Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise

by Carl E. Walter; Fraser J. T. Howie

  The partial recapitalization of the Big 4 banks, 1998

  On the collapse of GITIC and amid rumors of bank insolvency, in 1998 Zhu Rongji ordered a rapid recapitalization of the Big 4 banks to at least minimum international standards, which were the only standards available to China. A mountain of bad loans had been created in the late 1980s and early 1990s and ignored for 10 years. This was the typical approach of the bureaucracy toward intractable problems. By 1998, however, it had become obvious to the government that such methods increased systemic risk. At that time, China’s banks had never been audited to strict professional standards or, for that matter, to any professional standard. As with GITIC, no one could say with confidence how big the problem might be. Given Wang Qishan’s experience in having to answer an angry Premier’s questions about GITIC’s black hole, one can imagine the pressure people at the MOF must have felt as they sought to come up with a figure that would satisfy Premier Zhu.

  There was, of course, no time for a real audit, but someone was clever enough to come up with a number purportedly sufficient to raise bank capital adequacy to eight percent of total assets, in line with the Basel Agreement on international banking standards. This figure turned out to be RMB270 billion (US$35 billion). For China, in 1998, this was a huge sum of money, equivalent to nearly 100 percent of total government bond issuance for the year, 25 percent of foreign reserves and about four percent of GDP. To do this, the MOF nationalized savings deposits largely belonging to the Chinese people (see Table 3.2).

  TABLE 3.2 Composition of Big 4 bank deposits, 1978–2005

  Source: China Financial Statistics 1949–2005

  In the first step, the PBOC reduced by fiat the deposit-reserve ratio imposed on the banks, from 13 percent to eight percent. This move freed up RMB270 billion in deposit reserves which were then used on behalf of each bank to acquire a Special Purpose Treasury Bond of the same value issued by the MOF (see Figure 3.1).2 In the second step, the MOF took the bond proceeds and lent them to the banks as capital (see Figure 3.2). This washing of RMB270 billion through the MOF in effect made the banks’ depositors—both consumer and corporate—de facto shareholders, but without their knowledge or attribution of rights.

  FIGURE 3.1 Step 1 in recapitalization of the Big 4 Banks, 1998

  FIGURE 3.2 Step 2 in recapitalization of the Big 4 Banks, 1998

  As part of the CCB and BOC restructurings in 2003, these nominally MOF funds totaling RMB93 billion for the two banks were transferred entirely to bad-debt reserves and then used to write off similar amounts of bad loans.3 This left the Ministry of Finance responsible for repayment. For the banks this was a good deal, as the MOF was now obligated not just to “repay” what was originally the banks’ money anyway, but to use its own funds to do so. It is no wonder, therefore, that the bond maturities were extended to 2028, just as it is no wonder that the MOF did not support the PBOC approach to bank restructuring. How could it when, without the approval of State Council and National People’s Congress, it had no access to such massive amounts of money?

  Bad banks and good banks, 1999

  Having shored up the banks by such accounting legerdemain, work began on preparing them for an eventual IPO. Zhou Xiaochuan proposed the international “good bank/bad bank” strategy that had been used successfully in the Scandinavian countries and the US. This involved the establishment of a “bad bank” to hold the problem assets spun off by what then becomes a “good bank.” Zhou proposed the creation of one “bad” bank, called an “asset-management company,” for each of the four state-owned banks. It was a critical part of the plan that, after the NPL portfolios had been worked out, the AMCs would be closed and their net losses crystallized and written off, a process that was expected to take 10 years. In 1999, the State Council approved the plan and the four AMCs were established.

  The MOF capitalized each AMC by purchasing Special AMC Bonds totaling RMB40 billion or roughly US$1 billion each (see Figure 3.3). In line with the plan to close the companies, these bonds had a maturity of 10 years. But RMB40 billion was hardly enough to acquire bank NPL portfolios. More funds were needed and where else to get them but from the banks themselves? The AMCs, therefore, issued 10-year bonds to their respective banks in the amount of RMB858 billion (US$105 billion).

