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December 25, 2005

The Seed That Caused a Tidal Wave

An Unsteady Banking System in a Sea of Change

The Chinese stock market languishes, in large part because the state has yet to reform state ownership in listed state-owned enterprises (SOE). But, scrounging around, one finds that a number of root causes exist. As Li Xue-bin writes in "An Unhappy 15th Birthday for the Chinese Stock Market" in 中国经营报 (China Business):

"上市公司上市以后极度缺乏回报意识，而投资者入市后极度缺乏风险意识."

"After listing, companies profoundly lack payback consciousness and investors in the market profoundly lack risk consciousness." [Translation and italics are those of ABI editor.]

Investors with pie-in-the-sky expectations and companies that care little for shareholder value remind one of the hackneyed aphorism that oil and vinegar do not mix.

Little wonder, then, that Caijing (财经) magazine, consistently a proponent of market forces, editorializes against reform of the stock market, at least for now.

"In China, stock indexes never were an economic barometer and might never be, because the stock market has never been a crucial component of national economy. If the government really wants to provide the nation greater economic security, it should focus whole-heartedly on the banking sector, which holds nearly all the expendable income of the entire population."

While Hu Shuli (胡舒立), the editor, also encourages state monitoring of “commodities that make up the basic living costs of citizens, such as real estate,” the state banks remain the single sector most in need of urgent care. They touch all aspects of Chinese economic development, underpinning the export machine that keeps the system running, yet without much of a cure in sight.

Despite the creation of “Asset Management Companies” (AMC) under state control to take NPLs (non-performing loans) off of the books of the state banks [on which western banks expect to earn a return of 21-30% per annum],

"China can reasonably expect to recover only US$100-150 billion from resolutions of its NPLs, and while the AMCs can recover a substantial portion of this total from their own collection efforts and from sales to domestic investors, the domestic market can’t reasonably be expected to absorb it all."

The recent increase of 16.8% in the official GDP -- which Asia Times blessed only two days after its announcement by saying that “the new figures, which reflect a modernization of calculation methods, are widely accepted by outside analysts,” -- makes it appear that NPLs are less problematic to the Chinese economy than virtually every “outside analyst” has heretofore thought. But what makes these new GDP statistics any less inaccurate and unreliable than prior figures?

In 2006, per WTO requirements, foreign entrants to the banking system will finally see the removal of various requirements constraining their business models in China, putting additional pressure upon state banks to compete with healthier and more energetic foreign banks.

Whatever banking reform there has been has taken place ponderously -- in part because there is no solution that does not cause substantial pain to many actors. While 17 have been shuttered in recent weeks, many of the City Co-operative banks, despite questionable reasons for their continued existence, remain. Quoting an unnamed banking regulator, even they see no viable exit strategy for most of these enterprises：

“最大的问题就是我们还没有一个完善的市场退出机制。"

Far more subtle dangers exist at the interconnections of the new systems that have been created inorganically, opening potholes that could swallow the proverbial truck. The nexus where a vulnerable financial sector, nascent legal system, capable, yet overwhelmed regulatory apparatus and the general business public meet continually cough up seemingly minor problems, at least minor in developed economies, which reverberate in waves that find their impact throughout the economy.

Chongqing Cultivation Company Plants A Bad Seed

A company in Sichuan applied for a loan from the Agricultural Bank of China. In its due diligence, the bank discovered information that led it to the conclusion that a loan was too great a risk and denied the application. The company sued for damages. In a western nation, absent some extenuating circumstance of which I can’t possibly bring myself to imagine, such a suit would be readily dismissed. Instead, the Supreme Court of the city of Chongqing held for the company, and damages were assessed at 40% of the amount of the loan, about 800,000 RMB (USD 100,000).

The judge’s reasoning was based, it appears, on banking regulations issued by the People’s Bank of China (中国人民银行)

“这个案件是基于诚实信用原则，以及依据《贷款通则》中贷款人负有及时答复的义务做出终审判决的。”重庆高院参与审理此案的朱鸿春法官说。 [See footnote below for the relevant text.]

