BBVA Research

Can a successful bank restructuring

end in tears?
The case of China

Alicia García-Herrero
BBVA Research

Based on joint work with Daniel Santabarbara (ECB)

The views and opinions expressed herein are those of the authors and do not necessarily reflect those
of the institutions they are affiliated with
Outline

1. Key issues about China’s banking system

2. China’s s “successful” bank reform

3. The new wave of financial vulnerabilities

4. What to do next?

5. Some policy conclusions

2
 China’s banking system is huge
• China’s banking system is one of the largest in the world and too large given
its level of development
Private credit and per capita income,
Banking System Assets
average 2000-2008
(USD trn, 2010)
(% of GDP, 2000 constant USD)

150
18
ZAF
16

14
CHN MYS

Private credit to GDP (%)

12 THA

100
KOR
10 ISR
CHL
8 BHR
MUS
KWT
6
MAR
EGY SAU
HRV

50
NAM HUN
4
IND IRN CZE
UKRKAZ BRAPOL
PHL OMN
2 ZWE
SRB
KEN
PAK RUS
IDN
ECU
SEN PER TUR
ROU
0 NGA MEX
GHA
MOZ VEN ARG
TZA DZA
Italy
Germany

Australia

Hong Kong
Ireland

India
Japan

UGA
ZMB
United States

Netherlands
United Kingdom
China

France

Brazil

Switzerland
Spain

Canada

Korea
Taiwan
Russia
Belgium

AGO

0 0 5000 10000 15000 20000

GDP per capita (2000 constant USD)

Source: Fitch. Source: World Bank, WDI

3
 Key financing vehicle but mainly public
• The banking system is the main pillar of China’s financial system
• The big state banks play a crucial role
Financial asset portfolio Share on assets of banking institutions
(RMB trn, 2010) (%)
Banking system Stock market Bond market SOCBs JSCBs CCBs Other institutions

100

2010
80

20.3, 14% 60

40

26.0, 18%
20
95.3, 68%

0
2003 2004 2005 2006 2007 2008 2009 2010
Total financial assets: RMB 142 trn (356% GDP)
Source: CEIC. Source: CEIC.

4
And still, not fully behind the growth story

• More generally, China’s outstanding growth performance justifies the

general optimism about its future
• And yet, for such saving and investment ratios, growth is not so
spectacular
– too high saving ratios
– self-financing key (60%)
Misallocation of resources
– financial underdevelopment
– financial repression
• The successful finalization of China’s financial reform key for China’s
economic development

5
Resilience to global crisis points to successful reform

• China’s banking system has coped with the global financial

crisis without any major problems.
– In contrast with the very poor image of China’s banking
system in the first half of the 2000s

• So has the reform being so successful?

– To some extent yes: Chinese banks are now better
capitalized and more profitable

6
 Key bank indicators have improved
ROA1 Pre-Provision Profit over Assets1
2.0 2.5

JSCBs
1.5 2.0
JSCBs

1.5

percentage
percentage

1.0

0.5 1.0 Total

Total
SOCBs
0.0 0.5

SOCBs
-0.5 0.0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

NPL ratio2 Equity to assets1

30 10

25 Total JSCBs
8
Total
20
percentage

percentage
15
JSCBs
4
SOCBs
10

2 SOCBs
5

0 0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source:
Source:Bankscope
Bankscope based on reporting banks

7
However, key issues remain unresolved

Roots of the problem remains to be addressed

Not appropriate incentive structure

Main reasons are:

• Public interference on lending
• Financial repression

8
Outline

1. Key issues about China’s banking system

2. China’s s “successful” bank reform

3. The new wave of financial vulnerabilities

4. What to do next?

5. Some policy conclusions

9
How did the reform shape up?

• Based on three pillars:

— Bank restructuring: recapitalization and clean-up of NPLs

— Liberalization: reduction of government interference through

incomplete

• Ownership reform

• Price and quantity liberalization

— Financial regulation and supervision

10
 Restructuring process

MoF PBC (Central Huijin) CBRC CSRC

Capital
State-owned bank

Commercial bank
Phase 1: Phase 2: Phase 3: Phase 4:
Recapitalization Ownership reform Introducing Strategic Listing
Shareholding structure Investor
Strengthen
• Corporate governance
• Risk management
NPLs
disposal

