Author: Gill Baker
China’s banking system faces the kinds of challenges being grappled with by bankers worldwide – except that the sheer size of its industry presents a new level of complexity. The analogy of the oil tanker that needs a lot of space and time to change course is particularly apt in China’s case. And the task is made more daunting still by the need to get reform in place before World Trade Organization rules come into force, thereby opening up the market to a wave of international banks with massive experience and powerful brands.
The timeframe for the PRC’s entry is still hazy, although most commentators are reckoning on the end of this year. Nevertheless it has focused the minds of bankers and regulators to a sufficient degree for a raft of new rules to be issued in an attempt to strengthen balance sheets and clean up institutions ready for the arrival of international competition.
There is not going to be a sudden takeover of the mainland’s banking industry by foreign players. In the first two years of the WTO regime, banks will not be affected at all. After that, investment banking will be opened up to foreign competition, but that should have little impact on domestic institutions, which tend to focus more on retail and commercial business anyway. It is not until after year five that China is required to open its door fully to foreign banks for retail and commercial business. The government hopes that by then the local players will have got their act together.
Meanwhile, news regulations designed to strengthen the domestic banks come thick and fast. “Too many changes,” says Arthur Lau, associate director at rating agency Fitch IBCA, who is trying to keep up with the edicts. “Almost every day they have a new policy for the banks. Regulators in China want to step up the reform in the finance and banking sector to prepare themselves for WTO, so they are speeding up the process,” he explains.
Two of the most important changes – on disclosure and non-performing loans (NPLs) – have started to filter through into the current reporting season for 2000 accounts. These emphasize the difference in China’s banking industry between the big four state-owned banks – Industrial and Commercial Bank of China, Bank of China, Agricultural Bank of China and China Construction Bank – and the small and medium-size banks.
“The small and medium-size banks are more receptive to change, mainly because they are smaller and the structure is not as large and complex as the big four commercial banks, so it is easier for them to adapt,” says Lau.
From year-end 2000 all listed banks have been required to publish two sets of accounts: those under the Chinese accounting system and those conforming to internationally accepted accounting principles. The latter must be audited by an internationally recognized auditing firm.
Agreeing such changes has not been easy, as HSBC Securities analysts observe in a recent report: “In a country that for decades has not kept accounts, let alone management accounts or data for regulators, it is clear that monitoring has never been a major occupation. The absence of reliable monitoring of compliance makes the task of regulators more difficult than elsewhere. However, the correct policies are in place and full implementation at the micro level is only a matter of time.”
A painful culture change
The dual system is a fundamental change in a culture notorious for its reluctance to reveal accounting details. And the culture change is all the more painful when the new figures paint a far grimmer picture of banks’ financial health than those shown by the traditional Chinese accounting practices.
The contentious issue is differences in asset quality. Conforming to new reporting standards has made bankers and investors wince, because loan classifications under Chinese accounting standards are considerably more generous than those under their international counterparts. The latter do make comparisons on an international scale more meaningful, however.
It’s not just the extent of bad and doubtful debts but also the appropriate provisioning level that are coming under new scrutiny.
China’s most recently listed bank, Minsheng Bank, which floated last November, illustrates the point. Under international standards its auditors required 91% reserve coverage on NPLs, while under domestic accounting rules a mere 31% provisioning was required.
Despite the new standards, there is still uncertainty over the true state of China’s banks. As Lau admits: “No-one really knows what the real asset quality figure is for the Chinese banks.”
As a rough guess, however, he reckons NPLs could be 30% to 35% for the system as a whole if calculations are made under international standards. Within that total, the big four banks have much higher NPLs than the newer, smaller banks which have been spared the worst excesses of policy lending.
Bank of China has reported NPLs of 29% for the last year and Lau reckons the other three banks are likely to have even higher figures. Even under Chinese reporting methods the NPLs are in double digits, he adds.
Risk of repeating past mistakes
There is one loophole. Although all banks are required by the People’s Bank of China to hire internationally accepted auditors, they are not required to disclose the results unless they are listed. More flotations are on the horizon, however, in the run-up to WTO entry.
Vincent Chan, China economist and strategist at UBS Warburg, praises the transfer of Rmb1.2 trillion ($145 billion) of NPLs to asset management companies, but cautions: “China still needs to do a lot to prepare for WTO entry. The angle now is how China can avoid a repeat of the NPLs – this is a key issue.” The risk is that banks will continue to be lent on to prop up ailing concerns that provide employment and a social safety net for large numbers of Chinese people.
