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

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

  But this is all just window-dressing compared to the PBOC’s huge exposure to foreign currencies, shown as “Foreign Assets” on its balance sheet. Strengthening its capital base, therefore, would appear prudent. By doing so, the government could openly demonstrate its commitment to a strong banking system. Of course, the sovereign, with its vast riches, stands behind the PBOC, but it is not so simple.

  China’s massive foreign-exchange reserves give a false appearance of wealth: at the time the PBOC acquires these foreign currencies, it has already created renminbi. Under what conditions can these reserves be used again domestically without creating even larger monetary pressures? As they are, the reserves are simply assets parked in low-yielding foreign bonds and Beijing’s ability to use them is very limited. If the MOF is content to extend the life of the AMCs, consider how much more politically complex the issue of recapitalizing the PBOC would be.

  In any event, the government appears to lack the desire to take on such subjects. The pressure to pursue meaningful financial reform has diminished since the struggles of 2005. Drowned in the flood of Party-supported “loans”, China’s banks in 2009 were back to where they left off before the entire recapitalization program began in 1998: they are financial utilities directed by the Party, just as was the case when the Great Leap Forward began more than 50 years ago. Whatever problems may arise can easily be dealt away to obscure entities that few know or will remember.

  CHINA’S LATEST BANKING MODEL

  As Chen Yuan remarked, China should not bring “that American stuff over here . . . it should build its own banking system.” It is doing just that with the bits and pieces of its old financial system that have been assembled by the asset-management companies. Before the final clean-up of the Agricultural Bank of China and the 2009 loan surge, the fate of the AMCs was actively discussed among the Big 4 banks and the State Council. What should have happened, but apparently will not happen now, was described thus by one of their senior managers:

  For losses stemming from the first package of policy NPLs, the state will bear the burden [an estimated US$112 billion]. The losses on the commercially acquired NPLs [an estimated US$64 billion] are to come from the AMCs’ own operating profit after deducting the PBOC re-lending interest. If the price the NPLs were acquired at was not right, then any losses on the PBOC’s loans will be made up by AMC capital. In the end, the most likely outcome is that the AMCs will have to wrangle with the state.12

  This AMC official knew full well that if the AMCs were to take write-offs, they would be bankrupted, forcing the MOF to step in and cover the value of their outstanding bonds and loans from the PBOC. Failing this, the banks would bear losses to their capital that they were (and are) not in any position to bear.

  The collapse of Lehman Brothers in September 2008, however, changed this equation completely. The Chinese government acted as if a veil had been removed from its eyes as the international banking system teetered on the verge of collapse. Since at least 1994 and certainly from 1998, bank reform and regulation had been based on the American financial experience. Citibank, Morgan Stanley, Goldman Sachs and Bank of America were seen as the epitome of financial practice and wisdom. This American model and the vigorous efforts of the bank regulator and other market-oriented reformers to channel Chinese financial development within its framework immediately lost all credibility. But there was nothing to take its place. The banks, suddenly without restrictions, not only went on their famous lending binge, but also sought to grab as many new financial licenses as possible. As one senior banker said: “No one knows what the new banking model will be, so in the meantime, it’s better to grab all the licenses we can.” The easiest place to find a handful of these licenses was the AMCs. How did they come by so many?

  In addition to taking on problem-loan portfolios from the banks, the asset-management companies also assumed the debt obligations of a host of bankrupt securities, leasing, finance, and insurance companies and commodities brokers. Of the collapse of this part of China’s financial system just five years ago, the world remains ignorant. In many of these cases, the AMCs were meant to restructure debt into equity and then sell it to third parties, including foreign banks and corporations. The proceeds of such sales would have partially or, if well negotiated, fully repaid the old debt. But in the great majority of cases, these zombie companies were never sold, nor were they closed. Ultimately, their names changed and their staff employed, they emerged as AMC subsidiaries. Orient AMC, for example, proudly boasts a group of 11 members, incorporating securities, asset appraisal, financial leasing, credit rating, hotel management, asset management, private equity and real-estate development. Cinda, the largest and most aggressive AMC, has 14, including securities, insurance, trust and fund-management companies. By acquiring the parent AMCs, Chinese banks could in one swoop hold licenses that would, on the surface, catapult them into the league of universal banks.

  Of course, the banks were egged on by the AMCs, which did not want to be closed down. There was also an element of vindication: the AMCs were the repositories of unwanted staff who had been spun off as part of bank restructuring. Both began a game of chicken with the government, with the NPL write-offs as the target. By mid-2009, persistent rumors emerged that ICBC and CCB had each submitted concrete plans to the State Council to invest up to US$2 billion for a 49 percent stake in their respective affiliated AMCs. The very idea is astounding: 49 percent of what? But this was no rumor: by late 2009 Caijing magazine reported that the State Council had approved CCB’s 49 percent investment in Cinda valued at RMB23.7 billion (US$3.5 billion), with the MOF continuing to hold the balance.13 The total resulting registered capital of Cinda, including the MOF’s original RMB10 billion, was reported to be RMB33.7 billion. This is outrageous because it means not a penny of losses—operating or credit—had been taken by Cinda over its 10 years of operation. This is simply not possible, even if Cinda were the best-managed of the four companies. Or perhaps the operations of its myriad new subsidiaries had offset such losses. Who knew?

