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CESIFO ECONOMIC STUDIES
CONFERENCE ON UNDERSTANDING
THE CHINESE ECONOMY
10 – 11 June 2005
CESifo Conference Centre, Munich
Is the peg helping or hurting
China’s banking system?
(First draft)
Brad Setser
CESifo
Poschingerstr. 5, 81679 Munich, Germany
Phone: +49 (89) 9224-1410 - Fax: +49 (89) 9224-1409
E-mail: [email protected]
Internet: http://www.cesifo.de
CESifo Conference on “Understanding the Chinese Economy”
Is the peg helping or hurting China’s banking system?
First draft
Brad Setser
RGE and the Global Economic Governance Programme,
University College, Oxford
June 2005
The views presented in this paper are strictly those of the author and not of any other
individual or institution. This paper draws on the “China Trip Report” of Nouriel
Roubini and Brad Setser available at: www.rgemonitor.com.
Banks matter, particularly in China.1 Banking deposits are the dominant form of savings.
At the end of 2004, bank lending stood at around 140% of GDP, and the bank deposit
base was 185% of GDP. Bond market capitalization is $300 billion, about 20% of GDP.
Equity market capitalization is only $150 billion, less than 10% of GDP.
On a flow basis, bank lending accounts for the majority of all financing available to
Chinese firms – indeed, it offers virtually the only real source of financing other than
retained earnings. Bank lending provided $300 billion in new financing in 2004; down
from maybe $350 billion in 2003.2 By comparison, corporations raised only $4.5 billion
in the bond market and $16 billion from the sale of “A” shares on the Shanghai and
Shengzen exchanges.3 In the first quarter of 2005, banks accounted for an amazing
98.8% of all business financing apart from retained earnings.4
Despite their enormous current importance, commercial banks are a relatively new
phenomenon in “communist” China. Banks in the classic sense did not exist before 1990
– financial institutions were nothing more than a vehicle for implementing the finance
ministry’s economic plan. In the early 1990s, China bank lending grew like mad – with
generally disastrous results, at least from a financial point of view. A credit boom led to
inflation, and eventually to a painful slowdown. The banks lent heavily to loss making
state owned enterprises and were left with an enormous stock of bad loans. Depositors,
however, not only kept their existing deposits in the “bad” banks (in part because of the
absence of other choices) but also provided an ongoing flow of new deposits that allowed
the banks to continue to expand their lending book.
For all the talk of global financial markets, Chinese banks are providing more financing
than anyone for investment in emerging economies. The roughly $650 billion in new
bank loans made by Chinese banks over the course of 2003 and 2004 is over twice the
size of the market capitalization of the EMBI, the leading index of dollar-denominated
emerging market bonds. Lending from the big four banks is equal to about 80% of GDP
– they alone are far bigger than the total banking system of most other emerging
economies. Relatively speaking, far too little ink is devoted to China’s banks and far too
much to the market for international sovereign bonds.
This paper tries to address this imbalance. It looks at three core issues facing policy
makers responsible for the health of China’s banking system.
1
Jonathan Anderson of UBS generously supplied some of the data used in this paper. I do not share all of
his conclusions, but his well-documented arguments demand to be taken seriously. See “How to Think
About China, Part 3: Which way out for the banking system?” UBS Investment Research: Asian Economic
Perspectives, May 2005.
2
Different data series produce slightly different results: the IMF data indicates a $288 billion expansion in
2004, and a $334 billion expansion in 2003.
3
Government bonds dominate the bond market. Equity markets are poorly regulated, state owned
enterprises make up most of the listings (the majority of shares in these firms do not trade) and the stock
market has, at least recently, provided negative returns.
4
Richard McGregor, “China looks to Banks for 99% of all Financing,” Financial Times, 29 May 2005.
2
1) How to manage the legacy of past “policy” based lending – largely lending to
loss-making state owned firms.
2) How to manage the current credit boom, and to avoid the creation of a new
generation of loss-making loans.
3) How to manage the transition toward a more market-based system for allocating
credit.
The second issue – and I will argue the third – are closely tied to China’s exchange rate
peg. The peg, more than anything else, defines macroeconomic conditions inside China
right now. I drew a somewhat arbitrary line at the end of 2002, and defined all pre-2002
bad loans as “legacy” loans. Arguably, that line should have been drawn at the end of
2001, since by some measures credit growth picked up significantly during the course of
2002. But end-2002 also works. The US dollar – and thus the Chinese renminbi –
peaked in the spring of 2002. From 1998 to 2002, the renminbi tended to appreciate on a
real trade weighted basis; after 2002 it has tended to depreciate. The pattern of capital
flows also changed at the end of 2002. Before 2002, China’s ongoing (but at the time
relatively small) trade surplus and FDI inflows were offset by a steady flow of Chinese
capital out of China.5 However, by 2003 “hot money” started to flow back into China.
The net result: a surge in Chinese reserve accumulation. Including the $45 billion
transferred to two state banks in 2003, China’s reserve growth went from $74 billion in
2002 (an increase over 2001) to $159 billion in 2003 and $207 billion in 2004.
Chart 1: Money growth and lending. From Jonathan Anderson, UBS
30
Grow th rate (y/y %)
25
20
15
10
5
0
1998 1999 2000 2001 2002 2003 2004 2005
Broad money M2
Loans of financial institutions
5
Folkerts-Landau Dooley, M., D. Folkerts-Landau and P. Garber The US Current Account Deficit and
Economic Development: Collateral for a Total Return Swap NBER WP. No. 10727, September 2004
(http://www.nber.org/papers/w10727) argue that the capital flight from China if redirected back toward
China in the form of foreign direct investment. Capital outflows allow China, in effect, to outsource
financial intermediation: China’s savings is not invested by China’s banks but rather by global banks, who
allocate Chinese savings to foreign firms investing in China. In their model, ongoing trade surpluses are
necessary to provide collateral to offset the rising value of past foreign direct investment. Goldstein and
Lardy note that the amount of external intermediate was very small relative to the amount of domestic
intermediation – most investment in China is financed out of domestic savings intermediated through the
domestic banking system, not foreign FDI. See Morris Goldstein and Nicholas Lardy, “China’s role in
Revised Bretton Woods System: A Case of Mistaken Identity,” IIE Working Paper 05-02, March 2005.
3
This surge in reserves was only partially sterilized. Particularly in 20036 and early 2004,7
growing reserves led to a surge in money creation and a rapid expansion of bank lending.
2005 may mark a new phase in China’s macroeconomic cycle. Reserve growth continues
unabated. UBS conservatively estimates reserve accumulation of at least $20b a month,
or $240 billion a year.8 $300 billion is not out of the question. But during the course of
2004, China’s authorities grew worried, and sought to limit the credit boom.
Administrative controls were slapped on bank lending, slowing credit growth. The
result is now becoming apparent. Investment growth has slowed,9 slowing domestic
demand growth. As both John Williamson and Morris Goldstein have pointed out,
China’s underlying trade surplus was much larger than its reported trade surplus in 2003
and 2004, since an unsustainable investment boom temporarily led to a surge in
imports.10 In 2005, export growth has stayed strong while import growth has slowed,
both because of slower investment growth and because the surge in domestic capacity has
displaced imports. China’s trade surplus has surged.
