THE RURAL-URBAN DIVIDE

THE CHINESE FINANCIAL SYSTEM, SPRING 2014

PV VISWANATH

LUBIN SCHOOL OF BUSINESS

P.V. Viswanath

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LEARNING OBJECTIVES

• What are the social and political bases for differences in urban and rural entitlements?• What is the history of land rights from 1949 to present times in urban and rural areas?• Why are property rights tenuous all over China and even more so in rural China?• Why did TVEs succeed in the beginning? And why did they decline in the late 1990s

and after?• Describe the historical development of the rural banking sector.• Describe how the ABC’s focus on rural finance decreased over time.• What have the relative roles of the ABC and the ABD been in rural finance?• What are the different reasons given for the decline in lending in rural areas and to

TVEs in particular?• What is the role of property rights in the withholding of formal bank finance from

rural areas?

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RURAL URBAN DIVIDE

• The roots of the rural urban divide go back to the socialist period when virtually every business and productive enterprise was converted to public ownership and became subject to direct or indirect government control.

• Urban residents were organized by their place of employment, i.e. By their work unit or danwei ( 单位 ).

• Almost all urban work units were converted to state ownership, with two consequences.• One, urban danwei were knit into a formal hierarchy subject to direct

government control.• Two, the work units built up a system of social benefits and entitlements, which

was extended more or less uniformly to all urban workers.

• Urban residents became a relatively privileged group in Chinese society, and the work unit became the basic building block of urban society.

Barry Naughton, Chapter 5: The Rural-Urban Divide

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LAND OWNERSHIP

• Private property in land was eliminated in 1955 and the land in every village was pooled together and became the property of the village as a whole, of the collective. Collective ownership became the predominant form of ownership.

• Village residents automatically became members of the new agricultural collectives , and access to land was equalized within the collective.

• However, there was no mechanism to redistribute resources across collectives, and there were no standards of entitlements that applied to all rural residents.

• Collectives were encouraged to support social services out of their own local resources, but they had no claim on national resources.

• The agricultural collective could provide social-services and public-goods only if there was a surplus from the sale of agricultural produce.

• Rural residents were poorer than urban residents, and they had a cheaper and less comprehensive set of social institutions to serve them, as well.

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RURAL URBAN DIVIDE

• Why was there such a difference between rural residents and urban residents?

• Why did rural residents have no claim to social entitlements, while urban residents were favored with a system of social benefits and entitlements?

• One answer probably has to do with the fact that rural residents were primarily agricultural laborers, while urban residents were primarily factory or workshop workers.

• The nature of agricultural work is that there is a lot less labor specialization than in industrial work and thus it is easier to identify a worker with a particular unit of output.

• This means that whereas the urban dan wei is a natural unit, the agricultural collective is less so. This greater cohesiveness of the urban dan wei probably also meant that urban workers were able to work as a group to claim rights and entitlements, which were more difficulty for the more loosely structured agricultural collective to do.

• In addition, there was also a political basis for the urban-rural divide as we will see.

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THE POLITICAL BASIS OF THE DIVIDE

• The socialist plan involved the use of the rural and urban systems to carry out industrialization.• The rural system was used to extract low-cost food and fibers from the framers; the collectives

were supposed to manage agricultural labor and deliver grain to the government.• In the urban areas, the work units received government investment, and urban workers were

considered to be the vanguard of socialism, since they were involved in industrialization. Hence they received preferential treatment.

• The government used its control to purchase low-cost farm products, which allowed wages to be kept low and state-owned factories profitable.

• The whole dualistic system worked as an implicit tax on farmers, who had lower incomes because they were compelled to sell grain to the government at artificially low prices.

• Farming, thus, became an even lower-return occupation. Hence to keep the system going, farmers had to be kept tied to the land.

• This became a big problem towards the end of the Great Leap Forward when the economy was in shambles. The government kept extracting food from rural areas to feed urban residents and it became a big privilege to be a city resident.

