Chinese banks are passing the buck

Investors are becoming increasingly concerned about the deteriorating loan quality of Chinese banks, with a number of trends only serving to aggravate the issue.

Major Chinese banks have admiringly-low non-performing loan ratios at below 1 per cent, a result that even conservatively managed Australian banks would approve of. But the problem is that no one is taking that official figure too seriously.

It is naïve to think that Chinese banks can keep their loan quality consistently high after the massive expansion of credit in the last few years. Antony Dapiran, a leading banking lawyer with Davis Polk & Wardwell, is one such sceptic.

"One of the warning signs I saw was the mini bank run in Zhejiang a month or so ago. Any more incidents like that and there will be a real red flag. These things can spread like a wild fire once they start," said Dapiran.

Indeed, Walter Bagehot, an influential 19th century Victorian financial journalist, warned that "the peculiar essence of our banking system is an unprecedented trust between man and man. And when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may destroy it."

Outstanding non-performing loans soared 19.5 per cent in 2013 from 390 billion yuan ($67 billion) to 467 billion yuan, according to data disclosed by 12 major listed Chinese banks. During the same period, these 12 Chinese banks either transferred or wrote off 102 billion yuan worth of loans, an increase of 206 per cent compared to the same period last year, according to Caixin.

The Chinese Banking Regulatory Commission estimates the total amount of bad loans is about 592.1 billion yuan, or $101bn, which is the highest level since September 2008 when the American subprime meltdown was at its worst.

The outstanding non-performing loans of the big five major Chinese banks -- the Industrial and Commercial bank of China, Agricultural Bank of China, Bank of China and the Construction Bank of China and Communication Bank of China -- increased 16.1 per cent in 2013.

Both international and domestic investors are getting worried about the deteriorating loan quality. Some fund managers are shying away from allocating more money for Chinese banking shares. The Industrial and Commercial Bank of China’s shares have lost 7.5 per cent of their value since the beginning of the year.

Some investors are having flashbacks from the early 2000s, when non-performing loan ratios for Chinese banks were as high as 40 per cent of their total outstanding loans. Beijing had to bail them out through a massive injection of capital and transferred their bad loans to asset management companies, so-called "bad banks".

Several trends are conspiring to make the problem worse.

Many heavily indebted industries such as steel and coal are suffering from the severe problem of over-capacity and are under pressure from Beijing to restructure. According to China Steel and Iron Association data, 86 large and medium-sized steel mills have borrowed a staggering 3.09 trillion yuan ($529bn), more than one third of which was through short-term loans from banks.

Given the industry’s razor-thin margins and the constant pressure from the government to lift environmental standards, its ability to service the loans is in grave doubt. Many steel mills are essentially on life support from the banks.

The coal industry, which was a golden goose until a few years ago, is saddled with debt. The average leverage ratio for the industry is 64.03 per cent and large coal mines made a collective loss of 40 billion yuan in the first 11 months of 2013.

Even more worryingly, some steel mills and coal mines have used their bank loans to speculate in the property market or re-lend them to cash-starved private companies. The owner of Haixin Iron and Steel Group, the largest private steel mill in Shanxi province, has reportedly used bank loans to speculate in the sharemarket. The company has between 15 and 20 billion yuan in debt.

Weak macroeconomic conditions are also squeezing companies’ bottom lines and their ability to service their loans.

"Until recently, China’s economy had been growing at a relatively high rate, which appeared to have encouraged banks to support the weaker companies … however the Chinese economy’s slower growth trajectory implies that Chinese banks are likely to have higher problem loans arising from such lending," says Standard & Poor’s.

But the ratings agency is confident of Chinese banks’ ability to absorb potential losses and believes the financial power of Beijing is enough to put a cap on the brewing concern.

Dapiran, who has been behind some of the largest Chinese bank IPOs in Hong Kong, said, "The general consensus is that there is some kind of an issue, the magnitude of which is not yet known and which may turn out anywhere on the scale of benign to potentially disastrous -- only time will tell."

As far as people can tell, the current issue is nowhere near as bad as the banking crisis back in the early 2000s when many banks were technically insolvent. Chinese regulators are taking active steps to address this problem, which is always a good starting point.

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