Table 1. Key Indicators.
$ Billion
REER
(Goldman)
Exports
Export growth
(% Increase)
Trade surplus
1999
94.3
2000
95.3
2001
101.0
2002
98.6
2003
92.4
2004
90.0
2005f
93?
2006f
?
194.6
5%
249.1
28%
266.1
7%
355.6
22.5%
438.4
34.5%
593.4
35%
925
15%
34.5
34
44.3
25.5
31.7
770
33%
(ytd)
120
150
6
See Matthew Higgins and Thomas Klitgaard, “Reserve Accumulation: Implications for Global Capital
Flows and Financial Markets, Current Issues in Economics and Finance, Federal Reserve Bank of New
York, Volume 10, Number 10, September/ October 2004. They estimate that China sterilized about half of
its 2000-2003 reserve increase.
7
The stock of sterilization paper increased by 300% in 2004, rising from 303 RMB billion to 1108 RMB
billion. But this increase still did not come close to fully offsetting the impact of reserve growth. Standard
Chartered estimates that only 36% of the 2004 reserve increase was sterilized. That estimate probably
understates total sterilization, as it is based on the transparent auctions of PBoC bills ($62 billion), the
PBoC’s intervention in the repo market ($12 billion) and bond sales ($1 billion); direct placements of
PBoC paper with state banks were not included. The reported increase in the stock of PBoC bonds ($97
billion) exceeded the amount auctioned, which the PBoC placed some bonds directly with the state banks.
8
Reserves grew exceptionally rapidly in the fourth quarter, and, while the pace of reserve growth abated
somewhat in Q1:2005 to $50 billion, nominal reserve growth still exceeded the roughly $40 billion per
quarter pace seen during the first three quarters of 2004. Moreover, valuation changes added to China’s
reserve accumulation in q4, and reduced China’s reserve accumulation in q1. I estimate that the underlying
rate of reserve growth slowed more modestly that the headline numbers suggest, falling from around $85
billion a quarter in q4 to $55 billion a quarter in Q1. Q2 2005 reserve accumulation should exceed q1
reserve accumulation significantly – given all the recent noise about a revaluation.
9
Investment growth continues to exceed GDP growth, implying that China’s investment to GDP ratio is
still rising. It just is not rising quite as fast as before.
10
John Williamson. “The Choice of Exchange Rate Regime: The Relevance of International Experience to
China’s Decision,” Institute for International Economics, September 2004. Morris Goldstein, “Adjusting
China’s Exchange Rate Policies,” IIE Working Paper 04-01, Institute for International Economics May
2004.
4
Current account
surplus
Non FDI capital
flows11
Reserves
Change in
reserves
M2
(% increase;
December y/y)
Lending growth
(% increase.
December, y/y)
Real investment
growth
(% increase)
Memo: GDP
15.7
20.5
17.4
35.4
45.9
71.4
150
180
(1.6)
-44.1
(1.9)
-47.4
(1.5)
-7.4
(2.9)
-6.6
(3.2)
23.9
(4.3)
84.5
(8.1)
80
0
155
10
166
11
212
54
286
74
403
15912
610
207
910
300
1160
250
14.7
15.4
14.4
16.9
19.6
14.5
14.1
12.5
13.8
11.9
15.8
21.1
13.9
10
9.7
10.2
10.2
11.6
18.3
13.3
10-11
999
1080
1175
1266
1416
1647
1858
2065
Sources: Moody’s, Goldman Sachs, World Bank, UBS and Author’s own calculations
1. Legacy loans
The primary goal of this paper is too look at how these macroeconomic developments,
many of which flow from China’s peg to the dollar, have impacted on China’s banking
system. But it is important to be clear: a large portion of the banking system’s current
problems is not a function of China’s peg, directly or indirectly. No matter what happens
to the RMB-dollar or RMB-euro in 2005, China’s banks took in RMB deposits in the
1990s, used those deposits to make RMB loans, and lots of those RMB loans went bad.
No matter what happens to the peg, these “legacy” loans simply have to be written off to
clean up the balance sheet of the banking system.
In broad terms, the bank’s balance sheet can be cleaned up in one of two ways. The
government can finance a recapitalization, whether by buying bad loans from bad banks
at an above market price or by providing an injection of funds to the banks after they
write down their bad loans.13 Alternatively, the government can let the banks uses their
ongoing profits to finance the write-down of past bad loans.
China has both injected state funds into the banking system in 2003, 2004 and again in
2005, in part through the transfer of some of the People’s Bank of China’s (PBoC)
11
Sum of portfolio, net; “other capital flows”; and errors and omissions.
Including the $45 billion transferred to two state banks.
13
Moving bad loans off the books of the banks is called a “carve-out” – it avoids the need for the banks to
take a hit to their existing capital by transferring the bad assets to a third party. Since the banks often have
liabilities to the People’s Bank of China, it is relatively easy for the banks to transfer their liabilities to the
PBoC and some of their bad assets to a third party. In a recapitalization, a third party has to inject funds in
the bank after their initial capital has been written down. There is little practical difference between a
“carve out” and a formal “recapitalization” – both use state funds to improve the banks’ balance sheet. See
Anderson, May 2005.
12
5
foreign currency reserves to state owned banks. The state banks have also been
encouraged to use ongoing profits to workout past bad loans. The combination of low
deposit rates and a surge in new lending has increased the profitability of China’s
banking system and, as Jonathan Anderson of UBS has emphasized, the spread between
deposit and lending rates matters less than the ratio between the deposit rate (now 2.25%)
and the lending rate (the reference rate is 5.56, but average lending rate in 2004 was
around 6.5%). If the ratio between the deposit rate and the lending rate is large enough,
China’s banks earn more than enough on their performing loans to pay their deposits
even if a large fraction of the bank’s loans do not perform.
However, these attempts have yet to clear away the full legacy of past “policy” lending
by the state banks. The size of the “legacy” of bad loans on the books of the state
banking system at the end of 2002 was by all accounts enormous. Official estimates put
the number at $400 billion, 32% of China’s 2002 GDP. Informal estimates suggest a
higher number, more like $650 billion (around 50% of 2002 GDP). An additional 1,400
billion RMB ($168) billion in bad loans were taken off the banking system’s books in
1999 and given to four asset management companies.14 Between $255 billion15 (the
official number) and $385 billion (unofficial estimates) of these bad loans were on the
books of the big four state commercial banks. Since three of these four banks – if not all
four – have been earmarked for partial privatization, their health is of particular interest.
