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Back in 2009,in the midst of the global recession, China’s government launched a massiveeconomic-stimulus package that bolstered GDP growth by fueling a surge in banklending. But now it is becoming increasingly apparent to policymakers andinvestors that easy credit and lopsided policies have generated significantrisk for China’s banking system. Indeed, amid rising concern about banks’troubled assets, defusing financial risk has become the authorities’ centralgoal.
According tothe China Banking Regulatory Commission, commercial banks’ non-performing loans (NPLs)at the end of June totaled ¥539.5billion ($88.1 billion) – nearly 1% of outstanding loans. The loan lossreserve-fund balance was ¥1.5 trillion (up 19% from the previous quarter), theprovision-coverage ratio was 292.5%, and the loan ratio was 2.8%.
Government-backedloans amounted to ¥9.7 trillion, representing a 6.2% increase since lastquarter – nine percentage points lower than the average growth rate for allcategories of banking loans. And the balance of wealth-management productsstood at ¥9.1 trillion, of which non-standard credit assets accounted for ¥2.8trillion.
According tothe official numbers, NPLs do not actually account for a very high share oftotal assets, and the NPL ratio (0.96%) is manageable. The problem is that mostof China’s NPLs are off-balance-sheet loans, so the NPL ratio may be muchhigher – and China’s financial sector much riskier – than anyone realizes.
In fact, manybanks’ off-balance-sheet loans – often extended to higher-risk borrowers, likehighly leveraged real-estate developers and local-government financing vehicles– now exceed newly issued balance-sheet loans. If borrowers default on theiroff-balance-sheet loans, banks might choose to protect their reputations bycovering the difference using internal funds, thereby transferring the riskonto their balance sheets and increasing the NPL ratio.
Banks’exposure to local-government debt and the real-estate market has alreadyundermined the quality of their assets, increasing debt pressure and weakeningprofitability. Moreover, off-balance-sheet lending has helped to fuelover-investment in some sectors (especially infrastructure, iron and steel,energy, manufacturing, and real estate), leading to overcapacity and primingthe economy for the emergence of bad-debt “disaster zones,” which wouldincrease NPL ratios further. Moves to liberalize interest rates will put evenmore pressure on asset quality and bank profitability.
Against hisbackground, troubled assets will continue to be converted into liabilities.According to China’s Academy of Social Sciences, the volume of banks’ troubledassets fell from nearly ¥2.2 trillion in 2000 to ¥433.6 billion in 2010, whileliabilities formed from these dissolved assets grew from ¥1.4 trillion to ¥4.2trillion.
Eliminatingbanking-sector risk will require decisive government action, includingcomprehensive financial reform and effective risk-management strategies forfinancial operations in core sectors. But perhaps the biggest challenge will bedetermining which mechanisms will most efficiently address China’stroubled-asset problem. China has historically approached broad-scale relief of troubled assetsthrough three channels – capital injections, asset-management companies (AMCs),and the People’s Bank of China (PBOC) – all of which have seriousdownsides.
During thelate-1990’s Asian financial crisis, China’s four major state-owned banks, whichaccounted for more than half of the country’s banking sector, had acapital-adequacy ratio of only 3.7% (compared to the international standard of8%) and an NPL ratio of roughly 25%. In order to recapitalize these banks,China’s government issued ¥270 billion of special treasury bonds in 1998,injecting all of the proceeds into the banks as equity – and, in the process,creating significant financial liabilities.
In 1999, thegovernment decided that four newly established AMCs would purchase nearly ¥1.4trillion in troubled assets from these banks, using a combination of PBOC loansand AMC bonds issued to the banks. In order to mitigate the risk associatedwith these debt-funded loan purchases, the PBOC guaranteed the AMC bonds.
This approachgenerated substantial risk for the PBOC. And, although it strengthened thebanks’ balance sheets considerably, the AMCs had an averagetroubled-asset-recovery rate of slightly less than 25% in 2006, with actuallosses close to ¥1 trillion.
China is, ofcourse, not the only country that has struggled with troubled-asset relief.Since the 2008 financial crisis, American financial institutions’ assetwrite-downs have amounted to 13% of GDP. The Bush administration’s TroubledAsset Relief Program and the Obama administration’s financial rescue plan costnearly $2.2 trillion, with the Federal Reserve purchasing a massive amount ofbanks’ assets. In supporting financial-sector deleveraging, the Fed itselfbecame highly leveraged, and troubled assets still plague its balance sheet.
Given thesignificant flaws in existing troubled-asset-relief channels, another option – securitization– is being discussed in China. The PBOC already has called for banks tosecuritize their high-quality assets and sell the securities tointerbank-market investors; that could be a prelude to troubled-asset securitization.By selling troubled assets in the secondary market, commercial banks couldstrengthen their balance sheets while avoiding liability increases andenhancing asset liquidity.
Butsecuritization creates its own challenges, such as how to price the assets.Moreover, once a loan is securitized, the bank that issued it no longer has anyincentive to ensure repayment by the borrower, which raises the risk of defaultand drives up interest rates. Competitive securitization was a leading cause ofthe US subprime mortgage crisis; owing to defaults, mortgage loans remainAmerica’s number one troubled asset.
In order tomollify investors in the face of increased default risk, China’s governmentmight force commercial banks to strengthen their balance sheets throughcollateralization or to swap defaulted loans for new bonds, backed by China’sforeign reserves held in US Treasuries. But such requirements would lead toeven more risk.
A better solution would be to develop the credit-rating market,establish a more comprehensive regulatory framework for the financial system,and create an effective mechanism for ring-fencing risk. Such measures could offer thesecurity and credibility needed to enable the successful securitization of troubledassets, paving the way for China’s leaders to deepen financial reform
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