China is pushing ahead with its vow to open up its US$44 trillion domestic financial sector to foreign investors at a time when creditworthiness of some Chinese lenders is sinking, highlighted by the government's takeover of the troubled Baoshang Bank. The central bank has already said that it will back a pilot programme in Shanghai to remove the foreign ownership limit on firms providing securities and fund management services, while the local government in the northern municipality of Tianjin said in May that it will remove the foreign ownership caps for Tianjin-based Chinese banks and financial asset management companies. The Tianjin government also said it would support overseas banks in setting up both branches and subsidiaries locally, and encourage them to engage in yuan-based business. The acceleration of the opening of the domestic financial markets comes at a time when numerous smaller banks are at their most fragile, analysts said, with China needing foreign capital as its financial sector has accumulated a mountain of debt lent to cash-strapped companies and loss-making projects. But China’s priority on maintaining financial stability, and its stringent capital controls preventing a free flow of capital out of the country, shows that the process of liberalisation remains constrained, the analysts said. “This ‘liberalisation’ addresses China’s need for capital, but also displays Beijing’s distaste for any concessions beyond what is necessary,” said Brock Silvers, managing director of Kaiyuan Capital. “And the situation could deteriorate further absent any real progress at this week’s G20 [to ease trade tensions with the US].” As much as further market opening up could help appease demands from the United States, Daniel Tabbush, founder of Asian bank consultancy firm Tabbush Report, believes it is more geared towards addressing domestic problems, pointing out some similarities to Thailand’s decision to open up its banking sector to overseas investors before the 1997/1998 Asian financial crisis. The country had acquired a large burden of foreign debt, creating a huge appetite for capital raising, before the collapse of the Thai baht. In comparison, China’s banking system and currency are backed by US$3.1 trillion in foreign exchange reserves along with strong capital controls to safeguard against capital flight. This ‘liberalisation’ addresses China’s need for capital, but also displays Beijing’s distaste for any concessions beyond what is necessary Brock Silvers “Usually markets open up when there is a problem with the economy, when balance sheets are strewn with far more non-performing loans than they care to reveal,” Tabbush added. “At that time, the Bank of Thailand had closed its markets. [But] banks needed to raise capital and the easiest way was to allow foreigners to participate.” There are now concrete examples of the opening of China’s financial sector after Allianz was the first foreign insurer to be approved for a wholly owned insurance holding company in Shanghai. JPMorgan Chase, UBS Group and Nomura Holdings have also been approved to take majority stakes in local securities joint ventures. Yet the jury is still out on how much money the foreign institutions will commit in a slowing economy. This is particularly so given that the financial market outlook is clouded by rising concerns about funding problems faced by small rural and city commercial banks after Chinese regulators had China Construction Bank (CCB), the nation’s second largest bank, take over Baoshang Bank nearly three weeks ago. “The regulatory changes seem unlikely to offer meaningful near-term profitability [for foreign financial companies that want to do business in China],” Silvers said. “Generally speaking, the newly opened business lines are very competitive, with strong local players, at a difficult time in terms of macroeconomics and business cycles.” Usually markets open up when there is a problem with the economy, when balance sheets are strewn with far more non-performing loans than they care to reveal Daniel Tabbush The demise of Baoshang, a small bank in the autonomous region of Inner Mongolia in northern China, exemplifies how China’s small and medium-sized lenders have shrewdly hidden their credit risks to circumvent rules, only to be exposed as Beijing tightens regulations. The bank, which has not published any annual reports since 2016, was taken over at the end of May by authorities, who appointed CCB to assume daily operations to protect the interests of customers and depositors. “The asset quality of city commercial banks and rural banks have worsened this year because they tend to lend to smaller regional companies in undeveloped regions,” said Elaine Xu, an analyst at Fitch Ratings. In particular, small banks which have higher exposure to the northeastern region of Dongbei, and to industrial sectors with overcapacity, may have greater asset quality concerns amid a slowdown of the China economy, Xu added. It means smaller banks with exposure to such companies typically have relied more on off-balance-sheet shadow bank financing, have more vulnerable funding profiles and under-report asset quality problems compared with large state banks, given their narrower geographical focus and high local government influence, according to a Fitch Ratings report. The report estimates those likely to fall below the minimum capital thresholds under stress would include most of the city and rural banks, which cover more than 20 per cent of Chinese banking system assets. Baoshang’s last filing on its assets and liabilities showed the bank had a total of 156.5 billion yuan (US$22.7 billion) of outstanding loans at the end of 2016, a 65 per cent jump from the end of 2014. What may have been more worrying is that Baoshang is also key piece in disgraced financier Xiao Jianhua’s business empire, which holds stakes in hundreds of Chinese listed companies via proxies, spanning energy, financial services, technology and real estate, among a myriad of industries. Zou Lan, deputy head of the financial market department of the PBOC, said that the non-performing loan ratio for the nationwide micro and small-enterprises was 5.9 per cent as of the end of May, 4.5 percentage points higher than large-scale enterprises and 3.3 percentage points higher than that of medium-sized enterprises. But the health of China’s larger lenders may also be undermined going forward if they are relied upon to prop up a significant number of weaker banks, analysts said. CCB, entrusted to handle Baoshang’s business operations, itself faces slowing profit growth as well as Beijing’s order to lend more to private companies. Even government policy lender, China Development Bank, has not been spared as profit contracted for the first time in 2018 as liability growth shrank and the bank reached its lending limit. In the month since Beijing’s announcement of Baoshang’s takeover – which Fitch Ratings’ Xu called a stress test of the overall banking system – market unease had been growing about the prospect of more trouble ahead. The PBOC’s assurance that the Baoshang case was an isolated incident limited to losses by its largest creditors, underlined authorities’ focus to avoid financial system instability but did little to calm investors’ nerves and hold up market confidence. To allay market jitters and keep borrowing costs steady, the central bank and the China Securities Regulatory Commission have promised financing support to leading brokerages and fund managers in return for their backing of smaller brokerages. They were also told to increase their lending quotas for short-term bonds and offer more financing tools to support small securities firms. Over the past two decades, China’s small and medium-sized lenders have accounted for an increasing share of total financial system assets. Joint-stock, rural and city commercial banks now account for 44 per cent of the total assets, against the 40 per cent held by the big five state banks, while foreign and policy lending makes up the remaining 16 per cent. “It is difficult to fully contain and control risk in the system compared to before, so they are allowing foreigners to come in now,” said Tabbush Report founder Tabbush. “The fact they are allowing foreigners to own 50 per cent of an individual bank makes sense because it is hard to control the industry as it is now more fragmented.”