The large gap between official estimates and private estimates, and the general absence of
transparency in China, makes it difficult to know how many of those bad loans remain in
the banking system. One thing is clear: the enormous expansion of bank credit in 2003
and 2004 has significantly reduced the banks’ NPL ratio. New loans usually don’t go bad
immediately, particularly loans that carry a 6% nominal interest rate in an economy that
is growing, in nominal terms, by over 12% a year. Loan growth alone is on track to
reduce “legacy” NPLs from 26% of all “big four” loans to about 21% in 2004. Lending
from other institutions has grown faster from lending from the big four, so total legacy
bad loans in the broader banking system from 25% in 2002 to 17% at the end of 2004 -and about 15% by the end of 2005. Rapid GDP growth alone will be sufficient to reduce
the stock of official recognized legacy bad loans – including bad loans that have been
transferred to the Asset Management Companies -- from 45% of GDP in 2002 to 31% of
GDP at the end of 2005.
Table 2. Reduction in NPLs in the Chinese banking system as a result of loan
growth; Initial 2002 Stock from official estimates
$ billion
14
These asset management companies have sold some of their bad loans in the secondary market, and
started to slowly work out others. But recovery rates on these loans have been low. Some early recovery
rates were around 30 cents, but recovery rates on even the first batch of better loans fell to 15 to 20 cents on
the dollar. Indeed, it is not obvious that recovery rates have been high enough to cover the investment
companies’ administrative costs. Ultimately, most of the $168 billion will have to be made up by tax
payers in one way or another.
15
In the middle of 2003, the official number was lowered to around $240 billion, a number that is often
cited in the press. Current official estimates are even lower.
6
2002
2003
2004
2005
Total loans
performing loans
Non-performing loans
984.9
728.0
256.9
1164.3
907.4
256.9
1252.4
995.5
256.9
1373.2
1116.3
256.9
NPLs as % of total
26%
22%
21%
19%
78%
58%
20%
82%
64%
18%
76%
60%
16%
74%
60%
14%
1627.3
1225.4
401.9
1989.6
1587.7
401.9
2303.6
1901.7
401.9
2605.6
2203.6
401.9
25%
20%
17%
15%
Total loans as % of GDP
o/w performing
o/w NPLs
129%
97%
32%
141%
112%
28%
140%
115%
24%
140%
119%
22%
AMCs
168.2
168.2
168.2
168.2
All NPLs
570.2
570.2
570.2
570.2
45%
40%
35%
31%
1265.9
1412.0
1647.0
1858.0
State commercial banks
Total loans as % of GDP
o/w performing
o/w NPLs
All banks
Total loans
performing loans
Non-performing loans
NPLs as % of total
Total bad loans as % of GDP
GDP
Sources: UBS, IMF, Press reports and author’s own calculations
While these calculations ignore both the banks’ ability to use ongoing profits to writeoffs of existing bad loans and the transfer of bad loans to the PBoC, they provide a
baseline for assessing how much has been done. The PBoC reports NPLs were 13% of
all loans in the state commercial banks and “joint-stock banks” at the end of 2004. Since
the joint stock banks are in better shape than the commercial banks that implies a NPL
ratio of around 15% for the commercial banks -- and around 15% for the financial system
as a whole. If all new loans are performing, reducing the NPL ratio from 20% -- the
simple product of lending growth – to 15% implies about 25% of the legacy bad loans
have been written down or transferred to the PBoC. In dollar terms, that would imply
writing off about that about $65 billion in bad loans between the end of 2002 and the end
of 2004. That is quite plausible. Jonathan Anderson estimates that Chinese banks wrote
7
off $25 billion in loans in 200316, $30-35 b in 2004 and an additional $30b (RMB 250b)
of bad loans from two state banks (China Construction Bank and the Bank of China)
were transferred to the central bank – for a total reduction of $85 billion. A $65-85
billion reduction in NPLs in the state commercial banks – along with loan growth –
would be enough to bring the overall NPL ratio in the financial system to less than 15%,
to around $330 billion – close to the “official” estimate.
However, official statistics also probably overstate the overall health of the banking
system. Many analysts estimate that close to 40% of all loans – both in the state
commercial banks and in the financial system as a whole -- were either not performing or
were “impaired” in 2002.17 Loan growth plus a $65 b reduction in the existing stock of
bad loans would be sufficient to bring the ratio of “legacy bad loans” to all loans down to
around 25% of the state commercial banks total loan portfolio in 2004. The ratio for the
financial system as a whole would be a bit lower. Incidentally, these estimates parallel
current independent estimates of the NPLs in the financial estimate.
These loans are the legacy of policy decisions made prior to 2002 – often the legacy of
lending made in the 90s. They have to be cleaned up one way or another. This has two
policy implications. First, to the extent that the government expects the banks to use
ongoing profits to pay for the write off, the government has a strong incentive to continue
to keep deposit rates low – and to retain strong controls over deposit rates. Second, if the
government decided to clean up the legacy of past bad loans once and for all, its debt
would rise significantly. Consequently, there is little doubt that the government of China
has more debt than it officially recognizes.
Official data put end 2004 Chinese public debt at 33% of GDP and the IMF estimated a
2004 fiscal deficit of 2.2% of GDP. My ballpark math suggests GDP growth would have
reduced official recognized NPLS at the end of 2002 to around 35% of GDP at the end of
2004 ($570 billion). Ongoing write downs and the transfer of bad loans to the PBoC,
which could use some of its own profits to cover the cost of writing down bad loans,
might have cut that total by $65-70b, to around 30% of GDP. Even assuming a generous
recovery rate on NPLs of around 20 cents on the dollar (net of costs), the total cost to the
government of cleaning up the financial system could still be close to 25% of GDP.
International best practice would imply issuing a bond to recapitalize the banking system,
and paying a market rate on that bond -- say something close to 5%. The ongoing the
cost of servicing the recapitalization bonds then would be around 1.25% of GDP. More
realistic estimates put total current bad loans at close to 45% of GDP, and thus imply,
assuming a 20% recovery rate on bad loans, a total cost of around 35% of GDP. The
ongoing fiscal cost from the interest on recapitalization bonds would then be around 1.8%
16
According to Anderson, the banks set aside $12 billion to cover the costs of writing down $25 billion in
bad loans, and still had $20 billion or so in profits.
17
With rapid growth of nominal GDP and low lending rates, some firms can repay interest – particularly if
they receive a bit of help in the form of new lending (so called ever-greening) even if they have no hope of
ever repaying the principal.
8
of GDP. It is quite possible that China’s “real” public debt and “real” fiscal deficit are
really twice as large as the official numbers.18
2. Managing the surge in reserves, surge in money growth and surge in credit
Data about the stock of legacy bad loans tell us little about how the peg currently
interacts with the banking system There is little doubt, however, that the monetary
expansion generated in part by the surge in reserve accumulated needed to sustain the peg
contributed to rapid credit expansion from 2002 to 2004. The increase in lending has
been phenomenal. If the banks increase their outstanding loans by 2500 billion RMB
($300 billion) in 2005, the government target, they will have added around 8 trillion
RMB, or $1000 billion in new loans to their books since the end of 2002. So long as all
these loans perform, that would more or less double the banks’ stock of performing loans
in three years.
