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China’s banks forced to follow the government’s course

The real level of problem loans at China’s biggest banks is shrouded in mystery. The good news for investors is that whatever happens, the government will support them – it got them into trouble in the first place. But such state control has led to a reappraisal of what China’s banks have to offer. Elliot Wilson reports


JUST WHAT ARE we to make of China’s banks? World leaders, a bit ropey, poor-to-middling, or cataclysmically awful? Are they now the template on which emerging market banks will be based, or do they face future systemic pressures unparalleled in an economy at its stage of development?

And what is the banking system’s real level of non-performing loans? In a country where secrecy is a virtue, how can we ever really know how many failed bank loans are in the system?

The latter point first. A decade ago, China’s banks were a laughing stock, bursting with soured loans after two decades of uncontrolled lending. Then Beijing got its act together, listing its lenders in Hong Kong and Shanghai and launching an unparalleled crusade to boost transparency and adopt western-style management methods.

Many still boast valuations at or above the level of their largest global peers. At March 14 this year, Industrial and Commercial Bank of China (ICBC), the country’s largest bank, listed in Hong Kong and Shanghai, boasted a market capitalization of $239 billion, well above the largest listed leaders in the US (JPMorgan: $182 billion) and Europe (HSBC: $187 billion).

But then came the financial crisis and China’s banks reverted to type, retreating in on themselves to become again the submissive tools of their political overlords. When Beijing ordered them to lend, as it did during the financial crisis of 2009/10, they dished money out like sailors on shore leave. Beijing mandated the creation of an initial fiscal stimulus package worth $600 billion – a budget that was severely overshot.

 “There was a period before the financial crisis where Chinese banks were seen as western-oriented but that idea has been blown out of the water by the events of the past two to three years. The banks are now tools of the government again, and this is the way it will remain”

Mark Williams, Capital Economics

As a result, any pretence of being listed banks in the western sense has disappeared, perhaps for ever. “[China’s] listed banking vehicles are now largely an irrelevancy,” says Mark Williams, senior China economist at Capital Economics. “There was a period before the financial crisis where Chinese banks were seen as western-oriented but that idea has been blown out of the water by the events of the past two to three years. The banks are now tools of the government again, and this is the way it will remain.”

A Beijing-based distressed debt specialist notes: “It has always been amusing to me that people bought shares in these banks believing they are buying shares in real banks. They are not. They are buying shares in the Chinese government.”

This return to type led to the splurge-gun lending of 2009 and 2010. China’s banks officially doled out Rmb17.5 trillion ($2.7 trillion) in new local-currency loans – almost a quarter of China’s entire economic output – in those two years.

And despite exhortations to rein themselves in, including punitive measures such as regularly increasing reserve requirements, the lending orgy continues. In January 2011 banks disbursed Rmb1.04 trillion in new loans, up 18.5% year on year.

That prompted Liu Mingkang, head of the China Banking Regulatory Commission (CBRC), to grumble that by any measure lending had become “excessively fast”. Not that his words and actions – or those of any senior mandarin – seem to have any visible impact. According to Michael Pettis, professor of ­finance at Peking University’s Guanghua School of Management, loan growth is rising at a “greater rate than ever”, with total lending in 2010 “actually higher than it was in 2009”.

Fresh capital

Much of this splurge lending was siphoned out of state banks into state companies, whence it was dispersed into a dizzying array of investments. Another wave of fresh capital flooded into local government financing vehicles – investment trusts used to pump money into industrial projects to maintain high economic growth and prevent mass redundancies in the face of a weak export market.

Some of this cash was wisely directed into much-needed capital projects such as light rail systems and residential infrastructure. But much went into the sort of scattergun lending reminiscent of China in the 1980s and 1990s.

This led to the construction of ghost towns such as Kangbashi in Inner Mongolia, complete to the last detail bar one: inhabitants. Or the 2010 Asian Games in Guangzhou, more expensive than the 2012 London Olympics; and the two new financial hubs being built in the provincial capital of Henan province, Zhengzhou.

In a normal country, this sort of serendipitous, slapdash lending would quickly leach through the banks. Companies and project vehicles would be unable to service the cost of borrowed capital and loans would be recouped by the banks through sales to third parties.

But China doesn’t work this way. NPLs are a dirty word in a country where economic and social harmony is prized above all and where it is impossible, in legal terms, to declare a state-run company bankrupt.

