[John Lee] Lack of reform at Chinese banks

Washington, D.C. ― The Bank of China was the first of the country’s Big Four to deliver its results late last week, with the others to follow shortly. Profit in 2010 was up 28 percent. The most encouraging figure was the decline in the proportion of nonperforming loans (NPLs) which fell to 1.1 percent, down from 1.52 percent in 2009. Similarly impressive figures are expected for the other Chinese banking giants.

For commentators such as Tom Orlik writing in the Wall Street Journal, this is proof that China’s much maligned banks actually work. Remember that fragility in the banking system is commonly believed to be China’s “Achilles heel.” If so, these current figures tell me that Beijing has barely begun to reform their dominant state-owned banking system.

Let’s begin with a comment about the rise in profit which is the result of a combination of two things. Total bank loans issued by all banks jumped from around $740 billion in 2008 to $1.4 trillion in 2009, before falling slightly to $1.1 trillion in 2010. This means that total outstanding loans in the economy have jumped by around 50 percent over the past two years.

Beijing imposes a ceiling on deposit rates and a floor on lending rates meaning that the spread is 3.06 percent. This is far from the largest in the world, but is generous compared to those in other countries such as the U.S. and Japan where spreads tend to vary between 1 percent and 2 percent. Beijing has increased spreads in Chinese banks from 0.5 percent in 1996 and 2.2 percent in 1998 to the current figure in order to improve the books of its banks. Put simply, the more money China’s dominant state-owned banks lend, the more book profits they make.

The spike in loans is not itself a problem if the money is duly repaid. Falling from ratios of around 20 percent in the 1990s, and around 5 percent only three years ago, the current figure of 1.1 percent seems encouraging. In reality, the low NPL ratio 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 and the majority of these loans go to the approximately 120,000 (about 300,000 if subsidiaries are included) locally state-owned enterprises, 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 to effectively increase their fiscal revenues.

Although there are no comprehensive statistics, 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 even when all evidence suggest few significant improvements in the profitability of local SOEs from a decade ago tells us that something is not quite right with the indicative NPL ratios being released.

Third, an estimated 20-40 percent of these locally owned SOEs are engaged in property development. By (often illegally) seizing or acquiring land, local authorities in cahoots with developers re-classify the land as commercial before building and selling the property to a willing speculative real estate market.

According to some Chinese Academy of Social Sciences reports, local governments receive about half of their revenues from the property sector. In other words, the tax revenue function for local governments in China is largely based 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 will be immense.

Fourth, there is the matter of 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 obscured “other” category on the books of local bank branches. By the time local accounts are sent 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 the banks issuing falling 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 urging against the rollover of loans expiring at the end of 2011.

But Chairman Liu will have an impossible time ensuring that this directive is followed. In a recent conversation with a senior executive at the Bank of China, I asked him how confident he was about top-down policy ― such as a directive about the treatment of loans ― being implemented at the local branch level. Without hesitation and in a matter-of-fact response, he said that 30-40 percent of branches would comply. As for the other branches, no one could be sure.

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

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

By John Lee

John Lee is a research fellow at the Centre for Independent Studies in Sydney and the Hudson Institute in Washington D.C. He is author of “Will China Fail?” ― Ed.