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Chinese Banks’ Illusory Earnings

April 1, 2011

Over the past couple of days, China’s “big four” state banks have reported impressive profit gains for 2010.  Bank of China [3988.HK]  posted a 29% increase in net earnings over 2009, China Construction Bank (CCB) [939:HK] saw a 26% boost, ICBC’s [1398:HK] profits came in 28% higher, while the newly-listed Agricultural Bank of China (AgBank) [1288:HK] reported an eye-catching 46%  rise in profits.  The Hong Kong market, which had been fairly sour on Chinese bank stocks earlier this year, apparently liked what it sees.  Since last Monday’s opening (March 21), ICBC’s stock price has risen by 8.6%, Bank of China’s rose by 6.1%, AgBank’s rose by 7.0%, and CCB’s — despite falling short of even rosier analyst expectations — rose by 4.1%.  All four stocks are significantly above the recent lows they hit in February.

So are these profit figures to be believed?  Did Chinese banks really have such a stellar year in 2010?  The short answer to both questions is NO.

Banks basically have two costs of doing business.  The first is the cost of obtaining funds — usually the interest rate they pay to depositors.  The second is the losses they sometimes sustain when their loans don’t get paid back.  That second cost is very important, because if it’s not taken into account, banks would have every reason just to go out and make the riskiest loans possible to earn the highest return — the highest spread — over their cost of funds.  They’d see extremely high profits for a while, until a big chunk of those loans failed and the losses piled up, swamping the earlier gains.

The cost of failed loans is actually part of the cost of making those loans in the first place.  There’s no way to avoid some lending failures, and there’s nothing wrong with making a risky loan if you charge a high enough interest rate to compensate for that risk, and still come out ahead in the end.  To determine whether it really is coming out ahead or behind on the risks it’s taking, a bank tries to estimate what percentage of borrowers are likely to default (and what percentage it’s likely to recover if they do default), and charge that estimate as a loss at the time it first makes a loan.  It’s called a provision for bad debt.  If the estimate is reasonably accurate, the resulting figures will give you a pretty good idea how profitable that bank’s lending business really is.  If the loss estimates are too high or too low, you can get a very distorted picture of how the bank is truly performing. 

The same is true for regular businesses, for that matter.  The easiest way for a company to boost short-term revenues and profits is to start offering shaky customers easy terms of credit, no money down, no questions asked — and not take a higher charge against those sales to reflect the fact that a lot of those customers aren’t going to pay when the bill finally comes due.  The profits are illusory, and investors who look to them are deceived.

This year, regulators required Chinese banks to maintain a reserve of 2.5% against the value of their total loan portfolios as provision for bad debt.  This has been portrayed as a “rigorous” standard, compared to their miniscule rates of recognized non-performing loans (NPLs) left over after Chinese banks spent more than a decade cleaning up their books, with the government’s help.  Over the past two years, though, Chinese banks have engaged in a government-inspired stimulus lending binge that expanded their lending books by 58%.  So much money was lent so quickly that Chinese bank regulators spent the better part of 2010 just figuring out where it all went.  A 2.5% charge may sound impressive, compared to the tiny number of older loans that Chinese banks haven’t been able to work out, but during the last, similar round of “policy” lending that took place in the 1990s, about 35% (thirty-five, there’s no decimal point there) of all the loans that were made went bad, with around a 20% post-default recovery rate. 

There are many areas of recent lending — mortgages, real estate development loans, emergency working capital loans to keep failing exporters from going under, business loans diverted to stock and real estate speculation, business loans collateralized by land at inflated valuations — that give cause for concern.  But it is loans made to Local Government Financing Vehicles (LGFVs), special companies set up to fund ambitious and often redundant infrastructure projects, that have attracted the greatest attention.  At first, China’s banking regulators brushed aside concerns — these were, after all, government-sponsored projects — but later came to view these loans with growing alarm.  A comprehensive study leaked last summer from the China Banking Regulatory Commission (CBRC) suggested that only 27% of these loans could be repaid through cash flows; 23% were a total, irretrievable loss, and about 50% would have to be repaid “through other means,” presumably by calling on local government guarantees (which those governments lack the wherewithal to stand behind) or by seizing the undeveloped land pledged as collateral (appraised, all too often, at ridiculously inflated prices).

So let’s run some back-of-the-envelope numbers, based on what we know.  A couple days ago, the Chairman of ICBC announced that LGFV loans accounted for 10% of his bank’s total loan book.  He made this announcement in order to reassure everyone that ICBC and the other banks have the situation completely under control:

“It is important that people pay attention to this problem and we should be alert to the risks,” Mr Jiang said. “[But] I don’t believe this problem poses a systemic risk to the Chinese banking system.”

