(Beijing)—In an odd twist for China’s powerful banks, the biggest state-owned lenders last year started running low on the foreign currency needed for loans to enterprises investing overseas.
“Some commercial banks suspended U.S. dollar loans” after the dry spell began in mid-2011, a source at a Shanghai branch of a state-owned bank told Caixin. “Others charged interest rates of more than 5 percent. The market’s foreign currency supply has been tight.”
Fortunately for borrowers and banks, though, the drought appears to be easing.
Stepping in to fill the currency gap—and continue fueling a “go abroad” campaign promoted chiefly by major state enterprises and the government—is the central bank’s manager of China’s vast foreign reserves, the State Administration of Foreign Exchange (SAFE).
SAFE in recent months launched a credit mechanism that takes advantage of its access to the government’s US$3.2 trillion stash of foreign cash. The system has extended the use of forex reserves for foreign currency loans to enterprises through banks.
SAFE has been expanding its forex credit management department since late last year, following its decision two years ago to allow lending foreign reserves to companies through banks. The move was aimed at diversifying the nation’s forex investment channels and supporting Chinese enterprises with overseas ambitions.
Initially, only policy banks such as the China Development Bank (CDB) and the Export-Import Bank of China could participate in the credit program. Moreover, loans were restricted to projects considered nationally strategic, such as those tied to natural resources.
Under a May 2010 agreement, CDB and the Ex-Im Bank won permission to lend money controlled by SAFE and collect fees equal to as much as 2 percent of each loan.
“It was a reciprocal arrangement,” a CDB source said. “SAFE diversified forex reserves investment channels through banks, while banks got more foreign currency to support Chinese companies for ‘going out.’”
So far, SAFE’s decision to widen the door to forex lending has not meant that every “going out” enterprise gets the money it wants. For some would-be borrowers, the reserve manager’s credit restrictions stand in the way.
“There aren’t many companies eligible” for the loans, admitted one bank source.
Companies must be Chinese to qualify, the source said, and major state-owned enterprises are preferred. In addition, financing is only available for projects that fit the government’s “going out” strategy.
Most of the borrowed money, a source close to oil giant Sinopec Group told Caixin, has been used for overseas acquisitions.
Banks benefit by charging commission fees and classifying each loan as an off-balance-sheet business. But all deals are ultimately overseen by the government.
“The state decides which businesses reflect national strategic intent and whether the banks can treat the loan as an off-balance-sheet business,” one source explained.
How It Works
Central bank data shows net deposits of foreign currency by the nation’s banks declined between 2009 and 2011. Bank loans in foreign currency grew 19 percent annually, or a combined US$295 billion in three years, but total foreign currency deposits in the nation’s banks rose by only US$96 billion.
One bank source said the nation’s foreign reserves are tapped for only a portion of most business loans involving foreign currency. The rest of the cash comes from a participating bank’s own reserves.
This mixing of government and bank money for a single project encourages banks to manage risks through loan application and management procedures.
For one project, the source close to Sinopec said, a combination of about US$100 million from the nation’s forex reserves and bank funds were loaned to the company. The total amount borrowed was several hundred million dollars.
“Banks must ensure the security and profits of foreign reserves,” another source familiar with the credit scheme said. “Risks with these projects are low because companies obtaining forex reserve loans are usually large, state-owned enterprises with adequate guarantees.
“Even when problems occur, money from the forex reserves would certainly be guaranteed first.”
Many bankers argue SAFE should bear any risk associated with these loans because it stands to gain the most from interest rate spreads.
Unlike banks, SAFE lacks the ability to conduct loan application reviews and post-loan management. Banks accept these responsibilities, but they have little incentive to do a thorough job since they’re allowed management fees equal to only ten basis points, sources said.
For example, a subsidiary of China Ocean Shipping (Group) Co., China’s leading state-owned, liner shipping company, borrowed foreign currency from SAFE through the Bank of China (BOC). SAFE got 3.5 percent of the 3.6 percent interest charge, and BOC the rest.
Moreover, companies that borrow foreign currency are usually valuable bank clients entitled to privileges and favorable interest rates.
Foreign currency loans from SAFE are generally appealing for their low interest rates. A three-year loan in U.S. dollars, for example, can yield an interest rate on forex reserve financing of at least 350 basis points above the London Interbank Offered Rate, a bank executive said. The market price for the same loan would be 450 to 500 basis points higher than the London rate.
Several sources close to SAFE and its loan projects said protecting China’s foreign reserves is a priority for any type of financing through the new mechanism. And it’s generally agreed that a forex reserve loan must yield a return of at least 3.5 percent.
Tian Lin is a Caixin staff reporter. Staff reporters Zheng Fei and Zhang Yuzhe and intern reporter Zhou Qun also contributed to this article.