An investor looks at an electronic board showing stock information at a brokerage house in Shanghai on March 16, 2017. (Johannes Eisele/AFP/Getty Images)An investor looks at an electronic board showing stock information at a brokerage house in Shanghai on March 16, 2017. (Johannes Eisele/AFP/Getty Images)

China’s new impetus to rein in its financial sector has been underway for more than three months. The effects are already being felt in the financial markets, impacting short-term borrowing rates and the global commodities market.

In late February, Guo Shuqing was appointed the new chairman of the China Banking Regulatory Commission (CBRC), China’s main banking regulator. Barely a month into his role, Guo issued a flurry of directives described by state-controlled Xinhua as a “strong supervisory storm.”

Guo, 60, is widely seen as a tough regulator willing to challenge financial heavyweights. His predecessor, Shang Fulin, was focused more on maintaining order and stability and did little to assert control over the financial sector, which has grown fat on China’s debt binge in recent years.

The CBRC’s new directives arrive as Chinese Communist Party leader Xi Jinping shifts his anti-corruption focus to the financial sector. Last month, Xiang Junbo, former head of the China Insurance Regulatory Commission, was put under investigation. Sources close to Zhongnanhai—the headquarters of the Communist Party and the State Council—told The Epoch Times last month that there could be further housecleaning within China’s financial industry this year.

Several of the new policy directives from the CBRC aim to deleverage the country’s banking sector. Two main goals are to reduce shadow banking—an umbrella term used to describe various high-yield products sold by banks, insurance companies, and other financial institutions—and to tighten credit.

Shadow Banking Targeted

Shadow banking and other off-balance-sheet credit activities fueled much of China’s recent debt growth, especially by regional and local banks. The biggest type of shadow banking is the sale of wealth management products, which are issued by non-bank entities such as trusts, investment vehicles, or insurance companies but often sold by banks.


Ratio of asset management products to total bank assets by type. (Source: Moody’s Investors Service)

Such products, which circumvent typical lending rules and do not sit on bank balance sheets, have been a critical income source for banks, and often represent the only avenue of financing available for small businesses, local agencies, and ventures that cannot qualify for loans from big state-owned banks.

Off-balance sheet wealth management products totaled 26 trillion yuan ($3.8 trillion) at the end of 2016, an increase of 30 percent from the previous year, according to data from the People’s Bank of China, China’s central bank.

In early February, China unveiled the first coordinated approach to regulate shadow banking. The People’s Bank, the CBRC, and regulators of the insurance and securities industries drafted a joint regulatory framework to tighten supervision of all investment products sold to retail and institutional investors.

Off-balance sheet wealth management products totaled $3.8 trillion at the end of 2016.

This coordination is significant as “previous efforts to regulate the asset management industry have emanated from individual regulators and created opportunities for regulatory arbitrage,” said Moody’s Investors Service, in a Feb. 27 note. In other words, China’s fragmented regulatory framework often allowed banks to sell wealth management products that fall under the jurisdiction of a different regulator—with lower standards—than their underlying assets.

Guo Shuqing, Chairman of the China Banking Regulatory Commission, answers media questions in Beijing on March 8, 2015. (Feng Li/Getty Images)

Guo Shuqing, Chairman of the China Banking Regulatory Commission, answers media questions in Beijing on March 8, 2015. (Feng Li/Getty Images)

A few of the tools introduced by regulators this year include barring the sale of wealth management products derived from non-standard assets other than stocks, bond, and money-market securities and applying a leverage limit across asset classes. One way banks had to boost the interest on wealth management products was to borrow money, and this risky practice will now be curbed.

Short-Term Liquidity Squeeze

Regulators are also targeting the loosely regulated interbank market that allows banks to lend to each other.

The People’s Bank is achieving this by reducing the amount of liquidity available to banks. After skipping open market operations—where the central bank buys or sells government securities—on May 2, it did not renew the 230 billion yuan lending facility, which matured on May 3. Overall, the People’s Bank injected a net 10 billion yuan ($1.5 billion) into the market, a minuscule amount compared to past weeks.

The recent tightening moves have pushed up short-term borrowing rates. The overnight Shanghai Interbank Offered Rate (Shibor) reached 2.83 percent, while the seven-day Shibor reached 2.92 percent on May 5. Those were the highest rates since April 2015.

