China's ballooning debt: Is it time to address it?

While financial stability has been identified by the Chinese leadership as one of the top priorities for 2017, there is a rising concern lately about the health of China’s banking system, which is facing increasing pressure of bad debts. The real problem, however, lies in the slowdown of the Chinese economy itself and the inherent structural issues of China’s banking system.

As shown above, China still relies heavily on fixed investment, which rose to 80% of GDP by 2016. Yet the marginal return on investment has been steadily declining, as the total value of investment shot up while GDP growth rates dropped. Easy access to bank loans, especially for state-owned enterprises (SOEs), is partly to blame for the overinvestment. As a consequence, many of the investments aggravated the overcapacities in heavy industry and extractive sectors, contributing to the build-up of bad debts of the banks.

Due to underdevelopment of China’s financial market, bank loans accounted for 69.9% of China’s total financing for the real economy in 2016, and bond and capital markets only provided 16.8% and 7% of financing respectively, according to China Banking Regulatory Commission (CBRC).

In 2016, bank loans jumped 13.5% year-on-year to RMB 12.65 trillion, which is more than RMB 925.7 billion compared to the previous year. Two-thirds of the loans were extended to SOEs, which are known for their low efficiency and poor investment returns. Some are deemed as the “zombie enterprises” that rely on state support to stay afloat.

Chinese banks are well exposed to the non-performing loans (NPLs), the percentage of a bank's loans that is unlikely to be repaid. According to CBRC, the NPLs of major commercial banks rose to 1.74% by the end of 2016, with the balance of NPLs reaching RMB 1.51 trillion. This marked the 22nd consecutive quarterly growth of NPLs since the third quarter of 2011.

The Chinese level of NPL rates of 1.74% appears to be low, compared with the average rate of 2.7% for 30 global system banks in 2016. However, behind the gap lies the differences between international and Chinese accounting standards. While the international accounting system would classify a loan as NPL if the borrower has a repayment delay of more than 90 days or if the borrower is facing serious difficulties, the Chinese accounting standards distinguish two broad categories of “loan at risk”: (i) the non-performing loan (NPL) and (ii) the special mention loan. When the value of a collateral is sufficient to permit the repayment of a risky loan, the loan will most likely be classified as special mention loan instead of NPL under the Chinese accounting standards.

As the CBRC data has suggested, special mention loans rose more rapidly, climbing to RMB 3.35 trillion by the end of 2016, accounting for 3.87% of total loans, compared to 2.5% in 2014 when such category of loan were first accounted for by the CBRC. If both NPLs and special mention loans are taken into account, China’s bad debt levels will be much higher (see Figure 2).

Amid rising concerns, the Chinese government has remained adamant that there is no imminent systemic financial crisis. According to Mr. Yang Kaisheng, Special Advisor of the CBRC, at a press conference on 6 March 2017, China’s NPL rate remained low by international standards. Meanwhile, loan provisioning rates for big commercial banks remained above 70% and profits of commercial banks exceeded RMB 2 trillion. Coupled with over RMB 10 trillion of capital in cash, China is well-equipped to deal with any potential risks.

Yet the real level of bad debt in China might be much higher than the official figures, according to some international rating agencies.  NPL rates may have already been as high as 15%-21% for the financial system. If that was true, it would mean that if all these were written off, it would wipe out Chinese banks’ capital base.

Rising bad loans were also the main worry for the Chinese bankers last year, according to the Chinese Bankers Survey Report for 2016, which was published by the China Banking Association and PwC in February 2017.  According to the survey, up to 89.6% of interviewed bankers held that currently, the biggest challenge facing China’s banking sector is the increasing difficulty of risk control amid deteriorating asset quality. The respondents generally believed the ratio of NPLs of Chinese banks has not peaked, and more than 60% of them said the NPL ratio of their banks will exceed 1% in the next three years.

So, no matter how to measure it, China’s NPLs are far from reassuring. The scale of China’s total debt has risen from 164% of GDP in 2008 to 260% of GDP by the end of 2016, according to Bloomberg. While the government and households played a minor role, the lion’s share were corporate debts, and two-thirds of the debts came from SOEs.

Yet this is unlikely to lead to a financial crisis. It needs to be recognised that most of China’s debts are domestic in nature, with limited international debt, and the Chinese government has significant fiscal buffer and a lot of resources to keep things under control. Meanwhile, the Chinese economy still keeps growing, albeit at a slower rate. Many NPLs could be diluted and resolved along with economic expansions.

Going forward, China needs to properly handle the rapid growth of bank credit and the poor quality of many bank assets. To do this, it has to ensure that financial resources are allocated to productive forces in the market, regardless of the ownership of the enterprises. At the same time, the Chinese banks will need to step up their efforts to address the rising debt, including increasing screening and scrutiny before extending new loans, strengthening post-loan risk management, exploring new market-oriented and innovative methods such as transfer of bad assets, securitisation of bad assets, debt-equity swap, and credit default swap (CDS) to handle NPL problem.

The ongoing supply-side structural reforms provides clear guidance for this change. Excessive production capacities, especially from SOEs, will be shed off and the “zombie enterprises” be closed down, while corporate leverage ratios will be held at a much lower level. Once these jobs have been done, the Chinese banks will hopefully return to a good shape with less NPL risks.

In the meantime, the Chinese government should encourage more direct financing, such as the bond and capital markets, and reduce corporates’ reliance on bank loans.

Contact us

Frank Lyn

China and Hong Kong Markets Leader, PwC Hong Kong

Tel: +[86] (10) 6533 2388

Elton Huang

China Central Markets Leader and China and Hong Kong Entrepreneurial and Private Business Co-Leader, PwC Hong Kong

Tel: +[86] (21) 2323 3029

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