The Strength of China’s Banking System

Newsweek reports about the rise of Chinese banks.

(emphasis mine)
[my comment]

The Rise of Chinese Banks
Will they outgrow American financial institutions?
Dan Weil
Jan 5, 2009

The global economic contagion has spread to China, sending shudders around the world. Chinese leaders are worried about domestic social unrest, while U.S. leaders are worried about whether China will continue loading up on Treasury securities as our budget deficit explodes.

Yet one of the few bright spots is
the surprising strength of China's banking system. Remember when that system seemed on the verge of collapse? That's where the banks stood until the reforms of the past 10 years.

But now the picture is completely different. As former World Bank official Pieter Bottelier, now a professor at Johns Hopkins, notes, "The irony is that 10 years ago, China's banks were among the weakest in the world and
today they are among the strongest, however primitive their system."

How did they turn things around?

The short answer is that the Chinese government imposed many of the same market-based principles used in the West. (We'll get to why they seem to work better in China in a minute.) Officials improved regulations and supervision, introducing risk capital requirements and tightening nonperforming loan criteria and provision standards.

The government allowed banks to be listed on stock exchanges, which meant they had to report their earnings according to Western accounting standards. Now two of the world's three biggest banks by market capitalization are Chinese: Industrial & Commercial Bank of China, which is the biggest, and China Construction Bank, No. 3.

Beginning in 1998, the government recapitalized them. Several years later, the government used approximately $60 billion of its massive foreign currency reserves to help finish the job. And banks were able to dump their bad loans onto state entities created for the purpose of holding the waste, while the banks received safe Finance Ministry bonds in exchange. Income from these restructured assets accounted for 60 percent of ICBC's profit in 2006.

Under China's old risk-weighting system, the banks were able to declare that loans to state-owned companies carried zero risk. That allowed the banks to have huge balance sheets with virtually no capital. No more.
As of Sept. 30, the average capital adequacy ratio for all of China's publicly traded banks totaled about 13 percent [about double the average of US banks], well above the government's required standard of 8 percent.

The treatment of nonperforming loans has changed drastically as well. In the old days, such bad loans were simply rolled over, with skipped payments being capitalized into the loans. Then the government decreed that interest payments on a loan had to be received within 90 days for it to avoid being classified as nonperforming. Initially, the amount of nonperforming loans rose, but as of Sept. 30, 2008, nonperforming loans totaled only 2 percent of the loan total for the country's listed banks. That compares with 2.3 percent for FDIC-insured banks in the United States.

The provision system, which is how banks account for loans that may go bad, has changed, too. Before the reforms of the past decade, banks didn't have to create provisions for bad loans, regardless of the quality of their loan portfolios.
Now provisions are substantial. As of Sept. 30, provisions for loan losses among the listed banks amounted to an impressive 123 percent of their nonperforming loans.

In 2003, Chinese regulators let foreign investors increase their stakes in Chinese banks from 15 percent to 20 percent. That ruling gave the banks more capital and credibility, paving the way for their initial public offerings beginning in 2005.

It also gave the Chinese institutions access to Western management expertise, though
fortunately for the Chinese, they didn't match their Western brethren's excessive risk-taking.

And that's still paying off: China's publicly traded banks registered a 53 percent increase in net income in the third quarter of 2008 from the same period in 2007.

And perhaps most importantly,
Chinese banks skipped the subprime party. They will, at most, have to write off 0.1 percent of their assets as a result of owning toxic U.S. securities, estimates Nicholas Lardy, senior fellow at the Peterson Institute for International Economics.

But the global recession puts some of that progress at risk. China's explosive double-digit economic growth in recent years, powered by its potent export machine, made it easy for banks to glitter. The rapid slowdown of China's economy represents the biggest problem. China's economy expanded at an explosive 11.4 percent rate last year. Experts estimate that pace will soon slip to 5 percent to 8 percent. While such a figure would represent nirvana for the United States now, the three- to six-percentage-point decline is similar in magnitude to what the U.S. is going through. Double-digit growth in China sent corporate profits soaring. Pretax profits totaled 11 percent of GDP last year, up from 4 percent in 2001.

"You have to be a pretty bad lending officer to find someone who's not credit-worthy in that scenario," Lardy says. "Now the economy has slowed, and profits will go negative very soon. Then we will learn more about the quality of loans."

As for the financial crisis that began in the West,
it hasn't hurt China directly. But the resulting global recession has crimped demand for Chinese exports. And exports constitute a key component of China's economy. In addition, the government has protected banks by capping deposit rates and cutting bank taxes. That allows banks to cover up some deficiencies.

So Chinese banks are vulnerable. Nonperforming loans will surely increase.
Still, a crisis is unlikely. The government has many weapons to fight the economy's deceleration—witness the recent announcement of a $585 billion fiscal stimulus plan. And the banks are much better equipped to handle loan losses now than they were years ago.

"There are potential risks, the magnitude of which it's hard to assess," Bottelier says. "But there are nowhere near the problems facing this country."

