An analysis of China's four specialized state banks reveals an exceedingly fragile financial state. By western banking standards, these banks, which represent the bulk of China's banking system, appear technically insolvent. Present banking crises in several Asian countries suggest a thorough examination of China's specialized state banks might help reveal China's vulnerability to similar problems and thus the probability of a financial crisis. Regardless of whether the banks financial state leads to an economic crisis in China, the analysis will offer insight on how the banks have arrived in their present stituation, what reforms are being made by Chinese officials, and what inefficiencies remain.
BACKGROUND
Industrial
and Commercial Bank of China
Bank of
China
People's
Construction Bank of China
Agricultural
Bank of China
CHINESE FINANCIAL SYSTEM
Two
Tiered System
Monetization
PRESENT
SITUATION/IMPLICATIONS
Banking Crisis or Banking Distress?
Current
Required Standards
Bank
Capital
Non-Performing
Loans
Provisioning
Growth
in Lending
Policy Lending
Profitability
Bank of China
-credit profile
-financial analysis
-financial conclusion
RECENT REFORMS
Recapitalization
Credit Management
Other
Measures/Reforms
INTRODUCTION:
The recent currency crises
in Asia have revealed the frailty of banking systems in developing economies
regarded as the most robust and fastest growing in the world. The
inefficient allocation of credit to banks and enterprises over many years
lead to a troubling and underestimated abundance of non-performing assets.
When liquidity in these countries was shut off due to external currency
crises, which were initiated by the global market’s realization of internal
problems, banking systems collapsed under the weight of bad debt and other
inefficiencies. “Bubble” economies burst and financial crisis spread.
In China, the majority of
the banking system’s assets are concentrated on the balance sheets of four
“specialized” state commercial banks. These four banks, which have
executed the credit allocation plans of the state for many years, continue
to provide financial resources to ailing state-owned enterprises (SOEs)
and other unprofitable entities. As non-performing loans to these
and other businesses in China proliferate, and maturing debt and working
capital requirements are rolled over, a potentially crisis-inducing amount
of bad debt festers on the balance sheets of these four banks. Indeed,
academic and professional estimates are that non-performing loans are 20
percent or more of the combined assets of the specialized banks.
Technically, these banks are insolvent, yet they continue to operate.
An analysis of these four
specialized banks will attempt to reveal how serious their situation is,
given prevailing academic and financial professional opinions regarding
the health of a bank and the elements of an unsound banking system.
The financial status of these banks will be addressed, as will their background
and government policies that have greatly contributed to their present
situation. An opinion on the health of the banking system will
be proffered, as will an analysis of current government actions attempting
to rectify the underlying problems.
China’s four specialized banks operate under the State Council and the central bank in designated or specialized business activities or industrial sectors in China. These four banks are 100% state-owned and their responsibilities include:1
1)
operate as viable, profitable business institutions under the fundamental
regulations of financial businesses
2) grant loans to SOE’s under the state’s policies and plans
3) borrow and lend funds at interest rates controlled by the central bank
4) administer the transfer of funds in the economy
5) facilitate credit and settlement transactions
6) supervise the wage funds and cash management of enterprises with account
relationships
7) control the working capital of SOEs
8) handle international financial business and foreign exchange with central
bank oversight
The four banks operate under the supervision of the central bank and are subject to penalty if they fail to execute its directives.
THE INDUSTRIAL AND COMMERCIAL BANK OF CHINA
The Industrial and Commercial Bank of China (ICBC) was established on January 1, 1984, under the approval of the State Council. Its mandate is to handle urban industrial and commercial credit, savings, and settlements within the People's Bank of China (PBOC). The ICBC’s statute specifically states the bank is to “ support development of industrial production and enlargement of commodity circulation, to promote technical innovation and progress and to render service to the modernization of China’s socialist construction (ICBC, 1984).”2 The ICBC is headquartered in Beijing and maintains branches throughout China. It handles the following types of domestic business:3
1)
deposits of industrial and commercial enterprises, public agencies, and
individual enterprises
2) savings deposits of citizens, consumer loans
3) loans for the working capital, fixed asset, and research and development
requirements of enterprises
4) transfer settlement, cash settlement, commercial paper acceptance, and
bill discounting
5) entrusting, acting, leasing, investing, advisory businesses
6) issuance of bonds and other securities
The ICBC does conduct some
international financial business, including foreign exchange transactions.
The bank’s primary focus continues to be to provide working capital and
other financial services for China’s industrial enterprises. The
bank encourages the development of these enterprises by means of favorable
policies such as preferential loans and priority processing and settlement.4
BANK OF CHINA
The Bank of China (BOC) was
established in 1912 by the government and a group of Shanghai merchants.
