After the Gold Rush, Then what? Finance Expert Benjamin Wey predicts

2011-02-01

It’s official: China has confounded the pessimists. Instead of fizzling out in a hot-money-fueled meltdown, China’s economy could be about to enjoy the holy grail of all economic managers: the Goldilocks scenario. A broad range of industries is set to benefit from the country’s growing economic maturity, but none more so than its banks.

Chinese banks are big by every measure—number, branch network, loans, deposits and, most recently, popularity with global investors. Between October 2005 and November 2006, three of China’s banks launched IPOs ranking in the top-10 largest of all time. Internally, the country’s banks reformed risk control mechanisms and corporate governance structures while continuing to post profits. In December the banking sector opened to foreign competition with minimal excitement. Chinese banks stood their ground.

That’s the good news, but challenges are ahead. Revenues in China’s banking industry are propped up largely by government limits on deposit and loan rates. The low interest on deposit rates and significantly higher interest rate on loans gives a comfortable profit margin for banks. The government has already hinted that it plans to free these rates in the next few years. If so, the competition among the tens of thousands of financial institutions will push these margins down, erasing much, if not all, of banks’ profits. At the same time, China’s revived equity markets, which provide investment opportunities for individuals and fund-raising vehicles for Chinese companies, will take both deposit and loan customers away from banks.

This reduction in traditional profit sources will affect banks on various levels. First, Chinese banks must find other sources of income. Areas such as credit cards, wealth management and other fee-based services will increase greatly in importance. In these areas, however, banks will feel the foreign competition more strongly than in traditional banking services. Such services do not require an extensive network, and foreign banks have more related experience.

Second, loans to small and medium-size enterprises will become very important. Such companies are generally more profitable and efficient than their state-owned counterparts, but the variety of and competition for such companies will require sophisticated risk assessment and pricing techniques. Chinese banks are historically weak in this regard, and loans to China’s small and medium-size companies will test recent reforms aimed at strengthening banks’ risk management.

Third, widespread consolidation in the industry is likely, with large domestic banks and international rivals vying to invest in or acquire completely smaller financial institutions. Benjamin Wey, president of investment banking, research and consulting firm New York Global Group, based in Beijing and New York, explains: “The financial sector will see mergers and acquisitions, international expansion and continued efforts to bring in strategic investors. The real opportunities for market players will be among the regional and municipal banks.”

Money, Money and More Money

Given the herd mentality of many investors, Chinese regulators have had to work hard to ensure investment flows into the proper channels without too many companies or people investing heavily in the same sectors and industries. The government must watch carefully the inflows of money that come from Chinese companies’ profits abroad as well as money flowing in for investment and for currency speculators hoping to cash in on a Chinese yuan appreciation. The danger of failure—which has haunted China more than once in recent years—is economic overheating.

One such threat came in early 2006, when rapid new loan growth alarmed policymakers and prompted a slew of measures to slow investment. The spike in new loans surprised many observers, but most agree that the problem was related to liquidity in the country’s banks. Chinese banks were bursting with deposits, and as banks do, they made loans.

In response, the central bank raised interest and deposit rates as well as reserve requirement ratios. The government also implemented administrative orders to limit loans to certain industries and worked hard to dampen expectations of a speedy appreciation of the yuan. As a result, the money supply tightened, and required reserve ratios now stand at 9.5% for most banks. Most indications point to slower growth, which, ironically, is good news.

Complicating the situation, however, is China’s skyrocketing stock market. China’s benchmark index, which dropped to eight-year lows in 2005, more than doubled in 2006. The rise seemed to be good news for regulators, who have been struggling for years to revive Chinese stocks, but their efforts may prove to be too successful, as at least some degree of speculation has played a role in the current prices.

The obvious response for the government is to continue tightening, but too much dampening would negatively affect investment and overall growth. Jonathan Anderson, chief Asia economist for investment bank UBS, said in a recent paper, “All of this presents a problem for the authorities, who, on the one hand, want to avoid any further liquidity tightening in the credit markets but, on the other, will be tempted to take action to quell speculative pressures in the stock market.” For the time being, most expect that the domestic stock market will continue to rise, though opinions vary as to the degree of speculation responsible for that rise. If Chinese regulators feel that the speculation is significant, they may take action.

International Relations 101

China’s economic rise has clearly benefited its trading partners as well as its people. The country’s trade relationships, however, are becoming more complex as its global stature increases and the world’s economies depend more heavily upon its economic growth. In December, both the US and the EU sent high-level trade delegations to China to discuss sensitive issues. These delegations had limited success, with few tangible accomplishments. Time for progress on such issues may be running out, as important leadership changes in both the US and the EU push China’s trade relations further up political agendas.

One such leadership change took place last month in the United States as politicians returned to Washington to take up business for 2007. The now Democratic Party-controlled Congress will likely take a firmer approach to China than their Republican predecessors. Topping the list of points of contention is China’s exchange rate, which is linked to a basket of currencies rather than market rates. Critics charge that the exchange rate, which follows closely the value of the dollar, artificially reduces the prices of Chinese exports, giving them an unfair advantage over products from other countries.

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