Commentary: Are China's Banks Caught in Quicksand?

Bad loans could cripple the system and the economy

By Mark L. Clifford

China's Communist Party leaders are all proud Marxists. So they should know better than to pay too much attention to the hoopla over Jiang Zemin's retirement and Hu Jintao's promotion to party general secretary at the 16th Chinese Communist Party Congress just wrapping up in Beijing. If China's leaders were to dust off their tattered copies of Das Kapital, they would be reminded of the Marxist doctrine that the forces of labor and capital shape history. Individuals--even heavyweights such as Jiang and Hu--are simply along for the ride.

While delegates to the Congress watch the personality parade, those larger forces are shaping China's economy--and it's not pretty. The center of the maelstrom: the banks, which are being swamped by bad loans. The problem will cost some $518 billion, or 43% of this year's gross domestic product, to clean up, estimates debt rating agency Standard & Poor's. By comparison, the U.S. savings and loan bailout a decade ago cost about $160 billion, or just 3% of U.S. GDP at the time. Only the worst cases, such as Indonesia after the 1998 Asian debt crisis, have even approached the scale of China's current problems.

That means Hu's administration could be consumed by the biggest banking meltdown in history if a financial emergency spurs depositors to yank their money out of accounts. Even if they don't, the overhang of bad loans will sooner or later short-circuit growth by trashing government finances and leaving banks short of cash for lending to profitable companies. And in just four years, foreign banks will be able to compete freely in China--which means giants such as Citibank and HSBC will be able to scoop up the best customers, leaving state-owned banks in even worse shape.

China has made an effort to fix the problem. Officials have promised--and promised--to rein in government-directed lending to moribund state-owned enterprises. And the central bank has ordered the country's biggest banks to cut their bad credits to 15% of loans outstanding by 2005, from the current, officially acknowledged, range of 25% to 30%. The banks have been recapitalized with $33 billion in new funds, and four asset management companies have taken over nearly $160 billion in bad loans with an eye toward restructuring the debtors.

It hasn't worked. The asset management companies are mostly just redistributing the problem, not solving it. Analysts say they have resolved less than 15% of their portfolios, often through dubious debt-for-equity swaps that do little to change management behavior. And even when they appear to be making progress, it's an illusion. Last November, for instance, China Huarong Asset Management Corp. announced a deal to sell $1.3 billion in bad debts for 8 cents on the dollar to a consortium headed by Morgan Stanley, whose plan is to sell off the collateral that backs the loans. A year later, the deal still hasn't closed.

For nearly a decade, Chinese officials have maintained that a combination of rapid economic expansion and aggressive loan write-offs will solve the debt problem. Granted, China isn't alone in imagining that a strong economy can fix its banks. Japan and South Korea also thought they could grow fast enough to rise above a tide of bad loans. But those economic forces Marx saw as so powerful overwhelmed them. Banking problems are like weeds; unchecked, they take over a financial system. Faced with such a crisis, China should "set the plow low and rip out the roots rather than just trimming the buds when they turn brown," says Jack Rodman, an Asia debt specialist at consultancy Ernst & Young.

An even more troubling thought: If China can't deal with its bad loans at a time when annual growth tops 7%, what will happen if the economy sours? That may already be starting to happen. Last month, outgoing Premier Zhu Rongji cautioned that "there is overheating in the real estate sector"--often a warning sign of an economy in a bubble, which usually ends in a slump. A softening real estate market will send more loans into the problem category, warns Deutsche Bank economist Jun Ma.

So what should China do? For starters, the asset management companies need a new mandate. They should dispose of bad loans fast, not focus on the prices the loans can fetch in the secondary market. That change in attitude will at least get some dud assets in the hands of people who can make productive use of them. Next, the big banks need a new injection of capital so they can offset the huge write-offs they must take on their bad loans.

Finally, banks need to get better at assessing risk so they don't keep piling up bad loans. That means real auditors, both internal and external. And it means loan committees that evaluate projects based on cash-flow potential rather than political goals. The problem isn't insolvable--yet--thanks to China's low level of government debt. But the longer China waits, the higher the bill will be. China "has the opportunity to fix this problem methodically," says Fred Hu, a managing director at Goldman Sachs in Hong Kong.

Jiang Zemin asked a recent visitor--a savvy Chinese person from overseas he consults occasionally--what the three biggest economic priorities should be. The visitor's reply: "Banking reform, banking reform, and banking reform." Marx might well have agreed with that message, although Hu Jintao and the Congress delegates don't seem to be hearing it.

Hong Kong-based Regional Editor Clifford covers Asian finance.

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