Banking on Asia

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A HISTORIC SHIFT

Imagine that you could not buy a car or send a child to college unless you had all the money to pay for it in your savings account. Or that you had to apply to refinance the balance of your mortgage every five years, with no longer-term options available and no assurance of re-approval. Americans in particular take access to credit on reasonable terms for granted. It is in many ways the underpinning of a consumer society. We also take for granted the financial structure that makes it possible—a highly efficient banking system that keeps capital flowing freely and allocates it productively.

Only recently have Asians begun to tap into credit as a means of managing their lives. In contrast to Americans, Asians have a strong savings culture, due in part to a lack of access to credit on reasonable terms; this has forced individuals to adopt an extreme degree of financial independence. Meanwhile, Asian banks have taken savers for granted. Banks have been happy to take money from consumers, but were extremely reluctant to lend it back until recently.

Moreover, in the absence of competition, banks could pay low rates on deposits while charging higher rates for loans, generating wide spreads that supported bloated bureaucracies. This arrangement was condoned (if not encouraged) by Asian governments that were keen to use banks as a tool of the state, fostering industrial development in favored sectors of the economy.

Asian banks have historically served a social purpose, financing public infrastructure and construction projects that figured in government-driven growth strategies. Banks have long been the primary conduit of capital in Asian economies, where capital markets (that make possible direct investment in corporate equity or debt) have been slow to develop. Traditionally, banks gathered deposits from individuals and made loans to large corporations and public works projects. Recipients of those loans were often dictated by government in the name of economic development, with little regard for their ability to repay.

*Local Currency Bonds data for India and the U.S. are as of 2003;
Sources: Matthews, ADB, Bank of Japan,
CIBC, Federal Reserve, BEA, RBI, Bloomberg

IN SAFE KEEPING: Banks have played an overly large role in the development of Asia’s capital markets. While equity markets have gained ground in recent years, the role of fixed income markets has been stunted.

Consumers, meanwhile, had to look elsewhere for loans, as did entrepreneurs and small businesses—often to the black market or so-called “curb” markets, on terms that Westerners would consider usurious.

While capital has not necessarily been in short supply in Asia, what supply does exist has often been allocated inefficiently by banks. In China, where four large state-owned banks control about two-thirds of all banking assets, banks have traditionally been a government instrument for financing large state-owned enterprises (SOEs.) Companies with the potential to drive growth—entrepreneurial start-ups and mid-size businesses—have been denied access to credit. Japan had its Kireitsu and South Korea its Chaebol—large non-bank corporations whose management and directors were often intertwined with those of the “sister” (related-party) banks. For decades they were first in line at the credit window. In India, regulatory restrictions are the issue: government statutes require banks to place 25% of assets in government securities, 5% in cash equivalent reserves, and 36% of loans directed to “priority sectors” that may be of questionable economic merit.

Historically, the number of bad loans or “non-performing assets” in Asia, as a percentage of total assets, would often be unacceptable in a U.S. or British bank. Yet bank failures or closings have been rare. The fragile underpinning of the system is an implicit government “guarantee” of bank solvency. Regulators drag their feet, slow to shutter insolvent banks—thereby avoiding short-term panics, but compounding long-term, system-wide instability.

*India’s figures have been adjusted to include the estimated impact of the mandatory “statutory liquidity reserve,’’ which requires that all Indian banks keep 25% of assets invested in government-backed securities.
Source: Matthews, McKinsey, "The Promise and Perils of China’s Banking System," July 2006

ALL BUSINESS: With the exception of more developed economies such as Hong Kong and Singapore, Asian consumers have largely been cut off from credit, which banks have funneled directly to government projects or indirectly to government-linked industries.

Ironically, Asian countries enjoy substantial trade surpluses with the rest of the world, but the proceeds are not reinvested in Asia’s economies. Instead, the proceeds are kept offshore, invested largely in U.S. treasury instruments or government-backed agency bonds. The central banks of South Korea, Japan, Taiwan and China hold a staggering $2.3 trillion in foreign exchange reserves.

In theory, that large pool of capital could be re-circulated within Asia to promote continued economic development. Yet because the region’s bond and stock markets are relatively underdeveloped, banks by default would play the lead role in channeling that capital into the region’s respective economies. This is a risk that Asian governments appear unwilling to take. They would apparently prefer to earn a low but stable rate of return on those assets, rather than place those funds at risk in their own shaky banking systems. Far from being agents of growth, Asia’s banks have largely been a bottleneck to it. The U.S. serves, in effect, as Asia’s “offshore financial center.”