The Inevitable Collapse of China's Banks

Chinese banks were the belles at the global investment ball in 2006. The Industrial and Commercial Bank of China [ICBC] overtook Bank of America (BAC) on the last trading day of 2006 to become the second-biggest bank in the world in terms of market capitalization. Last year, no fewer than three Chinese banks were catapulted into the ranks of the world's ten-largest banks by market value. With 41% of the Shares FTSE/Xinhua China 25 Index (FXI) made up by Chinese financial stocks, the explosion in the value of these three banks largely is responsible for the index's meteoric rise last year.

click to enlarge

Chinese Banks: The Biggest Extreme Makeover... Ever

Western investment banks have done a remarkable job re-branding Chinese banks. Until 2005, Chinese banks were widely recognized as unwieldy state-owned lenders run by Chinese Communist Party apparatchiks, known more for a legacy of bad debts rather than for their world class commercial acumen.

Here's the irony. Chinese megabanks aren't even banks -- at least not the way we understand them. Carved out of the old Communist banking system just over 10 years ago, the state-owned banks' role has been to bankroll the government's massive infrastructure projects and to keep otherwise bankrupt state-owned enterprises [SOEs] afloat. As arms of the Communist government, Chinese banks have had no incentive to learn the disciplines of basic banking. Conversely, loan applicants never had to cobble together a business plan to get a loan -- or suffer the negative consequences of failure.

That's why it's no surprise that Chinese state-owned banks are a commercial disaster. The Chinese government has pumped over $434 billion to bail them out -- just since 1998. That's more than the GDP of banking giant Switzerland. The U.S. Savings & Loan scandal of the early 1990s cost to the U.S government barely registers in comparison. Add to that the estimated $358 billion in bad loans that China's four-largest banks officially have on their books today, and something smells rotten in Shanghai.

Gleaming new corporate headquarters notwithstanding, don't underestimate the backwardness of China's banks. The Bank of China does not have a centralized computer system to keep track of its client accounts. Corruption is ubiquitous. Its prospectus outlined fraud amounting to $737 million. Last April, it fired 75 bank officials for corruption and one former branch head was even given a (suspended) death sentence. And if you believe that the fish rots from its head, consider that the CEO of each Chinese megabank is a Communist Party crony.

The Coming Collapse: Truth... or Consequences

Peek behind the Wizard of Oz's (or Shanghai's) curtain, and you'll see that China's double-digit percentage growth rates are an economic sleight of hand that have come at a price of escalating bad debt and non-performing loans. At the end of 2004, bank debt in China stood at $3.7 trillion -- about twice the size of its GDP. That's the highest proportion of any economy in the world. And that debt is lent almost entirely by state-owned banks -- and over half of it by the Big Four. Today, Chinese state-owned enterprises [SOEs] owe banks over $2 trillion -- about the size of the entire Chinese economy. And the amount of outstanding loans is growing by $500 billion each year.

None of this will shock any student of Communist economies. This is just the way financial institutions in "soft budget constraint" socialist economies work. That is the insight of Communist Eastern Europe's only Nobel Prize caliber economist (and now Harvard professor), the Hungarian Janos Kornai. In socialist economies, cheap loans combined keep inefficient state-owned enterprise afloat. They also mean that a lot of goods are produced that shouldn't be produced in the first place. Throw in China's cheap labor and you see why the Chinese are selling Honda knock-off motorcycles at the price of their weight in scrap metal in Vietnam. This may lead to impressive rates of "top-line" economic growth in the medium term. But it also leads to the kind of massive misallocation of resources that eventually brought the Soviet Empire to its knees.

This makes the coming collapse of Chinese banks inevitable. And it won't be the first time it will have happened. In the Asian crisis of 1997, two Guandong banks went belly up -- exposing the massive non-performing loans given to the Chinese red chips floated in Hong Kong. Of course, investment bankers flogging shares of China's state-owned banks will tell you "this time it's different." But ply them with drinks at a Hong Kong hotel bar and they'll admit that much of the improvement in the balance sheets of China's banks comes from re-classifying hundreds of billions' worth of risky loans from "non-performing" to "special mention" -- and not because of any genuine change in lending practices.

