China’s banks and bad debt: where from here?

This is where the China economic debate really comes to a head.

There is no doubt China has built up a large stockpile of bad debt with the poorly planned/implemented stimulus package of 2009 and the clumsy use of stimulus ever since to moderate a tricky slowdown for an economy in transition. The numbers are huge, likely ending up well within the trillions of dollars and showing few signs of slowing soon. How will any resolution play out?

The conclusion of a surprising many is that there will be a banking crisis, with some (see Kyle Bass) going so far as to link such a potential crisis with a future CNH devaluation. That I see as pretty far fetched because China’s many state tentacles and lack of proper financial markets doesn’t lend itself to the typical Minsky-esque crisis. But the bank issue is a real one that needs better explanation. (For related blogs this year, see China’s economic policy messiness and capital outflows)

If the history of emerging and developed markets is littered with private sector debt build-ups leading to crises that undermine banking systems and cause deep recessions, what makes one think that China can avoid such an outcome?

As so often, this is where the failure to understand how China’s system works comes into play. Assumptions that China is bound by the same rules, while widespread, will lead to incorrect conclusions. Understanding the state-dominated system matters because China’s set-up is unlike any, especially for an economy of its size. China is neither a command economy nor a free market one: nothing in China yet comes close to being truly free-market given state ownership in the vast majority of big companies and all the biggest banks. While the stock market has gone through another of its dizzying ups and downs, financial markets remain heavily controlled and engineered by the relevant regulators. While the rest of the world scoffed and laughed at the state interventions to limit the stock market meltdown last year, that response was par for the course in China — and so far it seems the interventions have worked. Part of China’s ultimate reforms are gradually removing the state from such a heavy role in so many parts of the economy, but the pace of that process depends on both internal and external conditions because stability matters above all else for the CPC.

One thing jumps out: in this system, what is private sector vs public sector debt almost doesn’t matter. The state’s hand is everywhere. That doesn’t make it less of a problem, just the nature of the problem is different. Especially when pretty much all of the debt is in local currency.

At a mere 2% of total loans (if up from 1.5%), it’s pretty clear to anyone with a normal pulse that China’s bank NPLs are under-reported. But this is an economy where credit analysis is still in its early days because the banks play as much a fiscal role as pure lending one. Even while China has tried to change that with the policy banks (China Development Bank, under the direct control of the State Council no less) doing more of the overt social lending so the big banks could be big boys, the big state-owned banks still play a key role in the credit channel. Otherwise we wouldn’t be talking about them.

Here’s a quote for you:

“ The SOEs obtained the majority of their funding from the banks, in particular the four large SOCBs. These bank lenders often continued to extend loans to the same debtor with little regard to the latter’s ability to repay its loans, under the perception that the ultimate loss will be borne by the government.”

We might think this is a new problem. But this is from a 2005 NYU student paper talking about the late 1990s/early 2000s NPL clean-up of the time.

And yet the SOE/bank nexus is still ultimately what we’re talking about, if on a much larger scale.

My hunch (and it is nothing more than that) is that China’s unique structure will mean that a clean-up will happen in the least disruptive way possible. That means a drawn-out process of dealing with bad debt and consolidating smaller/mid-tier banks while avoiding any kind of run that would freeze up the interbank and bank funding markets.

Yet such a view is by no means guaranteed given the financial system’s many innovative ways of hiding bad loans and credit risk moving into the shadow banking system. But those problems are slowly being dealt with, and it seems unlikely that China’s regulators — being fairly omnipresent — aren’t aware of the risks in the system. The world hasn’t really stopped talking about this issue for a few years already.

So some bigger picture points to make about the NPLs and unique ways of hiding/masking problems, as well as the potential for interbank problems. Some of the below we borrow from CreditSights. Do follow its Asia bank analyst Matthew Phan at @mattphan1891. Also read the insights of former China bank auditor and UBS analyst Jason Bedford.

