China's banks need a bailout, and they need it soon

JONATHAN ANDERSON (Executive Director, Asia-Pacific Investment Research, Goldman Sachs)

This article originally appeared in the January 29, 2003 issue of South China Morning Post in Hong Kong and is reproduced here with permission from the publisher.

China's bankers and policymakers convened a few days ago to discuss financial policies and long-term solutions for the banking system's problems. Aside from the creation of an independent bank regulator, the most controversial item is a possible further bailout for China's "big four" state-owned commercial banks.

We may not see firm plans announced until after March, when the new generation of officials takes power, but the rumour mill is already churning: early reports in the Chinese-language press have talked about a recapitalisation package of 300 billion to 600 billion yuan (HK$282 billion to HK$565 billion), or 3-6 per cent of China's gross domestic product. This brings up three questions: should the government bail out the state banks? If so, should they do it now? And, how much financial assistance should they receive?

The many opponents of a bailout point to recent history. In 1998 and 1999, the government handed the state banks a total of 1.7 trillion yuan in additional capital and a substantial carve-out of bad loans. At the time, an estimated 20 per cent of the banks' loans were non-performing. These injections were meant to be a final solution to the banks' problems. However, by the end of last year, non-performing loans at the big four had grown to an average of 25 per cent - clear evidence that state banks continued to throw good money after bad and are incapable of identifying creditworthy borrowers. Under these circumstances, observers may say the best policy is to leave banks to pay for their own mistakes; the last thing the big four need is another "free lunch" at the taxpayers' expense.

Compelling arguments, to be sure. But are they accurate? Our own analysis shows exactly the opposite. What China's state banks desperately need is a comprehensive restructuring package involving significant further injection of fiscal resources and the rapid subsequent sale of strategic banking system shares to institutional investors. The logic is as follows:

First, it is simply not true that the big four state banks squandered earlier clean-up funds. No sooner had the 1999 carve-out been made than the banks adopted a new asset classification system showing average revised non-performing loan ratios of 30 per cent. In fact, the first "free lunch" was far too small, leaving the banks still saddled with enormous bad-loan burdens. As before, this load was a legacy of past misbehaviour rather than a reflection of current sins. How can we tell? Because under central government pressure to improve asset quality, the big four have not been lending enough in the past few years to generate significant new bad loans. Once we strip out mortgage lending, consumer finance and infrastructure credit from state banks' portfolios, we find the amount of funds flowing to the traditional state-owned enterprise sector has slowed to a trickle, barely enough to roll over non-performing exposures.

Second, state banks cannot resolve bad-loan problems on their own, at least not any time soon. At current levels of profitability and loan growth, the big four could feasibly reduce non-performing loan ratios by 2-3 percentage points a year. They could achieve this by recognising the losses that eat up nearly all their net operating income and leave them little room for new investment or meaningful adjustment of their operations. If we assume the official figure for non-performing loans - 25 per cent at the end of last year - is accurate, this would mean letting state banks "rot" for seven to eight years while they bring bad-loan ratios down to acceptable levels. If, instead, we accept the asset quality assessment of outside experts, who point to true non-performing loan levels closer to 40 per cent, the period would lengthen to 15 years.

Third, China can ill afford to let the big four rot for a decade or more. These banks hold most household and corporate deposits and account for the bulk of outstanding lending. They will be highly exposed once the financial system is fully opened to foreign competitors in four years. While China's smaller second-tier commercial banks and credit co-operatives have been growing at annual rates of 30-40 per cent, much of this growth is due to gains in market share in the existing corporate customer base rather than developing new business.

Fourth, far from having a long way to go in reforming state banks, the government has nearly exhausted its restructuring options. Since 1997, the big four have adopted new accounting and reporting systems, centralised lending decisions, created new management and supervision bodies, undertaken extensive retraining at all levels and removed personnel decisions from the hands of local governments, just to name some of the main measures. On paper, at least, these institutions are arguably closer to their Western counterparts than to the "old" state banks of a decade ago.

The only measure that would allow state banks to finally turn the corner and become independent market-oriented institutions is the introduction of strategic outside owners with a major influence on management. The government cannot realistically hope to sell shares in the four big state banks to strategic domestic and foreign investors until they have achieved reasonable non-performing loan ratios and positive underlying net worth. That should now be the state's main priority. (The alternative of simply floating shares in the domestic market to retail punters would do almost nothing to change management incentives.)

True, foreign investors have been queueing to buy strategic stakes in China's smaller commercial banks, many of which also have poor-quality loans. However, these institutions are currently doubling their loan assets every two to three years, so their growth prospects outweigh the weakness of their balance sheets. Investors are willing to pay a premium for future expansion.

This does not apply to the big four state banks. While their loan books are growing at annual rates in the high single digits, that would not outweigh insolvency should their loan losses be fully recognised today.

So China's banks need a bailout, and they need it very soon. How much should the government give? The bottom line is that a cautious approach will not solve the banks' problems: it could even make matters worse by forestalling future efforts. The government's aim should be to make the big four state banks fundamentally competitive and attractive to outside investors in the next two to three years, before the financial services industry is fully liberalised.

We estimate that in order to achieve this goal, banks should have non-performing loan ratios at or under 10 per cent by international standards, and an "underlying" capital adequacy ratio (after fully recognising loan losses) of at least 3-4 per cent.

Assuming the asset quality of state banks is no worse than the current official statistics indicate, we estimate that the government would need to provide no less than 800 billion yuan to bring banks to international standards by the end of 2005. That assumes a 40-50 per cent recovery ratio on existing non-performing assets.

Using what we believe to be more reasonable assumptions - a current non-performing ratio of 40 per cent and an average recovery ratio of only 25 per cent - the required government support to bring banks in line by the end of 2005 would be at least 2.4 trillion yuan.

That sounds like a substantial sum - more than 20 per cent of the expected gross domestic product for this year - but keep in mind that this is a "bare-bones minimum" estimate. It is aimed at getting banks just to the point where outside strategic investors could come in, providing additional capital to finish the job.

Whether it comes now or in the late spring, any new policy announcement regarding state banks is likely to be trumpeted as a strong step forward. However, investors should keep in mind the above maths in gauging the seriousness of the Chinese authorities' intentions.