1. Restructuring China’s Rural Credit Cooperatives: Lessons Learned Wang Jun, Senior Financial Sector Specialist EAP Region, the World Bank December 5, 2005

2. 1 Main points of the presentation What led to the reform pilot in 2003 Main features of the reform pilot Lessons learned A brief history of the RCCs Recent attempts at restructuring the RCCs Objectives and options Objectives Financial restructuring Diversity in organization formats Incentives Financial restructuring should be accompanied with operations restructuring Role of government Role of foreign and private investors

3. 2 Main players in China’s rural financial market How the RCCs became a virtual monopoly in rural finance Agricultural Bank of China Agricultural Development Bank of China Postal Savings and Remittances The RCCs over time have become the only comprehensive FI in the rural financial market Established as a specialized agricultural bank, but a became commercialized state-owned bank and withdrew from the countryside after 1998 Established in 1994 with the objective to take over policy lending from the ABC, and became a funding vehicle for procurement of grain, cotton and edible oil. A deposit-only financial institution that has been regarded as a capital sucking machine on the rural financial market, with about 80% of its over one trillion deposits taken from the countryside.

4. 3 But the RCCs were subject to conflicting mandates Social objectivesCommercial objectives The conflicting mandates only aggravate moral hazard prevalent in the RCCs To become commercially sustainable over time To be transformed into commercial entities with all forms of corporate governance in modern financial institutions To introduce commercial managerial systems and controls by mimicking commercial banks Support agricultural production Poverty reduction Rural financial stability Support the rural economy Support various policy initiatives by the local government

5. 4 The RCCs were subject to stakeholders with conflicting objectives The government Central Local The owners/clients: Members customers RCCs The regulatory authorities CBRC PBC The market: ABC PSRB Money lenders And they were no different than state-owned banks in the rural financial market

6. 5 Main objectives of the RCC reform pilot A three-pronged approach to restructuring the RCCs Improve corporate governance No one-size- fits-all approach Align incentives of stakeholders To improve service functions of the RCCs in the rural financial market Ownership transformation Create all forms of corporate governance Consolidate ownership at the county level Rural commercial banks Rural cooperative banks RCC union at the provincial level Hand over managerial responsibilities to the provincial government Allow the CBRC to concentrate on regulation and supervision of RFIs Fund historical losses through monetization and fiscal support

7. 6 The RCCs were given two options to compensate historical losses A re-lending facilitySpecial CB notes Local governments borrow from the PBC to cover 50% of the historical losses with cut-off date of December 31, 2002 Maturity ranges from 3 to 5 to 8 years depending on circumstances of the RCCs Interest rates charged were half of the that for required reserve And insolvency data were calculated according to a formula set by the PBC, which specified loss ratios to each category of loan classification A special note with two-year maturity, issued by the PBC to reforming RCCs in exchange of NPLs The special notes were not tradable, endorsable and could not be used as collateral But could be redeemed ahead of maturity with conditions attached Redemption of the special notes were conditioned upon improvements in RCC reforms, and would be verified based on performances of individual RCCs Criteria for redemption include: ownership transformation; corporate governance; capital adequacy; NPL ratio, etc. In the end almost all provinces opted for the special notes

8. 7 Capital adequacy of the 8 provinces before and after financial restructuring, 2002-04, in percent

9. 8 Aggregate capital of RCCs in the 8 provinces participating in the pilot Capital Adequacy Ratio Unit: % Net Capital Unit: RMB100 Million The aggregate negative capital of all RCCs stood at 122.74 billion at end 2002.

10. 9 Portfolio quality of RCCs appeared to have improved in the 8 pilot provinces, but did they really? Non-performing loans Unit: RMB 100 million Non-performing loans In percent The aggregate NPLs stood at 505.9 billion yuan at end 2002 And the average NPL ratio of all RCCs combined ws 37% at end 2002

11. 10 Looks can be deceptive: are the RCCs really making money? Profitability of RCCs in the 8 provinces Unit: RMB100 Million

12. 11 Volume of loan growth maybe, but hard to tell if agricultural lending also grew Outstanding Loans Unit: RMB100 Million Outstanding Agricultural Loans Unit: RMB100 Million

13. 12 The RCC reform pilot was given little time for experimentation July 2003August 2004 8 provinces participated in the pilot Jilin Jiangsu Jiangxi Shandong Shanxi Guizhou Zhejiang Chongqing 21 other provinces were brought in, with the exception of: Hainan which opted not to participate in the pilot Tibet where there are no rural credit cooperatives The hastiness in pushing the pilot, slightly one year into it, to the rest of the country seriously damaged credibility of the pilot scheme.

14. 13 Examples of perverse incentives The option to set up provincial RCCUThe option for PBC special notes All provinces chose to set up a RCC union at the provincial level, and personnel appointment became an obsession All eligible RCCs “chose” to be converted to Rural Cooperative Banks All provinces chose the PBC special notes as the funding option, given the apparent financial advantages In order to meet the requirements for redemption, local government offered guaranteed dividends payment to new shareholders Some bank regulators ended up being owners of RCCs under their regulation and supervision, especially in localities where new equity was hard to mobilize

15. 14 The role of government remains dubious Under the central governmentThe option for PBC special notes First the PBC, later the CBRC, served as both owner and regulator RCC managers were appointed by the government agencies at various levels The CBRC is supposed to limit its role to regulation and supervision The government protected the RCCs from market competition The government officials driving the RCC reform pilot got promoted or reassigned elsewhere, casting uncertainty over the future of RCC reform The provincial government assumed managerial power and run the RCCs through the provincial RCC Union RCC managers now appointed by the RCC Union representing the provincial government The “fit and proper test” by the CBRC sometimes become overbearing The government continues to protect the RCCs from market competition through entry and exit policies The central bank is preparing another pilot to introduce credit-only commercial microfinance institutions in 5 provinces, with the objective to increase competition in the rural financial market while bringing in commercially sustainable microfinance to improve access to finance

16. 15 The role of foreign and private investors in RFIs Limited experiment in equity participation by foreign and private financial institutions in the emerging RFIs –IFC and Rabobank in Hangzhou RCCU –IFC and Rabobank in Tianjin Rural Cooperative Bank Equity participation in the PBC sanctioned credit-only MFIs in selected provinces, which could serve to break the monopoly of RCCs in those localities Other experiments