1. NPLs at big banks (top 4 state-owned banks): Big banks play the game as much as any of them (unloading/repoing loans at reporting time only to bring them back on balance sheet) and indeed invented some of the games being played today within the broader system. But the bigger banks are likely not at the heart of the more problematic lending that has happened and is still happening. NPLs will certainly rise to something more like 3–4%, more recognition will happen in sectors where excess capacity is being addressed — coal, steel. From a macro point of view, seeing greater NPLs charged to these sectors as capacity is cut and unemployment support provided to laid off workers would be a big positive. There will be more disposals to asset management companies (AMCs) that were created for that very purpose in the early 2000s and will likely play a key role in whatever happens next. As CreditSights noted in its excellent February report based on discussions with local institutions, banks are expecting the CBRC to relax the 150% loan loss coverage requirement. Extend and pretend will never die, though. And let’s keep in mind that China has a very loose definition of what an NPL is in the first place, as per PwC.

2. Risks at mid-tier banks: This gets to the heart of where the problems really lie. The more compelling case for trouble is away from the big banks and at these lenders with names like Evergrowing Bank (insert Evergrowing/evergreening joke here). These institutions appear to want to stylize themselves as pseudo-asset managers via the massive growth in their lending via wealth management product structures (WMP, my old friend, it’s been too long): medium- to long-term loans repackaged into high-yielding money market funds refinanced at very short periods. We will get into WMPs/shadow banking more in a moment. As Reuters noted (thanks to Jason) back in January, these mid-tier banks are the ones aggressively expanding their WMP/shadow books that are only starting to see some light of day thanks to rules at least bringing them on balance sheet as “receivables”. At $1.8 trillion of loans, or nearly 20% of all commercial loans in H1 2015, the size is huge. As our colleagues at Breakingviews note, the pending Hong Kong IPO of mid-tier Zheshang Bank in Hangzhou is a pretty good example: look at the prospectus showing that its receivables have grown in less than three years to $62 bln from just over $3 bln (current USD/CNY rates).

Zheshang defines loans and receivables rather broadly: “balances with central bank, due from banks and other financial institutions, loans and advances to customers, and debt instruments classified as receivables”. Thanks for clarifying.

Financial assets classified as loans and receivables primarily include balances with central bank, due from banks and other financial institutions, loans and advances to customers, and debt instruments classified as receivables

Again, some of this is due to regulators forcing these assets on balance sheet, with receivables being the common line-item to be chucked into. And a look at the liability side of the equation shows this asset growth funded mostly by $37 bln of customer deposits (hello WMPs) and, of course, another $15 bln of debt. “Other liabilities” make up the rest (page 462).

What does this reflect? Oddly, it’s a testament to how China’s banking system has been far too rigid for far too long. So essentially mid-tier banks have picked up on some of the old bad beahviors of the big banks but have found a great business decision for doing so: deliver higher returns via WMPs that the overly rigid deposit rate system never allowed. In a sense, these banks have exploited both the debt/bad asset explosion to deliver returns to households that were never previously available. I know some folks don’t like to think so, but China’s huge economy masks the fact that it’s financial system is extraordinarily rigid and, actually, risk agnostic. The problems that result are pretty manifest: a lack of proper credit pricing, a lack of concern about credit risks because the government is always there *somewhere*. But also a lack of choices that don’t give a massively growing middle class many options beyond a low-yielding government bond market, the notoriously boom/bust stock market (even before this latest episode), property and WMPs.

3. Shadow banking and WMPs: Related to the above, I think former Standard Chartered China economist Stephen Green gave the best one-liner about WMPs ever when he noted back in early 2014 that:

“WMPs are where China’s new middle class is meeting interest rate liberalisation, and so far households like what they see.”

