The great pyramid of China

Are Chinese banks heading towards a pyramid-style capital structure?

That's the fear that some have after the Huijin, the domestic arm of China's main sovereign wealth fund, China Investment Corp, raised 54 billion yuan ($US8 billion) through a recent bond sale. Huijin eventually plans to raise 187.5 billion yuan through bond sales, and plans to use part of the proceeds to recapitalise China's largest state-owned banks.

However, according to a report in the Financial Times, the transaction is worrying analysts. There's a strangely circular quality to the transaction because the biggest buyers of the Huijin's bonds were none other than the large state-controlled Chinese banks.

One senior bond trader quoted in the FT story estimated that the large Chinese banks were responsible for purchasing more than 80 per cent of Huijin's first bond issue. Even more worrying is the suggestion that Huijin – which holds controlling stakes in most of the country's major banks – instructed the very banks it plans to recapitalise to subscribe heavily to its bond issue.

As the FT noted, Huijin holds controlling stakes on behalf of the state in nearly all of China's largest banks, including China Construction Bank, Agricultural Bank of China and Bank of China.

It's little wonder that Chinese banks are running up against capital constraints. They're able to earn a generous spread by taking deposits from companies and citizens and then lending the money on, mostly to large state-backed borrowers. Chinese banking is heavily regulated, with both deposit and lending rates set by the central bank.

Because they are effectively guaranteed to earn a generous spread on their loans, the Chinese banks have a huge incentive to let their balance sheets balloon in order to boost their revenues. According to the FT, the banks' business model is often referred to in China as "eating capital”. The banks lend much as they can until they come up against capital constraints, and have to return to the market to raise fresh equity.

There's very little incentive for Chinese banks to change their business model so long as deposit and lending rates are controlled, and as long as foreign competitors are prevented from enjoying a substantial share of the banking market.

But it's not without its risks. Chinese banks went on a massive lending spree in 2009, making a record $US1.4 trillion in new loans. But doubts are now emerging about the credit quality of some of their lending, particularly to local government financing vehicles, and on some property developments. This could leave the Chinese banks exposed to rising problem loans in future.

What's more, the huge government-directed lending spree has meant that the Chinese banks have to raise extra capital.

Recently, the Agricultural Bank of China raised $US22 billion when it became the last major Chinese bank to sell shares to the public. But it won't be the only big ticket capital raising of the year.

China's five biggest banks are expected to raise a total of $US63 billion this year by selling bonds and shares in order to replenish their depleted capital bases.

Huijin has indicated that it intends to use the proceeds from its planned bond program to recapitalise the Export-Import Bank of China and China Export and Credit Insurance Corp on behalf of the state. It has also promised to subscribe to the upcoming rights issues of Industrial and Commercial Bank of China, Bank of China and China Construction Bank.

But Huijin's plans have raised concerns. Ratings agency Moody's has warned that "recapitalising banks with bond proceeds from banks is credit negative because it increases the effective leverage of the banking system.”

Moody's points out that the net effect of the transaction is to increase both the assets, and the equity, of the banking system.

"However, the increases in assets and equity are artificial and without real economic substance: the increase in reported equity on banks' balance sheets enables the banks to lend more and effectively leverages up the system.”

Moody's says that the big Chinese banks have indicated that after they raise equity this year, they won't have to tap equity markets for another three years.

However, it says, "these announcements suggest the new capital likely won't last long and the banks' business model won't change fundamentally in the near term. But pain lies ahead if China's economic growth slows and the banking business model cannot adjust accordingly in time.”