Sun, Sep 04, 2005 page8

• China's banking faces a revolution

  • By David Hale
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  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.

  In the next business cycle, China's banks will be privately owned for the first time since 1949. They will give loans on the basis of commercial criteria rather than relations with big state-owned companies. They will be less vulnerable to political pressure from local governments to finance development projects. They are likely to place much greater emphasis on consumer lending, especially mortgages and credit cards. With China's mortgage lending equal to only 10 percent of GDP, compared to 60 percent to 70 percent in Western countries, there is huge opportunity for growth.

  The transformation in China's banking system, coupled with the recent decision to revalue the yuan, will require major changes in the conduct of monetary policy. Until recently, an exchange-rate peg dominated China's monetary policy, with interest rates unchanged for nine years until October last year, as the government attempted to manage lending through administrative guidance and credit controls.

  In the future, China will have to rely more heavily on interest rates to manage monetary policy, using the price of capital, not political considerations, to influence how firms make investment decisions.

  The transformation in China's banking system is complex and difficult because it involves a change in its fundamental nature. However, barring any major economic upheaval, the changes will have a positive impact, as capital allocation becomes more efficient. Increased emphasis on household lending should also create a better balance in the economy between capital spending and consumer spending than was possible during the expansion of 2002 to last year.

  David Hale is a specialist on Chinese banking and founding chairman of Hale Advisers, LLC and China Online, which provides daily business news on China.

  Copyright: Project Syndicate
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