China
Aug 20, 2003
Banking means never having to repay a loan
By John M Mulcahy
SourceA generation of China's bank managers, brought up on the notion that banks were bottomless automatic teller machines, are now discovering with dismay that loans are not gifts. China's banking system is insolvent to the tune of US$500 billion, and perhaps more, although there is no sign that the plug will be pulled, and indeed many of the excesses are continuing.
It would take a capital injection of $300 billion to $500 billion to put China's collective bank balance sheet in order. Meanwhile, as the clock ticks towards the next critical World Trade Organization (WTO) deadline - and full access to the renminbi (yuan) market for foreign banks by November 2006 - the risk is that China's banks will lose market share in the most lucrative market segments even as they strive to grow their capital.
While Islamic banking conforms to the strict Muslim teachings prohibiting interest, it would seem that communist Chinese banking could be defined as never having to repay loans. That is not surprising given the history of banking in China up to 1979. Assertion of property rights has hardly been the cornerstone of China's financial system over the past 50 years. The ability to recover debts by foreclosing and attaching assets is still in its infancy.
What now passes for commercial banking is principally the legacy of a closed-circuit financial system that was spun off into various component parts after Deng Xiaoping opted for what he called socialism with Chinese characteristics in the late 1970s. The biggest of the big four commercial banks, the Industrial and Commercial Bank of China (ICBC) was formed in 1984 out of the branch network of the People's Bank of China (PBOC), which is now purely the central bank.
On the face of it the sector is booming. From a platform of rapid growth in money supply (China's M2 grew by 16.8 percent in 2002 and is continuing to expand at this pace) the PBOC reported that loans extended by the banking sector rose 20 percent in 2002, compared with growth of 15 percent the previous year. Interest spreads averaging two percentage points have enabled Bank of China, the most profitable of the big four state-owned banks (the other three are the Industrial and Commercial Bank of China, the Agricultural Bank of China and the China Construction Bank), to treble profits before loan-loss provisions between 1998 and 2002, while the biggest of these behemoths, the Industrial and Commercial Bank of China (with nearly 600,000 employees), grew its profits before provisions by 250 percent over the same period.
But it is after loan-loss provisions that the rot in the system becomes apparent. After providing for loan losses, the Bank of China's profit in 2002 was only 22 percent higher than in 1998, a five-year period when China's nominal gross domestic product grew at a compound rate of more than 10 percent a year. China's compliance with conditions for its admission into the WTO has for the most part impressed observers, especially those who were skeptical that Beijing had any intention of meeting its WTO obligations. Indeed, the eager buildup of their China infrastructure by foreign banks - especially HSBC, Citibank, Standard Chartered, Bank of East Asia and several Japanese institutions - is a measure of their expectations.
China's banks are not capable of growing their way out of their current predicament, given their average 0.2 percent return on average assets, and a huge capital injection will be necessary. While non-performing loans as a proportion of assets have been dropping (for the big four banks the ratio dropped to 26.1 percent at the end of 2002 from 31 percent in 2001), this is almost entirely due to rapid growth in lending (20 percent over the period), and the question is what proportion of the new business will prove to be non-performing.
Historically, state-owned enterprises (SOEs) have suffered no penalties from reneging on debt, and the evolution of the free market over the past 25 years has not been accompanied by fiscal prudence or discipline. To cynics, the transfer of 1.4 trillion yuan ($170 billion) of dud loans to specially created asset management companies in 1999/2000 was the equivalent of shifting the deck chairs on the Titanic, as it solved nothing, and the core problem in China's banking system - lending to inefficient SOEs - has continued.
Even after that bloodletting, the banking system is in serious need of life-support, and by some estimates up to 50 percent of the big four assets can be described as problem loans. That amounts to more than 6 trillion yuan, or $750 billion. Bank lending continues apace, as the political pressure for growth overrides the virtues of aggressive credit control and risk management.
The scale of China's banking dilemma is, like most things in the world's most populous nation, breathtaking. Fitch Ratings builds into its sovereign rating of China an assumption of bank support costs equivalent to 45 percent of GDP. That is the arithmetic, but the reality is that a decision to write off its bad loans would create a fiscal burden for China that the leadership is understandably reluctant to take on board.
