China has been making 'under appreciated progress' on fixing its banks, but has a long way to go

China’s banking sector has been making unexpected progress towards dealing with its credit problem.

UBS conducted an analysis of 765 banks in China, and found that “contrary to market perception, bank capitalisation and bailouts have begun.” Put simply, China has started bailing out its banks.

UBS estimates that between 2013 and 2015, China’s banking sector disposed of somewhere between 1.65 and 1.8 trillion yuan ($248 to $270 billion) of bad loans and raised 620 billion yuan in capital — what UBS’s Jason Bedford refers to as “underappreciated progress.” But it still needs to dispose of a further 4.5 trillion yuan worth of bad loans, and raise another 2 trillion in capital.

So there’s still a long way to go for China’s banks. And moreover, there’s a disparity in how well banks in different geographical regions are able to raise capital and write off bad loans, which could be concerning.

“We also note that progress across the country was asymmetrical,” Bedford wrote, “with provinces with the weakest economic fundamentals recording the least progress in resolving issues.” So, the economically weakest areas are the ones that could have the hardest time dealing with the problem.

The map below shows the disparity. Red regions are those making the slowest progress — places like Inner Mongolia, which has only recapitalized 7 out of 18 banks, and Heilongjiang, which has only recapped 2 of 10, are some of the worst:

Bedford writes that “credit cycles are unforgiving and the progress of cleaning up the fallout is not easy.” But, he adds, “it’s a process,” and at least the process has started in China.

Another note from UBS released today references Bedford’s research, and remarks on how positive it is that the credit problem in China is increasingly being recognised and dealt with. The bank bailouts also signal some hope for reform in the country, the note says — other countries in the region, like Indonesia and India, with its likely passage of the goods and services tax have been implementing reforms.

However, the note says, this isn’t enough to “turn bullish” on China just yet.

The problem is that credit is still growing aggressively versus the economy, and until that changes, it’s important to be wary.

Bedford also mentions this in his research, saying that “the problem could be growing faster than the solution.” If credit keeps growing at a “two or three times multiple of GDP growth,” then the positive steps being taken could be outpaced by the growth of non-performing loans (NPLs).

According to research from BMI that was released on August 10, China reports that its NPL ratio is approximately 1.8%. But BMI researchers estimate that the true ratio is closer to 20% and could even to as high as 30%. Given how dangerous that situation is, the report says, the likelihood of a government bailout of the banking sector is increasingly likely.

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