It was brought under the control of the PBOC in 1949, and later assumed
its role as a foreign exchange and foreign trade bank. The BOC handles
all aspects of the foreign exchange business, including:5
1) foreign trade and non-trade settlements
2) international interbank deposits and loans
3) overseas Chinese and other international remittances
4) foreign currency deposits and loans, domestic currency deposits and
loans in regard to foreign exchange business
5) foreign exchange transactions and international gold transactions
6) trust business and consulting
7) syndicated loans
8) issuing eurocurrency bonds and other securities authorized by the state
9) investment in Hong Kong, Macao, and foreign countries or jointly managing
banks, financial companies
The BOC dominates the banking business in international transactions for China, trade and project finance, bilateral and syndicated loans, euroloans and bonds. The bank traditionally held a monopoly position in foreign exchange and international transactions, though this position has gradually weakened due to the increased presence of other specialized and foreign banks. The BOC maintains a significant foreign presence, with offices in New York and London.
THE PEOPLE’S CONSTRUCTION BANK
OF CHINA
The People’s Construction
Bank of China (PCBC) was established in 1954 as a center for appropriations,
loans, and settlements for the country’s capital construction.6
Headquartered in Beijing, the bank has both a fiscal and banking role.
Its role as fiscal agent or executor of the state’s capital construction
fund includes:7
1)
distribution of funds, supervision of projects implemented, settlements,
and auditing
2) management of financial accounts for capital construction, examining
and approving annual financial plans and
budgets, controlling financial outputs, and drafting financial management
regulations for the state
3) management of financial accounts of construction and installations and
enterprises
4) management of budgetary estimates, settlements of construction projects,
settlements of accounts,
examining the budgetary estimates of construction enterprises and projects
5) management of financial accounts of geological-prospecting activities
The PCBC’s banking role developed in the 1980’s as budget allocations declined relative to the demand for capital construction and the bank became a manager of credit as state transfer payments were changed to loans.8 The bank does maintain relationships with foreign banks and manages foreign currency denominated deposits, loans, and remittances.
The Agricultural Bank of China (ABOC) was separated from the operations of the PBOC in 1979 to be solely responsible for financing agricultural development. Though its headquarters are in Beijing, the bank maintains over 50,000 branches and offices in provinces and municipalities. Its primary functions include:9
1)
handling deposits from rural government institutions, enterprises, individuals,
and other organizations
2) providing loans to state-owned agricultural enterprises, collective
organizations, and farm households
3) handling deposits and loans of rural credit cooperatives
4) handling transfer and cash settlements and bill discounting
5) providing trust, lease, and consulting services
6) issuing bonds and trading in securities
7) handling any business stipulated by the state or entrusted to it by
the PBOC
The ABOC’s international business is focused on soliciting and implementing project finance from multi-lateral institutions such as the World Bank, Asian Development Bank, and the International Agricultural Development Fund. It has considerable foreign exchange transactions business and relationships with numerous foreign banks.
CHINESE FINANCIAL PLANNING
SYSTEM:
An analysis of monetary
policy in China is necessary to understand how credit and financial resources
have been allocated through the banking system and, consequently, how the
system has arrived at its present state. Indeed, the effect
this monetary system has had on the financial status of the four specialized
banks is profound and its examination will facilitate a more specific financial
analysis of the four banks.
Typical of centrally planned economies, China operated under a monobank system until reforms began in 1979. This centralized system relied on a system of direct controls that are predicated on separating production and consumption activities through the use of different monies. On Kit Tam (1995) points out that cash transactions are restricted primarily to the household sector for income and consumption, and transfer money (bank deposits operable primarily through transfers between accounts) to the non-household sectors for all inter-enterprise and inter-government transactions.10 This is an essential aspect of the monobank system for it establishes a dual-money or two-tiered system where the use of cash is restricted to one sector. The reform of this dual-money system is of paramount importance to China if it is to establish a modern and efficient banking system. Yet, since reforms began in 1979 and have accelerated through today, elements of this dual-money system persist. For example, consumers remain reliant on savings accounts and cash transactions. Consumer credit services in China are minimal; credit cards are rare, with debit cards being more common. Checking accounts and home mortgage financial services are also undeveloped.
On Kit Tam stresses that this monetary segmentation undermines the fundamental basis through which market-based economic calculations and transactions are made. The development linkages between savings and investment, and among households, enterprises and the government are thus distorted and impaired.11 While the major functions of money in a market economy are as a unit of account, as a medium of exchange and as a store of value, in the Chinese financial planning system the two segmented monies each do not fulfill those functions.12 These two monies (cash and transfer payments) are not substitutes.
Pre-reform the government
focused on controlling the cash in circulation as well as allocating bank
credits (loans) to support industrialization and agricultural development.
These transfer payments were strictly regulated, primarily used as investment
in fixed assets and working capital by SOEs. Indeed, these credits
were allocated based not on the level of bank deposits or reserves, but
rather on the development plans of the PBOC and state. As Gang Yi
(1994) asserts, the basis for credit is that every bank is owned by the
government, thus it is impossible for one of them to go bankrupt.
There is no credit in the form of collateral or a mortgage. If a
large number of SOEs (debtors) default on loans to a specialized bank (creditor),
the bank (debtor) has to default on its obligations to the central bank
(creditor).13
Thus when the assets and liabilities of the banking system changed (loans
to SOEs and deposits from the PBOC) the assets and liabilities of the central
bank changed as well (loans to the specialized banks and liabilities to
the Ministry of Finance and member banks).