  Even were it not bankrupt, one wonders at the amazing valuations characterizing the proposed Cinda transaction. Are Cinda and its unknown subsidiary, Huida, any different from those puffed up special-purpose vehicles whose deflation led to the bankruptcy of Enron, not to mention the near collapse of the American financial system in 2008? And there was more to the new arrangements. On the same day the Cinda deal was mooted, the MOF announced that Cinda’s RMB247 billion bond owed to CCB was to be extended for a further 10 years. This action undoubtedly represents the first step to extending the institutional life of the other three companies as well.14

  The year 2009 marked the end of banking reform as advanced since 1998. What will follow is beginning to look like a glossier version of the old Soviet command model of the 1980s and early 1990s. In the end, the Cinda deal could not be done in its proposed form. By mid-2010, however, a new structure for Cinda had been rolled out. Cinda was incorporated, with the MOF as the sole shareholder, and its valueless assets, including the loans it owes the PBOC, were spun off into the now increasingly ubiquitous “co-managed account” in return for more MOF IOUs. This left Cinda and its bevy of financial licenses able to begin the search for a “strategic investor,” which, of course, is expected to be CCB. From this continual recycling of debt, it seems that, despite its fantastic riches, the Party—and certainly the MOF—lacks the wisdom and the determination to complete the bank reform begun in 1998.

  IMPLICATIONS

  The question is often raised: does it matter how the Party manages this machinery for failed financial transactions? China, after all, has the wealth to absorb losses of this scale, if it is determined to do so. The answer to this question must be “Yes.” Every day, the press carries stories about China’s National Champions and its new sovereign-wealth fund seeking out investment opportunities in international markets. The internationalization of the renminbi has made headlines as China seeks to challenge the dominance of the dollar
as the international currency for trade and, perhaps someday, the international reserve currency. But little is heard from China’s banks; why?

  When in 2008 the Western banking sector was in full disarray and the world was applauding the Chinese for their stimulus package, Merrill Lynch and Morgan Stanley were going for a song. Where were China’s banks? A small deal in South Africa and a community bank in California were all there was to show for these proud financial giants. More recently, the head of one of the Big 4 banks dismissed the growth opportunities of developed markets such as the US: tell that to Jamie Dimon!15 One can well imagine how the US Government would have been forced to react had ICBC come to the Department of Treasury in those dark days with a full cash offer for Citigroup, Wachovia, Washington Mutual or Merrill Lynch. For China, the whole shopping basket would have been cheap. Opportunities forgone in a period such as the world has just passed through may never present themselves again. In contrast, China’s corporates, the China Development Bank, and its sovereign-wealth fund have actively sought international investments: why haven’t the banks?

  Put another way: if market valuations for Chinese banks are real and the banks are in such great shape, why hasn’t China’s banking model been exported? As US and European regulators and governments look for a way to prevent the next financial crisis, why is China’s model—with its asset-management companies, outright state ownership and central bank lending—not invoked? If, as some predict, China seeks to replace the US at the center of the global economy at some time in the near future, one would expect it to export not just capital, but also intellectual property. It is nowhere to be seen, nor is it expected.

  The story of the past 10 years suggests that China’s banks, despite their Fortune 500 rankings, are not even close to becoming internationally competitive. They simply do not operate like banks as understood in the developed world. Their years of protective isolation within the “system” have produced institutions wholly reliant on government-orchestrated instruction and support. When the Organization Department determines a bank CEO’s future, what can be expected? Despite the prolonged effort to reform the corporate-governance mechanism of the banks, can anyone believe that a bank’s board of directors is more representative of its controlling shareholder than its Party Committee? These banks are undeniably big, as they always were, but they are neither creative nor innovative. Their market capitalizations are the result of clever manipulation of valuation methodologies, not representative of their potential for value creation. In 2010, as one Chinese bank after another announced multi-billion-dollar capital-raising plans, one wonders what happened to the huge amounts of capital each had raised just three or four short years ago. Despite apparently outstanding profits, they have not grown their capital fast enough and that is even without considering any mark-to-market valuation of the now perpetual AMC bonds or their huge exposures to the domestic bond markets. The fact is they are now, and were even after their IPOs, undercapitalized for the risks they carry on their balance sheets, and this accounts for their outstanding return-on-equity ratios.

