Banking On China? Think Again

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High up on the Tibetan plateau at 10,000 feet lies the City of Golmud, isolated even by the standards of that barren land. With no airport and at least 16 hours from the nearest sizeable town by the fastest possible transport, the Han Chinese immigrants (imported to colonise the once free country of Tibet) of this fair city take their pleasures where they can.

One is to leave as soon as possible, made difficult by China's strict internal passport controls. More practical suggestions include a stroll to the local potash plant, the City's principle industry, a visit to the Cai Erhan Salt Lake, or to a giant half-empty dam (it doesn't rain much) or the hopelessly inefficient methanol plant.

In this centrally planned, neo-Stalinist nirvana, you can also wander through a maze of poorly constructed monumental buildings while sipping Golmud's exciting variety of toxic waters, available from the many corner stand-pipes; for as in most of China, environmental controls are non-existent.

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Yet it is not for all these delights that the city of Golmud deserves its own special entry in the Financial Hall of Fame. It is because its entire banking system has just collapsed. Run banker, run

In early May, the Kunlun Credit Co-operative in Golmud suffered a run by depositors, onrumours that its cash balance was down to $1,500. The panic quickly spread to the seven other credit co-operatives, whose tills were also empty, resulting in widespread rioting. All eight financial institutions closed down; by early June, the central Government belatedly embarked on a rescue plan. The cause for the collapse was simple prolonged fraud, on a massive scale, by senior bank officials operating hand-in-hand with Communist party cadres.

According to official estimates, non-performing loans for the eight lenders were 96%; the worst had a capital adequacy ratio of minus 189% at the end of 2004. Almost all of these loans had been given to bank directors and senior apparatchiks (usually the same thing) at no interest cost, most of whom then disappeared. No arrests have been made. The total amount of money stolen was tiny, probably no more than $20 million. Not an earth-shattering sum for China or anywhere else merely the life savings of the entire population. First there was GITIC

In 1998, the Guangdong International Trust & Investment Corporation (GITIC) collapsed. It was a specialist investment company' owned by the regional government of Guangdong province. The total debt was approximately $4.5 billion.

The collapse was caused by poor investment decisions, astonishingly bad management and an impressive level of old-fashioned theft. The Government came up with a ripping wheeze; to stuff foreign bankers with the losses. These lenders had become exuberant at China's explosive economic growth, following Deng Xiao Ping's liberal' reforms. They had naively decided that GITIC, as an enterprise owned by the regional government and controlled by the Central Bank of China, was government guaranteed and therefore represented a sovereign risk, i.e. very low. Like all bankers who have made bad decisions, they squealed like stuck pigs. Overnight foreign loans and investment dried up, as these foreign banks also tried to call in other outstanding loans.

China then, as now, needs massive foreign investment, credit and expertise to increase its current income per capita from $1,100 to at least a second-world level. The leadership quickly realised that foreign bankers and investors like to have their cake and eat it. As there were another 240 ITICs, of which over half were suffering the same problems, a bailout had to be arranged. As a consequence, around $170 billion worth of bad loans were transferred from these ITICs to various Chinese state banks. This was meant to be the end of the story. Throwing good money after bad

The Government renewed its efforts to attract foreign investment. First the Chinese diaspora was encouraged to invest in joint ventures. This policy was soon expanded to western multinationals. They were more than willing to take advantage of cheap labour, minimal environmental controls, tax holidays and light legal controls. Their western bankers were eager to see them replace their over-priced, often ill-educated workforces (with attitude problems) and fund a rapid relocation of their manufacturing to China.

Domestic Chinese banks in turn far preferred lending to western companies, whose assets they could squeeze and seize if the need arose, rather than to local companies, where the assets were as likely as not owned by a bank director or a senior Communist party official. Meanwhile, not only did the $170 billion of bad loans fester in the state banks' balance sheets, but grew like mushrooms. Both because China has been growing at anywhere between 7-12% p.a. over the last decade and because there is an almost total lack of social security or pension benefits, domestic savings are very high; thus national, city and regional banks all have vast deposits.

Loan growth therefore exploded as these were doled out (so poor are bank controls, the system can hardly be classified as lending) to the thousands of bankrupt state-owned enterprises to keep them afloat. In propping up these hopeless businesses, by giving them sufficient money to allow them to pay interest' on earlier loans, the fiction that they are servicing their debts and therefore solvent is maintained.

This has resulted in a remarkable balance sheet clean-up of the entire national banking system. In 2000, non-performing loans were officially nearly 40% of total loans, equal to more than $750 billion. No banking system at any time in history has survived for long with bad debts over 10%, let alone such a large number. Now they are allegedly a mere 20%.

The Government knew that excessive loan growth would be ultimately destructive and briefly tried to restrict new lending; but even this short slowdown resulted in too many businesses going to the wall. This was especially true of the small but vital private sector, whose access to loans was squeezed as banks cut them out first, in favour of foreigners and state enterprises.

Given that China's primary economic problem is finding new employment for five million people every year, which can only come from the private sector, such a result was politically unacceptable. (Even so, private enterprise still has a problem accessing cheap credit, one of the reasons why China's main stock market index has halved since 2000.) So loan growth was again allowed to let rip, with good money thrown after bad. This has made a dangerous problem critical. Scratch my back

Occasionally, weak attempts have been made to reform the financial system. In 2003 for example, and with considerable hullabaloo, the Bank of China fired 20 local bank managers (out of 3,000) for corruption. Care to bet that stopped the rot? More common are one-off' rescues, which repeat every few years. $45 billion was shelled out by the financial authorities in 2003 to prop up the Bank of China and the China Construction Bank, followed by $30 billion into ICBC. Even by western standards, these are simply huge numbers (Barings couldn't even lose a billion, despite trying very hard). All these reforms and bail-outs fail for one reason, the core problem of the Guangxi system. Guangxi (or connections) is not just having a Scottish Cabinet ruling England and Wales, or Enarques, all of whom attended the same two schools, running the French civil service. It is more subtle. It includes blood relatives and in-laws; it can extend to cousins of cousins, clans of the same name (China has only 100 proper surnames), people from your village or province and hopefully, senior politicians for whom one of your set once did a favour. It has been around for hundreds of years. Neither the Manchu nor Mongol rulers understood it or could break it.

