Cablegate: Underlying Challenges Hinder Rural Finance

DE RUEHBJ #6654/01 2880353
P 150353Z OCT 07




E.O. 12958: N/A

REF: (A) BEIJING 1081 and previous
(B) BEIJING 1482
(E) BEIJING 5600
(F) BEIJING 6365
(G) 06 BEIJING 23786
(H) 05 BEIJING 20769
(I) 06 BEIJING 13790
(J) BEIJING 3178


1. (SBU) Promoting rural finance has been a Central Government
priority during the past year, as government leaders recognize that
the significant financial services gap in rural areas adversely
impacts efforts to balance the economy. Rural finance reform was a
primary focus of the National Financial Work Conference in January
2007, and policies introduced this year have aimed to promote
greater competition by facilitating the entry of new players such as
village banks into the rural financial sector. Financial regulators
face difficult, and in some cases conflicting, objectives to make
financial institutions more commercially oriented while also
increasing services to rural areas. As a condition of
recapitalizing the Agricultural Bank of China (ABC), for example,
financial regulators are pressing ABC to establish a broader
presence in the countryside. These initiatives, however, would only
give farmers minimally improved access to credit unless the Central
Government addresses more fundamental issues that limit the
creditworthiness of rural borrowers such as land ownership and
agricultural insurance, as well as interest rate caps that limit the
ability of lenders to price risk accurately. Moreover,
rural-to-urban migration combined with the agricultural sector's
falling share in the economy will continue to make lending in cities
more attractive to banks than investing in rural financial services.

--------------------------------------------- ---

2. (SBU) Few rural financial institutions offer loans or deliver
other services to farmers. Rural Credit Cooperatives (RCCs) were
established to provide such services but have fallen short. Most
farmers in rural China have small plots of one-sixth of an acre or
less in size and are unable to expand their landholdings, because
all land in rural China is owned collectively (farmers lease the
land from the government for up to 30 years). Farmers are thus
unable to turn the land they lease into collateral for loans. Small
businesses are sometimes able to obtain loans in the countryside,
but many of these enterprises are state-owned. Financial
institutions ironically tend to drain rural areas of capital: they
lend out the savings of rural residents to customers in urban areas
where there is more collateral, more information about borrowers'
credit risks, higher growth and greater wealth.

3. (SBU) Improving financial services in rural areas is an important
part of the Central Government's efforts to balance the economy.
Government leaders recognize that there is a significant financial
services gap in rural areas. Rural financial sector reform was a
primary focus of the National Financial Work Conference in January
2007 (Ref A). At the March session of the National People's
Congress (NPC), Premier Wen Jiabao reiterated the need for reforming
rural finance alongside increasing the financial sector's overall
degree of openness (Ref B).

4. (SBU) The National Financial Work Conference in January and the
March session of the NPC launched a series of rural financial sector
reform measures:

--Ordered the Agricultural Bank of China (ABC), in the midst of its
own reform, to re-establish a broader presence in rural areas and
offer more financial services to farmers. In recent years, the ABC,
a state-owned commercial bank, has increased its share of lending in
urban areas and has had little to do with farmers. Most of its
lending in rural areas has been to state-owned enterprises.

--Allowed the Postal Savings Bank of China (PSBC), which was
separated from China Post, to extend small-scale loans to farmers.
With postal savings branches all over the country, the move to allow
lending by PSBC was seen as a means to diversify and increase the
number of institutions offering financial services in the
countryside. (Comment: Financial regulators had been reluctant to
allow the PSBC to engage in large-scale lending given its limited
capacity to assess and manage credit risk. End Comment.)

-- Encouraged financial institutions and non-government
organizations to introduce microfinance schemes in rural areas.

BEIJING 00006654 002 OF 004

--Announced new regulations for establishing village level banks,
building on pilot projects initiated by the China Banking Regulatory
Commission (CBRC) and People's Bank of China (PBOC). The
regulations lowered capitalization requirements and mandated that 20
percent of the capital would be sourced from large commercial banks.


