China plans to open its retail-banking market to foreign competition by 2007. An opportunity too good to resist? Perhaps, but foreign lenders will find retail banking in China hard going. Few of them have made material profits from the services they are currently allowed to provide,¹ and China’s uncertain regulatory environment means that retail banking may never have an entirely level playing field. Our research² suggests that outsiders could make a stronger start in retail banking if they learned to compete in the wholesale market, which is expected to open up to competition sometime between 2004 and 2007. By first entering the wholesale market, foreign banks will be able to build up their skills and brands and to acquire market knowledge while learning to cope with China’s fast-changing regulations. Early success will also help pay for the cost of entering the more lucrative retail-banking market later on.

Corporate deposit taking should be the first wholesale business that foreign banks consider. Beginning in 2004, they will be allowed to take renminbi deposits from local corporations on top of the foreign-currency deposits they can now accept. In 2001, local deposits stood at $530 billion and foreign deposits at $46 billion—together equal to almost half of the country’s GDP. These figures are high largely because the Chinese have few capital-market products (such as equities, bonds, or mutual funds) in which to invest as an alternative to savings accounts. Such products aren’t likely to appear soon: China’s institutional capital markets are underdeveloped, and strict controls prevent capital from flowing out to foreign countries. Thus corporate deposits are expected to grow at a rate of about 18 percent a year to 2010, even faster than the economy. With margins of 1 to 1.5 percent, deposits accounted for about $6 billion in revenues for banks in 2001 and could generate more than $20 billion by 2010.

The four big state-owned banks now hold 70 percent of all corporate deposits. But we believe that a few local joint-stock banks³ and most foreign ones should be able to compete against them. Because of regulations restricting the speed at which new branches can be opened, foreigners wouldn’t be able to match the state-owned banks’ massive branch networks. But since most Chinese companies are concentrated in the large cities and coastal provinces, local and foreign banks with small branch networks in such areas could still target corporate deposits. These banks have the advantage of more highly developed skills and international networks and would thus be able to offer better services and products to attract the state-owned banks’ increasingly sophisticated customers.

Foreign players will also be able to use cash they accumulate from taking deposits in order to finance their entry into other markets.⁴ Their next step could be to provide loans and value-added fee-based services to small and midsize enterprises. In China, these companies have been starved of loans because commercial banks assess a borrower’s risk entirely on its assets. Since most smaller businesses lack substantial assets, they receive few loans (Exhibit 1).

Interest rates are currently capped at two to three percentage points above the cost of capital, so banks can’t factor into their spreads potential losses and the higher operating costs associated with lending to smaller companies, which nonetheless demand a "big-company" standard of service. The Chinese government is gradually deregulating interest rates, but until it does, foreign banks with credit-risk-management systems that accumulate and analyze customer data should still be able to provide some loans profitably to small and midsize companies. While it remains uncertain when the government will relax the rate cap, total bank revenues from this segment could exceed $25 billion by 2010, up from less than $10 billion in 2002.

Some of the new revenues from small and midsize companies would come from fee-based services, which foreign banks could subsequently extend to large corporations. In 2001, income from fees for services such as trade finance, equity underwriting, and advice on mergers and acquisitions accounted for only 5 percent of the total operating income of all Chinese banks combined. This figure is much lower than it is in more developed markets, where service fees form a large component of the returns from corporate customers (Exhibit 2). Chinese banks miss out on these returns not as a result of regulatory restrictions but because, by and large, they don’t know what products to offer, how to package their products, or what to charge.

China’s external trade, which totaled $500 billion in 2002, is set to expand to $1.5 trillion by 2010, so the revenues banks receive from providing trade finance to corporations could well reach $5 billion to $10 billion by the end of this decade. Services linked to China’s capital markets, too, could yield sizable fees: these markets now provide approximately 15 percent of private-sector financing, a figure expected to reach 35 percent by 2010. Revenues from underwriting equity and debt will probably grow at a compounded annual rate of 13 percent, to $2 billion, by 2010; about half of this increase is expected to come from small-cap and mid-cap companies. M&A activity is predicted to grow by 30 percent a year and could generate service fees for banks of up to $400 million by 2010.

Aside from earning greater revenues, foreign banks entering China’s wholesale markets must learn to deal with local regulation. The government wants to balance economic growth with social and political stability and uses a combination of market regulation and direct intervention—usually swift and without consultation—to achieve its aims. We think the government is unlikely ever to halt bank liberalization, but it will probably move at a "two steps forward, one step back" pace. Foreign banks that gain a toehold in China during the early years of liberalization will be better prepared to cope with the backward steps and to exploit sudden movements forward than those waiting for certainty later on.