Banking On China's Reforms
Western Outfits Are Lining Up To Get Into The Hot Chinese Lending Market. But Fraud And A Buildup Of Property Loans Are Worrisome
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And both the Bank of China and the Industrial & Commercial Bank of China [ICBC] are preparing global offerings in 2006 that are expected to raise $16 billion. Western players are betting big on the premise that China's dysfunctional banking system, long known for gold-plated corruption and reckless lending, has finally cleaned out the stables and improved its credit standards.
REASONS TO WORRY? Yet two events in late January should remind investors of the risks that still hang over the Chinese banking system. On Jan. 31, a federal grand jury in Las Vegas indicted two former managers of the Bank of China, their wives, and a relative of one of the couples on charges of racketeering, money laundering, and fraud. The allegations involve an elaborate scheme to defraud the Bank of China of a staggering $485 million and launder that money through various means in Hong Kong, Canada, and casino accounts in Las Vegas [hence the U.S. connection and grand jury investigation]. Another ex-Bank of China official has already been convicted of similar charges.
Also in the same week, China Banking Regulatory Commission Chairman Liu Mingkang, a tough-minded reformer, announced on the commission's Web site that Chinese banks need to clean up their act "without continuous help from the government." More ominously, he and other officials have warned that Chinese lenders could be heading for another wave of nonperforming loans, given the buildup of credit in the real estate sector this decade.
So, is all the progress in cleaning up China's banks an illusion? No. Nonperforming loans have been whittled down to around $124 billion at the four biggest state-run banks. They were once well over twice that.
PULLING THE PLUG. More progress is likely, since Beijing is committed under its WTO agreement to fully liberalize its banking sector by the end of 2006. Starting next year, foreign banks will be able to open their own branches, take yuan deposits, and pretty much have full access to the mainland's nearly $1.8 trillion in household savings.
The arrival of foreign competition will force China's banks to shape up even more. It also means the government likely will no longer coddle the Big Four -- Bank of China, ICBC, China Construction Bank, and Agricultural Bank of China -- with bailouts to smooth the way. Beijing has spent $259 billion on such capital injections into this quartet of monster banks since the late 1990s.
Yet old habits die hard. While one could argue that fraud on the scale of the Bank of China case, which according to U.S. prosecutors began in 1991 and ran through late 2004, probably wouldn't occur today, corruption is still an issue. For instance, the official Chinese Xinhua News Agency recently reported that Liu's regulatory outfit punished 6,826 bank officials in 2005 for illegal actions or outright financial crimes.
Even a relatively reformed lender such as China Construction Bank disclosed in its October, 2005 offering prospectus that it experienced more than 100 cases of fraud and embezzlement by employees between 2002 and 2004.
HOT PROPERTY. A more immediate worry is whether there is a huge buildup of property loans that are in danger of turning sour thanks to the overheated real estate markets, especially in the big coastal city of Shanghai. "The whole property sector has been quite hot," says May Yan, vice-president and senior analyst with Moody's Investors Service in Hong Kong. She notes that a common practice among Chinese banks is to fully fund a real estate development, such as an apartment tower or housing complex, then hold on to the property and milk more loans by providing residential mortgages as well.
That's fine when values keep rising. Trouble is, China lacks an effective national bureau that can give banks an idea of the credit quality of both developers and individual borrowers. If there's a huge correction in property prices, the banks could be left holding the bag.
Moody's points out that default rates on loans to developers are already ranging from roughly 8% to 12%, according to the latest data. Property lending has also been one of the fastest-growing categories at many major banks. For instance, at China Construction Bank, about 25% of the loan portfolio is tied to the highly volatile real estate market. That may explain why Liu and the CBRC are sounding the alarm on this issue.
CLEANING UP. Not everyone is jittery about the prospects for a stronger Chinese banking system emerging on the mainland. Even if nonperforming loans keep growing again, the economy is storming and deposits are growing. UBS economist Jonathan Anderson, in a report sent to clients on Jan. 18, declared, "China's bank cleanup is very real indeed." He argues the large stock of bad loans that emerged earlier this decade was inevitable given China's push to shut down tens of thousands of inefficient state-owned enterprises in recent years.
He also points out that since the late 1990s, Beijing has set up four state-owned asset-management companies -- Great Wall, Cinda, Huarong, and China Orient -- that have absorbed roughly $400 billion in sour loans from the books of the Big Four. These so-called AMCs have been slow to work out those loans, thus some argue this is merely an accounting game of shifting unrecoverable loans from banks to asset companies. Yet, Anderson argues, Great Wall and others aren't deposit-taking institutions, and the systemic risk to Chinese banks has been lifted.
Still, recent events create the uneasy feeling that there is plenty of mopping-up to do within the sector. The overarching challenge for China is to refashion the banking system into one that's a lot more savvy about allocating risk. It is a safe bet that development is still some years away from becoming a reality.
Copyright 2006
, by The McGraw-Hill Companies Inc. All rights reserved.
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