FINANCIAL ALCHEMY FAILS TO HIDE RISK

While western governments argue over how to revive their ailing financial institutions, China's state- controlled banks have been relatively unscathed by the global financial turmoil.

That is partly because Beijing decided a decade ago to set up four bad banks, or asset management companies, to manage toxic assets. The move allowed the country's commercial banks to be transformed quickly into more market-oriented institutions.

“China's banking system is very healthy and has even been able to withstand such a huge global financial crisis,” says Tian Guoli, chief executive of Cinda Asset Management Corporation, the largest and most successful of the bad banks.

However, many analysts say although the establishment of the AMCs cleaned up the state banks, the transferred assets have become hidden risks within the financial system – at a time when Beijing is ordering banks to make huge loans as part of a fiscal stimulus designed to shore up crumbling economic growth.

The banking system's problems started in the late 1970s, when China's leaders began using financial institutions as piggy banks to fund pet projects.

In the wake of the Asian financial crisis in 1997 many of these projects were unable to service their debts and the country's banking system teetered on the brink of collapse.

In 1999 and 2000 China's largest banks transferred a combined Rmb1,400bn ($205bn, €163bn, £144bn) to the AMCs at full face value and in return mostly received 10-year bonds paying 2.25 per cent per annum – a clever piece of financial alchemy that allowed them to turn holes in their balance sheets into interest-bearing assets.

According to government estimates, the AMCs lowered the aggregate non- performing loan ratio at the big commercial banks by 10 percentage points, from well over 30 per cent, and helped lower the debt to asset ratio of the state-owned industrial sector by 30 percentage points.

“The benefit of the Chinese model is that it happened virtually overnight but the full liability went to the government and the taxpayer,” says Charlene Chu, a Beijing-based banking analyst at Fitch Ratings. “That's a little harder to do politically in the west.”

In the wake of the initial bail-out two things quickly became clear. First, there would need to be another large transfer of toxic assets from the banks as more non-performing loans appeared on their books, and second there was no way the AMCs would ever be able to repay the principal on the bonds they had issued to the banks.

“At the beginning there was an unrealistic expectation that they could quickly reduce the magnitude of the problem but they eventually realised the quality of the assets were abysmal,” says Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics, a think-tank, in Washington.

Beginning in 2003, the government carved out another Rmb1,000bn of non-performing loans from the banks and handed them to the AMCs, this time in exchange for a variety of government-backed bonds, often at discounts to their face value. Cinda says it has received about Rmb1,000bn in bad loans. The AMC says it made a profit last year of Rmb1.2bn, compared with combined profits for all four bad banks of Rmb2.3bn.

This is a rare insight into the finances of these entities, which have not released public figures for years but it is unclear how the profits are accumulated, or what the asset base of the AMCs is.

Until three years ago the AMCs were reporting aggregate returns of about 20-22 fen on the renminbi – a 20 per cent to 22 per cent return on the face value of the assets they received from the banks. However, they have since been much less forthcoming.

“These AMCs must by now be massively insolvent because all the better assets have been sold and they have used the proceeds to pay the interest on the bonds they issued,” says Mr Lardy.