Chart 2. Flow Lending. From Jonathan Anderson, UBS
600
New monthly flow lending (RMB bn)
500
400
300
200
100
0
-100
1998 1999 2000 2001 2002 2003 2004 2005
Monthly nominal data
Real new loans (sa)
This surge in lending is tied to the current peg in three ways:
•
•
Large capital inflows, if not sterilized, lead to rapid growth in the money supply,
in bank deposits and to rapid loan growth. The inflows bring foreign savings into
China on top of the funds available from china’s large (and growing) domestic
savings rate.
China cannot easily raise interest rates to cool the economy and reduce demand
for credit. Any increase in interest rates would increase the incentive for hot
money to flow into China – preventing the desired tightening in monetary
18
Paying interest on recapitalization bonds and foregoing profits from the state’s equity ownership of the
banking system amount to the same thing. One shows up as higher expenditure, the other as less revenue.
However, to the extent China wants outside investment in the state banks, it needs the banks to be
profitable and pay dividends – the state may be willing to forego profits on its investment to cover the cost
of old bad loans; outsider investors are unlikely to be as kind.
9
•
conditions absent a surge in sterilization. Low RMB interest rates create a strong
incentive for firms to take out credit, particularly in the context of rapid growth in
nominal GDP.
The undervalued RMB creates an incentive for those who can to borrow in
foreign currency to borrow in foreign currency. Any bank (or firm) that can
borrow in foreign currency and convert the proceeds into RMB would win in the
event of a revaluation. Banks that borrow in foreign currency and lend in foreign
currency are also doing booming business: Chinese firms understand that the
“real” value of their foreign currency denominated liabilities will fall with a
revaluation and are happy to take out foreign currency denominated loans.
Domestic depositors understand this game too, and are shifting their funds into
RMB: The People’s Bank of China reported that domestic foreign currency
denominated deposits fell by 6%, or about $4 billion, between November 2003
and November 2004.19 However, the external foreign currency liabilities rose of
Chinese banks rose, allowing their total foreign currency lending to increase. A
further surge in foreign currency borrowing recently prompted a crackdown – but
it is not clear if the crackdown will be effective.
In China, neither the price of foreign exchange nor the price of credit is set by the market.
Interest rates seem rather to be set to balance the needs of state owned banks and the
needs of state owned firms. Apart from attracting more inflows, any increase in deposit
rates would cut into bank profitability, particularly in a context where many loans are not
performing. An increase in the lending rate would cut into the health of state owned
enterprises, and risk increasing NPLs.
So far, low deposit rate have not prevented strong growth in bank deposits. Bank
deposits pay more than cash, and alternative savings channels are underdeveloped.
China’s capital controls certainly make it hard for domestic savers to move funds
offshore. But the controls are only reason why depositors are willing to accept low RMB
rates. After all, Chinese savers with existing funds offshore or in onshore dollar deposits
have been shifting into RMB accounts because of expectations that the RMB will
appreciate. This pattern is not confined to China. Low dollar rates and expectations of a
local currency appreciation are a general phenomenon in emerging economies now.
Argentina is not that different from China.
19
See People’s Bank of China, “Foreign Currency Deposits Continued to Increase” January 2005. Rising
corporate dollar deposits and growing external liabilities offset falls in household deposits. The joint
external debt data published by the OECD, BIS, IMF and World Bank show China’s short-term cross
border bank liabilities increased by $19.75 billion at the end of 2002 to $38.25 billion at the end of
September, 2004, and overall external bank debt rose from $36.6 billion to $64.8 billion. See also Eswar
Prasad, Thomas Rambaugh and Qing Wang, “Capital account liberalization and Exchange Rate Flexibility
in China: Putting the Cart Before the Horse,” IMF Policy Discussion Paper 05/01, January 2005. Prasad,
Rambaugh and Wang report that the Chinese banks foreign currency denominated lending (funded both
domestically and externally) rose from $81 billion in 2001 (6.9% of GDP) to $130 billion at the end of
2003 (9.2% of GDP). Chinese data suggests this trend continued in 2004. The People’s Bank of China
reports a $16.7 billion increase in foreign currency lending in the first 11 months of 2004. However, the
PBoC’s end-2003 stock numbers do not seem to quite match those in Prasad, Rambaugh and Wang.
10
China’s central bank recently has taken a series of steps to try to curb rapid lending
growth. The pace of sterilization seems to have been increased, and strict administrative
controls have been placed on new lending. These controls have had an impact. Credit
grew more slowly in the first quarter of 2005 (RMB 826 billion) than in the first quarter
of 2004 (RMB 913 billion). With broad money and deposits increasing more rapidly
than bank lending, the banks increasingly have plenty of spare cash on hands (i.e. they
are very liquid). Since the PBoC only pays 1% on its excess reserves, the banks have a
strong incentive to invest in PBoC paper. This drives down the PBoC’s sterilization
costs, but it also drives down the bank’s revenues.20
The combination of the 2003-04 lending boom and the subsequent deceleration of credit
growth consequently raises three core questions:
1) What faction of new lending will fail to perform? In short-run, the expansion of
lending has generated a surge in the stock of performing loans. However, the
long-run costs won’t be apparent for some time. Bank credit is large relative to
China’s GDP, and has been growing relative to GDP, so even if a smaller fraction
of new lending goes bad than in the past, the overall cost of the new bad loans
relative to China’s GDP could still be quite significant.
2) What happens to the health of the banking system if the PBoC crackdown on
lending continues, eroding their profitability? So long as deposit growth now
exceeds lending growth, cash-rich banks will buy the PBoC’s sterilization bills,
keeping the central banks cost down. But the more the banks are, in effect, forced
to hold low-yielding bills through lending controls, the harder it is use ongoing
bank profits to finance the write-down of past bad loans. The banks are not
making any money taking in deposits at 2.25% and lending to the PBoC at about
the same rate.
3) When will the supply of new sterilization bills exceed even the banks capacity to
absorb them? Declining rates on central bank paper hardly suggest difficulties
with sterilization. But the PBoC also did not fully sterilize even the Q1 reserve
increase and the pace of reserve accumulation – and thus the need to sterilize – is
likely to pick up over the course of the year. China’s capacity to sustain
exceptionally rapid reserve growth without eventually letting money grow too
rapidly and generating renewed inflation remains an open question.
New Bad Loans
Past experience suggests that a significant fraction of the most recent credit expansion
ultimately will go bad. Goldstein21 notes that roughly 40% of the loans made in past
Chinese lending bubbles ended up as NPLs, Jonathan Anderson of UBS has estimated
that 70% of the loans made in 1992 and 1993 failed to perform. However, Anderson
also argues that there has been real improvement in the banking system since the early-to-
20
See Stephen Green, “China Money Monitor,” Standard and Chartered Bank, April 2005
Morris Goldstein, “Adjusting China’s Exchange Rate Policies,” IIE Working Paper 04-01, Institute for
International Economics, May 2004.
21
11
mid 90s, and that would be a mistake to assume that China is likely to simply repeat past
mistakes.
