COMMENTARY

China's Banks Don't
Need a Bailout

By STEPHEN M. HARNER

The head of China's new bank regulatory agency proclaimed last week that "time is running out" for the country's state-owned banks to deal with their mountain of bad debts. Liu Mingkang's comments have encouraged the belief that a "big bang" solution in the form of a massive state-funded bailout is in prospect.

Mr. Liu's "do something" activism is laudable, even refreshing, in the context of China's plodding gradualist reform model. But, aside from real questions about whether a big bang is necessary at all, this attitude will soon confront a stark reality: the limits of China's domestic debt capacity.

A big-bang solution to restoring state-bank solvency would have the Chinese Ministry of Finance borrow money from the public by issuing bonds, and inject the borrowed money into the banks as new capital, allowing the banks to take provisions against and write off their bad debts. Foreign estimates of the size of the bailout are three trillion yuan ($360 billion), or some 30% of Chinese gross domestic product. This MOF action would effectively bring onto the budget state debt -- the residue of a failed state sector -- that previously had been "off the books."

As pointed out by Goldman Sachs' Fred Hu, a proponent of the big-bang approach, combining this bailout bill with China's existing government debt would raise total public debt to some 70% of GDP (and this before calculating the government's rising unfunded pension-system liabilities).

One of the many insights into the realities of Chinese economic development provided by the SARS crisis is that while resources have been lavished -- indeed, massively squandered -- in sectors where money was to be made, other areas, such as public health and basic education, have been short-changed. Although the government, following World Bank advice, has promised to construct a "social safety net" to catch the casualties from state-sector reform, no one knows where the money will come from.

One of the distinctive features of China's economy is the low level of tax revenues flowing to local and central governments. Tax revenues have been rising in recent years, but still amount to only about 14% of GDP. In 2002 the combined budget of local and central governments, with expenditures of over 17% of GDP, ran a deficit of 3% of GDP, financed by issuing bonds.

What is apparent from this is that even before facing the issue of a banking-system bailout, the resources of China's government have been insufficient to meet the demands for government investments and public service spending. Can China, then, afford to bail out the banks? The real issue here is public debt capacity. As is apparent from the massive public debts of countries as disparate as the U.S., Japan, and Belgium, government treasuries can and do pile up mountains of debt that the public "owes to itself." In Japan's case public debt has reached an alarming 140% of GDP. But there is definitely a limit to public debt, and it is the ability to pay interest while rolling over the principal.

The maximum amount that the government can pay in interest on its debt is the maximum tax revenue that the government can hope to raise minus the minimum possible level of noninterest government spending. The amount of interest the government must pay is the average interest rate times the amount of its debt.

Applying this equation to China, it becomes clear why there will be no big-bang resolution of China's nonperforming-loan problem. With debt equal to 70% of GDP and a 4% interest rate, the interest burden would be some 2.8% of GDP, or 20% of current tax revenues. But the government is already forced to take on debt to cover interest payments and current spending on a debt level half that large. It is likely that the slow upward trend of tax receipts will continue, and also that some of the government's recent pump-priming infrastructure spending will be curtailed. But there is little doubt that the "minimum" demands for government spending, including catch-up measures in the areas of public health, environmental protection, and education -- not to mention expanding the "safety net" -- will outstrip revenues for the foreseeable future.

There is, in short, no room "on the books" for a Chinese government bank bailout. But this is not the catastrophe that some fear. In this particular case, gradualism is the right approach, and it is working.

Since about 1999, all of the Chinese banks have been exerting great efforts to improve credit-risk management, particularly in the underwriting of new loans. Most of them have instituted credit-initiation processes that would be familiar to Western bankers. Not surprisingly, the weak state-owned companies -- the banks' traditional borrowers -- cannot meet the new lending criteria, so the banks have been making most of their new loans to government projects and to individuals buying houses, and investing funds in government bonds. From a portfolio-risk and cash-flow perspective, this is an improvement.

At the same time, under intense pressure exerted by both the People's Bank of China and, more effectively, by the Communist Party, bank officials have been obliged to treat reducing the level of existing nonperforming loans as a matter of urgency. Bad-debt provisioning at the major Chinese banks has been vastly increased, and the volume of nonperforming loans is being brought down by unprecedented write-offs.

To observe what is happening, take the example of China's largest bank, Industrial & Commercial Bank of China. At the end of 2002, ICBC estimated its nonperforming loans at 700 billion yuan, roughly 25% of its total loans. It forecast that the loss level would be 40%, or 280 billion yuan. Writing off these loans over a five-year period would require write-offs averaging 56 billion yuan a year. In 2002, the bank took a combined 38 billion yuan in reserves and write-offs of nonperforming loans, against profits before provisions of 44.3 billion yuan. ICBC estimates that by 2006 it will achieve a level of annual profits before provisions in excess of 70 billion yuan. In short, the bank has turned the corner and looks to have sufficient operating cash flow to work through its nonperforming loans over the medium term. The situation is similar for most other banks.

China's banks are on the mend, and they will find the capital to restore financial health from a combination of retained earnings and issues of equity or quasi-equity securities to the Chinese public. There is no need for a rescue that will cause China's public debt to balloon to unsustainable levels. Nor, among most government officials, is there any desire to see limited government revenues transferred to the banks. There are many other more pressing priorities and needs for government resources which are not, even now, being met.

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Updated June 4, 2003

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