Risks for U.S. banks investing in China
By Frederick W. Stakelbeck Jr.
web posted September 19, 2005
Recognizing China's enormous importance to the global financial marketplace and its future impact on the world economy in general, U.S. financial institutions such as Bank of America, Citigroup, J.P. MorganChase, Merrill Lynch, Morgan Stanley and others have recently invested billions of dollars in the Chinese banking sector.
In early September, Goldman Sachs, American Express and Germany's Allianz AG signed a deal to purchase 10 percent of China's largest state-owned lender, Industrial and Commercial Bank of China (ICBC), at a cost of $3 billion. Separately, Swiss Bank UBS AG, Royal Bank of Scotland (RBS), Bank of America and Singapore's Temasek Holdings have all invested heavily in the Chinese banking sector. Since June, foreign investors have poured more than $15 billion into the Chinese banking sector.
Increased investment in China comes at a time when many of America's largest banks have seen a greater percentage of their overall profits generated from international banking operations. According to a Federal Deposit Insurance Corporation (FDIC) quarterly report, "Summer Outlook 2005," Citgroup and JP MorganChase, the two largest U.S. banks in terms of assets, earned approximately 50 percent of their net income from operations outside North America. This trend is likely to continue, as other U.S. banks accelerate international investment, foster cross-boarder partnerships and revise corporate strategies.
Why China?
With an astounding one billion bank customers, a burgeoning middle class, cumulative household savings of $1.65 trillion and annual GDP growth of 9 percent, China is an attractive investment alternative for banks located throughout the world. "Companies are seeing some of their fastest growth in China, and its profitable growth," said Kristin J. Forbes, a former member of the White House Council on Economic Advisors.
For a Chinese banking industry designed primarily to process deposit transactions, the prospect of serving the diverse financial needs of millions of middle class citizens is daunting. China remains a developing market economy, as such; the Chinese banking sector lacks the expertise and skills in areas such as marketing, risk management, fraud mitigation and modeling. Add to this a historical reluctance of Chinese bankers to lend money without collateral, and U.S. banks could one day dominate the Chinese banking sector.
However, such dominance is not expected anytime soon, as U.S. banking activities in China remain limited to trade financing, foreign exchange, wholesale banking and corporate lending. As with other businesses operating in the unpredictable Chinese marketplace, foreign investment is encouraged, but only through limited or minority partnerships. As a result, mergers, acquisitions and joint partnerships may provide the most practical alternative for U.S. banks.
Changes to China's banking system as a result of concessions made to the World Trade Organization should improve the environment for foreign banks after 2006, but burdensome capital reserve, liquidity and deposit requirements imposed by the country's two banking regulators, the People's Bank of China and China Banking Regulatory Commission, will continue to pose problems for foreign banks.
Risks to U.S. Banks
Although the effects of the 1997 Asian financial crisis and the 2003 South Korean credit card crisis have passed, solvency problems continue to plague the Chinese banking system. In April, Standard & Poor's Rating Service estimated that it would take $190 billion to restore the capital base of two of the country's largest banks, Industrial & Commercial Bank of China (ICBC) and Agricultural Bank. The rating agency commented, "As the sole shareholder in both banks, the Chinese government will have to pay most of the recapitalization before the banks are in a position to attract investors."
This raises an important question: If bad debts associated with inadequate controls and ineffective management practices have already caused an asset and liquidity crisis, what are the impending risks for U.S. banks doing business in China? Certainly, an already cash strapped U.S. government would be unable to rescue U.S. banks from a considerable foreign investment misstep. "If the [Chinese] economy takes a stumble, the impact on the banks will be disastrous," says David Marshall, a banking analyst with Fitch in Hong Kong.
Consumer bankruptcies, poor underwriting standards and ineffective internal controls continue to worry foreign investors. The destructive impact of unleashing easy credit upon developing nations with nascent banking systems is a real danger for U.S. banks. "The [Chinese] banks have been very lenient so far," says Li Kui Wai, an economics professor at the City University of Hong Kong. "The system is really a problem."
Access to a national credit database remains uncertain, with some foreign banks forced to use one of the country's few credit bureaus, the Shanghai Credit Information Service's Consumer Credit Database System (CCDS), that holds a mere 3.7 million consumer records. "It will take many more years before Chinese banks have robust risk-management systems and sound financial profiles." says Fitch's Marshall.
The inherent instability of the Chinese banking system has generated calls from Chinese bankers for accountability and stability, "Profitability and risk management in the light of the market should be well balanced," said Soomee Har, head of Chinese consumer banking at Standard Chartered Bank. "It is critical to ensure the overall health of the banking industry. There is a lot of room to grow," she said. Ms. Har also advocates a structured approach to each individual customer using credit bureau, internal databases and background checks, thus, mitigating credit losses.
China's banking sector is also plagued by colossal bad loans, a lack of transparency, corruption and other abuses. Recent bank action to sell off non-performing loans and a capital infusion of $60 billion from the Chinese government have provided temporary relief, but there is no guarantee that major problems will not resurface again. Frank Newman, a former U.S. Treasury Department official in the Clinton Administration and a current executive with Shenzhen Development Bank visited China in 2005; he was shocked to find that financial reports on a particular $25 billion institution were nonexistent. "In all my years of banking, I've never seen anything like it," he said. Structural imbalances, increasing unemployment, inflation, stagnant wages, and difficulties securing reliable energy resources, are also concerns for U.S. banks.
Eagerness Can Lead To Mistakes
In private, Chinese President Hu Jintao has called for increased U.S. investment and a modernization of his country's banking industry. But in private, Mr. Hu has attacked the U.S. as "hostile." U.S. banks should give this dangerous paradox full consideration before adopting a unique China investment strategy. Of course, it would be naïve to think that U.S. banks will not explore the Chinese banking sector. But any investment action should be undertaken with extreme due diligence, a commitment to proven risk management practices and an understanding that at any moment Sino-western relations could dampen, and a state-sponsored purge could occur.
Will Hu Jintao and his cohorts in Beijing support the further globalization of the Chinese banking industry, allowing U.S. banks and other foreign entities to use their sizable capital reserves, expertise and skills to enter the domestic banking industry? If a full integration of the Chinese banking sector is unceremoniously thwarted, Beijing runs the risk of being labeled hypocritical, especially given its vociferous criticism of the Bush administration over recent protectionist action concerning U.S. energy interests.
Finally, can a Beijing government that regularly suppresses the free speech rights of its citizens, imprisons religious and political dissidents, arms rogue nuclear powers and supports some of the world's most notorious depots be trusted to protect the free enterprise rights of U.S. banks? 
Frederick W. Stakelbeck Jr. is an expert on bilateral and trilateral alliances as they relate to China foreign policy. His writings address the implications of China's emerging regional and global strategic influence and relationships upon U.S. national security.
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