Chinese banks are looking down the barrel of a staggering RMB 8 trillion – or $1.7 trillion – worth of losses according to the French investment bank Societe Generale.
Put another way, 60 per cent of capital in China’s banks is at risk as authorities start the delicate and dangerous process of reining in the debt-bloated and unprofitable state-owned enterprise (SOE) sector.
Disturbingly though, debt is not only not shrinking, it is accelerating, making the eventual reckoning far worse.
China’s overall non-financial debt grew by 15.2 per cent in 2015 to RMB 167 trillion ($35 trillion) or almost 250 per cent of gross domestic product (GDP).
That is up from 230 per cent of GDP the year before and the 130 per cent it was eight years ago before the global financial crisis hit.
The problem is largely centred on China’s 150,000 or so SOEs, which suck-up an entirely disproportionate amount of the nation’s capital.
SOE debt could easily overwhelm China’s banking system
“Although contributing to less than one-third of economic output and employment, SOEs take up nearly half of bank lending (RMB 37 trillion) and more than 80 per cent of corporate bond financing (RMB 9.5 trillion),” Societe Generale found.
“While the inefficiency of SOEs is gradually dragging down economic growth, recognising even a small share of SOEs’ non-performing debt would easily overwhelm the financial system.”
Despite their moribund financial performance, the SOEs still enjoy a considerable advantage in access to funding through the banking system than the private sector.
“To put things into perspective, a quarter of SOEs’ loans and bonds are equivalent to the entire capital base of commercial banks plus their loan-loss reserves, equivalent to 23 per cent of GDP,” Societe Generale’s China economist Wei Yao said.
On the bank’s figures, if just 3 per cent of loans to SOEs sour, commercial banks’ non-performing loans would double.
This is not out of the question given more than a quarter of SOEs are consistently loss making.
An industrial landscape littered with so-called zombie companies – technically bankrupt but still feeding on fresh capital – is central to the mounting crisis.
The Beijing administration has promised reform, with Prime Minister Li Keqiang famously stating, “For those zombie enterprises with absolute overcapacity, we must ruthlessly bring down the knife.”
But so far there has not been much ruthless knife-wielding.
Abundant credit is still greasing the wheels of industry as steel production – one of the favourite habitats of the zombie enterprises – is rattling along at record levels.
The credit splurge earlier this year to assist construction and infrastructure projects and support the official GDP target, giving steel and cement makers as well as Australian miners a hefty kick down the road, is only now starting to slow.
The broad outlines of the industrial restructuring announced earlier this year include reducing steelmaking by 100 to 150 million tonnes annually – or around 13 per cent – over the next three to five years, while coal production is targeted for a 9 per cent cut.
50pc of banks’ capital base at risk
However there was little or no detail about policy support for restructuring debt in the sectors.
Not surprisingly Chinese banks quickly responded by cutting credit lines to steel and coal companies, before policymakers had time to react.
“This was one key factor that triggered the sudden acceleration in bond defaults among SOEs recently,” Ms Yao noted.
“All in all, SOE debt restructuring could jeopardise 50 per cent or more of the banks’ capital base, which – if it materialises quickly – would almost certainly knock China’s banking sector into a systemic crisis.”
An earlier attempt at SOE reforms during the 1990s pushed banks’ non-performing loan ratios to between 30-50 per cent, rendering the entire banking system insolvent.
While authorities dawdled restructuring banks in response to the dramas of 20 years ago, they are unlikely to have the same luxury this time around.
“If the authorities do not foot the bill of SOE restructuring upfront, the recognition of credit risk on banks’ balance sheets will accelerate and overwhelm the system,” Ms Yao warned.
This however may still be a few years away, depending on how rapid the SOE restructure is.
“Eventually, the Government should – and probably will – help banks,” Ms Yao said.
“If the government were to make sensible decisions for the long run, the next bank restructuring would have to be much less kind to the banks and short-term economic growth.”
Choice between a hard landing or a lost decade
But the situation is far trickier than the last big salvage operation in Chinese banking.
Societe Generale is none-too-impressed with any of the ideas the government has floated so far; debt-for-equity swaps, loan securitisation or dumping the whole mess in asset management companies, the so-called “bad bank” solution.
While they are market based approaches, the Government and market may have decidedly different views on a ” fair value” for such distressed and often terminally ill assets.
Unlike the ’90s restructuring, a rampant economy won’t help “grow” the problem away this time.
The government has a responsibility, given a sizeable chunk of the problem has its origin in the massive RMB 4 trillion GFC stimulus package that helped create the overcapacity, disinflation and debt in the first place.
But the policy-makers are now facing a nasty dilemma over the pace of reform and restructure.
“A fast restructuring of corporates and banks risks an economic hard landing, since that could entail massive corporate defaults and big losses in terms of economic output, even in the case of a quick recapitalisation,” Ms Yao argued.
‘Hard landing’ will threaten social stability and global outlook
Given that a hard landing threatens not only social stability but also the global economic outlook, authorities have understandably chosen a slower, more gradual process.
This means attempting to slow defaults and occasional bursts of stimulus, topping up the needs of struggling SOEs and banks.
“The Government seems to think that it can restructure the worst part of the corporate sector – zombie SOEs – bit by bit and use the freed-up resources to support good corporates and the new economy,” said Ms Yao, however, she added that this is an overly optimistic view.
“There are two major risks with this gradual approach, in our view: a lost decade and policy uncertainty.”
In this scenario, debt will not be wound back and the bill to fix what is already a massive problem will only mount.
It is impossible to see the process being smooth, and the possibility of a very hard landing looms large, hardly a comforting thought given how spooked financial markets are already about China.
In those circumstances it would not take much for a Chinese crisis to become a full-blown global one.