MONETIZATION
With the onset of reforms,
changes to the two-tiered system have occurred. The unmanageable
(from the PBOC’s point-of-view) increase in household deposits as a percentage
of total deposits greatly restricts the PBOC’s ability to control the flow
of credit as these funds can be autonomously loaned out in the form of
cash by the banks. This more market-based approach to credit,
attracting longer-term deposits with favorable interest rates and realizing
growth in assets in the form of enterprise loans without the control of
the PBOC conflicts with the transfer payment and credit allocation approach
of the state. Thus the two-tier system is broken down and the central
bank weakened by the free market operations of the four banks.
Cash is now extended into the realm of production and investment and further
into the deposits of such enterprises; the process continues through
the multiplier and the economy is gradually monetized (Table 1).
Gang Yi (1994) asserts the reasons for this increase in monetization include:
the swift increase in free market reforms have lead to the rapid development
of self-employed and private businesses, the emergence of profitable and
efficient township and village enterprises (TVEs), and the introduction
of the responsibility system in rural agriculture bringing millions of
farmers in to the commodity marketplace. These lead to the increase
in the transactions demands of households and firms and the increase in
cash as a unit of payment.
Table 1: Indicators of Monetization in China (RMB
Billions)
| Borrowing from the Central Bank (PBOC) | Total Lending | Borrowing from PBOC as a percent of total lending | |
| 1986 | 268.2 | na | na |
| 1987 | 275.65 | na | na |
| 1988 | 336.12 | 1,024 | 32.8 |
| 1989 | 416.33 | 1,206 | 34.5 |
| 1990 | 508.29 | 1,476 | 34.4 |
| 1991 | 590.56 | 1,760 | 33.5 |
| 1992 | 670.99 | 2,108 | 31.8 |
| 1993 | 961.26 | 2,587 | 37.2 |
| 1994 | 697.23 | 3,283 | 21.2 |
| 1995 | 680.23 | 3,907 | 17.4 |
The above table indicates the increasing use of deposit liabilities in lending by the state banks, particularly in 1994 and 1995. By relying on primarily cash-based household and business deposits for a greater portion of their lending, the state banks greatly contribute to the gradual monetization of China.
Eventually, the market instead
of the state credit plan becomes the more important allocative mechanism
in practice. Consequently, the tool of the centralized system of
transfer payments is no longer there.14
Yet the traditional credit allocation plan of the state and PBOC
persists, affecting the balance sheet of the banking system. Indeed,
as On Kit Tam notes, the banking system is still required to ensure funding
and maintain the survival of SOEs and to provide loans to designated projects
or enterprises under the government’s industrial policy. Unfortunately,
with respect to the ability of the state banks to remain viable and profitable,
this situation is exceedingly deleterious. The financial analysis
which follows reveals alarmingly this problem.
PRESENT SITUATION/IMPLICATIONS:
Banks are vulnerable to market failures resulting from asymmetries of information. On the asset side, they assume the risk of valuing projects and funding borrowers whose ability to repay is uncertain. On the liability side, the confidence of creditors and depositors who have imperfect information on the bank’s well-being is essential to a bank’s ability to provide financial services.15 Illiquidity, excessive gearing, non-performing loans, poor management, government intrusion and weak oversight may lead to a loss of confidence in a bank and a run on deposits; the resultant domino effect of bank failures has serious negative externalities for an economy. The potential for such crises demands a thorough ex-ante analysis of a banking system’s relative health. In China, such an analysis, though difficult and inexact, can provide valuable insight into the probability of financial crisis for the world’s most populous nation.
BANKING CRISIS
OR BANKING DISTRESS?
Before characterizing the
Chinese banking system as one of incipient collapse or merely one of structural
weakness and distress, it is necessary to provide definitions of “crisis”
and “distress” and the sources of each. Sundararajan and Balino (1991)
provide some sample definitions of a financial or banking crisis:16
Macroeconomic evidence of an insolvent banking system might include excessive credit growth relative to GDP, rapid rises in asset prices along with an increased risk exposure, and financially and operationally fragile enterprises with high gearing (debt/equity), low profitability, and increased competition.20 Unfortunately, there are no benchmark indicators that will forewarn accurately of insolvency or a financial crisis. While macroeconomic variables may be similar among crises, no breakpoint exists in the data. For countries such as China, where transparency and accurate data are limited, the analysis is more inconsistent. Perhaps, as Michael Camdessus (1996) suggests, the lack of transparency, poor supervision, weak management, and excessive government involvement are the most important warning signs for they greatly distort incentives to clean up and prudently regulate banking systems.21 All of these elements are present among the four specialized banks in China.
Since the Commercial Bank Law of 1994, the state has required commercial banks to maintain capital adequacy standards mandated by the Basle Committee of Bank supervisors. This capital to risk adjusted assets ratio must be at least 8 percent. The Commercial Bank Law also requires all commercial banks to control their total loans at or below 75 percent of total deposits, with some flexibility.22 Liquid assets must be at least 25 percent of liquid liabilities and lending to any single borrower must be limited to 10 percent of total capital. Also, a bank’s overdue loans and bad loans cannot exceed 8 percent and 2 percent respectively of its total loans.23
BANK CAPITAL
Bank capital consists of
its owner’s equity in the form of retained earnings, paid-in-capital, and
reserves held at the central bank. The Chinese state is the sole
shareholder in the four state banks. Currently, bank capital as a
percentage of total assets does not meet the Basle standard of 8 percent
at any of the four state banks. Indeed, this ratio has weakened
over the years (Table 2).
