India’s development strategy in recent years has been “India for India” and “Make in India.” A form of self-reliance, or “strategic autonomy,” India’s policy approach is a reaction to insufficient progress with prior policies that opened India’s economy to global investment.² Today’s measured approach to foreign investment is not indicative of India’s insularity but of a deliberate and judicious decision-making process regarding foreign investments.

This policy of prudential engagement has also led India to step back from China’s outward investment under the Belt and Road Initiative (BRI) platform. India cannot – and does not want – to respond to BRI with the scale of investment that China has committed. However, there is a new emphasis on outward foreign investment from India. The Indian government has encouraged international investments by reducing the restrictions on Indian companies investing abroad and substantially raising the annual overseas investment ceiling to establish joint ventures and wholly owned subsidiaries. There has been an evolution in the upper limit for overseas investments with fewer restrictions on approvals over time. Since 2003, Indian firms have been granted permission to invest 100% of their net worth overseas in foreign joint ventures or wholly owned subsidiaries.³  In 2010, the ceiling was increased to 400% of net worth.⁴

This article aims to explore India’s outward foreign direct investment (OFDI), focusing on China’s BRI initiatives in India’s neighbors, which include Bangladesh, Sri Lanka, Myanmar, Nepal, Afghanistan, and Pakistan. We analyze similarities and differences between India and China in terms of the timing, scale, scope, and number of OFDI projects and financial commitments, using monthly investment data for Indian and Chinese projects in India’s neighbors during the period 2011-2022.⁵ The two data sets we use report overseas investments by entities in India and in China by project and by host country, reporting the total amount of the investment. We argue that China is moving aggressively to influence countries in India’s neighborhood using large-scale investment projects under the BRI initiative as an investment platform, while India has not responded in a major way to this challenge.

China’s BRI Investments

Before the year 2000, China severely restricted its companies from investing abroad. The “Go Out Policy,” later called the “China Goes Global” strategy, was decided on in 1999 and formalized in 2000. Initially, only state-owned companies were approved for OFDI, but later, large private companies were allowed to invest abroad, followed by others who qualified. This loosening of the regulations was reversed in 2017, with certain types of investments, such as entertainment, hotels, and real estate, being restricted to focus OFDI on technology, infrastructure, and resources and to manage the overall outflow of capital.⁶ Chinese OFDI increased steadily, initially in emerging markets and subsequently in developed economies, including the U.S. and EU. According to the Ministry of Commerce, as reported by the Rhodium Group, China’s annual outward investment peaked in 2016 at $181 billion, including $158 billion in mergers and acquisitions. Mergers and acquisitions began to drop substantially after 2018. Still, in 2022, the Ministry reported $117 billion dollars of investments, including $24 billion of mergers and acquisitions.⁷

In 2013, President Xi Jinping launched One Belt One Road, later renamed in English as the Belt and Road Initiative, as a channel for much of China’s OFDI. According to a joint working paper by the Green Finance & Development Center and the Griffith Asia Institute, 148 countries have officially joined the BRI platform.⁸ A 10-year celebration of the BRI was held in Beijing in October 2023. Representatives from many participating countries attended. Xinhua, China’s news agency, reported:

Statistics show that the BRI has helped lift about 40 million people out of poverty in participating countries. It has also galvanized up to 1 trillion U.S. dollars of investment globally and created more than 3,000 projects and 420,000 jobs over the past decade.⁹

After many years of large-scale infrastructure and energy projects, the future focus of BRI is changing toward more green projects, with smaller and private sector-led investments. Beijing is also approaching other countries, such as Saudi Arabia,
to help finance the next stages. The number of projects and amounts invested have fallen substantially since 2016. This decrease in Chinese OFDI is partly due to a growing sovereign debt burden in the BRI countries.¹⁰

The Regional Context

India is surrounded by countries that have formally signed memorandums of understanding related to BRI, including Pakistan, Afghanistan, Bangladesh, Myanmar, Nepal, and Sri Lanka. (See Table 1.) Pakistan is one of the largest recipients of investment from China, which began many years before the official launch of BRI in 2013. Bhutan is the only neighbor that has not joined the BRI. However, even Bhutan, which does not have diplomatic relations with the PRC, recently began talks with China to resolve their border dispute, adding to India’s concerns.¹¹

Table 1. Timing of India’s Neighbors joining BRI¹²

Numerous corridors also connect the BRI countries with China and China to distant lands, including Europe. Table 2 lists the four corridors that concern India the most. The China-Pakistan Economic Corridor is one of the most established and has been a concern to India for many years. It provides easy trade access to China, bypassing the Strait of Malacca, and provides Pakistan with significant military benefits.

Table 2. Four BRI Corridors in India’s Neighborhood¹³

At the start of China’s “Going Out Policy” in 2013, Manmohan Singh was Prime Minister of India (2004-2014). Initially India saw economic integration with China as a way to promote development by moving the long-time bilateral border dispute to the background. The Singh government welcomed the promotion of regional connectivity. When the Modi government came to power in 2014 the approach to BRI changed. The response was to reject BRI and instead to invest in India’s own connectivity projects, and to revive others.

For example, Project Mausam was begun in 2014 to promote connection between countries in the Indian Ocean via communications, culture and trade. The “Cotton Route,” initiated in 2015, aimed to connect India with Russia in one direction, and with SE Asia and East Africa, in the other direction. The “Spice Route” initiative is led by the State of Kerela to connect with countries that were involved in the ancient spice trade. Another major project was the revitalization of the Chabahar Port in Iran. India built the port in the early 2000s, committed to renovate it in 2015, and began the work in 2017.¹⁴ These were seen as part of a renewal of India’s long-standing “Look East” policy, now referred to as “Act East Policy,” which was directed toward strengthening India’s relationships with countries in South and Southeast Asia.¹⁵

This approach of promoting India’s connections with its neighbors was strengthened after President Xi visited Pakistan in May 2015 to announce the development of the China-Pakistan Economic Corridor, which would connect Kashgar in Xinjiang, China, to the port of Gwadar in Pakistan. India strongly opposed the project, mainly because it would go through Pakistan-occupied Kashmir. The proposed corridor between China and Pakistan triggered a significant change in India’s perception of the security relations in the region. The border clash with China in 2020 was another major setback in relations between India and ChinaTable 3 and calculations using the two databases..

The timing of these connectivity projects is consistent with an interpretation of India countering China’s BRI initiatives in the region. India’s official statements regarding BRI suggest that its objections to the BRI arise from a lack of consultation regarding the strategy and process of project selection and formulation and concerns over the debt burdens of BRI participant countries arising from Chinese investments. Although Beijing welcomed India’s participation in BRI, which could have been signaled by India’s participation in the 2017 BRI Forum, India decided not to attend.

While large Chinese investments tied to the Belt and Road Initiative may improve infrastructure development and increase opportunities in the Asia-Pacific region, India has been increasingly guarded about China’s outward foreign investment motives. The scale and number of Chinese investments in India’s continental and maritime neighborhood are of particular concern. India’s cautiousness stems from a worry that China’s expansive OFDI may increase China’s political influence in the region.

In the next section, we examine Chinese and Indian investments in India’s neighboring nations to understand if India’s investments are a reaction to China’s BRI investments. As noted previously, we focus on the following neighboring countries: Bangladesh, Sri Lanka, Myanmar, Nepal, Afghanistan, and Pakistan. While India has no investments in Pakistan according to our database, China’s investments in Pakistan are important in understanding China’s political, military and economic motives.

Regional Outward FDI

At the regional level, as seen in Table 3, China has made a small number of very large investments in India’s neighbors. From 2011 to 2018, China steadily increased the number of investments from 14 to 26 in these nations. The value of these investments totaled $6.3 billion in 2011 and climbed to $27 billion by 2015, and then dropped to $14.65 billion by 2018.There was a significant drop in Chinese investments to $7.3 billion from 2019 to 2020, coinciding with the pandemic. Post-COVID, China’s investments in these nations declined steeply, both in the number and value of investments, with only 12 investments valued at $2.3 billion in 2022. The 2022 level was even lower than the pre-BRI level of Chinese investments in these countries.

An examination of China’s investments in India’s neighboring nations shows that over 53% of China’s OFDI went to Pakistan, 27% to Bangladesh, and 10% to Sri Lanka, with the remaining 6% going to Myanmar, 3% to Nepal, and less than 1% to Afghanistan. The largest Chinese investment, both by number and value, was in Pakistan (87 investments worth $57.7 billion), with about half that value in Bangladesh (64 investments at $29.2 billion), followed by Sri Lanka (31 investments at $10.98 billion). China’s 19 investments in Myanmar were at $6.23 billion, 18 in Nepal at $3.51 billion, and two in Afghanistan at $0.61 billion.¹⁶

As Table 3 indicates, over the period 2011-2022, India made hundreds of small investments in its neighboring nations while never remotely approaching the amounts that China invested in. A large drop in India’s OFDI in 2014 coincided with China’s anticipated introduction of the overall BRI policy and the Modi government’s election in India that year.

