No Need to Panic, China's Banks Are in Pretty Good Shape

The extraordinarily rapid rise of debt in China, particularly in the corporate sector, has given rise to fears that the country may be unable to avoid a banking crisis that would slow its growth and have substantial negative spillovers on the global economy. This fear is based on recent estimates by the International Monetary Fund and some investment banks that a substantial portion of new lending in recent years has gone to state-owned companies producing oversupplied goods where profits have turned negative.

In fact, while lending more to corporates unable to pay interest and principal on previous loans means financial risks are clearly rising, it is likely that China is years away from a potential banking crisis, providing it with a window to slow the growth of credit to a sustainable level. A key reason for this judgment is that while the ratio of debt to GDP is quite elevated, China also enjoys a high rate of national savings. The level of debt a country can sustain depends significantly on the share of domestic savings in GDP.

Second, China's debt build-up is almost entirely in domestic currency. Local companies have been paying down their foreign currency debt since the third quarter of 2014, and it now accounts for only 5 percent of domestic debt. In contrast, a recent study of other emerging markets found that the median foreign currency debt as a share of total debt is four times the Chinese share. Moreover, China remains a large net creditor to the rest of the world. Thus, the country is not vulnerable to a financial crisis such as the one in Asia in 1997, which was precipitated by a refusal of foreign lenders to roll over their credit to Asian corporates.

Third, banking crises almost always begin with problems on the liability side of bank balance sheets. But Chinese banks' liabilities are overwhelmingly deposits, which are very sticky. Bank reliance on wholesale funding is minimal. Thus, loans plus off-balance sheet assets are roughly equal to deposits, far from the 120 to 150 percent ratios frequently seen in countries before the onset of banking crises. In any case, the central bank has substantial tools to deal with potential bank runs. For example, the required reserve ratio imposed on banks is currently 17 percent. This could be cut with hugely positive effects on bank liquidity.

Fears of an impending banking crisis are often based on the assertion that China's banks are far weaker than advertised. Given the huge acceleration of credit growth beginning with the global financial crisis, nonperforming loan (NPL) ratios in the 1 to 2 percent range are not credible on this view. But this argument does not recognize that some banks have been aggressively writing off NPLs, making low reported NPL ratios more plausible. For example, CITIC Bank and the Bank of Communications in the first half of 2015 disposed of 75 percent and 30 percent, respectively, of their year-end 2014 nonperforming loan balances. More generally, the average provision coverage ratio of Chinese banks is about 150 percent of reported NPLs.

Is it likely that weakened banks will ultimately be forced dramatically to slow their extension of credit, leading to a lengthy period of slow growth? This was the pattern in Japan, which some argue China is doomed to follow. But in the 1990s, when excess lending to poorly performing state-owned enterprises led Chinese banks to the brink of insolvency, the government initiated a massive recapitalization program that allowed the institutions to continue to lend, supporting the strong growth achieved in the first decade of this century. This was very unlike the situation in Japan, where the authorities for a decade refused to recognize weak bank balance sheets.

In addition, Chinese banks have far less exposure to poorly performing state-owned corporates than in the 1990s. In the mid-1990s, before the recapitalization of the banking system, loans to state-owned enterprises accounted for 62 percent of all renminbi loans of banks and other financial institutions. Today, that share has fallen to 30 percent, largely because banks have increasingly lent to private companies and to households. The former earn an average return on assets that is two to three times that of state companies and the latter have relatively strong balance sheets.

To reduce the risks that are accumulating in the financial sector, the authorities must move aggressively to curtail the flow of credit to chronically unprofitable, mostly state-owned corporates. The central government's campaign to close down these so-called zombie companies is already under way, but not surprisingly it is meeting resistance at the local level.

This resistance must be overcome and the central government must also deal with the existing stock of bad assets by some combination of accelerated write-offs and securitization of underperforming bank assets and even partial recapitalization of the weakest financial institutions.