The Magazine

Don't Bank on China

A flawed audit, or all too accurate?

Jun 19, 2006, Vol. 11, No. 38 • By GARY SCHMITT and JARED FEIGER
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EARLY LAST MONTH, the accounting firm of Ernst and Young released a report concluding that the "nonperforming" loans of China's banks totaled $911 billion (40 percent of China's GDP)--a figure that far exceeds the Chinese government's own estimate of $164 billion. Beijing's response to the report was not subtle: "The report not only seriously distorts the actual assets quality of the Chinese banking sector," but "its conclusions are absurd and incomprehensible." Ernst and Young withdrew the report the next day, citing fundamental errors in the analysis.

But was the report really that flawed? Or was the firm's report more right than wrong, and retracted only because doing business in China these days requires pulling one's punches?

Certainly, Ernst and Young's position as auditor for the state-owned Industrial and Commercial Bank of China, the country's largest bank, would give it insight into China's banking problems--and also the incentive to think twice about making the Chinese government angry. The report's timing could not have been worse, as several Chinese banks are gearing up this year for initial public offerings on the Hong Kong exchange that should bring in tens of billions of dollars in new capital. (Ernst and Young will earn millions when, as expected, the Industrial and Commercial Bank launches its IPO effort this coming September.) The last thing China's banks wanted to see was a sour report on their great volume of bad loans and their underlying financial condition.

Of course, China's problem with nonperforming loans (NPLs) is not new. In 1999, according to the "official" tally, NPLs accounted for 25 percent of the total amount of money loaned--a huge amount by international banking standards. The pace at which new loans increased was so great that even after the government moved many of the worst loans off the books to "asset management companies"--created expressly to deal with this mounting problem--and infused the banks with hundreds of billions in new capital, the official ratio still remained at 25 percent.

Moreover, NPL totals are expected to rise as a result of a flood of new lending by Chinese banks between 2002 and 2004 and "another credit surge" recently reported in the Economist. In the first four months of this year, Chinese banks lent 60 percent of the amount of credit they issued for the whole of 2005. This is bound to give rise to future bad loans.

In fact, the Ernst and Young report was not unique. Very few financial analysts believe China's "official" figure for NPLs. Most think the ratio of bad loans is considerably higher, maybe as high as 50 percent, according to Frank Song, director of Hong Kong University's China Financial Research Center. When suspected NPL figures are combined with prospective NPL estimates, the Ernst and Young report's figure of $900 billion is probably not wildly off the mark. In fact, previous estimates by Standard and Poor's and PricewaterhouseCoopers indicated that Chinese NPLs could very well top $800 billion; and Fitch Ratings has just put the number at close to $700 billion. Like any such assessment, it's possible that the Ernst and Young report was based on assumptions and analysis that could be called into question. But it's just as likely that the report's inconvenient timing was the reason it was retracted.

The reality is that China's leaders simply haven't been that interested in telling banks to stop throwing good money after bad. Loose credit has become a way of life not only for China's bankers but also for its bureaucrats and party officials. China's banks have an immense amount of cash to play with. The savings rate of Chinese citizens is extraordinarily high: Pensions are uncertain and demographic trends indicate that China's aging population of parents and grandparents can increasingly expect less and less help from their children. The largest banks are also state-controlled and have personal and institutional incentives to give loans to state-owned enterprises, which still make up a surprisingly large segment of the Chinese economy and typically bleed money. With party officials and their relatives sitting on corporate bank boards or managing one of the tens of thousands of largely independent local branches, the banks have become the world's largest ATMs for China's political and business elite. Add to this the fact that China's banks have, at best, rudimentary internal audit systems.