Red Capitalism (27 page)

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 and 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.

How, then, can the Party allow the banks to be disintermediated by capital markets or real outside competition? Protectionist measures, controlled exchange rates and fixed lending spreads ensure the Party’s control and the stability of the system, and virtually guarantee that the banks must raise new capital every few years to prime the cycle. Viewed from the outside, bank profits reassure retail depositors that their banks are sound and their deposits safe. International investors support bank shares since they are seen as proxies of a bank-driven GDP number. The banks use household deposits and new equity capital to fund new loans to drive GDP and to support the conceit that is China’s debt-capital market, which sustains the appearance of overall convergence toward a Western-style market system.

Instead of removing the risk burden from the banks, China’s backward bond markets create new risk. Making up around 30 percent of the total assets of the Big 4 banks, these “investment” portfolios enjoy negative interest spreads, leaving the banks exposed to significant market risk. In order to offset this weight, banks will inevitably lend more and increase credit risk. More asset bubbles, stock-market booms and problem loans are the inevitable product of this arrangement. The tools to deal with these problems, the AMCs, the MOF’s IOUs and the PBOC’s credit support, already exist. As has been shown with the first generation of bad loans, these measures have contained the problem and pushed the inevitable off into the future onto the agenda of the next Party leadership group and out of the memory of international observers. The cycles and the pressures that are building up “inside the system” can continue for a very long time. Where is the catalyst that will disrupt it? Even if the Emperor is ultimately seen to be naked, he is still the Emperor.

ENDNOTES

1
The Economic Observer
, January 11, 2010: 1.

2
The Economic Observer
, July 20, 2009: 41.

3
Zhu thwarted Chen’s first attempt in 1995 to establish an investment bank in favor of Wang Qishan’s joint venture with Morgan Stanley, CICC.

4
The Economic Observer
, July 20, 2008: 41.

5
The Economic Observer
, January 11, 2010: 1.