AMC Strategic investor

or MoF

11
 Cost of re-capitalization relatively limited but…
• In terms of capital, Chinese authorities have injected into major commercial banks
around 7% of GDP
Capital injected into SOCBs
Date Bank Ammount Financed by: Currency
RMB bn USD bn % GDP

1998-1999 SOCBs 275 33 3.3 Ministry of Finance RMB

CCB 186 22.5 1.4

2003-2004 PBC (Central Huijin) USD (FX reserves)
BoC 186 22.5 1.4

2005 ICBC 124 15 0.7 PBC (Central Huijin) USD (FX reserves)

2008 ABC 130 19 0.4 CIC (Central Huijin) USD (FX reserves)

12
NPLs transfered to AMCs have not been recovered

• In terms of NPLs transferred to AMCs, the cost was around 20% of GDP (after
recoveries (25%))
China's NPLs transfered to AMCs
(figures in RMB bn)
Date Source bank Destination AMC NPLs Financed by: Notes
(RMB bn) (% of GDP) AMC bonds PBC loans Other
1999-2000 ICBC Huarong 408 4.5 313 95
ABC Great Wall 346 3.9 346
NPLs purchased at 100% of book value,
CCB Cinda 250 2.8 247 3
bond maturity 10 years
China Development Bank Cinda 100 1.1 100
BoC Oriental 267 3.0 151 116
CCB and China
2000-2001 Development Bank Cinda 45 0.5
2004 BoComm Cinda 64 0.4
Purchased at 47% of book value, PBC
CCB Cinda 129 0.8 161
loans to 5 years
BoC Cinda 150 0.9
CCB Cinda 57 0.4
BoC Oriental 142 0.9 Transferred at 0% of book value
2005 ICBC Great Wall 257 1.4
ICBC Oriental 121 0.7 Purchased at 38% of book value, PBC
176
ICBC Cinda 58 0.3 loans to 5 years
ICBC Huarong 23 0.1
RMB 246bn represents a debt
ICBC 246 1.3 246 recognition by the MoF
Shanghai Bank Cinda 3 0.0 3 Transferred at 0% of book value
2007 Various banks Oriental 5 0.0 5
Shenzhen Comm. Bank Cinda 4 0.0 4
RMB 665bn represents a debt
2008 ABC 816 2.6 151 665 recognition by the MoF

13
 … or even recognized one decade later
• As a result of that transfer to the AMCs and their low recovery ratios, official NPLs
figures severely underestimate the stock of NPLs. Our calculations suggest:
– The original magnitude of the problem was around 37% of GDP
– NPLs are still close to 10% of GDP (RMB 3.5 trn)
– “True” NPL ratio is around 7% and reduction mainly based on rapid credit growth
NPLs in the banking sector
NPL ratio (%)
(RMB trn, 2010)
NPLs in AMCs and MoF (face value, after recoveries) Financial system NPL ratio (rhs, AMCs and MoF holdings incl.)
NPLs in the banking sector Banking sytem NPL ratio (rhs)
Total NPLs (after recoveries, % GDP, rhs)
40
5 50

35

4 40
30

25

% of total loans
3 30
RMB tn

% GDP

20

2 20
15

10
1 10
5

0 0 0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Authors’ calculation based on AMC reports and Dragonomics (2011) Source: Authors’ calculations and CBRC
14
Continued financial repression: another indirect cost
• In the 2000s, financial repression passed the final costs of restructuring to bank depositors.
– Real interest rates were artificially low
– No further financial market development (situation has not yet changed)
– Wide spread between lending and the deposit rates to shield banks’ profitability
Real GDP growth and real long term
Interest rate liberalization (%)
interest rates, average 2001-09 (%)
Reference rate on loans Reference rate on deposits
12%
Floor lending rate Ceiling lending rate
Ceiling deposit rate

10% 15

8%

10
Real IR

6%

4% China
5 ≈250 pb
EMEs
2% EA World
US

0% 0
0% 2% 4% 6% 8% 10% 12% 1990 1995 2000 2005 2010
GDP grow th

Source: Haver Analytics Source: PBC

15
Regulation and supervision improved but…

 Great strides in improving financial regulation and supervision but two

problems:
 Current crisis has put into question the international model of
bank regulation and supervision (Basel II, etc)
 Banking system still mostly public (or very much influenced by
central or local government)
– Enforcement difficult
Specially at China Development Bank and Eximbank which
are also becoming more powerful