India’s pattern of OFDI, measured as the percent of the total value of investment, primarily focused on Sri Lanka (52%), Myanmar (21%), and Bangladesh (21%), followed by a little over 6% in Nepal and less than 0.2% in Afghanistan. The number of India’s investments was highest in Sri Lanka (1197), followed closely by Bangladesh (1094) and about half the number in Myanmar (575), and fewer in Nepal (328) and Afghanistan (14). India’s focus on Sri Lanka contrasts with China’s relatively small investments.

Table 3: Total Number and Value of Investments by year in neighboring countries

*In USD Billions

Note: Neighboring countries include Bangladesh, Sri Lanka, Myanmar, Nepal, Afghanistan, and Pakistan

While some India government policies have directly encouraged Indian OFDI, other events within India during this period may also have spurred Indian OFDI, which is mostly private capital seeking profits. For example, the demonetization in 2016 and the introduction of the Goods and Services Tax in 2017 may have made Indian exports more expensive, incentivizing domestic firms to look for alternate investment options. Given India’s increasing technology prowess and the fact that OFDI technology spillovers are significantly positive in India, this further incentivizes firms to look outside India for investment options to complement exports.¹⁷ The rapid decline in the economic growth rate in India from a little over 8% in 2016 to approximately 4% in 2019 may also be a reason for Indian firms to seek investment options abroad to diversify their portfolios. Around the 2014 through 2019 period, the Indian financial sector faced one of its worst crises due to many non-performing assets in the banks, which hamstrung lending.¹⁸ Moody’s downgrading of India’s economic outlook from “stable” to “negative” in 2019 may have also incentivized Indian firms to invest outside India to hedge their bets and move their production abroad, increasing OFDI.¹⁹

Conclusion

Indian and Chinese entities have increased investment in South Asia. OFDI incentives differ between the two countries: private firms lead the way in India, while in China, it is the government. The BRI is the most apparent, explicit tool that China is using to increase its influence in the region, but even more importantly, to build infrastructure to be able to acquire resources from afar.

India’s policymakers and leaders are aware of China’s growing presence and are considering ways to respond. While the Indian government has initiated several projects, such as the Spice and Cotton Routes, Project Mausam and the revitalization of Chabahar Port in Iran, they are significantly smaller than China’s investments in terms of the number of OFDI projects, their scale and scope. India has indicated an interest in improving regional interconnectivity, which is similar to the goals of many of the BRI projects. However, the lack of transparency and the scale and geopolitical aspects of BRI have made India cautious about joining the BRI.

India has long maintained economic, political and military alliances, particularly with Bangladesh, Sri Lanka, and Myanmar. Given this, China’s value, type, and sectoral investments in these three nations may particularly draw interest from India about China’s OFDI motives. Given that these three nations are among the BRI nations, India’s investments in them may also be strategic from geopolitical and economic points of view.²⁰

However, our analysis indicates that while China is likely using BRI as a strategy to increase its presence and influence in India’s neighboring countries, the Indian government has yet to respond in a significant way to China’s moves. We also do not see any patterns of increased Indian OFDI in response to its neighbors joining BRI.²¹

Indian companies have invested in the region, primarily in Sri Lanka, Bangladesh, and Myanmar. However, our data show no priority for OFDI in neighboring countries or specifically in response to BRI. We do not find any OFDI response to BRI measured by timing or investment size.

Most Indian OFDI is driven by private sector companies that make investment decisions that align with their profit strategies. They have initiated many small projects and often favor Western, developed countries. In contrast, Chinese OFDI includes considerable investments by state-owned enterprises and potential governmental influence over the location and scale of OFDI. Chinese projects tend to be very large, funded by loans offered to the host countries by state-owned financial institutions, and led by state-owned companies. Finally, while not large in scale as measured by financing, India’s small, numerous, privately funded projects in this region may prove more sustainable with long-term positive impacts than China’s large-scale investment schemes.

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China’s Central Bank, the People’s Bank of China (PBOC), has developed its own digital currency. The electronic China Yuan, or e-CNY, results from a six-year effort and follows a crackdown on private cryptocurrency trading and mining in 2021. Authorities view private cryptocurrency as a threat to financial stability. While digital payments are popular in China, the rollout of a national digital currency puts the government in a space that had been designed to thwart central control. e-CNY also is a key part of China’s efforts to digitize its domestic economy to, in part, expand state control while also strategically positioning China to influence the global financial system.

Piloting the currency in four cities in April 2020, usage of e-CNY is rapidly expanding within China. The Beijing Winter Olympics was an opportune time to showcase the currency’s scalability by piloting it in 10 regions across China in February 2022. The People’s Bank of China has not disclosed the number of adopters of the e-CNY since October 2021, but its unofficial estimates are around 261 million wallets¹ with total transaction values of more than RMB 87 billion (approximately $13.75 billion).² These include both individual and corporate wallets, but it is uncertain if all the wallets are in use. According to the Digital Currency Institute, as of August 2022, more than 5.6 million merchants are accepting payment with the digital currency. Authorities allowed residents to use digital currency to pay utility bills and collect tax refunds and health insurance reimbursements.

China hopes to gain an advantage in the digital currency space even as central bankers globally have been skeptical about moving forward with their digital currencies. Their main concerns center around financial stability and privacy because governments would have access to the daily transactions of users. Inadvertently, the recent bankruptcy of FTX, formerly the world’s second-largest crypto exchange, may have created a watershed moment for regulation and the state’s role. The failings of FTX have led to increased skepticism about cryptocurrencies and financial stability, altering their trajectory in many parts of the world. As a result, the need to regulate digital assets, cryptocurrencies and the digital ecosystem has increased in urgency, shedding favorable light on China’s approach to using centralized control for financial stability. This article presents a summary of central bank digital currencies (CBDCs), China’s e-CNY and China’s motivations in taking the lead in this space. The article argues that e-CNY may be a double-edged sword. While the conveniences of a digital currency can move the country quickly toward financial inclusiveness, there is a danger of the state using the currency as a tool to control society.

Central Bank Digital Currencies vs. Mobile Money

Digital money is not a new concept. Virtual payments are increasingly becoming the norm, as credit cards and payment apps allow cashless transactions in China and elsewhere. Digital money is stored on a cloud server or a personal electronic device and can be used for exchanging goods and services by using payment apps. Mobile money utilizes existing commercial banking-based transactions to manage consumer wallet balances based on exchange with cash or credit lines or loans. Therefore, mobile money is the liability of commercial banks and other authorized financial institutions.

In contrast, national digital currency is issued by a central bank, which may serve as a medium of exchange and hold the same storage value.³ Therefore, a national digital currency is a direct liability to the central bank as it is the issuer of the currency. In this sense, CBDC is a new payment instrument that will either replace or coexist with paper money to represent local currency values, whereas mobile money is not a new instrument but rather a new type of payment transaction.

Mobile payments in China have experienced explosive growth with Alibaba’s AliPay and Tencent’s WeChat Pay, which have dominated the space. Innovations such as QR codes and digital wallets have transformed the nation’s shift away from cash and traditional credit cards. This rapid growth was outwardly encouraged but also resulted in ambivalence about the supervision over the payment systems from the People’s Bank of China. China’s Communist Party inserted Party members as part of both Tencent and Alibaba and Ant Financial’s governance structures so as to control the magnitude and speed of growth of these firms. In 2010, the People’s Bank of China enacted regulations that required foreign-funded third-party providers of online payments to obtain State Council approval to operate in the Chinese market. In addition, they would be subject to different rules from those governing domestic operators.⁴ As part of a deleveraging campaign in 2017, the People’s Bank of China extended its regulatory wand to end third-party providers and ordering funds transferred from commercial banks into Central Bank accounts. In 2019, the People’s Bank of China took over all deposits of platforms such as Alipay and WeChat Pay to address risks associated with shadow banking, while simultaneously moving user transactions data under the central bank umbrella.

More recently, the State Council launched an antitrust investigation into Alipay and WeChat Pay claiming to help smaller companies enter the market in the payments space. However, due to their ubiquity and innovation ability, Alipay and WeChat Pay have managed to maintain their dominant position. In addition, the central bank is aware that it must depend on more than commercial banks to expand the use of e-CNY. As of 2020, with over 94% of market share, they are the leading third-party providers for online payments in China with Alipay at almost 56% and Tencent, which includes WeChat Pay and QQ Wallet, at close to 39%.⁵ While Chinese authorities are stepping up efforts to encourage the use of e-CNY, the question remains whether consumers will download this new digital yuan app and switch from WeChat to Alipay. Hence integrating with WeChat and Alipay is key to growing the user base for e-CNY.

How Will e-CNY Work?

