This morning we co-hosted a conference call with our Industrials Team, lead by Managing Director Jay Van Sciver, featuring Carl Walter, co-author of Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise (2012). On the call, Carl dove deeply into the complexion of and outlook for the Chinese financial system – specifically its key risks, most misunderstood features and the outlook for reform(s).
The replay podcast is about 50 minutes in its entirely (~25 mins of prepared remarks and ~25 mins of Q&A); if you care on China, it’s worth every minute of your time. If, however, you enjoy a more passing interest on the subject(s), please enjoy the following collection of what we thought were some of the more critical, candid and/or colorful quotes from our expert, Carl Walter:
- RE: provincial and municipal governments – “Really, you’re looking at a huge country that’s much like Europe… you have the Germanys, you have the Frances, you have the Greeces and you have the Portugals. You have places that work and places that don’t work.”
- RE: why banks are so integral to the Chinese financial system – “Banks are the pillar of the system because they have all of the deposits. The Big 5 Banks hold over 60% of all deposits.”
- RE: corporate bond market – “People seem to think the corporate bond market is being developed to take pressure off of the banks… I’ve never read such shallow and meaningless stuff in my life… The guys that own the bonds are the banks. They are the only ones that have the money to lend.”
- RE: bonds vs. loans tradeoff – “Banks have lent long and have run up to various liquidity measures. On a net-net basis, you can lend less than if you [underwrite] a bond.” … “You can see there is a [consistent] 3% or so differential between [yields on] loans and bonds.” … “Why are you creating a bond market where 75% of the issuers are the same as your borrowers?... What does a bond market really mean when there are no real third party interests?”
- RE: banks being the source of the problem – “Bank lending is no longer the solution for China, which is why you have all this discussion about changing business models.”
- RE: Too Big To Fail – “The banks really are just too big to fail and I truly doubt that any of them will be allowed to fail… When Lehman Bros. was allowed to fail here or, rather, was put into bankruptcy, the Chinese were completely taken aback because they couldn’t understand how the US gov’t would let one of its blue-chip banks go under unless it the gov’t really didn’t have the capacity to support it. In my point of view, [a major bank failure] would never happen in China because it would truly mean that the gov’t doesn’t have the capacity to support it.”
- RE: contextualizing shadow banking – “The huge bulk of [lending over the last 3-4yrs] has not been the shadow banking market. It’s been the banks.” … “WMPs have grown to be about 13% of deposits and pose a real risk to the credibility of the banks.”
- RE: NPL estimates – “[Chinese banks] certainly are hiding NPLs. The biggest way to hide them has been to extend maturities. But there are problem loans there and sooner or later they are going to have to come out or the banks are not going to be able to continue to lend… [For comparison] in 1997, 25% of total loans were bad… [Applying 20% to today’s post credit bubble loan portfolio yields about CNY6 trillion.]… CNY6 trillion is a conservative figure. You’re going to see a lot more capital raising on behalf of the banks.”
- RE: why China can’t use FX reserves as fiscal firepower – “Foreign reserves can’t really save China’s banks.” … “The capital [i.e. US Treasuries] is sitting in New York in a subaccount at the Fed under the PBOC. The capital is in New York. The bank is operating in China. It doesn’t really have any capital. So what happened was that they did five-year currency swaps and swapped them into RMB with the shareholder, Central Huijin… Those swaps were done over a period of three years and were done in such a way that they would not cause any kind of pip in inflation. If you’re going to use foreign exchange reserves – of which China has a load – you can’t really bring them back into the country to use them. You’ve already created RMB when you got them. If you bring them back into the country, you’re going to create a similar amount of RMB all over again and you’re going to create an inflationary situation.”
- RE: national debt – “If you add local government debt plus estimated NPLs [to a “narrow” calculation that includes the MOF, Policy Banks, Ministry of Railways and Bank Subordinated Debt] you get to 97% [sovereign debt/GDP].”
