Banks and Economies: A Comparison of China Construction Bank and India’s ICICI
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Introduction
Two banks. Two countries. Two investments. One choice. This year investors had a unique opportunity to invest in banks of two fast growing emerging markets. China Construction Bank (CCB), one of the big four banks of China, listed 12% of its shares on the Hong Kong Stock Exchange and raised $8 billion from foreign investors. ICICI, India’s second largest private bank, raised $405 million in a global offering that listed its ADRs in New York.
Both China and India are huge markets that are growing rapidly. Each appears to have exceptional potential over the long term. Both CCB and ICICI have attracted strategic investors. The US Bank of America and Singapore’s Temasek owns large stakes in CCB. Deutsche Bank owns a large stake in ICICI. Both Banks of America and Deutsche are looking for strategic footholds to enter these markets.
On the surface, each of these companies looks to be safe and profitable investments. To truly understand the risk involved in any emerging market investment, it is necessary to go beyond the numbers. It is crucially important to examine the legal and regulatory environment. An in depth examination of the local legal conditions can expose the surprising reality of an investment from widely promoted general assumptions.
Investors want two things from their investments. They want a good return and they want their investments returned. In order to achieve both, they need a successful business that makes money. It must be run by managers who add value for shareholders. The shareholders’ interests in the company must be protected through good corporate governance. For a business to make money, it also has to avoid losing it. Potentially profitable returns can easily be squandered if the risks are too great.
This report will compare the potential of CCB and ICICI to make and lose money, the quality of their managers and finally their corporate governance to determine, which stock has the best chance of achieving a good return for the least risk.
China’s growth over the past decade has been nothing short of a miracle. Annual growth has averaged more than 9% and sometimes reached double digits. In the process, enormous amounts of money have been made as vast quantities of foreign investment poured into China. Against this back ground, China is an easy sell for promoters of Chinese stocks.
Many Chinese companies have listed in initial public offerings (IPOs) usually on the Hong Kong Stock Exchange. Usually these offerings have been extremely successful, raising billions of dollars. CCB is no exception. After an extensive period of preparation involving injections of government money and jettisoning billions of nonperforming loans (NPLs) into a specialized Asset Management Company (AMC), CCB was ready. Its IPO lived up to expectations. The odds of those expectations being realized are quite long.
Chinese banks are generally not very profitable. The average net interest margin is 2.36%. This compares unfavorably with interest margins in India of 3.45% and Indonesia with 5%. This is especially a problem for CCB because 90% of its operating income is dependent on interest income, compared with only 52% for ICICI.
The fact that there is a margin interest at all is a recent change. The main regulator of Chinese banks, the People’s Bank of China (PBOC), only recently allowed banks in China the freedom to set their own rates. This freedom is still limited. Rates paid on deposits cannot be more than a specific mandated ceiling and interest on loans cannot be lower than the regulatory floor. The problem for CCB is that its managers have very limited experience in factoring in an interest rate that reflects the risks of a particular loan.
ICICI does not have such restrictions. They pay or charge according to the market. Without government restrictions, ICICI’s managers have ample experience to price loans. This experience is in part reflected in Indian banks’ return on assets (ROA), which at 1.25% is one of the best in Asia, second only to Hong Kong. Chinese banks average ROA is only 0.5%, the worst record in Asia.
The principal problem with CCB is that even with the IPO, 72% of its shares are owned by the government under direct control of the State Council, China’s highest governing body. Even though I cannot find the word in over 500 pages of prospectus, China is a communist country run by a Communist Party. The requirements of the state will always come before the interests of CCB’s shareholders. The interest margin and the ability of CCB to make any money at all will reflect these priorities. The ICICI has no such problem. It is a private company in a democratic country.
ICICI status and origins have been beneficial for the bank in another way. Although both China and India have extensive diasporas, only ICICI has been able to capitalize on their banking needs. Some of the fastest growing subsidiaries of ICICI serve retail customers in both the UK and Canada. While CCB’s overseas presence is limited to representative offices in New York and London.
The problem with investing in emerging markets is that although the growth rates are often much higher than for companies in developed countries, the economically inefficient or nonexistent legal systems also increase the risk. If the profit potential is not commensurate with the risk, it might be a better idea to stay home.
Theft
Chinese banks including CCB certainly have a high level of risk. One of the most pressing problems has been one of theft. CCB, like the other State Owned Companies (SOEs) in China, is huge. Besides $521 billion in assets, it has more than 300,000 employees spread across 14,000 branches. This monolith is the size of a government ministry, which for many years, it was.
The problem with managing these huge companies is similar to governing China itself. For most of China’s history, the provinces have tried to escape the central authority of the emperor. This has been especially true since the start of the recent reforms when Deng bartered away central authority for local support. The process accelerated with the “Eat in Your Own Kitchen” policy, where local governments were to rely on local SOEs for revenue.
These local SOEs needed capital. They received it from the local branch of large banks like CCB. As a result local branches were run by a partnership of the branch manager, local officials and local SOE managers with little control from the central office in Beijing. They still are. Big branches of ICBC, one of the other big four state banks, have their own English language web sites. The branch mangers rule over their domains with impunity.
This collusion between the local elite has often led to cases where vast sums have been embezzled. The CCB prospectus points out that in the past CCB, employees have been involved in misconduct involving theft, embezzlement, fraud, bribes, mishandling of funds, improper loans and other malfeasance. This is a major problem for Chinese banks. The big four have lost an estimated $1.5 billion through financial crimes in the past three years alone.
Perpetrators have ranged from clerk typists to the bank’s chairman. Often these illegal schemes date back for more than a decade. Some involve complicity of officials from the regional government. It does not appear that the problem is going away. In fact, it may be getting worse. During the first six months of this year, 240 cases of corruption in state banks involving $197 million were reported.
