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Asia-PacificMay 27 2010

Is China heading for a home-grown crisis?

Rural support: in an effort to create social stability, China has allocated more financial support to farmersAs the global crisis weakened other major economies, China's huge lending spree sent its growth soaring, but it must hope that in having made credit so loosely available it has not inadvertently planted the seeds of a future home-grown crisis. Writer Brian Caplen
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Is China heading for a home-grown crisis?

After an unprecedented bout of lending in 2009, during which some banks grew their loan books by as much as 50%, the leading Chinese banks are moderating growth rates to between 15% and 20% in 2010 and 2011.

Last year's extraordinary activity was in response to the government's desire to stimulate the economy in the wake of the international financial crisis. It involved considerable infrastructure finance, some for projects that were brought forward as a way of boosting economic activity and some for projects that had previously been on hold and were allowed to go ahead.

At present, the leading banks have low non-performing loans (NPLs) and high coverage ratios, and senior Chinese bankers are confident that as lending growth moderates, their institutions will have soft landings.

Future worries

But some analysts fear that while the current situation appears sanguine, there could be problems later. They point to activities such as loan sales and securitisations among the medium and smaller banks about which they are concerned. They are also sceptical about any banking system's ability to fund an expansion of such scale without incurring bad assets, and say that higher NPLs are likely to emerge.

The government, too, is concerned about an overheated property market and uncollateralised lending to provincial governments. In an attempt to cool things down, without stalling the economy, new measures related to property lending were introduced in April, followed last month by an increase in the reserve requirements - the third this year - by 0.5 percentage points to 17% for large banks and 15% for smaller lenders.

But so far, so good, and clearly the ability of Chinese banks to ride out the international storm - with its knock-on effect on domestic exporters - almost completely unscathed has boosted management's confidence. There is renewed pride in the banks' corporate governance and risk systems. Reforms in branch networks and management structures are continuing apace and new products are being rolled out across the board. Capital ratios are high and the intention is to keep them that way. Fee income is rising.

Corporate and social responsibility as well as sustainable development are both big themes in China, and there are strategic moves to internationalise. On the face of it, there is no stopping the onward march and modernisation of the Chinese banks.

Moderate growth

Senior Chinese bankers accept that the high growth rates of 2009 cannot be sustained in the long term without causing side-effects such as inflation, and they are forecasting much more moderate loan growth in 2010 and 2011.

Last year's growth involved cramming huge numbers of project financings into a particular period to keep the economy on track. In 2008 and earlier, the Chinese central bank and other regulators had given administrative guidance to the commercial banks to restrain lending to some approved projects because of a shortage of credit. After 2008 [when the crisis hit] the administrators loosened the rules and more credit was dispersed. On the back of this, projects that were due to go ahead in 2010 and 2011 were brought forward increasing the rate of loan growth.

At present, Chinese banks are very focused on credit quality. If one looks at China Construction Bank's (CCB) six-point business strategy, for example, three points relate to credit quality - to adjust the pace of loan growth, minimise risk and control total credit exposure.

According to its first quarter results, CCB had an NPL ratio of only 1.35%, a drop of 0.15 percentage points from the end of last year, with a coverage ratio of 192.16%, an increase of 16.39 percentage points. The capital adequacy ratio was 11.44%.

Bank of China (BOC) had an NPL ratio of 1.3% in the first quarter (a drop of 0.22 percentage points) and a coverage ratio of 172.09%, an increase of 20.92 percentage points. Industrial and Commercial Bank of China's (ICBC) first-quarter figures showed a fall in NPLs by 0.19 percentage points to 1.35% and coverage of 179.76%, up 15.35 percentage points.

Property boom

With the economic stimulus package effectively keeping the economy on a growth track, the government's attention has turned instead to the overheating property market. Property prices in 70 major Chinese cities rose 11.7% year on year in March, faster than in February, when prices rose 10.7%, according to figures released by the National Bureau of Statistics in mid April.

This prompted China's state council to issue directives in mid-April raising the required down payment on many home purchases from 20% to 30% and from 40% to 50% for second homes. What's more, for second homes mortgage rates will now be at least 110% of the central bank's benchmark lending rate.

Chinese property stocks fell in response, leading Bank of America Merrill Lynch to release a report entitled Property Tightening: This Time It's Real. "These tightening measures mark the true turning point of property-related policies and the property sector of this cycle," wrote Ting Lu, a Merrill economist based in Hong Kong. One bank reported a 40% decline in mortgage applications as a result of the measures.

Banks have strengthened their lending criteria and raised prices of mortgage loans as a result of the directives. Bankers say that the more stringent lending requirements will prevent overheating and will squeeze out speculators, but add that declines in mortgage lending will be offset by increased auto and consumer lending.

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BOC's chairman, Xiao Gang

Corporate governance

Extensive reform is still going on across the board in Chinese banking and there is huge confidence in the success of the project now that Chinese banks have come through the crisis in such good shape. BOC's chairman, Xiao Gang, has talked about building a system of "corporate governance with Chinese characteristics".

In an article on BOC's website, Mr Xiao writes: "Many [Western] banks' boards emphasised short-term interests, but ignored sustainable profits in the long run. They boasted about the role of banks in economic development and society, but neglected the basic activities of material production and exchange.

"They relied on the financial innovation of the 'elites', but failed to do more to help the majority of employees in their career development. In this sense, it is high time for the board of directors to think about social responsibility seriously."

