Chinese Banks Enjoy Few Bad Loans But Central Bank Warns Of Risks

Chinese commercial banks continue to enjoy relatively low non-performing loan ratios. The banking regulator just released figures from the third quarter, showing that bad loans remained unchanged at 1.74%, At the same time, Zhou Xiaochuan, governor of the People’s Bank of China, has been issuing increasingly stark warnings over China’s financial stability that are difficult to ignore.

How can banks flourish while cracks in the system are forming?

Zhou’s warnings

While Zhou has often spoken in favor of financial reform, his language regarding the state of the Chinese financial system has grown more dramatic in recent weeks as he warns of potential crisis. It’s time to pay attention to what he is telling us.

In mid-October, Zhou stated that corporate debt was too high at a Group of 30 seminar in Washington. A few days later at the 19th Party Congress in Beijing, he warned that China must defend against a “Minsky Moment.” (A Minsky Moment occurs when there is a major collapse in asset prices, leading to a financial crisis.)

A few days ago, Zhou also posted an article on the central bank website, stating:

Overall, the financial situation in our country is good. However, at present and for a period in the future, China’s financial sector is still in a period of vulnerability to high risk. Under the pressure of multiple factors at home and abroad, the risks are wide and varied….It is necessary to prevent the occurrence of ‘Black Swan’ incidents as well as to prevent the risk of ‘gray rhino’ incidents.

Clearly, 69-year old Zhou is not attempting to mince words in the days before his retirement. He’s warning of a potential financial crisis or collapse, something serious that the government will not be able to easily mop up. This is difficult to parse for many China watchers, either those who have been warning of crisis for the past 10 years and wondering why it hasn’t happened yet, or those who view China’s financial system as simply unassailable. This time, the warning is coming from the central bank governor, which means the threat of instability is real, and present.

Low NPLs but instability within?

Zhou is right: There is instability within China’s financial system. Even though banks currently show low ratios of non-performing loans on their balance sheets, a year ago they had stepped up the pace of writing off or selling bad loans. Bad loans can be sold off to central and local asset management companies, or “bad banks.” In addition, some corporations with high levels of debt have been encouraged to participate in debt for equity swaps, in which banks transfer the loans to special purpose vehicles for conversion to equity. Local governments have been issuing municipal bonds. Both of these actions can disguise bad debt by keeping it off banks’ loan books. Some banks have also permitted corporations to restructure their loans.

However, even though the China Banking Regulatory Commission under Guo Shuqing has issued a flurry of regulations since April, corporate debt in particular remains high. S&P warned in September that China’s corporate leverage would remain persistent due to continued credit growth. Indeed, China’s credit to the non-financial sector as a percentage of GDP grew both quarter over quarter and year over year in the first quarter of 2017, according to data from the Bank for International Settlements. Excessive credit to firms must be curbed in order to maintain lower non-performing loan ratios.

Other potential losses lurk beyond the visible banking sector. Zhou warned specifically about the asset management industry, calling it a “relatively chaotic situation.” Lack of uniformity of regulation and oversight has made it difficult to control risks. The asset management industry consists of banks (especially in off balance sheet products), fund houses, insurers and trust firms. Asset management products have often been used to disguise lending to risky sectors, and even though rules proposed in February stated that consumers would be responsible for losses, it is not clear that consumers now believe this.

Local governments are also operating outside of direct bank loans. Zhou noted that fiscal reforms to rein in local government borrowing were necessary. This is because increased reliance on convoluted public-private partnerships and municipal bonds among local governments for funding and ongoing indebtedness of local government financing vehicles present serious concerns over potential bad debt, especially as many local government projects continue to focus on low-return infrastructure.

Pay attention to Zhou

Zhou’s warnings deserve our attention when considering China’s debt situation. While commercial banks appear more or less healthy, it has taken quite a lot of maneuvering to create this appearance. Furthermore, many of the risks now can be found either off banks’ balance sheets or in other financial products which are less straightforward to assess.

Zhou will soon step down from his position, but he is clearly trying to alert the world that China’s financial sector contains fault lines that may be triggered. While there is no crisis at present, there is a possibility that one might appear.
Source: Forbes

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