Bondster

Enter the Dragon: Industrial and Commercial Bank of China tip toes into India

China took its first cautious step in entering India's banking market. On Monday, 23 May 2011, the Reserve Bank of India (RBI) approved the opening of a branch of the Industrial and Commercial Bank of China (ICBC), China's largest bank. ICBC's branch is expected to begin operations in six months.   

ICBC had formally made an application after Chinese Premier Wen Ji Bao's India visit in December 2010. This is not ICBC's first foreign operations. ICBC, where U S investment bank Goldman Sachs holds a 3 per cent stake, already has presence in the US, Europe and Asia. This is however, the first time after a Communist government took control in 1949 that a Chinese bank has made a presence in India.

The RBI approval for an ICBC branch in the country was more in the nature of reciprocity. Four Indian banks --– State bank of India, Punjab National Bank, Bank of India, Canara Bank and Allahabad Bank – already have branch presence in Shenzen, Shanghai and Beijing. Some more Indian banks are awaiting approvals for opening either representative offices or branches in China.

Deviation from Intent?

Reciprocity applied, the branch approval for a Chinese bank, is a deviation of RBI's intent of permitting foreign banks to operate only as subsidiaries. Although, India permits both the branch as well as the subsidiary route for foreign bank presence, the latter is preferred. This was especially in an environment where foreign branches were of banks that that have inadequate disclosure requirements and confer priority to domestic depositors/borrowers over their foreign branch liabilities in the event of liquidation. 

The preference for wholly owned foreign bank subsidiaries was also to ensure compliance to host country oversight, since banks are treated as systemically important financial institutions. Regulation by host countries allowed "Greater leverage to host country to ring fencing subsidiary operations in the event of a crisis."

But with reciprocity as the overriding criteria, deviation from intent was inevitable.  The deviation from the intent was not just applied to China alone. American, European and Middle East banks (Middle East Banks are almost entirely closely held and their origins are from autocratic or quasi-feudal environments, where banking regulations favour managements over customers) have all benefitted from the RBI's deviations. As a result most foreign banks operate through branches instead of subsidiaries.

Capital appears to be a crucial factor. For subsidiary operations it is Rs 3 billion ( $ 65 million), though there is a chorus in the government and the RBI for raising the capital to Rs 10 billion ($ 220 million). However, there are no specific capital requirements for branches. Instead the branches are expected to comply with a minimum capital to risk weighted asset ratio of 10 per cent at all times. This is in addition to maintaining a required reserve ratio (Cash Reserve Ratio in India) of 6 per cent.  

India's Banking laws also prescribe that foreign branches deposit cash or securities with the RBI, equivalent to the paid up capital and reserves and maintain an assets to deposits ratio of 75 per cent under the Banking Regulation Act. The laws also demand that the branches deposit 20 per cent of their respective profits with the RBI balances. In addition foreign banks are also expected to invest up to 24 per cent of their deposits into mandated securities including sovereign debt as a prudential measure.

Regulatory arbitrage?

On paper such regulations appear stiff. But for foreign banks the regulations are a laugh. In China the required reserve ratio is 27 per cent and in the U S it is 10 per cent. Low regulatory ratios confer considerable befits in form of financial arbitrage. The mandated investments in Chinese government bonds as prescribed by China's banking Regulatory Commission is 30 per cent. It is six per cent less in India. In the U S and in Europe there is currently no preemption of bank deposits into sovereign debt. 

Instead of being a price for access to host country banking market, Indian regulations in reality are a reward! The reason: Most foreign banks use the swaps as capital resources for bank lending operations. Deposit resources are only a small component. U S banks, the original architects of Swaps, routinely borrow funds from global branches, where the costs are low. So, foreign banks have credit portfolios in excess of 100 per cent of their deposits.

In the current environment the U S dollar is a carry currency. Swap funds are raised at sub-one per cent rates. Inclusive of swap costs, the effective price tag on inter branch borrowings by foreign branch swaps is around 2.23 per cent for every Rs 100 for 91 days. What the foreign banks earn currently earn is 9.62 per cent. This is assuming an 8 per cent yield on 91 day t-bills and 11 per cent commercial paper. Net earnings therefore translate to 7.4 per cent. India, with such high spreads, obviously is a highly profitable banking market.

High spreads are enticing for the sovereign wealth fund of China, considering the low yields earned in $ treasuries. Till the middle of last year almost all of China's foreign exchange reserves were parked in a combination of  $ Treasury Bills, Notes and Bonds. The U S Fed's Quantitative Expansion has triggered a shift. China remains a large buyer of U S treasuries, though the buys are mostly shorted dated securities. Long dated Treasury Notes and Treasury Bonds are less favoured. The shift to short term bills have pushed down $ Treasury yield spreads between one and ten years to 300 basis points.   

