the foreign firms enjoyed a modest market share in Shanghai. AIG had premium income there of 315 million RMB compared to 884 million for Ping An and 296 million for China Life. Other foreign firms included Manulife (68 million RMB), Aetna (67 million RMB), AXA Minimetals (25 million) and Allianz Dazhong (23 million RMB). AIG has the largest market share because it enjoys a ten year head start over other foreign players.

Ping An is still a state owned company, but it plans to list on the stock exchange in the near future. Zurich Insurance has a large shareholding in New China Life and hopes to expand its stake in the future.

In former communist countries, insurance was often sold on the basis of group policies through employers. In China, group policies are important but individual policy sales are growing more rapidly. In Beijing, for example, individual sales are now equal to 65% of all sales compared to only 47% two years ago.

Until 1999, the primary life products offered by all companies were ordinary life, endowment life and pension insurance. Yields were fixed and linked to bank deposit rates. As interest rates fell to low levels during the late 1990’s, the low returns discouraged demand for traditional life products. But the government then relaxed the rules and permitted more experimentation with investment linked products. Ping An, for example, introduced a product linked to the securities market which received an enthusiastic consumer response. Since March, 2001, companies have been able to offer policies with three possible investment options; government bonds, commercial bank deposits, and securities investment funds. The equity option is one of the three dozen securities investment funds managed by China’s ten authorized investment management companies.

The WTO Treaty will open the dollar for further expansion of foreign firms in the Chinese insurance industry.

Under the rules, foreign firms will be allowed to establish branches to sell non-life products.

In the life insurance sector, foreign firms will have two options for development. They can establish a joint venture with a Chinese company and have a shareholding which does not exceed 50%. They can purchase a 25% market share in an authorized domestic Chinese life insurance company.

The exception to these rules is AIG. As a result of its early arrival and close relationship to the Chinese government, it has been allowed to establish a business without a JV partner and to operate in more areas than Shanghai. But as a result of the WTO agreement, it will now be allowed to expand in only four more cities and will have to pursue a JV agreement to operate elsewhere.

Most foreign firms have gone the joint venture route. New York Life recently formed a JV with the leading appliance company, Haier. In 1996, Manulife of Canada formed a JV with the conglomerate, Sinochem. AXA formed a joint venture in 1999 with the metals trader, Minimetal. Allianz has a joint venture with the Dahzong taxi company. The problem with the JV’s is that they are still subject to severe geographic limits (primarily Shanghai). They also require minimum capital of 100 million RMB. The geographic constraints will be phased out in 2003 and 2005.

Two foreign firms have decided to become minority shareholders in existing Chinese companies with national distribution. Zurich has a large shareholding in New China Life while Winterhur has purchased a large stake in Taiking Life. As these firms have diverse ownership, it is likely that Zurich and Winterhur will expand their shareholdings in the future.

In the decade ahead, the Chinese insurance market is likely to enjoy both rapid growth and an increasing level of competition. Many foreign firms are attracted to the potential scope for future market development in China. They are especially intrigued by the fact that China will be a potentially huge market for products focused on retirement savings. At present, China has a primitive pay as you go pension system in its state owned companies. There will have to be a further massive expansion of retirement savings as China’s population ages. On the basis of current population trends, China’s old age dependency ratio will rise from 11% in 1999 to 25% in 2030 and 36% in 2050. In 2030, China will have 300 million people over the age of 60 compared to fewer than 100 million today. Goldman Sachs has produced reports suggesting that China will need $3.2 trillion of pension assets in 2030 to provide retirement income for its people. If China introduces personalized retirement savings products rather than just employer plans (defined contribution rather than defined benefit) the assets could even grow to $6.4 trillion. Personal pension products could be attractive because China is estimated to already have 80 million retail shareholders compared to 55 million members of the Communist Party.

The growth of retirement savings will also have profound implications for the development of China’s capital markets. Pension funds need to invest in securities, so their growth will also fuel expansion of stock and bond markets. China re-opened its equity market after a forty year suspension in 1990. The number of listed companies has grown from 14 to nearly 1100. The market capitalization now exceeds $525 billion or a sum just over 50% of GDP compared to numbers in the 20-60% range for many developing countries. China also has developed markets for Treasury bonds and corporate bonds. In 1999, the T-bond market was worth 401 billion RM. The corporate bond market is much less developed. At the end of 1999, there were only 10 listed bonds with a market value of 50 billion RMB. But bond issuance during 1999 rose to 20 billion RMB, so there is potential for the market to expand more rapidly in response to both institutional and retail investor demand.

