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The Risk Side of Investing in China’s State-Owned Banks

The Bank of China (BOC) and the China Construction Bank (CCB) —two of the country’s Big Four [1] state-owned banks—are both racing for initial public offerings (IPO) sometime in 2005, possibly on the New York stock exchange. “We hope that all our financial indices can reach the standard of a listed company at the time of our initial public offering,” said Li Lihui, President of the BOC.

Both banks are negotiating with potential strategic investors—probably more sophisticated financial institutions—who will buy stakes in the Chinese banks and help them streamline their operations, said the presidents of the two banks. They did not want to reveal the investors’ names, however, citing “commercial secret concerns.”

Why are the banks so eager to get listed on the overseas exchanges? What are the major risks for overseas investors if they choose to purchase their stocks?

The Crisis Facing China’s Banking System

Two major health indicators for the banking system are the non-performing loan (NPL) ratio and capital adequacy ratio. Measured by these two indicators, all the Big Four state-owned banks face financial crisis.

According to China’s official numbers, the NPL ratio­ —the ratio of bank’s non-performing loans to the total outstanding loans—of China’s commercial banks have been far below the international standards in the past few years. [2] In the first quarter of 2002, Dai Xianglong, then Governor of the People’s Bank of China, mentioned on more than one occasion that the NPL ratio of China’s commercial banks was 25.3 percent. In November 2003, Zhou Xiaochuan, current central bank governor, said in an interview with Xinhua News agency that the volume of NPLs at the end of June 2003 amounted to 2 trillion yuan (US$241.5 billion), with an NPL ratio of 22.2 percent.

Those official figures, however, are not in agreement with mainland experts. Some mainland scholars argued that the ratio of 22.2 percent is misleading since it did not include the 1.5 trillion yuan (US$181.1 billion) of non-performing assets that were transferred to four asset management companies (AMC). Another argument is that the Chinese loan classification system defines the NPL in the loosest terms in favor of lower ratios.

According to estimates by international investment institutions, the Big Four are in deep trouble. In September 2003, Standard and Poor’s estimated that the NPL ratio of Chinese banks was between 44 to 45 percent, while the ratio of outstanding loans to GDP stood at 138 percent by the end of 2002, compared with 88 percent in 1995.

The high NPL ratio is naturally associated with a low capital adequacy ratio, a measure of the financial strength of a bank, usually expressed as a ratio of its own capital to its assets. A worldwide capital adequacy standard, drawn up by the Basle committee of the Bank for International Settlements, requires banks to have capital equal to 8 percent of their assets. The capital adequacy ratio of Chinese banks has been dropping ever since 1978. In 1995, the figure was 3 percent.

With the huge NPLs, the state banks, which are also the major banks in China for individual savings accounts (ISA), essentially are relying on the cash in ISAs to balance the books.

If the state-owned banks can still survive for now despite the astonishing NPL ratio, thanks to Chinese-style socialism, they face an overwhelming challenge in the coming years, when they are no longer the sole players in the Chinese market.

In the agreement to join the World Trade Organization (WTO), China has promised to open its banking business—in all places and all currencies—to foreign banks in 2006. That means the full market access would enable overseas banking giants to vie with their Chinese rivals for high-end clients, the most valuable clients for banks, and for a large part of Chinese currency deposit market, high-caliber banking professionals, and for such lucrative services as intermediate service, international settlement and foreign exchange service. If a large wave of ISA withdrawal occurs, the Big Four, which are already burdened with the high NPL ratio, could become bankrupt after 2006.

Failed Rescue Becomes Window Dressing

In recent years, the Chinese government has been trying to put the financial system back in order. One of the important measures it has been taking is to strengthen the capital adequacy ratio.

In 1998, China’s Ministry of Finance injected a sum equal to US$32.5 billion into the Big Four state banks.

In 1999, there came another US$157.0 billion of relief for the Big Four. Four asset management companies (AMC), one for each of the banks, were formed.

The third and most recent one was in January 2004, when BOC and CCB received a shared injection of US$45 billion in preparation for their IPO on Wall Street.

