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Terminal Issues of the Chinese Banking System

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by William B. Gamble
Published on March 21st, 2005

It is well known that the Chinese financial system has problems. It is generally assumed that these problems, like many in China, can be fixed. The cure is reform. The popular perception is that as China reforms, the issues will be resolved. It isn't and they won't. To solve the problem requires a legal system, but a legal system requires the Communist party to give away their most precious asset, power. This they will not do.

The problem in China is severe. The government owns almost every bank in China and they are all insolvent. Not only are they insolvent, the amount of their nonperforming loans (NPLs) is huge. Private economists have estimated that the real ratio of NPLs is between 35 and 40% of assets. This translates to between $374bn and $749bn worth of dud loans for the four largest state owned banks. My guess is that they are much higher. In the last two years alone, these banks have made $360 billion in new loans. If they get any of that paid back, it will be a miracle. In contrast, India has the same problem. They have $22bn in bad loans.

It is not uncommon in Asia for governments to use their banking systems to channel capital to personal or politically favored borrowers regardless of credit risk. Whether the bank loan is made to a member of a keiretsu group in Japan; to another member of a family's holding company in Indonesia; or to a politically connected company in Thailand, the result is always the same. The loans don't get paid back! Eventually, the banks become insolvent. China is no exception. Its banks were originally simply conduits for the government to provide loans for State Owned Enterprises (SOEs).

SOEs are attractive to Beijing for a variety of reasons. They provide revenue to their owners whether they were municipalities, provinces or ministries. They provide employment for both ranking and lower level communist party members. They provide special perks for the leaders and jobs for everyone else. They pay for housing, schools, healthcare and pensions. They can purchase scarce resources for China's growing economy. They are encouraged to grow into national champions. China's growing international prestige demands companies that can compete with multinational companies on a global scale. In short, they give the government power.

There is only one problem with SOEs. They do not work. China's computer leader, Lenovo, is being squeezed on its home turf. White goods manufacturer, Haier, hold onto market share in China with ruinous price wars and cannot breakout of niche markets in international sales. Shanghai Automotive Industry Corp (SAIC) lacks the technologies and design skills to compete with even Chinese rivals.

SOEs do not exist to make profits, so they don't. A legal system provides six methods of insuring good corporate governance, and none apply to SOEs. SOEs pay nothing for their capital. The Chinese banking system lends money to SOEs and they lose it.

The Chinese government would like to stop this hemorrhage. They would like to have their banking system lend on the basis of credit risk. They could do this by lending to the most vibrant part of the Chinese economy, private companies, but this would divert money and power from SOEs. So they tried something else.

The government thought consumer loans would be a better risk. The problem is that in a society without a legal system, loans are often made to the well connected rather than the well financed.  Game theory teaches that borrowers need a legal disincentive to force them to pay back debts. Without it, they don't. In China about a third of the consumers don't pay back the loans. Apparently, the Chinese government never considered what happened in Korea. Even though Korea actually has a legal system, the proliferation of credit cards, swamped several banks with bad debts along with one in ten Koreans.

Central registries and credit bureaus are in their infancy. The process of repossessing collateral especially cars is almost impossible. Customers use false names or disappear, so judgments, when and if they are obtained, remain uncollected. Even if the banks can repossess the cars, selling them is another problem. The used car market is also in its infancy.

The result is that instead of saving the banking system, consumer loans have made it worse.  One of the big four state banks, China Construction Bank is owed $1.2 billion dollars for home mortgages, car loans and credit card debt. The total amount of nonperforming consumer debt for all four state banks is $10.8 billion dollars. One of the banks, the Agricultural Bank of China is the worst offender. It holds nearly half.

Chinese state banks do not just lose money on loans to SOEs and consumers. Enormous amounts are simply stolen. In this year alone, it was reported that there were two thefts from China Construction Bank in Jilian one for $65 million and another one for $8 million. China Construction also lost $13 million in Zhuhai in Guangdong. The Industrial and Commercial Bank was ripped off to the tune of $845 million. Last year the United States handed over an employee suspected of stealing $485 million from the US branch of the Bank of China. Wang Xuebing, CEO of China Construction was fired and imprisoned in 2002 for corruption. His successor, Zhang Enzhao was just sacked allegedly for accepting kickbacks in exchange for loan approvals. And these are the incidents we know about.

This creates a problem.  It is one thing to use taxpayer money to stimulate your economy, quite another to use bank loans.  The great thing about taxpayers is that you do not have to pay them back.  Depositors are different. Eventually, they would like to see some of their money back and hopefully with interest.

The Chinese have a different view of the problem. They think they have solved it. Chinese and several other Asian countries have tried to imitate an American solution.  During the banking crisis of the late 1980s, the United States federal government created the Resolution Trust Corporation (RTC). When a bank became insolvent, the RTC took over its loan portfolio in exchange for guaranteeing deposit. Once the RTC had title to the loans, it would foreclose on any collateral and sell it as quickly as possible.  The bank would be closed. The depositors would be paid off.  The difference between the value of the collateral and the liability to the depositors was borne by the taxpayer. The RTC was wound up.