China’s digital currency is legal tender, issued and backed by the Central Bank. It will be a traceable replacement for notes and coins and have all the functionality of paper currency – a medium of exchange, a unit of account, and a store of value. e-CNY has two tiers with the first exclusively made up of a few commercial banks that can facilitate the exchange of digital currency with cash or bank deposits. The second tier is the People’s Bank of China, which controls the supply of e-CNY and manages the digital currency payments between the first-tier banks. Policy makers describe the Chinese digital currency network as “one coin, two databases, three centers.” “One coin” is the encrypted digital unit of currency guaranteed by the PBOC. The “two databases” refers to the People’s Bank of China’s ledger that keeps track of all outstanding e-CNY, and all the e-CNY ledgers by the lower-tier banks (Lee et al, 2021). The “three centers” reside within the People’s Bank of China. They comprise a certification center that maps the identities of all digital wallet users, a registration center that tracks ownership of digital wallets and the transactions of their users (Louie and Wang, 2021), and a big data analysis center that monitors payment flows. The central bank will limit how it tracks individuals, noted Mu Changchun, who is leading the project at the People’s Bank of China calling it “controllable anonymity.” Central Bank officers emphasize that the monitoring is primarily to combat illegal activities, including money laundering, terrorist financing, and tax evasion. In addition, the institutions that issue the currency to users are required to meet compliance regulations with payment rules such as capital controls and sanctions.

Currently, e-CNY can only be purchased through China’s six large state-owned banks and Tencent and Ant Group bank affiliates that control China’s two leading digital retail payment platforms. e-CNY users may be individuals or corporations, and each of these “wallet-holders” has different transaction limits. Wallets can be software-based via the e-CNY app, which can be downloaded from the e-CNY app stores, or they can use AliPay and TenPay apps as the interface allowing users to manage their transactions.⁶ Wallets can also be hardware-based, allowing for contactless transactions. Additionally, other options are being piloted that may include reusable prepaid cards, not linked to any specific bank, that may hold small amounts of the digital currency but may offer some privacy.

What Is China’s Motivation to Take the Lead?

On the domestic front, the e-CNY can help China promote inclusion by giving individuals in all of China easy access to financial transactions. The People’s Bank of China has announced a goal of having more than a billion users before any other country can take substantial steps toward developing a central bank digital currency of its own (Hoffman et al., 2020). The People’s Bank of China can also implement monetary policy while identifying problem areas to help devise policies to ensure price and financial stability (Aysan et al., 2014, 2015). Furthermore, unlike paper currency, digital currency helps track and monitor the use of currency after issuance. This tracking can help prevent fraud and illegal transactions, guaranteeing increased safety for the public.

On the international front, the use of digital currency helps China gain a stronger foothold in the global financial system. First, it would help reduce China’s dependence on the U.S. dollar-denominated financial system. Second, it would allow China to leverage its position as the leader in CBDCs. Given the increasing movement toward cashless societies worldwide, many nations are considering digital currencies, and they may turn to the Chinese model to emulate. This would give China a first-mover advantage in exporting its technology.

Further, the People’s Bank of China is also introducing technology that allows and promotes the digital yuan to be used in cross-border payments. This would permit China’s security agencies to surveil the financial activity of Chinese citizens and any foreign individuals or entities doing business with China. This surveilance ability may have major international security implications.

Transparency, Privacy, and Digital Currencies

The fundamental differences between decentralized digital currencies (aka most cryptocurrencies) and centralized digital currencies (CBDCs) lie in information control, privacy, and transparency. Most cryptocurrencies were created to move power away from one single organization to a network to avoid giving control to any single authority, such as a central bank. Transparency in decentralized digital currencies is critical. Everyone in the network can see all transactions made and received by any user since all the revenue streams are placed on a public chain, called the blockchain, which serves as a public ledger.

In the case of CBDCs, all transactional information is stored within the central bank and not shared. Unlike cryptocurrencies, CBDC transactions are not anonymous but subject to government monitoring. CBDCs are virtual like cryptocurrencies but issued by the government instead of the private sector (Prasad, 2021). The use of CBDCs is a trade-off between security and privacy. Because the central bank backs them, they are considered a secure investment.

Further, the People’s Bank of China determines the supply depending on the prevailing economic conditions, unlike cryptocurrencies, whose supply is limited. Central bank digital currencies require complete verification of the investor’s or purchaser’s identity, unlike cryptocurrency, which is attractive because of its anonymity. With CBDCs, the People’s Bank of China can monitor and hence regulate the use of the currency by any individual or business.

While free market advocates promote the idea of decentralized digital currencies, policymakers express concern that these currencies are vulnerable to abuse in funding terrorism and criminal activities. Many nations, therefore, see central bank digital currencies as the better alternative: digital money that can be conveniently used for transactions while providing the security that comes with its central bank issuance. Countries monitor transactions even with cash for financial and national security threats such as money laundering, terrorist financing and tax evasion. Additionally, governments set thresholds for customs declarations and cash transactions that trigger compliance regulations when they reach a certain volume (Pocher, N and A.Veneris, 2022). As the world moves increasingly toward cashless societies, financial and national security threats remain and may be exacerbated. Most nations, therefore, fall somewhere along the spectrum of privacy-transparency versus security trade-offs.

Privacy, Security, and Promotion of e-CNY

Despite hesitation among other large economies, China is forging ahead with its e-CNY project. It has ramped up the spread of digital currency and plans to position itself as the leader in CBDCs. The People’s Bank of China wants users to make offline payments with their digital wallets to spend e-CNY in remote areas of rural China or in-flight. Unlike conventional bank accounts, e-CNY wallets will likely reside within the internet of things devices, including home and vehicle sensors. While China’s payment system is largely dominated by WeChat and Alipay digital wallets, the government has found a balance to work with these private entities without completely clipping their wings.

The People’s Bank of China says a defining principle of the digital yuan is “controlled anonymity.”  PBOC Governor Yi Gang stated that the two-tier operation is designed to protect personal privacy and maintain financial security. He said the Central Bank, as the first tier, only processes inter-institutional transactions and thus does not deal with individual transactional information. Second-tier financial institutions provide digital currency exchange services to individuals and businesses, collecting personal information only as needed.

China argues that the two-tier structure will preserve the private sector’s well-established technological innovation and operational prowess, particularly given the size and complexity of China’s geography and economy. Instead of taking commercial banks out of the picture, the idea is to include them as the lower tier for the distribution of e-CNY through software applications. The private banks may gather information on their users and use that data only for target marketing purposes and to manage the users’ wallets to facilitate withdrawals and deposits.

While intended to be “cash-like,” the digital yuan is designed to allow the People’s Bank of China a degree of visibility and control that real cash does not permit. Each digital currency token would include a cryptographic algorithmic expression identifying the token’s owner and the purchase transaction. Not all data will be available to those transacting in e-CNY, but the data will be available to the Central Bank for security purposes. Thus, true anonymity does not exist, as currency registration and traceability are built into e-CNY transactions. That process, augmented by data mining and big-data analysis, provides the People’s Bank of China with the ability to have complete oversight over the use of the currency. While the argument forwarded is that this oversight will control tax evasion, money laundering, and terrorism financing, this may not be true as most illicit activity is not conducted over formal monetary channels.⁷

While the Central Bank desires scalability and increased adoption of e-CNY, people need more incentive to switch from popular digital wallets such as WeChat and Alipay. Therefore, the People’s Bank of China is using a mix of persuasion and arm-twisting to roll out the digital currency. It seeks to get citizens to participate in the e-CNY project by playing the safety and security card.⁸ It also uses promotional discounts to encourage increased use of e-CNY. The state-funded e-CNY network also offers businesses lower fees than the more established Alipay and TenPay network platforms.

In addition, there is talk of converting government and state-owned enterprise payrolls to e-CNY, forcing its increased use within China. More recently, the State Administration for Market Regulation (China’s antitrust regulator) has also launched regulatory actions against monopolies and e-commerce platforms to hasten the adoption of e-CNY. As a result, Ant Group was urged to give consumers more choices in payment methods. Following this, Tencent and Ant Group’s bank affiliates began fast-tracking the use of e-CNY by enabling the purchase of the digital yuan. As large Chinese tech companies start partnering with state-owned banks in pilot projects facilitating the consumer use of the e-CNY, this could impact the data gathered by Alipay and WeChat Pay and reduce their market share in payment platforms.

