Features : Fuel For The Growth Engine Annual Report

Over the past decade, China’s government has been working on an ambitious plan to improve the health, transparency and effectiveness of its country’s sprawling banking system. Weighed down with bad loans, mired in bureaucracy and often plagued by corruption, the banking system was in dire need of reform—and reform it did.
Moody’s Investors Service estimated in a 2005 report that from 1998 through mid-2005 the Chinese government spent around $431 billion in capital injections and bad debt disposals to strengthen the country’s banks. As part of the reform process, the banks sought out strategic foreign investors that could share technology, risk-management techniques and industry know-how. The government also pushed banks to list on foreign stock exchanges, where transparency requirements were high.

The results of the restructuring process have so far been overwhelmingly positive. Net profit for China’s banking sector as a whole increased 50% in 2007, according to a recent report from accounting and consulting firm KPMG. The IPOs of China’s biggest state-owned banks rank as some of the largest in history. More impressively, the proportion of non-performing loans (NPLs) of China’s banks has dropped drastically. The KPMG report found that 75 of the 83 banks surveyed had NPL rates below 5%, and 41% reported rates below 2%.

These signs of progress could be misleading, however. The rapid growth and high enthusiasm of recent years accompanied strong economic growth in China and around the globe. But poor loan decisions take time to show up on balance sheets, and slowed economic growth often brings them to the surface. For that reason, the coming year could reveal much about the true impact of China’s banking reform.

Alistair Scarff, head of Merrill Lynch’s Asia-Pacific financial institutions research, explains: “Chinese banks are now for the first time facing a true cycle as listed, commercial banks. This is going to put to test the changes that have taken place since their restructuring and reform process began. For their technology, credit reform, credit processes, credit culture, it will be major testing time.”

China’s most recent economic figures indicate that tough times could lie ahead. Exports, in Chinese yuan terms, dropped 9.6% in November, and December numbers are likely to be worse. A January report by investment group CLSA concluded that manufacturing conditions in China declined for the fifth straight month and that in December Chinese manufacturing contracted and manufacturers’ total workforce shrank at the sharpest rates since CLSA began publishing its China manufacturing reports in 2005.

The cooling economic activity hit China’s export-oriented southeastern province of Guangdong especially hard. The province’s deputy governor, Huang Longyun, announced in January that Guangdong’s export growth last year slumped to 5.6% from 22.3% in 2007. He added that the number of migrant workers had dropped from 20 million to 15 million and could drop by another 5 million in 2009.

Economic Pain Spreads Wider
The drop in export growth will hit banks hard, especially those in China’s southeast. “The export story is the most visible and arguably the easiest to track,” explains Scarff. “There is a slowdown; therefore, these companies are no longer able to sell their products and are already operating on razor-thin margins. That is going to be where things start to hit hardest.”
Cooling export growth, however, is only part of the story. Real estate prices in many markets around China have shot up in recent years. To avoid overheating, the government in 2007 began tightening its monetary policy. As the global economic crisis intensified, however, the market cooled quickly. Turnover dropped off steeply, and prices are coming down. China’s National Development and Reform Commission (NDRC) reported in January that real estate prices in 70 large and medium-size cities dropped by 0.4% in December, the first such drop since the government began publishing the figures in 2005.

The consequences for banks are significant. Most Chinese banks are heavily invested in real estate development projects. Falling real estate values, if the trend continues, could push up default rates. “The appetite for China property among the investor base has diminished considerably,” says Scarff, and as a result banks’ asset quality may suffer.

Pieter Bottelier of the John Hopkins School for Advanced International Studies (SAIS) points out that the real estate market is closely tied to many of China’s large industries. “From an economic perspective the big state-owned construction and building companies are more important than export companies,” he says. “Cement, glass, steel, copper and aluminum—I think the downturn is very strongly felt in these industries. If China can succeed in reviving the housing sector, the big benefit would be to get these big companies off the danger list.”

The government is working hard on that revival. The central bank has lowered interest rates significantly, and the banking authority has loosened conditions on mortgage agreements, including lowering the down-payment requirements. Those terms will help, Bottelier says. “My guess is that we just need to wait for the easing of interest rates and mortgage terms to kick in,” he says, “and given the tremendous ongoing demand for urban housing in China, there is a reasonable chance the market will stabilize sometime in 2009.”

The government is not relying on looser lending conditions alone to revive the construction sector, however. China has introduced an ambitious 4 trillion yuan ($585 billion) stimulus plan that will involve heavy investment in infrastructure construction.

The government has also said that the stimulus will supply funds for social welfare services including education, medical care and pension benefits. Such moves would free up some of China’s tremendous pool of household savings for consumption. Greater domestic consumption then could lessen the country’s dependence on exports and investment and eventually result in better-sustained economic growth.

Bottelier adds: “In China you have an unusual situation in the sense that the measures to stabilize the economy in the short term to prevent too deep of a downturn, especially the increase in spending to social sectors, can be perfectly consistent with the medium- and long-term reform objective, which is to rebalance the economy to be more dependent on domestic consumption growth and less dependent on export growth.”

Beyond greater social service spending, the government is working on other methods to increase wage levels and employment. The banks, as the central elements in the financial system, play important roles. Through the banking system, the government is trying to increase funding for rural areas and small and medium-size enterprises. Both areas hold benefits for the economic health of the country. The benefits for banks are there but less obvious.

China’s rural banking market is serviced largely by inefficient rural banking cooperatives and informal banking networks. Greater financial efficiency in such areas would help the government in terms of social stability and in providing domestically centered economic growth. Banks, on the other hand, could gain from more efficiently serving the market.

Lending to small and medium-size enterprises (SMEs) is another area where the government is encouraging banks. Once again, the push has significant benefit for the economy. These SMEs, generally speaking, are less capital intensive and more service oriented. They are also more risky investments, however, and thus have more challenges getting funding.

This reform faces at least one key problem, though. For Chinese banks, which are now listed, commercially oriented companies, lending to rural areas and riskier SMEs may not be the best commercial decision. Leo Wah, banking analyst for Moody’s in Hong Kong, explains: “The government wants banks to lend, but the problem is that they need to protect the balance sheet, especially since many of them are now listed companies. They cannot simply give out money when they receive applications.” Still, Wah believes, the government emphasis may lighten some of the pressure on SMEs and rural borrowers.

The dilemma is not unique to China, but within the challenge lies an opportunity to begin correcting the domestic imbalances that threaten the sustainability of China’s growth and the stability of the world’s increasingly integrated financial system.

Thomas Clouse