Against the background of some of the worst economic news for China in a decade, in the past three months a deluge of new bank lending has hit the economy. The latest figures show that, after a robust pickup in lending growth in the last two months of 2008, in January loan growth hit its highest level since November 2003 — an astonishing 1.62 trillion yuan, or more than twice the total in January 2008.


At first glance, this may seem puzzling. After all, economic conditions are worsening dramatically: Exports are in freefall, contracting 17.5% in January alone, and economists’ GDP growth predictions are tumbling with them. (The IMF now predicts 6.7% growth for China this year.) Yet, as the prospects increase that more companies will default on loan repayments while investment demand drops, banks are giving out new loans like there is no tomorrow. As Morgan Stanley’s chief economist for Greater China, Wang Qing, said in a recent report, “Rapid bank credit expansion has become perhaps the only bright data point, as a stream of bad news about the economy hit the wire in recent months.”


What accounts for this apparent anomaly? The answer lies with the government’s four trillion yuan stimulus package, announced last November, and the supporting expansionist monetary policy it has laid out since. Together, these measures are designed to kick start the economy. But they rely heavily on the banks to do so: Commercial banks are expected to come up with 500 billion yuan to support the state-led plan, and they are also being encouraged to lend to the private sector.


Nevertheless, recent credit growth has been so intense that some investors and analysts are beginning to fret. Given the present economic malaise, they fear that banks will be exposed to rapidly mounting non-performing loans (NPLs), damaging their profitability.


How great are these new risks, and how well will the banks be able to handle them? The shift away from policy tightening to monetary expansion, together with the demands placed on banks under the stimulus program, seem likely to eat into banks’ profits this year. However, experts interviewed by China Knowledge at Wharton generally do not expect non-performing loans to grow to a worrying degree. Loan growth, though dramatic at the moment, will moderate later in the year, they suggest. When things calm down, however, banks and regulators will need to refocus on addressing long-term issues and find ways for financial institutions to manage evolving risks and complement economic restructuring.


Credit Tidal Wave

Until just a few years ago, Chinese banks stood for non-commercial lending and high levels of NPLs. Before a pre-privatization clean-up in 2003, NPLs are believed to have topped 40% of total loans outstanding; now, Chinese banks boast balance sheets that might be the envy of many of their Western peers. By the end of last year, NPL ratios had fallen below 2.5% by official counts. Meanwhile, a rough calculation based on publically available figures for the first nine months of 2008 shows that Chinese banks’ revenues may have climbed by more than a third last year, while profits appear to have surged by over a half (albeit greatly aided an enterprise tax cut last year).


“There is no doubt that the efforts by the Chinese banks, including the largest four banks with large government ownership stakes, have paid dividends in recent years,” says Qian Jun, a finance professor at Boston College. “Currently, they are in very strong positions relative to their counterparts in the U.S. and Europe.”


Yet, since their overhaul, banks have not had to deal with anything like the demands they will face from the stimulus package and sudden shift from monetary tightening to loosening. In the last months of 2008, China launched a range of expansionist monetary measures, most obviously by slashing interest rates five times in the last quarter. The benchmark one-year lending rate was cut to 5.31%, while the one-year deposit rate was lowered to 2.25%. On top of this, China’s central bank cut 50 basis points off the required reserve ratio in late December, in a move analysts say will free up several billion yuan for banks to lend.


Also at the end of last year, the State Council introduced a nine-pronged set of measures designed to promote financial market development. These have since been elaborated upon in greater detail. Among other things, lending restrictions will be relaxed and banks will be helped to write off NPLs, while banking system liquidity and money supply are set to be increased. It has emerged that some small- and middle-size banks will be allowed to surpass the 75% loan-deposit rate. Extending credit to support mergers and acquisitions will be permitted, and banks will be encouraged to lend to small- and medium-size enterprises (SMEs).


Indeed, expectations that China’s economic fundamentals will weaken before a recovery is possible, together with emerging worries about deflation, imply that a relaxed monetary policy will be a feature of the landscape this year. Further interest rate cuts are widely expected.