Conclusions

The digital yuan offers China more than just fine-tuned monetary policy and improved anti-money laundering software. Using e-CYN gives the CCP unparalleled insight into the Chinese people’s finances and significant levers to carry out punitive state action. In addition to basic information about users and transactions, various metadata associated with users’ movements and devices could also be infused with big data. Increased use of the e-CNY has huge implications for the financial world as it enables the creation of the largest database of centrally governed transactions (Hoffman et al., 2020). The People’s Bank of China will possess a trove of information on its users, providing tools for censuring and surveilling individuals. The Central Bank’s e-CNY vision is summarized by President Xi Jinping’s claim that it is necessary to strengthen omnidirectional supervision, standardize all types of financing behavior, and seize the opportunity to launch special programs for financial risk regulation.⁹

Given a world driven by data, e-CNY is a double-edged sword. The use of e-CNY promises to be more inclusive, providing more people and firms easy access to financial services. Concurrently, it raises fears about the central bank having access in granular detail to the movement of money among individuals and businesses, creating concerns about its implicit use as a surveillance tool by the government. To alleviate such fears, China passed an omnibus privacy law, the Personal Information Protection Law (PIPL), in November 2021, designed to regulate online data and protect personal information. The PIPL followed closely on the heels of China’s Data Security law enacted in September 2021. The latter applies to a wide range of data processing activities, including processing personal information. The scope and penalties of any violations are expected to be complex and detailed for the PIPL when doing business in China.

In addition to privacy and transparency concerns, in expanding the use of the e-CNY in cross-border payments, China hopes to establish itself as a leader in the global digital currency race. In doing so, one of the motivations may be to undermine the dominance of the U.S. dollar in international payments. Moreover, internationalizing the e-CNY may help China circumvent any sanctions imposed by the United States and its partners. China’s innovations surrounding the e-CNY are changing the financial landscape at home and forcing its competitors abroad to acknowledge China as a new powerful, innovative force in the digital currency space.

References

Aysan, A.F, Fendoglu, S., Kiline, M., 2015 Macroprudential polices as a buffer against volatile cross- border capital flows, Singapore Economics Rev, 60(01), 1550001.

Aysan, A.F, Fendoglu, S., Kiline, M., 2014, Managing short-term capital flows in new central banking: unconventional monetary policy framework in Turkey. Eurasian Economics Rev, 4(1), 45-69.

Aysan, A.F., F.M. Kayani, 2022, China’s transition to a digital currency does it threaten dollarization? Asia and the Global Economy, 2, 100023.

Hoffman, S. J. Garnaut, K. Izenman, M. Johnson, A. Pascoe, F. Ryan and E. Thomas (2020). The flipside of China’s Central Bank digital currency. The Australian Strategic Policy Institute Limited, Policy Brief Report no. 40/2020.

Lee, D.K.C., L. Yan and Y. Wang, 2021, A global perspective on central bank digital currency, China Economic Journal, 14 (1), 52-66.

Movroydis, Johnathan, (2022), What the rise of China’s Digital currency could mean for the US, https://www.gsb.stanford.edu/insights/what-rise-chinas-digital-currency-could-mean-us/ https://www.hoover.org/news/qa-rise-chinas-central-bank-digital-currency-concern-us-government-argues-darrell-duffie

Pocher, Nadia and Andreas Veneris, (2022) Privacy and Transparency in CBDCs: A Regulation-by-Design AML/CFT Scheme, IEEE Transactions on Network and Service Management, 19(2), June, pp 1776–1788 https://doi.org/10.1109/TNSM.2021.3136984

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Alibaba, the Chinese e-commerce firm, raised $25 billion from its initial U.S. public offering (IPO) in September 2014 putting China on the e-commerce world map. This exemplified China’s ongoing transformation from a low-skilled, cheap labor manufacturing assembly economy to a higher-skilled, innovation-based service economy. China’s 12th five-year plan defined the communications sector as a central tenet in its new economic developmental model with the Financial Industry Reform Plan sharing center stage.¹ At the same time, the adoption of mobile technology within China has been remarkable in acting as a catalyst in changing consumer behavior, creating access to goods and services and targeting marketing and expansion of the consumer base for businesses. With the promise of inclusiveness, mobile technology is increasingly permeating various sectors covering financial inclusion of banking the unbanked; assisting farmers in rural areas by providing market information regarding price, demand, and information on weather, fertilizers and pesticides; creating virtual classrooms in the education sector; spurring online commerce in retail and wholesale; and expanding delivery of health care services.

Our specific focus in this article is how mobile technology is transforming the landscape of the payments industry in China. This research has been motivated by a confluence of several recent events:

1. In 2011, the China Banking Regulatory Commission (CBRC) planned to increase the number of rural commercial banks and has been encouraging banks, both domestic and foreign, to establish tangible links across the nation and meet the financial service needs in the rural areas.
2. The 12th five-year plan outlines financial inclusion programs that deliver full financial services with a greater emphasis on the finance industry serving the real economy, as well as support for technological innovation, economic restructuring, manufacturing, and above-average growth rates in lending in rural areas, specifically to small and micro enterprises (in rural and urban areas).
3. The number of subscribers to mobile phones in China has grown from seven percent of the population in 2000 to almost 90 percent in 2013.² We argue that mobile technology’s ubiquitous nature, as well as its capacities in the financial services sector, make it a perfect mechanism to align commerce and payments. In China, where consumers often lack access to other noncash forms of payments, such as checks or credit cards, and where e-commerce is rapidly on the rise, mobile payments (mPayment³) and mobile commerce (mCommerce) are gaining traction and are rapidly transforming the payments industry.

Banks, given their experience in the industry and governmental support, have a distinct advantage. However, the financial service sector is expanding to offer both traditional payment and settlement services alongside non-financial services.⁴ Thus the financial sector is increasingly faced with competition from technology companies in the areas of remote account access; online commercial transactions such as people to people, business to business and business to consumer (P2P, B2B, and B2C); and outreach to remote rural areas in mCommerce and mPayment arenas. In addition, banks are heavily regulated compared to the technology companies, limiting their easy transition to mobility.

Mobile Technology in China – a brief background

Although limited, recent literature has shown evidence of relationships between mobile penetration and economic growth in both developing and developed nations.⁵ While the pervasive nature of mobility has helped include the disenfranchised in developing countries, the focus has largely been in communications and information-gathering. Researchers have noted that increases in mobility result in increased productivity thus creating a competitive advantage in nations with large investments in technology infrastructure.⁶

Up until 2004, the Chinese mobile communication market was dominated by two large companies, China Mobile and China Unicom. The dynamics of this changed in 2007 when China joined the World Trade Organization (WTO), opening this market for foreign companies to compete thus changing the mobile landscape. With a large number of Chinese companies entering the mobile ecosystem to support the increasing mobile subscriber base (expected at 700 million smartphone subscribers by 2018⁷), the market for mobile holds great promise in China. It is estimated that by the end of 2018, the population of smartphone users will increase from 38 percent to 51 percent. Companies in China are increasingly able to penetrate the rural and urban markets simultaneously, using mobile technology innovations.

The payments industry is at a tipping point around the world largely due to mobile technology. New non-banking players such as PayPal, Apple, Alipay, and Google have entered the payments arena, changing the financial services landscape. The radical changes in this industry in China have been thrust forward largely because of two events: the Chongqing Rural Commercial Bank (CRCB) IPO in 2011 and Alibaba’s IPO in 2014.

In July 2011, CRCB introduced the first mobile banking product in western China to expand mobile financial services and products for corporate customers.⁸ CRCB raised US$1.48 billion in an IPO in Hong Kong. This company is one of China’s largest lenders to farmers and small businesses, and is expected to be the first in a wave of listings by smaller rural-focused Chinese banks. With the mission of being financially inclusive of agricultural and rural areas and supportive of small, medium and micro businesses, CRCB centered its innovative efforts on developing mobile payment services.

Simultaneously, Alibaba – through its platforms, Taobao (similar to eBay for C2C) and Tmall (similar to Amazon for B2C), with payments facilitated by Alipay – has dominated the development of e-commerce in China. With its recent IPO, Alibaba is now a global contender in e-commerce around the world. Morgan Stanley estimates that while still in its initial phase, China’s e-commerce industry will be about 18 percent of the country’s retail sales by 2018, up from eight percent in 2013.⁹ The Morgan Stanley study also purports smartphone penetration will increase online shopping, especially in the lower-tier cities in China where a majority of the active mobile devices are registered and where most internet access is via mobile usage. Furthermore, the internet provides a level playing field for small entrepreneurs, who make up a majority of Chinese firms, since they can compete better in the online market compared to offline commerce. Concurring, the Boston Consulting Group notes that small and medium-sized companies in emerging markets are largely leapfrogging older generations of technology used in developed nations.¹⁰

In many ways, e-commerce has stimulated the growth of the e-payment arena in China. Because of rapid growth of internet users, improved online services coupled with lifestyle change due to rising incomes, China lends itself to creating a huge market for ePayment services outpacing even the United States.¹¹ A new industry of mobile operators and technology companies are entering into the payments industry once monopolized by the financial services industry, which is rapidly expanding from ePayment to mPayment.