Given that no one in China, include the country’s own leaders, trusts any official statistic, calculating sour loan ratios is largely guesswork. The last time ICBC estimated its NPL ratio, at the end of September 2010, it stood at 1.15%.

Liu Mingkang, CBRC, thinks lending has become “excessively fast”

Bad loans as a proportion of total loans at ICBC’s overseas branches was reckoned to be even lower, at 0.5%. Across the entire banking sector, from the big-four banks to small city lenders and development lenders, the overall rate of NPLs is estimated by the CBRC at between 2% and 3%. Few people, probably including senior China bankers, believe their institution’s own internal figures.

It is worth estimating the total quantity of soured loans in China. Talking to the CBRC, it places the total pool of dud loans at about Rmb900 billion, or about double the Rmb450 billion to Rmb500 billion estimated at end-2010 by the People’s Bank of China. That would place NPL ratios at about 4% to 5%.

But even this is less than the likely figure. Capital Economics’ Williams reckons that 10% to 20% of the roughly Rmb4 billion in new loans siphoned into local government financing vehicles in just one year, 2010, or up to Rmb800 billion, will fail totally. In March, Barclays Capital estimated that 15% of the money loaned to provincial bodies was siphoned into infrastructure projects that are “less than 30% covered by cash flows” and have little or no chance of making their interest payments.

None of this is yet showing up on the books of banks, which prefer to ever-green most financing – rolling over loans every time they come due – for fear of looking foolish in front of their superiors.

Still sour

Barclays estimates the ratio of soured loans at the leading four Chinese banks – ICBC, Bank of China (BOC), China Construction Bank (CCB) and Agricultural Bank of China (ABC) – at between 15% and 20%, with about one in five at BOC having failed entirely. Hong Kong-based Asianomics puts total distressed debt in the country’s banking system at about $400 billion.

During a recent series of interviews with Beijing-based NPL specialists – a mix of foreigners and Chinese nationals – all were asked about the likely level of failed loans at Chinese lenders. The lowest estimate was 10%; the highest “40% or 50%”, or roughly the same rate of NPLs that banks were burdened with a decade ago.

Few on the mainland are willing to go on the record. One of the few who will, Capital Economics’ Williams, does so because he lives in London and is far from the crushing consensus of China’s numbers machine. Williams says it is a “reasonable assumption” that the NPL ratio “will go up to 8%, 9%, 10%”.

He adds: “The problem here is that serious problems have yet to be acknowledged by [China’s leaders], and bad-loan numbers are sure to increase significantly over the next couple of years.”

How much does all of this matter? Will a new influx of bad loans really shake the foundations of Chinese banking, as it has done before, and as it did in Europe and the US in late 2008?

Some observers believe it will. In March this year an old report by Fitch Ratings, which went largely unnoticed on issue in June 2010, caused a stir around the world. China, Fitch warned darkly, faced a 60% chance of a full-blown banking crisis by mid-2013, with a London-based director, Richard Fox, warning of “holes in bank balance sheets” if the current mainland real estate bubble were to burst.

“In most developed countries, over the long term GDP growth and interest rates match”
Michael Pettis, Peking University

Fox added: “We are talking about systemic crises here, affecting most of the major banks. A crisis is something which technically decapitalizes the banking system.” Fitch’s exhortations follow its downgrading of China’s banks in June 2010 to MPI3, the highest of three risk categories. That indicator correctly alerted the world to fiscal crises in Iceland and Ireland, although it failed to warn of problems in Spain.

Sixty percent of all emerging-market nations downgraded to an MPI3 rating by Fitch face serious systemic banking crises within three years. The likelihood of a crisis – say, a run on a smaller bank that spreads to the wider industry – is raised when you add to the mix soaring property prices and credit growth in excess of 15% over the course of two years. Chinese credit growth averaged 18.6% in 2008/09 while house prices rose more than 30% over that period.

Again, what does this really mean? If faced with a clearly unsustainable rising level of failed loans, Beijing will merely bail out troubled lenders, as it did on a regular basis in the late 1990s and early 2000s, using foreign exchange reserves or by issuing bonds payable by the banks to their masters within the finance ministry.


The risk of a looming banking crash in China is often overblown by zealous foreign observers – after all, Beijing controls all the moving parts of the banking industry and can manipulate the system as it sees fit, shifting money from one institution to another to stave off liquidity problems in a specific area.

