In the fourth quarter of 2007, when US banks first started their subprime writedowns, Chinese banks reported 60% year on year earnings growth. In March 2009, the FT included a large spread in its “the Future of Capitalism” series on how Chinese banks that weren’t even in the top 50 by market cap in 1999 are now the top three—Industrial & Commercial Bank of China, China Construction Bank, and the Bank of China. Recently, these banks reported a year on year 20% increase in issued loans. Considering loans account for 4/5ths of these Banks’ earnings, one would expect a year on year increase in earnings. However, CCB’s profits fell 18.2%, BOC profits fell 14.1%, and ICBC’s profits rose only 6.2%.
The reason for the decrease in earnings is tighter margins and rising credit costs. This quarter alone, credit costs doubled to $2.5bn. This likely indicates trouble for the Chinese financial system in the next 5-10 years. Chinese lending is a top-down process. The government sets lending levels targeted to keep people employed and to prevent instability. The increase in lending in China is not going to dynamic private companies but state owned enterprises and small, inefficient production facilities. STRATFOR reports Chinese lending is creating oversupply as it boosts export industries in an effort to maintain employment, creating a structural mess because of a lack of demand.
Chinese banks are no strangers to bad debt. Starting in 1999, Chinese banks transferred Rmb 2,400bn to four asset management companies (AMCs) in exchange for bonds backed by the People’s Bank of China. These bonds were worth the full face value of the bad debt, even though the loans were only worth 1/3 the amount. This trade left Chinese banks exceptionally well capitalized. The Chinese bad bank scheme reflects the same alchemy of finance that characterized the subprime boom. It is essentially hiding (and mispricing) risk. The AMCs only have to pay back interest on these 10-year bonds. Because their assets are worth 1/3 the face value, the AMCs will never be able to repay the principle when these bonds mature over the next few years. At this point, the government will have to fill the void, but considering current economic conditions, it is more likely for them to rollover the loans and deal with them in the future.
If you combine the old bad debt that was never addressed properly with the billions of new loans that are likely doomed to a similar fate, you get a serious financial problem. Not now, but in a few years, the government will have to make substantial bail-outs. I wrote in my last post on China that being able to control the velocity of money is one of the benefits of an authoritarian regime. It may be a benefit in the short run, but it is its bane in the long run. The Chinese financial system is structurally inefficient. It is simply too young of a system to have fully revealed these inefficiencies.