Examples of mobile payment system in China

Tencent’s WeChat’s e-red envelope and mobile payments¹²

Distributing “red envelopes” is a famous tradition in the Chinese New Year. In 2014, the popular application WeChat promoted the WeChat Red Envelope [Weixin hongbao 微信红包 ]. Users only needed to link their bank cards to WeChat to be able to distribute or claim an e-red envelope that then could be used to send money to friends, or to pay bills, hail taxis, pay for parking, buy movie tickets and book flights. Even though Tencent did not reveal how many new bank cards had been linked with WeChat, it announced that from December 30th, 2013, until January 8th, 2014, more than eight million Tencent WeChat users participated in e-red envelope distribution. More than 40 million e-red envelopes have been claimed, and on average, each user claimed four to five e-red envelopes. WeChat’s success with its e-red envelope largely depends on the social network built by Tencent. Despite the surge in the use of WeChat e-red envelope, ZhiFuBao, the liaison payment company (similar to PayPal for eBay) from Alibaba, remains the market leader for online payment, especially in the mobile payment market. Alipay has become increasingly used to pay for theater tickets and is also used more recently to invest in money market funds called Yu’e Bao. By the end of 2013, ZhiFuBao had three billion users and more than one billion of these users paid over 900 billion RMB through their mobile devices.
These micro-payment businesses are increasingly being used in online markets, the sales of insurance products, stock exchanges, P2P lending, and have become some of the greatest competitors for traditional banks in China.

Taxi booking and mobile payment¹³

Consumers in China can now book or hire taxis through smartphone apps in real time. The two biggest apps, KuaiDi and DiDi, claim 97 percent of the taxi booking app market in China. By the first quarter of 2014, KuaiDi had as many as 6.23 million orders a day, covering 261 cities. DiDi had 5.21 million orders a day, covering 178 cities. To be able to cultivate and sustain a large market base for mobile payments, marketing strategies of such apps often focus on discounts in payment schemes such as consumers bundling their bank cards into their mobile devices.

Perhaps due to the novelty, these applications have raised concerns. First, the apps allow consumers to raise prices of hiring a taxi, or tip the driver in real time, creating concerns about illegal and irregular competition. Second, it excludes the elderly who seldom use mobile devices, and creates increasing difficulty for the elderly to hire a taxi. Third, it lures away consumers from the government’s official taxi booking platform. This latter concern resulted in the government quickly launching new regulations covering pricing and information sharing between different platforms, among other restrictions.

Sustainability

Mobile technology in China has created a value chain that includes financial institutions, operators, third party providers (TPP), device vendors and technology providers, with increasing collaboration among these participants. Alongside competition, there are also concurrent alliances being created among the various participants in the mobile technology network. The biggest breakthrough is seen in the online banking platforms. Banks have a relationship advantage with their customers, as well as trust due to the in-built capacity of data security centers. Because of infrastructure limitations in offering physical wired banking services to remote and rural locations, banks can work closely with application and solution providers to deliver integrated technology and security in the mobile banking space. Given the wide coverage of mobile networks and the high penetration of mobile phones in the countryside, banks in China are now able to circumvent geographic barriers and expand business coverage by offering mobile payment and financial services to remote rural locations. These services include money transfers to credit card management to wealth management and other online banking services. In addition, non-financial services are increasingly becoming commonplace, ranging from payments of utilities to business travel and hospital registrations, to managing phone accounts, among others. Many national commercial banks have introduced various financial IC (integrated circuit) cards with special features in 30 provinces and there is a push for alliances with public service departments such as transportation, health, and education.

The growth of the mPayment sector in China holds tremendous promise due to strong program support from the central and local governments, who have developed policies to support and advance e-commerce and mobile technology. The 12^th five year plan places emphasis on expanding the scope of e-commerce to industries such as heavy industry, logistics and tourism, improving online sourcing and retailing capability, boosting cross-border and mobile e-commerce, and creating a more secure online e-commerce system (Xin, Chen, 2011).¹⁴, Chinadaily.com.cn, Available from: http://www.chinadaily.com.cn/bizchina/2011-07/13/content_12893796.htm, (Accessed 22 October 2011).] In addition, the People’s Bank of China (PBC) in 2006 published the China Payment System Development Report, which for the first time publicly disclosed the data and policy leanings of the payment system. Weighing in, Su Ning, Deputy Governor of the PBC stated, “The payment system was an important component of a country’s economic and financial system, and the foundation of economic and financial operation. The development of the payment system and the improvement of the payment efficiency could boost the economic, financial, and social developments, influence peoples’ lifestyle, and enhance the quality of life.”¹⁵ The PBC has also developed the Measures for the Management of Payment and Settlement Organizations, which created a licensing regime for ePayment service providers. Hence this sector is becoming regularized and institutionalized.

Limitations

Penetration of technology in the countryside is a boon to financial inclusion. Yet the daunting task of investment in mobile networks and the viability of the mobile value chain remain a bane to the adoption and diffusion of mCommerce and mPayment. As China shows signs of an economic slowdown, one concern is that this may cause the government to rethink some its investment priorities, possibly impeding some of the mobile growth initiatives.

mPayment is primarily used to mitigate transactions’ costs by offering a gamut of services for a lower average cost by bundling goods or services. From the business standpoint, this allows for cost savings via increases in scale and scope. From the consumers vantage point however, in order to achieve these economies, the consumer may need to increase his/her purchase size and limit choices to a few goods/services to take advantage of the economies of scale.

Many challenges remain, and policies and legal infrastructure are still being refined and promoted. Banks and non-bank operators are separately regulated, and the expansion of mobile financial services is still a work-in-progress. Technology companies are threatening the banking turf in the areas of remote account access, online commercial transactions such as P2P, B2B, B2C and outreach to remote rural areas in mCommerce and mPayment arenas promoting financial inclusion. Given their unique accessibility to their client information, banks have the advantage of offering a multitude of services including brokerage, insurance, real estate services, and trust services, among others, while remaining leaders in the mobile financial services industry. The development of mCommerce and mPayment appears to be the next frontier for banks with an established mobile internet presence. However, while banks are protected by the government and are relatively safe from bankruptcy – unlike technology companies – the latter face less regulatory scrutiny and have a freer rein in developing products and offering innovative solutions.

Regulators have to walk a thin line between fostering innovation and promoting self-regulation while protecting the safety and soundness of the financial system. This causes them to limit banks’ strategic choices in transitioning to mobility. One such example is seen in the highly restrictive bank technology rules that were recently announced by PRC banking regulators wherein all banks are required to prove that their computer technology and software are “secure and controllable.” The extreme measures taken in this regard require banks to provide all sensitive intellectual property, such as their source code for all software to government regulators in China. In trying to address cyber-security issues, China has announced plans to become more self-reliant in its lagging chip and server industries. China has also tightened restrictions for internet companies in the past year, as it seeks to secure control over its online environment. These restrictions may negatively affect the mPayment industry that includes several foreign players in the banking and non-banking sectors.

Conclusions

Given that financial inclusion has increasingly become a policy priority and is seen as a complement to financial stability goals, the outreach capacity of mobile payment services, combined with the rapid growth of e-commerce, is becoming more commonplace in China. The Chinese government has aided in the development of mobile technology and is working to correct issues with poor infrastructure, logistical limitations and government restrictions.

Concurrently participants in China have enthusiastically invested in technology, capital and human resources needed to gain competitive advantage in the mPayment industry. However, investors should also be aware that the e-commerce business model for China has been tweaked and the internet sector regulated, enabling domestic incumbents to grow without much foreign competition. Potential deregulation of the internet industry in the long term could also change the competitive dynamic over time. In addition, mobile devices cause ongoing concern for security as sensitive information can be easily stolen or lost. In this regard, the Chinese government has been imposing regulations regarding online transactions as noted in the recent bank technology rules. With recent concerns around the world about data security issues in some large firms, this may limit the growth of the mCommerce and mPayment industry. Thus the future landscape of the payments industry in China, while transforming, remains uncertain at this juncture.

________________________________________________________________________

Dr. Vijaya Subrahmanyam, Professor of Finance, Stetson School of Business and Economics, Mercer University-Atlanta; subrahmany_v@mercer.edu

Dr. Juan Feng, Associate Professor, Department of Information Systems, City University of Hong Kong, Hong Kong; juafeng@cityu.edu.hk

Murthy Nyayapati, Former Director and co-organizer of GMIC (one of the largest mobile internet conference) in China and Silicon Valley; murthy.nyayapati@gmail.com

The post Mobile Technology in China: A Transformation of the Payments Industry appeared first on China Research Center.

Chinese policymakers are considering reforms to open China’s equity markets to foreign capital. A proposed International Board would allow both foreign firms and China’s domestic private firms to list on the new Shanghai exchange. With China’s increasing role in the global economy, it appears logical for China to open its markets further to foreign capital. However, this proposal has yet to be implemented, indicating there are both potential benefits and possible hidden costs, at least to some of the players involved. This article analyzes the pros and cons of launching an International Board in China, both for China’s economy and for Chinese and foreign firms. The conclusion is that having an International Board is an essential step in the development of China’s financial markets.

