“Yes, we have a long way to go but we are walking.” These modest conclusions from Bank of China’s (BoC) executive assistant president Zhu Min seem to mask not only what China’s largest bank has achieved but also underestimates the transformation that has taken place at BoC and the entire banking sector in the last two years.
Speaking at The Banker’s recent “Banking on China” seminar in London, Dr Zhu noted: “China’s overall banking market is expected to grow much faster than gross domestic product (GDP) in the next five years and the growth rate of retail business, deposits and renminbi products will be higher.” Given recent GDP growth rates in excess of 9% and the continued high rates expected, this seems more than “walking” pace.
Can China’s banks perform well enough to keep the country’s high growth going? Matt Bekier, principal at McKinsey & Company in Hong Kong (also speaking at the seminar), adds a word of caution. “Since the country’s capital markets remain largely underdeveloped, banks serve as the primary source of long-term funds. Banks lending would have to expand by about 15% a year for China to meet its target of 7%-8% annual growth in GDP,” Mr Bekier says. “Yet as a result of the amount of bad debt that must be written off – to say nothing of the banks’ low profitability and limited credit skills – we estimate that China’s banking system can safely sustain annual loan growth of only 5%-7%, which is far below the level needed to maintain economic momentum and keep unemployment in check. The higher growth can be sustained only if regulators, banks and investors collaborate to achieve a step change in risk management skills.”
Profound changes
Is a step change being achieved? Are banks and regulators doing enough? In what McKinsey forecasts will be the second largest banking system in the world by 2014, profound changes have taken place in the past two years. Bank of Communications (BoCom) and China Construction Bank (CCB) have both successfully completed their listings in Hong Kong and raised $1.89bn and a record $9.2bn respectively. This follows the government’s $45bn capital injection into BoCom and CCB in 2003 and $15bn into Industrial and Commercial Bank of China (ICBC) last April.
Capital ratios have improved and the new regulator, the China Banking Regulatory Commission (CBRC) has also helped to restructure dramatically the previous poor bad-loan position. Says CBRC director-general Han Mingzhi: “These four banks – ICBC together with BoC, CCB and BoCom representing approximately 50% of market share in terms of assets – have restored solvency. This has strong implications for the supervisor as it has helped create an essential element for a sound banking industry. It is encouraging to note that by end-September 2005, around 70% of banks measured in terms of assets are in compliance with the supervisory capital requirement (of 8%).”
Mr Han, speaking in London, says that the CBRC has stepped up the monitoring of loan quality as well as helping to strengthen sound corporate governance frameworks. He adds: “It is encouraging to note that banks’ balance sheets have improved and the trend is likely to continue. By end-October 2005, the non-performing loan (NPL) ratio for commercial banks as a whole dropped to single digit, that is 8%.” He also notes that since it was set up in 2003 the CBRC has issued more than130 supervisory rules and guidelines on capital adequacy, large exposures, connected lending, underwriting, due diligence, derivative transactions, operational risk and more.
Giant strides
The CBRC has certainly made giant strides but Mr Bekier warns: “Unfortunately, the measures adopted to improve corporate governance focus on the largest banks scheduled for initial public offerings (IPOs) in the next few years. Exercising tighter control over a handful of large banks is far simpler than transforming corporate governance in the 120 or so smaller regional and local banks and the nearly 200,000 credit cooperatives that command 40%-50% of total banking assets in China. These smaller institutions are particularly prone to corrupt lending practices but harder to regulate because they are so numerous and geographically dispersed.”
Nevertheless, foreign investors have sensed the changes taking place and have decided to act. According to figures from the Washington-based Institute of International Finance (IIF), net direct investment into China reached $53.1bn in 2004 and is forecast to remain around this figure in 2005 and 2006, representing one-third of all direct investment to emerging markets. Net private capital flows are expected to decline to a still high $87bn in 2005 from $101bn in 2004. The IIF adds that China’s reserve accumulation is likely to reach an all-time high of nearly $230bn in 2005, bringing reserves to nearly $840bn by the end of 2005.
In terms of banking, up until last November, 18 foreign institutions had invested in 16 Chinese banks with investment volume amounting to about $13bn, no small sum.
Foreign investment
Why have banks such as Royal Bank of Scotland and Bank of America paid $3.1bn and $2.5bn respectively for stakes of around 10% in the big four banks? While one UK chief executive said they may have paid too much, others take a more optimistic long-term perspective and see the huge potential in the entire Chinese market, especially in the small and medium-sized enterprise (SME) and retail sectors.
Kevan Watts, chairman of Merrill Lynch International, notes that SMEs account for 50% of GDP but only 10% of the loan market, and Standard Chartered Bank chief economist, Gerard Lyons, explains that consumer lending at present accounts for less than 5% of Chinese bank business and is set for massive expansion. Chief executives in major Chinese banks, without exception, are keen to expand in retail with many, such as China Everbright Bank, predicting retail will reach 50% of their business within a few years (see p103).
The huge potential in these relatively new sectors is a strong cause for optimism, and while there are obvious concerns over credit quality in such virgin territory, the size of the virtually untapped consumer sector in a country of 1.2 billion people is breathtaking. Bank of China forecasts retail deposits in China to grow overall by over 70% in the three years to 2008 to reach Rmb22.2trn.
Although analysts such as Joe Studwell, editor of China Economic Quarterly, are critical of China’s reforms, lack of bankruptcy infrastructure and ability to price capital, investors have taken well to the two bank IPOs in 2005, and Merrill Lynch’s Mr Watts estimates that the four major bank IPOs forecast for the next year or more could raise up to $25bn. These are BoC ($5-$8bn), ICBC ($5-$10bn), Agricultural Bank of China ($5bn) and China Merchants Bank ($1.5bn), all set for 2006, except AgBank, which is set for 2007/8.
The government and the CBRC’s efforts to strengthen the banking sector in the past three years have brought significant results. BoC’s Dr Zhu is correct, however, when he says there is still a long way to go. The IPOs, the retail revolution and improved profitability are yet to become a reality or spread throughout the banking sector. But a credible new framework is in place and China’s banks are in the process of a genuine restructuring and increasing foreign help is moving at a swift pace to be the catalysts their economy desperately needs.
