Modern history


China’s Fortress Banking System

“[W]e should not bring that American stuff and use it in China. Rather, we should develop around our own needs and build our own banking system.”

Chen Yuan, Chairman, China Development Bank

July 2009

In China, the banks are the financial system; nearly all financial risk is concentrated on their balance sheets. China’s heroic savers underwrite this risk; they are the only significant source of capital “inside the system” of the Party-controlled domestic economy. This is the weakest point in China’s economic and political arrangement, and the country’s leaders, in a general way, understand this. This is why over the past 30 years of economic experimentation, they have done everything possible to protect the banks from serious competition and from even the whiff of failure. In spite of the WTO, foreign banks consistently constitute less than two percent of total domestic financial assets: they are simply not important. Beyond the pressures of competition, the Party treats its banks as basic utilities that provide unlimited capital to the cherished state-owned enterprises. With all aspects of banking under the Party’s control, risk is thought to be manageable.

Even so, at the end of each of the last three decades, these banks have faced virtual, if not actual, bankruptcy, surviving only because they have had the full, unstinting and costly support of the Party. In the 1980s, the banking system had barely been re-established when uncontrolled lending at the insistence of local governments led to double-digit inflation and near civil war. The Asian Financial Crisis of 1997 drove internationally significant financial institutions such as Guangdong International Trust & Investment Corporation into actual bankruptcy. This compelled the government to undertake a bottom-up reorganization of the banks that it admitted publicly had 40 percent non-performing loan (NPL) levels. The origins of this restructuring can be traced to 1994, when the framework of a system that closely followed international arrangements was sketched out, including an independent central bank, commercial banks, and policy banks. The 1994 effort was stillborn, however, given the priority to bring raging inflation, which peaked at over 20 percent in 1995, under control. In short, China’s banking giants of 2010 were under-capitalized, poorly managed and, to all intents, bankrupt just 10 years ago.

A third decade has now gone by during which the banks completed their restructuring and subjected themselves to international governance and risk-management standards. By 2006, three of the four state banks had completed successful international IPOs. After the outbreak of the global financial crisis in 2008, China’s banks emerged as apparent world-beaters, besting their peer group in the developed economies in size of market capitalization and even topping the Fortune 500 list. They seemed to have weathered the global financial crisis well. But just, at this point, the Party, facing the seeming collapse of China’s export-driven economy, reverted to its traditional approach and ordered the banks to lend unstintingly to drive the economy forward. This green light may have erased whatever standards of governance and risk control that bank management had learned over the previous decade.

By the end of 2009, the banks had lent out over RMB9.56 trillion (US$1.4 trillion) and warning lights were flashing as capital-adequacy ratios approached minimum internationally mandated levels. In 2010, these banks are scrambling to arrange huge new capital injections totaling over US$70 billion (if Agricultural Bank of China’s IPO is included). Looking forward, the lending binge of 2009 threatens, and will most certainly generate problem loans of sufficient scale to require yet a third recapitalization in the next two to three years. China’s major state banks, the National Champions of the financial sector, appear to be heading toward a situation not unlike that of 1998. But their problems will, in fact, be much worse than 1998 since the old problem loans of the 1990s were only swept under the carpet. The “bad” banks, which took on those NPLs, were poorly structured, with the result that the “good” banks have remained liable. The government’s penchant for ad hoc funding arrangements, an unwillingness to open the problem-loan market to foreign participation, and the belief that it can perpetually put off the realization of losses pose a threat to the financial strength of China’s banks long before the NPLs of 2009 arise.

China’s banks look strong, but are fragile; in this, they are emblematic of the country itself. The Chinese are masters of the surface and excel at burying the telling detail in the passage of time. Their past experience tells them that this strategy works. But China, perhaps more than at any time in its long history, is now closely enmeshed with the larger world. The collapse of GITIC would never have taken place had it not been caught up in international financial arrangements. China’s financial system, similarly, has become increasingly complex; this complexity has begun to erode the effectiveness of the Party’s traditional problem-solving approach of simply shifting money from one pocket to another and letting time and fading memory do the rest. Tied up as it is in financial knots, the system’s size, scale and access to seemingly-limitless capital cannot forever solve the problems of the banks.


In China, capital begins and ends with the Big 4 banks. The banking system has thousands of entities if the 12 second-tier banks, the urban and rural banks, Postal Savings Bank, and credit cooperatives, are included. But the heart of the system includes just four: Bank of China (BOC), China Construction Bank (CCB), Agricultural Bank of China (ABC) and, the biggest of them all, Industrial and Commercial Bank of China (ICBC). In 2009, state-controlled commercial banks held over US$11 trillion in financial assets, of which the Big 4 banks alone accounted for over 70 percent (see Table 2.1). These four banks controlled 43 percent of China’s total financial assets.

