Re-capitalization; precondition for higher Chinese bank ratings

Terry Chan, director of financial services ratings at Standard & Poor''s explains what needs to be done to re-capitalize the Chinese banking system.

If China's state-owned banks are to achieve the targets set for them by the government in respect of non-performing loans (NPLs), loan loss provisions, and capital adequacy by 2005, additional support will most likely be required. The performance of the financial institutions are likely to remain constrained by their need to make additional loan loss provisions over the next decade if they rely solely on their own abilities to generate capital.

The banks' net profits, as measured by return on assets, are likely to remain at low levels as these institutions continue to use a large portion of their operating profits before provisions to write off non-performing assets, reverse unrecoverable interest receivable, and make additional provisions for non-performing assets. The rapidly expanding loan books of the banks are likely to help boost their operating profitability in the near term. However, the quality of their unseasoned loan portfolios could become a stumbling block on the road of financial sector reform.

If the institutions are to improve their credit profiles sufficiently to warrant higher ratings, they must adequately recapitalize and further improve their asset quality. Such improvements would be crucial to any upward revision in the ratings on the institutions, but would not necessarily provide sufficient reason in themselves.

The recapitalization could be conducted either directly by equity injections or indirectly by disposal of the bulk of the respective institution's nonperforming loans at close to face value. The level of recapitalization would, naturally, vary for each institution but in all cases would be likely to exceed the internal capital generation capacity of the institution in question.

Decade of Problem Loans Unless More Equity Injected

China's "Big Four" state-owned commercial banks are unlikely to reduce their ratios of nonperforming loans to total loans to 15% by 2005 in line with the wishes of the central bank, the (PBOC), given the current operating performance of the wider banking sector. Standard & Poor's estimates that the country's banking sector, acting alone, will need at least 10 years and possibly as many as 20 to reduce its average NPL ratio to a more manageable 5%. The cost of the necessary write-offs could be equivalent to well over $500 billion or over 40% of China's estimated gross domestic product of $1.3 trillion for 2002. Accordingly, the rate of NPL reduction desired by the country's authorities will almost certainly require some form of government intervention, possibly through injections of fresh capital or through further transfers of NPLs, beyond those already made, to asset management companies (AMCs) owned by the Ministry of Finance.

Centralization Improves Internal Discipline

Several years of banking reform have weakened the influence of local government officials over the lending decisions of the Big Four, although this is not necessarily the case for other domestic banks. A first stage of reform centralized control within the respective headquarters of the Big Four, making branch managers accountable to senior management in Beijing and not to provincial or municipal level party officials. However, centralization also strengthened the control of the central government, which can now more effectively dictate terms to the Big Four.

The next stage of reform will be to increase the autonomy of the banks from the central government. Failure to move in this direction could result in a regime of politicized lending at the behest of local officials being replaced by a regime of politicized lending at the behest of central government officials.

The planned stock market listings of some of the commercial banks will introduce new owners, facilitating a shift towards genuine autonomy for bank managements and, if pursued far enough, ultimately provide an element of external market discipline. Even under ideal circumstances, however, the transition will take many years.

In the interim, banking sector reform will continue to be driven largely by the decisions of the ruling Communist Party's Financial Work Commission, a body of senior party members and financial experts which balances the need to reform the financial sector against the party agenda of ensuring continued social stability.

Operating Profits Insufficient to Allow Major Write-offs

China's banks currently have an average operating return on average assets (ROAA) of about 1.0%. Operating ROAA is defined as profit before loan loss provisions and tax. Based on a survey of major banks' balance sheet figures for 2000 and 2001 and taking into consideration some data for 2002, the banks' average ratio of loans to assets is estimated at about 60%. This implies an average operating return on average total loans (ROAL) of 1.67%.

Recent comments by Chinese government officials have put the average NPL ratio of the country's Big Four banks at about 25%, down from a previous estimate of 30% by the PBOC. Assuming the more recent estimate is accurate and that the revised ratio is also correct for the wider banking sector as a whole, it would take more than six years for the banks to reduce their average NPL ratio to 15% (i.e. the current 25% NPL ratio less the targeted 15% NPL ratio divided by the implied 1.67% operating ROAL) assuming that no new NPLs arise.