Chinese banks, which listen carefully to what Beijing says about whether and how much they should lend, have already taken the hint. Unlike U.S. financial institutions which, despite receiving trillions of dollars in bailout cash, have been constrained by problems of their own, most Chinese banks have adopted aggressive lending targets.


Rising Risks

In general, analysts have been supportive of these moves to loosen lending conditions. “Banks should and will increase their lending,” says Wang Tao, head of China economic research at UBS. Credit expansion will be critical to sustaining domestic demand, she argues, and most of the funds needed for sustaining investment growth will have to come from banks. Greater lending also helps to fend off gathering deflationary fears, she notes: Price increases slowed to a thirty-month low in January, while consumer price inflation has dropped to just 1%.


Nonetheless, the scale of credit expansion in recent months has begun to ring alarm bells. The pace of bank lending in January and February has taken everybody by surprise, notes Wang. “If this continues, another type of risk – misallocation of resources and sustainability of growth – will become an issue.”


Where do the potential risks lie? Judging from the recent pronouncements of analysts, they run the gamut of loans for huge infrastructure projects to smaller private companies. According to Chen Changhua, head of China research at Credit Suisse, local governments in particular are putting pressure on banks to support the local infrastructure works. This will lead to rising levels of NPLs, he predicted in a recent report. Moreover, as Chinese Financial Times columnist Wu Zheng has noted, large infrastructure projects such as high speed railways tend not to yield profits in the short term, promising to dent banks’ profitability.


Further risks lurk in private sector lending. Granting loans to SMEs (many of which are highly dependent on the troubled export sector) is now encouraged. But, as Ha Ji Min, chief economist of CICC, noted in a report, the private sector has slowed in recent months. Against the back drop of a slowing private sector, a question mark hangs over the profitability of some investments, he warns.


Banks have also been cautioned by China’s top banking regulator, the China Banking Regulation Committee (CBRC), about their exposure to risk amongst the large clients who have sucked up much of the recently extended credit. (Large customer NPL stock and ratios begun to climb as early as May last year.) The regulator has also cautioned of the growing danger of risk contagion among interlinked companies.


Sink or Swim?

Are banks ready to deal with these new dangers? Some think not: An Xin Security’s research department, for instance, predicts that banks will face a tough challenge to maintain asset quality this year. An Xin expects NPL levels begin to rise from the first half of this year, and continue doing so for one or two years.


Others are less pessimistic. Some point to the fact that the CBRC has required a provision coverage rate of at least 130% while instructing banks to keep the NPL growth rate under strict control. “My view is that the risk will not be too big, since Chinese commercial banks are already independent commercial organizations and have set up complete risk management systems and will not lend blindly,” says Xu Jie, managing director of the commercial banking division, head of marketing, and president of the Suzhou Region at China Minsheng Bank. Only in the unlikely event of spiraling bankruptcies nationwide would Chinese banks’ asset quality be significantly undermined, he says.


Xu told China Knowledge at Wharton about Minsheng’s own experience. Reinforcing risk management capabilities is a central pillar of the bank’s strategy for stepping up lending to SMEs, he says. Under a five-year development plan, Minsheng has become the first Chinese lender to establish a division focused solely on SMEs. It has set up six regional teams in southern China to service them, and developed a range of targeted products. At the same time, the bank has sought to set up a system of independent risk evaluation throughout the layers of its operations: Minsheng headquarters’ risk management committee has its own risk management officers in divisional headquarters, while the division in turn sends out people to oversee lending in the regions.


Yet some suspect that Chinese banks lack valuable experience in dealing with risk. The foundation for Chinese banks’ current good health (their focus on traditional business and limited connection to global markets) could prove a liability: Chinese banks now focus on fee-generating services but lack of experience in more “risky” but (done right) more profitable businesses such as derivatives and global investment, points out Boston College’s Qian. “I’m not sure their risk control and management skills have been tested yet.”


Some in the industry confirm that there can be a gap between risk management on paper and in practice. A manager in the headquarters of Shanghai Bank reports that while risk management structures giving headquarters some oversight in lending decisions are now in place, there is a difference between “methodology” and “implementation.”


