Chinese banks feeling the heat

Following on from last night’s post on S&P’s recent report on China and commodities, the Royal Bank of Scotland (RBS) yesterday released an interest report (available below) on the precarious position of the Chinese banking system.

Here are some key extracts:

Chinese banks’ aggressive credit expansion in the past two years greatly facilitated China’s strong economic recovery during the global financial crisis. Since the beginning of 2009 until now, total loans at Chinese banks grew by 65%. In other words, close to 40% of their total loans were lent out in the past two and a half years, especially in 2009 when the world was in a financial crisis. China’s financial system is highly leveraged with the ratio of bank loans to GDP already hitting 120%, higher than the peak level of Japan during its financial bubble. This ratio could be even higher if offbalance sheet loans are factored in…

In addition to LGFV loans, loans to the buoyant property sector could also be a concern. These include loans classified as property loans, which are about 20% of Chinese banks’ loan book, as well as loans that were lent out as corporate loans but subsequently channelled into the property sector. Also, some of the LGFV loans possibly went to the property developers as well.

Moreover, off-balance sheet lending has become another issue since 2010 when the government tried to put a brake on lending, especially on loans to the property sector and LGFVs. The rapid growth of off-balance sheet financing, such as entrusted loans, trust loans and bill acceptance, has added more worry to the already questionable balance sheet of Chinese banks…

Given the current situation of their asset quality and capital base, we think that Chinese banks will have difficulty in sustaining their past loan growth. This will have a significant impact on its macro economy because Chinese banking lending, including on-balance sheet and off-balance, has big implications for China’s economic growth. 

People argue that the reliance of the economy on bank lending has declined significantly in recent years, as evidenced by the fact the economy kept growing even after bank loan growth started to come down in 2010. However, we noticed that although bank RMB lending has slowed, other forms of financing have not slowed down…

China’s high economic growth can hide much of the asset quality and capital problems at the banks. However, if growth comes down, the banks will be left facing serious issues. Moreover, with potential asset quality and capital problems, it will be difficult for the banks to keep providing financing to the economy at their current pace over the medium term…

Many may argue that this is not a serious issue because the Chinese government can easily recapitalize the banks just like it did before the big banks had their IPOs. However, we do not think that it will be so easy the second time around. Previously when the government recapitalized the banks, it owned 100% of their shares and therefore there was no question about the government footing the bill for non-performing loans. Now, however, Chinese banks are the largest banks in the world in terms of market cap, and it will not be easy for the government to foot the bill without sharing the burden with shareholders. Moreover, given China’s high loan-to-GDP ratio, cleaning up the banks would be much more costly than before. Finally, the process of re-capitalization would be painful and would likely affect the banks’ role of supporting China’s economic growth in the meantime.