China's three policy banks are under pressure to separate their functions from state banks and diversify their sources of income. When the State Development Bank, the Agricultural Development Bank and the Export/Import Bank were formed in 1994, their mandate was to shoulder the burden of policy loans from the four specialised banks to allow them to operate on a commercial basis. In reality, however, they are far too small to shoulder all policy loans. It would be difficult for the specialised banks - Industrial and Commercial Bank of China (ICBC), Bank of China (BOC), Agricultural Bank of China (ABC) and China Construction Bank (CCB) - to become genuine commercial banks. It is not surprising to see recurrent debates on the nature of policy banks and their level of autonomy since their establishment. Sceptics query whether China has taken the right track, while the government hails them as a major achievement in banking reform. An economist at the State Council Development Research Centre said: 'When policy banks were proposed several years ago, there were worries whether we were just creating three more specialised banks on top of the existing ones.After these years, it proves the worries.' China wants to commercialise the specialised banks by giving them unprecedented autonomy in extending loans, but government interference remains a major obstacle to making lending decisions. The People's Bank of China recently told specialised banks that they should lend more to designated enterprises, a move generally seen as slowing down the commercialisation progress. Joe Zhang, an analyst at W. I. Carr, said some banking officials had earlier proposed scrapping the Agricultural Development Bank as its functions overlapped with those of the Agricultural Bank. Beijing dismissed the proposal as it was unwilling to back-paddle on the reform programme, he said. It is estimated that 30 billion yuan (about HK$28.91 billion) has been spent in the past two years on administrative costs, including the setting up of branches. 'But the progress of these banks is not obvious and some banking officials even proposed winding up the policy banks,' Mr Zhang said. He was optimistic that the policy banks could eventually perform the role assigned to them. 'The three policy banks are just too small and the specialised banks have to shoulder some policy loans. But we need to start somewhere,' he said. According to a recent World Bank report, the ABC and the ICBC have transferred some policy loans to the Agricultural Development Bank of China, while the State Development Bank has not accepted any disbursed policy loans from the China Construction Bank. Director of the graduate school of the People's Bank of China, Tang Xu , said it was difficult to distinguish policy loans from commercial loans. It was also important to ensure that policy banks did not duplicate the functions of state banks, he said. 'I think the Export/Import Bank and the State Development Bank will not overlap with the state banks,' he said. 'But the Agricultural Development Bank and the ABC might overlap when the former extends its branches to cities and villages.' The Agricultural Development Bank has set up branches in most provinces and is planning to expand its network across cities and towns. Mr Tang said: 'It is not cost-effective for the policy bank to set up branches in towns and villages because its operation is limited in scale.' Mr Tang said some bankers were proposing to let ABC's local branches handle the 'grass-root' operations of the policy bank. But not all local branches were willing to take on the responsibility. It is understood that some officials at the policy banks have requested that commercial loans be included in their portfolio. The request was rejected by the state, but it indicates that the policy banks could lose their aim of formation. The World Bank has advised Beijing to issue detailed regulations on how policy banks should meet their charters. It should also state whether losses from bad debts should be covered by the budget. 'The State Development Bank's initiative to seek state-owned enterprises and commercial banks as guarantors is a response to the absence of such a provision and defeats the purpose of setting up policy banks in the first place,' it said. But even if questions about their role and definitions of policy and commercial loans are clarified, policy banks will have to overcome a big hurdle before they can carry out their jobs fully - to diversify sources of income. Only when policy banks have the financial strength to take over all policy loans can the specialised banks concentrate on commercial loans. As policy banks do not accept deposits, their income relies on government grants and bond issues in China and overseas. State banks are obliged to buy the bonds from the policy banks with a fixed portion of their deposits. An analyst at the People's Bank of China's Policy Research Office, Shen Bingxi , has said before the existing funding channels for policy banks were insufficient. He said issuing bonds to state banks should not be a main source of income for policy banks as it would limit state banks' flexibility to use their assets. The obligation on state banks to purchase bonds from policy banks was tantamount to a 'tax levy', Mr Shen said. He urged the PBOC to distribute postal savings, which accounted for 5.4 per cent of China's deposits, to policy banks.