China’s banks are still in real trouble

Since China’s four major state-owned banks reported results last week, analysts have been cheering. Profit growth was up and non-performing loan ratios were down. Much has been made about progress in improving underwriting standards. But it would be wise to hold off on the euphoric pronouncements — and to take a closer look at how the banks produced these results.
Most important, there’s little sign of deleveraging. Those banks increased total loans by 10.2 percent in 2016, to $12 trillion. That means lending is still growing much faster than gross domestic product. More worrying, shadow-banking assets — such as wealth-management products — increased by 15 percent, significantly faster than loan growth. The two sectors increasingly seem linked, suggesting that shadow-banking problems may yet become traditional-banking problems. So far, pledges to deleverage have remained just that: pledges.
Further, the two positive trends that analysts identified — a drop in non-performing loans and an increase in profits — are undermined by the underlying data.
Non-performing loan ratios fell slightly at two of the big four banks and showed slower growth at the other two. But even that meager progress resulted partly because banks — with the government’s encouragement — set up special-purpose vehicles dedicated to raising capital, including by issuing securitized bonds to buy up bad loans from their parent corporations. Agricultural Bank of China Ltd (BOC). reported disposing of 73 billion yuan in loans this way. That’s an extremely troubling trend, as banks appear to be obscuring rather than resolving their debt problems. And even so, total non-performing loans dropped by only two one-hundredths of a percentage point.
Making matters worse, the banks are setting aside less capital to cover bad loans. Capital reserves to cover NPLs grew at only 5.4 percent for the big four, and most of that was driven by Bank of China Ltd., the best-run and most prudent of the bunch. Excluding BOC, reserves grew by only 2.6 percent, well slower than growth in traditional loans and 82 percent slower than growth in the most risky type of loans in wealth-management products. This directly affected reported profits. Excluding a 50 percent increase in NPL costs at Bank of China, the cost to cover bad loans at the big banks was up just 1 percent. In other words, they’re boosting profits by setting aside less capital. If (again excluding Bank of China) they had increased reserve capital at the same rate they increased lending, profits would’ve actually shrunk by almost 2 percent.
The modest increase in profits also reflected a large decrease in taxes and surcharges. The major banks reported that the amount they paid to the government had decreased by between 52 percent and 63 percent. This primarily reflected tax subsidies offered to buy distressed local-government bonds under a swap program: In essence, the central government mandated interest rates well below the market level, but made up for it with a tax subsidy. To put that in perspective, the decrease in taxes was equal to 612 percent of the increase in profits.
China’s government has talked at length about deleveraging, controlling shadow banking, managing financial risks and applying market solutions. But the banks are doing just the opposite. New lending continues to grow faster than GDP. Investors are still piling into risky wealth-management products. And the banks are boosting profits by setting aside less capital to cover bad loans and relying on subsidies. Profit growth may make analysts smile, but this isn’t a sustainable plan for China’s banks or its economy.
By and large, the banks understand this, and typically blame regulatory guidance that encourages incremental profit growth. Because the government is the primary shareholder at the big banks, it has less interest in clamping down on poor risk management and more in ensuring continued dividend payments, which it uses to fund infrastructure projects that in turn prop up economic growth. It’s a perfect feedback loop of moral hazard.
China’s leaders continue to talk about reducing financial risks. But if they want to tackle these problems effectively, they need to significantly slow loan growth and prudently reduce bank purchases of wealth-management products. They also should end the practice of boosting paper profits by refusing to set aside capital to cover bad loans. And they shouldn’t get too excited about the meager progress the banks have just reported.
— Bloomberg

Christopher Balding is an associate professor of business and economics at the HSBC Business School in Shenzhen and author
of “Sovereign Wealth Funds: The New
Intersection of Money and Power”