Long read: China’s vanishing banks are threatening social stability

Harshad Shah is a Chartered Accountant with an independent practice in India. We don’t know him personally but this long & hard hitting blog from Mr Shah was brought to our attention by a switched on civil servant in Delhi. Whilst we are not in a position to verify the facts & figures cited in the block, the picture that the blog paints of China resonates with what we hear from friends in that struggling economy. To be specific, as per Mr Shah’s blog: “China’s banking sector is facing a full-scale crisis. In just one week, 40 banks disappeared, absorbed into larger institutions. Today, Jiangxi Bank of China went under, further escalating the crisis. China’s smaller banks are struggling with bad loans and exposure to the ongoing property crisis…. Some 3,800 such troubled institutions exist. They have 55 trillion Yuan ($7.5 trillion) in assets—13% of the total banking system—and have long been mismanaged, accruing vast amounts of bad loans. Many have lent to real estate developers and local governments, gaining exposure to China’s property crisis. In recent years, some have revealed that 40% of their books are made up of non-performing loans. Bank of Jiujiang, a mid-tier lender, recently revealed that its profits might fall by 30% due to poorly performing loans. This rare disclosure highlights the severity of the situation. The authorities have been pushing for more transparency, but the true extent of the bad debt problem is still emerging. The four state AMCs created to manage bad debts are now struggling themselves, with one needing a $6.6 billion bailout in 2021.”

Basis Mr Shah’s blog, beyond the massive scale of Chinese banks’ bad debt problem, there are 3 other facets to this crisis which make investing in China a real challenge for anybody other than the most ardent Sinophine.

Firstly, the authorities’ lack of transparency: “China’s main way of dealing with small, feeble banks: making them disappear. Of the 40 institutions that vanished recently, 36 were in the Liaoning province and absorbed into a new lender, called Liaoning Rural Commercial Bank, which was created as a receptacle for bad banks. Since it was set up in September, five other institutions have been established to do similar work, with more expected…

This regulatory vanishing act will probably pick up pace. S&P Global, a rating agency, reckons it will take a decade to complete the project. While fewer bigger banks are easier to regulate, combining dozens of bad banks only creates bigger, badder banks. The fact remains that the Chinese economy is in an extended and pretend state.”

Second, the problem extends beyond the banks and deep into the colossal shadow-banking sector (i.e. NBFCs) where disclosure norms are murky & hence the depth of the crisis is hard to fathom: “China’s shadow banking system has expanded dramatically since the 2008 international financial crisis, causing widespread concern. In December 2020, a report by the Policy Research Bureau of the China Banking and Insurance Regulatory Commission conducted an in-depth study of China’s shadow banking problem for the first time….

Regulatory arbitrage is common: Taking advantage of imperfect regulatory systems and inconsistent standards, various institutions engage in regulatory arbitrage activities in the “gray area,” leading to many instances of “driving without a license.”

Rigid redemption expectations: Most products promise to maintain capital or minimum returns and have rigid redemption expectations. Insufficient information disclosure and low transparency….

Outstanding credit risk: Bank-led, customer rating standards are significantly lower than those for loan customers, leading to greater credit risk….

At the end of 2020, the balance of wide-caliber shadow banking was 236.44 trillion Yuan, and the balance of narrow-caliber shadow banking was 150.47 trillion Yuan. The two totaled about 386.91 trillion-Yuan, accounting for 87.02% of the assets of national financial institutions…..

In 2020, the top five financial institutions in shadow banking accounted for 40.42% of the total balance of wide-caliber shadow banking.”

Thirdly, the banking and shadow banking crises are in turn linked to China’s real estate sector which by itself seems to be going through and extended bear market: “Since 2020, China’s real estate market has been under significant strain. Potential home buyers are increasingly concerned about job security and future earnings, reducing their intent to purchase property. Additionally, defaults on project deliveries have eroded consumer confidence, exacerbating the situation.

Key Indicators of Decline

a) Investment Decline: Real estate investment in China has declined by 9.8% in 2024, following a 10% decline in 2023….

b) Unsold Assets: The total value of China’s unsold land and property is estimated at $4 trillion, up from $3 trillion at the peak of its real estate boom.

Banks’ Narrow Path past Property Crisis

China’s major banks have managed to avoid catastrophic failures despite the property bubble burst. However, they face the looming threat of poor earnings. Real estate directly and indirectly accounts for an estimated 159 trillion Yuan of total bank loans in the country, equivalent to 38% of lenders’ assets in 2023. Non-performing loans stood at 1.59% of the total at the end of 2023, down from 1.73% two years earlier. This is impressive considering the property sector, which accounts for around a fifth of GDP, is engulfed in a liquidity crisis affecting indebted developers like Country Garden and the bankrupt China Evergrande.

Developers make up a small percentage of banks’ real estate exposure. Most of the exposure comes from residential mortgages and corporate borrowing collateralized with property. These loans typically do not exceed 60% of the asset’s value and are concentrated in wealthier cities where home values have been stable. Thus far, defaults have been rare. Despite underreporting overall bad loans, Chinese banks spent years before the property crash cleaning up their balance sheets….However, profitability is being squeezed amid sluggish loan demand and increased household deposits. Average net interest margins on earning assets at the Big Five fell to 1.55% last year from over 2% in 2019, and are forecast to fall further to 1.36% this year.

Recent policy changes have not helped. Earlier this year, the central bank cut a benchmark interest rate used for long-term lending to funnel cheap credit into strategic sectors….”

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