Features : After the Gold Rush

Local and international banks operating in China will face increasing challenges over the coming year. The opportunities remain undiminished, though

Its official: China has confounded the pessimists. Instead of fizzling out in a hot-money-fueled meltdown, Chinas economy could be about to enjoy the holy grail of all economic managers: the Goldilocks scenario. A broad range of industries is set to benefit from the countrys growing economic maturity, but none more so than its banks.

Chinese banks are big by every measurenumber, branch network, loans, deposits and, most recently, popularity with global investors. Between October 2005 and November 2006, three of Chinas banks launched IPOs ranking in the top-10 largest of all time. Internally, the countrys banks reformed risk control mechanisms and corporate governance structures while continuing to post profits. In December the banking sector opened to foreign competition with minimal excitement. Chinese banks stood their ground.

Thats the good news, but challenges are ahead. Revenues in Chinas banking industry are propped up largely by government limits on deposit and loan rates. The low interest on deposit rates and significantly higher interest rate on loans gives a comfortable profit margin for banks. The government has already hinted that it plans to free these rates in the next few years. If so, the competition among the tens of thousands of financial institutions will push these margins down, erasing much, if not all, of banks profits. At the same time, Chinas revived equity markets, which provide investment opportunities for individuals and fund-raising vehicles for Chinese companies, will take both deposit and loan customers away from banks.

This reduction in traditional profit sources will affect banks on various levels. First, Chinese banks must find other sources of income. Areas such as credit cards, wealth management and other fee-based services will increase greatly in importance. In these areas, however, banks will feel the foreign competition more strongly than in traditional banking services. Such services do not require an extensive network, and foreign banks have more related experience.

Second, loans to small and medium-size enterprises will become very important. Such companies are generally more profitable and efficient than their state-owned counterparts, but the variety of and competition for such companies will require sophisticated risk assessment and pricing techniques. Chinese banks are historically weak in this regard, and loans to Chinas small and medium-size companies will test recent reforms aimed at strengthening banks risk management.

Third, widespread consolidation in the industry is likely, with large domestic banks and international rivals vying to invest in or acquire completely smaller financial institutions. Benjamin Wey, president of investment banking, research and consulting firm New York Global Group, based in Beijing and New York, explains: The financial sector will see mergers and acquisitions, international expansion and continued efforts to bring in strategic investors. The real opportunities for market players will be among the regional and municipal banks.

Money, Money and More Money

Given the herd mentality of many investors, Chinese regulators have had to work hard to ensure investment flows into the proper channels without too many companies or people investing heavily in the same sectors and industries. The government must watch carefully the inflows of money that come from Chinese companies profits abroad as well as money flowing in for investment and for currency speculators hoping to cash in on a Chinese yuan appreciation. The danger of failurewhich has haunted China more than once in recent yearsis economic overheating.

One such threat came in early 2006, when rapid new loan growth alarmed policymakers and prompted a slew of measures to slow investment. The spike in new loans surprised many observers, but most agree that the problem was related to liquidity in the countrys banks. Chinese banks were bursting with deposits, and as banks do, they made loans.

In response, the central bank raised interest and deposit rates as well as reserve requirement ratios. The government also implemented administrative orders to limit loans to certain industries and worked hard to dampen expectations of a speedy appreciation of the yuan. As a result, the money supply tightened, and required reserve ratios now stand at 9.5% for most banks. Most indications point to slower growth, which, ironically, is good news.

Complicating the situation, however, is Chinas skyrocketing stock market. Chinas benchmark index, which dropped to eight-year lows in 2005, more than doubled in 2006. The rise seemed to be good news for regulators, who have been struggling for years to revive Chinese stocks, but their efforts may prove to be too successful, as at least some degree of speculation has played a role in the current prices.

The obvious response for the government is to continue tightening, but too much dampening would negatively affect investment and overall growth. Jonathan Anderson, chief Asia economist for investment bank UBS, said in a recent paper, All of this presents a problem for the authorities, who, on the one hand, want to avoid any further liquidity tightening in the credit markets but, on the other, will be tempted to take action to quell speculative pressures in the stock market. For the time being, most expect that the domestic stock market will continue to rise, though opinions vary as to the degree of speculation responsible for that rise. If Chinese regulators feel that the speculation is significant, they may take action.

