WARNINGS OF RISKS TO CHINA BANKS / THE NEW YORK TIMES ( HIGHLY RECOMMENDED READING )

July 14, 2010

Warnings of Risks to China Banks

By DAVID BARBOZA

SHANGHAI — A week after the Agricultural Bank of China raised nearly $20 billion from global investors in one of the biggest stock offerings in history, analysts are warning about growing risks to China’s banking system.

A report released on Wednesday by Fitch, the credit ratings agency, said Chinese banks were increasingly engaging in complex deals that hid the size and nature of their lending, obscuring hundreds of billions of dollars in loans and possibly even masking a coming wave of bad real estate and infrastructure loans.

The report also said that Chinese regulators understated loan growth in the first half of the year, by 28 percent, or about $190 billion, and that many banks continued to secretly shift loans off the books, creating a “pervasive understatement of credit growth and credit exposure.”

“The growing amount of credit moving out of the banking system through these channels is one of the most disconcerting trends we’ve seen in China in recent years,” Charlene Chu, a Beijing-based banking analyst at Fitch, said of the practice of repackaging loans and moving them off bank balance sheets.

While China’s economy remains robust, the report is troubling because the country’s recovery has been fueled by aggressive lending and soaring property prices. Lending by state-run banks was one of China’s most aggressive forms of stimulus last year, but analysts constantly warned that banks could face the risk from overbuilding and nonperforming loans.

Beijing is trying to tame housing prices, rein in overly aggressive lending and stop banks from shifting loans off their books.
China’s biggest banks, like Bank of China and China Construction Bank, are relatively healthy, analysts say. But many banks could face sizable risks if borrowers failed to repay loans.

Analysts say that trying to rein in growth is a delicate and precarious balancing act and that even regulators are struggling to keep up with the rapid innovation in the banking system.

Chinese banks reported a sharp drop in lending in the first half of the year after record amounts in 2009, suggesting that the economy was growing at a strong clip with more normalized lending.

But Fitch said on Wednesday that lending had continued to be aggressive — powering the economy, but raising the risk of nonperforming loans.

Much of the lending through off-balance-sheet channels is fueled by trust companies, mostly privately owned, that are partnering with banks and engaging in complex deals that involve repackaging loans into investment products — akin to an informal type of securitization.

The deals are essentially disguised loans, analysts say. Beijing has tried repeatedly to stop the practice, but analysts say that banks and trust companies have come up with innovative ways around the rules.

Last week, the China Banking Regulatory Commission ordered banks to stop working with trust companies to securitize or repackage loans, according to industry analysts. But the regulator made no official announcement.

A spokesman in Beijing for the commission declined to comment on Wednesday, insisting that senior officials needed to be alerted to the request for an interview.

Stephen Green, a Shanghai-based analyst at Standard Chartered Bank, said trust companies in China were acting as intermediaries and partnering with banks to raise and then lend money to a variety of projects.

According to his estimate, trust companies raised hundreds of billions of dollars in 2009 and the first five months of 2010, partly because depositors were frustrated by low interest rates at banks, and trust companies were willing to offer double that amount with principal guaranteed.

Mr. Green called the practice troublesome.
“There’s limited transparency, so obviously that’s a red flag,” he said in a telephone interview.

Worries about a potential wave of bad loans have led regulators to pressure Chinese banks to raise more capital and strengthen their balance sheets.

Banks have also been pressed to lower their exposure to local government debt — money often raised for huge infrastructure projects.

But analysts now say they believe that banks are lowering their exposure to local debt and hiding the size of their lending by working even more aggressively with trust companies.

Analysts say that last year the process worked something like this: a bank would hand over a big loan, say $50 million, to a private trust company in exchange for $50 million in cash. Then the trust company would create a wealth management product out of the loan and give it to the bank to sell to investors and depositors. The money raised would be given back to the trust company.

Investors would receive as much as double the regular saving rate and their principal when the loan was repaid.

That $50 million would then be given to the trust company as if it were an investment; in fact, it was a short-term, high-interest loan to finance a real estate project.

Now, analysts say, to get around new regulations, the transactions are much more complex, but have the same aim — to pretend that a loan is an investment.

If the developer or trust company fails and cannot repay the loan, analysts say the banks could face huge, unrecognized risks. But curtailing the practice will not be easy, Ms. Chu at Fitch Ratings said.

“Before, banks were trying to create these things with trust companies to get them out,” she said. “But now, with inflation and interest rates so low, and property prices low, bank customers are going into banks and demanding this option.”