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FEATURE STORY: The Rise and Reform of China’s Risk Prone Banking Sector
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Towards the turn of this millennium the Chinese authorities set about paving the way for a 21st century banking sector fit for a rising economic superpower. 1995 was the year in which the government enacted the Commercial Bank Law, an act which essentially led to the commercialisation of the so called ‘Big Four’: the Bank of China (BOC), the International and Commercial Bank of China (ICBC), the China Construction Bank (CCB) and the Agricultural Bank of China (ABC).

Today, these colossal banking institutions are some of the biggest in the world. Whilst they have returned enormous amounts of profit over the past decade or so, they are not too dissimilar to their counterparts in Europe and North America in that they are now also fraught with toxic assets and risky balance sheets. As a number of reforms are currently underway, that will change the nature of the system significantly, we take a look at the ins and outs of the Chinese banking sector.

China’s Rise to Banking Dominance

There are many reasons why Chinese banks have risen to the very top of the global earnings list. Statistics for 2013 released by Relbanks indicate that ICBC is still the world’s largest bank with a market capitalisation of USD 234 billion. Slightly behind them is China Construction Bank, which boasts a behemoth balance sheet and has a market cap of just over USD 207 billion. The Agricultural Bank of China and the Bank of China also made the world top ten list, coming in at 6th and 9th respectively. There is little doubt that Chinese banks are now incredibly important to the overall balance in the global financial system.

It is no surprise that China’s boom from the start of the century to the present day has sent profitability within the country’s banking sector through the roof. The nation’s construction activities, as well as the rise of China’s middle class consumers, have brought a great deal of revenue to the Big Four and other, smaller financial organisations. What’s more, the Chinese banking sector did not take a significant hit after the global financial meltdown of 2008.

Risky Business

Up until the last couple of years, the Chinese government had seemingly been very happy to fuel the banking sector’s robust growth by providing liquidity and policy support. More recently, however, the authorities have started to tighten their regulatory belts when inflation and asset bubbles have become an increasingly significant threat to the sustainability of the country’s long-term economic growth.

Amongst the major threats to the banking sector is the red hot real estate market. Estimates for the historic growth of property prices in China vary substantially. Official statistics indicate that property prices have risen by around 155% over the last 8 years. However, research conducted by the National University of Singapore and Tsinghua University in Beijing shows that prices rose more than 250% between 2004 and 2009 alone. Added to this, the easy credit policies which followed on from the government’s stimulus injection after the 2008 crisis have caused an enormous run up in property investment over the last few years. As a result of this lending and spending frenzy, the number of so called 'bad loans' or 'toxic assets' on Chinese banks’ balance sheets has risen to levels which many analysts are saying could bring down the entire economy in a similar fashion to the US subprime mortgage crisis.

A number of commentators around the world are even going as far as to say that the banking situation in China is much worse than that of most western countries. Muddy Waters Research analyst Carson Block has argued that "the domestic Chinese banking system is a mess, with an enormous amount of bad loans, or loans waiting to go bad. The problems of China’s lenders are greater than those of Western banks on the eve of the financial crisis". Furthermore, economists at Nomura recently released a report saying that the triple whammy of too much leverage in the banking sector, elevated real estate prices and an economic slowdown would lead to a financial crisis in the country sooner rather than later. The current situation is definitely giving investors, policymakers and business owners plenty to get anxious about.

Shadow Banking

To add fuel to the financial fire, policymakers’ attempts to slow down speculative borrowing are being counteracted by the country’s thriving ‘shadow banking’ sector. Whilst this activity may sound somewhat sinister, it simply refers to non-bank creditors lending money through private channels. The truth is that whilst the People’s Bank of China can tighten the mainstream credit market, it has limited scope to prevent any of its cash flush citizens and institutional lenders from offering their own financing schemes.

Many of these private lending organisations are very much in the public eye and are operating very openly with little oversight from the central authorities. The largest of these is Citic Trust, which turned over a staggering CNY 2.7 billion in 2012. Ping An Trust, which is a subsidiary of the insurance giant Ping An Insurance Group, is another example of large firms with venture capitalist-style arms to their businesses.

Shadow banking activity is currently causing a great deal of concern in relation to both the public and private sectors.  Former IMF chief economist Ken Rogoff suggests that "the main concern is that 'hidden debt' will come flying out of the woodwork on to public balance sheets in a slowdown, ultimately leading to a problem". Unlike the banks which operate directly under state supervision, these shadow lenders may well be concealing a key part of the overall puzzle in terms of how much debt there really is.

The Long Road to Reform

Reforming such a complex and colossal sector of the economy is no easy task. Nevertheless, the central government and the People’s Bank of China are determined to reinvigorate the current banking system and set up a framework which is more in line with their overall economic objective of maintaining growth.

The most recent high profile policy development has been the so called ‘liberalisation of bank lending rates’.  From July onwards commercial banks in China have been allowed set their own lending rates and can now compete against other market players. But this may only be the start of things to come. According to Danske Bank analyst Flemming Neilsen, "China is moving towards a fully convertible currency and floating exchange rates. Their next step will be to widen the daily trading band for the RMB (yuan). They should do that within the next three months."

It is hoped that such market orientated policies will give the economy a much needed boost. However, only time will tell how far policymakers are willing to go in reforming the banking sector. Moreover, it remains to be seen how much of an effect these changes will have. One thing can be certain though, the reforms won’t happen overnight.

By Melvin Shaw
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