Source:The Banker and respective annual reports
This gets to the true heart of the issue. Understanding how the Chinese banks were relieved of their problem-loan burdens leads to a clear understanding of their continuing weakness. The data in Figure 2.6 show an impressive and factual reduction in total non-performing commercial bank loans over the seven years through 2008. In 1999, the NPL ratio (simply put, bad loans divided by total loans) of the Big 4 banks was a massive 39 percent just before spinning off the first batch of bad loans totaling US$170 billion in 2000. From 2001 to 2005 ICBC, CCB, and BOC spun off or wrote off a further US$200 billion. In 2007, ABC, the last of the major banks to restructure, spun off another US$112 billion, making a total among the four banks of around US$480 billion.
FIGURE 2.6 Non-performing loan trends in the top 17 Chinese banks, 1999–2008
Source: PBOC, Financial Stability Report, various; Li Liming, p. 185
It is thought that the bulk of these bad loans originated in the late 1980s and early 1990s when bank lending flew out of control, as it did in 2009. If that is the case, this nearly US$480 billion in bad loans was equivalent to about 20 percent of China’s GDP for the five-year period from 1988 to 1993, the year Zhu Rongji applied the brakes. A more important point, perhaps, is that the banks silently carried these NPLs for a further five years before anything was about them and another 10 years went by before they were said to be fully worked out (but not written off).
The US savings-and-loan crisis of the 1980s may help put China’s NPL experience into some perspective. The Federal Deposit Insurance Corporation (FDIC) has calculated that during the 1986–1999 period in the US, the combined closure of 1,043 thrift institutions holding US$519 billion in assets resulted in a net loss after recoveries to taxpayers and the thrift industry of US$153 billion at the end of the clean-up in 1999.6 In other words, the recovery rate achieved was over 60 percent. In contrast, the commonly noted rate in China after 10 years of NPL-workout efforts is considered to be around 20 percent.
This vast difference in recovery rates on comparable amounts, together with the dramatic decrease in NPLs shown in Figure2.6, raises a host of questions. If, in fact, the NPL rates of Chinese banks have now improved to such a degree, is it because they are lending to better companies that have the capacity as well as the willingness to repay, or did their original SOE clients simply start to pay again? If the latter is the case, why were the previous problem-loan recovery rates so low? A significant change in client base can be ruled out: Chinese banks overwhelmingly lend to SOEs and always have, largely because they are viewed as reliable, unlike private companies. In retrospect, this attitude seems to be mistaken.
The Party tells the banks to loan to the SOEs, but it seems unable to tell the SOEs to repay the loans. This gets at the nub of the issue: the Party wants the banks to support the SOEs in all circumstances. If the SOEs fail to repay, the Party won’t blame bank management for losing money; it will only blame bankers for not doing what they are told. Simply reforming the banks cannot change SOE behavior or that of the Party itself. Improved NPL ratios over the past 10 years, therefore, suggest a dramatic improvement in the willingness of SOE clients to meet their loan commitments, the selection of investment projects that actually generate real cash flow, or some other arrangement for bad loans.
THE SUDDEN THIRST FOR CAPITAL AND CASH DIVIDENDS, 2010
If it is true that lending standards have improved significantly, perhaps there is no need to be concerned about the after-effects of the 2009 lending binge; the quality of Chinese bank balance sheets will remain sound and the level of write-offs manageable. The frantic scrambling for more capital from early in 2010, however, suggests otherwise. The CEO of ICBC, Yang Kaisheng, has written a uniquely direct article analyzing the challenges facing China’s banks.7 In it, he describes China’s financial system:
In our country’s current level of economic development, we must maintain a level of macroeconomic growth of around eight percent per annum and this will inevitably require a corresponding level of capital investment. Our country’s financial system is primarily characterized by indirect financing (via banks); the scale of direct financing (via capital markets) is limited.
