The Economist, 27 October 2005
It is a staggering thought: communist China now has a bank more valuable than Barclays, American Express or Deutsche Bank, financial institutions at the heart of Western capitalism. At more than $66 billion following its initial public offering in Hong Kong on October 27th, China Construction Bank (CCB) boasts a larger market capitalisation than any of these three. CCB's listing, which raised $8 billion from foreign investors for 12% of its shares, is the largest global flotation for four years, China's biggest and the biggest ever for a bank. CCB garnered another $4 billion ahead of its float by selling stakes of 9% to Bank of America and 5.1% to Temasek, Singapore's investment agency.
This is quite a transformation for a bank that was technically insolvent less than two years ago and which, despite a hastily applied commercial gloss, is still a government agency, plagued by bad debts and corruption so pervasive that just five months ago its then chairman was arrested for bribery. In private, China's leaders must be marvelling that they have pulled off this sale. Yet their ambitions are far greater. Bank of China (BOC), the second of the “Big Four” state banks, with foreign investors already aboard, is planning a $5 billion foreign listing in early 2006. Industrial and Commercial Bank of China (ICBC), the biggest, is appointing advisers for a $10 billion flotation late next year or in 2007. Many of the smaller joint-stock and city banks now too have foreign investors and are eyeing overseas listings.
Beijing is encouraging this rush to market as the most fundamental step in reforming the economy since Deng Xiaoping opened China to the world in the late 1970s. Since then, the country's banks have been almost wholly responsible for channelling the population's sky-high savings into industry and investment. Given China's failure to develop healthy stock and bond markets, bank assets have ballooned to almost 30 trillion yuan ($3.7 trillion) in 2004, or 210% of gross domestic product (GDP). That is the highest of any big economy, says Nicholas Lardy at the Institute for International Economics in Washington, DC: India is at 170%, Brazil 160% and Mexico 100%.
Sadly the banks have been disastrous middlemen, lending on government instruction without a view to their profits. They have poured money into wasteful infrastructure projects and kept broken state-owned enterprises (SOEs) afloat. Not only has this created huge non-performing loans for the banks themselves, but also because China's investment is so unproductive, it has to shovel ever more money into its economy to maintain its current growth. Already, China needs almost $5 of fresh capital to generate $1 of incremental output, a far worse ratio than Western countries and even India. In the first quarter of 2005, fixed-asset investment reached an incredible 54% of GDP, 10 percentage points above the household savings rate. No country can sustainably invest more than it saves and China must raise the productivity of its economy.
That is why overhauling its banks is so critical to securing the country's future growth. China's political leaders have an iron commitment to bank reform—a commitment backed with cash. Since 1998, Beijing has injected more than $260 billion into its banks via straight handouts and by allowing the Big Four to shift dud loans into separate state-backed companies. This is about twice what South Korea spent to restructure its banks after the 1997-98 Asian crisis and about what America needed to bail out its savings & loans industry. Mindful of the long paralysis of Japan's indebted financial system, China is pumping in funds before a financial meltdown. Weijian Shan, a director at Newbridge Capital, a private-equity firm which owns a controlling 18% stake in Shenzhen Development Bank (SDB), is impressed: “the government is taking the pain before it is too late, showing it understands that China's economic development depends on a healthy banking system.”
Beijing realises too that money alone will not do the trick. Since 1998 it has raised accounting, prudential and regulatory standards. Before then, the banks could book interest income for up to three years even if it was not being paid; now they can do so for only 90 days—the international norm. In 2002, the old lenient system whereby banks provisioned just 1% of their loans regardless of risk, was replaced by a five-tier classification tying the size of the provision to loan quality. Meanwhile, the central bank's decision last October effectively to lift the ceiling on commercial loan rates should, in theory, allow banks to charge more to riskier borrowers.
The biggest change, though, has been the creation of a central regulator, the China Banking Regulatory Commission (CBRC), carved out of the central bank in 2003. Headed by Liu Mingkang, a respected former president of BOC, the regulator is trying to shift the banks' focus from mindless loan and deposit growth to preserving adequate capital and generating decent returns on it. Lenders that do not meet a capital ratio of 8% of risk-weighted assets (as decreed by Basel I, a global standard) by 2007 face sanctions—including the removal of senior management. The regulator's 20,000 staff are trying hard to ensure compliance. “At every board meeting, the CBRC guy is right there taking notes and pounding the table,” says Stephen Harner, a former diplomat who now sits as an independent director at Hangzhou City Commercial Bank.
The rush for reform
All this has given an urgency to reform efforts. Almost all China's 128 commercial banks have introduced better governance, shareholding and incentive structures, and have added independent directors to their boards. Senior managers are investing in new risk systems and trying to change bad old habits such as having the same person make and approve a loan, a practice that encourages corruption.
