China's Rural Banks: Soft Underbelly Of The Financial System

Includes: CHIX, FXI
by: William Gamble


Last month a rural bank in China experienced a run.

Rural lenders in China were the fastest growing part of the Chinese financial system.

They had close ties and made loans to local governments.

Many of these loans have gone bad. In addition, rural banks have problems attracting deposits.

Since they are small it is unlikely they will be bailed out, so they make up another weak link in the Chinese financial system.

Recently something happened that should not have. A bank in China experienced a run. Last month China had its first bond default. Last month rumors started that the Jiangsu Shenyan Rural Commercial Bank was on the verge of collapse. Lines of depositors desperate to withdraw funds formed outside one branch.

The bank did all it could to reassure depositors. It promised to operate 24 hours to serve customers. It piled up stacks of money in the windows to prove it was solvent. The governor of Shenyang County north of Beijing promised the depositors that their money was safe. Finally, the People's Bank of China (PBOC) stepped in to assure that they would back up the bank.

The immediate crisis passed, but the problems still persist. The customers of the bank do have cause for concern. A few local credit cooperatives and loan guarantee companies have gone bust. In Shenyang this year, they lost a total of Rmb 80 million ($13 million).

It would be easy to brush aside the bank run and the collapse of some lightly regulated rural credit companies. You could look at it as a purely local problem due to mismanagement. It could be dismissed as a tiny part of a much greater whole. Shenyang Bank managed only Rmb 12 billion ($2 billion). This represents just 0.01% of the total assets in the Chinese banking system.

If the problems were merely limited to one town and one bank, there wouldn't be a cause for concern. But it isn't. The troubles at Shenyang bank are just the most recent sign of a financial system under stress.

The stress is neither local nor small, because it originates from a wide systemic cause. Like every other government, China's reaction to the 2009 recession was to provide massive stimulus. Unlike other governments, China did not use taxpayer money. It put lending quotas on state owned banks mandating loans mostly to local governments and state owned industries.

But there was another problem. The recession threw 20 million migrant laborers out of work. Unemployed workers returning back to their villages threatened to cause social unrest. So the Chinese government needed a way to get the stimulus money out into rural areas.

In 2009, there were only 100 rural banks, seven rural lending companies and 11 credit cooperatives. The number of banks was increased tenfold to 1,027 by 2011. The number of rural cooperatives exploded to about 5,000 today. Firms originally began as micro lenders were allowed to become banks if their non-performing loan ratio was under 2% and they had profits for two years. In addition, the Ministry of Finance provided subsidies of 2% to healthy rural banks. Since this is China, these new banks provided loans to the lowest levels of local governments.

The rural lending institutions not only proliferated, they grew far faster than their urban counterparts. While the five largest state owned banks, Bank of China, Agricultural Bank, ICBC, China Construction Bank, and Bank of Communications, grew by 270% over the past ten years, the rural banks grew at 440%. They now make up 10% of the total Chinese financial system.

Like other Chinese financial institutions, the rural banks lent to local governments, but ultimately to the wrong local governments. The rural cooperatives and banks provide the bulk of credit to hundreds of millions of local farmers, but they also have close ties to financially strapped local governments below the provincial level. Many of these loans were made again as part of the 2009 stimulus packages. As the loans come due, many of these smaller government entities will have difficulty repaying.

The problem was highlighted by a regulation issued March 8th by the China Banking Regulatory Commission (CBRC). The CBRC's latest regulation prohibits rural banks from providing fresh funding either directly to local governments or by purchasing investment vehicles issued by them including bonds, bills or trust products. This is going to be a major problem for the local governments since many will need to refinance those loans to keep current.

The size of these rural lenders and their main clients increases exponentially the probability that they will be allowed to fail. The central government would certainly bail out a large national lender. The top 30 banks might be able to rely on provincial governments. But the smallest lenders are probably out of luck.

But nonperforming loans are not the only issue that concern rural banks. They also have problems with the other side of the equation: deposits. Qichun county is in the province of Hubei near the city of Wuhan. It is rural county and its economy is based on growing herbs. It has a population of 1.03 million, but only a fraction of the population still farms. About 80% of the working age population migrates to the coastal cities in Guangdong and Fujian. They don't bank at the local banks in Qichun. They have debit cards issued from banks in large coastal cities, which allow them to transfer funds back home. The local banks also do not have savings books products.

Without a steady deposit base, rural banks have to rely on the interbank market. The rates in this market have been exceptionally volatile since the People's Bank of China (PBOC) started tightening interest rates last year.

The interbank market is far more expensive for the rural banks. It is partially funded by new money market products provided by Yu'E Bao, or "Leftover Treasure." Yu'E Bao was created by internet giants like Alibaba. Its growth exploded. It now has 81 million depositors and Rmb 500 billion ($81 billion) assets under management. The reason is simple. It gives savers 6% far above the 3.3% capped interest provided by the state banks. Rural banks therefore can tap the interbank markets, but at interest rates that eat into their margins. They cannot take advantage of the capped rates that help subsidize the large state banks.

Lack of liquidity, dodgy loans and the absence of a central government guarantee is a sure fire recipe for a collapse. The question is not whether there will be more runs on small banks like Jiangsu Shenyan Rural Commercial Bank. There will be. The question is whether there will be enough of them to metastasize and affect the entire financial system.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.