Are Chinese Banks Hiding “The Mother of All Debt Bombs”?

Financial collapses may have different immediate triggers, but they all originate from the same cause: an explosion of credit. This iron law of financial calamity should make us very worried about the consequences of easy credit in China in recent years. From the beginning of 2009 to the end of June this year, Chinese banks have issued roughly 35 trillion yuan ($5.4 trillion) in new loans, equal to 73 percent of China's GDP in 2011. About two-thirds of these loans were made in 2009 and 2010, as part of Beijing's stimulus package. Unlike deficit-financed stimulus packages in the West, China's colossal stimulus package of 2009 was funded mainly by bank credit (at least 60 percent, to be exact), not government borrowing.

Flooding the economy with trillions of yuan in new loans did accomplish the principal objective of the Chinese government — maintaining high economic growth in the midst of a global recession. While Beijing earned plaudits around the world for its decisiveness and economic success, excessive loose credit was fueling a property bubble, funding the profligacy of state-owned enterprises, and underwriting ill-conceived infrastructure investments by local governments. The result was predictable: years of painstaking efforts to strengthen the Chinese banking system were undone by a spate of careless lending as new bad loans began to build up inside the financial sector.

When the Chinese Central Bank (the People's Bank of China) and banking regulators sounded the alarm in late 2010, it was already too late. By that time, local governments had taken advantage of loose credit to amass a mountain of debt, most of it squandered on prestige projects or economically wasteful investments. The National Audit Office of China acknowledged in June 2011 that local government debt totaled 10.7 trillion yuan (U.S. $1.7 trillion) at the end of 2010. However, Professor Victor Shih of Northwestern University has estimated that the real amount of local government debt was between 15.4 and 20.1 trillion yuan, or between 40 and 50% of China’s GDP. Of this amount, he further estimated, the local government financing vehicles (LGFVs), which are financial entities established by local governments to invest in infrastructure and other projects, owed between 9.7 and 14.4 trillion yuan at the end of 2010.

Anybody with some knowledge of the state of health of LGFVs would shudder at these numbers. If anything, Chinese LGFVs are known mainly for their unique ability to sink perfectly good money into bottomless holes in the ground. So taking on such a huge mountain of debt can mean only one thing — a future wave of default when the projects into which LGFVs have piled funds fail to yield viable returns to service the debt. If 10 percent of these loans turn bad, a very conservative estimate, we are talking about total bad loans in the range of 1 to 1.4 trillion yuan. If the share of dud loans should reach 20 percent, a far more likely scenario, Chinese banks would have to write down 2 to 2.8 trillion yuan, a move sure to destroy their balance sheets.

The Chinese government, to its credit, was also aware of the danger of this ticking debt bomb. Unfortunately, it used a solution that merely delayed the inevitable. In the first half of this year, Beijing announced a policy of mandating banks to extend by one more year the deadline for local governments to repay their bank loans that were about to mature.This move was taken, in all likelihood, to conceal the festering problem in the financial sector during the year of leadership transition. But it did nothing to defuse the debt bomb.

If debt taken on by LGFVs was the one shoe that has dropped, what about the other shoe?

Obviously local governments were not the only culprits during China's credit bubble in 2009-2010. There were other participants in this frenzy of borrowing and spending. With the slowdown of the Chinese economy, these participants are, like the proverbial naked swimmers exposed by falling tides, coming out of the woodworks.

Over-leveraged real estate developers, for example, are struggling to stay a step ahead of bankruptcy. The Chinese media has reported several instances of suicides of bankrupt real estate developers. Some bankrupt businessmen simply vanished. According to a story in the South China Morning Post in May this year, 47 business owners disappeared in 2011 to avoid repaying billions in bank loans.

Chinese manufacturing companies, state-owned and private alike, could be next in line. Their profit margins are notoriously thin. With excess capacity a systemic problem in the Chinese economy, a slowdown in economic growth will result in a rapid build-up of inventory and a glut of unsold goods in all industries. Getting rid of their inventories at a discount will wipe out their slim profits and incur financial losses. Some of the loans extended to them in good times will surely go bad.

But the potential risk for a financial tsunami is greatest in China's shadow banking system. Because of very low-yield for savings by Chinese banks (since deposit rates are regulated) and competition among banks for deposits and new fee-generating businesses, a complex, unregulated shadow banking system has emerged and grown significantly in China in the last few years. Typically, the shadow banking system pushes something called "wealth management products," which are short-term financial products yielding a much higher rate than bank deposits for investors. To evade regulatory oversight, these products do not appear on a bank's balance sheet. According to Charlene Chu, a highly respected banking analyst for Fitch ratings, China had about 10.4 trillion yuan in wealth management products, about 11.5 percent of the total bank deposits, at the end of June this year.

Since borrowers that use funds provided by wealth management products tend to be private entrepreneurs and real estate developers denied access to the official banking system, they have to promise a higher rate of return. Obviously, higher return also means higher risks. Although it is impossible to estimate the percentage of non-performing loans extended through wealth management products, using a conservative 10 percent baseline would mean another 1 trillion yuan in potential bank losses.

The shadow banking system has another function: channeling funds to borrowers or activities explicitly banned by government regulation. In the last two years, the Chinese State Council has tried to deflate the real estate bubble by limiting bank loans to real estate developers. But banks can skirt such restrictions by ostensibly lending to each other, with the funds ultimately going to financially stretched real estate developers. Chinese banks do this out of their own survival instinct. If they do not lend to effectively delinquent real estate developers who have borrowed large amounts, they would have to declare these loans non-performing and suffer losses. On the balance sheets of Chinese banks, such loans are technically classified as claims on other financial institutions. According to a recent report in the Wall Street Journal, inter-bank loans today account for 43 percent of total outstanding loans, 70 percent higher than at the end of 2009.

Disturbingly, none of these huge risks are reflected in the financial statements of Chinese banks. The largest state-owned banks have all recently reported solid earnings, high capital ratios, and negligible non-performing loans. For the banking sector as a whole, non-performing loans amount to only 1 percent of total outstanding credit.

One things is evident here. Either we should not believe our "lying eyes" or Chinese banks are trying to hide the mother of all debt bombs.
The Diplomat