China's Banks Won't Survive the Next Financial Earthquake
How does China's banking system work?
Chinese banks aren’t internationally competitive. Years of protective isolation has produced institutions wholly reliant on government-orchestrated instruction and support. But cracks are already starting to appear in the country’s financial infrastructure. And when a financial earthquake does come, China’s system will be shaken to its core. Ahead, we’ll tell you about an upcoming “tremor”.
On May 12, 2008 a magnitude 8.0 quake struck southwestern China, destroying several villages in Sichuan Province.
Surprisingly, it wasn’t the quake itself that killed more than 70,000 and left another 18,000 missing … it was the buildings.
On paper, building codes in China are well-defined and up to international standard.
But enforcing these codes is another story.
Chinese contractors feel pressure to complete projects ahead of schedule and cut corners. Builders substitute cheap materials in order to cut costs. The omnipresent specter of bribery and corruption also looms large.
As a result, modern Chinese structures are weak and vulnerable to shock, causing a high number of preventable deaths.
But corruption and shoddy construction aren’t limited to Chinese buildings. Its banking infrastructure is on equally shaky ground.
Chinese banks are undeniably big. Measured by assets, the top four banks in the world are Chinese.
The commercial banking sector's net profit rose to 1.65 trillion yuan (US$240 billion) in 2016, a 3.54 percent increase from 2015.
But their market capitalizations are the result of clever manipulation of valuation methodologies, not representative of their potential for value creation.
Chinese banks are undercapitalized (don’t have enough capital flowing through the companies system to conduct normal business operations) for the risks they carry on their balance sheets, which accounts for their outstanding return-on-equity ratios.
Despite apparently high profits, Chinese lenders in 2016 likely posted their lowest interest margins since the global financial crisis
And bad debt continues to drag on performance. The bulk of China’s lending is directed to state-owned enterprises (SOEs). Unfortunately, these have a bad habit of not paying back their loans.
So how is China slashing bad debts from their books to make their banks look profitable?
It’s simply hiding the bad loans.
Cooking books with Chinese characteristics
China has a well-proven infrastructure in place to hide bad loans.
Known as “bad debt managers”, China’s four centrally controlled asset management companies (AMCs) were set up in 1999 to swallow toxic assets from banks.
The Big Four AMCs: Huarong, China Orient, China Great Wall and Cinda all swallowed a lion’s share of non-performing loans (NPLs). From 1999 to 2004 loans worth over 2 trillion yuan (US$242 billion) were transferred.
Though mostly bad, the loans were usually sold at full face value.
They were paid for with ten-year bonds, backed by China’s government, that the AMCs issued to the big state-owned banks. But since most NPLs failed to recover in that time, these bonds were extended another decade. So the bail-out is still going on.
The Big Four are seeing huge profits. With low interest rates, AMCs borrow cheaply and lending to companies at much higher rates to restructure problematic loans.
What the AMCs have done with their assets is unclear, as they have not released proper accounts. Some NPLs have been sold but reportedly at only 20 percent of face value.
AMC Cinda, for example, recently sold bonds to China’s finance ministry. These bonds have since been wiped clean from its balance-sheet without any explanation for where they went.
Many conclude that AMCs are virtual holding-tanks where the debt neither stays nor departs.
They could be insolvent.
But that hasn’t stopped the AMCs expanding into other areas.
AMCs have gobbled up small banks and expanded into fund management, broking, commodities trading and insurance.
In the absence of public scrutiny, few have called into question the quality of bank balance sheets and earnings.
The next financial tremor
Over the past several years, China’s banks have enthusiastically entered consumer businesses; credit and debit cards, auto loans, and mortgages have become common in the country’s rich coastal areas.
Countless financial analysts have called the growing consumer class in China the next “megatrend” in investment.
But if Chinese start spending, they save less.
And China’s financial system is almost wholly reliant on the heroic savings rates of the Chinese people; they are the only source of non-state money in the game.
The special relationship between AMCs and China’s central bank works for now because everyone saves and liquidity is rampant.
If Chinese borrow and spend with the same enthusiasm as Americans, China’s current banking system will be strained to the point of breaking.
China’s banks operate within a comfortable cocoon woven by the Party and produce vast, artificially induced, profits that rebound handsomely to the same Party.
Despite worrying vibrations being detected across China’s financial sector, the current leaders have little incentive to change the system and meaningful economic reforms are unlikely.
With rampant corruption, China’s banking infrastructure is a façade unable to withstand change and competition.
The interplay between Chinese savers, AMCs and the country’s central bank will determine how to invest in the region in the coming years.