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

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

  FIGURE 5.9 Step 2: MOF buys US$ from the PBOC to capitalize CIC

  After the money had changed hands, CIC for all intents belonged to the MOF. Although it reported directly to the State Council, its top senior management came from the MOF system. This was not necessarily a loss for the reform camp, since CIC was also staffed at senior levels with officials historically associated with market reform. But there was an awkward technical problem arising from the MOF’s arrangement: how would interest be paid on its underlying Special Bonds? The cost involved amounted to around US$10 billion annually. The surprising answer was that CIC would pick up the interest. As the head of CIC dryly commented, the burden was about RMB300 million for each day CIC was open for business. How would CIC, a newly established entity not meant to be a short-term investor, have the immediate cash flow to cover such a huge obligation? The solution to this problem by itself has put an end to further hope of bank reform.

  Careful calculation, however, had been given to this solution; it reveals how in 2007 the Party desired to organize China’s financial system and goes to the heart of the PBOC’s loss of institutional clout. Even before CIC received its new capital, the US$200 billion had been budgeted and spent, and only one-third of it related to its advertised mission as a sovereign-wealth fund. The other two-thirds, some US$134 billion, was to be spent on, first, a planned recapitalization of ABC, the CDB and other banks and financial institutions and, second, the outright acquisition of Central Huijin from the PBOC. In one stroke, CIC became China’s financial SASAC.

  One might ask why a sovereign-wealth fund would want to own or invest in domestic financial institutions already owned outright by the government: the money would just be going around in circles. But this is exactly what happens “inside the system.” The attractive professional face its management presents internationally is belied by the reality that CIC is, at best, only a part-time sovereign-wealth fund. Its most important role is to serve as the lynchpin of China’s financial system. That system has been restored to one inspired by the old Soviet model centered on the MOF and with a weak central bank.

  The MOF is the obvious winner in this domestic game and it is a purely status-quo power. Its victory ultimately has significant negative implications for continued bank reform and can clearly be seen on referring back to Table 3.3, which shows the pre- and post-IPO controlling shareholders of China’s major banks. From the very start of bank reform in 1998, the fundamental point of contention between the MOF and the PBOC has been over which entity owns the state banks on behalf of the state. Once reform entered its critical stages in 2003, the plans of Zhou Xiaochuan’s group of reformers began to affect the economic and political interests of the MOF. When Huijin recapitalized CCB and BOC, it did so in a way that established direct economic ownership and, at the same time, used the MOF’s equity interest to write off problem loans; no longer did these two banks “belong” to the MOF empire. In the years after Zhou’s political defeat in 2005, the MOF won back control, starting with the ICBC and continuing through ABC, at least in part because of the PBOC’s difficulties managing its primary responsibilities: inflation and the currency. But this was hardly the only reason.

  A contributing part of the PBOC’s political weakness during the crucial year of 2005 was the terminal illness suffered by Vice Premier Huang Ju, who was in charge of the financial sector. In early 2005, Huang stepped aside for treatment and the Premier assumed his portfolio. Consensus politics resumed and the consensus was that Zhou Xiaochuan had overreached. Reform is not about consensus. It was an easy decision that rocked no boats to allow the MOF to retain as equity its 1998 capital contribution in ICBC. So Huijin, after injecting US$15 billion, received only 50 percent of ICBC and the MOF’s 1998 contribution remained. The bureaucratic pendulum had begun its backward swing. By late 2007, with CIC’s outright acquisition of Huijin, the status quo had been fully restored.

  The argument in favor of this acquisition was simple: CIC was responsible for the interest on the Special Bonds. Acquiring the banks gave it access to their dividend stream.11 Since it all belonged to the state anyway, what difference did it make? The fact is, it did make a difference and not just to the bureaucracies involved. If CIC were to acquire Huijin, then SAFE would want its original investment back. The US$67 billion price represented the original net-asset value of its investments in all three banks and a collection of bankrupt securities companies.12 Since it would be simply a transfer of state-owned assets between state agencies, by government rules, there need be no premium paid. It was just a matter of accounting and the money going from one pocket to the other. The change in “owners,” however, would have a huge impact on reform moving forward.

  For CIC, the acquisition worked out very well. According to its first full-year financial report for FY2008, CIC carries at a market value of US$171 billion what it acquired from the PBOC for only US$67 billion. This increased in 2009 to over US$200 billion but, of course, included investments other than Huijin at that point. These investments by Huijin allowed CIC to claim a profit in its first year and so helped deter criticism of its controversial (and loss-making) investments in Blackstone and Morgan Stanley. But there was one small detail that had not been properly considered: three of the Big 4 banks were now internationally listed: the Party was no longer just playing “inside the system.”

  CIC squeezes its banks

  Beyond its mark-to-market profit on its bank investment portfolio, CIC also relied on the banks for the cash flow to make its interest payments on the MOF bonds, not to mention to pay dividends to MOF that helped it meet its obligations on the IOUs given to ICBC and ABC. The Huijin arrangement designed by the PBOC team placed CIC in a position to receive dividends paid by the banks (see Chapter 7 for further details). This rich source of cash had originally been designed to help offset the unrecoverable loans the PBOC had made to the AMCs in support of bank restructuring. The Huijin arrangement acted as a form of taxation that would, over time, have reduced the PBOC’s credit losses and strengthened its balance sheet.

