China’s mind-boggling hidden debt problem

The Diplomat says that China’s lending spree was much greater than the $1.7 trillion previously reported and that bad debts could dwarf the existing capital in the banking system:

From the beginning of 2009 to the end of June this year, Chinese banks have issued roughly 35 trillion yuan ($5.4 trillion) in new loans, equal to 73 percent of China’s GDP in 2011. About two-thirds of these loans were made in 2009 and 2010…China’s colossal stimulus package of 2009 was funded mainly by bank credit (at least 60 percent, to be exact), not government borrowing….

local governments had taken advantage of loose credit to amass a mountain of debt, most of it squandered…local government debt totaled 10.7 trillion yuan (U.S. $1.7 trillion) at the end of 2010…the real amount of local government debt was between 15.4 and 20.1 trillion yuan, or between 40 and 50% of China‚Äôs GDP…local government financing vehicles (LGFVs), which are financial entities established by local governments to invest in infrastructure and other projects, owed between 9.7 and 14.4 trillion yuan at the end of 2010…

Chinese LGFVs are known mainly for their unique ability to sink perfectly good money into bottomless holes in the ground…If 10 percent of these loans turn bad, a very conservative estimate, we are talking about total bad loans in the range of 1 to 1.4 trillion yuan. If the share of dud loans should reach 20 percent, a far more likely scenario, Chinese banks would have to write down 2 to 2.8 trillion yuan, a move sure to destroy their balance sheets…

the potential risk for a financial tsunami is greatest in China’s shadow banking system…a complex, unregulated shadow banking system has emerged and grown significantly in China in the last few years. Typically, the shadow banking system pushes something called “wealth management products,” which are short-term financial products yielding a much higher rate than bank deposits for investors. To evade regulatory oversight, these products do not appear on a bank’s balance sheet…China had about 10.4 trillion yuan in wealth management products, about 11.5 percent of the total bank deposits…Although it is impossible to estimate the percentage of non-performing loans extended through wealth management products, using a conservative 10 percent baseline would mean another 1 trillion yuan in potential bank losses.

The shadow banking system has another function: channeling funds to borrowers or activities explicitly banned by government regulation. In the last two years, the Chinese State Council has tried to deflate the real estate bubble by limiting bank loans to real estate developers. But banks can skirt such restrictions by ostensibly lending to each other, with the funds ultimately going to financially stretched real estate developers. Chinese banks do this out of their own survival instinct. If they do not lend to effectively delinquent real estate developers who have borrowed large amounts, they would have to declare these loans non-performing and suffer losses. On the balance sheets of Chinese banks, such loans are technically classified as claims on other financial institutions. According to a recent report in the Wall Street Journal, inter-bank loans today account for 43 percent of total outstanding loans, 70 percent higher than at the end of 2009.

Disturbingly, none of these huge risks are reflected in the financial statements of Chinese banks. The largest state-owned banks have all recently reported solid earnings, high capital ratios, and negligible non-performing loans.

If bad loans are 20% of total loans, “Chinese banks would have to write down 2 to 2.8 trillion yuan, a move sure to destroy their balance sheets.” Total loan loss reserves at Chinese banks are 1.2 trillion RMB, so the balance shhets would be decimated. Half a decade ago, China had some of the same problems, but robust growth made things easier to deal with. That’s unlikely to be the case this time.

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