16
And wrong incentives remain

• The underdevelopment of capital markets have distorted savings

– High corporate savings: limited alternatives of corporate funding
– High household savings parked in bank deposits
• The low cost of capital have created incentives to over-invest
• Banks continued to be used to pursue broader policy goals (e.g., lending to
local government and SOEs)
• The public ownership impeded the establishment of a commercially driven
financial system
– Implicit guidance on the direction of new lending
– Guaranteed interest margins
– Limited ability and willingness to differentiate loan rates
• This environment has contributed to inefficiencies in credit allocation and a
build-up of financial vulnerabilities
17
Outline

1. Key issues about China’s banking system

2. China’s s “successful” bank reform

3. The new wave of financial vulnerabilities

4. What to do next?

5. Some policy conclusions

18
 6
8
10
12
14
16
18
20
0
10
20
30
40
50
60
70

-20
-10
Turkey China
Singapore Turkey
Mexico Venezuela

Source: Fitch
Argentina Argentina
Brazil India
Kazakhstan Hong Kong
Switzerland Brazil
Belgium Indonesia
Philippines Nigeria
Saudi Arabia Colombia
Japan Poland
Indonesia Philippines
Hong Kong Thailand
Thailand Kazakhstan
Germany Malaysia
Denmark Singapore
Czech Republic Russia
Egypt Peru
United Kingdom Italy
Romania Mexico
Malaysia Australia
Korea Portugal
United States Sweden
South Africa Canada
Colombia United States
Russia Norway
Sweden Israel
Netherlands Switzerland
Poland Korea
Chile Finland
Peru Taiwan
India Romania
Israel New Zealand
Capital adequacy ratio, 2010 (%)

Finland South Africa

Austria Saudi Arabia
Cumulative Loan Growth 2009-2010 (%)

New Zealand France

Norway Egypt
Canada Belgium
Venezuela Greece
Greece Austria
France Netherlands
China Spain
fast credit growth but low capitalization

Spain Chile
The current status of the banking sector:

Italy Denmark
Australia Germany
Taiwan Ukraine
Portugal United Kingdom
Ireland Japan
Nigeria Ireland
19
 Financial vulnerabilities might be mounting

• Historical experience shows that banking crisis are associated to (i) the lending
growth and (ii) the non-financial sector indebtedness
Private Credit/GDP, pre-stress period (%)
t-6 t-5 t-4 t-3 t-2 t-1
250
21.8%
30.0%
36.0%

200

34.8%

150

37.2%
100

50

0
US 2002-2007 UK 2002-2007 Japan 1985-1990 Korea 1994-98 China 2006-2011e
Source: IFS, CEIC, (e) China: estimated for 2011, total bank loans adjusted for off-balance sheet lending
20
Three factors have increased financial vulnerabilities

The banking system has increased its vulnerability due to three factors
 Fiscal:
Banks become the main channel of financing of the huge 2008-2010 stimulus
package
 Monetary and Financial repression
Very lax monetary policy – together with financial repression – has
contributed to the housing bubble to which banks are increasingly exposed
 Both factors have also contributed to the creation of a parallel unregulated
financial system, China’s shadow banking system, which is growing much
faster than the rest of the financial system and also accumulated important
risks

21
 Financing the 2008-2010 stimulus package
• In November 2008, 8% GDP 2 year fiscal stimulus package announced
• Only 1/3 to be financed by central government, rest locally for infrastructure
investment. Banks have been the main lenders of a much bigger package
M2 and credit growth (%) Social financing (RMB trn)
Loan in Local Currency Loan in Foreign Currency
M2 M2 Target Credit Off balance sheet lending Bonds
Equities Insurance
35 Social Financing
15

30

12
25

20 9 .

15
6

10
3
5

0
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011*
2005 2006 2007 2008 2009 2010 2011

Source: CEIC. Last observation Q3 2011.

Source: CEIC. Last observation Q3 2011.
22
 Fiscal stimulus: local governments’ role
Local governments took the leading role but hampered their finances
notwithstanding the larger revenues from land sales
Investment sponsored by central / Local government revenues and
local governments and SOEs (% GDP) expenses (% of GDP)
Central government Local government Revenues Expenditure Fiscal balance

20 20
60

15 15
50

10 10
40

5 5
30

20 0 0

10 -5 -5

0 -10 -10
2004 2005 2006 2007 2008 2009 2010 1996 1998 2000 2002 2004 2006 2008 2010
Source: CEIC. Last observation 2010. Source: CEIC. Before the central government transfers and rebates, exclude land
sales.

