Seeking Alpha
Profile| Send Message|
( followers)  

<< Return To Part 1

Evolution of the Modern Chinese Banking System

Since 1994, Beijing has publicly maintained the fiction that only the balance sheets of its commercial banks dictate the health of its banking system, while policy banks, operating as sovereign arms of the state, merit a hands-off treatment akin to that of a government agency. However, this bifurcated framework, long flawed, is now fundamentally inappropriate for at least three key reasons.

First, policy banks are very much a part of the traditional banking system, sharing the same regulator as commercial banks and subject to regular, albeit limited, disclosure in the China Banking Regulatory Commission (CBRC) annual report. Moreover, policy banks remain interconnected to all other segments of the banking universe by two foundational facts: not only are policy banks funded primarily by selling their bonds to the commercial banks, but all are ultimately back stopped by the Chinese government. A shortfall in one sector would inevitably affect the funding streams for the other, with ripple effects throughout the entire system.

Second, many of the distinguishing features of policy banks, such as the authority to issue so-called "special financing bonds" (SFBs) are currently being phased out. Unlike debt issued by commercial banks, Chinese accounting rules expressly designate policy bank bonds as equal to sovereign debt, meaning banks that buy these bonds can count them at a zero-risk weighting on their balance sheets. This accounting gimmick has created a huge competitive advantage for policy banks, allowing them to raise capital (and thus loan it out) at far cheaper rates than their competition. Not surprisingly, commercial banks lobbied furiously to have this privilege revoked, a directive applied to CDB in 2009 but reportedly delayed until 2012.

Third, from a practical standpoint, very little now distinguishes policy banks from commercial banks anyway. Since 2008, China's commercial banks have essentially devolved into policy lending arms themselves, tasked initially with dispensing China's enormous 2008 stimulus package (an amount equal to 12% of China's 2009 GDP), and now with credit conditions somewhat tightened, prioritizing loans to state-owned companies deemed politically important.

Meanwhile, policy banks have moved largely in the other direction, steadily becoming a force in commercial lending and now competing directly with China's commercial banks for customers. In fact, its continued sovereign-like privileges notwithstanding, CDB was technically transformed into a stock holding commercial bank in late 2008, and according to its Mission Statement now adheres to a "market-oriented, commercially-viable approach." China Exim, meanwhile, added its own market-oriented division and by 2008 had expanded its proprietary business profits so dramatically that they reportedly completely covered the bank's (declared) losses from policy-lending operations.

Nevertheless, this status quo, in which policy banks operate as hybrids able to use sovereign-like advantages to steal market share from the commercial banks, is clearly unsustainable. Political pressure continues to build from powerful patrons of the commercial banks, who resent policy bank encroachment on their turf--one reason why SFB issuance authority was ordered revoked. Policy banks also face rising borrowing costs following a series of inflation-fighting interest rate and reserve requirement hikes undertaken by the central bank earlier this year, while the yuan's steady appreciation against the dollar has ensured that the banks' sizable holdings of dollar-denominated loans continue to erode in value.

Moreover, with Beijing increasingly concerned over the likelihood of a returning global recession, its appetite for funding virtually unlimited policy bank credit lines appears to be coming to an end. The government understands that risk-weighting policy bank bonds as zero on Chinese bank balance sheets is merely an accounting sleight-of-hand that disguises systemic risk in the short term, and is therefore desperate to get these entities off the permanent public dole.

Yet, with minimal transparency and implausibly optimistic financials, will foreign investors be willing to step in and recapitalize these entities? If not, and Beijing simply forces its commercial banks or other SOEs to continue to prop them up through debt or equity purchases, how will risks to the banking system writ large not be exacerbated further?

With over three trillion dollars in foreign exchange reserves, China controls a substantial amount of monetary firepower to wield in the event of a crisis. In theory, those reserves could be used to recapitalize any policy bank with significant forex exposure (an option not available for the primarily yuan-denominated obligations of the commercial banks, because of China's closed capital account), but such a bailout would hardly be a demonstration of these banks' viability to global investors.

A bailout, moreover, would almost certainly force policy banks to forswear the market and continue as wards of the state, in turn forcing commercial banks to either dramatically restructure their portfolios to handle the new (above-zero) risk weightings of policy bank bonds or else force a decision that SFB issuance authority be extended indefinitely, further undermining Beijing's attempt to modernize and deleverage its financial system. In other words, these systemic problems have no easy solution.

Looking to 2012, China's banking system will be entering a transformative, but also highly vulnerable, period. Until Beijing finds a way to disentangle its policy bank hybrids from the current subsidy structure that bankrolls their excesses while disguising their true liabilities, investors should find little solace in the record-breaking profit announcements of Chinese banks. In fact, should the global downturn continue to accelerate, these problems will likely show up on Beijing's doorstep sooner than anyone expects.

Source: The Crisis Ahead For China's Policy Banks: Part 2