Investors in Chinese banks held their breath this past January as a troubled investment vehicle, Credit Equals Gold, faced a payment deadline. China was about to see its first high-profile default, it seemed. But as had happened many times before, an unknown white knight stepped in to bail out the 3 billion yuan ($A520 million) fund that the Industrial and Commercial Bank of China had marketed to its customers. The identity of the rescuer was recently revealed to be Huarong Asset Management, which paid 95 cents on the dollar for its troubled assets.
The bailout raises troubling questions about Beijing's plans for the financial system.
The four asset management companies were set up in 1999 to handle the bad debts of China's four giant state-owned banks. They were supposed to shut down in 2009, but the global financial crisis gave them a new lease on life. Instead of spinning off restructured companies they had acquired through debt-for-equity swaps, the asset management companies were allowed to keep their difficult-to-obtain financial licenses and go into the restructuring business as free-lancers.
With insurance, securities, futures, mutual fund, leasing and the sine qua non trust companies, they repositioned themselves as universal financial institutions pursuing commercial gain. After the State Council forbade China's own banks from acquiring AMCs for themselves, international investors fought to get in as strategic investors prior to presumed Hong Kong IPOs, believing that asset management companies had the expertise to benefit from a rising tide of problem loans.
But now, like the big state banks themselves, asset management companies are being enlisted in the Party's struggle against financial losses of all kinds. That includes not just bank loans, but also junk bonds and illiquid wealth management products such as Credit Equals Gold.
How did Huarong finance the acquisition of Credit Equals Gold? Surely not from its own cash flow: ICBC, the bank that spawned both Huarong and Credit Equals Gold , lent it the money so that its banking customers would remain almost whole. The point is that neither ICBC nor Huarong had a legal obligation to solve this problem -- they did so in the name of social stability. Even if Huarong and ICBC claim this as a one-off, the reality is that it can't be. There is too much bad debt outstanding and there are too many political implications for Beijing to allow the market to run its course.
And so the shell game begins again, assuming it ever ended. Assets and money move from one shell to the next as Beijing seeks to maintain the fiction that the banks' non-performing loan ratio is 1 per cent. It's no wonder the chairman of Huarong was reported on the company's own website as wringing his hands over the explosion of bad loans in the first half of this year, a time he described as a "grim and complicated" business environment. Perhaps he is bemoaning an IPO prospectus that now might need to be significantly rewritten to re-reposition Huarong as a state run asset management company and not a commercial financial institution -- an action that would raise many questions about the business case for investing in such an entity.
If the financial statements of Cinda, another of the asset management companies, provide any guidance to what can be expected from Huarong, the bad loan market has indeed picked up significantly over the past year. From total assets of $US27bn ($A28.8bn) in 2011, at year-end 2013 Cinda boasted a balance sheet of around $62bn. At this rate, combined asset management company balance sheets will quickly surpass their 2005 peak of $US260bn.
How is such rapid growth financed? As in the case of Credit Equals Gold, China's banks have stepped up.
In the past year bank borrowings more than doubled to $US28bn, with sales under repurchase agreements and bond issuance (also to the banks of course) adding another $US3bn. In the meantime, the central bank's own loans mature at year-end 2014 and client deposits at its securities subsidiary continue to decline. All of this stands against a backdrop of Cinda's own inevitably negative cash flow: The banks will have no choice but to lend if the fiction of a 1 per cent non-performing loan ratio is to be maintained.
Here lies the difference from China's first experience with NPLs 15 years ago. Back then the size of the problem was quantifiable, even before the asset management companies were established. A comprehensive plan including write-offs, sales, spin-offs, restructurings and the country's foreign exchange reserves allowed the banks to emerge recapitalised and purged of bad loans, with the Ministry of Finance rightfully holding what was left over.
Today it is anyone's guess just how large the problem is. In the past four years, China's total banking assets have grown to be more than 2.5 times the country's GDP and almost twice the size of the entire U.S. banking system, supposedly without incurring significant problem loans.
Making the challenge even greater is the fact that over the same period, China has added to the complexity and opacity of its financial system by relying on clever accounting and a plethora of off-balance-sheet and unlisted companies and agencies. These actions seem to be encouraged by the government, not as part of a program of financial liberalisation but as an attempt to maintain social stability.
In contrast, in 1998 all but a handful of trust companies were shut down entirely and the entire universe of urban and rural credit cooperatives was restructured. Today this same handful of trust companies working with small city commercial banks have become the heart of a shadow banking system whose size can only be roughly estimated.
All of this allows Beijing to push debt around the system and even, seemingly, make it vanish. The addition of provincial asset management companies and provincial ability to legally run budgetary deficits will greatly add to this complexity. The financial shell game has simply gained more shells.
With Premier Li Keqiang promising GDP growth of 7.5 per cent, a figure even he confesses not to believe, the question has become whether the leadership believes China's public data about the financial system. With all the smoke and mirrors and other more pressing political priorities, the only certainty is that financial reform in China will remain a mirage that vanishes as it nears.
Messrs. Walter and Howie are the authors of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise" (Wiley). This piece was originally published in The Wall Street Journal. Reproduced with permission.