Table 2: Risk-Weighted Capital Adequacy of the Specialized
Banks
| Industrial and Commercial Bank | Agricultural Bank of China | Bank of China | People's Construction Bank of China | |
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6.81% | na | 5.59 | 11.17 |
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5.45 | na | 7.2 | 9.75 |
|
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5.48 | 7.49 | 6.72 | 8.72 |
|
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5.35 | 6.41 | 6.69 | 7.4 |
|
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5.13 | 5.50 | 6.31 | 6.32 |
|
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6.57 | 4.10 | 5.35 | 4.79 |
|
|
5.7 | 6.95 | 7.37 | 4.31 |
While additional paid-in-capital must come from the state, growth in
profits should result in growth in retained earnings, and thus a stronger
capital base. However, the relative profitability of the four state
banks has weakened as well (Table 3). Growth in retained earnings
has significantly lagged growth in assets (loans) at the banks, thus further
debilitating the capital adequacy ratio. This is also an indication
that the quality of loans has deteriorated, leading to lower growth in
profits.
Table 3: Pre-Tax
Income of Specialized Banks
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The presence of an alarmingly high amount of non-performing assets as a portion of total assets is perhaps most threatening to the four banks and is also very difficult to accurately ascertain. Though information on the actual extent of non-performing loans is scarce and unreliable, the amount is estimated to be between 20 and 30 percent of total loans outstanding. As Nicholas Lardy (1997) notes, loans are classified in China in three ways:24
1)
Past Due Loans – loans not repaid when due or not repaid after the due
date has been extended.
2) Doubtful Loans – loans that have been past due two years or more or
loans that have been extended to a borrower
who has suspended production or whose project is no longer being developed.
3) Bad Debt – the value of loans that have not been repaid after the borrower
has been declared bankrupt and
gone through liquidation.
These classifications contrast sharply with western banking standards, where loans are classified as delinquent if interest or principal is past due for 90 or 180 days. In addition, when banks classify a single loan as past due they must classify as such the entire amount of loans extended to that particular borrower.25 Chinese practice classifies as past due only the fraction of the single loan that is delinquent, greatly understating the value of total past due debt. Furthermore, the bad debt classification significantly postpones the full write-off of a bad loan against the bank’s income until the entire liquidation process has been completed, which can take many years. In China, debtors, particularly SOEs, are allowed to borrow further to pay present interest and principal payments. This interest capitalization process preserves the earnings of banks and the healthy status of loans as long as liquidity is available.
PROVISIONING
The PBOC has dictated that
banks may not classify more than 2 percent of all loans as “bad debt” and
no more than 5 percent of loans as “problem loans,” regardless of the current
state of a bank’s asset portfolio. Nonetheless, China’s specialized
banks still need to provide for these non-performing loans by setting aside
reserves. This can be done in two ways. First, reserves must
be set aside for existing non-performing loans; these reserves must over
time equal the nominal value of the loans so they may be completely written
off.26 Second,
loan loss reserves can be provided as a buffer against further loan losses.
Currently, provisions for non-performing loans by the four state banks are minimal. Lardy asserts this is due to political concerns. The PBOC is interested in preserving the integrity of the banking system, which implies that banks be required to adequately provide for non-performing loans.27 Yet proper provisioning would greatly reduce banks’ gross earnings, in turn reducing the income taxes paid to the Ministry of Finance. Therefore, the Ministry of Finance prefers limited provisioning to preserve the earnings of the banks, and thus income taxes paid. Indeed, current Ministry of Finance regulations stipulate that banks set aside only 1% of their capital as loan loss reserves. Not surprisingly, information on the amount of current provisioning by banks is unreliable.
