Matthews Asia Snapshot

Remembering Hainan Development Bank

Week of June 15, 2012

With tropical weather and white sand beaches, Hainan Island is often referred to as the “Hawaii of China.” Popular particularly among Chinese honeymooners, Hainan attracts tourists from around the world. Few, however, recall the island’s darker days when it was mired in the failure of Hainan Development Bank (HDB). In June 1998, China’s then regulator of commercial banks announced the closure of HDB, which was saddled with bad debts.

While there have been other troubled Chinese banks that have shut down, HDB has been the only bank to be completely liquidated since China opened up its economy. HDB’s story remains a reflection of some of the deficiencies of China’s current financial system. One of the country’s early regional commercial banks, HDB was established to fund the growth of China’s special economic zones in the early 1990s. However, it was built on a shaky foundation. Regulators discovered that about US$111 million of the US$205 million initial capital went back to several founding shareholders in the form of loans. When HDB was established, the island’s property bubble had already burst, leaving much bad debt in the local financial system and exposing HDB to property sector speculation.

From its start, HDB had inherited about US$314 million of bad property loans from five troubled trust companies in Hainan province. At the end of 1997, the local government merged another 28 troubled credit unions on the island with HDB, sealing HDB's doom. These credit unions had similarly high levels of bad real estate debt, but what made them even more toxic was that they had secretly offered interest rates—as high as 20% a year—to attract deposits and stay afloat. When HDB absorbed them, management dropped the unsustainably high rates. Depositors quickly withdrew their savings, which led to a run on the bank. Within months, HDB announced it would shut down.

In the 14 years since then, China has made significant progress in its banking sector reform. Most of its state-owned banks and regional banks have been recapitalized and become public companies. They therefore fall under more scrutiny from public shareholders. China has also created a separate banking regulator to oversee the sector. But there is still strong local government influence in terms of bank lending decisions. And some key risk management mechanisms, such as a national deposit insurance system—critical for the prevention of another failure like HDB—are still absent.

More fundamental changes could be implemented, such as the development of a more liquid and broad bond market to ease the Chinese economy’s heavy reliance on its banking system; the reopening of an interest rate futures market to help investors better hedge risks; and policies to allow Chinese banks to truly be independent capital allocators. But what is encouraging is China’s plan to liberalize its interest rate and ongoing efforts to reform its financial system.

Sherwood Zhang, CFA
Research Analyst
Matthews International Capital Management, LLC

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