Friday 23 January 2009

No Time for Backsliding on Bank Reform

The grumbling that followed foreign investor pullouts must not weaken China’s resolve to continue banking reform.

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Guanyu said...

No Time for Backsliding on Bank Reform

The grumbling that followed foreign investor pullouts must not weaken China’s resolve to continue banking reform.

By Hu Shuli, Caijing
20 January 2009

The winter turned suddenly colder when foreign investors recently started dumping their Chinese bank shares. The Li Ka-shing Foundation, Union Bank of Switzerland, Bank of America and Royal Bank of Scotland scaled back or liquidated investments, despite rumours that China would not allow foreign capital pullouts.

Afterward, the investors reported impressive returns which, set against a backdrop of global market gloom, triggered a wave of criticism in China. The old canard that China’s state banks were sold off too cheaply was heard again.

Cool-headed analysis helped quiet the grumblers. But now, more than simple rebuttals are needed to defend China’s banking system. Reform-minded policymakers must go beyond affirming the positive results of bank reform that attracted foreign investors in the first place.

Policymakers proved they understand that a foreign investment exit is a normal business practice. However, if the global financial crisis continues, Chinese banks may face larger withdrawals of foreign capital this year. That could slow what’s been five years of sizzling financial globalization in China and challenge the nation’s effort to open markets and hasten reform.

Reformers must be prepared for a crisis and turn what’s unfavourable into favourable. They must boldly pursue across-the-board domestic banking reform and explore the diversification of bank equity. What should not come on the heels of exiting overseas capital is a re-nationalization of Chinese banks.

So far the pullout of overseas capital has had little impact on domestic banks. With adequate capital, strong profitability and high quality assets, Chinese banks are not over-leveraged like their western counterparts. Moreover, the Chinese government’s huge forex reserves and ample tax revenues are available to cushion potential shocks to Chinese state-backed commercial banks.

By the end of 2007, some 30 overseas strategic investors had provided US$ 22 billion to 24 Chinese banks. Now, given the deleveraging of the global financial system, overseas financial institutions are very likely to opt for reducing their stakes. They may exercise their options after meeting the requirements of two-year lock-up periods.

To be sure, relative to the 48 trillion yuan in deposits and US$ 1.95 trillion in forex reserves, the total amount that could be withdrawn by the foreign investors is minor. And pullouts may be offset by investments from other overseas financial institutions bullish on China.

Nonetheless, the impact of such withdrawals should be carefully considered. Without strategic partners, some Chinese banks may change their governing structures. And these banks may face deteriorating asset quality and the capital challenges.

In 2009, despite the Chinese government’s economic stimulus package, sliding profits will weaken investment growth in the private sector. Production capacity is unlikely to be utilized as export demand softens. As a result, the near-term bank earnings outlook is not upbeat.

The banking system depends on the real economy for earnings. It is the economy’s largest creditor. And although earnings among Chinese enterprises declined sharply in the fourth quarter 2008, bank lending still showed year-on-year growth.

This loan growth, reported against sliding profits, reflected a delay in the banking sector’s response to the economic cycle. Rising defaults in coming months can be expected to increase non-performing loan losses, which in turn will affect the bottom line for banks that earn 3 to 5 percentage points on the difference between loans and deposits. Against this backdrop, if a bank’s governing structure weakens and government intervention increases, profitability will be negatively affected.

Capital losses could prompt major, state-owned banks to rely on central bank guarantees to ensure asset quality and amortize losses. But that would send us back to the closed system of the old days. Local governments with limited ability to replenish capital are already major shareholders of a large number of small- to medium-sized banks. Thus, a management crisis could turn into a credit crisis. And if this happens, the global financial crisis will infect the Chinese banking industry, with serious consequences.

In the past, the banking industry was plagued by inefficiency and portfolios burdened by non-performing loans. Since loan losses far exceeded capital, banks were widely considered technically insolvent.

After trying all sorts of options, reformers pulled off a feat by transforming the industry through government asset injections, strategic partnerships, overseas exchange listings, financial restructurings and stronger governance. At that time, due to various constraints, reforms proceeded only through foreign investments and overseas listings, limiting foreign investment ratios. The end result was a substantial series of steps to reform banking system equity.

Thanks to this reform, Chinese banks have been able to withstand the impact of the global financial crisis – so far. But the overseas market environment has undergone overwhelming change. Looking forward, we expect more difficulties and challenges. But we also see emerging opportunities for reform.

A worthwhile course of action for the near-term would be to reduce state shares in banks and make way for domestic investors to hold equity in financial institutions. At the same time, major state-owned banks could be weaned from their reliance on the government’s forex reserves.

As we pursue a more open banking system, we should glean lessons from our success in attracting foreign capital. Banks should improve their governance structures in ways that allow additional involvement by overseas and domestic investors.

Gradual reform of the banking sector is not going away. But at this critical juncture, direction and policy goals must be clearly expressed, with wisdom and courage.