GROWTH IN LENDING
Table 4: Total Lending by Financial Institutions in China
(RMB Billions)
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The lending data from Table 4 likely underestimates the growth of credit in the reform period for banks have an incentive to avoid reporting new loans in the effort to comply with lending quotas prescribed by the central bank. Nicholas Lardy (1997) describes the ways in which the four state banks have hidden the extension of credit, including: repurchase agreements, discounting, trust loans, and “other assets.” Repurchase of financial assets is the extension of credit by banks in exchange for government bonds or other financial assets owned by enterprises.28 Discounting is the extension of working capital by banks to enterprises in exchange for the future accounts receivable from sales, purchased at a discount by the banks. Banks are not required to report their discounting and repurchase agreements as loans. Trust loans include the management of funds on deposit (entrusted) at the bank; the bank in turn lends these funds according to an agreement with the depositor. In 1995, trust loans were equivalent to 14 percent (RMB 550 billion) of the regularly reported lending by the specialized banks. Finally, loans can be categorized on the banks’ balance sheets as “other assets,” the details of which are not revealed. By 1995, “other assets” had increased from 1 percent of the four banks’ assets to 3 percent, or RMB 253 billion.29
POLICY LENDING
The allocation of credit
according to the policy mandates of the state, though decreasing, is still
prevalent at the four state banks. As Lardy notes, banks are required
to support government objectives, primarily through the extension of credit
to “strategic” industries or the continued subsidization of unprofitable
SOEs. Funds earmarked by the State Planning Commission flow through
the PBOC to the four state banks; these funds amounted to RMB 268
billion in 1985 and grew to RMB 960 billion by 1993, roughly one-third
of their total lending.30
What is most alarming is that the output of these SOEs as a percentage
of China’s GDP has been steadily decreasing, though the massive provision
of credit continues. Loans are also extended at the behest of local
and provincial government officials, though these are financed with short-term
household deposits. Indeed, policy lending represented over half
of the lending of the state banks and one-half of this lending was provided
by the PBOC. Loan quotas on regional lending are also imposed by
the Planning Commission and PBOC to redirect credit to less-developed regions;
as noted earlier, these quotas are frequently violated by the four banks.
PROFITABILITY
Profitability of a bank
can be analyzed with a number of accounting measures, including return
on assets (operating income/total assets), return on equity (net income/equity),
and the spread between the interest paid on deposits and the interest earned
on loans. While nominal profits of the four state banks have grown
consistently through the 1990’s, relative profitability has weakened (Table
3). Nicholas Lardy (1997)
asserts that the stated profits of the specialized banks are misleading
as the banks overestimate net earnings in a number of ways. First,
as aforementioned, provisioning for non-performing loans is inadequate
and thus grossly overstates earnings, as proper write-offs should be deducted
from pre-tax income.31
Indeed, provisions in 1995 of even 1 percent of loans would have reduced
return on assets by 25 percent. Second, deposit insurance premiums
do not exist in China. Generally, these pre-tax expenses range from
.25 percent to 1 percent of deposits. In China, had contributions
of .2 percent of deposits occurred in 1994, pre-tax earnings would have
decreased by 18 percent.32
Third, income statements for Chinese banks do no properly charge interest
expense against earnings. Banks charge this expense on a cash-basis;
only when the actual interest is paid, which is at maturity on a time deposit,
does it affect earnings. Banks instead should book the expense on
a annual basis. Ironically, in times of inflation when depositors
shift to higher interest rate and longer-term deposits, cash interest expense
for the banks is delayed further, thus improving short-term profits.
Fourth, the practice of capitalizing interest payments, called “evergreening,”
greatly distorts banks’ income statements as debtors pay maturing interest
and principal with new loans, enabling banks to book the earnings.
This practice is widespread in China, but the exact extent is unknown.
Fifth, off-balance sheet investments, many of which are in loss making
trust and investment companies or securities dealers, are not shown in
consolidated financial statements.33
BANK OF CHINA
A specific analysis of one
of the four state banks’ financial statements will provide insight into
the severity of the banks' situation, though the reliability of the financial
statements is questionable.
As China’s second largest
bank, the Bank of China functions as the leading conductor of international
financial business and maintains 525 overseas offices in 19 countries and
territories around the world. It frequently accesses the international
capital markets through the issuance of a range of Eurobonds, Samurai Bonds,
Yankee Bonds, and Asian bonds with maturities extending out to 20 years
and priced with a spread only slightly higher than Chinese sovereign debt.34
The Bank of China, given its global exposure, is regarded as being the
most technologically advanced of the four state banks in China in terms
of systems development and modernization. Management asserts it is
focusing the bank towards more profitable investments, such as investment
banking and retail banking in Hong Kong, and away from traditional policy
lending. The Bank of China is the most profitable of the four state
banks and generally regarded as the healthiest.
Credit Profile
Table 5: Credit Ratings of Specialized Banks
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| Agricultural Bank of China |
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| People's Construction BOC |
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| Industrial and Commercial BOC |
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| Bank of China |
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The Bank of China is rated
Baa1 by Moody’s and BBB by Standard & Poor’s. Its credit profile
is based on the depth and diversity of its local and international assets
and China’s supportive regulatory environment - i.e. the assumption
that the Chinese government would back up the bank’s liabilities in a time
of crisis. Measures that effect its credit rating include profitability,
asset quality, and capital adequacy.35
The financial analysis that follows indicates that these relative measures
of health are very poor; clearly, the credit of the Bank of China,
from the international capital markets’ point-of-view, is backed by the
treasury of the Chinese government.
