China's Banking Reform - The Good, the Bad and the Ugly

Banking reform in China will take much longer than the official rhetoric has it, delaying currency convertibility.

Despite their establishment last year to speed up bank restructuring, China’s asset management companies (AMCs) cannot function properly due to the presence an inadequate legal framework and questionable incentives. The ugly truth is that banking reform will take much longer than the official rhetoric has it. This protracted process will delay currency convertibility and - insofar as foreign banks are concerned - the complete liberalization of the Chinese banking market.

The good AMCs

Beijing established four AMCs last year, based on the Resolution Trust Corp (RTC) model in the US, to buy bad loans from the state banks. This measure improves banks’ balance sheets at one stroke. The AMCs have purchased about Rmb1.1 trillion ($133 billion) of non-performing loans (NPLs) as of the end of June. This is about 60% of the total NPLs in the system. The AMCs funded this with some initial capital injected by the Ministry of Finance, and central bank credit and bonds issued with a government guarantee.

Some of these bad debts are being swapped into the equity of the underlying state-owned enterprises (SOEs), so that the AMCs have become owners of these companies. The debt-equity swaps enable banks to break the logjam of bad debt that has been undermining their performance and ability to lend.  They also lighten up the SOE’s debt burden (Chart 1) and help restore their profitability (Chart 2).

 chart1 long-term

chart2 industrial

It is hoped that through their new ownership rights, the AMCs will be able to restructure some of the SOEs and break the state banks’ habit of pouring household savings into the SOE black hole. The AMCs will eventually sell their equity back to the private sector.  However, there are some major obstacles that will render the AMCs ineffective in doing their job in the next few years.

An inadequate legal framework

With the AMCs buying NPLs from the banking system, the easy part of recapitalization is being done.  Next comes the hard part – selling off the assets.  For the AMCs to function effectively, they must be able to go after debtors – they must have legal recourse against debtors in order to price the debt properly. But the AMCs will not be able to sell the assets since the prospective buyers are unsure if they will be able to enforce their security in court and get their hands on the assets if they want to.

The Chinese system provides creditors with little legal recourse against borrowers. State bank loans in China is little different to the equity sunk into the SOEs because the borrowers do not think they need to pay back their creditors.  The Chinese bankruptcy laws also discriminate against creditors, while law courts are not reliable enforcement vehicles. They often rule in favour of labour groups over the owners of capital.

The AMCs cannot become RTCs until China reforms its legal framework so as to allow the proper pricing of bad debts and create the incentive and safeguards for investors to buy these assets. Only legal reform and strong law enforcement can break the Chinese “no-payback” mentality, which is a major source of moral hazard in the banking system.

Unfortunately, judicial reform is a difficult and protracted process. This means that the AMCs’ function will be limited to acting as a “warehouse” simply absorbing bad loans for the time being. The current recapitalization amounts merely to a transfer of bad debt from the banking system to the public sector.

Bad incentives

Defaulting SOEs will have little incentive to improve their management and banks will have no incentive to recover NPLs if they believe government bailout agencies, such as the AMCs, will absorb their losses. There are also serious incentive problems among many officials and SOE managers in using the AMCs.  While the debt-equity swaps implemented by the AMCs are meant to address the NPL problems by identifying problem SOEs for restructuring, many government and enterprise officials still see them as just another way to salvage the crumbling SOEs.

Normally, the last thing a manager would want is a debt-equity swap because it is a market selection process that picks “losers” that must be restructured. The first thing new equity holders would do after the swap is to replace the management in the company so that the managers should run for cover when they hear about debt-equity swaps. This is not the case in China where a different mindset operates.

Facing the potential risk of massive unemployment and social unrest, the government has hindered the market selection process by keeping many non-viable SOEs afloat. This forbearance is translated into mounting NPLs in the banking system. Despite the central leadership’s drive to change, many local officials and managers still believe implicitly that the firm, as a public entity, is sacred and that the purpose of the reform is to preserve its assets.  

Hence, they lobby hard for debt-equity swaps in the belief that the new majority equity holders, or the AMCs, will not have the authority and ability to break up the firm. This mentality defeats the purpose of the debt-equity swaps and essentially makes the AMCs toothless tigers.

The ugly truth

The ugly truth is that, save for some accounting issues, nothing major has changed in the SOEs despite the AMCs. There is an illusion that the recent debt-equity swaps have helped improve a firm’s profitability by relieving its debt obligations. However by not changing management, it is only a job half-done.  

Ironically, the debt-equity scheme is progressing very slowly due to technical difficulties. These surround which assets in the SOE should be picked for the swap and whether an SOE should buyback its shares to protect the AMC from heavy losses. Only a fraction of the intended Rmb400 billion in ($48.3 billion) of swap deals have been signed, and most of the Rmb72.5 billion in swaps signed last year – with 66 firms – remained only pledges on paper. 

In a nutshell, there are those who believe China’s state sector should be scrapped to rid the banking system of bad loans. They believe the AMCs and the debt-equity swaps are the first step to radical changes. There are also those who think having a state sector is fine but that some SOEs need to be revived via debt relief, in which case debt-equity swap is a means to do so.

The battle between these two mentalities will not disappear soon. The AMCs – plagued by inadequate legal infrastructure and incentive problems – will not be able to function like America’s RTC and cure China’s banking woes quickly.  Even with a determined central leadership, banking reform is a long drawn-out process that can last for over a decade.

Implications

However, China’s banking problems will not explode thanks to a closed capital account, little foreign debt and ample domestic savings to underwrite government bailouts. Beijing has demonstrated a strong will to reform and entry to the World Trade Organization (WTO) will act an external means of discipline in the overall reform process. Hence, optimism about China’s outlook is justified, but it should not be exaggerated.

The steady fall in China’s risk premium (Chart 3), as approximated by the forward points in the RMB NDF market, suggests that the market has priced in (or might even have over-priced) China’s reform progress. Thus, the decline in the China premium has probably hit bottom.

chart3 chinese

A protracted bank reform process will also delay the full opening up of China’s banking sector to foreign banks. Simple banking products, like lending, deposit taking and transaction banking, will remain the main products of the mainland banks in the next few years. Though foreign banks are strong in diversified products that leverage global markets and cross border technology, such services will probably remain outside the scope of China’s slow-changing banking laws, preventing foreign player from fully exploiting their strengths.

But the de-leveraging process should have a positive implication for the economy and the equity market. The debt-equity swaps will help re-liquefy corporate balance sheets, which is positive for equity prices. While these swaps are only half-baked – because the AMCs have yet to sell off their bad assets – Beijing has pledged to cover the losses incurred by the AMCs in the asset sale process. It is thus keen to see strong equity markets so as to reduce its bailout cost by allowing the AMCs to fetch higher sale prices. To minimize Beijing’s fiscal burden, the PBoC will most likely remain accommodative so as to buoy asset prices during the course of bank restructuring.

Last but not least, the AMCs’ inability to clean up the banking mess will also delay full currency convertibility. The state banks’ excessive exposure to the SOEs is the fundamental obstacle preventing free, cross-border portfolio flows because it inhibits the development of market-driven interest rates. As long as the SOEs remain a big liability to the banking system, interest rates will continue to be policy driven to keep them afloat before they are restructured.

In general, if domestic interest rates, adjusted for exchange rate movement, do not conform to international interest rates, exchange rate volatility would ensue under free capital flows. International interest rate equalization, in turn, requires China to employ market-determined interest rates. A fully convertible Rmb will need to wait until the bank restructuring process is completed, and this could be as far as 10 years away.

Chi Lo is regional head of research & senior treasury economist, Standard Chartered Bank Hong Kong.

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