China has 'one last chance' to clean up its mammoth bad debts

Getty Images. At a time of slowing growth, acute overcapacity in some sectors and rampant credit growth, concerns over the creditworthiness of Chinese borrowers show no signs of abating at present.

Hedge fund managers, including Kyle Bass, are actively betting on a full-blown banking crisis. Credit ratings agencies are warning that the government, along with a great number of state-owned enterprises, may have their credit ratings cut in the months ahead.

Michelle Lam, an analyst at Lombard Street Research, believes that China is now in the last chance saloon when it comes to cleaning up the nation's ballooning bad debts, suggesting that, should current concerns grow into something more sinister, the government will be forced to "resort to more radical measures".

According to Lam, non-performing loans (NPL) rose to 4 trillion yuan ($US615 billion) last quarter, representing some 5.5% of total commercial bank loans in China.

Lam suggests this level, already enormous, may be understating the true size of bad debt levels in China's banking system.

"Most market estimates suggest China’s actual NPL ratio could be around 10%, dwarfing the current official figure of 1.7%," she said.

"Under the extreme assumption that all net new bank lending to non-financial businesses since 2012 simply went to roll over bad debt, the NPL ratio could be as high as 25% of total loans, or 30% of GDP."

China's real gross domestic product (GDP) was 67,670.8 billion yuan, or around US$10.3 trillion, last year, meaning non-performing loans under the extreme assumption put forward by Lam could top US$3 trillion.

Oof.

"Our estimates based on a static model suggest that Chinese banks in aggregate today will be able to meet the Basel III core Tier-1 capital requirement if the NPL ratio remains below 10%," says Lam.

"But under the extreme scenario, banks will need fresh capital of 8-10 trillion yuan to meet the Basel III target."

A bailout of the banking system by the government, in other words.

Here's Lam on what options are available to the government should non-performing loans hit levels outlined under the severe scenario.

Beijing will likely have to resort to more radical measures. When it recapitalised the banks in the late 1990s, Beijing financed the operation mainly by issuing special government bonds, drawing on FX reserves and offloading bad loans to state-owned asset management companies (AMCs). The government can use these options again. But Beijing cannot afford to indulge in creative accounting this time around.

It would be positive if Bejing lets the bad loans be written off, or lets them to be bought by the AMCs at their market value. The government can then step in and recapitalise the banks afterwards and allow AMCs to behave like proper institutions. US, Swedish and Japanese experience suggests that recognising bad debts, shifting them into some form of ‘bad bank’ and leaving behind transparently solvent banking institutions creates confidence, limits damage, and helps the economy, thereby reducing the eventual losses once the recovery process has been effected. But the pain could be prolonged if Beijing decides once again to sweep the problem under the carpet by letting it sit on the banks balance sheet or, insufficiently written down, on the AMC’s balance sheet.

Lam believes that China should be able to avoid a full-fledged banking crisis, even if the government fully accounts for all bad debts held on the balance sheets of Chinese commercial lenders.

However, she believes that China still has a price to pay for racking up debt as quickly as it has done in the years following the financial crisis.

"Officials have declared their determination to avoid regional or systemic financial risks, but the litmus test is whether they will permit genuine defaults," says Lam.

"On that score, the jury is still out."

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