China launched an aggressive bank recapitalization program on January 5 by injecting $45 billion from its $400 billion-strong foreign exchange reserves into the Bank of China (BOC) and China Construction Bank (CCB), two state-owned banks preparing to list on foreign stock markets next year. The move is the first step of a strategy to spend more than $100 billion in government funds to strengthen the big four state-owned commercial banks (the Big Four). The other two of the Big Four, the Industrial and Commercial Bank of China (ICBC) and the Agricultural Bank of China (ABC), are expected to be next in line to receive similar bailouts. The recapitalization is also part of the bank reform package that Beijing announced last December, which included raising the individual foreign ownership limit on local banks from 15 percent to 20 percent of total assets.
The continuing need for bailouts clearly indicates that bailout programs by themselves are not sufficient to reform the banks fully. Beijing is opening another round of financial reform, but the pressing concern is whether this round will work and whether China has enough time to fix its state-owned banks.
We can probably get a clue from its public debt picture. The situation at first glance looks grim: Government debt has surged in recent years—by 250 percent since 1997, from ￥550 billion ($66.4 billion) to ￥1.9 trillion ($229.5 billion) in 2002 (see Figure 1). This raises the fear that rising indebtedness will soon bring about a fiscal crisis and derail bank reform. The assumption is that Beijing's high debt load will block reorganization of China's insolvent banks because such a program will revolve around government borrowing. Such a view is wrong on two fronts.
The continuing need for bailouts clearly indicates that bailout programs by themselves are not sufficient to reform the banks fully.
Recapitalization alone is not enough
First, China has already tried massive bank recapitalization, without success. That is why the government has been more hesitant this time around. Back in 1998, Beijing issued ￥270 billion ($33 billion) in special bonds to recapitalize the Big Four. Then in 1999, it created four asset-management companies (AMCs)—Xinda for CCB, Huarong for ICBC, Dongfang for BOC, and Changcheng for ABC. The AMCs received ￥400 billion ($48 billion) in seed capital from the Ministry of Finance (MOF) and issued ￥1 trillion ($121 billion) worth of MOF-guaranteed bonds. They then used these funds to buy ￥1.4 trillion ($170 billion) of bad loans from the state banks at face value.
But the program has failed to cure the banks' woes. Since 1998, the percentage of bad loans on the banks' books has not fallen much, and the AMCs have had limited success in recovering or selling off the bad assets. Meanwhile, corporate governance, transparency, and risk management at the Big Four have only shown slight improvement. Giving banks more money after they have piled up losses through imprudent practices thus risks creating a moral hazard situation in which they are encouraged to keep on lending recklessly.
Deeper pockets than you might think
Second, China's government debt levels are still low enough to afford further bank recapitalization. The 250 percent jump in government debt from 1997 to 2002 may seem horrifying, but the total debt-to-GDP ratio, as of 2002, was only 18 percent. Even with today's estimated total debt at about 25 percent of GDP, China's public debt is still far below the 60 percent threshold that the international community deems unsustainable for a healthy economy.
Further, despite the surge in debt, the cost of debt-servicing has plunged thanks to falling interest rates (see Figure 2). The government paid an average 9.4 percent coupon on domestic Treasury bonds issued in 1997 (it was above 10 percent before that). But the average interest rate on government debt dropped to only 2.4 percent in 2002.
China's public debt will remain stable for another three to four years, giving Beijing that much time to recapitalize and reform the banks without interruption from market volatility.
Beijing now spends less on interest payments as a percent of total government spending than it did six years ago. It paid an estimated ￥65 billion ($7.9 billion) in interest on domestic debt in 1997 and ￥100 billion ($12.1 billion) in 2002. Granted, this is a 54 percent rise. But distributed over five years, the rise is not excessive, especially with strong economic growth averaging 8 percent each year. Furthermore, annual interest payments have been stable since 1998, ranging between ￥91 billion ($11 billion) and ￥100 billion ($12.1 billion), despite the surge in total debt. As a percentage of total government spending, total interest payments on domestic and foreign debts dropped from 7.6 percent in 1997 to 5.5 percent in 2002.
Critics fret that an eventual upturn in the interest rate cycle will crush Beijing's finances, as rising interest rates will raise the debt-service burden swiftly. But the impact of interest rate volatility on debt-servicing costs will be limited because of the recent changes in the term structure of China's public debt. The average maturity of Chinese T-bonds lengthened from 3.4 years in 1997 to 6.7 years in 2002, and most of these bonds carry an interest coupon of less than 4 percent. By extending the term structure, Beijing has effectively locked in three to four years of interest payments at less than 4 percent a year.
Hence, China's public debt will remain stable for another three to four years, giving Beijing that much time to recapitalize and reform the banks without interruption from market volatility. Incidentally, this timeframe coincides with China's promise to open up the banking sector to full foreign competition under its World Trade Organization agreement. But that also means that the government is racing against time. Four years is not a lot of time to complete the daunting task of bank reform.
Strong medicine needed
The new bank reforms that Beijing unveiled on December 1, 2003, opening the sector further to foreign competition, are still too mild and limited in scope to fix the system within the timeframe imposed by the public debt constraint. The decision to put only two state banks in a pilot reform program indicates either complacency or reluctance to shake up the system.
It is also unclear how successful the new method of recapitalization will be. Rather than directly injecting funds, Beijing has established the Central Huijin Investment Co., Ltd. to effect the fund transfer and supervise the investment in the state banks. The central bank transferred foreign exchange to Huijin, which then used the funds to purchase equity stakes in the two banks. Huijin will recruit officials from MOF, the State Administration of Foreign Exchange, and the central bank for its board of directors. But it is hard to see how Huijin will be more effective than these entities, which already have full regulatory and supervisory responsibilities for the banks. To be effective, Beijing should appoint independent experts from both inside and outside China to Huijin's board to guide the recapitalization process.