TABLE 2.1 Relative holdings of fi nancial assets in China, FY2009 (RMB trillion)

Source: PBOC Financial Stability Report 2010, various.

Note: *includes brokerages and fund-management companies.


Such a concentration of financial assets in the banking system is typical of most low-income economies (see Figure 2.1).1 What differs in China’s case, however, is that the central government has unshakable control of the sector. Foreign banks hold, at best, little more than two percent of total financial assets (and only 1.7 percent after the lending binge of 2009), as compared to nearly 37 percent in the international lower-income group. This will not change anytime soon. A very senior Chinese banker was asked in early 2010 about the government’s strategy for foreign banks and where the foreign sector would be in five years. He replied after some thought: “I don’t believe anyone has thought much about this; I expect that in five years’ time, foreign bank assets will constitute perhaps two or three percent of total bank assets.” Despite the undeniable economic opening of the past 30 years and the WTO Agreement notwithstanding, China’s financial sector remains overwhelmingly in Beijing’s hands. There appears to be little political acceptance of the need to diversify the holders of financial risk.

FIGURE 2.1 Concentration of banking assets by country income group


Source: Data from 150 countries; based on Demirguc-Kunt and Levine (2004): 28

If one looks at incremental capital raising, it is obvious the stock markets in Hong Kong, Shenzhen and Shanghai are an afterthought. It is bank lending and bond issuance that keep the engine of China’s state-owned economy revving at high speed. For example, 2007 was a record year for Chinese equity financing: more than US$123 billion was raised, but in the same year, banks extended new loans totaling US$530 billion and debt issues in the bond market accounted for another US$581 billion. In the past decade, equity as a percentage of total capital raised has been measured in the single digits as compared with loans and debt. Who underwrites and holds all that fixed-income debt? Banks hold over 70 percent of all bonds, including those issued by the MOF (see Chapter 4). Taking this a bit further, in the stock markets as well, the huge deposits placed by institutional investors seeking share allocations in the primary market are also funded by loans from banks. In China, the banks are everything. The Party knows it, and uses them as both its weapon and its shield.


Today’s banking system is the child of the financial crises that began China’s 30 years of reform and ended each of its next two decades. At the close of the Cultural Revolution in 1976, there were no banks or any other institutions left functioning. Beijing faced the challenge of institutional design and it was natural that it fell back on traditional Soviet-inspired arrangements. These can be described roughly as a Big Budget, the MOF, and small banks that did little more than lend short-term money. Nor was there an important role for a central bank. Most important of all, the key management of the banks was not centrally controlled by Beijing, but by provincial Party committees (the local Party always needs money). Over the course of the 1980s, this arrangement built up into a lending spree that ended in inflation, corruption and near civil war in 1989. In 1992, the Party, fired up by Deng Xiaoping’s words in Shenzhen, took the economy and its banking system straight back to where it had been in 1988. There were spectacular bubbles and busts, most notably the Great Hainan Real Estate Bust of 1993 (outlined later in this chapter).

In line with its decision in 1990 to try out capitalist-inspired stock markets, in 1994, Beijing abandoned the Soviet banking model in favor of one based largely on the experience of the United States. New banking laws and accounting regulations, an independent central bank, and the transformation of the four state banks into commercial banks all followed. Three policy banks were established to hold non-commercial loans. This effort, however, was stillborn, sidetracked by Zhu Rongji’s greater priority to bring the country’s raging inflation under control. It took the Asian Financial Crisis and the collapse of GITIC in 1998 to catalyze a sustained effort to transform the banks along the lines of the framework adopted in 1994.

China’s leaders, no matter who they were or are, know that the country’s financial institutions are the source of the greatest threat to financial and social stability. They differ significantly, however, over how to minimize this threat. The traditional impulse of the Party has always been toward crude outright control. For the banking system, this has meant an absence of control and the creation of new crises. Realizing this, Zhu Rongji and his team adopted a more sophisticated approach from 1998. Much as they did in reforming the SOEs, this team sought to create a more independent banking system by adopting international methods of corporate governance and risk management. Once this was in place, the key decision was to submit the whole to the scrutiny of international regulators, auditors, investors and law by listing the banks in Hong Kong rather than in Shanghai. The experience of China’s banks in the 1980s and 1990s shows why Zhu would seek such an approach and also sheds light on bank behavior in 2009.