However, earlier capital injections did not generate the expected effect because the state-owned banks kept accumulating new NPLs, thanks again to Chinese-style socialism. Every year, about 500-600 billion yuan (US$60.37-72.45 billion) of new bad loans piled up on top of the existent 3 trillion yuan (US$362.24 billion) of non-performing assets. In 1999, total non-performing assets in the banking system were about 2 trillion yuan (US$241.5 billion). That year, the government “peeled off” 1.4 trillion yuan (US$169.05 billion) of them by injecting US$157.0 billion and transfering NPLs to asset management companies. However, year 2002 saw additional 1.7 trillion yuan (US$205.27 billion) of non-performing assets. That is right, as more cash is poured in, the pit only gets bigger.

The most recent capital injection was for BOC and CCB only, the two state-owned banks preparing for overseas stock listing. After this one-time capital injection of US$45 billion from the Chinese central government, the two banks reportedly reduced the NPL ratio to 5.16 percent for BOC and to 3.74 percent for CCB at the end of September 2004, close to meeting the international standard. Both banks, advised by international investment bankers, look forward to raising fund in billions on the global capital market.

With a history of previously failed efforts to restore order in the Big Four, the recent capital injection appears to be more of a window dressing than real reform, because the fundamental reasons for accumulating NPL are not being addressed.

State-Owned Banking in Chinese-Style Socialism

The fundamental reason for the accumulation of NPLs is the so-called, “soft budget constraint” enjoyed by the state-owned enterprises (SOE). As a socialist country, China needs to maintain some major SOEs, although the private sector has already accounted for roughly 60 percent of the Chinese GDP. Up to the end of the1980s, the SOEs had been receiving budget in the form of fiscal allocations from the Treasury. The enterprises were de facto production units, with the appointed government officials working as managers. With no responsibility for loss or gains, the managers have no incentive to lower the cost and respond to market changes, and are therefore enjoying a so-called “soft budget constraint.” At the end of the 1980s, the central government decided to change the financial allocation to loans from state banks instead. However, the debt has not posed any real budge constraint due to the fact that, if the SOEs fail to pay back the loan, the bank will eventually have to bail them out. Both Being owned by the state, the banks and the SOEs are just like the left and right pockets of the government. After all, both state-owned banks and SOEs are under the same directive of Party officials.

Overseas IPOs and Unsolved Issues

Because the central government cannot afford periodic “socialist free lunch” for big state banks, and the domestic stock market does not have the capacity to raise the capital needed to heal the banks, floating the ailing state lenders on overseas capital markets seems an appealing solution. However, some major issues are not resolved and these should concern the investors who are interested in buying those IPOs.

The First Issue: Who Is in Control?

The first problem is that the vast majority of the funds raised by Chinese firms listed overseas have been for SOEs. On the surface, the listing of state-run firms in the global capital market should dilute state control and increase accountability to investors. Paradoxically, it may serve only to expand the resources under state control. One such example is given in the 2004 Annual Report by the U.S.-China Economic and Security Review Commission, on China Telecom Corporation Limited (CTCL).

The review states, “CTCL is a shareholding limited company with shares listed on the New York and Hong Kong stock exchanges. Almost 80 percent of its stock, however, is owned by China Telecom Group Company, a traditional SOE with no shares that are directly owned by the Chinese government, while less than 12 percent of the equity was sold to the public. By creating a controlled subsidiary in the form of a shareholding company and selling a small proportion of its shares to the public, the parent SOE actually increased the value of assets under state control.”

Although the BOC and CCB have recently been “reformed” to share-holding companies, investors are still in doubt whether the Chinese government would let go of its control. Central Huijin Investment Co. Ltd, a state-owned firm, is now controlling all of the 186.4 billion shares of Bank of China Limited. It might be hard to trust whether BOC can operate independently of government control. There have also been worries concerning the fact that high-level executives are appointed by the government. The newly appointed President of BOC, Li Lihui, who once worked in the central bank and ICBC, was Deputy Governor of Hainan Province before accepting his current position.