Foreign investment service groups are excited about the potential opportunities in China’s emerging capital markets. They hope to establish niches in both the stock broking and fund management sectors. At present, China has 101 licensed brokerage firms and ten fund management companies.

As a result of the recent boom in stock trading and company IPO’s, five of China’s brokerage firms had profits last year which exceeded $100 million. The ten fund management companies are very small. They control about $6.8 billion of assets spread over thirty three closed end funds. As a result, they represent a very small share of the market compared to mutual fund companies in North America or Western Europe. But in recent months they have begun to introduce open end funds and pursue joint ventures with foreign managers in order to improve their level of professional competence. In fact, six of China’s fund management companies now have joint ventures with foreign firms. Three British firms have formed joint ventures compared to one Canadian and two German firms. Two American banks have formed joint ventures to offer trustee services while it is likely that other American groups will pursue joint ventures in the fund management industry itself.

Under the WTO rules, foreign firms cannot enter the securities or fund management sectors on their own. They have to pursue joint venture agreements and accept a shareholding of less than 33% during their initial years. As Chinese firms have far less experience in both the securities and fund management sectors than foreign firms, it is clear that China wants to open these sectors very gradually in order to develop a higher standard of professional competence among its own people.

Conclusion

The development of the financial service industry in China will offer many exciting opportunities for banks, insurance companies, securities firms and other players in the industry. China has the potential to emerge during the next fifty years as one of the largest markets in the world for a wide range of products. But China will also want to regulate the speed of market liberalization in order to nurture its own companies and lessen the risk of macroeconomic instability resulting from speculative surges of bank lending or other capital inflows. The East Asia financial crisis of 1997-1998 was a stark reminder that global banking institutions often pursue reckless lending policies when they enter new markets for the first time.

The implementation of China’s WTO agreement should be more transparent in the financial service industry than in the manufacturing and commercial sectors. It is easier for countries to impose informal barriers to trade in goods than trade in financial services. As Japan has often demonstrated, it is possible to inhibit goods trade through health and safety regulations as well as restricted access to the distribution system. It is possible to block trade in financial services only through explicit regulatory actions which have to be publicly announced for all to see. The Chinese government could attempt to guide the business of state owned companies to state controlled financial institutions, but as the state owned companies represent a rapidly shrinking share of total economic output and suffer from significant credit quality problems it is doubtful that such policies will significantly impede foreign financial institutions. On the contrary, most foreign banks want to focus upon China’s new private sector, especially the entrepreneurs leading the way in wealth creation and promotion of economic growth.

As China becomes more comfortable with a significant foreign presence in its financial service industry, negotiators from the U.S. and Europe should attempt to remove the barriers to majority control of fund management and securities firms. Joint ventures are a useful way for foreign and Chinese companies to become familiar with each other during the first stages of China’s integration into the global financial system, but they are unlikely to be an optimal strategy for such highly competitive businesses indefinitely. It is also quite possible that the sheer size of China’s economy could set the stage for a major Chinese financial services group to emerge which might want to play a role elsewhere in Asia or in the world as a whole. Such a firm could then emerge as a lobbyist to remove China’s trade barriers in order to enhance its market access in North America or Europe. The Bank of China is already making plans to launch its Hong Kong subsidiary on the local stock market. In ten years, the Bank of China might want to play a role underwriting securities or offering other corporate finance services far from China. In such a scenario, it will not want to be constrained by the side effects of restrictive trade policies at home.

The financial service industry was one of the first to pursue global opportunities during the 19th century through the export of capital from London to developing countries elsewhere in the world. But despite the fact that capital is mobile, there has been little cross border integration of financial service firms. Most companies are still rooted in the regulatory and tax framework of a particular nation state even if they have offices in many countries. London continues to be the most global financial center because of its history as an intermediary for offshore money and the willingness of Britain to let foreign firms completely dominate many sectors of its financial service industry. But in the next generation, there are likely to be more cross border mergers of national firms because of the impact of technology on the cost of international activities and the pressure on institutions in the old industrial countries to diversify into new high growth regions. As this transition occurs, China will initially play host to many more foreign firms and then gradually nurture financial institutions which will themselves emerge as global players. When Shanghai becomes a regional and then international financial center, the trade agenda of China’s financial institutions will increasingly converge with the American, European and Japanese companies now seeking access to China’s market.