. INTRODUCTION Banking reforms are at the core of Chinas strategy to improve the intermediation of its large private sector savings. As part of the financial liberalization program, reforms in the banking sector have been implemented over the last two decades, replacing the monobank system with a multilayered system that separates commercial lending and central banking functions Considerable progress has been made in restructuring three of the four major state-owned commercial banks(SCBs)and, by end-2005, all three banks announced the selection of major foreign financial institutions as strategic investors with minority ownership stakes. The three banks have also recently completed initial public offerings(IPOs). Opening the banking sector to foreign competition is part of that broader strategy by the Chinese authorities to enhance the efficiency of banking sector through various channels including greater financial innovation and improving corporate governance in banks Increasing foreign participation has been one of the key trends in the Chinese banking system in recent years. Foreign banks do business in China either directly through their own branches and subsidiaries or indirectly as minority investors in Chinese banks. The indirect participation has grown rapidly in recent years, particularly in 2005, as almost all major Chinese banks now have a foreign strategic investor. Since June 2004, foreign investors bought over US$ 17 billion worth of shares in Chinese bankS. This paper takes stock of the involvement of foreign investors in the Chinese banking sector, drawing on international experience with foreign banks in other emerging markets. Direct participation has remained elatively small, but it is likely to grow over time as remaining restrictions are eliminated effective December 11, 2006 under the WTO agreement(Box 1) Unlike many other emerging market or transition economies, China's domestic banks have well-established and extensive presence, thus direct market penetration by foreign banks may not be easy. While in most other countries, foreign investment took the form of direct takeover or majority shareholding, foreign investment in China's banks has taken the form of minority shareholding with very limited management involvement. Thus, how much nfluence foreign investment will have on the domestic banks' core business-and most importantly, risk management--is therefore debatable. Many of the strategic investors have also entered into separate arrangements with the domestic banks in noncore businesses such as credit cards. which brings both benefits and risks In these areas the foreign banks technological advantage and global networks can increase efficiency and help to expand these markets 2 Details of the progress made by China in banking sector reforms can be found in Podpiera(2006) This excludes the most recent agreement, finalized in late 2006, in which a consortium led by Citigroup(and including domestic participants as well) acquired an approximately 85 percent stake in the Guangdong Development Bank for about $3. 1 billion3 I. INTRODUCTION Banking reforms are at the core of China’s strategy to improve the intermediation of its large private sector savings. As part of the financial liberalization program, reforms in the banking sector have been implemented over the last two decades, replacing the monobank system with a multilayered system that separates commercial lending and central banking functions. Considerable progress has been made in restructuring three of the four major state-owned commercial banks (SCBs) and, by end-2005, all three banks announced the selection of major foreign financial institutions as strategic investors with minority ownership stakes. The three banks have also recently completed initial public offerings (IPOs). Opening the banking sector to foreign competition is part of that broader strategy by the Chinese authorities to enhance the efficiency of banking sector through various channels including greater financial innovation and improving corporate governance in banks.2 Increasing foreign participation has been one of the key trends in the Chinese banking system in recent years. Foreign banks do business in China either directly through their own branches and subsidiaries or indirectly as minority investors in Chinese banks. The indirect participation has grown rapidly in recent years, particularly in 2005, as almost all major Chinese banks now have a foreign strategic investor. Since June 2004, foreign investors bought over US$17 billion worth of shares in Chinese banks.3 This paper takes stock of the involvement of foreign investors in the Chinese banking sector, drawing on international experience with foreign banks in other emerging markets. Direct participation has remained relatively small, but it is likely to grow over time as remaining restrictions are eliminated effective December 11, 2006 under the WTO agreement (Box 1). Unlike many other emerging market or transition economies, China’s domestic banks have well-established and extensive presence, thus direct market penetration by foreign banks may not be easy. While in most other countries, foreign investment took the form of direct takeover or majority shareholding, foreign investment in China’s banks has taken the form of minority shareholding with very limited management involvement. Thus, how much influence foreign investment will have on the domestic banks’ core business—and, most importantly, risk management—is therefore debatable. Many of the strategic investors have also entered into separate arrangements with the domestic banks in noncore businesses such as credit cards, which brings both benefits and risks. In these areas, the foreign banks’ technological advantage and global networks can increase efficiency and help to expand these markets. 2 Details of the progress made by China in banking sector reforms can be found in Podpiera (2006). 3 This excludes the most recent agreement, finalized in late 2006, in which a consortium led by Citigroup (and including domestic participants as well) acquired an approximately 85 percent stake in the Guangdong Development Bank for about $3.1 billion