This statement of fact says two important things about China’s banking system. First, there is an overall economic goal of eight percent growth per year that requires “capital investment.” Second, the source of capital in China relies mainly on the banks. In other words, bank lending is the only way to achieve eight percent GDP growth.
With estimates of loan growth, profitability and dividend payout ratios, Yang then states that the Big 3 banks plus the Bank of Communications will, over the next five years, need RMB480 billion (US$70 billion) in new capital.8 Yang is saying “raised over five years,” but these banks are trying to raise this amount in just one year, 2010. Putting aside ABC’s proposed US$29 billion IPO goal, by April 2010, the other banks had already announced plans to raise RMB287 billion (US$42.1 billion), as shown in Table 2.3.
TABLE 2.3 Reported capital-raising plans by the Big 5 banks, May 2010
Source: Annual and interim bank reports, Bloomberg; industry estimates as of May 2010
This is an astounding amount, coming as it does only four to five years after their huge IPOs in 2005 and 2006 had raised a total of US$44.4 billion. Yang goes on to say that if market risk, operating risk, and increasingly stringent definitions of capital requirements are considered, then the capital required will be even greater. What he doesn’t mention, though, is the risk of bad loans. It would seem that Yang’s point in citing these facts is that China’s current Party-led banking arrangements do not work, in spite of the picture presented to the outside world. It is a defense of the model put forward by Zhu Rongji in 1998.
The experience of the past 30 years shows that China’s banks and their business model is extremely capital-intensive. The banks boomed and went bust with regularity at the end of the 1970s, 1980s and 1990s. Now another decade has gone by and the banks have run out of capital again. Even though they appear healthy and have each announced record profits and low problem-loan ratios for 2009, the Tier 1 capital ratios of the Big 3 are rapidly approaching nine percent, down from a strong 11 percent just after their IPOs in 2005 and 2006. Of course, the lending spree of 2009 was the proximate cause. As an analyst at a prominent international bank commented: “The growth model of China banks requires them to come to the capital markets every few years. There’s no way out and this will be a long-term overhang on the market.”9 But it is not just the lending of 2009 or even their business model that drives their unending thirst for capital; it is also their dividend policies.
The data in Figure 2.7 show actual cash dividends paid out by the Big 3 banks over the period 2004–2008, during which each was incorporated and then listed in Hong Kong and Shanghai. The figure also shows the funds raised by these banks from domestic and international equity investors in their IPOs. The money paid out in dividends, equivalent to US$42 billion, matches exactly the money raised in the markets. What does this mean? It means international and domestic investors put cash into the listed Chinese banks simply to pre-fund the dividends paid out by the banks largely to the MOF and Central SAFE Investment. These dividends represented a transfer of real third-party cash from the banks directly to the state’s coffers. Why wouldn’t international investors keep the cash in the first place?
FIGURE 2.7 Bank IPOs pre-fund cash dividends paid, 2004–2008
Source: Wind Information for IPO amounts; Statement of cash flows, bank annual reports
Investors, as opposed to speculators, put their money in the stocks of companies, including banks, in the expectation that management will create value. But in these three banks, this is not what is happening because the capital did not stay in the banks. Yes, the minority international investors acquired stocks that vary in value in line with market movements. This gives the impression of value creation on their portfolios, but these movement
s are, in fact, due more to speculation on market movements driven by any number of factors including, for example, overall Chinese economic performance. This should not be confused with value investing: the banks themselves are not putting the money to work to make the investor a capital return. For this reason alone, the market-capitalization rankings are misleading.
As for the Chinese state, which holds the overwhelming majority stake in these banks, such payouts mean the banks will require ongoing capital-market funding after their IPOs. This, in turn, means the government must, in effect, re-contribute the dividends received as a new equity injection just to prevent having its holdings diluted. There can be only one IPO for each bank and one infusion of purely third-party capital.10 What is the purpose of running a bank that pays dividends to a state that must then turn around and put the same money back again? Why sustain dividend payout ratios at 50 percent or higher? This begins to look very much like some sort of Ponzi scheme, but to whose benefit?
