Meet China's Latest $1.8 Trillion "Problem"

Last summer we outlined how Chinese banks obscure trillions in credit risk.

The powers that be in Beijing aren’t particularly keen on allowing the banking sector to report “real” data on souring loans - especially given the fragile state of the country’s economy. In some cases, the Politburo will pressure banks to simply roll over bad debt, effectively kicking the can.

In addition, banks carry around 40% of their credit risk outside of “official loans.” Here’s what Fitch had to say last year:

“Off-balance-sheet financing (I.e. trust loans, entrusted loans, acceptances and bills) accounted for 18% of official TSF stock at end-2014, up from less than 2% just over a decade ago,” Fitch wrote. “Of the off-balance-sheet exposure reported at individual banks, this is equivalent to 15% of total assets for state commercial banks and 25% for mid-tier commercial banks, on a weighted average basis. These ratios would be even higher if we included entrusted loans (see Figure 2), although this information is not disclosed at all banks. Fitch estimates that around 38% of credit is outside bank loans."

In many cases, channel loans (so credit extended by banks via non-bank intermediaries) are carried as "investments classified as receivables" on the balance sheet. 

Now, as more Chinese firms lose access to traditional financing amid rising defaults and increasing economic turmoil, banks are increasingly turning to channel loans as a way of extending credit.

In turn, the amount of "investment receivables" on many mid-tier banks' books is soaring to dizzying levels. "Mid-tier Chinese banks are increasingly using complex instruments to make new loans and restructure existing loans that are then shown as low-risk investments on their balance sheets, masking the scale and risks of their lending to China's slowing economy," Reuters reports. "The size of this 'shadow loan' book rose by a third in the first half of 2015 to an estimated $1.8 trillion, equivalent to 16.5 percent of all commercial loans in China."

Specifically, the banks are using DAMPs and TBRs, but more important than the intricacies of the structures is what the practice means for the market's ability to acurately assess credit risk in China. "The concern is that the lack of transparency and mis-categorization of credit assets potentially hide considerable non-performing loans," UBS' Jason Bedford warns.

But that's not all. Investment receivables only carry a 25% risk weighting, which means the banks aren't holding adequate reserves to backstop losses on loans that by their very nature are more risky than traditional financing. "Banks must also make provision of at least 2.5 percent for their loan books as a prudent estimate of potential defaults, while provisions for these products ranged between just 0.02 and 0.35 percent of the capital value at the main Chinese banks at the end of June," Reuters goes on to note.

Just how large is this exposure, you ask? In a word: huge. At Industrial Bank for instance, the size of the "investment receivables" book doubled during 2015 and now sits at a massive $267 billion or, as Reuters adds, more than its entire loan book and equivalent to "the total assets in the Philippine banking system."

And it's not just Industrial Bank. At the aptly named "Evergrowing Bank", investment receivables are CNY290 billion, a figure which is also larger than the bank's pile of traditional loans.

"In the past banks (made loans and) held assets. Now banks manage assets," Zhang Changgong deputy governor of China Zheshang Bank (where investment receivables also doubled last year) says.

Fair enough, but that's just semantics. You can call them "assets" or "investments" or "receivables" or whatever the hell else, but at the end of the day, these are loans. And the bank shoulders the entirety of the credit risk. "To structure these deals, a bank typically engages a friendly trust, securities, or asset management company to set up a financing arrangement for a bank client," Reuters writes. "The bank then buys the beneficiary rights to the investment product using a special purpose vehicle." 

Right. Of course if you hold the beneficiary rights, common sense says you also shoulder the vast majority of the risk. Or, as one senior executive told Reuters on the condition of anonymity, "if the originating bank does not promise to pay from its own pocket should any default happens, no trust company would agree to collaborate."

What should jump out at you here is that this is just about the worst case scenario at every turn. Banks are piling up exposure to the riskiest subset of borrowers at a time when economic fundamentals are deteriorating on a near daily basis. Meanwhile, this exposure is being carried on a line item that allows the banks to avoid provisioning for the losses that will almost certainly materialize in the not-so-distant future. At one bank, this one line item is larger than the entire Philippine banking system.

Of course this also reflects a theme we've been discussing for quite some time: namely that China is trying to deleverage and re-leverage at the same time. The channel loans described above are part and parcel of the shadow banking system which ground to a halt after years of explosive growth. Now, Beijing can't decide if it's better to kick the can by allowing banks to mask bad debt and pile up still more exposure outside of their traditional loan books or crack down, let the whole thing unwind, and start from scratch after the misallocated capital has been purged. 

Whatever the case, this cannot last forever, and when the unwind finally comes and trillions in defaults on channel loans, trusts, and WMPs ripple through China's economy, even the NBR won't be able to say "7% growth" with a straight face.