The expansive 1980s

In 1977, China was bankrupt; its commercial and political institutions in tatters. There was no real national economy, only a collection of local fiefdoms held together by a broken Party organization. What strategy could be used to pull it all back together? Looking back to the 1949 revolution, China had sought to create a central planning system with the assistance of Soviet advisors in the 1950s. But, parsing those years between 1950 and the Anti-Rightist Campaign of 1957, only a start had been made. From 1957 to 1962, Mao Zedong threw China into its first prolonged period of disorder and invited all Russians advisors to go home. Pushed aside when the heavy costs of the Great Leap Forward were totaled up, Mao quickly made his comeback and, in 1966, threw the country into chaos for a further 10 years.

Under such chaotic circumstances, how much of a government, much less any planning system, really could have been put in place? Whatever the answer, there was no banking system when the Gang of Four was deposed in 1976; everything had to be rebuilt and the only model anyone knew of was based on blueprints the Soviet advisors had left behind. At the start of the reform era in 1978, there was only one bank, the PBOC, and it was a department buried inside the MOF. From this small group of only 80 staff, a great burst of institution building began.

New banks and non-bank financial entities proliferated wildly in the government’s enthusiasm for what it saw then as financial modernization (see Table 2.2). By 1988, there were 20 banking institutions, 745 trust and investment companies, 34 securities companies, 180 pawn shops and an unknowable number of finance companies spread haphazardly across the nation. Every level of government succeeded in establishing its own set of financial entities, just as they have now set up “financing platforms” of every kind. It was as if money could be conjured up simply by hanging up a signboard with “financial” on it.

TABLE 2.2 The proliferation of financial institutions in the 1980s

Type and number of institution

Date founded


20 banking institutions including:

People’s Bank of China

January 1978

Bank of China

January 1978

People’s Construction Bank of China

August 1978

Agricultural Bank of China

March 1979

Industrial and Commercial Bank of China

January 1984

China Investment Bank

April 1994

Xiamen International Bank

December 1985

Postal Savings

January 1986

Ka Wah Bank

April 1986

Urban Credit Cooperatives

July 1986

Aijian Bank and Trust Co.

August 1986

Wenzhou Lucheng Urban Credit Cooperative

November 1986

Bank of Communications

April 1987

China Merchants Bank

April 1987

CITIC Industrial Bank

September 1987

Yantai Housing and Savings Bank

December 1987

Shenzhen Development Bank

December 1987

Fengfu Housing and Savings Bank

December 1987

Fujian Industrial Bank

August 1988

Guangdong Development Bank

September 1988


745 trust and investment companies including:

China International Trust & Investment Corp.

October 1979

ICBC Trust

April 1986

Shenyang Municipal Trust & Investment Co.

August 1986

China Agricultural Trust & Investment Corp.


Bank of China Trust & Investment Co.


China Economic Development Trust


Guangdong International Trust & Investment Co.

December 1980


34 securities companies



180 pawn shops

from 1984


an unknown number of finance companies

from 1984

At such an early stage of revival, and lacking any professional staff, banks could hardly be anything other than an appendage of the Party organization and the Party did not understand how to use the banks. This can be seen in the mission statement devised by the government for banks: “The central bank and the specialized banks should take as their objective economic development, currency stability and increasing social productivity.” This statement juxtaposed economic growth with a stable currency, but in the Party’s hands, the former will always win out. More critically, there was a basic flaw in institutional design: the banks were organized in line with the government administrative system. Although the PBOC may have been a part of the State Council in Beijing, its key operational offices were at the provincial level and here they were subordinate to local Party committees. Throughout the 1980s and into the 1990s, the local Party controlled the appointment of the senior PBOC branch managers as well as those of the other banks. Of course, the preference of the local government will always be for growth and easy access to money. As the consequent raging inflation in the late 1980s attested, combining poorly trained staff with political enthusiasm was tantamount to playing with fire.

Just as in 2009, these institutions loaned out money unstintingly so that by the late 1980s, inflation officially reached nearly 20 percent (see Figure 2.2). As administrative controls were imposed, there began to be runs on local bank branches. Inflation, corruption and lack of leadership experience eventually led to the events of 1989. After the crackdown of 1989 and 1990, the whole thing began again: a few speeches by Deng Xiaoping in Guangdong in early 1992 and the financial system ran out of control. The Great Hainan Real Estate Bust provides an illustration of just what this means.

FIGURE 2.2 Inflation vs. loan growth, 1981–1991


Source: China Statistical Yearbook, various; China Financial Statistics 1949–2005.

