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Chi Time: China’s Debt Vulnerability (II) – A Banking Crisis?

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In the middle of difficulty lies opportunity

Albert Einstein

While China’s external funding risk is low, its domestic credit risk due to slowing economic growth is quite high, as I argued recently[1].  Indeed, over the years many market players have bet on a banking crisis in China and expected losses to wipe out as much as a third of the banking system’s total equity[2].  These worries have dire implications on China’s systemic risk.

A ticking time bomb…

To understand this potential “Armageddon” scenario, one needs to know the biggest risk exposure of the Chinese banks.  It is not in the loans to the state-owned enterprises (SoEs) or the households.  The former still enjoy implicit guarantee from the government, though Beijing is retreating from this policy selectively, and the latter still have a strong balance sheet, despite the recent increase in the household debt from a very low base.

The highest credit risk lies in the loans to the non-state companies and non-bank financial institutions (NBFIs).  The latter include investment companies, brokerages, mutual funds, asset managers, trust companies, auto-financing and financial leasing companies and private loan companies.  They do not enjoy the same degree of implicit guarantee as the SoEs and the large banks do, and are not properly regulated.

Data shows that loans to all enterprises and NBFIs totalled RMB107 trillion in 2018 (Table 1), accounting for 75% of total loans.  Let us assume two loss scenarios, one with a 10% loss and the other with a 15% loss on these loans. Given the structural down-shift in China’s growth environment, a 10%-15% non-performing-loan scenario looks plausible.  There could also be bad debt arising from other loan categories.

There were RMB3.8 trillion loan-loss provisions in the banking system in 2018.  Experience also shows that Chinese banks had an average bad-debt recovery rate of 20%.  Assuming all the provisions would be used to cover the losses and the same bad-debt recovery rate going forward, the potential net loss to the banking system would amount to RMB4.8 trillion and RMB9.1 trillion under scenarios 1 and 2, respectively (Table 1).  Meanwhile, Chinese banks had an aggregate equity capital of RMB21.7 trillion.  This stylised example shows that if the bad-loan ratio were to rise to 10% or 15%, the estimated losses could wipe out between 22% and 42% of aggregate bank equity (Table 1).

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… That won’t detonate

So the worry about a Chinese banking and currency crisis should be real.  But this view hinges upon the creditors’ behaviour.  In an open and mature market, which is how most western analysts see China, the creditors would lose faith in the banks and cut funding, crushing the economy and the exchange rate due to capital flight.

However, the creditors in China are mainly the households, as banks source over 80% of their funding from retail deposits.  Since the banking system is ultimately backed up by the government’s implicit guarantee policy, the Chinese people believe this public “put” option will continue to support the banks. Hence, there has not been any loss of public confidence so that the probability of bank runs and financial contagion is negligible.  Meanwhile, China’s closed capital account locks up domestic liquidity, providing a backstop for keeping the banking system whole.

Even though the central government is calling for a clean-up of “zombie” companies, it is also asking banks to ensure the process would not cause any financial instability, i.e. not to cut off funding abruptly.  Granted, this policy is not going to solve China’s debt and capital misallocation problems.  But it means that China could avoid a financial implosion for much longer than most people think.

Furthermore, the Chinese banks and the government are not sitting on their hands to wait for a crisis.  They have improved risk and policy management, as reflected by the increase in loan loss provisions by 93% and bank equity by 76% between 2014 and 2018.

So long as there is no loss of public confidence and the creditors in China do not cut off funding to the banks and NBFIs which, in turn, do not cut off funding to the companies, there would be no financial crisis or collapse in the renminbi exchange rate.  Despite all the worries, there have been no signs of capital flight; otherwise there should have been significant and persistent depletion in domestic deposits (Chart 1).

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The risk lies somewhere else

All this is not to deny the financial risk in China.  There is indeed a rising risk of localised financial failures, thanks to the rapid expansion of small and regional banks[3] (Chart 2) many of which have engaged in regulatory arbitrage through opaque and complex financial activities funded by wholesale funding.  Note that interbank borrowing by small and regional banks had risen from 12% of their total funding sources in 2015 to a peak of 18% in 2017 before moderating to 13% recently due to Beijing’s deleveraging policy.  Meanwhile, interbank funding only accounts for about 2% of the large commercial banks’ total funding sources (Chart 3).