“We expect liquidity to remain volatile and financial deleveraging to continue, with more ‘mini hikes’ in market rates and tighter new regulations,” wrote Deutsche Bank, in a March note.



Recent Shibor trends reflect tightening of credit (Source: Nomura Securities)

Slowing Economic Growth

The higher funding costs could have real-world economic implications, such as lower availability of credit for businesses and, ultimately, slower GDP growth.

But it’s likely that the official 6.9 percent GDP growth in the first quarter—above most economic forecasts—has given regulators room to curtail credit growth and still attain Beijing’s 2017 annual growth goal of 6.5 percent.

Chinese stocks have languished in recent weeks due to lowered expected future growth. The Shanghai Composite Index trailed other major global indices over the last 30 days, with a decline of 5.4 percent.

More regulatory clampdown may be on the horizon.

The global commodities market—especially sensitive to Chinese demand—has felt the biggest impact. Brent crude was down almost 11 percent over the 30 days ending May 5. Prices of iron ore, copper, and coal futures were also lower over the same period. Iron ore traded on the Dalian Commodity Exchange and hot-rolled coil and steel rebar traded on the Shanghai Futures Exchange plunged by their daily respective maximum allowed rates on May 3.

More regulatory clampdown may be on the horizon. A new rumor is circulating that Guo, the hawkish head of the CBRC, may soon take over as chief of a newly formed super-regulator, the amalgamation of current regulators for the banking, securities and insurance industries, according to the South China Morning Post.

For the Chinese financial industry and global investors, all signs point to further market volatility ahead.

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Pakistani and Chinese workers sit on an excavator as they leave the newly built tunnel in northern Pakistan's Gojal Valley, on Sept. 25, 2015. The project is part of China's ambitious One Belt, One Road initiative. (Aamir Qureshi/AFP/Getty Images)Pakistani and Chinese workers sit on an excavator as they leave the newly built tunnel in northern Pakistan's Gojal Valley, on Sept. 25, 2015. The project is part of China's ambitious One Belt, One Road initiative. (Aamir Qureshi/AFP/Getty Images)

China’s “One Belt, One Road” initiative seeks to makes infrastructure investments in more than 60 countries across Asia, Africa, and Eastern Europe. But it also could burden China’s already capital-constrained banks with even more risky assets, increasing default rates and further destabilizing the country’s financial system.

The program lends to developing countries to finance roads, bridges, and other infrastructure projects as part of Beijing’s broader efforts to expand trade and influence.

While policy banks such as the Asian Infrastructure Investment Bank (AIIB) have pledged support, a large portion of financing expects to come from China’s major commercial banks.

Source of Demand

The project has been described as China’s version of the “Marshall Plan.” It aims to do more than just upgrade the infrastructure of developing countries. The initiative was created partly to cultivate new markets to buy up China’s large excess capacity in the steel, coal, and container shipping industries.

Beijing for years has looked to cut dependency on heavy industries. But it cannot do so without simultaneous lowering economic growth rates and creating potential social instability in its poorer inland and Northeastern provinces whose economies depend on coal and steel production.

Projects sponsored by One Belt, One Road provide a vehicle to sell such surplus coal and steel to developing countries, and increase utilization of maritime shipping.

Repayment Question

According to estimates from Fitch Ratings, total overseas loans—including One Belt, One Road—extended by Chinese banks during the first half of 2016 totaled $1.2 trillion, with commercial banks providing two-thirds of the funding.

“The lack of commercial imperatives behind OBOR (One Belt, One Road) projects means that it is highly uncertain whether future project returns will be sufficient to fully cover repayments to Chinese creditors,” a Jan. 26 Fitch report warned. In other words, the ratings agency is skeptical as to whether the loans would be repaid as agreed. Fitch assigns “junk” ratings to several markets China invests in, but a few nations, such as Laos, have no rating at all and are highly risky.

The entire project is more of a political gamble than a calculated commercial venture. It would be less a concern if One Belt, One Road was primarily funded by infrastructure or policy banks, or the Chinese government directly. The issue lies in that most of the funding for the initiative was provided by commercial banks. These banks hold most of the cash savings of ordinary Chinese consumers, are publicly listed, and their stocks are widely held by retail investors.

“Banks do not have a track record of allocating resources efficiently at home, especially in relation to infrastructure projects—and they are unlikely to have more success overseas,” Fitch said.