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URBAN PROPERTY RIGHTS• All urban land was nationalized during the 1950s. However, especially after China embraced

the development of small-scale enterprises, the national government could not exercise effective oversight of all its assets.

• The authority to managed state firms was thus delegated to local governments, though nominal ownership remained with the national government.

• While urban land is owned by the state, a system has evolved in which rights to use land for up to 50 years are bought and sold. A market for transferable urban leaseholds emerged during the 1990s, and under this system, the use rights of existing occupants are usually recognized, and with the permission of the local government, these rights can be legally bought and sold.

• Land transactions are taxed, but most of the value is captured by the occupying enterprise, the local government, or private parties.

• The nominal, centralized ownership of urban land by the state allowed the recognition of use rights and of their sale and purchase by the state or by its delegated agents (local governments), who had the right/ability to change the rules.

• The larger size of urban population clusters (towns and cities) probably also meant that they were able to claim more resources from the center. Of course, the national government itself was located in a city, i.e. Beijing, which made it easier for all cities to claim more privileges than villages.

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RURAL PROPERTY RIGHTS

• Rural land was owned by collectives. Ownership rights in the countryside were never as centralized – as concentrated in the hands of bureaucrats – as was the case with urban state ownership. Rural households retained their houses and the land the houses were on, and had access to the agricultural land through the village collective.

• During the rural reforms of 1978-1984, collective farming ended in almost all of China, and family farms returned as the dominant agricultural form. Each collective divided up the land among its individual household members. But although land is worked by individual households, the formal ownership still remains with the collective. There is no formal system of private property of rural land.

• Farmers sign contracts with the collective giving them land-use rights for periods of up to 50 years, but they do not own the land free-and-clear. As a result:• Land can be periodically redistributed making ownership temporary. The lack of secure land

tenure affects farmer incentives, and land cannot be used as collateral for borrowing. Land use-right markets have been slow to develop.

• Out-migration can mean giving up rights to the land, which discourages migration to the cities and underemployment in rural areas.

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TOWN AND VILLAGE ENTERPRISES

• In rural areas, property rights are complex and locally negotiated. There is no national registry where property rights are inscribed. Instead, each individual village holds records of the land-use rights that have been distributed by village action. Over time, rural land has became more valuable and industrial and commercial used of rural land have exploded.

• But rural land is officially “collective” property and use rights were given to families for agricultural purposes. As a result, when there is an opportunity to convert land to industrial or commercial use, or lease land to an outsider, local officials take those business decisions, arrange compensation or relocation for displaced farmers and, in the process, enrich themselves.

• During the 1970s, rural nonagricultural collective enterprises developed. After 1982, these became the TVEs. Ultimate ownership stayed with the collective, while use rights were delegated, often to highly entrepreneurial firm managers. Nevertheless, TVE property rights remained fuzzy.

• In spite of this, TVEs prospered through the 1980s for several reasons: a) rural wages were lower; b) TVEs took advantage of state monopolies; c) local governments, which controlled TVEs supported them; d) formal taxes on rural enterprises were low, compared to high expropriation of SOE profits by the state; e) local governments controlled RCC and bank capital and they favored the TVEs; f) rural deposits were kept locally and re-lent to TVEs and other rural businesses.

• This meant that rural incomes did grow, in spite of their lower status compared to urban areas, although this situation would change drastically after the banking reform of 1993-1995.

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PROBLEMS OF RURAL FINANCE

• With this background, we can better appreciate the problems of rural finance. • TVEs have languished. Whereas in 1979-1988, rural net income grew at 12% p.a., compared

to a 6% growth in urban disposable income, in 1992-2002, the numbers were 5% and 7% respectively, and in 2003-2006, still lopsided at 5.5% p.a. for rural income and 9.25% for urban income. (Source, Yasheng Huang, Capitalism with Chinese Characteristics.)

• The area of cultivated land has decreased by close to 10% in the last ten years, corresponding to rapid urbanization.

• The current Chinese premier, Xi Jinping, has put a special emphasis on continued urbanization. This implies that China’s self-reliance in agricultural products will face a lot of problems.