ICICI in contrast is much smaller. It has only $38 billion in assets 562 branches and only 18,000 employees. As a private and more focused organization without the legacy as an organ of the state, ICICI employees have not helped themselves to the bank’s assets. Also, India’s prowess in IT has been used to create advanced risk management tools to spot problems before they become critical.
Non Performing Loans
Although very serious, the embezzlement problem pales when compared to the problems of bad loans. Past estimates of non performing loans in China have topped $700 billion. I do not believe that the present real number is any different, just better hidden.
According to the prospectus, the problem of NPLs at CCB has been solved. As recently as December 2002 CCB’s nonperforming loans equaled 16.87% of their entire loan portfolio. CCB has been able to bring this amount down to only 3.91% as of June of 2005. This reduction in NPLs is astonishing when compared with other countries, which have experienced banking crises. In Sweden, the United States, and Thailand the reduction of a smaller percentage of bad loans took many years. In Japan NPL reduction took over a decade, partly because even independently audited Japanese banks kept ‘discovering’ more NPLs over time.
Even if we assume that the amount of NPLs on CCB’s books is correct, there is a major question as to whether or not CCB’s lending practices will simply create more. The main problem again is that CCB is a government owned institution. As such it shares a problem with government owned banks the world over. Its lending policy is subject to political influence. Politicians unlike bankers make loans for political rather than economic reasons. The problem is particularly acute in the case of China, because the Chinese government is the sole prerogative of the Communist Party. So Chinese banks make loans to insure the party remains in power.
The CCB prospectus lists various committees, but it appears to omit the most important. All SOEs have Communist Party committees although their existence, purpose and power are rarely discussed or acknowledged. In the CCB the party committee was chaired by the chairman of CCB, formerly Zhang Enzhao until his resignation in disgrace. Mr. Zhang resigned, because he was charged with accepting bribes. His predecessor at CCB, Wang Xuebing, was arrested on corruption charges that occurred while he was head of the Bank of China.
The present chairman of CCB, Guo Shuping, is also the secretary of the party committee. During his predecessor’s tenure the Party committee held “dozens of meetings” and even debated over small loans. In contrast, the board met rarely. In an interview last spring, Guo Shuping said that the power of the Party committee was contrary to the bank’s bylaws, and promised change. He did not discuss the conflict between his two roles.
Since the Party has not been removed from the loan making decision process, the amount of NPLs has been rising not falling. There are two reasons why the percentage of bad loans has not increased. Chinese banks have been able to dispose large amounts of bad loans to their AMCs and the total amount of loans has been rising.
This problem is particularly serious in the branches. The local branch manager, the local political official and the head of the local SOE are, of course, all members of the Communist Party. The local SOE provides revenue for the local government, perks and jobs for local Communist Party members, as well as jobs for the local population. The necessity of keeping all of these constituencies happy plays a large part in the branch manager and the local branch’s party committee’s decisions to lend to local SOEs. The political considerations almost always work in the SOEs favor. If the SOE loses money and the loans go bad, they are simply transferred to the bank’s AMC, where they remain until joined by new NPLs.
If the local branch stops lending money, there could be real problems. According to the Chinese government’s own statistics in 2004, there were 74,000 so called ‘mass incidents’, which could include anything from a sit in, strike, demonstration up to a full scale riot. These incidents involved a total of 3.7 million people. If that were not bad enough, the number of these incidents has been growing. In 1994, by comparison there were about 10,000 such incidents involving 730,000 participants. So when it comes to a choice between cutting jobs and closing down the local SOE and another dud loan, the local officials will lean on the local branch manager to make the loan. The authorities in Beijing may not like it, but they have little choice either. The party must remain in power at all costs.
The problem of politicians engineering loans is not limited to China. Like China, government ownership of banks creates a major conflict of interest. The Ministry of Finance owns India’s Public Sector Banks (PSBs), which control 80% of the Indian’s financial assets. The Ministry is controlled by the party in power.
The difference is that although India’s banking system is subject to political interference, it is also not hobbled by the monopoly of a single party. India, as a democracy, has many parties. Like political parties everywhere, each party is happy to exploit evidence of inappropriate political interference especially in the banking system. Any branch manager, who favors the politician of one party, may find himself subject to criminal charges by the politicians of the opposition after the next election.
India, unlike China, has a lively free press. Scandals sell newspapers all over the world. Banking scandals are particularly popular. They would have an almost universal appeal to depositors. They are a great opportunity for publicity hungry politicians. So any misdeeds within the banking system are heavily covered and editorial venom spews forth upon any immoral elected officials or incompetent regulator.
The Indian bankers are subject criminal prosecution. The Indian judiciary is an independent coequal branch of government. It has the power to punish both politicians, regulators and bankers, who improperly use bank assets for their own purposes. In China, the judiciary, often retired military officers, is simply another organ of the state. It does not have the power to enforce its decisions on other branches of government. Although lower level criminals can be put to death, high level party members can get off with little or no punishment.
Another major difference between the big four Chinese banks and commercial public sector Indian banks is that many of the Indian banks were originally private. They were nationalized in 1969. Since they were taken over by the central government, they have always been controlled from New Delhi. They never were subject to the influence or control of local interest groups. As a result they are free from local political pressure that affects the branches in China. When Indian banks are subject to local control like the cooperative banks, they suffer the same problems as banks in China.
Still, despite their generally sound operations, PSBs in India cause another problem. It is not only the politicians who can influence the banks. The PSBs can very effective in influencing politicians. Like the PSBs in Taiwan, they have been very successful in protecting their interests against private and foreign banks. In addition, they have powerful unions, who are determined to retain their privileged status.
