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Bad banks, bad idea

14 October 2013 By Joe Zhang

At the end of the 1990s, China’s banks faced a rising tide of bad debts, and Beijing came to the rescue. Financial insiders still see that move as necessary, wise and courageous. On the contrary, bailing out the banks was a bad idea. It would be a mistake to repeat the trick.

Then, as now, China’s lenders had lent too much. Between 1984 and 1997, their loans grew 24 percent per annum. It couldn’t continue forever. In 1998, as non-performing loans started to increase, the growth rate fell to 15 percent, and then 8 percent and 6 percent in the next two years. By that point, bad loans in the banking system were close to 30 percent of total lending.

If Beijing had done nothing, this credit slowdown could have forced a loan contraction, or even a recession. That would have been a blessing in disguise: it would have ushered in much-needed improvement in the quality of credit allocation.

Sadly, the necessary adjustment never happened. China’s authorities instead set up four asset management companies – Cinda, Orient, Huarong and Great Wall – to take over the “toxic” loans, and between 1999 and 2005, they took out around 2 trillion yuan (roughly $300 billion at today’s exchange rate) of bad assets. They did this at 100 cents on the dollar, without forcing the banks to take a haircut.

This had two side-effects. First, it gave everyone false hope that the banks had suddenly become solid and that there would be future bailouts if the bad debts ever piled up again. Second, it left the banks with masses of liquidity. The resulting equity injection was equivalent to 20 percent of their loan balance. The banks had received massive inflationary power with a few strokes of the pen.

Print away the pain

What came next was inflation, and more lending. The government was already running a deficit in 1999-2000 equivalent to 15 percent to 19 percent of its budget. So to fund the bailout, the Ministry of Finance let the monetary printing press do the work. Rates were aggressively cut too.

That drove annual loan growth as high as 21 percent in the following three years. The resulting spending and investing generated huge sales taxes and dividends for the Ministry of Finance, which then helped recapitalise the banks again in subsequent years.

Banks are now hooked on rapid loan growth. Even when the central bank forced them to keep 20 percent of their deposits in reserve, it was not enough to neutralise the power of the additional “high-powered” money in the banks. Subsequent IPOs and fund-raisings have given them even more firepower, keeping average loan growth since 2000 up to a 16.6 percent annual rate.

But sensible lending opportunities have not grown, and cannot possibly grow, that fast. That means that bankers have competed to find new customers and lowered their credit standards, both knowingly and unknowingly. That is a surefire recipe for a crisis.

Repeat and repent
Were the AMCs really necessary? It’s unlikely. There are two misconceptions. First of all, depositors were never at risk. There was absolutely no erosion of public confidence in the banks in the 1990s, despite the government’s public admission that all the banks were technically bankrupt. Some financial institutions went bust, but no individual depositor lost money.

Second, banks never faced a capital crisis. In order to accommodate the double-digit loan growth of the past three decades, lenders certainly needed more capital. But it would have been better for the economy if much of that lending had never happened. Besides, borrowers wouldn’t all have failed to repay at once, so credit growth would have slowed, not collapsed entirely.

Today, the world is worried about China’s bad debts again. There are loud calls for another round of recapitalisation. But that would be a grave mistake.

Instead, the best thing for China’s financial system would be to downsize the banks via special dividend payouts, and allow their lending capacity to gradually decline. That should force discipline into their lending processes, and reduce the risks of badly allocated credit.

Some pessimists estimate that China’s bad debts are more than 10 percent of the total, enough to wipe out the sector’s capital. But as long as depositors’ confidence in the banks remains high, and loans don’t all fail to pay back at once, that needn’t matter very much. Bailing out the banks at a stroke will only leave them emboldened to make the same mistakes again.


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