The fallout from the U.S. financial turmoil has been a topic of keen discussion in China. China’s exposure to the ongoing credit crunch is still limited, given the closed nature of the country’s financial markets. The ongoing global financial turbulence will have a limited impact on China's banks and financial system, which are, to the chaos developed in the U.S. and other parts of the world, relatively shielded from those problems, one reason being that Chinese banks are less involved in the highly sophisticated financial transactions and products. However, the sudden downfall of several prominent global institutions has concerned authorities about ripple effects and is prompting a reassessment of the pace of China’s financial sector reforms. The turmoil in the US financial markets will undoubtedly weigh on China’s plans to introduce more complex financial instruments and services.

China’s exposure

A few Chinese lenders were subject to losses from investing in foreign assets involved in the Wall Street crisis, but the scope and scale were small and the banks had been prepared for possible risks: Chinese banks had only invested 3.7 percent of their total wealth in overseas assets that were prone to international tumult. The ratio of provisions to possible losses had exceeded 110 percent at large, state owned listed lenders, 120 percent at joint stock commercial banks and 200 percent at foreign banks.

The U.S. federal government’s intervention in the financial markets is being watched intently by authorities in Beijing, given China’s sizable holdings of U.S. government and housing agency debt. According to U.S. Treasury data, as of July 2008, China had invested US$ 518.7 bn in U.S. treasuries, while holdings of long-term debt issued by federal agencies (primarily Fannie Mae and Freddie Mac) have been reported at approximately US$ 440 bn. According to a recent article in the Wall Street Journal, China’s four biggest listed banks held a combined US$ 23.3 bn in debt issued or guaranteed by Fannie and Freddie as of mid-June, but have begun paring their holdings. Chinese banks have also begun disclosing their exposure to Lehman Brothers. China’s biggest lender, ICBC, holds US$ 151.8 mn of Lehman Brothers debt; the Bank of China has exposure of US$ 128.8 million, comprising $ 75.62 million of Lehman bonds, and $53.2 million in loans. Seen in the context of Chinese banks’ total assets, the direct impact on asset quality does not appear excessive.

Universal banking

Most of the banks resided in China where capital control made it more difficult to move money in and out. Besides, the country's large foreign reserves prevented the financial system from a lack of liquidity, which was troubling the strained international markets.

The recent crisis involving major Wall Street firms is sparking debate about the preferred model of organization in the financial sector. This has been an area of interest for regulators in China, where commercial/retail banking, investment banking, fund management and insurance firms have traditionally operated within vertical segments. In recent years, Chinese financial holding companies such as Everbright and CITIC have received government approval to combine various financial business lines under one organizational umbrella. China’s leading private insurer Ping An has diversified into banking, securities and asset management businesses following a series of acquisitions, and the country’s largest banks have made headway in expanding their portfolio of feebased services. The unfolding financial crisis in the U.S. may be viewed as empirical evidence in support of the universal banking model in China.

The globalization of Chinese financial institutions

Listed Chinese banks are massive in terms of market capitalization and assets, but their business reach remains limited in terms of functional and geographical diversification. In 2007, we witnessed the first wave of overseas investments by Chinese banks, many of which were bolstered by IPO proceeds, rising profits and surging share prices. Prominent examples included China Development Bank’s purchase of a 3.2% stake in Barclay’s, China Minsheng Bank’s acquisition of a 9.9% stake in San Francisco-based UCBH Holdings and ICBC’s purchase of a 20% stake in South Africa’s Standard Bank. Chinese sovereign entities were also active in investing overseas – the China Investment Corp. made early investments in Morgan Stanley and Blackstone Group, acquiring 9.9% of each company. In view of the global financial turmoil, Chinese financial institutions are likely to adopt a more cautious approach towards overseas investments.

Implications of China’s monetary easing

In the midst of turmoil in global stock markets, China’s interest rate cut on September 15, the first in six years, was likely prompted by growth concerns and a desire to offer a measure of relief to the troubled property sector. This shift in policy marks the beginning of an easing cycle. In the near-term, the combined impact of an interest rate cut and an anticipated boost in fiscal spending will have varied implications for key sectors of the economy:

- Banks
With deposit rates left unchanged, the cut in lending rates will have a marginally negative impact on Chinese banks’ earnings. The RRR cut will however improve short-term liquidity for smaller banks (China’s five largest banks are excluded from the cut), and decrease funding costs for institutions that are net-borrowers in the inter-bank market.

- Property
The property sector stands to benefit from a reduction in borrowing costs. Meanwhile, the 9bps cut in mortgage lending rates exceeding 5 years (18bps for mortgages under five years) should provide modest support for property demand. Beyond the immediate impact of the rate cuts, expectations of further monetary easing may serve to improve prevailing negative sentiment towards the sector.

- Infrastructure
With infrastructure projects easier to finance, construction and building materials companies stand to benefit. Supporting reconstruction-related infrastructure projects, the PBoC announced a two percentage point cut in RRR for financial institutions in regions affected by the Sichuan earthquake in May. This policy move builds on the ambitious infrastructure investment plans previously announced by the government. We expect a more proactive fiscal policy in the coming months to bode well for China’s infrastructure sector.