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THESE WOULD APPEAR TO BE GOOD TIMES TO BE A Chinese banker. Mainland banks are among the world’s biggest and most profitable lenders. In the first six months of 2012, China’s so-called Big Four commercial banks — Industrial and Commercial Bank of China, Bank of China, China Construction Banking Corp. and Agricultural Bank of China — amassed profits of $61 billion, more than twice as much as the four biggest U.S. lenders. ICBC, China’s biggest bank, alone reported profits of $19.7 billion, greater than those of JPMorgan Chase & Co. and Wells Fargo & Co. combined.

Those profits, however, have been produced in a benevolent environment of government controls and implicit support that provides China’s banks with sizable interest margins, a captive deposit base to fund operations and limited competition from nonbank financial companies. It’s a system that has regularly required banks to ignore moral hazard and finance government-backed investments. Those conditions may now be changing, though. As China’s economy slows and loans start to sour, banks are having to use more of their earnings to settle bad debts.

China’s commercial lenders also are facing fresh competitive challenges as Beijing introduces market reforms and tightens oversight of banking activities. In recent months China’s banking regulators have cracked down on the fees banks charge their customers and taken the first steps toward liberalizing interest rates. The government is introducing rules and capital requirements that are pushing domestic banks to properly recognize their own balance-sheet risks, including accounting for a growing pile of doubtful loans.

As a result of these twin pressures, Chinese bank profits are certain to get squeezed, says Dong Tao, chief Asia economist for Credit Suisse in Hong Kong. “The heyday of China’s banking sector is behind us,” he says. “The monopolistic profits and high margins that banks have enjoyed over the last decade are entirely unjustified.”

The health of China’s banks is crucial because of their size and the role they play in the country’s economy. Beijing has used the big state-controlled banks as effective policy levers; much of the government’s 4 trillion yuan ($635 billion) stimulus program that revived the economy in 2009 was conducted through bank lending.

On paper, at least, the banks appear stronger and better capitalized than at any time in the past three decades. Many of these firms are reporting profitability margins and capital levels that rival or outstrip most of their Western counterparts. The country’s ten biggest banks showed an average core capital adequacy ratio of 9.5 percent at the end of June and a return on assets of 1.28 percent, according to Pricewaterhouse­Coopers estimates. U.S. banks had an average tier-1 ratio of 13.21 percent at the end of June; return on assets in the third quarter stood at 0.06 percent at Bank of America Corp., 0.11 percent at Citigroup, 0.99 percent at JPMorgan Chase and 1.49 percent at Wells Fargo.

China’s biggest banks have raced recently to raise additional capital ahead of the government’s January deadline to start phasing in the stricter standards of Basel III, selling 150 billion yuan of subordinated debt in November and early December. Beijing will require systemically important banks to lift their capital adequacy ratios to 11.5 percent, including tier-1 capital of 9.5 percent. For other banks the requirements are 10.5 percent and 8.5 percent, respectively. Among those now selling debt are Agricultural Bank of China, which is seeking to raise 50 billion yuan, and China Construction Bank, which is issuing 40 billion yuan in debt. Under Basel III the cost of issuing subordinated debt is expected to rise because investors must be willing to write down the value of the debt for it to be counted as regulatory capital.

The Big Four banks “are speaking about their risk-adjusted return on capital more than ever before,” says Michael Werner, senior banking analyst at Sanford C. Bernstein & Co. in Hong Kong. Although share prices of China’s Big Four banks have risen by 26 to 34 percent from their October 2011 lows, they were still between 18 and 35 percent below their November 2010 highs. “The concern is that earnings are going to decline and nonperforming loans are going to rise,” explains Werner, who has placed an overweight rating on ICBC, Bank of China and China Construction Bank.

Overall, Chinese banks reported nonperforming loans of just 0.97 percent of assets at the end of September, just above the system’s historic lows, reached in 2011. The trend in NPLs is troubling, however. They have risen for four consecutive quarters, the longest such stretch in eight years. In addition, banks continue to set aside cash to cover bad and doubtful debts, suggesting they anticipate an increase in NPLs. Provisions for China’s ten biggest lenders increased to 325 percent of NPLs in the first half of the year, according to PWC.

