China Banks' Risk Profile

The bulk of market capitalisation in Asian equity is in bank stocks. China has been leading the way, and the banks' health should be monitored closely. We know of the rampant bank lending that has been on going for the past 12 months. Now we need to know the extent of the potential bad debts and how that would play out in 2010. We already know that bad debts for credit cards have already doubled year on year and that is an ominous sign.

China's banks posted strong profit growth in Q3 2009 as new lending continued to surge. The jump in new lending meant that non-performing loans decreased as a percentage of assets. Regulators started to tighten lending standards in Q3, which along with the need to meet new capital adequacy requirements, could eat into profits. However, a shift toward longer-term loans and of savers into demand deposits may increase the net-interest margin for banks, which fell through Q3 2009 due to lower interest rates.

Capital Adequacy Ratios

Fitch warned that due to "major ongoing weaknesses in loan classification and disclosure of off-balance-sheet exposures" China's banks' capital positions are probably worse than they appear. The banks have used an increasing amount of off-balance-sheet transactions to bundle loans and sell them to investors, which represents a "growing pool of hidden credit risk." These transactions free up space on the banks' balance sheets so that they can increase their lending without lowering their capital adequacy ratios.

China’s Banking Regulatory Commission denied reports that it would raise the minimum capital ratios to 13% in 2010 from 10-11% now, but it said that banks would need to develop “medium-to-long-term plans” to replenish capital after the lending binge of 2009. As of September, all of the largest banks except the Bank of China had capital ratios over 12%. The shift toward longer-term loans from Q2 2009 has boosted the net interest margins of China’s banks, but the loans also come with higher risk weightings, pushing down their capital ratios. In order to maintain their 12% capital adequacy ratios, China’s 11 largest listed banks would need to raise an additional RMB368 billion (US$43 billion) in capital, according to calculations by BNP. Core capital adequacy ratios at the banks fell to 8.9% at the end of September 2009, from over 10% at the end of 2008.

In August 2009, the WSJ reported that the China Banking Regulatory Commission was considering a ruling that subordinated debt held by other banks would no longer count as supplementary capital. Estimates suggested that as much as 51% of subordinated debt issued by banks (RMB210.0 billion in H1 2009, three times the total amount for 2008) was held by other banks. In October, regulators issued a ruling that was significantly easier for banks to meet: Only subordinated debt acquired after July 1, 2009 would need to be deducted from Tier-2 capital. This will make it more difficult to replenish capital by issuing subordinated debt but does not require significant changes as a result of the ruling.

When the government recapitalized the banks in the late 1990s, it formed asset management companies (AMCs) to purchase non-performing loans from the banks, which were funded through bonds held by the banks. The AMCs have had very low recovery rates on the NPLs, and their bonds may have to be rolled over or written off. The government opted to allow at least one of the recapitalization bonds that allowed China's banks to become commercial enterprises to be rolled over for another decade. A US$36.2 billion bond held by Cinda Asset Management was to come due at the end of September, but was rolled over for another ten years. Writing off the principle due would have cost CCB more than half of its net assets, and the remaining bonds, which come due in 2009/10, are expected to be rolled over as well.

From October 2009, insurance companies will be allowed to invest in the property market. This will allow state-owned banks to transfer underperforming commercial property holdings to insurers at book value, and insurance companies will not have to write down the property values because they will be booked as long-term assets. This lets insurance companies diversify their assets to better match the duration of their liabilities but also protects banks' balance sheets.

Central Huijin, a division of China's sovereign wealth fund, said that it would continue to buy shares in China's three largest banks to reassure investors and stabilize their share prices.

How Much Will Non-Performing Loans Increase?

The increase in NPLs may come in mid to late 2010 given that they tend to peak 12-18 months after a credit boom. However, the revival in property markets and increase in mid- to longer-term loans may limit the deterioration of assets.

The surge in NPLs would be limited to RMB400 billion (US$58.5 billion) in 2010, but another RMB250 billion (US$36.6 billion) in NPLs could emerge in 2011. If credit is tightened more in 2010, NPLs would jump higher.