Financial
Analysis
In 1996, operating income
as a percentage of total assets, effectively the Bank of China's business
return, is exceedingly low (.78%). Net return on assets, or net income/total
assets, is a meager .36%. This low profit level suggests the bank
would realize net losses if it began to write off its bad debts on the
income statement. Indeed, if the Bank of China were to write off
only 1% of its total loans for 1996, the bank would have realized a net
loss. Not surprisingly, the 1994 to 1996 income statements show virtually
no provision for doubtful debts (or only insignificant amounts), explaining
the bank’s ability to earn a net profit. Data on loan loss reserves
are unreliable; however, even if the loan loss reserves of 2.44%
of total gross loans reported by the Bank of China in 1996 is accurate,
it is still vastly inadequate. Correspondingly, the equity/total
assets ratio indicates the bank likely has insufficient capital against
which it can absorb net losses (negative equity). Therefore, if as
estimated non-performing loans represent 20% of assets, and were they properly
accounted, it would lead to insolvency. Other measures point to the
non-performing loan situation, including growth in assets (loans) versus
growth in profits. Growth in assets averaged roughly 7.7% from 1993
to 1996, while growth in net profits averaged only 1.5%. This suggests
either a decrease in loan quality or in net interest margin, yet net interest
margin slightly improved (4 basis points) from 1994 to 1996.
The Bank of China’s weak
profitability measures coupled with insufficient capital reserves and exacerbated
by Nicholas Lardy’s examples of how
state banks overestimate income lead to a dire financial conclusion;
the Bank of China is virtually insolvent. Take this a step further.
Given the Bank of China’s reputation as the healthiest and most profitable
of the four state banks and making an assumption regarding the ICBC, ABOC,
and PCBC, the state banking system in China is technically insolvent.
This assertion comes as
no surprise to banking officials and government leaders in China, particularly
Zhu Rongji. Therefore, it is necessary to examine some recent reforms
undertaken by the state and PBOC and aimed at mitigating the problems of
the state banking system and gradually improving its financial situation.
RECENT REFORMS:
On March 1, 1998 the National
People’s Congress Standing Committee approved a plan to allow the Ministry
of Finance to issue Rmb 270 billion (US$ 33bn) worth of special treasury
bonds to recapitalize the four state banks. This action is meant
to not only improve the capital adequacy ratio of the four state banks,
but to serve as an injection of liquidity into the Chinese economy.
This decision follows a February 25 order from Beijing for state banks
to lend based on borrowers’ ability to repay. Banks are now to lend
according to contemporary risk assessment techniques and not according
to government directives or relationships between bankers and state owned
enterprise officials. These two actions, the capital injection and
the instruction on credit management, represent an major initiative spearheaded
by Zhu Rongji to change the banking system. In effect, the banks
are being forced to change their lending policies in exchange for a considerable
injection of capital to deal with current non-performing loans and provide
liquidity for future loans. The details of this initiative
provide insight into the potential for success or failure of broad based
banking reform in China.
Given estimates of non-performing loans for the Chinese state banks at 20 to 30 percent of assets, or more than $200 billion, the $33 billion capital injection represents only a first step. Though details of the recapitalization plan are few, the tools at the disposal of the central bank for injecting liquidity into the state banking sector are limited. These include: a change in the required reserve ratio, a change in the discount rate, and open market buying and selling of government securities. Xu, Pinkel, and Currimbhoy (1998) suggest the following steps are likely; these essentially result in the changing of the reserve ratio through the issue of special treasury bonds by the Ministry of Finance.
1) Reduction in the required reserve ratio.
The government has said the special treasury bonds will be sold mainly
to the major commercial banks. However, aggregate cash holdings at
the four state banks as of the end of September 1997 amounted to only $8
billion, while the bond issue is for $33 billion. Thus the People’s
Bank of China (PBOC), who holds these reserves, must free up more funds
for the banks to buy these bonds by lowering the required reserve ratio.
The ratio currently stands at 13%, on top of which is an additional 7%
mandatory reserve ratio, implying a total effective reserve ratio of 20%.36
To release enough cash to buy the bonds, the PBOC must reduce the reserve
ratio from 20% to at least 14.5%, thus effecting the following changes
on the aggregate balance sheet of the four state banks (Table 6).37
Table 6: Impact on Balance Sheet of Cut in Required Reserve
Ratio (US$ Billions)
| Required Reserve Ratio: 20% | Required Reserve Ratio:14.5% | ||||||
| Assets | Liabilities | Assets | Liabilities | ||||
| Reserves | 119 | Deposits | 596 | Reserves | 86 | Deposits | 596 |
| Cash | 8 | Equity | 25 | Cash | 41 | Equity | 25 |
| Loans | 645 | Others | 201 | Loans | 645 | Others | 201 |
| Others | 50 | Others | 50 |
2. Ministry of Finance issues debt.
The special bonds would then be issued to the four state owned banks
who would use their increased cash to acquire the $33 billion worth of
bonds. This would represent a transfer of a cash asset to bond asset
on their aggregate balance sheet, with no assumption of new liabilities
(Table 7).38
Table 7: Impact on Balance Sheet of Bond Placement
(US$ Billions)
| Reserve Ratio: 14.5% | Reserve Ratio: 14.5% | ||||||
| Assets | Liabilities | Assets | Liabilities | ||||
| Reserves | 86 | Deposits | 596 | Reserves | 86 | Deposits | 596 |
| Cash | 8 | Equity | 25 | Cash | 41 | Equity | 58 |
| Loans | 645 | Others | 201 | Loans | 645 | Others | 201 |
| Bonds | 33 | Bonds | 33 | ||||
| Others | 50 | Others | 50 |
3. Ministry of Finance injects the same amount ($33 bn) as new capital.
The Ministry of Finance could then take the $33 billion raised from the special bond issue and inject fresh capital into the banks.39 The banks’ aggregate equity would increase by the same amount ($33 bn), as would their cash holdings (Table 7).