And it’s not as if the country’s leaders are merely standing idly by waiting to be tested. Higher reserve requirements, rising interest rates and more punitive measures, particularly applied to smaller mainland banks, have all been imposed in recent months, forcing banks to issue new bonds and equities to boost capital adequacy ratios.

Yet there is much that Beijing is not doing with its banks. Non-performing loans might not yet be a problem, at least officially, but if that is really true it is only because of the artificially low rate of interest.

In a more normal economy, interest rates would be set at around the level of GDP growth, which is between 10% and 14%, depending on which set of figures you read, and most likely at the upper end of that scale, while the benchmark lending rate is set at just 6%.

That rate is likely to be raised twice in the first half of the year, following three separate increases in late 2010 and early 2011, each designed to tackle worrisome inflation levels, hovering at about 5%. Rising prices are an added side effect of the poorly directed, scattergun bank lending of recent years.

Raising interest rates to parity with GDP growth would benefit China’s legion of banking customers, who tend to leave their savings in loss-making deposit schemes at banks, which in turn use that capital to lend at low rates and, on the order of Beijing’s apparatchiks, to state-owned enterprises.

Counter to development

This is how China operates, yet it works counter to the smooth development of any well-oiled economy. As Peking University’s Pettis notes: “In most developed countries, over the long term the two numbers [GDP growth and interest rates] match.”

If China raised interest rates, it would boost retail consumption – the stated aim of the Politburo – as people would be earning more from the renminbis in their pockets. Another plus would be that state companies and local authorities would think twice about simply throwing money at wasteful projects that are economically unviable and do little more than create future bad loans at the expense of a few, short-term construction jobs.

On the downside, higher interest rates would cause a spike in non-performing loans. After all, at such low levels of interest it’s easy to assume that a lot of debt is serviceable and that loans, particularly in China, come with a certain level of implied debt forgiveness.

It’s a great trick, as long as it lasts. A Hong Kong-based NPL specialist notes: “Raise the interest rate to 14%, on a par with GDP, and see how many loans fail. That’s the real stress test. My guess is that around half of all loans then would prove to be non-serviceable.”

The broader point here is China’s weak banking system. Many global banks have wobbled in the past few years, but any lender, any banking structure, should be able to stand on its own two legs. As Carl Walter, co-author of Red capitalism: The fragile financial foundation of China’s extraordinary rise, notes, post-financial China is “a jerry-built financial structure caught somewhere between its Soviet past and its presumably, but not assuredly, capitalist future”.

Put another way: the strength of China’s banks, and the quality (not quantity) of the assets they hold, does matter, not because of the NPL ratio or the fear of future financial stress tests, but because a weak financial system denudes domestic and thus global economic growth.

“The real problem,” says Capital Economics’ Williams, “is that a weak financial system will condemn China to low long-term economic growth because banks are the government and because lending results from political relations rather than emanating from where the best returns can be found. China got away with this 10 years ago when US consumers were happy to buy whatever extra industrial production the country could produce but it’s not going to be the same this time.”

The People’s Republic is in a strange position. Its banking system is to be envied superficially. It is both strong, dominating the domestic financial landscape, and yet absurdly brittle, hollowed out, as it was in the 1980s and 1990s, by an unenviable and probably unmeasurable slug of bad loans.

Non-performing loans might be 1%, 10% or 50%. In many ways it doesn’t matter. China’s banks are stuck in a time warp. The $600 billion stimulus package, lauded to the heavens when announced by Beijing in late 2008, is now cuttingly referred to by one venerable mainland economic thinker as “the worst policy blunder of all time”.

All it did was to start a new round of splurge-gun lending in 2009 and 2010, creating a new mountain of bad loans that remains hidden from view inside the vast, murky Chinese machine.

Whatever happens, Beijing and its all-powerful finance ministry will always be on hand to shore up liquidity, suck out bad loans and, if required, to stave off a run on any wobbly lender.

One day, probably not long from now, and possibly around mid-2013, China will be forced to clean up its banks and recapitalize them, whisking away the rank old non-performing loans and pausing briefly before engaging on another round of berserk lending. In China, every day is déjà vu, all over again.

See also:

The Chinese way with sovereign wealth

You read it here first:

Euromoney pointed out the perils of China’s lending boom March 2010 with ‘Stimulus spree leaves China on the edge’

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