Banks, Venture Capital, and FinTech in China
Following our research on the history of the Chinese financial system, the China team turned to the banking sector, financial markets, venture capital, financial technology, and special economic zones. These are the main trends we identified: a distortion of non-performing loan (NPL) data, faulty valuation of Chinese banks, an influx of government funds pouring into venture capital, and the emerging fintech industry.
For decades the Chinese banking sector has suffered from liquidity and loan quality issues -- the COVID-19 pandemic has only exacerbated the situation. According to the U.S.-China Economic and Security Review Commission (USCC), banks up and down the totem pole are being pressured to raise new capital and dispose of bad loans despite Beijing requiring lending to struggling companies. This dynamic imposes limitations on the ability of Chinese banks to foster economic growth. Additionally, this issue has led investors and other creditors to evaluate banks based on the likelihood that the government will back-stop losses instead of the banks’ fundamentals.
In response to the 2008 financial crisis, the Chinese government launched a 4 trillion yuan ($586 billion) package that, in general terms, safeguarded economic growth but led to risky expansion on the part of banks, leaving them with insufficient cash to cover short-term risk and dramatically increased the volume of NPLs held. Since the passing of the stimulus, the banking sector has grown with little regulation despite a high degree of Chinese Communist Party (CCP) control. This has resulted in banks repackaging their loans as investments, skipping financial disclosures, and lending to risky borrowers. Given these slate of foundational issues with the banking sector, we are skeptical of the government’s official NPL figure of 1.8% as of 2018. Fitch Ratings, a major credit rating agency, estimates the true figure is about 20%. GMT has not independently calculated an NPL proportion but our analysis of the fundamentals indicates that the figure from Fitch Ratings is credible.
Conversely, Chinese venture capital (VC) firms are not exhibiting major growing pains as of yet. The growth of VC firms has coincided with an influx of government funding, regulation of foreign investment in VC-related activities (it is important to keep in mind that while the government has opened up investment for public markets, the same is not the case for local and private firms that are the focus of VC activities) and the emergence of innovation incubators. In recent years, the government has injected large sums of capital into PE and venture capital firms largely via government guidance funds. In 2015 and 2016, these guidance funds ushered in a notable round of VC growth. Following 2017, a slowdown in the approval process made it more difficult for VCs to acquire funding. Overall, our outlook on Chinese VCs is optimistic despite a limited dependence on guidance funds.
The final trend we examined at length was the emergence of a strong fintech sector in China. Beginning in 2013, Alibaba and Tencent have launched a slate of fintech products including payment platforms, money market funds, and peer-to-peer lending platforms. We have recognized the implications for the competitive landscape involving Ant Financial and WeChat pay disrupting the business of banks. Initially, these peer-to-peer lending and payment platforms directly competed with banks’ consumer lending businesses. In recent years, due to a knee-jerk response from major banks and Chinese regulatory commissions, fintech firms like Ant pulled back from direct competition and have pivoted to providing a platform for banks to access their large and growing user base.
Following the China team’s presentation on these trends to the GMT membership, the discussion revolved around potential distortion of data regarding NPL numbers and implications for foreign and domestic investors. Arguments were made about the impending problem a large NPL volume can pose for the Chinese economy and the ethicality of distorting this crucial data. Despite the potential risk a large NPL volume poses for China, a consensus developed around the fact that NPLs are a common economic characteristic of developing economies. The main consequence identified resulting from potential data distortion lied in the negative implications for investors trying to evaluate Chinese banks. It became clear that until NPLs truly make an exit via regulation and economic maturity, foreign and domestic investors will have to rely on the likelihood of the government back-stopping bank losses as an evaluative factor.
Last week’s research and Monday’s discussion have given us insight into the change we can expect regarding the volume of NPLs in China and have informed our decision to focus analysis moving forward on VC and the banking sector’s impact on competition between state-owned enterprises and private firms.