China's banks have a nasty case of indigestion

China Bohai Bank

10/09/2024 23:00

(The author is a Reuters Breakingviews columnist. The opinions
expressed are her own.)
    By Robyn Mak
       HONG KONG, Sept 11 (Reuters Breakingviews) - China's
financial sector has serious heartburn. For decades, Beijing has
leaned on its state-controlled banks to turbo-charge growth by
extending credit. But lenders are now clogged with risky assets.
The result is something like indigestion: not critical, but
painful for the $17 trillion economy.
    On paper, the country's banks look remarkably healthy given
2020's twin shocks of the pandemic and a burst property bubble.
Official data show them sitting on 3.3 trillion yuan, roughly
$460 billion, of non-performing loans. Add in another $670
billion of less-problematic-but-still-pesky "special mention"
loans, which include credit extended to struggling property
developers and cash-strapped local governments, and it doesn’t
even reach 4% of their aggregate lending.
   The problem is, asking China’s official data collectors about
bad debt is like asking a dyspeptic patient how much junk food
they really eat. Other sources take a gloomier view. Bad loans
in the property sector today alone could be over $1 trillion,
reckons research firm GavekalDragonomics.
    Even so, the chances of a chaotic implosion of China's
tightly-controlled financial system are extremely low. China's
four biggest lenders - Industrial and Commercial Bank of China
 601398.SS   1398.HK , Bank of China  601988.SS   3988.HK ,
China Construction Bank  601939.SS   0939.HK  and Agricultural
Bank of China  601288.SS   1288.HK  - are all state owned and
too big to fail in every way. Moreover, regulators and bank
executives have spent years devising ways to manage the bad debt
problem, and while that system is strained, it still more or
less works.
 
    THREE-COURSE PROBLEM
  
        Think of the sector's problem assets as coming in three
distinct flavours. The least unpalatable are loans are mostly
politically connected ones from local government financing
vehicles, or LGFVs - the 3,000-plus entities created by local
governments mainly to fund infrastructure projects. Last year,
LGFV debt topped $8.5 trillion, according to the International
Monetary Fund. Fitch Ratings estimates credit provided to LGFVs
could account for up to 17% of total assets at the banks it
covers.
    Because of the political nature, lenders have little choice
but to keep rolling over that kind of debt before it comes due
for repayment. Zunyi Road and Bridge Construction, an LGFV based
in Guizhou province, received a 20-year extension on a $2
billion loan with the interest rates halved, local media
reported. Not all of the projects these loans finance are duds;
LGFVs also fund useful infrastructure like metro stations. But
helping them out eats into banks’ profitability. Under a severe
stress scenario where 15% of LGFV loans are renegotiated, bank
sector profits would decrease by 6%, estimates asset manager
Pimco.
    That’s disagreeable but not terminal. Larger and
well-capitalised banks can take the earnings hit, though shakier
regional and rural banks will require some combination of
government bailouts and consolidation. And some bad loans may
yet come good. As for the other two flavours of bad debt, banks
are likely to try and get these out of their system one way or
another. Over the past few years, lenders have stepped up the
pace of bad asset disposals, which since 2020 have surpassed 3
trillion yuan a year, or nearly 3% of GDP, according to
researcher Dinny McMahon at Trivium.
    The first category are assets that can be sold, auctioned or
securitised. China's bankruptcy process is still underdeveloped,
and onerous restrictions and lengthy court settlements mean it's
still more efficient for banks to directly offload toxic loans
to mostly state-backed investment vehicles known as “asset
management companies”, even at a loss. Standard Chartered-backed
 STAN.L  China Bohai Bank  9668.HK , for instance, plans to sell
assets worth 29 billion yuan at an up to 40% discount, which
will result in a financial hit equivalent to more than
three-quarters of its 2023 earnings.
    Asset management companies are themselves overstretched in
many cases, so often act more like a clearinghouse than an
investor, selling on the loans they buy to specialist funds like
ShoreVest. These investors can make double-digit returns from
underlying collateral. Despite slumping real estate values,
logistics warehouses and shopping malls across the country, for
instance, are still generating cash, according to ShoreVest
founder Benjamin Fanger.
    The remaining group of loans are those where banks will try
to recover the outstanding amount themselves, and tap provisions
to cover any outstanding losses. These write-offs totalled 1.3
trillion yuan last year, per GaveKal. Lenders like Ping An Bank
 000001.SZ  have beefed up in-house capabilities to collect on
delinquent credit card dues, mortgages and such. 
 
    DINER’S REMORSE
  
        Through warehousing, selling and writing off loans,
China's banks are muddling through. But not without cost.
Profitability is being squeezed amid sluggish credit demand,
interest rate cuts and Beijing's calls for lenders to funnel
cheap credit into strategic sectors. Average net interest
margins at the big four, plus number-five lender Bank of
Communications  601328.SS   3328.HK , are forecast to fall to
1.4% this year, from over 2% in 2019, according to Visible
Alpha; As a result, the average return on equity is expected
to fall to 8.6% from 10% over the same period.
    Because Chinese banks are required to set aside capital to
cover losses from write-offs, a shrinking bottom line will make
it harder to maintain the current pace of asset disposals,
notably at rural commercial lenders, which make up 14% of all
Chinese bank assets. They have the lowest profitability but the
highest non-performing loan ratios. Large-scale
recapitalisation, which can mean local governments issuing bonds
for the purpose, may be required.
    The bigger concern for Beijing's economic planners is how to
prop up economic expansion. For past two decades, the country
has relied on investment-driven growth by allocating credit to
state and privately-owned firms. That is no longer possible:
using historical data on nominal GDP growth created from loans,
and assuming banks maintain a 30% dividend payout ratio,
JPMorgan analysts calculate that banks would need more than a
10% return on equity to generate enough capital that they can
help the government hit its economic expansion target this year.
    Pumping out debt isn’t the only way to get growth. China for
years has sought ways to stoke domestic consumption. That is
probably the next chapter for China's economy. In the meantime,
the stakes are rising. If consumers don’t pick up the slack, the
economy slows, bad debts are likely to rise even further, and a
nasty case of financial dyspepsia will turn into something
worse.
    Follow @mak_robyn on X

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Graphic: China's risky bank debts are piling up    https://reut.rs/4cmiMtA
Graphic: Chinese lenders have stepped up toxic asset disposals  
 https://reut.rs/47mxrnM
Graphic: Chinese banks' net interest margins are plunging    https://reut.rs/4eh0v27
Graphic: Rural Chinese lenders are the weakest link    https://reut.rs/3TjMnx6
    ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
 (Editing by John Foley and Aditya Srivastav)
 ((For previous columns by the author, Reuters customers can
click on  MAK/   
robyn.mak@thomsonreuters.com))