ICBC reported a pre-tax profit of RMB 215 billion ($32.6 billion) in 2010, including a RMB 28 billion ($4.2 billion) charge for expected loan losses.  That charge brought ICBC’s cumulative bad debt provision — its reserve against future NPLs — to RMB 167 billion ($25.3 billion), just under 2.5% of the value of its entire loan book, which stood at RMB 6.8 trillion (a little over $1 trillion) at the end of 2010. 

ICBC’s chairman says that it made RMB 640 billion ($97.0 billion) in post-crisis LGFV loans, over the past two years.  If we go by the estimates compiled by the CBRC, roughly 23% of these loans are just out-and-out non-recoverable, which in ICBC’s case equates to RMB 147 billion ($22.3 billion).  Another 50% can be repaid only through alternative means (by seizing collateral, for example) and must be seen as questionable.  That equates to another RMB 320 billion ($48.5 billion).  Over that same two-year period, ICBC made provision for RMB 51 billion ($7.7 billion) in loan losses (RMB 23 billion in 2009 and RMB 28 billion in 2010). 

If we look only at the LFGV loan category, and generously assume that all of the new bad debt provisions applied to LGFV loans, the results are striking.  Even if only the LGFV losses that are virtually dead certain are counted (Scenario A-1 below), ICBC is understating its likely losses by RMB 96 billion ($14.5 billion).  Its cumulative bad debt allowance should be RMB 263 billion ($39.8 billion), 58% higher than reported.  If that correction was applied in 2010, the bank’s pre-tax profit would shrink to RMB 119 billion ($18.0 billion), down 29% from RMB 167 billion in 2009.

Let’s assume, in addition, an effective recovery rate of only 50% on the dubious repayments “through other means” (Scenario A-2).  That would require a boost in ICBC’s bad debt reserves to RMB 423 billion ($64.1 billion), 2.5 times the reported figure.  Taking this additional charge would create a pre-tax loss of RMB 41 billion ($6.2 billion) for 2010, and wipe out about 1/3 of the bank’s equity capital cushion.

Due to several highly profitable years, ICBC reported equity capital (assets net liabilities) of RMB 822 billion ($125 billion) at the end of 2010.  If all of the bank’s  “lost cause” and “repay by other means” LGFV loans (a total of RMB 467 billion, or $70.8 billion) were charged as a provisional loss (Scenario A-3, which might reasonable if you’re going to be forced to seize relatively illiquid collateral to try to make good on the loan), it would change ICBC’s RMB 215 billion ($32.6 billion) pre-tax profit for 2010 into RMB 201 billion ($30.4 billion) pre-tax loss and wipe out over half of the bank’s equity capital.

ICBC’s management might reply that their LGFV loan portfolio is stronger than average, since one of China’s largest banks might be able to cherry-pick only the best local government projects to lend to.  Perhaps — although so much money was flowing out the door I doubt they, or anyone else, had time to make certain.  Keep in mind, though, that this is just one category of lending that is generating worry.  We’re assuming a 100% performance rate for all the other scary kinds of lending I mentioned earlier — an assumption that is as unrealistic as it is generous.

So let’s assume that this round of expansive policy lending fares much better than the last one, and just 10% of the RMB 2.2 trillion in net new lending that ICBC made over the past two years goes bad (Scenario B-1).  That’s RMB 222 billion ($33.6 billion) in loan losses, more than four times the loss provisions ICBC actually made during that period.  The RMB 171 billion ($25.9 billion) additional charge would reduce ICBC’s 2010 pre-tax profit by a factor of almost five to RMB 44 billion ($6.7 billion), erasing about 1/5 of its reported equity capital. 

If you raise the projected NPL rate to 20% (Scenario B-2, a very reasonable estimate given both history and the more recent LGFV estimates coming from regulators), the bank registers a RMB 178 billion ($27.0 billion) pre-tax loss for 2010, destroying almost half of its capital cushion.  Apply the 35% rate from last time around — hopefully not the case, but not out of the question either — and ICBC begins flirting with the prospect of insolvency (Scenario B-3).

(click the above chart to expand and view it in original, more readable size)

A reporter yesterday asked me why, knowing what they know about LGFVs and other troubled lending areas, the regulators don’t just require China’s banks to recognize loan loss provisions higher than 2.5%.  I could only think of that exchange between Tom Cruise and Jack Nicholson in A Few Good Men:  “I want the truth!”  “You can’t handle the truth!”  Maybe China’s banking regulators prefer to shield investors and other market participants from the harsh truth while they figure out how to solve the problem.  However, the truth — whether investors can handle it or not — is pretty easy to calculate based on readily available information.  It’s entirely possible that the scenarios I’ve outlined are too pessimistic — but it’s not obvious that they are.  The various assumptions I’ve used are reasonable enough that I think you’d have to make a case for why they are wrong.

