Before China’s 2009 partial banking deregulation, five state-owned banks dominated China’s banking system with branches covering 85% of the country, while joint equity banks — smaller, private institutions serving local markets — had branches covering only 9%, due to strict regulations. In 2009, China eased these controls to promote economic growth through increased financial competition, allowing joint equity banks to open new branches and extend loans to enterprises previously overlooked by the state banks. What were the impacts on the banking sector and economic growth? 

The data. The 2009 reform targeted specific regions in China based on the pre-deregulation distribution of bank branches. Researchers compared cities unaffected by the reform to those impacted, analyzing how new joint equity banks competed with the big five banks, how these banks responded, and how firms reacted. The study used data from the China Banking Regulatory Committee’s (CBRC) registry system, containing over 7 million loan contracts from the 19 largest banks in China between 2006 and 2013, comprising 80% of China’s bank loan market in that period. Additional CBRC data detailed over 200,000 branches of approximately 2,800 banks from 1949 to 2016. The final dataset from the Chinese Industry Census included detailed information on investment, employment, performance, and profitability trends for all of China’s major firms.

Outstanding loans: deregulated cities versus regulated cities

After deregulation, joint equity banks proliferate. Deregulation removed restrictions on branch openings, causing the number of joint equity bank branches in deregulated cities to increase by 8.6% within two years. Prior to the deregulation, joint equity banks operated in only 9.5% of Chinese cities. However, just one year after the deregulation, they expanded to 15.7% of Chinese cities. Granted with more access to new markets, their market share rose from 24.5% in 2008 to 33.5% in 2010. Meanwhile, the incumbent big five banks showed minimal expansion and little change in their lending practices in deregulated cities. 

New bank branches primarily lend to state-owned enterprises (SOEs), but this bias diminishes over time. In the first year following deregulation, new joint equity banks increased their total lending to SOEs by 39.3% in deregulated cities, and their lending share to SOEs grew by 18.6%. In contrast, the incumbent big five banks did not alter their lending habits to SOEs. The authors conclude that the initial tendency of joint equity banks to favor SOEs arises from a lack of information about the creditworthiness of private firms in deregulated cities. Consequently, they prefer lending to SOEs that enjoy implicit financial backing from the government, despite SOEs’ lower average efficiency. However, this biased trend persists for only two years.

Over time, new banks obtained more soft information to better predict creditworthiness of private firms. Following deregulation, banks’ ability to assess firms improved over time. Two years after opening a new branch, joint equity banks could identify 22.6% of potential loan failures, increasing to 42.3% by the third year. Eventually, these banks became better equipped to lend to more productive firms, gradually reducing loans to less efficient SOEs. Consequently, new branches experienced a 62.5% decrease in default rates for private firms. These improvements weren’t observed for SOE loans, despite their having received disproportionately more loans. 

Private firms benefit from new access to credit. The deregulation resulted in a 33.6% increase in fixed asset growth and an 11.2% rise in employment for private firms. Their net income growth and return on assets (ROA) increased by 91.8% and 21.6%, respectively. SOEs saw no similar benefits in deregulated cities. Additionally, private firms' interest rates dropped by 6.6%, while SOEs' borrowing costs remained unchanged. The positive effects on private firms were more pronounced in cities with less banking competition before the deregulation.  

Lending to SOEs curbed the growth potential of the reform. Researchers estimated that diverting new loans to unproductive SOEs instead of private firms resulted in a loss of GDP growth potential of the reform. Deregulation led to significant growth for private firms in borrower assets, employment, net income, and ROA, altogether contributing to a 0.97% GDP gain. However, lending to less productive SOEs, which did not see these gains, caused a 0.25% GDP loss. The authors conclude that increased credit granted by the deregulation was, in some sense, “lost” due to biased lending towards inefficient SOEs, highlighting the importance of implementing financial reforms in conjunction with other market reforms, such as tightening the soft budget constraints of SOEs.