China’s debt-shrinking machine loses its magical power

One research group, Gavekal Dragonomics, calls it “the magical debt-shrinking machine”. When the Chinese government first confronted a mountain of non-performing loans (NPL) in the state-owned banking sector, it came up with a seemingly ingenious solution.

Rather than write-off NPLs totalling 1.4 trillion yuan (S$291 billion), or almost 20 per cent of gross domestic product in 1999, specially created asset management companies bought them off the country’s “big four” state banks at full face value, paying with government-backed 10-year bonds.

When the bonds came due in 2009, after a decade of rapid economic growth, the NPLs purchased 10 years earlier were worth less than five per cent of GDP, in theory making them much easier to write off.

As Beijing confronts increasing scepticism about the country’s high debt-to-GDP ratio, the hunt is on for another magical debt-shrinking machine.

There is, however, much evidence to suggest that the first miracle machine only helped China avoid a potential debt crisis 20 years ago by postponing it — to today.

The debate over the government’s debt strategy, or lack thereof, intensified earlier this month with the release of first-quarter economic data.

The data had something for everyone. Chinese officials could point to year-on-year GDP growth of 6.7 per cent that, combined with debt-for-equity swaps and other policy tools, they believe will help them contain debt levels and eventually manage them down to less frightening levels.

Critics, on the other hand, argued that the admittedly respectable growth figure was the inevitable and short-lived by-product of a huge run-up in credit over the first three months of the year.

This is where the performance of the original magical debt-shrinking machine is particularly instructive, by helping to assess whether Beijing has the wherewithal to grapple with complex NPL challenges or is more adept at ignoring them until a crisis erupts.

While the ingenious debt machine initially worked its magic by shrinking the country’s turn of the century NPL stockpile to a manageable level by 2009, this otherwise well-laid plan was disrupted by the global financial crisis.

The last thing Beijing wanted to do as it launched a 4 trillion yuan economic stimulus package to counter the effects of the crisis was recognise the losses on 1.4 trillion yuan of bad loans.

So the bonds with which the asset management companies had purchased the dud loans at full face value were rolled over for another 10 years, delaying the reckoning to 2019.

In three years’ time, the original 1.4 trillion yuan tranche of NPLs absorbed by the asset management companies, and an additional 4.4 trillion yuan they took on by 2010, will have shrunk even further as a percentage of China’s GDP.

So long as China’s state banks have not repeated their past errors and amassed another huge stockpile of dud loans, it should all work out as originally envisioned.

According to China’s banking regulator, that is exactly what has happened.

The China Banking Regulatory Commission puts the sector’s overall problem loan ratio at a manageable 5.5 per cent.

But in its latest Global Financial Stability Report, the International Monetary Fund estimates that more than 15 per cent of overall commercial lending in China is “potentially at risk”, raising the prospect of banking sector losses totalling 4.9 trillion yuan or 7 per cent of GDP.

The inconvenient truth is that China’s overall stock of NPLs may well be far higher.

In 1999, it was relatively easy to assess the fragility of China’s banking sector.

The big four state banks accounted for more than 60 per cent of domestic banking assets — and most of that was plain vanilla commercial lending to state-owned enterprises.

Today, their share is less than 40 per cent, according to Wigram Capital Advisors, compared to 44 per cent held by smaller regional banks. More worryingly, all banks’ assets have swelled to include opaque wealth management products.

“They’re not taking the steps they need to take,” says Wigram’s Rodney Jones.

He adds that Beijing needs to “pre-commit public money, recognise the problems building up in smaller banks and deal proactively with weak institutions” — precisely what the magical debt-shrinking machine failed to do. Financial times

ABOUT THE AUTHOR:

Tom Mitchell is the Financial Times’ Beijing Bureau Chief.