Systemic Risks

One Belt, One Road hardly represents the first instance that commercial banks have been forced to put political interests ahead of profitable commercial activity.

While the structure of most loans is not public, it is believed that the loans have variable seniority, with the most senior (least risky) tranches going to the commercial banks. But if returns are subpar, the initiative could put further strain on an already taxed banking system.

Chinese domestic infrastructure loans already make up a disproportionately large part of total non-performing loans (NPL) within the banking sector.

Officially, China’s NPL ratio—the ratio of NPLs to total loans outstanding—was 1.81 percent during the fourth quarter 2016, a bit higher than the 1.76 percent reported at the third quarter, according to the China Banking Regulatory Commission.

But independent estimates peg the actual rate of NPLs at much higher. Third-party estimates from CLSA and other banks state China’s NPL rates to be as high as 15 to 20 percent.

Infrastructure loans already make up a disproportionately large part of total non-performing loans (NPL) within the banking sector.

Beside the rate of bad loans, the speed of growth in total debt has been dizzying. Debt in the non-financial sector grew almost 75 percent since 2011, compared to the 8.6 percent in debt growth during the same period leading up to the 2008 financial crisis.

Additional loans from the One Belt, One Road initiative will likely only exacerbate China’s growing NPL problem, and could lead to a banking system crisis.

And the crisis wouldn’t just be confined to the Chinese banking system. From the perspective of borrowers, failure to repay the loans could trigger crises for the governments and regional economies of the countries receiving the investment.

Some countries, such as Laos, provided guarantees or asset collateral to backstop their One Belt, One Road loans, which could raise lending recovery rates in the event of repayment difficulty. For example, Kyrgyzstan’s debt from China’s Export Import Bank was almost 20 percent of its GDP in 2015.

Whether the ambitious One Belt, One Road project can succeed will have huge ramifications within the Chinese banking system, and impact the economic well-being of several regions.

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Chinese retirees walk on the street in Beijing Oct. 16, 2014. (Kevin Frayer/Getty Images)Chinese retirees walk on the street in Beijing Oct. 16, 2014. (Kevin Frayer/Getty Images)

To boost returns and support a growing population of aging pensioners, China is embarking on a plan to centralize management of pension funds and divert more money into riskier asset classes.

The blueprint calls for transferring portions of local and regional pension funds to the centrally managed National Social Security Fund (NSSF), which is based in Beijing and has broader mandates to invest in riskier assets such as stocks, stock funds, and private equity.

The expansion of the NSSF and deployment of money into the stock market serves a dual purpose for the Chinese communist regime. In theory, investing in the stock market should generate greater returns and boost the size of the fund to cover growing pension commitments. This is something the local and regional funds couldn’t previously accomplish due to their investment restrictions and the low interest rate environment.

In addition, funneling more institutional money into China’s equity markets could reduce stock market volatility by decreasing influence of fickle retail investors. The more stable fund flow from pension funds should stabilize markets which has suffered from sudden retail investor inflow and outflows in the last two years.

Beijing began outlining a transfer of assets to the NSSF since last June, in the midst of Shanghai’s stock market bubble and subsequent crash. Guangdong Province was the first to transfer assets to the NSSF, and other provinces are following suit. As of December 2015, the NSSF managed 1.9 trillion yuan ($276 billion) of assets.

High Reward, Higher Risk

Currently, local and provincial pension funds are restricted to investing in safer asset classes such as bank debt and government bonds to preserve capital. But due to low interest rates, such investments have generated such meager returns that many pension funds find themselves unable to cover retirement payouts at a time when more state employees are approaching retirement.

The NSSF has no such restrictions and can invest up to 40 percent in stocks. At the end of 2015, 46 percent of NSSF’s assets were direct investments into companies, while the remainder were managed assets and investments, including stocks. According to the National Council for Social Security Fund which administers the NSSF, its assets appreciated 15.2 percent in 2015 and 8.8 percent inception-to-date.

Those are good returns, assume the figures are believable. But investment returns and monetary policy are often fleeting. Within a different set of circumstances—a higher interest rate environment, for example—the fixed-income heavy local and provincial pension funds could beat the returns of the riskier NSSF.

What this asset transfer from provincial funds to the NSSF means is that going forward, the fortunes of all Chinese state retirees now rest upon investment managers in Beijing.

