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Saturday, October 29, 2005

The Economist: China's Risky Strategy for Financial Sector Reform

The Economist is worried that China's insistence on attempting to reform its financial sector without lifting limits on foreign ownership of financial sector firms puts their economic future at risk:

A great big banking gamble, The Economist: It is a staggering thought... At more than $66 billion following its initial public offering ... on October 27th, China Construction Bank (CCB) ... is the largest global flotation for four years, China's biggest and the biggest ever for a bank. ... This is quite a transformation for a bank that was technically insolvent less than two years ago and ... is still a government agency, plagued by bad debts and corruption... Beijing is encouraging this rush to market as the most fundamental step in reforming the economy since Deng Xiaoping opened China to the world in the late 1970s. Since then, the country's banks have been almost wholly responsible for channelling the population's sky-high savings into industry and investment. Given China's failure to develop healthy stock and bond markets, bank assets have ballooned ... Sadly the banks have been disastrous middlemen, lending on government instruction without a view to their profits. ... That is why overhauling its banks is so critical to securing the country's future growth. China's political leaders have an iron commitment to bank reform—a commitment backed with cash. ... Beijing realises ... that money alone will not do the trick. ... it has raised accounting, prudential and regulatory standards. ... The biggest change, though, has been the creation of a central regulator, the China Banking Regulatory Commission (CBRC)...

The restructuring has been helped by a benign environment. ... Strong revenue growth and offloading bad debts on to the government has inflated bank profitability. ... CCB looks much cleaner, ...has stronger reserves, .... Its listing prospectus says that loans to “new” customers ... are one-third as likely to go sour as those to older clients, suggesting regulations are working. ... Well, it would, if that were indeed ... true... Independent estimates put bad debts at 20-25%, far exceeding official figures. ... bad loans are rising, not falling ... If economic growth slows, a new wave of bad loans will hit. ... Chinese banks [do not have] the earnings power to absorb them... Two sobering conclusions follow. The first is that even a tiny deterioration in business conditions ... would wipe out earnings at China's banks. The second is that even if the economy remains good, the banks cannot generate enough internal capital to support their current levels of loan growth. ... To close that gap will take a fundamental transformation of how Chinese banks operate. The banks simply do not understand how to price risk or spot a dodgy borrower. Neither flexible interest rates nor loan classifications can help if credit officers cannot tell good loans from bad. The current boom has led loan officers to believe the value of collateral always goes up. The real battle for bank reform will be won or lost in the branches. ... These are massive organisations to turn around, after all. CCB alone has 14,250 branches and 304,000 employees. ...

Meanwhile, strategic foreign investors are supposed to bridge the gap—with money, but especially with skills in risk management and advanced financial products. ... given limited ownership rules, foreign banks can have only a modest influence on strategy or operations at their Chinese partners. ... To reform its banks properly, China must allow foreign takeovers. And its banks must be allowed to merge and fail. ... as banks in Poland and the Czech Republic discovered, preventing foreign takeovers simply delays bank reform and means more costly bail-outs. ... Instead, China is gambling on going it alone. By rushing poorly reformed banks to market and sucking in a bit of money and know-how ... from foreign investors, it hopes to improve them sufficiently and sufficiently rapidly before the economy runs into a headwind. The size of that gamble should not be underestimated.

    Posted by on Saturday, October 29, 2005 at 12:27 AM in China, Economics, Financial System | Permalink  TrackBack (0)  Comments (6)

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