Recent reports have pegged open interest in the world’s largest IPO at nearly US$400 billion. That’s a lot of capital ready to speculate on a still unproven Chinese macroeconomy, particularly in the face of its ongoing structural woes. Could this be the end of the beginning for capitalism in China? Or perhaps the beginning of the end

The Enduring Allure of China
by Peter Zeihan,

The Industrial and Commercial Bank of China (ICBC) is expected to raise nearly $22 billion in an initial public offering (IPO) — the largest in history — after shares are made available to retail investors Oct. 27. The ICBC offering is the latest in a series of IPOs involving Chinese banks, into which Western investment firms have poured billions since 2005.

china_skylineWhat is surprising about the expectations for the offering is not only the tremendous amount of cash likely to be raised, but the fact that it comes only months after a number of major global accounting firms began taking note of serious structural weaknesses in China’s financial system. Recall that, in early summer, a series of reports were issued by Ernst & Young, PricewaterhouseCoopers, McKinsey Global Institute and Fitch concerning the problem of nonperforming loans (NPLs) and questioning the long-term stability of the Chinese market.

These reports, we noted, aligned with a long-standing Stratfor forecast as well; the structural weaknesses have been apparent and widely discussed in the Chinese press for years. What is curious, then, is not why mainstream accounting firms and consultancies suddenly began to question the prospects of China’s economy, but rather why foreign investors are continuing to pile into the state’s banking industry regardless.

The simple answer, of course, is “irrational exuberance.” The shine of a market that services 1.3 billion people — and a chance to carve out a piece of that market for oneself — is difficult to ignore. But there is more to be considered: China has gone to considerable lengths to generate the impression that the systemic weaknesses are being addressed and to make its banks (and other state industries) appear attractive to foreign investors. It is no accident that a spate of banking IPOs — Bank of Communications ($1.6 billion raised), China Construction Bank ($8 billion), Bank of China ($11.2 billion), China Merchants Bank ($2.6 billion) — have been announced since June 2005. It also is no accident that ICBC, one of China’s “Big Four,” is going public at this time — as the transition period for full World Trade Organization membership is drawing to a close.

Beijing, which long has been aware of the economic weaknesses (not to mention the political and social implications stemming from them), has been pursuing a brilliant strategy that bears some consideration.

A Structural Dilemma

China long has had a pressing need to address its NPL problem — and limited means of doing so. The core issue, as has been noted many times, rests in the attitude toward loans and state-driven industries — with lending practices that differ sharply from those common in the West.

For Western lenders, money is viewed as a scarce commodity, and loans are allocated with rates of return and profits in mind. In the Chinese system, capital has been viewed as a political asset, allocated to achieve social aims. Controls over what kinds of collateral could be used, credit histories and sources of income have not been critical considerations.

Given such values, citizens have little choice but to funnel their savings into state-owned banks (remember that legendary Asian savings rate?). Historically, those banks then have parceled out the cash — at below-market rates — to projects that contribute to the social good of mass employment. From Beijing’s perspective, it does not matter if these projects (which typically have been state-owned) turn profits or even break even financially. A bum project that runs to the red, but keeps many Chinese employed, was considered a success — and besides, it could always be buoyed up by more loans. Ultimately, projects became mired in massive debt, and the banks were saddled with masses of NPLs.

Clearly, this system would lead to instability even in a perfect world — and China is far from perfect. Because of wealthy coastal magnates, local leaders now dabbling in business and the ever-present availability of easy loans, the Communist Party, and the Chinese system in general, is massively shot through with corruption. Former President Jiang Zemin in 1998 attempted to start closing down some of these dud projects — particularly the redundant and wasteful commercial projects at the local level — but met with massive backlash from local officials who had no desire either to face hordes of local unemployed or to give up suckling on the mother’s milk provided by state banks.

As we noted in May 2005, a destabilizing shock appeared to be all but unavoidable by December 2006, when the transition period for China’s WTO accession ends. At that point, foreign banks — which, unlike their Chinese counterparts, actually charge interest for their loans and pay out interest on deposits — will be allowed to set up shop throughout China. Odds are that the average depositor would move his money out of the state banks, denying them the resources they need to keep the system running and leading to financial chaos and collapse.