Pointing to problems of recurring NPLs in central European economies, Chan is concerned at the possibility of that happening in the PRC, and urges a rethink on the way NPLs are dealt with.
“China does not have a lot of time to do it. In five years it will have to deal with the issue of foreign banks able to tap local deposits and if Chinese banks are still not healthy that is a serious concern,” says Chan. “The market seems to have praised a lot of what the Chinese government has done, but this is far from enough and it will not be easy,” he adds.
As if to emphasize the authorities’ determination to reform, however, a financial sector conference has been organized for later in the year to encourage debate on reform.
Many of the banking sector’s woes can be laid at the door of the state-owned enterprises, believes Chan, who is particularly critical of the way in which some state-owned enterprise (SOE) subsidiaries have been allowed to walk away from their debts while the banks continued to lend to their parent companies. “How can they have any discipline?” he asks. “Banks need market discipline. You are inviting a big moral hazard problem and this needs to be addressed otherwise the asset management companies will not be a big success.”
Asset management companies (AMCs) to deal with NPLs have not generally been a success in emerging markets anyway, notes Chan, who pinpoints lack of action once assets have been acquired as the most troubling aspect of this poor performance. The US model, in which assets and underlying collateral were immediately resold to investors providing new capital is the best model for running such an operation, whereas China and other emerging markets face the danger of NPLs simply being transferred to a new entity and then left to stagnate.
Much of the reluctance to enforce loan recovery effectively boils down to political considerations. “China is still concerned about the fate of the state-owned enterprises, but if you do not create some pain it is very difficult to improve market discipline,” says Chan. He adds: “The key issue is not the existing NPLs, it is whether you can ward off future NPLs.”
Another factor contributing to NPL problems is the tendency in China to restructure loans with debt-to-equity swaps. Chan reckons around a third of NPLs have been restructured in this way, and says it lets off some borrowers, who effectively escape servicing their debts and simply saddle creditors with poorly performing businesses. The key to troubled company restructuring and bad-debt clean-ups is in attracting new capital and putting assets on a productive footing. There has to be a carrot and a stick.
“The Chinese government has not done enough to bring some high-profile cases of bankruptcy. Someone has to take the responsibility,” says Chan.
Although the asset management companies may be facing a tough time, from the banks’ perspective they have received full value for their NPLs and, says Chan, have been completely bailed out. “Creating asset management companies is the right decision, but something more has to be done to make them independent from the interests of banks,” he adds. “The government is at a crossroads and they need to decide how to go ahead, but there is still too much worry about unemployment and social stability.
Restating interest earnings
In addition to the new international accounting regime, perhaps the other most significant regulation aimed at tightening up China’s banking system is the central bank’s policy on accrued interest, which, says Lau, significantly affects banks’ profit and loss accounts.
In 1998-99 the banks were allowed to accrue interest on loans that were overdue by up to two years. Under new international practice, that has been slashed to 180 days, after which accrual must stop.
The result has been that before 2000 interest income had been hugely inflated, with a corresponding overstatement of profitability, and starting this year the banks begin the painful task of reversing the interest income they have accrued in the past three years. They have been given five years over which to spread the reversal, but it is still going to be a daunting task.
Lau’s back-of-an-envelope calculation, based on 1998/99 NPL growth of 30% to 40% and a net interest margin of 2% to 3%, arrives at a figure of 12% of interest income accrued that needs to be reversed.
“It’s a big number that will depress the banks’ profitability over the next five years as they do not have the capital to reverse it all in one go,” he says, adding that for last year most banks reported spectacular increases in lending but very little in interest income, illustrating the point.
These fundamental changes in approach do synchronize nicely with the WTO agenda, however, giving the domestic banks some breathing space to bed down the new regime before the full force of outside competition begins to bite in five years’ time.
The impact of the WTO regulations will vary in the context of the different classifications of China’s banks. On the one hand there are the big four, then the shareholder commercial banks such as China Everbright Bank and CITIC Industrial Bank, which have branches in the major cities nationwide. Thirdly, there are the regional banks such as Beijing City Commercial Bank and Shanghai City Commercial Bank, which have a narrower coverage.
The first group of banks are expected to withstand foreign competition because of their enormous network of branches, their customer bases and established range of products and services.
The regional banks may have a bigger challenge as they are not as large and do not have the capacity for expansion in order to compete with the foreigners’ huge resources and expertise, nor to develop their products as fast as the big four.