• Nearly 200 million people from rural areas have left their homes for cities, in order to find jobs. But because of hukou ( 户口 ) rules (laws controlling urban residential rights), they are not able to become urban residents.

• Rural residents do not have proper access to banking services.

• How will the financial system deal with this planned urbanization and, at the same time, fulfill the financial services needs of China’s rural sector?

Chen Xiwen, “Agricultural Financing in China: the Difficult Transition from a Planned to a Market System”

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HISTORICAL DEVELOPMENT

• Before reform was the mono-bank period. The PBOC and the rural credit cooperatives (RCCs) were the only financial institutions in the entire country. The RCCs, under the supervision of the PBOC were responsible for taking in deposits from rural residents.

• RCCs also provided production loans to collectives and to farming households. They also issued small amounts of daily-living loans to farming households.

• The RCCs and the PBOC itself were under the control of the Ministry of Finance. They served fiscal and budgetary functions and operated as deposit-taking institutions.

• Since the financial sector worked on a command basis, the need for banking services was not great.

• Hence in the beginning, RCCs provided a satisfactory level of financial services.

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THE POST-REFORM PERIOD

• In 1979, the Agricultural Bank of China (ABC) was re-established (it had existed prior to 1949, but had been effectively subsumed under the PBOC in the pre-reform era. It was in charge of the financial needs of the rural areas, just as the ICBC (industry and commerce), the BOC (foreign exchange business) and the CCB (construction and fiscal functions) were in charge of their separate functional areas.

• In 1979, the RCCs were put under the oversight of the ABC. • At this point, banks began to play the role of financial intermediaries, as opposed to

simply being departments of the Ministry of Finance, playing a planning role. Still, relatively stringent financial controls remained in place.

• After the mid-1990s, with the transition to a full-fledged commercial banking system (after the promulgation of the 1995 Law on Commercial Banks of the People’s Republic of China”), banks began to operate with the full scope of financial intermediaries. At the same time, banking laws and a banking regulatory system were considerably improved and strengthened.

• Rural areas now discovered that that funding sources were greatly diminished.

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RURAL FINANCE: THE EARLY POST-REFORM PERIOD

• From 1970 to 1985, rural areas received large loans. • The ratio of agricultural loans to agricultural production actually increased from 14.5%

in 1970 to about 22% in 1995. This, at a time, when the production value of farming, animal husbandry, timber and fishing rose 28 times!

• Including loans made to TVEs (Town and Village Enterprises), rural loans went from 9.9% of total loans to 20% in 1995.

• From 1980 to 1993, deposits at the ABC and credit cooperatives increase at an average annual rate of 25.7%. Total loans increased at an average annual rate of 24.1%.

• The total production value of agricultural cooperatives increased at a rate of 22.1% p.a.• In other words, rural credit services responded to the growing needs of the rural

economy.• Farmers’ incomes doubled from 1978 to 1985, grew 72.6% from 1985 to 1990 and

increased 129.9% from 1990 to 1995.

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RURAL FINANCE AFTER BANKING REFORM

• The third period was the commercial banking system period. Policy banks have been separated from the commercial banks. The new policy banks were the Export-Import of China Bank (Eximbank), the China Development Bank (CDB) and the Agricultural Development Bank (ADB). At this point, the ABC became a State-owned commercial bank, like the CCB, ICBC and the BOC.

• The ADB was to handle rural financing and to assume policy responsibilities formerly held by the ABC. This included policy-related loans for assuring adequate inventories of grain, cotton, and food oils, loans for purchasing agricultural by-products, and loans for farming expenditures. The bank served as fiscal agent in support of agriculture, both in making payments and in providing oversight.

• The total assets of the ADB at year-end 2011 were 1.95Tr 元 . However, the total assets of the ABC were 11Tr 元 . The total assets of the County Area Banking Business at the end of 2011 were 4.4Tr 元 , or about 40% of the total assets of the bank. But about 2.4Tr 元 of the total (i.e. 55%) were actually lent by the County Area division to other areas of the bank. This means that the ACB only had 1.75Tr 元 out in loans, i.e. an amount even smaller than that of the ADB, which is one-tenth of its size. In contrast, in the mid-1980s, about 98% of ABC loans were made to rural areas.

