Bank shortcomings exposed as Chinese economy founders
The Chinese economy is growing ever more slowly – probably slipping even faster than officially admitted, and from a base whose size is possibly exaggerated too. In the midst of this, the orthodox banking sector is doing unorthodox things on a grand scale, while being undermined and bypassed by an even more unorthodox grey financial sector.
China’s economy is slowing. Profits at leading state-owned enterprises (SOEs) are stagnating. The mainland’s plodding, unsophisticated banks face an uncertain, troubled future. Many observers, including regulators and leading Communist Party officials, deem grey-market shadow finance to be out of control. How worried should we be?
The first issue first, as it informs so much of what happens across the People’s Republic. Generating hard topline facts on China’s economy has never been easy. Data provided by the official National Bureau of Statistics are trusted by almost nobody.
The agency once issued a GDP figure before the fiscal year was even complete. In the mid-2000s, in an attempt to make the Party appear to be in charge of a serenely growing economy, it understated GDP; now it probably embellishes it. Even premier Li Keqiang says he uses the NBS “for reference purposes only” – hardly a ringing endorsement.
For want of an accurate source, the NBS is all we have. Thus, officially at least, China’s economy will grow by 7.5% this year and at 7.4% in 2014. Few non-mainland economists, having seen GDP slow from 7.9% in the final quarter of 2012 to 7.5% in the second quarter of 2013, follow this line. Barclays tips GDP to come in a shade under 7% this year. Qinwei Wang, China economist at London-based Capital Economics, expects growth to slow to around 6%. Andrew Polk, resident economist in Beijing at The Conference Board’s China Center for Economics and Business, places real growth levels at “between 5.5% and 6%”.
Others are yet more circumspect. Anne Stevenson-Yang, founder of Beijing consultancy J Capital Research, asks whether China has tipped into recession, citing a recent “shocking slide” in consumer spending, with luxury goods sales in Shanghai tumbling 30% year on year in the first half. “China’s leaders have consistently and publicly based their expectations of sustained high GDP growth on household consumption. This is not happening,” she says.
Another issue relates not to growth but size. Many economists have long believed China’s economy is smaller than publicly stated. In August, those concerns were given substance in a report issued by Christopher Balding, associate professor at Peking University’s HSBC Business School. Balding’s report suggested that GDP had been “significantly overstated” for years thanks to “wilfully fraudulent” inflation data that exaggerated real disposable income. China’s economy, he concluded, was up to $1 trillion (12%) smaller than stated, cutting its real size to around $7 trillion.
Nor is it easy to find precise industry data, even in areas such as power generation, probably the key economic metric for any emerging market. When thermal power (which makes up 85% of China’s energy mix) slumps, the shortfall in projected production is immediately and precisely covered by a sudden and very brief spike in hydropower output, even in water-poor months. This happened in the third quarter of 2012 and in the first four months of 2013.
Steel production, according to the NBS, jumped 15% in the first three months of 2013, despite respected analysts such as Paul Adkins, managing director of Shanghai consultancy AZ China, finding that demand had hardly moved. Aluminium production spiked 17% in the first three months and continued rising, even though building starts were down.
Even the NBS clearly doesn’t trust its own figures. In August, it suspended the release of data from a purchasing managers’ index. “We can’t ensure all industry-specific data can reach accuracy requirements,” the agency said. “[W]e were concerned that some of the numbers may affect related investors and users.”
And sometimes information goes missing entirely: cement output data disappeared entirely for the first three months of 2013, and again in June. This, one Beijing economist says, tends to happen when industry data “makes overall growth figures look palpably ungettable”. How, he asks, “can GDP be rising at 7% to 8%, when construction is slowing, retail sales are lagging, and the profitability of SOEs is being called into question?”
This point is telling. China’s leading state firms appeared for years to bestride the Earth, guzzling assets in economies as diverse as Australia and Zambia. Profits soared, as did global influence in such areas as solar power, wind turbines and heavy equipment production.
Yet many have long wondered how well leading SOEs, still China’s economic bedrock, are run and how they will fare in a slowing economy. Many are still propped up, fully or partly, by central and local authorities. In 2012 more than 98% of the companies listed on China’s A-share markets received state subsidies, totalling Rmb55 billion ($9 billion), up 17% year on year. State largesse accounted for around 15% of the average SOE’s profits last year, or around Rmb42 million per firm.
Moreover, official data are usually only available from listed companies. J Capital’s Stevenson-Yang notes that when SOE parent company records are revealed (usually in bond prospectuses) they usually show “much higher levels of subsidies than to their listed subsidiaries”. Parent companies then selectively inject cash into subsidiaries “in order to maintain positive results at the [subsidiary] level, which is visible to investors”. Reality, as ever in China, is an illusion.