  When CIC acquired Huijin in late 2007, it acquired direct economic control over China’s major banks via their boards of directors and a decisive vote in the matter of their dividends. There would be no intervening levels of ownership, management, and powerful Party secretaries to muddy the issue (as was the case in the SASAC’s state-owned enterprises). Huijin was controlled by the PBOC which, in turn, is controlled by the Finance Leadership Group at the very top of the Party hierarchy. In sum, now MOF was in a position to recommend, if not decide, how much was to be received by . . . itself.

  This takes the story full circle back to the bank IPOs. The dividend payout ratio of around 50 percent for all three banks is not necessarily excessive by international standards for banks that are growing at a stable rate and in a normal business environment where bad loans and securities losses are not material. This, however, does not describe the situation faced by the Chinese banks. These banks drive national economic growth by increased lending typically at 20 percent a year and in certain years, such as 2009, much more. But from 2008, Huijin’s new duty would be to pay interest on CIC’s bond obligations to the MOF as well as help the MOF make good on its IOUs. Since the banks are publicly listed and audited by international accounting firms, cash dividends paid by them are transparent to all. To some extent, they might serve as a reliable indicator of how the government thinks about its banks.

  In the early days of restructuring, as NPLs were being spun off to the AMCs and capital rebuilt, asset growth was tightly controlled (see Figure 3.7 for the years 2001–2005) and capital ratios were rapidly bolstered. After their respective listings, however, lending, profits and dividends for all three banks grew rapidly, particularly after CIC acquired Central Huijin in 2007. From that point, total dividends immediately increased to a level sufficient to cover CIC’s interest obligations, leaving plenty left over to reduce the outstanding restructuring IOU due to ICBC from RMB143 billion (US$18 billion) to
RMB62 billion (US$9 billion) (see Figure 5.10). Of course, to the extent that CIC and its banks were responsible for making such payments, the national budget was freed of the obligation.

  FIGURE 5.10 Big 4 bank IPOs, cash dividends paid and CIC, 2004–2009

  Source: Huijin; bank annual audited financial statements

  These financial arrangements raise questions about the future path of China’s bank reform. Given the experience of 2009, there is no question but that banks have reverted to their former business model as the Party’s financial utility. But is it really possible that dividend policy is being set to meet the MOF’s own parochial needs? The appearance certainly suggests that the listed banks have become cash cows subsidizing the MOF’s efforts which, among other things, are aimed at sidetracking the institutional influence of the PBOC. Worse yet, it is outrageous that the full amount of cash dividends paid during this period has been funded by the IPOs of state banks (as discussed in Chapter 2). From a very simplistic point of view, international and domestic investors handed over US$42 billion in new capital to the banks and indirectly to the MOF, yet received in those years less than US$8 billion in dividends. Beyond that, is it possible that under pressure to maintain dividends, bank managements might easily be encouraged to increase lending? With fixed spreads over the cost of funding, more lending assures more earnings, higher dividends, better stock price and higher rankings on the Fortune Global 500. Then came the economic stimulus package, which provided all the excuse needed to do just that.

  Not even a year later, in early 2010, however, the combination of 50 percent dividend payouts and binge lending have created huge challenges for the banks. Most challenged of all must be Bank of China, whose loan portfolio grew nearly 43 percent in 2009 while the other major banks hit levels over 20 percent. Given the high dividend payouts and asset growth, it is hardly surprising that the banks rapidly grew out of their capital base, with BOC and ICBC rapidly approaching capital ratios close to pre-IPO levels (see Table 5.2).

  TABLE 5.2 Trends in core capital-adequacy ratio, 2004–1H 2010

  Source: bank annual and interim audited reports

  From that point, there was much government hand-wringing as to how bank capital could be increased. In early 2010, each of the banks announced record 2009 earnings and improved NPL ratios . . . and one after the other, each has announced plans to raise for a second time that US$40 billion chunk of capital they had raised from their IPOs and then paid out to the state (see Table 2.3). Of course, the state would be required to disgorge capital as well if it desired to maintain its shareholding. So it was not surprising when rumors emerged that Huijin, the direct majority shareholder of the major banks, was seeking approval for a large capital injection of up to US$50 billion to match its share of bank capital and maintain its equity position.13 Even more interesting, CIC had requested an additional US$200 billion from the MOF. Both requests were subsequently cut back significantly, Huijin to an RMB190 billion (US$28 billion) bond issue and CIC to US$100 billion.

  The dividends, the excessive lending and the scramble for new capital can all be ascribed, at least in part, to the MOF’s acquisition of banking assets from the PBOC. Had China Investment Corporation been capitalized directly from China’s foreign-exchange reserves, it could have remained a pure sovereign-wealth fund and the MOF would have had its own counterpoint to SAFE Investments. Had there really been the need to sterilize such a massive amount of RMB, the Special Bond could have been issued separately. But the MOF combined the two and the resulting structure twisted the heart of China’s financial system into this awkward bureaucratic and economic position.

