< http://www.feer.com > BANKING Wasteful Transfusion
The addiction of China's big state banks to rash lending could defeat a drive to drag them out from under a mountain of bad debt before they go public. The poison still runs deep in their veins By Tom Holland and David Lague/HONG KONG Issue cover-dated January 22, 2004 IT'S BAILOUT time again for China's Big Four state-owned banks. For the third time since 1998, the government has stepped in to prop up these technically insolvent behemoths that account for more than 70% of lending and deposits in China. Beijing doled out a total of $45 billion to Bank of China and China Construction Bank in late December. Analysts say that the full bill could reach $120 billion by the time the other two banks are recapitalized as part of the same programme. That's on top of two earlier rescue efforts that cost a total of $202 billion. The $45 billion was aimed at bolstering investors' confidence in the two institutions ahead of their flotation on international stockmarkets, and was warmly welcomed, mostly by merchant banks hungry for fees from the planned listings. But the unusual way in which the money was pumped in and its unconventional source--China's foreign-exchange reserves--left some analysts believing the injection will merely feed the banks' long-standing addiction to reckless lending. For unless the Big Four can make real progress in curbing the accumulation of new bad loans, this bailout, like its predecessors, will simply amount to another exercise in flushing money down the drain. "They have thrown more money at it but they haven't really dealt with the problem," says Stephen Harris, an associate professor at the National University of Singapore. At first, most foreign observers greeted the capital injection as solid evidence that Beijing is committed to restructuring its state-owned banks. Ratings agency Standard & Poor's, for example, immediately revised its outlook on China Construction Bank and Bank of China to positive from stable. But a closer examination of the mechanism used, and of the few details so far released by the Chinese authorities, leaves plenty of questions unanswered. Most significantly, there is the stipulation that the money cannot be used for writing off nonperforming loans, or NPLs. The new capital is in dollars, which are fine for capitalizing Chinese banks, but not much good for writing off bad loans denominated in renminbi. There is little chance that the banks will be allowed to convert the money any time soon. Such heavy renminbi buying would place an intolerable upward pressure on China's currency, forcing the authorities to buy dollars and borrow renminbi to soak up the local currency liquidity released. That would defeat the object of using foreign exchange to recapitalize the banks. But if the banks can't convert the new cash, holding it on their capital accounts will free up existing capital for writing off bad loans. It will also give them leeway to raise more capital in the form of subordinated debt, much of which will also be committed to write-offs. The big problem for overseas observers, including potential investors, is that it remains unclear just how many NPLs the state banks are carrying on their books, or at what rate new NPLs are being created. At the end of September 2003, for instance, China Construction Bank, regarded as the healthiest of the Big Four, had an official NPL ratio of nearly 12%, down from about 15% at the end of 2002. At first that appears encouraging. But the fall in the proportion of NPLs must be seen in the light of a rapidly growing loan book, widely thought by analysts to have increased by around 20% last year. In those terms, the drop in the ratio of NPLs to loans can be almost entirely accounted for by the overall increase in lending, rather than by the aggressive write-offs CCB claims. "In the past two years most Chinese banks have witnessed very strong loans growth. That makes the NPL ratio look smaller," explains George Lee, an analyst at specialist emerging-markets rating agency Capital Intelligence in Hong Kong. There are other worries. First, there is the widespread suspicion that the official NPL levels are an optimistic fantasy. Most international observers estimate the real levels for all of China's banks to be much higher, with Standard & Poor's saying the true ratio is as high as 45%, or about $850 billion. "We are very, very cautious and suspicious regarding Chinese banking numbers," agrees Lee. That $850 billion would dwarf the estimated $145 billion-175 billion it cost the United States to bail out defunct savings-and-loans institutions in the 1980s, and the $377 billion worth of Japanese loans officially classed as nonperforming at the end of March 2003. But it pales into insignificance besides some estimates of the true size of Japanese banks' NPLs that have ranged up to $2 trillion. Then there are questions about the quality of new loans in China. Right now, with the economy growing at a real rate many economists believe to be 10% or higher, the banks are riding the heady uprush of a booming business cycle. "Recent loans look like very good quality. We are not seeing many go bad right now," says David Marshall, managing director at Fitch Ratings in Hong Kong. "But when the cycle turns down, that's when the bad loans will start to appear." While some analysts believe China's banks have rigorously tightened credit standards, many argue that the lending splurge of the past year will end up magnifying the NPL mess. "The new loans may not pose a problem in the short term, so the loan base will appear sound for the next 12 or 24 months," says Lee at Capital Intelligence. "But two or three years down the road, the new loans could turn sour and become NPLs." Not only have banks enthusiastically embraced lending to developers in China's highly speculative property sector, but they