A good example of this is China Ocean Shipping (Cosco). The nation’s largest dry bulk carrier handed Rmb900 million to its Shanghai-listed subsidiary, China Cosco Holdings, in 2012. Yet, notes Stevenson-Yang, this barely begins to reflect the “myriad subsidies” channelled to the group’s 20-plus subsidiaries, or the asset injections that enabled China Cosco to sustain losses of around Rmb10 billion in each of the past two years. Analysts reckon the parent company now owes around $14 billion in unpayable debt.
At every level, the state sector is facing headwinds. An annual survey of more than 150 mainland state firms covering 17 sectors, issued in August by Standard & Poor’s, found ‘high levels of debt’ accumulated ‘during the credit boom of the past five years’. (Roughly: since China started pump-priming its economy with stimulus cash in the wake of the Lehman Brothers collapse).
In the intervening period, notes Christopher Lee, Standard & Poor’s managing director of corporate ratings for Greater China, the credit ratios of China’s top corporates “have deteriorated steadily, most notably profit margins and debt payback”.
Lee believes the capacity of leading state firms to service debt has “weakened compared with a year ago”, leaving corporates with highly leveraged balance sheets “particularly vulnerable in the current slowdown”. Most sectors are suffering, he adds, including oil and gas, telecommunications and banking.
And if debts are rising and profits fading at SOEs, China’s banks, for too long overly dependent on soliciting business and extracting money from (increasingly troubled) state-run firms, must also be in distress. Indeed this issue – the increasingly scratchy state of the mainland’s largest lenders – might be the biggest emerging threat to China’s ability to finance and grow its economy effectively.
Many observers already point to cracks in the edifice. One base point of reference lies in the rising stock of soured loans. China’s official non-performing loan ratio is still at historically (some say unrealistically) low levels, flat at just under 1% at end-June, according to the China Banking Regulatory Commission (CBRC). But the total stock of soured lending rose Rmb13 billion to Rmb540 billion in the three months to end-June, the seventh straight quarterly increase. Loan impairment losses at Bank of Communications (BoCom), China’s fifth largest lender by assets, surged by 19% in the first six months of 2013. Many including Li-gang Liu, chief China economist at ANZ, see Chinese banks issuing new shares, or launching initial public offerings in an effort to shore up liquidity and absorb rising soured loans. Two mainland lenders, Everbright Bank and Hefei-based Huishang Bank hope to raise up to $2 billion from Hong Kong initial stock sales in the coming months.
Profits are still growing, but more slowly. The mainland’s second-largest lender, China Construction Bank (CCB), posted the smallest gain in earnings in five quarters in the three months to end-June. Issuing its second-quarter financials on August 26, CCB blamed rising bad loans and a slowing economy as profits inched up to Rmb60 billion. An analyst survey by Bloomberg tipped profits at the country’s largest lenders – CCB, Industrial & Commercial Bank of China and Bank of China – to grow by less than 10% in 2013, the slowest rate since the three launched blockbuster IPOs in 2005/06.
The broader issue here is that China’s current crop of leading banking officials have only experienced the best of times. Since being bailed out in 2003/04, notes a Hong Kong-based expert on the mainland’s financial industry, “the banking sector has not been subjected to a recession. Nor have they had to deal with a struggling economy. My concern is that there are going to be asset-quality issues at the banks if China’s economy really starts to struggle.”
Analysts have long pointed to the danger inherent in a system where state-owned banks channel most of their capital into the maw of leading SOEs. In this climate, notes Charlene Chu, an analyst at Fitch Ratings: “Everyone is part of one big family, so there’s more tolerance for non-payment [and] forebearance.” This codependent relationship works fine in the good times, But when things are otherwise, Chu adds, “it allows [an] unhealthy, imbalanced dynamic to go on longer and further than it would in other countries”. Others believe the CBRC’s prescriptive view of NPLs will force soured-loan status on substantially overdue loans.
This codependency is particularly unhealthy for leading state banks, for two main reasons. First, it allows the banks to coast along, posting net interest margins (NIMs) that, while superficially healthy, could and should be far higher. But they aren’t: while banks such as HSBC and Bank of America generate substantial profits from small and medium-sized enterprises and credit card collections, China’s leading state banks remain addicted to more conservative SOE lending, which, even in the good times, suppresses net interest margins.