China’s stock market development

China began to reform its economy in 1978 when Deng Xiaoping rose to power. Notwithstanding such reforms, firms continued to be largely owned and operated as state-owned enterprises (SOEs), and their lackluster performance implied the necessity of the discipline of a stock market. The government believed that adopting a Western market model, with its diversified ownership and strong regulations, would lead SOEs to become more efficient and competitive in the global marketplace. The Shanghai Stock Exchange was established in 1990. A large amount of investment in technology and infrastructure followed, to develop the exchange. However, while the investment in modern technology was intended to bring the Chinese equity markets up to par with the Western world, the resemblance was minimal at best. In part, this may be a result of trying to fit a U.S.-style stock market into a Chinese-type command-economy, wherein much of the equity market is run and owned by SOEs which, in turn, also regulate the markets. To correct these deficiencies, China has made efforts to be more financially inclusive, and China’s regulatory body, the China Securities Regulation Commission (CSRC), is playing a critical role in changing the composition of market participants.

Chinese firms typically are classified by ownership type as state-owned enterprises, domestic privately-owned enterprises or foreign-funded enterprises. SOEs are either wholly owned by the government or have majority shares belonging to the government (state-holding enterprises). Privately-owned firms by definition are not state-owned but are private limited liability corporations and private sole and partnership enterprises. Foreign-funded enterprises include firms that are registered as joint ventures, cooperatives, sole-proprietorships or LLCs that are funded with foreign funds, including funds from Hong Kong, Macao or Taiwan.¹

The government increasingly has been making provisions to attract foreign firms and their investments. Given these efforts, the Chinese stock markets have grown substantially, in both wholesale and retail investment sectors. Financial markets in China offer different types of shares. The most prominent are A-shares and B-shares, which are issued by companies incorporated in mainland China. The main difference between A-shares and B-shares is who is allowed to trade them. A-shares, the largest class of shares in China, are renminbi (RMB) denominated shares, which can be traded only by Chinese nationals and foreign institutional investors classified and authorized as Qualified Foreign Institutional Investors (QFII). B-shares are denominated in foreign currency, USD or HKD. They were originally designed solely for foreign investors, but since March 2001, they also include domestic retail investors with access to foreign currency.²

In 2002, institutional investors made inroads into China’s markets. By 2011 they accounted for only two percent of the total stock market value, but their depth and impact on the Chinese markets was substantial, because of the composition of the participants in the program. Eighty percent of the 192 QFIIs approved since 2002 are long-term investors, including asset management companies, insurers and pension funds. Further, in April of 2012, the CSRC raised the investment ceiling for QFIIs to $80 billion from $30 billion, and in July China eased its investment controls on QFIIS allowing them to enter the interbank bond market. These moves will increase the importance of QFII investors in China. On the flip side, China also has begun to allow domestic institutional investors to invest abroad via the Qualified Domestic Investors (QDII) program, allowing them to diversify risk and reduce excess liquidity.

China’s equity markets also have witnessed innovations. For example, ChiNext in Shenzhen lists companies in high growth sectors, and there is now a futures stock exchange. Mini-QFII recently was introduced, which allows qualified Hong Kong subsidiaries of China’s securities and fund management companies to channel RMB deposits in Hong Kong into the mainland financial markets via investment products. With a high savings rate, and few investment options because of limited product offerings, when the government and regulators offer new financial products, the market in China responds quickly.

The Chinese markets have grown tremendously, and in June 2012, based on domestic equity market capitalization, both Shanghai and Shenzhen exchanges in mainland China were listed among the top 10 largest exchanges in the world with market capitalizations of 2,411 billion and 1,149 billion USD respectively.³ By the end of fiscal year 2012, the Shanghai exchange had 944 companies listed with A-shares and 54 with B-shares.

The latest development is the expected rollout of the Shanghai Stock Exchange’s International Board allowing foreign companies access to the Chinese markets and domestic investors to share in the returns achieved by international companies. While in theory this seems like a logical next step, market analysts in China have not been completely on board with the idea. Many argue that while the International Board may successfully put China on the global financial map, the ride may be very bumpy because of possible effects on the existing system. The recent global economic downturn has increased funding pressures in the A-shares market, and some market experts voice concerns about the proposed International Board creating pressure to sell existing shares to raise cash to buy stocks on the new exchange. Further, the financial crisis largely has halted the B-shares market, and analysts argue that the introduction of the International Board may result in redundancy with B-shares. Market experts also have pointed out potential problems in share price evaluation, erratic capital flow and supervisory issues that remain unresolved.

Before launching the International Board, China’s regulators need to spell out listing requirements, reporting regulations and disclosures. So far, information has gotten out through news reports. These indicate that the Board will require a company seeking a listing to have a market capitalization of more than 30 billion yuan ($5.5 billion) and a combined three-year net income of more than 3 billion yuan.⁴ In addition, proceeds of an initial public offering may only be used abroad.⁵ These are reasonable stipulations by international standards. However, there are concerns around financial disclosures including issues surrounding the use of Chinese accounting standards for non-Chinese companies trading in China, and the type of reconciliation approaches that may be required. Details, if any, are very nebulous on how Chinese regulators would enforce the International Financial Reporting Standards, or the role of auditing and disclosure requirements for non-Chinese firms who list on the International Board. Criteria for non-Chinese accounting firms to audit non-Chinese firms listing in mainland China need clarity, and so far there seems to be little documentation regarding this issue. Critics strongly urge postponing the launch of the Board until some or all the aforementioned issues have been addressed. Hence, while the Chinese government expressed the possibility launching the International Board to allow foreign firms and domestic private firms to list back in 2009, this has not yet materialized.

Benefits to Chinese firms

Research suggests that the fundamental reason for countries to have a stock market is to provide financing and liquidity for corporations.⁶ Because of the political environment within China that favors state-owned firms and investments, private firms in particular have an uphill battle finding financing for projects or expansion abroad. A large number of foreign firms and private domestic firms have expressed interest in the development of an equity market to be able to gain access to available liquidity. Additionally, since the 1980s, as part of the reform process, China has implemented a policy of zhengqi fenkai, which translates as “separating government functions from business operations.” In the process, China’s SOEs were increasingly privatized. However, this trend has exposed the weaknesses of many of these state-owned companies laden with legacy assets, including obsolete equipment and technology, and expensive social policies that include health care and worker pensions. The potential spillover effect of know-how from foreign firms that may list in the Chinese market is thus considered as a benefit to firms in China. Hence skepticism regarding the opening of the International Board may be only temporary.

While China disallowed non-state-owned companies from the stock markets if they listed elsewhere, it also increasingly made SOEs “public” by issuing shares while continuing to hold majority control. The IPO (initial public offering) process in China is largely mythical since it often is funded by loans from a state-controlled bank and not outside investors. For instance, the Agricultural Bank IPO in 2010 was largely funded by other SOEs. In addition, only a small number of Chinese companies that are not state-owned can trade in the Shanghai markets. The more practical issue is that this leaves no room for non-state companies to raise outside capital, and for listed firms to be correctly valued via trading. Opening the markets to foreign firms should help create liquidity, visibility, depth and better market pricing for firms. To truly reform the Chinese markets, however, the state must exit the equity markets.

As the line between state-owned and privately and/or publicly owned firms blurs, the challenges that confront them would not be dissimilar. Chinese multinationals have sought growth, requiring additional capital and visibility (branding) that the larger markets abroad more easily offer. Many of these multinational firms have listed abroad because the CSRC does not allow them to list on the Shanghai or Shenzhen exchanges once they incorporate outside of the PRC. As Chinese companies move from an export orientation to an outward FDI strategy, many companies find themselves ill-prepared to compete in the global markets. The lack of qualified manpower and adequate technology, and limited experience and knowledge of strategy and business processes, puts both private- and public-sector firms equally at a disadvantage in the global arena. Liquidity needs and expansion of products and markets are significant factors regardless of ownership type.

In order to gain ground in the global markets, these companies go abroad to seek talent, tap new markets, search for raw materials and acquire new technologies. China’s direct outward investment was only around $20 billion in 2006, but reached around $365 billion by 2011. In addition, while expanding geographically, concentrating largely on developing nations, resource-rich Australia and Canada, since the early 2000s investors have moved more toward Europe and North America.⁷ While expanding Chinese companies have had to learn to be apolitical and deal with regulatory policies with regards to governance, disclosures, financial reporting and intellectual property rights, thus forcing them to face a steep learning curve upon expansion.

Further, with capital controls still imposed by the State, large firms that list and trade abroad currently are unable to repatriate profits. If foreign firms are allowed to list in Shanghai, they will be able to more easily retain profits within China, which will create greater liquidity in the domestic markets. Thus, by trading both domestically and in foreign markets where they are listed, they could create more depth in the Shanghai market, and their fundamentals would more accurately reflect their true value. In addition, Cavoli, McIver and Nowland’s (2011) study of a sample of Asian markets suggests that higher trade openness, higher output growth and lower inflation may be associated with a greater proportion of foreign listings. They note that the extent of foreign listings on domestic stock exchanges (cross-listings) may serve as one measure of financial and economic integration among nations.