The problem isn’t the disparate investment strategies between funds—competent investment managers can disagree on asset allocation philosophy. Pensioners should be concerned that the interests of NSSF investment managers in Beijing may not always align with those of the retirees.

Exposure to Non-Performing Loans

The NSSF already appears to be doubling down on its risky bets by dipping into increasingly more toxic asset classes that could partially be motivated by political pressures.

The four massive state-owned asset management companies—set up to buy piles of non-performing loans (NPLs) from Chinese banks—are in the midst of raising new capital from a combination of IPOs and strategic investments from insurance companies and pension funds.

The NSSF will invest in at least two of these “bank banks,” as they’re commonly referred to—China Great Wall Asset Management and China Orient Asset Management. Both are also seeking IPOs early next year.

The bad banks were set up by China in 1999 to resolve the nation’s NPL problems resulting from years of bank loans to mismanaged state-owned enterprises (SOEs). The bad banks bought NPLs from state banks, freeing the latter’s balance sheets so they could keep lending to SOEs.

These bad banks essentially act as clearinghouses for China’s bad-debt problem. Beijing is able to shift such devalued—and sometimes worthless—assets away from the banks’ balance sheets, swapped out for either cash or bonds issued by the bad banks. That’s how the country’s big banks can claim sub-2 percent bad-loan ratios.

Initially, bad banks were given ten-year loans to finance the asset purchases and were supposed to go away after winding down the NPLs in ten years. But China’s debt-fueled economy has been generating so many NPLs that these bad banks are here to stay and need capital infusions to keep buying more NPLs.

And that’s where Beijing wants the NSSF and other retail investors to step in. Need more evidence that the interests of Beijing are going to increasingly influence management of pension assets? China’s recently deposed Finance Minister Lou Jiwei was appointed as the new chairman of NSSF, according to financial magazine Caixin.

Early Retirement and Social Unrest

At the same time, some Chinese provinces are instituting early retirement plans to push workers off active state payrolls. At least seven provinces—mostly in the Northeast—announced the plans, in part to comply with Beijing’s directive last year to reduce steel and mining capacity.

Similar to the 1990s policy enacted by then-Prime Minister Zhu Rongji, these early retirees don’t count toward official unemployment statistics and their pension benefits are deferred. China’s official retirement age for state employees is 60 for men and either 55 or 50 for women depending on position. Early retirement plans generally accelerate those rules by five years. They get a reduced monthly stipend during the five years, but must wait until the formal retirement age to enjoy pension benefits.

This alone has generated a spate of small but growing protests in the nation’s rust belt. If NSSF’s returns falter and the fund has trouble meeting its liability payments in the future, Beijing’s problems could quickly exacerbate.

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A Bank of China branch in the City of London May 13, 2016. Bank of China is one of a number of Chinese banks looking to expand their presence abroad. (Dan Kitwood/Getty Images)A Bank of China branch in the City of London May 13, 2016. Bank of China is one of a number of Chinese banks looking to expand their presence abroad. (Dan Kitwood/Getty Images)

In an effort to curb runaway real estate prices, major banks in Australia—a popular destination for Chinese real estate investors—have stopped lending to foreign property buyers without domestic income.

Enter Bank of China, China Construction Bank, and the Industrial and Commercial Bank of China. Chinese purchases of Australian real estate barely skipped a beat, as local branches of Chinese banks have stepped in to fill the gap.

Chinese banks are following their corporate and retail clients by expanding abroad, bucking a global banking industry trend of retrenching.

However, compliance and regulatory obstacles could slow their ambitions. And despite recent gains, their overall global footprint is unlikely to challenge current market leaders in the near future.

According to data from China’s Ministry of Commerce, China’s outward direct investment (ODI) rose to $103 billion between January and July 2016, a 61.8 percent increase from the same period last year.

The United States and Germany were the most popular destinations for Chinese foreign investment, driven by major corporate mergers and acquisitions.

Chinese domestic banks are attempting to ride this wave. At the end of 2015, more than 20 Chinese banking organizations had set up 1,300 locations across 59 countries and territories, according to data from Bank of China.

“Chinese banks’ overseas loans increased by more than $600 billion since 2010 to reach near $1 trillion at the end of 2015, and are likely to grow further with the government’s support for companies’ ‘go global’ policies,” wrote the IMF in an August report “China’s Growing Influence on Asian Financial Markets.”


