Emerging Markets Banks #3. Closer look on China and India

Banks are mirrors of the economy. The typical Westerner bank  is a borrower and the typical Asian a saver. Is it that simple? Should EM Banks take the globe or focus at home? This ‘The Economist” article brings an analysis comparing banks from China and India to western peers.

Rambo in cuffs
May 13th 2010
From The Economist print edition

Balance-sheets are less powerful than they look

WESTERN bank bosses often suspend their critical faculties when discussing their emerging-market peers. Suddenly it is not the next quarter that matters but the long-term flow of world historical forces. “They think about time in a very different way,” says one, Zen-like, before adding: “History always follows a course.” What lies behind this mumbo-jumbo is the recognition that emerging-market banks are not just getting bigger but also have piles of excess deposits because they are based in countries with high levels of savings. This would appear to give them a decisive advantage over Western banks that rely on fickle borrowing markets to do business. To add to rich-world banks’ discomfort, developing-world banks tend to have high capital ratios too. In banking, especially after the crisis, whoever has the deposits and the capital usually wins.

The reality is a bit more complicated than that. Banks are indeed mirrors of the economy, so banks’ balance-sheets reflect the fact that the typical Westerner is a borrower and the typical Asian a saver. Emerging-market banks tend to have vast branch networks that suck in deposits from thrifty families and companies. Only some of these get lent out again. Banks park the surplus with the state, by buying government bonds or keeping it in central banks. The state in turn acts as the international recycling agent for those excess savings: it lends them to Western countries through its foreign reserves or through a sovereign-wealth fund, for example by buying US Treasuries, mortgage bonds or money-market instruments.

Overextended Western banks do the exact opposite: they borrow from capital markets to plug the hole created by having more loans than deposits. This shows up in the ratio of loans to deposits, which for rich-country banks rose to alarming heights in the run-up to the crisis (though they have since come down somewhat), whereas those for emerging-market banks remained healthier.

Another way of measuring the differences is to look at the absolute funding gaps. Although by and large rich and poor countries’ banks are not lending to, or borrowing from, each other directly, there is a symmetry to the figures that is not entirely coincidental. In 2008 the surplus of customer deposits over loans (ie, excess savings) at listed emerging-markets banks was about $1.6 trillion, compared with a deficit of about $1.9 trillion at rich-world banks (see chart 4). The imbalances of the world’s economies are reflected by their banks.

A Western bank with masses of excess funding would be deemed to have a huge competitive advantage. Surely the same applies to entire countries’ banking systems? Emerging-market banks could use their surplus funds beyond their borders, for example by lending directly to foreigners and taking market share from rich-country firms. By doing so they would be bypassing central banks and sovereign-wealth funds, recycling excess savings directly themselves. But this is not what happens. For a start, the funding position of emerging-market banks is less impressive if China is excluded. And even in markets with excess savings these are not always evenly distributed, with a lot of them stuck in sleepy state banks. Some firms are doing their best to change that: ICICI’s Ms Kochhar, for example, is setting up lots of new branches to boost its deposits.

Banks that do gather excess deposits may find the government wants to get its hands on them. This could be for prudential reasons. For example, China’s regulator requires banks to keep 17% of their deposits with the central bank and tinkers with this ratio to control the economy. Or it could be because the government needs the cash. In India banks are obliged to use about a quarter of their deposits to buy government debt, which helps the government fund its budget deficit. Mr Bhatt of State Bank of India says there is little chance that this will change soon: “It is the model in this country,” and allows the government to spend on development.

So complementary and yet so far
But suppose that when everything is said and done banks still have piles of excess deposits? This is broadly true of China’s lenders. Can they find a way to marry their savings-rich firms with the indebted equivalents of the West? There is already a real-life case study: HSBC. It has always gathered more deposits in Hong Kong than it lends out. In 2002 it bought a mirror image of itself, Household, an American consumer-finance firm with $106 billion of loans and no deposits. It announced at the time that it was “bringing together one of the world’s top asset-generators with one of the world’s top deposit-gatherers”. Those labels could be applied respectively to America’s and greater China’s entire banking systems.

The acquisition failed because of bad debts at Household, but the original premise was wrong too. HSBC’s regulators, like most around the world, did not want deposits in one country to be used to finance a subsidiary overseas, exposing the bank to foreign-exchange and counterparty risk. Michael Geoghegan, HSBC’s chief executive, says it might have found fiddly ways of getting Asian customers to fund Household, perhaps by securitising Household’s loans and selling them to HSBC’s Hong Kong subsidiary; but the bank chose not to do so because it felt that would disadvantage its Hong Kong depositors. He says the regulatory climate has got more difficult since the crisis, and “it’s getting harder to move liquidity around” among subsidiaries.