• Correspondingly, the ability of rural enterprises to attract loans dropped. In 1986, bank loans represented 28.3% of non-farm operating income; however, in 1999, this ratio dropped to 20%.

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ABC VERSUS ABD

• The ABC is an agricultural bank, only in name. • The Bank’s website says:

• Being one of the major integrated financial service providers in China, the Bank is committed to catering to the needs of Sannong ( 三农 , i.e. three rural issues, agricultural, rural areas and farmers) and capitalizing on the synergy between the Urban Areas and the County Areas. The Bank strives to expand into the international market and provides diversified services so as to become a first class modern commercial bank. Capitalizing on the comprehensive business portfolio, extensive distribution network and advanced IT platform, the Bank provides various corporate and retail banking products and services for a broad range of customers and carries out treasury operations for our own accounts or on behalf of customers. Our business scope includes, among others, investment banking, fund management, financial leasing and life insurance.

• This statement provides lip service to the rural areas, but the emphasis is elsewhere. For example, the ABC has a branch office at 277 Park Avenue, New York, a location that is noted for its lack of Chinese farmers.

• Nevertheless, in 2009, the CBRC encouraged the ABC to take further steps toward setting up its rural-based Strategic Business Unit and improving its banking services to the rural economy at the county level; however, as we saw, as of 2011, the ABC was only minimally involved in rural finance.

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ABC VERSUS ABD• The first seven items under the heading Business Scope of the ADB are:

• Providing loan services for the purchase, reserve and distribution of grains, cotton and edible oils; • Providing loan services for the special reserve of meat, sugar, tobacco, wool and chemical fertilizer; • Providing loan services to leading industrial enterprises in agriculture, forestry, animal husbandry, side-

line products and fishery sectors, as well as in grain, cotton and edible oil processing; • Providing loan services for the purchase of grain, cotton and oil plant seeds; • Providing loan services for the upgrade of grain storage facilities and the technical innovation of cotton

enterprises; • Providing loan services in support of small agricultural enterprises, and agricultural science and

technology projects; • Providing loan services in support of the construction of rural infrastructure projects, including roads,

power grids, water supply systems (including drinking water projects), and information networks (postal service and telecommunications), as well as energy and environmental facilities in rural areas;

• Clearly, the ADB has replaced the ABC as China’s rural bank, but it is much smaller and does not have the resources necessary to finance agricultural development. Most of its resources are raised through bonds and not through deposits; in 2011, deposits were only 0.36Tr 元 , while 1.5Tr 元 were raised from bonds and PBOC borrowings. The ABC’s rural division, in contrast, had 4.4Tr 元 in deposits. Hence it would seem that there is a net draining of resources from rural areas to urban areas.

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DECLINE IN RURAL BANKING

• Once the banking system was restructured and modernized, and as part of it, the ABC was converted into a commercial bank and the ADB set up as the agricultural development bank in its place, other changes followed.

• Collateral and guarantees were required for obtaining a loan. State owned commercial banks could extend banking credit only on the basis of clearly defined assets.

• After the Asian Financial Crisis in 1997, the authorities moved to a zero-tolerance stance on nonperforming assets – at least to private individuals. The result was a several contraction in rural financing.

• Agricultural production fell from 20% of GDP in 1996 to 11% of GDP in 2006.• The ratio of agricultural loans to all loans dropped to 5% between 1998 and 2006, half of

what it had been previously. • From 1995 to 2003, TVE production was around 45% of GDP, yet the percentage of TVE

loans to total loans dropped from 8% to 4% in 2004. • The entire rural financial system was diminished – there was a decrease in the number of

financial entities, a decrease in credit loans, net outflow of funds, and management jurisdiction withdrawn from local areas to higher authorities.

