China wants its banking industry to share the pain and help to boost a slumping economy—to the tune of 1.5 trillion yuan ($212 billion).
To combat the worst economic downturn in 40 years as the country attempts to rebound from the CCP virus crisis, the Chinese Communist Party’s (CCP) State Council has asked its banks to forgo up to 1.5 trillion yuan in profits.
It’s an unprecedented and shocking demand and serves as a sobering reminder that China, under the CCP, is still fundamentally a socialist, command economy.
There’s a lot to unpack on multiple fronts. First, Beijing is reaching beyond its traditional monetary policy toolkit to boost the economy. Second, banks will suffer financially as the central government is squeezing its profits during a period in which profits may already be slim to none, given the expected number of loan defaults.
Third and most importantly, this sends a terrible message to shareholders—many of whom are foreign investors. Shareholders have few rights in the operations of the companies they believe they own, and these for-profit companies can, without notice, become nonprofit organizations in the service of the CCP. This probably isn’t what the shareholders signed up for when they bought their bank stocks.
Bank Margins Squeezed
The State Council, or China’s cabinet, announced the push in mid-June. While the form it will take varies, banks are expected to lower their lending rates, cut fees and service charges, defer repayments on existing loans, and provide more unsecured loans to small businesses. Unsecured loans are loans provided without liens on a company’s assets, which provide a level of guarantee should the borrower default.
Economically, the announcement is akin to a policy stimulus, albeit Beijing isn’t sacrificing its state budget. It’s passing the cost to the country’s financial institutions and, ultimately, their defenseless investors.
At a very high level, a bank’s business model is to make money on interest spreads. It attempts to lend or invest at a higher interest rate than the interest it has to pay depositors or creditors. Forcing banks to lend at lower rates squeezes revenues without a corresponding decrease in the cost of funding.
And Chinese banks were already facing unprecedented stress even before the mandate to sacrifice profits.
Many borrowers are facing solvency issues, and the level of nonperforming loans (NPL) is set to increase. S&P Global expected the officially reported NPL ratio for Chinese banks to be around 2.2 percent in 2020, up slightly from 1.74 percent in 2019. Unofficially, S&P estimates that the industry’s nonperforming assets will increase to 7.25 percent in 2020, up 2 percent from last year.
UBS estimates that in a case where China’s economic growth is at 4.8 percent annually until 2021, China’s banking sector could see a 39 percent decrease in profits, according to a Bloomberg report.
Disregard for Shareholders
Chinese bank shares have declined in Hong Kong and mainland Chinese exchanges since June 16, when the measures were proposed.
A Beijing mandate forcing banks to sacrifice profits—essentially coercing the banks’ owners to take losses at the behest of the CCP—is a violation of corporate governance protocols. It serves as another reminder to foreign investors that Chinese companies are unfit as investments.
The U.S.–China Economic and Security Review Commission (USCC) issued a report on May 27 warning U.S. regulators that Chinese banks pose a systemic threat that is increasingly worrisome, as an increasing number of U.S. savers, pensioners, and retirement accounts own Chinese stocks, including in Chinese financial institutions.
“They remain beholden to and supported by the state,” the report says. “The Communist Party-state retains the ability to intervene decisively in the banking system to achieve desired outcomes.”
Chinese companies—including many of its banks—are part of MSCI and FTSE Russell’s emerging markets and global markets indices. Chinese domestic onshore bonds also make up a portion of the widely followed Bloomberg Barclays Global Aggregate Index. And many popular investment funds in the United States are mandated to follow the indices by buying securities issued by Chinese companies.
In just a few weeks, the USCC report has proven alarmingly prescient.