The Chinese investor would then have a potpourri of investment options, including both blue chips and red chips, thus integrating China into the global equity markets. If capital controls were relaxed concurrently with the launching of the International Board, Beijing could allow for cross-border transactions in yuan, thus letting its value be determined in the financial markets via trading. With increasing discussions in the country of making RMB an international currency, this would be an important step toward that goal.

More recently, some Chinese companies have been permitted to settle trade transactions in yuan via Hong Kong banks, and the yuan is being used more frequently in trade conducted between China and its trading partners. In a mere three years, the share of China’s international trade settled in yuan increased from zero to eight percent in 2011. Increasingly, yuan-denominated securities are available for investors, such as the “dim sum” bonds traded in Hong Kong. As China’s economic might continues to grow, the influence of its currency will inevitably increase with it. Consistent with this internationalization, and with plans to make Shanghai a global financial hub, the new Board will list shares by foreign companies denominated in yuan.⁸

Benefits to firms listing in China

Two reasons largely predominate with regard to why foreign firms list in China. One is to seek capital and the other is to diversify risk. With China’s high growth and savings rate, foreign firms can gain access to new sources of capital and expand their investor base to include those who previously had limited investment options. Reese and Weisbach (2002), Karolyi (2006), Hail and Luez (2009) and others have noted financial benefits for firms that cross-list including increased opportunities to raise capital, higher liquidity, greater visibility, and lowered costs of capital.

With growing consumer sophistication in China, there is a large untapped market for foreign firms to sell their goods and services. For well-positioned foreign firms, the opening of Chinese financial markets may create an investment boom, especially in this post-financial crisis period in the U.S. and Europe. Chinese buyers are likely to be a great market for diversifying products and services offered by these firms. In addition, if Chinese multinationals aim at growing via acquisitions of firms in the developed nations, foreign firms may be able to divest of assets/divisions more easily and it may be a win-win for both. In addition, firms in U.S. and Europe in post-crisis mode may welcome joint ventures and partnership alliances in China to diversify their risks as well as gain new revenues. As China is closely connected to the East Asian Tigers and Japan through fairly well-developed production networks (Prime, Subrahmanyam and Lin, 2012), access to those markets may be available via a listing in China, thus making it more attractive for the long run.

The scarcity of resources and human capital, caused by Chinese multinationals also vying for the same resources and workforce as the foreign multinationals, could be a hindrance. On the other hand, because employment opportunities are being limited in Europe and the U.S. for trained professionals in the post-crisis era, Chinese firms or foreign firms in China may offer employment opportunities, thus positively impacting global unemployment. Hence there are numerous positive outcomes that could result from establishing an International Board in China.

Many Chinese companies have been successful and today appear in the Fortune 500. However, restrictions are still imposed by Chinese regulations on domestic firms listing on the Shanghai exchange if they have listed abroad. As the Chinese government contemplates the introduction of the International Board, transparency of information, corporate governance, price discovery and economic development are all necessary for efficient functioning of a public stock market. These are areas in which the Chinese government needs to invest time and effort so China can compete internationally to attract domestic and foreign firms to list in China. This would also greatly benefit Chinese firms, as they would learn to respond to policy structures and changes domestically before expanding globally.

While it is not clear as to when the Chinese government will launch the International Board, for China to be a major player in the global markets, this is a necessary step. China’s financial markets have witnessed a major transformation in the past couple of decades, but the global financial crisis of 2008 seems to have dampened that process somewhat. Recent media reports indicate, however, that the government in China is focusing on the technical details with regard to listing, leadership of the Board, and related policies, and may have more definite plans concerning the opening of the Board possibly in the coming year. Reports indicate that more than 300 international companies have contacted the CSRC expressing interest in listing with the Board.⁹ For the country’s growth and development to continue, the Chinese government should launch the International Board allowing foreign firms and all private domestic firms to list in the Shanghai markets. The focus going forward should be on creating and sustaining an efficient, diversified, liquid and stable financial market.

References

Cavoli, T, R, McIver and J. Nowland, “Cross-listings and Financial Integration in Asia,” ASEAN Economic Bulletin, Vol 28 (2), 2011, pp 241-56.
Hail, L. and C. Leuz, “Cost of capital effects and changes in growth expectations around U.S. cross-listings.” Journal of Financial Economics, 93, 2009, pp 428-54.
Karolyi, G.A., “The world of cross-listings and cross-listings of the world: challenging conventional wisdom,” Review of Finance, 10, 2006, pp 99-152.
Prime, P. B., V. Subrahmanyam and C.M. Lin, “Competitiveness in India and China: the FDI Puzzle,” Asia Pacific Business Review, Vol 18, No. 3, July 2012, pp. 303-333.
Reese, W. and M. Weisbach, “Protection of minority shareholder interests, cross-listings in the United States and subsequent equity offerings,” Journal of Financial Economics, 66, 2002, pp. 65-104.

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Introduction

China’s vast rural areas and lesser known cities have become a focus of attention both for China’s banking industry and foreign banks. A major signal of this trend came in 2010, when AgBank of China, one of the country’s major banks, made an IPO that became known as the manna from heaven for the nation’s western, rural regions. The bank is now aiming at narrowing the gap with the affluent coastal areas.¹, ² Foreign banks, such as Canada’s Bank of Nova Scotia and Spain’s two largest banks, BBVA and Banco Santander, are increasingly investing in smaller Chinese banks in the hope of profiting from rapid growth in the financial sector³. Banco Santander, in fact, agreed to take a 19.9 percent stake in a joint venture with China Construction Bank Corp. to provide banking services outside China’s major cities, according to The Wall Street Journal. Much of the interest by Chinese and foreign banks is focused on China’s City Commercial Banks (CCBs) and Rural Commercial Banks (RCBs), which largely serve small and medium-sized businesses sprouting up across China.

There are other indications that CCBs and RCBs could become the focus of a new wave of expansion in the Chinese financial sector. In December 2010, Chongqing Rural Commercial Bank, one of China’s largest lenders to farmers and small businesses, raised US$1.48 billion in an IPO in Hong Kong in what is expected to be the first in a wave of listings by smaller rural-focused Chinese banks⁴. In addition, four Chinese RCBs in east China’s Jiangsu Province have won approval from the country’s banking regulator for their IPO plans. China’s Banking Regulatory Commission (CBRC) said it encouraged and supported qualified rural financial institutions to pursue listings. ⁵

A focus on rural areas and smaller cities could help ease the yawning and growing gap between China’s largest cities and the countryside. Despite China’s rapid urbanization, particularly in coastal provinces, the majority of China’s total population still lives in rural areas ⁶. China’s rural-urban wealth gap has been an issue of concern, with the average annual income for a rural worker around RMB 5,150 ($750) while those in the cities earned RMB 17,180 ($2,510) on average in 2009 ⁷. A recent study showed that the current banking system meets only about 60 percent of rural household financial needs, and about half of rural agricultural needs.⁸

This research focuses on assessing CCBs and RCBs as vehicles for easing gaps in China’s economic development and as a sector of interest by foreign investors. The essay will include an explanation of the services they provide to growing and yet underserved small and medium-sized firms found in smaller cities and rural regions and an analysis of how and why foreign banks are looking to invest in these lesser known Chinese banks.⁹ The first task is a brief history of CCBs and RCBs.

Background

In 1995 the first of the CCBs came into existence with the key aim of boosting local economic development and small and medium enterprises (SMEs). China’s CCBs are joint-stock commercial banks established by local governments, enterprises and residents. These banks sprouted from shareholding reform and former urban credit cooperatives. They are allowed to open branches only within their home cities. Few of the CCBs have any private investment capital and have largely been used to finance local government projects. They are thus influenced by local governments, which are perhaps more bureaucratic and less developed than the central government. CBRC reports indicate that these banks are largely present to grant loans to SMEs that operate within city boundaries.

Several RCBs have been created since 2001 in order to improve financial services in the countryside. The four RCBs of Zhangjiagang, Wujiang, Changshu and Jiangyin have received approval for an IPO and, along with Chongqing RCB’s IPO in Hong Kong, they have placed RCBs in the forefront of China’s banking industry. Since the CBRC revised regulations covering rural banking in 2006, allowing foreign banks to operate alone or with partners, HSBC, Standard Chartered and City have all established their presence in China’s interior.¹⁰
In a move to further close urban-rural income gap, the Banking Commission and the Chinese government are planning to increase the number of RCBs more than tenfold to 1,027 by the end of 2011. This development will be particularly focused on central and western China, where most people are farmers with little access to financial and loan services.¹¹

The CBRC actively encourages foreign banks to engage in business with small and medium-scale enterprises, but most foreign banks believe these endeavors are relatively risky, and their financial information is not transparent. In addition, foreign banks lack the networks required to reach them. Thus an alternate route has been to invest in or create alliances with CCBs. Under similar encouragement from the CBRC, foreign banks are also increasingly involved with rural banking via RCBs. This helps them establish links across the nation in a more tangible fashion and meet the needs for banking services in the rural areas.

