June 10, 2004
Written by Stratfor.com
STRATFOR INTELLIGENCE BRIEF

Summary

Despite yet another clampdown on lending to underscore the shaky foundations of China's financial sector, Western banks are showing a continued appetite for Chinese banking assets. Beijing's ability to maintain these banks' interest in China will be a key factor in determining how bad things might become with the Chinese economy.

Analysis

The China Banking Regulatory Commission (CBRC) announced May 31 that it will require banks to re-examine loans approved before March 31 for high-value projects in the steel, aluminum, cement and construction industries. The CBRC also called on banks to stop extending new loans to the steel, aluminum and cement sectors, and said that it will begin spot checks across the country to ensure compliance with the new rules.

The same day, a notice in the China Securities Journal noted that four government entities in Shenzhen had agreed to sell a cumulative 18 percent stake in the Shenzhen Development Bank

(SDB) to the private U.S. equity firm Newbridge Capital. This makes Newbridge the bank's largest single shareholder, allowing it to capture a majority of the bank's board seats under Chinese law.

On June 1, the China Post reported that China Construction Bank (CCB) successfully sold three packages of "settled assets" worth 4 billion yuan ($482 million) for 1.4 billion yuan ($169 million), or around 35 percent of their book value. Deutsche Bank purchased one package of assets, and Morgan Stanley purchased two packages. The assets reportedly include buildings, empty lots and other collateral on some of the bank's non-performing loans (NPLs).

This marked the first sale ever in China of such "settled assets," and follows successive failures by China in the fall of 2003 to sell several packages of NPLs when the bidding price from foreign buyers was too low.

Despite increasingly regular interventions by banking regulators that are aimed at slowing down out-of-control lending in China's banking sector -- and growing anxiety about China's financial future in general -- it appears that Western banks continue to have an appetite for Chinese assets. At the same time, the CCB and SDB deals indicate that China has to go to new lengths to attract foreign buyers.

This hunger is essential for Beijing and underscores China's growing dependence on the appetites of Western banks for risk and their willingness to continue betting on China with their feet, and their funds.

Faced with a nearly insurmountable non-performing loan problem at various state-owned banks, Beijing appears to be making a bet of its own: that market forces brought to bear by the incoming foreign banks will be the silver bullet for China's banking woes, bringing the market discipline that its own banks don't have and that its regulators cannot properly enforce. Foreign banks like Newbridge -- and those banks that Beijing hopes will buy large chunks of the four state-owned banks through planned initial public offerings in the next few years -- will also bring much- needed capital injections.

The problem for Beijing is that it must continue to hold the interest of Western banks -- and their faith in a long-term payoff -- in the face of mounting evidence that the Chinese banking system is rotten. Thus, Beijing has begun to sweeten the deals. It allows Newbridge to become the single-largest shareholder in a Chinese bank -- an important first. And it allows foreign banks to directly purchase the collateral underlying its bad loans, rather than the bad loans themselves, for the first time. This is a better deal for the banks -- removing the messy step of actually trying to collect bad debts -- even though the assets might be heavily overvalued.

With ownership comes greater knowledge, and Newbridge -- expert at dealing with distressed Asian banks -- will gain rare insight into the underbelly of Chinese banking. It will not be pretty: CCB is widely considered to be one of China's worst banks, and Newbridge's findings will certainly make the rounds of the international banking community, lifting the Chinese veil just a little bit farther. Likewise, Morgan Stanley and Deutsche Bank will get further insight into the assets backing so many of China's NPLs, including how the valuation of assets meshes with reality.

As with so much else in China, this is all about managing the message. For now, Beijing has a fairly reliable facilitator in the international banking community. Western banks have placed a major bet on China's success, and they are not eager to see it fail. For instance, Morgan Stanley has a long-standing relationship with CCB and was chosen in March to be a main underwriter (along with Citigroup) for CCB's planned overseas IPO, estimated at $5 billion. Based on that figure, CCB's underwriters should clear around $175 million in expected underwriting fees, on top of similarly huge fees for other Chinese IPOs. Some $25 billion in hoped-for IPOs this year would translate into approximately $875 million in underwriting fees, which (let's face it) could color the investment banks' judgment about the long-term viability of the companies they are underwriting.

With hundreds of millions of dollars at stake in fees alone -- and now even more at stake as new owners of Chinese real estate -- Western banks have a vested interest in the continuation of the "China Miracle," at least until the IPOs can be completed and Chinese companies can be put to the rigors of the "market." This dovetails with China's interests, and it appears for now that China's banking IPOs just might move forward even as the NPL problem goes largely unaddressed.

However, Stratfor does not have a lot of faith in the ability of Western banks to make prudent decisions about emerging markets. Whether one looks at the Asian financial crisis, Russia, Argentina or Brazil, their track record for protecting their clients and their shareholders is fairly rotten. Combine that with the momentum of the China euphoria and the promise of huge riches as China privatizes, and banks have a vested interest in continuing to paint a pretty portrait of China.

Beijing is counting on it.

(c) 2004 Strategic Forecasting, Inc. All rights reserved.

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