China's GDP growth: money down the drain

Some cynics say investment banks used the opportunity of the World Trade Centre Attack to rewrite their global and US economic forecasts, which were beginning to look absurdly optimistic even before the attack.

Well, it seems UBS is the first investment bank to allow its analysts to fire their salvoes against China. The investment bank has provided an excellent antidote to China hype in its latest China Strategy Quarterly. This should give investors, who have been looking at China as a safe haven in the existing poor climate, food for thought.

Although China's third quarter GDP growth of 7% (officially ù most analysts discount that by at least two percentage points), is the highest in the world, it is an indication of an underlying overall weakness that the banking sector's non-performing loan problem is not being solved faster, says Vincent Chan, head of China economics and strategy at UBS Warburg.

The problem lies in the fact that despite of all the investment which has led to sky-rocketing national GDP growthù a figure which merely reflects economic activity, regardless of how efficient it is - these investments have not provided rising profit and larger operating surpluses.

Between 1994 and 1999, China's operating surplus as a percentage of GDP was only 21.3%, lower than Taiwan, Korea and the US, and higher only than Japan, the dunce of the class, on 20.5%.

Low operating surpluses lead to low retained earnings, which in turn means equity capital cannot be built up. This means a greater reliance of companies on, or a shift of risk to, the banks. The consequences for the banks of shovelling money into domestic companies is existing NPL levels of on average 34% for the state owned banks, even after the transfer of Rmb1.3 trillion to the asset management companies.

Chinese companies' inability to turn a decent profit, and the consequent dependence on the banks is reflected in their low return on equity. According to UBS, the Chinese A-share market has the lowest ROE of any stock market in Asia, despite having the highest financial leverage.

UBS blames the low levels of ROE on intense price competition reducing profit margins, low asset turnover due to huge overcapacity through overinvestment, and the growth of poor quality companies getting listed on the China's stock markets.

This last point is not surprising as the government has been trying to lure investors into the stock market in order for them to spend their one $1 trillion of savings in re-capitalizing stone age SOEs and ensuring party and state officials keep their jobs.

Cheap and badly allocated capital, with no punishments for mistakes, lies behind the overinvestment, says UBS.

The flip side of the strong rise in investment ratios in China  has been spiralling growth in depreciation - 'consumption of fixed capital'  - of almost 20% per year, much higher than even the capital destroying 13.54% registered in Korea.

"The extremely high investment ratio (i.e. over-investment) is the key reason for the high growth of fixed capital consumption," concludes UBS's Chan.

Even when a company does achieve an operating surplus, a high proportion needs to be paid in interest, since China's industrial sector has extremely high gearing, with debt equity ratios of 158% in 2000, despite efforts to drive this down. Chinese companies also suffer from a 33% income tax rate.

The effect of supporting these companies on China's Big Four Banks, the Agricultural Bank of China, ICBC, Bank of China, and China Construction Bank, has not been good. The increase in loans to these companies has caused loan growth to outstrip equity capital, in spite of a government infusion of yuan 270 billion in 1998.

UBS estimates that the equity to asset ratio, more commonly known as the capital adequacy ratio, was just 4.5% for the country Big Four banks, who got 62.6% of all deposits, and made 68.4% of all loans last year.

Later figures are hard to verify, since in a baffling move, the country's central bank, the People's Bank of China stopped publishing statistics on owners' equity from the first quarter of last year.

Rmb56 billion will be needed to increase the CAR of the Big Four to 8% by 2002, estimates Tracy Yu, head of banking research, with the funds coming through subordinated debt issues, the stock market, or as a last resort, direct government injection.

There are also serious concerns about the exposure of Chinese banks to the equity markets. UBS's Yu estimates that Rmb2 trillion, or 15% of total assets could potentially be sited in equity investments. This is disturbing, since the equity markets, which have been guilty of more than their far share of  "irrational exuberance" thanks to a deliberate government policy of creating a US style wealth effect, have been falling back to earth this year.

Finally, the cost to income ratio for Chinese banks is horrendous.

We all knew Chinese banks were bankrupt thanks to misguided government lending, but not twice over.

The Agricultural Bank of China for example has costs of 108% to income, while ICBC has costs equivalent of 78% of income. BOC comes out best with 65%, while CCB come in at 68%.

Of these costs 29% are categorized as "other items" ù which can in practice be defined as funds spent on banquets, foreign cars and lining pockets" ù reflecting the self-serving management practices of Chinese companies.

So the big four Chinese banks are not just technically bankrupt on the loans side, which is often blamed on government directed lending to loss making SOEs, they are also bankrupt due to their inability to keep costs below income, one of the most basic tasks of any company.

However, on the positive side, a meltdown of the financial system is not on the cards, estimates UBS. China's closed capital accounts and low level of foreign debt makes it possible for the authorities to act as a lender of last resort, rather than foreign investors, whose tend to move fast and in unison once confidence falls.

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