Chinese Banks Test Investors' Patience

Times Staff Writer

Foreign companies have been practically stepping over one another to invest in Chinese banks, but it will probably be a long time before anybody walks away with happy returns.

Just ask Frank Newman, a turnaround artist who took the helm at Shenzhen Development Bank a few months ago. When the former No. 2 man at the U.S. Treasury Department arrived at the bank, an institution with $25 billion in assets, he was amazed that there were no financial reports on the company's divisions. The bank's thick book of bad debts was fraught with surprises: One real estate loan had been neglected for 12 years. Many others, he learned, were actually collectible because borrowers had hidden assets.

"In all my years of banking, I've never seen anything like it," said the 63-year-old Newman, who helped revive Bank of America in the 1980s and Bankers Trust a decade later.

Analysts consider China's financial sector to be the weakest link in the nation's booming economy. The Chinese central government has poured tens of billions of dollars to prop up its big banks, which have been hobbled by corruption and lax lending practices. At the same time, Beijing has encouraged foreign firms to buy a stake in them, to inject capital and much-needed technical and management know-how.

Many have been happy to oblige. In recent months, Bank of America Corp., Royal Bank of Scotland, American Express Co., Goldman Sachs, Merrill Lynch & Co. and others have pledged to invest billions of dollars in Chinese banks.

The allure is China's huge banking market, which is dominated by four state-owned banks but will be open to all comers at the end of 2006 under Beijing's agreement when it joined the World Trade Organization. Foreign banks are buying stakes now to get a toehold in that market, and investors are betting that China's banks will be reformed and someday become valuable publicly listed companies.

Chinese banks have made progress, but they're still loaded with bad debt and operate inefficiently. Weak corporate management and corruption remain a problem at many banks. Last weekend, China's bank regulator reported that 1,700 employees were held for embezzlement and other bank crimes in the first half of this year.

There could be more trouble ahead.

Leading analysts say China's economy is downshifting. Corporate profits are weakening, as are Chinese imports of steel, oil and capital goods. Real estate activity in places such as Shanghai is slowing.

"For the last three or four years, [China banks] have been operating in a very benign environment," said Nicholas Lardy, a China expert and senior fellow at the Institute for International Economics. But now, he said, "I think we're at a turning point where the economy is likely to grow more slowly."

That doesn't mean China's economy will tumble; few are expecting that. But given that Chinese banks have been lending liberally to private enterprises during good times, a downturn is almost certain to set the financial industry back, said Stephen Green, senior economist for Standard Chartered Bank in Shanghai.

"Inevitably, there will be a second large wave" of troubled loans, Green said.

The central government will see to it that the biggest banks don't fail because that could lead to social disorder, which could be disastrous for the Communist Party leadership. But a relapse would be more costly to Beijing, which already has handed out about $100 billion to banks, mostly to the big four: Industrial & Commercial Bank of China, Bank of China, China Construction Bank and Agricultural Bank of China.

The cash infusion has helped those four banks collectively trim the percent of bad loans from 35% a few years ago to about 10%, according to Chinese government figures. But some analysts think that the share of problem loans is much higher than that. When analyzed with government support excluded, each of these four Chinese banks has an unfavorable D rating from Standard & Poor's.

"We don't think their credit quality will improve substantially because of a new partner," said Connie Wong, an S&P; analyst in Hong Kong, explaining that it was partly because foreign investors can acquire only a minority stake, thus giving them relatively little control over operations and management.

A foreign company is essentially restricted from owning more than 20% of a Chinese bank. And a Chinese lender can have only up to 25% of its total shares in foreign hands before it faces significant constraints.

In June, Bank of America announced it would spend $2.5 billion for a 9% stake in China Construction Bank, which is expecting to list its shares on the Hong Kong Stock Exchange this year. For that, the Charlotte, N.C.-based bank got one seat on the Chinese bank's board of 14 members, although analysts say the deal also could give BofA opportunities to jointly market credit cards and other fee-generating products.

The problems at China Construction Bank and the others go back decades, a legacy of a centrally planned economy in which banks functioned to serve state-owned enterprises and keep party bureaucrats happy. Even today, entrepreneurs complain that the big commercial banks favor state-owned firms. But Beijing is trying to change that culture and bring its lenders up to international snuff before December 2006, when foreign banks will be allowed to do business directly with Chinese consumers.

China's big four hold most of the nation's $1.4 trillion in savings deposits as well as the lion's share of loans. Competing against them are about 120 city commercial banks and so-called shareholder banks. A few of them are listed in China's stock exchange. Still, said CLSA Asia-Pacific Markets analyst Andy Rothman in Shanghai, "There are no private banks in China because the Communist Party controls all of the country's financial institutions."

Newbridge Capital, a Fort Worth-based private equity firm, paid $145 million late last year for an 18% stake in Shenzhen Development Bank. Other foreign firms that have opted to invest in smaller Chinese banks, partly so they can have greater influence, include Citigroup Inc., which for now holds 5% of Shanghai Pudong Development Bank, and Britain-based Standard Chartered, which last week agreed to invest $123 million for a 20% interest in Bohai Bank in the northern city of Tianjin.

But as Newbridge's early experience suggests, it's going to be a long slog. Newbridge is unusual in that it has managerial control at Shenzhen Development Bank. The equity firm brought in Newman as chairman, who has helped recruit chief financial, credit and systems officers from Taiwan, Hong Kong and California.

Newman, a former deputy Treasury secretary in the Clinton administration, replaced half of the branch managers. Newman says some of them were running their operations like fiefdoms. He also beefed up the bank's debt collection staff and then had them go after delinquent borrowers by using the courts and in at least one case by turning to Shenzhen police.

That helped the bank collect $185 million of bad debt in the first six months of the year. But the bank still has $1.8 billion of nonperforming loans in its books. That represents a hefty 10.7% of the company's overall loan portfolio. The average nonperforming loan ratio in the U.S. is closer to 2%.

Still, Newman says, there's "tremendous opportunity" to attract customers at Shenzhen Development Bank with credit cards, home mortgages, wealth management and investment funds -- all of which are in their infancy in China.

Yang Qingling, a banking analyst in Beijing, agrees. Not only are these products not developed, but Chinese banks also haven't really needed to compete for even basic customers, she says. Virtually all of them offer the same measly 1% interest rate for ordinary savings deposits. Yet Chinese can't invest in overseas markets, and China's stock market is dysfunctional, so most continue to sock away their incomes in their neighborhood banks.

"I don't think the service is good," Yang said. "There isn't much difference between them."

That's where foreign banks see an opening. But analysts caution that it'll hardly be a cakewalk.

Last year Chinese officials lifted the ceiling on interest rates for loans, giving banks the ability to charge risky customers a rate well above the government's benchmark rates. But Beijing didn't abolish the minimum rate that banks could offer.

Lardy, the China expert, says the Chinese central bank never explained the rationale for the lower limit. But he suspects that one reason may have been to keep foreign competitors at bay. The upshot is that international lenders with expertise in sizing up the best borrowers won't be able to offer them much lower rates and beat domestic banks on price.

"I think it will take a long time for foreign banks to increase market share," Lardy said.

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