My Blog

February 22, 2008

As if keeping time with Victor Shih’s article (see previous entry) Standard & Poor’s warned yesterday that non-performing loan ratios in China have risen, and added that corporate defaults in 2008 may increase because of tighter credit controls and weakening demand from a slowing U.S. economy.  NPLs for the major commercial banks (the big five plus the 12 joint-stock banks) stood at 6.63% of total loans at the end of September 2007, and rose to 6.74% by the end of December.  This may seem like a small increase in the ratio, but remember that this increase occurred during what can only be described as optimal times – the economy grew at well over 11% in the 4th quarter, the country was flooded with new money, inflation increased faster than interest rates (which causes debt payments to decline relative to revenues and asset values), loans expanded rapidly (which should push the NPL ratio down), and equity issuance surged.

We can only guess what will happen if Chinese borrowers are hit by a combination of rising interest payments, slowing external demand and credit constraints.  There are already good reasons to suspect that the NPL ratios seriously underestimate the true extent of NPLs, and of course it is well know that most of the improvement in the NPL ratio during the last five years (the NPL ratio was around 20% in 2003) occurred because of the huge increase in loans outstanding – total loans outstanding grew by over 16% in 2007.  The question is whether that increase in loans, made during what can only be described as a party atmosphere, doesn’t include a large amount of future bad loans.  Bad loans, as old bankers always point out, are usually made during good times.

In that context I should bring up an interesting (and alarming) article from yesterday’s Spiegel titled “German State-owned Banks on the Verge of Collapse”.  The opening paragraph says:

The German government has had to bail out state-owned banks with taxpayers' money after their managements recklessly gambled away billions on subprime investments. But if a state-owned bank were to go under, the consequences could be disastrous for the whole economy.

The article describes how the state-owned banks, “one of the key pillars of the country's banking system”, had engaged in such reckless lending behavior during the boom years of the recent past that they were almost wholly unable to withstand last year’s credit contraction.  A number of the largest banks have been forced to their knees, and there is an increasing risk that a few major defaults could bring the whole system down.

It is a nightmare scenario that the government financial supervisory authority now believes is increasingly likely. Germany's public-sector banks speculated far more heavily than private banks in American subprime mortgage securities. Now these banks' beleaguered executives are calling on the government to bail them out from a disaster of their own making.

For Wolfgang Reuter, the author of the piece, a major cause of the crisis was the skewed incentives created by state ownership and effective state guarantees.

Ortseifen and Matthäus-Maier are perfect examples of the fatal mix of amateurism, greed and political protection that is symptomatic for many of Germany's state-owned, partially state-owned and public sector banks. It is an environment that can only thrive in the shadow of the state -- and that has drained more than €20 billion from the public treasury within the last decade.

Until now, the government has always been there to pick up the tab in the end. Fully aware of this safety net, the executives at state-owned banks gambled with their employers' assets as if there was no tomorrow. Munich-based BayernLB did it with stocks in Singapore, Bankgesellschaft Berlin with real estate investments, and WestLB with holdings in British companies.

Anyone who is not responsible for bearing the consequences of the risks he or she takes can easily turn into a gambler. And the bets kept increasing in recent years, getting more and more public-sector banks into financial hot water. Now the banks find themselves lacking the assets they need to weather the turmoil of an international financial crisis.

I bring up the German experience to make two points.  First, the speed in which a banking system can unravel after many years of what seemed like robust growth is often astonishing, and the way in which the unraveling takes place is almost always unexpected.  Second, state ownership is no guarantee of safety.  In fact in the German case it seems that state ownership may have exacerbated the poor lending decisions.

I shouldn’t need to make the last point, but I cannot remember how many times I have been assured that the difference between Chinese banks and non-Chinese banks is that unlike the latter, Chinese banks are state-owned, and that fact makes a banking crisis in China nearly impossible.  Wrong on both counts.

You can read the Speigel article at http://www.spiegel.de/international/business/0,1518,536635,00.html

Comments (6) for "NPLs for the big commercial ...

