Financial firms need to go global

It goes without saying: Globalization of the Chinese financial industry is key to the globalization of China's enterprises. If China doesn't have a sound financial industry, there's no way its industries will expand overseas.

In the early 2000s, only Chinese commercial banks were making headway in their overseas expansion plans, but after 2009, overseas investments from throughout China began picking up.

Overseas direct investment (ODI) from China is that in 2007, ODI was $1.67 billion (1.17 billion euros). The figure reached $8.73 billion in 2009.

There are three main reasons for the sharp growth. The demand caused by ODI from nonfinancial industries. To meet the demand of nonfinancial enterprises, Chinese commercial banks and other financial institutions sped up outbound development.

Second, China Investment Corporation, in 2009, increased investments in the midst of the financial crisis. The total investment amount reportedly reached $6.54 billion in 2009.

Third, the financial crisis made some financial assets undervalued. Some financial institutions then sold their Asian assets selectively, which provided a great opportunity for Chinese financial institutions to swoop in on inexpensive prices and plan their global expansions.

Thus far, there have been losses and gains in China's overseas investments from its financial industry, which didn't take advantage of the crisis. Fortunately, the potential for overseas investments is still great. If the financial industry speeds up its plans for overseas investments, it would lay a solid foundation for China's improving global competitiveness.

As the Chinese financial industry transitions into globalization, various financial institutions need to apply for licenses to conduct commercial banking, asset management and private banking. But the more important task for Chinese financial institutions is to enhance their service capacity for Chinese enterprises overseas.

Right now, there are many favorable conditions for outbound investment of Chinese financial institutions.

Chinese financial institutions already have a foothold overseas. The proportion of overseas assets and revenue has increased steadily. More and more commercial banks have adopted the practice of mergers and acquisitions (M&As) as the major way of outbound investment.

The financial crisis provided the best investment opportunity for China. The US subprime mortgage crisis and the European sovereign debt crisis severely broke the financial system and institutions of the West. But the bad thing is that Chinese financial institutions barely grabbed onto the opportunities at their feet. In 2008 and 2009, when the crisis was the severest, M&As sharply declined from a peak in 2007, with figures of $2.5 billion and $1.29 billion, respectively.

This shows that after the global economic collapse, Chinese financial institutions made inaccurate judgments and underestimated the stimulus measures of other nations' central banks (especially the US Federal Reserve). Chinese financial institutions also did not fully understand the influences of the financial crisis. The economic recession had a limited impact on most of Asia. Some countries, such as Japan, made full use of the crisis and increased their overseas M&As.

Fortunately, judging from the current financial market and economy in Western countries, excessive liquidity will not save their weak economies and financial industries. High unemployment rate and low revenue indicate that the effects brought by the financial crisis will not disappear in the short term. The pressure on Western commercial banks will not be reduced until 2019. That is to say, during this time, many M&A opportunities will still be there for Chinese financial institutions.

The globalization of nonfinancial industries has created new demand for financial industries. According to the Ministry of Commerce, in 2010, ODI from nonfinancial industries reached $59 billion; total ODI was $258.8 billion. The surge in ODI between 2003 to 2009 has increased the demand from Chinese enterprises overseas. But they are small in scale and have incomplete credit records, so it is difficult for Chinese enterprises, especially small- and medium-sized enterprises, to receive financial support overseas. Domestic financial institutions in China should support them with bank credit and offshore financing.

Besides credit and loans, domestic financial institutions (especially domestic investment banks), could provide consulting services on outbound investments and M&As. Right now, most of the overseas M&A have to rely on foreign investment banks and law firms.

But in the aim to develop further, Chinese financial institutions are still facing challenges. It is a critical moment for Chinese financial industries to make some strategic adjustments.

First, they should adjust their balance sheet structures. Most Chinese commercial banks rely too heavily on deposits and loans. At the end of 2009, the deposit ratio and loan ratio for all four major commercial banks reached 90 percent and 50 percent, respectively.

Meanwhile, the deposit ratio for Western commercial banks ranges between 30 percent and 50 percent. The main reasons are because consumers and enterprises in the West spend a great deal and have low deposit rates. They tend to increase their income by investments rather than deposits. Therefore, to gain a foothold in the overseas market, Chinese financial institutions should perform more financing from bonds markets and increase the ratio of agency bonds in their portfolio.

Secondly, Chinese financial institutions should push to increase profits from the capital market because once the proportion of deposits and loans falls, the original business model would be at a great risk.

Third, they must adapt to their customers. Currently, the purpose of Chinese financial institutions is not to become global financial organizations, but to provide consulting and financing services for Chinese overseas investments. For this reason, the locations of overseas branches should be at countries and regions that are key to Chinese overseas investment, such as investments in resources in Australia and Canada, and manufacturing in Europe and in the US. Institutions should also account for the nations' local economic environment and regulations to reduce risk.

The rise of China's financial industry plays a key role in the country's global economic status but it needs strong government support. The Chinese government should pay attention to the globalization of the financial industry and solve a number of problems.

One of the problems is solving the issue of funds outstanding for foreign exchange. Chinese commercial banks usually deposit 15 percent of assets with the central bank; European commercial banks, on the other hand, deposit about 4 percent of their assets. These deposits aren't as profitable and Chinese commercial banks are running the risk of having a poor revenue stream and losing out on their global competitiveness.

The second problem is the supplement of capital funds through various channels. Chinese commercial banks should further inject capital and diversify their shareholders.

Another purpose of injecting more capital is to reduce the operation risks of Chinese commercial banks. The financial leverage is quite high for the four major commercial banks of China. Without enough capital funds, these banks might not be able to keep their operations afloat and some might even encounter unpredictable problems.

One possible solution is to have State-owned enterprises as their shareholders. Some SOEs have purchased several small and regional commercial banks, but these banks aren't capable of going global. It is more practical for commercial banks such as Industrial and Commercial Bank of China and Bank of China to shoulder this task.

The last problem is the difficulty in adopting a more market-oriented and international management. Major commercial institutions should reform how they appoint officers and employees. First, employ suitable people to run China's financial institutions and separate ownership from management. Let the market determine the course of operations at commercial banks. Second, maintain the term of chairman while extending the term of office of general manager and board of management, set the term of office of general manager based on performance, and provide more effective incentives for long-term investments.

The author is an investment research fellow with the Chinese Academy of Social Sciences.