Proxy to a crisis?

When Agricultural Bank of China (ABC) sells US$30 billion worth of shares in Hong Kong and Shanghai sometime in the next few months, it will almost certainly be the world’s biggest ever initial public offering.

It will also mark the coda to a highly successful exercise that has seen China’s banking system transformed in less than a decade from an insolvent morass of bad debt and failed investments into the breeding ground for the world’s most valuable and profitable financial institutions.

But how much has really changed at the banks? I suspect not very much.

Sure, Chinese bankers have learnt to talk about "risk management" and "capital adequacy" in the same reverential tones they once used to discuss "dialectical materialism" and "dictatorship of the proletariat." But bank managers in the provinces still lend to the companies and projects favored by their local Communist Party cadres, and they still procure and extend "favors" and bribes as part of their normal business.

One step back

In fact, following a decade of improvement in the banks’ corporate governance and independence, last year saw them take a step backward in response to direct orders from Beijing for lenders to prop up the shaky economy with as much credit as they could get out the door.

China’s banks extended US$1.4 trillion last year – around twice the amount of new loans handed out in 2008. In doing this, the banks effectively did away with many of the risk management procedures they’d put in place in recent years. Anecdotes abound of bank managers calling up their buddies at state-owned enterprises and begging them to take a few billion renminbi so the banker could meet his lending targets.

With the economy hit hard by the financial crisis in late 2008 and early 2009 and China still suffering from its perennial problem of overcapacity, most big companies were not investing in new production lines. They piled into China’s real estate market instead, helping to push land prices to record highs and re-inflating the property bubble on a much larger scale than ever before.

 Another big chunk of the frenzied lending went to local governments via specially formed shell companies that circumvented rules banning regional governments from borrowing from banks or capital markets directly. These loans were spent on sewage pipes, bridges and public squares that make the local party officials look good but will not generate any financial returns. The original loan made by the bank will likely go unpaid.

The central government has decided in recent months that China’s ridiculously overheated real estate market needs to be brought under control and has introduced a series of measures that are likely to burst the property bubble, leading to a big drop in the value of real estate and land in the coming months and years. Combined with the inability of government investment vehicles to repay many of their loans, this means a huge new crop of bad debt at the state-controlled banks.

Financial fallout

This is not the view of the apocalyptic naysayers who regularly predict the imminent collapse of the Communist regime. It is the mainstream view of analysts, economists and Chinese bankers themselves, many of whom have happily gone on the record to predict a serious collapse in asset quality as the consequences of last year’s credit binge play out.

Where experts disagree is on whether banks’ deteriorating balance sheets will lead to a serious financial crisis that could threaten economic and social stability in the world’s second largest economy.

Essentially, the Chinese government used the banking sector to save the economy in much the same way the US, UK and other governments used direct government stimulus package spending to prop up growth. In most developed countries that outlay is explicit government spending and it shows up on the books. In China the bank-driven stimulus package is implicit government spending and, if it is taken into account (bear in mind the banks have to be recapitalized by the state), the country’s national debt is actually much higher than official numbers suggest.

So, can I interest anyone in US$30 billion worth of shares in a Chinese bank whose main business is supposed to be lending to the nation’s impoverished rural masses?