The Banking Regulatory Committee is raising minimum capital adequacy requirements from 8% in 2008 to 11% by 2010, but the PBoC controls the reserve requirements, blunting the regulators’ ability to control loan growth.

FT Dragon Beat: If 1/6 of the RMB20 trillion in bank lending to be issued from 2008 to 2010 goes sour, then the government's liability would be RMB3.3 trillion, which is about the same as all the nonperforming loans recognized so far.


p/s photo: Freida Pinto

China's Growth Story Too Dependent On Easy Credit?

Just how dependent is the China growth over the last 6 months on the easy credit conditions? This blog has been harping on the liquidity trap that is almost inevitable. The flip side is that the markets in China and HK will continue to benefit as Beijing would continue to "allow and encourage" more state firms to list in Shanghai and/or do a H-share listing - both very effective ways to drain some of the liquidity from the system, or at least keep it within a sphere where it could be 'controlled' somewhat.

Bank lending surged in H1 2009 to RMB7.37 trillion (US$1.08 trillion), more than three times higher than H1 2008. The figure, totaling 25% of China's annual GDP in 2008, is 47% higher than the government's RMB5 trillion target for 2009. There is significant monthly variation, however. Available data suggests that lending slowed in July 2009 even more than in April and May 2009, but June loans surged to RMB1.53 trillion (US$224 billion), a return to Q1 levels. New loans could surpass the revised RMB10 trillion benchmark for 2009. The scale of loan extension has sparked sustainability concerns, raised the risk of non-performing loans (NPLs) and helped to fuel asset-price inflation (property and equities). However, concerns that the government might rein in loans contributed to a weakening of equity markets in early August.

Will Lending Growth Continue?

• Banks lent RMB1.53 trillion (US$224 billion) in June, more than double the RMB664.5 billion extended in May, sparking concerns that tightening may follow. M2 rose 28.5% in June, and outstanding loans were up 34.4% y/y in June (both record highs). The central bank may have already started to tighten, selling more bonds to soak up some of the liquidity.
• The reported lending figures from China's largest banks suggest that July's new lending should total around RMB400 billion (US$58.6 billion). Many of the commercial bills from earlier in the year will be refinanced in July through September, reducing new lending. Still, credit availability will likely remain relatively loose.
• The big four banks reportedly cut lending to RMB168 billion (US$24.6 billion) in July from RMB497 billion (US$72.7 billion) in June, though smaller banks have increased their share of lending in recent months from about half to two-thirds. As a result, lending may not have slowed as much as some estimate.
• If state-owned banks contributed one third of July new bank lending, like they did in Q2, then the July figure should come in around RMB500 billion (US$73.2 billion). Though if the trend of smaller commercial banks contributing a greater share continues, the actual figure could be higher.
• The narrowing spread between M1 (18.7% y/y in May, up from 17.5% in April) and M2 (25.7% y/y in May, down from 26% in April) suggests that economic growth is gaining momentum as corporations are increasingly confident and willing to embark on future investments.
• Loan growth shifted toward medium- and long-term loans in Q2. Commercial bills accounted for 21% in April, down from 32% in Q1, while other short-term loans declined by nearly RMB80 billion. Deposits again outpaced loans, reducing the loan-deposit ratio, which should marginally ease fears of bad debts, as firms are storing liquidity.
• Even if loan growth slows, the net increase in loans might be around RMB8-8.5 trillion, 26-28% above 2008 for loans outstanding.

Factors Behind Lending Expansion


• The People's Bank of China (PBoC) is unlikely to tighten monetary policy because the central bank is not accountable for regulating bank risk. Bank lending is playing an important role in the fiscal stimulus, and the central bank may plan to pump in money to fill holes in banks’ balance sheets from bad loans.
  