The Great Hainan Real Estate Bust

On April 6, 1988, the entire island province of Hainan was made a Special Economic Zone (SEZ). At that time, Hainan was not the home of super five-star resorts and skinny fashion models it has become today. It was a backward tropical island with few natural resources other than its beauty and geographic position near disputed oil and gas fields in the South China Sea. Thanks to Beijing’s decision, however, it unexpectedly became, for a brief time, China’s version of the Wild West. Hundreds of thousands of enthusiastic young people poured into the boom towns of Haikou and Sanya, attracted by the promise of economic growth that more than 30 favorable investment policies were expected to generate. These policies encouraged the creation of an export industry and this, in turn, was expected to lead to a boom in hotels, entertainment and, of course, real estate.

If Shenzhen was the most westernized SEZ because of its proximity to Hong Kong, then Hainan was the pure Chinese version. In a territory the size of Taiwan, and in a complete financial vacuum, 21 trust companies sprang into existence. In Hainan, the trust companies were the banking sector; there was nothing else. Competition was intense in what was the nearest to virgin economic space that China could present. No one thought about any export industry. Everyone understood their opportunity: real estate. In China, it is always real estate. The special status of the trust companies, together with new policies permitting the sale of land-use rights, created explosive profit opportunities. Suddenly, 20,000 real-estate companies materialized—one for every 80 people on the island. Housing prices doubled twice in three years.

The catalyst to Hainan’s real-estate craze came from the outside: the Japanese developer Kumagai Gumi, later bankrupted by the Asian Financial Crisis, acquired a 70-year lease on 30 square kilometers of land encompassing the entire port area of Haikou. Imagine that deal! Instead of developing port facilities, the company turned to residential development, selling 900 mu (about 150 acres) of land at RMB3 million per mu. Why would any businessman develop port facilities when industrial land only sold for RMB130,000 to RMB150,000? With such opportunities, it was not an empty boast when people spoke of buying up every inch of land in Haikou. The Hainan get-rich-quick business model soon became the envy of the entire country in 1992, the year Chinese history seemed to come to an end and everything seemed possible.

Then came 1993 and the start of Zhu Rongji’s efforts to bring the national economy, and the real-estate sector in particular, under control. The geese and their golden eggs disappeared; speculators fled, leaving some 600 unfinished buildings and RMB30 billion (US$4 billion) in bad debt behind. In this one SEZ alone, publicized bad debt totaled nearly 10 percent of the national budget and eight percent of the national total of non-performing property assets! This is what creative local financing in China means. Today in 2010, in every provincial capital across the country, exactly the same kind of real-estate boom has developed and for the same reasons: Party-driven bank lending.

The Hainan debacle led directly to the Party’s first effort to develop “good” bank/“bad” bank reforms in 1994. As part of a host of initiatives, three policy banks, including the now-prominent China Development Bank (CDB), were established to hold strategic, but non-commercial, loans. At the same time, the Big 4 banks were meant to become fully commercial institutions. This strategy to modernize the Big 4 banks, however, never gained traction until 1998 when GITIC collapsed.

Guangdong International Trust & Investment Corporation

The Hainan blowout was containable within the Chinese system; the GITIC implosion was not because it and Guangdong were exposed to the global economy. GITIC’s financial collapse in 1998 posed a real threat to China that has been all but forgotten. But GITIC, and how it was controlled by the provincial Party, is little different from how today’s financial institutions are managed and regulated. After all, as recently as 2008, the mighty Citic Pacific burned up over US$2 billion on a purely speculative and un-hedged foreign-exchange bet (and had to be recapitalized). GITIC came at the time when the entire Asian development model had exploded into the Asia Financial Crisis. Despite the calm face it presented to the outside world, China was severely affected by dramatically decreased export demand channeled through Guangdong Province, which was then, as now, that part of the country most exposed to international trade and investment. At the time, just 10 years ago, China’s total foreign-exchange reserves were only US$145 billion, as compared to its international debt of US$139 billion.

GITIC’s bankruptcy, still the first and only formal bankruptcy of a major financial entity in China, threw unwanted light on the Party’s financial arrangements. It called into question the central government’s commitment, if not its capacity, to stand behind its most important financial institutions. GITIC in the 1990s was, after CITIC, the nation’s largest and most prominent trust company and acted as the international borrowing “window” for Guangdong, its richest province. In 1993, prior to issuing its first (and only) US$150 million bond in the US, GITIC received the same investment-grade rating from Moody’s and Standard & Poor’s as the MOF. Its senior managers were well known among foreign bankers for their active participation in cross-border foreign-currency and derivatives markets. One of its subsidiaries was publicly listed in Hong Kong and its chairman had been the subject of a BusinessWeek cover story.2 All foreign bankers were “close” friends with Chairman Huang and all had drunk his premium wines in the club at the top of the company’s 60-storey tower in Guangzhou. GITIC was a National Champion before there were National Champions.