Indeed, when Ernst & Young suggested in 2005 that banks' bad debts in China might amount to as much as $911 billion, the Chinese government quickly suppressed the report. That should be no surprise. Repressing the truth is what Communist governments are best at. But the next time you hear about China's $1 trillion of foreign reserves, remember that this world record stash is barely enough to pay off its bad banking debts. And with cheap loans financing a big chunk of China's 10%+ annual economic expansion, bad debts may approach $2 trillion before the bubble bursts.

Think of the Chinese economy like the bus in the movie "Speed." The Chinese economy is like the bus that has been rigged with explosives. If its speed drops to below 50 mph, it will explode. The Chinese authorities' challenge is to keep the bus going above 50 mph until the bomb can be (somehow) defused. If economic growth does slow, SOEs won't be able to service their debts and the entire banking system will collapse on itself. And even $1 trillion won't be enough to save it.

Here's what's worrisome. The Chinese bus will eventually run out of gas. And the Chinese economy plays a much bigger role in the global economy than it did during the Asian Crisis of 1997. China's troubles will have a much greater impact on the U.S. economy than the collapse of the Soviet Union -- an economy that accounted for less than 1% of U.S. trade in 1991.

Ironically, it is not the inevitable rise of China's banks that poses the greatest challenge to the global economy. But rather, it's their inevitable collapse.

Disclosure: Author has no position in above-mentioned stocks.

Comments

[thomas1:]

I am baffled by what the author has written.

2007 Feb 05 06:33 AM

[Lei Yang:]

You can stop reading at "the CEO of each Chinese megabank is a Communist Party crony." Some of the "free world" citizens just can not get their head around the fact that one of the best economic development story in the history of the world is being pretty much driven by a bunch of "Communist Party cronies". Those "cronies" have managed to keep a huge nation facing tremendious difficulties growing over 8% year over year for last twenty years. They apparently had been so ignorant of the fact that their economy was meant to have an "inevitable collapse" for some many times along the way that they couldn't even pause the growth for a year or so.

But rest assured, these "commies" are nothing but tiredless. They will keep working on it, and, eventually, for Milton Friedman's sake, eventually deliver a crash in next decade or so.

2007 Feb 05 09:48 AM

[PirateP:]

This argument seems largely based on the assumption that China is just like the Soviet Union, hence the reference to Kornai. It's a mistake to make this analogy due to the increasingly market-driven nature of the Chinese economy. Many of the problems from the soviet union came from shortages of fundamental infrastructure, like food production and distribution. Infrastructure seems to becoming less of a problem, not more, for China as its economy grows since the government seems to understand that its growth depends on such infrastructure. Compare China's infrastructure to that of India, a democracy, where almost any analyst can tell you that the infrastructure requires much more investment to continue to produce growth. See economist article.

2007 Feb 05 10:50 AM

[Chris Thomas:]

Lei Yang:

While many in the American press wrongly dismiss the Chinese government as a handful of corrupt Communists, it would be disingenious to ignore the massive structural problems facing the Chinese economy and society.

China has come far from Mao's day. It government is starting to resemble the Middle Kingdom's meritocratic roots - the loyal are slowly being replaced by the talented and beaurocrats are turning into technocrats. Regardless of the current state of the CCP, one must applaud this trend.

At the same time, the CCP is a bloated, corrupt organization that has a heavy hand in the Chinese economy. The author of this article is spot on - the country's financial institutions are a wasteland of no performing loans and constant mismangement. If you ignore this basic fact, you are being blinded by the China growth story and as an investor you are setting yourself up for disaster. Whether you like it or not, it's a risk. And you have to keep an open mind.

To the author: what is your opinion of having a short position on FXI? It seems obvious to me that there is a massive speculative bubble in mainland China's equities, but I have been tentitive to short the FXI because it is made up mostly of Chinese blue chips. The overvalued crap that is prime to short is all in Shanghai or Shenzhen, but you bring up a good point - that the FXI is 41% composed of financial stocks. Thoughts?

2007 Feb 05 11:11 AM

[dennis.ma:]

You should, and good luck

2007 Feb 06 11:39 PM

[Bharath Sri...:]

I am sure author realises that China acts like one single company u may call as China Inc. This has various sectors within this Inc. which cross subsidizes the other sectors. At the end of the day, if this China inc manages to retain or reduce the external debt while providing earning opportunity to all the people of China, taking care of health and education while utilizing them as a factor for production in a benevolent way, why should China be worried. For us in the outside world we have something to worry because, this China Inc can generate some surplus capacities in some sectors which may be put in the world market at their marginal costs (or may be subsidized costs). Thus it may be dangerous to predict the doom of any particular sector in China in isolation without considering the China Inc as a whole.

