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Econographics July 26, 2022

Slow growth exacerbates China’s financial stability risks

By Hung Tran

China’s growth has nearly halted as its GDP edged out a 0.4% year-over-year increase in the second quarter of 2022. The slowdown will threaten the country’s 2022 growth target of around 5.5%, especially since Omicron infections have flared up again in several cities, necessitating local lockdowns. Many international financial institutions have downgraded China’s growth estimates for 2022 to a range of 3.5%-4.3%, and projections are not optimistic for a rebound in 2023.

More importantly, visible growth slowdown has spread losses in the real estate property sector to the banking sector, mostly among small and medium-sized provincial banks. For now, the magnitude of damages is manageable, but a sustained period of slow growth would generate greater losses in more economic sectors, banks, and companies. This pattern raises the risk of a financial crisis and economic recession, unless authorities act now to resolve, recapitalize, and consolidate weak, small banks and highly indebted developers. China’s government should also establish a robust resolution and recapitalization framework for banks and companies to replace the current ad hoc approach.

Weak spots in China’s banking sector

China has a large banking sector with assets amounting to 336 trillion yuan ($50 trillion), or almost 300% of its GDP, compared with a bank asset-to-GDP ratio of 75% in the US. Four large state-owned banks dominate China’s banking scene: Industrial and Commercial Bank of China (ICBC), Construction Bank of China (CBC), Agricultural Bank of China (ABC), and Bank of China (BOC). At the end of 2021, by international standards these banks were adequately capitalized (with Tier 1 capital ratios averaging above 12%) and profitable (with returns on equity ROE more than 9%). Both measures are comparable to those of US banks, while European banks are better capitalized but have a lower ROE of 4%. China has a non-performing loan (NPL) ratio of 1.72%, in between the US, with 0.84%, and the Euro Area, with 2.32%. In short, the dominant players in the Chinese banking system look healthy at present.

However, the Achilles’ heel of China’s banking system is its 4,000 small and medium-sized provincial banks. All together, they have about 77 trillion yuan ($11.5 trillion) in assets, slightly less than a quarter of total assets of the Chinese banking system. The weaknesses stem from their flawed business model, in which small banks are often thinly capitalized, rely on costly and volatile interbank markets for funding, and lend to small and medium-sized enterprises (SMEs) – which tend to have high credit risks and high non-performing loan ratios. Moreover, small banks have been plagued with corruption and other wrongdoing.

This was typified by the case of Baoshang Bank. The bank grew 30-fold from its founding in 1998 to 2019 thanks to a policy-driven lending boost to SMEs and was seized by the authorities in May 2019 due to “serious credit risks”. Baoshang Bank was then declared to be bankrupt and was liquidated a year later (the first Chinese bank to have been liquidated two decades) after it was uncovered that the bank made 150 billion yuan of related loans, which became non-performing, to billionaire Xiao Jianhua’s Tomorrow Group Holdings—Tomorrow had a 89% stake in the bank and Xiao is now on trial. This episode created a hiccup in China’s interbank repo market when even some short-term AAA bank debts were refused as collateral due to market participants’ fears of counterparty risks. The People’s Bank of China (PBOC) had to inject a net 250 billion yuan to the financial system to restore market liquidity.

Since then, many small banks have gotten into trouble and had their problems resolved by Chinese authorities. The process is non-transparent, by which an ad hoc group of provincial and local governments, state-owned banks, and companies is put together to buy out the failing banks. The practice is referred to as the “one bank, one policy” approach, associated with Guo Shuqing, the Chairman of China Banking and Insurance Regulatory Commission (CBIRC). More recently, several small banks in the provinces of Henan, Anhui and Liaoning ran into severe cashflow problems and in mid-April had to significantly limit, or to freeze, withdrawals by depositors. Those banks have suffered from the practice of offering high interest rates to attract depositors from afar through digital channels, some operated by China’s big social media platform companies; and then invest the proceeds in Wealth Management Products (WMPs) in the hope of generating high returns to pay back depositors—something the authorities have tried to discourage. The slowing economy since the beginning of this year has caused many WMPs to underperform expectations, rendering many small banks (like those mentioned above) unable to generate sufficient income to meet withdrawal demands—hence the need to limit withdrawals.

Small banks have also been hit by the refusal of a growing number of home buyers to pay interest on mortgages taken from banks to buy unfinished housing units, which have remained incomplete due to the construction slowdown and many developers being embroiled in debt crises. At present, 28 of the top 100 developers have negotiated a debt restructuring with their creditors or have defaulted outright on both onshore and offshore obligations. These developers have left about 100 projects in 50 cities identified so far as unfinished. Mortgage loans on these projects are estimated to be about 1.5 trillion yuan ($222 billion)—a miniscule amount in terms of China’s total bank assets. However, the amount of high-risk credit can grow quickly amid speculation about which banks are going to be hit next—fostering a sense of crisis and undermining public confidence in the Chinese banking system, especially its small banks. Deterioration of the property sector—which accounts for almost one-third of China’s GDP and a quarter of all bank loans—could snowball into a banking and economic crisis.

