We knew China's banks were sick. But we didn't know they were this sick. That, in essence, is the latest lesson from the debate over revaluing China's currency. Beijing doesn't want the yuan to strengthen, since that could hurt the export machine that employs hundreds of millions of Chinese. At least, that's the line China has taken in its public skirmishes with the U.S. and Japan. But Beijing doesn't dare stress another huge reason for its fierce defense of its currency policy: its shaky financial system. Instead, it has taken outside players -- such as Standard & Poor's Corp. and a number of economists -- to point out the elephant in the living room. Among all the major economies, China has the sickest banking system. And this at a time when China's economy is growing 7% a year.
It has long been known that China's state-run banks are saddled with billions in loans that will never be repaid. Chinese officials are aware of this. But the latest warning was an especially loud wake-up call. In a rating note published Sept. 15, S&P said that confidence in China's banking sector is so low that volatility from a revaluation could pull its big banks under. Officially, only 21% of Chinese loans are nonperforming, but S&P puts the number at closer to 45%. Says Ping Chew, a director of S&P in Singapore: "We are afraid the banks will go bankrupt."
This sounds counterintuitive. After all, it's widely accepted that the yuan is undervalued by up to 40%, so if it gains in value by that much, why should that threaten the banks? One reason is that a jump of that size would hurt some of the banks' biggest borrowers by wiping out exporters' profits. If heavily leveraged firms can't service their loans or borrow new money, that could bring China's growth to an abrupt halt.
Also, a revaluation would increase pressure on China to loosen capital controls further. If Beijing caves on this point, speculators could eventually move their money offshore where it can earn a higher return. Many local Chinese, aware of their banks' ill health, would also use looser capital controls to swap into U.S. or Hong Kong dollars. Nobel prize-winning economists Joseph E. Stiglitz and Robert A. Mundell both warned in mid-September of a collapse in liquidity if China tampers with the yuan prematurely.
WORSE THAN JAPAN. Such dire scenarios may be academic: The Chinese won't revalue, right? But the discussion underscores just how fragile things are. China's Big Four banks -- Bank of China, China Construction Bank, Industrial & Commercial Bank, and Agriculture Bank -- hold 70% of China's total savings of $3 trillion. But that's long been used to subsidize money-losing state companies. Andy Rothman, China head of Hong Kong-based investment bank CLSA Asia Pacific Markets, says that even if the banks recover as much as 20 cents on every dollar of bad loans, the remainder would still amount to 30% of gross domestic product. "As a share of GDP, it's a bigger problem than Japan," he notes.
It gets worse. Despite a commitment to reform, China still lacks competent lenders. Banks have been making more loans to private enterprises and to smaller businesses. Yet one foreign banker estimates that 70% of such loans go sour because the borrowers are corrupt or simply don't know how to run a business. Beijing has been claiming lately that the ratio of bad loans to total loans is falling. That claim is misleading. The volume of new loans is growing so fast that the percentage of old bad loans is bound to fall.
Can China create a viable bank system? Yes, if it appoints bankers who base loans on careful risk assessments. Few experts, unfortunately, see much chance of that anytime soon. But the rancorous debate over the yuan makes it clear China can't put off fixing its broken banks forever. By Frederik Balfour in Shanghai