CHINA BANKS FACE DAUNTING MONEY SQUEEZE / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

September 26, 2013 9:19 am

 

China banks face daunting money squeeze

 

By Henny Sender

 

Fears banks lack risk management skills for brave new world

 

 

The path of financial reform in China is becoming ever more tortuous. Bankers gathered at a Singapore summit last weekend say the next step on the path is interest rate deregulation, which could come in the next 18 months, bringing in its wake myriad headaches both for the banks and for many of their customers.

 

It is a logical next step. By deregulating rates, Beijing hopes to stem the growth of the shadow banking system, which has been largely driven by the desire of those with excess cash to earn more interesting amounts on their savings while borrowers who cannot get loans at the artificially low rates at the banks currently hope to attract funds by paying more for them unofficially.

Deregulating rates is also a necessary precondition for removing controls on capital flows. As long as the price of money is kept artificially low, and investment outlets scarce on the mainland, the moment funds are allowed to leave China, they will do so in search of higher returns offshore.

China has already removed the floor on interest rates, emboldening state-owned enterprises to ask for lower borrowing rates. With the next step, removing the ceiling on rates, depositors will ask for more returns on their savings, squeezing the money banks make in the process.

While the banks have been told to prepare for this change for a while, doubts linger about whether they have the risk management skills for this brave new world. Banks in far more sophisticated markets have yielded to the temptation to borrow short and lend long to swell their margins with disastrous results.

Costs of deregulation

The challenge will be especially daunting for second-tier banks, just below the big four state-owned banks, Bank of Communications and Citic Bank. Already, major international and regional bankers are cutting back their credit lines to these banks, fearing that the state safety net may not apply to them. (At the same time, large shareholders in the larger state-owned banks worry that these banks might be asked to take over their troubled weaker peers, as happened in Japan.)

Another consequence of the coming deregulation will be a rise in the cost of capital for most borrowers. In the long run, that could be a good thing. When capital is expensive, it tends to get allocated more carefully.

But for now, unfortunately, that rate rise comes at the same time as the financial health of China Inc is deteriorating. Many companies, including the listed companies, are supporting an increasing load of debt on declining operating cash flows, according to work done by Hong Kong-based Forensics Asia, while accounts receivable are also growing. The old problem of triangular debts may reappear once more.

The banks are already bracing themselves for another round of bad debts. At the moment, all of them have about a 1 per cent non-performing loan ratio, with generous provisions. Still, that 1 per cent hardly reflects reality.

But there are powerful vested interests beyond the banks that are responsible for that. The Ministry of Finance counts on taxes from the banks and any write-offs reduce the income from which the tax bill is calculated, thus reducing tax receipts. Central Huijin, the arm of China Investment Corp which holds the government shares in the banks, needs the dividends the banks pay out.

Shadow banking

Over recent years, lending in China has become less political in some ways. Beijing has long fought to reduce the influence of local governments on the local branches of the big banks. For a time it appeared that the effort had succeeded. But now it is clear that the local governments continued to borrow, but through the shadow banking system.

The scale of that borrowing has been the subject of intense speculation. In coming weeks, Beijing will put out a number that is expected to be at least twice the current estimates, reflecting in part changed definitions, according to those familiar with the matter.

Many of these loans are believed to be backing infrastructure and property projects whose viability is in question. Even though they may not be on the balance sheets of the banks, they may still come back to the banks as bad debts.

Meanwhile, outsiders have long been lecturing the Chinese banks on the need to resemble their counterparts in the West. Fortunately, they have not always been persuasive, which is why Chinese balance sheets are not teeming with overly complicated, highly leveraged instruments that nobody really understands. But the next step is still likely to be messy and there may well be victims, as was the case a while ago when foreign lenders were shocked to see that the government did not always stand by investment companies.

This time, the shockwaves may be even larger.


Copyright The Financial Times Limited 2013