China’s time bombs: the banking system

In this series of posts on the ticking time bombs that face China, we’ve discussed energy and the environment and the demographic issues that are ahead for China. In this post we’ll consider the third time bomb that faces China, its banking system:

China’s banking system is like a ticking time bomb. Saddled by mountains of bad loans and insufficient capital base, collapse of the state banks will cause an implosion of the Middle Kingdom, predict many doomsayers. Many say time is running out as foreign competitors are slated to pry open the banking sector in 2006, as China pledged to open up the sector as part of its commitment to the World Trade Organization (WTO).

However, whether or not foreigners are allowed to compete is beside the point – as any trade bureaucrat will tell you, there is more than one way to dodge WTO obligations. The key issue: if unreformed, the ailing state banks will indeed drag the Middle Kingdom down.

The biggest single problem with the banking system that most critics point to is non-performing loans i.e. loans that aren’t being repaid and have little prospect of being repaid. The Chinese banking industry has always been politically-directed rather than profit-directed. Bureaucrats use their influence to channel loans towards state-owned or politically connected businesses. Some of these loans are state-directed to prop up thousands of inefficient state-owned companies. Some of these loans are cronyism. Some are probably fraud.

No one knows the actual scope of this problem some estimates reaching as high as 50% of assets. State infusion of hard cash hasn’t been entirely effective in solving this problem since frequently money was lent out immediately rather than being used to compensate for loan write-offs.
This attempt to loan their way to solvency isn’t likely to be effective since without increased rigor the new loans may be as non-performing as
the old ones were.

Much has been done to address the problem of non-productive loans. There’ve been sell-offs and write-offs. The proportion of NPL’s being reported is down:

Having conducted the above-said financial restructuring, the balance sheets of the two pilot banks were thoroughly “cleaned” and the financial status of both banks had been totally ameliorated. By the end of 2004, CCB and BOC’s Non-performing Loan (NPL) ratio became 5.09 percent and 3.70 percent respectively, their respective capital adequacy ratios became 8.62 percent and 11.95 percent respectively, and their NPL Provisioning Coverage Ratios were 71.70 percent and 69.90 percent respectively. Accordingly, the celebrated providers of credit ratings in the world raised their ratings for China’s state-owned commercial banks.

So they’re doing great, right? Maybe not:

Since China’s banking regulator published last year’s non-performing loan (NPL) statistics for state-owned banks last month, state media have been crowing about a historic policy success.

They call it a “double reduction” in bad loans: a drop in the absolute amount of outstanding bad loans and in the NPL ratio, adding that, as it was the third year of “double reduction”, there is hope the NPL problem has finally been solved.

A closer look, however, reveals that the situation last year was actually worse than the previous two. The ratios fell only because of significant one-off disposals of bad loans in May and June and a rise in overall lending.

In short, the patient is better because the symptoms have been masked, not because the illness is being cured. Many fear the NPL figures will get worse this year as companies and projects fail in a climate of tight money.

And not all of officialdom is cheering last year’s NPL statistics. China Banking Regulatory Commission (CBRC) deputy chairman Shi Jiliang made a critique of the state banks just three days after the results were released on January 13.

“The Bank of China [BOC] and China Construction Bank [CCB] have shown some preliminary progress, but their task ahead is very onerous … the state banks have the same defects as state companies, with low efficiency, poor internal management and `everyone eating out of the same pot’.

“They have an enormous amount [of work] to do to change their true nature, stop a worsening of their assets and change from being state banks into real commercial banks,” he told an international seminar in Beijing.

The second major problem facing the Chinese banking industry is corruption. You can hardly go a day without reading of some major corruption incident:

Scandalous crimes have been alarming China’s banking sector in recent months. They include fraud at a branch of Agricultural Bank of China at Baotou in Inner Mongolia Autonomous Region, which amounted to 115 million yuan (US$13.9 million) and a typist at the Bank of China fraudulently obtaining US$6 million from the State bank.

In addition to shedding light on banks’ operational risks, such scandals also reflect the achievements of banking reforms, as banking supervision is enhanced and banks become more transparent, Tang Shuangning, vice-chairman of the CBRC, said.

The commission has urged banks to rectify their inadequate rules and ineffective inspection procedures, which otherwise may lead to huge losses.

Meanwhile, the commission has also demanded better computer systems for automatically detecting wrongdoing and risks.

A quick Google search on such incidents revealed nearly a billion dollars in bank fraud in the last year or so. And that’s just what’s been detected.

The combination of crime, politically-motivated loans, non-productive loans, and lax oversight has effects. Take a look at this survey of 3,000 Chinese bankers and brokers. I’d like to quote the whole thing but I’ll restrain myself:

1. General How much corruption is there in China’s financial sector?

Respondents	%
Very common	36.6
Fairly common	45.2
Rare	12.8
Does not exist	5.4

and

Defaults and punishments Do banks pursue defaulters?

Respondents	%
If they discover them, they pursue them vigorously	13.7
They know who they are, but they never pursue	20.3
They discover them, but only pursue some of them	19.8
They do not look and they do not pursue	46.2

The people most in-the-know in the Chinese banking industry apparently don’t have a lot of confidence in it.

At this point in the post I’d meant to explain that for a country to sustain development it must have a functioning credit and banking system that has the most important asset a bank can have: confidence. But I won’t belabor the point. China’s banking industry is another time bomb
that must be defused in order to secure a decent future.

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There’s a blog you should know about that I discovered while I was researching this post: Elite Chinese Politics and Political Economy. The blog and its blogger, Dr. Victor Shih—an assistant professor of political science at Northwestern University—have been great resources.

Previous posts in the “China’s time bombs” series:

China’s time bombs: the environment
China’s time bombs: Gray China
China’s time bombs: one more word on the pension system