Thursday, 1 August 2013

China's dangerous 'bad loans' threaten banks

In the final half of this year, authorities in China wish to counter mounting debt risks in an effort to stabilise the country’s growth.

The fine-tuning of policies will hopefully bring Chinese gross domestic product growth closer to their goal of 7.5%, even while this figure is the purported “lower limit” for GDP growth. Some Chinese economists have already stated that Beijing must not allow growth below 7%.

The government announced last week that reforms are set to continue. And yet curiously, while the public announcements about not dipping below a particular percentage level are sounding clear, the Communist Party’s 25 most-senior officials in the Political Bureau – or Politburo – do not seem to display a drastic sense of urgency.

With the rising amount of nonperforming loans (NPLs), the Politburo may have to ramp up the tempo on reforms in the very near future to try and put a tourniquet on easy credit. Theoretically, reform shouldn’t be a huge problem for China because more than half of total loans and deposits are owned by China’s dominating state-owned commercial banks.

Chinese banks are not as independent as their Western counterparts due in part to the fact that nearly 95% of China’s key commercial banks are controlled by the central government.

But heavy state guidance has created a raft of inefficiencies in the financial system. To keep employment high - an almost existential imperative for Beijing - large amounts of the country’s funds were given to unprofitable state-owned enterprises. Many of these businesses defaulted on the loans and departed the marketplace leaving the banking sector with large amounts of bad debts.

Commercialising the banks increased efficiency in many ways but ultimately aggravated the growing problem of nonperforming loans. Speculation in land and stocks increased, pushing up property prices, conjuring even more unrecoverable debts.

These were then used as collateral for greater loans, a scenario which lead in many ways to the Chinese banking crisis of the 1990s.

At that point, China dealt with the crisis as best it could by injecting enormous amounts of funds into the banks while forming four separate “bad banks” asset management companies to lump with the poorly failed loans. But the bad loan problem wasn’t fundamentally fixed and they began piling up again.

The NPL cycle returned in 2000 as the total NPL value hit 1.4 trillion yuan. A decade later in 2011, these loans have reached approximately 5 trillion yuan and now threaten to break the financial sector.

Recognising this problem, China’s leaders are likely to continue with reforms and are expected to liberalise the country’s interest rate policy by abolishing the maximum rates banks can offer their depositors. This should go some way in disincentivising investors from accessing the black market or “shadow economy” for loans.

In the long term, China’s fiscal policy changes should increase competition between domestic banks, forcing them to diversify their portfolios just to stay ahead. There is a chance China can deal with its bad debt problem sufficiently, but what is not clear is whether the Politburo is ready to undertake the necessary reforms.

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