China outward direct investment (ODI). (Source: IMF)

China Construction Bank, its second-largest bank by assets, is looking to expand its footprint from 24 to 40 countries and increase foreign contribution of pretax profit from 1.7 percent as of 2015 to 5 percent by 2020, according to its Chairman in a recent speech in Hong Kong.

Among its peers, Bank of China has the biggest foreign operation, contributing to 23 percent of its pretax profit last year.

Bucking a Trend

Chinese banks are pivoting abroad while established global banks are scaling back.

Ten years ago, New York-based Citigroup Inc. had a retail presence spanning 50 countries from Tokyo to Madrid serving almost 270 million people globally. But profit and regulatory pressures have caused the bank to close or divest operations in more than half of those locations, including Turkey, Guatemala, and Japan.

The retrenching at Citi, HSBC, and other global banks has been quick and dramatic. The goal is to get leaner by focusing on the most profitable customers such as high-net-worth individuals and multinational corporations.

That has also been a goal of Chinese banks—as wealthy consumers and both private and state-owned companies look for foreign assets, the banks have been there to lend.

There’s also a political component to the expansion. China’s state-directed “One Belt, One Road” initiative have forced Chinese banks to enter emerging markets in the Middle East and West Asia where the banks otherwise wouldn’t venture. That’s a major reason the “big five” Chinese banks have been ahead of smaller banks in expanding abroad.

Regulatory Push Back

Chinese banks’ activities are coming under increasing scrutiny, especially in Australia where they’ve exported the hyper lending that fueled China’s real estate bubble.

Chinese banks have financed the majority of recent Chinese purchases of property and corporations in Australia. Loans originated by Australian branches of Chinese banks increased at four times the rate of growth for loans originated nationally during the first quarter of 2016, according to Australian government data. This has prompted regulators to warn that such rapid expansion by foreign lenders could become a systemic threat to the Australia’s financial system.

“One is duty bound to observe that there is a history of foreign players expanding aggressively in the upswing only to have to retreat quickly when more difficult times come,” Reserve Bank of Australia Governor Glenn Stevens said in a speech in Sydney in March. Stevens did not single out China specifically.

Lack of controls adhering to the more stringent foreign regulatory framework is another common risk facing Chinese banks with overseas aspirations. The U.S. Federal Reserve last month ordered the New York branch of the Agricultural Bank of China to improve its anti-money-laundering (AML) infrastructure after examiners found “significant deficiencies” in its AML controls.

While the Fed did not specify what the violations were, the regulator said on Sept. 29 that it had found major flaws in risk management — monitoring and combating illicit banking transactions — at the bank’s local branch.

Agricultural Bank of China is the latest example of Chinese bank having difficulties with U.S. AML and know-your-client rules. The Fed gave similar warnings last year to Bank of China and China Construction Bank regarding AML procedures.

And there’s reason for the heightened scrutiny. Global Financial Integrity, a Washington-based financial industry watchdog, estimated that between 2004 and 2013 China was the world’s biggest source of illicit monetary outflows, according to Reuters. China accounted for about 28 percent of the $4.9 trillion in illicit funds moving from the world’s ten biggest economies.

China’s “Big Five” banks are approaching 10 trillion yuan in combined overseas assets.

Minding the Gap

Despite the challenges, China’s “Big Five” banks are approaching 10 trillion yuan ($1.5 trillion) in combined overseas assets for the first time.

But they still lag behind their global peers in many respects and have inadequate business models. “The over reliance on interest income [at Chinese banks] as a profit model most definitely requires change,” according to a joint PwC-Renmin University study on internationalization of banks.

Currently, Chinese banks provide a financial support network for Chinese businesses and nationals in overseas markets, especially as Chinese companies need to transfer cash to make acquisitions abroad or invest in local R&D.

The banks generally focus on commercial and merchant banking, and do not offer a full product suite including asset management or investment banking like their international peers. As more countries and organizations use the yuan to settle payments, Chinese banks’ overseas influence and product portfolio could grow.

That’s the easy part. But Chinese banks lack the single most important element for any bank’s success: trust.

Major Chinese banks answer to the Chinese Communist Party, not its customers. Their systems and processes are often archaic. For political reasons, state-owned lenders eschew global industry-leading software for homegrown systems. Risk management and corporate governance is often lax.

For Chinese banks, the business framework for global expansion is in place. The trust? Not so much.