5. (SBU) The October 2006 visit by Grameen Bank founder and Nobel
Peace Prize Winner Mohammed Yunus and the subsequent CBRC
announcement on relaxing barriers to market entry for financial
institutions in rural areas kicked off a year of intense government,
private sector, and NGO interest in microfinance in China. NGOs,
including international NGOs such as the Ford Foundation, Mercy
Corps, and HOPE International, have been actively promoting
microfinance in China for several years. In addition, Chinese
organizations such as the China Fund for Poverty Alleviation (CFPA)
and Center for Environment and Poverty Alleviation (CEPA) have
implemented successful microfinance projects in recent years (see
Refs C, D, and E). Farmer cooperatives also have pooled financial
resources to provide small loans to members. Contacts in Shanxi
Province have told us those informal efforts have been more
successful than PBOC-sponsored pilot projects (Ref F).

6. (SBU) The Central Government focused much of its attention in
2007 on promoting village-level banks. The first such bank, Yilong
Huimin County Bank, was established in Sichuan Province in February.
HSBC announced in August that it would be the first foreign bank to
establish a village-level bank, having received approval from the
CBRC to set up a rural bank with registered capital of RMB 10
million in Hubei Province. The Shanghai-based Chief Economist of
the Bank of Communications said in September that rural banks are a
recent trend in response to commercial banks' withdrawal from
county-level institutions, and while it would be difficult to earn a
profit from village-level banks in the near-term, large banks'
efforts to offer financial services in rural areas would demonstrate
to regulators their political commitment.

7. (SBU) Officials at Citibank and Standard Chartered agreed,
stating that establishing a village-level bank would not help
commercial banks' bottom lines but would be done to facilitate
approval of licenses for urban and coastal branches. They
maintained that any rural finance initiatives would need to overcome
persistent underlying problems that prevent rural residents from
accessing credit.


8. (SBU) Because farmers are unable to own their own land, and thus
pledge land as collateral, lending to farmers is risky. In some
localities, farmers are considered low risk for defaults for
micro-loans because of their determination to repay their loans, but
these small loans to facilitate the purchase of agricultural inputs
are not generally considered to be sufficiently profitable for banks
given relatively high fixed costs. In other places, farmers are
considered high risk because there is no existing culture of
repaying loans. The Deputy Head of the Finance Department in Inner
Mongolia Autonomous Region told Econoff that if farmers were able to
use their land as collateral, it would be a tremendous benefit for
the financial sector in Inner Mongolia's countryside.

9. (SBU) The Central Government is reluctant to allow land reform,
however, due to fears that if market-based land transactions were
permitted, there would be significant risks both for ensuring food
security, with the potential for transfer of land from agricultural
to non-agricultural uses, and protecting farmers' social welfare, as
land serves as a form of social security in the absence of a
developed social safety net and widespread availability of a broad
array of private insurance products (Ref F). As a result, banks shy
away from opportunities in the countryside. The Assistant Mayor of
a Third-Tier city in Hubei Province, for example, noted in November
2006 that the financial sector in the countryside remains dormant
even while banks are pouring into urban areas in Central China and
elsewhere (Ref G).

10. (SBU) The only rural finance model that appears to have
circumvented the land policy challenge is in the livestock sector
where farmers are able to borrow money to purchase more livestock
and expand their businesses. If they default on these loans, their
property (the animals) can be repossessed. Some companies (such as
Meng Niu in Inner Mongolia) have effectively utilized this financial
model to help both farmers and the companies (Ref H). The livestock
model, however, is only viable so long as the livestock sector is
growing rapidly (as it is today).


BEIJING 00006654 003 OF 004


11. (SBU) There is no agricultural insurance, leaving banks hesitant
to lend to farmers who may be wiped out by a natural disaster.
Although farmers receive many subsidies from the government,
agricultural insurance is not one of them. The government provides
relief to farmers after natural disasters, but those bailouts are
minimal compensation to meet basic needs only and would not be
sufficient to repay outstanding loans. While the private insurance
market is growing in China, it is not growing nearly as quickly in
rural areas. Where insurance is available in the countryside, it is
normally in villages close to major cities.

12. (SBU) During Econoff's visits to the countryside, farmers
repeatedly have lamented that the lack of agricultural insurance
leaves them one bad harvest or natural disaster away from poverty.
Hedging against such eventualities is one of the major reasons for
the high savings rate in rural areas. (Note: The lack of financing
for health care and education remains the primary reason for the
high savings rate of farmers. End Note.) There clearly is a need
for agricultural insurance, but as the representative for an
American company based in Western China said, smart companies are
not interested in providing low profitability agricultural insurance
unless they have a political reason to do so.


