China's Banks: The Tree That Hides The Forest

What is really going on with China's financial markets? Its large state-owned banks are the biggest in the world in terms of total assets, while its financial system is increasingly fragile. At the end of the day, as China's economy needs rebalancing, so does its financial system.

Indeed, China’s banks appear to have low levels of bad debts, ample liquidity and low leverage, but in reality they suffer from a nationwide property bubble, the worst of Asian crony lending practices, and the appearance of a voracious and unstable shadow banking system.

Chinese large state-owned banks would appear to be among the strongest in the world, the rankings being based on Tier 1 capital. China now holds four places in the Top 10, and has 96 banks in the Top 1000 ranking.

However, a wise caution needs to be voiced: notwithstanding the fact that on most measures Chinese banks now score as well or better than Western banks, ultimately their big test will be how they cope as China’s growth slows over the next few years.

When you think about it, since the Lehman shock of 2008, China's state-owned banks, which dominate the financial sector, have undertaken massive lending to state-owned enterprises and above all to local governments to help prop up the economy by infrastructure projects, many of which are white elephants. The rise in China's debt is even greater when "shadow banking" is taken into account.

For instance, Fitch has estimated that total credit (including shadow-bank lending) may have reached 198% of GDP at end-2012, up from 125% four years earlier. The proliferation of other forms of credit beyond bank lending is a source of growing risk from a financial-stability perspective.

Already, in recent months, we have also seen a credit crunch in China's interbank lending market, engineered by China's central bank, a sign that it wants to reign in excessive credit growth.

However you look at it, what seems clear though is that China's banks are sitting on a whole lot of contingent liabilities and bad debts. This is the inevitable consequence of too much credit being directed and allocated for political, rather than commercial reasons. And, granted, official asset quality statistics on China's banks are like a mirage: they look beautiful, but they are made out of thin air.

This is nothing new to China. The government bailed out the banking system in the late 1990s, and has the wherewithal to do it again. But it represents a terrible waste of resources for a country where many people still live in poverty, and a large share of its much-vaunted emerging middle class is still very much in the vulnerable lower middle class category.

Over the past couple of years, the Chinese government has also made moves to progressively internationalize the Chinese currency, the yuan or renminbi. This is a sensible move for the world's second biggest economy. But this is only being done at this stage for international trade transactions ("current account"). The government is not yet ready to liberalize China's capital account in part because the financial system is still underdeveloped.

Not unsurprisingly, concomitantly, the Chinese economy hemorrhaged $3.8T illicit financial outflows from 2000 through 2011. There was in fact a sharp rise in annual illicit financial outflows over the period, increasing from $172.6B in 2000 to $602.9B in 2011 -- with reports of even greater outflows in 2012 in the lead-up to China's political leadership change. Interestingly, despite capital controls, illicit financial outflows from China are by far the highest of any country worldwide.

While, China managed to stabilize the economy in the face of the recent global financial crisis, much of its rise as an export dynamo has been financed by foreign direct investment from multinational enterprises (rather than Chinese companies) which are still responsible for the majority of China's exports. But the current functioning of China's financial system is also very costly, and is not well adapted to the country's development requirements moving forward, for several reasons.

While continued state ownership, guarantees and intervention in bank activities enables the government to pursue its macroeconomic, sectoral and other goals, finance is not allocated efficiently. On the contrary, too much is wasted in infrastructure of little value, and industries with massive excess capacity.

The inefficiencies of China's financial system mean that it is very costly to maintain and potentially unstable. And while huge foreign exchange reserves provide a useful buffer against currency crises, as Japan has shown, they do not provide protection against the risk of a domestic financial crisis.

At the end of the day, China’s banking behemoths are too beholden to the state. Most Chinese banks have no clue today about customer service, risk management or credit assessment. It is time to set finance free. China must separate banking from crony state capitalism. The best way to do this is privatization.

Clearly, the Big Four Chinese banks are led by senior figures in the Communist hierarchy, with bosses shuttling easily between banks and regulatory agencies. They funnel lending to cronies at inefficient SOEs, thereby starving dynamic “bamboo capitalists” of credit. The country’s biggest financial institutions are so closely held by the state that they are, in effect, arms of the treasury.

Given the ambivalent attitude of the Chinese authorities that seem not to know what they want, either:

(i) shrinking the credit bubble by means of a lesser money supply with the risk of causing massive refi risks, and thus bankruptcies, and hence massive rise in unemployment

(ii) propping up the ailing state enterprises as well as real estate sector with the aim to keep GDP growth at minimum 7% per year. But propping up, means reigniting the credit bubble.

So, what will it be: do we shrink the credit bubble and hence deleverage the economy with a LT objective to transform the economy, or do we keep economic growth at minimum 7% with the short term aim to avoid massive protests caused by massive unemployment?

Despite its economy being only 15% bigger than the US economy (ie. GDP of $17.6T vs $16.3T in terms of GDP based on purchasing power parity (PPP)), China’s money supply is (on a broad measure) is already 61% bigger than that in the US.

As difficult as it all may seem, the stakes are very high, and reforms will be very difficult. Continued inefficient use of China's financial resources will weaken its future growth prospects and expose it to even great risks of financial instability.

While there is a worldwide backlash against austerity measures prescribed by supranational institutions, ironically China is the notable example where austerity is sorely needed.

As many of you now know, history is quite literally littered with examples of political change provoked by financial crises. Ultimately, the Chinese Communist Party's dictatorial "mandate from heaven" is at risk, which is maybe the best news of all.