Chinese bankers make the point that the state retains a controlling interest in the large banks and so has a longer-term perspective than many smaller institutional or retail shareholders. As well as the management there is a board of directors, a high number of non-executives and a supervisory board all participating in governance. They say that this structure prevents the salaries of the senior management getting too high and stops excessive risk taking.

One leading banker says: "Our aim is to build a modern bank with a corporate governance system to match. It helps to have a shareholder with a majority stake, whereas in the West shareholders may only have a 2% to 3% stake and are not very influential. Under Chinese law quite a lot of issues must go to the shareholders for approval."

Chinese banks are also busy restructuring. CCB, for example, has been active in reducing management layers from five down to two or three across both wholesale and retail businesses. BOC's strategy has been "scaling up, optimising structure, building brand, strengthening infrastructure, slashing cost and sharpening competitiveness", according to its 2009 annual report.

Corporate and social responsibility and sustainable developments are themes constantly being talked about in China - a fact that may surprise some observers given the country's poor track record in areas such as the environment.

ICBC's chairman, Jiang Jianqing, says in a report that "in 2009 we proactively advocated green finance and vigorously promoted the Green Credit Policy. We also gave support to development projects in the fields of new energy, comprehensive resource utilisation, energy saving and environmental protection as well as to the development of the modern service sector."

In announcing its interim results in August 2009, CCB spoke of its emphasis on making financial services for small enterprises and the "three rurals" (farming industry, farmers and rural areas) the focus of its credit business. In a report, CCB also described how it has been following a policy of "guaranteeing loans to some industries while suppressing loans for some others" by restricting new loans to "high-pollution, high-energy consumption, resource-dependent" and overcapacity industries and withdrawing from industries with high risks or high NPL ratios while keeping the scale of its bill business under reasonable control.

Areas of concern

The bill business is one of a number of areas in Chinese banking that has some analysts concerned. The others are securitisation, loan sales and the prospects for asset deterioration, given that there has been such a large spike in lending.

China's discounted bills are basically a trade finance instrument under which, if an exporter can gain a bank acceptance of his order, he can then discount the bill at either this bank or a second bank. The second bank, however, in buying the bill is taking on the risk not of the exporter but of the accepting bank who retains the corporate risk. In China this is a huge business, accounting for 23% of new lending in the first half of 2009, and is attractive to the banks because they can compete on price as opposed to the more regulated general lending. However, it makes analysing banks' corporate risk exposure somewhat complex. By subtracting the discounted bills plus acceptances, Fitch estimates that China Minsheng Banking Corp's and China Merchants Bank's credit exposure grew by 48% and 42%, respectively, in the first half of 2009.

Fitch says that banks under its coverage had leverage of 20 times (equity to non-bank credits), which points to the need to raise more capital and, of course, there are concerns about asset quality, which is worrying even the sovereign analysts.

"The weak banking system is a large contingent sovereign liability [assets to GDP are 174%]," says a sovereign report on China released in mid-January. "Fitch is concerned about a possible deterioration in banks' asset quality following a significant acceleration in loan growth in 2009 and the growing popularity of unreported loan transactions. Falling NPL ratios do not necessarily indicate that banks' asset quality is improving." Why not? Because the balance sheet has expanded so much that, by definition, the percentage of NPLs will have fallen in line.

The great irony is that while on some levels the Chinese banks have taken note of the failings of Western banks - in corporate governance and remuneration structures - in other ways they are indulging in opaque securitisations and loan transactions that echo the originate and distribute model that caused problems in the international banks. With massive credit expansion burning up capital, it is easy to see why such manoeuvres might be attractive and they are a way round loan quotas as well as capital and liquidity regulations. Sound familiar?

The securitisations involve wrapping up loans and selling them as wealth management products, giving a pick-up over deposit rates but hardly sufficient considering the risk involved. There is no tranching to separate out the payout order and the underlying is from a single credit. There are no figures available on the volumes of loans involved, only the numbers of products available. Banks say they are off balance sheet but, as with the subprime crisis, they might themselves be liable for reputational reasons should there be a problem.

Information is also sparse about the growing business of loan transactions. In China, this mostly takes the form of the big nationwide banks selling loans to the smaller city commercial banks, co-operatives and finance companies, as well as the China Postal Savings Bank.

Opaque indicators

In its annual review of Chinese banks, published at the end of last year, Fitch says: "Purchasing institutions typically pay 10% to 20% below the base interest rate for the loan and selling banks record the income in fees and commissions. Typically, selling banks continue to service the loans, collecting payments from borrowers and passing these funds on to the institutions that purchased the loans. Selling banks will sometimes enter a counter-agreement to repurchase the loan at a later date. In these instances, the loans may not appear on either the seller's or the buyer's financial statements and the loan may temporarily vanish."

No one can be certain of the potential for these activities to cause problems in the Chinese banking system. The leading Chinese banks have undergone huge reforms since listing and have vastly improved their management and risk systems.

The next bank to follow the initial public offering path is likely to be the China Everbright Bank, which has been reported as seeking a listing in Shanghai in June, giving it market access ahead of the Agricultural Bank of China, which is planning to list in both Shanghai and Hong Kong.

Overall, Chinese banks are planning to raise debt and equity to the tune of $46.5bn this year, which should go some way towards protecting them if there is a fallout from last year's lending spree.

Unlike the Western banks in the run-up to the subprime crisis, the Chinese banks appear to recognise the challenges that they face and be addressing them. This augurs well for Chinese banking over the next couple of years.

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