One of the greatest challenges China must confront before the WTO treaty enters into force in 2007 is to prepare the country's banking system for privatization and competition with foreign banks. The government has established a new agency, Central Hujin Investment Company, to manage and re-capitalize big state-owned banks before they are sold. Hujin has already injected US$60 billion of China's foreign-exchange reserves into the Bank of China, the China Construction Bank and the Industrial and Commercial Bank. The Agricultural Bank will also require new capital, although the government is not yet preparing it for privatization.
The government's rescue policies appear to be working. During the past two months, Bank of America has announced a US$2.5 billion investment in return for a 9 percent stake in the China Construction Bank, and the Singapore-based holding company Temasek paid US$1.4 billion for a 5.1 percent stake in China Construction Bank. The Royal Bank of Scotland is leading an investment group that will invest US$3.1 billion more in the Bank of China, while Goldman Sachs and Germany's Allianz are close to an agreement to acquire a 9.9 percent stake in the Industrial and Commercial Bank for a similar sum.
The government hopes that these foreign investments will set the stage for the banks to go public on stock exchanges in Hong Kong and elsewhere next year, whereas foreign banks are investing with an eye to penetrating the enormous Chinese market. The big three state-owned banks have vast branch networks and employ hundreds of thousands of people. Foreign banks could never hope to achieve such comprehensive coverage without a local partner. They will focus initially on sectors such as credit cards but could develop other joint ventures. HSBC also announced a major investment in Ping An Insurance, which could set the stage for experiments with bancassurance in the future.
The Bank of Communications listed on the Hong Kong stock exchange shortly after the HSBC investment, so it has been able to provide the market with more information than the banks that are still awaiting privatization. Goldman Sachs is bullish, believing that the bank can record 17 percent loan growth this year, a 20-basis-point improvement in margins, and significant growth in fee income.
The major concern, however, is evidence of a growing volume of non-performing loans. The Bank of Communications' performance suggests that China's lending boom of 2003 and last year could lead to another wave of defaults this year and next. Last year, the investment share of GDP rose to 45 percent -- one of the highest levels in recorded financial history -- as banks financed a huge expansion of property development and manufacturing capacity. Now, the largest banks are claiming significant increases in non-performing property loans, while the glut of new industrial capacity implies that some firms may not have adequate profits to service their debts.
Although the Bank of China curtailed its lending growth to only 6 percent last year because of concerns about credit quality, many new local banks have expanded their lending aggressively, and could now suffer huge losses as the economy slows and firms' solvency weakens.
In these circumstances, privatization will have profound consequences for China's economy. The recent capital-spending boom produced a burst of speculative lending in 2003 and last year, because the banking system was still state-owned and responsive to political pressure -- until the government itself imposed credit controls in April last year to prevent a sharp upsurge in non-performing loans.