This is not a problem that has been visited on the country by some dark foreign force. It is entirely self-inflicted, and will have to be resolved internally. While the Bank of China successfully raised equity through the flotation of its Hong Kong affiliate last year, and China Minsheng Banking Corp is considering an initial public offering (IPO) in London or Hong Kong to raise up to $1 billion, there is no chance of international investors bailing out China's decrepit state banking system.
The arrival of Citibank, HSBC, Deutsche Bank and other major multinational banks, in accordance with WTO requirements, will add to the quality of China's banking system, but it will not come close to addressing the intrinsic flaws in the system. From the current base of 1 percent, split among 190 licensed foreign banks, this sector will grow quickly from 2006. However, even the most optimistic outlook would suggest it cannot achieve market share of more than 10 percent by 2010, and even that would require a doubling of market share each year from 2006. It is also certain these banks will concentrate their energies on the better-quality corporate borrowers and the highest of high net-worth individuals.
Once the WTO-inspired reform is introduced, it is likely foreign banks will initially target the renminbi deposit base, enabling them to build a liability base from which to expand their lending activities. Competition for deposits is a comparatively new phenomenon in China, and typically ignored by the bigger banks. That is about to change, and the danger of losing the cream on its market to the foreign invaders is only one challenge facing China's commercial banking sector.
In fact, there is a strongly held view among some economists in China that the country should simply shut the door on the past and write off all problem loans, starting with a clean sheet of paper. That is easier said than done, though, and even closing the big four banks will not necessarily give rise to a new culture of fiscal rectitude among the SOEs. In a recent analysis of China's banking outlook, the rating agency Standard & Poor's points to the emergence of new real estate bubbles in a number of Chinese cities, as well as weak disclosure and an inefficient SOE sector as some of the risks to the banking sector. These risks are ameliorated by the continuing rapid growth in the economy, the high savings rate and the de facto fixed exchange rate, as well as China's powerful external fiscal position - the country's foreign reserves are close to $350 billion.
That said, the shortfall in bank capital and the looming pension crisis (China has no pension fund to speak of) are the biggest fiscal headaches facing Beijing as China battles to take its place among the world's economic superpowers. Deftly passing the parcel, former premier Zhu Rongji (himself a former head of the PBOC)blithely stated that resolution of the banking problem would be for "another generation". Indeed it is, and although addressing the re-capitalization will hardly be taken lightly by any generation, it would be folly to write off the bad loans without a comprehensive reform of both the banking system and of the SOEs. It is apparent that the SOEs have become addicted to comparatively easy credit, and dire warnings about the consequences of this affliction are not enough to cure the SOE managers of their conviction that "the banks will provide".
In a sense, China has a quality problem. The post-Cultural Revolution generation has learned the art of consumption. Mobile telephone and Internet access outlets stand alongside department stores in prime retail areas, while relics of the past, posters of Mao Zedong and used "Little Red Books" of the Great Helmsman's philosophy are relegated to street stalls. A statistical measure of this new cult of consumption is the ratio of domestic credit to gross domestic product (GDP). Already high at 88 percent in the mid-1990s, by the end of 2002 domestic credit was almost 140 percent of GDP. The proliferation of shopping malls in cities across the country and the penetration of global brands into the domestic market provide one perspective of China's emergence. But there is another perspective, as the reform of SOEs stumbles along.
Standard & Poors suggested that the faster growth of credit than of the overall economy pointed to unproductive or under-productive lending. It was the climate of easy credit that produced the collapse of Southeast Asia's currencies and economies in 1997. "The ratio is likely to increase further should the government persist in stimulating domestic consumption and investment through increased bank lending."
Despite the radical re-casting of China as the fastest-emerging economy in the world, the fact is that managers of SOEs are in many cases still driven by non-commercial instincts. The emphasis on output rather than profits was not confined to tractor manufacturers in Stalinist Russia. "Policy lending" to inefficient state companies remains a fact of life in China, and even though the ratio of lending to SOEs vs non-SOEs has shifted in favor of the non-SOE sector (now estimated at 50:50 against 55:45 two years ago), the baggage of the past has not disappeared.