Notwithstanding that, it is not going to be easy for even the largest incoming banks to conquer the market overnight. “We think the foreign banks are not going to be able to expand their networks as comprehensively as they would like. China is a huge market and they will selectively open branches. The most likely scenario is for them to join forces with the shareholder commercial banks to develop the market,” says Lau.
As HSBC Securities puts it succinctly: “Most critical of all the gains, China is increasing the competitive tension for its existing financial institutions. Many of these will lose their best staff to new entities unless they list, which means they must comply with accounting standards, and be forced down the competitive route. This means domestic institutions will need to more quickly adopt new regulations or be compared unfavourably, thus overcoming present reluctance. It appears the intention is to make the current herd improve its performance, not kill it with a stronger imported breed.”
The composition of credit in China’s banking system is also changing, from borrowing exclusively by state-owned enterprises towards more and more credit extension to the private sector, to householders for residential mortgages and to multinational companies, with an accompanying improvement in the quality of loan portfolios. Total loans to the private sector are still probably only around 10% of outstanding loans, although they are the fastest-growing segment.
Membership of the WTO will simply expedite the changes that are already under way. “As far as the banking sector is concerned China is getting into a brave new world,” says Frederick Hu, Asia-Pacific chief economist and strategist for Goldman Sachs. “There will be tremendous competitive pressure from global groups like Citigroup and HSBC but the domestic banking system has a window of opportunity of two to five years where they have to get themselves on to a stronger footing so they can compete with the international banks.”
Network lead not decisive
Chinese banks’ extensive branch networks and existing customer basis will not be enough in themselves to insulate them from the foreign influx, Hu warns. “They work in the Chinese banks’ favour but that in itself is no guarantee they will succeed and survive in the post-WTO environment. If they do not change the way they are operating fundamentally, if they do not improve credit culture and capability for risk management, they will be in big trouble,” he says.
To be fair to the leaders of some of China’s best banks, including those who have worked abroad or in the international departments of their own banks, they know this full well. The challenge is to spread new skills and ways of thinking through, in some cases, massive organizations.
Douglas Beal, principal in AT Kearney’s Asia-Pacific financial institutions practice, sees reforms as more bank driven than government initiated. “In general what we are seeing now in the last year is that all these mainland financial institutions and banks have realized they are going to have to shape up and they are going to have some problems when they have to start competing on even ground with the foreign banks. It’s not like a mass organized movement to reform, it is more some of the forward-thinking managers of some of the banks that are figuring it out on their own,” he says.
“They are open to ideas from foreign consulting firms and many of them are trying to set up partnerships with foreign financial institutions. Usually the foreign institution does it for free, they give some of their know-how but they get a shot at an equity stake in the future. They look at it as an investment,” he adds.
It’s not an easy or an even process. Beal sees some Chinese banks coming to him looking for a new computer system, when actually the problem is more to do with internal operation systems and processes that need to be addressed first.
“Customer segmentation is something Citibank and HSBC are very good at. Banks in China have no idea how to segment their customers and as a result the foreign banks will easily cherry-pick the 5% to 10% of customers that make up 90% of profitability,” he explains.
While the commercial banks, both foreign and domestic, will have their work cut out, the investment banking scene is likely to be a different story. Initially at least there is not likely to be much effect on local banks because under the current law domestic commercial banks are not permitted to engage in investment banking business. It tends to be securities houses or specialist finance companies that take this business, although a number of the banks – including foreign firms – have found ways to tap into the market through joint ventures such as that between China Construction Bank and Morgan Stanley.
But though local players have a niche in terms of the domestic capital markets, foreign banks are still likely to have the upper hand where Chinese issuers are looking to tap the international markets. Nick Andrews, managing director of equity capital markets at Credit Suisse First Boston, confirms that most foreign investment banks are keen to get a toe in the market.
In the context of WTO, he says: “Most people generally believe this can only be a good thing for investment banks. It can only increase the amount of capital raised offshore by China.”
But he recognizes that the country is also seeking to develop its own domestic capital markets, citing oil company Sinopec, which recently raised a large amount on the domestic markets at significantly higher valuations than where its shares were trading internationally.
“At the same time as the WTO is increasing investor appetite for China, China is also using its own capital,” adds Andrews. “There are huge pools of capital onshore, and from the corporate finance perspective it’s a no-brainer,” he says. “China is very keen to develop its domestic capital markets, improve them and bring them into line with international practice.”