The shift has also pushed China' to Euro denominated securities. At the peak of the Greek financial meltdown in July 2010, China's Premier Wen Jiabao then on a visit to Athens offered to buy $ 40 billion Greek Government bonds.  China also purchased Spanish government Debt. In July 2010, when the Euro was on the boil, Spanish government bond yields had topped 8 per cent in July as prices fell on the back of desperate selloff by panic stricken investors. Initial purchases by China's State Administration for Foreign Exchange (SAFE) buy of $505 million, changed the situation and pulled up bond yields back from the brink. After sustained purchases China now holds €25 billion Spanish Euro bonds lifted at very steep discounts, at yields as high as 8 per cent. The buys were through shrewd sale of short term $ securities, especially maturing Agency debts and replacing them with high yielding Euro bonds. Such buys have helped push up the Euro, against the $.

Chinese Yield hunt

Addition of Indian sovereign bonds into this kitty will diversify the investments, mitigate the risks and at the same time increase the yields. Buying Indian debt however is a different ball game. Indian bond markets are still tightly regulated. So China's  for yield hungry Sovereign Wealth fund, there are entry barriers even if wants to enter into sub-sovereign or even corporate debt. Operating through the Foreign Institutional Investor route is possible. 

But there are physical limits of $ 10 billion in sovereign debt ad $20 billion in corporate debt.  

With an external reserve chest of $ 3.04 trillion, ten times India's foreign exchange reserves, the limit is chicken feed and hardly contributes to making a 0.5 per cent impact on the weighted yield of China's investments. Obviously, FII is simply not the route take, want a piece of the salivating yields. Banks are clearly a better route. Even if the entire bank capital is invested in government debt, China would still be earning far higher returns on its reserves than in $ or in Euro at almost the same risks.

China's interest though is not confined to just government debt. It is more in sub-sovereign debt. Chinese banks are funding, India's power projects, especially the 3960 mw Anil Ambani backed Reliance Power Projects in Krishnapattanam on India's East coast state of Andhra Pradesh, Tilaya in Jharkhand and Sassan in Central India. The projects cost $12 billion or $ 4 billion a piece. Chinese banks' project debt is $ 9 billion in the group. Such large exposure to a single promoter makes lenders vulnerable. Indian banks are governed by tight single borrower exposure limits. American and European banks have their own set of internally controlled limits. Chinese banks however are risk savvy. Besides, the the projects have already entered into bulk supply contracts with growing states, Andhra Pradesh, Tamilnadu, Karnataka, Tamil Nadu, Maharastra, Punjab, Gujarat, Rajasthan and Haryana. All these states have provided funded payment guarantees for 25 year electricity purchases.

That essentially means the entire Chinese banks' exposures in the project debts are completely ring fenced, well almost. (This is assuming Chinese boilers, turbines and generators comply with performance guarantees. Chinese equipment has already failed in power projects in West Bengal State. Exchange risks would also need to be hedged). Even after factoring in exchange depreciation risks bank lending to the power project translates to returns of over 12 per cent.

First step to a Common market?

The entry of ICBC may be the first cautious step of the dragon in its hunger for higher yields and less riskier investments. Three other siblings – China Construction Bank, Agricultural bank of China and the Bank of China are also expected to follow ICBC's trail. ICBC is the largest Chinese commercial bank as bilateral trade expands between the two Asian countries.

Yet there is an element of trepidation over China's entry. The concerns are partly political, and largely economic. India and China have seldom been the best of friends. After 1962, it is only since this decade that both have grudgingly accepted each other, though even this acceptance is occasionally interspersed with some sabre-rattling.  

The misgivings are economic. Trade between the two countries is currently about $80 billion and heavily tilted in China's favour. But trade volume between the two could quickly cross $100 billion. The import of raw materials and export of manufactured products have caused some fury in this country

But the main worry is the transfer of reserves from U S Treasuries into India. The transfer, however small, is expected to bring in a new set of headaches. This is especially at a time when efforts to tame inflation show signs of flagging. Food price inflation in the country is currently at 16.53 per cent. Exports are weakening with the Euro zone and $ zone troubles.  

As China starts investing into Indian fixed income securities, the pointers are clear – liquidity will tighten. This is because the RBI is obsessed with inflation. And inflation containment demands non-intervention in foreign exchange markets. That means bond yields are likely to harden further from the current levels. Indian Bond yields are likely to cross 9 per cent this year. Already one year yields are over 8.33 per cent. Ten year sovereign yields are 8.5 per cent.   

Exchange rates volatility is bound to increase with a bias for a Indian Rupee appreciation. For exporters, inflows of $ from China translate into threat of being completely driven out of business.  Alternatively would need to be supported by fiscal sops. Indian policy makers have a choice of fiscal deterioration or a widening current account deficit. Perhaps this may be sufficient reason for introducing a Tobin tax. Or it could just be the beginning of a fruitful cohabitation between the Dragon and the Elephant -- a precursor to the World's largest Common market, larger than NAFTA or European Union or ASEAN.