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Undoing Chinese Bank Reform

May 7, 2009

This op-ed of mine appeared in the Wall Street Journal on May 7, 2009.  The direct link is here.

Undoing Chinese Bank Reform
by Patrick Chovanec

While Western governments debate how to reform their banking sectors, Beijing is now facing a different problem: how to keep from gutting the last decade of banking reform it’s already been through. There’s a very real danger that policy makers will undo their earlier efforts in the name of short-term stimulus.

The central problem is the Chinese government’s strategy of stimulating the economy through an enormous expansion of bank lending. The government has turned to the banks to finance half of its four trillion yuan ($586 billion) stimulus package. In addition to that, the government has set high targets for commercial lending to support businesses. China’s lenders pumped out more than 4.5 trillion yuan in new loans in the first quarter of 2009, 8% more than in all of 2008.

This is eerily reminiscient of an earlier era when the government leaned heavily on banks to finance economic growth, and especially large state-owned enterprises. In the 1980s and ’90s, Chinese banks piled up a colossal tangle of politically directed bad debts that either could not be repaid, or were never meant to be repaid in the first place. In 2003 nonperforming loans made up 20.4% of banks’ total loan books, a face value equivalent to 16.5% of GDP. This threatened to swamp the entire economy.

Beijing managed to clean up that problem with the help of the new China Banking Regulatory Commission, $100 billion in new government capital, and foreign “strategic partners” to train banks in global best practices. Nonperforming loans were brought down to 2.5% by the end of 2008. This was accompanied by a deeper change in corporate culture, as bank staff started thinking like bankers instead of like agents of government policy. A decade of difficult reform culminated in Hong Kong stock listings for three of the big four — Bank of China, Industrial and Commercial Bank of China and China Construction Bank — with the fourth, Agricultural Bank of China, on the way. Yet despite this hard-won progress, Beijing is now in danger of backsliding.

On the surface, China’s banks appear to be remarkably healthy. The CBRC reports that this year, despite the economic slowdown, nonperforming loans have continued falling, not only as a percentage of the rapidly expanding base but in absolute terms. China’s banks, the story goes, are a well-tuned engine capable of lifting the Chinese economy up.

A closer look, however, raises several red flags that regulators haven’t been able to address satisfactorily. Take existing loan portfolios even before the rash of new stimulus lending. Given the severe drop-off in Chinese exports, along with the worldwide widening of credit spreads (reflecting increased risk of defaults), it strains credulity to believe that the health of these portfolios could be improving. In reality, the CBRC recently allowed Chinese banks to minimize the recognition of nonperforming loans by rescheduling loans before maturity and “evergreening” troubled loans by rolling them over into new ones. In contrast, NPLs recognized by foreign banks operating in China — which generally follow the stricter rules of their home regulators — have more than doubled since the start of 2008.

Existing loans, however, are of minor concern compared to new ones. China’s banks are approving loans not because the business climate is promising or because proper credit analysis indicates they can profit by doing so, but because the government has told them to let the money flow. And the figures in financial statements suggest that the banks are making inadequate provision, in terms of increased reserves or the like, for any of these “loans” going bad.

CBRC officials appear unperturbed, saying in public statements that the loans are going into stimulus projects sponsored by the government, which will certainly repay. But with so many infrastructure projects in the works, experience indicates that not all will meet their cost and revenue projections. While provinces and municipalities are unlikely to openly default, they will enjoy plenty of leverage in renegotiating repayment conditions if necessary.

Most of the new loans are far riskier than that kind of lending. In the first quarter, just 37% of new lending was for medium- or long-term loans, the type one might expect for funding infrastructure projects. More than half — 2.4 trillion yuan — was short-term, including nearly a third (1.5 trillion yuan) in so-called bill financing to temporarily cover a company’s payables. These loans have grown 150% since the beginning of last year. That suggests they are being used as stop-gap funding to help save companies with cash flow troubles avoid bankruptcy, at least for the moment. Others have suggested these low interest loans are being used to fund high-risk speculation in stocks and real estate. Either way, it’s hardly a “safe” bet for banks.

Back-of-the-envelope calculations suggest this could become an even more serious problem than Beijing faced in its last round of banking reform. Then, the nonperforming loan ratio eventually exceeded 20%. If that rate were applied to the new loans already issued in the first quarter of this year, 912 billion yuan can be expected to go bad, more than doubling the 550 billion yuan in bad loans currently on the books. And the year is barely getting started. If the overall credit expansion continues at the current pace, China’s banks are on track to make up to 3.6 trillion yuan in rotten loans, far exceeding the 2.2 trillion yuan paid-in capital in the country’s entire banking system. Even if lending does slow, or proves somewhat safer than the historical pattern suggests, the numbers are still alarming.

Perhaps the Chinese government is assuming it can just buy its way out of any banking crisis by orchestrating another round of bailouts. It has the money. A replay of the government’s $100 billion pre-IPO recapitalization would require just 5% of the country’s massive foreign currency reserves. If that’s the price of maintaining employment and preventing unrest, China’s leaders will happily write the check. Despoiling and recapitalizing the banks is one of the few mechanisms Beijing has to inject its outsized dollar-denominated reserves into the domestic economy.

But that still doesn’t make this credit explosion — and any subsequent bailout — a good policy idea. For one thing, shareholders are sure to suffer. At the minimum, they face dilution when new capital is injected. But the real damage to their interests can’t be quantified in terms of bad debt ratios or total shares outstanding. Global investors bought into China’s bank IPOs in the belief that those banks, which once functioned merely as conduits for state subsidies, could remake themselves into profit-making enterprises. Today, that promise is looking far less believable.

The promise of bank reform was important to more than just shareholders — functional banks run on commercial principles will be crucial to China’s long-run economic success. China needs responsible economic stimulus, but it also needs banks that allocate capital efficiently, governed by a credible regulatory regime. With public debt at a record low, the government could have borrowed stimulus funds and spent them directly as needed. Instead, it let the banks run wild. It’s a dramatic setback, and China will be counting the cost for a long time to come.

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