  China’s banks are at the mercy of domestic political disputes and this emphasizes their passive role in the economy. As others have noted, China’s banks have traditionally operated like public utilities. Zhu Rongji’s effort to push the banks toward an international model has been stopped and the banks have reverted to their traditional role. Without question, in 2010, they are again huge deposit-taking institutions, extending loans as directed by their Party leaders. Whatever degree of influence their boards of directors and senior management may have gained over the past decade, from 2009, they are no longer much more than window-dressing, as is the previously well-regarded bank regulator. If banks are about measuring and valuing risk, these entities, having begun to learn, have now quickly forgotten.

  Any argument that they have no need to study “that American stuff” since the bulk of their “lending” is to state enterprises is demonstrably specious: SOEs don’t repay their loans. Banks know that it does not matter whether or not such loans are repaid. First, the Party has taken all responsibility and management cannot be blamed for following orders. Second, as this chapter has shown, there is already a well-proven infrastructure in place to hide bad loans. The future development of the AMCs, as well as the almost-virtual “co-managed account,” now seems assured. Careers can be lost only if managers fail to heed the Party’s rallying cry. It is the Party, and not the market, that runs China and its capital-allocation process.

  In the absence of public scrutiny, few have called into question the quality of bank balance sheets and earnings. This is understandable domestically, where the media is subject to the Party’s “guidance,” but it is also the case outside of China. International stock markets and brigades of young equity analysts have lent the credibility of their institutions to the idea that banks in China are just that, banks, and have value, if not as individual institutions, then as proxies of the country’s economy. That is just the point: they are indeed proxies of the economy “inside the system.” In this economy, the Party makes what organizational arrangements it likes, a prime example being the bank buy-back of the un-restructured AMCs. The public line supporting this idea as put forth by an analyst at a major American bank goes: “The asset managers will have the largest capitalized banks in the world behind them which are interested in their expanded business, so there are valid business reasons why this [investment in the AMCs] should happen.” Other foreign analysts at major institutions have eagerly echoed this thought.

  Such unthinking commentary does China no service. It would be even more dangerous if the Chinese government were lulled into believing that the Big 4 banks are in fact world class and proceeded to encourage them to expand internationally. What effect would the consequent scrutiny by Western regulators and media have? Having seen what constant media focus on sub-prime debt and securitization vehicles caused in the US in 2008, however, no one should be sanguine. Bear Stearns and Lehman Brothers, it should be remembered, disappeared over a weekend. China’s political elite has surely learned a lesson from this experience, just as it has from other international financial crises.

  In China, political imperatives make significant internationalization of the banks unlikely. The Big 4 banks form the very core of the Party’s political power; they work in a closed system with risk and valuation managed by political fiat. True, China’s banks have taken on an international guise by public listings, advertising campaigns and consumer lending. As 2009 has shown, however, such change is superficial: true reform of their business model remains a goal that will be the more difficult to reach the closer it is made to seem. These banks will always be closely guarded and directly controlled domestic institutions. Leaders of major international banks in recent years have spoken of creating “fortress balance sheets” able to withstand significant economic stress. In China, there is also the drive to create a fortress, but it is one that seeks to insulate the banks from all external and internal sources of change in the belief that risk should remain under the Party’s control.

  In 2009, China’s banks extended a tidal wave of loans exceeding RMB10 trillion. If in the next few years, these loans do not give rise to a significant volume of NPLs and continue to be carried on balance sheets at full face value, the banking system by definition must continue to be closed. On the other hand, if risk classifications based on international standards are applied consistently, a repeat of the 1990s experience is in the making, with huge volumes of unpaid loans and the banks again in need of a massive recapitalization. Already, the tsunami of lending and high dividend payouts have stretched bank capital-adequacy ratios and forced the need for more capital, which comes largely from the state itself. It is somewhat ironic that the demand for capital can also be mitigated by reducing loan assets, ensuring that the AMCs will continue to play a central role.

  There is a further important aspect to this arrangement. Over the past several years, China’s banks have ent
husiastically entered consumer businesses; credit and debit cards, auto loans and mortgages have become common in the country’s rich coastal areas. From 2008, the collapse in exports has revealed a great weakness in China’s export-dependent economic model; experts from all sides have urged the government to develop a domestic consumption model similar to that of the US (always the US model!). Pushing in the same direction is China’s ageing demographic. If the government does seek to replace export demand with domestic consumption, this suggests that the domestic savings rate will decline, as will household deposits. What will happen to the banks then? Today’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 AMC/PBOC arrangement works for now because everyone saves and liquidity is rampant. What happens to bank funding if the Chinese people learn to borrow and spend with the same enthusiasm as their American friends? From this viewpoint, a profusion of new investment and consumer-lending products appears unlikely. Similarly, this view suggests that full funding for social security is a reform whose time will not come.