China’s indebted local governments splash out billions to save struggling small banks

Poor liquidity at China’s regional banks could trigger instability in the state-owned financial system, reduce the credit supply for the real economy, and potentially spill over to a wide range of industries
Last year, the People’s Bank of China identified 366 ‘high-risk’ financial institutions across the country

Banking & finance

Amanda Lee

Published: 10:00am, 30 Sep 2023

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China’s local governments are spending billions – and amassing more debt – to recapitalise the nation’s cash-strapped small banks amid growing default risks facing many regional economies.

American credit rating agency Standard & Poor’s Global Ratings estimated that local governments in China have borrowed a total of 152.3 billion yuan (US$21 billion) so far this year to replenish the balance sheets of small banks in China’s financially weaker regions of Liaoning, Gansu, Inner Mongolia, Henan and Heilongjiang. In 2022, the borrowing totaled 63 billion yuan, the agency said.

China’s regulators have stepped up their supervision of the country’s small lenders over the past few years. The sector, which is supposed to support county- and rural-level economies, has been plagued by poor governance, fraud and weak balance sheets.

Last year, the People’s Bank of China (PBOC) identified 366 “high-risk” financial institutions, including city commercial banks and rural commercial banks, as well as village banks. Poor liquidity at regional banks in China could trigger instability in the state-owned financial system, reduce the credit supply for the real economy, and potentially spill over to a wide range of industries.

“In our view, systemic stability is a priority for the Chinese government. However, local governments may not consider supporting smaller banks through special-purpose bonds if the governments themselves are already heavily indebted or if the banks’ performance won’t see enough improvement to keep up repayments in the future. The central government could still step in with other alternatives when needed, but banks with poor prospects, and which do not threaten financial stability, may still be left to fail,” said Susan Chu, senior director at S&P Global Ratings.

Special-purpose bonds are a form of off-budget debt that local governments use to raise cash for a particular policy, infrastructure project, or to solve a certain problem. In recent years, proceeds from these bonds have also gone toward subsidised housing, ecological conservation and new energy. While these bonds are not considered part of the official budget, the debt they amass has grown significantly every year since 2019.

In 2020, the Ministry of Finance approved a total of 550 billion yuan worth of special-purpose-bond proceeds dedicated to helping small banks. There is an estimated 74.7 billion yuan left in the quota, according to S&P’s estimates.

In 2019, Chinese regulators had to seize control of Baoshang Bank, which went bankrupt a year later. The PBOC also bailed out Jinzhou Bank and Hengfeng Bank in 2019. The central bank has since pledged to reduce the number of “high-risk” financial institutions, and there has been growing consolidation among the small banks promoted by local governments.

“The aim of the consolidation in the small banks is to achieve better risk diversification,” said Nicholas Zhu, senior credit officer at Moody’s Investors Service. “The question remains as to whether that risk diversification is material enough to improve the overall capital adequacy. It certainly helps, but it is likely that after the consolidation they may still need to safeguard their capital base in the future.”

The 550-billion-yuan quota accounted for only around 0.9 per cent of the risk-weighted assets of regional banks at the end of 2022, Zhu estimated. Risk-weighted assets are used to determine the minimum amount of capital that a bank must hold, given their exposure to risks in lending and other assets.

Luo Zhiheng, chief macroeconomic analyst with Yuekai Securities Research, said that local governments’ increasing role in regional economies, including the curbing of risks in the small-bank sector, could exacerbate their financial problems. Many local governments that have relied on land-sale revenue have taken a big hit from the property crisis.

“At this moment in time, local governments have become dependent on special-purpose bonds as a means to make up for the funding deficit,” Luo wrote in Caixin magazine on September 22. “In reality, the proceeds may just be used to fund something that doesn’t derive any economic benefit, or just to pay up salary, as well as other things they are not supposed to use it for.”

Additional reporting by Ji Siqi