Bank Runs Show China’s Need For Bank Deposit Insurance

THE THREE DAY run on Jiangsu Sheyang Commercial Bank and then on Rural Commercial Bank of Huanghai earlier this week highlights the need for explicit bank deposit insurance in China to replace the implicit guarantees that the government will stand behind depositors. Jiangsu Sheyang is a small rural lender whose 12 billion yuan ($1.9 billion) in assets is barely a rounding error in the total assets of China’s banking system. Yet the panicky withdrawal of funds from four of its branches on nothing more than a rumor that a customer had been denied a withdrawal of their funds needed a full-court press by authorities, including a very public demonstration of large stacks of cash bearing the central bank’s seal being made available, to restore depositors’ confidence and bring the run to a halt.

Setting up a bank deposit insurance scheme would also provide a point of differentiation between the formal and shadow banking systems, making the former more attractive to depositors who are starting to see a number of failures of shadow banking products, albeit small-scale ones, along with, pertinently in Jiangsu Sheyang’s case, the failures of some rural credit co-operatives in the province in January, whose bosses fled in the face of investment losses.

It would also provide a firebreak of sorts between the two banking systems. That might help calm the nerves of policymakers, already frazzled by China’s first corporate bond default and mounting anxiety about the real estate market. They worry that a shadow banking collapse could reverberate into a bigger systemic buckling of the financial system. In the interim, China has resorted to a bit of old-fashioned regulation. The suspected original rumormonger has been arrested.

Details Emerge Of China’s New Privately-Owned Banks

DETAILS ARE SEEPING out about the pilot programme announced in January to establish a handful of new private banks this year. These are intended as a first step towards providing competition to China’s giant state-owned banks and an alternative to the shadow banking system for small businesses in need of mainstream banking services.

Earlier this week, Caixin quoted a China Banking Regulatory Commission official outlining arrangements that paired some deep-pocketed investors, including internet company Alibaba, which operates China’s largest e-payment service, Alipay, with autoparts maker Wanxiang Group, and Tianjin Shanghui Investment with copper producer Huabei Group. Each of the five pairs, it seems, will focus on a specific customer segment and test a different banking business model. Initially, at least, the new banks being kept from going in direct competition with the big state banks’ existing businesses.

The Alibaba-Wanxiang partnership is intended to serve small and family businesses, which are likely to already by Alibaba customers, whereas the Shanghui-Huabei pairing would take only corporate clients. The Alibaba-Wanxiang bank will have caps on the size of the loans it can make and deposits it can take. Another pairing, social networking and online gaming company Tencent and Shenzhen-based Baiyeyuan Investment, will also have a cap on its loan size but will have a deposit minimum, not maximum.

What is not clear is the niche being carved out for the other two pairings, Shanghai investment companies JuneYao Group and Fosun Group, and Zhejiang’s electrical equipment maker Chint Group and industrial chemicals producer Huafon Group. Something in wealth management or personal finance seems likely for JuneYao-Fosun.

The five new private banks will be set up in Shanghai, Tianjin, Zhejiang and Guangdong. The banking regulator says they will start operating once they meet required standards, including forming a “living will” that will outline how the bank will shut down in an orderly manner in the event of a failure.

Banking On Privately Owned Banks

THE ANNOUNCEMENT EARLIER this week of a pilot programme to establish three to five private banks this year is a tiny first step towards providing competition to China’s giant state-owned banks and easier access to mainstream banking services for small businesses. Don’t forget that many of China’s 3,000 banks are already majority privately owned but they collectively account for just 11% of the banking sector, underlining the embedded advantage the big state-owned banks derive from their national branch networks and the immense deposit bases those provide, as well as from their political connections and implicit state guarantees.

