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Hidden dragons

Hidden dragons

Source: Chris Skinner, TowerGroup

In the second of a two-part report, Chris Skinner looks at Chinese banking reforms and the emergence of a new superpower.

Last month, I reviewed India’s markets and banking prospects in depth, with the conclusion that Indian service and financial professionals will be teaching the world how to manage banks ten years from now. In a similar manner, China will be teaching us how to deploy bank infrastructures ten years from now. In particular, China is of interest due to the fact that, in order to fulfil obligations to the World Trade Organisation (WTO), Beijing is to opening its financial firms to foreign competition. The new rules come into force on 11 December, and will allow foreign banks to offer services directly to Chinese consumers in yuan currency.

A Chinese take-away

China’s economic prosperity is largely due to the major government reform programme of Deng Xiaoping during the 1980’s. Xiaoping’s vision moved China away from centralised planning and control, closed to international trade, into a thriving market-oriented economy. His government achieved this by liberalising prices, decentralising fiscal policies to local government and increasingly allowing State-Owned Enterprises (SOEs) to act autonomously.

Xiaoping’s reforms were continued through the 1990’s by his successor Jiang Zemin and were paid homage to in a recent speech by the current Chinese President, Hu Jintao, who stated “from 1978 to 2003, China's GDP increased from US$147.3 billion to over US$1.4 trillion, with an average annual increase rate of 9.4%; its total foreign trade volume grew from US$20.6 billion to US$851.2 billion, with an average annual growth rate of 16.1%; and the poverty-stricken population in the rural area dropped from 250 million to about 29 million”.

Similar to India, a key aspect of China’s growth has been through targeted education, with China producing over 800,000 science and engineering graduates in 2005, more than any other nation, and expecting to rise to over a million science and engineering graduates by 2010, more than the total number of graduates in these disciplines leaving American, Japanese, French, German and British universities.

This will continue to fuel China’s manufacturing prowess and is critical to China’s future growth plans as, unlike India, China has an ageing population issue. India has a growing population where 70% are under the age of 36. China has a declining population due to the Planned Birth Policy introduced by Deng Xiaoping’s administration in 1979 to cope with the demands of a society with scarce resources.

China will have to look hard for future workers to continue to sustain its growth phenomena. That is not difficult though, when unofficial figures estimate that China has almost 260 million unemployed people, about the population of the USA.

China’s real issues lie elsewhere, including how to manage pollution and energy supply, how to convert state-owned enterprises (SOEs) from nationalised to privatised industries, and how to rebalance the poor rural populations in the West with the growing affluent urban populations of the East. All of these relate back to China’s banking structures, or lack of them.

China’s banking: A renovation project

Many of China’s issues in restructuring to support its economic powerhouse status relate to the financial system. For example, China currently has foreign currency reserves of almost a trillion dollars, growing at over $17 billion a month. As a result China’s central bank, the People’s Bank of China, regularly buys dollars from the commercial banks and substitutes them for Renminbi bonds. With so much money in government’s hands, is it any wonder that China is spending so grandly on major projects such as the Qinghai Tibet railway. The railroad is the world's highest, and the final section to Lhasa was opened on 2 July 2006 at a cost of $4.2 billion. China has invested over $125 billion in the Western provinces since 2000, including the controversial three gorges dam projects, and has $21 billion more planned. All of these investments are part of the rebalancing of wealth and commerce between East and West China.

However, China’s banking has more fundamental issues. For example, until 2001, the banks were wholly owned by China’s government and had no function other than to take monies from China’s citizens to invest the funds in government projects and enterprises. That is why China’s banks had little concept of customer services or of managing risk.

Bank lending in China was authorised by the People’s Party, with 95% of corporate loans made to SOEs. Accordingly, China’s banks are reportedly suffering from around 40% of non-performing loans, the highest in the region. With a trillion in foreign currency reserves available from the government to bail out any bank that gets into problems it may imply that the issue is covered, but it does lead to some major questions around China’s future.

First, the government is actively trying to shift from the majority of workers being employed by SOEs to a more commercial and competitive economy. Some of these SOEs have already been transformed, such as the car industry, and many are employed in building and construction, with 40 airports, 26 underground railways, 30 nuclear power stations and over 50,000 miles of motorway being built over the next five years.