In China they set up Asset Management Companies (AMCs), which were supposed to imitate the RTC. In 1999, each of the four large state banks: Industrial and Commercial Bank of China, Bank of China, China Construction Bank and Agricultural Bank of China set up an AMCs - Huarong, Orient, Cinda and Great Wall respectively. But they deviated from the RTC model.  $170 billion worth of bad loans was not just transferred the AMCs. They were "sold" to the AMCs. The AMCs received worthless loans.  The banks received 10-year bonds yielding 2.25% per annum at the face and not the market value of the loans! So the banks have magically turned a liability, bad loans, into an asset, AMC Bonds without a haircut.

The AMCs proved no better at collecting the Non Performing Loans than the banks. The deficient legal infrastructure, that encouraged the banks to make the loans in the first place, made it impossible to get rid of them. Rather than collecting the collateral and selling it, like the RTC, the AMCs ended up just sitting on the loans. Japan had a similar experience.

Any creditor has four alternatives for disposing of a bad loan.  They can try to collect the loan, or at least the collateral, from the debtor. They can force the debtor into bankruptcy.  They can exchange the debt for equity in the debtor's enterprise.  Finally, but least likely, they can sell the loan.

Whatever their deficiencies, the AMCs were setup and the loans were transferred. This was supposed to solve the problem. It did not. Like their Japanese and Thai counterparts, the state banks just kept on lending. The needs of profitless SOEs overrode the needs for fiscal discipline.

As we saw with the cars, collecting a debt is almost impossible in China. The problems were confirmed by the President of the Chinese Supreme People's court in his annual report in March 2004. He said that the difficulty of executing civil and commercial judgments had become a major chronic aliment often leading to chaos in the enforcement process. He stated that there were few solutions to this problem.

Since state banks were originally just a conduit to provide capital to state companies, there are often no records, no collateral, no mortgages or security interests.  Even good collateral with a legally enforceable security interest is hard to find.  Managers of State Owned Enterprises often strip assets and transfer them to their own private companies.

Local courts protect local companies, because they usually report to the same local communist officials. According to a famous Chinese legal expert, there is less than a tenth of a percent chance of winning a case against the local company, whatever the merits of the case. The judges can be effective, but only if they are working for a local loan shark. Then they will advise debtors to pay back the loan shark and not worry about loans to state banks or AMCs.

China's has been expecting a reform of its bankruptcy system for the last five years. The present law, created in 1987, does not work. In the absence of bankruptcy, you are stuck with an equity swap. The AMCs and banks exchange debt of an insolvent State Owned Enterprise for equity in the same insolvent State Owned Enterprise. Again, this slight of hand replaces a liability on the balance sheet with an asset.

The most optimistic method to dispose of the loans would be to sell them. Over the last two years the papers have been full of "deals". These deals always show an enormous amount of bad loans being "sold" to Morgan Stanley, Goldman Sachs or whomever.

Upon closer inspection, many of these "deals" are actually contingency agreements, where the western company agrees to help in collecting the debt in exchange for a percentage of the funds collected. Although I am sure that there are some bargains to be had and money to be made, in September 2004, Lone Star, the US private equity group that specializes in distressed assets, closed its office in Beijing.

The problem is that without a legal system, the loans are not worth anything. The Chinese statistics claim that they are collecting 20%. The only real bankruptcy that I know of, that of GITIC in Guangdong province yielded about 2 cents on the dollar. This the real reason for all of the delay in selling the loans. If their real value, which I believe to be about 3% of face was widely accepted, then the enormity of the problem would certainly have a disastrous effect on any investment in China.

Despite all of these problems, the Chinese have continued to assert that the ratio of bad loans in its banks has continued to fall. According to Chinese regulators Bank of China has cut its bad loan ratio from 17.8 per cent to 4.55 per cent in one year, China Construction Bank has cut its ratios to 2.14 %, but the Agricultural Bank of China was still stuck at 29%.  According to regulators, 19 banks in China have reached international capital adequacy ratio of 8 per cent. If this is correct, the Chinese cleared up more bad loans in a shorter time than the United States, Japan, Sweden, Thailand, Indonesia and India.

Just this February, this fiction had become so bad that the China Banking Regulatory Commission (CBRC) decided to tell the truth. "If we analyze the figures coolly and include the assets from the two banks that were transferred and use the original specifications, then the NPL amounts rose to some extent. This is certainly a matter of great concern." The National Audit Office is now auditing the CBRC itself allegedly for upsetting bankers by doing its job.

Since they have been so "successful", all of these banks are considering Initial Public Offerings (IPOs).

They are not the only ones to consider IPOs. Now, the AMCs want to do it. Originally, like the Resolution Trust Company, these were considered to be temporary vehicles to be wound up after they disposed of all of their bad loans. Since they have only been able to manage the assets and not sell them, they want to turn themselves into permanent profit-oriented financial institutions. They want to be able to compete with investment banks in a wide range of services. This transformation has the blessing of Chinese banking authorities, because it keeps the problem covered up.

The problem with the Chinese banking system is quite simple. There are no rules, no legal system, and no legal disincentives. It is designed that way. The Communist Party of China wants to hold onto power. It wants to run the country and the banking system according to its will. Mere laws might restrict its unfettered discretion to use the savings of over a billion people anyway it wants. The problems of the Chinese banking system cannot be solved until the party relinquishes that discretion. When it does, it may be too late.

William B. Gamble, President of Emerging Market Strategies, appears regularly in the business media and is author of Investing in China: Legal, Financial and Regulatory Risk(Quorum Books, 2002).

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