Nevertheless, the bailouts are sorely needed. The Big Four, which account for almost 70 percent of total PRC bank assets, are technically insolvent. Their bad debts are estimated at 25 percent of total loans by the government, but private sector estimates put them at double that amount. Even under some optimistic private-sector estimates of a bad-asset recovery rate of 25 percent, a reduction of the bad-loan ratio to 12 percent within a few years, and a low capital-asset ratio of 3 percent (well below the Bank of International Settlements guideline of 8 percent, because state banks are underwritten by Beijing), the cost of bailing out the Big Four would exceed ￥2 trillion ($241.5 billion), or almost 25 percent of China's 2003 GDP.
Given the depth of the problem, just repackaging the bad loans without addressing their root causes—lax accounting, policy lending bias, and poor corporate governance standards—will not work. Further recapitalization and the 5 percent increase in the individual foreign ownership limit of Chinese banks to 20 percent are also insufficient to fix state-bank woes without accompanying reform in the domestic capital market.
Without an efficient capital market, Chinese banks, as the primary source of capital for the economy, will continue to face policy lending pressure. And the stock and bond markets are currently both dysfunctional. The domestic stock market is rife with speculators and distorted by the government through its quota system on initial public offerings. Officials tend to favor the listing of loss-making state firms while keeping the jewels for the government, leading to an adverse selection problem in which only bad firms are selected for listing. The corporate bond market, on the other hand, suffers from thin trading, heavy bureaucratic control, and irrational pricing.
Solving insolvency
Control is the thorniest issue in banking reform, as the Big Four are fully government-owned. Even if the banks are listed publicly, regulations dictate that the government maintain 75 percent ownership, making it difficult to establish a truly commercial culture at the Big Four. Their strategic importance as lenders to the state firms, which employ 85 million workers, also means politics and lending will remain entwined. Meanwhile, the state banks themselves are huge, with a workforce of 1.4 million and 116,000 branches nationwide.
The state banks' long history as the government's lending arm has also established the primacy of policy objectives such as social stability and equal income distribution over commercial objectives. As a result, the state banks have little experience with commercial practices such as managing risk and pricing capital. As a stopgap measure for financial reform, the banks are outsourcing the modern risk assessment process to foreign experts. But the system is still changing at a glacial pace.
Simply listing the banks in the domestic stock market will not solve this ownership problem. Unless capital can be allocated by market forces, particularly by freely adjusting interest rates, banks will be unable to make their own lending decisions based on proper risk analysis. But the government still sets bank interest rates, though it is slowly widening the band of allowable rates. Stock market reform is also necessary so that company performance can be adequately reflected in stock market valuations, which would lead to efficient capital allocation.
Greater foreign ownership may not necessarily improve banks' performance either, because the legal, institutional, and cultural infrastructure of the local system matter more to bank operation than foreign management. Beijing must ultimately end state control of the banks. But this, in turn, depends very much on stock market reform to inject market discipline into the system.
Don't forget the bonds
Capital market reform should also be extended to the Chinese corporate bond market. Beijing has so far used bond issues to help manage the macroeconomy, for instance, to soak up excess liquidity in the economy. But the corporate bond market, which provides fuel for the growth of the private sector, has remained minuscule and largely closed to foreign investors.
Corporate bond issuance peaked in 1992, with ￥681 billion ($82.2 billion) issued. Last year, only ￥32.5 billion ($3.9 billion) worth of corporate papers were issued. Though outstanding corporate bonds have risen from ￥52 billion ($6.3 billion) in 1997 to ￥133 billion ($16.1 billion) in 2002, they pale in comparison with the total ￥13 trillion ($1.6 trillion) in outstanding loans in the banking system. The share of corporate bonds in the larger bond market is also dwindling, falling to 4.3 percent of all outstanding bonds last year from almost 7 percent in 1997.
Beijing has curbed the growth of the corporate bond market because of the high-profile scandals in the 1990s, most notably Guangdong International Trust & Investment Corp. (GITIC), which defaulted on $4.7 billion in debts in 1998. The incident led to international criticism of GITIC for misleading creditors into believing the central government had guaranteed GITIC's debt when it had not.
More crucially, the central bank's strict control over interest rates makes it impossible to price corporate bonds according to market forces and credit risks. Other problems also include the lack of a strong bankruptcy law and huge default risk. And Chinese state firms (the largest borrowers of capital) have access to cheap money via the banking system and the domestic stock market, so they have no incentive to tap the bond market for funding.
The State Council has recently announced its intention to strengthen the corporate bond market—and capital markets in general—but implementation plans are not yet apparent. Beijing will need to liberalize the embryonic corporate bond market by cutting red tape (notably the seven agencies in charge of approving new bonds), relaxing interest rate controls, and strengthening independent credit rating agencies. Only when these steps are taken effectively will a strong secondary bond market emerge.
Racing against time
China's window of opportunity for bank reform is closing rapidly. Recapitalizing the banks, identifying the bad loans, and spinning them off to the AMCs is the easy part of reform. But these moves are not sufficient to cure the banking sector's ills. As an exit strategy for recapitalizing the banks, Beijing must also act decisively to create an environment in which AMCs can sell off bad loans to recoup their losses. All this will involve fundamental reforms to the legal system, institutional framework, and corporate culture.
At the same time, China needs to reform the capital market both to fuel the growth of the private sector and resolve the political ownership of the banking sector. With less political intervention and more credible financial data, banks will have a better chance to run loan books on a commercial basis. Such market discipline is a prerequisite for the ultimate success of banking reform.