  FIGURE 3.3 AMC capitalization by the MOF and each bank, 1999

  These bonds represent the major flaw in the PBOC plan. The significance of the bonds is that the banks remain heavily exposed to their old problem loans even after they had been nominally “removed” from their balance sheets. The banks had simply exchanged one set of demonstrably non-performing assets for another of highly questionable value. The scale of this exposure was also huge in comparison to bank capital (see Table 3.1). Given the size of the bank recapitalization problem in comparison to China’s financial capacity at the time, the government had little choice but to rely on the banks. But this approach was not in line with the international model and did not solve the problem.

  In the Scandinavian and US experience, the national treasury had not only capitalized the bad banks, but it had also provided financing to them so that the resulting “good” banks had no remaining exposure to their old bad loans. They had become the problem of the national treasury and ultimately their cost would be paid for from taxes. In China, as long as the government’s reliance on the banks to fund the AMCs remained “inside the system,” it may not have mattered. A supportive bank regulator could rule that AMC bonds were those of semi-sovereign entities and the question as to their creditworthiness could be avoided. But once these banks became listed on international markets and were subject to scrutiny by other regulators and investors, international auditors would inevitably question the valuation of these bonds. The AMCs were thinly capitalized at about US$5 billion. The bonds they had issued totaled US$105 billion and the assets they funded had, by definition, little value. What if the AMCs could not achieve sufficient recoveries on the NPL portfolios to repay the bonds due in 2009?

  NPL portfolio acquisition by the AMCs, 2000

  The first acquisition of bad-loan portfolios by the new AMCs began and was completed in 2000. A total of RMB1.4 trillion (US$170 billion) in NPLs was transferred at full face value, dollar-for-dollar, from the banks to the AMCs. This was funded by the bond issues and a further RMB634 billion (US$75 billion) in credit extended by the PBOC (see Figure 3.4). The obvious question that arises is: if these loans were really worth full face value, why were they spun off in the first place? There are a number of possible reasons for this. One is that any write-down by the banks in 2000 would have wiped out all capital injected by the MOF in 1998 and there was, as yet, no consensus on where new capital would come from. Given the amounts involved, there were, after all, limited choices. This is surely part of the answer. Another part is that this transfer was equivalent to an indirect injection of capital since the replacement of bad loans with cash would free up loan-loss reserves (if any). Going forward, it would improve bank profitability and capital by reducing the need for loan-loss provisioning.

  FIGURE 3.4 AMCs’ additional funding from the PBOC, 2000

  The rest of the answer is that the government was unable to reach consensus on the valuation of these “bad” loans. After all, these loans had all been made to SOEs which were, by definition, state-owned. Anything less than full value would suggest that the state was unable to meet its own obligations, a position anathema to Party ideologues. But that was just the point: the state was unable to meet these obligations. So instead of bankrupting all SOE borrowers—that is, basically the entire industrial sector—the Party chose to keep the potential losses concentrated on bank balance sheets. Instead of resolutely addressing the problem by writing the loans down, it decided to push the matter off into the future and on to some other politician’s agenda. Of course, in 2009, the Party decided to do the same thing, so the AMC obligations were pushed off a further 10 years. This is how things work “inside the system.”

  PBOC
recapitalizes CCB and BOC, 2003

  Official data indicate that after this first tranche of bad loans was removed in 2000, the four banks still had RMB2.2 trillion (US$260 billion) more on their books, and this was before a stricter international loan-classification system was implemented in 2002. The government took a hard look at bank capital levels, but its own resources remained very limited. Its conservative approach extended to an aversion to increasing the national debt. If the banks were truly to be strengthened, they needed more capital and a lot of it. Zhou’s plan had concluded that this could only be provided by international investors. But the problem was how to make bank balance sheets and business prospects strong enough to attract them.

