Wanted: A Big Broom For China's Banks

Beijing is trying to sweep away corruption and bad loans at its huge state lenders before taking them public

China's banking system seems to be suffering from kleptomania. Zhang Enzhao, chairman of state-owned China Construction Bank Corp., resigned in March after bribery allegations showed up in U.S. court documents. In the past five months two other big state lenders -- Bank of China and Industrial & Commercial Bank of China (ICBC) -- have been tarred by loan fraud and embezzlement scandals. On Apr. 25, China Banking Regulatory Commission Chairman Liu Mingkang openly called for more audits and better regulatory scrutiny to "win the uphill battle" against corruption.

Liu and other top officials are pulling out all the stops to repair the image and mend the balance sheets of China's scandal-prone banks. The cost of this rescue is mounting. Chinese financial authorities were forced to shell out $45 billion to prop up Bank of China and China Construction in late 2003. And on Apr. 26 the government agreed to pump $30 billion into ICBC. China's central bank, the People's Bank of China, will divert $15 billion from its $600 billion-plus foreign exchange stockpile to ICBC, while the Finance Ministry will kick in an equal amount in subordinated loans. At the same time, the PBOC has subsidized the purchase and transfer of problem loans from China's four state-owned banks.

It all adds up to a massive -- and crucial -- salvage job for Chinese President Hu Jintao's government. Hu has set a lofty goal for the state bank sector: to meet global standards of transparency and lending and qualify for public offerings of their shares in the world's major bourses. That is all supposed to happen by 2007, when foreign players will be allowed unfettered access into China's banking industry. While the bailout money helps, it won't stop Chinese banks from shoveling funds into other state-owned businesses with little regard for risk or return. "Putting money in is the short-term solution," says Song Guoqing, an economics professor at Beijing University. "But having real competition between the banks is much more difficult."

To push Hu's ambitious agenda, the CBRC and the PBOC are bearing down hard on China's banks to flush out scandalous behavior, fire renegade bank executives, and finish the cleanup of dodgy loan books. "Nobody should be surprised by the gremlins now coming out of the woodwork," says a Western investment banking source in Hong Kong.

NOW'S THE TIME

While the Chinese have their work cut out for them, the timing is right for a financial sector face-lift. The economy is rip-roaringly strong, fewer borrowers are defaulting than in years past, and investment banks such as Morgan Stanley (MWD ), HSBC Holdings (HBC ), UBS (UBS ), and Deutsche Bank (DB ) are actively courting mainland banks as partners. What's more, state financial support, plus serious investment in back-office technology and more rigorous loan classification, have improved the outlook. At the end of 2003, Standard & Poor's pegged nonperforming loans within the entire Chinese banking sector at 40% of all banking assets. Now, it says, the total is closer to 31%, or some $700 billion. "The banks are improving their internal operations," notes S&P credit analyst Connie Wong in Hong Kong.

That said, at best only two of China's Big Four banks -- the quartet account for 60% of all bank assets -- are anywhere near ready for prime time as listed companies. Yet with liberalization due in two years, at least three of the four majors are expected to be listed in some way by the end of 2006. The betting among bank-industry officials is that China Construction will be the first to list, as soon as this fall. It hopes to raise $5 billion in its initial public offering and sell 10% of the listing to Morgan Stanley, already an adviser to China Construction and at least one other Western bank, possibly HSBC. Thanks in part to the government cash infusion and tighter lending controls, only 3% of China Construction's loans are nonperforming. That's down from 9% at the end of 2003. Next up is Bank of China, the nation's top foreign-exchange lender. It's in talks with Royal Bank of Scotland, Deutsche Bank, and UBS about selling equity stakes.

These initial IPOs will be all-important test cases for China's whole financial sector. Yet changing the credit culture at big Chinese banks is a tall task. Some senior bankers seek future political appointments and are reluctant to turn down loans to power brokers. Weijian Shan, a managing partner of U.S. private equity fund Newbridge Capital, which owns an 18% stake in Shenzhen Development Bank Ltd., notes that many Chinese branch managers are used to reporting directly to bank presidents. That practice means no effective central control of loan growth or risk. "Branches operate as fiefdoms," points out Shan. Shenzhen Bank, which is listed on the Shenzhen stock exchange, has assigned two senior executives to oversee its 225 branches.

That's a wise practice if you consider the recent case of Beijing-based China Minsheng Bank, a mainland lender listed in Shenzhen that hopes to raise $900 million in a secondary offering in Hong Kong in May. On Apr. 21 the bank disclosed that a former senior employee at its Guangzhou branch in southern China allegedly doctored financial records to approve a $36 million loan. Some $100 million has gone missing so far this year thanks to similar fraud cases at other banks.

Another unresolved issue is just how autonomous publicly traded banks will be from meddling. After all, the government will still hold majority stakes in the post-IPO China Construction and Bank of China. That means it will be hard to cut off loans to state-owned companies. At the same time, Beijing is unlikely to let any of the big four banks go under. "It is a combination of political meddling, but also a level of comfort," says Robert Broadfoot, managing director of Hong Kong-based Political & Economic Risk Consultancy Ltd.

The larger problem is that banks still account for some 80% of all credit allocation in China; the rest comes from the country's two small domestic exchanges and its minuscule corporate bond market. Loans to the Chinese private sector and nonfinancial government enterprises are now clocking nearly 160% of gross domestic product, vs. about 120% in 2000. Such zeal to lend could eventually become a major headache if the economy slows down and more loans sour, as was the case in the mid-1990s.

Last decade's boom-bust cycles bedeviled China precisely because it lacked the kind of banking culture that could calibrate loan growth to changing economic circumstances. The recent news of scandals in the banks is scary, but at least something is being done about them. Better to have financial skeletons coming out of the closets now than in five years -- once the banks have already gone public.

By Brian Bremner, with Dexter Roberts in Beijing

— With assistance by Dexter Roberts

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