Is China on the verge of a banking crisis?

Many indicators indicate that China is very close to a financial crisis. However, the Chinese government has been able to keep things under control. A debt restructuring plan that is backed by the state shows Chinese government officials may have learned certain lessons from the disastrous loan crisis that state-owned banks experienced throughout the late 1990s. The tight control of banks and their top executives has, for a long time, provided China an ideal platform to manage their financial establishments.

However, limiting the impact that financial contagion has on the economy is different from supply-side policies central planners have relied on. In addition, unlike the 1990s, when the issue was mostly about inadequate practice in lending, the underlying causes of the current problems are more complex and affect both the liability and asset side of the balance sheets of banks.

In many ways, this is a case of an example of history repeating itself. In 1998, the Chinese government invested RMB around 270 billion (3.18 percent from GDP) into the four biggest state-owned banks in order to bail them out. Twenty years ago, it was not difficult to determine the sources of the recurrence of a bank crisis.

In the last month, three of China’s biggest state-owned banks announced increases in their non-performing loans (NPL) percentages as of the year 2016, which is the percentage of loans with defaults in comparison to the total. In the Bank of China, their ratio for NPL increased three percentage points to 1.46 percent. ICBC bank increased 12 basis points up to 1.62 percent, and the Agricultural Bank’s NPL ratio continued to be the highest among the banks of China’s biggest ones at 2.37 percent.

Official information reveals that bad loans comprise approximately 6% of all loans, with a rate of 1.74 percent, as well as “special mention” loans (which are past due but not yet classified as non-performing) of 3.92 percent. There is a reason to believe that this is an underestimation. Provincial statistics show that for a lot of less wealthy provinces, the NPL ratio is significantly greater. Central area Shanxi was reported to have the official ratio for NPL of 2.34 percent at the close of 2015. and the IMF estimates the riskiness of corporate loans account for about 15% of total loans in China. This amounts to about 7% of GDP more than the cost of the bailout in 1998.

In addition, even though the expansion of credit to the non-financial industry has slowed substantially since the beginning of 2016, the rate of growth in social financing as a whole, which is a broad measure of liquidity and credit, is growing at a rapid pace. This means that money is making its way to the banking system,  which is keeping those so-called “zombie” firms afloat. The result is that credit is diverted away from the productive sector and hampers the country’s efforts to move into a “talent-driven economy.”

History is repeated

The re-emergence of the bad loan issue suggests that China’s banks do not have the autonomy and transparency of the risks across their loan portfolios that are essential for the management and pricing of risk. In the early 1990s, the transfer of bad loan portfolios to large state-owned enterprises caused a skew in the risk distribution on the balance sheets of banks. Today, the placing of the risk off-balance sheet, which is less obvious and less visible, exacerbates this issue.

One reason lies in the financing part. Smaller banks, which increased their assets by more than 17 percent in 2016, do not have access to the larger deposit-raising branch networks as well as international listings on the stock market. This means that they are more dependent on less volatile short-term interbank funds and products off-balance sheet.

However, foreign investment’s contribution to capital formation has waned. In the 1990s, it was often responsible for around 10% of total capital creation. Since the time, it has dropped to less than 3 percent. Local sources must plug this gap and have led banks to use riskier financing models.

State control

It is believed it may appear that the Chinese government has already preempted the end to the country’s corporate debt. Particularly striking is the method by the way Chinese companies have paid down foreign currency loans, which currently represent a small portion of social financing total. This is accompanied by the revived scheme that allows struggling businesses with debt to swap it in exchange for equity. For instance, in the industry of steel. Instance SinoSteel, a SinoSteel which is owned by the state, SinoSteel was allowed the swap of RMB 27 billion in debt to equity convertible bonds in September of 2016.

That means that state banks are able to be liable for the risks of these businesses on their balance books. Incredibly, banks are unable to exercise the autonomy of their operations to rescind these state policies and corporate governance systems to oversee the repayment process.

In the meantime, Chinese stock markets continue to be plagued by an excess of state enterprises with poor corporate governance. Thus, equity markets seem not well-positioned to handle massive amounts of debt.

These indicators all suggest that although the threat of a bank crisis is very high, An opaque financial system also limits the risk of spreading spread. This is different from both the US and the UK during the lead-up to the financial meltdown of 2008-09. It also creates the issue of economic reforms in terms of how to lay the foundations for an increasingly multi-faceted financial system without jeopardizing stability.

As of now, capital control and the repayment of foreign currency loans suggest that there aren’t many avenues through which the selling of debt could lead to an economic collapse of the value of assets. Despite the concerns of 2016 about capital outflows, China’s foreign currency reserves have stabilized.

However, there is a longer-term cost. China is more susceptible to capital outflows. Incorrections and errors on the national accounts continue to be significant and suggest that there is a persistent lack of recording capital outflows. This capital loss should be a resounding warning to all those that China is able to play a lead role in globalization or offer the necessary investment or currency services to power the post-Brexit world economy.

The Chinese government’s emphasis on managing debt will result in more stricter regulations on speculation-based international investments. This will also be the opportunity to examine China’s centrally designed financial system in the near future.

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