The restructuring has been helped by a benign environment. China's economic boom fuelled annual loan growth of almost 16% over the past four years and deposit growth of 18% a year. Lending to consumers, which started only in 1997, has exploded, increasing 123 times to more than 2 trillion yuan ($250 billion) in seven years, says Merrill Lynch, an investment bank. Corporate loans still dominate, but mortgages, car and education loans now make up 11% of the total and 26% of new lending, says Mr Lardy (see chart 1).
Strong revenue growth and offloading bad debts on to the government has inflated bank profitability. Last year, China's 13 biggest banks made net profits of 90 billion yuan ($11 billion) and a decent-looking return on equity (ROE) of almost 11%, says Fitch, a credit-ratings agency. Over half came from CCB, the sector's poster child, which expects net profits of 42 billion yuan ($5.2 billion) for 2005. Though it is only the third-largest lender, aggressive management, leadership in mortgages and the number two position in debit and credit cards have helped it achieve an industry-leading ROE of over 25%.
Meanwhile, the headline non-performing-loan ratio reported by the CBRC fell to 8.8% of total loans by this June, down by half since the end of 2003. CCB looks much cleaner, with a ratio of 3.91%. It has stronger reserves, with loan-loss provisions of 64% of its bad loans compared with 15% average for its peers. Its listing prospectus says that loans to “new” customers (acquired since 2000) are one-third as likely to go sour as those to older clients, suggesting regulations are working. On this basis, CCB looks only a bit worse than developed-world banks.
Well, it would, if that were indeed the true picture. Independent estimates put bad debts at 20-25%, far exceeding official figures. The CBRC itself paints an alarming picture. In an internal report leaked to Shenzhen's Securities Times, the CBRC found system-wide bad loans actually rose this year, if a disposal from ICBC was excluded. It expects 30 billion yuan in new bad loans in 2005. And on October 14th having inspected 11 banks, the CBRC concluded that it is “common practice” for banks to ignore regulations and fail to monitor loans, and that bad-loan levels are “not accurately revealed”. Poor accounting means that the banks themselves are unsure of their bad loans. Others do not tell. Lai Xiaomin, head of the CBRC's Beijing office, admits that “when our banks disclose information, they don't always do so in a totally honest manner.”
That bad loans are rising, not falling—Fitch estimates by 8% in the first half of 2005 once government-funded write-offs are excluded—is not surprising. China's banks went on a lending binge between 2003 and 2004, partly to “grow out of” their bad loan problem. Many loans will go sour, as Beijing has moved to curb overheated sectors such as steel, cars and property. If economic growth slows, a new wave of bad loans will hit. In addition, banks carry alarmingly high levels of “special mention” loans, ranked as performing but where a borrower's circumstances have worsened. Even at CCB, these are 14% of the total.
Look at the books
A new surge in bad debts would be bad enough if Chinese banks had the earnings power to absorb them, but they do not. Behind the headline numbers, their basic profitability is very poor. An average net interest margin of 2.36% looks decent compared with the 1.5-2.5% in developed markets. But David Marshall, head of Asian financial institutions at Fitch, argues that Chinese banks need far wider margins to cover the risks typical of an emerging economy. Indonesian banks, for example, boast a 5% net interest margin and Indian banks 3.45%. Meanwhile, Chinese banks are too dependent on loan income. More stable income from commissions and credit-card fees is only 13% of total revenues, half the level at Indian banks and just one-third of Thailand's. And while costs at Chinese banks are low, at 45% of revenues, this reflects poor investment in training and IT, not better efficiency.
Put all of these factors together and the return on assets (ROA) generated by China's banks, at less than 0.5% last year, is the worst in Asia (see chart 2). Granted, they look better measured by ROE, but this too is deceptive. The excellent 25% CCB highlights in its prospectus is really 17% after adjusting for a tax break. More crucially, the sector's 11% reflects inadequate levels of equity (in other words, capital) rather than high returns. The industry has a capital-adequacy ratio of barely 8%. Mr Marshall argues that China's banks should be carrying capital of at least 15-20%, as banks in Indonesia do, to guard against unforeseen risk. If they did, their ROEs would drop to 5% or less—a much truer reflection of their innate level of profitability.
Two sobering conclusions follow. The first is that even a tiny deterioration in business conditions that either reduces margins or increases bad loans would wipe out earnings at China's banks. The second is that even if the economy remains good, the banks cannot generate enough internal capital to support their current levels of loan growth. Ryan Tsang at Standard & Poor's, a credit-ratings agency, estimates that to avoid more capital injections the banks have to generate an average ROA of 2.1%, almost five times current levels.
Clueless lenders
To close that gap will take a fundamental transformation of how Chinese banks operate. The banks simply do not understand how to price risk or spot a dodgy borrower. Neither flexible interest rates nor loan classifications can help if credit officers cannot tell good loans from bad. The current boom has led loan officers to believe the value of collateral always goes up.