Like China, India has suffered from a large percentage of NPLs. Although no where near the levels in China, as recently as 2000, the NPLs were as high as 12%. Unlike China, as a result of reforms allowing for faster execution on collateral, the national rate of NPLs has been declining. In 2002 it was 10%. It declined to 8.8% in 2003 and 7.2% in 2004. Although politically motivated policy loans have been an issue, problems with poor contract enforcement, lack of credit information and weak bankruptcy laws have been more of a problem. These problems exist in China only much worse.
ICICI was originally created as a development bank in the early 90's. As a result its loan book suffered from several policy loans that went bad. Since it became private it is subject to the interests of its shareholders rather than national or local politicians. As a result of aggressive loan collections, its gross NPLs have dropped from 9.4% in the end of March 2004 to less than 3.5% today. With provisions and write offs, the net NPLs have been reduced from 2.87% in 2004 to 0.97% today.
ICICI’s capital adequacy ratio is almost 12%. This is a little better than CCB’s at 10.7%. CCB’s ratios must be considered in light of CBRC guidelines. These allow for certain assets to be assigned 0% of risk. In other words, the assets would be equal to bonds issued and guaranteed by the government. It is understandable that certain assets like cash and gold would be in this category. What is interesting is that bonds issued by AMCs are also included with no risk.
According to the prospectus in 1999, CCB transferred worth of NPLs with a principal value of 250 billion yuan ($30 billion) to its AMC, Cinda, in exchange for a ten year bond worth 247 billion yuan and 3.0billion yuan cash. The problem is that by definition the NPLs were not worth their principal amounts. Since 1999 Cinda and the other three AMCs have been trying to recover some of the funds lent. They have tried to collect or auction off any collateral or sell the NPLs. They have failed miserably.
Buyers, especially foreign buyers, have shown little interest, because the NPLs were worthless. Even when outside buyers were interested, they were often excluded because their bids were considered too low. Instead many of these NPLs are being traded between the AMCs themselves.
Originally conceived in the mode of the US Resolution Trust Corporation, they were supposed to be temporary vehicles set up to dispose of collateral from NPLs. Now the AMCs have taken on a life of their own and are now looked upon as permanent financial institutions in their own right. Both Cinda and Huarong, the AMC for Industrial and Commercial Bank of China, have applied to the Chinese government for permission to provide a full range of financial services to compete with investment banks and even to list publicly!
Besides the transfer between CCB and Cinda in 1999, CCB also transferred NPLs to Cinda in 2003 and 2004. Despite its risk free capital adequacy rating, it is doubtful that the bonds issued by Cinda are worth any where near what they are valued on CCB’s books. In reality they may be worth only a small fraction. So a large part of CCB’s regulatory capital simply does not exist.
In some ways India has the reverse problem. In game theory a debtor’s best move is not to pay back a loan. Creditors know this, so their best move is not to lend. In the past, lending to the private sector was riskier than it is today. So Indian banks, especially the PSBs, have invested in more government securities than the statutory capital ratio regulations require. This may have made the banks sound, but it has dried up credit for the Indian businesses.
Regulatory Environment
In order to stem the hemorrhaging, the Chinese government in 2003 created a bank watchdog, the China Banking Regulatory Commission (CBRC). The CBRC in its role as regulator has perhaps discovered more problems than it has prevented. According to a leaked report the CBRC said that after an examining 11 banks, it discovered that the banks ignored the CBRC’s regulations. It also found that the accounts were so bad that the banks did not have an accurate picture of the number or amounts of their NPLs. They were also not ‘completely honest’ in disclosing information to the CBRC.
The CBRC has three problems. The first might be cured in time. The other two are far more intractable. CBRC is a new institution. It will take time before it develops the expertise to adequately regulate the banking industry in China. China has a major shortage of accountants trained in modern capitalist accounting
The second problem has to do with a basic conflict of interest that plagues every Chinese regulator. The CBRC is a government agency. It is undoubtedly staffed by members of the Chinese Communist Party. It is regulating banks owned by the government that are managed by bankers, who are also members of the CCP. When there is a conflict between the interests of depositors and minority shareholders verses the government or CCP, it is likely that the interests of the CCP and the government will prevail.
The last problem with the CBRC is that it is a representative of the People’s Bank of China and the State Council. In other words, the central authority in Beijing. Local party officials have enormous power coupled with economic incentives to thwart the CBRC’s regulations and directives. Without an independent judiciary, the CBRC may not have the authority to enforce its orders. Even if it does, the interests of the Party may overrule enforcement. As a result the CBRC may not be able to create sufficient legal disincentives to encourage or insure compliance.
In India banking regulation is under the auspices of the Reserve Bank of India (RBI). The RBI is a far older institution than the CBRC with decades of experience. In addition the RBI can call on a large number of competent accountants schooled in the Indian version of GAAP or IFRS. In fact the quality of Indian accountants is so good that accounting is one of the professions that is part of the out sourcing industry.
For most of its functions the RBI is considered independent. This has greatly aided it in its regulatory function. The stability of Indian banking in general, especially after the Asian financial crises of 1997, is in part due to its supervision. However, its decision as to whether it should liquidate or merge an ailing PSB is a political one. It has recently drawn fire for its slowness in dealing with an insolvent bank. Like the Federal Reserve Bank in the US, it has been criticized for its level of transparency.
ICICI as a private bank would not present any conflicts for RBI. The regulation of ICICI will most likely be up to international standards. Since much of its outsourcing industry must be benchmarked to international standard by necessity, India’s regulatory agencies have made a consistent and usually successful effort to achieve internationally recognized standards of competence. International investors can be assured that the banking regulatory environment in India will protect their investment.
