The global economic contagion has spread to China, sending shudders around the world. Chinese leaders are worried about domestic social unrest, while U.S. leaders are worried about whether China will continue loading up on Treasury securities as our budget deficit explodes.
Yet one of the few bright spots is the surprising strength of China's banking system. Remember when that system seemed on the verge of collapse? That's where the banks stood until the reforms of the past 10 years.
But now the picture is completely different. As former World Bank official Pieter Bottelier, now a professor at Johns Hopkins, notes, "The irony is that 10 years ago, China's banks were among the weakest in the world and today they are among the strongest, however primitive their system."
How did they turn things around?
The short answer is that the Chinese government imposed many of the same market-based principles used in the West. (We'll get to why they seem to work better in China in a minute.) Officials improved regulations and supervision, introducing risk capital requirements and tightening nonperforming loan criteria and provision standards.
The government allowed banks to be listed on stock exchanges, which meant they had to report their earnings according to Western accounting standards. Now two of the world's three biggest banks by market capitalization are Chinese: Industrial & Commercial Bank of China, which is the biggest, and China Construction Bank, No. 3.
Beginning in 1998, the government recapitalized them. Several years later, the government used approximately $60 billion of its massive foreign currency reserves to help finish the job. And banks were able to dump their bad loans onto state entities created for the purpose of holding the waste, while the banks received safe Finance Ministry bonds in exchange. Income from these restructured assets accounted for 60 percent of ICBC's profit in 2006
Under China's old risk-weighting system, the banks were able to declare that loans to state-owned companies carried zero risk. That allowed the banks to have huge balance sheets with virtually no capital. No more. As of Sept. 30, the average capital adequacy ratio for all of China's publicly traded banks totaled about 13 percent, well above the government's required standard of 8 percent.
The treatment of nonperforming loans has changed drastically as well. In the old days, such bad loans were simply rolled over, with skipped payments being capitalized into the loans. Then the government decreed that interest payments on a loan had to be received within 90 days for it to avoid being classified as nonperforming. Initially, the amount of nonperforming loans rose, but as of Sept. 30, 2008, nonperforming loans totaled only 2 percent of the loan total for the country's listed banks. That compares with 2.3 percent for FDIC-insured banks in the United States.
The provision system, which is how banks account for loans that may go bad, has changed, too. Before the reforms of the past decade, banks didn't have to create provisions for bad loans, regardless of the quality of their loan portfolios. Now provisions are substantial. As of Sept. 30, provisions for loan losses among the listed banks amounted to an impressive 123 percent of their nonperforming loans.
In 2003, Chinese regulators let foreign investors increase their stakes in Chinese banks from 15 percent to 20 percent. That ruling gave the banks more capital and credibility, paving the way for their initial public offerings beginning in 2005.
It also gave the Chinese institutions access to Western management expertise, though fortunately for the Chinese, they didn't match their Western brethren's excessive risk-taking.
And that's still paying off: China's publicly traded banks registered a 53 percent increase in net income in the third quarter of 2008 from the same period in 2007.
And perhaps most importantly, Chinese banks skipped the subprime party. They will, at most, have to write off 0.1 percent of their assets as a result of owning toxic U.S. securities, estimates Nicholas Lardy, senior fellow at the Peterson Institute for International Economics
But the global recession puts some of that progress at risk. China's explosive double-digit economic growth in recent years, powered by its potent export machine, made it easy for banks to glitter. The rapid slowdown of China's economy represents the biggest problem. China's economy expanded at an explosive 11.4 percent rate last year. Experts estimate that pace will soon slip to 5 percent to 8 percent. While such a figure would represent nirvana for the United States now, the three- to six-percentage-point decline is similar in magnitude to what the U.S. is going through. Double-digit growth in China sent corporate profits soaring. Pretax profits totaled 11 percent of GDP last year, up from 4 percent in 2001.
"You have to be a pretty bad lending officer to find someone who's not credit-worthy in that scenario," Lardy says. "Now the economy has slowed, and profits will go negative very soon. Then we will learn more about the quality of loans."
As for the financial crisis that began in the West, it hasn't hurt China directly. But the resulting global recession has crimped demand for Chinese exports. And exports constitute a key component of China's economy. In addition, the government has protected banks by capping deposit rates and cutting bank taxes. That allows banks to cover up some deficiencies.
So Chinese banks are vulnerable. Nonperforming loans will surely increase. Still, a crisis is unlikely. The government has many weapons to fight the economy's deceleration—witness the recent announcement of a $585 billion fiscal stimulus plan. And the banks are much better equipped to handle loan losses now than they were years ago.