  The question boiled down, in part, to how much each bank could afford to actually write off. The PBOC found that of the four banks, only BOC and CCB had sufficient retained earnings and registered capital to make full write-offs of their remaining bad loans while leaving a small but positive capital base. Neither ICBC nor ABC was capable of achieving this in 2003, and both would have ended up with negative capital; that is, they would have been factually bankrupt. But if BOC and CCB’s RMB93 billion in capital was to be written down, where could the money be found to build it back up? After much argument, Zhou Xiaochuan proposed the only possible solution: use the foreign-exchange reserves. As the famously outspoken Xie Ping, then director of the PBOC’s powerful Financial Stability Bureau, put it: “This time, we did not just play a game with accounting [a direct jab at the MOF’s methods in 1998]. Real money went into the banks.”

  Zhou’s plan was approved by the State Council and on the last day of 2003, each bank transferred the value of its capital and retained earnings4 into bad-debt reserves and wrote it all off. In other words, the MOF’s total capital contribution to the two banks—RMB93 billion—was written off, but the MOF remained obligated to repay its 1998 Special Bonds. This fact alone highlights the seriousness of the Party’s intention to restructure the banks and is emblematic of the PBOC’s ascendancy over the MOF at the time. The two banks each received US$22.5 billion from the country’s foreign-exchange reserves by means of the PBOC entity Central SAFE Investment (discussed in greater detail in Chapter 5). Shortly thereafter, in May and June 2004, the banks disposed of an additional total of RMB442 billion in problem assets via a PBOC-sponsored auction process prearranged to create loan recoveries and further additions to their capital accounts. As a result of all these actions, BOC and CCB were in a position to attract foreign strategic investors and ultimately to proceed with IPOs in 2005 (see Table 3.3). But the side effect was to exacerbate the political struggle over bank reform: the PBOC now owned 100 percent of both CCB and BOC.5

  TABLE 3.3 PBOC/Huijin ownership rights in major Chinese banking institutions

  Source: Huijin; bank annual financial reports and ABC offering prospectus

  Note: Dates of IPOs include those for both Hong Kong (H) and Shanghai (A) IPOs. “Other State” investors include strategic Chinese investors such as SOEs. For BOC, all NSSF (4.46 percent) and foreign strategic investor shares (13.91 percent) were converted into H-shares at the time of the IPO and are included in the Public number. Jianyin is a 100 percent subsidiary of Huijin.

  “Commercial” NPL disposals, 2004–2005

  In line with the PBOC blueprint, a second round of NPL acquisition by the AMCs, totaling RMB1.6 trillion (US$198 billion), followed in 2004 and 2005. In addition to a second batch of bad loans of RMB705 billion from ICBC, portfolios also included RMB603 billion from a number of smaller, second-tier banks. For these transactions, the PBOC provided the necessary funding, with estimated credits of up to RMB700 billion (see Figure 3.5 and Table 3.4) But this time, the PBOC had already taken a down payment copied straight out of the MOF’s 1998 playbook: in 2004, it had issued compulsory Special Bills totaling RMB567.25 billion (US$70 billion) to BOC, CCB and ICBC. These bills could not be sold into the market and were designed to mature in June 2009 as a part of the unwinding of the entire AMC arrangement.

  FIGURE 3.5 PBOC funding for ICBC NPL disposal and commercial loan auctions

  TABLE 3.4 AMC funding obligations, 2000–2005

  Source: Caijing , July 25, 2007: 65; PBOC, Financial Stability Reports, various

  In issuing the bills, the PBOC accomplished two things. First, it removed the liquidity it had created by financing the NPL spin-offs; and, second, it in effect extracted from the banks a partial pre-payment of about 33 percent of its maximum lending to the AMCs. In essence, this Special Bill was a predecessor to the mammoth Special Bond issued by the MOF in 2007 to capitalize CIC and it was issued largely for the same reason: to control excess liquidity.