- RE: broad-based financial reform – “How do you reform interest rates – which are now fixed by the PBOC – when you have banks that are frozen in time with long-term loans with fixed interest rates and a big chunk of their corporate bond portfolio – which also long-term and has fixed interest rates? How are you going to reform your interest rates when it’s going to require a tremendous recapitalization of the banks? And you can’t hide it, because these banks are all listed in Hong Kong.” … “If you really want to reform this market, you’re going to dismantle everything that’s made it work so far. And you’re going to dismantle the levers of control the government and the Party has. I can’t imagine real serious reform.”
- RE: CNY and capital account liberalization – “How are you going to liberalize the RMB?... How are you going to reform [China’s financial system] by opening up the RMB markets? What would be the first thing that happened? People say that the RMB will appreciate. My comment is there’ll be a vast swooshing sound as people take their money out of the country.”
- RE: interest rate reform triggering a massive bank recapitalization requirement – “The real cost of capital is nowhere near 3% in China… As soon as you [liberalize deposit rates and] put on a more realistic cost of capital, you’re going to lose money on the banks’ bond portfolios – which are 25-30% of their balance sheets. And similarly, you’ll lose money on their loan portfolios as well.”
- RE: previous financial sector reforms – “Between the Asian Financial Crisis to 2005, there was a real serious effort to restructure the Chinese banks… My view of it is that the new leadership came in and didn’t have an appreciation for what was accomplished and stopped it. Serious people [in China] don’t want financial reform because they would not be the beneficiaries of reform – for example, the big SOEs.”
- RE: NPL evergreening – “Rolling this stuff forward so they can buy time to decide what to do is the typical bureaucratic way of dealing with this [NPL] problem. That will only make the problem worse.”
- RE: social unrest – “Unless GDP picks up in the next 3-5 years, there’s a possibility of some real social problems there [in China].”
- RE: sustained slowdown in fixed assets investment – “[Fixed assets investment] has to come down [as a percentage of GDP] because I don’t think the banks can continue to support this stuff. If you look at total social financing growth, we’re talking about [incremental] lending that’s over 30% of GDP the last four years… If a big chunk of [bank] assets are nonperforming and another big chunk of [bank] assets are long term and if [bank] deposits aren’t growing, then how are [Chinese banks] going to make new loans? You’ve got to have new liquidity. And the export sector, the WTO is what provided all this new liquidity. If you look at any of these charts – look at household savings – all of these things take off like rockets. [Look at] foreign reserves… [Look at] foreign direct investment. All of these things took off like rockets. The amount of liquidity injected into that system was unbelievable and that’s what allowed the banks to make all these loans. And now that liquidity is not being created.”
- RE: key players in the reform process – “I thought Hu Jintao and Wen Jiabao were the most useless people I’ve ever seen in my life. The new [President], Xi Jinping, impresses me. The new Premier [Li Keqiang] is not impressive. He’s a bureaucrat and if you’re a bureaucrat, you’re not going to achieve anything in that environment.”
Enjoy your evening,
ABOUT CARL WALTER
Carl Walter joined Stanford's Walter H. Shorenstein Asia-Pacific Research Center (Shorenstein APARC) during the winter and spring terms of the 2012-13 academic year after a career in banking spent largely in China. Walter has contributed articles to publications including Caijing, the Wall Street Journal and the China Quarterly. He is also the co-author of Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise (2012) and Privatizing China: Inside China's Stock Markets (2005).
Walter lived and worked in Beijing from 1991 to 2011, first as an investment banker involved in the earliest SOE restructurings and overseas public listings, then as chief operation officer of China's first joint venture investment bank, China International Capital Corporation. Over the last ten years he was JPMorgan's China chief operating officer as well as chief executive officer of its China banking subsidiary.
Walter holds a PhD in political science from Stanford University, a certificate of advanced study from Peking University and a BA in Russian Studies from Princeton University.