Last week I wrote about China's economy. In this issue I will examine challenges facing China's financial services, a particularly relevant issue given the credit turbulence in the United States.
Among Chinese financial institutions, the banking industry stands out as the preeminent sector. There are four major categories: the central bank, state-owned commercial banks, state-owned policy banks and joint stock banks. Among the biggest players include China Construction Bank, Bank of China, Agricultural Bank of China and the Industrial and Commercial Bank of China, which are dubbed the "Big Four". The commercial banking industry will operate with estimated total revenue of $40 billion in 2008.
Emphasizing "Guanxi," or personal connections in Mandarin Chinese, customers in China are biased toward investing in local banks. In a survey conducted in 2007 by McKinsey & Co., 78 percent of respondents prefer doing business with local banks, an increase from 66 percent in 1999. This partiality toward native institutions has resulted in huge capital inflows into the Big Four. As the Chinese economy continues to grow, demand for Chinese banks remains very strong. In fact, ICBC raised $19 billion on both the Hong Kong and Shanghai Stock Exchanges in 2006, marking the world's biggest initial public offering.
As Chinese banks continue to absorb fresh capital, they are afflicted by a high level of bad loans. The $205 billion of debt in Chinese banks is non-performing -- this means 13 percent of total banking assets are not collectable from the borrowers. If the fast-growing economy slows down, banks are going to take huge write-downs, similar to what many U.S. banks like Bear Stearns and Citi have done recently.
Reducing bad debt requires major regulatory and institutional shakeups within the Chinese banking industry. Cultivating strong corporate governance and developing superior products could optimize banking operations. The demand for advanced financial services in turn presents many investment opportunities for western financial firms.
If you think predatory lending is only an American problem, think twice. Many Chinese borrowers submit fake addresses and lack valuable property as collateral. Bank employees are not trained with strong risk-management backgrounds. Naturally, when these "subprime" borrowers failed to submit their interest payments, loans default and lenders suffer. By introducing the relatively disciplined Western corporate culture, Chinese banks will improve their operational performance.
Furthermore, younger customers under 40 in China pay great attention to individualized services and products. They are willing to spend more on financial advice than their older counterparts. Many American and European companies have extensive experience and advanced financial analytics to help their customers design products that fit their specific needs.Thus, by partnering with American banks, Chinese banks would gradually develop the capacity to offer these similar personalized features.
The lack of sophisticated financial analytics at Chinese banks hinders their assessments of the credit risk of new firms with unverified technology. As a result, the Shanghai and Shenzhen Stock Exchanges severely restrict capital access to startup companies. This credit crunch leaves many Chinese entrepreneurs with one option -- private equity.
PE funds primarily invest in growing and small companies in hopes of selling them later for profit.
While many PEs in China reap lucrative IPO profits, they face tremendous political hurdles and lack ownership rights in companies in which they invest.
From 2001 to 2003, the total venture capital investment in China grew $1,928 million. The leading players in China include foreign investors such as Baring Private Equity Partners and Carlyle Asia Venture Partners (both Bush 41 and 43 are current employees), while Beijing High Technology Venture Capital and Tsinghua Venture Capital dominate the domestic force.
To achieve higher profitability, the outdated Soviet-style SOEs have been restructuring, selling and privatizing their assets. This presents opportunities for PE funds as they quickly buy up these SOE business units. They restructure the new acquisitions and sell them for handsome profits through IPOs. There have been major success stories with such Chinese companies. In March 2003, Goldman Sachs and Walden International Investment Group helped Semiconductor Manufacturing International Corp obtain a $1.8 billion IPO on the New York Stock Exchange. On the Hong Kong Stock Exchange, Morgan Stanley and Goldman Sachs in 2004 raised $1.5 billion for Ping An Insurance Co., one of the largest insurance companies in China. With the economy growing fast, venture capital investments in China remain attractive.
Tremendous political impediments will potentially limit PE growth in China, however; the Chinese government imposes heavy protectionist sanctions on foreign capital groups. Just last year, Xiaoling Wu, deputy governor of China's central bank, stated that China's growing foreign reserves have "forced the government to tighten controls on foreign capital inflows." Such restrictive capital control would severely limit the development of PEs because most of the bigger deals were underwritten by foreign groups. With less PEs, entrepreneurs will find less cash available for investments and therefore suffer from a potential capital drought.
Although the Chinese economy has become the envy of the world, its financial sector has yet to catch up to meet the capital requirements that a developed nation exhibits. By allowing better transparency and loosening government control, China will continue to grow and emerge as a world superpower.
Paul Chen is a second-year student majoring in economics and mathematics major. He can be reached at paulchenUVA@gmail.com.
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