Some market players believe China would see a banking crisis soon, with losses expected to amount to US$3.5 trillion, 30.4 percent of the banks’ total equity, or four times larger than the equity hit that US banks took during the subprime crisis.
Recent reports that China had almost US$600 billion in unpaid receivables, the largest amount since the late 1990s, only aggravated such fears.
These worries must have practical implications on the valuation of Chinese banking stocks and the safety of savers’ deposits at Chinese banks.
To understand the rationale of this “Armageddon” scenario, one needs to know where the biggest risk exposure of Chinese banks is.
It is not the loans to the state-owned enterprises (SoEs) or the households. The former enjoys implicit guarantee from the government and the latter has a strong balance sheet.
The highest credit risk lies in the loans to the corporate sector and non-depository financial institutions (NDFIs).
The latter include investment companies, brokerages, trust companies, auto-financing and financial leasing companies and private loan companies.
They do not enjoy the same degree of implicit guarantee as the SoEs and the banks, and are not regulated properly.
According to banking and official data, loans to enterprises and NDFIs totalled 79.4 trillion yuan (US$12.27 trillion) in 2015, which accounted for 84.5 percent of total loans.
Let us assume two loss scenarios, one with a 10 percent loss and the other with a 15 percent loss on these loans. These would mean expected gross losses of 7.9 billion yuan and 11.9 billion yuan under scenario 1 and 2, respectively.
Official data shows that the banking system had an aggregate 2.3 trillion yuan loan-loss provisions last year. Experience also shows that Chinese banks had an average bad-debt recovery rate of 20 percent.
Assuming all the provisions would be used to cover losses and the same bad-debt recovery rate going forward, the potential net loss to the banking system would amount to 4.0 trillion yuan and 7.2 trillion yuan under scenario 1 and 2, respectively (equal to gross loss – loss provisions – loss recovery).
Chinese banks had an aggregate equity capital of 13.1 trillion yuan in 2015. The stylized example here shows that if banks’ bad-loan ratios were to rise to 10 percent or 15 percent, the estimated losses could wipe out 31 to 55 percent of the banks’ aggregate equity (expected net loss divided by equity).
The losses we have assumed here are arbitrary. If realized losses were lower/higher, the hit on banks’ equity would be lower/higher.
Given the prevailing economic weakness in China, a 10 to 15 percent non-performing-loan scenario looks plausible. There could also be bad debt arising from other loan categories.
Conventional wisdom has it that China would be facing a banking and currency crisis soon. But this view hinges upon the creditors’ behavior.
In an open and mature market, which is how most western analysts see China, the creditors would lose faith in the debtors and cut funding. The banking system would collapse, crushing the economy and the exchange rate.
However, the creditors in China are the households, who are ultimately backed up by the government’s implicit guarantee policy.
So there is no loss of public confidence in the financial system. This also means that the probability of bank runs is very low.
Meanwhile, China’s closed capital account helps lock up domestic liquidity, providing a backstop for keeping the banking system whole.
Even though the central government is calling for a clean-up of zombie companies, it is asking banks to ensure the process does not cause any financial instability, i.e., not to cut off funding abruptly.
Granted, this policy is not going to solve China’s debt and capital misallocation problems. But it means that China could avoid a financial implosion for longer than many analysts have expected.
So long as there is no loss of public confidence and the creditors in China do not cut off funding to the banks and NDFIs which, in turn, do not cut off funding to the zombie companies, there would not be a financial crisis or capital flight out of China or a collapse in the renminbi exchange rate.
Indeed, there have been no signs of capital flight; otherwise one should have seen a significant depletion in domestic deposits.
The recent FX reserve losses have largely been a result of valuation effect and capital outflows stemming from Chinese companies repaying foreign debt and portfolio (hot money) outflows.
However, there is no free lunch. The cost of sustaining the banking system under the prevailing policy framework is that many of the zombie companies would not be forced out of the system or restructure, despite Beijing’s pledge to improve corporate efficiency.
This means that China’s SOE reform would be a slow-going process, delivering only mediocre economic and productivity growth in the medium term.
But an “Armageddon” scenario for China is not a fair bet.
Opinions expressed here are the author’s and do not necessarily reflect those of BNPP IP.
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