Back in 2009, in the midst of the global recession, the Chinese government launched a massive economic stimulus package that bolstered GDP growth by fueling a surge in bank lending.
However, now it is becoming increasingly apparent to policymakers and investors that easy credit, and lopsided policies, have generated significant risk for China’s banking system. Indeed, amid rising concern about banks’ troubled assets, defusing financial risk has become the authorities’ central goal.
According to the China Banking Regulatory Commission, commercial banks’ non-performing loans (NPL) at the end of June totaled 539.5 billion yuan (US$88.1 billion) — nearly 1 percent of outstanding loans. The loan loss reserve-fund balance was 1.5 trillion yuan (up 19 percent from the previous quarter), the provision-coverage ratio was 292.5 percent and the loan ratio was 2.8 percent.
According to the official numbers, NPLs do not actually account for a very high share of total assets, and the NPL ratio (0.96 percent) is manageable. The problem is that most of China’s NPLs are off-balance-sheet loans, so the NPL ratio may be much higher — and China’s financial sector much riskier — than anyone realizes.
In fact, many banks’ off-balance-sheet loans — often extended to higher-risk borrowers, like highly leveraged real-estate developers and local-government financing vehicles — now exceed newly issued balance-sheet loans.
If borrowers default on their off-balance-sheet loans, banks might choose to protect their reputations by covering the difference using internal funds, thereby transferring the risk onto their balance sheets and increasing the NPL ratio.
Banks’ exposure to local-government debt and the real-estate market has already undermined the quality of their assets, increasing debt pressure and weakening profitability.
Moreover, off-balance-sheet lending has helped to fuel over-investment in some sectors, leading to overcapacity and priming the economy for the emergence of bad-debt “disaster zones,” which would increase NPL ratios further. Moves to liberalize interest rates will put even more pressure on asset quality and bank profitability.
Against this background, troubled assets will continue to be converted into liabilities. According to China’s Academy of Social Sciences, the volume of banks’ troubled assets fell from nearly 2.2 trillion yuan in 2000 to 433.6 billion yuan in 2010, while liabilities formed from these dissolved assets grew from 1.4 trillion yuan to 4.2 trillion yuan.
Eliminating banking-sector risk will require decisive government action, including comprehensive financial reform and effective risk-management strategies for financial operations in core sectors.
However, perhaps the biggest challenge will be determining which mechanisms will most efficiently address China’s troubled-asset problem.
China has historically approached broad-scale relief of troubled assets through three channels — capital injections, asset-management companies and the People’s Bank of China — all of which have serious downsides.
During the late-1990s Asian financial crisis, China’s four major state-owned banks, which accounted for more than half of the country’s banking sector, had a capital-adequacy ratio of only 3.7 percent (compared with the international standard of 8 percent) and an NPL ratio of roughly 25 percent. To recapitalize these banks, China’s government issued 270 billion yuan of special treasury bonds in 1998, injecting all of the proceeds into the banks as equity — and, in the process, creating significant financial liabilities.
In 1999, the government decided that four newly established asset-management companies would purchase nearly 1.4 trillion yuan in troubled assets from these banks. To mitigate the risk associated with these debt-funded loan purchases, the bank guaranteed the bonds.
This approach generated substantial risk for the People’s Bank of China. And, although it strengthened the banks’ balance sheets considerably, the asset-management companies had an average troubled-asset-recovery rate of slightly less than 25 percent in 2006, with actual losses close to 1 trillion yuan.
China is not the only country that has struggled with troubled-asset relief. Since the 2008 financial crisis, US financial institutions’ asset write-downs have amounted to 13 percent of GDP.
The administration of former US president George W. Bush’s Troubled Asset Relief Program and the administration of US President Barack Obama’s financial rescue plan cost nearly US$2.2 trillion, with the US Federal Reserve purchasing a massive amount of banks’ assets.
Given the significant flaws in existing troubled-asset-relief channels, another option — securitization — is being discussed in China.
The People’s Bank of China already has called for banks to securitize their high-quality assets and sell the securities to interbank-market investors; that could be a prelude to troubled-asset securitization. By selling troubled assets on the secondary market, commercial banks could strengthen their balance sheets, while avoiding liability increases and enhancing asset liquidity.
However, securitization creates its own challenges, such as how to price the assets. Moreover, once a loan is securitized, the bank that issued it no longer has any incentive to ensure repayment by the borrower, which raises the risk of default and drives up interest rates. Competitive securitization was a leading cause of the US subprime mortgage crisis.
In order to mollify investors in the face of increased default risk, China’s government might force banks to strengthen their balance sheets through collateralization or to swap defaulted loans for new bonds, backed by China’s foreign reserves held in US Treasuries. However, such requirements would lead to even more risk.
A better solution would be to develop the credit-rating market, establish a more comprehensive regulatory framework for the financial system and create an effective mechanism for ring-fencing risk.
Such measures could offer the security and credibility needed to enable the successful securitization of troubled assets, paving the way for China’s leaders to deepen financial reform.
Zhang Monan is a fellow of the China Information Center and China Foundation for International Studies and a researcher at the China Macroeconomic Research Platform.
Copyright: Project Syndicate
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