The Enduring Allure of China

Team Infidel

Forum Spin Doctor
The Industrial and Commercial Bank of China (ICBC) is expected to
raise nearly $22 billion in an initial public offering (IPO) -- the
largest in history -- after shares are made available to retail
investors Oct. 27. The ICBC offering is the latest in a series of
IPOs involving Chinese banks, into which Western investment firms
have poured billions since 2005.

What is surprising about the expectations for the offering is not
only the tremendous amount of cash likely to be raised, but the
fact that it comes only months after a number of major global
accounting firms began taking note of serious structural
weaknesses in China's financial system. Recall that, in early
summer, a series of reports were issued by Ernst & Young,
PricewaterhouseCoopers, McKinsey Global Institute and Fitch
concerning the problem of nonperforming loans (NPLs) and
questioning the long-term stability of the Chinese market.

These reports, we noted, aligned with a long-standing Stratfor
forecast as well; the structural weaknesses have been apparent and
widely discussed in the Chinese press for years. What is curious,
then, is not why mainstream accounting firms and consultancies
suddenly began to question the prospects of China's economy, but
rather why foreign investors are continuing to pile into the
state's banking industry regardless.

The simple answer, of course, is "irrational exuberance." The shine
of a market that services 1.3 billion people -- and a chance to
carve out a piece of that market for oneself -- is difficult to
ignore. But there is more to be considered: China has gone to
considerable lengths to generate the impression that the systemic
weaknesses are being addressed and to make its banks (and other
state industries) appear attractive to foreign investors. It is no
accident that a spate of banking IPOs -- Bank of Communications
($1.6 billion raised), China Construction Bank ($8 billion), Bank
of China ($11.2 billion), China Merchants Bank ($2.6 billion) --
have been announced since June 2005. It also is no accident that
ICBC, one of China's "Big Four," is going public at this time -- as
the transition period for full World Trade Organization membership
is drawing to a close.

Beijing, which long has been aware of the economic weaknesses (not
to mention the political and social implications stemming from
them), has been pursuing a brilliant strategy that bears some
consideration.

A Structural Dilemma

China long has had a pressing need to address its NPL problem --
and limited means of doing so. The core issue, as has been noted
many times, rests in the attitude toward loans and state-driven
industries -- with lending practices that differ sharply from those
common in the West.

For Western lenders, money is viewed as a scarce commodity, and
loans are allocated with rates of return and profits in mind. In
the Chinese system, capital has been viewed as a political asset,
allocated to achieve social aims. Controls over what kinds of
collateral could be used, credit histories and sources of income
have not been critical considerations.

Given such values, citizens have little choice but to funnel their
savings into state-owned banks (remember that legendary Asian
savings rate?). Historically, those banks then have parceled out
the cash -- at below-market rates -- to projects that contribute to
the social good of mass employment. From Beijing's perspective, it
does not matter if these projects (which typically have been
state-owned) turn profits or even break even financially. A bum
project that runs to the red, but keeps many Chinese employed, was
considered a success -- and besides, it could always be buoyed up
by more loans. Ultimately, projects became mired in massive debt,
and the banks were saddled with masses of NPLs.

Clearly, this system would lead to instability even in a perfect
world -- and China is far from perfect. Because of wealthy coastal
magnates, local leaders now dabbling in business and the
ever-present availability of easy loans, the Communist Party, and
the Chinese system in general, is massively shot through with
corruption. Former President Jiang Zemin in 1998 attempted to start
closing down some of these dud projects -- particularly the
redundant and wasteful commercial projects at the local level --
but met with massive backlash from local officials who had no
desire either to face hordes of local unemployed or to give up
suckling on the mother's milk provided by state banks.

As we noted in May 2005 , a destabilizing shock appeared to be all
but unavoidable by December 2006, when the transition period for
China's WTO accession ends. At that point, foreign banks -- which,
unlike their Chinese counterparts, actually charge interest for
their loans and pay out interest on deposits -- will be allowed to
set up shop throughout China. Odds are that the average depositor
would move his money out of the state banks, denying them the
resources they need to keep the system running and leading to
financial chaos and collapse.