13. (SBU) An additional impediment to rural lending is interest rate
caps that limit the ability of lenders to price risk accurately.
While regulators have eliminated interest rate caps in urban
lending, the caps -- though loosened to some degree -- are still in
place in the countryside, further giving financial institutions
pause as to whether or not the benefits of rural lending outweigh
the costs.


14. (SBU) In the past, state-owned banks, the Agricultural Bank of
China (ABC) in particular, and rural credit cooperatives (RCC)
provided financial services in rural areas. ABC, however, is not a
specified financial institution for rural business as its name would
suggest. It is one of four state-owned commercial banks running
operations nationwide, and its lending has been increasingly
concentrated in urban and coastal areas. Despite the Central
Government's push for ABC to return to the countryside, Standard
Chartered's Senior Economist told Econoff he does not believe ABC
will turn into much of a force for rural finance given its focus on
profits and its lack of experience in the rural sector. An ABC
Branch Manager in Qingdao told Econoff in 2005 that his bank has
virtually no business in the countryside, and a local Agriculture
Bureau official in Xinjiang Autonomous Region said in 2006 that the
ABC's only rural lending is to agricultural state-owned enterprises
(Ref I).

15. (SBU) RCCs were developed at the local level, and thousands of
RCCs operate in rural areas. These institutions still account for
91 percent of agricultural lending in China. Many RCCs have failed,
however, because of poor corporate governance, insufficient capital,
and inadequate supervision. RCCs lend little money to farmers and
instead focus on providing loans to small- and medium-sized
enterprises, many of which are state-owned. These loans are
supported by local governments which have connections to the
companies, and the RCCs' default rates have climbed as these types
of loans have increased in number. The manager of Henan's
Provincial RCC admitted in 2006 that government pressure to lend to
certain companies has led to bad loans at the expense of lending to

16. (SBU) The few successful examples of RCC lending in China are
the result of RCCs partnering with private companies. In the Meng
Niu case, for example, Meng Niu serves as a guarantor for RCC loans
to herders, who then are able to purchase more livestock and sell
more milk back to the company (Ref H). An official at the Zongshen
Motorcyle company in Chongqing said that Zongshen sometimes works
with RCCs to help provide loans to farmers to purchase motorcycles
in rural areas. Motorcycle companies in China cannot offer their
own financing and therefore must rely on RCCs or other financial
institutions to provide loans in the rural sector, which in the case
of motorcycles, is one of the fastest growing markets.


17. (SBU) One important factor inhibiting investment in rural
financial services is rural-to-urban migration. With between 150
and 200 million farmers already having left the countryside to move
to the cities, many banks wonder if there even will be a market to

BEIJING 00006654 004 OF 004

service in the future. Rural-to-urban migration will have a huge
impact on the future of financial services in rural areas, as
financial institutions assess the comparative profitability of
lending to a shrinking population of farmers versus collecting
transaction fees from migrant remittances.

18. (SBU) Banks that are willing to go to rural areas, including ABC
and PSBC, have found that remittance services is more lucrative than
issuing small loans to farmers. On average, more than half of rural
income is derived from remittances from relatives in cities.
Discussions with farmers in the countryside have revealed that since
relatives normally only return home once a year during the Chinese
Lunar New Year, the majority of these remittances are wire
transferred via bank cards from urban areas to villages.

19. (SBU) There are varying reports on transaction costs on these
transfers, with some farmers in Shaanxi Province complaining to
Econoff that fees range from eight to twelve percent on the transfer
(Ref J). The World Bank's Chief Economist, however, reports that
the PSBC transfer system, with its large branch network, is one of
the most efficient in the world charging approximately one percent
on transfers from cities to the countryside. Regardless of the
transfer cost, banks may find that as a result of China's ongoing
depopulation of the countryside, operations in rural areas are most
profitable when they focus on remittances rather than the loan
portfolio, thereby further hindering the development of
comprehensive financial services in rural areas.


20. (SBU) Our focus in analyzing China's rural financial reform
should be on what large banks such as ABC and PSBC do. While
microfinance is garnering significant attention from the government,
media, and public, it is not going to have a meaningful impact on
rural development and will serve only as an instrument for poverty
alleviation. The Central Government might be increasingly tempted
to use the ubiquitous Postal Service branches as outlets for
domestic banking and insurance services, thereby prompting national
treatment concerns with competing foreign firms. Our expectation on
the land issue, however, is that there will be no movement on land
reform for the foreseeable future due to political considerations.


© Scoop Media

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