Retail Lending
In the past both CCB and ICICI have had problems lending to corporations. In CCB’s case, much of the lending went to shore up unprofitable SOEs. In 1997 then Premier Zhu Rongji promised to get rid of all unprofitable SOEs within three years. In 2000 after the big four state banks including CCB were recapitalized, the then governor of the PBOC, Dai Xianglong, promised that there would not be any more free handouts to the banks "Not even a snack.” Five years later, it is obvious that the SOEs retained their political clout and are still getting recapitalized with billions to make up for loses of new NPLs.
The Chinese government had an idea. Rather than lend to unprofitable SOEs, it would increase its retail lending through mortgages, credit cards and automobile loans. According to the CCB prospectus 14% of their loan portfolio is made up of residential mortgage loans. Unfortunately, because of the lack of an economically efficient legal system, retail loans in China are not any more successful than loans to SOEs.
Part of the problem is that if a consumer defaults on a loan, the bank cannot collect on the collateral. In theory, mortgage lending secured by a residence should be reasonably safe. Unlike cars, houses and apartments can’t be easily hidden. This does not mean that real estate in China is risk free collateral. Knowing where the property is does not mean that the property is subject to foreclosure.
According to the CCB prospectus, the Supreme Court of China issued a ruling stating that “courts may not foreclose on, auction off, or otherwise liquidate” the borrower’s main residence. So if the property market goes south, the CCB may not be able to foreclose on collateral for a large part of 14% of its loan portfolio. The bad news is that the property market has deteriorated. Shanghai’s real estate market has fallen between 25 and 30 percent this year. The number of transactions has fallen by 50% and 1000 brokers are out of business.
The problems of residential mortgage loans are illustrated by their contribution to NPLs. Nonperforming residential mortgage loans expanded by 35.8 per cent to 4.67 billion yuan between December 2004 and June 2005 alone. Since they represent 76.6% of all retail loans, all of the banks including CCB are already experiencing significant losses in this area.
The Chinese banks have not been any more successful with personal loans. In the first six months of this year, personal loans increased by 37.1% to 8.18 billion yuan. Car loans are especially a problem. More than 36% of car loans are in default for a total of 90 billion yuan ($11 billion). Although the Agricultural Bank of China accounts for about half of these bad loans, the other three large banks are losing large amounts as well.
ICICI problems with corporate loans started during its early years when it was involved in project financing. The worst loan was to the infamous Enron inspired Dahbol project. Since then, it has radically changed its portfolio to become one of the largest retail lenders in India. Presently retail loans make up 47% of ICICI’s loan portfolio. It has one third of all mortgages, car loans and a quarter-share of the 13.1m credit cards issued by all banks. It also has a successful and profitable micro finance program.
If India had China’s collection problems, these retail loans would represent a large risk. Although India’s bad loans are larger than in developed countries, they are still quite manageable. The worst problem is with credit cards. Problem loans have reached a level of 6% compared with about 2% in the US and UK. To compensate for this risk, the RBI increased the risk weight on credit cards from 100% to 125%, so all Indian banks, including ICICI, have had to increase their capital requirements.
Car loans and housing loans are not anywhere near the problem of credit cards. Nonperforming car loans make up about 3% and housing loans are about 2%. Collection of auto loans in India has been helped by the growth of the used car market. As young professionals enter the market for used cars, the spread between loans for new and used cars has dropped. This has helped lower losses from car loan defaults, because the repossessed cars can be easily sold. This is contrast to China where the used car market has not developed and 400,000 unsold used cars add to the glut.
Part of the problem with retail loans in India and China is the lack of information. Both countries lack extensive data bases of credit information on consumers. In this area, the Indian banks have a substantial lead. Last year, the largest Indian Bank, the State Bank of India, HDFC, the largest mortgage lender and Dun & Bradstreet created a data base with information on 20 million potential retail borrowers.
The problem in China is severe. In one case a single borrower was lent enough in multiple mortgages to buy 128 apartments. The PBOC is finally trying to rectify the problem. Just this year it created a pilot system for six of China’s richest provinces, which involves about 100 banks. A private company, Experion has also applied to the Beijing regulators for permission to establish a data base, but has not yet been granted a license. There is doubt that they will ever succeed. The old adage that information is power is especially relevant in a communist country where all information is strictly controlled. It is unlikely that either the banks or the government will give up such an important asset.
Collateral
As all bankers know, a bad loan is not a problem if there is adequate collateral that can be liquidated quickly. In jurisdictions that favor debtors, from southern states in the US to former and present socialist states like India and China, realizing collateral can be a challenge.
In China the problem is particularly grave. The first hurdle for a Chinese bank will be to determine if there is any collateral. In countries with weak legal systems, there is a great reliance on relationships (guanxi) as a law substitute. This is conspicuously true in China where the Communist Party reinforced the custom. Much of the lending of the state banks was made based on personal or company guarantees rather than on property. Worse, the banks themselves often provided financial guarantees to connected clients. So there may not be any collateral for a loan and the bank may not be able to collect from the guarantor. In contrast, when the bank is the guarantor, it is easy to find, but the guarantee may not show up in its financial information.
The vast majority of Chinese bank loans are to SOE’s. CCB is no exception. Early loans to SOEs were often not documented, so there is no evidence that there was any collateral or even a loan. Title to personal and real property is a new concept to a communist country. If everything belongs to the state, why keep records? Records, when they exist can be difficult to find, filled with inaccuracies or unavailable without connections or bribes. Managers of SOEs often will remove the collateral from the SOE and place it in their own companies, where it is beyond collection.
