Banking Problems Crop Up In China

Although the financial news focus has been on the so-called stress-testing of European banks – tests which have been too easy for comfort -- the bigger news is surely the admission by China of the loan loss potential of its banks.

The China Banking Regulatory Commission said that as much as 20 percent of 7.7 trillion yuan loans to regional government entities could become non-performing. These were mostly for infrastructure and building projects many of dubious commercial value and comprised the lion's share of new lending last year of 9.6 trillion yuan.

These alone could mean losses of 5 percent of the loan portfolio. At present nonperforming loans are just 1.3 percent and banks have appeared to be good investments on the back of strong margins and rapid asset growth. They trade on an average of 13 times earnings.

In the face of now-confirmed worries about bank financing of local government-owned entities, Chinese bank shares have been relatively steady. Although they have been raising capital to reflect expanding loans, they have been extremely profitable – more than twice the global average and so able to build capital without too much resort to shareholders.

The listing of Agricultural Bank of China in mid-July may have been lackluster but to get such a gigantic issue away at this time demonstrated that belief in the China story is still strong among foreigners starved of good news from elsewhere. Meanwhile global liquidity and low interest rates almost everywhere are pushing sovereign wealth funds into equities like ABC even if they have to close their eyes as they do so.

It is hard to imagine that after such a prodigious state-directed rise in lending last year, losses on loans to entities other than regional government enterprises will not also increase. In sum, it is quite likely that unless the data is fudged and more money or easier terms are provided to borrowers there will be a huge increase in NPLs which would wipe out a chunk of the banks' core capital. That ratio currently stands at a seemingly comfortable 8-9 percent of risks assets for the major Chinese banks. But 5 percent losses would require shareholders to dig deep into their pockets to restore the capital bases and enable loan growth to continue.

Of course, such disasters for shareholders may not happen. As before, the central government may take many of the bad loans off the bank books and onto special purpose vehicles. The government budget, not the shareholders would take the hit. Or regional governments may be called upon by the central government to use local revenues to bail out their defaulting corporate entities. This would be fair as these vehicles were created to get around controls on borrowing by local governments but politically might be very difficult.

One way or another there is a large price yet to be paid for the lending spree which sustained China's growth during the global slump but led to much non-productive investment that was financed by interest-bearing loans. Indeed, there is now a clear struggle going on between the People's Bank of China, the central bank, which wants to rein in these loans in the name of responsible banking and those in the central government who fear it will lead to a sharp fall in gross domestic product growth, and those in regional governments who still have big projects under construction that have been financed by banks through corporate vehicles.

A major problem of some sort is in the works but how long it takes to materialize will depend on the PBoC's success. Sharply reining in credit now, at the cost of a similar growth slowdown, should enable the system to absorb NPLs without too much agony. But let the situation drag on, pretending that the problem is an illusion – as happened in Thailand and elsewhere in the 1994-97 era – is storing up a crisis of the Asian magnitude in perhaps two to three years. As the banks are mostly state-owned they will not face the same problems as Thailand's but they will be immensely costly to the government and accompanied by both a sharp rise in government debt and a halt to new lending. In other words, a prolonged period of slow growth.

For the PBoC, the state of bank lending is not its only worry. With US$2.5 trillion in foreign exchange reserves it may have to prepare to take enormous losses on its US dollar holdings if China is eventually forced into a major revaluation. Such losses are not simply balance sheet items. They are actual yuan liabilities to local depositors. The loss is a loss to the nation and will ultimately be another drag on growth. An artificially weak yuan has boosted exports and China's prestige but at a cost both today, in terms of real incomes, and tomorrow in terms of capital losses

The US is not the only major country where politics has meant more benefits today to be paid for later.