CHINA’S BANKS: THE ONLY TWO THINGS YOU NEED TO KNOW

By Gordon G. Chang

There are two things to know about the banking system in China. First, the major state banks, the so-called Big Four, are insolvent. Second, the effort to bail them out is not working. Everything else is simply detail.

The most important is this: The crisis in the Chinese banking system is perhaps the most serious in the world today. The cause is not hard to understand. The Big Four, over the course of just a decade, have squandered the savings of a great people at the direction of Beijing. Senior technocrats tried to reform state-owned enterprises by replacing direct subsidies from the central treasury with loans from the four largest banks (Bank of China, Industrial and Commercial Bank of China, China Construction Bank and Agricultural Bank of China).

The theory was sound: Wean sick SOEs off grants and make them self-sufficient. In practice, the plan was a disaster: State enterprises knew they didn’t have to pay back the banks. So they didn’t. In an economic system divorced from economic reality, banks effectively became gift givers. They essentially vacuumed cash from small savers and disgorged it onto state enterprises at the direction of thousands of officials. The process was easy, quick and absurd.

The massive transfer of assets from the banks to the enterprises is a matter of indifference to government technocrats. After all, the state owns both. It is, however, a matter of concern to others: Hundreds of millions of China’s savers. Year after year they sock away a sum equal to about 40 percent of gross domestic product. That puts them atop world rankings for thriftiness. The Chinese are not just “squirrels,” as they have been called, but world champion squirrels. At the end of 2001, household savings, according to official statistics, amounted to the equivalent of US$894.1 billion, up 14.7 percent from the year before and 24.0 percent from 1999.

The Chinese can deposit, but can they withdraw? Today, the Big Four, which hold somewhere in the neighborhood of 60 percent of the deposits and make about 66 percent of the loans in China, are insolvent. Perhaps no one has a good understanding of the situation. “There is no simple answer to finding the level of nonperforming loans among state-owned banks,” admits a high official at one of them. Before the last partial recapitalization, which began in 1999, the best guess as to percentage of nonperforming loans was 50 percent.

Beginning in 1999 the central government recapitalized the Big Four by taking US$157.0 billion of nonperforming debt off their books. After this recap, the People’s Bank of China, the central bank, said that nonperforming loans constituted about 25 percent of the Big Four’s portfolios. That figure is taken as gospel by some analysts today, but we have to remember that the central bank before the recapitalization also said that the percentage of nonperforming loans was 25 percent. In other words, we were led to believe that the biggest bank recapitalization in Chinese history had no effect on the balance sheets of the Big Four. When it comes to statistics, China’s central bankers have lost credibility.

In fact, almost all the estimates of these loans were correct. You could justify any percentage depending on the standards used for classifying loans. Beijing officials allowed commercial bankers to adopt the loosest standards. In the last few years classification rules have been tightened, but today devious techniques allow even the worst loans to appear sound. The Big Four have continually “rolled over” troubled loans so that they appear on their books to be altogether new ones.

So what is the condition of the Big Four today? Again, the best work of the analysts is still guesswork. The central bank claims that nonperforming loans fell during last year by US$11.0 billion to 25.37 percent. That number surely understates the problem. Some observers guess 50 percent.

The condition of each of these mammoth banks varies widely, however. One observer says that the rotten loans of Agricultural Bank of China could constitute as much as 90 percent of its portfolio. That sounds too high, but nonetheless this bank needs emergency room treatment.

The hunt for accurate figures is an interesting exercise, of course. Yet the big news in China’s banking system is not how sick the banks are today. The issue is the ongoing creation of new stinky loans. The Commercial Banking Law, adopted in 1995, made China’s banks responsible for their own operations and, at least as a theoretical matter, freed them from outside political interference. As a practical matter, however, Communist Party and government officials continue to treat the Big Four as a “secondary budget,” a convenient source of funding for all sorts of purposes.

Today, observers report that Beijing has begun to exercise restraint in using the Big Four as their piggy banks. Yet these financial institutions have continued their lending to state enterprises because there is still a reluctance to do business with the private sector. Figures vary, but it appears that loans to state enterprises comprise about 85 percent of the total portfolios of the Big Four.

There is hidden support of the state, however. Today, the central government itself is borrowing from its own institutions. Some 30 percent of its announced expenditures is funded by the proceeds of sovereign treasury issues, and state banks dutifully take up these low-interest obligations as they are issued. When the Big Four run out of liquidity due to their purchases of central government debt, as they do from time to time, the People’s Bank of China provides interim funding to tide them over. Money, therefore, is circulating in a closed system, with many parts of the state financing one other at the same time.

How long can this circular flow of cash continue? The Big Four have committed many sins, but the worst may be borrowing short and lending long. That’s the classic formula for default around the world. China’s biggest banks take deposits from individuals, and these must be paid back either on short notice or on demand. The loans to state enterprises are essentially long term. The Big Four banks can thus continue to support state purposes only as long as China’s champion squirrels continue to make more deposits.

Will China’s savers continue to save with the state? The consensus is yes. How long? Indefinitely. This, however, is not possible: Nothing insolvent lasts forever. Moreover, there are forces effectively fixing a deadline. First, the state itself is trying to develop equity markets in Shanghai and Shenzhen. Moreover, insurers are touting their products to the public as new forms of savings. Thus, as China’s squirrels find alternative means of investment, the seemingly endless flow of new deposits is diverted to nonbanking institutions.

Second, foreign banks will be able to take local currency deposits from local residents in five years pursuant to China’s agreement to join the World Trade Organization. There are about 200 foreign banks in China now, but they remain marginal players with around 1 percent of deposits and 2 percent of loans. Although foreign banks may not attract many deposits in the future, only a small reduction in the flow of funds to the Big Four may be enough to cause trouble. Domestic banks occasionally are not able to honor requested withdrawals.

Third, declining interest rates do not help. In February China’s central bank announced its eighth straight interest rate cut as a means of stimulating a stagnating economy. The Big Four and other state banks have lost funds to the illegal deposit-takers in the past. From units of the Communist Party to the entrepreneurial couple next door, unauthorized parties effectively compete with banks by offering relatively high rates of interest on deposits. The state has begun to execute those who offer attractive interest, but officials cannot catch all who respond to the call of the market.

And then there is irrationality. Every once in a while China’s docile savers go on the rampage as they withdraw their money in stampedes with passbooks. In April 1999, for example, depositors withdrew US$108 million in the course of just a few days from the Bank of Communications, generally acknowledged as the strongest of all of China’s state-owned banks. Rumors posted on the Internet about embezzlement triggered the massive withdrawals. Even the Big Four have suffered bank runs.

The Chinese people have withdrawn their money for the craziest of reasons and for no reason at all. Yet, unbeknownst to most of them, they already have the best rationale to start a run: Their banks are insolvent. What will happen when they find out?

Maybe we should take comfort from Laurence J. Brahm, the author of China’s Century. “The Chinese government is not stupid enough to allow the state-owned banking system to collapse,” he assures us. Brahm may be right. But we have to wonder: Now that Beijing’s technocrats got the Big Four into this mess, are they also capable of performing one of the most difficult bank rescues in history?

[Next issue: Nasty surprises rock China’s banking sector. And there’s something even worse. Banking reform is failing in the People’s Republic.]

Gordon G. Chang is the author of The Coming Collapse of China, published by Random House.