The "communist cronies" the author refers are very well aware of the fact that the outside world cannot ignore their population for growth and are demanding a slice of their future profits upfront if they need to be allowed to operate in China. So far they have been successful.

We may like to call it unfair practice, government interference in entrprenuership and so on....but we have to decide whether we can ignore China in our business plan. Some of the countries in the third world still endowed with rich natural resources may like to stick with China not because of any special love for communism, but just because they are fed up with what I would like to call "interventional captialistic benevolance" if you get what I mean.

2007 Feb 05 09:02 PM

[All Roads L...:]

As Lei points out, the people in Beijing are neither idiots nor are they going to always get it right... but they are trying.

This is an excellent post, and I commend Nicholas on his write up.

Through my previous work, I was involved on several of the early NPL project valuations and it was just plan scary. What has always been the biggest concern since that point is how a bank can go from 40% bad debt to 11% in just under 12 months. Well, in the middle of a property boom where the middle class looks for leverage, it is not difficult to see how the denominator on the equation was able to ridiculously fatten itself and bring those numbers down.

Remember that while the government did assign each big 4 bank a AMC to help clean up that bank's balance sheets, those AMCs are under PBOC. It is a shell game really where the PBOC, the AMCs, and the big 4 just hide their non-performing loans and wait for the day that they just magically disappear.

The first three years of resolving these assets properly (i.e. through public auction and private placement) were a mess. the data provided through the cautions was often incomplete and that drove valuations through the floor. Match that with the rule that you cannot sell State owned assets below book value, and you end up with failed auctions. CCB magically got around this by offering a buy back on assets without clean title 30 days after the auction. What happened? investors weighted those as 90% valuation levels (knowing the courts would never clean the assets) just to drive the 5% valuation to 45%. Amazingly, all three closed.

The problem root of the problem, as suggested above is that the banks do not have the internal structures in place for effective risk analysis and management, and that is before political favors are called in.
If the banks are unable to root out the rot, China is in for a rude awakening. At some point they will run out of lifelines.

Kudos to Nicholas

2007 Feb 06 02:04 PM

[dennis.ma:]

I think our friend Nicholas might be a little jealous of others that he had miss the chance to bank on the Chinese financial stocks. So if writing this article can make him feel better and happier, I think we should encourage him to write more for health reasons.

P.S. I'm just guessing but, are u a big fan of Tom Clancy?

2007 Feb 06 11:43 PM

[All Roads L...:]

Aparently, the banks have not really learned much in the 5 years since they have "turned around".

2007 Feb 09 02:24 AM

[VVV:]

"All truth goes through three stages:

First, it is ridiculed.

Second, it is violently opposed

Finally, it is accepted as obvious"

-Arthur Schopenhauer

The fact that China is an open (trade oriented economy) does not alter their banks' "soft budget constraint" behavior. Again, I refer you to Kornai for the more technical aspects of the microeconomic argument. Arguably, China has it worse. The Soviet Union was autarkic- insulating itself from world trade flows. China's open economy execerbates the pressure the Chinese policymakers to live up to the Potemkin Village economy they have created. The China Mania reminds me of the "this time its different" praise heaped upon the Soviet Union in the 1930s. Check out Paul Johnson's Modern Times for some juicy quotes. Also with respect to Communist party "cronies," check out the prospectuses of any of the Chinese megabanks. The corruption in these banks is rampant. One official was even given a (suspended) death sentence. But in securities law "disclosure cures all" - so there won't even be a cause of action against the banks or their underwriters when the banks implode.

When should you invest in FXI? After it's dropped 90% from its peak, and Business Week is running a cover story on corruption in Chinese banks dwarfing the corruption in Worldcom or Enron by a factor of 10 to 1.

2007 Mar 01 06:50 PM

[ordinary bloke:]

Wow! Good thing my savings are invested in Western Banks (In Iceland). Thank goodness the West's Banking system are safe.

2008 Oct 04 01:58 PM