The outcome of what started as a familiar story of poor management showed how seriously Premier Zhu Rongji took the issue of moral hazard and the threat posed by a weak financial system. This stands in direct contrast to the government’s approach to the banks in 2009, as will be discussed in later sections. The proximate cause of GITIC’s collapse was its inability to repay US$120 million to foreign lenders in 1998. Zhu Rongji, outraged that its financial losses were unquantifiable, ordered Wang Qishan, then senior vice-governor of Guangdong, to close GITIC in October 1998. In January 1999, it was declared bankrupt in what was a huge shock to the international financial community’s view of China. Rumors rapidly began to spread, both inside and outside the country, that “China’s commercial banks are technically bankrupt.” These threatening assertions forced Premier Zhu to make the following clarification to reporters at a news conference following the National People’s Congress in March 1999:

I think that those [international] banks and a few financial institutions are too pessimistic in their estimates of this problem; that is, they believe that China is already in the midst of a financial crisis and does not have the capacity to support its payments and is not creditworthy. China’s economy is rapidly growing; we have US$147 billion in reserves and balanced international payments. We are completely able to repay our debt. The issue is whether or not the government should repay this kind of debt.3

Given the level of international concern and a desire to enforce financial discipline, Zhu ordered GITIC’s bankruptcy to proceed in accordance with international standards. A fully transparent process was led by the international accounting firm KPMG acting as the company’s liquidator. GITIC was publicly investigated more thoroughly than perhaps any Chinese financial institution before or since. The findings are a matter of public record and should not be forgotten. The scale of its failure was breathtaking. A preliminary KPMG review of its finances as of April 1999 showed total assets of US$2.6 billion set against liabilities of US$4.4 billion. During the four-year liquidation process, 494 creditors registered claims totaling US$5.6 billion, of which US$4.7 billion represented those of 320 foreign creditors.

In the end, GITIC’s creditors faced the fact that 90 percent of the company’s loans and commitments were unlikely to ever be met. Over 80 percent of its equity investments in some 105 projects spread across the province had also failed and were without value. The recovery rates for GITIC alone was 12.5 percent and for its three principal subsidiaries ranged from 11.5 percent to 28 percent. The picture this presents of the operations of a major financial institution was shocking and continues to be shocking: just where did these billions of dollars go? The answer is that many of the real-estate and infrastructure projects GITIC financed are still there, but are now owned by other arms of the government.

Today, in 2010, bank officials and regulators readily admit that much of the lending in 2009 went to projects without immediate cash flow, such as real estate and high-speed railways. Even so, they continue, in the future such infrastructure will be of great value. What they are describing is the GITIC financing model. The only question is: which entity will end up holding today’s bad loans?

In 1998, however, Zhu Rongji did not take such a sanguine view of bad lending. The collapse of GITIC led to the closure of hundreds of trust companies and thousands of urban credit cooperatives across the country. More importantly, it initiated a serious effort to centralize control of the Big 4 banks in Beijing’s hands and marked the start of their restructuring. Zhu Rongji got it: if GITIC was a hyped-up financial fraud, were the state banks any different? The answer was “No” and so began the strong effort to recast China’s banking system after that of the United States, which was seen then as the best.


It is a testimony to the extensive bank restructuring demanded by Zhu Rongji that China’s banks have withstood the global financial crisis so well. While many major banks in developed countries were bankrupted by the crisis in 2008, China’s banks have emerged seemingly untouched and, some would argue, even strengthened. Listed on the Hong Kong and Shanghai Stock Exchanges, six of these banks now rank highly in the Fortune 500 and one, ICBC, is the largest by market capitalization in the world and the second-largest company overall, behind only ExxonMobile (see Figure 2.3). In contrast, JPMorgan, currently America’s strongest bank, comes in at a distant nineteenth place. Compared to 1998 when their non-performing loan ratio exceeded 40 percent, China’s banks have obviously come a long way.