Judging from the figures above, it’s hard to argue with that. Even though the asset-liability mismatch is enormous and the potential risks to the financial system are clear. The simple fact is that the household sector wanted returns that could not be delivered through the deposit system, and thus a nifty compromise was found. As much as anything, it’s a testament to China’s sheer lack of financial development. PBOC Governor Zhou gave a recent speech touting equities as a necessary step for households and companies to find a less debt-driven mix of funding for the financial economy and was ridiculed for wanting to sponsor a new stock market bubble. But that criticism misses a key point: China desperately NEEDS an institutional investor base that can mediate savings between different assets in a way that has not happened yet. Remember, the Shanghai Composite remains a joke precisely because there isn’t yet any proper pension/institutional investment arm to balance out its very young markets (the Shanghai Composite itself being a mere 26-year-old). The development of a proper institutional investor base, which will be much more equity driven and also much better at making credit quality decisions, is necessary. Finally ending the fixed bank deposit regime, which quietly happened last October, is a big and long overdue step (read PBOC Deputy Governor Yi on the implications). Still, China has a long way to go. I’d be long asset managers in its economy.

But go back to that blog quoting Stephen Green. These are not new issues. More than two years ago the PBOC was cracking down on the voaltility being created each quarter-end by WMP-related flows.

So familiarize yourself with TBRs (trust beneficiary rights) and DAMPs (directional asset management plans), together known as tongdao 通道 financing. As per Credisights:

Since 2013, the regulators have forced banks to limit the scale and growth of this ’tongdao’ exposures and to bring them back onto balance sheet. We understand that the banks transfer these shadow assets onto balance sheet over time, by refinancing the underlying asset on balance sheet typically in the receivables book as the financing arrangements with the trusts/DAMPs mature. As this process has gone on for a few years now, the balance of TBRs/DAMPs reported under receivables has grown enormously, but we understand there is still some that is off balance sheet. The banks are mostly unwilling to disclose this number but say it is included as part of outstanding nonprincipal guaranteed wealth management products (WMPs)

With the Zheshang example above and this, at least you know where to look. As do the regulators. What happens next, let’s see.

As the PwC reported cited above said, this is still going to be a process. Precisely because this is a financial system still in development and where political considerations (often left unsaid) play a big part.

We see it as inevitable that NPLs in China’s banking sector will continue to rise to levels unprecedented since banking reform measures were undertaken 15 years ago. How high they will go is anyone’s guess as Beijing has the ability to control the speed of loan defaults as a significant portion of the lending in the system is done by state-owned banks and companies. We therefore see the rise of a financial crisis in the banking sector as being extremely low. However, the unfortunate side-effect of government intervention in the NPL situation is that the financial system is currently not resolving the underlying NPLs — many are not being worked out on a commercial basis. This means that a change will be required to create a sustainable long-term solution.

I’m not sure I could say it any better. This is as much about the financial development of a large and still fast-growing economy as about really dealing with bad loans. If the capital outflow problem has been overstated, mainly because banks/companies are paying down FX loans/debt, then China is free of one of its very few vulnerabilities. And this is where I really disagree with Michael Pettis. China’s ability to monetize this debt will only severely hurt households if it results in a hyperinflation that seems unlikely. The PBOC has plenty of means to monetize the paydowns of some of this debt to relieve the burden on AMCs, banks, policy banks and others in a way that isn’t going to be inflationary. The bigger problem is not the forced low-return environment on household savings as the lack of financial development that has sparked a chase by the burgeoning middle class for returns in slightly dodgy financial products. Finally doing away with the deposit-rate cap is a start but only a start. Ultimately, China needs a major reformation of its banking system as part of a broader financial maturation for an economy of its size.

Going back to Creditsights:

While the big banks (45% of system assets) are indeed carrying surplus deposits relative to loans and receivables, we think the mid and small sized banks are not. The receivables book thus poses credit risk for smaller banks. One question we asked banks is what happens if a small bank defaults. Our assumption has been that if needed, one of the big four banks would step in to acquire it. But the big banks adamantly deny this, saying that any M&A decision is made on a commercial basis and that their branch networks are broad enough that they have no need to acquire a small local lender. Rather, the big banks think that some regional banks, or nonbank FIs, might be interested to expand their networks and could step in. The big banks also argue that the introduction of deposit insurance was precisely to allow for the failure of weaker bank.

This is where it starts to get very interesting, if not in the hyper-crisis manner portrayed by so many these days.

Table: Creditsights on China bank NPLs