CHINA: THE FUNDRAISING DILEMMA

Summary

     China is considering how to supply capital to its lending institutions. The main options -- to provide direct capital infusions from the central government for free, to trade government loans for equity stakes in the institutions, or to have the banks independently raise funds on capital markets -- all have significant downsides for Beijing as it attempts to continue the country's rapid economic growth.

Analysis

     The Communist Party of China's Central Economic Work Conference concluded on Dec. 7 after top leaders, including Chinese President Hu Jintao, gathered to map out economic policy for the coming year. The conclusions of the conference were mostly expected, highlighting the need to increase domestic consumption, reduce reliance on exports, close the gap between urban and rural standards of living, and maintain robust fiscal stimulus and loose monetary policy throughout 2010.

     Critical to this policy is the fact that China will maintain high levels of bank lending in the coming year -- current estimates predict new lending will reach 7.5 to 8 trillion yuan ($1-$1.2 trillion). This raises the question of how banks will get the necessary capital to do so.

     The only institutions capable of supplying enough financing to keep the Chinese economy growing are the banks. China's banking system is dominant in its overall financial system, consistently accounting for around 80 percent of total financing in non-financial sectors of the economy (compared to 20 percent in the United States). In 2009, this portion increased to above 85 percent, as the banks have provided nearly 10 trillion yuan ($1.46 trillion) worth of new loans to boost the economy. Most of these loans are provided by state-owned and joint-stock commercial banks in the "Big Four" state-owned commercial banks: the Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB) and Agricultural Bank of China (ABC).

     Chinese authorities will undoubtedly press banks to increase loan scrutiny and shift their lending profiles away from the riskiest borrowers, but credit policies have always been loose in China, and this is not likely to change soon -- most notably because the government is committed to supplying fresh loans for stimulus projects begun in 2009 as well as supplying the usual yearly lending to major industrial, commercial, agricultural and other sectors.

     Thus the question for Chinese policymakers is how to keep the banks sufficiently capitalized. Estimates suggest that a combined 300-400 billion yuan ($44-$59 billion) will be necessary for the Big Four in the coming years. There are several options, ranging from direct government capital infusions, and government purchases of stakes in the banks, raising funds on equities markets or issuing bonds. Each option has its advantages and disadvantages.

     First, the central government could inject the cash with no strings attached. After all, the country holds roughly $2.3 trillion in foreign exchange reserves. The central government has provided funds for roughly 1 trillion yuan out of the 4 trillion yuan-stimulus and development package announced in November 2008 and opted to let the banks and local governments handle the funding for the other 3 trillion yuan. Certainly the central government could choose to bolster the banks -- it has dipped into its reserves before to recapitalize the banks, including in 2004 when it transferred $45 billion to the China Construction Bank and Bank of China. But that was meant to be an exception, since at the time the banks were having their balance sheets purged of bad assets to prepare them for public listing on stock markets. Far more likely, the central government will avoid capital injections until an emergency or crisis, lest it give the banks an implicit blank check to lend without managing risks.

     The other option is for the government to provide the banks with funds in exchange for equity shares in the banks. STRATFOR sources indicate that China's Ministry of Finance (MOF) is currently attempting to gain stakes in the Big Four banks. The MOF has pointed to its assistance in the current crisis as well as the bank bailouts of the early 2000s, in which it sold hundreds of billions of yuan worth of bonds to finance the removal of bad assets from the banks, as justifications for buying shares now. The idea that the MOF could buy stakes in the banks seems normal during a year in which governments have bailed out banks across the board. Even in Western developed countries like the United States, where government ownership of companies is frowned upon, this option has been chosen as a last resort to bolster banks' capital positions amid financial turmoil.

     The difference, however, is that many of the endemic problems in China's financial system arise from too much state involvement. All of the banks descended from the centralized banking system of the Maoist period, in which almost all banking and finance belonged to the People's Bank of China. Beijing has gone to great pains (especially since the late 1990s) to reform its financial system in a more market-oriented direction. Of course there has never been any doubt that Beijing retains control of the state-owned commercial banks -- primarily through the Huijin Corporation, which is the state-run company that holds controlling stakes in several of the top banks. But having the MOF buy equity now (since it would increase political influence and reverse efforts at cultivating a more free-market mentality and ownership structure) could drive away investors who have little interest in seeing their investments become even more susceptible to the Chinese bureaucracy's interests. There is no doubt that turf battles will result from the MOF's attempts, as rumors of the MOF's interest in acquiring holdings have already provoked a reaction from Huijin, which despite its state-run status has been known on occasion to lean toward private shareholders' interests.

     The bottom line is that the banks will either need to raise more capital to continue their current pace of lending through 2010, or they will be forced to reduce lending. The former threatens a deluge of share or bond issuances on markets, or to involve greater state involvement in banks that would reverse reforms, both rattling confidence in banks' loan portfolios and overall outlook. The latter could simply halt the economy's growth by starving businesses of credit, something that the central government, with its concerns for social stability, will not allow. Hence the lending must continue. STRATFOR will observe how the different institutions -- the Big Four, Huijin, the CBRC, the stock markets and stock regulator, and the central government -- negotiate ways to manage the risks of new lending while seeking the capital necessary to keep it going.

Copyright 2009 Stratfor.