China’s debt molehills could turn into mountains

August 27, 2013

By John Foley

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The mountains are high, and the shareholders are far away. China’s banks are reporting results that suggest their bad debts are under control and earnings healthy. But where investors don’t easily see them, risks are growing. It’s at the local level that the problems with China’s debt build-up could escalate most rapidly.

The six large and mid-sized lenders that had released half-year figures by Aug. 27 reported an average 15 percent increase in earnings. Non-performing loans were, on average, a mere 0.9 percent of the total. Look closer, however, and things are more precarious. Take the export-dependent east coast. China Construction Bank increased its charges against future bad debt in the Yangtze River Delta by 52 percent year on year. China Merchants Bank’s reported bad loans in the area increased by 37 percent, while Shanghai Pudong Development Bank increased its provisions in the three delta provinces by 76 percent.

Some industries are also a greater cause for concern than the headline numbers suggest. In the over-expanding retail sector, bad debts are rising. Pudong Development Bank reported retail and wholesale bad loans increased by 22 percent from the year end, CCB by 19 percent. At China Merchants Bank, the number rose by 48 percent, and at Industrial Bank 50 percent. With so many privately owned companies in retail, there is less chance of local or central government stepping in as it might in, say, shipping or steel.

Diversification protects the big lenders. But even at China’s megabanks, a small problem could still escalate. China’s shadow banking system has spread credit risk to institutions whose finances aren’t visible, like credit guarantee companies. Banks also play pass-the-parcel with debt, repackaging loans into investments such as “trust beneficiary rights”. These instruments, which channel loans through off-balance sheet vehicles but leave banks with the underlying credit exposure, accounted for almost half of new assets accrued by Industrial Bank and Pudong Development Bank in the first half.

Lenders and regulators are aware of the risks. CCB chairman Wang Hongzhang warned of the potential for a “hidden crisis”, even as his own institution showed no change in its bad debt ratio. That contrast shows how unhelpful reported bad debt numbers have become. Bank investors need to watch for the molehills before they turn into mountains.

 

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