World Economy

China Lenders Saddled With Surging Bad Debt

China Lenders Saddled With Surging Bad DebtChina Lenders Saddled With Surging Bad Debt

Predictions of a Chinese banking system bailout are going mainstream. What was once the fringe view of permabears and short sellers is now increasingly being adopted by economists at some of the world’s biggest banks and brokerages.

Nine of 15 respondents in a Bloomberg survey at the end of last month, including Standard Chartered Plc and Commonwealth Bank of Australia, predicted a government-funded recapitalization will take place within two years. Among those who provided estimates of the cost, a majority said it will exceed $500 billion.

While a bailout of that size would be a far cry from the $10 trillion forecast of US hedge fund manager Kyle Bass in February, the responses reflect widespread concern that Chinese lenders will struggle to cope as bad loans surge. Even as some analysts said a state recapitalization would put the banking system on a stronger footing, 80% of respondents predicted news of a rescue would weigh on Chinese markets—dragging down bank stocks and the yuan while pushing up government borrowing costs and credit risk.

“A recapitalization will happen after the Chinese government comes clean with the true nonperforming loan figure,” said Kevin Lai, the Hong Kong-based chief economist for Asia ex-Japan at Daiwa Capital Markets. “That will require a lot of money creation.”

Bad Debt

At CBA in Sydney, analyst Li Wei said the Bloomberg survey was the first time he’d estimated the timing and cost of a recapitalization. The topic became more prominent after an article calling for the nation to tackle leverage and bad debt appeared in the People’s Daily in May. That same month, Societe Generale SA issued a 48-page report war gaming restructuring options for China’s state-owned enterprises and banks.

Chinese lenders are grappling with a growing mountain of bad debt after flooding the financial system with cheap credit for years to prop up economic growth. Non-performing loans jumped by more than 40% in the 12 months ended March to 1.4 trillion yuan ($210 billion), or 1.75% of the total, according to government data. The figures are widely believed to understate the true scale of the problem, with Credit Lyonnais Securities Asia Ltd. estimating NPLs were probably closer to 11.4 trillion yuan at the end of last year.

Chinese banks will be able to maintain relatively high capital levels even if they’re hit by severe shocks, the central bank said in its 2016 financial stability report last month. A stress test of 31 large- and mid-sized Chinese banks showed their aggregate capital-adequacy ratio falling to 10.97% from 13.32% in a worst-case scenario, the PBOC said. China will require systemically-important banks to have a ratio of 11.5% by the end of 2018.

Some economists are less sanguine, predicting that Chinese banks will need state help as loan losses erode capital buffers. A majority of the survey respondents said policy makers will use a mix of foreign reserves, state assets sales, sovereign bond issuance or money printed by the central bank to fund a recapitalization.

Most of the economists who estimated a tab for a bailout said it will cost at least $500 billion, with forecasters from CBA and Hamagin Research Institute saying it could climb to as much as $3 trillion.

Gov't Stepping In

It wouldn’t be the first time China’s government has stepped in to support its banks, most of which are still majority-owned by the state.

When the country’s NPL ratio climbed to as high as 40% in the late 1990s, policy makers sold special bonds to recapitalize the four biggest lenders and set up state-run bad banks to buy 1.4 trillion yuan of soured loans at face value.

The effort was largely a success, setting the stage for more than a decade of breakneck growth that turned China into the world’s second-largest economy and helped many of its biggest companies tap into global capital markets.

A government bailout “will help write off bad debt and help banks clean up their balance sheets,” said Ding Shuang, the head of Greater China economic research at Standard Chartered in Hong Kong. “It’s a positive thing if it really happens.”