China’s banks face no-win situation; Given the continued downgrading of Chinese prospects, there may well be worse to come

May 21, 2013 5:29 pm

Inside Business: China’s banks face no-win situation

By Henny Sender

Given the continued downgrading of Chinese prospects, there may well be worse to come

When hundreds of private equity executives met in Washington last week to discuss emerging markets, China dominated the debate. This outcome at the International Finance Corporation and Emerging Markets Private Equity Association conference is hardly surprising, given how important China is for the health of the world economy and for the price of everything from coal to copper to credit.

Analysts have downgraded China’s growth prospects once more, making it clear that its slowdown is more than a cyclical phenomenon. Growth of 8 per cent used to be the floor and has instead become the ceiling, as Ruchir Sharma, managing director of Morgan Stanley Investment Management, puts it. Slowing growth is not necessarily a bad thing, if the quality of the growth improves. Maybe in time, it will. But not today. The rebalancing is still more aspiration than reality.All this is likely to have an adverse impact on China’s big banks, including Agricultural Bank of China, Bank of China, China Construction Bank and Industrial & Commercial Bank of China.

The concern about China’s slowdown is grounded partly in the speed with which credit is growing in China. The figure for total lending, which includes the non-banks as well as the banks, hit nearly Rmb8tn ($1.3tn) in the first four months of the year, significantly higher than the Rmb4.85tn for the same period a year ago, according to JPMorgan. Today, China’s total credit is almost double its gross domestic product.

But more worrying is the declining efficacy of that credit. The amount of capital being put to work is swelling, but the productivity of that capital is plummeting. Five years ago, a dollar invested produced a dollar of GDP growth. But today it takes $3 to $4 of investment to produce a dollar of output – and the quality of that output is suspect. There is overcapacity across many Chinese industries, from shipbuilding to solar.

Too much money is also going into the property market. From a macro point of view, too much luxury property is not a bad thing, because if it is not affordable, the price will drop until buyers are found and more housing then becomes affordable, which is what China needs. But a fall in prices will hurt the banks, which will be left with the bad loans.

It used to be that banks were considered a proxy for economic growth. Now it is more complicated. The banks are in a no-win situation. If they increase lending, they risk more bad loans, given the overcapacity. And if they do not, their growth slows and the inevitable bad loans, which are tiny today, become a bigger part of their portfolio. At the same time, regulation is also making all banks less profitable as an inevitable side effect of trying to make them safer.

Much has been written about the growth of the non-banks or shadow banks in China and their growing contribution to the increase in credit. But that implies a compartmentalisation that does not exist. At the heart of the shadow banking system are trust companies, which are lightly regulated because they do not take deposits. They exist because the system has outgrown the tightly controlled interest rates that were meant to channel Chinese savings to the state-owned enterprises at the cheapest possible price. But a large percentage of trust companies are in turn owned by the banks.

Shadow banks make the system more flexible, which is a good thing. Their money is more expensive, which may or may not be a good thing. But it is not clear whether they do a better job allocating capital than the big banks, which are still heavily controlled by the party and still channel too much money to the big state-owned enterprises. Sadly, though, non-banks are too often involved in murky related-party transactions that make them as incestuous as the banks.

Moreover, the ripple effects of a Chinese slowdown may be worse outside the country than inside. Among those likely to be hardest hit are the commodity-producing countries in the emerging markets and the banks that lent to them for projects conceived to meet demand from China years ago when its economy was booming. According to Mr Sharma at Morgan Stanley, for example, capital expenditure on energy and materials is up 600 per cent in five years, much of it based on extrapolating from China’s 10 per cent growth rate back then.

That means earnings are already starting to slow at local banks in these markets and at international banks such as Standard Chartered that based their strategy on emerging markets all being buoyed by China. Given the continued downgrading of Chinese prospects, there may well be worse to come.

Henny Sender is the Financial Times’ chief international finance correspondent