  The ICBC and ABC recapitalizations, 2005 and 2007

  In contrast to its involvement with BOC and CCB—where its 1998 cash capital contribution had been fully written off but its liability stayed in place—in the case of ICBC, the MOF’s original RMB85 billion remained, so that the PBOC/Huijin’s contribution was reduced to US$15 billion, equivalent to 50 percent of the bank’s equity. Two years later, in 2007, ABC’s recapitalization followed the ICBC model, but things appeared to have changed completely. As before, Huijin contributed new capital from exchange reserves to the tune of US$19 billion to ABC, and the MOF’s 1998 contribution remained in place. But, as will be discussed in Chapter 5, by this stage, Huijin belonged to the MOF, not to the PBOC.

  While, on the surface, things appeared to be consistent with the PBOC approach, in fact the entire structure of bank ownership had reverted to the status quo of the pre-reform era, with the MOF in control. Not only ownership was affected; the entire restructuring of problem-loan portfolios was different, as was the government’s attitude towards the banks. With the apparently successful rehabilitation of BOC and CCB, the Party was, in effect, telling the banks that they now had to share the burden. From this came the lending binge of 2009; the banks had once again reverted to their role as a simple utility.

  THE MINISTRY OF FINANCE RESTRUCTURING MODEL

  The MOF, of course, was unhappy with its subordination to the PBOC following the restructuring of the banks up to 2004. Historically, this was almost the first time that their roles had been reversed. However, as described above, from 2005, the MOF was able to exert its influence over the banking system once again, a process that culminated with the establishment of China Investment Corporation (CIC) in late 2007 (see Chapter 5). The principal difference between the MOF’s approach and that of the PBOC was that it assumed direct responsibility for the funding and repayment of problem-loan disposals. This, in fact, appeared to nudge things much closer to the international model. The PBOC had succeeded in pushing the MOF away from control of the reform process, but its complex funding arrangements for NPL disposals, although practical given the government’s limitations, had never been a good solution. From the start, the AMCs had been thinly capitalized and faced the hopeless task of recovering 100 cents on each dollar of problem loans. How could they really be expected to repay the PBOC, much less the banks?

  Looked at closely, however, the MOF’s solution also had its weak points. In 2005, when it assumed control of ICBC’s ongoing restructuring, the MOF partially replaced AMC bonds with its own paper. That year, a bad-loan portfolio of RMB246 billion was transferred to a “co-managed account” (see Appendix) and ICBC—unlike in the BOC and CCB cases—did not receive cash. Instead, it received what can be called “MOF IOUs” as well as the traditional AMC bonds (see Figure 3.6).

  FIGURE 3.6 NPL restructuring for ICBC and ABC, 2005 and 2007

  The case of ABC, too, is a pure example of this same MOF approach. Some 80 percent—RMB665.1 billion (US$97.5 billion)—of its NPLs was replaced on a full book-value basis by an unfunded MOF IOU.6 As with ICBC, the NPL hole on its balance sheet was replaced with a piece of paper conveying the MOF’s vague promise to pay “in following years”, according to the related footnote in its annual financial statement. For ICBC’s receivable, this period is five years; for ABC, it is 15
.

  On the plus side, this receivable had the advantage of being a direct MOF obligation and relieved the banks of any problem-loan liabilities. Moreover, since ICBC and ABC did not receive cash, excess liquidity did not become a problem. These were the advantages to this approach, but there were also disadvantages.

  The details of the underlying transactions for the two banks show that this approach is another instance of pushing problems off into the distant future. Actual title to the problem loans was transferred to the “co-managed” account with the MOF. The banks were authorized by the MOF to provide NPL disposal services. But what exactly is this MOF IOU? It may represent the obligation of the Ministry itself, but, notwithstanding the fact that the MOF represents the sovereign in debt issuance, does its IOU represent a direct obligation of the Chinese government? It would have been a far cleaner break had the MOF simply issued a bond, funding the AMCs directly from the proceeds and using cash to acquire the NPLs. There would have been no need for the PBOC to extend credit at all. That was how the United States Department of Treasury funded the Resolution Trust Corporation during the savings-and-loan crisis.