How China Forces Savers to Support SOEs
May 17, 2011
China's recent crackdown on underground banks is the latest sign that the leadership fears the banking system is vulnerable to a financial crisis. It believes that protecting the state banks from competition is the only way to safeguard the whole state apparatus, including banks, SOEs and the party. If the state banks (which are the four commercial banks plus the policy banks China International Trust and Investment Corp. and Bank of Communications) start losing deposits to nonstate banks, they will have less cash to lend to state-owned enterprises (SOEs). Given that over 90% of the circulating funds of the SOEs are financed by state bank loans, loan cutbacks would leave them insolvent. But even after cutting back on loans, a drop in deposits would still leave state banks without cash, since SOEs can pay only about 8% of the servicing on their loans. This series of events, albeit unlikely, could trigger a string of financial defaults in the state sector and a financial crisis that could only be averted by huge cash injections and debt clearance by the central bank. Such a crisis would cause incredible damage to the economy. China's state banks supply over 60% of China's total loans, control over 80% of its financial assets, employ 57% of all financial-sector employees, and own over 70% of all Chinese bank branches. China's outstanding loans were over $600 billion in 2010, almost equal to China's 2010 gross domestic product. About $240 billion, or 40%, of these loans are nonperforming. The combination of the SOEs' welfare-style benefits for employees and controlled prices for their products has reduced both their incentive and ability to be profitable. In 2010, they consumed 73.5% of industrial investment, employed 70% of the industrial labor force, yet only produced 45% of the country's output. Despite their disproportionate access to investment funds, value added per SOE worker is half that of nonstate companies. But despite the state companies' poor performance, the Communist Party forces state banks through the State Council to continue supporting them because they are the only remaining major constituency for the party, and many are owned by the military. Therefore, any defaults in the state sector could lead not only to a financial crisis, but also to a political and social crisis. The government, however, can't help the banks with the SOEs' unpaid debt. Government revenue as a percentage of GNP has fallen to 11% in 2010 from 21.5% in 1985. It is interesting that the illegal financial sector arose in the first place out of the banks' own desire to avoid a financial crisis. In light of their loan quotas, interest rate caps, and forced lending to state companies, the only attractive option available is turning to the underground loan market. There are three major underground loan markets in China, and the state banks are involved in all of them. The three underground markets are bank to bank (interbank) loans, bank loans to companies, and company to company loans. Most transactions involve a combination of arrangements to disguise the loans. The current underground loan rates for interbank loans is between 14% and 15%; bank loans to companies cost between 16% and 20%; and company-to-company loans cost between 20% and 24%. Historically, the illegal loan rates have been at least double the official loan rates. The loan rates are dependent on the closeness of the relationships between the participating parties--the better the relationship, the lower the loan rate. Deposits at nonstate banks are not guaranteed, so the spread between illegal and official loan rates is smaller. In fact, though there actually were illegal banks involved, they accounted for a small part of the underground activity. The government's crackdown mostly relates to illegal lending activity by otherwise legal institutions. Typical underground loan transactions involve having legal banks circumvent interest-rate caps by offering large depositors and borrowers above-market rates. The banks, the depositors and agents who do the legwork of finding companies in need of cash all split the interest rate spread between the illegal and the official rates, while the borrowing company gets the loan it would not otherwise have received. Indeed, it often does not matter if the company pays the loan back, because the state banks' deposits are fully guaranteed by the central bank. The borrowing company has already paid the spread up front, and the depositors still earn the legal rate on their deposit. The interbank market became a conduit for banks to lend to their subsidiaries for activities outside the government's credit plan. Some $23.25 billion (10% of the total) of state-bank loans between 1992 and 1993 were illegally loaned on the underground loan market via interbank loans between state banks and other financial institutions to private corporations-though 67% could not be recalled. They circumvent quotas. Why did this whole mess take place? China's leadership has traditionally solved problems based upon the famous Chinese idiom ``have head pain, fix head; have foot pain, fix foot,'' rather than trying to solve the root of the problem. Until China's government attempts to remove the structural distortions in China's financial system, such as loan quotas, interest rate and price caps that naturally force institutions to engage in illegal actions, and encourage new market entrants to compete with the state sector, China's financial system will continue to be one of the least efficient and developed financial systems in Asia. Survival is an instinct inherent in both individuals and institutions, and the private market has proved to be the best way to mediate competition among the players. If China's state institutions could charge market rates reflecting relative risk and scarcity, the underground market would dissolve and the state would actually capture more profits and start growing out of its self-destructing, centrally planned economy. China, and its 1.2 billion people, would escape an impending potential financial crisis. Mr. Brennan is a consultant for Richina Advisors, a Beijing-based management consulting firm.
