Bulging bad debts give China a new banking dilemma

There are two pieces of received wisdom that open and close almost any conversation about Chinas banks. Firstly, they face a looming bad debt problem that will make the 2008 US banking bust seem like a bugle before a foghorn. Secondly, this doesnt matter because the Chinese do things differently any bad debts can be simply magicked away. China has form on this front. In the late 1990s a piece of apparently costless circular financing took a big chunk of bad debts from the four largest banks and parked them at their original value in four specially created bad banks, or asset management companies. These were funded in full mostly by the banks themselves via the Ministry of Finance. Those asset management companies led by Cinda and Huarong are now being rehabilitated to seek equity investments from foreign banks and public market share listings. This apparently is to create professional, privatised vehicles to play a marketoriented role in dealing with the next round of bad debts. But if bad debts can be magicked away, what need is there for market actors? The question we need to ask is whether China can afford another round of non-performing loans. Literally, does it have the money to make the problem go away? In the late 1990s, when Cinda and its peers were created, bad loans accounted for about a fifth of all the loans the four biggest banks had on their books. The four bad banks took over three-quarters of these or Rmb1.4tn worth. Chinas gross domestic product was Rmb8.9tn ($1.45tn) in 1999 and government debt was 11.4 per cent of that, or Rmb1tn. So the bad debts were chunky. Borrowing to fund a bail out would have more than doubled government debt but still the national balance sheet would have looked healthy enough. China today is a different country. Credit has grown spectacularly. Since 2008, when global crisis led the Chinese government to launch a vast stimulus programme, total credit has more than doubled, according to many estimates.

Total debt outstanding across banks, shadow finance entities, bond markets and the government stands at 220 per cent of GDP, according to analysts at Goldman Sachs and Morgan Stanley. In real numbers, that ratio equals almost Rmb115tn of debt. Deducting the central governments direct borrowing from that still leaves a figure of Rmb105tn, by Morgan Stanleys numbers. If a fifth of that was non-performing as in the late 1990s, that would be Rmb21tn of bad debts or a whopping 40 per cent of GDP. The official figures for non-performing loans in the banks claim slightly less than 1 per cent of debts are bad or Rmb540bn. This ignores all the shadow finance debt to which banks are very much exposed. The truth probably lies somewhere in the middle of this vast gulf. For the banks alone, recent share price levels suggest investors expect bad loans to total about 5-6 per cent of the books. Analysts and economists shy away from hard predictions. Richard Xu at Morgan Stanley has instead put a number on high-risk credit across the system. This is mostly loans for trade finance, manufacturing, construction and local government financing vehicles. These high-risk credits amount to Rmb10tn, Mr Xu says. That is only about 10 per cent of all outstanding debt or half the level of 1999s problem loans but it is still almost a fifth of GDP. However, this time around true government debt, including what is owed by the provinces, is far greater than it was in 1999. Estimates range between almost half of GDP for many analysts to as high as 70 per cent for Kenneth Ho, a strategist at Goldman Sachs. Whatever the number, the government has much less wiggle room on its balance sheet now than in 1999. But it could not really afford to buy off the problem then either. There was no magic in the bad debt solution the bill was simply paid by ordinary depositors over many years. The cap on deposit rates that has held down funding costs has helped to give super profits to the banks, which hit 2.9 per cent of GDP last year, way above the peak level of any other country, according to Mr Xu. More than 80 per cent of bank sector income goes to the government via shareholder dividends and taxes on profits, according to another expert. This cannot be repeated. Chinese people receive such low interest rates on the main

saving option available to them that they are forced to save more and spend less to reach their goals. If China is to rebalance, savers cannot foot the bill for more bad debts. Paul J Davies is the Financial Times Asia financial correspondent paul.j.davies@ft.com www.ft.com/insidebusiness