The pilot scheme is another piece in the mosaic of financial reform that is itself part of the grander design for rebalancing China’e economy. It starts to fulfill one of the pledges made at last November’s Third Plenum policy meeting, though the qualification requirements to establish one of these new banks remain unclear. But broadly what will make them different from existing private banks is that they are intended to be entirely privately financed, and would “bear their own risks” — no de facto policy role nor implicit state safety net.

Another way to further open up the financial sector, increase competition, and provide small businesses with an alternative source of finance to the shadow banking system would be to make it easier for foreign banks to enter or expand in the industry. The state’s banking overseer, the China Banking Regulatory Commission, is looking at that but it wants to let some home-grown “trusties” to get established first.

That could include restructuring some existing state owned local and regional banks under new private ownership. A range of non-financial sector players have expressed interest in getting into banking since the possibility was floated last year. Among them are Wang Jianlin, chairman of Dalian Wanda, one of China’s biggest property developers. Others include another developer, Macrolink Real Estate, retailers Shanxi Baiyuan and Suning, which already has millions of customers using its online payments system and a network of 1,700 stores, and Internet giant Tencent.

Averting China’s Local Government Defaults

The Financial Times‘ estimate that China’s banks rolled over three quarters of the 4 trillion yuan ($642 billion) of local government debt that fell due at the end of 2012 to avert defaults puts a hard number on a soft but growing fear that has been gnawing away at China’s policymakers for some years.

Some history bears retelling. Much of Beijing’s stimulus package in response to the 2008 global financial crisis flowed through local government spending on public works. Local government debt rose by 62% in 2009 over the previous year, as local authorities laded up with bank debt–and the banks, state owned, with potential bad debt. Bank borrowing increased by a further 19% in 2010. By the end of that year, China’s central government debt was a modest looking 17% of GDP. Its local government debt was the equivalent of 27% of GDP.

By February 2011, the China Banking Regulatory Commission (CBRC) was alarmed to discover that more than half of new bank lending wasn’t meeting its new credit rules designed to mitigate the build-up of potentially bad loans. The CBRC’s particular concern was direct and indirect lending to the three top tiers of local government, provincial, municipal and county-level local authorities.

The following month, the finance ministry alerted the National People’s Congress (NPC) that “local governments face debt risks that cannot be overlooked,” though the line was buried deep in a budget report. What concerned officials was the risks involved in the 7.7 trillion yuan of bank loans (as of June 30, 2010) made to local governments’ captive investment vehicles. These local officials were using to get round restrictions on direct borrowing. A finance ministry audit turned up more than 6,000 of them. The audit also found that there was no cash flow to repay 23% of their loans. The suspicion was that by the time the ministry made its report to the NPC the numbers had worsened significantly, intensifying a general concern in Beijing about the overall weakness of local-government governance.

By November 2011, officials were fearful that China’s local government debt had reached 13.7 trillion yen ($2.2 trillion; Italy’s outstanding sovereign debt at the time was $2.6 trillion) including a previously uncounted 3 trillion yuan borrowed by townships, the administrative tier of government below counties. Reforms to local government finance started to be put in place and a rolling 2 trillion-3 trillion yuan bailout deployed to shore up loans backing projects with neither collateral nor viable cash-flow to cover their debt service. Banks were also made to plump up their cushions of capital reserves.

These measures were sufficient to keep the situation manageable through last year. The risk of a local government debt default remained low–as long as economic growth remained brisk and state-owned banks could be made to absorb the worst bad debts. When growth slowed in the middle two quarters of 2012, the banks had to take more of the strain. How much more is delineated by the the Financial Times estimates, as is the challenge China’s local governments face in working down their massive debt loads.

There is one intended and one unintended consequence of all this. Banks have all but stopped extending new loans to local governments. Some authorities have turned to the nascent municipal bond market to raise new debt. But others have turned to the shadow banking system comprising unregulated non-bank financial institutions including trust companies. There have been a series of defaults and near-defaults around these in the past couple of months. None catastrophic. At least not yet. If China’s debt bomb seems to be ticking less loudly, that may just be because it has moved.

