Combination lock to recombination unlock

When China transformed its manufacturing sector, India lagged behind. Today China is transforming its banks, and India may once again be lagging behind. Over the last one year China has embarked on a radical strategy of selling PSU banks to foreigners and to the private sector.

How is the banking sector in China being reformed? It is widely known that Chinese banks are in very bad shape, with loans given to PSUs made at the behest of the government which don?t get repaid. China is selling shares of these very PSU banks. In the last one year, Bank of America, Goldman Sachs, the Royal Bank of Scotland, UBS, Merrill Lynch, HSBC and American Express have all bought stakes in Chinese banks. China Construction Bank?s IPO in Hong Kong in late 2005 raised $9.2 billion. The Bank of China topped that, raising $11.2 billion in an IPO in mid-2006. And in October, the Industrial and Commercial Bank of China (ICBC), the largest bank of China with over $800 billion in assets, sold 16% for $22 billion in the world?s biggest IPO. Today, ICBC has a market capitalisation of roughly $130 billion.

Moreover, China has not stopped at only selling minority stakes in PSU banks. It has even privatised one. Guangdong Development Bank, which is roughly half the size of the State Bank of India, has been sold to a consortium of foreign and private buyers, led by Citigroup. Guangdong Bank is essentially bankrupt. However, the consortium paid $3.1 billion in order to get an 86% stake. With its 500 branches and 12,000 employees the Bank offers Citigroup an opportunity to be part of the fastest economy in the world.

Why might India lag behind? First, in contrast to India, the Chinese Communist Party has already begun privatising banks by selling off 20% to foreigners. Hardly any politician or party in India appears to believe, at least publicly, that India should even consider going this way. PSU banks remain a holy cow. It may be years before the political class squarely discusses such sales.

The second remarkable thing about Chinese banking, when compared with India is the sheer size of Chinese banks. The biggest Chinese bank, ICBC, has assets of $800 billion and a market capitalisation of $130 billion. In comparison, India?s largest bank, SBI is a midget with assets of $110 billion and a market cap of just $14 billion. Indian and Chinese banks will soon compete in world markets ?just as steel firms do today. If there is a size difference, it will be harder for India to achieve market share in international finance. Why are Indian banks so small? Some of the reasons are exogenous to banking policy. For example, the first factor is the difference in GDP. Chinese GDP in 2006 stands at $2.2 trillion, while India?s is at $0.78 trillion. Bigger GDP equals bigger banks. But Chinese GDP is 2.8 times India?s, so proportionally SBI should have assets of $310 billion and market cap of $40 billion. Clearly, the GDP difference explains some of the gap, but not all of it. The next issue is India?s relative success with the equity market. With speculative price discovery and minimal government interference in capital allocation, India?s equity market is quite robust, and so equity financing dominates the corporate sector. The market capitalisation of the biggest 2,548 Indian firms stands at $767 billion, while the aggregate bank borrowing of all these firms stands at only $50 billion. China, as yet, lacks a comparable stock market, and firms rely much more on banks.

Still, India?s equity tilt reflects a mix of progress in the equity market and a lack of progress on banking reforms and the debt market. While an equity-dominated financial system is the direction in which all mature market economies go, such a shift should not come about on account of incompetent banks. It should be the outcome of genuine competition between stock markets and banks for the funding of business.

Indian banking policies remain weak in several ways. Take the aspect of competition policy, for example. In terms of barriers to competition, the sector is one of India?s worst. The freedom to enter the market simply does not exist. Domestic banks need RBI permission just to open branches. All foreign banks, put together, are permitted to open only 18 branches a year. There are rules that keep voting rights below ownership levels, reducing investment incentives and the market cap of banks. As a result of all the strictures, new bank entrants are few and far between. In the last one decade, only two serious new banks?Yes Bank and Kotak Mahindra Bank?have entered the industry. Low competition, coupled with RBI?s intrusive model of regulation that seeks to control the minute details of banking, hobbles innovation. Across the world, global companies which might be called ?banks? are engaged in every financial activity imaginable. In India, however, we are still in a paradigm where RBI narrowly defines the business called banking, and prevents banks from engaging in any other activities. This yields unhealthy, small, underdiversified and uncompetitive banks.

Such restrictions on business are a throwback to 1970s-vintage economic policy. In order to make progress on these questions, there is a need to make a fresh start, by rethinking the laws, shifting banking regulation away from the RBI, and bringing in a new team which is able to inject fresh ideas.

?Ila Patnaik is a senior fellow at the National Institute of Public Finance and Policy. These are her personal views