This simultaneous transaction will effectively change the required reserve ratio for the state banks from 20% to 14.5% and result not only in a boost to their cash assets, offset by the reduction in their required reserve assets, but also an increase in new bond assets offset by their increase in aggregate equity. This would allow the banks to provide new loans and, via the multiplier, inject liquidity into the Chinese economy. They will also be able to write off existing non-performing loans. The benefits can be more easily seen through the banks’ income statement.
Income Statement
The banks will earn a return
on the $33 billion in cash by loaning it out to customers. In addition,
the $33 billion worth of bonds will provide an annual yield, while the
offsetting equity, effectively owned by the government, has no cost.
Thus earnings will increase due to interest income from new loans and from
the special treasury bonds. The banks will then be able to make higher
provisions for bad debt in the their income statements without experiencing
massive losses. Depending on how much of the $33 billion is written
off, the banks should continue to earn a net profit. The bottom line
has been unaffected, while the non-performing loan problem has been mitigated.
Indeed, without the capital injection and with the provision for bad debt
in the income statement, the banks would experience considerable net losses
(and no taxes paid to the Ministry of Finance), which would result in negative
equity. Given that current aggregate equity is only $8 billion, and
estimated bad loans are at $200 billion, the banks are unable to absorb
the provision and avoid bankruptcy.
Balance Sheet
An analysis of the banks’ balance sheet (Table 7) after the transaction reveals a healthier situation. The assets-to-equity ratio will decline from 32.9 to 14.7. The liquidity position of the banks is improved as cash and marketable securities assets have increased with no offsetting cost. The excess liquidity ratio, cash and marketable securities over total deposits, will increase from 1.3% to 12.4%.40 The increased equity, which will be owned by the Ministry of Finance and is cost free, also bolsters the balance sheet as an increase in bank capital.
Yield Curve
The effect on the yield curve in China would be positive as well. The yield curve should steepen due to the increased issuance at the long end (the special treasury bonds) and the increased liquidity at the short end (cash available for loans). The absolute effect is uncertain, as the amount is only $33 billion, but opposite pressure at both ends will exist. A steeper yield curve will help the banks’ profit margins, for they are paying short rates on liabilities (deposits) and lending in the mid-to-long end, as well as earning long rates on the special treasury bonds. Better profit margins will increase operating profits.
Benefits/Costs
By boosting their operating profits the recapitalization plan allows the state banks to provide for more non-performing loans in the income statement. Subsequent net profits aid the health of the banks’ balance sheet by bolstering their equity base, a cushion against future provisions for bad loans and potential net losses. The bond assets held by the banks will result in operating income and provide a liquid asset which can be sold should more cash be needed. The steepening yield curve also bolds well for profits as banks pay short and lend long. The increase in cash will have a positive impact on Chinese economic growth through the multiplier effect as the $33 billion is lent by the banks.
However, as the $33 billion represents only a first step in the recapitalization of state banks, expectations of further capital increases puts further upward pressure on the long rate and increases the borrowing costs of the government. Government revenues must therefore be raised to cover the costs of capital injections. Ultimately, Chinese taxpayers will pay for the bailout of the state banks.
To prevent the repetition
of past inefficient capital allocation and thus squandering the capital
injection, Zhu Ronji has ordered banks to overhaul their credit management
by the end of the year. Banks are to implement modern risk assessment
techniques when analyzing potential borrowers. These will include
the adaptation of international loan classifications; loans will
be assessed under five categories instead of the present three.41
A precursor to this order by Zhu Rongji was the December 25 announcement
by the People’s Bank of China that China will abandon the annual lending
quota system for the state commercial banks, effective Jan. 1, 1998.
Thus banks will no longer be required to lending a certain amount of funds
annually, primarily to state owned enterprises, nor will there be a ceiling
on lending in certain market segments or geographic regions.
In the future, banks will
need to strike a balance between their funding and lending activities.
They will have greater autonomy in lending funds, but the PBOC will continue
to issue guidelines with respect to lending volume.42
The PBOC will have to take an active role in overseeing the implementation
of new credit analysis techniques. Banks must remain in compliance
with previously outlined National Lending Rules from August 1996.
These include:43
Bank Rights and Responsibilities:
OTHER MEASURES/REFORMS
Over the past 18 months
state officials have taken various measures to improve oversight of the
state banks. In 1997 the Ministry of Finance injected $3.6 billion
into the banking system to help banks writer off loans to SOEs. In
November 1997, the PBOC announced plans to establish a special board of
supervisors to monitor the performance of the state banks. The board
will be responsible for evaluating the quality of the banks’ assets and
to oversee the management practice of top officials at the four banks.
In addition, special boards will be established at each state bank with
the sole purpose of monitoring the bad loan situation.
On April 14, 1998, the PBOC instructed state banks to classify loans in accordance with Basle standards. This constitutes a profound change to the financial reporting of state banks and perhaps signals a more candid admission of the bad debt problem by state officials.44 Likely, this will be followed by further asset injections, enabling the state banks to begin to recognize non-performing loans in their financial statements.