A Stimulus By Any Other Name

When is stimulus spending not a stimulus package? When it is previously planned projects just being brought forward, apparently. State media are reporting that Beijing is saying that it is not going to stimulate the economy in the way it did after the 2008 financial crisis (via Bloomberg). That pumped 4 trillion yuan ($600 billion) in to China’s economy, an steroid-like injection of credit whose side-effects are still being felt in persistent inflation, ailing bank debt and excess industrial capacity.

With the economy again slowing, the temptation is to fall back on tried and trusted methods of state capitalism, and the devil, again, take the consequences. Up to point. Latter this year a new generation of leaders will be ushered in who will have to establish their political legitimacy and sustain the Party’s legitimacy through making all Chinese better off. A delicate balance between a quick fix and sustainable growth will have to be found that still promotes the long-term rebalancing of the economy.

So all praise to five-year plans. The National Development and Reform Commission, the agency that oversees national planning and green-lights individual projects lower down the development food chain, has the capacity to advance 1 trillion-2 trillion yuan-worth of infrastructure projects. It has already approved nearly 900 projects in the first four months of this year, twice the number in the corresponding period of last year. If anything, the pace of new approvals is gathering.

The constraint on policymakers is anunwillingness to repeat 2008s reliance on bank lending to local authorities to finance the stimulus, and a reluctance of the big-state owned banks to make their balance sheets creak any more under a further burden of new loans. Hence the talk on more private-sector financing of the proposed infrastructure investment in railways, energy, green technology, telecoms, healthcare and education.

This month, Beijing has announced a series of measures to give more scope to private capital and to expand domestic demand by subsidizing sales of consumer goods (as it did after 2008). Whether China’s private lenders will provide better judges of risk than their state-owned counterparts is yet to be seen, especially when there are national development goals breathing down their necks. Yet there is also no getting away from the fact that lending outside the state-owned banking sector is rudimentary or informal. The big state owned banks will still have to do most of the heavy lifting of a new stimulus, however it is labeled. Everyone will want to keep their load as light as possible.

China’s Big Banks’ Wealth Management Products Raise Concerns

An often overlooked red flag about the creditworthiness of China’s big state-owned banks was raised by Fitch Ratings on Monday. In a report reaffirming the ratings of the Industrial & Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China and Bank of Communications, the U.S. credit rating agency noted:

One key risk over the short-term is Chinese banks’ rapidly growing wealth management offerings, of which state banks are the leading issuers. At end-Q1 12, Fitch estimates that the amount of outstanding wealth management products in the banking system reached 10.4 trillion yuan ($1.6 trillion). While this represents a relatively low 12% of total deposits, an estimated half of all new deposits are raised through these products. Poor matching of the maturities of the liabilities with the assets underlying the products means banks often do not have money coming in on the products to repay investors upon maturity. Instead, banks often rely on new issuance or product rollovers to repay investors.

This is a different concern to the more common one about the quality of the banks’ loan books in the wake of the credit-fueled stimulus splurge that followed the 2008 global financial crisis which saw the banks’s credit exposure growing twice as fast as nominal GDP in the three years to the end of last year. That widening gap raises questions about borrowers’ ability to repay as these loans fall due this year and next, especially as the economy slows. We are already seeing the big banks showing great forbearance, especially to local government borrowers, and dutifully finding ways to keep those pressures on asset quality from showing up in higher non-performing loans numbers.

The expansion of wealth management products threatens the big banks less with solvency issues and more with funding and liquidity ones, given how important this activity has become to deposit growth. True, as Fitch acknowledges, the banks’ state backing, strong deposit networks and 19% capital reserve ratios provide “substantial resources” to absorb increasing funding or liquidity strains were there to be a disruption to the wealth management business. And if the worst came to pass, Beijing would likely shore up the balance sheets of  failing institutions, as it has shown itself willing to do in the past. But it could be bumpy. What happened in the informal banking sector in Wenzhou provides a microcosmic reminder of what can go wrong when a slowing economy can’t keep up with the race for yield.

