Executive summary

Abbreviations and acronyms

ABC	Agricultural Bank of China
CASS	Chinese Academy of Social Sciences
IFI	International Financial Institution
MOF	Ministry of Finance
NGO	Non-Governmental Organization
PBC	People’s Bank of China
PMOs	Project Management Offices
RCCs	Rural Credit Cooperatives
SHG	Self-Help Group
SOCB	State-Owned Commercial Bank
TVEs	Township and Village Enterprises
WFP	World Food Programme

Introduction

Context

To date, IFAD has provided 15 loans to the People's Republic of China on highly concessional terms (0.75% service charge), for a total commitment of USD 380 million. Most of these loans involve integrated agricultural development projects, and about two thirds of the loan funds are allocated to credit components. Recent projects have increasingly targeted rural women in terms of literacy programmes, health care and skills training.

Project design has shifted slowly from being entirely supply-driven, whereby government offices were responsible for credit delivery through project management offices (PMOs), to interventions using the services of local financial services institutions, namely, rural credit cooperatives (RCCs).

Under the PMO system, the Ministry of Finance (MOF) borrows from IFAD and, through two-to-three administrative levels, supplies the funds to Township Finance Offices. These offices bear the credit risk and are responsible for delivering credit to households and for repaying IFAD loan funds to County Finance Bureaux. With the help of village implementation groups, the township PMO identifies the borrowers for credit delivery. PMOs are staffed with government line agency staff, who provide project-related extension services and training to beneficiary households.

In the late 1990s, IFAD realized the importance of mainstreaming rural financial services. As such, its last four projects introduced a new concept whereby RCCs deliver financial services. It was thought that sustainability would be enhanced if project credit were to be channelled through the existing rural financial infrastructure; thus there was a strong argument for shifting credit delivery, recovery and associated risk to the RCCs. However, no proper formal study was ever undertaken to explore the in-depth institutional constraints on, and strengths/weaknesses of, the two models.

Thematic Study: rationale and objective

Stakeholders - IFAD included - are beginning to recognize the potential value of using a strengthened RCC system. However, many programmes have been based on grant finance: funds pass directly to RCCs, bypassing MOF. In order to contribute to ongoing dialogue on ways of improving policy in support of RCCs, IFAD commissioned the present thematic study to formally assess the strengths and weaknesses of the RCC model vis-à-vis the PMO model; examine variations in the performance of RCCs; and develop a reform programme for stakeholders based on poverty alleviation by means of microfinance.

Projects studied

The study was conducted in two phases and covered four ongoing representative IFAD projects in China.

Rural financial instutions in China

Development and clientele

The official rural financial organizations operating in China are the Agricultural Bank of China (ABC); Agricultural Development Bank of China (ADBC); and RCCs. Non-official financial organizations include rural credit foundations, mutual savings associations, the informal sector and microcredit projects targeted at poverty relief that have developed in recent years.

RCCs in operation

RCCs are rural financial institutions whose main borrowing clients are farmers and Township and Village Enterprises (TVEs). RCCs are required to allocate more than 50% of total loans to its members. Generally, loans of more than CNY 3 000 require the mortgaging of assets, and very large loans may require both mortgaging and other collateral security. At the present time, the People's Bank of China (PBC) - the Central Bank - has allowed RCCs to use, on a trial basis, a joint liability concept for granting small loans. In 1999, the RCCs were allowed to grant consumption loans to farmers, mainly for the construction of houses, education and medical treatment. RCCs lend for all activities, including production, consumption and business, to individuals, privately-owned enterprises and TVEs.

The RCCs are nominally independent cooperative banks at the township level, each RCC being responsible for its own profits and losses. At the county level, RCCs are linked through an RCC union. PBC is involved in RCC management (approval of staff and disciplinary action) .

Trends in financial service provision

In 1990-97, the annual growth rate of deposits in the formal financial system was as high as 31%. In 1997, total deposits in the official financial system in rural areas amounted to CNY 2 225 000 million, or 27% of total deposits in financial organizations nationwide. In 1990, loans outstanding in official financial organizations throughout the country amounted to a total of CNY 1 517 000 million, compared with CNY 440 000 million in loans outstanding in the official rural financial system. By 1997, total loans outstanding to TVEs (CNY 367 000 million) were over half the total RCC loan portfolio (CNY 727 000 million), while the household sector's share of loans (CNY 174 000 million) was 24% of the total.

