China’s Financial System and Currency

1. China’s Financial System and Currency Joe Horn September 9, 2006

2. Table of Contents China’s Financial System China’s Currency Regime Themes for the Future

3. China’s Financial System

4. Overview • China’s economy ranks 4th in the world in terms of total GDP. With an average growth of 10% for the past quarter century • Despite its overall economic strength, the financial system is less robust • However, the sector has seen promising progress on the institutional and regulatory fronts • The sector has attracted US$21 billion in foreign strategic investment and US$20 billion from IPOs of CCB and BOC in Hong Kong Securities Banks • Hurt by 5 years of stock market weakness • Weak credit systems and NPLs in hundreds of billions of dollars Insurers Trusts • Small, weak, scattered • Hurt by weak stock market and low bond yields

5. Current State of Banking Industry in China The Big Four • Approx 60% of the banking sector controlled by just 4 banks, the “Big Four” state-owned banks, namely ICBC, ABC, BOC, CCB • The Big Four are burdened by historical problems, and are immersed in new ones: • Legacy of policy lending, leading to higher than average NPL ratio • New lending is hampered by poor credit system • The Big Four operate in the most remote of locations • Frequent scandals • However the Big Four do benefit from their leading positions • Scale • Enjoy beneficial treatment by the Government • De facto Government guarantee on deposits • The relative stability of the Big Four has prevented a system failure

6. Structure of the Banking System in China Today Source: HSBC Securities, 2001.

7. Structure of the Banking System in China Today Source: Fitch 2006.

8. Development of China’s Banking System Time line and history of banking reforms: By 1984: ABC, CCB, BOC and ICBC were separated from the central bank. Each bank dominated one sector of the economy. 1984: As part of Monetary Reform, the four “specialized” banks became “for-profit” commercial banks. 1986: The Bank of Communications was reestablished. 1992: Separation of commercial banking and investment banking. 1994: Three new policy banks were to be established: China Development Bank, Import and Export Bank of China, and Agricultural Development Bank.

9. Development ofChina’s Banking System 1995: Release of Commercial Bank Law and Central Law Bank. The Big Four became responsible for their profits and losses. The People’s Bank of China status as a central bank was also legally confirmed. Post 1995: Development of share-ownership commercial banks, in which various levels of government, local institutions, and individuals, hold shares. 1998: Lending quotas abolished. 1999: State Council approved the establishment of the four bank Asset Management Companies which each acquired significant assets form one of the four state-owned commercial banks. 2003: Creation of Commercial Banking Regulatory Commission. Carved-out from the People’s Bank of China as separate entity with mandate to regulate banking sector. Banks given increasing discretion over lending rates.

10. State of China’s NPLs • China has possibly the most NPLs of any country in the world • In 1999, the government created four AMCs (Orient, Great Wall, Cinda, Huarong) to deal with the NPL problem. In 2005, a fifth was established called Huida • As of Dec 2005 US$330 billion had been transferred to the AMCs • AMCs have successfully sold NPLs to third parties, including foreign parties, disposing of close to US$10 billion in 2005 • US$200 billion still on AMC books • AMCs recovery rate improving. Cinda managed to recover 31% on face value in 2005

11. State of China’s NPLs • The problem is not the old NPLs but the new • Banks are generally getting better at lending, but China is suffering severe shortage of bankers with commercial lending experience • Important to look at NPLs and Special Mention • Securitization of NPLs will be new theme Problem Loans in China US$ bn Source: Fitch 2006, from PBoC, CBRC and banks. Excludes NPLs at Huida.

12. Securities and Trusts • Securities companies are mostly unprofitable, burdened by weak oversight, poor governance, and systemic burdens • Jilin efffect • Non-listed shares • However, sector looks better now that IPO moratorium lasting over a year recently lifted, and recent stock market rebound • 58 “ITICS”, many of which were weakened after Asian crisis • Often operate in areas restricted to banks Shanghai Composite Index

13. Insurance • China’s insurance sector is regulated by China Insurance Regulatory Commission • Historically propelled by premium growth of approx 25%, but hindered by weak stock market • This lead to nearly 45% of investments being placed in very low-yielding bonds • Now, growth is lower but bond yields should improve, and recently insurers allowed to expand their investment possibilities • Possibility to invest in banks • Possibility of investing up to 10% of their capital in offshore markets => nearly US$500 billion from just the top three insurers • Foreign participants have started to enter into the market with Allianz, Aegon, Carlyle, etc. Look forward to formation of financial holding companies

14. China’s New Currency Regime

15. Evolution of the RMB Regime During the planned economy(1949-1978) • Bank of China was the only specialized bank involved in FX business • All FX receipts/purchases were surrendered to the State • The nation never incurred foreign borrowing or allowed FDI • The State Administration of Foreign Exchange established to control FX matters • The RMB exchange rate regime was reformed and two currencies were established: FCY and RMB; only the former was convertible • Enterprises were permitted to retain a portion of their FX earnings • Dual exchangewas unified into a common RMB, de facto pegged to the US$ • Standard inter-bank FX marketwas established During the transition period (1979-1993) After 1994

16. Descriptionof Current Regime “July 21, 2005, China adopted a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies” PBOC China Monetary Policy Report RMB vs US$

17. Drivers of Currency Revaluation Shift in Economic Policy External Pressure Inflation Control Continued Liberalization

18. Drivers of Further Revaluation Economic Policy Shift • Government policy will gradually shift towards promoting consumer- driven rather than export-driven economy • Revaluation forces exporters to become more efficient • Revaluation increases buying power for corporates and consumers alike Continued Financial Liberalization • The medium term goal of Government is to continue liberalization of the capital account • Currency flexibility is an important pre-condition for a healthy liberalization

19. Comments • Initial 2%, followed by additional 2% is less than many expected • Never came close to 0.3% daily variation limit • Basket is unknown, but heavily US$ weighted • “Reference to a basket” not “linked to a basket” Euro, Yen, RMB vs US$ 100% = Jul 2005 • Transition has been considered smooth by most, so can expect more flexibility in 2006 • Government will not let RMB rise much further until tools are in place… • … AND until government confident in economy’s ability to absorb shock

20. Effects of China on the World Economy Inflation Interest Rates US CPI US Fed Funds Rate Yield Curve Profitability • Due to threat of relocation, wage increase in the developed world has been suppressed • US and European companies have benefited from unparalleled profitability in the past 75 and 30 years respectively US vs France Yield Curve The world will increasingly get used to dealing with the RMB as a major currency

21. Themes for the Future

22. Long Term Themes for the Financial Sector • Foreign participation to continue in local banks, CBRC highly supportive • Local incorporation of foreign banks to increase • Gradual reduction of savings could hurt some banks but benefit other financial institutions • End of “easy” NPLs, any future NPL problems will be harder to deal with • Financial holding companies to emerge

23. Long Term Themes for the Currency • Further development of hedging instruments and exchange • Interest rates likely to continue to rise • Despite recent tightening, RMB has in effect loosened substantially versus the US$ • More flexible capital account

24. Long Term Themes for the Economy • China remains growth story and should be able to maintain average growth above 7% over next 2 decades • Resource dependency • Ability to cope with global/US slowdown • Liberation of precautionary savings as safety net is enforced • China will have to address growing inequality } Key factors GINI Coefficient • China will have to increase “real” productivity • Otherwise terms of trade will deteriorate

25. Long Term Themes for China • Population expected to peak in 2030, but is ageing more rapidly than other countries did at this stage of development • Development of services sector • China is not crash-proof, but is resilient Source: UNDP, UBS estimates