Chinese policymakers also could see this problem approaching, and they have no intention of letting the financial system be the state’s downfall. Thus, they embarked on a creative strategy.

The Cleanup Strategy

Again, the U.S. or Western model of cleaning up the system — a painful purge of corruption and implementation of stringent financial policies — does not apply. For the Chinese, there is simply too much at stake: As recently as three years ago, the central government, which has a vested interest in lowballing these figures, pegged the total stock of bad loans at 35 percent of gross domestic product.

The Chinese could not apply the model used in the United States during the savings and loan crisis of the 1980s. At that time, independent auditors went through the books of suffering S&Ls and chopped up their loan portfolios, ranking the pieces in terms of the chances that debtors ever could pay them off. Those loans were then packaged together, ranked and sold to other — healthy — banks. Some of the S&Ls were closed; others faced massive personnel and policy overhauls. Some of the S&L corporate clients went out of business. Some S&L officers went to jail.

China, rather than going down such a capital-centered route, has come up with a two-pronged strategy designed to fit its own social needs.

First, the Chinese cleaned the banks’ books. The government simultaneously has pumped out cash from its now trillion-dollar foreign currency reserve to recapitalize the banks, and transferred the bulk of the NPLs to “asset management corporations.” These asset management entities are ostensibly responsible for collecting on the bad loans — though, because these remain government-owned, Beijing has no intention of forcing compliance on that issue. The asset management firms issue bonds to the banks for the full face value of the loans, making the banks’ balance sheets look sparklingly clean indeed.

Second, the banks — drawing on the full authority of the Chinese state — seek out foreign investors, either through IPOs or strategic capital allocations from foreign corporations. This is a critical step, for four reasons:

• Foreign corporations know how to run a bank, and can provide the skill sets needed for (new) tasks such as loan evaluation, risk assessment and internal anticorruption checks. For the government, these kinds of processes could be quite troublesome at times, but also can be very handy.

• It undercuts any competitive instincts the foreign banks might have. By bringing foreign entities to partner with the state banks under the current system, the odds that those so invested would attempt to go solo come December — when WTO restraints on competition are lifted — are greatly reduced. And that means less instability stemming from contests over Chinese depositors’ savings.

• Foreign banks have cash — which, obviously, the Chinese desperately need.

• Most important, a foreign bank that buys into a Chinese bank gets access to tens (sometimes hundreds) of thousands of local branches. Any way you cut it, that is a sweet asset. Once the foreigners are in, they have a vested interest in working with the Chinese to make the financial system more functional — which has been the point of the strategy all along.

This is the strategy that several Chinese banks already have followed: Bank of Communications drew capital from HSBC; China Construction Bank found an investor in Bank of America; and ICBC, which opened its IPO to institutional investors Oct. 16, lured Goldman Sachs.


Given the upcoming share sale to retail investors, ICBC’s history of action is, of course, particularly worthy of study.

Since 2004, it has transferred about $85 billion in bad loans, through asset management company Huarong. Then, in 2005, it received a $15 billion cash injection from Central Huijin Co., the Chinese recapitalization body. Finally, earlier this year, ICBC sold a 5.8 percent stake to a consortium led by Goldman Sachs for $3.7 billion.

As a result, the bank, which had an NPL ratio of more than 21 percent at the end of 2004, had (by its own, and therefore questionable, assessment) reduced that number to 4.1 percent as of June.

Intriguingly, foreign investors seem not to have noticed how ICBC got from Point A to Point B. Some concerns about the bank’s lending practices have been voiced — most recently, following news in September that ICBC had funded a company, Fuxi Investment, that has been linked to the widening pension funds scandal. However, seemingly no attention has been given to the fact that China has been transferring NPLs from, and providing capital infusions for, state banks — including ICBC — for years, without overhauling their corporate decision-making processes or management.

Not to mention the short-lived impact of all of those global accounting firm reports in May.

But the anomaly in all of this — the lure of China to Western investors — remains. Digging up information about the problems in the Chinese system is not difficult; every bit of it is regularly reported in the state-run press. Government statistics are frequently optimistic, but even Beijing’s own estimates clearly point to significant structural problems. The Chinese, obviously, have been paying attention and communicating. What is puzzling is why the message does not seem to be getting through.