China’s banking system - the dragon's Achilles heel

January 4, 2006

Raghuram Rajan, the Research Director for the IMF, recently gave his assessment for the global economy, pointing out weaknesses and suggesting remedies. One of the more glaring weaknesses is that of the state run Chinese banking system. These banks have invested 40% of China’s GDP in primarily state owned businesses, which are not very profitable. As a result, the banks have a lot of non-performing loans on their books.

What It Means:

Until now, this has not been a problem, since China has been so far behind that most investment, in airports, power plants, and roads, have spurred growth regardless of how well they are run. This is a weakness on the banks’ books, and needs to be offset with safer assets. Chinese banks must reform their retail banking operations, and lend more to consumers. This will also spur domestic demand, and provide a customer base for the businesses the banks have invested in.

To this end, Chinese banks have encouraged limited investment by Western banks to learn how to increase retail banking and provide people with something other than savings account to put their money into. These banks currently do not have a retail loan program - no car loans, no credit cards. This forces Chinese households to save to be able to buy anything, from washing machines to houses, which further depresses demand.

The stock market also needs to become more transparent, so that Chinese people can invest in mutual funds in addition to saving. Put simply, more of the return on China’s growth needs to go to the Chinese people, and less to businesses.

Action Steps:
With an 10% annual GDP growth rate, you can’t afford to not have China in your portfolio. However, there are risks involved, and so that’s why it should be part of a well-diversified asset allocation. That way, if the bottom does drop out in China’s banking sector, you are less exposed.

Source: IMF