FIGURE 2.3 Fortune 500 ranking of Chinese banks vs. JPMorgan Chase, FY2008


Source: Bloomberg and Fortune

It is true that China’s banks today are stronger and their staff more professional than 10 years ago. Senior management has been quick to learn to “walk the walk” and talk the banker talk and there is a more sophisticated, internationally savvy banking regulator. A closer look, however, suggests that organizational miracles are miracles precisely because they are few and far between. The market-capitalization data shown in Figure 2.3 is a misleading comparison of apples to oranges. Can a JPMorgan, with 100 percent of its shares capable of being traded in the market each day, be compared to banks such as ICBC that have less than 30 percent of their shares tradable (see Figure 2.4)? Market-capitalization figures are based on a traded market price for one share multiplied by the bank’s total number of shares. This assumes, as is always true in international markets, that the entirety of a company’s shares is listed. The resulting market-cap figure, therefore, represents investors’ consensus on the valuation of a company’s ongoing operations. As has been shown elsewhere,4 since A-shares, H-shares, and China’s famous variety of non-tradable shares all have different valuations, the value of the ICBC’s market-cap figure will vary enormously depending on which price is used.

FIGURE 2.4 Comparative share floatation of listed banks, FY2008


Source: Wind Information

To arrive at the ICBC’s market-cap figure, Bloomberg analysts added the value of the bank’s Hong Kong-listed shares to that of all the domestic shares. But the domestic shares include A-shares trading on the market in Shanghai and the formerly non-tradable, now locked up, shares held by government agencies. These latter shares are valued at the full tradable A-share price. What would be the value of an ICBC A-share if the government decided to sell even a small part of its 70 percent holdings? The answer has already been provided by the market reaction in June 2001 to the CSRC’s plans to do just that: prices collapsed.5 This share structure and the company valuation problem is the same for all other Chinese banks and companies. There is no good way to arrive at a market-cap figure that is comparable to listed companies in developed markets and private economies.

To illustrate this point further, take the following simplistic calculation: use 30 percent, the amount of its tradable market float, of ICBC’s market-cap figure of US$201 billion, or US$60 billion, as a rough proxy for the bank’s market value. This approach gives consideration to the dilution effect of the current 70 percent of the bank’s shares as if they were available to trade. Despite its crudeness, this result is no less inaccurate than any other. Whatever the number, this serves to highlight the fact that China’s banks are worth somewhat less than the number the Bloomberg researchers calculate.

Markets are not simply a valuation mechanism. International stock exchanges are called markets because companies can be bought and sold on them. In China and Hong Kong, given absolute majority government control, shares trade, but companies do not. Major merger and acquisition (M&A) transactions do not take place through the exchanges; they are the result of government amalgamations of state assets at artificial prices. Would that it were possible to gain a controlling interest in a listed Chinese bank or securities company simply by acquiring its listed shares and making a public tender!

One way to make a straightforward comparison between US and Chinese banks is based on their total assets. The fact that many international banks are larger than even the largest Chinese banks is not unreasonable given that the respective GDPs of many developed economies are many times that of China. But as the data in Figure 2.5 illustrate, the Big 4 banks are in the same league as many of their international peers and they tower over Chinese second-tier banks. Asset size gives an idea of significance to the economy but, taken alone, is not a good measure of the strength of these banks; asset quality is.

FIGURE 2.5 Selected international and Chinese banks by total assets, FY2008


Source:The Banker and respective annual reports

This gets to the true heart of the issue. Understanding how the Chinese banks were relieved of their problem-loan burdens leads to a clear understanding of their continuing weakness. The data in Figure 2.6 show an impressive and factual reduction in total non-performing commercial bank loans over the seven years through 2008. In 1999, the NPL ratio (simply put, bad loans divided by total loans) of the Big 4 banks was a massive 39 percent just before spinning off the first batch of bad loans totaling US$170 billion in 2000. From 2001 to 2005 ICBC, CCB, and BOC spun off or wrote off a further US$200 billion. In 2007, ABC, the last of the major banks to restructure, spun off another US$112 billion, making a total among the four banks of around US$480 billion.

FIGURE 2.6 Non-performing loan trends in the top 17 Chinese banks, 1999–2008


Source: PBOC, Financial Stability Report, various; Li Liming, p. 185

It is thought that the bulk of these bad loans originated in the late 1980s and early 1990s when bank lending flew out of control, as it did in 2009. If that is the case, this nearly US$480 billion in bad loans was equivalent to about 20 percent of China’s GDP for the five-year period from 1988 to 1993, the year Zhu Rongji applied the brakes. A more important point, perhaps, is that the banks silently carried these NPLs for a further five years before anything was about them and another 10 years went by before they were said to be fully worked out (but not written off).

