Rumors had been swirling since the beginning of 2007 that China Development Bank (CDB) would set off on the path to become a commercial lender. After a lengthy wait, confirmation finally came from the People's Bank of China, the central bank, on the last day of 2007. With the approval of the State Council, the Central Huijin Investment Co. Ltd. (Central Huijin), a subsidiary of China Investment Corp. (CIC), sealed an agreement with CDB in Beijing. Accordingly, Central Huijin immediately injected $20 billion into CDB, creating high hopes for the implementation of its reform plan in 2008.

Born at the right time

CDB came into being in 1994 together with another two policy banks, namely the Export-Import Bank of China and the Agricultural Development Bank of China. The move was intended to separate policy-related business from commercial business and relieve state-owned commercial banks burdened with dual tasks. As outlined by the State Council, CDB, with a start-up fund of 50 billion yuan ($6.8 billion) appropriated by the Ministry of Finance, would mainly serve as a vehicle of long-term financing for the development of national infrastructure and key projects of pillar industries.

According to public financial data, CDB has boasted sound asset quality and a low ratio of non-performing loans for a long time, overshadowing many commercial banks. By the end of 2006, the outstanding balance of its assets topped 2.27 trillion yuan ($311 billion), with its non-performing asset ratio and non-performing loan ratio standing at 0.73 percent and 0.72 percent, respectively. In 2006, the bank raked in total profits of 29.1 billion yuan ($3.9 billion), turned over 18.5 billion yuan ($2.5 billion) of tax and generated a net profit of 16.5 billion yuan ($2.3 billion). All these statistics indicate that CDB is capable of functioning healthily without government subsidies. Endowed with a solid financial foundation, the commercialized reform will empower the bank to become one of the best financial institutions of China in terms of asset quality.

Central Huijin is a wholly state-owned investment corporation, approved by the State Council on December 16, 2003. With registered capital of 372.47 billion yuan ($50 billion), it exercises the right and performs its obligation as an investor in many key financial institutions, such as Bank of China (BOC) and China Construction Bank (CCB). Its helping hand has already been extended to the Industrial and Commercial Bank of China, CCB, BOC and China Everbright Bank, smoothing their paths in going public.

As disclosed earlier by Vice Minister of Finance Li Yong, Central Huijin will commit nearly $67 billion, one third of the capital fund of CIC, to help financial institutions such as CDB and the Agricultural Bank of China. This will greatly assist CDB in lifting its capital adequacy ratio and strengthening its risk-resistant ability, laying a solid cornerstone for its planned reform.

The reform of CDB had been put on agenda at the National Financial Work Conference held in January 2007, but stalled due to a capital blank to fill. Annual reports of recent years indicated that the capital adequacy ratio of CDB had been taking a hit. The ratio dipped from 11.58 percent at the end of 2002 to 8.05 percent at the end of 2006, barely crossing the threshold of 8 percent required by the China Banking Regulatory Commission.

In its annual report 2006, CDB attributed the drop in its capital adequacy ratio to a surging balance of loans. However, financial institutions engaged in long-term financing are more vulnerable to deficit and even bankruptcy, as the mid- and long-term credit risks and market risks are harder to control. As a result, the pressure is on them to maintain a much higher capital adequacy ratio than other commercial banks.

Bai Qinxian, Director of the Research Institute of International Finance at Liaoning University, said, "After reorientation, China's policy banks should report a capital adequacy ratio comparable with that of comprehensive development banks of developing countries, such as the 16.2 percent of Korea Development Bank and the 14.3 percent of the Brazilian Development Bank. Generally, 15 percent-20 percent is an ideal range."

It's estimated that the $20-billion capital injection will push CDB's capital adequacy ratio up to or even slightly above 15 percent, a landmark step toward the reform target.

Reform prospects

The Ministry of Finance and Central Huijin will each hold a 50-percent stake in CDB, in the aftermath of the agreement. But its strategic planning is still far from the destination. Other strategic investors will also be introduced in the future.

CDB's reform plan is scheduled for implementation in 2008, but its tone was already set at the 2007 National Financial Work Conference. Its dedication to mid- and long-term credit business remains unchanged, and issuing financial bonds is still its major financing source. It will moderately add an investment banking business, absorb enterprise deposits, and be involved in businesses like securities, trusts and funds, but will be barred from retail business.

In initial years after its inception, CDB was subjected to the principle of no branches and entrusting CCB with credit business. In recent years, it has been allowed to open 33 branches and four offices in key areas to meet demand.

No retail business means CDB will still rely on issuing bonds and securities products in the future to raise money, instead of widely pooling the deposits of individuals. It will further function as a wholesale bank granting mid- and long-term loans to enterprises and institutions.

After the reform, CDB will install a parent-subsidiary corporate system with independent legal entities. The parent company expresses the national strategic intentions with the state as its absolute controlling shareholder. Two subsidiaries will be developed. One is an investment corporation and the other a commercial bank specializing in mid- and long-term credit business. Thus CDB will erect a governance structure like other modern commercial banks.

The parent and subsidiary companies will be allowed different ownership and governance structures. They can maintain the current operational model of integrating policies and the market while being separate in organization, administration and financial affairs. Besides this, the subsidiaries are eligible for a shareholding system.

Guo Tianyong, Director of the Research Center of Chinese Banking Industry at the Central University of Finance and Economics pointed out that the separation can clearly differentiate CDB's policy-related and commercial businesses. This will be conducive to realizing a real market-oriented operation.

In addition, CDB has been enjoying a much lower synthetic fund cost than commercial banks in issuing bonds, taking advantage of its unparalleled national credit. This is an object of condemnation from commercial banks. For a long time, CDB has been the country's third largest bond issuer, only after the People's Bank of China and the Ministry of Finance. This is largely due to the vigorous demand of bonds ensured under its quasi-government status as a policy bank. The low cost of financing has also contributed to its success. However, commercialization may deprive it of these advantages.

"Real commercialization means the bank would assume sole responsibility for its profits and losses," Guo said. "It's self-evident that the bonds issued will by no means be immune to defaults if bankruptcy occurs." CDB will therefore be running the risk of losing the favor of institutions.

As a double-edged sword, the reform of CDB will expand its business, but at the same time may raise financing costs, posing a major challenge to its reorientation. Compared with other banks after joint stock reform, CDB's disadvantages such as a deficient grassroots network, unitary business lineup and narrow financing channels will all add to the uncertainties hanging over its path of reform.

In July 2007, CDB spent 1.5 billion pounds (2.2 billion euros) to buy into Barclays Bank at a price of 7.2 pounds per share, a new record for overseas expansion of a domestic financial institution. This also came to the global banking industry as a huge shock, but an illuminating avenue for the future commercialization of Chinese banks.

"This will benefit the commercialization and globalization awareness of China's policy banks, as they can draw on the advanced management expertise of international banks with long histories," Guo said.

"With the help of the capital injection, CDB can diversify its financing to better grasp the opportunities of overseas investment and further accelerate its pace of overseas commercialization," echoed Bai.