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The “Hidden” Costs of China’s Bad Loans

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The “Hidden” Costs of China’s Bad Loans

Non-performing loans may not bring down China’s banks, but they will hinder its economic transition.

Non-performing loans (NPLs) are the blood pressure of an economy – high blood pressure doesn’t make a heart attack inevitable, but it certainly signals problems. Similarly, even though China’s level of NPLs doesn’t spell doom in and of itself, it can signal potential problems – such as the popping of a credit bubble.

At this point, China’s figures on bad loans aren’t particularly good, but they’re not at emergency levels either. In 2012, for instance, China’s NPLs rose by 64.7 billion yuan (US$10.4 billion) to reach a total of 492.9 billion yuan ($80 billion), though the ratio of bad loans to good ones stayed steady at 0.95 percent. More recently, at the end of last March, NPLs totaled 524.3 billion yuan ($84.8 billion), which was up more than 20 percent year-on-year, and 33.9 billion yuan from the start of 2012, China Daily reported, citing China Business News.

Bad loans are coming from a range of industries, but particularly the shipping, chemical, wind power, construction, and photovoltaic industries that are centered in China’s manufacturing powerhouse – the Yangtze River Delta.

What is causing NPLs now? On a very basic level, a period of expanded credit (S&P says loans grew 60 percent in 2009-2010) has turned into soured loans as growth has slowed.  Much of the credit issued was distributed inefficiently in already overinvested sectors, and the expected returns have not materialized.   

The ratios don’t look bad—certainly nothing compared to the 40 percent NPL ratio in the 1990s—and Chinese bank officials believe that the loan situation to be under control. Still the large size of the NPLs should elicit attention, and there are a few additional factors that should heighten our concern.

First, analysts question the accuracy of NPL figures, since they can come “from falsified statistics from local banks, for whom non-performing loans can result in official sanctions,” according to News China Magazine. Reporting discrepancies are a common problem in China, in everything from agricultural production to growth figures, especially when there are counterincentives to accurate reporting. 

Although the ratio is low now, it looks as if we are at the bottom of a rather steep hill. Interestingly enough, the ratio of NPLs, a commonly-used indicator, may stay low (or even decrease) because of the sheer volume of new loans issued. This is not a sign of fewer bad loans, but perhaps a sign of more bad loans to come in the future. 

For example, Forbes reported that in January, “China’s banks extended 1.07 trillion yuan in loans marking the highest monthly total in the last three years.”  Banking analyst Jim Antos told the Financial Times that the “absolute volume” of NPLs increased 15 percent last year, matching the 15 percent increase in banks’ overall loans. Furthermore, loans that should have turned bad a long time ago have been allowed to limp along with government-approved rollovers. The Financial Times noted that the rolled-over local government loans have either been restructured or refinanced through the issuance of bonds.  

Common sense says slowing growth (believed by most analysts to be inevitable for China) will hinder the ability of borrowers to repay loans.  A large percentage of loans have been issued through local government financing vehicles (a type of shadow banking) to local developers. The loans use land and property prices as collateral, which means that falling real estate prices could have a very detrimental effect on the ability of the borrowers to repay these loans. As Standard and Poor’s credit analyst Kim Eng Tan warns in the China Daily,  “We believe a number of these local government financing platforms will still default,” though he notes that “the systemically important commercial banks are unlikely to be destabilized by these NPLs.”

An interesting new development is the recent launch of the first local government-backed asset management company (AMC) in Jiangsu province.  The AMC is supervised by a triumvirate of local government financial supervisors, and comes in response to a new Ministry of Finance and China Banking Regulatory Commission allowing local AMCs. The AMC in Jiangsu was established largely to clean up bad loans in the photovoltaic and steel sectors, including Suntech Power, in which it is heavily involved. Suntech owes banks 7.9 billion yuan (appx. US$1.3 billion), but is a government priority thanks to its 10,000 employees and 400 suppliers. Analysts expect that Zhejiang, Shanghai, and Guangdong could be next in establishing AMCs. These local AMCs, however, will not have the kind of financial backing that central government AMCs enjoy, and one questions how useful they will be. 

In short, the question is not if the entire banking system is at risk. At this point, that does not seem to be the case. Rather, it’s what the cost of cleaning up this mess will be, and the structural inefficiencies and issues that allow this problem to continue to worsen.

In a 2011 article, Michael Pettis discussed how NPLs are resolved at the expense of household income, because banks are allowed higher profits through a wide difference in lending and deposit interest rates (which are both artificially low). This hurts depositing households and essentially grants loan forgiveness to borrowers due to the lower-than-natural interest rate. Despite some regulators expecting that another NPL crisis could be cleaned up quickly and without too much pain, Pettis notes the cost is not only limited to the level of cash needed to bail out banks. Instead, “the combination of implicit debt forgiveness and the wide spread between the lending and deposit rate has been a very large transfer of wealth from household depositors to banks and borrowers. This transfer is, effectively, a large hidden tax on household income, and it is this transfer that cleaned up the last banking mess.”  With the central government trying desperately to increase household income to bolster the economy and reduce China’s reliance on exports, this is a powerful point about the true costs and dangers of NPLs.

One of the key sources of NPLs are state-owned enterprises (SOEs): the government directs the banks to lend to SOEs no matter how inefficient or non-profitable they are. NPLs will continue in this sector until the larger issue of these anachronisms is resolved. 

One very large and general problem, which I will just briefly touch on, is the perverse incentives at the local level.  Since revenue sharing reforms in 1994, local governments have been strapped for cash, and have thus promoted breakneck growth, spurred on by loans. Anxious to attract developers and business, they have set up financing options that are now a significant source of NPLs.  This is a major political and economic issue in China.

At this time, the level of NPLs is being monitored carefully, though there are many directions from which more bad loans could come in the near future. China’s debt issue, and its ability to service this debt as growth naturally slows, will be a key area to watch in the next year.