Indian, Chinese banks plunge at different rates

By Chan Akya

What's the difference between falling 20 meters and falling 60 meters? Well, in the first instance you go "thud, aaaaaarrrggghhh", and in the second you go "aaaaaarrrggghhh, thud". That crude comparison could well illustrate the difference between the Indian and Chinese banking systems.

In the long run, I believe the Chinese banking system poses greater dangers and is more likely to collapse from the sheer weight of its problem loans. Foreign banks looking to enter both markets must do so with eyes wide open.

Legend has it that Chinese bankers keep a shredder handy in their office for the express purpose of destroying business cards of their borrowers. You see, they never intend to call them back about the loans, as that's the responsibility of a different department.

The latest gross domestic product (GDP) figures from China should make the the People's Bank of China nervous, as indeed it has. (The central bank announced further restrictions to lending on July 21.) While export-oriented growth remains high on the back of Americans being too lazy to manufacture anything themselves, the sector's profitability continues to decline.

Using official data from both the United States and China, it is easy to calculate that the average price of Chinese goods sold in the US has been falling the past few years, despite rising input costs (copper, for example). That puts manufacturers in a quandary, as the good old Chinese maxim of "work hard, be successful" simply doesn't work in practice.

So they do the next best thing - ie, borrow from banks and speculate in the local asset markets, particularly property and stocks. Walk around the Pudong district of Shanghai and you can see the impact of a building boom, with great monuments to corporate success all around you. More troubling, you will see the same sights greeting you in downtown Guangzhou, Shenzhen, Chengdu and, of course, Beijing.

China is a manufacturing economy, and the proportion of Grade A office space thus appears far higher than is economically warranted. This is, however, also the reason for the Chinese GDP to ramp up nicely, as all the infrastructure and building activity adds to recorded economic growth.

Banks, trying to recover their money from companies' manufacturing operations, find themselves having to support such speculation to improve their chances, echoing the "ever-greening" scandal of Japanese banks in the 1980s and 1990s. The party comes to an abrupt halt once liquidity is drained away from the system. This is precisely what the central bank is now doing with hikes in lending rates and, more important, by issuing policy diktats aimed at removing bankers' temptations to lend.

When an essential condition for banking crises does not occur, namely a wary central bank, why then do I express pessimism about the longer-term outlook? Quite simply because politics makes an essential difference. China's leaders owe their legitimacy to the continuation of strong economic conditions and, at the very least, substantial employment.

A continuation of restrictive banking policies reduces the country's ability to absorb the people being thrown off by public-sector companies, as the sector aims to achieve profitability. With profits unlikely to improve any time soon, as the export sector remains fiercely competitive, this means further job losses are unavoidable. When economic growth slows, China's government will have much to worry about, and will likely instruct the central bank to reduce or withdraw its restrictions. In effect, this would push the resolution of any asset bubble to the longer term, which would obviously also cause a manifold increase in the costs of dealing with the problems.

I believe that rather than the end game being forced on the Chinese banks by their own central bank, extraneous forces are more likely to cause the adjustment. Some possible examples include a recession in the US and Europe, uncovering of other banking scandals in China and, of course, internal disquiet in the country. When the reckoning does come, expect also to see a large-scale increase in problem loans from the retail sector, as was observed in the case of the various international trust and investment corporations that were shuttered in the late 1990s. Chinese people will take every opportunity to avoid paying back their loans, and a bank failure presents the perfect opportunity to do so. The resulting avalanche of bad loans will cost the country about 20% of its GDP, in my opinion.

Meanwhile, legend has it that becoming an Indian banker is the cherished dream of the middle classes, but defaulting to banks is the path to riches for India's upper classes.

The Indian banking system is a relatively small part of the economy, with banking assets to GDP barely crossing a third, and with nationalized banks such as the State Bank of India group making up a large portion. That said, private and foreign banks have an increasing role to play in the system, far higher than their command of banking assets would suggest. India's banks face losses on so-called priority loans as well as the long workout process that problem loans are subject to. However, these loans are isolated, with a few leading public-sector banks absorbing a bulk of these exposures. Also, and quite unlike in China, India's political establishment is not very sensitive to the level of interest rates, and is therefore unlikely to oppose the Reserve Bank of India's judgment in the matter.

Indian banks have been profitably lending to the middle classes for centuries now, as banking goes back a few generations, particularly in the richer parts of the country such as the north and the west. The explosive growth rate in personal and mortgage finance in recent years, however, bears close watching. A number of Indian middle-class borrowers have tapped the willingness of commercial banks to lend money, a development over the past 10 years that destroyed the dominance of the Housing Development Finance Corp in the sector.

With new private-sector and foreign banks leading the charge in innovation, even the moribund public sector has had to catch up. By and large, even with large economic risks looming - for example, borrowing by individuals working in call centers and information technology - companies could become substantially more risky if a downturn hits these sectors. Similarly, the central bank is worried about inflation causing further rate hikes, which I believe will pressure quite a few of these young borrowers and lead to bad debts climbing above 5%.

In terms of skill sets, though, unlike in China, Indian bankers go through years of credit training, with cross-department exposure available to all officers in nationalized banks. This has allowed the nationalized banks to dominate the market for large corporate lending. Changes in the mid-1990s allowed for specific banks to assume the lead position in banking consortiums, thereby reducing the ability of large corporate borrowers to "borrow from Peter to pay Paul". Larger consortiums, particularly those comprising non-nationalized banks, have been shown to have lower loan losses. This experience is vastly different from that of China.

This leads us to the main causes of banking losses in India, namely corruption, a slow legal process and government meddling. The ruling Congress party started the fashion for open house loans (known locally as loan mela), wherein banks tend to lend small amounts of money to a large number of poor peasants. Most of these loans have led to losses.

The second area of losses is due to the prevalence of corruption, particularly at the heart of the second-tier nationalized banks such as Indian Bank. These losses have usually revolved around single banks taking on the total exposure of politically connected corporates that find themselves in dire financial straits for various reasons. The process of declaring bankruptcy and imposing financial restructuring is overly long, and usually contributes to higher losses given default.

The worst-case scenario comes about if the Reserve Bank of India hikes rates even as a slowdown bites into the export-oriented sectors. Resulting losses from this scenario would cross 5% of GDP in my opinion, even after considering the lower severity of default.