Carl Walter, a seasoned China expert and co-author of two books on China—Red Capitalism and Privatizing China—shared a worrying picture of China’s financial reform and some major risks snowballing in the country’s banking system.

Walter, speaking to a packed audience at the Stanford Graduate School of Business, used the metaphor of the Forbidden City to explain the fragmented financial system in China. Although national banks are key to the entire operation of the country, they are not managed as such. These big banks, accounting for over 60% of China’s financial assets, do not have their own lending or capital pricing models because they make loans as instructed by the central government. “The banks themselves are obstacles to financial reform… To some extent, China banks are all policy banks,” Walter argued.

The talk on Financial Reform in China: Obstacles to Change is part of the China 2.0 seminar series presented by the Stanford Program on Regions of Innovation and Entrepreneurship (SPRIE) at the Stanford Graduate School of Business.

Walter, former COO of J.P. Morgan’s China businesses as well as CEO of its banking subsidiary in China, agreed that there was progress in China’s financial reform during the 1990s. The country witnessed the milestone of its first national capital market in early 1990s when the Shanghai Stock Exchange came into existence. He also expressed respect for former President Jiang Zemin and former Prime Minister Zhu Rongji, who were ardent supporters of reform. However, despite the progress that has been made, the whole system remains a “closed one.”

The financial crisis in 2008 made the continuation of reform more difficult by to a large extent discrediting the Western financial model. Moreover, the tremendous extension of credit over the past five years to create jobs and maintain a very high rate of economic growth has called into question the earlier efforts to transform China’s banks into commercial institutions. “From 2008 when the economic stimulus package was inacted, there was an explosion in credit. In the last four years credit has exceeded over 30% of the GDP in each year, yet growth is declining,” Walter noted. Over 50% of China’s GDP growth currently comes from investment, but with bank balance sheets increasingly illiquid with long-term loans that are unlikely to be repaid, this investment-driven model can no longer work.

The banks themselves are obstacles to financial reform… To some extent, China banks are all policy banks.
-- Carl Walter, co-author of Red Capitalism

“There is something wrong with the governance of the banks. They are run by the Party. The Party does not trust the market to channel capital to the best opportunities,” Walter pointed out sharply. In the last 30 years, Walter points out that banks have never been independent institutions operating on commercial principles. Although the party believes it can manage financial risk, it is the banks that must passively absorb all the credit, interest and market risk. China’s banks are all policy banks because the government does not have sufficient taxation capacity to support its ambitions for the state sector through the national budget. “This is most interesting aspect of China,” says Walter.

As China is playing an increasingly larger role in the world economy, Walter urges China’s financial sector to reform by implementing tax reform and “allowing private sector forces to take over.” Changes will be slow. One of the key questions is how to lower the existing walls in the financial “Forbidden City” such as the nonconvertible RMB currency and non-participation of foreign players in the domestic financial markets—foreigners have 1.7% of China’s financial assets. The government, however, is naturally reluctant to surrender the financial basis of its power, so Walter does not see this happening anytime soon. Yet without these reforms, he does not see a secure financial future for China.

The Stanford Program on Regions of Innovation and Entrepreneurship would like to thank the Greater China Business Club (GCBC) at the Stanford Graduate School of Business for their contribution to the article.