China-watchers are paying close attention to the structural slowdown in China’s economy and the potential risks in China’s banking system.
First published in November 2019.
Although the US-China trade war and the protests in Hong Kong have hogged the news headlines this year, China-watchers are also paying close attention to the structural slowdown in China’s economy, and with that as backdrop, to the potential risks in China’s banking system. This year, 3 minor banks have had to be rescued or bailed out, and quite recently, the authorities had to intervene in the case of 2 others, that had experienced runs. These institutions may be minnows, but they remind us that China’s 4,500 mostly smaller lenders are at the centre of concerns about the risks in shadow banking, over-lending, and the weak funding structure of their liabilities.
With China’s foreign debt rising more quickly now – $2.1 trillion in June, according to SAFE, the equivalent of nearly 68 percent of reserves – China’s banks may be in the spotlight even more because of their desire and need for US dollar funding at a time when the trade and tech war is threatening to go financial too. Expect the financial system to remain in focus in 2020.
The economic backdrop to China’s financial sector wobbles is not great, and therefore also important, since it is only likely to exacerbate under-reported non-performing loans, and low capital adequacy and liquidity positions among weaker lenders. October’s data releases, for example, revealed that fixed asset investment increased by 5.2 percent in the first 10 months of 2019, but this was the lowest such growth measure since 1995. Private sector manufacturing investment has almost ground to a halt, and were it not for infrastructure investment and a seemingly unsustainable buoyancy in real estate investment, the alarm bells would be ringing rather louder.
Retail sales, which include spending by governments and businesses, were up in money terms by an annual 7.2 per cent, but was the lowest since the SARS outbreak in 2003. Employment has been falling in the industry and construction sectors for some time, and service sector jobs are still growing, but on a significantly slowing trajectory. So, if you’re a bank with a lot of borrowers facing debt service difficulties or constraints, this is not great news.
To summarise the acknowledged incidents this year, in May, the authorities were obliged to take over an Inner Mongolian bank, called Baoshang Bank, and, unusually, imposed haircuts (that is, forced losses) on corporate and household depositors. The ‘shock’ precipitated nervousness in Chinese financial markets, and in the summer, in two further small lenders, Bank of Jinzhou which had to be rescued by a consortium lead by the giant ICBC, and Hengfeng Bank, which had to seek a capital injection from China’s sovereign wealth fund. Shandong Province is now its largest shareholder. Very recently, two other banks, Yingkou Coastal Bank in Liaoning Province, and Yichuan Rural Bank in Luoyang in Henan Province experienced runs, necessitating official intervention, confidence boosting rhetoric and liquidity.
These banks typify the small lenders that permeate the Chinese financial system, spanning joint stock and city commercial banks, and rural and village banks. Many are concentrated in the coal, steel and heavy industry parts of China, especially in the north east of the country, which are in the forefront of the economic slowdown, but by no means the only sectors confronting tougher times.
To address the specific issues these banks faced, but more importantly the risk of contagion because of the prevalence of banks borrowing from one another, the People’s Bank of China and the China Banking Regulatory Commission have had to pay close attention to liquidity in financial markets, and the occasionally dysfunctional behaviour of funding costs and availability, and credit spreads. Banks are now being encouraged to merge or restructure if they encounter bad asset or liquidity problems, and as a matter of course, raise more capital if they can, and look to local governments as a backstop if needs be.
The IMF’s October 2019 Global Financial Stability Report, though a dense read at the best of times, has covered many of these developments and the vulnerability of smaller banks.
Dinny McMahon at MacroPolo also has a recent report out on how the authorities are tailoring their response.
As mentioned earlier, these lenders are much less well endowed with capital and liquidity buffers, and have much higher non performing loan ratios. They are also much more dependent on volatile, and risky short-term funding of their loan books – often to the tune of about 30-40 per cent of total liabilities. In a banks report produced earlier this year, UBS noted that among the 250 smaller banks under its microscope, there was a capital shortfall of nearly Yuan 2.5 trillion (or $343 billion).
It also exposed to scrutiny something we have known for a while, namely that many banks, especially smaller ones, have not only been prolific in the shadow banking industry, but also in disguising loans as so called ‘investment receivables’, which is to say assets. Known by complex names, such as trust beneficiary rights and directional asset management plans, these are, to repeat, loans dressed up as assets, and used to disguise lending to evade regulatory lending curbs, under-state non performing loans, and build up wholesale (very short-term) funding. Through the use of these and similar financial products, banks have been able to bypass, for example, regulations that restrict loans to a single borrower to 10 percent off assets (slightly higher in the case of a group plus subsidiaries).
In a just published paper on Chinese shadow banking, an official of the People’s Bank of China, currently working at the BIS, Guofeng Sun, explained the peculiarities and risks in Chinese shadow banking. Unlike western shadow banking, which revolves mainly around the credit created by non-banking financial institutions, China’s is much more about the creation of money by banks, using for example, the accounting treatment that generates liabilities from assets, as suggested above.
Since 2016, it is fair to say that the authorities have moved to shut down some of the more egregious forms of risk taking and bad financial practices, forced banks to bring assets back on to their balance sheets, and presided over some slowdown in credit creation. According to Moody’s, the size of the shadow sector has fallen from 86 percent of GDP in 2016 to 68 per cent at the middle of 2019 – roughly unchanged in US dollar terms – and the PBC reports that total social financing – the broadest published measure of credit has slowed from about 16 to 11 percent per annum.
We don’t know how secure these changes are as the authorities are moving incrementally, and continuously to tweak the amount of monetary, credit, infrastructure, and bond issuance stimulus running the economy in the face of an apparently unstoppable economic slowdown. The China Beige Book, which surveys over 1,000 companies several times a year, reported in September that shadow lending was in the throes of a marked revival.
These things will require our close attention, because the Chinese financial system is still running considerable risks.
● As stated above, smaller and medium-size banks have considerable funding risk weaknesses, as well as capital and liquidity shortfalls;
● Like the Fed and the BoE in 2007, the PBC in 2019-20 may think it knows about financial plumbing, and where all the quirky risks lie, but it is just as unlikely to be fully aware of the extent and scale of connectivity and multiple layers of leverage involved in complex funding structures;
● Banks are at risk mostly not from bad assets per se, but when liquidity dries up, and the investment/loan products that banks have issued to purse reckless lending in the past and the sources of funds on which they depend are not necessarily stable and reliable, especially in a darkening economic outlook.
The systemic dilemma for banks, regulators and the government is the same, although it takes different forms.
Banks have to improve their financial ratios and resilience but can only do this in the context of shrinking their loan books, especially to SOEs and local governments. Regulators have to emphasise adequate capital adequacy, liquidity and solvency but wean the financial system away from short-term funding dependency, interminable bail-outs and implicit guarantees that undermine financial stability sooner or later. The government has to strike a balance between deleveraging, defaults and weaning the economy off credit dependency, and lower economic growth, with all the politics and jobs implications that accompany that.
As 2020 dawns, financial stability isn’t getting any easier.🔷
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