Optimists will counter that, even if ICBC and the other banks suffer destabilizing losses, the “big four” are all state-owned, and the Chinese government would almost certainly step in and bail them out.  That may well be true.  But there’s a big difference between making that kind of “failing but too big to actually fail” argument and accepting the claims — put forward in their latest financial statements — that China’s banks are sitting pretty and awash in profits.

17 Comments leave one →
  1. Bill permalink
    April 1, 2011 1:39 pm

    Thanks for this analysis. Could you add some perecrive as to how this situation is different, or similar, to that of the US TBTF banks? Is there a major banking system that is actually solvent when you take away all the explicit and implicit subsidies?

    • prchovanec permalink*
      April 1, 2011 2:11 pm

      I don’t think the conclusion that no major banking system is solvent is warranted (although it sounds very dramatic). However, you’re right to point out that this kind of kid-gloves treatment is hardly limited to China.

      I’ve been reading recently about the Third World debt crisis that unfolded in the 1980s, mainly involved U.S. bank loans to Latin America. When it became clear that many of these loans were not going to be repaid, at least according to the original terms, the Fed leaned on bank examiners not to be too stringent in requiring banks to recognize losses while a work-out was being negotiated (over a period of several years).

      Ultimately, this crisis was resolved through the introduction of “Brady Bonds” that allowed banks to get the damaged loans off their balance sheets, albeit at a (acceptable) loss. So there may be an argument to be made for not pushing banks too hard to recognize losses when a work-out is still possible (this may be the case with LGFV loans in China, although a work-out would likely take the form of an effective government bailout, with the central govt stepping in to back up overextended locals).

      Still, it’s worth noting that at least one major U.S. bank, Continental Illinois, did fail due to Third World and oil patch debt that went bad. At that time, it was the 7th largest bank in the U.S. So when losses are real and permanent, going easy won’t change the final outcome.

    • prchovanec permalink*
      April 1, 2011 2:25 pm

      I should add, in order to address your main question more directly, that there are two issues that can bring a bank (or any company) down: illiquidity and insolvency. Illiquidity means you don’t have enough cash on hand to cover your immediate obligations. Insolvency means your liabilities are greater than your assets. You can be illiquid (and go bust) without being insolvent, and you can actually be insolvent and stay in business for at least a while as long as you are liquid — which is often what happens in bankruptcies. One problem is that if you are illiquid, you may have to sell off assets at a loss to raise cash, and those losses may drive you into insolvency.

      That is exactly the danger in any banking crisis or credit crunch — that perfectly solvent businesses will be forced to close their doors, or will be actually driven into insolvency, because they can’t get their hands on enough cash, when panicky creditors call their loans. When Bear Stearns, Lehmen, AIG, etc. melted down in 2008, nobody knew what their assets were worth, how much money they had lost, or whether they were truly insolvent — they were just afraid they were. If the panic had spread, a lot of perfectly good banks, who had sustained losses but were still solvent, might have gone down as well. So Treasury and the Feb stepped in to provide liquidity (sometimes are a very steep cost) in order to call a “time out.” TARP couldn’t change the money that banks or anyone else had actually lost on bad investments, but it could prevent a spiral of further losses caused mainly by panic, at least until the losses could be sorted out. Of course, stepping in, by extending money in exchange for notes or equity, wasn’t without risk — if the rescued institution did turn out to be insolvent, the govt could lose some of the money it put in. But it was willing to take that risk to forestall greater losses.

      • Bill Bishop permalink
        April 2, 2011 8:20 am

        It sounds like you are more in the “2008 crisis was a liquidity not a solvency crisis” camp; I think it was both, with more insolvency than most want to admit, especially as the banks are back and the revisionism is in full bloom.

        Do Chinese banks mark assets to fantasy as much as US banks? Or are they even worse than our TBTF banks?

      • prchovanec permalink*
        April 2, 2011 8:44 am

        I wouldn’t say I’m in the camp you suggest, I agree there were serious solvency issues for some key banks and other institutions, and that both insolvency and illiquidity played a role. As I say, the two are distinct in concept but practically intertwined.

