Bank Loans with Chinese Characteristics

In the paper Bank Loans with Chinese Characteristics: Some Evidence on Inside Debt in a State-Controlled Banking System, forthcoming in the Journal of Financial and Quantitative Analysis, we study the process of bank lending to corporations in a transitional environment. A simple model of a pooling equilibrium suggests that both negative and positive announcement effects are possible, depending on whether the banking system is run on purely commercial terms or is subject to political goals. Empirical results are based on a sample of large loans from Chinese banks to listed Chinese borrowers. We find that poorly performing firms are more likely to receive bank loans, and these loans appear intended to keep troubled firms afloat as subsequent long-run performance is typically poor. Stock values for Chinese borrowers typically decline significantly around bank loan announcements. Furthermore, these negative announcement effects are heightened for borrowers with frequent related-party transactions, poor subsequent performance, high state ownership, no foreign class shares, loans from local bank branches, or loans intended to repay existing debt. Thus, the Chinese stock market appears to understand corporate performance and what these loans mean, and responds accordingly, in contrast to the widely-held perception that it is inefficient.

Our results are of interest to a variety of policy makers and regulators. China’s banking system is still a work-in-progress, as indicated by the unflattering associations between bank borrowing and poor corporate performance that we document. Our study provides lessons for other less-developed countries, and, given recent failures in U.S. and European banking systems, is of even broader interest given that state ownership and control of banks has unexpectedly become much more common around the world.

The condition of China’s banking system is of interest to a variety of potential investors. For example, in 2006, Bank of China and Industrial and Commercial Bank of China raised $22 billion and $11 billion respectively in initial public offerings on global stock markets. More recently, the authorities encouraged, then reined in, large increases in bank lending intended to stimulate the economy but potentially stoking another real estate bubble.45 Foreign banks and other strategic investors placed huge amounts of funds in these banks in the form of direct purchases of minority ownership stakes. Our results highlight the substantial risks that China’s banks pose for investors. While China’s high savings rate (40% of GDP) helps keep the country’s banks afloat, a financial crisis or significant drop in the savings rate could easily expose the poor quality of many of the banking system’s assets and precipitate bank runs.

Our results also contribute to understanding broader paradoxes in China’s economy. Given large imbalances in trade and investment, China has come under pressure from the U.S. and other major trading partners to make the yuan a fully convertible currency valued purely by market forces. It is commonly believed that such a move by China’s government will lead to further appreciation of the yuan and a reduction in trade and investment imbalances. However, if controls are removed and China’s citizens send their savings overseas for diversification or other purposes, it is plausible that a freely-floating yuan will decline in value, rather than appreciate. A stampede out of the yuan would be associated with massive withdrawals of funds from Chinese banks which, in turn, would impede the ability of the banks to continue subsidizing poor-performing Chinese corporations. This in turn could lead to massive unemployment and social instability as these firms collapse, thus threatening stability in China and beyond. Indeed, the Chinese government has indicated its belief that the currency regime cannot be fully liberalized until reform of the banking system is complete. Thus, our study of Chinese bank loans reminds us of the far-reaching consequences and contradictions that arise in reforming state-led banking in a transitional economy.

The full paper is available for download here.