The Second Issue: Minority Share Holders’ Rights

The second problem concerns the minority shareholder rights. Within the current legal framework of China, foreign investors can have at most 33 percent of shares of Chinese banks. The purpose of this limitation is to protect domestic financial institutions from foreign control. Until now, foreign holdings of Chinese bank shares are all under 20 percent. This structure has prohibited foreign investors from exerting real influence on the banks they partially owned.

The Third Issue: Poor Regulation and Practice

A third problem is the fact that China does not follow international accounting standards.

The China Banking Regulatory Commission (CBRC) was established in 2003 to monitor the banking system. According to Dongxiang magazine, in a meeting in August 2004, the CBRC disclosed that the five biggest banks including People’s Bank of China and the Big Four have funds of 40 billion yuan (US$ 4.83 billion) in violation of bank regulations. Four major problems among the financial institutions include: a) falsification of accounts, cooking multiple accounts and destruction of original records; b) illegal transactions on the foreign exchange, with the profit deposited in personal accounts; c) misappropriation of special funds; and d) falsification of the NPL ratio and the figure for non-forming assets.

In 2003, after examining the national financial system, CBRC unveiled 1,242 financial institutions and 3,251 personnel with records of illegal operations.

Following are some of the recent cases of corruption in major state banks:

In December 2003, Wang Xuebing, former president of CCB, was sentenced to 12 years in jail for taking bribes.

In February 2004, Liu Jinbao, former head of the BOC (Hong Kong) branch was arrested and formally charged with “economic crimes.”

In February 2004, China Minsheng Banking was under investigation for falsifying a shareholders meeting that never took place in 2000, prior to its IPO on the Shanghai Stock Exchange.

In March 2004, Liang Xiaoting, former deputy chief executive of BOC (Hong Kong) and deputy general manager of China Construction Financial (Hong Kong) Ltd., was sentenced to life imprisonment for bribery.

In August 2004, Ding Yansheng, vice president of BOC (Hong Kong), was arrested on charges of embezzlement in 2001. Zhu Chi, another vice president of the branch, was also under investigation related to the case.

If no mechanism is set up to address those issues, the overseas IPO of the state banks can become a trap for international capital to finance close-to-bankrupt socialist banks. The history and situation in the Chinese domestic stock market is a good example of how the socialist government regards the stock market as a cash machine for financing SOEs.

China’s Domestic Stock Market

To understand China’s domestic stock market, you only need to remember one number: 90 percent—90 percent of the listed companies are SOEs, and 90 percent of the security companies are state owned or publicly owned.

According to the U.S.—China Economic and Security Review Commission’s 2004 Annual Report, “Unfortunately, providing the general public with a means of diversifying investment portfolios and hedging consumption/income risks are not among Beijing’s primary reasons for encouraging its citizens to invest in its domestic capital markets. The Chinese government often manipulates the markets to advance its political agenda. Rather than allowing capital markets to support the growth of vibrant private enterprises, China’s leaders view them as a means to achieve social and industrial policy objectives and to subsidize SOE restructuring, goals that are unrelated to market-based considerations.”

Recent years’ stock market experience has shown a pattern that when the market shrinks, the government encourages bank loans to financial institutions for stock market transactions, and when the market is bullish, the relevant administration started to punish the “illegal loans.” For example, at the end of February 2001, Chinese stock market indices rose suddenly and sharply after an injection of funds from some institutions and individuals, encouraged by the central government. A few months later, the People’s Bank of China started to investigate some commercial banks for “illegally extending credit.” Within the one month of July 2001, the total market value of the Chinese stock market shrank to the amount of 700 billion yuan (US$ 84.5 billion), with a 14 percent drop in the market indices.


Even though after the most recent window dressing the state-owned banks look lean and profitable, their past history and current practices may well suggest otherwise. After several “socialist free lunches” (capital injection by the central government) failed to put the Big Four back in order, overseas IPO may become a “capitalist free lunch” for ailing China state-owned banks.

[1] The Big Four: The Big Four are Bank of China (BoC), Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), and Agriculture Bank of China (ABC).
[2] The NPL ratios of current world’s top 100 banks are between 2-3 percent. The average NPL ratio of domestic listed banks is below 6 percent.

Li Ding is an economist based in Washington, D.C.