CONCLUSION:
An argument exists that
the technical insolvency of the four state banks is unjustified, for they
should not be analyzed in accordance with western standards. Some
economists assert that the state banks can not be separated from the state
treasury. Andy Xie (1997) states that serious independent commercialization
of the four banks can not occur until state enterprise reform has been
mostly completed. As these banks are commercialized, the government
will have to assume most of their non-performing loans; this becomes
part of the price the government has to pay for SOE reform.45
Liquidity concerns that could cause a greater economic crisis should therefore
be traced to the solvency of the central government, and not of the state
banks. Presently, China’s debt appears manageable at 33 percent of
GDP and economic growth near 10 percent. While SOE reform, and thus
banking reform, will put downward pressure on revenues and upward pressure
on expenditures, it does not appear to be crisis inducing.46
Looking Forward
Thus the question remains
as to whether the apparent insolvency of the Chinese banking system will
unavoidably lead to a greater financial and economic crisis, like those
of its Asian neighbors. With limited capital account convertibility
of the renminbi, an external currency shock is unlikely, as domestic investors
are unable to convert renminbi assets into foreign currency assets and
China has ample foreign currency reserves (over $130 billion). Lardy
(1998) notes that capital inflows from foreign investors primarily are
long-term direct investments, decisions which are not easily reversable.47
An internal shock, characterized by a run on deposits by individuals, appears
equally unlikely, for confidence in the state banks is high. However,
in the face of greater export competition from Asian exporters, a devaluation
of the renminbi could lead to inflationary expectations, increasing interest
rates on time deposits and incentives on the part of consumers to reallocate
their investments away from cash assets and into goods; these factors
could lead to a liquidity crunch.48
Yet, as long as growth in
GDP remains robust and inflation manageable, Chinese officials should have
time to gradually clean up the balance sheets of the state banks, though
not without considerable cost to taxpayers. Banking reform will require
corresponding reform of state owned enterprises, leading to continued upward
pressure on unemployment. Other measures must be pursued by the appropriate
authorities, including the introduction of competition into the banking
system from new domestic banks and foreign banks. The four state
banks continue to dominate the competitive landscape for financial services
and are largely insulated from foreign competition. Interest rates
must gradually be liberalized in step with improvements in the state banks’
balance sheets. Monetization of the economy must continue, with an
increase in the ability of consumers to open checking accounts and consumer
credit accounts. Decision making autonomy and proper credit risk
evaluation must be followed; state mandates in this respect should
no longer be ignored by local government and banking officials.
Without the acceleration of banking reform, made easier in times of economic growth, the probability of a major Chinese financial crisis increases. Until the allocation of capital through the four specialized banks in China becomes more transparent and more competitive, short-term reform will prove futile and financial resources will continue to be wasted on a massive scale.
1) C.R. Dipchaud, Z. Yichun, M. Mingjia, The Chinese Financial System (Westport, CT: Greenwood Press, 1994), p. 47.
2) Dipchaud, Yichun, and Mingjia, p. 51.
10) On Kit Tam, "Monetary Management and Financial Reform," in On Kit Tam, ed., Financial Reform in China (London: Routledge, 1995) p. 5.
13) Gang Yi, Money, Banking and Financial Markets in China (Colorado: Westview Press, 1994) p. 69.
15) C.J. Lindgren, G. Garcia, M.I. Saal, Bank Soundness and Macroeconomic Policy (Washington DC: IMF, 1996) p. 6.
16) V. Sundararajan, T. Balino, "Issues in Recent Banking Crises," in Sundararajan, Balino, eds., Banking Crises: Cases and Issues (Washington DC: IMF, 1991) p. 2.
18) Lindgren, Garcia, and Saal, p. 10.
21) M. Camdessus, "Promoting Safe and Sound Banking Systems: An IMF Perspective," (http:///www.imf.org).
22) Jun Ma, "Banking Reform: From Administrative Control to a Regulatory Framework," p. 7.
24) Nicholas Lardy, "The Evolving Banking System," in N. Lardy, China's Unfinished Economic Reform, 1997.
34) "Bank of China - The Issuers," HSBC Markets, February 11, 1998.
35) "Bank of China - The Issuers," HSBC Markets, February 11, 1998.
36) S.X. Xu, J. Pinkel, S. Currimbhoy, "China's Banks - Bond Plan is a Small First Step," Merrill Lynch & Co., March 6, 1998, p. 2.
41) "China Tightens Lending, to Sell Bonds to Help Banks," Bloomberg Business News, February 25, 1998.
42) "China Abolishes State Bank Lending Quotas," Bloomberg Business News, December 29, 1997.
44) James Kynge, "China's Economy Starts to Slow Down," Financial Times, April 14, 1998.
45) Andy Xie, "Is China Facing a Banking Crisis?" Morgan Stanley Research, October 1997, p. 2.
47) Nicholas Lardy, "China's Precarious Future," Wall Street Journal Interactive Edition, February 5, 1998, p. 2.