International Relations 101

Chinas economic rise has clearly benefited its trading partners as well as its people. The countrys trade relationships, however, are becoming more complex as its global stature increases and the worlds economies depend more heavily upon its economic growth. In December, both the US and the EU sent high-level trade delegations to China to discuss sensitive issues. These delegations had limited success, with few tangible accomplishments. Time for progress on such issues may be running out, as important leadership changes in both the US and the EU push Chinas trade relations further up political agendas.

One such leadership change took place last month in the United States as politicians returned to Washington to take up business for 2007. The now Democratic Party-controlled Congress will likely take a firmer approach to China than their Republican predecessors. Topping the list of points of contention is Chinas exchange rate, which is linked to a basket of currencies rather than market rates. Critics charge that the exchange rate, which follows closely the value of the dollar, artificially reduces the prices of Chinese exports, giving them an unfair advantage over products from other countries.


Ma:Healthcare sector

is set to benefit from

growing government


This issue may be even more important in Europe, where France will soon elect a new president. While the value of the Chinese yuan remains closely linked to the value of the US dollar, the euro has appreciated greatly against both currencies, making European products expensive in foreign markets. Support for Frances two presidential candidates, both of whom have expressed concern over losing domestic jobs to overseas manufacturing bases, is largely split.

The French election, Peking University finance professor Michael Pettis believes, will be intense, with foreign trade as one of the primary issues. There are two candidates that are billing themselves as non-mainstream. Trade policy will be a big issue, especially with the appreciation of the euro, he says. The consequences for China of ramping up the debate over its exchange rate policy could be significant, he explains: The greatest fear is that the US or other markets will implement protectionist measures. That would be bad for everyone, but it would be especially bad for China.

Kicking Up Consumption

Chinas trade surplus is troublesome for China as well as its trading partners. The countrys strong dependence on exports makes it vulnerable to external economic shocks and global economic downturns. For this reason, China also has strong incentive to reduce its dependence on foreign trade and to try out a variety of strategies to boost domestic consumption. The most obvious approach would be to allow the yuan to appreciate more rapidly. This would decrease the prices of imported goods, encouraging Chinese people to purchase more. The problem, according to Pettis, is that the Chinese financial system is simply not prepared for more rapid yuan appreciation.

Pettis remarks: The banking system is still not ready. Chinese banks cannot handle big financial shocks. He also points out that greater yuan appreciation could negatively affect Chinas agricultural sector, upon which most of Chinas 1.3 billion citizens depend for their livelihoods. Chinas agricultural sector operates relatively inefficiently, with thin profit margins. A stronger yuan would bring in more agricultural imports, driving profits down even further, he says.



Chinas banking

system is not

ready for rapid

yuan appreciation

The government is instead considering other strategies aimed at boosting domestic consumption. In a recent report, Deutsche Banks Greater China chief economist Jun Ma details recent policy moves that may reveal part of the governments strategy. According to the report, the central government is currently working on regulations that would require state-owned enterprises to pay dividends more often. For listed companies, this would put more money in the hands of stock-owning Chinese citizens, hopefully encouraging them to spend more.

More important, though, the dividend payouts would increase government revenue. The government, Ma points out, spends more of its money than individuals do. This money, he predicts, will be used largely to develop social services such as education, social security and, particularly, healthcare. Among the consumer sectors, we think one of the bright spots will be healthcare, as the government has explicitly stated the goal of providing universal healthcare coverage within the next five years, he writes.

The investment in better social services addresses the problem from two angles. First, greater spending stimulates current consumption, increasing demand for products and people needed to provide these services. Second, strengthened social services, including healthcare, education and social security, reduce the need for individuals to save. Thus, people are willing to consume more. This approach, however, will take time to implement, and its benefits will surface only gradually. For the short and medium terms, the courses of action are less clear.

Thomas Clouse