farrell presentation

The Value of Financial System Reform in China and India: 

The Value of Financial System Reform in China and India Diana Farrell, Director McKinsey Global Institute January, 2007

AGENDA: 

AGENDA China’s Financial System India’s Financial System

CHINA FINDINGS: 

CHINA FINDINGS China has made steady advances in modernizing its financial system and in mobilizing savings, reflected in the doubling of China’s stock of financial assets relative to GDP over the past ten years. China’s banking sector plays an unusually large role in its financial system. Capital allocation in the system is poor: wholly and partially state-owned companies continue to absorb most of the funding from the financial system, while private enterprise, the engine of China’s growth, receives a disproportionately small share. As a result, China’s investment efficiency is declining. The dominant bank sector, though improving, remains highly inefficient and potentially vulnerable. Reforms that enable a larger share of funding to go to the most productive companies and improved the operating efficiency of financial system components would raise GDP by $321 billion annually, or 17 percent. China’s financial system’s remaining problems are intricately linked across its component markets, and will therefore require an integrated approach to reform.

CHINA’S FINANCIAL SYSTEM DEPTH IS HIGH GIVEN ITS GDP PER CAPITA : 

Note: China’s depth would be at 220% of GDP in 2004 according to recent GDP restatement. It is unclear how new GDP calculation methodology would affect China’s 1994 GDP. Source: WEFA; BIS; FIBV; WDI; IMF; GFS; McKinsey Global Institute analysis. Stock of bank deposits, bonds and equity, 2004 Percent of GDP GDP per capita (at purchasing power parity), 2004 US $, logarithmic scale CHINA’S FINANCIAL SYSTEM DEPTH IS HIGH GIVEN ITS GDP PER CAPITA 1994-2004 evolution for select countries Position in 2004 Malaysia Singapore South Korea India Brazil Mexico Japan United States United Kingdom China South Africa Chile Thailand Norway New Zealand Egypt Philippines Hungary Turkey Indonesia Russian Federation Tunisia United Arab Emirates Ukraine Vietnam Australia Sweden Canada Taiwan Finland Czech Republic Saudi Arabia Nascent Emerging Mature

CHINA’S FINANCIAL SYSTEM IS DOMINATED BY THE BANKING SECTOR: 

CHINA’S FINANCIAL SYSTEM IS DOMINATED BY THE BANKING SECTOR 2004 financial stock components Percent, US $ billion 100% = CAGR2 1994–2004 Percent Note: Numbers may not add to 100 percent due to rounding. 1 Reflects China’s recently restated GDP. 2 CAGR = compound annual growth rate. Source: McKinsey Global Institute Global Financial Stock Database 1,428 19,627 47,729 396 4,291 1,602 214 350 1,105 130 675 247 471 Depth GDP multiple China Indonesia 10.5 3.5 9.4 3.4 6.0 20.5 11.0 6.4 2.8 12.3 1.0 8.8 6.5 Hong Kong Japan United States Malaysia Singapore South Korea Chile Thailand India Philippines Mexico

PRIVATE COMPANIES GET A DISPROPORTIONATELY SMALL SHARE OF LOANS: 

1 SOEs are defined as wholly state owned. 2 Most of the shareholding enterprises are partly state owned. Some are state controlled, some are not. 3 Collective enterprises are owned by the population. Many are run like private enterprises, but some are effectively controlled by local political interests. 4 Fully private enterprises include local privately owned enterprises, foreign joint ventures, and wholly owned foreign enterprises. 5 Breakdown of industrial value added by ownership type, 2003, as determined by the Organisation for Economic Co-operation and Development. 6 Total corporate and government bank lending, based on a survey on commercial bank new loans conducted in 2002 by the People’s Bank of China. This is the most recent publicly available data on lending by company type. In the absence of more recent data, we are making the assumption that new lending in 2002 reflects the stock of outstanding credit in 2004. A higher portion of new lending today may go to private companies, but we have no evidence of this. Source: OECD; PBOC; McKinsey Global Institute analysis 23 19 6 52 GDP5 35 27 11 27 Corporate loans outstanding6 State-owned enterprises1 Shareholding enterprises2 Collective enterprises3 Private and foreign enterprises4 PRIVATE COMPANIES GET A DISPROPORTIONATELY SMALL SHARE OF LOANS Comparison of GDP and corporate bank loans outstanding, 2003 Percent State-owned enterprises Shareholding and collective enterprises Private and foreign enterprises 11

THE PRODUCTIVITY OF STATE-OWNED FIRMS IS HALF THAT OF PRIVATE COMPANIES: 

100 Direct state control 146 Indirect state control, LP1 >50% Indirect state control, other 216 Collective >50% 221 Private, LP1 >50% 208 Private, individual >50% 192 Private, non- mainland >50% 200 Private, other x2 170 THE PRODUCTIVITY OF STATE-OWNED FIRMS IS HALF THAT OF PRIVATE COMPANIES Average Total Factor Productivity (TFP) of large industrial firms Direct state control led firms = 100 1 Legal person. Source: OECD (Dougherty and Herd, 2005); McKinsey Global Institute analysis State controlled and collectives (48% of companies) Privately controlled (52% of companies) 170

