Opinion & Commentary
The problem with China’s banks – unknown and unknowable
In a recent conversation with a senior executive at the Bank of China, I asked him how confident he was about top-down policy being implemented at the local branch level. For example, if BOC issued a categorical directive about lending standards or reserve ratios, would these orders be adhered to? Without hesitation and in a matter of fact response, he told me that management were confident that 30-40 percent of branches would comply. As for the other branches, no one could be sure.
In a country where bank loans constitute over four fifths of all financial activity, this goes to the heart of assessing the health and resilience of not just the Chinese banking system but also its economic model. There is no doubt that Chinese banks are weighed down with non-performing-loans (NPLs), even if their books deny that this is the case. For those with significant investment in Chinese commercial banks, the good news is that there is no foreseeable liquidity problem due to almost perfect domestic savings capture by the state-controlled banks. But the official accounts of China’s banks indicating reasonable financial health simply do make sense. Just as senior banking executives cannot predict what the majority of their branches will do, they are also dealing with concocted figures fed through a bottom-up process with little accountability, transparency and credibility.
Prior to the Global Financial Crisis (GFC), fixed investment (overwhelmingly funded through domestic bank lending) was responsible for about 40 percent of GDP growth. In the horror years of late-2008 to mid 2009, fixed investment constituted an estimated 70-80 percent of GDP growth, falling to around 50-60 percent currently. Significantly, bank lending jumped from US$750 billion in 2008 to US$1.4 trillion in 2009, before falling to about US$1.2 trillion in 2010.
This is not itself a problem. But there are a number of things to consider. For starters, around 75 percent of the loans go to state-controlled entities, rising to 90 percent during the GFC. Second, most of this is taking place at the local level: local branches lending to state-controlled entities owned by local governments. There are a few hundred central SOEs (with a few thousand subsidiaries) compared to over 100,000 local SOEs with tens of thousands more subsidiaries. Hence, the financial health of the huge centrally owned SOEs such as Chinalco tells us almost nothing about how the country’s local SOEs – who receive the bulk of the country’s capital - are faring.
There are two concerns here. First, local governments are prohibited from borrowing from banks or issuing bonds. To get around these restrictions, they create state-owned commercial entities. These entities receive the lion share of loans from local bank branches with much of it ploughed into the local property market through the process of (often illegally) acquiring land, re-classifying the land as commercial, and building on it. Indeed, about 50 percent of local government revenues come from the property market. In other words, the tax revenue function for local governments in China is largely based on the perpetuation of a property bubble. Should it deflate or burst, the impact on both local government budgets and the books of local bank branches will be immense.
Second, excluding those involved in the property sector, around half of the locally state-owned enterprises offer zero or negative return on investment. NPLs are simply rolled over, pay-back periods extended, or else placed in an ‘other’ category in the books. By the time local accounts are passed on to officers at the provincial and central levels, there is little hint of the true extent of loans that will never be repaid.
The central accounts of China’s commercial banks indicate that NPLs constitute less than 5 percent of outstanding loans – a perfectly acceptable figure. Extrapolating from multiple localised case studies, the figure could be anywhere between 20-40 percent (and this doesn’t include the scenario of the property bubble bursting.) The true national NPL figure could amount to anywhere between 40-70 percent of GDP according to the private calculations of many Chinese economists. For Beijing and for foreign investors, the true figure is terrifying but inherently unknowable.
With respect to China’s banks, it is not a matter of ‘If it ain’t broke, don’t fix it’ but ‘We know it’s broke but it can continue going for awhile... and besides there is no pain free way to fix it.’ Dangerous as it is, China’s banking model can continue to roll on for quite awhile because of the extent of domestic savings capture. But paradoxically, the time to divest stock holdings in Chinese banks will come if and when Beijing gets serious about genuine financial reform and corporate governance in China – since the immediate shock to the Chinese financial system and political-economy will be immense.
Dr. John Lee is a research fellow at the Centre for Independent Studies in Sydney and the Hudson Institute in Washington DC. He is author of Will China Fail?
