China’s remarkable growth continues – China has apparently now passed the US in industrial production, with the world GDP title in its sights (see previous post).

So how incredibly fortunate it is that the USA retains its commanding lead in the services sector! Clearly, future opportunities will abound in such sectors as retail and food services, debt collection, and of course government and related services. Based on recent government initiatives, the medical and military service fields seem particularly well positioned. We owe a huge debt of gratitude to all our heroes who serve overseas, in present and future military adventures, declared and otherwise. But those also serve who merely wait at home, for where would our GDP be without imputed rent on owner occupied housing? The fortitude of our world-beating service providers and consumers makes my eyes well up. I can’t help whistling a few bars of John Philip Sousa as I suppress the urge to chant “USA! USA!”

And yet there is one corner of the services sector, where we imagined we were invulnerable, but now find China surpassing the USA and emerging as world-beaters: bank shenanigans.

I just read the remarkable book Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl E. Walter and Fraser J. T. Howie, and think it’s worth a quick summary.


After the 1978 liberalization, banks expanded lending liberally to real estate ventures in the Special Economic Zones, moving their franchise beyond lending to state owned enterprises. As it turned out, the tropical island of Hainan did not have the anticipated potential that had enabled 20,000 real estate companies to flourish. And the backing of the rock solid Chinese government apparently did not extend to ensuring that state-owned enterprises (SOEs) which experienced the downside of the free (or freer) markets actually made good on the loans made to them at the behest of patriotic duty and the party.

Hence, after some years of pursuing hope as a strategy and delaying recognition of non-performing loans (NPLs) and inadequate capital, a bailout of banks was deemed necessary and desirable. And where else to look but at the bastion of capitalism, the USA and its experience with massive leverage, the RTC, off-balance sheet entities and delayed recognition of losses and ‘too-big-to-fail’? The restructuring of the banks took shape in multiple steps.

Step 1: in 1998 reserve ratios were reduced. This freed up room on balance sheets, which the banks used to buy a special 7.2% bond issue from the MOF.

Step 2: the MOF simultaneously turned around and bought 7.2% bank bonds which the banks booked as long-term capital. Presto, capital ratios were miraculously replenished!

Step 3: a good-bank, bad-bank strategy similar to the RTC. For each of the 4 big banks, an ‘asset-management company’ (AMC) was created. The AMCs were initially capitalized by $1B in loans (all figures USD) from the MOF.

However, there was apparently some political difficulty in shelling out the large sums needed to capitalize the AMCs in a way that would have enabled them to take the necessary volume of NPLs off the books. Where to get the rest of the cash but from the banks themselves? The banks then loaned $105b to the AMCs to enable them to purchase bad loans at full face value. By this unusual and creative expedient, the banks swapped the NPLs for bonds backed by the AMC’s assets, which were the NPLs themselves, enhanced by the undoubtedly fully reassuring state backing of said AMCs. The central bank kicked in additional financing of $75b in loans to the AMCs to buy additional NPLs.

Step 4: Conveniently ignoring the fact that the NPL problem was still there, swept under the rug with the AMCs, take the banks public. If you wondered why Hank Paulson spent so much time in China, it was to find collections of state assets that could be cleaned up, repackaged as national champions, and sold as future world-beaters and proxies for China’s amazing growth. With that kind of action, you couldn’t keep Paulson and other investment bankers away with a stick. 3 of the 4 big banks went public, the straggler, Agricultural Bank of China, didn’t make it until 2010.

But Western style finance turned out in 2009 to be somewhat less robust than met the eye. As Chinese exports cratered in the financial crisis, it was imperative to keep the economy going. The state called on the banks to lend, and on industry and local government to step up with investment projects. In their patriotic duty, banks rose to the task, enabling governments to seize land from farmers and build apartments, not to mention high speed rail, and any other pet project local politicians fancied. In 2009, banks grew their loan book 30+% – BOC over 40%. Many of the projects were half-baked, premature, or possibly tainted with corruption, and it seems likely that they may not yield cash flow for some time, if ever.

Which leads us to today.

The 4 big banks are the lynchpin of the financial system, as of 2009 controlling 43% of financial assets. Bond markets are immature and consist largely in banks floating bonds at politically determined interest rates that they themselves hold to maturity, essentially loans by another name. Stock markets are similarly immature, with slivers of SOEs held by the public investors, which have no influence or control rights.

The state still owns majority stakes in the banks and retains control, with management appointed by the party. Loans are still politically mandated, along with appropriately modest interest rates as befits projects backed by the government (whose power and strong credit somehow does not always guarantee that these loans are repaid on time)

The more reform-minded officials hoped at the outset that the AMCs would be wound down, the losses would be recognized, by the state guarantors if necessary. Publicly held banks would move toward international accounting and credit standards, and over time the financial markets would mature. And as it turned out, the AMCs were not wound down, when the initial bonds came due, they were simply rolled over.

For now, the banks are reporting record profits, and low NPL ratios. This a mathematical artifact, since the massive volume recent-vintage loans isn’t yet seasoned enough to go sour. The banks still sport huge market caps and pay large dividends. One might question the wisdom of a hefty dividend, since rapid economic growth in China means rapid bank loan growth, necessitating an equity base that grows in parallel. Even with prudent lending and without paying fat dividends, the banks would need to periodically come to the market to refresh equity capital.

A future restructuring seems in the cards, it’s just a matter of how long it takes for an NPL problem to emerge, how big it gets, how long it is swept under the table.

As long as China’s economic performance continues and the country retains its vast FX reserves, the country clearly has the wherewithal to weather significant storms. The question is simply who will bear how much of the losses: the central government through the AMC guarantees, the local depositors who have no other outlet for savings and receive below-inflation returns, or the shareholders.

What’s clear is the first-rank market caps of the banks (ICBC is the biggest bank in the world by market cap) are not related to their performance. They simply reflect investors’ estimation of the likelihood they will continue to receive the dividends, and desire for an exposure to a proxy for Chinese growth. Dividend reduction would be a loss of face and future access to capital. The GITIC insolvency ended up in losses for creditors who thought they had state backing. If the political winds blow against continued liberalization, it’s not impossible that a bank’s management might be purged and required to make public self-criticism, and shareholders might have to take a haircut. (Some days, purging and public self-criticism, not to mention the ultimate price of execution for corrupt managers, would seem like management practices Western finance could benefit from)

What’s also clear is that China’s world-class manufacturing has not been accompanied by world-class financial markets. China’s economy is not in a process of continuous liberalization toward free market capitalism. It reflects the highly selective application of market incentives in a politicized, state-centric economy. Minority equity investors will get whatever returns the political winds blow their way. In the Chinese stock market, control is not for sale, there are no mechanisms to bring stock returns in line with economics, which are in any case totally dependent on the political winds.

To paraphrase what someone said about George Steinbrenner, there is nothing quite as junior as being China’s junior partner.

Further reading:

Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl E. Walter and Fraser J. T. Howie

Wall Street Journal book review of Red Capitalism, reviewed by Edward Chancellor

Forbes: China Banks’ Illusory Earnings.

FT Alphaville: China’s useless banks.