However, a third of the SOEs are non-performing and should be closed down or sold off. This would lead to a further 150 million lay-offs, and the pay-offs incurred would increase the NPL rate which is already running at almost a trillion dollars – the same amount as China’s currency reserves. Of more concern is the fact that if China’s banks begin to behave as banks in other commercial centres behave, then it could cause much more civil unrest creating instability in the economy.

Equally China’s banks have already had to be bailed out by the government through recapitalisation of their balance sheets since the late 1990’s to the value of $215 billion. This means that Chinese banks have to generate at least $25 billion more in annual revenues to service that cost than banks in other countries.

Second, China’s financial markets have no defined capital markets or commercial banking. China’s capital markets purely fund SOEs, with companies unable to borrow from the bond markets and no recognised equities markets. According to McKinsey, China’s capitalisation of the equity market is a third of GDP, with half of that capitalisation for SOEs. That means that only 17% of commercial firms trade on the equities markets, compared to 60% in other emerging economies.

Even more telling is that the corporate bond market is virtually non-existent. The corporate bond market is just 13% of GDP, compared to over half in other emerging markets. Those bonds fund SOEs, with companies borrowing 95% of their funding through bank loans.

The net result is that McKinsey estimates that China could:
  • reduce its cost of capital by $14 billion a year through creating a vibrant bond market;
  • that more efficient equities markets would reduce the costs of share issuing and trading by over $1.5 billion a year, even at today’s small volumes; and
  • that China would realise over $320 billion a year in savings through improvements from financial reform, equivalent to a 17% increase in GDP.

This is part of the reason why, unlike India, China has embarked on a radical reform program of its banking operations, which began with World Trade Organisation (WTO) requirements to change in 2001.

China’s banking: reforming through 2007

China joined the WTO in 2001 and made a number of concessions in so doing, not the least of which was to open its banking market to foreign competition. The process has been to allow increasing foreign direct investment in domestic banks over the past five years, with open and direct competition commencing in 2007. This is dissimilar to India, in that China is releasing the handles on its financial institutions fully once deregulation is complete, whilst India still has highly protective barriers to foreign entry.

Initially, the restrictions to foreign investment in Chinese banks was that foreign ownership could not exceed 25% of a bank and no single investor could own more than 19.9%. These restrictions will gradually be lifted and, as a result, many firms are taking the opportunity to grab a slice of Chinese banking.

In particular, as from 11 December 2006, foreign firms are able to offer services directly to Chinese consumers in yuan currency, from deposit accounts through loans and credit cards. With 1.3 billion Chinese consumers to target, that is not a bad market to go for.

These firms are taking a calculated risk however.

On the one hand, foreign bank investors in Chinese banking are desirous of the prospects of creating a new capital market and equities exchange as a third major business hub to match those of London for Europe and New York for the USA. They are also avaricious for the country’s growing ‘consumer class’ which is around 20% of the total population, or a quarter of a billion people. These are consumers who previously could not invest overseas, did not have access to high net returns and are potentially eager for European and American banking style services. In order to do this, foreign banks will need to be locally incorporated, with a registered capital in China of at least one billion yuans (around €100 million), as well as holding at least a further 100 million yuans (€10 million euros) for each branch in China. There are other rules imposed also, such as foreign banks required to have a maximum 75% loans to deposits ratio by 2012.

On the other hand, China’s banks are still unstable, without a strong understanding of customer service or risk management as previously mentioned. As foreign banks enter into Chinese banking, they do run the risk that their non-performing loans are with State-Owned Enterprises (SOEs), in other words with the Government. If overseas banks begin to apply strong credit risk management techniques the result will be that they will stop providing and servicing loans to SOEs and will begin to call them in. Meanwhile, the very same banks are also likely to begin creating financial instruments that divert consumers’ investments away from China’s SOEs and into commercial banking or, even worse, overseas products. Either approach would cause the People’s Party to rethink the reform process and potentially close down some of these ‘joint ventures’ with the overseas player, in so doing, losing their investment.

Nevertheless, the rewards outweigh the risks according to most bank investors and so the re-energising of Chinese banking will continue. This was demonstrated by the flotation of the Industrial & Commercial Bank of China (ICBI) on 20 October 2006.

The IPO turned out to be the largest the world has ever seen, with the $19 billion sale dwarfing the $12 billion raised from 53 IPOs in the second half of 2006 on Wall Street. Even more noteworthy was the fact that, by the end of the first day of trading, the Chinese lender had a market value of about $157 billion which was more than Goldman Sachs Group and Lehman Brothers Holdings put together, according to Fortune magazine.