“We don’t put much stock or faith in the accuracy of NPL data in terms of magnitude,” says Charlene Chu, senior banking analyst at Fitch Ratings in Beijing. “What’s important here is the direction of NPL growth.”

More bad loans are expected as corporate repayment problems add to balance-sheet difficulties, particularly at China’s smaller financial institutions, says Yao Wei, China economist at Société Générale in Hong Kong. “The number of companies in apparent default or with cash flow problems is on the rise,” says Yao. “We are at the beginning of a new NPL cycle.”

Local government financing vehicles may be driving that cycle. LGFVs, as the vehicles are known, are special-purpose limited- liability companies designed to undertake local development projects, notably infrastructure such as highways, bridges and ports. The vehicles are crucial to the economy because China prohibits its counties, cities and provinces from taking bank loans or issuing bonds. Transparency at these entities is uneven at best, and debts are not often publicly disclosed.

Loans to LGFVs represent a big chunk of the banking system’s assets. According to a 2011 report by China’s National Audit Office, borrowing by 6,576 LGFVs amounted to 26.5 percent of gross domestic product at the end of 2010, up from 17.7 percent two years earlier. About 80 percent of the sector’s debt, or some 8.5 trillion yuan, was owed to banks. Some analysts believe the real numbers are even worse. Moody’s Investors Services says China’s government may have underreported LGFV debt by as much as 3.5 trillion yuan.

Given their outsize debts, the LGFVs may pose the most serious danger to the country’s banking system since the late 1990s, when nonperforming loans to state-owned enterprises drove the cumulative NPL ratio for the Big Four lenders above 30 percent, contends Patrick Chovanec, professor of business at Tsinghua University in Beijing. “There are logical questions about whether you will have a reprise of what took place in the 1990s,” he says.

At the time, China’s central government responded decisively by restructuring the Big Four, stripping out problem loans and placing them with government-run asset management companies. Between 1999 and 2009, Beijing removed 3.2 trillion yuan worth of bad debts from bank balance sheets, reducing the overall NPL ratio to 9.2 percent and paving the way for the banks’ partial privatization via initial public share offerings.

More than half of LGFV borrowing was designated for municipal construction, communications and transportation projects, the audit office said. Many of these investments, however, were either uneconomic from the start or financed with short-term borrowing, and they now generate insufficient cash flow to repay even interest on the debt. By the end of 2010, more than 1 trillion yuan in LGFV borrowing was designated for highway construction, China’s audit office noted, and many of those roads remain under construction, making repayment “heavily dependent on raising new debts.”

“It’s fine to build a subway or water treatment plant, but these types of investments usually break even and are backed by future tax revenue,” Chovanec says. “They shouldn’t have been built using commercial loans.”

The experience of   Yunnan Highway Development & Investment Co. highlights the dangers posed by LGFVs. The largest road building company in the southwestern province of  Yunnan, the outfit ran up debts soon after it was formed in 2006, as toll collections failed to meet the high costs of construction in the mountainous region. During the five years ended in 2010, Yunnan province invested 204.2 billion yuan on building transportation infrastructure, more than twice the amount invested in the previous five years. In April 2011, Yunnan Highway stunned its creditor banks when it announced it was halting principal payments on its borrowings. The company claimed some 100 billion yuan in liabilities. Similar repayment problems emerged at other government-backed companies, including Hunan Highway Construction & Development Corp. in the inland province of Hunan and Shanghai Rainbow Investment Corp., a municipal highway and real estate development firm.

Chinese banks may be asked to devote additional balance-sheet capital to keep loans from souring, using the same kind of “extend and pretend” policies that Japanese banks employed in the 1990s, says Chovanec. “In Japan the zombie banks became so preoccupied with preventing bad corporate debt from overflowing into the economy that they lacked the capacity to make new loans,” he notes.

