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Pacific Economic Forum Dialogue Series: The financial rise of China

Friday, April 13, 2007

In a recent speech in the Pacific Economic Forum Dialogue Series, Davies shared his perspective on the next phase of Chinese economic reform — photo: A. Grimes

"As you all know, it’s grown by 10 per cent a year for more than two-and-a-half decades. The latest figures for the Chinese dollar reserves show that their reserves now stand at $1.2 trillion (they’ve gone up by $200 billion in the last quarter) and those reserves are mainly held in U.S. treasury bills and bonds," said Davies, who advises the Chinese government on banking and securities reform and sits on the boards of Morgan Stanley in New York and Paternoster PLC, a new British insurance company.

"The market cap of the Shanghai and Shenzhen exchanges exceeded Hong Kong in the last quarter for the first time ever. These markets are now becoming ones that are very significant to the world financial market," explained Davies, who went on to share his perspective on the next phase of reform in China, particularly in the financial sector.

"If you look at total global financial stock, China is now five or six per cent of the global financial stock," said Davies. "However, the striking thing about the Chinese financial system, and something which is a great weakness for China still, is that it is extremely heavily dependent on the banking system."

"In the U.S., only about 20 per cent of financial assets are represented by bank deposits. In the Euro Zone, it is almost 30 per cent and even in India, it’s only just over 40 per cent," said Davies. "Typically, at the Chinese stage of development, the equity and bond markets have begun to play a bigger role in financing the economy. China is stuck in a very bank-dominated financial system and that is, of course, quite a significant weakness as equities and bonds are much better shock absorbers in the case of any kind of economic downturn."

"The system is not very stable, and this is one very important message and one the Chinese well understand. But it’s proving very difficult for them to deal with," said Davies.

And then there is the issue of non-performing loans.

"In a sense, the Chinese non-performing loan problem is an accounting matter," said Davies. "It’s a question of where you put the casualties of economic reform. If you have an economy that is growing at 10 per cent a year, it is not that every company in that economy is growing at 10 per cent a year. Some have been growing at 50 per cent a year and some have gone bust. The question is, what do you do with the casualties?"

"Typically, what’s happened in China is that the bad debts of the casualties have been left in the banking system, and the really striking thing about Chinese bad debts is not the amount of bad debt there has been in this booming economy. It’s the incredibly low recovery rate."

In the past, the recovery rate on loans has been close to zero due to the fact that when a company fails, regional governments tend to claim the assets, buildings and land as state property.

"Recovery rates have improved because they are now creating a legal climate in which a bank does have a lien on what is there when a company goes bust," said Davies.

The country is also changing their lending approach to focus more on the credit worthiness of borrowers rather than handing out money based on political factors.

Three of China’s four dominant banks too have undertaken IPOs, brought in strategic partners (including HSBC and the Bank of America) and established joint ventures in areas where they lacked expertise, such as the credit card business and leasing business.

"These IPOs have been absolutely huge," said Davies. "China Construction was over $9 billion U.S., Bank of China was $13 billion in total and ICBC, $22 billion. These banks are now reasonably well capitalized, have increasingly good IT, have increasingly strong strategic partnerships with people who can train their people and are really ready to take on the world," said Davies. "This is going to be a big change to the competitive landscape in Asia... these are institutions with global ambitions, and we better realize that."

On top of that, recent market movement in Shanghai actually affected the New York and London markets.

"This was an interesting wake-up call," said Davies. "It looks as if we are now seeing the beginnings of the ability of the Shanghai market to take on some of the burden of financing growth."

According to Davies, the Chinese are also preparing to more actively manage their $1.2 trillion in trade reserves by diversifying their holdings of U.S. assets into real estate, hedge funds and private equity holdings.

Given all of the progress that China has now made in participating in the world financial markets, Davies finds it astounding that China has not yet been included in most of the global forums in which the financial system is managed. Among them, the G8, the Financial Stability Forum (the key body that brings together all of the world’s regulators and central banks to look at financial stability), the Basil Committee on Banking Supervision (10 of the 13 members of the Basil Committee are European), or the governing body of the insurance association.

"We simply have to integrate China into this decision making bodies because at the moment, what we’re trying to do is to manage the world in the old way," Davies concluded the Pacific Economic Forum Dialogue Series event. "And we have this huge elephant over there with the capacity to make serious waves in our comfortable little world."

Opportunities for Canadian banks in China?
"The Canadian banks have not been as ambitious as some others in taking sizeable stakes and putting serious money on the table," said Davies. "I suspect that it [the opportunity for Canadian banks] is going to be in the areas of trade finance and some of the niche areas that the Chinese don’t have terrifically good expertise in. I could imagine in the brokerage area, Canadian banks have a good reputation for retail brokerage skills, which I think could be very much used in China. But the real opportunity is probably going to be intermediating the very sizable Chinese-Canadian trade."

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