Boom...or bust: Is China heading for big trouble?

A surge in lending and a dash to buy houses is pushing the communist-run country down the West's path to crisis. Richard Northedge reports
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The Independent Online

A surge in bank lending. A speculative rush to buy houses – not just second properties, but third or fourth homes. Soaring property prices. Banks hiding the loans off their balance sheets. Surely it could not be happening again? And not so soon? But it is – in China.

The world's most populous country survived the crash that crippled economies in the West, but Beijing did so by stimulating spending, especially by pushing money into property. Now the regulators are worried that boom will lead to bust there too.

The China Banking Regulatory Commission (CBRC) has asked the country's lenders to stress-test their balance sheets to see what will happen if house prices fall by 10 per cent, 20 per cent or 30 per cent.

The answers are worrying. Banks have been told to raise more capital to strengthen their reserves and curb property lending, though they will not have to bring off-balance-sheet loans – estimated at £200bn – into their accounts until the end of next year. But three of China's biggest banks announced plans last week to raise more than 200bn yuan (£19bn) from shareholders.

However, in a country still moving from communism to capitalism, the banks, the borrowers and the shareholders are all part of the state. Although leading banks such as Bank of China, China Construction Bank, and Industrial and Commercial Bank of China are listed on the Beijing or Shanghai stock markets, the state still controls them via its Central Huijin Investment vehicle. The government must thus subscribe for much of the new capital or see its stakes diluted.

Over the past decade, Western countries have relied on China as a source of both cheap imports and capital as the export proceeds are reinvested in America or Europe. But the property boom has absorbed not only money that would have been deposited in foreign countries but funds that would have been lent to small businesses. A growing proportion of the Chinese economy is based on inflated property values rather than manufacturing or exporting.

Bank lending rose by a third last year to a record £1trn, but much of it was to state-owned enterprises (SOEs) many of them property and construction companies. Local government bodies were among the land speculators. If these borrowers default, it will mean public agencies failing to repay public banks that require public money to save them. Central Huijin Investment issued Y54bn of bonds last week to fund the banks' recapitalisation, and plans Y134bn of further issues, but the main buyers of such bonds are the commercial banks that it is helping.

Observers fear the Chinese banking system is creating an unsustainable pyramid of debt and that once banks stop lending, property prices will tumble and borrowers will default, leaving banks with bad debts – the same chain of events that caused chaos in the West. Officially, property prices rose 12.4 per cent over the past year, but, in a huge country, that average disguises sharp peaks, especially in the Yangtze and Pearl River delta regions.

The World Bank is watching the situation carefully. "Developments since the onset of the global crisis have triggered questions about the role of state-owned enterprises," admits Ardo Hansson, the bank's lead economist.

"With its emphasis on construction and infrastructure, the stimulus has directly benefited SOEs more than non-SOEs. Most large construction companies and steel and cement companies supplying them are SOEs, and having close relationships with the governments and the banks, the SOEs seem to have benefited strongly from the monetary stimulus," he says.

"Moreover, the local government platforms carrying out the infrastructure construction that boosted investment into 2009 are classed as state-owned enterprises. Easy credit also led some SOEs to spend heavily on land amid the property boom."

Xiao Gang, the chairman of the Bank of China – which announced its own plans last week for a Y60bn rights issue – denies banks were told to raise lending or make loans to government agencies. "Many people have reasons to believe that China's lending spree last year – which saw record new loan volumes of nearly Y10trn – was the result of the government's intervention," admits Xiao, adding sarcastically: "The evidence seems obvious; the government holds stakes in those banks and appoints the chief executives. Naturally, the banks became the movement's cash-machine. But this is not true. They did not act on government orders. I never received any instruction from the government."

But in remarkably frank admissions, he conceded that Chinese banks were motivated by many of the same faults that led to the financial crisis in Europe and the US. Banks wanted to expand their lending before the crisis was curbed by regulators, he said. "During the crisis, the government stimulus package created a window of opportunity for which the banks had been waiting for years. Part of this included lifting the cap on bank lending. Profit is the main driving force of banks. Listed banks have shareholders. Money must be made each quarter and each year to improve certain performance indices," says Xiao. Bankers' performance-based bonuses account for half to 70 per cent of pay, he says.

Net interest margins on domestic lending are almost double those on international loans, the bank chairman said. "In such an environment, which bank wouldn't want to increase its lending? The more banks lend, the more profit they earn. Simple." And, he adds: "Chinese banks are smart enough to take the risk-averse approach and focus on lending to large state-owned enterprises. These SOEs often enjoy monopolies in their sectors and favourable conditions in an industry, and enjoy quasi-government credit ratings."

This has improved the quality of the banks' loan books, even though it has been at the expense of lending to small and medium-size enterprises, he claims. "The banks are fully aware of the risk of granting loans to SMEs, which are more often than not short-lived and often lack transparent financial transactions," he said. "What's more, once an SME loan turns bad, bank staff are more likely to be questioned – and perhaps punished – than if an SOE defaults. Often such questioning is accompanied by suspicions of corruption."

He blames competition between banks for the surge in lending, and the pressure to match other lenders. And, echoing the "irrational exuberance" comment by former US Federal Reserve chairman Alan Greenspan, Xiao admitted: "This 'herd' instinct could have contributed to the irrational expansion of their business."

The China Banking Regulatory Commission claims to have learnt lessons from the Western crash, but its vice-chairman, Wang Huaqing, is critical of US and British control systems. "The complicated, overlayering supervisory architecture of the US has failed to effectively guard against the global financial crisis," he says. "Similarly, the unified supervisory architecture in the UK has performed no better. Just like there is no unified corporate governance model in the world, there is no one-size-fits-all supervisory architecture."

The watchdog has told banks to curb property lending, however, especially to borrowers seeking to buy third homes. Agricultural Bank of China resumed lending on Wednesday after an eight-day freeze.

China's economic growth will fall from 11.1 per cent to 9.7 per cent next year according to estimates by the Organisation for Economic Co-operation and Development. Such a figure would be welcome in the West, but Hansson at the World Bank warns: "Real-estate investment is set to contribute significantly to growth in most of 2010. But later in the year, the impact of recent property tightening measures should kick in. The mortgage-related measures are likely to affect housing sales, and presumably prices, substantially."

The banking regulator is still analysing how a substantial fall in property prices could affect lenders. A spokesman admits to asking banks how a 10, 20 and 30 per cent fall in average house prices would impact on loans. "Different scenarios and assumptions do not represent the CBRC's view on the trend of real estate market development, and do not signal changes in the credit policies of the real-estate market."

No more boom and bust then? At Bank of China, chairman Xiao is cautious. "Things are complicated," he says. "So will be the solution."

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