It is worth remembering that four China’s five biggest state-owned banks rank among the six largest banks in the world. Just as their sheer size means credit losses could be significant, so the volume of the wealth management business means a disruption of it could put pressure on China’s sovereign credit rating should Beijing have to provide material support.

China Trims Banks’ Reserve Requirements

China’s central bank is cutting the capital reserve ratio for the country’s banks by 50 basis points, effective May 18th, a further cautious easing of monetary policy in the face of a slowing economy. The biggest banks’ capital ratios will fall to 20%.

Recent economic indicators on trade and industrial output have been weak. Although inflation is falling the bank does not yet think it is stable. Hence the choice of the third cut in the banks’ reserve ratios in six months to continue pumping liquidity into the system. New bank lending in April, at 682 billion yuan, was particularly sluggish, despite spiking the month before. February’s 50 basis points cut added an estimated 400 billion yuan ($63 billion) to the system. So cuts of this scale are modest, and intended to avoid encouraging any return to speculation in property markets. Keeping the planned measured deflation of property prices on track takes interest rate cuts off the table for now.

Breaking Up China’s Big Banks

Every leading nation’s big banks wield political clout. China’s, being state-owned and run by big political players in their own right, sit more easily at the center of power than most. They see it as their rightful place. Both they and the government see their role as providing conduits of national policy. Administrative guidance to the banks sets the course for their customers in business and industry in the cause of economic growth, be that slowing inflation, deflating bubbles or stimulating growth. So when Prime Minister Wen Jiabao says the big banks’ monopoly needs to be broken as they make easy money for themselves while denying loans to cash-strapped small and medium-sized enterprises he needs to be assured that he is safe in rattling such powerful cages and that the need to do so is urgent.

In the words of the song, breaking up is hard to do. Yet Wen’s words at least get the idea on the table and add to the determined thrust by the economic reformers to use the leadership transition now underway to revitalize near moribund financial reform. Wen again pointed to the pilot scheme in Wenzhou to create alternative financing channels for small and medium-sized enterprises in the city that have hitherto been forced into the usurious shadow banking system. This is being seen by some as an experiment that if successful will be expanded more broadly as a necessary underpinning of the rebalancing of the economy towards domestic demand.

The prime minister’s words came as regulators further opened capital markets to foreign investors. That, though, is politically easier to do than taking on the big banks, large redoubts of vested interests that they are. The opportunity to do so may lie in the slowing economy turning more bank loans sour. Government has had to step in once before to clean up the state-owned banks’ balance sheets. The price for doing so again could be more conditional. And might it even include the big banks improving their rudimentary credit-risk analysis? A bit more competition wouldn’t go amiss in that regard, while plenty of entrepreneurs would be happy to have their creditworthiness judged on their business prospects rather than their political connections.

Bringing Wenzhou’s Black Lenders Out Of The Shadows

Wenzhou is a case study in the deep fault lines underlying China’s financial system. While big state-owned enterprises could get credit easily and cheaply, even in the face of the official squeeze on bank lending to cool inflation, small and medium sized company owners and entrepreneurs had to turn to the underground banking system where interest rates can top 60%. In Wenzhou, it is estimated that lending through the shadow banks, also known as black banks and which run from unregulated lending pools to loan sharks, amounts to $78 billion a year — accounting for a fifth of the lending in the city. Some 90% of its households supply the capital in an attempt to get a higher yield on their savings than is available from official banks.

Yet the city, which prides itself on its entrepreneurial flair, has also seen a rash of suicides and absconsions by heavily indebted borrowers unable to meet their crushing interest payments, especially as the economy slowed and speculative real estate and stock market investments, into which much of the borrowed money had been directed, fell in value. Around 100 business owners from the city disappeared or declared bankruptcy. Though only a few firms have collapsed, the interconnectedness of small businesses causes cash-flow reverberations up and down supplier and customer chains. One in five of Wenzhou’s  360,000 small and medium-sized enterprises reportedly stopped operating last year due to cash shortages.