Thus the big-three state banks have NIMs of between 2.5% and 2.7 %, using the latest available data, while at smaller municipal or regional lenders, margins are far higher. Guangdong Huaxin Bank, Bank of Hebi, Bank of Inner Mongolia, Bank of Taizhou and Longjiang Bank boast net interest margins of between 3.11% and 4.86%. Perhaps unsurprisingly, all these lenders have diversified lending books notably skewed toward smaller, private enterprises. If this isn’t an issue for China’s big state banks, it should be: falling profits at SOEs and a slowing economy will eat into net interest margins. ICBC president Yang Kaisheng has warned of falling margins this year at China’s largest lender.
Second, there is an added problem related to NPLs: notably, that they are too low. This might sound counterintuitive, yet for a bank to be profitable, it needs to take real risks. China’s lenders have evolved with the opposite aim in mind, wherein avoiding risk is far more important. This harks back to Beijing’s fear of repeating the mass banking bailouts that occurred in 1999, 2003/04 and 2007, completely successfully but at a huge and enduring cost to the nation’s finances.
China, notes one Guangdong-based NPL specialist who works with the asset management companies (AMCs) set up in 1999 to store the first round of soured loans, describes the country’s attitude to NPLs as a variation on the Goldilocks principle. “China either has too many NPLs, or too few, but they never have the right amount.”
Even the better-run AMCs, such as Cinda and Huarong, now preparing for planned IPOs with their financial partners (UBS and Standard Chartered have both pumped capital into Cinda), moan about the paucity of NPLs being made available. Perhaps unsurprisingly, the leading bears on NPLs in China are the very AMCs who make the bulk of their profit by servicing soured loans.
And there’s another substantial downside to the excessive caution that guides thinking at China’s leading banks: the creation of a vast, sprawling and eminently more innovative shadow financial sector. Grey-market lenders are the real national drivers of financial creativity. China’s banks, by contrast, have not heeded Giuseppe Tomasi di Lampedusa’s words in “The Leopard”, where he cautions that “everything needs to change, so everything can stay the same”.
Few of Beijing’s leading lenders have adapted to a changing economy, where the fastest-growing firms are SMEs, micro- and small-sized enterprises (MSEs – a sector that includes the vast majority of what could be labelled real privately run Chinese corporates) and wealthier and middle-class individuals. “If I had an awful lot of time and money,” notes one Beijing investment banker, “I would set up a micro-credit firm lending to small private firms. That’s where the real money’s being made.”
This lack of creativity and inspiration among large, formal lenders has led to the creation of a vast and patchily regulated grey market that continues to grow year upon year, and that has within its weaponry the ability to undermine the formal banking system. JPMorgan reckons shadow finance is now worth around $6 trillion – 70% of GDP. A classic example is wealth management. Lacking sophisticated investment channels for their surplus savings, and loth to invest in the few official products that exist (lame mainland-listed securities; a worryingly bubbly property sector), millions of citizens have turned to wealth management products (WMPs).
These WMPs are often viewed with suspicion, perhaps because they have grown with such rapidity. An industry worth just Rmb1 trillion 10 years ago has proliferated, growing to Rmb9.85 trillion by end-June, according to the CBRC. Fitch Ratings’ Chu puts the value far higher, at around Rmb13 trillion.
And to be fair, a few have in recent times gone spectacularly bust, notably Shanghai Fanxin Insurance Agency, which filed for bankruptcy in late 2012 after the owner fled the mainland with Rmb500 million in customer’s money. Some WMPs lure customers in with spectacularly unlikely boasts, promising unattainable returns of up to 15% a year. China is one of the few countries where bait seems to work all too often.
No lesser a luminary than Xiao Gang, head of the China Securities Regulatory Commission (CSRC) and a former Bank of China chairman, has described the worst WMPs, which don’t have their principal guaranteed by banks and which channel the savings of ordinary citizens into risky bets such as derivatives and loans to property developers, as “Ponzi schemes”.
Yet the odium in Xiao’s words also reflects an underlying fear of what WMPs represent. China’s banks have been horribly slow to offer their own wealth products to clients. Many have started, but the industry is dominated by trust companies and securities firms. Banks prefer to continue to favour simple time deposits, typically offering grudgingly low rates of returns. To be fair, banks are limited to offering government-mandated rates, while returns on, say, one-month time deposits have inched up in recent times, in some cases as high as 3%. But these are still outgunned by even the more cautious WMPs, which promise – and usually deliver – annual rates of return of at least 4.5%.
Lenders dislike WMPs for a rationally self-serving reason: time deposits that actually lose money for individuals have long been both a generous source of profit and an easy way of boosting capital reserves to fund favoured SOEs. Banks also face a double whammy here: sooner or later, Beijing will liberalize interest rates – indeed, with rates of return on WMPs and banking time deposits edging slowly closer, that process is already happening. When complete, it will, says a Beijing-based partner at a global consulting firm, be a “body-blow to banks, which will be forced to compete in ways they never have before”.
