Chinese Debt Issues Lurking in the Shadows

As if the mounting pile of failed loans to local governments isn’t enough of a concern on its own, The Diplomat’s Minxin Pei writes that the hidden debt – the product of off-balance sheet “shadow lending” – may be the biggest risk to China’s financial system:

[…] Because of very low-yield for savings by Chinese banks (since deposit rates are regulated) and competition among banks for deposits and new fee-generating businesses, 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. According to Charlene Chu, a highly respected banking analyst for Fitch ratings, China had about 10.4 trillion yuan in wealth management products, about 11.5 percent of the total bank deposits, at the end of June this year.

Since borrowers that use funds provided by wealth management products tend to be private entrepreneurs and real estate developers denied access to the official banking system, they have to promise a higher rate of return. Obviously, higher return also means higher risks. 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. For the banking sector as a whole, non-performing loans amount to only 1 percent of total outstanding credit.

Despite the concerns of China analysts such as Pei, the state-run Global Times reports that a debt crisis isn’t imminent:

China’s net sovereign assets amounted to 70 trillion yuan ($11.06 trillion) in 2010, and there is little possibility that the country will encounter a sovereign debt crisis in the long-term period, a senior government adviser said over the weekend.

The figure is a response to increasing international suspicions on China’s sovereign debt situation, Li Yang, vice president of the Chinese Academy of Social Sciences (CASS), said at a seminar on China’s sovereign balance sheet held Saturday in Beijing.

China’s net sovereign assets, calculated as the country’s sovereign assets minus liabilities, continued to increase between 2000 and 2010, which means the country has the ability to pay off its debt, Li said.

But he did not provide the amount of China’s sovereign debt.

See also previous CDT coverage of China’s shadow lending system.

September 11, 2012 2:34 AM
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Categories: Economy