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A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, China. (Kevin Frayer/Getty Images)A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, China. (Kevin Frayer/Getty Images)

One year after the mini-devaluation of the Chinese currency, China is getting desperate about its corporate debt situation and is directives to evergreen loans. According to an Aug. 8 Caixin report, the banking regulator is now telling banks to get rid of bad bank debt by swapping it for equity.

Local media Caixin reports that the China Banking Regulatory Commission (CBRC) issued a directive to encourage government owned so-called Asset Management Companies (AMC) to buy bad loans from banks. This exercise worked well during the last banking bail-out at the beginning of the millennium and China has prepared itself for another round since 2012, when local governments started to set up 27 new AMCs. 

Instead of keeping a loan that a company can’t repay and writing it down, the bank would get an equity stake in the company. Because banks aren’t allowed to hold equity in companies, they would sell the equity stake to an AMC at a price the bank can afford without hurting bank equity too much. AMCs would get the money from local or the central government or the central bank. 

The directive says that firms in the troubled steel and coal sectors will be the first to try the arrangement. However, only companies should be supported which have made efforts to cut overcapacity and improve profitability and whose problems are temporary, similar to another directive by the CBRC and first reported by Chinese National Business Daily about rolling over defaulted loans. 

(Société Générale)

(Société Générale)

“A Notice About How the Creditor Committees at Banks and Financial Institutes Should Do Their Jobs” tells banks to “act together and not ‘randomly stop giving or pulling loans.’ These institutes should either provide new loans after taking back the old ones or provide a loan extension, to ‘fully help companies to solve their problems,’” the National Business Daily writes.  

The recent leaks in relatively quick succession may be proof of hedge fund manager Kyle Bass’s concern of “the Chinese corporate bond market freezing up,” as he said in an interview with RealVisionTV in June. “We are seeing the Chinese machine literally break down.

“In the West, the speculation is always about the Lehman moment in China. That is a Western fantasy. Chinese politicians know what’s coming up and have a plan to manage the bad loans,” Horst Loechel, an economics professor at the Frankfurt School of Management told the Wharton Business School. Evergreening and debt for equity swaps seem to be that plan.

Kyle Bass estimates bad loans in Chinese banks could lose up to $3 trillion in bank capital if all loans were properly written down. 

In transactions from 2015, where banks sold defaulted loans to AMCs in Zhejiang province, they only received 32 percent of their original value, down from 43 percent in 2014 according to a regional AMC manager quoted by Caixin.  

The announcement comes in the wake of seven government-owned coal miners in Shanxi being allowed to extend maturities on existing debt, according to state mouthpiece Xinhua, a shipbuilder failing to make a payment on a $60 million one-year bond on Aug. 8 according to Bloomberg, and a developer defaulting on a $380 million offshore bond in Hong Kong, according to the Wall Street Journal. 

For good measure, the National Association of Financial Market Institutional Investors (NAMFII), an organization backed by the central bank, has enquired with major banks and brokers to see whether it would be possible to roll out a credit default swap market in China, according to the Wall Street Journal. Credit default swaps are insurance contracts on bond defaults, precisely what China needs right now.

According to the report, the regulator responsible for the $8.5 billion corporate bond market with soaring defaults, is drafting rules to make Chinese CDS compliant with international practices. The Journal reports that the regulator will soon ask the People’s Bank of China (PBOC) for approval.

After 39 defaults this year totalling $3.8 billion, it is about time. 

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Amidst a backdrop of souring loans and diminishing reserve ratios, Chinese banks last week announced the least encouraging quarterly earnings in almost a decade.
Facing a challenging domestic and international economic environment, the banks’ underlying profits are deteriorating. The rising figure of official and nonofficial toxic loans are evaporating reserves and without drastic cuts to minimum reserve requirements, all but guarantees future losses.
It may be time to say goodbye to the industry’s string of quarterly profit increases and 10 percent dividend yields.
For years, Chinese banks managed earnings by adjusting provisions for bad debt which have been comfortably above the regulatory minimum. That threshold sits at 150 percent of existing non-performing loans (NPLs), which Beijing lowered from 200 percent to help banks’ bottom lines and free up capital.
A Loan by Any Other Name
China’s official bad loan ratios sit between 1.5 percent and 2 percent at major banks. That figure is widely recognized as understated—even the most bullish investors peg the true NPL ratio to be in the high single digits.
Charlene Chu, partner at Autonomous Research Asia and head of its China banks research group, estimates that NPLs are as high as 22 percent system-wide, according to a recent interview with Barron’s Asia.
The discrepancy between these figures—and what makes calculating China’s NPL proportion so difficult—lies in what one considers to be debt. Chinese banks and regulators, and many mainstream Western research firms, analyze NPLs within a bank’s loan portfolio.
Nobody wants to be the first to report a profit decline after so many years of growth.— Richard Cao, Guotai Junan Securities