Reuters reports that Chinese banks' mortgage books are in good shape.

Chinese banks' mortgage books in good
Tue Jan 6, 2009 9:09am IST

BEIJING, Jan 6 (Reuters) - Delinquency rates on Chinese banks' property loans remain low, especially for residential mortgages, in spite of a downturn in the real estate market, a central bank official said on Tuesday. Banks had extended 2.95 trillion yuan ($432 billion) in home loans by the end of November, up 10.6 percent from a year earlier and accounting for about 10 percent of their local currency lending, Huo Yingli, a deputy director in the financial market department of the People's Bank of China, told a news conference.

FinanceAsia reports that China's banks look set to absorb shocks in 2009.

China's banks to absorb shocks in 2009, says S&P;

The ratings agency predicts that the problems facing Chinese banks this year will not be big enough to result in ratings downgrades.

Standard and Poor's outlook on China's banking sector is stable. "Major banks are financially positioned to absorb the shocks that are likely to mark 2009, provided the government doesn't interfere too much in their lending processes," the ratings agency says in a report published yesterday. The problems that the sector faces are not of a magnitude that they could lead to a negative ratings change on the major banks, it concludes. [This is the same S&P; that gave 'AAA' ratings to toxic subprime securities, but they might know what they are talking about this time.]

The main policy risk comes from the possibility that the government will meddle in how the banks lend money in order to help stimulate the economy. This could take the form of marginal borrowers exploiting a relaxation in lending policies. For example, the report adumbrates a situation where funding for infrastructure projects, which will form the backbone of China's recent stimulus package, could occur on the basis of who the project sponsor is, rather than on the viability of the actual project. If this occurs, says the report, it will hold back efforts to build a banking system based on fully commercial principles.

Away from the policy risks, there is corporate lending — exporters with fat inventories and empty order books are likely to contribute to a rise in China's corporate default rate in 2009. The report suggests a historical link between a slowdown in GDP growth and non-performing loans (NPL). So with S&P; predicting GDP growth to be as low as 7.3% in 2009, compared to an estimated 9.5% in 2008, bad debts could be on the rise.

On the plus side, the government's $586 billion stimulus package, higher tax rebates on exports and cuts in interest rates could all help boost GDP, thus limiting the rise in NPLs.

On the whole, though, S&P;'s baseline scenario has the NPL ratio increasing by 204bp, on the basis of a 50% reduction in Ebitda margins and a 300bp cut in the average loan rate. A decrease in the rate of loan growth, which has averaged 14.6% per annum over the past six years, could also contribute to an increase in the NPL ratio.

In the sector's favour are the mark-to-market gains that the banks will accrue from their domestic debt investments over the first half of the year, with a decline in benchmark deposit rates and the excess liquidity in the interbank market pushing up bond prices. Apart from Bank of China, most Chinese banks have little exposure to overseas debt. [China's capital controls protected them from America's financial insanity.]

The report notes that the sector's fundamentals are strong. Chinese regulations governing the loan-to-deposit ratio combined with the high savings rate have left the country's banks with a good level of liquidity. In November 2008, across the industry, the loan-to-deposit ratio was 65.94% [in the US the loan-to-deposit ratio is about 90%].

Furthermore, the rated banks are well capitalised, especially the “big three” — Bank of China, Industrial and Commercial Bank of China, and China Construction Bank — all of which have been the targets of recapitalisation injections from the government. High levels of capital should “provide a cushion against the expected pressure on credit quality and earnings over the next one or two years”, says the report.

This is not to say that all is well. The sector will not be completely unscathed by global turmoil, although it should avoid much of the downturn. “The sector outlook is now stable, instead of cautiously positive, to reflect our view that the strong positive momentum of the banking sector in recent years will moderate considerably in 2009,” says S&P.;

My reaction: Chinese banks have spent the last ten years getting rid of their bad loans, and are now among the strongest in the world. Banks in the US, by contrast, have spent the last ten years making increasingly stupid lending decisions and creating an ungodly mess with their financial derivatives (subprime CDOs squared, credit default swaps, etc).

The real reasons why China's banks are in such good shape today are:

1) They are 'primitive' compared to the banks in developed nations like the US. They didn't play around with securitization (bundling loans into securities to sell to investors). They don't have off balance sheet financial vehicles (US banks still have trillions in off balance sheet vehicles ( SIVs, VIEs, etc)). Finally, They didn' t . Chinese banks just made boring regular loans to individuals and businesses that had a reasonable chance of paying it back. Very 'primitive'.

2) The underlying strength of the Chinese economy transfers over to its banking sector to a good extent. A decade of double digit growth provided the perfect environment for Chinese banks to strengthen their books.

3) To fight inflation, China has tried to contain its money supply growth by implementing policies which forced Chinese banks to lend less. These policies included credit ceilings. floor on lending rates, ceiling on deposit rates, higher capital requirements, and strict rules governing lending decisions. As a result, China's banks are underleveraged compared to the rest of the world.

