China must resolve its bad loans, not disguise them

Ted Osborn warns of a Japanese-style lost decade if problem is put off

PUBLISHED : Monday, 05 May, 2014, 7:11pm
UPDATED : Tuesday, 06 May, 2014, 1:46am

Everyone knows China has a bad debt problem. Since 2008, trillions of yuan of new loans have been pumped into the economy via the banks and a good chunk of it is expected to go bad.

For the most part, few are predicting a Lehman-style banking crisis on the horizon. This is because Beijing has a track record of keeping a lid on things. Usually, at the first sign of trouble, authorities step in and ensure creditors are paid.

There are exceptions. Recently, the authorities allowed Shanghai Chaori Solar Energy Science & Technology to default on its domestic bonds, the first ever domestic bond default in China. More recently, the China Securities Regulatory Commission announced that another issuer, Xuzhou Zhongsen Tonghao New Board, had failed to make an interest payment when scheduled and may be heading for bankruptcy.

In reality, such failures are isolated. Beijing is not about to allow banking or bond defaults to occur on a massive scale, particularly after witnessing what happened to Western banks during the global financial crisis. So they allow a few defaults to occur to keep banks and bondholders on their toes.

However, while banks in China are working to resolve some non-performing loans, they do not have the capacity to resolve them all. Instead, banks are working to keep these loans at a level that is acceptable to the regulators. Right now, it is around 1 per cent of total loans.

There are many ways for banks to manage this ratio in China. The easiest way is to roll over a suspect loan for another year. "Extend and pretend" was the preferred method of many US and European financial institutions between 2008 and 2010 and was perfected by the Japanese in the 1990s.

Another method is to remove non-performing loans from their books entirely by selling them to one of the big four state-owned asset management companies. Bad loans are being sold to these companies, but not in big quantities. Banks are reluctant to sell such loans to the asset management companies if it will lead to their taking a loss, so they price them near book value. At this level, the asset management companies can't make much profit, so few deals get done.

A more novel approach has emerged in which asset management companies make a new loan to the bank's non-performing loan customer, essentially taking over the bank's exposure. The asset management companies are happy to do this because the bank will often lend them the funds to do so. They can also charge the debtor a much higher interest rate than the bank.

On the surface, deals like this look good. The bank gets to remove a problem loan from its books and in the process usually makes a profit. And, by taking the bad loan off the bank's hands, the asset management company has done what it was set up to do, and also gets to start booking some good interest income.

But, in reality, nothing has changed. Unless something transformative occurs, the debtor will still have difficulty repaying the loan when it matures. It is still a non-performing loan, but it is now disguised as a performing loan on the asset management company's books. That could mean a big problem for the company down the road, and, potentially, the originating bank. It's really nothing more than playing musical chairs with loans, with no real benefit to the Chinese financial system.

This game cannot continue indefinitely. Sooner or later, these non-performing loans must get resolved or China will face a Japanese-style lost decade. The authorities understand this but are hesitant to force banks to tackle the problem, largely in fear that such actions would destabilise a slowing economy under reform. Only time will tell if the nation's banks will still be standing strong when the music stops.

Ted Osborn is a partner at PricewaterhouseCoopers Hong Kong/China