        I can’t claim to be an expert on the post-crisis asset quality of US banks. However, whenever I talk about the asset quality of Chinese banks, there are always plenty of (knowledgeable) people who say “the US banks are doing that too!” (for instance, not writing down real estate collateral that is impaired). What I would say is, I think it’s a lot easier for Chinese banks to get away with it a lot longer, on a lot bigger scale, much like Japanese banks did in the 1990s, than it is for US banks which you have both debt and equity markets where you have a pretty vibrant mix of market participants able to take short as well as long positions, and you hear a range of very critical views expressed (especially post-crisis). I’m not saying correctons happen overnight, but they happen, as the subprime crisis actually illustrates.

        The reason for my focus on Chinese banks is because, unlike the post-crisis environment in the US, there appears to be a fairly uncritical acceptance of the numbers they are putting out, and because they’re operating in a regulatory environment that can brush these issues under the rug far more effectively than in the US (not necessarily for lack of US banks or regulators trying).

      • Bill Bishop permalink
        April 2, 2011 9:04 am

        I am not arguing with you. I think this is a great post. My initial reaction is of the course the Chinese banks are lying, with the active encouragement of the regulators, though it is good to see some very well reasoned numbers.

        The point I have been trying to make is that the US banks, and regulators, may be much more similar to the Chinese banks than most would like to admit. I think it is important that we have that perspective, as the Chinese regulators have even less incentive to listen to Western advice and criticism when our banks also mark to fantasy and our central banks also engage in financial repression by cutting rates to near zero in order to subsidize recapitalization of the major banks, among many other policies to provide explicit and implicit banking subsidies.

        Maybe we are all Japanese when it comes to banking now.

  2. Hua Qiao permalink
    April 1, 2011 2:50 pm

    Oh, but Patrick, it’s no problem. Just sell the bad stuff to Cinda and Huirong like was done in 1999 and 2004 and take bonds back from them (seller financing). Voila, you have good assets. It’s just that you will have to renew them at maturity because there is no “there” there.

    • prchovanec permalink*
      April 1, 2011 2:55 pm

      Heh heh … yes, we all know that 🙂

  3. Bob Dobs permalink
    April 1, 2011 6:18 pm


    Have you seen this article at FT/Alphaville? ( Isabella Kaminska appears to be onto something regarding a China/commodities connection and she’s written a series of articles on the topic. Perhaps I’m wrong, but I get the sense that your articles here and her insights on commodities could come together to paint a clearer picture of this issue.

  4. April 1, 2011 9:49 pm

    Great post. Awesome to see the detailed dissection and some real analysis beyond the hype. I forwarded this to some colleagues. Well done.

  5. Lynette O permalink
    April 2, 2011 12:22 am

    Thanks for this interesting post. A comment on the difference between insolvent and illiquid. In the past, Chinese banks have become insolvent, particularly the rural banks, but not really illiquid because savings keep coming in because of lack of alternative savings instruments and savers’ lack of knowledge about the banks’ real financial situation.

    Question: do you have information on China Development Bank’s balance sheet or know where to get it? Thanks.

  6. James Greenleaf permalink
    April 11, 2011 4:24 am

    Excellent post. I have been following your blog since last year, and have come to greatly respect your insights into the Chinese economy. This post superbly summarizes what have been afraid of since China appeared to emerge relatively unscathed from 2008-9’s collapse in consumer demand despite their economies dependence on exports of consumer products.

    A number of questions:

    1) Is there any way to trace Western investor’s exposure to bad Chinese debt? In this regard I would like to call your attention to an article from The Economist the other day ( about Chinese companies frequently engaging in shady “reverse mergers” with shell companies to raise capital while avoiding significant portions of the disclosure process involved in more legitimate IPOs. The article also mentions Deloitte’s resignation as auditor from China MediaExpress, a reverse-merged NASDAQ-listed company, after losing all confidence in the financial reporting done by the company. A large number of Chinese small cap firms have appeared on US exchanges in the past few years, but I know the bulk of equity capital raised has been on Hong Kong exchanges and I know nothing about the disclosure requirements and transparency of those capital markets. I would very much like to know if there is any way to trace the amount and sources of capital raised by Chinese firms of questionable solvency on capital markets throughout the world.

    2) Related to the first question, is there any way we can determine how much of the global economic recovery is owed to the continued strong GDP growth of China post-2009? The 2007-8 economic crisis was, by all economic measures I’ve seen, the greatest credit-crunch since the 1929-32 crisis, and yet the pain inflicted seems to have been similar in magnitude and duration to any normal cyclical downturn that has occurred in the past 50 years. My fear is that the relatively swift recovery has been largely attributable to a Chinese engine which deliberately overheated itself in the hope that they could bluff their way through the recession until Western consumption returned and thereby avoid the nightmare of having to justify party control in an environment of economic stagnation. The problem is that they didn’t understand that Western consumption would not return to prior levels any time soon given the massive de-leveraging made necessary by the credit-crunch. Instead, I fear China may have temporarily replaced US consumerism with a false, inflation-driven consumerism which has created a fool’s gold recovery. I see this in two major areas. First, the strong German recovery is fueled largely by surging exports of luxury goods to China and other booming developing-world countries. Second, those same developing world countries have been booming on the basis of high commodity prices, which are again fueled by demand from Chinese industry and infrastructure spending.

