NPLs: China’s trillion renminbi problem

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Non-performing loans will haunt the People’s Republic in 2009.

The global financial crisis might exacerbate an Rmb1 trillion ($540 billion) problem that China will have to deal with next year. That is the approximate total of the non-performing loan portfolios held by the four state-backed asset management companies set up in 1999 to hive off bad assets from the big four Chinese banks. The four firms, Cinda, Huarong, China Orient and Great Wall, were created to take on the non-performing loans of banks and are due to wind up by the end of 2009.

Now the Chinese authorities are contemplating how to digest the NPLs held by these four companies that have not been resolved, at a time when the banking system faces a new wave of bad loans.

The four companies are funded by borrowing from the People’s Bank of China and by issuing bonds that pay 2.25%.

What options are open to China once that deadline approaches? The government could simply set up a new vehicle for the bad loans held by the four asset management companies and postpone dealing with the problem. It could also require the People’s Bank of China to digest the problem, perhaps aided by the commercial banks, which will have to give up hopes of recovering the money they invested in the four companies’ bonds. Whichever route is chosen the digestion will not be painless, and there ought to be lessons for regulators and bankers in the west as troubled financial institutions there form or consider forming similar bad banks to hive off underperforming assets.

This solution has attracted much support for providing a quick means of cleaning up the balance sheets of financial institutions and restoring their credibility. The problem, as China’s experience has shown, is that the resulting vehicles will find it difficult to generate returns in excess of their cost of funding.

The result may be a problem deferred rather than a problem solved. China’s example demonstrates that there is no guarantee that conditions, say, 10 years after the formation of a bad bank will be better than they are on the day they are formed. In the case of the four asset management companies they are substantially worse, and if the rate of nonperforming loan growth accelerates rapidly in 2009 these four companies will be attempting to close at an extremely difficult time.