Friday, September 26, 2008

The U.S. Financial Crisis: The China Connection

For many years, Treasury Secretary Henry Paulson, his predecessors at Treasury, and other prominent American academics and financiers lectured China on the need to reform its financial system and how to do it. China succeeded in fixing its banks, but not on the basis of the advice given by U.S. experts. Perhaps China’s successful recapitalization of its banking system provided Paulson with some valuable information on how to resolve the U.S. financial crisis.

China began to dismantle its central-plan economy in 1978 with agricultural reforms, followed by manufacturing. China’s 10 percent annual real growth since 1978 led to a massive increase in bank lending, resulting in many bad non-performing loans (NPLs). China forcefully addressed this problem. The goal was to enable the big four state-owned commercial banks—the Bank of China (BoC), China Construction Bank (CCB), the Industrial and Commercial Bank of China (ICBC), and the Agricultural Bank of China (ABC)—to sell stock and operate as public companies. This required cleaning up their balance sheets. As recently as the fourth quarter of 2003, NPLs in the four banks were estimated at 20 percent of total loans, with skeptics putting NPLs even higher.

The process of fixing China’s banks began in the midst of the Asian financial crisis in 1998. The Chinese government doubled the banks’ capital bases by giving them $32.5 billion through complex swap agreements, in which bad assets were exchanged for government bonds. In 2001 and 2002 China established four asset management companies that bought $169 billion worth of NPLs from the four banks at face value, thereby taking them off the banks’ balance sheets. Despite these measures, NPLs continued to erode the capital bases of the banks. In early January 2004 China transferred $45 billion from its foreign exchange reserves to BoC and CCB, equally split between them.

At the end of 2004, China announced plans to inject capital into ICBC and ABC to enable them to spin off NPLs and build a new corporate governance structure as publicly-listed companies. The government injected $15 billion into ICBC in April 2005. Three of the banks went public. CCB raised $8 billion in its IPO of October 21, 2005, BoC raised $9.7 billion in May 24, 2006, and ICBC raised $21.6 billion in the largest IPO in history on October 20, 2006. Some of the world’s biggest banks and financial institutions invested billions of dollars to acquire minority stakes in the three banks. ABC’s IPO will likely transpire in the next few years. Altogether, the Chinese government spent more than $400 billion to fix China’s banks.

As head of Goldman Sachs, Paulson frequently traveled to China to explore business opportunities. At Treasury he established a twice-yearly meeting with China known as the U.S.–China Strategic Economic Dialogue to discuss issues of mutual interest. Perhaps China’s success in transforming its decrepit banks into world-class financial institutions influenced Paulson’s design of the $700 billion package announced on September 19, 2008, to remove bad assets off the books of U.S. financial institutions.