    Two more points I have noted in my capacity as a law student. First, US firms have come out of the crisis producing record earnings, which they are by-and-large retaining as enormous cash hoards. Much of the reason for this is the deferral under US tax law for earnings attributed to overseas subsidiaries until those earnings are redistributed domestically. This has given incentive to those managements who want to report higher earnings by deferring as much tax as possible to use those retained earnings to purchase assets overseas. This not only boosts demand for Chinese assets and accordingly contributes to inflation, but means that such acquisitive companies may be increasing Western economy’s exposure to any China bubble by taking those inflated assets onto their balance sheets as goodwill. This is especially worrisome if any of these companies used debt to make such acquisitions. The second thing is that, whereas the major multi-national law firms ceased hiring and made layoffs in almost every practice area when their financial services clients nearly collapsed, the one practice area which seems to have remained relatively hot (other than bankruptcy) has been the China FDI and M&A business. Wherever lawyers are busy making regulatory filings and writing disclosure documents you can be fairly certain that Investment Bankers and Fund Managers are heavily involved as well.

    Suffice it to say, for all these reasons I would very much like to have better insight into the exposure Western economies have to these concerns with China.

    3) Do you believe that the recent intense crackdowns on Chinese dissidents and free communication by the Communist party may presage an awareness on their part that these financial issues will not be able to be swept under the rug, and that economic pain for Chinese citizens is not far off? This may be pure coincidence, because the Arab revolutions have made Communist official paranoid, but I can’t help but wonder at the accounts I have read that this particular crackdown is of an especial intensity.

    4) Finally, for those of us to young and uneducated to be familiar with how Chinese monetary policy-makers handled the previous bouts of non-performing loans, could you provide us with that historical context? I’ve read some things (which were frankly beyond me intellectually) about how the Government, banks, and SOEs cycled the debt through in such a way that it became not a problem (sounded something like money-laundering to my, again uneducated, ears), but I would greatly appreciate your describing the process as clearly as you laid out the bank’s solvency concerns in this post.

    Again, thank you sir for your excellent blog, and I look forward to your response.

    • prchovanec permalink*
      April 19, 2011 8:37 am

      You raise a number of challenging questions that deserve a thorough response. The answer to the last question is particularly complex, although if you can’t wait for my reply, I suggest taking a look at the recently published book “Red Capitalism”. It describes previous rounds of the recapitalization of Chinese banks in all the detail you could ever hope for. I’ll try to address this issue in the future, though.

  7. Hyuk-tae Kwon permalink
    April 18, 2011 10:41 pm

    Not sure why the statics may be vastly different between your back-of-envelop numbers and what it is reported.

    About 63% of the LGFV loans are completely or basically covered by cash flows generated by the projects,” ICBC’s Yang said, adding most of the loans were issued in regions that are financially strong, such as Shanghai, Beijing and Tianjin. Yang said the nonperforming loan ratio of lending to local government financial platforms is 0.3%, well below the 1.08% ratio for all loans. ICBC expects to keep its nonperforming loan ratio below 1.10% in 2011.

    Either the breakdown given by the CBRC is entirely off or ICBC is using completely different definition for nonperforming loan?

    • prchovanec permalink*
      April 19, 2011 8:27 am

      Only time and the bank’s further disclosures will tell which is a more accurate assessment (Yang’s or the CBRC estimates that leaked out). Nevertheless, the implicit admission that 37% of ICBC’s LGFV loans are NOT covered by cash flow is still somewhat alarming.

      The low NPL ratio is easier to explain. As I understand it, some LGFV loans do not even require interest payments during the initial years. Since no payments are due, the loan couldn’t possibly be “bad” yet, even if it’s going to go bad down the road. In other cases, it’s possible that the entity has other revenue streams (e.g. land sales) to meet initial interest payments, but may run into trouble later, especially when required to begin repaying principal.

      Remember that a NPL ratio has two elements, the numerator (how many loans have gone bad) over the denominator (how many loans have been issued). When you have a big lending boom, the denominator expands right away, lowering the NPL ratio. Only later — perhaps several years later — do you start seeing the quality of the loans reflected in the numerator, possibly causing the ratio to rise.


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