Even if there is collateral, it is very difficult to attach it because of the decentralized nature of the Chinese political system. Local officials can be slow in providing information about assets of local companies. Branch managers have been known to protect their clients by delaying court orders until either money or assets have been transferred.
Local courts are usually staffed by retired PLA (People’s Liberation Army) army officers with little or no legal training. They are undoubtedly members of the CCP. Judges, even if they are lawyers, are subject to intense pressure. Their pay, housing, children’s education and possibility of promotion are in the hands of local officials. If that isn’t enough, judges can be intimidated by other means. In one case, officials threatened to transfer the judge’s daughter to another city.
Even if the judge is reasonably honest, saving jobs may make more sense than enforcing a loan. After years of socialist education and indoctrination, the welfare of workers may come before a legal concept. Ensuring social stability to protect the CCP’s monopoly on power would also be part of the legal arithmetic.
If CCB or its AMC, Cinda, are unable to collect on a loan, they might want the option of putting a debtor into bankruptcy. Last April, the Chinese government declared that it would put 1,828 large and medium firms into ‘policy bankruptcy’. The problem is that any assets salvaged from this type of bankruptcy are used to compensate laid off workers before creditors. Loans become write offs rather than nonperforming. Real bankruptcy barely exists in China. The 1987 bankruptcy law does not work, is not enforced and only applies to SOEs. Its replacement has been in the works for the past five years.
Indian banks have had problems collecting collateral too. Its legal system makes foreclosing on collateral difficult, but not impossible as in China. The ICICI prospectus makes it clear that loans to corporations are usually over collateralized with security interests in real and personal property including the plant and equipment, inventory, receivables, liens on fixed assets and pledges of financial assets.
The Indian legal system is far more entrenched than in China. There is a much greater reliance on contractual interest in collateral than guarantees. The law of secured interests in India is based on English common law and is well established. Since private property was never outlawed in India, documentary title to real and personal property is usually available and accurate. In some states it is freely available on line.
Political interference in making the loans and collecting them does exist in India. Most Indian banks and often the largest debtors are national, so with the exception of the cooperative banks, local officials have been unable to exert their power. Nevertheless, politicians have had an effect, because the PSBs account for about 53% of the NPLs or about $12bn. Foreign and private banks like ICICI do not have any where near the same problem. Their share of the total NPLs is about 23% or about $5bn.
The main problem in India is the courts. Although the judges are professional lawyers, there are far too few of them and they tend to take two month vacations. The scarcity of court time has resulted in a massive court back log that has made foreclosure on a debtor’s property extremely difficult.
Recently laws including the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act) and the establishment of the Debt Recovery Tribunal have helped banks get smooth possession of collateral without dilatory delays in the regular courts. ICICI was one of the first banks to use these new tools. In a recent case ICICI was able to invoke the act and recover their entire $4.5 million loan after a sale of the collateral.
Management
The board of CCB looks to be relatively independent. There are 15 directors. Of the 15, eleven are not executives of CCB. Three independent directors are foreigners. One represents Bank of America, a strategic investor. Another is the chairman of the Shinsei Bank, a Japanese bank that was resurrected by an American private capital firm.
The problem with the management of a Chinese state owned bank is that the appointment of senior management remains within the purview of the Chinese Communist Party. All though not stated in the prospectus, the Chinese directors resumes all list high government positions. These positions are reserved for party members. So it is almost a certainty that all of the Chinese directors are party members, who owe their jobs to their membership and rank within the party.
Apparently the lower management of CCB has its problems. Again CCB’s managers were appointed by the Communist Party, often by officials of the local cadre. It would also be safe to assume that most if not all of these managers are also members of the Communist Party. Party membership does have its advantages. It does not create a competent banker. In an interview with the Chinese financial magazine, Caijing, the present chairman of CCB Guo Shuqing “said that ‘more than 90 per cent’ of the bank's business managers were ‘unqualified’ and that CCB had problems in nearly every aspect of its business.”
Since the PSBs are owned by the Ministry of Finance, which is controlled by the party or coalition in power, it is likely that some of the managers of PSBs owe their positions more to party affiliation than to ability. However, unlike China, the party in power does change in India. A political appointee, who evidenced incompetence running a PSB, would naturally gain the gleeful attention of the opposition and swift removal upon a change of government.
In contrast, the management of ICICI reports only to its shareholders. Its largest investor is the Indian government through the Life Insurance Corporation of India and the General Insurance Corporation of India together own 17% of the stock. Under Indian law, its voting power is limited to 10%. ICICI has 17 directors, of which eleven are independent. Its board reads like a Who’s Who of Indian business. It includes Lakshmi Mittal, who owns the largest steel company in the world. Many of its executives have also worked for large western firms including KPMG and Citibank. Some hold degrees from US universities. Although no party affiliation is listed for any of the directors or management, their resumes exhibit only private sector business experience.
Corporate Governance
In 1993 the Chinese government passed its corporate code. The code is a very interesting and surprising piece of legislation. When the legislation was drafted, most of the businesses in China were SOEs. One would have thought that the code would protect the SOEs and their power, but it does not. Quite the reverse. The code is very biased toward the rights of shareholders, probably more so than the corporate codes in the US.
It is not until you remember, who the shareholders are, that it begins to makes sense. Prior to the passage of the law, SOEs were directly managed by the governmental unit that owned them. The result of government management and interference, then as now, was a disaster. The SOEs hemorrhaged money.
To solve the problem, the Chinese created a code that would separate the owners of an SOE from the managers. The government became a shareholder and the managers were supposed to be free to run their business at a profit. It did not work.