  What to do with Huijin is perhaps the biggest topic on the agenda of the Fourth National Finance Work Conference in mid-2010. This is part of a much broader power grab by the MOF, which hopes to use Huijin as the basis of a “Financial SASAC” that would become, among other things, the Super Regulator for China’s entire financial sector, replacing “one bank and three commissions.”14 Even if this were to happen and Huijin were to be freed of CIC, the arrangement with regard to the Special Bond would likely remain. Then there is the question of which state entity would pay CIC the US$67 billion it is nominally worth and where the money would come from. The point of this is that Huijin and its banks continue to be the object of a bureaucratic ping-pong game domestically that increasingly exposes the internationally listed banks to the valuation judgment of international investors precisely at the time that the government has actively desired to cut back foreign influence.

  CYCLES IN THE FINANCIAL MARKETS

  It is well recognized that China’s currency policy of fixing the RMB exchange rate against the US dollar greatly limits flexibility in interest rates. This by itself means that real fixed-income markets cannot readily develop. There is another dimension to this problem. China’s banks depend on Party-guaranteed profitability created by mandated minimum spreads between deposits and lending rates. The profit generated here from corporate borrowers subsidizes their “investment” in sub-market-priced government securities. This can work only so long as they operate in a protected domestic oligopoly well insulated from outside pressures. Foreign banks exist in China only to provide the suggestion of an open market. With profits guaranteed, banks have never had to be creative in competing for customer support. Nor have they had to worry about new capital or problem loans: these are the Party’s problems, not those of bank management. So when the Party calls for development of the bond market, the banks follow, even though bonds are little more than disguised loans. The corporate-bond market stops there: there is no secondary market. But the fixed-income market is more than just corporate bonds.

  In recent years, the flood of US dollars from a large trade surplus and inflows of hot money, the consequent creation of new RMB, the need to sterilize that RMB to prevent inflation and asset bubbles have combined to distort the very institutions on which the financial system is built. When in 2007 the MOF argued that PBOC notes were insufficient to offset excess RMB, the ensuing political solution attached itself to the wholly unrelated establishment of CIC. It was argued that CIC’s capitalization solved two major problems: temporarily controlling money creation and putting to use a large portion of the country’s foreign reserves. This was a clever ad hoc solution that became complicated by CIC’s acquisition of Huijin.

  Leveraging Huijin’s bank investments to pay interest on the MOF’s bonds may have seemed a good idea at the start; it appears that the Party mistakenly believes its own advertising about its banks being rich and strong. But it linked the stresses of China’s domestic financial markets directly to the international financial markets. This has created an economic and political exposure contrary to the fundamental interests of the “system.” An unconvertible currency, fixed exchange and interest rates and the need for strong bank lending to drive GDP growth create inevitable and predictable demand for huge amounts of new bank capital that, in turn, depends on international and domestic capital markets. With over US$70 billion in new capital to be raised, these markets will, in the end, be demanding and price sensitive, even if many friends of China internationally and domestically stepped up to make Agricultural Bank of China’s US$20 billion IPO an apparent success as it was.

  An economic stimulus package that in retrospect appears to have been excessive gave banks a free option to expand their lending. But stimulus or not, this is what the Party’s banks do in any circumstances, as history has shown. With mandated loan spreads, RMB10 trillion (US$1.5 trillion) in new loans grew bank earnings dramatically. It is important to note as well that banks are happy to lend to local governments—at the behest, of course, of the local Party secretary—directly or through bonds. Can they go bankrupt? Are they lesser credit risks than SOEs? The interim announcements of the Big 4 banks in 2010 have been full of record profits and very high loan-loss reserves and, given rapid loan-portfolio growth, inevitably declining NPL ratios well below two percent. It is all a matter of simple mathematics an
d has nothing to do with strong management performance or value creation. There will be record dividend payouts and further improvements in their Fortune 500 rankings. But the lending explosion rapidly depleted bank capital. The first decade of the twenty-first century now appears to have ended, just as each of the last three decades of the twentieth century did, with China’s major banks in desperate need of massive recapitalization.

  This marks the completion of one full cycle of China’s money machine; it has taken 10 years. But the fault lines, created playing by the rules “inside the system” while pretending to abide by international standards and regulatory requirements, have begun to be clear. The second cycle can now be reliably mapped out and illustrates why true reform of the system is unlikely. Mandated minimum loan-to-deposit spreads sustain bank profitability thereby guaranteeing that dividends can be paid out to investors, namely Huijin. Huijin, in turn, must meet the demands of CIC, which must meet the demands of the MOF Special Bond. In the cases of ICBC and ABC, too, the MOF must make repayments on its special IOU arrangements. Even if Huijin were separated from CIC, each year cash would flow up from the banks to the MOF and then from the MOF back to the banks. The banks will expand lending to borrowers to drive high GDP-growth numbers and generate greater profit as long as China’s export and non-state sector remains weak.