Credit obtained by farmers from the informal market is estimated at more than four times that obtained from official credit institutions. From the farmers' perspective, therefore, the informal credit market is far more important than the official credit market.

Interest rates

China recently experienced its first year of net deflation. Inflation-indexed deposit rates were introduced in the mid-1990s, with Government paying out subsidy elements to commercial banks in order to stimulate domestic savings growth. Lending interest rates, however, remained relatively low. It has been argued that the two main reasons for keeping these rates low were to stimulate household consumption and demand, and to secure preferential and low-cost access of state-owned enterprises (SOEs) to much needed liquidity.

PBC has recognized the relatively high cost structure of RCCs compared with that of institutions such as ABC or state-owned commercial banks (SOCBs). PBC allows RCCs to be flexible when setting lending rates in order to partially offset both the high costs associated with reaching large numbers of small clients and the burden of non-performing loans. PBC allows RCCs a 50% band spread over the normal lending rate ceiling. However, although it helps RCCs, this flexibility is insufficient. RCCs remain at a competitive disadvantage compared with other rural financial institutions, such as ABC or the state-owned Industrial Bank. All new 'innovative' microfinance projects charge interest rates higher than those of RCCs. Typical customer profiles in small townships differ from those in the larger county towns, where SOCBs, including ABC, operate.

The costs for RCCs to mobilize deposit funds and administer their loan portfolios are higher owing to difficulties in reaching dispersed rural households, and because transactions are comparatively small. The predictable result of interest rate regulation in a high-cost retail banking environment is that RCCs tend to prefer investments in bonds and securities in order to generate income, instead of advancing those funds as loans to rural people. Within the present system, RCCs find it difficult to compete with both formal and semi-formal institutions.

Interest rates on informal loans vary greatly. Borrowing between friends and relatives can be interest-free. Interest on loans for production and commercial purposes is generally one-to-two times higher than that of official financial institutions. Compound interest is generally not used: interest rates are flat rates based on the initial principal amount. In the coastal regions, where informal lending is popular, normal loan interest rates are generally a monthly flat rate of 2%.

Regulatory framework

The RCCs are directly supervised and managed by the Cooperative Financial Management Department of PBC. RCCs in all areas are required to set up county-level apex institutions that provide a clearing house service for local RCCs. The apex institutions collect management fees from their affiliates and have their own financial service businesses.

Although RCCs are defined as rural cooperative economic organizations, no law on credit cooperatives has yet been enacted. PBC has published management regulations and guidelines to improve and strengthen farmer assistance services.

Poverty alleviation strategies

China has made remarkable achievements in improving the standard of living of its people and in realizing sustained economic growth over the last two decades. The rural poor population - using the official poverty line definition - fell from 250 million in 1978 to 36 million in 1999, or from 30.7% to 4.2% of the total rural population. In 1997, the World Bank estimated the incidence of rural poverty at almost 13.5% (applying the USD 1 per day criterion), which indicates a poverty level of 2.5 times the official standard. This means that still more than 10% of the rural population still live in deprived conditions.

Government loan programmes for poverty alleviation

The Government has used three channels for poverty alleviation: subsidized loans; food-for-work; and budgetary grants. Resources have been increased substantially for all three components of the poverty alleviation programme, but the emphasis on food-for-work has been reduced over time. The Government approved a quantum jump in the resources allocated to the subsidized loan programme.

The Chinese authorities believe that subsidized loans constitute a helpful tool for poverty alleviation. This is based on the perception that, first of all, the poor are unable to access the formal credit market as they lack the assets necessary for mortgage and collateral; and, secondly, that the poor cannot afford to repay the loans at full market interest rates. Since its establishment in 1986, the Government's Poverty Alleviation Leading Group has provided subsidized loans for the poor as a key instrument for reducing poverty.

The national leading group approves subsidized loan allocations to the different provinces on an annual basis. Leading groups at provincial level, operating through Poor-Areas Development Offices, approve loan allocations to counties and townships. At the county level (and the provincial level for large projects), loans are allocated for approved projects. ABC administers the subsidized poverty loan programme for nationally designated poor counties, and is authorized to reject loans applications.

