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Good News for Chinese Banks, Bad News for Reforms

John Lee

As expected, China’s four banking giants are rolling out impressive figures. Industrial & Commercial Bank of China (ICBC) announced a 28% jump in profit the same day Agricultural Bank of China (AgBank) said its earnings surged 46%. The Bank of China (BOC) was actually the first to deliver results last week, reporting that its profit jumped 29%. In fact, China Construction Bank was the only one of the four to miss expectations with a mere 27% rise in earnings.

For many observers, the most encouraging figures were the declines in most of the bank’s nonperforming loan (NPL) ratios. ICBC expects it to remain below 1.1% throughout 2011, BOC is around the same level, while AgBank’s was 2.03%. This is a particularly good result for AgBank because it’s a major lender to rural clients who have struggled in recent times . A number of commentators, such as Tom Orlik writing in the Wall Street Journal, will see this as proof that China’s much maligned banks do indeed actually work.

However, the latest figures tell me that Beijing has only just barely begun to reform its state-owned banking system.

The rising profits reported at China’s state-run banks are the result of a surge in loan growth and a favorable interest margin. Total bank loans issued jumped from around $740 billion in 2008 to $1.4 trillion in 2009, before falling to $1.1 trillion last year. This means the total outstanding loans in the economy have jumped by nearly 50% over the past two years.

The deposit and lending rates imposed by Beijing gives Chinese banks a spread of 3%. This is nowhere near the largest in the world, but still looks generous compared to those in other countries, such as the U.S. and Japan where they tend to vary between 1 and 2%. Beijing has been increasing the spread in Chinese banks to improve the quality of their assets. Put simply, the more money China’s dominant state-owned banks lend, the greater their profits.

The spike in loans is not itself a problem if the money is duly repaid. Falling from ratios of around 20% in the 1990s, and around 5% only three years ago, the current figure of 1.1% seems encouraging. But that low NPL figure is highly misleading for a number of reasons.

First, bad loans take time before they can be officially classified as non-performing. Assuming no improvement or degradation in the quality of borrowers, the huge increase in new loans over the past two years will invariably drive down the NPL ratio in the short term.

Second, around three-quarters of all bank loans are granted to state-owned-enterprises (SOEs), and the majority of these loans go to approximately 120,000 (300,000 if subsidiaries are included) local SOEs, rather than the 100 or so centrally managed SOEs. The explosion in the number of local SOEs is due to the fact that local governments are prohibited from borrowing or issuing bonds. To get around these restrictions, they have created state-owned commercial entities that allow them to increase their fiscal revenues.

Although there are no comprehensive statistics available, multiple case studies of local SOEs suggest that over one-third offer zero or negative return on capital. The fact that NPL ratios are falling, while at the same time that there’s been few improvements in the profitability of the companies receiving the loans seems to indicate that something is amiss.

Third, an estimated 20 to 40% of these locally owned SOEs are engaged in property development. According to some Chinese Academy of Social Sciences reports, local governments rely on the property sector for about half their revenues. In other words, the tax revenue for local governments in China is largely dependent on the perpetuation of a property bubble. Should it deflate or burst, the adverse impact on both local government budgets and the books of local bank branches would be immense.

Fourth, there is the matter of an accounting sleight of hand. Conversations with branch managers reveal that they need to consistently hit low NPL targets to maintain their jobs. Many actual NPLs are placed into an obscure ‘other’ category on the books of local bank branches. By the time they’re submitted to head office officials and included in the consolidated accounts, the official aggregate of NPLs do not reflect the true extent of the problem.

Despite Chinese banks issuing lower NPL ratios, authorities in Beijing are well aware that they have a NPL problem. Earlier in the month, China Banking Regulatory Commission Chairman Liu Mingkang issued a directive against the roll-over of loans expiring at the end of 2011.

But it may be impossible for Chairman Liu to ensure that this directive is even followed. In a recent conversation with a senior executive at the Bank of China, I asked how confident he was about top-down policy like this one being implemented at the local branch level. Without hesitation and in a matter-of-fact tone, he said that management was confident that 30 to 40% of branches would comply. As for the other branches, nobody could be sure.

Moreover, given that local governments have become reliant on commercial entities as a significant contributor to their fiscal revenue, they’re not about to allow local branches to reveal the full extent of the NPL problem because this would invariably lead to reduced lending.

Only a decrease in lending to SOEs and accurate reports of loan quality will signal the onset of genuine reform. Until then, the weaknesses in China’s banks are unknown and probably unknowable.

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