China's banking blind spot

Tensions over the fate of blind Chinese activist Chen Guangcheng have cast a long shadow over the Washington's attempts to persuade China of the benefits of economic reforms at high-level talks now underway in Beijing.

Senior US officials, including Secretary of State Hillary Clinton and Treasury boss Timothy Geithner, wanted to use the talks to drive home the message that China needs to do more to rebalance its economy, by reducing its reliance on exports and boosting the spending power of Chinese consumers.

And early indications were encouraging. Senior Chinese leaders appeared more willing to discuss issues such as easing restrictions on the foreign ownership of Chinese banks, and forcing Chinese state-owned enterprises to pay higher dividends than they have been in the past.

After all, the US criticisms of the Beijing model – that huge state-owned enterprises are given large advantages to the detriment of smaller privately owned businesses and Chinese consumers – mirror many of the criticisms made by China's internal critics, who are pushing for far-reaching reforms to the Chinese economy.

Indeed, the reformist push seemed to get the upper hand last month after Chinese premier Wen Jiabao launched a stinging attack on China's massive state-controlled banks. "Let me be frank. Our banks earn profit too easily. Why? Because a small number of large banks have a monopoly," he said in an interview on Chinese radio. To break their monopoly, he said, "we must allow private capital to flow into the finance sector."

The attack came in the wake of a move by the Chinese authorities to give the green light to a trial program in the bustling commercial city of Wenzhou. The trial allows private lenders – whose legal status has always been uncertain – to set up investment companies lending to small and medium sized businesses. Smaller companies have long complained that they are starved for credit because China's huge banks prefer to lend to state-owned enterprises, which enjoy an implicit government guarantee.

Wenzhou shot to national prominence late last year after its underground banking system suffered a major crisis. Several dozen borrowers, who had taken out loans from private money-lenders at astronomical interest rates, found that they were unable to pay their loans and either fled overseas or to different parts of the country, leaving their creditors behind.

Reformers have also been heartened by recent comments made by China's central bank boss, Zhou Xiaochuan, who argued that conditions were "basically ripe” for allowing markets to set interest rates. The Chinese government has long been reluctant to allow the market to set interest rates because of concerns that it would dent the profitability of the big Chinese banks by forcing them to compete for deposits.

At present, Chinese banks offer an interest rate of 3.5 per cent for one-year deposits, even though China's inflation rate is expected to hit 4 per cent this year. As a result, Chinese savers face a negative real interest rate.

But many are sceptical of these reform initiatives. They argue that entrenched power of the large state-owned banks makes it unlikely the Wenzhou trial will be expanded throughout China.

Similarly, massive state-owned enterprises can be expected to resist other major reforms that threaten to disrupt their current privileged position, under which they enjoy dominant market positions but pay pitiful dividends – usually 10 per cent or less of their profits – to their major shareholder, the Chinese government.

Last month, Lin Zuoming, president of the state-owned commercial and military aviation company AVIC, gave an indication of the strength of the opposition to economic reforms. The idea of privatising state-owned enterprises, he said, was a "conspiracy” being pushed by China's foreign enemies.

At the same time, many Chinese conservatives are wary of dismantling the privileges of the state-owned enterprises because they fear that the Communist Party will see its power evaporate if it relaxes its grip on the country's economy.

Even without the heightened tensions stirred by Chen Guangcheng, it is far from certain that Washington's message on the benefits of reforms would have had the desired effect.