But for China, a large amount of credit resides outside that scope, in the form of wealth-management products (WMPs). WMPs are a catchall for financial instruments that may reside on or off balance sheet to provide new financing or to service existing debt.
These products are structured differently than loans, which utilizes the bank’s existing balance sheet. In a typical product, the bank contributes capital to a partnership entity with non-bank counterparties such as securities firms or investment trusts, to issue credit to a struggling company. Instead of a loan, the bank holds an investment in an unrelated partnership.
The structure is somewhat similar to a collateralized loan obligation (CLO) or collateralized debt obligation (CDO). But here, instead of raising mostly outside capital as would a CLO, the bank could hold majority of both debt and equity.
Such financial engineering allows banks to dress up their balance sheets. Loans masquerade as investments, which have a lower risk weighting than debt under Chinese capital adequacy rules, allowing the bank to report a lower NPL ratio and set aside less reserves.
Such WMPs are often the only credit available to “zombie” state-owned enterprises facing restrictions on formal borrowing, such as those in the steel, cement, and manufacturing industries.
Autonomous believes that total outstanding WMPs grew 57 percent in 2015, with off-balance sheet WMPs up 73 percent. “If WMPs grow just 25% to 30% this year, they will be twice as big as the combined amount of structured investment vehicles and conduits that blew up on Western banks during the global financial crisis,” Chu said.
Reserve Ratio Cut Expected
The banks, meanwhile, struggle to meet even the official NPL reserves on their books.
To eke out a first quarter profit gain, two of the four largest state-controlled Chinese banks had to lower bad loan provision at March 31 to below the regulatory minimum.
Bank of China and Industrial and Commercial Bank of China Ltd. (ICBC)’s buffer has fallen to 149 percent and 141 percent, respectively. China Construction Bank is slightly above at 152 percent. The bank with the most NPLs, Agricultural Bank of China, has a coverage ratio of 180 percent.
“The regulator is probably tolerating such a temporary breach and a cut in the ratio is on the way,” Hou Wei, a Hong Kong based analyst at Sanford C. Bernstein, said in a Bloomberg report. Nomura research indicates that China’s reserve ratio could be cut from 150 percent to 120 percent without material risk to China’s financial system.
During last week’s earnings disclosure, China Construction Bank Chairman Wang Hongzhang said that it was possible that the reserve ratio may be cut to between 120 and 130 percent, but qualified that statement by saying the degree of ratio cuts may not be standard across the industry.
The temptation is there. According to BNP Paribas research last year, a small cut of minimum reserves of 10 percent points would boost bank earnings by 7 percent across the industry.
Reckoning Ahead?
Cutting reserves is a double edged sword. It can boost earnings and allow a bank to lend more, but it weakens the bank’s capital and its ability to withstand loan losses—which is on the rise.
The official NPL ratios are at their highest levels in several years. At this point, relaxing loan reserve ratios in the face of deteriorating asset quality sends a bad message and puts into question the intention and role of Chinese regulators, a Fitch Ratings note suggested earlier this month.
But even if Beijing cuts reserves down to the 100 percent level pre-financial crisis, is it enough? If the current ratio of official NPL more than doubles to 4 or 5 percent, loan losses would carve into banks’ retained earnings and tier-one capital, estimates Sanford C. Bernstein.
“For the first quarter, [the banks] can still maneuver a bit by cutting costs here and there, and end up with zero profit growth and still maintain the minimum NPL coverage ratio—but for the full year nobody can achieve both,” Richard Cao, analyst at Guotai Junan Securities in Shenzhen, told Bloomberg.
“Nobody wants to be the first to report a profit decline after so many years of growth,” Cao added.
But they may not have a choice. Quarterly earnings and dividend levels—which the banks hold sacrosanct—will be cut.
After all, nobody wants to be the first to trigger a global financial crisis either.

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