Of course, it is more than that: China’s banks are the country’s financial system. But, as the analyst said, they operate a business model that requires large chunks of new capital at regular intervals. With high dividend payouts and rapid asset growth, consideration must inevitably be given to the issue of problem loans. How can banks as large as China’s grow their balance sheets at a rate of 40 percent a year, as BOC did in 2009, without considering this? Even in normal years, the Big 4 banks increase their assets through lending at nearly 20 percent per annum. Throughout 2009, as the banks lent out huge amounts of money, their senior management emphasized over and again that lending standards were being maintained. How was it, then, that the chief risk officer of a major second-tier bank could exclaim even before 2009: “I just don’t understand how these banks can maintain such low bad-loan ratios when I can’t?” His astonishment suggests there may be less-than-stringent management of loan standards by the banks’ credit departments. This is undoubtedly true.
The most important fact behind the quality of these balance sheets, however, goes beyond common accounting manipulations or even making bad loans. These things are inevitable almost anywhere. It goes back to the financial arrangements made by the Party when weak bank balance sheets were restructured over the years from 1998 to 2007. A close look at how these banks were originally restructured highlights the political compromises made during this decade-long process. These compromises have been papered over by time and weak memories on all sides: it is highly likely, for example, that China’s national leaders believe that their banks are world-beaters. In the past, sweeping history under the carpet might have been enough; people would have forgotten. Today, it is far from enough, even for those operating inside the system. The key difference with the past is that the quest to modernize China’s banks was made possible by raising new capital from international strategic investors and from subsequent IPOs on international markets. China’s major banks are now an important part of international capital markets and subject to greater scrutiny and higher performance standards . . . just as Zhu Rongji had planned.
ENDNOTES
1 See Demirguc-Kuntand Levine 2004: 28.
2 “Inside the world of a red capitalist: Huang Yantian’s financial powerhouse is helping to remake China,” BusinessWeek, May 1994.
3 Li, Liming and Cao, Renxiong, 1979–2006 Zhongguo jinrong dabiange (1979–2006 The Great Reform of China’s banking system). Shanghai: Shiji chuban jituan : 474.
4 Walter and Howie 2006: 181ff.
5 Ibid., Chapter 9.
6 Curry and Shibut 2000.
7 21st Century Business Herald 21 , April 13, 2010: 10.
8 Yang excludes ABC, which listed its shares later in 2010.
9 “ICBC says China’s banks need $70 billion capital,” Bloomberg News, April 13, 2010.
10 The first round of fund raising via an IPO involves the sale of new shares. This brings new capital into the bank and dilutes the original shareholdings. Thereafter, if the bank sells shares again, the Chinese state must also inject money or have its stake diluted.
CHAPTER 3
The Fragile Fortress
“Growing big is the best way for Chinese banks to make more money . . . This model of growth, however, neither assures the long-term sustainable development of the banking sector nor satisfies the need of a balanced economic and social structure. Things are very complicated; so will be the solutions.”
Xiao Gang, Chairman, Bank of China
August 25, 20101
When the Asian Financial Crisis threatened the stability of China’s financial institutions in 1997, Zhu Rongji sponsored a group of reformers surrounding Zhou Xiaochuan, then chairman of the CCB, to come up with a plan. The immediate threat to confidence in the banks was addressed by the MOF injecting new capital into the banks in 1998. As a second step, Zhou’s group proposed a “good bank/bad bank” approach to strengthen the balance sheets of the Big 4 banks. Modeled after the Resolution Trust Corporation (RTC) in the US, asset-management companies (AMCs) would be established for each of the banks. The AMCs would become the “bad” banks holding the non-performing loans (NPLs) of the resulting “good” banks. These bad banks would be financed by the government and be responsible for recovering whatever value possible from NPLs. The State Council approved the proposal and in 1999 the AMCs were set up. (See appendix for organizational charts of China’s resulting financial system).