 

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Normally, an increase in reliance on wholesale funding raises systemic risk because when the interbank market seizes up, as it typically does during times of financial stress, the interbank participating banks would be vulnerable to funding squeeze which would, in turn, create a domino effect on the system.  In the developed markets, this could lead to a systemic collapse.

But China is different.  The People’s Bank of China (PBoC) would most likely step in either to keep funds flowing or force the major banks to take over the small troubled ones, as it did in 1998 when it asked the Industrial and Commercial Bank of China to bailout the Hainan Development Bank, and again between May and August 2019 to bailout three regional banks: Baoshang Bank, Jinzhou Bank and HengFeng Bank[4].

Not yet a dire problem

Many observers argued that China’s regulatory arbitrage activity funded by the wholesale market looked similar to the situation in the US before the subprime crisis in September 2007, and projected a financial meltdown in China sooner or later.  However, the comparison with the US situation is not appropriate at this stage.  This is because the majority of the Chinese banks do not rely on wholesale funding, which is a major determinant of bank vulnerability during the US subprime crisis.  In China, wholesale funding accounts for only 14.5% of total funding, according to the PBoC, compared to 75% at the peak in the US system.

Furthermore, virtually all banks in China are owned (directly or indirectly) by the government.  There are only five private (small) banks, and foreign banks account for less than 1% the banking market share in China.  All the major NBFIs are also majority-owned by the government.  The point is that the state is behind the Chinese financial system.  The US crisis was triggered by private creditor decision to cut off funding for over-extended firms such as Bear Sterns and Lehman Brothers.

Granted, the state ownership and implicit guarantee policy in China have distorted rational creditor behaviour.  But ironically, they help preserve the system.  In the event of defaults by small institutions, the government can also order the big state-owned banks to keep credit flowing.  There is certainly risk in the Chinese financial system, but it is not yet imminent and systemic.

No free lunch

However, the cost of sustaining the banking system under the prevailing policy framework is insufficient market forces to force exit of the zombie firms.  This means that China’s SOE and corporate sector reforms would only proceed in slow motion, delivering mediocre economic efficiency in the medium-term.

At this stage, an “Armageddon” scenario for the Chinese banking system is not likely.  The game changer will be the opening of the capital account and scrapping of the implicit guarantee policy quickly, as many experts have demanded.  But such moves are impractical as they would crush the Chinese system before any benefits of full convertibility, debt reduction and structural reform can be seen.  So one can only expect a gradual pace of financial and capital account liberalisation according to Beijing’s discretion.

  • 1. See “Chi Time: China’s Debt Vulnerability (I) – Déjà vu”, 19 November 2019.
  • 2. See “Bass: China banks may lose 5 times US banks’ subprime losses in credit crisis”, CNBC, February 10, 2016    http://www.cnbc.com/2016/02/10/kyle-bass-china-banks-may-lose-5-times-us-banks-subprime-losses-in-credit-crisis.html“Economic Collapse of China, Bank of Jinzhou Next to Fall”, Guerrilla Stock Trading. July 28, 2019   https://www.guerillastocktrading.com/business/economic-collapse-of-china-bank-of-jinzhou-next-to-fall/“Chinese Bank On Verge Of Collapse After Sudden Bank Run”, by Tyler Durden, ZeroHedge, November 11, 2019    https://www.zerohedge.com/markets/chinese-bank-verge-collapse-after-sudden-bank-run
  • 3. These banks include joint-stock banks, city commercial banks and rural commercial banks.  Joint-stock banks have mixed public-private ownership with the majority stake still held by the (central or local) government.  The city and rural commercial banks also have mixed ownership but with only a minority stake held by the local government (the central government is not involved).
  • 4. See “Chi on China: China’s Bank Failures – A Turning Point for the System”, 28 August 2019.

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