Conclusion: The deflation fears going around in China right now are overblown. The greater risk remains inflation by far.

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0 Responses to The Strength of China’s Banking System

  1. Anonymous says:

    "The main policy risk comes from the possibility that the government will meddle in how the banks lend money in order to help stimulate the economy. This could take the form of marginal borrowers exploiting a relaxation in lending policies."

    I'm trying to understand why China will stop buying US Treasuries and I think what I just quoted is the reason.

    The risk of the Chinese government meddling in how China lends money and putting relaxation in lending policies is greater because China's economy has slowed from a decrease in exports and will continue to slow down unless China works on stimulating domestic consumption because the rest of the world will continue to buy less of China's exports as they(the rest of the world) focus more on paying off their debt. In order for China to avoid hyperinflation and stimulate their economy at the same time, China has to drop it's dollar peg and refuse to buy the amount of Treasury debt needed for US' bailouts because with the high price of US Treasury debt along with the amount of US Treasury debt needed for all the continuing US bailouts and US stimulus packages, China will end up printing massive amounts of Yuan to buy all those US Treasuries. With the massive amounts of Yuan being printed there is a great chance that as they are trying to stimulate their economy through a relaxation in bank lending that hyperinflation will occur.

    Is this why China will stop buying US Treasuries and why China will not fund the US bailouts?

    The main point is these US bailouts will not help China's exports will it? China will still have the same problem with exports decreasing except if they choose to also fund US' bailouts they(China) will also have the risk of hyperinflation. China will need to stimulate it's economy because of the crash in it's exports and with the enormous amounts of Yuans being printed, with a start of relaxation of bank lending there is a huge risk of hyperinflation.

    Is this right?

    So there is no benefit for China to continue to buy US Treasuries? China's exports will crash regaurdless? In order for China to save it's economy it must focus on domestic consumption?

  2. The most important reason why China may not invest in the USA is self interest. China will spend money on it's own economy first by way of stimulus projects. It is a no-brainer that you would develop your own country first as a priority.

  3. "In order for China to avoid hyperinflation and stimulate their economy at the same time, China has to drop it's dollar peg"


    "Is this why China will stop buying US Treasuries and why China will not fund the US bailouts?"

    Yes, but here is how I see it happening. China tries to both keep its dollar peg and stimulate its domestic economy at the same time. As a result, China's money supply is going to expand at an extremely rapid pace while its economy slowly shrinks because of falling exports. Either this months or next months, inflation in China is going to stop falling and start rising quickly.

    At some point after inflation goes above 20%, Chinese officials are going to start panicking. They are not only going to drop the peg, but also start selling their US holdings in order to get inflation back under control.

    "China's exports will crash regaurdless?"

    Yes. Think about it: you can't go on selling on credit forever to someone who is obviously broke.

    "In order for China to save it's economy it must focus on domestic consumption?"

    Pretty much.

  4. Nonsense. We'll see how strong China's banks are when their exports are cut in half, as they will be shortly.

    Jesus... the "China's taking over the world" hysteria reminds me of the coverage of the Soviet Union during the Red Scare. All of the

    China's economy is a leveraged play on western consumers, and a total sham. China's banks might be in decent condition for now, but the real economy is not. The US economy is a sham as well. In fact, the entire world economy has deep structural problems. But people focus only on the problems here; stop being so geocentric, people.

  5. "Nonsense. We'll see how strong China's banks are when."

    I never Chinese banks were not in trouble, I said they were "among the strongest in the world". Due to China's capital controls, they were isolated from the rest of the world. That means they have no exposure to the US-lead financial insanity which swept up most banks: subprime loans, off-balance sheet vehicles, exposure to the 50 trillion credit-default-swaps market, etc. That alone makes them attractive by comparison.

    "their exports are cut in half, as they will be shortly"

    So you believe Wal-Mart sales are going to crash by 50%? Wal-Mart was the only retailer whose sales ROSE this past holiday season.

    (To be fair, once the dollar crashes, I expect China imports to fall close to 50%)

    "China's economy is a leveraged play on western consumers."

    You aren't thinking this through. Let me ask you this, where do you expect worldwide demand to hold up the best?

    Commodities--Oil, gas, steel, etc
    Capital goods--Airplains, Catapillars, Machinery for new factories, Machinery for new mining/oil exploration projects, etc

    Durable goods--SUVs, CARs, appliances, business equipment, electronic equipment, home furnishings, etc

    Luxury goods--brand name products, designer clothing, artwork, etc...

    Cheap consumer goods--Everything you buy at Wal-Mart

    Guess what China makes? Cheap consumer goods.

    I am sure China's exports will fall, but they will fall less then the export of any other country. The US consumers will stopped shopping anywhere else by the time they begin to cutback on their

    (By the way, if you can think of anything that is going to hold up better than cheap consumer goods, I would love to hear it.)

    If the China's economy is a "total sham", then what does that make the US economy?

    Do you REALLY BELIEVE that demand for our boings, caterpillars, and SUVs is going to hold up better than demand for cheap consumer goods?

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