McKinsey Global Institute

The Value of Financial System Reform

in China and India
Diana Farrell, Director
McKinsey Global Institute

January, 2007

AGENDA

Chinas Financial System

Indias Financial System

CHINA FINDINGS

China has made steady advances in modernizing its financial system and in
mobilizing savings, reflected in the doubling of Chinas stock of financial assets
relative to GDP over the past ten years. Chinas banking sector plays an
unusually large role in its financial system.

Capital allocation in the system is poor: wholly and partially state-owned

companies continue to absorb most of the funding from the financial system,
while private enterprise, the engine of Chinas growth, receives a
disproportionately small share. As a result, Chinas investment efficiency is
declining.

The dominant bank sector, though improving, remains highly inefficient and
potentially vulnerable.

Reforms that enable a larger share of funding to go to the most productive

companies and improved the operating efficiency of financial system components
would raise GDP by $321 billion annually, or 17 percent.

Chinas financial systems remaining problems are intricately linked across its
component markets, and will therefore require an integrated approach to reform.

CHINAS FINANCIAL SYSTEM DEPTH IS HIGH GIVEN ITS

GDP PER CAPITA
Stock of bank deposits, bonds and equity, 2004
Percent of GDP

Position in 2004
1994-2004 evolution
for select countries

Mature

500
Japan

450

Malaysia

400

United Kingdom
South Africa

350
300
250
200
150
100
50
0
1,000

United States

China

Emerging

Thailand

Nascent

Chile

Sweden
South
Korea

Singapore
Australia
Canada

Taiwan
Finland

India

Saudi Arabia
Norway
Brazil
New Zealand
Turkey
Czech Republic
Hungary
Philippines
Mexico
Russian Federation
Indonesia
Tunisia
Vietnam
United Arab Emirates
Ukraine

Egypt

10,000

100,000
GDP per capita (at purchasing
power parity), 2004
US $, logarithmic scale

Note: Chinas depth would be at 220% of GDP in 2004 according to recent GDP restatement. It is unclear how new
GDP calculation methodology would affect Chinas 1994 GDP.
Source: WEFA; BIS; FIBV; WDI; IMF; GFS; McKinsey Global Institute analysis.

CHINAS FINANCIAL SYSTEM IS DOMINATED BY THE

BANKING SECTOR

Equity
Corporate debt
Government debt

2004 financial stock components

Percent, US $ billion
100% =

4,291

247

350

30

33

Bank deposits

1,105

15
8
5

130

675

19,627

22

25

19

35
7

4
11
21

11

Depth
GDP multiple

471

43

40

13

19

11

11

214

47,729

34
55

60

21

34

29
30

35

Malaysia

Chile

United States

19

Singapore

21

Hong Kong

30

12

South Korea

32

Japan

33

Mexico

33

Philippines

35

11

India

36

14

Thailand

37

Indonesia

43

35

China

45

396

11
46

1,428

27

12

72

CAGR2
19942004
Percent

1,602

20.5

6.5

2.8

12.3

1.0

8.8

3.5

11.0

10.5

6.0

3.4

6.4

9.4

8.7
2.21

1.0

2.1

4.2
1.7

1.5

Note: Numbers may not add to 100 percent due to rounding.

1 Reflects Chinas recently restated GDP.
2 CAGR = compound annual growth rate.
Source: McKinsey Global Institute Global Financial Stock Database

1.0

2.4

3.7

4.0

2.3

4.1

PRIVATE COMPANIES GET A DISPROPORTIONATELY SMALL SHARE OF

LOANS
State-owned enterprises
Shareholding and
collective enterprises
Private and foreign
enterprises

Comparison of GDP and corporate bank loans

outstanding, 2003
Percent
State-owned enterprises1

23

Shareholding enterprises2

19

Collective enterprises3

Private and foreign enterprises4

52

35

27

11
27

GDP5

Corporate
loans
outstanding6

SOEs are defined as wholly state owned.

Most of the shareholding enterprises are partly state owned. Some are state controlled, some are not.
3 Collective enterprises are owned by the population. Many are run like private enterprises, but some are effectively controlled by local political interests.
4 Fully private enterprises include local privately owned enterprises, foreign joint ventures, and wholly owned foreign enterprises.
5 Breakdown of industrial value added by ownership type, 2003, as determined by the Organisation for Economic Co-operation and Development.
6 Total corporate and government bank lending, based on a survey on commercial bank new loans conducted in 2002 by the Peoples Bank of China. This is the
most recent publicly available data on lending by company type. In the absence of more recent data, we are making the assumption that new lending in 2002
reflects the stock of outstanding credit in 2004. A higher portion of new lending today may go to private companies, but we have no evidence of this.
Source: OECD; PBOC; McKinsey Global Institute analysis
1

THE PRODUCTIVITY OF STATE-OWNED FIRMS IS HALF THAT OF

PRIVATE COMPANIES
Average Total Factor Productivity (TFP) of large industrial firms
Direct state control led firms = 100
x2