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IRREGULAR BORROWING

• As a result of the withdrawal of credit by the formal banking sector, farmers were forced to turn to private lenders. From 2000 to 2003, farmers had to borrow 3 元 from private sources for every 元 borrowed from a bank. These numbers are from surveys done by the State Statistical Bureau’s Research Team on farming households.

• The Ministry of Agriculture did a similar analysis and found that the proportion of loans from official sources had dropped from 47.76% in 1986 to 15.52% in 2000.

• The reason given by some researchers for this is that the return on capital in rural areas has dropped and hence the contraction of credit is rational.

• Other scholars feel that the gap in credit between urban and rural environments is too great, and is due to inadequate financial information at the farming village and household level. The resultant information asymmetry leads banks to feel that micro-loan customers have excessive costs and excessive risks. Once again, the reduction in rural credit is rational.

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WHY WAS THERE A DECLINE?

• World Bank, studies, however, show that the marginal profit on investments in Chinese agriculture increased 16 times between 1978 and 2001; and increased 15 times in towns and villages.

• The marginal profit on capital invested in TVEs was consistently higher than that on urban investments since the mid-1980s , and by 2001, this indicator for TVEs was five times what it was for urban industry.

• Hence the contraction of financing in rural areas was not caused by a lower return on investment.

• Rather the reason was that the commercial banking system was modernized very rapidly and commercial banks did not take into account the antiquated asset-ownership system in rural areas.

• While private property rights are the basis for loans in modern banking, such a system still does not exist in rural areas of China, as we have already seen.

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PROPERTY RIGHTS IN RURAL CHINA

• One, whereas urban land belongs to the state in China, agricultural or rural land belongs to the collective. Agriculturally used land, farmer’s homes, and the land on which they are built cannot be bought and sold and cannot be used as collateral.

• Furthermore, many government entities have to be dealt with, before property can be registered as collateral. Registration expenses are high, the waiting time is long and regulations about asset registration change constantly – all of which make it difficult for an entrepreneur to seize quickly vanishing business opportunities.

• These circumstances were not taken into account by the banking authorities in making rural loans.

• Two, credit evaluation standards are set at the main headquarters of a bank in Beijing and are applied consistently across the country. Often, these standards are inappropriate for rural applicants.

• Three, county-level branches of SOBs do not have the power to issue loans.

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STEPS TO IMPROVE RURAL FINANCE• In 1999, RCCs began to implement microcredit loans that did not require collateral and they have

achieved an over-98% loan-repayment ratio for this special plan. • However, overall, RCC NPLs were high, and this is partly why in 1977, the government transferred

oversight responsibility of the RCCs from the ABC to the PBOC. In 2003, the State Council transferred management of the RCCs to provincial-level governments, and assigned supervisory oversight of the RCCs to the CBRC. As part of this process, the RCCs got a lot fo additional capital from the PBOC, helping to reduce their NPL ratio from 37% in 2002 to 9.3% in 2007. In 2004, the RCCs made an aggregate profit for the first time in ten years.

• The China Development Bank (CDB) has been innovative in providing financial resources for the extension of loans without collateral, instead accepting local government credit as backing for loans. This program has been successful and the NPL rate in 2006 was only 0.73% in this program.

• The CDB’s website notes the following:• In 2012, the Bank supported the development of China's real economy and strived to provide solutions for

financing difficulties faced by small and micro-enterprises… The Bank also created innovative lending products, such as the microloan syndication in Sichuan, loans for youth entrepreneurs in Henan, and micro-poverty alleviation loan in Guizhou. Incremental loans to the SME-financing sector amounted to RMB 264.5 billion in 2012, a 16.13% increase from prior year. The Bank's lending efforts benefited close to 20 industries, including manufacturing and farming (of crops, forest, livestock and fisheries), and 1.87 million small to medium-sized enterprises and self-employed vendors; and helped to create 4.87 million jobs.

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STEPS TO IMPROVE RURAL FINANCE

• In 2007, the Postal Savings Bank was officially established as a bank (separate from the postal service) and began experimental services in rural areas.