In 2000, huge problem-loan portfolios were transferred to the AMCs, freeing the banks of massive burdens and enabling them to attract such blue-chip strategic investors as Bank of America and Goldman Sachs. These international investors were brought in less for their money than for the expertise that the government hoped could be transferred to its banks. But, in a rising crescendo of criticism, conservative and nationalist critics claimed a “sell-out” to foreign interests. Even so, in 2005, CCB enjoyed a wildly successful IPO in Hong Kong, raising billions of dollars in new capital. With this IPO, Zhu and Zhou’s efforts achieved a very significant success where, several years before, few had believed such a thing possible for a Chinese bank. Unfortunately, the very success of bank reform fed the fire of conservative criticism which was now amplified by the PBOC’s institutional rivals, who wanted to cut Zhou and the central bank down to size. Among these rivals were the NDRC, the CSRC, the CBRC and, most particularly, the MOF. The impact of this concerted criticism affected the financial restructuring process, beginning with ICBC and continuing through to ABC. It also had the effect of ending Zhou’s integrated approach to capital-market and regulatory reform.
The practical consequence for the bank reform was the creation of two different approaches to balance-sheet restructuring. Of course, the original plan for all four banks was superficially retained, even after the MOF assumed the leading position in the reform of ICBC and ABC in 2005. No better ideas had been generated as a result of all the criticism, so each of the four banks raised capital through IPOs. But the paths to restructuring differed, as did the manner in which NPL portfolios were disposed of. The major financial liabilities remaining on bank balance sheets arising from the two different approaches are shown in Table 3.1. Information in this table is derived from the banks’ financial statements under the footnote “Debt securities classified as receivables.” The table illustrates the continuing and material exposure of China’s major banks to securities created as a result of their restructuring a decade ago. The simple message of these “receivables” is that the old bad debt has not gone away; it is still on bank balance sheets but has been reclassified, in part, as “receivables” that may never be received.
TABLE 3.1 Restructuring “receivables” on bank balance sheets
Source: Bank audited financial statements, December 31, 2009
What is the nature and value of these assets? The various PBOC securities, as well as the 1998 MOF bond, are clear obligations of the sovereign. But what value should be assigned to the AMC bonds or, for that matter, the MOF “receivable?” Obviously a r
eceivable due from the MOF is similar to a government bond . . . on the surface. The bond, however, has been approved by the State Council and the NPC as part of the national budget. Such government bonds will be repaid either by state tax revenues or further bond issues. Who has approved the issuance of that IOU? How will it be repaid? These are important questions, given each bank’s massive credit exposure to these securities. For example, the total of these restructuring assets is nearly twice ICBC’s total capital, with the AMC bonds alone representing 53 percent. The sections below seek to understand how these obligations arose and what they practically represent in order to determine their value and structural implications for the banking system as a whole.
THE PEOPLE’S BANK OF CHINA RESTRUCTURING MODEL
From the viewpoint of strengthening the banks, the original PBOC model was the most effective, providing additional capital to the banks through a combination of more new money and better valuations for problem loans. In the first step in 1998, bank capital was topped up to minimum levels required by international standards. This was followed by the transfer of US$170 billion of bank NPL portfolios to the AMCs at 100 cents on the dollar. These “bad banks” paid cash, using a combination of PBOC loans and AMC bonds, for the bad-loan portfolios. However, these injections of cash came just at a time when inflation was looming. Consequently, the PBOC sterilized the incremental cash on bank balance sheets by forced purchases of PBOC bills, which could not be used in any further financing transactions. This is the source of the PBOC securities listed in Table 3.1. In 2003, additional bad loans remaining on the balance sheets of CCB and BOC were completely written off up to the amount of the total capital of each bank, a total of RMB92 billion (US$12 billion). Bank capital was then replenished from the country’s foreign-exchange reserves and with investments from foreign strategic investors. CCB and BOC were restructured in this way and completed successful IPOs in 2005 and 2006.
Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise Page 6