For the moment China’s banks show little appetite for taking positions in risky Western assets. Bank of China did boost its foreign-currency lending in 2009 by a stonking 47% to about $200 billion, or about a quarter of its loan book, but this was matched by $190-odd billion of foreign-currency deposits. The bank actually reduced its holdings of foreign-currency securities by an eighth, “in accordance with the global financial-market situation”—a polite way of saying in order to avoid dud Western assets. Its latest annual report notes “growing concerns” over the finances of southern European banks and governments.

Deposits don’t travel
There are other ways of utilising excess deposits abroad, says Anthony Stevens, a consultant at Oliver Wyman. The most obvious ones are hedging, organising swap lines with foreign banks and encouraging domestic customers to switch their deposits into foreign currency, thereby making them take the exchange-rate risk. But none of these are large-scale options in countries with partially closed capital accounts. And in China in particular, given the undervaluation of the renminbi, the last thing policymakers want is banks whose asset bases would fall as the currency appreciated. Far better for the currency risk to be borne by the central bank and sovereign-wealth funds. In the medium term, as customers spend more and save less, the pool of excess cash in emerging-market banks may shrink. Until then it will be hard to use that strength abroad.

What about the emerging-market banks’ capital positions? At the end of 2009 these banks had a weighted-average Tier-1 capital ratio of 10%, in line with rich-world banks, but this probably understates their advantage. Excluding China’s banks (which have been busy raising equity since), the ratio was 12%. And the new capital rules known as “Basel 3” are likely to be much less painful for emerging-market banks, which typically have higher-quality capital and smaller investment-banking units (which will be heavily penalised by the new rules) than their rich-world peers. At the same time they are likely to be more profitable than banks in Europe and America, which will allow them to create new capital faster.

Even so, emerging-market banks will still be short of capital. That is partly because of bad debts. In most places the cycle has already turned for the better. In Brazil Bradesco has said that the worst is over. Sizwe Nxasana, chief executive of FirstRand, one of South Africa’s big four banks, notes that impairments are falling off and the performance of loans to lower-income customers has been “very good” during the downturn. But in both India and China the position is less clear-cut. Indian banks have lowish levels of non-performing loans but have built up relatively small reserves against them. These reserves act as a buffer against losses before capital is eaten into. Adjusting for that could knock a percentage point or so off Indian banks’ capital ratios.

China’s banks seem to have lots of reserves relative to the current level of non-performing loans, but that level seems implausibly low given how much they have been lending. Bad-debt reserves relative to the size of total loans are smaller, especially compared with Western firms that have taken massive hits in anticipation of losses. For example, Bank of China has roughly the same size of loan book as JPMorgan Chase or Citigroup, but only around half the level of bad-debt reserves.

Still, assume the best: that after a lending boom of several years, bad debts at emerging-market banks are under control. Surely, then, with their high profitability, they should be throwing off plenty of excess capital? Not necessarily, for the faster they grow, the more capital they will need to set aside to support new loans. And although emerging-market banks generate decent returns on equity, in aggregate they pay out about a third of that in dividends, limiting the amount that is retained and added to their capital bases.

Less than meets the eye
The maths of this can be pretty eye-watering. Assume that emerging-market banks really increased their risk-adjusted assets at, say, 20% a year yet maintained the same return on those assets, capital ratios and dividend payout ratios as they had last year. To back new assets, such as loans, they would need $4 trillion of new capital over the next ten years, only $2.6 trillion of which would come from retained profits. They would need to raise $1.4 trillion from external sources—about one-and-a-half times the total capital America’s 19 biggest banks had at the end of 2008. Even assuming growth of 15%, the shortfall would be some $400 billion. One option would be to cut dividends, but neither private nor public shareholders would like that.

At the same time Western banks are actually likely to release capital as they wind down bad assets. Royal Bank of Scotland has about $30 billion tied up in its “bad bank” but will probably have to use that to repay emergency aid from the state, its current majority owner. Still, banks that have either largely paid back the government, such as Citi, or never accepted aid, such as HSBC, could eventually have capital coming out of their ears. Vikram Pandit, Citi’s boss, recently told investors that “nobody wants to talk about excess capital,” but “at some point down the road we’re going to have to figure out what to do with” it.

The balance-sheets of emerging-market and rich-world banks are like the coasts of America and Africa: they look like a good fit. One group of lenders is overloaded with excess deposits but in need of capital, the other is short of deposits but likely to generate capital. It would seem like a template for much closer integration, but bringing the two groups of banks together might be as difficult as melding continents. That partly reflects the problems emerging-market banks face in shifting excess funds into foreign-currency assets, or among subsidiaries in different countries. But most emerging economies now also have less appetite than they did for letting foreigners in, and much more for state involvement in banking. And far from being ready to take on the globe, most emerging-market bankers are consumed by their colossal and growing businesses at home.


About Janar Wasito

Janar Wasito is the manager of Magis Capital in San Diego, CA. He is a graduate of Harvard and Stanford Law School, and a former Marine Officer.
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