Business Asia via NewsEdge :

Foreign banks are entering China’s financial-services market, targeting rural households. But can they succeed where domestic banks have already failed?

More than two years after Chinese authorities relaxed controls in December 2006, foreign banks are gingerly stepping into China’s rural financial-services market. Previously, they had concentrated on providing international-banking and wealth-management services to China’s affluent urban population, as well as to small and medium-sized enterprises (SMEs). So reaching out to the “little guys”, as a Standard Chartered spokesperson put it, is a paradigm shift of sorts for these banks. It is also uncharted territory considering China’s sickly but still-overbanked economy.

Indeed, this is a challenge that China’s own lenders have already tried and failed to surmount. Between 1995 and 2005 the “Big Four” state banks—Industrial and Commercial Bank of China, China Construction Bank, Bank of China and Agricultural Bank of China (ABC)—downsized their branch networks by almost 50%, with the majority of closures occurring in rural areas. The banks had failed to hold down their non-performing loan (NPL) ratios. For example, ABC, the leading provider of rural credit, slashed the number of its branches to 28,234 outlets from 67,092. At the end of 2007, despite its withdrawal, ABC still had Rmb818m (US$120m) of NPLs on its books, largely as a result of bad debts accrued at its rural branches.

Yet studies conducted between the late 1990s and 2005 by China Agricultural University and the agriculture ministry have demonstrated time and again that there is strong demand for credit from rural households and SMEs. But in the absence of loans from commercial banks, this demand is being serviced primarily by informal lending channels. For instance, a 2003 study conducted in Anhui province and cited in a February 2008 paper by He Guangwen of China Agricultural University noted that out of a total of 524 loans made to rural households and SMEs, not one was issued by a commercial bank.

Stepping into the void

Now, though, on the back of the Chinese government’s push to raise rural incomes and boost domestic demand, foreign banks are stepping into the void. HSBC of the UK, which took an early lead in December 2007 by establishing a rural branch in Zengdu, Hubei province, followed a year later by opening two more branches in Dazu county near Chongqing and Yong’an in Fujian province. Then earlier this year HSBC opened its fourth branch in Beijing’s Miyun county. Joining the wave was Standard Chartered, another UK bank, cutting the ribbon on its first village bank on the outskirts of Inner Mongolia’s capital, Hohhot. Citibank of the US is launching its first lending company in Hubei’s Gong’an county.

Each bank is taking a markedly different approach. HSBC cited Zengdu’s vibrant agriculture-based export sector as the reason for opening its first branch there. Half the mushrooms imported by Hong Kong are sourced from the area, and there is also strong potential to increase exports of fungus, orchids and agricultural by-products. HSBC’s Yong’an venture will look to exploit recent demand for financial services from forestry-related enterprises, which have emerged following China’s first trial of a collective forestry-ownership scheme in the county. HSBC’s focus is not on issuing microcredit to individuals looking to expand small operations but on attracting deposits from wealthy entrepreneurs with existing business, and offering agribusiness loans to SMEs and facilitating transactional banking services for export-based enterprises.

For its part, Citibank is entirely focused on offering credit, especially to self-employed people and micro-enterprises. Gong’an is a good place to start, as it already has a significant number of cotton, rice and vegetable-oil producing enterprises, as well as rapidly developing auto-parts, plastic and chemical industries. County officials say Chinese banks in the area are profitable, unlike their branches in other underdeveloped areas. Citibank has cited its first customer, a businessman with a coal-and-sand-shipping operation on the Yangtze River, as a typical target client. After the man was turned away by several domestic institutions, Citibank offered him a Rmb130,000 loan to purchase a truck to transport raw materials. The US bank also expects demand from individuals who require loans for home renovation, car purchases and medical emergencies.

Meanwhile, Standard Chartered’s move to offer direct financing in Inner Mongolia’s Helingeer county was based on the region’s consistent double-digit growth, and is part of a wider rural financial-services strategy that includes consultation with agribusiness and work with intermediaries like the China Foundation for Poverty Alleviation. Currently, only deposit and remittance services are offered at the Helingeer branch, but there are plans to introduce lending services in the near future.

Standard Chartered is confident it can operate its village bank as a sustainable business. Though it has been cagey about releasing any hard facts or targets, its risk-management model is based on a prior microfinance programme offering loans to cotton farmers in Xinjiang. In contrast, Citibank is starting from scratch and has said it needs to build experience before rolling out more operations.

A number of obstacles

Even though these initial ventures are part of a long-term strategic push, all the foreign players hope to make money right away. But they face a number of obstacles. Andrew Cainey, a Shanghai-based consultant at Booz & Company, notes the difficulty of finding and retaining high-quality staff in rural areas, and the dangers of assessing risk and offering unsecured credit to a diverse and disparate community. Mindful of this, Citibank’s Gong’an business is conducted entirely in Chinese, eliminating the need for expensive bilingual staff. All lending is also conducted on a face-to-face basis, and there are plans to conduct onsite visits to potential borrowers. Standard Chartered’s village bank has adopted a similar approach.

Above all, however, China’s uncharacteristically deep economic slump makes this a testing period for the banks to be rolling out rural operations. The families in the countryside of an estimated 20m unemployed migrant workers are struggling, with remittances which had accounted for some 40% of their incomes drying up. Many rural farms and households do not have spare cash to make deposits. So while they may look for loans to expand their businesses, the banks may find creditworthy borrowers hard to come by.

The banks must also contend with mixed signals from the China Banking Regulatory Commission (CBRC). The government is pressuring all the banks to lend to jolt the economy, and there are fears that this may result in a return to the bad old days of sky-high NPLs. Yet the regulatory body has said it will not tolerate an increase in bad loans.

Bureaucratic costs

One feature of all of the foreign banks’ rural operations is that they are distinct from the locally incorporated entities through which they do their mainstream China business. That means, in addition to having to liaise with the CBRC and their China headquarters, they will be under direct supervision from their home institutions. Offering unsecured credit will not go down well in financial-crisis-struck New York or London. As a result, bureaucratic costs are sure to be high. What is more, with their internally required loan-deposit ratio in China set at 75%, HSBC and Standard Chartered may struggle to attract enough deposits to meet the demand for credit.

The biggest challenge, of course, is that all the banks will try to succeed where the Chinese banks have failed, and keep NPL ratios below the required 10%. But it is far too early to gauge the viability of the foreign banks’ forays into rural China. Regardless, Citibank intends to open another branch in Hubei soon, and has approval for an operation in Dalian. One hint of the foreign banks’ prospects in the near term will be whether these and further openings proceed as planned.

<<Business Asia -- 03/20/09>>