23
 Stimulus package: lending breakdown
• Lending from big state commercial banks to ‘enterprises’

Changes in outstanding loans by institution Changes in outstanding loans by sector

(RMB trn) (RMB trn)
Households
2006 2007 2008 2009 Other loans in domestic currency
Enterprises: short term and bill financing
4.5 Enterprises: long term
10
4.0

3.5 8

3.0
6
2.5

2.0
4
1.5

1.0 2

0.5
0
0.0
State Share Policy Bank Urban Rural Foreign
Commercial Holding Commercial Financial Institution -2
Bank Bank Bank Institution 2007 2008 2009 Q1 2010

Source: CEIC. Last observation 2009. Source: CEIC. Last observation Q1 2010.

24
 How can this lending binge affect banks’ asset
quality? Looking at a similar event in 1998
• In 1998, in the midst of a sharp slowdown,
China introduced a large stimulus package, Loans issued (lhs)
New default loans (lhs)
which had some common characteristics Implicit default rate (rhs)
Average default rate (rhs)
to that of 2009-10. 1400 40

– Stimulus relied on bank lending to 36

35
1200
SOEs and Local Governments
30
– The majority of those loans became 1000
non performing

% of loans issued
24 25
800
– New NPLs were 28% of loans 22

RMB bn
20
issued from 1998-2000 600
– NPL ratio was officially higher 15

than 25% in 2002, and several 400

10
estimated it around 40-50% (Ma,
200 5
2006)
• That policy was at the origin of the 0 0

restructuring efforts put in place in the 1998 1999 2000

first half of 2000s
• The total cost associated to the reform
was around 25% of GDP (Ma, 2006)
Source: Bankscope. Estimates based on a sub-sample of banks with
NPLs available. That sample was skewed towards the best performing
institutions.
25
 Impact on stimulus package on bank asset quality:
some simulations
Impact of the loan financing of the stimulus package
(RMB trn, otherwise indicated)
Official data Scenario A Scenario B Scenario C
National
PBC Audit Office Optimistic Baseline Pessimistic
Assumptions
Recognized loans to LGFVs (as of Dec-2010) 14.4 8.5 14.4 14.4 14.4
Default ratio (% of LGFV loans) 26% 26% 26% 39% 50%
Nominal GDP growth (2010-20) 11% 11% 16% 13% 9%

Results
Loans default 3.7 2.2 3.7 5.5 7.2
Loans default (USD bn) 551 325 551 815 1059

New NPLs (% 2010 GDP) 9.4 5.6 9.4 13.9 18.1

New NPLs (% 2020 GDP) 3.3 2.0 2.1 4.1 7.6
Δ NPL ratio (2015) 4.6 2.7 3.7 6.3 9.8
Δ NPL ratio (2020) 2.8 1.6 1.8 3.4 6.3
Source: Authors’ calculations based on PBC, NAO, China Securities Journal and CEIC

• Official sources (CBRC & China Securities Journal) have estimated 26% of LGFV loans
to be very difficult to recover and that other 50% could be only paid back using external
sources of finance
• Even if this implies a sizable increase in NPLs, China’s growth would, once more,
manage to reduce the problem to a manageable
• NPLs could be around 14% of 2010 GDP but only 4% of GDP in 2020 26
However, current quasi- fiscal losses have increased

• The root of current problems is the lack of

local governments’ funding and the stimuli- Public debt and contingent liabilities
driven nature of lending: (% of GDP)
Official debt ratio Policy bank bonds
MoF recapitalization bonds NPLs in the banking sector
• If government recognize all the contingent NPLs in AMCs
Ministry of Railways
Local government debt

liabilities in the financial sector, debt to % GDP

GDP ratio could raise over 80% (18% 90

officially reported) 80

70

60
• If the losses were mainly borne by
commercial banks, it would damage their 50

private shareholders and tarnish the efforts 40

carried to set up a commercially banking 30

sector in China (recapitalization needs as 20

high as 600 billion) 10

0
2007 2010
• However, growth over time would reduce Source: Authors’ calculations based on CEIC and Dragonomics (2011)
both problems to a more manageable level
27
 2. Housing bubble and possible bust
• Negative real interest rates appear to have boosted asset price inflation
1-year reference deposit and lending Property and stock prices
rates (%) (month-on-month growth rates and levels)
1-year deposit rate (real) 1-year lending rate (nominal) Shanghai composite (lhs)
1-year deposit rate (nominal) Property price index (rhs)
7000 102
9

6000

6 101
5000

previous month=100
1990 Dec=100
3 4000
100
3000
0

2000
99
-3
1000

0 98
-6
2006 2007 2008 2009 2010
2004 2005 2006 2007 2008 2009 2010 2011

Source: CEIC. Source: CEIC.

