Inside China’s banks

Carl Walter knows something about China’s banks. He was until recently the COO of JPMorgan China and before that held a senior position at China International Capital Corporation. His recent book with Fraser Howie, Red Capitalism: The Fragile Financial Foundations of China’s Extraordinary Rise, examines the Chinese financial system. Walter recently spoke to PE Asia

What are two misconceptions PE firms have about China’s banking and why are they misconceptions?

The first misconception is that Chinese banks are banks. They are not banks. They are deposit-taking corporations that invest at the direction of the Communist Party. The second issue is that because they are not banks, Chinese banks are not about evaluating risk. They do not have the capacity to evaluate risk because the Party evaluates it. For such entities the watch-word is “There is no risk in China.”

Chinese banks are not about evaluating risk. They do not have the capacity to evaluate risk because the Party evaluates it.

How do Chinese banks and PE firms work together now?

Chinese commercial banks do not participate in private equity. The state hasn’t historically appreciated such foreign ‘speculative’ investment, and the banks in any event cannot lend to PE firms largely because they do not have large operating entities onshore. If a foreign company wants to come into China and buy 30% or 51% of a company, they have to bring their own money in. 

Do Chinese banks have their own PE divisions? 

No, they do not. Chinese banks have not adopted the universal bank model. And to the extent that everything is owned by the state, they don’t need a private equity business; the government simply uses administrative orders to combine strong and weak firms together. City governments have put together so-called private equity funds, such as Tianjin’s Industrial Fund, but they invest in whatever projects the government tells them to invest in. It’s simply state planning all over again. 

Is the playing field in China for foreign and domestic private equity firms a level one? 

No, of course not. And it never will be, at least not in the current configuration of China. 

There are some good domestic PE funds. I think the best one is CDH [Investments], which is a formed around a group of people who came from CICC. But generally speaking most are extensions of government agencies.

If you are a Chinese private equity firm, you can do deals that foreign firms might be unable to do. It is a way to monetise assets in a seemingly legal way; it is a disguised form of privatisation. But even if you are a non-state PE firm, you still need to be aligned with the government. I think this is a difficult game for foreign companies to play; it can get very complicated. [Shu Wang], a founding partner of CDH, has good technical and professional skills, but he also has the advantage of being Chinese. 

Firms that utilise RMB-denominated funds reputedly face fewer hurdles than US-dollar denominated funds. Will this continue to be the case? 

Yes, and one reason is because you have a non-convertible currency and currency controls. Remember that there is so much liquidity in China, about two times GDP, so it’s very difficult to get approval to bring in capital because it’s inflationary. If you have the ability to put together a domestic RMB-fund, you don’t face these problems. 

Are tighter lending policies in China a positive or negative for PE firms?

Once these companies sell out to a private equity company, the new owners may be stuck with a company that can't borrow

I think it makes little difference. Private equity firms will not be allowed to invest in big companies that don’t have any problem accessing money. Instead, PE firms will be forced to invest in smaller start-ups or companies that are having difficulty getting money. The trouble is that once these companies sell out to a private equity company, the new owners may be stuck with a company that can’t borrow. 

Determining the extent of bad loans held by China’s banks is difficult. Should private equity firms in China be concerned? 

In the near term, it shouldn’t make any difference. The bad loans at the state banks will be taken care of; the government has the wherewithal and the techniques to do that. The private equity firms should only be concerned if the firms they invest in are unable to borrow. 

Given the health of Chinese banks (tighter credit, bad loans) are there any opportunities for private equity firms to profit?

There is a huge pile of bad loans in local government entities, so things could get really bad at the provincial level and below. In that case, China may become a lot more attractive to invest in as the government is forced to cash out. We might see a wave of privatization similar to the late 1990s. But that privatisation period benefitted local managers, not foreigners. Whether foreigners will be allowed to come in and invest in some of these companies – and they may not be worth investing in – I don’t know. I believe there would have to be real concern about systemic risk for the market to open. It may come to that, but we won’t know for another year or two. 

The longer Beijing goes without recognising that it has a huge problem loan inventory – that is the longer foreign investors are unaware of this issue – the bigger that problem is – and the greater will be the trouble Beijing will have to confront. Maybe the government will be able to deal with the debt, but I think that sometime in the next five years it will become a major systemic issue. It’s very hard to say how this will play out. The last time China had a problem like this, in the late 1990s, 30-40 percent of their loans were bad. They were forced to do something, and that’s what gave opportunities to Bank of America and others to invest. 

I think that when conditions are bad, when the banks are in trouble, that’s when opportunities for foreign financial institutions will be best. It’s when private equity firms will be able to do something. But right now I don’t think there will be significant opportunities. 

Recently there was an alliance between three major PE firms (Permira, TPG Capital, KKR) and a subsidiary of China Development Bank. Do you see this link up as significant? What are the advantages and disadvantages? 

China Development Bank has always tried to be a universal-type bank. In 1995 they wanted to set up something like CICC, but Zhu Rongji would not allow it. Chen Yuan (CDB’s chairman) has ambition, but CDB is basically a sovereign policy bank, one that invests all over China as well as in Africa and Latin America. It’s a rhetorical question, but why do they want to go into private equity? 

I don’t believe there are any advantages to it. It looks attractive on the surface – CDB is a major player- but the reality is that what the private equity firms are getting into will not be profitable from a capitalistic perspective. CDB invests in infrastructure projects in the poorest poor parts of China, and of all the Chinese banks, it probably has the greatest exposure to indebted local government entities. 

China is a country that doesn't really believe in return on investment

The private equity firms may think they are investing alongside a really savvy lender, but again it reminds me of state planning. This is just another example of foreigners trying to break into the financial sector in China, when the Chinese don’t want real foreign participation. And investors should remember that China is a country that doesn’t really believe in return on investment. So I suppose this approach is probably the second best way to enter the financial sector. The best way would be to do it yourself. 

The disadvantages are that the kind of projects the private equity groups will be offered will not be ones they are particularly interested in, and they will be minority partners. It’s very easy to think that something like this will turn out well, but it’s also easy to kid yourself. Let’s wait and see where they are three years from now. ?