Beijing’s approach to managing the LGFV debt issue certainly raises questions about how banks are recognizing these loans and whether they will be able to successfully absorb local government bad lending through earnings over time. “There isn’t a quick solution,” says Yi Zhang, senior analyst at Moody’s in Beijing. “It depends on the strength of the economy.”

Clearly absent has been the decisiveness that accompanied the restructuring of the Big Four banks more than a decade ago. In December 2010, China’s banking regulator told commercial lenders to adjust their risk-weighted assets to include cash flow coverage for LGFV loans. Some lenders claim to have scaled back their LGFV exposures even as they secured additional collateral. Bank of China, for example, says it reduced its lending to LGFVs by 6.5 percent in the first half of 2012, to 394.9 billion yuan, or 6.26 percent of its loan book. Ping An Bank Co., formerly Shenzhen Development Bank, slashed its LGFV lending to 42.5 billion yuan, or 6 percent of loans, at the end of September; two years earlier such borrowing accounted for more than 20 percent of the bank’s loan book. 

Beijing has turned to domestic debt markets to help local governments raise fresh capital and allow LGFVs to refinance their borrowing. The Ministry of Finance is bolstering local government coffers by stepping up its sponsorship of debt issues, announcing auctions of 250 billion yuan on behalf of municipal and provincial governments this year, a 25 percent increase over last year’s issuance.

Beijing also has allowed local government companies to pay off bank loans and extend debt maturities by issuing their own bonds. During the first ten months of the year, LGFVs raised 631 billion yuan through debt sales, according to statistics compiled by HSBC Global Research in Hong Kong. More than half of those funds were raised through the issuance of enterprise bonds, which are approved by the National Development and Reform Commission, China’s top planning body, and regarded as carrying an implicit government guarantee.

And who’s buying these bonds? Chinese banks have emerged as some of the biggest investors, absorbing as much as 50 percent of issues this year. The sale of such bonds to banks may simply be delaying the recognition of problems with the underlying bank debt, contends Zhiming Zhang, HSBC’s head of China research in Hong Kong. China’s domestic bonds carry implicit guarantees and, as with LGFV loans, China has not permitted a domestic bond to default. “Investors who are buying or holding these bonds are banking on policy support rather than an issuer’s credit fundamentals alone,” Zhang says.

Among the local government companies now looking to sell debt is Yunnan Highway, which has appointed underwriters for a 2 billion yuan, six-year note, according to a November report by 21st Century Business Herald. The company’s fundraising documents says Beijing-based Dagong Global Credit Rating assigned a credit rating of AA+ to the bonds after the firm unloaded indebted secondary roads to improve its credit outlook.

The profitability of Chinese banks is also facing a threat from Beijing’s recent efforts to jump-start reform of its financial sector. In recent months the government has launched experiments aimed at liberalizing the flow of finance. In March the State Council introduced a pilot scheme in coastal Wenzhou that encouraged the private sector to invest in banks and credit companies. The move lifted restrictions on ownership limits and enabled the region’s informal lenders to reorganize as shareholding banks or private equity firms.

“The barriers have been cleared for private capital to enter the banking sector,” Shang Fulin, chairman of China’s banking regulator, told reporters in November.

Chinese regulators also have cracked down on the service charges banks can impose on customers, in response to widespread complaints about hefty increases in bank fees. In November, for example, the State Council notified banks that merchant fees for bank card transactions would be reduced as of February. Fee income for China’s top ten listed banks rose by 38 percent in 2011, but the growth rate slowed to 6 percent in the first half of this year, when it totaled 223 billion yuan, according to statistics compiled by PWC.  At China Construction Bank net fee and commission income declined by 2 percent in the third quarter of 2012; such income had grown by 31.6 percent in 2011. “The bank perhaps wasn’t entirely fair in how we charged fees to different enterprises,” CCB president Zhang Jianguo told reporters in August. “Some fees weren’t reasonable.”

