China’s policymakers have grand economic ambitions for the Middle Kingdom, but the haphazard flow of capital in the country could prove a stumbling block.

Chinese banks are notoriously inefficient, largely due to state interference. The country’s largest banks, such as Industrial and Commercial Bank of China (Hong Kong: 1398) and Bank of China (Hong Kong: 3988) are majority owned by the central government. Consequently, these banks are wielded as instruments of policy. Owned primarily by local and municipal governments, smaller urban and rural cooperative banks are generally even more poorly run.

The loan books of most Chinese banks show the heavy-handed influence that various governments exert on bank management.

While Chinese economic growth slowed in 2011 and 2012, a common complaint among small- and medium-sized businesses (SME) was the lack of available credit. Interestingly, over this period the People’s Bank of China injected more than RMB1 trillion of liquidity into the system.

Most of the excess credit created at China’s largest banks by the additional liquidity was allocated to the large state-owned enterprises (SOE) in the country, as evidenced by the sharp increase in debt on their balance sheets.

SMEs were largely left out of the largesse, an unfortunate decision on the part of banks and the government. SMEs create nearly 75 percent of jobs in urban areas and are responsible for about 60 percent of China’s economic growth. SMEs also produce more than half of China’s tax revenue.

This skewed access to credit largely stems from the fact that SOEs possess greater political pull, allowing them easier access to capital. There’s little personal or professional risk for Chinese banks making loans to them, since they’re simply rolled over if they go bad. This dynamic also forces many SMEs to turn to the grey or even black market for loans, where annual interest rates resemble those charged by loan sharks, at double or even triple the prevailing bank rate.

Loans Gone Sour

Not only is that bad for the SMEs, it’s also bad for the banks because loans to large SOEs do occasionally go bad.

The graph below shows the ratio of non-performing loans to total assets (NPL ratio) for the various types of Chinese commercial banks. Government influence in lending decisions and the bad loans that creates is clearly shown in the data.



The NPL ratios run the highest at rural banks, where lending decisions are largely policy driven because management mostly consists of local government officials. Political interference is the primary cause behind NPL ratios that are typically in excess of 1.5 percent.

Larger state-owned banks are for the most part better managed, but their role as a policy arm of the central government still results in an NPL ratio of about 1 percent.

By contrast, the NPL ratio at foreign banks is typically just half that of state owned banks. While government influence isn’t totally absent—it’s the price of doing business in China—most lending decisions are market-based, producing better performing loan portfolios.

However, not all Chinese banks are state or foreign-owned.

Joint stock commercial banks (JSCB) are a class of institution created by the Chinese government in the mid-1990s as a result of its financial reform efforts. As with foreign banks, they’re not totally free of government influence, but no government holds a significant stake in the businesses.

Able to operate on their own terms, JSCBs typically run NPL ratios similar to those found at foreign banks, even those outside of China. That’s thanks to the fact that credit risk is at the top of the criteria considered in the underwriting process.

Another advantage for JSCBs and the businesses that they serve is that they’re largely locked out of the SME lending market. However, the SME market is wide open to them and serves their main customer base.
While JSCBs boast an asset base that is just a fifth the size of the state-owned banks, their market share has been growing at nearly twice the rate, to the point where they now control about 17 percent of China’s lending market.

JSCBs also score higher by every measure of banking efficiency, offering higher returns on both assets and equity and lower cost of capital, despite the fact that they generally don’t have access to cheap government funding.

Recognizing the greater efficiency of the private banking sector and the need to provide more “fuel” for the country’s SMEs, last spring the China Banking Regulatory Commission (CBRC) announced that it would allow private companies to buy into banks through stock placements, share subscriptions, mergers or acquisitions. It also announced that it would allow and encourage private lending companies, those which currently operate in China’s grey market, to become commercial banks.

So far, there have been few takers on CBRC’s offer of liberalization, largely due to the fact that it requires a fairly minimum share ownership for the main entity behind the bank’s creation. That requirement has precluded many smaller lenders from forming combinations to create new commercial banks.

Most would argue that the reforms don’t go far enough, because the stranglehold the state maintains on the banking sector has led to a great deal of mal-investment. However, they mark the central government’s recognition that more has to be done to encourage the growth of SMEs. It’s also a tentative acknowledgement that perhaps the government doesn’t always know best when it comes to lending.

Given their rapid growth, sound, almost-Western banking and lending practices, and acknowledgement of their key role in China’s future growth, JSCBs are much more attractive right now than the country’s large, state-owned banks. Unfortunately, there are only a handful of JSCBs that are exchange-listed and only three have H-shares listed in Hong Kong, the only class of shares available to foreign investors.

That said, one of the first and most successful JSCBs is listed in Hong Kong and is the subject of this issue’s Stock Spotlight.