So serious has the credit crunch and the risk of a bad-debt implosion become in Wenzhou that, a police crackdown on borrowers having failed to deter the lending, the State Council has now approved a pilot project to bring this shadow system into the light. Some lenders will be allowed to convert to rural banks or micro-finance companies, big state-owned banks will be directed to make more credit available in the city (as they already have been), and new savings and investment vehicles, including offshore ones, will be opened up to city residents and small and medium-sized enterprises. These vehicles will offer potentially better returns than bank savings accounts. (With the persistence of inflation over the past 18 months, real interest rates have been negative.)

The proposals are also intended as a test of expanded financing channels for small and medium-sized businesses, as well as an attempt to drain the property and stock markets of speculative capital that authorities would prefer used to keep growth and employment going in the real economy. What is not yet clear is whether these new  institutions will experiment with market-set interest rates, as the original set of proposals put forward by the city government last November had called for. That may still be a reform too far.

Nationally, the underground banking system was officially said last year to have $470 billion in outstanding loans, though unofficial estimates are half as much again. Fitch, a U.S. ratings agency, has estimated that every other yuan now lent in China comes through a shadow bank. That is a scary share for an unregulated sector surrounded by still inflated asset bubbles. It is fault line that runs deep and far beyond Wenzhou.

China Said Set For Big Boost To Muni-Bond Market

China looks set to give a big boost to its nascent muni-bond market this year. The Finance Ministry is to quintuple the quota for local government bond issuance to 250 billion yuan ($40 billion) this year, Caixin reports.

In addition, more provinces will reportedly be added to the list of those able to issue bonds directly. Since 1994, the ministry has done that on behalf of local governments but started an experiment in direct issuance in October last year with Shanghai, Shenzhen, Guangdong and Zhejiang. That privilege will be extended to six more provinces and municipalities. The ministry is expected to maintain the close control over the bond issuance by the larger group that it has exercised over the trial quartet, including having a big say over what the funds raised can be used for.

Expanding the muni-bond market is both part of the broader reforms of the financial system and local government finances. The latter are teetering under the burden of 10.7 trillion yuan of debt, at least 3 trillion yuan of which falls due by the end of this year. Much of the debt piled up as a result of the stimulus spending in the wake of the 2008 global financial crisis. Much of it is infrastructure loans, for things like toll roads to nowhere, that are weighing heavily on the creditworthiness of China’s banks.

Earlier this month the China Banking Regulatory Commission ordered banks to clean up their balance sheets with regard to local government lending. It first told them to do that in June last year, but progress clearly hasn’t been rapid enough, or, as a result of the cooling of both the economy and the property market, problem loans are mounting. Good and bad loans alike were probably rolled over when banks tackled the 2 trillion yuan of local government loans that fell due last year. Another red flag raised by China’s audit office: irregularities it has found with 530 billion yuan worth of the lending. Taken together, an estimated 2 trillion-3 trillion yuan of local government lending has soured, which would be sufficient to raise the banks’ non-performing loan ratios to 5% from their current average of 1.1%.

The new quota of 250 billion yuan for bond issuance won’t wipe away the problem but every little bit helps–though places like Greece serve as a reminder that bond issuance is not an infallible inoculation against the highly contagious disease of government fiscal profligacy. Yet while the immediate priority is to deflate China’s local-government debt bubble before it can go damagingly pop, an expanded muni-bond market also pushes provincial and municipal governments in three other desirable directions: less reliance of land sales to raise revenue, less need for the off-balance sheet financing via captive investment vehicles that local authorities have resorted to get round restrictions on official borrowings, and more transparency generally about their finances.