During this renovation of Chinese banking we will see a new form of banking appear, which will teach Europe’s and America’s banks a few lessons.

Lessons to be learnt from China’s banks

The biggest lesson European and American banks will learn from China is in technology. Just as America has been the technology powerhouse of the world for the last half a century, China intends to be the world’s technology powerhouse for the next. That is why you cannot buy any electronic goods these days without a ‘made in China’ label somewhere on the product, whether it be a Lenovo PC or a Konka TV. But China’s real focus is to own the next generation of technologies, and the People’s Party is investing heavily in new areas from next generation Internet to next generation mobile. With 400 million mobile telephone users and 110 million Internet users, over 60 million of those on broadband, China is revolutionising services and products dramatically and with full government backing.

China is prioritising technology due to issues with the last major innovations in technology, which by-passed most of the country. By way of illustration, when the foundations of the Internet were being laid in the 1980s, the USA created the network and dominated the system. That is why each American on average owns six IP (Internet Protocol) addresses, compared to 26 Chinese having to share one IP address, according to the International Telecommunication Union.

So China is putting dollars into technology, and big dollars. For example, IPv6 – Internet Protocol Version 6 – is the chosen standard for the next generation of the Internet. The Chinese government created a project that ran from the end of 2002 until August 2003 called the China Next Generation Internet, which aimed to champion China’s leadership in this area. The project was supported by the National Development and Reform Commission, the Ministry of Science and Technology, the Ministry of Education and other leading government ministries, and received over $175 million investment. Similarly, the government lends support to leading technology providers, such as Huawei which provides internet networking facilities, and provides grants to business to experiment with new technologies.

It is not surprising when you have a business that has jumped from 10% of the world’s electronics production to 18% between 2000 and 2003 at a CAGR of 15.4% and is now worth over $200 billion a year. Similarly, China will have the world’s largest broadband enabled population, with 140 million citizens on high speed lines expected by 2010.

The result is that Chinese banks are reaping the rewards of this spend. According to TowerGroup Research, bank IT spending in China increased 32% annually from 2004 to 2007, rising from $10.1 billion to $23.2 billion, which is faster than anywhere else in the world. This spend is going into new core systems and into new technologies such as WiMAX, the next generation wireless standard, IPv6 and fourth generation mobile telecommunications.

One illustration of this leadership in technology was the give-away Swatch-style World Cup 2006 watch from Chinatrust Commercial Bank during the summer. The watch was used to promote the soccer world cup in Germany, and incorporated a contactless MasterCard PayPass chip. The idea being that you could walk around Beijing and when you saw a CD or DVD you wanted, you just flashed the watch over the reader and the product was purchased. Simple, innovative and far and away ahead of anything Western European or American banks are doing with these RFID chips so far.

The end-game of all of these changes is that China is creating the world’s next generation technologies and systems, with Kingdee, ZTE, Lenovo and Huawei leading the pack. These firms are suddenly appearing in the Top 100 leading technology firms of the world. Watch out as China will soon be to technology what America was for the last fifty years.

Conclusions on China and India: Tigers you cannot ignore

Throughout this article and in last months, I have tried to objectively appraise China and India in depth, and compared and contrasted the two countries.

From a banking viewpoint, both countries offer exciting opportunities as they have been closed to foreign bank entry until recently.

Neither country has sophisticated capital markets or commercial banking, and retail bank lending, savings and deposits are also relatively untapped. There are major differences however.

India’s banking systems are more cosmopolitan with some capabilities for commercial lending and equities. This could be leveraged if it were not for the concerns of India’s central bank that India’s banks, if opened to foreign competition, do not know how to compete. As a result, India’s reform process is very slow.

China, on the other hand, has been forced to change fast as part of its accession to the WTO. Therefore, the banking markets are revolutionising with investment and foreign skills. China, in the short term therefore, will be the major market to watch.

In the long term, it is different.

China, in the long term, will be teaching American and European banks how to use technology, but its markets will gradually dwindle and wane as their citizens grow old. Conversely, India has 7 out of 10 citizens under the age of 36. Therefore, whilst China teaches the world about the next generations of technology, India will be producing the next generations of IT managers and skills.

The final vision of 2020?

London becomes the outsourced trading operations for India’s banks?

New York provides the offshore clearing and settlement systems for Beijing?

You never know, it just might come true.

Chris Skinner is a director of TowerGroup and founder of Balatro.
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Author's email: Chris Skinner

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