Spreading fallout of the property sector debt crisis

Declining property sales and values have also hurt municipal and local governments, which have relied on property sales for 42% of their revenues. As revenue from land sales dropped by more than 30% in the first half of 2022 from levels one year ago, the central government eased its campaign to curb local governments from borrowing and issuing bonds through Local Government Financing Vehicles (LGFVs) to limit their financial stability risks. Specifically, the Ministry of Finance is considering allowing local governments to issue 1.5 trillion yuan ($220 billion) of special bonds in the second half of this year to speed up infrastructure investments in support of the faltering economy. These measures are being taken even though LGFV debt climbed to 53 trillion yuan ($8.2 trillion), or 52% of GDP, at the end of 2021 and LGFV credit risks have increased significantly. In the past year, incidences of default by LGFVs have risen—42 LGFVs defaulted on non-standard debt (such as trust loans, accounts receivable, and bills of exchange, which are not traded on exchanges or in the interbank markets).

Corporate debt default in China has also been on the rise. So far this year, China’s bond defaults hit $20 billion compared with $9 billion for the whole of last year—with developers accounting for the bulk of defaults. Slow growth means more bond defaults can be expected. However, these levels of default imply a very low default rate on the outstanding volume of non-financial debt.

Despite struggling to manage financial risks across many sectors, the government has succeeded at times in curtailing shadow banking activities—those using funding and investment instruments which are poorly regulated and harbor obscure risks. The size of this sector has been reduced by 40% since 2017 to stand at 57 trillion yuan ($8.9 trillion) or 49.8% of GDP in 2021—the lowest in 13 years. However, the practice of raising funds through and investing in WMPs, entrusted loans, and other similar vehicles by making use of digital channels is still prevalent, presenting another source of financial stability risks.

Finally, on top of domestic weaknesses in the property and small bank sectors, China must manage its first overseas debt crisis as a creditor. Chinese state-owned banks (SOBs) have lent a total of $838 billion to countries participating in the Belt and Road Initiative (BRI) since its inception in 2018 until 2021. While many projects have been useful for participating countries, many have not generated adequate commercial returns. The pandemic and fallout from the war in Ukraine have led several countries to default on their external debt (like Sri Lanka) or suffer acute debt distress (like Pakistan). From 2018-2021, China has had to renegotiate terms of $70 billion of BRI loans, with the pace accelerating in recent years. Though Chinese SOBs often offer “rescue loans” to help debtors service their borrowings and avoid default, once they are in default, China must negotiate a restructuring of the loans. This process reduces their present values by extending maturities and cutting interest rates or principal amounts. While BRI loans are small relative to total assets of SOBs, sharply rising credit risks and costs related to these loans will burden Chinese banks’ earnings outlook in the foreseeable future—something China can ill-afford given its domestic problems.

Slow reactions by Chinese authorities

Given the significant risks mentioned above, it is difficult to understand the complacent attitude of Chinese authorities responding to the plight of depositors at small banks. Their attitude may give some indications about the quality of supervision of small banks in China, which often acts counterproductively. For example, withdrawal restrictions caused long lines of depositors at affected banks waiting to get their money out and led to demonstrations in Zhengzhou, Henan’s capital. Local authorities reacted by directing plainclothes policemen to beat up demonstrators and turn on the “Code Red” on their cellphone COVID-19 apps to prevent them from appearing at public places.

Their actions triggered widespread indignation and protests on social media. After several months of inaction, the CBIRC and PBOC stepped in. They conducted an investigation, blaming the irregularities on a gang of criminals which controls those banks, using them to engage in illegal activities. The PBOC has also begun to facilitate payments to small depositors of up to 50,000 yuan, telling all depositors to be patient. Since China’s deposit insurance scheme is supposed to protect deposits up to 500,000 yuan, the decision to pay only 50,000 yuan has raised further questions instead of reassuring depositors. Authorities have also urged banks to cooperate with local governments to help fund developers finish their residential projects.

Actions to resolve, recapitalize, and consolidate weak banks and indebted developers

China’s authorities need to urgently deal with slow growth and its related problems. Firstly, they should use their strong sovereign balance sheet to resolve, recapitalize, or liquidate ailing property developers and weak small banks. China has been cautious in using public resources to support its economy during the pandemic. As a result, China’s general government debt to GDP ratio of 77.8% compares favorably with that of the developed countries averaging 115.5%. China’s fiscal and central bank balance sheet space needs to be utilized now to stop the rot among small banks and indebted developers from spreading to the rest of the economy.

Secondly, they must promulgate a clear and robust resolution, recapitalization, and liquidation legal regime to avoid the inefficiency and uncertainty of the current ad hoc “one bank, one policy” approach. They also need to beef up China’s deposit insurance fund with a modest balance of 96 billion yuan ($15.1 billion) at the end of 2021, compared with the US Federal Deposit Insurance Corporation’s $119.4 billion.

Finally, China should make its operations more transparent and predictable to restore public confidence in the banking system. Failure to quickly implement these measures will not only threaten China’s financial and economic stability, but its political stability as well.

Hung Tran is a nonresident senior fellow at the Atlantic Council, former executive managing director at the International Institute of Finance and former deputy director at the International Monetary Fund.

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