A bridge to offshore markets
And that is being achieved in some cases by listing important flagship industrial companies offshore, in New York and Hong Kong, and then relisting them back on the China stock exchanges, having established a degree of credibility and transparency in line with international approaches. Sinopec was just such a company, which listed in the US and Hong Kong and is now trading on the Shanghai market at a premium.
“It’s raising the bar for expectations of what should be happening in Shanghai. It’s management of domestic expectations,” says Andrews. In addition to the transparency issues, there are other reasons why a Chinese company might want to raise capital offshore, he suggests.
Raising hard currency – particularly US dollars for companies in dollar-based industries – is another reason. And the listing back home of companies that had gone offshore is gradually bringing down average P/E ratios on the domestic markets.
That said, the number of Chinese enterprises wanting or able to tap the overseas markets at the moment is still fairly limited, with only the largest companies in any position to make inroads. Thankfully, for medium-size companies – state-owned or private – the domestic markets are large enough and becoming more sophisticated.
Anna Borzi, financial services analyst at HSBC Securities, says she can understand the attraction of high P/Es and domestic appetite in the local markets for smaller bank issuers such as Shanghai Pudong Development Bank. The offshore capital markets come into their own when a bank is considering an overseas acquisition, as that bank is rumoured to be. “They may wish to list and raise money in the market in which they may wish to make an acquisition, hypothetically,” says Borzi.
“When you get to the large banks there is no doubt there are those that are of the size to be international players and a big part of that is having both debt and equity investors, and also bringing back into China international best practice,” she says.
Minsheng Bank has received approval from the Central Bank of China to issue the republic’s first convertible bond. The Rmb2.4 billion five-year deal is expected towards the end of the year and is being lead-managed by local houses. Shenzhen Development Bank has got permission for a similar deal and is waiting to gauge market reception to the Minsheng deal before launching it.
“Because of the non-convertibility of the currency, it is still very much a domestic game, but we are going to see more developments of that market,” predicts Andrews, who adds: “I am sure there is quite a lot of learning to do, but I never cease to be amazed by the market savvy in China.”
Meanwhile, Bank of Communications is considering inviting foreign investors to take up to 15% of its equity, a move that would represent a new departure for mainland China banks. Although Bank of Communications may be making a particularly bold move, most large banks want to raise equity in some shape or form.
“They would like to have capital. Asset-quality issues in the Chinese system are a huge problem and in order to clean up the banks they need a lot of capital to write off the loans,” says Lau. Even among the big-four banks, only Bank of China has a BIS capital adequacy ratio higher than 8%. More flotations are also in the pipeline, with Hua Xia Bank expected to be next to market, followed by China Merchant Bank.
Privatization of the big four is still a long way off, however. Their assets make up 90% of the banking system, and they are considered too big to sell off effectively. Indeed it would be unwise to believe China’s capital markets, while huge, are somehow limitless.
“Just consider the size of the big banks. They rank in the top 50 in the world by assets, and you have got to start thinking whether there is sufficient appetite in China if the big four were going to list 50% of their equity. To have international position, branding and capital currency there is no doubt there will be strong demand for them to list internationally,” says Borzi.
Pension fund potential
The whole restructuring exercise in the PRC should also be viewed in the context of the country’s pension system, and indeed it is a driving force behind the reforms, believes Man Chan Wah, head of research at Worldsec International. “Pensions are not the most exciting topic in the world, but China’s pension system is basically bankrupt, and they have to shift from a pay-as-you-go to a personal self-funding system,” he says.
Essentially China is facing the same problem that economies are facing worldwide – a pension system under which a shrinking number of current workers’ contributions are being used to pay out pensions to a growing number of older, retired people. “It’s something they cannot get away from. The writing is clearly on the wall. It’s just a question of how soon they can make the necessary changes. As with most things in China it is not a very easy task to execute,” he adds.
Clearly pension funds need domestic markets to invest in and expert, perhaps foreign, managers. HSBC Securities is particularly excited about plans to allow foreign investment in red chip A-shares, enabling direct exposure to the local market. Most notable of the offshore deals have been China National Offshore Oil, which raised $1.4 billion in January with a Hong Kong listing, and Travel Sky, which raised $150 million.
And there are more in the pipeline, reckons Andrews, who is tipping the fixed telecoms sector for one of the next big sell-offs, as soon the utility is split into two regional entities for the north and the south.
“The thing about restructuring in China is that it is always difficult, but everything is possible,” he adds.
