The $3.9 trillion loan binge

Forget turning left for business class on boarding the aircraft. Back in 1974 it was more a case of China’s political elite lacking the foreign exchange to make a trip abroad.

As retold by Carl Walter and Fraser Howie in Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, the backdrop was Deng Xiaoping’s trip to the United Nations in New York, seen today as a crucial step towards ending China’s self-imposed international exile.

But the delegation nearly didn’t make the journey, because the Chinese banks could barely find the dollar funds (less than $40,000) to cover their US travel itinerary.

Today, booking a few business class seats isn’t going to be a problem for China’s top cadres – given the nation’s $3 trillion of forex reserves. What’s more, the most recent Forbes Global 2000 list (published in April) would make for some triumphant in-flight reading. With banks elsewhere losing much of their lustre amid a slew of post-credit crunch scandals and recriminations, China’s financial institutions have risen quickly up Forbes global rankings.

Paupers in 1974, four of China’s big banks (Agricultural Bank of China, ICBC, Bank of China and China Construction Bank) rank among the top 21 firms in the list (in 22nd place is Apple). Leader of the pack is ICBC, in first place for financial services by market cap, as well as taking number one position as the world’s most profitable lender last year, earning $33 billion.

But is some of that ‘Masters of the Universe’ magic starting to look frayed at the edges? In their most recent financial results – announced last month – China’s five biggest lenders (Bank of Communications joins the Big Four we’ve mentioned above) were still able to announce that aggregate earnings were up by 13%. But this was down significantly on the 33% increase a year before. And the investor narrative has also taken on an edgy tone, with talk of rising bad debt, as well as anxiety that the days of bloated net interest margins – the profit mainstay for the sector – are coming to an end.

“The deterioration trend is just beginning” was the latest warning from rating agency Moody’s. “The announcements show deteriorating asset quality and slowing profit growth, which are credit negative because they mean the end of a multiyear streak of improving financial performance.”

So the banks are feeling unloved?

They have plenty of critics. Frustrated borrowers fret that they can’t get loans in the first place, while existing ones complain about being pursued for repayment too aggressively. Investors are frustrated by share prices that have fallen further than the index averages. Even the government has jumped on the bandwagon, following a highly publicised attack on the sector’s monopoly profits by Chinese premier Wen Jiabao in April.

The banks’ results were also awaited with trepidation last month, on speculation that credit conditions have been deteriorating sharply, in step with China’s growth prospects.

But in fact, many of the headline numbers looked resilient. Because new loans have been growing faster than defaults, non-performing loans actually dropped to 0.9% in the second quarter, the lowest in more than a decade, according to the banking regulator. That hardly sounds like a crisis, especially compared to 1999, when 39% of loans at the Big Four were classified as non-performing. The result then was the state swallowing up much of the bad debt into new asset management companies as part of a huge recapitalisation of the financial sector.

So why the anxiety today?

In part because of fears that more debt could soon go bad once again, following more than Rmb25 trillion ($3.93 trillion) of new lending between 2009 and 2011.

Wei Guoxiong, chief risk officer at ICBC, seemed to suggest as much in comments widely reported by the Chinese media last week. “Past experience has taught us that a bad loan crisis usually comes three years after a period of abnormal credit surge,” he advised. “There will be a notable rise in bad loans in the banking sector this year.”

So there’s also a more sceptical undercurrent to the coverage of the banks’ loan portfolios, especially when so much of the surrounding news on the Chinese economy has been downbeat.

For instance, when Bank of China announced that its own NPL ratio had fallen by a fraction in the first six months of the year, its stock price still sold off by 5%. Maybe that was because analysts had caught sight of BOC’s “overdue” loans actually increasing by 18% (or Rmb7 billion) in the first half. Perhaps they wondered too why BOC has opted to take a much smaller impairment charge than last year.

Loans are classified as non-performing if interest payments are overdue by more than 90 days, says Reuters. But the banks have been reporting greater deterioration in other categories, including “special mention” and “delinquent” loans. The worry is that some of these loans could end up being classified as non-performing in the foreseeable future.

“There is evidence of higher NPLs in the pipeline,” the latest Moody’s report concurs. “Special-mention loans, in which a borrower currently able to make interest and principal payments faces a negative development in his payment capability, are generally on the rise. Delinquent loans, defined as any loan with principal repayment or interest payment overdue at least one day, are also rising.”

The banks are trying to call in debt?

Lenders have been getting tougher with some borrowers. The coverage from Reuters this week has looked at loans made to steel firms during the peak of the previous credit boom. Unsurprisingly, some of the cash seems to have ended up in property speculation or the stock market – with steel executives now complaining that they didn’t even want the money.

“After the financial crisis, banks begged us to borrow money we didn’t need,” Li Huanhan, the boss at Shanghai Shunze Steel Trading told a Shanghai court. “We had nothing to do with the money, so we turned to other investments, like real estate.”

Now, of course, conditions have taken a turn for the worse. For Li, the struggle is over a debt of Rmb3 million that China Minsheng Bank has been trying to recall since June. But his case is just one of numerous examples in which banks are chasing their clients, often to the apparent bemusement of the borrowers themselves. There is also a growing clamour for more time to meet repayments. “Banks should consider the greater good and not just focus on protecting their own interests,” insisted the head of Shanghai Shunze’s local chamber of commerce. “[But] instead of pumping in more blood to save the patient, they’re choosing to draw more blood.”