28
 Banks’ exposure to property market increasing

Real estate loans Local government financing vehicles

(RMB trn, %)
Mortgages (RMB trn)
Loans to developers (RMB trn)
Real estate loan growth (%, yoy) (rhs)
Real estate loans (% loans) (rhs) Local government
12 50

Equity: cash and

land
10
40

8
Loan
30
Banks LGFVs
6 Land as
collateral
20
4

10
2
Infrastructure projects

0 0
2006 2007 2008 2009 2010 2011

Source: CEIC.

29
 3. Growing shadow banking

• China’s informal and unregulated shadow banking Off-balance sheet lending

system has grown rapidly because of a ‘de facto’ (RMB trn)
financial liberalization Loan in Local Currency Loan in Foreign Currency
Off balance sheet lending Total lending
• Now 50% of new lending and nearly one third of 14
total lending
12
– depositors to shift from bank deposits to higher
yielding products 10

– lenders to circumvent the tight access to the 8

.

banking system
• Two kinds of shadow banking: informal lending and 6

off-balance sheet lending (with important role of 4

trust companies in many cases related to banks)
2
• Growing financial stability concerns, especially given
the lack of regulation and oversight 0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011*
– Large exposure to real state developers
Source: CEIC. Last observation Q3 2011.
– Liquidity issues related to maturity mismatches

30
Outline

1. Key issues about China’s banking system

2. China’s s “successful” bank reform

3. The new wave of financial vulnerabilities

4. What to do next?

5. Some policy conclusions

31
 How to succeed with the reform?
• Incentive structure needs to be more market oriented to prevent the build up of
financial vulnerabilities.
• These are some measures and their expected achievements
– Ownership reform: through more private ownership (more openness to
foreign ownership would also help).
• Reduce the use of the banking system as a policy tool
• Improve the access to finance by SMEs and households
– Interest rate liberalization
• Reduce the artificially low cost of capital
• Reduce precautionary savings
• Help to properly price the credit risk
– Promote capital market development
• To free up space in banks’ balance sheets to SMEs and households
– Expand perimeter of financial supervision and regulation
• Avoiding regulatory arbitrage should limit incentives of shadow banking
32
 Interest rates liberalization: impact on profits

• One of the main reasons why interest rates are not liberalized is protecting
bank profitability but: How much would be the impact of such liberalization?
• With a simple exercise - lowering njet interest margin in China at the level of
Emerging Asia, US or euro Area before the crisis - NIM could go down
between 7 to 54%.
• However, analysis does not take into account: (i) adjustment through
quantities (only prices); (ii) no model for the relationship between interbank
interest rates and retail rates
Scenario 1 Scenario 2 Scenario 3
Results NIM China equals to NIM China equals to the US NIM China equals to euro
(% changes from 2008 actual data) ASEAN+Korea large commercial banks area historical average
2008 2007 2008 2007 2008 2007
Net interest margin -12.0 -6.9 -12.3 -9.2 -52.6 -53.6
Profit before taxes -21.8 -11.4 -22.4 -15.1 -95.6 -88.1
Pre-tax ROAA -24.4 -17.0 -25.0 -20.7 -98.2 -93.7
Source: Authors’ calculations based on Bankscope balance sheet and income statement data of China’s commercial banks

33
Outline

1. Key issues about China’s banking system

2. China’s s “successful” bank reform

3. The new wave of financial vulnerabilities

4. What to do next?

5. Some policy conclusions

34
 Some policy conclusions
• The reform is clearly not over!
– despite the positive indicators, wrong incentives remain
• Financial vulnerabilities are building up:
– recent credit surge linked to the abuse of the banking system to pursue
policy goals
– too loose liquidity conditions has fuelled asset prices, with increasing
exposure from banking system
– a shadow banking system is developing to circumvent the low cost of
capital and credit constrains which inherent risks
• To complete the reform, incentives have to changed
– ownership reform
– interest rates should play its signalling role under market forces.

35
Comments welcome

36