have continued to make new loans to many of the state-owned enterprises that were the source of their original problems. While some of the most hopeless companies have gone to the wall, there are plenty of inefficient state-sector companies still receiving new loans as a form of social welfare. "The government is loath to cut off credit," says Fred Hu, a managing director at investment bank Goldman Sachs. "The question is the size of the black hole." Hu, like other experts, say the biggest danger is that the banks will continue their unsound lending and poor risk management. The experts want to see a comprehensive and credible restructuring plan, a medium-term business strategy, sweeping changes in credit policies and risk control. They also want improved management and governance to stop senior managers acting more like party officials than bankers and to halt politically motivated loans to ailing state-owned enterprises. "The government injection of capital is meant to catalyze bank reform and speed up the process. This is necessary, but by no means sufficient," says Hu. The International Monetary Fund has made clear that much more needs to be done to build a healthy financial sector. On January 9, the IMF's representative in Beijing, Ray Brooks, said it was of "critical importance" for China to move quickly on restructuring the Big Four to prepare them for competition with foreign banks from 2007. "While the details of this package are being worked out, we understand that further measures that will be taken include an upgrade of internal management, more strict auditing requirements, more prudent provisioning for loan losses and closer oversight by the supervisory authorities," Brooks said. Then there's the unusual source of the $45 billion. Tapping China's foreign-exchange reserves to shore up the banks is a cunning sleight of hand. It means that Beijing doesn't have to borrow the money in the home market, and the impact on the headline reserve figures is not obvious at first. At the end of 2003, China announced that its reserves stood at $403 billion. That compares with $401 billion at the end of October. Presumably, without the injection, China's reserves would have ended the year at $448 billion, up from $286 billion at the end of 2002. That's a massive 57% increase, which would only have fuelled international demands for China to raise the value of its currency. But by injecting foreign reserves into its banks, Beijing makes an upward revaluation of the renminbi far less likely this year. If China were now to raise the value of its currency by 20%, as some economists are demanding, that would severely erode the renminbi value of the banks' new dollar capital, again defeating the purpose of the whole revaluation. Then there are the strings that the Ministry of Finance appeared to attach to the injection, lauded by analysts as demonstrating Beijing's determination to avoid moral hazard. Officials described the money as a loan, on which the banks would have to pay interest, and said that the funds were not to be used for writing off bad assets, but for strengthening the banks' capital bases. This is disingenuous. If the cash is to be considered as core capital, it must be equivalent to shareholders' equity. True, the banks are not yet incorporated as joint stock companies, but when they are, analysts expect the $45 billion to be converted into shares held as assets on the books of a government company--Central Huijin Investment--created specifically for that purpose. "This is what we want to see: Common equity going into the banks," says Marshall at Fitch. As for paying interest, it is reasonable to assume the money is held as U.S. Treasury bonds, which are yielding about 4%. Clearly the Ministry of Finance wants at least some of this income to be handed over. In the near term the government is likely to use more of its foreign-exchange reserves to recapitalize Industrial & Commercial Bank of China, and possibly Agricultural Bank of China--the remaining two members of the Big Four. Meanwhile, CCB is lining up Western investment banks to underwrite a Hong Kong stock offering some investment bankers believe could come as early as the first quarter of 2005, or even late this year. And there is little doubt that if the Chinese economy continues its growth and if sentiment in world equity markets remains bullish, foreign investors will line up to buy the stock. Assuming slower loan growth of around 10% this year, CCB will end the year with about 4 trillion renminbi ($483 billion) in assets. To meet international capital-adequacy requirements, the bank will need capital of 320 billion renminbi to operate internationally. Existing shareholder equity is worth around 110 billion renminbi, and the new injection is the equivalent of 186 billion renminbi. Add an assumed subordinated debt issue worth 41 billion renminbi ($5 billion) and a similar-sized IPO, and CCB will have sufficient capital to meet international standards as well as to write off enough NPLs to push its official bad-debt ratio down toward the single-figure levels that international investors demand. Of course, that won't necessarily mean that CCB will prove to be a good investment. Doubts will persist over the true level of NPLs as well as the credit-risk assessment of new loans. "Window-dressing is a bad term," says Lee at Capital Intelligence, "but that's really what they have to do." By buying stock in any of the Big Four banks, investors will be making a direct play on China's economic growth, but they will also be running the risk of inheriting the toxic waste of its communist past. A 'MUST DO' LIST FOR CHINA'S BANKS . Cut off loans made to state firms for political reasons as social welfare . Tighten loan criteria and risk management . Make managers act as professional bankers, not as party members . Improve auditing and hunt down corruption