Guangxi has its strengths; it provides a support net for the weak and dispossessed. Very large personal networks on a national level can make the creation of new businesses and raising capital a remarkably smooth operation. It also embeds corruption, deeply. Thus any attempt at reform becomes mired and compromised. Government regulators find themselves having to pull the plug on their own connections, including perhaps their bosses or even worse, senior army officers and politicians.

This is why so many of Hong Kong's listed red-chip' companies, run by wholly unqualified children of senior officials, were able to get all the funding, licences and assets they wanted in record time. Another more recent example of a Guangxi in operation took place in July this year; an order from the Government that the state-owned commercial banks must lend $1.2 billion to around half of the country's 130 securities firms which in practice have gone bust. Each has a major political connection. It is into this hopeless financial morass that western bankers have now decided to invest. Mass hysteria

When every major bank has the same brilliant idea at the same time, shareholders should start to attend AGMs to ask serious questions; depositors should be very nervous. One good example of western banks having the same disastrously clever idea at the same time was between 1993 and 1996.

In July 1997, a banking crisis started to roll across Asia. This did not seem to be a western bank problem, until it became apparent that the BIS reporting banks (a quasi-regulatory body which includes every significant or sound bank in the world) had loaned the equivalent of their entire Tier 1 capital (i.e. all their reserves, plus) to just four small countries Korea, Thailand, Indonesia and Malaysia.

They had no natural business in these nations but wanted to take advantage of superior growth and higher interest rates. The collapse of the banking systems in these countries, whose joint GDP was then less than that of Germany, caused a domino effect into Russia, South Africa, Latin America and then the hedge fund, Long Term Capital Management. It was a very close run thing; a global banking crisis was only narrowly averted. Today, most leading western banks have agreed that they must be in China, seemingly irrespective of the price, because of its rapid growth. They cannot resist the lure of potentially 1.3 billion savers and borrowers. They have swallowed the myth that the balance sheets of China's financial institutions have been cleaned up.

These banks are now shelving out considerable sums for the tiniest toehold in the China market. Not surprisingly, one of the earliest players was Hong Kong's Hang Seng Bank. In 2003, together with the finance arm of the World Bank and the Government Investment Corporation of Singapore, it plonked down $324 million for a 24.9% stake in China's Industrial Bank. Its parent, the better known HSBC, subsequently shelled out $1.75 billion for a 19.9% stake in the Bank of Communications.

Both of these banks have an economic imperative and a level of knowledge about how to work in difficult Asian countries, which means they might even make a small return on capital, one day. For almost all other major banks, there must be considerable doubt.

Bank of America is paying $3 billion for a 9% stake in China Construction Bank; Dutch-based ING Group bought a 19.9% stake in the Bank of Beijing for €166 million. Newbridge Capital of the US bought 18% in the Shenzhen Development Bank. There is now hardly a major foreign bank not sniffing around Chinese banks and assets in one form or another.

Those who have either been snoogling or have stated they are looking at major bank or asset deals include the Commonwealth Bank of Australia, Britain's Standard Chartered Bank, JP Morgan, Credit Agricole, Morgan Stanley, Bank of Nova Scotia and many, many more. It is a global herd. The reasons given are almost identical; to quote Bank of America's chairman, It makes sense if you are looking to tap into economic growth'. Walter Wriston, former head of Citibank, won financial immortality with a similar comment countries don't go bust'. Citibank almost folded two years later when Mexico suffered one of its perennial meltdowns.

A near-term reason may be more prosaic fees. China is desperate to resolve its hideous domestic bad debt problem through the use of foreign capital. It can see no other way of solving its banking crisis except by importing more and more capital. For these foreigners, there is the delicious personal prospect of huge fees and bonuses. The current flotation plans for myriad Chinese banks and insurance companies could produce, assuming all go ahead, underwriting and placement fees of over a billion dollars by the end of 2006. Approximately half of this amount will drop straight into the hands of the executives who engineered these deals; by the time the solids hit the air conditioning, they will have long moved on to retirement or other banks because of their international expertise All these foreign banks can only buy minority stakes, not control, as Chinese law bars this. All claim to be playing the long game; that their expertise will help sharpen up the domestic banks, i.e. that they can break the thousand year old Guangxi system. None to date have had a return on capital above its cost.

Even more wonderfully, they actually believe they know the true balance sheets of the banks they are buying. 1,500 years ago, the Chinese not only invented accounting, they then invented quadruple accounting; a true set for limited internal use, another for the government, one for the investors and then one for their wives. We are suspicious that mustard-keen western MBAs, whose sights are fixed on 1.3 billion consumers and their near-term bonuses, rather than the $750 billion worth of bad debts in the system, can see through these multiple fictions. Little Golmud and its recent financial meltdown will soon slip back into oblivion. Every storm starts with a small cloud. That China is wandering into a banking crisis is a certainty; we don't know when it will start, or how, but it is inevitable. Remember Golmud By Bedlam Asset Management

For more from the unconventional fund management group, visit Bedlam