Banking & Finance, Talking Point

Don’t bank on it

Two cases may point to serious trouble ahead for China’s financial sector

Don’t bank on it

In hot water: Xu Ming

Perhaps bankers should have paid more attention to the smell test. After all, anyone who claims to have made their first fortune from a ‘shrewd’ deal in shrimps deserves to have their credentials thoroughly scrutinised.

Such was Xu Ming, who grew from prawn trader to business titan in just a few short years. He amassed huge wealth and influence – until he was detained for ‘economic crimes’ two months ago.

Xu featured in our book, China’s Tycoons last June. For years the well-connected entrepreneur expanded his business empire into chemicals and real estate, buying up hospitals and even Dalian’s football team.

But Xu hasn’t been seen in public since March 15, when he was arrested. And he now has the dubious honour of being the first of the 75 businesspeople profiled in China’s Tycoons to fall foul of the law, too.

His company Dalian Shide is also in trouble. That could have repercussions for banks, none more so than Bank of Dalian, which has been preparing to IPO.

Bad loans in Dalian?

Rumours of problems at Shide first surfaced in late March, when China Construction Bank was reported to be demanding that the conglomerate repay its loans. Subsequent to this a spate of media articles probed Shide’s finances, speculating that it had built up a pyramid of debt as it expanded from its core business – PVC steel window frames and doors – into frothier areas like property. Shide was forced to release a public statement denying that it faced financial problems (see WiC147). But the latest news is that the company is being sued, with lawsuits filed in Liaoning and Henan provinces. According to Century Weekly: “At least eight banks have filed lawsuits against Dalian Shide and its subsidiaries to secure repayment for loans they made to the troubled conglomerate.”

Apparently, Shide owes at least Rmb8 billion ($1.26 billion) to 38 banks, including Bank of China and China Agricultural Bank. Perhaps not surprisingly its links to local lender Bank of Dalian are deepest of all – Rmb1.75 billion in unpaid debts. The bank itself is being probed, reports Century Weekly, as some of these loans may have been made illegally. Muddying the picture further: Shide was Bank of Dalian’s fourth biggest shareholder.

Shide first bought into the bank in 2001 and the conglomerate seems to have relied on it to support much of its expansion over the past decade.

Lending to Xu or Bo?

How much of Shide’s Rmb8 billion of loans will go bad remains a matter of speculation. But what’s most troubling about the Shide situation is what it says about lending practices. As WiC has reported before, Xu’s corporate rise was connected to his close relationship with Bo Xilai, the toppled Party boss of Chongqing. They got to know each other when Bo was mayor of Dalian – indeed, Shide’s big break came when it won a huge government contract courtesy of Bo. It’s now thought that Xu reciprocated by helping the Bo clan to amass an offshore fortune. He’s also said to have paid for the politican’s son to be educated in the UK and US.

Evidently, when banks were lending to Xu, they saw him as a proxy for Bo. As such they made loans without thinking too hard about the credit risk, assuming that Shide would always have access to new money to repay the old.

This points to a flawed system where access to credit is available to businesspeople not because of their cashflow, but because of their connections. Which begs the question: how many other companies – like Shide – have used their political clout to fund reckless expansion? And how much of that lending will go bad, if their access to capital also gets closed off?

More evidence of problems…

Last week there was more bad news for China’s banks. China Business News reported on Friday that a top guarantee company had filed for bankruptcy. Beijing Zhongdan was a major player in the country’s credit guarantee industry, a business which helps companies secure loans from banks by vouching for their credit.

In Zhongdan’s case, there are 22 banks now exposed, and on the hook for Rmb3.1 billion. Again, it is too early to know how much of the debt will be recovered, but the banks with the biggest outstanding loans are known: Bank of Beijing, Agricultural Bank of China and China Everbright Bank.

Moneyweek reckons that Zhongdan had been using its “good relationship” with the banks to push through loans that never should have been made. The magazine spoke to one small company (with 20 staff) that Zhongdan had vouched for. “Frankly speaking I didn’t think my company merited such large loans,” the manager admitted. The firm’s yearly profit was about Rmb1 million, but Zhongdan helped it borrow Rmb50 million from three separate banks. What happened next is what makes the Zhongdan debacle even more interesting.

The company only used Rmb8 million of the borrowed funds. Zhongdan persuaded it to ‘invest’ the remaining Rmb42 million in its own wealth management products. These promised a high return, and were lent out in turn by Zhongdan at massive interest rates in the underground banking market.

In fact, Zhongdan persuaded its clients to pump Rmb1.3 billion into its wealth management products. Then the reckoning: when a number of the banks asked their clients to repay their own loans, they turned to Zhongdan to redeem their wealth management products. But it balked because of its own perilous finances. Suddenly the banks became aware that all the loans guaranteed by Zhongdan were at risk.

A banker with China Merchants Bank told Century Weekly: “We were careless. In hindsight, there were a lot of clues showing there was a problem.”

A potential crisis?

The China Banking Regulatory Commission has just reported $167 billion in non-performing loans in the banking system at the end of last year.

But Charlene Chu of Fitch, the rating agency, believes that banks are masking the true level of their non-performing loans, by rolling over bad debt and even turning to the shadow banking sector for stopgap financing. She suggests too that if a tenth of the banking system’s outstanding credit turns sour in the next two years, all of the sector’s profits and 39% of its equity will disappear.

The Economist seems to agree, pointing out in its most recent edition that China’s banks look very profitable today but that the figures are “misleading” and the banks are “storing up trouble”. Bloomberg columnist Jonathan Weil concurred, calling the banks “paper tigers”.

So are Shide and Zhongdan the proverbial canaries in the coal mine, warning of a systemic problem?

Jonathan Anderson of Emerging Advisors Group, doesn’t think so. In a research paper published this week, the high-profile economist makes the case that the trigger for most banking crises is when financial institutions lose their access to funding. But Anderson says that’s not a problem that China’s banks are likely to face, as they have “virtually no external funding, a low dependence on domestic interbank funding, moderate loan-deposit ratios and lots of liquidity tied up in required reserve deposits at the central bank.”

That seems to suggest that China will avoid one of the more dramatic manifestations of financial meltdowns: a run on the banks.

Anderson also makes the observation that China has experience when it comes to handling NPLs: “It’s clear that the banking system is already facing a rise in bad debt and non-performing loans – but keep in mind that the Chinese system is geared to operate with almost infinite NPL ratios (as they did in the 1990s and early 2000s). And the numbers today are much lower than they were back then.”

His forecast is that there will be a gradual recognition of bad loans, as well as slower credit growth, but no sudden crisis. All the same, the effort to clean up the banking books will “dampen” China’s GDP prospects, Anderson warns.

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