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It is now quite well-known now that non-performing loans in China are surging, and loans at risk of turning non-performing are also on the rise. But we are always suspicious on these figures as they look artificially low. And here is why.
The Chinese banking sector is dominated by state-owned banks, and as we said in our guide to Chinese monetary policy, the most powerful tool in People’s Bank of China toolbox in stimulating credit is not interest rates, nor reserve requirement ratio, but state directed lending, or in some other literature: window guidance. The state may have a defined target of new loans, and may even have specific sectors that they wish the lending to be directed to. In turn, banks will lend because they are told/persuaded/forced to.
Even though the risks in China‘s financial system are surfacing as we and many others have been expecting. For the moment, however, reported NPLs remain quite low. That is because loans to borrowers who are unable to service their debts and/or repay the principals might very well be rolled over to new loans (ever-greening loans), avoiding these loans being classified as non-performing. This has been one of the ways that China used to deal with its banking crisis in the early 2000s, and indeed a report from the Financial Times early this year suggested that this might well be happening again:
China has instructed its banks to embark on a mammoth roll-over of loans to local governments, delaying the country’s reckoning with debts that have clouded its economic prospects.
Since the principal on many of the loans is not repayable, banks have started extending maturities for local governments to avoid a wave of defaults, bankers and analysts familiar with the matter told the Financial Times. One person briefed on the plan said in some cases the maturities would be extended by as much as four years.
With difficult economic environment and massive overcapacity in the economy, however, some of the companies would simply not survive in an environment without government influence in bank lending. That is not China, however. Bank of America Merrill Lynch’s recent note suggested that with government’s focus on growth stabilisation to ensure political and financial stability of the country, banks will be rolling over debt that would otherwise go bad, and banks will be asked to provide support to companies which would otherwise go bust. With this going on, a mass production of “zombies companies” has probably started: With growth stabilisation becoming the top priority of the Chinese government as the economy slows further and further, keeping credit flowing in the economy despite debt deflationary pressure is one of the most important thing, if not the most important. As we said, China’s most powerful tool in controlling credit growth is directed lending (more politely called window guidance), and banks have been told to roll-over debt (as mentioned above) and to lend to local governments financing vehicles (LGFVs) to support growth.
While NPLs should be under control this year for political/financial stability, we are concerned that more “zombie companies” are being made in the economy.
In the recent NPL turmoil, local governments typically required banks “not to withdraw loans”, and some provided liquidity support to distressed borrowers. Such “government support” may help contain bankruptcy, unemployment, and banks’ reported NPLs in the near term, but in our view it does little to help borrowers restore profitability, and may create “zombie companies” with no commercial viability. Government support could result in the transfer of debt burden from corporate to governments/LGFVs.
This is probably not unfamiliar for people who have studied Japan’s lost decade. Indeed, Japanese banks were under government’s influence in the 1990s not to withdraw support for companies which would otherwise go bust as their real estate investment blown up after the bubble burst. As the Chinese government maintains a fair control over credit, it is not at all unimaginable that China may face a similar fate. As BofAML points out:
In 1988, Japan’s corporate sector was highly leveraged with debt/GDP at >100%, while central government debt/GDP was relatively low at ~50%, very similar to China today. After the bubble-burst in the early 1990s, the Japanese government tried to engineer a “soft-landing” of the economy, with the result that leverage shifted from the corporate sector to the government sector over time. Intervention by the government further increased the difficulty for banks to recognise NPLs and foreclose on collateral. Many “zombie companies”, which need constant bailouts in order to operate, were created.
Should the government be committed to rebalance the structure of the economy, however, it is ultimately inevitable that some companies have to go:
In our view, the troubled sectors/borrowers reflected a fundamental issue with China’s growth model, which needs to upgrade from low-cost manufacturing, refocus on the real economy, and explore new growth drivers. To achieve that, we believe it is inevitable to allow the failure of some uncompetitive companies, so as to release the capital and labour to more promising industries.
The problem is that to allow this happen, it could create very negative shock in the near-term. As we pointed out, for example, that the massive investments in real estate in the past few years cannot be sustained, yet because real estate investment contributes to roughly 10% of GDP, failure of large number of players in the real estate industry will be very negative for growth in short-term, especially if you consider the impact of a slowing real estate industry on other industries.
For the sake of maintaining growth, the government can force banks into supporting these real estate companies, for example, so that they can keep building. But creating zombies is not going to help rebalancing the economy.
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