Throughout the 1990s, as China pushed for growth at all costs, the big state-owned banks extended up to two-thirds of their balance sheets to SOEs. By some estimates at least 50 percent of the loans accumulated by the banks are non-performing, and even the most conservative estimates put NPLs at more than 25 percent. To put that into perspective, based on a total loan book of 13 trillion yuan, equivalent to $1.6 trillion, China's banking system is in need of $400 billion to $800 billion in fresh capital.
The problem is that the government has no option but to increase bank lending. In the overall scheme of things, China's leadership is committed to the social contract that keeps the Chinese Communist Party in power. As long as the economy grows and individual prosperity continues to rise, the masses will see no difficulty in the prevailing arrangements. However, should China's economy stagnate or reverse, there is the risk of popular dissent.
In managing the financial sector China would benefit from a few years of Groundhog Day - the movie in which the past endlessly rewinds itself - with respect to its bank balance sheets. There is a need to freeze NPLs for long enough to grow more capital. Unfortunately, that is an aspiration unlikely to be realized. The transfer of the worst loans to asset management companies has let the banks off a very large hook, but there are many other hooks in an economy unrehabilitated in many respects from the inefficiencies of the past.
Growth of 8 percent a year in gross domestic product has been funded in no small part by easy credit, and there are many who believe the holes in bank balance sheets represent the price China must pay to pull itself up by the bootstraps.
The creation of new banks is no panacea, even if institutions such as the Bank of Communications and CITIC Industrial Bank, both established in the 1980s, have demonstrated that banks in China are capable of sound principles. Bank of Communications was the first bank in China to apply asset-to-liability management, according to Nicholas Lardy of the Brookings Institution. "That meant that the quantity of loans that it could make was limited primarily by the quantity of deposits that it could attract, rather than by the loan quotas that were handed down by the central bank to each of the large state-owned banks."
While that principle is not exactly avant-garde in banking terms, China's peculiar political structure has prevented the big four banks from refusing many of the SOE loans that are now haunting them. The growth in non-SOE lending, it is hoped, will eventually leech the system of its problem loans, although the new lending has its own risks, given that the fastest-growing segments are residential mortgage lending, automobile loans and general consumer credit.
Further evidence that the curtain has by no means been drawn on SOE lending comes from a publication from China's National Bureau of Statistics. The "Communique on the Main Results of the Second Census of Basic Units in China", published in January this year, noted that the private sector, collectively owned shareholdings and other corporations defined as private, produced 50.4 percent of income generated by business corporations in 2002. The remaining 49.6 percent of income was generated by state-owned and controlled corporations. It is improbable that China will turn the credit tap off to SOEs when they are still generating almost half of the country's income.
When China introduced equity markets for the first time since the establishment of the People's Republic, Deng Xiaoping stressed that this was an experiment. Twenty years later, and with market capitalization in excess of $600 billion, the experiment appears to have succeeded. Now, an experiment no less radical than the re-introduction of stock markets is needed to place China's banking system on a sound foundation. Whether that is achieved through the wholesale write-off of non-performing loans or a massive injection of new equity, or a combination of such measures, China will need to address its banking shortcomings without too much further delay.
It is likely that banks such as Citibank, HSBC, Deutschebank and the other foreign banks preparing for a substantial upscaling of their China activities will be concentrating on the most reliable borrowers. These are also the borrowers that will produce genuine profits for China's domestic banks and provide the foundation for well-structured bank balance sheets in the future.
The spirit of reform is undoubtedly in place, but the mountain of non-performing loans appears insurmountable at this stage without comprehensive reform. FitchRatings believes China may be vulnerable to a banking crisis, due to the weaknesses in the system. "However, because of the strength of China's external position, notably its growing foreign reserves, FitchRatings believes that, unlike the banking crises that happened in other countries in Asia in 1997/98, the trigger for a banking crisis in China is more likely to originate from internal rather than external shocks."
John Mulcahy has been covering Asia for 20 years, as a journalist with the South China Morning Post and Far Eastern Economic Review and as equity research head at Vickers da Costa, Peregrine and UBS.
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