Even a very low number of new NPLs, say 1% of a bank's loan book a year, would increase the length of the write-off process to about a decade.

Naturally, any turnaround of distressed companies coupled with the banks' own recovery efforts would speed up the process of resolving the sector's NPLs. Nevertheless, recoveries on NPLs are expected to be low as demonstrated by the recent experience of the AMCs, which are reported to have recovered (on a cash basis rather than through debt-for-equity swaps) slightly more than 20% of the value of the loans in cash which they have recovered over the past three years, which in turn amount to about 22% of the total.

Even if banks improve their credit risk management systems, a small portion of the loans extended in recent years will fail to perform, as would be the case in any banking system.

Unless the government permits the Big Four to make a second round of loan sales to the AMCs (the first involved NPLs worth Chinese renminbi (RMB) 1.4 trillion or $169 billion) or takes other steps to enable the banks to reduce their NPLs, the PBOC's goal of halving banks' NPLs in four years from 2001 will be difficult to achieve.

Proper Implementation of NPL Standards to Take Time

China's banks are moving from a system where NPLs were not publicly disclosed to one in which a large degree of subjective judgment is involved in classifying NPLs. While the PBOC has commendably requested the country's banks to adopt a five-grade loan classification system, which aims to define NPLs based on international norms, the practical implementation of these standards is fraught with difficulties.

Most other developing banking systems in Asia use classification systems which are more reliant on quantitative measures, specifically the number of days past due. In short, because China's banks rely on the subjective judgment of credit and loan officers in branches throughout the country, it is reasonable to assume that the figures reported are likely to be understated. The level of NPLs is also likely to be understated because of the highly politicized nature of statistical reporting prevalent in China, where lower and mid-ranking officials are reluctant to disclose any figures that might undermine targets set by the country's leadership, or disprove its achievements. Moreover, banks' NPL ratios exclude foreclosed assets and equity received through debt-for-equity exchanges. These assets and equity holdings are generally less than liquid and should be included in any conservative calculation.

Higher NPLs Will Take Longer to Write Off

Standard & Poor's estimates that the NPL ratio of China's banking sector is close to 50%. If China's banks choose to absorb the losses on their loans over time to avoid reporting losses on their income statements and so avoid pushing their reported equity into negative territory, it would take them more than 20 years to bring their NPLs to the more manageable level of 5%.

Standard & Poor's estimates that the average recovery rate on China's NPLs is about 15% because of the country's uncertain property rights situation and the banks' legacy of lending to state-owned enterprises on a non-commercial basis. To bring the average NPL ratio down to 5%, the banks would need about 23 years (i.e. a 50% NPL ratio multiplied by a loss rate of 85% (i.e. 100% minus a 15% recovery rate) less a 5% residual NPL ratio divided by a 1.67% average ROAL).

Both estimated time periods, of six years using the PBOC's 25% NPL estimate and 15% target ratio, and 23 years using Standard & Poor's 50% NPL estimate and 5% target ratio, would be shortened by an improvement in operating ROAL as the burden of NPLs eases over time and the ratio of productive loans to total loans rises.

Fresh Equity Needed

Regardless of which levels of assumed NPLs and provisioning are adopted, the outcome is that fresh equity is needed if the Chinese banking system is to be placed on a sound commercial footing. Many Chinese banks, including the Big Four, have indicated interest in tapping equity markets, and in particular the domestic market. However, the massive amount of equity funding required to write off the country's NPLs indicates that a degree of government equity injection may be required.

Estimating the NPL ratio of the banking sector (excluding the policy banks) at 25% would mean the sector's problem loans amount to RMB3.1 trillion ($374 billion) against total loans extended by Chinese financial institutions, which amounted to RMB12.4 trillion ($1.5 trillion) at the end of 2002, while an estimated NPL ratio of 50% would translate to problem loans of RMB6.2 trillion ($749 billion). These projected problem loan levels are, respectively, more than four and nine times the paid-in capital (not including retained earnings and other reserves) of the Chinese banking sector, which stood at about RMB722 billion ($87 billion) at the end of 2002.

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