Research increasingly notes that it is beneficial for foreign lenders to team up with a CCB or RCB.¹² CCBs and RCBs benefit both directly from capital investments as well as from knowledge transfer gained from experienced management and financial innovations in products and services obtained from foreign partners. CCBs and RCBs also benefit indirectly by being able to offer superior products and services that make them more competitive in the domestic market. In turn, these alliances with Chinese banks could potentially result in further endeavors for foreign banks. They not only are an easier route for foreign banks, but they also help the banks grow organically with local incorporation. Recently, Australia and New Zealand Banking Group Ltd. (ANZ), one of Australia’s top lenders, announced plans to invest in China via expansion of its branch network and seeking local incorporation.3 At present the bank owns a 19.9 percent stake in Shanghai RCB and a 20 percent stake in Bank of Tianjin, a CCB. Other banks in Australia also similarly hold stakes in CCBs. This is expected to lead to a rush of second-tier regional banks from the West investing in China with the intent of expanding into less urbanized areas.

City Commercial Banks

Recent research has been mixed on the performance of CCBs. A 2007 KPMG study noted that China’s banking sector assets grew at a compound annual growth rate of about 13 percent since FY 2000 reaching a massive $3.8 trillion; CCBs account for five percent of that total.¹³, ¹⁴ The study also shows that their performance has been less than stellar with poor capital adequacy, high non-performing loans (NPLs) and limited market penetration. Consequently, these banks have had regulatory mandates to reduce their NPLs to 15 percent by 2005 and maintain an eight percent capital adequacy ratio (CBRC, 2006 Annual report). In their defense, more recently, Giovanni Ferri (2009) finds that while CCBs have low market share, they boast of high growth and better performance than the State Owned Commercial banks (SOCBs). In addition, he points out that while their performance was a mixed bag, they had a 13.2 percent growth in assets in 2005, and their ROEs and ROAs were still higher than those seen in SOCBs. Ferri’s paper, although recent, was based only on a small sample of CCBs for which data was available in Bankscope.¹⁵

By 2005, there were 113 CCBs. That number rose to 140 by FY 2009. By the end of 2005, the average capital adequacy ratio of China’s CCBs was 5.14 percent, and the number of CCBs with the capital adequacy ratio up to eight percent rose to 36 from 18 in early 2005. CCB NPLs totaled RMB 84.2 billion in 2005, decreasing by RMB 21.7 billion in 2004, and loan quality improved; only 7.7 percent were non-performing in 2005, four percentage points less than the previous year and down from 30 percent five years previously. (CBRC Reports, 2006). ¹⁶

From 2006 to 2009, according to official Chinese statistics, CCB assets almost doubled.¹⁷ During this time both the average growth in assets as well as the share of CCB assets in proportion to all banking institutions rose each year (see Table 1). This perhaps reflects the growth of Chinese SMEs creating an increased need for CCBs.

Table 1: City Commercial Banks’ Quarter-end Balance, RMB 100 million, %

Fourteen of these 140 banks had assets that exceeded RMB 100 billion, more than 50 percent (70 banks) had assets of RMB 10 billion-100 billion and more than 50 banks held less than RMB 10 billion (CBRC report, 2009-10). The NPLs in China’s banks had been in decline by 2005 and continued a downward trend from 2006 to 2009. The average outstanding balance on loans of RMB 75.8 billion had gone down to almost half of that, or RMB 46.2 billion, by FY 2009. Also, in contrast to the aforementioned KPMG (2007) study, the proportion of NPLs as a share of total loans declined in all commercial banks, and in CCBs, NPLs went from 6.29 percent of total loans in 2006 to only 1.76 percent in 2009, steadily declining each year (see Table 2).

Table 2: Commercial Banks’ Non-Performing Loans (NPL) as of end-year, 2006-09

Source: China Banking Regulatory Commission Report.

What has caused CCBs’ improved performance in the latter years, and is that performance sustainable? CCBs’ major advantage lies in that they are local, with capital and ownership derived from the communities they serve. They are expected to become prominent players in the future of China’s banking landscape since private enterprises in China—mostly SMEs—produce some 52 percent of GDP but account for only 27 percent of outstanding loans.¹⁸ Ferri (2009) finds that the performance of CCBs is significantly and positively related to the level of economic prosperity in the provinces where they are located. They have recently thus attracted foreign banks that are seeking strategic investment opportunities in China. The improved performance (decline in NPLs) may be a result of increased competition perhaps resulting in more efficient performance.

In a recent Pricewaterhouse Coopers (PWC) survey, foreign banks note that despite an increasing threat from domestic banks, China’s market appears extremely strategic with the expectation of aggressive development. As they expand into China’s large market base of lenders and focus on the SMEs, will they be able to sustain their growth?

Rural Commercial Banks

RCBs regard SMEs as their key clients to provide them with business operations aimed at serving the agriculture sector and other rural industries. Historically, bank lending to rural areas has not performed on par with lending to urban areas. In order to encourage banking to rural areas, the CBRC and central government have considered new incentives such as tax cuts, lowered capital requirement for rural banks, and subsidy programs that include infrastructure development, some of which have already been initiated. ¹⁹, ²⁰ This effort has not gone to waste. Table 2 shows a dramatic jump in average outstanding loans for RCBs in 2009 and a definite reduction in NPLs over time showing movement in the right direction. The recent Agbank IPO and Zhangjiagang RCB IPO approval of December 2007 may improve the outlook for RCBs. ²¹

In December 2010 Chongqing RCB, the largest bank in the municipality, was the first Chinese mainland-based rural bank to list on the Hong Kong Stock Exchange.²² Upon its debut it did not perform to par, and its shares later fizzled in trading, reflecting skepticism among Chinese investors. However, it marked an important point in Chinese banking since it is expected to be the beginning of an era of similar listings by RCBs and CCBs in Shanghai and Hong Kong as these banks look to the markets to bolster their balance sheets and raise capital for expansion.²³ It is also a test to gauge foreign-investor interest in the growth of China’s hinterlands. RCBs may be seen as a means to provide capital to rural areas, and foreign banks may find RCBs an easier way to penetrate rural markets, which still require extensive networks. Evidence of such is noted with banks such as ANZ Bank, which not only opened a rural branch near Chongqing last year but also has a 20 percent stake in the Shanghai RCB as well as in Banco Santander SA’s joint venture with China Construction Bank Corp. in rural banking. The future may lie there if a viable operating model can be developed to control risk and manage non-performing loans by perhaps requiring adequate capital.

Unfinished Agendas

In China, alongside a huge untapped market for financial services, many challenges still face both the CCBs and the RCBs. Banks operating in the inner provinces and in the rural banking market are faced with a lack of experience, lack of talent and the high costs of building infrastructure and networks. With the newer economic policies, foreign banks are increasingly attracted to CCBs and RCBs as a strategic option to penetrate the Chinese banking market thus diversifying their portfolios while simultaneously limiting their investment and hence risk.²⁴ So far, foreign banks in China have displayed lower NPLs as a share of total loans than local commercial banks. Non-performing loans have gone from 0.87 percent of total loans in 2006 to 0.74 percent in 2009. Thus CCBs and RCBs are increasingly looking to foreign banks as a boon rather than a bane since this may be their opportunity to expand by obtaining more access to capital while simultaneously learning about new products and adapting new strategies without having to reinvent the wheel. In December 2007, HSBC became the first foreign bank to set up a rural bank in China and now has seven rural branches; the largest network among the overseas banks. Richard Yorke, HSBC’s former China CEO, recently commented: “The rural banking sector is under banked, so we are seeing strong demand for the right product and for the right services. There is strong untapped demand in that market.”;²⁵ Katherine Tsang, China CEO of rival Standard Chartered, has also said that her bank’s first rural branch in Inner Mongolia has been running better than expected. “Rural banking is a long-term commitment and we are not in a rush to make quick money. We will set up more rural banks, if the first one proves to be a role model.”²⁶

Alongside typical transactional issues, Chinese banking is rampant with issues such as lack of transparency, government interference, non-productive assets, NPLs and lack of technical know-how among others. As one ponders the future of Chinese banking, many of these issues need to be addressed both for the CCBs and RCBs that intend to expand, and foreign banks that plan to expand into China via mergers with these institutions. Strong support from the Chinese government and more incentive policies to support RCBs and CCBs are needed and may help with their long term sustainability and the future of Chinese banking.

References

Ferri, Giovanni, “Are New Tigers supplanting Old Mammoths in China’s banking system? Evidence from a sample of city commercial banks,” Journal of Banking and Finance, 33, 2009, 131-140.

Gale, Fred, “Financial Reforms Push Capital to the Countryside,” The Chinese Economy, 42 (5), Sep-Oct 2009, 58-78.

Brough, Paul, “China’s City commercial banks: Opportunity Knocks?,” KPMG, 2007.

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