Targeting is an important issue still needing to be resolved by policy-makers. The normal annual interest rate for subsidized poverty loans has been 2.9%, or about one third of the regular rate of interest charged by RCCs, which were not used directly in the poverty alleviation lending programme.

Experience with microfinance in China

Willingness to experiment

In China, 'rural finance' refers to lending by formal financial institutions, whereby loans are granted under financial sector regulations set by PBC. The term 'microfinance' refers to poverty-focused credit operations of civil society and government departments that are exempt from PBC's normal financial sector regulations. In China, 'microfinance' has literally come to mean lending that is based on the group solidarity concept or joint liability and is seen as a potentially effective tool to transfer poverty reduction funds to poor families. Microfinance in China started with a pilot project mounted by the Agriculture Development Institute of the Chinese Academy of Social Sciences (CASS), based on the Grameen Bank model or the solidarity group model. Its emphasis is on production loans to poor families.

Characteristics of Donor- and Non-Governmental Organization (NGO) - assisted credit schemes

Rural credit schemes in China have four common characteristics that have a negative effect on prospects for building up viable financial services over the long term, and are not usually integrated into the mainstream rural banking system. Most existing credit schemes have adopted technologies and methodologies borrowed from other countries. They are project-based, i.e. they receive external funds, but are directly funded only during the life of the project. The staff of most credit schemes in China are, at one and the same time, employees of government departments or other agencies. There are no structured plans for developing core competencies in financial service provision across institutions and for mainstreaming microfinance into the rural financial infrastructure.

Target Group

Microfinance programmes usually target resource-poor households, with special focus on women in poor regions. Governmental-funded projects for poverty reduction through microfinance using subsidized interest loans emphasize inclusion of the poorest families in the target group. Indeed, poor families registered with the Government form the basic target group. Such programmes do not, however, specially target women, whereas the main target group of most external donor-funded projects and the CASS Funding the Poor Cooperative are women.

Design of financial services

First loans provided under most government microfinance projects do not generally exceed CNY 1 000, with repayments over one year and an annual interest rate of between 2.9% and 7.2%. Civil organizations' microfinance projects generally grant loans of CNY 400-1 000, with repayment over 3-12 months. Such loans are either repaid in a lump sum on maturity or in weekly or monthly instalments. Civil organization- and donor-funded projects are authorized to charge higher annual interest rates ranging from 12% to 20%.

Microfinance projects implemented by civil organizations provide a compulsory savings scheme, but not a full range of financial services. A government-funded subsidized loan programme is being implemented through ABC, which provides a full range of financial services. Most projects implemented by civil organizations have poor accounting and financial reporting systems, with inadequate tracking of income and expenses, loan quality and business progress reporting.

Sustainability

Some pilot microfinance projects have achieved operational self-sustainability. PBC authorized an increase in interest rates for microfinance loans, and thus improved profitability. The CASS Funding the Poor Cooperative pilot projects in three counties achieved operational self-sufficiency by the end of 1997. Although the Qinghai project funded by the Australian Agency for International Development is located in a poor area, it does not specifically focus on resource-poor households except in terms of providing small loan amounts. The project, which is implemented by local agricultural banks, has achieved operational self-sufficiency through a policy of higher interest rates combined with strict control of costs and loan quality.

Policy dilemma

In 1988, PBC and ABC undertook a joint study on microfinance projects. The study cast doubts on the legality of the Funding the Poor Cooperatives programme set up by the Government to handle subsidized poverty reduction interest loans as agents of ABC. It was argued that non-financial organizations have no right to act as intermediaries and/or handle microfinance activities that are essentially financial in nature. Since 1999, ABC has directly issued subsidized loans to rural families for the purpose of alleviating poverty. Insisting that microfinance should be integrated into the financial system is a step in the right direction. However, in the absence of policies to mainstream microfinance and develop competition in the rural financial system, the growth of microfinance institutions (MFIs) is constrained.