In July we reported on similar frustrations in Zhejiang, where hundreds of businesses have been petitioning the local authorities to stop the banks from calling in loans (see WiC160).

But the banks are under revenue pressure too?

Aside from the speculation about their balance sheets, banks also face new questions about their longer term profitability. A particular fear is the reductions they may experience in the spread between what they demand in interest rates from borrowers and what they have to pay out to their depositors.

Traditionally, these net interest margins have been set within a highly beneficial range by the central bank, the People’s Bank of China. The spread has then delivered the overwhelming share of the banks’ operating income. Todd Dunivant, HSBC’s head of banks research in Asia-Pacific, calls it the “lifeblood” of banking profits.

But the central bank has begun to allow more flexibility in the range as it looks to encourage more market-driven interest rates. As banks adjust to competing more aggressively for business, there are signs that the spread could be starting to narrow (see WiC158 for more background). This isn’t likely to be a rapid deterioration (indeed some banks were able to report a small increase in net interest margin last month). But bigger picture, the net interest margin looks more likely to shrink rather than grow in the months and years ahead.

Nonetheless, for the short term Dunivant says that the impact of diminishing net interest margins is being overplayed. Nor does he expect declines in the spread to hit bank profitability as hard as some have suggested. Although banks have been giving better terms to depositors as they compete for funding, they haven’t moved so aggressively to offer new, lower-interest loans to their customers.

Also in the Big Four’s favour, says Dunivant, is the beginning of a shift away from the disproportionate share of lending traditionally extended to larger, state-owned clients. Instead, more credit is likely to flow to small and medium-sized enterprises, largely in the private sector. In part this is a policymaking goal: small and medium-sized firms contribute more than half of China’s tax revenue and GDP, as well as the large majority of employment, so Beijing wants to see these companies get more credit. But it also stems from expectations that state-owned firms are going to raise more capital from the bond market in future, rather than rely on traditional bank loans. Both trends could benefit the Big Four, as SME borrowers will pay more interest on their loans, slowing some of the erosion in lending margins.

Is that going to protect banking profits?

Maybe. But higher interest rates are demanded from SMEs because many of their loans are seen as much riskier too. Correspondingly, some of the worst of the loan delinquency is currently being reported among smaller clients, especially exporters from the coastal zones.

Fortunately for the Big Four, they seem less affected than some of their mid-sized rivals, who have greater exposure to this type of client base. Ping An has been one of the worst hit, reporting a 51% increase in its non-performing debt. The city of Wenzhou in Zhejiang is a particular bleak spot, accounting for almost 28% of Ping An’s bad loans. Wenzhou made up an even higher proportion of troubled lending for the Bank of Communications – about 90% of its Rmb887 million in new loan defaults in the most recent quarter.

There is symbolism here. Wenzhou can be painted as a reckless case, overly dependent on underground lending (when the economy slowed and speculative investment unravelled, this dependence triggered a chain-reaction of defaults). But the city also has a reputation as the heartbeat of China’s private economy: where it leads, the rest of the country is often said to follow. If their experience in Wenzhou is anything to go by, China’s banks could be forgiven for going slow on lending to SME clients.

It would help if the economy showed more signs of life?

Definitely. Despite concerns about shrinking interest margins and the gloomier picture on bad debt, HSBC says the macro-economic outlook is the primary factor in shaping the financial sector’s performance.

For example, if the purchasing manager indices (PMIs) start to show a positive trend, it is normally a solid indicator that corporate profits are going to strengthen in the months ahead. As firms start doing better, they have fewer difficulties paying off current loans. There’s also more likelihood that they will request new ones.

Unfortunately, current sentiment on the economy is very weak. HSBC’s own China PMI has been on a woeful run with negative ratings for ten consecutive months. The most recent survey (for August) indicated yet another contraction, as the index dropped to its lowest reading (47.6) since March 2009. Analysts blame a collapse in new orders both at home and overseas. They detect few signs of the pick-up in domestic demand needed to offset the weak international conditions.

In turn, that makes it more likely that Beijing will turn back to investment to get growth closer to targeted levels. Sure enough, last week we reported that local governments seem to be gearing up for another round of stimulus spending. We queried how this would be financed but most likely the state-owned banks will be required to play an important role once again, even though the balance sheet impact of the last round of loans is still to be fully determined.

In this context the banks are returning to a familiar role as tools of government policy rather than masters of their own destiny.

More positively HSBC says the banks are at least being allowed to respond to new loan requests from local governments in a more variegated way, charging higher interest rates for riskier projects than during the previous wave of loans starting out in 2009.

But that won’t be much comfort for more pessimistic investors, worried that a big chunk of such lending will inevitably go bad. That will mean raising yet more new capital. Over the past year the seven biggest banks have already raised $51 billion in new money, reports the New York Times, with $17.7 billion more in the pipeline.

Public shareholders are naturally unimpressed by all that dilution. Witness the trouble China Everbright Bank is having getting away its Hong Kong IPO. Last year it had initially targeted a $6 billion deal, but by last month it still had not been able to price a much smaller $1.5 billion offering. Will it get the listing done this year? As litmus tests go, this will be an interesting one to watch – indicating whether the allure of China’s banking sector has faded for global investors.

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