• China’s early postal savings system accepted deposits, but did not offer credit services, which resulted in an outflow of funds from rural areas. Since 2007, PSBC has initiated several pilot programs to offer rural residents more banking services. For example, it launched trial operations of small loan products in seven provinces starting in mid-2007.

• Small loan products include loans to rural micro enterprises, farmer credit loans, and loans mutually guaranteed by groups of farmer households. In 2008, PSBC took steps to strengthen its corporate governance structure, set up an independent financial accounting system, and operate in line with commercial bank requirements. It also expanded its micro finance services in 2008, issuing over RMB60 billion (US$8.8 billion) in small deposit-pledged loans and micro loans, more than 70% of which was used in rural areas.

Source: Country Analysis Unit, Federal Reserve Bank of San Francisco, May 2010

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STEPS TO IMPROVE RURAL FINANCE

• In December 2006, the CBRC made it easier to set up Town and Village banks and loan companies and permitted farmers to organize Farmer’s Mutual fund supporting organizations. However, entry barriers were still high and there were many restrictions – for example, 20% of all shares of a new rural bank had to be owned by a commercial bank and loan companies could only be set up by a commercial bank. Individuals could be shareholders in rural banks, but could not start them.

• However, new regulations promulgated by the CBRC in October 2013 allow individuals to start rural banks.

• Individuals will also be able to set up rural credit cooperatives, county-level banks or small lending associations.

• The CBRC has also tried to interest foreign banks in setting up rural banks. As of end-2008, foreign bank entities, including HSBC Bank (China) Co. Ltd., Citibank (China) Co. Ltd. and Standard Chartered Bank (China) Ltd., had established seven new-type rural financial institutions in China.

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CBRC PRIORITIES FOR RURAL FINANCE

• In a May 2007 interview to Caijing magazine, CBRC Chairman Liu Mingkang highlighted six aspects of systematic reform:• Reform the loan application process: tailor the process to meet rural conditions.• Differentiate between small-scale loans to farmers and loans to large companies:

develop separate assessment and performances measurement schemes to incentive bankers to make loans to farmers.

• Enhance information sharing among different financial institutions: track borrowers in default and develop a comprehensive nationwide credit rating system.

• Train more people to work in rural lending: provide specialized training on the management of rural credit risks.

• Set up professional performance measurements and award/penalty mechanisms: align compensation and promotion for rural lenders with performance.

• Use interest rates as a tool in pricing risks: liberalize interest rate policies, especially with respect to rural lending. This, in particular, will allow banks to charge more for taking on more risk, and it would give incentives to banks to make rural loans.

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CHANGING RURAL LAND RIGHTS• There are also moves afoot to allow trade in land-use rights in rural areas, which should

improve the ability of rural residents to obtain loans.• For example, according to an online article in Finance and Commerce on Nov. 18, 2013,

in Anhui province, “farmers would be given more flexibility in how their allotted plots are used and more opportunities to profit from China’s booming real estate market.”

• Following a key meeting to set economic policy for the coming decade, Communist Party leaders in November 2013 pledged to give rural residents greater property rights and to close the gap in opportunities between rural and urban residents. Their statements gave no details on how it would be done. However, policy changes in China often come as a result of small-scale experiments carried out by local officials acting on signals from national leaders.

• Any reforms are sure to meet resistance, especially from local governments that have done well from the requisitioning of land. But the Anhui government is taking an initial step: It plans to survey its land to identify the current holder of rights over every plot by the end of 2015.

http://finance-commerce.com/2013/11/china-to-test-farmers-right-to-transfer-plots/#ixzz2t9EluGtI

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THEMES

• Social and political explanations for the primacy of urban areas over rural areas.

• The role of property rights in the flow of finance.• The connection between (the lack of ) property rights and (the lack of)

proper incentives for bank officials, as well as for rural residents and village/town government officials.

• The role of weak property rights in the exploitation of rural residents by local politicians and the improper urbanization of arable agricultural land.

• Steps from above to improve rural finance and local initiatives to improve rural property rights.