Fragile state of China's financial system

Tue, Nov 20, 2012, 00:00

SERIOUS MONEY:Winston Churchill addressed the British public in a radio broadcast during the autumn of 1939, and declared that Russia “is a riddle, wrapped in a mystery, inside an enigma”. The statesman’s words could well be applied to China today, where years of impressive economic performance have lifted millions out of poverty, and seen the economy become the world’s second-largest – after the US.

However, this rapid development has been fuelled by a fragile banking system that has teetered on the brink following every “great leap forward” in the post-Mao reform period. Indeed, problem loans are virtually certain to surge in the aftermath of the latest lending binge, which started in 2009, and the adverse economic impact could resonate for years.

To appreciate the fragile structure that underpinned China’s rapid growth over the past three decades, it’s important to understand major developments in the banking sector, which effectively is the country’s financial system.

The so-called “Big Four” – the Industrial and Commercial Bank of China (ICBC), the China Construction Bank (CCB), the Bank of China (BOC) and the Agricultural Bank of China (ABC) – still account for 45 per cent of total financial assets, close to 60 per cent of all household deposits, and roughly 50 per cent of the total equity capital in the financial system.

Following the foundation of the People’s Republic of China in 1949, the country’s capitalist network of commercial banks was closed down, and replaced by the state-owned People’s Bank of China (PBOC), which functioned as both a central bank and the nation’s primary commercial bank. The PBOC served as the government’s “lending arm” and disbursed funds to state-owned enterprises according to government fiat.

Reforms orchestrated by vice-premier Deng Xiaoping in 1979 brought an end to the PBOC’s monopoly power, as its commercial banking functions were gradually removed through the creation of spin-off entities that would become known as the Big Four.

The Big Four served as policy-lending “conduits” for governments during the first reform period, where lending decisions were dictated by local government officials. Not surprisingly, an ill-advised credit expansion followed, and a surge in inflation to close to 20 per cent resulted in near civil war in 1989.

Loan growth reaccelerated in the early 1990s, and deterioration in the banks’ asset quality led to the second stage of reforms in 1994. Three policy banks were established to assume the policy-lending activities of the Big Four, and bank management was obliged to adopt asset liability management techniques.

The Asian financial crisis in 1997 forced China’s policymakers to belatedly address the issue of problem loans, which had reached alarming levels. The Big Four banks received a capital injection of $33 billion in 1998, and four asset management companies were established the following year to accommodate the transfer of $169 billion worth of non-performing loans – an amount equivalent to 18 per cent of gross domestic product.

The balance sheet clean-up continued, as the Big Four were prepared for partial privatisation. The reforms appeared to put the banking system on a sounder commercial footing. They didn’t, as Chinese policymakers’ response to the “global financial crisis” undermined the sector’s commercial orientation. The banking sector granted $5.4 trillion in loans from the beginning of 2009 to the summer of this year – an amount equivalent to 73 per cent of the country’s GDP – and fears over the banks’ capital adequacy have resulted in the reclassification of $438 billion worth of loans to local government financing platforms.

This is widely believed to be only the tip of the iceberg, as a surge in both “policy” and “relationship” lending in recent years allowed for the funding of uneconomical projects throughout the economy. Slower economic growth is virtually certain to reveal the true extent of the credit losses.

The re-emergence of misguided “policy” lending in response to the financial crisis, means that China’s Big Four banks could well require a further state-backed recapitalisation in the not-too-distant future. The cost will be borne by heroic Chinese households – whose high savings rates fund the banking system. A successful rebalancing of the economy – away from investment and towards consumption – appears unlikely.

Investors should be aware China’s financial system remains extraordinarily fragile, and the potential economic costs are enormous.

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