•
•
•
•
The 2003-04 lending boom was smaller and shorter than the lending boom in the
early 90s. In 1993, M2 (money and bank deposits) grew by over 40% -- and the
y/y increase in investment in fixed assets topped 60%. The peak increase in late
2003/ early 2004 was far smaller, with money, credit and investment growing by
around 20%.
The banks’ lending portfolio is changing. Notably, the banks are lending less to
China’s state-owned enterprises (SOEs). While loans to SOEs still account for
about 50% of all bank loans, Anderson estimates lending to SOEs accounts for
only 35-40% of all new lending. Over time, the banks exposure to SOEs is
falling.
The SOEs that are getting loans are better credits than in the past. Over the past
few years, the least profitable SOEs have been shut down and the remaining SOEs
are profitable on a cash-flow basis.
The bank’s loan portfolio is now more diverse. The banks are increasingly
providing mortgages, auto loans and even direct consumer loans.22
Anderson’s conclusion: “Banks will still face new bad loans, but the relative size of the
current flow NPL problem should be orders of magnitude less than in the previous
cycle.”
It consequently seems likely that China’s banks won’t get into trouble in the exact same
way as in the early 1990s – they are not lending exclusively to unprofitable SOEs. A
more interesting question, though, is whether Chinese banks are making new mistakes –
notably lending too much to the “hot” real estate sector or lending too heavily to China’s
booming export sector.
China’s banks clearly have more exposure to the real estate market than in the past,
whether through loans to property developers (commercial lending) or through mortgages
(consumer lending). Real estate lending has been a classic source of banking trouble in
other economies – both advanced economies and emerging economies. For example,
Thai banks got into trouble financing a construction boom in Bangkok in the mid-90s.23
22
Watch consumer lending pick up rapidly as soon as western banks are allowed into China. The
opportunity to build a credit card franchise seems to be the bait that may prompt western banks to invest in
China’s big four despite their manifest weaknesses. The margins on credit cards are particularly juicy in a
market where banks can fund themselves locally at 2.25%. Competing with Chinese banks to lend to
Chinese firms is far less attractive: commercial lending is a competitive business and western banks would
face extensive competition.
23
Thai banks financed themselves with large amounts of short-term external borrowing, and Thailand was
running a large current account deficit prior to its crisis. Chinese banks generally finance themselves in
renminbi – though their foreign currency borrowing is growing. More importantly, China is running a
large and growing current account surplus, while Thailand was running a large current account deficit.
Foreign currency borrowing poses fewer risks in the event of a revaluation (which makes foreign currency
denominated debt easier for domestic borrowers to repay) than in the event of a devaluation.
12
Financing private real estate development could prove almost as treacherous as financing
state-owned enterprises.
The exposure of China’s banking sector to China’s export sector also must be increasing.
Exports grew by 30% -- actually a bit more – in 2003 and 2004 and look to be growing at
a similar clip in 2005, far faster than the overall economy. Some of this expansion was
financed by retained profits and/ or direct investment from abroad, but was financed
through the domestic banking system.
Lending to the export sector is rarely considered a source of risk. Many emerging
economies have borrowed from abroad in foreign currency to finance ongoing current
account deficits, and consequently have to worry about the risk that devaluation would
increase the real value of foreign currency denominated debt. In this context, export
revenues provide a natural hedge against the risks otherwise associated with foreign
currency borrowing. However, the equation changes somewhat in China, which has a
large current account surplus and faces substantial pressures for appreciation, not
depreciation. In this context, overexposure to the export sector is potentially risky. A
revaluation – if not offset by higher prices or reduced import costs – reduces the domestic
currency revenues of exporting firms.
That specific risk is probably manageable. To the extent Chinese firms are competing
against other Chinese firms, raising prices won’t be a problem. And Chinese exports
include large amounts of imported content, and a revaluation would lower the cost of
many imported inputs. Some firms may be able to offset reduced exports with higher
domestic sales. Most analysts believe that a 10% or larger revaluation would have
relatively a relatively modest impact on China’s export sector. A bigger concern is that
too many firms may be investing on the expectation that 30% y/y export growth will
continue. That may prove to be overly optimistic. The OECD forecasts global trade to
grow at 8% in 2005. Over time, it will be harder and harder for China’s exports to grow
substantially faster than overall trade.
Chinese exports now account for a large share of global trade, particularly if intraregional trade inside Europe and the “NAFTA” area is netted out. At the end of 2004,
China’s goods exports (in dollar terms) were 75% of US goods exports exports. At
current growth rates, China will export more goods than the US at the end of 2006,24
despite having an economy that even then will only be about 1/6 the size of the US
economy. Exports to the US accounted for about 12% of China’s GDP at the end of
2004, and that could rise to 16% by the end of 2006. China is almost as dependent on the
US market as Mexico.25 Even if China’s exports have a large amount of imported
content – spreading the risk – there is little doubt that China’s economy is becoming
24
China’s goods exports at the end of 2004 totaled a bit under $600 billion. Two years of 30% growth
would bring the total to $1000-1010 billion. US 2004 goods exports were $815 billion. Two years of 10%
growth (roughly the q1 2005/ q1 2004 rate) would raise the 2006 total to $ 985b. In reality, both Chinese
and US export growth is likely to slow somewhat.
25
US data on Chinese imports does not match Chinese data on exports to the US, largely because of the
different treatment of goods transshipped through Hong Kong. These calculations use US import data. US
imports from China were around $195 billion in 2004.
13
increasingly exposed to the global business cycle, not to mention protectionist pressure in
Europe and the US.
Finally, Chinese banks may have financed the over-expansion of certain industrial sectors
– producing local gluts that will drive prices and profits down and ultimately generate
new NPLs. Even in a rapidly growing market, supply can increase faster than demand.
This has already happened in China’s auto sector, and it looks likely to happen in other
sectors. In some sector, Chinese firms have been able to displace imports – but that may
not always be possible.26
A smaller fraction of the lending associated with the most recent credit boom is likely to
go bad than went bad in the early 90s -- if only because such a high fraction of previous
lending boom went bad. But a small fraction of a big number is still a big number. And
by any measure, the current credit boom has been big. If the banks meet the
government’s 2005 lending target, bank lending will have increased by a bit under $900
billion since the end of 2002, around 50% of China’s 2005 GDP. And while lending
growth and investment growth never grew quite as fast as in the early 90s, they still grew
fast enough to push investment as a share of GDP above its 1993 peak.27
China is now investing about 45% of its GDP and China’s capital stock is no longer so
small that it is obvious that China can profitably re-invest half of its yearly domestic
product. Work by some Chinese economists suggests a sharp fall off in the marginal
productivity of capital, and total factor productivity.28 Labor productivity has been
growing in large part because each unit of labor is now combined with more capital. The
cheap price of capital is one reason why investment has soared in relation to GDP. In
this dimension China looks like the “Asian Miracle” that went bust in the 1990s: high
growth driven more by growth in factor inputs (notably the rapid accumulation of capital)
than by growth in total factor productivity in economies with very high (excessive) rates
of investment.29
Table 3. Bad loans in the Chinese banking system, assuming a higher initial level of
“legacy” NPLs and no write down of NPLs out of ongoing profits
$ billion
26
Jonathan Anderson argues that the rapid expansion of production between 2002 and 2004 generated
economies of scale that helped firms sustain profits even in the face of rising input costs. However, going
forward, as the economy cools off, firms will not be able to offset rising input costs with comparable scale
economies and the intrinsic advantages of higher capacity utilization.
