Abstract:
· The omnipresence of the state in the Chinese banking system leads to suboptimal capital allocation by favoring the financing of state-owned enterprises at the expense of private companies.
· Rising debt levels and a gradual slowdown in demand have fueled the accumulation of non-performing loans in the banking sector.
· China’s non-performing loan ratio, which appears low, is actually much higher when accounting differences are taken into account. Similarly, an analysis of the interest coverage ratio indicates that the risk of default is actually much higher;
· Nevertheless, regulators are fully aware of these risks and have implemented a series of measures aimed at containing risks in the financial sector.
Article published in partnership with China Economy Podcast
The downgrade of China’s sovereign rating on September 21, 2017, by the rating agency Standard & Poor’s once again puts China’s debt and banking sector in the spotlight. The ratio of non-performing loans (NPLs) has risen steadily since 2011, only stabilizing at around 1.75% at the end of 2016.
Structural imbalances, excessive debt, and the economic slowdown are the main challenges facing the Chinese banking system. The level of non-performing loans is actually much higher than official data suggest, and the risk could be even greater according to our estimates.
Structural imbalances in the Chinese financial system
Structural imbalances within the Chinese banking system lead to suboptimal capital allocation.The quasi-state-owned banking system lends tostate-owned enterprises (SOEs). In other words, the state acts as both lender and borrower, thereby generating moral hazard and significant inefficiencies within the domestic economy, notably by preventing the allocation of resources to the most productive sectors of the economy. As a result, Chinese SOEs receive two-thirds of bank loans, even though they generate only 10% of GDP. At the same time, private companies, particularly SMEs, face credit rationing. A significant proportion of companies receiving bank loans do not generate enough profits to repay their debt, exacerbating the risk of default in the banking system.
High levels of debt and a gradual slowdown in demand have fueled the accumulation of non-performing loans in the banking sector.The RMB 4 trillion investment stimulus plan announced in the wake of the 2008 financial crisis has exacerbated the imbalances in China’s growth model, which is largely based on investment. With a sharp rise in investment and a gradual slowdown in growth, the marginal efficiency of capital has deteriorated significantly and debt accumulation has become a growing vulnerability for China. The level of debt of non-financial entities rose to 260% of GDP at the end of 2016, compared with 160% at the end of 2008, according to Bloomberg. This trend over the last ten years puts China at the top of the list for debt growth among all G20 countries. In addition, domestic and external demand has gradually weakened, putting pressure on companies to generate the cash flow needed to repay their debt. These repayment difficulties are reflected in banks’ balance sheets in the form of an increase in non-performing loans.
The level of risk within the banking system is a cause for concern
The rate of non-performing loans in China is actually much higher than the level suggested by official data.Non-performing loans amounted to 1.74% of total loans in 2016, which is low compared to many developed countries (see Chart 1). However, this figure masks significant accounting differences. While international accounting standards consider a loan to be non-performing if the borrower is more than 90 days past due or has difficulty repaying the principal or interest, Chinese accounting standards distinguish between two broad categories of « risky loans »: (i) non-performing loans and (ii) « special mention loans. » Under Chinese accounting standards, when the value of collateral is sufficient to ensure repayment of a loan, the loan is classified as a special mention loan rather than a non-performing loan. It is therefore necessary to take « special mention loans » into account to ensure that an international comparison is appropriate. When these are included in non-performing loans, the non-performing loan ratio rises to 5.61% of total loans at the end of 2016 (see Chart 2). In addition, Chinese banks actively manage their non-performing loans. According to Bloomberg, the 18 Chinese banks listed on the stock exchange have written off or transferred more than RMB 1.4 billion in non-performing loans off their balance sheets since 2008. If these non-performing loans had remained on their balance sheets, this would have resulted in an additional 2.1 percentage points of non-performing loans in 2016. In total, without active management of non-performing loans by banks, the non-performing loan ratio would reach around 7.7% at the end of 2016, well above the global average.
However, the level of risk in the banking sector could be even higher.Analyzing 3,774 Chinese companies, we find that the repayment capacity of some Chinese companies is a cause for concern. In 2016, 11.8% of the debt in our sample was held by companies with an interest coverage ratio[2]of less than one. In other words, these companies do not generate enough operating income to cover their entire interest expense (see Chart 3). The amount of risky debt is particularly high in the industrial and construction sectors, where overcapacity is weighing on companies’ operating results. Finally, institutions such as the rating agency Fitch andthe brokerage firm CLSA estimatethat the rate of non-performing loans could be between 15% and 21% of total loans, a rate about ten times higher than that published by the Chinese authorities.
Chart 3: Amount of debt with an interest coverage ratio of less than 1 in 2016
Financial stability is a priority for the government
Nevertheless, the Chinese authorities are actively intervening to contain risks in the financial system.In March, as the People’s Bank of China (PBoC) began tightening liquidity in the interbank market, the banking regulator, under the leadership of its new chairman, Guo Shuqing, issued a series of guidelines restricting risky practices and requiring banks to report all transactions, particularly those related to shadow banking, the non-banking financial sector. Guo Shuqing, issued a series of guidelines restricting risky practices and requiring banks to report all transactions to them, particularly those related to shadow banking, the less regulated non-banking financial sector . The major challenge for Chinese regulators remains improving the transparency of the financial system. To achieve this goal, Chinese regulators could follow the example of the European Central Bank (ECB) by launching an Asset Quality Review (AQR) program in the banking sector. The ECB completed its first AQR in 2014 to assess the quality of the balance sheets of 130 lenders and restore investor confidence in the soundness of the euro area financial system. Finally, despite the significant level of risk in the banking sector, it is important to remember that, given the dominant role of public banks in the lending process, the government is in a position to intervene to prevent defaults that could have a systemic impact.
Conclusion
Persistent structural imbalances have contributed to increased debt and vulnerabilities in the Chinese financial sector. The rising cost of financing for financial institutions and regulatory measures to control the risks associated with shadow banking, while positive, do not appear to be sufficient.
The challenge of rapidly increasing debt calls for structural reforms, starting with state-owned enterprises and the financial system. However, implementing these reforms remains difficult due to the significant potential social costs in terms of employment and opposition from certain interest groups, particularly in the financial sector.
At the 19th Communist Party Congress at the end of October, five of the seven members of the Standing Committee of the Political Bureau of the Communist Party of China, the Party’s highest authority, will have to give up their seats to new members. It will be up to this new generation of leaders to set the direction for curbing financial risks.
