Reading of the New Policies for Forex Loans

In order to dispose the surplus foreign exchange at hands and support the national strategy of “Going Out”, the Chinese foreign exchange administration plans to lend loans to the foreign companies and governments through the China Development Bank.

The State Administration of Foreign Exchange (SAFE) is exploring renovation to the policy-oriented foreign exchange credit lending. New systems will be formed, in which the SAFE will entrust China Development Bank to conduct the policy-oriented investment projects featured with government cooperation, such as “exchanging news with oil”.

The SAFE aims at removing part of the foreign exchange stress and scatter the foreign exchange assets. Meanwhile, this shift make the SAFE turn from a traditional foreign exchange administrator to a supplier of foreign exchange credit loans.

The new policy was gestated at the end of 2009, when the State Council required the SAFE to make clear of the policy-oriented projects of the credit loans for Sino-Russia oil trade. The SAFE was also required to study how to lend these kinds of loans and formulate related lending system. Meanwhile, it was asked to cooperate with the Chinese state-owned enterprises’ (SOEs) strategies of “going abroad to make investments in overseas market”.

The initial move the SAFE made was to ink an agreement with China Development Bank on the entrustment of credit lending. The bank set up a new department specialized in the “credit lending subject entrusted by the SAFE’. According to the insider, the main targeted customers of this project are those SOEs having the will to make overseas investment and the foreign government or enterprises having cooperation with Chinese.

The entrustment loan lending is a kind of off-balance-sheet business, which means that the consigned commercial banks can only charge for commissions as the income from intermediary business. The SAFE doesn’t have pre-lending review, post-lending management and the other commercial banks’ risk control abilities, is forced to make the consigned banks take all the rights of risk control. “The commercial bank has to work for the SAFE for a limited amount commissions while most profits from foreign exchange financing,” said an insider who bears a grudge.

“Taking a long view of the national development strategy, this business pattern is somewhat reasonable,” said a financial expert. “But the biggest problem is who has to assume the risk.”

Pressure from Foreign Exchange Reserve

From 2009, China signed a series of contracts of “exchanging oil with credit loans” with Russia, Brazil, Venezuela, Kazakhstan and Turkmenistan. The contract value amounted to 60 billion US dollars and therefore China can get 75 million tons of crude oil from these countries.

For example, the agreement between China and Russia stipulates that China lends long-term loans of US$ 25 billion to Russia every year and in exchange, Russia exports 15 million tons of crude oil to China each year. The valid term of the contract is from 2011 to 2030.

China Development Bank plays the leading role in those aforementioned projects. In addition, Bank of China, the Export-Import Bank of China and Agriculture Bank of China are engaged in these deals.

China Development Bank was once haunted by the single source of capital. So was the Export-Import Bank of China. Previously their foreign exchange capital comes from buying foreign currencies from the inter-bank foreign exchange market. Then a thought hit the foreign exchange administrators’ heads – since most of the projects China Development Bank invested are the ones based on the government cooperation, why not use the Chinese government’s foreign exchange reserve as the source of the commercial bank’s source of foreign change. In that way both of the huge foreign exchange reserve of the country and the professional credit lending ability of commercial bank can be fully used.

This was thought to be a positive move, especially when the drastic increase of foreign exchange reserve and limited channels of investment are severely stressing the SAFE as well as the People’s Bank of China – the central bank of China.

China’s economy has been undergoing fast increase since it joined in the WTO in 2001. Meanwhile, its RMB never gets rid of the pressure of appreciation. Its foreign exchange reserve also keeps increasing at a fast pace.

Before 2002, the annual increase of China’s foreign exchange reserve never exceeded 50 billion US dollars. From 2002, China’s foreign exchange reserve increased by 33% year on year. Presently, the foreign exchange reserve held by the People’s Bank of China reached 2.4 trillion US dollars, twice as large as three years ago.

Theoretically, the central bank only needs to retain the foreign exchange assets with good fluidity on the balance sheet to meet the demand of short-term foreign loans and export in three months. The reasonable amount is 500 to 600 billion US dollars. Therefore, the central is thinking of new, safe and lucrative investment methods apart from the traditional ones.

China Investment Corporation, which was founded in September 2007, is a state-owned company specialized in overseas investment. “The foundation of China Investment Corporation made the first step, which was not followed up,” said Li Yang, deputy director of the Chinese Academy of Social Sciences.

Presently, the increasing expectation for the RMB appreciation makes the commercial banks and enterprises not want to hold too many foreign exchange assets. They all finish exchange settlement immediately they receive foreign exchanges.

Thus came out a strange scenario: on the one hand China’s foreign exchange reserve always stays in the track of increasing; on the other hand, the commercial banks in China are haunted by the shortage in foreign exchange position. Meanwhile, the demand of the enterprises for the foreign exchange credit never wane because of the lower interest rate of foreign exchange loans than the one of RMB loans.