27
Raghuran Ragan and Eswar Prasad, “China’s Financial Sector Challenge,” Financial Times 10 May 2005
Also see the charts in Morris Goldstein, “The Chinese Economy: Prospects and Key Issues,” Institute for
International Economics April 2005.
28
Hu Angang at “China’s Economic Emergence,” April 7-8, Columbia University. Professor Hu notes that
the low cost of capital also creates an incentive to substitute capital for labor, and thus works against
China’s attempts to create jobs for underemployed rural workers migrating to the cities.
29
A busting of the investment bubble in China would not lead to the external debt payments crisis that East
Asia faced in 1997-98. China has a large stock of reserves, low amounts of short term foreign currency
debt, capital controls and a current account surplus. Still, the Chinese hard landing would take the form of a
domestic financial crisis. The risk is that the over-extended financial system stops lending, leading to a
severe credit crunch, an investment bust and a domestic recession.
14
2002
2003
2004
2005
984.9
590.9
394.0
1164.3
770.3
394.0
1252.4
858.5
394.0
1373.2
979.2
394.0
40.00%
32.63%
28.13%
24.84%
77.80%
46.68%
31.12%
82.46%
54.55%
27.90%
76.04%
52.12%
23.92%
73.91%
52.70%
21.20%
Total loans
performing loans
Non-performing loans
1627.3
976.4
650.9
1989.6
1338.7
650.9
2303.6
1652.7
650.9
2605.6
1954.6
650.9
NPLs as % of total
40.00%
32.72%
28.26%
24.98%
128.54%
77.13%
51.42%
140.91%
94.81%
46.10%
139.87%
100.35%
39.52%
140.24%
105.20%
35.03%
AMCs
168.2
168.2
168.2
168.2
All NPLs
819.2
819.2
819.2
819.2
64.71%
58.02%
49.74%
44.09%
0.0
0.0
54.3
90.6
101.4
169.1
146.7
244.6
64.71%
64.71%
61.86%
64.43%
55.90%
60.00%
51.99%
57.25%
1265.9
1412.0
1647.0
1858.0
State Commercial banks
Total loans
performing loans
Non-performing loans
NPLs as % of total
Total loans as % of GDP
o/w performing
o/w NPLs
All banks
Total loans as % of GDP
o/w performing
o/w NPLs
Total bad loans as % of GDP
New NPLs
if 15% go bad
if 25% go bad
Total NPLs as a % of GDP
if 15% go bad
if 25% go bad
GDP
Sources: IMF, UBS, press reports and author’s own calculations
If 15% of the new loans go bad, that would add $130 billion (around 8% of GDP) of bad
loans to the financial system’s books – on top of the existing stock of legacy loans. If
25% go bad, the total increase would be more like $220 billion (well over 10% of
15
China’s 2005 GDP. Let’s assume that the banks can set aside $15 billion a year to
provision against losses on future bad loans, and that $15 billion is enough to cover losses
on $30 billion of distressed debt. Bank lending is growing by about $300 billion year –
so the banking sector’s total stock of NPLs would roughly stay constant if “new” NPLs
are less than 10% of total new lending. That seems a bit optimistic.
The state commercial banks
These calculations focus on the entire banking system. Most attention, however, focuses
on the big four state commercial banks. The government has acknowledged that these
banks had a starting stock of $255-260 billion in NPLs in 2002, before the recent credit
expansion – out of a loan portfolio of around $950 billion. The government argues that
these NPLs were reduced to $240 billion during the course of 2003, and to around $190
billion by the end of 2004.
The distribution of NPLs is not uniform among the state banks. CCB is considered to be
in slightly better shape than the BOC (though its chairman was recently forced out in a
corruption scandal) and both are considered to be in better shape than the larger ICBC.
The Agricultural Bank of China (ABC) is considered to be in the worse shape of all the
state commercial banks – many suspect it will never be privatized and instead will be
turned into a “policy” bank.30 At the end of 2004, the CCB has $285 billion in
outstanding loans, and the BOC around $215 billion – compared to the $448 billion of
ICBC.
Market analysts estimate that around 15%, of $75 billion, of the CCB and BOC’s lending
portfolio is impaired in some way, even after $30 billion in bad loans were transferred to
the PBoC. The PBOC transferred $45 billion of the country’s foreign exchange reserves
to these two banks in December 2003 ($22.5 billion each), but this alone seems
insufficient to generate a positive net worth for these banks. The recapitalization of the
Industrial & Commercial Bank of China (ICBC) is an even bigger challenge. $15 billion
was transferred from the central bank’s reserves to the ICBC in April 2005, and the
ministry of finance is expected to kick in another RMB 125 billion ($15 billion).
However, Fitch Ratings estimates the ICBC needed at least $50 billion,31 and UBS
analysis suggests the ICBC needs around $100 billion.32
What is worse: Rapid loan growth or lending to the government at cost?
The credit boom of 2003 and 2004 cannot be undone. It happened, and either will or will
not generate a new round of bad loans. The real question is what will happen going
30
Market analysts estimate NPLs of around 15% in CCB and the BOC, relative to the government’s
estimate of under 5%. They put the ICBC’s bad loans at around 30%, v. the government’s 19%. And they
estimate 40% of the ABC’s loans are not-performing.
31
See Bloomberg, April 22, 2005
(http://www.bloomberg.com/apps/news?pid=10000080&sid=aLgLJpRdMaDU&refer=asia).
32
Jonathan Anderson “China: Ten questions about the ICBC recap,” UBS Investment Research, 25 April
2005. UBS estimates that about 30% of the ICBC’s lending portfolio is bad ($134 billion), but even
Chinese bad loans should have a small recovery value.
16
forward. High levels of domestic savings, a financial system that channels most savings
to the banking system, low borrowing rates and strong reserve inflows that – if not
sterilized – translate into rapid money growth all create the underlying conditions for
further credit expansion.
The ‘owners” and regulators of China’s big banks are effectively the same. China’s
owner/ regulators currently face a core choice. In the short-run, the more the banks lend,
the more they earn – and the easier it is to use ongoing profits to write off past loans. But
using current profits to clean up the legacy of bad loans made in the 1990s probably
implies failing to provision realistically against likely losses on the current generation of
loans. Indeed, if expected losses on marginal loans are high enough, the bank regulators
are doing themselves a favor – at least in the long run – by limiting bank lending and
forcing the banks to buy sterilization bills. The banks don’t make money lending to the
central bank of China, but at least they don’t lose money.