Meanwhile new or recently emerged shadow products spring up all the time. Some are logical and innovative reactions to the plodding caution of the formal banking sector; others are weird and implausible.
Take the rise in popularity of trust beneficiary rights transfers (TBRTs), which are corporate loans that masquerade as interbank assets, allowing one bank to lend to another indirectly through trust companies and bridge companies. The June decision by the People’s Bank of China to withhold funding (which drove up short-term interest rates and placed pressure on overextended lenders) was widely seen as a shot across the bows of banks most heavily involved in TBRTs.
It remains to be seen if the central bank’s bold move will pay off. In the short term, it nearly proved disastrous, leading to a cash crunch that caused the Shanghai interbank overnight rate to spike to a record 13.4% on June 20 from 2.1% the previous month. Stocks took a beating, with the Shanghai Composite Index slumping by 5.3% on June 25, the biggest one-day drop in almost four years. For a brief moment, Beijing resembled London or New York in September 2008 in the wake of the collapse of Lehman Brothers. Only when the PBoC was ordered to reverse its decision did China avoid a run on its wheezing lenders.
Yet the PBoC clearly felt it had to do something about TBRTs. This is a fast-growing market: in an April research note, Hong Kong-based CIMB analyst Trevor Kalcic estimated that total outstanding TBRT loans stood at Rmb1.7 trillion at end-2012, up 35% year on year.
Kalcic warned that the “strong[est] growth in TBRT balances” was seen at smaller lenders. Interbank assets tend to be lower at big state banks, ranging from 7% at ICBC to 10% at BoCom, rising sharply among second-tier or city commercial banks, with levels highest at China’s sole privately owned lender, Minsheng (33%) and at Huaxia Bank (24%) and Shanghai Pudong Development Bank (21%).
Regulators have started in recent months to show their teeth over these products. While TBRTs and foreign-currency interbank entrusted payments (IEP) remain legal, renminbi-denominated IEPs and repo transactions with rural cooperatives have been outlawed.
Yet when it comes to many far more nebulous and risky shadow products, regulators are, as yet, nowhere to be seen. Take entrusted lending (EL), which involves the largest SOEs effectively channelling capital directly to one another. Banks are almost an after-thought here, used purely to guarantee or ‘entrust’ a loan as it passes fleetingly through its virtual hallways.
EL makes a perverted sort of sense – after all, big SOEs across, say, the chemicals or telecoms sectors probably know companies in their supply chains better than any bank ever could. But this further undermines banks, which are in effect verifying and supporting their own disintermediation.
“Corporate deposits are leaving the banking sector, which is a huge issue in itself,” says the Beijing-based management consultant. “And why China thinks it’s a good idea to let their corporates lend to each other is beyond me.” This imparts the sense that the banking system is being absorbed into the grey market even as the latter quietly bypasses it. “The membranes between grey market and banks are very porous,” notes Matthew Lowenstein, an analyst at J Capital Research. “This is another facet of grey-market lending that too few people are talking about.”
Another disconcerting development is the rise in the power of SOEs’ internal finance companies. These bodies, effectively internal treasury divisions, would at any normal global corporate be a cost centre, not a profit centre. Yet at many leading SOEs they are starting to act as de facto internal financing operations. The Beijing management consultant recalls seeing a Chinese trust company take a 20% stake in the internal finance company of a leading SOE. “I was baffled, until I realized that these finance companies were acting as a conduit for TBRT business,” he says. “It was a very disturbing moment.”
Strange indeed – but then these are strange times in the People’s Republic. Troubled state firms propped up by subsidies and lending to one another; an increasingly disintermediated banking sector, plodding and unwieldy, lacking the intellectual rigour to compete in a more complex financial world; and shadow finance products, innovative and creative, growing and metastasizing, leaking into every unattended corner of the world’s second-largest economy.
And a slowing economy at that. One thing here is clear: a golden economic era is now coming to a close. “Our base-line scenario is an ongoing sustained slowdown for the next five to 10 years,” says the TCB’s Polk. Andy Rothman, Shanghai-based China macro strategist at brokerage CLSA, adds: “We need to get used to the fact that the boom is over. The days when you could just roll out of bed and make money, or the days when you could expect that the growth rate for most things was going to be faster next year – that’s done. Every year, most major economic data points are going to be growing more slowly.” Are Beijing or its backward banks ready for this brave new world? It seems unlikely.