State
controlled
and
collectives
(48% of
companies)

Direct state control

Indirect state
control, LP1 >50%
Indirect state
control, other

100
146
170

Collective >50%

216

Private, LP1 >50%

Privately
controlled
(52% of
companies)

Private,
individual >50%
Private, nonmainland >50%
Private, other

221
208
192
200

Legal person.
Source: OECD (Dougherty and Herd, 2005); McKinsey Global Institute analysis

THE EFFICIENCY OF CHINAS INVESTMENT IS DECLINING

Years
China

1991-1995

Investment required to
produce $1 additional GDP **

3.3

1996-2000

4.6

2001-2003

India

1995-2004*

Japan

1961-1970

South
Korea

1981-1990

4.9

4.1

3.5

3.7

* Fiscal years, finishing in March of the following year

** This metric is known as the incremental capital-output ratio
Source: World Bank 2004 World Development Indicators; PBOC, Reserve Bank of India, McKinsey Global Institute analysis

60 PERCENT OF NPL REDUCTION IS DUE TO TRANSFER OF BAD LOANS

TO ASSET- MANAGEMENT COMPANIES
Source of NPL reduction for large state-owned commercial banks, 20012005
Percent of loan balance
31.1

12.4

8.6
10.1

NPLs at the
end of 2001

NPLs
transferred to
assetmanagement
companies1

NPL resolution NPLs at the

and dilution
end of 20052
due to growth

1 A total of $150 M was transferred between 2001 and 2005, which represents 12.4 percent of the 2005 loan
balance.
2 End of Q3.
Source:
CBRC; PBOC; McKinsey Global Institute analysis

WEAK BANK PERFORMANCE IN CHINA CREATES VULNERABILITIES

Root causes of weak

performance

Key vulnerabilities

Weak governance and lack

Renewed NPL build-up

of commercial mindset

Operational weaknesses in
lending and risk management

Decentralized structure with

local autonomy

Sharp reductions in liquidity and

profitability, due to concentration
of profits, from:

Foreign bank entry

Corporate bond market
development
Real estate exposure

REFORMING CHINAS FINANCIAL SYSTEM COULD BOOST GDP BY UP TO

$321 BILLION ANNUALLY
Potential benefits of financial reforms in China
US $ billion
Indirect impact
on growth
259

Direct impact on efficiency

62

14

25

Increased
bank
efficiency

Percent
of GDP

1.3

20

Migration of
more
payments to
electronic
platforms

Increased
Elimination
market debt
of informal
intermediation lending

1.0

Source: McKinsey Global Institute analysis

0.7

0.1

Increased
Direct impacts
equity trading of financial
efficiency
system
reforms

0.1

3.2

Increased
productivity
due to better
capital
allocation

13.4

10

CHINA: AN INTEGRATED PROGRAM OF FINANCIAL REFORMS IS

NEEDED

Reforms to improve allocation of capital

1 Improve governance and increase competition in the banking sector
2 Change collateral requirements for small businesses to improve
access to credit
3 Support development of an independent consumer credit bureau and
a corporate rating agency
4 Deregulate the corporate bond market
Reforms to balance the financial system
5 Deregulate bank interest rates ahead of current schedule
6 Spur growth of domestic institutional investors through deregulation

7 Create a more strategic relationship between HKSE and mainland

equity markets
8 Change equity IPO process to allow private companies and SMEs to
compete for funds
Reforms to improve overall system efficiency
9 Accelerate improvements in the payments system
10 Further liberalize the capital account
Source: McKinsey Global Institute analysis

11

AGENDA

Chinas Financial System

Indias Financial System

12

INDIA FINDINGS

Indias financial system has lower depth than other fast-growing Asian
economies, indicating a low level of financial intermediation in the economy.
Although the lauded equity market is sizable and growing, the banking sector
dominates but does not lend broadly and the corporate bond market is small.

An array of financial system policies direct capital allocation in India. As a

result, the fast growing private sector gets little credit while the government in
various forms absorbs the vast majority of the intermediated capital.

Moreover, the state-dominated banking sector features low competitive

intensity and significant inefficiencies.

Reforms that enable a larger share of funding to go to the most productive

companies and improve the operating efficiency of financial system
components would raise GDP by up to $48 billion annually.

Further reforms (financial and economic) could raise Indias real GDP growth
rate to 9.4% annually, on par with China.

