Chinese Banks' Bad Loan Nightmare

China's credit risk is probably much worse than the official non-performing loan (NPL) data suggests, according to Société Générale's China macro strategist, Wei Yao.

"We do not anticipate an outright banking crisis as the government will certainly keep intervening at each turn on the way to avoid such an outcome, however, this is no reason to feel relieved," Yao wrote in a note to clients. "While we do not anticipate an imminent hard landing, the landing will nevertheless be multi-year and bumpy in our view."

Economic growth in China this year is forecast to slide to its lowest rate since 1999, stoking fears of losses from bad loans as struggling companies and local governments delay or stop repayments.

Many of the problem loans Chinese banks face stem from a state-directed lending spree in the wake of the global financial crisis in 2008.

The lending binge has left banks overexposed to local governments and property-related ventures.

Last year, Beijing said local governments had piled up 10.7 trillion yuan ($1.7 trillion) in debt, or the equivalent of 25 percent of China's annual economic output.

Reported rates of Chinese banks' bad loans are still low, running at 0.9 percent of all bank loans at the end of the second quarter, according to the China Banking Regulatory Commission.

However, that's the third straight quarter of rising bad loans and the longest streak of deterioration in eight years.

Non-performing loans rose by 18.2 billion yuan in the three months ended June 30 to 456.4 billion yuan. Bad loans surged at all types of banking institutions, including the largest state-owned lenders, rural banks and foreign banks.

Moreover, many suspect that banks are slow to categorize questionable loans and others go unreported.

Bank of China (HKG: 3988), the country's No. 4 lender and the first to release earnings, set a worrisome tone for the rest of the "Big Four."

While non-performing loans fell to 0.94 percent at the end of June, from 0.97 percent at the end of March, overdue loans grew by 17 percent in the first six months of year, suggesting that more loans may turn bad in the near future.

Agricultural Bank Of China Limited (HKG: 1288), the country's No. 3 lender, said Wednesday its non-performing loan ratio stood at 1.39 percent at the end of June, down from the 1.44 percent it reported at the end of March.

China Construction Bank Corporation (HKG: 0939) warned Sunday that the bank is facing rising levels of overdue loans, despite a decline in bad loans.

The country's No. 2 lender by assets said its bad-loan ratio fell to 1 percent as of June 30 from 1.09 percent at the end of last year, but loans overdue soared 60 percent from the end of last year.

Overdue loans in the Yangtze River Delta region -- including Jiangsu and Zhejiang provinces and Shanghai -- accounted for more than 50 percent of the increase, while sectors such as wholesale and retail manufacturing were responsible for 65 percent of the overdue loans, CCB Vice President Zuofu Chen said at a media briefing in Beijing.

Zhejiang probably boasts the most risk-loving group of enterprises and the most active underground banking in China. Since the third quarter of 2011, the underground system has been imploding due to the severe liquidity crunch and the deceleration in growth.

Concern over CCB's asset quality has been rising after media reports that 17 of the 47 business owners who disappeared last year to escape loan repayments were CCB clients, and a 3-billion-yuan loan to Zhejiang Zhongjiang Holding Co Ltd was at risk as that company filed for bankruptcy.

Chen confirmed that the bank has lent Zhongjiang 3 billion yuan, but added that CCB has set aside sufficient provisions against it.

Industrial and Commercial Bank of China (HKG: 1398), also a member of China's "Big Four" state-owned banks, is scheduled to report earnings and problem loans on Friday.

The number of companies in default or with severe cash flow problems has surged since the second quarter, according to Societe Generale's Yao.

The economic slowdown does not seem to be the only cause, and, in many cases, not even the major one. The common mistakes include involvement in speculative activities (e.g. property speculation or commodity trading) massive capacity expansion (e.g. shipbuilding and solar panel manufacturing), outsized commitments to complicated webs of mutual loan guarantees and high exposure to underground banking, according to Yao.

This table from Yao shows a selection of high-profile non-performing loan cases in the past three months. And the footnote points out that all of the top 10 Chinese solar panel makers have liquidity problems:

Source: Société Générale’s China macro strategist Wei Yao.

It's Far From Over

The history of banking crises suggests there is no definitive linear correlation between the peak of non-performing loan ratios and the scale of the pre-crisis credit boom, as it also depends on how the situation is contained and resolved.

In the sample of 42 crisis episodes complied by Laeven and Valencia (2008), average annual credit growth to GDP prior to the crisis was about 8.3 percent. Between 2009 and 2010, this same ratio for China reached 27.8 percent and 20 percent, respectively.

"It is hard to see how China's NPL ratio could stay at the current level," Yao said.

Source: Société Générale’s China macro strategist Wei Yao?

The exact trajectory and the end point of the bad loan issue are difficult to predict. Economies with less government intervention, such as the U.S., usually see non-performing loans peaking one or two quarters after growth troughs.

In contrast, Japan was very slow in recognizing and resolving its non-performing loan problem -- a problem which started in the early 1990s. The NPL ratio didn't peak until 2002, and much damage was done in the meantime to the banking system and indeed to the overall economy.

The chart below from Bank of America Merrill Lynch shows what happened to Japanese banks' NPLs in the years after the country's real estate bubble peaked. For a while, NPLs and NPL ratios stayed low until when banks couldn't hide them any longer, perhaps.

Source: Bank of America Merrill Lynch.

The next chart illustrates just how long it took for Japanese banks to recognize their losses.

Source: Bank of America Merrill Lynch.

"China, where the government is even more involved in the economy, is running a clear risk of a prolonged NPL cycle," Yao said. "Local governments have poured millions of capital into rescuing failing corporates."

Initially, the intention was just to support local growth, as the troubled corporates were once local champions. More recently, local governments intervened to avoid domino defaults when dozens of corporates were trapped in one big network of mutual loan guarantees.

It is estimated that the fact that 60 percent of recent defaults occurred in Zhejiang has something to do with the loan-guarantee structure in which a corporate pledges to repay overdue loans for another.

Chinese government can pretty much "force" banks into rolling over debts by avoiding them being classified as bad debts, and to "force" banks into lending more to "stabilize growth" and to kick the can way further down the road, and pray that things will recover soon.

"If China continues to prefer gradualism for fear of an imminent banking crisis, the explicit NPL ratio may not rise much above 2 percent in 2013," Yao said.

However, the fiscal cost will only be higher the longer the process drags on. And a bigger concern is that more resources may be locked in these non-performing assets.