THE EFFICIENCY OF CHINA’S INVESTMENT IS DECLINING: 

THE EFFICIENCY OF CHINA’S INVESTMENT IS DECLINING Years Investment required to produce $1 additional GDP ** China * Fiscal years, finishing in March of the following year ** This metric is known as the “incremental capital-output ratio” Source: World Bank 2004 World Development Indicators; PBOC, Reserve Bank of India, McKinsey Global Institute analysis India Japan South Korea 3.3 4.6 4.9 4.1 3.5 3.7 3.7

60 PERCENT OF NPL REDUCTION IS DUE TO TRANSFER OF BAD LOANS TO ASSET- MANAGEMENT COMPANIES: 

60 PERCENT OF NPL REDUCTION IS DUE TO TRANSFER OF BAD LOANS TO ASSET- MANAGEMENT COMPANIES 1 A total of $150 M was transferred between 2001 and 2005, which represents 12.4 percent of the 2005 loan balance. 2 End of Q3. Source: CBRC; PBOC; McKinsey Global Institute analysis Source of NPL reduction for large state-owned commercial banks, 2001–2005 Percent of loan balance 31.1 NPLs at the end of 2001 12.4 NPLs transferred to asset- management companies1 8.6 NPL resolution and dilution due to growth 10.1 NPLs at the end of 20052 8.6

WEAK BANK PERFORMANCE IN CHINA CREATES VULNERABILITIES: 

WEAK BANK PERFORMANCE IN CHINA CREATES VULNERABILITIES Weak governance and lack of commercial mindset Operational weaknesses in lending and risk management Decentralized structure with local autonomy Root causes of weak performance Renewed NPL build-up Sharp reductions in liquidity and profitability, due to concentration of profits, from: Foreign bank entry Corporate bond market development Real estate exposure Key vulnerabilities

REFORMING CHINA’S FINANCIAL SYSTEM COULD BOOST GDP BY UP TO $321 BILLION ANNUALLY: 

REFORMING CHINA’S FINANCIAL SYSTEM COULD BOOST GDP BY UP TO $321 BILLION ANNUALLY Potential benefits of financial reforms in China US $ billion Source: McKinsey Global Institute analysis 25 2 1 62 Direct impact on efficiency Indirect impact on growth Percent of GDP 259 Increased equity trading efficiency Elimination of informal lending Direct impacts of financial system reforms Migration of more payments to electronic platforms Increased bank efficiency Increased market debt intermediation Increased productivity due to better capital allocation

CHINA: AN INTEGRATED PROGRAM OF FINANCIAL REFORMS IS NEEDED: 

Source: McKinsey Global Institute analysis Reforms to improve allocation of capital Improve governance and increase competition in the banking sector Change collateral requirements for small businesses to improve access to credit Support development of an independent consumer credit bureau and a corporate rating agency Deregulate the corporate bond market 1 2 3 4 Reforms to balance the financial system Deregulate bank interest rates ahead of current schedule Spur growth of domestic institutional investors through deregulation Create a more strategic relationship between HKSE and mainland equity markets Change equity IPO process to allow private companies and SMEs to compete for funds 5 6 7 8 Reforms to improve overall system efficiency Accelerate improvements in the payments system Further liberalize the capital account 9 10 CHINA: AN INTEGRATED PROGRAM OF FINANCIAL REFORMS IS NEEDED

AGENDA: 

AGENDA China’s Financial System India’s Financial System

INDIA FINDINGS: 

INDIA FINDINGS India’s financial system has lower depth than other fast-growing Asian economies, indicating a low level of financial intermediation in the economy. Although the lauded equity market is sizable and growing, the banking sector dominates but does not lend broadly and the corporate bond market is small. An array of financial system policies direct capital allocation in India. As a result, the fast growing private sector gets little credit while the government in various forms absorbs the vast majority of the intermediated capital. Moreover, the state-dominated banking sector features low competitive intensity and significant inefficiencies. Reforms that enable a larger share of funding to go to the most productive companies and improve the operating efficiency of financial system components would raise GDP by up to $48 billion annually. Further reforms (financial and economic) could raise India’s real GDP growth rate to 9.4% annually, on par with China.