13

INDIAS FINANCIAL DEPTH IS LOW COMPARED TO OTHER

ASIAN NATIONS
Financial depth, 2004
Financial assets as a percent of GDP

Equity
Corporate debt
Gov. debt
Bank deposits

420
400
371

79
161

259
235

214

63
151
96
28
3
20
44

34
11
51
55

Indonesia Philippines

160

70

56

23
24

34

68
India

39
13
20

68
26

97

78

Thailand

Korea

Source: McKinsey Global Institute Global Financial Stock Database

50

161

50

74

42

44

119

120

146

187

China

Singapore Malaysia

145

Japan

14

LESS THAN HALF OF COMMERCIAL CREDIT GOES TO INDIAS PRIVATE

SECTOR
Distribution of commercial credit*
$ Billion, percent
100% =

Private corporate
discretionary
Private corporate
Priority lending**
Agriculture
Household
enterprises &
proprietorships
Public sector
enterprises

122

35

5
7

211

30

13

11
7

44

39

1999

2004

* Gross bank credit excluding financial companies; Includes corporate bonds and private placements, loans and
investments from the government to public sector enterprises.
** Estimate of lending to small corporations equals other priority sector lending outside of agriculture and SSI
Source: CSO; RBI; MGI; Public Enterprise Survey

15

INDIAN FIRMS RELY HEAVILY ON RETAINED EARNINGS

Sources of funds raised
$ Billion; percent, 2000-05*
100% = 204
2
Equity

Debt

20

1916
2

40
3

562
3

34

39

89

10

78

393

40
47

52

72

63

India

100

26
35

Internal
funds

91
4

Japan

59

Indonesia South
Korea

55

55

47

Singapore Malaysia US

42

Hong
Kong

* Based on sample of 160 companies per country outside of US. Companies were ranked by gross sales, and 40
companies from each quartile were taken as the sample. US sample
Source: Bloomberg, MGI

16

INDIAN BANKS LEND A SMALL PORTION OF DEPOSITS

Commercial bank loans outstanding
Percent of deposits, 2004*

131 130
119

G7 average: 118**

114 113
101
81

81

80

79

76

* United states is 2003 data (2004 unavailable)

** Straight average; excludes Luxembourg and Iceland for which data is unavailable
Source: RBI; EIU; McKinsey analysis

Philippines

Mexico

Singapore

Brazil

Japan

Poland

Thailand

Korea, Rep.

United States

Malaysia

Canada

United Kingdom

Chile

China

South Africa

66

61

61

53

Turkey

83

Czech Republic

90

India

93

17

INDIAS GOVERNMENT AND STATE-OWNED COMPANIES CONSUME 70%

OF SURPLUS SAVINGS
Sources and uses of net savings
Percent of GDP, average 1994-2004

9.0

1.2
3.2

7.0

Household
net savings
to the
financial
system
Source: CSO; McKinsey Global Institute

Net foreign
capital
inflows

Private
corporate
borrowing

Public
sector
borrowing

18

FINANCIAL REFORM IMPACT:

$22 BILLION DIRECT, $26 BILLION INDIRECT

Increasing efficiency
Shift financing mix
Total impact

Direct impact of financial system reform

Indirect impact

$ Billion, 2004
21.8
0.3

25.5

2.3

5.1

6.3

Improved
allocation
of capital

18.9

Capturing
more savings

6.6

7.8

Improved
banking
efficiency
to best
practice
Percent
of GDP

1.1

Fully
implement
electronic
payment
system

0.9

Migrate
informal
lending to
formal
banks

0.7

Reduce
corporate
bond
default
rates to
benchmark

Shift in
financing
mix from
bank
loans to
bonds

Direct
impact
of financial
system
reform

0.1

0.3

3.2

Source: RBI; CSO; McKinsey Global Institute Analysis

3.5
19

FINANCIAL SYSTEM REFORM COULD BOOST GROWTH TO CHINESE

LEVELS
Real GDP
$ Billion 2000

CAGR
2004-2014

1600
Baseline

1400
1200

9.4%

Efficient investment
and financial market
reform

6.5%

1000
800
600
400
200
0
1994

CAGR
1999-2004
5.9%

1999

2004

2009

2014

* Forecasts of investment rates from Oxford Economic Forecasting

** Efficient investment ICOR is the average rate implied if the public sector and households are as efficient as the private
corporate sector between 1999-2004. See exhibit x.x and the technical appendix
Source: CSO, RBI, OEF, MGI
20

INDIAS REFORM AGENDA MUST ADDRESS ALL PROBLEMS TOGETHER

Reforms to improve capital allocation
1 Lift most priority lending requirements, asset allocation restrictions,
and guaranteed deposit schemes
2 Reduce state ownership in the banking sector
3 Strengthen corporate governance in public sector banks
4 Lift restrictions on foreign ownership in banks
5 Spur development of the corporate bond market
Reforms to hasten development of financial intermediaries
6 Deregulate the insurance industry
7 Ensure pension reforms are enacted without limitations
8 Continue reforms of mutual fund industry
Reforms to capture more household savings
9 Introduce gold deposit scheme to capture value of gold expenditures

Reforms to improve overall system efficiency

10 Faster development of electronic payment system
11 Separate the regulatory and central bank functions of RBI
12 Lift remaining capital account controls
Source: McKinsey Global Institute analysis

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