The government is pushing for banking sector reform as part of its wider goal of rebalancing the economy, explains Michael Pettis, a senior associate at the Carnegie Endowment for International Peace and finance professor at Peking University’s Guanghua School of Management. Beijing is seeking to foster domestic consumption and rely less on the kind of investment-led growth that propelled national development over the past three decades. The old growth model depended on a ready supply of cheap bank financing to state-owned enterprises.

“It’s unsustainable,” Pettis says. “We’ve reached a point where investment is no longer being channeled to economically viable projects. It has become uneconomic and wealth-destroying.”

Although China’s banks successfully mobilized national savings to build automobile factories, mobile telephone networks and other critical infrastructure, inexpensive credit more recently has led to widespread waste, inflated real estate prices and overproduction in everything from steel and cement to solar panels and household appliances. Investment’s share of China’s GDP grew to a remarkable 49 percent in 2011, according to Nomura International. That’s higher than peak levels reached in either Japan or South Korea during their strongest periods of growth.

Investment-led growth has come at the expense of the country’s household savers, who have had few alternatives for investment outside of bank deposits. China’s capital account remains closed, preventing offshore investment, and government-­set deposit rates have been fixed at artificially low levels for most of the past decade. China’s one-year deposit rate produced negative real returns nearly half the time between 2004 and 2010, according to Nicholas Lardy, senior fellow at the Peter G. Peterson Institute for International Economics in Washington.

Making changes isn’t going to be easy, says Jonathan Anderson, president of Emerging Advisors Group in Beijing. “China has a very controlled and coddled banking system,” he points out.

China’s banking system remains mainly state-owned and government-directed. Bank credit makes up more than two thirds of all fundraising in China, and the nonbank financial sector is still in its infancy. The central government controls its Big Four commercial lenders, as well as Bank of Communications Co., through shareholdings held by the Ministry of Finance and by Central Huijin Investment Co., the domestic arm of sovereign wealth fund China Investment Corp. These five lenders remain the backbone of the banking system, collectively holding 47 percent of the country’s 113.3 trillion yuan worth of banking assets at the end of 2011. China’s biggest lenders continue to enjoy implicit government support and still lend freely in line with government programs aimed at boosting growth. They are likely to provide much of the 1 trillion yuan needed to finance 55 projects, including subways, roads, ports and sewage projects, that were approved in September by the National Development and Reform Commission.

Although China abandoned formal lending quotas in 2011, the central bank continues to control credit growth through measures such as reserve requirements and loan-to-deposit ratios. The banks, in return, have benefited from government-set deposit rates that guarantee commercial lenders outsize profits. China’s banks continue to earn about three quarters of their income from interest revenue. The net interest spread for domestic loans has been nearly twice as large as that for foreign currency loans in the international market, according to Xiao Gang, chairman of Bank of China. Such spreads only encouraged banks to increase lending, especially to their state-backed clients. “In such an environment, which bank wouldn’t want to increase its lending?” Xiao wrote in a 2010 comment published by China Daily. “The more banks lend, the more profits they earn. Simple.”

After a decade of 30 to 40 percent compound annual earnings growth, bank profits have become so large that they are a source of national anxiety. The combined net profits of the 16 banks listed on the Shanghai and Shenzhen stock exchanges reached 545.2 billion yuan in the first half of 2012, representing more than one half of all corporate profits reported by the 2,475 companies at both exchanges.

“Frankly, our banks make profits far too easily,” retiring Prime Minister Wen Jiabao told an April business roundtable that was broadcast on China National Radio. “Why? Because a small number of major banks occupy a monopoly position, meaning one can only go to them for loans and capital.”

Breaking up an effective cartel is certain to face opposition, says Credit Suisse’s Dong. “You are talking about taking somebody’s lunch away,” he explains. “This isn’t just any lunch box; it’s a golden bowl. There are lots of vested interest groups that will come against you.”