“This case is based on the principles of honest credit, and based upon the duty of the lender as set forth in the Regulations on Loans to respond in a timely fashion, said Judge Zhu Hong-chun, participant in the adjudication of this case at the Chongqing Supreme Court.“

In other words, an enterprise considered a bad risk can nevertheless sue for significant damages merely because the lender did not respond in a timely manner to the application. The application itself created a right of timely response and its violation gave rise to a right to damages.

Here is a money-making scheme in the offing. A business could make a business out of filing loan applications throughout the country, hoping that some banks would fail to respond in a timely fashion, and then sue for damages. With perhaps tens of millions of loan applications in the system, imagine the potential liability of the state banks.

Powerless to overturn this case at law, Agriculture Bank, perpetually the weakest of the four big banks, appealed to the People’s Bank of China. The PBOC responded with the non-answer one might have expected, i.e., that the court fulfilled the requirements of the law.

The Chinese Banking Regulatory Commission, however, has gone ballistic, noting the extraordinary danger that this case may present to the banking system at large, despite the fact that the Chinese legal system does not adhere to a system of precedent. In its missive (银监办函（2005）135号 ), found in this article, to the People’s Supreme Court, the CBRC requested the Chongqing court to amend its decision. In other words, at the same time it stresses the importance of banking fundamentals, such as diligent risk assessment, often dismissed in the past, the CBRC insists on playing an end-run around the legal system.

But where else could they go? The People’s Bank of China, who had issued the regulations, was clearly unwilling to change them. They are the apparatus now standing on higher ground. Will higher powers step in? It is anyone’s bet whether or not the CBRC might push the PBOC off of this mountain, but storm clouds are brewing.

NOTE:

The relevant clause reads:

第二十三条 贷款人的义务：
一、应当公布所经营的贷款的种类、期限和利率，并向借款人提供咨询。
二、应当公开贷款审查的资信内容和发放贷款的条件。
三、贷款人应当审议借款人的借款申请，并及时答复贷与不贷。短期贷款答复时间不得超过１个月，中期、长期贷款答复时间不得超过六个月；国家另有规定者除外。
四、应当对借款人的债务、财务、生产、经营情况保密，但对依法查询者除外。

FOLLOW UP, December 28, 2005
[In an interview dated December 22, 2005, Liu Ming-kang (刘明康), Chairman of the China Banking Regulatory Commission (中国银行业监督管理委员会), stated the reasoning behind government approval of recent foreign investment in state-owned banks.

这样做的好处是什么呢？投资主体和利益主体多元化之后，国家财政就不可能再为商业银行的经营亏损“埋单”，否则就有悖于市场公平竞争的原则。基于这种政策理念，引进战略投资者的政策设计和目标导向就不是为了“引资”而是“引智”。也就是说，银行不应该迫于资本充足率达标压力而“引资”，而是要引进国际发达市场的银行先进服务理念、管理经验以及产品开发与维护的技术，迅速提升核心竞争能力。

The stated motivation behind the approval of these investments is simply that state banks require foreign expertise. Later in the interview, the other shoe drops. The state will, he insists, no longer pick up the check:

　　在改制、引入战略投资者和上市之后，国有商业银行从国有独资公司转变为公众公司，切断了国家动用财政和外汇储备对已股改的国有商业银行进行不断“输血”的渠道。因此，这次改革，就是要从制度上切断国家的“输血”机制，建立和完善自身“造血”机制。可以说，股权多元化不仅从体制上消除了商业银行指望国家救助的道德风险，而且在法理上排除了国家再度“输血”的可能，高标准的监管问责制也才能够实施。这也使此次注资真正成为“背水一战”前的“最后晚餐”。

There is nothing new in these statements. The old questions remain. Are foreign expertise and capital sufficient to make a jaguar out of a wooly mammoth? Are the exhortations and manipulations of one regulatory organ sufficient induce systemic change?

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