Stop indulging China's banks or risk another crisis

        Financial Times, 10 July 2014,  By Joe Zhang,

China's 18 biggest banks are listed on both domestic and overseas stock markets. Beijing last week approved another 11 banks lower down the pecking order to go public, too.

In a country threatened by an expanding credit bubble, it is surprising that no one has raised any concerns about this decision. This move would add fuel to China's credit fire: enabling more banks to raise more capital will enlarge the capital base and the lending capability of an already bloated banking sector.

The government is pursuing two other equally damaging policies. One is the relaxation of credit through a targeted cut to the banks’ reserve requirement ratios. The other is the encouragement of listed banks to sell preference shares now that their stocks are mostly trading below book value.

The Chinese government does not need to justify its policy moves to anyone. But there are two reasons often cited by officials and analysts. First, the government feels the economy has been too weak and need a jolt through expanding the amount of credit in the system. Second, the banks need more capital to fund an increase in lending while maintaining a reasonable capital adequacy ratio.

However, there is a third, untold reason: the government thinks many banks are burdened by bad debts, and that their capital cushion is not as robust as claimed.

These widely held views may sound reasonable but they are a terrible basis on which to make policy. The Chinese economy, under the influence of fiscal and monetary stimulus for the past 36 years, is saddled with industrial overcapacity and weak corporate profitability.

Consider just one crude comparison: the US economy is about 80 per cent bigger than the Chinese economy, as measured by gross domestic product and based on the current exchange rate. But the value of the US stock market is at least seven to eight times bigger, even after stripping out foreign companies listed in the US.

What is behind the huge valuation gap? US companies are more profitable than Chinese ones. Despite the deployment of quantitative easing by the Federal Reserve, money supply has increased at low single-digits in recent years compared to a rate of 13-14 per cent in China. Chinese companies are drowning in credit.

But it is politically difficult for Chinese banks suddenly to acknowledge a much higher level of bad debt, let alone to write them off. In any case, the tax men will not allow it.

The banking sector is the country's biggest taxpayer, accounting for more than 60 per cent of all revenues. If the banks admit to holding a much higher percentage of bad debts and write them off, their net profit will collapse and so will their ability to pay their taxes.

The only realistic way to contain the Chinese credit bubble is to starve the banks of new capital. Here are three proposals for how to achieve this.

First, the Chinese government should ban any bank fundraising. True, the equity investors in thousands of unlisted banks deserve to have an exit. But one way to provide this would be to list the banks without allowing them to sell new shares via a process called listing by introduction. This allows some shareholders to quit the company, but the business’s capital base does not increase.

Second, Chinese regulators should stop urging the banks to sell preference shares. The banks’ management teams need no urging here, as they know more about empire building than generating sustainable returns on investments.

Third, China’s banks should be forced to distribute most, if not all, of their net profits each year as dividends. Their existing lending capability should be sufficient to support the economy for many years.

Some might ask whether the Chinese banks should replenish their capital base if they have been eroded by bad debts. Yes, of course, but only if it is accompanied by a major writedown of bad debts.

Another question is whether China should create some “bad banks” to handle the vast amounts of bad debt in the banking industry. The answer: absolutely not. The last time China did this in 2000-2001, the bad banks proved to be the origin of today's credit bubble. With a blanket deposit insurance regime, China’s banks are merely an extension of the government apparatus. In this institutional set-up, capital adequacy ratios are not very meaningful.

Despite being a much smaller economy, China's money supply is (on a broad measure) already 61 per cent bigger than that in the US. At the same time, China's credit balance is compounding at a high annual rate of 13-14 per cent off a very high base.

In recent years, there has been a backlash across the world against austerity measures prescribed by the likes of the International Monetary Fund. However, China is the notable example where austerity is sorely needed.

The writer is author of ‘Party Man, Company Man: Is China’s State Capitalism Doomed?’ and a former manager at the People’s Bank of China.