China Unloading Bank Shares, Transferring Debt Risk To Foreigners

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On Tuesday, Li Jiange, the vice chairman of Central Huijin Investment Ltd., told reporters in Frankfurt that the Chinese central government plans to reduce its holdings in the country’s largest state banks.  He gave no indication when sales might take place although he suggested they will occur slowly.

When Huijin speaks, investors listen.  The company is the primary domestic investment unit of China Investment Corp., the country’s $650 billion sovereign wealth fund, and in the last few years Huijin has been buying shares in the country’s bigger lenders, including the biggest, Industrial and Commercial Bank of China.  Now, Beijing looks like it is going to reverse this partial renationalization.  Li Jiange’s words, according to the South China Morning Post, are “the first major signal from Huijin, which controls bank assets on behalf of the Beijing government, on diversifying away from majority holdings in the banks.”

Color foreigners happy.  “I would say, this is an interesting signal that the government is rethinking whether it is necessary to hold large majority stakes in strategic enterprises like the big state banks,” said Andrew Batson of Gavekal Dragonomics in Beijing, to the Post.  “If the government were indeed to change its role to a minority rather than majority shareholder in a large number of companies, that could have a big impact on how state firms are run.”

Batson, in all probability, is too optimistic about the impact of Beijing selling down majority stakes in state lenders.  The Communist Party controls the big banks not because it owns majority stakes.  It controls them because it issues orders to their senior officers, virtually all of whom are Party members, and maintains its cells in these organizations.  Beijing, not surprisingly, acts with little or no regard to shareholder interests, making critical decisions that are implemented in top-down fashion.  Whenever it sees its vital interests at stake, it will not let anything stand in the way.

Need proof?  At the end of 2008, Premier Wen Jiabao forced all of China’s major lenders to open up the lending taps.  In five years, beginning at the end of 2008, China’s banks increased their assets by about $14 trillion, an amount equal to the entire U.S. commercial banking sector.  Even if you do not add in the shadow banking risks that will eventually come back onto Chinese bank balance sheets, the lending blowout must be the biggest expansion of credit in history.  That was good for growth rates but ultimately bad for banking institutions.

Because the state banks are the most important economic instruments used by the country’s leaders, it is unlikely that a regime obsessed with control will ever give up its ability to make these institutions act as it wishes, whether or not it holds majority stakes.  If Beijing ultimately sells bank shares, as Huijin’s Li Jiange intimates, it is because Chinese officials want others to bear the cost of the repair of balance sheets.

Even after the lending spree begun at the end of 2008, Chinese banks claim their nonperforming loan ratios have remained low.  The average NPL ratio at the end of Q2, according to the China Banking Regulatory Commission, was only 1.08%.

Some things in China never change.  At the end of the 1990s, the People’s Bank of China, then the country’s bank regulator, claimed NPLs were only 1% of bank assets when the actual figure was at least 40% and perhaps closer to 60%.  Today, nobody knows what the real ratio is, but the biggest banks all trade below book, an indication the markets are skeptical of official numbers.

In recent quarters, official NPL ratios have been creeping upwards, a few basis points at a time.  For instance, in the first half of this year, the average NPL ratio increased eight basis points.

In all likelihood, bank balance sheets deteriorated much faster than that.  For instance, in the first quarter, Industrial and Commercial Bank of China, which marketed an ultra risky wealth management product known as “Credit Equals Gold #1” to its customers, loaned 3 billion yuan to Huarong Asset Management Co.  Huarong, one of the “bad banks” formed in 1999 during the last China banking crisis, then used the loan proceeds to buy the assets of the product so that the product’s sponsors could redeem holders, who eventually received all principal and 95% of interest.

Chinese authorities prevented a default that could have taken down the Chinese banking system because ICBC, as that gigantic bank is known, made a politically directed loan.  The trust assets Huarong purchased—principally a loan to a dodgy coal miner in Shanxi province—have a value substantially less than the amount of its obligation to ICBC, and, depending on loan terms, this could be ICBC’s problem.  Even if Huarong is on the hook, the unrealized loss will surely come back to haunt the bank at some point.

“The point is that neither ICBC nor Huarong had a legal obligation to solve this problem—they did so in the name of social stability,” write Carl Walter and Fraser Howie in the Wall Street Journal.  “Even if Huarong and ICBC claim this as a one-off, the reality is that it can’t be.  There is too much bad debt outstanding and there are too many political implications for Beijing to allow the market to run its course.”  As Howie wrote to me and others a few days ago, “This is pure red capitalism.”

No wonder Huijin wants to get out of its Chinese bank investments.  And so do central authorities in Beijing.  Bank of Communications, China’s fifth largest bank by assets, signaled it will sell additional shares.  Last month, the State Council issued approval to China Everbright Group, a “wholly state-owned enterprise,” to become a joint stock company, a move necessary to a sale to investors.  Currently, the Ministry of Finance and Huijin hold stakes in Everbright, which holds shares in a large bank.

And last December China sold shares of Cinda Asset Management Co., another of the bad banks, in a Hong Kong initial public offering.  Now, Beijing is going to sell off Huarong shares, perhaps in the first half of next year in Hong Kong.  On the 28th of last month, Huarong announced it had sold 21% of its shares for $2.4 billion to domestic and foreign institutions including Warburg Pincus; Goldman Sachs; and Khazanah Nasional, Malaysia’s sovereign wealth fund.

As the Financial Times noted, sources familiar with the bailout of Credit Equals Gold #1 indicated that Huarong tried to keep news of the ICBC loan quiet because of its planned offering.  “Huarong’s involvement in such an obviously political bailout,” the paper noted, “would have undermined its argument to investors that it has transformed itself from an arm of the state into a commercial entity operating purely on market principles.”

It’s telling that Li Jiange, the Huijin vice chairman, did not express enthusiasm for Huarong.  Instead, he told the reporters in Frankfurt he wanted to buy into European banks.

Gordon G. Chang Contributor

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