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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.

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