The Coming Collapse of the Chinese Banking System

Andrew Michael Teo

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During the Asian Financial Crisis of 1997, China saw two of her financial institutions in Guangdong collapsed, one of which was the notable Guangdong International Trust and Investment Corp (GITIC), which was established in 1980 and owned by the Guangdong Provincial Government.

The collapse of these two financial institutions revealed the massive non-performing loans that were given to Chinese red chips, which are Chinese companies incorporated outside Mainland China but whose shares are listed in Hong Kong. Investment bankers, flogging shares of China’s state-owned banks, admitted that much of the improvement in the balance sheets of China’s banks comes from re-classifying hundreds of billions’ worth of risky loans from “non-performing” to “special mention” — and not because of any genuine change in lending practices.

In the wake of the last recession, China’s local and regional government had undertaken massive infrastructure projects that saw them racking up huge debts funded by borrowings from the banking system rather than through issuance of government bonds.

These debts are usually channeled through “special-purpose” financing vehicles, known as Local Government Financial Vehicles (LGFV), which are basically state-owned enterprises, which allow them to get around the laws that require them to keep balanced budgets.

The Chinese banks, which are carved out of the old Communist banking system just at the turn of the millennium, have been bankrolling these state-own enterprises and keeping them afloat which would otherwise had gone bankrupt.

Since these Chinese banks are state-owned and they form part of the Communist government, they have had no incentive to learn the disciplines of basic banking. Conversely, loan applicants never had to cobble together a business plan to get a loan — or suffer the negative consequences of failure.

During the last recession, Chinese banks had expanded credit at a record pace in 2009 and 2010, making more than 17.5 trillion yuan (US$2.7 trillion) of new loans as the government moved to offset a collapse in exports during the global recession. About a third of LGFVs do not have sufficient cash flow to service their debt, according to China’s banking regulator.  This amount does not include the amount of credit that had been extended to LGFVs even before the last recession kicked in.

Despite this, the Non-Performing Loan (NPL) in China fell sharply as at end of 2010, according to China Banking Regulation Commission (CBRC). Of the total loans that were given out in 2009, only US$ 55.5 billion, or 1.15% of the total loan, are seen as non-performing.

However, in light of its analysis, Moody’s estimated, in a July 5th statement that the Chinese banking system’s economic non-performing loans could reach between 8% and 12% of total loans. That is closer to the 10% to 18% estimated in Moody’s stress case than the 5% to 8% that constitutes the agency’s base case.

The official China Securities Journal reported in October 2010 that more than one quarter of those loans that occurred in 2009 and 2010 to finance those massive infrastructures projects through LGFV are at risk of default.  The journal reported that money went to projects that failed to meet official regulations either faced “serious defaults risk” or was embezzled.

Despite repeated denials by the Chinese government in regards to the health of their banking system, some concrete data has emerged regarding the potential size of the problems that may be lurking on China’s bank balance sheets — in particular, the losses that may be incurred from risky stimulus loans made to LGFVs, sponsored and supposedly guaranteed by provincial and local governments.  However, cases had revealed that the Chinese Central Government later nullified those guarantees

Various parts of the Chinese government have different estimates of the total size of local government debt, but one of the more authoritative figures puts it at about 37 per cent of GDP at the end of last year, according to the GaveKal-Dragonomics economic research firm. By including a range of other liabilities that Beijing is explicitly or implicitly on the hook for – such as ballooning debt at the railway ministry, bonds issued by so-called policy banks that lend on behalf of the state, and bad debts in the state-owned banking system.

GaveKal-Dragonomics estimates that China’s real debt-to-GDP ratio could be as high as 90 per cent. Other analysts believe the total debt-to-GDP ratio is more like 70-80 per cent, and Fitch Ratings makes a conservative estimate of about 48 per cent gross general government debt by the end of last year, based on the opaque and incomplete information available. The main point is that China’s debt burden is much higher than she would like to admit, and much of that debt has piled up in the past few years, which was a result of Beijing’s response to the global financial crisis.

“Even though headline sovereign debt levels are low in China, so much quasi-sovereign activity happens through the banking system that if you include some of those contingent liabilities, the number can get very big,” says Charlene Chu, head of Fitch’s China Bank Ratings. “People forget that China undertook its fiscal stimulus package through the banking system rather than by issuing public debt in the same way other countries did.”

While government debt in China, which is financed through the banking system, is definitely much larger than it appears at first glance, nobody, however, is predicting an imminent banking crisis. On the other hand, it does not rule out one over the next few years.

According to Michael Petit, Standard and Poor’s managing director of Asia-Pacific Corporate and Government ratings, China, saddled with bad loans and a critically weak banking system, risks stifling her rapid economic growth and reform process. He also said “the most visible weakness” in China’s banking system was the extent of its problematic loans.

Given both the dominance and weakness of the banking system, “the risks China are facing in setting down a liberalizing path are in making a misstep,” he cautioned.

“Its reform program needs to be carefully coordinated and implemented in a sequenced approach to avoid any unwanted disruption to its economic system,” Petit said.