According to the data published by People’s Bank of China on May 11, the balance of foreign exchange deposit of financial institutions in China was 204.3 billion US dollars at the end of April while the balance of foreign exchange credit reached 413.4 billion US dollars. The ratio between foreign exchange credit and deposit reached 200%. In comparison, such ratio was 182% at the end of 2009.

The central bank has been trying to diversify the foreign exchange assets holders to decentralize the risk of foreign exchange assets. For example, it allowed the commercial banks to buy foreign currencies by themselves in 2002. However, exchange settlement was not included in these deals and the banks had to assume the exchange rate risk alone.

China Development Bank and the Export-Import Bank of China were given a red light for their business of issuing US$ debt to overseas market in 2007 due to increasing pressure of foreign exchange reserve. According to the data, China Development Bank’s balance of foreign exchange credit was 101 billion US dollars at the end of this March.

Misery of China Development Bank

When the SAFE started the reform to the policy-oriented loans, it chose China Development Bank as its partner. According to the agreements inked by the two organizations, the overseas investment projects, which has occurred or will occur in 2010 and the following years, are considered as the off-balance-sheet business. China Development Bank, as the agent bank can charge for the commissions, whose proportion is 1% to 2%.

The aforementioned agreements of “trading oil with loans” with many countries saw China Development Bank’s name signed on the most outstanding place. All these agreements’ terms are above 10 years.

The source said that China Development is turning into a commercial bank. Its foreign exchange credit business includes these policy-oriented loans and the commercial business the bank developed by themselves.

By now China Development Bank has sent more than 100 working teams to the countries in Asia, Africa and Latin America. A complete international cooperative business network is built. China Development Bank is also copying its development-based financial philosophy into its international cooperation field.

“The biggest possible damage to overseas investment comes from the country-risk. The overseas middle- and long-term loans are featured with the huge amount. Therefore the risk gets centralized in a certain country,” said the expert.

“When your fate is tied with the country, you will shoulder smaller risk,” said a source from China Development Bank. However, disagreements have arisen in estimating risks.

Whether these developments are policy-oriented loans or commercial businesses is the first sector failing to see the consensus.

“Which businesses are included in the scope of national strategy should be designed by the government,” said a source from China Development Bank.

The source felt depressed when talking about this arrangement: “These kinds of businesses have a high pricing level. The revenue depends on the risk control abilities, pricing level and assets quality. If the risk is under control, the profits gained from these businesses are much higher the commission income.”

In his opinion, China Development Bank, which is at the turning period, needs to increase its scale in those commercial businesses, so that it can have long and stable income source. However, if these businesses exist as the off-balance-sheet businesses, the profits will be greatly reduced. “The 1% to 2% commission is not satisfactory enough.”

An insider from the Export-Import Bank of China thinks that this measure has both positive and negative influence. In his opinion, the bank can develop the business without shouldering big responsibility and risk. That equals enabling the bank to foster a team with international experience.

“To foster an experienced team specialized in international business needs at least 10 years, as well as a group of new tools, new technologies and new talents,” said the aforementioned insider. “It is hard for China Development Bank, which just started its international business team, to have such an experienced team.”

Who Will Assume the Risk?

But the insider also said frankly that the entrustment loan business pushes the commercial bank into the test of moral risk. He thinks that the off-balance-sheet business casts no stress upon the bank, so it doesn’t need to think of benefit. The credit lending process and results are monitored by the consigner, i.e. the SAFE, who has to assume bigger risk.

“The spread is eaten by the SAFE, say, most of the profits are taken by it. Who will be responsible for the post-lending management and risk control?” said an expert. The biggest risk of this business pattern lies in the morality.

“This means to allow the banks to launch new business without any costs. The bank uses the other’s money to develop its own business. If successful, the bank can earn quite a little from its efforts. If wrong, the two parties must have endless disputes about who will take the responsibility,” said the aforementioned expert. This may even disturb the normal development of the bank’s core business. “Suppose, is there anyone able to commit themselves to doing something unrelated with them?”

A senior financial expert said that the bank probably has loose control of and less dedication to the business not related with them. The credit lending business needs a complete series of technology, including judging market risk, operation risk, credit risk and the country risk, which is the most difficult. It entails corresponding professional abilities. “We can not neglect or lessen the control risk due to the so-called ‘national strategy’, which may hide bigger risk, like cash embezzlement,” said the expert.

Some people advise buying the domestic US$ debts with the foreign exchange. Featured with low risk, this can help the bank to earn more foreign currencies.

But this method is also haunted by a problem. Is China Development Bank, which has developed a lot of policy-oriented businesses, a policy-oriented bank or commercial bank? During the process of transformation, the vague identification casts a shadow over the prospect of China Development Bank.