However, the stock of sterilization bonds that the government needs to place with the
banks is potentially large. Anderson estimates that underlying demand for money is
increasing by about $70 billion. But even if $70 billion of China’s reserve increase does
not need to be sterilized, with reserves increasing by $300 billion in 2005, the central
bank would still need sterilize $230 billion to avoid potentially inflationary money
growth. That is about twice what it sterilized in 2004.
Indeed, if reserves increase by $300 billion in 2005, China may end up with the worst of
both worlds. Rapid reserve growth will fuel money growth that is strong enough to
generate a bit of inflation. Deposit rates will be kept down to support the banks and
lending rates will be kept down to support China’s state-owned enterprises, keeping real
rates very low. Credit growth will be held below deposit growth by administrative
controls, generating a market for the central bank’s sterilization bills. But credit growth
will be strong enough to generate a reasonably supply of future bad loans.
3. Is China making progress toward a more market-oriented financial system?
China has long argued that it has a plan to liberalize its financial and exchange controls
and gradually loosen the peg over a medium-term horizon. This plan envisioned a
carefully sequenced set of reforms. China would take steps: to recapitalize the domestic
financial and banking system; to list the state banks on the equity market and allow
foreign equity participation to improve their management, to liberalize domestic capital
markets (at least partially), to liberalize certain exchange controls to augment demand for
foreign assets (more two way flows would reduce the need for the PBoC to intervene to
keep China’s current account surplus and FDI inflows from creating pressure for
appreciation); to allow more “onshore” foreign exchange trading; to create hedging
instruments to help allow firms and financial institutions manage the currency risk that
would accompany more flexibility.
China seems to have planned to adjust the peg after all these steps were well under way.
However, this medium term plan was conceived in an environment where the RMB was
17
under far less pressure and China’s reserve increase was much more subdued. Sticking to
this timeline increasingly appears to be neither politically nor economically feasible. The
financial costs of the reserve accumulation are mounting on the back of rising reserve
accumulation. US pressure to adjust the exchange rate is, if anything, growing even
faster than China’s reserves.
Nor is it clear that China’s continued adherence to the current exchange rate peg is
providing time and space for the gradual emergence of a more market-based banking
system – a system that would be better prepared to weather the rigors of either a revalued
RMB or an exchange rate regime that allows some flexibility, such as a band around a
basket peg (No one thinks China can move immediately to a free float).
Some changes have been made. Lending rates were partially deregulated in the fall of
2004. The technical infrastructure for a foreign currency market has been created,
though turnover remains low. The authorities have not only indicated their commitment
to list several of the state commercial banks on the stock market, but have backed that
commitment with the injection of new capital into the banks. But for every step forward,
China has also taken a step backward in the face of the pressures created by rising
reserves and the associated tendency toward rapid money and credit growth. Right now,
credit growth is controlled by administrative fiat, and administrative guidance is playing
a big role in determining which sectors still get credit – and which sectors do not.
Anderson – unlike some observers, like Morgan Stanley’s Andy Xie, does not oppose
changing the peg. But he also argues that the peg has not precluded significant
improvement in the health of the Chinese banking system. The surge in lending has
increased the size of the bank’s performing loan portfolio, making it easier for the banks
to recapitalize themselves out of ongoing profits. The recent introduction of
administrative controls prevented large excesses. In an economy where large amounts of
credit are still allocated administratively, Anderson argues administrative controls remain
an effective tool – in some ways better than higher lending rates.
“Keep in mind that in an economy with heavy state ownership and influence, the
interest rate may not be best tool for macro control. For example, if regional
government officials are promoting inefficient investment projects through direct
pressure on local state-owned banks, then simply raising the price of credit may
actually cause an adverse reaction; inefficient projects will still borrow if they are
not focused on repaying the loans, while good firms and projects will be hurt by
the higher cost of credit. In other words, local administrative pressures should
also be met by an administrative reaction from the center, and this is precisely
what we have seen in the past few years, with “window” guidance, sectoral
investment restrictions and other administrative measures.”
That assessment seems a bit too rosy. There was a significant expansion of credit prior to
the recent administrative tightening, and the banks presumably financed at least some
inefficient projects then. Investment has risen to very high levels relative to GDP. It is
not clear that a banking system with perfect incentives could successfully intermediate
18
between China’s enormous savings and its equally enormous current pace of investment.
Moreover, administrative guidance alone is no guarantee against making bad loans.
Potential problems exist at several levels. First, the banks have no capital of their own at
risk and, like zombie banks everywhere, have an incentive to gamble for resurrection –
indeed, the whole lending boom could be seen as one huge gamble for resurrection.
Second, individual bankers at the local level have strong incentives to lend. The benefits
of local lending accrue locally: a new factory that generates jobs, a local real estate boom,
and more rapid local growth. Yet losses – at least in the state commercial banks –
ultimately are picked up by the central government. The degree of effective central
supervision over the activities of the local branches of the big four state banks is far from
clear. Third, so long as credit is not allocated by price, there is a huge incentive for
corruption. The ability to borrow at 6% or less in an economy growing – in nominal
terms – at 12% is quite valuable. Some projects probably get funded in return for a bit
extra on the side.
Real interest rates are no longer negative, but they remain very, very low. The 5.6%
lending rate is now above consumer prince inflation, but it is about equal to the current
annual increase in the producer price index. Credit in China remains far cheaper than it
was in say early 2002, when real interest rates were above 6%.33 And compared to the
typical Latin economy, credit is amazing cheap. To take an extreme example, compare a
5.6% nominal cost of funds and 12-15% nominal growth (China now) with 12% nominal
cost of funds and a shrinking economy (Argentina in 2000 and 2001).
Keeping credit from expanding to match demand at current interest rates consequently
requires heavy administrative controls. Rajan and Prasad have noted:
But financial-sector restructuring cannot be divorced from other policies. For
instance, maintaining a fixed exchange rate reduces the independence of China's
monetary policy. In the face of capital inflows and pressures for appreciation, the
government is forced to keep interest rates low. This implies cheap, subsidized
capital to banks and companies. The government then has little choice but to use
administrative measures such as moral suasion to control growth in lending and
investment. This is not consistent with training the banking system or state
enterprises to respond to market incentives.
The banking system is if anything further away from allocating credit on the basis of
price than it was a few years ago. Nor have steps to develop alternatives to bank credit
gone anywhere. As the Financial Times has reported, the banking system provided 99%
of credit in the economy in 2005.34
33
Morris Goldstein, “The Chinese Economy: Prospects and Key Policy Issues,” Institute for International
Economics, April 2005.
34
Companies are now funding themselves at low cost by issuing short-term bills in the inter-bank market to
tap into the banking system’s excess liquidity.
19
The Chinese authorities have emphasized the need to gradually prepare the financial
system – and the real economy – for greater exchange rate flexibility and capital
mobility, and consequently, and exchange rate move large enough to reduce the pressures
created by large inflows would be a mistake. They worry that if Chinese depositors could
move funds out of the domestic banking system they would. So long as the banks are
liquid even with low deposit rates, there large portfolio of NPLs is not a problem.