• The Banking Regulatory Committee is raising minimum capital adequacy requirements from 8% in 2008 to 12% by 2010, but the PBoC controls the reserve requirements, blunting the regulators’ ability to control loan growth.
• The China Banking Regulatory Commission may rule that subordinated debt held by another bank will no longer qualify as supplementary capital. Estimates suggest that as much as 51% of subordinated debt issued by banks (RMB210.0 billion in H1 2009, three times last year's total level) is held by other banks, which could lead banks to curtail new lending. That would be an easier path to better capital-adequacy ratios than finding buyers for the debt outside of the financial sector.
• The China Banking Regulatory Commission suggested that a concentration of credit in some industries and businesses may pose a threat to the financial system. Banks should rely more on syndication to share the risks from new lending, the secretary of the commission said.
• Loan growth is driven by monetary policy that encourages banks to expand loan portfolios. Banks make up for lower loan margins with expanded loan volumes and an assumption that stimulus-related credit losses will be covered by the central and/or local government. The increase in corporate loan portfolios and credit expansion may threaten the medium-term outlook for Chinese banks.
  
• Michael Pettis, Peking University: "Tighter monetary policy may be necessary to contain future inflationary pressures, but the unclear economic outlook and political priority of growth make this unlikely."
  
• Wu Xiaoling, PBoC Deputy Governor: The government's moral persuasion is declining. Banks should diversify, but not lend excessively in search of sustainable profits.
• Loan curbs postponed investment in H2 2006, while loans and investment reaccelerated in Q1 2007.
  

Risks from Lending Growth

• The efficiency of new loans is in doubt, as the economy does not have the capacity to turn these new loans into real activity. Potential tightening policies would further challenge the financing of small and medium sized enterprises.
• NPLs may not reach 1990s levels, as most of the current round of lending has gone to local-government-backed projects rather than unprofitable state-owned enterprises. Also, because Chinese banks are more dependent on deposits than wholesale markets for funding and China's capital account remains closed, there is little risk of a financial crisis.
• As much as 20% of the bank loans in the first five months of 2009 (US$170 billion) was invested in the stock market, while another 30% may have been used for discounted bill financing.
• China's National Audit Office found that six Chinese banks in 2008 had extended more than US$4.39 billion worth of irregular loans, an indication of inadequate management at some of the banks' local branches. The issues included improper land purchases, fraudulent mortgages and loans to non-qualifying property developers and non-approved mortgages.

p/s photos: Meisa Kuroki

China's Lending Explosion

Is there anything wrong with China's lending spree. The central bank basically "advised" banks to ratchet up their lending, and the banks followed dutifully for the past couple of quarters with amazing results.

First of all, you cannot suddenly find so many attractive "borrowers" to lend aggressively to. Secondly, not many will say no when you offer to lend them money.

To be fair, this strategy pulled the domestic economy from falling further along with the ill effects of a global economy in crisis, but at what price. As I have mentioned before, this has to play itself out, and will not result in a sudden correction in property or stock prices in China. The liquidity rush will soon find its way into higher equity prices in China (hence bullish for the rest of the year for Chinese equity), and some may trickle back into Chinese property mart as well. Brace for high default rates when the music stops, probably after Chinese New Year in 2010.

China’s new lending more than doubled in June from a month earlier, increasing concerns bad loans and asset bubbles will emerge amid a credit boom.

New lending was 1.53 trillion yuan ($224 billion), the central bank said on its Web site today, bringing total lending this year to 7.4 trillion yuan. The calculation for new loans is preliminary, the central bank added.

The government is countering an export collapse by flooding the economy with money to fuel domestic demand. Rapid credit growth poses a risk to the nation’s lenders and a concentration of credit in some industries and businesses may damage the stability of the financial system, the banking regulator said yesterday.

Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment. Already China recently failed to complete a $4.1bn auction of one-year government bonds, which suggested that investors are positioning for higher inflation caused by the credit surge.

