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China’s Worst Banks: The ‘Lehman’ Factor

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Pacific Money

China’s Worst Banks: The ‘Lehman’ Factor

Insights from Brandon Emmerich.

China’s Worst Banks: The ‘Lehman’ Factor
Credit: Pixabay

Mercy Kuo regularly engages subject-matter experts, policy practitioners, and strategic thinkers across the globe for their diverse insights into U.S. Asia policy. This conversation with Brandon Emmerich founder of Granite Peak Advisory, a New York-based research company – discusses the risks in China’s banking sector.

Explain the relationship between China’s regional banks and loss-making companies.

China’s regional banks are heavily incentivized to keep loss-making companies alive. To avoid recognizing loan losses, the banks instead roll over loans to zombie firms, which, in the short term, allows the banks to maintain an illusion of profitability.

Local governments also are loathe to see loss-making companies go out of business. These firms, especially the large ones, can be the employers-of-last-resort in regions without any other source of economic dynamism. Additionally, these firms contribute a significant proportion of revenue to their local government through the VAT levied on their operations. Local banks, owned directly and indirectly by the local government, do their part to keep the doors open for these firms.

Assess funding sources of China’s worst regional banks and their risk exposure.

In China, many banks with the worst indicators for asset quality also rely heavily on unstable sources of funding such as interbank borrowing. For example, the Bank of Shengjing  ̶  recently profiled in the FT as the poster-child for weak regional banks  ̶  secures only 48 percent of total liabilities from deposits, a comparatively stable source of funding, while the rest must be borrowed. For comparison, that number is 77 percent for Wells Fargo and 80 percent for ICBC.

This is problematic because capital borrowed on the interbank market is of short duration and can disappear during a liquidity event — not unlike what we saw with Lehman in 2008. For the moment, China’s weakest banks are highly dependent on the trust of the creditors they borrow from. This means that China’s financial system is very interconnected and the risk of contagion is very high should one institution fail.

If China’s economic growth slows, what’s the impact on local banks?

All banks thrive in periods of robust economic growth and China’s regional banks are no different. In a booming economy, banks enjoy a diverse selection of viable projects to finance, which allows them to safely grow assets, and thus profits. Additionally, they take few losses on existing loans as borrowers, experiencing income growth, are able to make interest and principal payments on time and in full.

As economic growth slows, banks struggle to grow assets and also take a hit as borrowers default on their loans. This is true of all banks, not just Chinese banks.

Unfortunately, Chinese local banks are particularly sensitive to an economic slowdown because of their poor asset quality. Only 35 percent of total local bank assets are traditional loans  ̶  much of the remainder are an alphabet soup of risky financial engineering  ̶  Wealth Management Products (WMPs), Directional Asset Management Plans (DAMPs), and Trust Beneficiary Rights (TBRs)  ̶  designed to circumvent regulations against lending to speculative real estate development projects. Also, they’ve grown their assets very quickly over the last three years – 37 percent CAGR [compound annual growth rate] compared to 15 percent for the big banks –  which is often the first sign, like in the U.S. subprime crisis, of decreased lending standards which precede defaults.

Should economic growth slow, China’s regional banks will certainly take losses on the sketchy assets filling their balance sheet.

How is the Chinese government reforming and addressing risky lending practices?

Chinese policymakers have recently imposed more restrictive macroprudential measures and started a process of forced recapitalization for some of the weakest banks. The government is also making a vigorous show of reining in the most egregious shadow banking practices. Although local and foreign media have reported fawningly on these surface-level changes, they’re missing the forest for the trees.

For years in China credit has grown faster than income, the result of which is an unprecedented binge of money creation. Even though the U.S. economy measures 60 percent larger than China’s, total bank deposits  ̶  money  ̶  in China are more than double that of the United States. This means the ratio of economic output to money supply in China is more than triple that of the United States. The toothpaste is already out of the tube. Policymakers are mostly helpless to do anything but watch as this giant ball of liquidity rollicks through Chinese assets hitting home prices, equities, apple futures contracts, and artwork, just to name a few of the most salient examples.

Truly addressing risk in the financial system would mean a radical deleveraging of the Chinese economy the result of which would be lower incomes and a massive hit to asset prices, especially homes. Frankly, I don’t believe Chinese policymakers are willing to take that pain. At least for the foreseeable future, reform will remain limited to the margins and the fundamental problems created by years of runway lending will remain.

Is there potential for a “Lehman” factor among China’s worst banks that might trigger a global financial crisis? If so, what key indicators should U.S. banking and policy decisionmakers watch?

While there is the potential for a “Lehman” factor among China’s worst banks, the transmission mechanism to global markets will be much different than from what we saw in 2008.

Lehman failed when it could no longer borrow in the interbank market. China’s worst banks, bloated with toxic assets and highly dependent on interbank borrowing for survival, could therefore suffer a liquidity shock very similar to Lehman in 2008. A vicious cycle of asset sales to meet creditor demands could then push one or more of these weak banks into bankruptcy.

However, weak Chinese banks today differ from Lehman in 2008 in terms of their interconnectedness to global financial markets. Because Chinese banks are comparatively insulated from the global financial system, I don’t believe that a liquidity event would directly impact global banks. That being said, China is one of the global economy’s most important trading partners, so a domestic deleveraging would have severe negative consequences for the marginal Chinese demand that the global economy has come to depend on.

U.S. policymakers should keep an eye on the health of China’s weakest regional banks  ̶  they are the canary in the coal mine. Should China face a deleveraging of the banking system, this set of small regional banks will probably be the first to face problems.