The Economist, 6 April 2006
The mainland's banks have never looked in better shape. On April 6th China Construction Bank, the country's third-largest lender, reported its results for 2005. Although net income dipped a bit, operating profit (a better reflection of its underlying business) rose by 17%, boosted by robust loan growth in a booming economy. The bank's shares have risen in price by more than half since it listed in Hong Kong last October, the first of the “Big Four” state banks to do so. Meanwhile, the share price of the smaller Bank of Communications (BoCom) has doubled since listing last year. No wonder that Industrial and Commercial Bank of China and Bank of China (BoC), another two of the Big Four, are as eager to sell shares this year as foreign investors are to buy them.
Reality, though, is less rosy than it appears. The banks look healthy largely because of repeated capital infusions, initially from the Chinese government but latterly also from foreign strategic partners and the capital markets. Moreover, the bad loans sluiced overboard in past bail-outs look as if they are being replaced by a new wave. China's rapid growth may be producing good-looking profits today, but it is storing up problems for tomorrow.
The biggest threat is overcapacity in almost every industry. Take steel, a big client of the state banks. China's rapacious demand drove steelmakers' profits from 5 billion yuan ($600m) in 1999 to more than 125 billion yuan last year. This triggered a surge of investment in new plants—worth 650 billion yuan in the past five years, two-thirds of it financed by the state banks. Today China has excess steelmaking capacity of 120m tonnes, or a third of its output. “No other country even produces 100m tonnes of steel—and that's China's excess,” marvels Nicholas Lardy, a senior fellow at the Institute for International Economics in Washington, who put the numbers together. The result is plunging returns. In the first two months of 2006, the steel industry's profits were 75% lower than a year before. On March 30th Baosteel, China's biggest producer, reported its first quarterly drop in net profits in more than three years. Stocks of steel are expanding and cashflow is drying up. Despite signs that global steel prices may be picking up, many steelmakers will find it hard to pay back the loans they took out to finance their expansion.
This overcapacity—and declining profits—is repeated in many industries, from power generation to cement, coke, aluminium, car parts and luxury property. All told, the banks face a fresh burst of bad loans, says Mr Lardy: “This could erase some of the very hard-won progress in bank reform in the last eight years.” The concerns go right to the top. At the annual meeting of China's parliament in March, Wen Jiabao, China's prime minister, pointed to a growing risk to the banks from a build-up of inventories.
Yet while the government has tried to curb investment in some industries, in others its foot remains firmly on the accelerator. It plans to splurge 2 trillion yuan on railways, including several new subway lines in Shanghai, in the next five years; to build 24,000 km (15,000 miles) of expressways by 2010; and to have 30 nuclear power stations by 2020, against nine now. Much of this will be financed by the banks, and not all with state guarantees. Dong Tao, chief Asia economist at Credit Suisse, thinks a lot of it will not be commercially viable: “The returns will not be high. There will be a lot of new pressure on the banks.”
Nor can the banks rely on new consumer spending to bail them out. Although pundits have been hailing the emergence of the Chinese consumer for years, net new household borrowing declined in 2005, estimates Mr Lardy, and accounted for less than 15% of net bank lending. Last year, for the first time in nine years, the share of bank loans to households failed to grow.
These threats would be worrying enough if the banks had learnt how to lend properly. But they haven't. A new working paper by economists at the IMF finds that the big state banks still do not price their loans according to either the riskiness or the profitability of the borrower. An embarrassing tale last month of five officials at a remote branch of BoC, who embezzled 430m yuan, is further evidence that old, bad habits remain. Behind their newly burnished facades, China's banks still carry rot within.
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The mainland's banks have never looked in better shape. On April 6th China Construction Bank, the country's third-largest lender, reported its results for 2005. Although net income dipped a bit, operating profit (a better reflection of its underlying business) rose by 17%, boosted by robust loan growth in a booming economy. The bank's shares have risen in price by more than half since it listed in Hong Kong last October, the first of the “Big Four” state banks to do so. Meanwhile, the share price of the smaller Bank of Communications (BoCom) has doubled since listing last year. No wonder that Industrial and Commercial Bank of China and Bank of China (BoC), another two of the Big Four, are as eager to sell shares this year as foreign investors are to buy them.
Reality, though, is less rosy than it appears. The banks look healthy largely because of repeated capital infusions, initially from the Chinese government but latterly also from foreign strategic partners and the capital markets. Moreover, the bad loans sluiced overboard in past bail-outs look as if they are being replaced by a new wave. China's rapid growth may be producing good-looking profits today, but it is storing up problems for tomorrow.
The biggest threat is overcapacity in almost every industry. Take steel, a big client of the state banks. China's rapacious demand drove steelmakers' profits from 5 billion yuan ($600m) in 1999 to more than 125 billion yuan last year. This triggered a surge of investment in new plants—worth 650 billion yuan in the past five years, two-thirds of it financed by the state banks. Today China has excess steelmaking capacity of 120m tonnes, or a third of its output. “No other country even produces 100m tonnes of steel—and that's China's excess,” marvels Nicholas Lardy, a senior fellow at the Institute for International Economics in Washington, who put the numbers together. The result is plunging returns. In the first two months of 2006, the steel industry's profits were 75% lower than a year before. On March 30th Baosteel, China's biggest producer, reported its first quarterly drop in net profits in more than three years. Stocks of steel are expanding and cashflow is drying up. Despite signs that global steel prices may be picking up, many steelmakers will find it hard to pay back the loans they took out to finance their expansion.
This overcapacity—and declining profits—is repeated in many industries, from power generation to cement, coke, aluminium, car parts and luxury property. All told, the banks face a fresh burst of bad loans, says Mr Lardy: “This could erase some of the very hard-won progress in bank reform in the last eight years.” The concerns go right to the top. At the annual meeting of China's parliament in March, Wen Jiabao, China's prime minister, pointed to a growing risk to the banks from a build-up of inventories.
Yet while the government has tried to curb investment in some industries, in others its foot remains firmly on the accelerator. It plans to splurge 2 trillion yuan on railways, including several new subway lines in Shanghai, in the next five years; to build 24,000 km (15,000 miles) of expressways by 2010; and to have 30 nuclear power stations by 2020, against nine now. Much of this will be financed by the banks, and not all with state guarantees. Dong Tao, chief Asia economist at Credit Suisse, thinks a lot of it will not be commercially viable: “The returns will not be high. There will be a lot of new pressure on the banks.”
Nor can the banks rely on new consumer spending to bail them out. Although pundits have been hailing the emergence of the Chinese consumer for years, net new household borrowing declined in 2005, estimates Mr Lardy, and accounted for less than 15% of net bank lending. Last year, for the first time in nine years, the share of bank loans to households failed to grow.
These threats would be worrying enough if the banks had learnt how to lend properly. But they haven't. A new working paper by economists at the IMF finds that the big state banks still do not price their loans according to either the riskiness or the profitability of the borrower. An embarrassing tale last month of five officials at a remote branch of BoC, who embezzled 430m yuan, is further evidence that old, bad habits remain. Behind their newly burnished facades, China's banks still carry rot within.
