The Institutional Risk Analyst: Blank Check: Deconstructing Chinese Banks

Yesterday when we saw the quarter-page ad in the Financial Times seeking a chief risk officer for China Construction Bank ("CCB"), we were torn: Should we laugh at this ersatz financial intermediary trying to acquire credibility by running such an ostentatious advertisement in the western press? Or should we cry over the fact that many, many credulous gringos, especially among the ranks of professional investors, commercial bankers, regulators and government officials, will be impressed by such a display?

Only a week before, we thought we'd really seen it all. Regional broker dealer Ferris, Baker Watts brought an IPO for an empty shell company, kind of a publicly registered private equity fund that starts life with no assets and promises to invest the proceeds of the offering in something meaningful. The Washington Post reports that in the past year, more than three dozen "blank-check" companies nationally have registered to go public and that $480 million has been raised since the beginning of 2004.

This latest evidence of too many dollars chasing too few investment opportunities in the US applies even more to China. Think of CCB and other Chinese financial institutions as "blank check" banks. They do not yet have the inner workings or functions of a bank as defined in the industrial nations, in part because virtually all credit and commercial transactions in China are controlled by the Communist Party. Indeed, if CCB were to actually hire a new CRO who is not familiar with China's financial and political system (which are one and the same), that lucky guy or gal might be very surprised by their actual job responsibilities - but not as surprised as some of the foreign banks who are currently shoveling money into the furnace by "investing" in China.

Our friend Sol Sanders , who has covered Asia as a journalist for three decades, confirms the full dimensions of the ongoing financial mania in China, a kleptocractic free-for-all which makes the asset grab by communist officials after the fall of the Soviet Union seem polite by comparison. Sanders wrote last week that "No sooner had the Royal Bank of Scotland taken its $1.6 billion plunge into the Bank of China than a deputy chairman received a lengthy prison term. In March, the Bank chairman was removed for alleged bribery. Shortly before 50 staff members were accused of embezzling $85 million. Earlier this year a branch manager fled the country with $120 million."

A western banker reports to the Institutional Risk Analyst that Chinese Communist Party officials are busily stealing much of the dollar inflow raised by direct investment, a repeat of the classical method refined by the Latin American debtor countries in the 1980s to deprive credulous gringos of their hard currency. Senior officials, aided and abbetted by western bankers, reportedly spirit these funds away to the safety of banks in Asia, the US or EU, even as the Chinese economy heads for one of its periodic "adjustments."

The impending $5 billion IPO for CCB seemingly should be cause for alarm among western regulators and bankers, but in fact the opposite is the case. With various foreign banks "invited" to invest in CCB, this to provide further validation of the economic reform efforts of China's Communist Party, CCB will come to market sometime later this year. Of note, CCB is not permitted to operate a branch in the US, again because of its links to China's government.

We hear that Citigroup (NYSE:C) was essentially coerced into making an investment in CCB after it was threatened with being "shut out" of China's financial services market. If you believe that there are really 300 million bankable consumers in China, perhaps investing billions of dollars in CCB or other Chinese banks makes sense. This logic certainly seems to have convinced the management of Bank of America (NYSE:BAC), which paid $3 billion for a 9% stake in CCB. But with little details such as a lack of property rights or legal due process, and fraudulent financial information, still unresolved in China, we wonder how foreign banks can justify investing or lending - at least without treating such commitments as 100% reserved for loss.

Fact is, CCB and the other "banks" in China are not really financial intermediaries and do not generally extend credit to private companies. As arms of the Chinese government, banks are used primarily to support state run enterprises ("SREs") and provide a slush fund for Communist Party officials and corrupt managers. None of the classical credit or even financial functions of a western bank are to be found inside a Chinese state-owned bank, nor do they have any of the most basic internal controls or reporting systems necessary for a transparent, prudential operation.

Indeed, according to one western banker based in Beijing, CCB and the other large Chinese banks lend primarily to SREs, which in turn make small, usurious loans to private companies - with the requisite bribes to the Communist Party officials involved. All of the knowledge, credit information and lending experience that you would expect to find inside Chinese banks is instead ensconced inside the SREs, which remain under firm Communist Party control. When you hear the glib reports in the western media about 10% of China's loan market being non-performing, says our observer, multiply that number by 5, 7 or even 9 times and you'll be closer to the economic reality.

Even though the shortcomings of the Chinese "banking system" are manifest, the western media is already banging the tambourine in support of the CCB offering. The Financial Times called the IPO "a pioneering listing that is crucial for Chinese bank reform." But reform of what?

Until the Communist Party deigns to allow truly independent private economic activity, which is a contradiction in terms, reforms are meaningless. No amount of foreign investment is going to change the basic fact that China's leaders do not recognize or even understand what it means to operate private banks with private borrowers and private property in a market economy where corruption is not the dominant factor in everyday life.

Sander's summarizes China's economic outlook: "China's economy is like the old burlesque comedian with a loose string when pulled disintegrates his suit. That a crash is coming is gospel for many China watchers. At dispute is when, which trigger, how big, the political fallout, and how and when economic growth recommences."

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