Chinese NPLs: unsafe at any level

Elliot Wilson
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Reported NPLs implausibly low, but low rate not indicative of economic vigour

China’s reticence about reporting realistic levels of non-performing loans in its banking sector is masking deeper-rooted problems and even stifling economic growth, experts have warned.

Beijing spent much of the past decade transforming its banking sector, a process beginning with a series of big bailouts and culminating in a procession of heavy-duty initial public offerings, each bigger than the last. Since the mid-2000s, China’s state banks, once hobbled by soured loans comprising as much as half their entire books, now regularly issue NPL figures that are so low that many find them hard to believe.

In late January, banks in China’s eastern financial capital, Shanghai, issued raw data showing city-wide NPLs of just 0.66%. Lian Ping, chief economist at Bank of Communications, has tipped NPLs at China’s fifth-largest lender to remain stable at just shy of 1% in 2013. The latest nationwide data available from the CBRC, China’s bank regulator, show NPLs remaining flat at 0.95% for the six months ending in September 2012.

China’s state media regularly parade such data alongside national growth figures: GDP is tipped to grow at north of 8% this year.

Others aren’t so sure, arguing that rock-bottom NPL figures are not a natural indicator of broader economic vitality – quite the opposite. "Chinese banks aren’t generating NPLs at a natural growth rate because they are still partial to lending in such a way that they don’t leave much of their lending portfolio exposed to areas of the economy that pose a significant risk of default, particularly privately owned SMEs," says Jason Bedford, senior manager, financial services, at KPMG in Hong Kong.

Non-performing loans RMB billions Source: China Banking Regulatory Commission

Bedford, who authors an influential annual mainland banking survey, uses an analogy with human pathology: that not all bacteria are bad. "Banks are a reflection of an economy’s economic cycle and should have naturally growing NPLs," he says.

The long view of this problem is that China’s overly powerful banks, led by the big four lenders – Industrial and Commercial Bank of China (ICBC), Bank of China (BOC), China Construction Bank (CCB) and Agricultural Bank of China (ABC) – have become dangerously risk-averse. While most lenders worldwide spread lending across multiple sectors, scaling up and down to disburse loans to blue-chip firms and fast-growing enterprises, in China the reverse is true.

Beijing has long favoured the promotion of state-owned enterprises, particularly a small cabal of about 100 centrally controlled big companies. That compels the big four to divert lending into the hands of China’s estimated 110,000 SOEs, leaving private firms, barring a few with global reach, to share the crumbs.

To China’s leaders, it makes sense to control government firms using public money pumped through state-run lenders. Yet that also leads, experts warn, to a dangerous lack of diversification and risk-aversion, wherein Chinese lenders don’t naturally generate NPLs because they aren’t lending to areas of the economy that pose greater risk.

In a normal, competitive banking sector, risk creation occurs naturally. As net interest margins are squeezed, banks are forced to lend to higher-risk entities, pricing loans accordingly. This happens across all but a few financial industries. Even during the peak of the most recent economic cycle in 2007, eurozone banks posted average NPL ratios of 2%, according to Ernst & Young.

Determining what classes as a soured or failed loan in China is difficult, even impossible. Losses and dud loans are regularly rolled over, often for decades. A superficially stringent five-category structure that stratifies problem loans – from the least troubled (classified a "pass") to the most troubled (classified a "loss") – is deemed largely irrelevant. The last three categories are regarded as "non-performing", yet few banks divert loans into these groupings.

Then there is the added complication of the country’s labyrinthine bureaucracy. "Never underestimate [Chinese officials’] ability to use counterintuitive rules to reach a conclusion they happen to like," says a Beijing-based NPL expert. "It is not uncommon for me to find 20-year-old NPLs that haven’t been written off for some obscure administrative reason [such as] the company never paid its taxes."

Occasionally, a Beijing mandarin will go off-message. In June 2012, the state newspaper China Daily published an editorial quoting a CBRC official concerned that NPLs were falling despite a surge in problem loans. Yet such consternation is rare, as Beijing knows that most Chinese citizens would associate a spike in bad loans with a looming economic downturn.

A possible sign of things to come emerged last year in Wenzhou, a coastal city in the southeast synonymous with private enterprises and the grey-market lenders that finance them. When many of those shadowy proto-banks failed last year, NPLs jumped, from 1.36% at end-2011 to 3.43% at end-November 2012. One banking expert in the city puts the real NPL ratio at "around 10%". He describes NPL ratios in Wenzhou, an economy almost entirely based on privately owned small manufacturers, as "more normalized" than anywhere else in the country.

Ultimately, warn experts, the truth will out. One foreign adviser to a leading Chinese asset management company believes the real NPL ratio is "easily 10 times" the current rate "and probably as high as 20% if off-balance-sheet [bad loans are] factored in". The truth is probably somewhere in between.