I would ask to differ. Banking industry as a whole, no matter private or state-owned, is "a risk-loving industry guaranteed as a public utility." (Martin Wolf, FT.com, "Why banking remains an accident waiting to happen" ). If the bankers' risk taking behavior produces gain, it goes to their bonus and dividends. When they make mistakes and loss occurs, all taxpayers have to pay for saving them, i.e. Northern Rock nationalization. Since their liabilities and risks are virtually socialized, maybe the industry should be public owned in the first place. By fatbrick - 2/22/2008 7:35 AM

The stuff that I read said that this was Agricultural Bank of China's fault. By orgulous - 2/23/2008 1:16 AM

fatbrick: Since their liabilities and risks are virtually socialized, maybe the industry should be public owned in the first place. My personal observation is that in banks in the US, the two primary actors are the managers and the employees who are trying to make as big a bonus as possible and the government which mandates risk controls. Shareholders in financial institutions seem to be just another source of capital and have very limited power in the system. I don't think that who owns the banks is as important as who regulates the banks, and one reason I'm sort of optimistic about Chinese banks is that I think that the regulators have done a good job, but we'll see when the business cycle turns. I'm not too worried about the big three, but where I think the crisis could be is in the joint-stock commercial banks. As far as German banks go..... It's amazing how different people will tell the same story. One funny thing is that if you have an institution that is 50% public and 50% private then if things go well, people call it "semi-private", but if things go badly it suddenly becomes "state-owned." One common theme that I've seen in the subprime mess is that public sector people get paid a lot less than people in the private sector so you have trouble attracting the top people. This leads to a situation in which people argue that governments are fundamentally incompetent so that they should be starved for funds, which then keeps the government incompetent. By Twofish - 2/23/2008 2:03 AM

Wanna see something REALLY scarry? Check this: http://www.atimes.com/atimes/China_Business/IL14Cb01.html exerpt: ...in 2002, the total Chinese investment in US agency mortgage-backed securities was just over $100 million. By June 2006, this number had grown to over $107 billion - a nearly 1,000-fold increase in less than five years. Given the size of Chinese mortgage purchases and the heavy concentration of acquisition across the later years of the US housing bubble, one would assume serious loss risk. ...If we assume that China has been growing her agency purchases in line with the rates of growth of her foreign reserves or US trade surplus, the numbers would be huge. China at present has reserves - depending on how inclusively they are measured - in the $1.5 trillion range. This is the result of astronomic growth across the past two years. China’s trade surplus with the US has risen rapidly. Multiple rounds of successful initial public offerings of Chinese firms have built up large caches of dollars. Thus, dollar holding have soared since June 2006 data was collected. If we assume anything like parallel growth in mortgage holdings, we would be moving toward massive Chinese mortgage exposure. In the first nine months of 2007, mainland China net purchased $61.5 billion in US agency bonds. OK. Now ask yourself this: If the Wall Street houses who packaged and underwrote much of this subprime junk have taken, say, $50 billion or so of writeoffs so far, how much more will have to be written off by their CUSTOMERS who bought that vast bulk of that paper? Chief among them, it looks like it was the Chinese. The author of this story estimates a figure of upwards of $250 billion of China's $1.5 trillion of US-denominiated reserves being held in such US mortgage-backed paper. And given the nature of Chinese central bank opacity, there may never be any proper accounting of the mark-to-market losses incurred. By Tenega - 2/23/2008 4:50 AM

Tenega, Agency guaranteed mortgage-backed securities? I think that they are backed by U.S. government. If I am correct, then I cannot imagine what would happen if U.S. government defaults. I suppose that China's 200 billion agency debts is the least problem people should worry about at that time. By fatbrick - 2/23/2008 7:16 AM

Tenega: OK. Now ask yourself this: If the Wall Street houses who packaged and underwrote much of this subprime junk have taken, say, $50 billion or so of writeoffs so far, how much more will have to be written off by their CUSTOMERS who bought that vast bulk of that paper? Agency back paper consists of prime mortgages which are unlikely to have the same sorts of problems as subprime and weren't packaged by Wall Street investment banks. GSE's aren't completely risk free, but if there was any chance that Fannie and Freddie would default, this would be a financial earthquake dozens of times worse than anything we've seen thus far. By Twofish - 2/25/2008 5:11 AM