The US savings-and-loan crisis of the 1980s may help put China’s NPL experience into some perspective. The Federal Deposit Insurance Corporation (FDIC) has calculated that during the 1986–1999 period in the US, the combined closure of 1,043 thrift institutions holding US$519 billion in assets resulted in a net loss after recoveries to taxpayers and the thrift industry of US$153 billion at the end of the clean-up in 1999.6 In other words, the recovery rate achieved was over 60 percent. In contrast, the commonly noted rate in China after 10 years of NPL-workout efforts is considered to be around 20 percent.

This vast difference in recovery rates on comparable amounts, together with the dramatic decrease in NPLs shown in Figure2.6, raises a host of questions. If, in fact, the NPL rates of Chinese banks have now improved to such a degree, is it because they are lending to better companies that have the capacity as well as the willingness to repay, or did their original SOE clients simply start to pay again? If the latter is the case, why were the previous problem-loan recovery rates so low? A significant change in client base can be ruled out: Chinese banks overwhelmingly lend to SOEs and always have, largely because they are viewed as reliable, unlike private companies. In retrospect, this attitude seems to be mistaken.

The Party tells the banks to loan to the SOEs, but it seems unable to tell the SOEs to repay the loans. This gets at the nub of the issue: the Party wants the banks to support the SOEs in all circumstances. If the SOEs fail to repay, the Party won’t blame bank management for losing money; it will only blame bankers for not doing what they are told. Simply reforming the banks cannot change SOE behavior or that of the Party itself. Improved NPL ratios over the past 10 years, therefore, suggest a dramatic improvement in the willingness of SOE clients to meet their loan commitments, the selection of investment projects that actually generate real cash flow, or some other arrangement for bad loans.


If it is true that lending standards have improved significantly, perhaps there is no need to be concerned about the after-effects of the 2009 lending binge; the quality of Chinese bank balance sheets will remain sound and the level of write-offs manageable. The frantic scrambling for more capital from early in 2010, however, suggests otherwise. The CEO of ICBC, Yang Kaisheng, has written a uniquely direct article analyzing the challenges facing China’s banks.7 In it, he describes China’s financial system:

In our country’s current level of economic development, we must maintain a level of macroeconomic growth of around eight percent per annum and this will inevitably require a corresponding level of capital investment. Our country’s financial system is primarily characterized by indirect financing (via banks); the scale of direct financing (via capital markets) is limited.

This statement of fact says two important things about China’s banking system. First, there is an overall economic goal of eight percent growth per year that requires “capital investment.” Second, the source of capital in China relies mainly on the banks. In other words, bank lending is the only way to achieve eight percent GDP growth.

With estimates of loan growth, profitability and dividend payout ratios, Yang then states that the Big 3 banks plus the Bank of Communications will, over the next five years, need RMB480 billion (US$70 billion) in new capital.8 Yang is saying “raised over five years,” but these banks are trying to raise this amount in just one year, 2010. Putting aside ABC’s proposed US$29 billion IPO goal, by April 2010, the other banks had already announced plans to raise RMB287 billion (US$42.1 billion), as shown in Table 2.3.

TABLE 2.3 Reported capital-raising plans by the Big 5 banks, May 2010

Source: Annual and interim bank reports, Bloomberg; industry estimates as of May 2010


This is an astounding amount, coming as it does only four to five years after their huge IPOs in 2005 and 2006 had raised a total of US$44.4 billion. Yang goes on to say that if market risk, operating risk, and increasingly stringent definitions of capital requirements are considered, then the capital required will be even greater. What he doesn’t mention, though, is the risk of bad loans. It would seem that Yang’s point in citing these facts is that China’s current Party-led banking arrangements do not work, in spite of the picture presented to the outside world. It is a defense of the model put forward by Zhu Rongji in 1998.

The experience of the past 30 years shows that China’s banks and their business model is extremely capital-intensive. The banks boomed and went bust with regularity at the end of the 1970s, 1980s and 1990s. Now another decade has gone by and the banks have run out of capital again. Even though they appear healthy and have each announced record profits and low problem-loan ratios for 2009, the Tier 1 capital ratios of the Big 3 are rapidly approaching nine percent, down from a strong 11 percent just after their IPOs in 2005 and 2006. Of course, the lending spree of 2009 was the proximate cause. As an analyst at a prominent international bank commented: “The growth model of China banks requires them to come to the capital markets every few years. There’s no way out and this will be a long-term overhang on the market.”9 But it is not just the lending of 2009 or even their business model that drives their unending thirst for capital; it is also their dividend policies.

