Bolstering China's Banks

Beijing seems serious about reform, and bad-loan burdens are easing

The Chinese have proved again and again in recent years that when it comes to business, it's a mistake to underestimate them. The latest example is the banking system, declared by analysts as recently as a year ago to be hopelessly crippled by political lending and bad debt. Beijing has spent much of 2004 proving those naysayers wrong by getting serious about bank reform. First it announced a massive, $45 billion bailout of state-owned China Construction Bank Corp. and Bank of China early in the year. Since then officials have pushed banks to move billions of dollars' worth of bad loans off their books, rein in lending to dubious projects, and improve risk-management systems. Yes, there are still too many "policy" loans being made to limping state-owned enterprises and too few to private companies. But unlike the Japanese, who spent the 1990s avoiding the painful steps needed to fix their banks, the Chinese seem ready to tackle the problem.

Plenty of additional changes are in the pipeline. In late November, Great Wall -- one of four state-owned asset-management firms set up to work out the bad debt of the Big Four banks -- announced it will auction off bad loans with a face value of $18 billion to foreign investment banks in March. That's a staggering amount, considering that less than $7 billion in nonperforming loans has been sold to foreigners since 1999. "We're sensing a real policy shift here," says Larry Sperling, a distressed-debt trader and managing director at Credit Suisse First Boston (CSR ). The loans are expected to sell for anywhere between 3 cents and 20 cents to the dollar.

Then on Dec. 1, Liu Mingkang, head of the China Banking Regulatory Commission, announced that because of stringent new government standards and a massive bad-loan cleanup, 21 Chinese banks will meet international capital adequacy standards by yearend. "The sector is getting healthier and stronger," Liu told reporters in Beijing. China is racing to upgrade its banking system in advance of a 2007 World Trade Organization deadline for fully opening the sector to foreign competition.


Beijing's efforts have started to pay off. In July rating agency Standard & Poor's (MHP ) moved Bank of China and China Construction Bank, two of the Big Four, up to investment grade, a milestone since the two plan to list their shares overseas in the next 12 to 18 months. In a November report, S&P said that nonperforming loans at Bank of China had fallen to 5.46% of assets as of June, down from 16.29% six months earlier, while China Construction Bank's declined from 9.12% to 3.08% over the same period. The Big Four hold 60% of banking assets.

For the banking sector overall, which includes 131 banks, S&P reckons China's nonperforming loans as a percentage of outstanding loans have dropped from 50% two years ago to 35%. Official Chinese statistics are more optimistic, putting bad loans at about 13%, down from 17.5%. The rating agencies are impressed. "They have broken the back of the banking problems," says Ping Chew, sovereign credit analyst for China at S&P.

This year, China has also made progress in creating a secondary market for its nonperforming loans. In April, CSFB arranged China's first securitization deal, raising $300 million by selling 90% of the nonperforming loans at the Ningbo branch of Industrial & Commercial Bank of China, the nation's largest lender, to institutional investors. Also, in the first such transaction since 1999, Bank of China and China Construction Bank transferred a combined $33 billion worth of bad loans to asset-management firms this summer. And legislation is in the works, says CSFB's Sperling, that is designed to streamline the approval process by which foreigners can buy debt.

That's not to say China's banks are out of the woods. One reason nonperforming-loan ratios have fallen is that the banks have been making lots of new loans in the past 18 months, thus reducing the ratio of bad loans to the total. It's not yet clear how many of the new loans will turn sour. "You've still got a banking system that's owned, operated, and regulated by the state," says Andrew Rothman, China country head at CLSA Asia-Pacific Markets. But it's also a banking system that now stands a decent chance of being fixed.

By Frederik Balfour in Hong Kong

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