Author: Lynette Ong, University of Toronto
Credit has been the subject of much scrutiny in China, where there have been broad concerns about rising non-performing loans and wasteful lending to state-owned enterprises.
While major government-owned banks steal the most headlines, it’s also important to understand how credit operates at the grassroots levels. Unsurprisingly, that system has risks and inefficiencies of its own.
Rural Credit Cooperatives (RCCs) are China’s main official banking institutions servicing borrowers outside of cities. The lack of alternative savings institutions and investment channels has made RCCs very popular savings options in rural China, where often the only other option is to keep household savings under the mattress. The banks are then officially charged with lending those funds to support agricultural development among farm households.
Despite this official mandate, most of these funds do not find its way into enterprising farmers’ pockets. Throughout the 1980s and 1990s, about half of all RCC loans went to township and village enterprises (TVEs), which are small or medium-sized enterprises located in and managed by township and village governments. This bias toward government enterprises did not yield positive returns for the cooperatives. Indeed, before they were restructured in 2003, about half of China’s 40,000 RCCs were technically bankrupt or had negative net worth. On one estimate, the rate of bad loans to TVEs was as high as 80 per cent in the late 1990s.
In developing countries, it’s not uncommon for rural banking institutions to direct a disproportionate amount of their loans to large rather than small borrowers. But there are unique political and economic reasons for this phenomenon in China.
Although officially banking institutions, RCCs have been forced to walk a line between China’s fiscal and banking systems, which serve inherently different economic and social objectives. The fiscal system plays a redistributive role: it collects taxes from the ‘haves’ and redistributes the revenue in the form of social services to the ‘have-nots’, at least in theory. In contrast, the banking system has an intermediary purpose: banking institutions pool capital from savers and allocate it to borrowers, with the price of loans reflecting the risk profiles of the borrowers.
RCCs mingle two systems by using savings to serve a fiscal role. This can bring huge inefficiencies in capital allocations. Loans often end up in the hands of politically well-connected borrowers who have little incentive to repay them.
Local interference in credit allocations is an unintended consequence of the Communist Party cadre evaluation system and the fiscal system. Cadre evaluation prioritises local economic growth and improvement of fiscal revenue. This forms the basis of local officials’ promotion and career performance. Local governments are additionally responsible for financing around 70 per cent of government expenditures, significantly more than in most countries. These include the bulk of government social services. But local governments also face a systemic imbalance between the expenditures they are expected to make and the means they are given to generate revenues. To meet the central government’s demands, local officials siphon resources from formal credit institutions to finance local industrial development for the purpose of raising revenue.
Like all local bureaucratic agencies in China (RCCs aren’t government agencies, strictly speaking, but they have had a long history of being subject to local government control), the cooperatives are subject to a dual accountability system, one part of which is political. Under the system, managers in township cooperatives report to county cooperative unions, but they were also accountable to township party secretaries. Similarly, county cooperative unions were also answerable to county party bosses.
Until the late 1990s, local party secretaries had veto power over use of personnel and financial resources held by the cooperatives. RCC managers formerly were appointed, evaluated and promoted by local party secretaries. This system explains the bias in lending patterns toward local government-related firms and projects across all locales, even though the cooperatives’ mandate was to serve the agricultural and rural community.
As part of the 2003–05 reform package, the central bank provided RMB165.6 billion conditional debt-for-bills swaps and RMB830 million earmarked central bank loans to help RCCs clean up their debt burdens and toxic loans. Together, the bailout accounted for about 10 per cent of RCCs’ loan portfolio in 2003.
The bailout raises the ‘moral hazard’ that RCCs will expect to be bailed out again because they have managed to get away with bad financial decisions in the past. The central government’s financial rescue amounts to an indirect bailout of local authorities, and this has also allowed local governments to shirk their financial responsibility.
As local government debt mounts, the actions of RCCs and other rural financial institutions are a key part of this growing risk. If reforms are not enacted to promote lending for purely economic grounds, the inefficiency of lending for political reasons will eventually become unsustainable.
A version of this article was first published here in China Economic Review.
Lynette Ong is an associate professor of political science at the University of Toronto, where she is also a faculty member of the Asian Institute at the Munk School of Global Affairs. Her most recent book, Prosper or Perish: Credit and Fiscal Systems in Rural China (Cornell University Press, 2012), is available here.