Demand for financial services

Credit access

Limited credit for poorer households

Formal and informal loans are widely available to the public in rural China. Nevertheless, the detailed and unusual survey data used for analysing credit constraints in the present study clearly point to harsh constraints for the resource-poor strata of the population, implying that policy-makers and donors would do well to revisit their policies and procedures in this regard. The survey of farm households in six poor counties undertaken by CASS in 1997 shed much-needed light on resource-poor farmers' demand for, and receipt of, credit. The majority of households (54%) with outstanding formal loans are unable to obtain additional formal loans.

The data suggest that, even when formal credit is obtainable, amounts are limited - especially to households in the poorest population groups. They also stress the great importance of informal credit in poor areas and the need to incorporate features of informal credit markets into microfinance strategies with a view to reaching resource-poor households. Another equally significant and unexpected finding is that rural households in the poorest quartile are indeed able to borrow and service an amount equal to the average borrowing of the richest quartile.

Credit supply

Rural credit cooperatives are cooperatives in name only. They are regulated and managed by PBC, supply the majority of formal loans in the rural areas and account for two thirds of all household deposits. Almost two thirds of all loans go to the household sector although, in more developed rural areas, the TVEs and county enterprises are the major borrowers.

On average, households borrow from a network of 15 persons, varying from 12 in the poorest asset quartile to 18 in the richest. Not less than 80% of all important network members are relatives; 53% live in the same village. Households in the poorest quartile tend to be net borrowers in these relationships, borrowing on average four times more than what they lend. It stands to reason, therefore, that these households provide more exchange labour than they receive.

Credit market participation

It is surprising that richer households are much less likely to borrow, as one might expect such households to become involved in self-employment and other non-cropping activities calling for greater financing. The level of financial intermediation (ratio of loans to economic output) is generally expected to increase with the level of economic development.

Equally striking is the large percentage of the poorest households that take out formal loans. More than 40% of households in the poorest asset quartile took out formal loans in 1997 (mainly from RCCs) compared with 22% in the richest quartile. About half of those who took out formal loans also borrowed informally. Lower-income households have little difficulty in using credit productively, but are restricted by limited access. In short, limited credit access and associated restrictions are more likely to explain borrowing behaviour than low productivity of enterprises for which low-income households seek credit. On the other hand, the relatively high incidence of formal borrowing on the part of the poorest people negates the proposition that credit rationing in China excludes the poor from formal financial markets. Indeed, subject to access to funds, the poorest group is more likely to borrow from formal sources than the richest people are. One explanation is that, in poorer areas, the lack of enterprises means that financial institutions are more likely to lend to households, especially when institutions have limited ability to intermediate funds through interbank markets.

Willingness to borrow

Almost 50% of households in the lower income groups were willing to borrow from RCCs under current conditions, provided there was no need for collateral or a guarantor. In the richest quartile, only 30% expressed such willingness (but this is not to suggest that providing such loans would be desirable without building necessary safeguards to ensure repayment). This implies that many of the poor are constrained by supply limitations or loan requirements: they do not lack suitable uses for available funds.

Economic activities, cash flow and demand for credit

The demand for productive loans generally depends on the economic activities of the households concerned. Nearly all households in the sample group pursued cropping and livestock activities, while less than half were engaged in wage earning (48%) and self-employment (29%). More households in the richest group were engaged in non-farm activities (56% in wage earning and 37% in self-employment), compared with those belonging to the poorer strata of the sample.

Economic activities have different financing needs. More was needed for livestock (75%), followed by self-employment activities (64%), cropping (27%) and wage income (5%). The borrowing propensity was highest for cropping (29%), followed by self-employment (22%) and livestock (10%). Borrowing for cropping was much lower in the richest asset quartile (17%) and, for livestock, it was much higher in the poorest quartile (17%).

It was found that, while borrowing more on average, the rich were much less likely to borrow than the poor. While they were more likely to engage in self-employment activities, only one fifth of all rich households so engaged borrowed to finance their activities directly. At the same time, the rich were much less likely to borrow for cropping or for consumption compared with the poor, and richer households were apparently able, and preferred, to self-finance most activities.

Potential for savings mobilization

There is huge potential for increased savings mobilization, meaning that rural production and growth could be made less dependent on external financial transfers. Only 16% of households were reported as having savings, the percentage (23%) being higher for the rich. In total, the value of liquid assets averaged CNY 2 767 per household compared with CNY 1 078 in average borrowing.