Cross-posted from Kate Mackenzie at FTAlphaville.
China’s “bad bank” debts from the 1990s are being paid off by the government,increasingly rapidly of late. What this means for China’s big banks depends on which perspective you come from. It’s arguably a rather good thing in the near-term.
What it means for the broader economy is more complicated.
Firstly, some more on the fiscal financing of the “bad banks” which were setup in 1999 with the intention of sorting out a big chunk of the big four banks’ non-performing loans (other chunks were directly taken on by the Ministry of Finance and the PBoC). As we know, those bad banks — asset management companies or AMCs — didn’t seem to make much progress repaying the banks from whom they had bought the bad loans at face value for a good decade. But since 2009 they have been paying them off much more quickly — and the AMCs themselves have expanded into numerous other financial services, and are heading towards public listings. (Cinda is likely to be first cab off the rank, later this year.)
On the original question of whether the Chinese authorities had recently begun to repay the AMC’s bonds, Bernstein Research is quite certain this has been going on for several years.
Bernstein’s Michael Werner wrote in April that fears about whether the AMC would repay the bonds the banks’ held were unwarranted — largely because the Ministry of Finance has made its support for the AMCs clear. mWerner has rated three of the big four banks as ‘outperform’ and Agricultural Bank of China as ‘market perform’.
For the banks holding AMC bonds, Werner wrote, repayment risk isn’t a problem. The only real downside: they were not allowed to shift the AMC bonds and take on higher-yielding assets instead:
We do not consider the Big 4 banks’ AMC or other restructuring-related bonds to be at risk for repayment, which is a key concern among investors. Nonetheless, we would view the repayment of these bonds as a positive for the large Chinese banks due to the opportunity cost of holding this debt which yields below-market interest rates.
Even that won’t be a problem for long, as he estimated China Construction Bank’s exposure to the AMC bonds (its affiliated AMC is Cinda) would fall to zero within a year. Although he was writing several months ago, recent amping up of Cinda IPO news probably just adds weight to this view.
In fact, the AMCs themselves have benefited from Ministry of Finance in another way: the MoF has been “carving out the legacy NPL disposal business from their commercial operations”, and thus freeing them up to run profits from forays into “other” activities (brokerage, financial leasing, private equity, insurance) . Leaving some rather healthy-looking numbers:
As the AMCs disclose more financial information as part of the preparation for their IPOs (each of the four AMCs disclosed their basic income statement/balance sheet info for 2011-12), their commercial operations appear financially healthy and their ROEs are in the 14-21% range. This is the direct result of the MoF carving out the legacy NPL disposal business from their commercial operations. With MoF backing, we see no risk to the repayment of the banks’ AMC exposures.
So, there you have it.
Despite the government vowing in the early years after the AMCs’ establishment that it would not facilitate moral hazard by facilitating more NPL transfers, the resolution of the 1999 bad debts is really turning into the mother of all moral hazards: the banks escape with almost no penalty for their ill-considered lending.
Presumably, making good on these bad loans means there’s been little incentive to improve lending practices, either.
In fact, Anne Stevenson-Yang of J Capital Research wrote in March that the early aspirations that the Chinese bad banks would facilitate more responsible lending has given way to a consolidation of the big banks’ financing of the powerful state-owned entities:
The AMCs were to assume debt from fundamentally viable companies and swap it for equity. This was part of the massive SOE restructuring plan of the time: the AMCs were expected to act like private equities—stern and dispassionate board directors motivated by profit. It was thought that this would help create SOEs that thought and acted like commercial companies. To the contrary, the result was an implicit guarantee to SOEs that they would not go bankrupt, which in turn supported the general disregard for debt-equity ratios and any calculation related to servicing debt.
The SOEs’ are widely acknowledged to be one of the biggest hurdles to China reforming its economic strategy, due to a combination of their poor performance, easy access to credit, and significant political power.
And what happens when the bad debt is taken on by, or paid off by, the government? Stevenson-Yang again:
Meanwhile, the actual deficit seems to have disappeared. One chunk of debt sits in the accounts of MOF as obligations held in trust, whatever that means. Another portion has been extended without penalty for a decade. Part of it resides in the original capitalization for the AMCs from PBOC and subsequent subsidies, on obscure bases, that were made. The banks continued selling NPLs in new tranches. In 2004, for example, the PBOC bought 320 bln in NPLs at par and then sold them to theAMCs for 40% of par value. This happened again in 2005 and 2006.
Finally:
Overall, the unending bailout has meant that a smaller and smaller proportion of China’s wealth is available to its people to spend on things like education, health care, and public services like parks and libraries and clean environments: that is what lower consumption and higher savings/investment means. I would argue that the average Chinese citizen is a good deal wealthier now than a decade ago but that much, even most of that wealth is in illiquid assets, like property, whose real value will ultimately turn out to be a lot less than its book value today.
Now we come back to the reasons for the astonishingly low rate of consumption in China, which has been falling over the last decade. Essentially, banks take money out of private hands and put it into the accounts of the SOEs. When the transfers build up to the point where the banks are illiquid, the national government issues debt and often fails to book it as debt on the national accounts.
On the simplest level, this dynamic has two effects: to convey outsized profit to companies owned by the government and to subsidize exports by making them cheaper to produce as well as by controlling the value of the Renminbi.
Stevenson-Yang described a “state-corporate fusion” a the core of China’s economic strategy, in which the Ministry of Finance, the Peoples Bank of China and state-owned enterprises “mix and match every manner of financial, fiscal, and fiduciary tool to meet the consensus goal of producing world-pacing growth figures”.
The question is, what’s the end game? Particularly if there remains little incentive for the investments fuelled by all this fiscally-financed lending to be directed towards more useful purposes.
In the meantime, the misdirected investment from stimulus spending still hasn’t been recognised on the country’s balance sheet. And “even compared to China’s record-breaking forex reserves”. Where might it eventually show up? Currency devaluations and inflation, Stevenson-Yang wrote. This, she says, is why it’s important to watch China’s net flows of hard currency.
