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Banking means never having to repay a
loan
By John M Mulcahy
A
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.
(Copyright 2003 Asia Times Online Ltd.
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