The next big China worry on Wall Street

Over the last few months investors have moved from worry to worry about China’s economy.

The first worry was about China’s real GDP growth numbers.

Then the country’s stock markets crashed in June and August, and Wall Street worried about the government’s handling of that.

With economic indices flashing red, the government then devalued China’s currency.

Now Wall Street is moving on to another worry, the banking system.

Over the last week, S&P, Moody’s and Macquarie have all published warnings about debt and non-performing loans (NPLs) and nonperforming assets on Chinese bank balance sheets.

The basic gist of what they argue is — we don’t know know what we don’t know.

“Bank investors quite rightly have shifted back to the fundamentals, and the main area of investor focus now appears to be back to the trend of asset quality deterioration,” Macquarie wrote in its note.

The problem isn’t just that Chinese banks are carrying a lot of debt. It’s that, because of its large shadow banking system (debt held that does not appear on bank balance sheets) we don’t know how much debt banks are actually holding.

“We won’t pretend that we know for certain what the “true” level of NPLs / NPAs might be. Neither does any other individual, in our view.”

Last Monday, S&P changed its outlook on the Chinese banking system from stable to negative.

“We view economic risks for China’s banking industry as high,” S&P said in a report. Big lending by banks and the country’s informal shadow-banking system between 2009 and 2013 “has led to high risks of economic imbalances and elevated credit risks in the economy,” it said.

Then on Tuesday Moody’s released a report explaining how we know the shadow banking system has been growing over the last few months.

From Bloomberg:

There has been a surge in a balance-sheet item known as receivables, which often includes shadow funding such as trusts and wealth products, said Moody’s Investors Service. Fitch Ratings said it is hard to analyse this escalation in activity. Listed banks excluding the Big Four saw short-term investments and other assets — which include receivables — jump 25 per cent in the first half, compared with total asset growth of 12 per cent, data compiled by Bloomberg show.

Moody’s thinks that, if you add what’s on the books with what’s in the shadow banking sector, China could see NLP ratios hit 10%-12%.

Sanford C. Bernstein & Co. analyst Wei Hou wrote that that would cause a “sizable credit crisis” in other countries.

So yeah, something to worry about.

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