The real battle for bank reform will be won or lost in the branches. While reforms have changed much at head offices, they are hard to enforce elsewhere. Guo Shuqing, CCB's new chairman, admitted shortly after he got the job, that “more than 90% of the bank's risk managers are unqualified”—a bold statement from a man wanting to list his company.
A pyramid of cards
These are massive organisations to turn around, after all. CCB alone has 14,250 branches and 304,000 employees. Their historic decentralisation makes them especially hard to control. In a book to be published in November, Wu Jinglian, China's most respected economist, notes that until a decade ago provincial branches of commercial banks borrowed funds directly from provincial offices of the central bank and lent them to local customers. They enjoyed “legal person status” and did not require authorisation from head office. Even today, big branches of ICBC have their own English-language websites—emphasising their independence. “Branch managers are kings in China,” concurs Frank Newman, an American who took over as chairman of SDB on behalf of Newbridge earlier this year.
At all banks there is a struggle between head office, which wants to centralise processes, and local staff who are in thrall to the demands of local officials and industrialists and who disobey their branch managers on whom they depend for their promotions at their peril. Unhelpfully, the branches are being monitored by a regulator that faces the same problems as its charges—too many unqualified staff spread too thinly. Han Mingzhi, head of the CBRC's international department freely admits, “we lack people who understand commercial banking and microeconomics. It is a headache for the CBRC.” The result is that it will take China's banks years to establish proper corporate governance, a genuinely commercial culture and hence decent profitability.
Meanwhile, strategic foreign investors are supposed to bridge the gap—with money, but especially with skills in risk management and advanced financial products. The lure of China's high growth and huge population has triggered an astonishing stampede, attracting some $18 billion in foreign direct investment in China's banks in one year. The first big deal was the $1.7 billion HSBC paid for a 19.9% stake in Bank of Communications (BoCom), the fifth-largest lender. Then came CCB. Since then, a consortium led by the Royal Bank of Scotland has put $3.1 billion into BOC, Temasek another $3.1 billion and Switzerland's UBS $500m, while Goldman Sachs and Germany's Allianz are investing in ICBC. Only Agricultural Bank, the Big Four bank with the deepest problems, has failed to attract a Western investor.
In return, the international banks get a cut-price entry ticket: Bank of America paid 1.15 times book value for its stake in CCB, which has now floated at almost twice book. They also gain access to a branch network and client list they could never afford to replicate, even after World Trade Organisation rules force China to open its domestic banking market fully from end-2006. Every deal is thus accompanied by a joint-venture in savings and insurance products and, of course, credit cards—the Chinese financial market that has every foreign investor salivating.
Only 12m of the 880m bank cards in China are genuine credit cards. So McKinsey, a management consultancy, predicts exponential growth from this segment, and profits of $1.6 billion by 2013. Yet McKinsey also notes that half of existing accounts are unprofitable. Chinese pay their bills in full each month, show little loyalty to brands and are unimpressed by foreign-backed offers. Ron Logan, head of HSBC's credit-card venture with BoCom, says acquisition costs are soaring as competition heats up, with everything from DVD players and holidays used to entice customers, further eroding profits. Jean-Jacques Santini of BNP Paribas, which just bought one-fifth of Nanjing City Bank, warns investors: “expect to lose money on credit cards for the first three or four years.” The only way for investors to make decent returns in the short term is by betting on a big rise in post-IPO share prices. Everything else they take on trust.
A very Chinese welcome
Meanwhile, given limited ownership rules, foreign banks can have only a modest influence on strategy or operations at their Chinese partners. Newbridge is an exception since it has won genuine management control of SDB, which is small and has a widely dispersed ownership. HSBC's vastly greater size compared with BoCom, means it might, in time, have a significant say. The rest are restricted to one or two board members each, while the appointment of senior management remains with the Communist Party. “Can China's banks be fully reformed while staying under government control? I doubt it,” says Mr Marshall.
To reform its banks properly, China must allow foreign takeovers. And its banks must be allowed to merge and fail. Yet even if Beijing raises cumulative foreign-ownership limits above the current 25% next year, as the CBRC expects, it is unlikely to relinquish control of a major bank. Worryingly, the CBRC seems ambivalent about foreign participation. Mr Han says he doubts the wisdom of raising the ceiling on foreign investment “if we don't get something in return”. Yet as banks in Poland and the Czech Republic discovered, preventing foreign takeovers simply delays bank reform and means more costly bail-outs. A stockmarket listing cannot really help while the state remains in charge: minority investors can do little to change poor corporate governance or influence strategy.
Instead, China is gambling on going it alone. By rushing poorly reformed banks to market and sucking in a bit of money and know-how (not to mention greater scrutiny) from foreign investors, it hopes to improve them sufficiently and sufficiently rapidly before the economy runs into a headwind. The size of that gamble should not be underestimated.
;