INDIA’S FINANCIAL DEPTH IS LOW COMPARED TO OTHER ASIAN NATIONS: 

INDIA’S FINANCIAL DEPTH IS LOW COMPARED TO OTHER ASIAN NATIONS Source: McKinsey Global Institute Global Financial Stock Database 51 11 151 3 20 44 96 Indonesia 24 97 214 Thailand 235 78 26 Korea 120 400 Malaysia 55 145 420 Japan 13 20 187 259 China 42 119 371 Singapore 44 2 160 India 34 68 Philippines 146 Financial depth, 2004 Financial assets as a percent of GDP 56

LESS THAN HALF OF COMMERCIAL CREDIT GOES TO INDIA’S PRIVATE SECTOR: 

Distribution of commercial credit* $ Billion, percent LESS THAN HALF OF COMMERCIAL CREDIT GOES TO INDIA’S PRIVATE SECTOR 35 5 122 1999 30 13 211 2004 100% = Private corporate discretionary Private corporate Priority lending** Agriculture Household enterprises & proprietorships Public sector enterprises * Gross bank credit excluding financial companies; Includes corporate bonds and private placements, loans and investments from the government to public sector enterprises. ** Estimate of lending to small corporations equals “other” priority sector lending outside of agriculture and SSI Source: CSO; RBI; MGI; Public Enterprise Survey 39

INDIAN FIRMS RELY HEAVILY ON RETAINED EARNINGS: 

India 2 72 1916 Japan 3 63 40 Indonesia 3 59 562 South Korea 55 2 Singapore 4 55 91 Malaysia 47 100 US 42 393 Hong Kong 100% = Equity Debt Internal funds 78 204 89 * Based on sample of 160 companies per country outside of US. Companies were ranked by gross sales, and 40 companies from each quartile were taken as the sample. US sample… Source: Bloomberg, MGI INDIAN FIRMS RELY HEAVILY ON RETAINED EARNINGS Sources of funds raised $ Billion; percent, 2000-05* 52

INDIAN BANKS LEND A SMALL PORTION OF DEPOSITS: 

G7 average: 118** INDIAN BANKS LEND A SMALL PORTION OF DEPOSITS Commercial bank loans outstanding Percent of deposits, 2004* * United states is 2003 data (2004 unavailable) ** Straight average; excludes Luxembourg and Iceland for which data is unavailable Source: RBI; EIU; McKinsey analysis

INDIA’S GOVERNMENT AND STATE-OWNED COMPANIES CONSUME 70% OF SURPLUS SAVINGS : 

INDIA’S GOVERNMENT AND STATE-OWNED COMPANIES CONSUME 70% OF SURPLUS SAVINGS Source: CSO; McKinsey Global Institute Household net savings to the financial system Net foreign capital inflows 3.2 Public sector borrowing 1.2 Private corporate borrowing 7.0 Sources and uses of net savings Percent of GDP, average 1994-2004

FINANCIAL REFORM IMPACT:$22 BILLION DIRECT, $26 BILLION INDIRECT: 

FINANCIAL REFORM IMPACT: $22 BILLION DIRECT, $26 BILLION INDIRECT Source: RBI; CSO; McKinsey Global Institute Analysis Direct impact of financial system reform $ Billion, 2004 7.8 Improved banking efficiency to best practice 6.3 Fully implement electronic payment system 5.1 Migrate informal lending to formal banks 0.3 Reduce corporate bond default rates to benchmark 2.3 Shift in financing mix from bank loans to bonds 21.8 Direct impact of financial system reform 0.9 1.1 Percent of GDP 0.7 0.1 3.2 0.3 Increasing efficiency Shift financing mix Total impact Indirect impact Capturing more savings Improved allocation of capital 25.5 6.6 18.9 22 3.5

FINANCIAL SYSTEM REFORM COULD BOOST GROWTH TO CHINESE LEVELS: 

FINANCIAL SYSTEM REFORM COULD BOOST GROWTH TO CHINESE LEVELS Real GDP $ Billion 2000 * Forecasts of investment rates from Oxford Economic Forecasting ** Efficient investment ICOR is the average rate implied if the public sector and households are as efficient as the private corporate sector between 1999-2004. See exhibit x.x and the technical appendix Source: CSO, RBI, OEF, MGI CAGR 2004-2014 9.4% 6.5% CAGR 1999-2004 5.9% Baseline Efficient investment and financial market reform

INDIA’S REFORM AGENDA MUST ADDRESS ALL PROBLEMS TOGETHER : 

Source: McKinsey Global Institute analysis Lift most priority lending requirements, asset allocation restrictions, and guaranteed deposit schemes Reduce state ownership in the banking sector Strengthen corporate governance in public sector banks Lift restrictions on foreign ownership in banks 1 2 3 4 Spur development of the corporate bond market Deregulate the insurance industry Ensure pension reforms are enacted without limitations Continue reforms of mutual fund industry 5 6 7 8 Introduce gold deposit scheme to capture value of gold expenditures Faster development of electronic payment system 9 10 INDIA’S REFORM AGENDA MUST ADDRESS ALL PROBLEMS TOGETHER 11 Reforms to improve capital allocation Reforms to hasten development of financial intermediaries Reforms to capture more household savings Reforms to improve overall system efficiency 12 Separate the regulatory and central bank functions of RBI Lift remaining capital account controls

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