Just something more to chew on, in 2005 Ernst & Young published a survey estimating that the bad loans in the Chinese banking system equaled close to $900 billion. Since then there has been enormous speculation in both the stock and real estate market. The average urban residential property prices fell by 15 to 30 per cent over the next two years from their levels at the end of 2008. Of course, by the end of 2008 they had already fallen from there 2007 highs. You cannot have real estate fall that much without having bad loans. Here is the juicy part, according to the prospectus for the Commercial Bank of China, it is illegal in China to foreclose on residential property.So what are bad loans? Bad loans = immediate write downs? No, they are then carried as what??? ... long term assets??? The reality is that no one knows exactly how bad the situation is in any bank. Information has value and is not disclosed unless required by law or for consideration. Since the banks in China are owned by the state, there is no legal requirement.


Something's gotta give ... but let's have a bull run first...

p/s photos: Elanne Kong Yuk Lam

China Should Lend More To Emerging Asian Nations

Things do get lost in translation. When I read what Luo Ping said about the USA and its currency. Luo Ping is the director-general at the China Banking Regulatory Commission. I am not laughing at his English, but its really quite funny. Luo must have gotten good laughter as he mentioned the following in his speech in New York yesterday:

"Except for US Treasuries, what can you hold? Gold? You don't hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. for everyone including China, it is the only option."

Eeerrr, Mr. Luo must have gotten a bit exuberant. There are plenty of things you can hold besides US Treasuries. Yes, I agree that you will need to hold a substantial sum of Treasuries in order for the global economy not to collapse overnight, but a better way would be to reveal a long term plan to bring down US Treasuries from say 80% of your portfolio to 70% by end 2011 and to 60% by 2015. This way everybody knows there is a strategy in place. Its not impactful immediately because its out there in the horizon, but at least the US would know for sure they really, really have to get their house in order or face a huge currency depreciation. Right now, everybody thinks the US dollar will depreciate, even Obama and Geithner, but it will probably not happen in a drastic fashion as in their minds they still think the world needs US more than the US needs the rest of the world. Thus most top dogs in US government do think that, while it may not be financially prudent or wise, the rest of the world will continue to lend to the US in the forseeable future even though they may be screaming and kicking.

Not being able to hold Japanese govenment bonds? Where Mr. Luo got that from, of course you can, just not so much. Let me give China a great idea:
LEND TO EMERGING ASIAN COUNTRIES IN THEIR OWN CURRENCIES
Since China loses so much money in Treasuries on currency movements, plus that move tends to encourage bad behaviour by US consumers... they just consume and consume and no savings. Why not encourage emerging countries in Asia instead, I am sure they will give you a better bang for your buck.

You can lend the equivalent of $20bn each to Malaysia, Indonesia, Thailand, Vietnam ... and US$10bn to Cambodia, Laos, Bangladesh... by holding bonds in their local currencies. Hence these countries will pay back to China in local currencies as well. These bonds will be for a 6 year period, with interest payments being zero for the first year, and then benchmarked to the prevailing local BLR for the rest of the 5 years.

Why should China be so generous? One, it adds to proper investing in a broader consumer base. Two, it add more economic might to Asia as a region by having more robust FDI and consumer base. Three, it will help cement stronger ties with China with the rest of Asia. Four, this is exactly the role that China should be stepping into to assume the future economic leadership and influence. Five, it allows for a kind of currency swap arrangement with smaller countries, which will allow for better depth and protection to emerging markets' currencies.

Seriously, China will not and should not look for the money to be repaid but rather "refinanced" at the end of 6 years PROVIDED these countries have shown that they have invested most of the funds properly. Yes, the countries may have to "kowtow" a bit to China, but hey, thats the money politics and business pragmatism that we all know so well. The idea may sound well on paper but these smaller nations will need to convince themselves that this is the right thing to do as well, instead of letting natinalistic fervour and narrow-mindedness destroy this idea.

Back to Mr. Luo's speech in New York:

"We hate you guys. Once you start issuing $1 trillion-$2 trillion... we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do."

You gotta love the guy. From the text of his speech, obviously he meant nothing venomous by his use of the word "hate", it was probably well used to lighten up the situation and probably elicited much laughter.

p/s photos: Amy Fan Yip Mun