Chinese policymakers also could see this problem approaching, and
they have no intention of letting the financial system be the
state's downfall. Thus, they embarked on a creative strategy .

The Cleanup Strategy

Again, the U.S. or Western model of cleaning up the system -- a
painful purge of corruption and implementation of stringent
financial policies -- does not apply. For the Chinese, there is
simply too much at stake: As recently as three years ago, the
central government, which has a vested interest in lowballing these
figures, pegged the total stock of bad loans at 35 percent of gross
domestic product.

The Chinese could not apply the model used in the United States
during the savings and loan crisis of the 1980s. At that time,
independent auditors went through the books of suffering S&Ls and
chopped up their loan portfolios, ranking the pieces in terms of
the chances that debtors ever could pay them off. Those loans were
then packaged together, ranked and sold to other -- healthy --
banks. Some of the S&Ls were closed; others faced massive personnel
and policy overhauls. Some of the S&L corporate clients went out of
business. Some S&L officers went to jail.

China, rather than going down such a capital-centered route, has
come up with a two-pronged strategy designed to fit its own social
needs.

First, the Chinese cleaned the banks' books. The government
simultaneously has pumped out cash from its now trillion-dollar
foreign currency reserve to recapitalize the banks, and transferred
the bulk of the NPLs to "asset management corporations." These
asset management entities are ostensibly responsible for collecting
on the bad loans -- though, because these remain government-owned,
Beijing has no intention of forcing compliance on that issue. The
asset management firms issue bonds to the banks for the full face
value of the loans, making the banks' balance sheets look
sparklingly clean indeed.

Second, the banks -- drawing on the full authority of the Chinese
state -- seek out foreign investors, either through IPOs or
strategic capital allocations from foreign corporations. This is a
critical step, for four reasons:

Foreign corporations know how to run a bank, and can provide the
skill sets needed for (new) tasks such as loan evaluation, risk
assessment and internal anticorruption checks. For the government,
these kinds of processes could be quite troublesome at times, but
also can be very handy.

It undercuts any competitive instincts the foreign banks might
have. By bringing foreign entities to partner with the state banks
under the current system, the odds that those so invested would
attempt to go solo come December -- when WTO restraints on
competition are lifted -- are greatly reduced. And that means less
instability stemming from contests over Chinese depositors'
savings.

Foreign banks have cash -- which, obviously, the Chinese
desperately need.

Most important, a foreign bank that buys into a Chinese bank gets
access to tens (sometimes hundreds) of thousands of local branches.
Any way you cut it, that is a sweet asset. Once the foreigners are
in, they have a vested interest in working with the Chinese to make
the financial system more functional -- which has been the point of
the strategy all along.


This is the strategy that several Chinese banks already have
followed: Bank of Communications drew capital from HSBC; China
Construction Bank found an investor in Bank of America; and ICBC,
which opened its IPO to institutional investors Oct. 16, lured
Goldman Sachs.

Conclusion

Given the upcoming share sale to retail investors, ICBC's history
of action is, of course, particularly worthy of study.

Since 2004, it has transferred about $85 billion in bad loans,
through asset management company Huarong. Then, in 2005, it
received a $15 billion cash injection from Central Huijin Co., the
Chinese recapitalization body. Finally, earlier this year, ICBC
sold a 5.8 percent stake to a consortium led by Goldman Sachs for
$3.7 billion.

As a result, the bank, which had an NPL ratio of more than 21
percent at the end of 2004, had (by its own, and therefore
questionable, assessment) reduced that number to 4.1 percent as of
June.

Intriguingly, foreign investors seem not to have noticed how ICBC
got from Point A to Point B. Some concerns about the bank's lending
practices have been voiced -- most recently, following news in
September that ICBC had funded a company, Fuxi Investment, that has
been linked to the widening pension funds scandal . However,
seemingly no attention has been given to the fact that China has
been transferring NPLs from, and providing capital infusions for,
state banks -- including ICBC -- for years, without overhauling
their corporate decision-making processes or management.
 
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