China’s credit risk is rising, probably much more rapidly than the official non-performing loan (NPL) statistics indicate. SocGen is concerned as they think we are only seeing the beginning of the end of this NPL cycle. While they do not anticipate an outright banking crisis, as the government will certainly keep intervening at each turn on the way to avoid such an outcome, this is no reason to feel relieved. The reason being a major structural element in China's NPL cycle as many industries have massive excess capacity - after years of aggressive expansion that ran way ahead of demand growth - which eventually has to be eliminated. This process will take some time, during which faster depreciation in the form of deleveraging and consolidation will be unavoidable; and while expectations of an imminent hard landing may be overdone, the landing will nevertheless be multi-year and bumpy in their view.
Societe Generale: The NPL issue is rearing its ugly head
According to the China Banking Regulatory Commission (CBRC), total NPLs at China's commercial banks reached CNY 456.4bn at end-Q2, 4.2% qoq and up 11.9% (or CNY 48.6bn) from the trough in Q3 11. The NPL ratio was unchanged at 0.9%, due to a similar pace of loan growth. However, special-mention loans that are doubtful but still performing increased to CNY 1.5tn, while the total loan loss reserves set aside were CNY 1.3tn.
Some places are doing much worse.
A bottom-up search returns an even more worrying picture. The number of stories on companies in default or with severe cash flow problems has surged since early Q2.
The economic slowdown does not seem to be the only cause, and, in many cases, not even the major one. The common mistakes include involvement in speculative activities (eg. property speculation or commodity trading), massive capacity expansion (eg. shipbuilding and solar panel manufacturing), outsized commitments to complicated webs of mutual loan guarantees and high exposure to underground banking (eg. many SMEs in Zhejiang).
More NPL woes ahead
The history of banking crises suggests there is no definitive linear correlation between the peak of NPL ratios and the scale of the pre-crisis credit boom, as it also depends on how the situation is contained and resolved. In the sample of 42 crisis episodes complied by Laeven and Valencia (2008), average annual credit growth to GDP prior to the crisis was about 8.3%. Between 2009 and 2010, this same ratio for China reached 27.8% and 20%, respectively. It is hard to see how China’s NPL ratio could stay at the current level.
There is also a structural element in China’s NPL cycle. As we pointed out last week, many industries have massive excess capacity after years of aggressive expansion that ran way ahead of demand growth.
Eventually, China has to eliminate these inefficient capacities. This process will take some time, during which faster depreciation in the form of deleveraging and consolidation will be unavoidable (and margin compression has already begun).
Acute agony or chronic pain
The exact trajectory and the end point of the NPL issue will be difficult to predict. Economies with less government intervention, such as the US, usually see NPLs peaking one or two quarters after growth troughs. In contrast, Japan was very slow in recognising and resolving its NPL problem – a problem which started in the early 1990s. The NPL ratio didn’t peak until 2002, and much damage was done in the meantime to the banking system and indeed to the overall economy.
China, where the government is even more involved in the economy, is running a clear risk of a prolonged NPL cycle. Local governments have poured millions of capital into rescuing failing corporates.
We think, at the end of the day, the central government will have to take the burden onto its own balance sheet as the NPL cycle reaches its final days of reckoning. The fiscal cost will only be higher the longer the process drags on, and a bigger concern is that more resources may be locked in these non-performing assets.