In game theory, agents, employees and managers’ best move is to cheat their principals, employers and owners. The main purpose of good corporate governance is to be sure they don’t. If there is a supervisor, it is the agent’s best move to corrupt the supervisor.
The problem was and is the Chinese Communist Party and state ownership. Although the managers were no longer government officials, they were chosen by government officials all of whom belonged to the party. Since the manager owes his job and promotion to the party, his incentive is to reward to his party bosses even at the expense of the state. Since the owner is the state or everyone, no one is in charge.
After the division between the state and the state owned company, the managers had more freedom. They could also use their additional freedom to enrich themselves at the expense of the company. As long as they also enriched or satisfied their immediate superiors or anyone with whom they had connections (guanxi), they could steal as much as they liked. As a result, the managers were able to indulge themselves in a whole range of questionable activities that would make an Enron executive blush. They transferred SOE assets to their own companies. Paid themselves large salaries, perks or just plain embezzled. Two good examples are the two previous CEOs of CCB. Mr. Zhang Enzhao was fired in the spring of 2005 for alleged corruption. He had headed CCB since 2002 following the sacking and, later, imprisonment of his predecessor, Wang Xuebing, for corruption.
One of the reasons why so much corruption exists in China is because there are huge economic incentives and few legal disincentives. The CCP is loath to discipline its own ranks. Since there is no free press in China and no investigators outside of the government, there is no one with an incentive to uncover misdeeds by SOE company executives or government officials. If anyone is brave enough to challenge the system as a whistle blower, they are far more likely to be punished than the wrongdoer.
To gain advancement with the system, SOE management and government officials, like other agents and employees throughout the world, must achieve certain objectives. With few restrictions, everyone, from managers to government officials, has an economic incentive to show that they have reached their objectives or their perceived objectives whether they have or not. Without any restraints, everyone cooks the books, provides false numbers or simply makes them up. So every number in China, from the number of children to the amount of profit, is suspect. If auditors do show up, they are likely to be threatened or killed by the local organization.
According to the CCB prospectus, the largest shareholder is Huijin a wholly state owned investment company that is answerable to the Chinese State Council, the highest governing body in China. Since Huijin owns 70% of the shares of CCB, far in excess of a majority, it controls the CCB. Bank of America, a large strategic investor, has only one seat. Under the Chinese corporate code, Huijin can change the bylaws anytime it wants. It can hire and fire management at will and has often done so.
The government is the majority owner of three telephone operators, China Telecom, China Mobile and China Unicom. Each of these companies is listed outside of China with a large number of minority shareholders. Each company competes fiercely against the other two. Last fall the government without explanation rotated the CEOs of each company and put them in charge of one of the others. The CEO of China Telecom was replaced by Wang Xiaochu, a top executive at China Mobile. China Mobile’s CEO became Wang Jianzhou, of China Unicom. Mr. Wang's job at Unicom was filled by Chang Xiaobing, China Telecom’s CEO.
In theory the State Council and the minority shareholders interests are aligned. It is in the interests of both to have CCB financially strong and profitable. The State Council and the minority shareholders have an interest in stopping corruption and managerial incompetence. The problem is that the State Council has other interests.
The State Council is not only the highest organ of government, it also leads the CCP. Despite some well publicized and failed experiments in democracy, the CCP has not shown any interest in giving up any power in any way. To maintain control and party supremacy, the State Council must support party members and quell unrest. This means money.
The Chinese save at least 25% of their incomes. They put their savings into state (the only) banks. So the banks are the major source of funds. Over the years, various leaders have promised, sworn, taken oaths, guaranteed that unprofitable SOEs will be shut down and that there would not be any more bail outs. Yet they continue, because without the loans, the SOEs will collapse. If the SOEs collapse, social unrest could overwhelm the party and the State Council. So the State Council has an imperative. Through its proxy, Huijin it must order CCB to continue to support the branch managers and the SOEs if it wants the party to survive.
The Indian corporate code as incorporated in the India’s Company Law is something that would be very familiar to any American lawyer. India’s law is based on common law. The Indian Supreme Court will often cite cases of the US Supreme Court as precedent. The Indian Company Law is in some ways outdated.
There have been movements to reform, modernize and benchmark the Company Law. These initiatives were started under the previous BJP government and are being carried on by the present Congress led coalition. They have not yet been passed and are the subject of considerable controversy. Nevertheless, the probability that the Company Law will be amended and modernized are very high.
However, since PSBs are owned by the Ministry of Finance, the provisions of the Company Law have little effect. So PSBs in India are subject to many of the same problems of the state owned banks in China and elsewhere. They are sometimes under political pressure to loan money to SOEs and the selection of management can be influenced by politicians. There are major differences.
The main problems with Indian Banks began under Indira Gandhi in 1969 when she nationalized most of the banks. There have been several attempts to privatize these banks, but so far they have failed. The regulator, the RBI, is moving very slowly. The present ruling coalition dominated by the Congress party must placate its socialist partners. At present the left wing partners have lobbied successfully to limit privatization.
The prior government wanted to lower state ownership in the PSBs to 33%. This has been raised to 51%. Out of the 27 PSBs, only two, Dena and Oriental are down to this minimum of 51%. Four PSB, Central Bank of India, Indian Bank, United Bank of India and Punjab and Sind are 100% owned by the government.
In addition to limiting privatization, the present Indian government has also limited foreign ownership of banks to 5%. It is likely that this will change. Indian banks including the PSBs have to meet stringent capital adequacy norms in the Basel II regime beginning 2007. The weaker PSBs, predictably including three banks that are totally owned by the government, Punjab and Sind Bank and United Bank, need to triple their tier II capital. The Indian government has severe deficit, so the only way that the PSBs can raise the cash is by going private and letting the foreigners buy in.
