Moody's Issues Stern Warning On China's Pyramid Bank Recapitalization Scheme; Has CIC Entered A Funding Crisis?

Tyler Durden's picture

Moody's is out with a surprisingly frank appraisal of the Chinese banking system's precarious capitalization trend, by looking at the recent RMB 54 billion capital raise in the interbank market by the domestic arm of the Chinese Sovereign Wealth fund (CIC), which was "the first part of an RMB 187.5 billion overall fund-raising
program mainly to provide additional capital to the three largest
state-owned banks, a policy lender, and a policy insurance company." As Moody's oh so correctly concludes: "Recapitalizing banks with bond proceeds from banks is credit negative
because it increases the effective leverage of the banking system.
The
transaction’s impact on the system is limited in this case because the
increased leverage is not significant, but it would be problematic if
effective leverage continues to increase and China’s economic growth
stalls." Moody's stops one step short of calling this transaction what it is: using debt purchased by other banks to recapitalize deteriorating loans on the banks' asset side: "the increases in assets and equity are artificial and without real
economic substance: the increase in reported equity on banks’ balance
sheets enables the banks to lend more and effectively leverages up the
system
.
Assuming banks fully deploy the capital raised, the resulting
increase in the risk-weighted assets would be RMB 187.5 billion divided
by 11.5% (the minimum capital requirement)." What is also not said, but is glaringly obvious, is that the Chinese sovereign wealth fund is likely in a major need of recapitalization, courtesy of its extensive US financial sector equity holdings.

From Moody's:

Last week, Huijin, the domestic arm of China Investment Corp (China’s sovereign wealth fund), raised RMB 54 billion in the domestic interbank market. It was the first part of an RMB 187.5 billion overall fund-raising program mainly to provide additional capital to the three largest state-owned banks, a policy lender, and a policy insurance company.

 

Recapitalizing banks with bond proceeds from banks is credit negative because it increases the effective leverage of the banking system. The transaction’s impact on the system is limited in this case because the increased leverage is not significant, but it would be problematic if effective leverage continues to increase and China’s economic growth stalls. Even without an official breakdown of the bonds’ investors, we think most are banks, since in China non-bank institutional investors (e.g., insurance companies and funds) are still small.

 

For the sake of simplicity, we assume banks are the only bond buyers to illustrate the effects. For the banking system, in accounting terms, the net effect of this transaction is that assets increase by the amount of bond investment and equity increases by the same amount. However, the increases in assets and equity are artificial and without real economic substance: the increase in reported equity on banks’ balance sheets enables the banks to lend more and effectively leverages up the system. Assuming banks fully deploy the capital raised, the resulting increase in the risk-weighted assets would be RMB 187.5 billion divided by 11.5% (the minimum capital requirement). The Huijin bond on bank balance sheets is a sovereign credit and requires no bank capital.

The need for large amounts of capital less than five years after the major banks’ IPOs reflects the banking system’s fast credit expansion and China’s uninterrupted robust economic growth over the past several years. The guaranteed administered spread between the loan rate and deposit rate also encourages banks to grow by expanding their balance sheets. For them, growing the loan book is much easier and quicker than developing capital-efficient businesses or exploring underserved markets that generate higher yields but are riskier and require expertise. The underserved markets include the private sector, which is more efficient and one of the drivers of sustained economic growth.

The banks’ balance sheets are expanding so fast that they very quickly run into capital constraints. Huijin’s scheme propels growth through increased leverage. Its success relies entirely on real productive growth.

After they raise capital this year, major Chinese banks have been announcing they won’t need to come to the equity market again for another three years. These announcements suggest the new capital likely won’t last long and the banks’ business model won’t change fundamentally in the near term. But pain lies ahead if China’s economic grows slows and the banking business model cannot adjust accordingly in time.