The data in Figure 2.7 show actual cash dividends paid out by the Big 3 banks over the period 2004–2008, during which each was incorporated and then listed in Hong Kong and Shanghai. The figure also shows the funds raised by these banks from domestic and international equity investors in their IPOs. The money paid out in dividends, equivalent to US$42 billion, matches exactly the money raised in the markets. What does this mean? It means international and domestic investors put cash into the listed Chinese banks simply to pre-fund the dividends paid out by the banks largely to the MOF and Central SAFE Investment. These dividends represented a transfer of real third-party cash from the banks directly to the state’s coffers. Why wouldn’t international investors keep the cash in the first place?

FIGURE 2.7 Bank IPOs pre-fund cash dividends paid, 2004–2008


Source: Wind Information for IPO amounts; Statement of cash flows, bank annual reports

Investors, as opposed to speculators, put their money in the stocks of companies, including banks, in the expectation that management will create value. But in these three banks, this is not what is happening because the capital did not stay in the banks. Yes, the minority international investors acquired stocks that vary in value in line with market movements. This gives the impression of value creation on their portfolios, but these movements are, in fact, due more to speculation on market movements driven by any number of factors including, for example, overall Chinese economic performance. This should not be confused with value investing: the banks themselves are not putting the money to work to make the investor a capital return. For this reason alone, the market-capitalization rankings are misleading.

As for the Chinese state, which holds the overwhelming majority stake in these banks, such payouts mean the banks will require ongoing capital-market funding after their IPOs. This, in turn, means the government must, in effect, re-contribute the dividends received as a new equity injection just to prevent having its holdings diluted. There can be only one IPO for each bank and one infusion of purely third-party capital.10 What is the purpose of running a bank that pays dividends to a state that must then turn around and put the same money back again? Why sustain dividend payout ratios at 50 percent or higher? This begins to look very much like some sort of Ponzi scheme, but to whose benefit?

Of course, it is more than that: China’s banks are the country’s financial system. But, as the analyst said, they operate a business model that requires large chunks of new capital at regular intervals. With high dividend payouts and rapid asset growth, consideration must inevitably be given to the issue of problem loans. How can banks as large as China’s grow their balance sheets at a rate of 40 percent a year, as BOC did in 2009, without considering this? Even in normal years, the Big 4 banks increase their assets through lending at nearly 20 percent per annum. Throughout 2009, as the banks lent out huge amounts of money, their senior management emphasized over and again that lending standards were being maintained. How was it, then, that the chief risk officer of a major second-tier bank could exclaim even before 2009: “I just don’t understand how these banks can maintain such low bad-loan ratios when I can’t?” His astonishment suggests there may be less-than-stringent management of loan standards by the banks’ credit departments. This is undoubtedly true.

The most important fact behind the quality of these balance sheets, however, goes beyond common accounting manipulations or even making bad loans. These things are inevitable almost anywhere. It goes back to the financial arrangements made by the Party when weak bank balance sheets were restructured over the years from 1998 to 2007. A close look at how these banks were originally restructured highlights the political compromises made during this decade-long process. These compromises have been papered over by time and weak memories on all sides: it is highly likely, for example, that China’s national leaders believe that their banks are world-beaters. In the past, sweeping history under the carpet might have been enough; people would have forgotten. Today, it is far from enough, even for those operating inside the system. The key difference with the past is that the quest to modernize China’s banks was made possible by raising new capital from international strategic investors and from subsequent IPOs on international markets. China’s major banks are now an important part of international capital markets and subject to greater scrutiny and higher performance standards . . . just as Zhu Rongji had planned.


1 See Demirguc-Kuntand Levine 2004: 28.

2 “Inside the world of a red capitalist: Huang Yantian’s financial powerhouse is helping to remake China,” BusinessWeek, May 1994.

3 Li, Liming and Cao, Renxiong, 1979–2006 Zhongguo jinrong dabiange image (1979–2006 The Great Reform of China’s banking system). Shanghai: Shiji chuban jituan image: 474.

4 Walter and Howie 2006: 181ff.

5 Ibid., Chapter 9.

6 Curry and Shibut 2000.

7 21st Century Business Herald 21 image, April 13, 2010: 10.

8 Yang excludes ABC, which listed its shares later in 2010.

9 “ICBC says China’s banks need $70 billion capital,” Bloomberg News, April 13, 2010.

10 The first round of fund raising via an IPO involves the sale of new shares. This brings new capital into the bank and dilutes the original shareholdings. Thereafter, if the bank sells shares again, the Chinese state must also inject money or have its stake diluted.

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