Don't Bank on China

...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...

...Ernst and Young withdrew the report the next day, citing fundamental errors in the analysis...

...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...

...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...

...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...

...In fact, the Ernst and Young report was not unique...

...Loose credit has become a way of life not only for China's bankers but also for its bureaucrats and party officials...

...And while undoubtedly some in China do, others don't...

...But they are running headlong against a well-established and well-connected system of elite corruption...

...But was the report really that flawed...

...But it's just as likely that the report's inconvenient timing was the reason it was retracted...

...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 compa-nies"—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...

...As Minxin Pei notes in his fine new book China's Trapped Transition, "Few authoritarian regimes can rely on coercion to maintain power...

...And to protect that system, the Chinese are only allowing their non-Chinese partners minority ownership positions which, in turn, only give them a limited say over banking practices...

...The bubble in real estate may, of course, burst, and it's an open question whether the world's consumers will, against rising protectionist sentiments in industrial nations, continue to support the ever expanding capacity of Chinese manufacturing or, for that matter, buy all its products...

...Plenty of analysts have seen these problems and have predicted China's economic downfall for some years now—and it hasn't happened...

...Western financial experts keep looking at China as though it simply wants to be another Western-style, economic force...

...The buildup in domestic liquidity —^savings, plus massive foreign investment—has led to an inflated domestic real estate market and massive spending on infrastructure and manufacturing capacity, investments that now account for nearly half of China's economic output...

...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...

...The last thing China's banks wanted to see was a sour report on their great volume of Gary Schmitt is a resident scholar and Jared Feiger is a researcher at the American Enterprise Institute...

...The laws of economics may be complex, but they do, in the end, punish those who ignore their most rudimentary precepts...

...Of course, China's problem with nonperforming loans (NPLs) is not new...

...In addition, Beijing rightly suspects that allowing Chinese citizens to place more savings and profits in markets outside of China would result in a run on deposits that the state banks could not survive...

...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...

...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...

...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...

...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...

...Those in China who want it fixed are hoping that, by bringing in Western financial partners, they can raise additional funds and, through a coupling of management techniques, begin to bring better practices to mainland banks...

...China is no different, and its banks remain a critical element in the regime's strategy for self-preservation...

...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 reality is that China's leaders simply haven't been that interested in telling banks to stop throwing good money after bad...

...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...

...bad loans and their underlying financial condition...

...Most autocracies mix coercion with patronage to secure support from key constituencies, such as the bureaucracy, the military, and business groups...

...So, the question is, will the banks be fixed...

...China's banks have an immense amount of cash to play with...

...In fact, previous estimates by Standard and Poor's and PricewaterhouseCoopers indicated that Chinese NPLs could very well top $800 billion...

...At least, not yet...

...Add to this the fact that China's banks have, at best, rudimentary internal audit systems...

...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...

...Ernst and Young will earn millions when, as expected, the Industrial and Commercial Bank launches its IPO effort this coming September...

...This is bound to give rise to future bad loans...

...Moreover, the nearly 170,000 state-owned enterprises being supported by the banks cannot, Beijing believes, be allowed to go out of business...

...However, that's the point...

...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...

...and Fitch Ratings has just put the number at close to $700 billion...

...Very few financial analysts believe China's "official" figure for NPLs...

...China's leaders are increasingly worried about rising unemployment and the social unrest that might follow...

...The Communist party sees the banks as too important, in allocating resources and ensuring political support, to turn them over to independent actors...

...BY GARY SCHMITT & JARED FEIGER EARLY LAST MONTH, the accounting firm of Ernst and Young J 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...