In addition the example of China is always pressing on the Indian government, which is envious of Chinese growth and ability to attract foreign capital. Right now with the stock market at all time highs, rapid economic growth and financial stability, the requirements of Basil II are in the future. There is little pressure for change. But if the economic situation deteriorates, the Indian government, like the Korean government, will probably decide that foreign capital and management are a price worth paying for financial stability.
Of course, the problems of the PSBs have nothing to do with ICICI. As a private company it is run in the interests of its shareholders. ICICI is listed on the Bombay stock exchange and is subject to the strict requirement of corporate governance required for listed companies. It is also subject to Indian securities laws, which are modeled on the United States Securities Act. The Indian securities regulator, The Securities and Exchange Board (SEBI), although subject to criticism, is becoming more effective. India’s financial press is filled with investigative reporting on all aspects of Indian companies. ICICI must file reports both in India and with the US SEC, which has jurisdiction over ICICI’s ADRs.
Law and economics enumerates six criteria that require good corporate governance. Managers have economic incentives and legal disincentives that require them to add value to investor’s shares. If managers do not do their jobs the company could go out of business or it could be bought out. If they fail in their duties they could be fired by an independent board, thrown out by empowered shareholders or subject to legal prosecution or regulatory discipline. Finally, their direct ownership in options is supposed to align their economic interests with the interests of the owners.
The real difference between CCB and ICICI is that the Indian private bank is subject to all of the limitations and the Chinese state owned bank is subject to none. ICICI is a private bank. It could go bankrupt at any time. CCB is 72% owned by the state. If its bad loans exceed its capital, it will most likely be bailed out again by the state.
ICICI’s shares are publicly listed. It could be taken over by another bank at any time. The only restriction is that bank could not be a foreign bank. It is unlikely that the Chinese government will sell its majority stake in CCB anytime soon. If it performs poorly, nothing will happen.
ICICI’s managers could be fired by its independent board or by the shareholders for poor performance at any time. If they violate their fiduciary duty, they could be prosecuted by just about everybody. They could be subject to criminal prosecution by the Indian SEC, SEBI and by the US SEC. Even Eliot Spitzer could investigate. ICICI’s shares are listed in New York as ADRs and come under US jurisdiction. They could also be prosecuted by criminal authorities in India and the US. They could be the subject US and Indian shareholder law suits.
CCB’s management is under the protection of the Chinese government State Council. To keep their jobs, they must satisfy the wishes of the State Council and no one else. The strategic foreign investors can suggest a change of management, but their suggestions can ignored.
In theory, the CCB’s management can be subject to investigation and prosecution by the Chinese securities regulator, the CSRC, and the banking regulator, the CBRC. In practice neither organization would move against the management without permission of the State Council. Since management is most likely in close contact with the State Council, it is doubtful that many of their decisions would be independent. So unless there is outright fraud, the present management would stay on regardless of performance.
As I will discuss, CCB listed in Hong Kong. Although it is subject to the Hong Kong regulatory authorities, Hong Kong is still a part of China. Hong Kong does have an independent legal system, but it is still subject to influence and pressure from the mainland. Since it is listed in Hong Kong, CCB management is not subject to US jurisdiction. Unlike the management of ICICI, its management is not subject to supervision or discipline by any US authority including the SEC. CCB’s agents in the US would be subject to US jurisdiction for acts committed by them in the US. For example, the Bank of China’s New York branch was fined $20 million for improper practices by it employees over the past decade.
There is another economic and legal disincentive that encourages management to abide by good corporate governance. An active and free financial press with strong economic incentives to investigate and report poor management to the investment community is one of the strongest disincentives to managerial mischief. In India, there is a free and very active financial press. In addition, just this year the Indian government lifted its ban on printing operations in India by foreign newspapers like the Financial Times, the Asian Wall Street Journal, and the International Herald Tribune.
In contrast China has no free speech. The internet is closely monitored. There is an excellent financial newspaper called Caijing, but it is limited by what it can publish. If it oversteps its bounds, it can closed down and its editors thrown into prison. Foreign journalists are also restricted. If they transgress arbitrary boundaries, they could be expelled from China or exclude from new source. In addition pressure could be put on their employers to get rid of them. The Chinese government recently ruled that foreign newspapers could not be published in China.
Exchange
CCB listed in Hong Kong and not New York. It was reported that present SEC chairman scandalized a room filled with Chinese regulators and politicians by suggesting that Chinese capitalism might collapse like the Qing dynasty in 1911. Mr. Cox’s references to Chinese history were not his only comments that provoked ire. Prior to the listing of CCB, Mr. Cox said that CCB had not listed in New York because it could not meet regulatory requirements. He suggests further that there might be problems with its balance sheet, management and nonperforming loans.
The Chinese and their western advisors were quick to counter attack. They called Mr. Cox irresponsible and inappropriate. However, they ducked the question. The statement on their web site said that their ability to meet US regulatory requirements was irrelevant, because they had chosen Hong Kong. They did not say that they could have met the requirements, but chose Hong Kong for other reasons.
The Chinese do not wish to list in the US for two reasons. First, the stringent regulatory requirements of Sarbanes-Oxley make a US listing more expensive. Second, the litigious environment of a US listing would mean that any malfeasance or inaccuracies in the CCB’s statements might result in litigation. China Life listed in New York and immediately after its listing it was hit by law suits and an SEC investigation over a very small inaccuracy. Apparently someone forgot to disclose the loss of $652 million.
Sensing a possible diminution of their oversized wallets, some investment bankers claimed that Asian markets have matured and are sufficiently transparent for investors to make informed judgments as to the quality of a company. But are they?