However, the moment depositors flee, though, the banks would come under stress. They
also argue that China needs time to develop a foreign exchange market and instruments
that will allow Chinese exporters and importers to hedge exchange rate risk.
The first argument is not very persuasive. Prasad, Rimbaugh and Wang correctly note
that a revaluation need not imply a loosening of China’s capital controls: “exchange rate
flexibility by itself is unlikely to create strong incentives (or channels) to deposits out of
the Chinese banking system.” Foreign banks are allowed to compete in the local
renminbi deposit market starting in 2006 but, as Anderson notes, the risk that this will
prompt widespread flight out of the state banks has been exaggerated. 35 So long as
Chinese depositors expect the government to stand behind the state banks, they have little
need to worry about the underlying quality of their loan portfolio. Moreover, it is not
obvious that the foreign banks will want to attract a huge surge in deposits. Building up
lending capacity takes time. Right now, neither lending in the interbank market nor
lending to the Chinese government is profitable. Foreign banks will cut their deposit rate
rather than accumulate large sums that they cannot lend out at a profit. China’s
authorities probably will be able to “force” foreign banks to take over large numbers of
existing bank branches, if not entire banks, if they want to expand rapidly
No doubt, letting Chinese banks bet on the foreign exchange market creates a new
opportunity for the banks to take on risk – or at least a vehicle for the banks to join the
rest of the world and make a bet on the future of China’s peg. Since the banks’ are
generally underwater, their own capital is not at risk: care needs to be taken to assure that
the banks don’t make large and risky foreign exchange bets in a gamble for profits.
However, the same incentive problems are present in a wide range of bank activity. In
many ways, the risk associated with the banks core business of taking in RMB and
lending out in RMB is far larger, just because the sums involved are larger. The bottom
line is simple: China’s banks need to be closely regulated in all their activities until real
private capital is at risk.36
35
A corollary of this view is that the renminbi might well fall if China loosened capital controls and
adopted a more flexible exchange rate regime. Close analysis suggests that the deposit outflow needed to
put significant pressure on the current exchange rate would need to be very large indeed. Remember that
China looks set to run a trade surplus of around $120 billion in 2005 and to attract an additional $60-$70
billion from FDI inflows. These inflows would allow China to finance a deposit outflow equal to $180$190 billion, over 10% of China’s expected 2005 GDP, without drawing on its enormous stock of reserves.
Global investors are underweight Chinese assets just as much as Chinese private citizens are “underweight”
in global assets. Complete liberalization would likely give rise to two-way flows: foreign investors seeking
risk and higher returns would offset Chinese investors seeking safety abroad.
36
It should be easier for the PBoC to monitor and regulate the activities of those banks permitted to
operate in the foreign exchange market than to monitor and regulate all domestic banking activities.
20
Conclusions
The health of China’s banking system cannot be divorced from health of overall
economy. This is always true, but it is particularly true for China. Total bank lending is
a very large share of GDP, so China’s banks have exposure to almost every corner of
China’s economy in one way or another. Moreover, the Chinese banking system lacks
many of the specific weaknesses of that leave the banking sectors of other emerging
economies uniquely vulnerable to particular kinds of shocks. The banks do not have a
large foreign currency mismatch, nor do they operate heavily in foreign currency. Most
domestic deposits are in renminbi. China’s banks – unlike say Turkey’s banks -- are not
primarily a vehicle for financing the government’s fiscal deficits. Treasury bills/ bonds
account for a relatively small share of their assets, though the banks holdings of PBoC
sterilization bills are rising fast. The business of China’s banks – even its state banks – is
financing Chinese business.
No one doubts that China is growing fast. But there is reason to worry that China’s
growth is unbalanced. Investment is unusually high as a share of GDP. While
investment growth has slowed, overall levels of investment in all probability remain
unsustainably high. Chinese consumption growth lags Chinese GDP growth. China’s
economy, and indirectly if banking sector, increasingly depends on exports to make up a
shortage of domestic demand. If export demand were to falter without a surge in
domestic demand, China’s growth would slow, and NPLs would surge. Similarly, any
fall in investment as a share of GDP – a possibility if the current credit boom produces
significant over-capacity, would test China’s economy and its banking sector.
China faces another potential risk. Its banks might adopt more market-based behavior at
precisely the wrong time, augmenting a cyclical slowdown. If something causes the
Chinese economy to slow and NPLs to increase, bank capital will start to fall. Purely
state run banks could ignore rising NPLs and keep on lending. But more commercially
oriented banks might try to prevent their capital adequacy ratios – something that is most
easily done by curbing their new lending. That, however, would add to the cyclical
slowdown.
Finally, China’s growing dependence on the US and European market to make up for a
shortage in domestic consumption demand poses another risk. Countries that run large
trade surpluses and relying on export demand for growth even in relatively good times
may not be able to run even larger trade surpluses in an effort to export their way out of a
severe domestic slowdown. Remember, that emerging Asia went into the “Asian crisis
of 97-98” with a current account deficit, not a surplus. And the US current account
deficit was only around 2% of GDP. The 97-98 crisis was marked by a sharp fall in
investment, no fall in savings and a surge in emerging Asia’s current account surplus.
That was offset by a surge in the US current account deficit, which rose to around 4% of
US GDP. The US acted as the importer of last resort, pulling emerging Asia out of its
recession. If investment in China were to slow even more than it has, China could
experience something like the Asian crisis, though the proximate cause would not be a
the sudden withdrawal of short-term external credit. But rather than enter into the crisis
21
with a current account deficit, it would start with a large structural surplus. And the US
would start with a current account deficit of 6% of GDP, not a deficit of 2% of GDP.
That would make it much harder – politically as well as economically – for the US to
play its classic role as an importer of last resort.
China should not count on external demand to make up for further fall in domestic
demand. Fortunately, China has plenty to scope to help itself through any slowdown. Its
debt levels are relatively low. The state has scope to pick up the tab of legacy bad loans,
as well as any new NPLs on the most recent credit expansion. Indeed, given state
ownership of the banking sector, the government really has no choice. High levels of
domestic savings should keep real interest rates in China relatively low, limiting the
ongoing fiscal costs associated even with a bank bailout bill of 30%, 40% or even 50% of
GDP. China’s foreign exchange reserves are not an ideal asset to use to cover the costs
of bailing out the banks – RMB assets would provide a better match -- but it is still worth
noting that China’s state has substantial assets as well as large implicit liabilities. Most
of all, the very low level of private Chinese consumption leaves open the possibility that
strong consumption growth might offset an external shock – or an unexpected fall in
investment.
China’s current growth has been based on the rapid expansion of sectors of its economy
that are already well developed: savings, investment and exports are all growing rapidly.
Yet the longer this pattern of expansion continues, the bigger the future risks. Both
China’s internal imbalances and to global imbalances are now becoming large. China’s
capacity to reorient its economy to rely more on domestic consumption demand, and the
ability of its still developing financial system to manage the transition, will likely be put
to the test.
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