What’s US$225 billion between friends? If you are accounting firm Ernst & Young and your friend is the Chinese government, the answer is: quite a lot. The figure in question is what E&Y’s Asia Pacific Financial Solutions team added to official estimates of the value of bad debts held by the Big Four state banks in a report released last month. All told, the NPLs in China’s financial system were put at US$911 billion (a conservative appraisal, the report said), with the Big Four accounting for US$358 billion.
Coming shortly before Bank of China started marketing its initial public offering, an outraged – and PR-conscious – People’s Bank of China (PBOC) branded the report "ridiculous and barely understandable". It also found a way out. E&Y’s auditing arm was responsible for going over the books at Industrial and Commercial Bank of China – how come this new report failed to tally with the NPL information outlined in the audit?
E&Y was left with a choice: denounce the NPL report or admit to making errors on the audit. Perhaps wary of the impact an angry Beijing could have on its business interests in China, the accounting firm withdrew the report, saying its analysis of the Big Four’s bad debts "cannot be supported and … is factually erroneous". The discrepancy was blamed on an unverified UBS research report.
Having gripped China’s financial sector for a week, the denouement of this episode could well be a hollow victory for economic pragmatism over independent analysis. But it has nevertheless reopened the debate on the effectiveness of China’s financial sector reform.
When it comes to bad debts, E&Y are no slouches. It was they the PBOC called on when it wanted an experienced eye cast over the NPLs held by the Big Four and the asset management corporations (AMCs) in 2000. Huarong AMC came knocking a year later and asked the firm to help it launch China’s first ever international NPL auction.
Moreover, other reports appear to corroborate E&Y’s view, although they don’t quote such stunning figures. PricewaterhouseCoopers warned that still substandard bank lending policies were responsible for rising NPLs, while the International Monetary Fund concluded that "it remains unclear the extent to which currently reported data reflect the true credit risk in loan portfolios".
Disregard the contentious US$225 billion and the picture E&Y paints of China’s financial sector is still not a pretty one. The Big Four may be driving their NPL ratios below the 5% mark, but the bad debts removed from the banks’ books still lurk in the system.
The four AMCs set up in 1999 to dispose of these debts have dealt with just US$100 billion of the US$330 billion transferred to them, which effectively means most of the NPLs have been moved from one state-owned enterprise to another – a problem removed but not resolved. NPL auctions have become more frequent but they have been disrupted by a lack of transparency and disputes over terms, prompting several foreign bidders to turn to real estate investments instead. Meanwhile, there are fears that the need for tighter lending policies drummed into the banks’ top level management has yet to filter its way through the branch networks. The tide of new NPLs has yet to be turned.
Several economists made reassuring sounds in the wake of the report’s release. The bulk of the NPLs have been taken off the banks’ books, they argued, and the government has a strong track record in pushing forward with reform. Given that the NPLs were transferred from the banks at face value in the interest of the balance sheets and the AMCs have no way of recovering what they "paid" for them, a government bailout is inevitable at some point. And, as the economists pointed out, this means China will probably resolve its bad debts in less time than it took the Japanese.
But this isn’t the point. Japan’s banks finally resolved their NPLs when Prime Minister Koizumi effectively threatened to nationalize the banks unless they took action. A tough measure – and one that couldn’t be replicated in China’s state-run financial system – it was ultimately dependent on lenders taking responsibility for their loans.
If they are truly going to absorb the lectures they have been given on sensible lending, China’s banks must face the financial consequences when loans turn sour. This doesn’t mean passing on problems to the AMCs but taking a hit on the balance sheet for mistakes made. With the advent of incentive programs at Chinese firms whereby management rewards are tied to performance, bankers would be far more scrutinizing of loan applications if their own pay were effectively at stake, too.
NPLs are difficult to define. Government policy of flagging up overheating sectors means that banks may more readily shove a debt-ridden steel company into the non-performing category than a firm operating in the electronics sector. Factor in "special mention loans" and the differing interpretations banks attach to them, and the puzzle becomes even more complicated.
While it’s difficult to ascertain the precise value of NPLs sitting on the books of China’s financial institutions, it is clear that banks are still granting loans at a startling rate. The first four months of 2006 saw US$197.1 billion doled out in new loans, nearly two-thirds of the PBOC’s lending target for the entire year. Downturns in specific sectors or nationwide could well leave even more companies unable to make good on their monthly payments.
A number of measures have been introduced in a bid to stem the tide, including the first interest rate increase in 18 months and a ban on local governments guaranteeing bank loans for infrastructure projects. But in the long run, the most effective means of bringing the banks into line is by making them both aware of and responsible for the consequences of any poorly-directed lending.
Hu’s a clever boy, then
President Hu Jintao’s face betrays very little, his public actions perhaps even less. This is a man who lives in a world of composite order; Premier Wen Jiabao is the one who glad-hands the farmers and stages the hearts-and-minds press conferences. Therefore it is difficult to imagine precisely what Hu was thinking when first a Falun Gong protester invaded his White House press conference with George W. Bush, and then his hosts introduced the PRC’s national anthem as that of the "Republic of China". Perhaps not quite a slap in the face, but still rude.
If he required consoling, though, all Hu needed to think about were the subsequent stages of his international trip. In terms of China’s current energy-driven foreign policy and treading judiciously on US toes, it could not have been planned any better. First up Saudi Arabia, a key oil provider to the US but one that is keen to diversify its customer base due to discomfort with American military activity in the Middle East.
Hu and King Abdullah discussed the possibility of a Chinese strategic oil reserve serviced exclusively by Saudi sources. Riyadh may have sufficient supplies to satisfy all and sundry for the time being, but the planners in Washington are unlikely to feel comfortable about warming relations between the world’s largest oil exporter and its second biggest importer.
Then on to Nigeria, where Hu rubber-stamped a deal that will make China a shoo-in for oil drilling rights in exchange for infrastructure investments. PetroChina already has an oil supply deal in the country while China National Offshore Oil Corp has agreed to pay US$2.7 billion for a 45% stake in a fresh oil block. Again, this represents a Chinese encroachment onto US turf: up until now, the only foreign interest in Nigeria’s oilfields was American or European. The US relies on the Gulf of Guinea for 15% of its oil imports and is keen to see this proportion increase to 25% in 10 years time. With China now in town, Washington is unlikely to get things all its own way in this energy hotspot.
The Middle East and Nigeria were the bonus prizes after a Washington trip that, aesthetic gestures aside, Hu came out of looking like the winner. He greeted US business with open arms, spending longer with big-hitters from the multinationals than he did with the politicians. And when it was time to sit down with White House officials, Hu said enough to satisfy their trade surplus and currency concerns without actually making the solid commitment to renminbi reform that Congress is crying for.
US politicians are making all the voter-friendly, China-unfriendly noises that characterize an election run-in, but was Beijing branded a currency manipulator by the Treasury Department? Of course not. Pragmatism, not dogmatism, is the way forward – far more can be achieved with a China that is willing to talk than one which recoils in the face of possible trade sanctions.
And China is giving ground. The renminbi has crept past the USD1:RMB8 mark, and there are signs that it will continue its incremental appreciation. Measures to liberalize the capital account by letting Chinese banks, brokers, insurance firms and fund managers use foreign currency are another sign of goodwill.
These capital outflows should eat into China’s mountain of foreign currency but restrictions on how the money can be invested means that, for the short term at least, these bites will be small ones. Hu seems to be the one holding the cards right now and so progress is taking place at Beijing’s pace, not anyone else’s.