There are three problems with the regulatory environment in Hong Kong. Although the courts in Hong Kong are justly famous for the professionalism and fairness, there are some crucial conflicts of interest, which would tend to lessen the quality of investor protection.
Hong Kong has two regulators, the Securities and Futures Commission (SFC) and the Hong Kong Stock Exchange, which is owned by the Hong Kong Exchanges and Clearing Company. This company is not only listed, it also collects most of its revenue from new listings and stock trading. So one of the regulators is has more of an incentive to protect its shareholders than to protect other investors.
Not only is the SFC’s power shared with a listed company, its powers are defined by contract and not statute. The rules that the SFC is supposed to enforce are the listing rules of the Hong Kong Exchange. There are no statutes to back up those rules. This means that the SFC can only impose contractual remedies like delisting. It cannot impose criminal penalties. The rules can also be changed by the stock exchange if it feels that it is in its best interest to do so. There is no independent referee armed with strong legal disincentives.
Even if there was a statutory regime that gave the SFC real power, it might be compromised. Hong Kong may have its own legal system, but it is still part of China. Beijing can and does exert both influence and pressure to bend the authorities in Hong Kong to its will. Since CCB functions under the authority of the State Council, any legal threat brought by investors could be seen as a threat to China. As such, the State Council could use at least its influence to blunt the attack.
The second problem has to do with jurisdiction. For a regulator to have a meaningful legal disincentive, it has to be able to enforce its orders. The authority of the Hong Kong legal system does not extend past its borders onto the mainland. The SFC might have jurisdiction over securities fraud in Hong Kong, but to enforce its orders it would have to have jurisdiction over CCB’s directors and assets. They are all located in China.
In order to have witnesses testify or to get documents, the SFC has to ask the company to supply them. If the company refuses, its can only apply to the Chinese regulators like the Chinese Securities Regulatory Commission (CSRC) for help. In the past it has threatened to do so, but rarely does.
The real power in China is the security apparatus, not the regulators. If the authorities in Beijing feel that an individual has overstepped his bounds, they will be arrested. It is unlikely that the State Council, as the majority owner of CCB, would be interested in enforcing a judgment from Hong Kong, New York or anywhere else against its own company.
The third problem is free speech. Any regulator must rely on companies to voluntarily produce documents. The companies usually do so because there is either a legal disincentive to do so or there is an economic disincentive. One economic disincentive would be the possibility that an investigative financial journalist might find information that would damage the reputation of a company or its management. There may be a free press in Hong Kong, but there is not one in China. In order to discover information about Chinese companies, there must be a financial press that is free to do its job. This is impossible in China.
The Indian securities watchdog SEBI does not share the SFC’s conflicts or limitations. Unlike the SFC, the Indian securities regulator, SEBI, has authority derived from statute. SEBI also has the power to write its own rules and does not share them with the brokers who run the Bombay stock exchange. There are a few overlaps with other regulators, specifically the Company Law Board. Pending legislation to amend the Company Act, may clarify some of these problems.
SEBI has the power to search and seize property. It can also impose substantial fines. Since its jurisdiction runs throughout India, it can enforce its penalties on companies and directors anywhere in the country. India shares the common law with the US, so there is a greater likelihood that the courts of both countries will honor each other’s judgments.
Through its interest in the Life Insurance Corporation of India and the General Insurance Corporation of India, the Indian government does own 17% of the outstanding shares of ICICI. Under Indian law, its voting power is limited to only 10%. This does present a conflict. In the case of ICICI, it is doubtful that the Indian government would use its influence to limit any action by SEBI, because the interest is a minority interest and quite small compared to the many public companies it owns outright.
In India freedom of speech is guaranteed by Article III, section 19 1a of the Indian constitution. India has a very lively financial press. It also has several investigative muckraking organizations. Unlike China, India is a democracy, so the electorate in India acts as a strong limit to inappropriate government action.
Finally, ICICI is listed in New York as an ADR. It is subject to American Jurisdiction. ICICI files its documents with the SEC and is subject to Sarbanes Oxley and plaintiff securities lawyers just like any other American company.
Conclusion
Contrary to popular opinion, Communism is far from dead in China. The simple fact is that the Chinese Communist Party is the sole power in China. It has no intention of giving up its monopoly or any aspect of its power.
The main feature of a socialist state is that it dominates both economic and political power. Economic power has been central to the CCPs success in retaining political power. One of the main methods that the party has used to exercise their economic power is through its control of state owned banks. Through these banks it can suppress private companies, which it views as a threat. It can encourage foreign investors when it wants them or throw them out when they have served their purpose. It can maintain social stability by providing jobs and party loyalty by providing perks.
But there is a cost. The cost is the ever increasing pile of bad loans. The party can hide these loans in the AMCs. They can provide another bail out, but they cannot make the problem go away without threatening their hold on power. So when all is said and done there is no possibility that Chinese state owned banks in general or CCB in particular will ever be profitable. Any full disclosure would most likely reveal that CCB is insolvent. The party is happy to take foreign investors’ money. It is doubtful that they will give it back.
In contrast ICICI is a well run, transparent private company that is subject to both Indian and US economic incentives and disincentives. It holds primary market share in one of the fastest growing economies in the world. The Indian regulatory and legal framework is being reformed, perhaps not as fast as markets would wish, but it is occurring. They also do not need a revolution to change a moribund system. From foreign investors’ stand point, there is very little risk and an enormous potential for profit.
William Gamble of Emerging Market Strategies is a lawyer and economist specializing in the developing world, based in Providence, R.I.. IASC is pleased to be able to offer his commentaries. This latest, based on exhaustive research, looks at India and China by comparing two leading banks, each seeking foreign investment.