The size of China’s bad loans has been a source of controversy.

Global auditing firm Ernst & Young had in May 2005 estimated that the Chinese financial system was exposed to US$900 billion dollars in bad bank loans but later retracted its opinion due to suppression from the Central Bank which said that NPLs that stood at US$358 billion for the big four state-owned commercial banks alone “seriously distorted” reality.

Fitch Ratings had said in May 2006 that China’s banking system still contained about US$476 billion in non-performing and problem loans.

“Although no one can know for sure, China’s banks and instrumentalities are probably sitting on a trillion dollars of doubtful loans at this moment,” Gordon Chang, a China expert and author of “The Coming Collapse of China,” told the hearing of the US-China Economic and Security Review Commission.

He warned that “a bank failure in the next few years is possible, if not likely” and that China’s banks, “almost without exception, are hopelessly insolvent from a balance sheet point of view.

“Chinese banks are blowing up their balance sheets at unprecedented rates,” he said, adding that banking failure would “almost certainly lead to a collapse of the economy” and cause the political system to be even more fragile.

Chang also said that China was burdened by too much debt.

Beijing claims that China’s debt to gross domestic product ( GDP) ratio is only 18% but Chang said it was a staggering 81%, based on his “conservative” calculations.

Petit, of Standard and Poor’s, said China’s overly rapid loan growth suggested “vulnerability to an eventual economic slowdown and to the emergence of a new wave of problem loans.”

But he hastened to add that the Chinese government had the wherewithal to prop-up its banking system through additional capital infusions or purchases of troubled loans, if needed.

Even so, China’s “critically weak banking system” placed a “massive contingent fiscal cost on the government,” he said.

Petit noted that “overlap” between the Chinese government — the main shareholder in the banking sector — and banks and borrowers and the frequent rotation of Chinese Communist Party members through them was “inimical to the creation of arms-length relationships.”

It is “likely to inhibit the creation of effective corporate governance practices alongside a culture of commercial banking,” he said.

In April this year, ratings agency Fitch downgraded China’s currency outlook from stable to negative, citing potentially destabilizing easy credit and the possibility of non-performing loans (NPLs) in Chinese banks hitting 30%. If NPLs reach too high a level, it could overwhelm the Chinese banking system and leave it unable to absorb the resulting losses.

While the Chinese government has set targets to control the amount of lending done by banks, there are hidden sources of credit and loans that Fitch’s believe may add up to 2 or 3 trillion Yuan this year.

Despite the downgrade, China’s rating is at AA-, which indicates a fairly low risk of default. However, given the rise of cheap credit combined with informal and off-book lending, the Chinese government is seeking to rein in excessive lending.

China’s fiscal picture is not quite as pristine as Beijing would have the world believe, but surging growth rates tentatively cover up a lot of sins and the situation remains much worse in the west. China’s inflation hit another 3-year high at 6.5% in July. By itself, that rate is not especially high, and Beijing has succeeded in checking inflation in the past. Even as the economy grew quickly over the last decade, overheating was not a problem—GDP grew at an average annual rate of 10.5% from 2001-10, but consumer prices rose an average of only 2.2% per year during the same period.

However, China is facing the possibility of a stagflation, which is a sign that Beijing’s monetary policy has reached its limit. Unwinding that policy may be painful both for China and the world.

China’s double-digit percentage growth rates are economic sleights of hand that have come at a price of escalating bad debt and non-performing loans. At the end of 2004, bank debt in China stood at US$3.7 trillion, which is about twice the size of its GDP, and is lent almost entirely by state-owned banks. That’s the highest proportion of any economy in the world. Presently, Chinese state-owned enterprises owe banks over US$2 trillion. This is about the size of the entire Chinese economy. And the amount of outstanding loans is growing year by year.

However, any student of socialist economies will not find this shocking since this is just the way financial institutions in “soft budget constraint” socialist economies works.

In socialist economies, cheap loans combined keep inefficient state-owned enterprise afloat. They also mean that a lot of goods that are produced should not be produced at all in the first instance as it leads to massive misallocation of resources and wastages. As this is the case in China, it should also explain how she managed to achieve double digit growth. With cheap loans financing a big economic expansion plan, China bad debts maybe approaching the threshold before the bubble bursts.

This, thus, makes the coming collapse of Chinese banks even more inevitable. If the banking system in China collapses, it will not be the first time since the Asian Financial Crisis.

Due to this, China’s economy has to keep moving lest her state-owned enterprises are not able to service their debts and the entire banking system will collapse on itself. However, if the economy eventually runs out of steam, and with China playing a much bigger role in today’s global economy than it did during the Asian Financial Crisis, her troubles will have a stronger impact on the U.S economy and the world than the collapse of the Soviet Union in 1991, which accounted for less than 1% of U.S. trade.

Ironically, it is not the inevitable rise of China’s banks but rather, it is their inevitable collapse that poses the greatest challenge to the global economy and global financial system.

Photo courtesy of Wikipedia