At another level, though, it is possible these concerns will turn out to be academic. Given the policy-driven nature of much of the new lending, standard risk controls will likely not apply, argue some industry experts. It is likely that in some cases, it is the government, not banks, who will determine to whom the cash flows. In such cases, it is likely that the buildup of NPLs in 2009 would then lead to a subsequent bailout in 2010 or 2011 to help the clearing of policy-related NPL’s.


Unsustainable Tsunami

Still, simply extrapolating expectations of how far NPLs will rise this year based on the current explosion of lending seems unrealistic. Analysts have their doubts about how long banks can keep this up this frenetic pace, suggesting that loan growth will slow later in the year.


“The rapid loan expansion will unlikely be sustainable through 2009,” argues Morgan Stanley’s Wang Qing in a recent research note. For one thing, following a period of tight monetary policy, a significant portion of the credit growth reflects the unwinding of pent-up demand for short-term working capital, he explains. In a similar vein, chief economist of Fujian-based Industrial bank Lu Zheng Wei noted in a report that mid-to-long term loans have mainly gone to fiscal stimulus program projects, and low risk note financing. “It’s very probable that when these safe pies have been carved up, the loan increase will stagnate in the latter half of this year.”


There are further reasons to think that NPLs will not spiral this year. Historical precedents imply a slowdown in loan growth if China’s economy worsens as economists expect. In previous rounds of policy stimulus, during the Asian financial crisis in 1998-1999 and the bursting of the internet bubble around 2000–2001, worsening economic circumstances were accompanied by falling bank credit growth, Wang Qing points out. (He attributes this to a lack of appetite among investors for investments in the manufacturing sector, in the face of excess capacity and falling external demand.) “Loan growth will likely peak in the coming months on the back of deteriorating economic fundamentals,” Wang argues. This should allay concerns among investors about a potential deterioration of banks’ asset quality through overly rapid credit expansion, he adds.


“Depending on the severity of China’s economic slowdown and the scale of the forced increased lending, Chinese banks may end up making some bad loans, but I don’t view this problem to be too serious,” Boston College’s Qian Jun notes.


Beyond 2009

Whatever the risks for banks, it would be hard to find an opponent to China’s fiscal stimulus package as a short-term palliative. Nevertheless, several experts and practitioners we spoke to were at pains to stress the importance of dealing with shortcomings in the economic and banking systems in the long-term.


Even though it is necessary in the short-term, attempting to countermand the losses to the export sector by encouraging state-owned banks to lend to China’s large state-owned enterprises (SOEs) will create even more macroeconomic imbalance, explains Pascal Nouvellon of Cofidis, a large European-based consumer finance institution. The long-term challenge will be rebalancing the economy away from over reliance on exports and in favor of domestic consumption. Developing a faster and better consumer credit market is one way to do so, and it has proven helpful in other economies, he says.


A proper way to re-balance the focus towards domestic spending is to evolve regulation in order to let international consumer finance players form joint-ventures in China — for example, in a format similar to what is now authorized for securities brokerage firms. “Such a change in regulation would certainly encourage international consumer finance firms to grow their investment in China,” says Nouvellon. Like securities brokerage firms, consumer finance companies could help supporting China’s economy by transferring their specific know-how especially in the field of consumer lending risk management, he notes.


For their part, Chinese banks stand to gain from reinforcing risk management capabilities, experts say. One reason for this is that the money flow from banks’ traditional business, simply relying on the interest spread, looks like it will dwindle. Currently, the roughly 2% to 3.5% gap between the central bank-imposed lending and deposit rates provides banks with a steady stream of income: Essentially, banks are able to charge more interest on loans than they have to pay on customers’ savings. Though gargantuan by global standards, however, these interest spreads are set to close.


Banks may therefore have to look increasingly towards new sources of income. “Going forward, it is likely that China’s financial system will be more integrated into the global systems, since there are benefits to such integration when markets are in good condition,” says Qian Jun. However, since this would increase the likelihood of incurring direct impacts from financial crises elsewhere in the world, there would be wider implications for banks. “It is important that they learn from what went wrong with the U.S. banks and the causes for the subprime loans-led crisis,” Qian advises. “They should also strengthen the training of risk management and control of all levels of management.” Regulators, likewise, must improve their monitoring of systemic risk,