VZCZCXRO9234
PP RUEHCN RUEHGH RUEHVC
DE RUEHBJ #6654/01 2880353
ZNR UUUUU ZZH
P 150353Z OCT 07
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 2772
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC
RHEHNSC/NSC WASHDC

UNCLAS SECTION 01 OF 04 BEIJING 006654 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958:  N/A 
TAGS: EFIN ECON EAGR PGOV SOCI CH
SUBJECT: UNDERLYING CHALLENGES HINDER RURAL FINANCE 
 
REF: (A) BEIJING 1081 and previous 
(B) BEIJING 1482 
(C) GUANGZHOU 889 
(D) GUANGZHOU 937 
(E) BEIJING 5600 
(F) BEIJING 6365 
(G) 06 BEIJING 23786 
(H) 05 BEIJING 20769 
(I) 06 BEIJING 13790 
(J) BEIJING 3178 
 
SUMMARY 
------- 
 
¶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. 
 END SUMMARY. 
 
PROMOTING RURAL FINANCE IS A GOVERNMENT PRIORITY 
--------------------------------------------- --- 
 
¶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. 
 
 
MUCH ADO ABOUT MICROFINANCE 
--------------------------- 
 
¶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. 
 
LAND REFORM NEEDED FOR COMMERCIAL VIABILITY 
------------------------------------------- 
 
¶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). 
 
NO AGRICULTURAL INSURANCE TO COVER LOSSES 
 
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. 
 
INTEREST RATE CAPS IMPEDE RURAL LENDING 
--------------------------------------- 
 
¶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. 
 
OVERCOMING THE LEGACIES OF ABC AND THE RCCS 
------------------------------------------- 
 
¶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 
farmers. 
 
¶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. 
 
THE RURAL-TO-URBAN MIGRATION PHENOMENON 
--------------------------------------- 
 
¶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. 
 
COMMENT:  LOOKING TOWARDS THE FUTURE 
------------------------------------ 
 
¶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. 
 
PICCUTA