China is ready for any banking crisis that may come
Frank Newman and Dan Newman say those who warn of a collapse of China’s banking system due to bad loans overlook the risk-management tools at the government’s disposal, and its willingness to use them
Recent articles warn that China will soon face a banking crisis. Bad debt will cause Chinese banks to tumble, they say, with shock felt throughout the world. But these predictions misjudge the capacity of the Chinese government.
Looming trouble doesn’t show in official data: non-performing loans comprise just 1.75 per cent of reported loans, a reasonable figure by international standards. Analysts worry the figures understate the problem, but Chinese banks have already taken precautions. Their loan-loss provisions are currently about 200 per cent of their non-performing loans; in the rest of the world, 100 per cent is considered solid protection. Even if such loans were to double, China is ready.
Still, there is concern the shocks may deepen. Some analysts believe that “special mention” loans may become uncollectible, and estimates of non-performing loans rise to nearly six times the current reported level.
Such reports often imply that all problem loans will become complete losses, which would be far from historical patterns. Non-performing loans are grouped into three categories – substandard, doubtful, and loss – and many problem loans, especially those classed as special mention and substandard, have been collected over time. Especially in a growing economy, some troubled companies recover, property values increase, and hidden assets are discovered, all leading to recoveries of at least portions of loans that had been troubled or even written off.
But what if the situation turns much worse? The central government has the ability to prevent problems from becoming systemic, by absorbing a portion of the loan risk. In 1999 and 2000, it assumed non-performing loans from the largest banks, using government bonds and newly created asset management companies. The programme worked extremely well, and the banks then supported the rapidly growing economy. Now, after years of economic growth, those bonds are insignificant in China’s overall financial system.
In such a new plan, the central government could essentially say: “The banking system supports the growth of the Chinese economy, and now we have decided that the government will cover a portion of the risk taken in providing such support. Western countries used direct government funding to counter their financial crises, and we will now step in, in a way appropriate to China, to assure stability.”
In this illustrative programme, each bank could exchange up to 10 per cent of its loan portfolio, at a 10 per cent discount, for government bonds. The bonds would be tradeable, with market rates and a maturity of approximately 10 years. The programme might be called “The 3 Tens”: 10 per cent of loans, 10 per cent discount, 10-year bonds. Each bank could select the loans it wished to exchange, but would bear 10 per cent loss, containing the “moral hazard” that could be involved if lenders make loans expecting the government to assume all the risk. The government would place the non-performing loans from the banks with asset management companies, which work to collect as much as possible.
It would be quite manageable financially. Even a nearly sixfold increase in non-performing loans would put about 10 trillion yuan (HK$11.8 trillion) at risk. After the 10 per cent discount, it would mean approximately 9 trillion yuan of government bonds placed with the banks in exchange for the loans.
Since China’s financial system has approximately 150 trillion yuan of total financial assets, of which approximately 100 trillion yuan are forms of bank loans, the new bonds would amount to about 6 per cent of total financial assets. Total financial assets in China may well grow about 12 per cent annually, and in 10 years will be three times the current level. So, 9 trillion yuan of bonds maturing after 10 years would amount to just 2 per cent of total financial assets. Interest rates on 10-year government bonds are running at about 3 per cent, so annual interest payments would amount to less than two-tenths of 1 per cent of total financial assets.
In this example, the cost to the banking system might be about 500 billion yuan, net of existing provisions. That amounts to about 3 per cent of the banking system’s equity, easily replenished with a few months’ earnings once the banks were operating without the drag of the non-performing loans.
While the financing by the government would be a small portion of the overall financial system, the real economy would benefit greatly from avoiding a financial crisis and ensuring a stable, healthy banking system.
Of course, this is just an example, and a programme to stabilise the banking system, if ever needed, could have many variations. Some loans will be collected, and variations of the programme could be introduced to reduce net financing. The entire programme could be done without government bonds, by the central bank crediting the reserve accounts of banks for the 9 trillion yuan.
Contrary to common misconceptions about quantitative easing, such reserves, which are the fundamental form of liquidity for banks, cannot be lent to companies or individuals; reserves can be used only for transactions between banks and the central bank.
In addition, the government should encourage the banks to improve credit policies and procedures, to better allocate credit to productive uses. Also, as further funding continues to be appropriate for infrastructure benefiting the economy and society – such as environmental improvements, urban transport, and water systems – the central government could fund them directly, as is often done in many other countries.
It is unlikely that a programme such as The 3 Tens will be necessary. Smaller steps, such as the central government taking over some obligations regarding local government activities, will help ease current troubles. Economic growth helps significantly, and the government can do its part in supporting useful infrastructure programmes and growth of productivity. But even if its banking system were to face substantial problems, China could cope very effectively.
Frank Newman is chairman of Promontory Financial Group – China, a former deputy secretary of the US Treasury, and former chief executive and chief financial officer of major banks in the US and China. Dan Newman is an economics researcher and writer