The scope and pace of future reform will depend on the policies of China’s new leadership, headed by Xi Jinping, a former governor of Zhejiang province who was named general secretary of the Communist Party at the organization’s 18th National Congress, in November, and is due to succeed Hu Jintao as president in March. A reshuffling of the heads of top regulatory bodies is expected to have taken place by then.

Xi has indicated that his government is preparing to address many of the system’s structural problems. In December, at the first Politburo meeting since the leadership transition, Xi said national policy will focus on “expanding domestic demand and fostering new consumption growth areas” while controlling industries experiencing overcapacity, Xinhua News Agency reported.

“The consensus of received wisdom is that China had big waves of radical reforms — agricultural reforms in the 1970s and 1980s, big state enterprise reforms and opening to the World Trade Organization in the 1990s,” says Emerging Advisors’ Anderson. “The last and biggest issue is reforming the financial system.”

Liberalization of government-set interest rates stands at the center of the current effort. In July the People’s Bank of China announced that banks could lower rates for renminbi-denominated loans to as little as 70 percent of the central bank’s designated benchmark rate. A month earlier the bank allowed commercial lenders to raise their deposit rates to as much as 110 percent of the benchmark. They were the first significant changes to deposit and loan rate rules in more than seven years.

According to outgoing central bank governor Zhou Xiaochuan, additional measures are likely to be adopted gradually. “Interest rate liberalization is a process that will take a while,” Zhou told reporters in November.

The process is bound to hurt banks, says Bin Hu, a Hong Kong–based senior analyst at Moody’s. “Allowing banks greater flexibility to set rates will narrow net interest margins and reduce profitability,” Hu says. Moody’s estimates that net profits at China’s commercial banks will drop 3 percent, or 28.5 billion yuan, in 2012 as a result of the measure. In 2013 the impact may be as much as 79.6 billion yuan. Challenges to bank liquidity also may result as depositors seek higher interest rates and banks respond by extending credit to higher-risk borrowers. “We may see more capital markets activity, proprietary trading, underwriting, derivative trading, to make up for loss of profitability,” Hu says.

Growing competition over deposits is already pressuring banks’ profit margins and adding a layer of instability to their funding. Deposits grew by 13.2 percent in the first ten months of 2012, the slowest growth rate since China began to reform its economic system more than 30 years ago; deposits grew by 27 percent a year, on average, between 1994 and 2011.

A primary cause of the decline has been the proliferation of wealth management products, which banks have promoted to attract household and corporate depositors. Rates for wealth management products are not regulated and typically range 50 to 100 basis points above rates for traditional bank deposits. Although sold by banks, the products are run by third-party wealth managers, which channel the funds into a variety of investments, including real estate, infrastructure and private equity.

The popularity of wealth management products soared following the credit explosion of 2009 as commercial banks sought to off-load loans by effectively securitizing them into off-balance-sheet investments, says Fitch’s Chu. The rating agency estimates that the market for such products totaled 12 trillion yuan at the end of September, equivalent to 16 percent of deposits for China’s state commercial banks. For nonstate banks the percentage is even higher. “It does present some risk to the system,” says Chu. “This is essentially a form of securitization where you take assets, package them up as an investment product and sell them to depositors at a Chinese bank.”

The general mismatch of assets and liabilities, along with the absence of disclosure, even has some bankers worried. Most wealth products have maturities of less than one year, and some are as short as a few days. “Many assets underlying the products are dependent on some empty real estate property, or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations,” Bank of China chairman Xiao wrote in a China Daily comment in October. “When faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme.”

All of these developments, along with the anticipated deterioration of loan books, spell trouble for commercial bank profitability in the years ahead. “Any way you slice it, banks are big losers from reform,” says Emerging Advisors’ Anderson. Although China’s biggest state lenders are expected to use their balance sheets and extensive branch operations to maintain pricing strength, competition for deposits and loan income for smaller lenders is expected to increase. Beijing, which continues to rely on its banking sector to implement economic policy, will need to move slowly, weighing the costs and benefits of reforms. “You can’t just take bank profits away and deal with rising bad loans, while keeping credit stable,” Anderson says.

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