Banks in China are both the villains and heroes of the country’s economic success. They fuel the extraordinary economic expansion that is the envy of the world. However, they are also one major cause of the overheated growth, inflation and other excesses that have accompanied each of the booms of the past two decades.
The story seems to be repeating itself in the current cycle. In the past two years, banks have been making a record volume of loans, leading to 100%-300% growth in investment in some industries. As inflation has slowly risen, the government has shelved numerous industrial projects, the central bank has tightened money supply and the banks have been ordered to reduce lending.
There is a concern that Chinese banks, which are already burdened with a poor balance sheet, will get bruised further because of the slowdown. “What banks fear most are big economic swings. When the economy is good, banks do well. But when this is followed by a major economic decline, a large number of bad loans might appear,” warned Zhou Xiaochuan, governor of the People’s Bank of China, the central bank, at a recent seminar in Beijing.
China’s liquidity-driven, boom-to-bust cycles confirm that its banks need more reform before they can promote, and not harm, healthy and sustainable growth. Their poor risk management and herd instinct to expand and contract lending collectively increase volatility and waste, ending each cycle with a mountain of bad loans.
The cycle begins
The current round began in 1999, when investment picked up after years of stagnation. Fixed asset investment, the benchmark for industrial activity, rose from a year-on-year 7.1% increase to Rmb2980bn ($359.8m) in 1999, to 28.4% (Rmb5510bn) in 2003. Supporting such growth was a doubling of money supply, with M2 (the broadest measure of money) rising from Rmb11,980bn to Rmb22100bn during the same five years.
Many of the new loans were made by order of provincial governors, mayors and other local officials to their pet projects. In China’s half-reformed financial system, banks – most of which are state-owned and staffed by career bureaucrats – have difficulty refusing to fund projects initiated in the name of promoting local development.
In 2003, investment in new projects increased by a year-on-year record of 71% to Rmb1690bn. As the country basked in the euphoria of a record inflow of foreign capital and rising global status, banks readily approved loan applications backed by local governments that were anxious to boost economic growth at all costs.
Xu Dianqing, an economic professor at the University of Western Ontario who runs a think tank in China, says investment activity spreads like wildfire. “Local governments use bank loans and proceeds from land sales to launch projects that will look good on their resume. They build big government office blocks, grandiose roads, deluxe international conference halls, stadiums, bridges and industrial zones.”
In 2003, local governments planned 122 exhibition halls, 45 of which aimed to be “either the biggest in Asia or in the world”, says Mr Xu. There were also 600 malls and 54 subway systems on the drawing board. He fears that many of these multi-billion yuan projects, funded by medium to long-term bank loans, would be half-aborted – as the Chinese say: “Born with a broken tail.”
Consumers joined in the spending fever, buying a record number of properties and cars. In Shanghai, where property prices have on average doubled in the past few years, buying a second property for investment purposes is especially popular. Banks were happy to lend to individuals, as a way of diversifying their client base from inefficient state firms. There is a tendency of “blind loan expansion among banks, which is likely to lead to new financial risks”, according to Tang Shuangning, deputy head of the China Banking Regulatory Commission (CBRC), which was set up last year to regulate banks.
Sounding the alarm
The central bank sounded the first alarm in June last year, even while the world marvelled at China’s impressive growth. In the now-famous Document 121, it tightened lending requirements on property loans. It said mortgages could be provided only for completed apartments, dampening investment speculation and squeezing developers with insufficient funds. Individuals buying a second property would be given a smaller mortgage than the standard one of 80% of their property value. Turning to property companies, the central bank said they could only borrow when their projects were at an advanced stage.
In September 2003, and again in April 2004, the central bank raised the reserve ratio of banks, from 6% to the current 7.5%-8%. The increases froze an estimated Rmb260bn of the banks’ funds. In March 2004, it raised the rediscount and short-term refinancing rates by 0.27% and 0.63% respectively. It also squeezed another source of liquidity, foreign-exchange inflows, with the purchase of $10bn to $15bn of foreign exchange each month. Still foreign exchange reserves continued to swell, from $286.5bn at end-2002 to $431.8bn at end-March 2004.
Regulator intervenes
The CBRC, the fledgling regulatory body which has been learning fast in the fast-moving environment, weighed in with its strongly worded directives. In February this year, it issued detailed restrictions on property loans, supporting the central bank’s policy announced last June. It investigated the flow of bank loans to industries with excess investment, including iron and steel, aluminium, cement, real estate and automobiles.
A month later, the commission further tightened its supervision of bad loans at the top four state banks, targeting the top five branches of these banks and clients that have been late with the repayment of loans worth Rmb100m or more. In mid-April, it sent five inspection teams to seven provinces – Guangdong, Zhejiang, Henan, Hebei, Hubei, Jiangxi and Jiangsu – to check if local banks were adhering to the new policies.
The State Development and Planning Commission (SDPC), known as “the brake” because it has the authority from the prime minister to stop unauthorised projects, dispatched dozens of supervisors in March and April this year to find out which provinces and cities continued to defy orders from the north.
Action pays off
The concerted actions of these top three government bodies sent stock markets in Asia tumbling. Investors fear that if the greatest economy in the region contracts, it will drag its neighbours down as well. In China, though, the impact has been pronounced, as local governments waited for more signs of Beijing’s political determination before submitting themselves to the new party line.
Fixed asset investment continued to grow in April 2004, with a year-on-year increase of 42.8%, with property investment still up 30.4%. And new investment in the steel and cement sectors doubled in the first quarter.
The central government finally said it meant business. On March 14, 2004, Premier Wen Jiabao set the tune of the new austerity campaign when he spoke to hundreds of journalists in Beijing. “This is a major test to our government, a test not any less than that posed by the outbreak of SARS [severe acute respiratory syndrome] last year. If we manage well, this big ship of our economy will have a smooth sailing; if not, there will be serious setbacks.” In the ensuing weeks, this theme was repeated whenever Mr Wen had a chance to speak in public.
Iron-fisted measures
Backing the rhetoric is a series of iron-fisted measures that threaten to remove government officials and bank managers from their job if they remain defiant. Both the SDPC and CBRC are hard at work, making sure the investment bubble is pricked as soon as possible. The planning commission is going through the country’s long list of investments in iron and steel, aluminium, cement, government offices and training centres, light-rail systems, golf courses, exhibition halls, conference centres, large shopping centres and all projects launched this year. It will then decide which projects will be terminated, suspended, cancelled or approved.
The banking regulator, meanwhile, is busy inspecting bank loans for fixed-asset projects valued at Rmb30m or more. It has ordered all financial institutions to complete an internal review of their loan portfolio, to make sure that they do not lend to projects prohibited by the planning commission.
“The thinking of the central government is now very clear,” says Larry Lang, an economics professor at the Chinese University in Hong Kong. “It wants to maintain a stable financial environment, with a target growth of 17% in money supply, and stable interest rate and foreign exchange rates. On the other hand, it is also using administrative orders to cool down overheated industries.”
While preoccupied with the austerity campaign, the central bank has not been lax in pursuing banking reform. The central bank’s Mr Zhou said the restructuring of the two major state banks, China Construction Bank and Bank of China, into joint-stock holding institutions with a clearer ownership structure was on track. The next step is to list them on the stock market, to raise funds as well as to expose them to market discipline. There are high hopes that once they become listed companies, Chinese banks will be more risk-conscious and will bring more good than harm to China’s next stage of growth.
