Wednesday 30 December 2009

Disguised loans magnify risks in Chinese banks

In January last year, this column warned that “Chinese banks may not be as solid as they look”.

It argued that a combination of rapidly expanding lending books, sketchy credit standards and fudged loan classifications meant that asset quality and capital adequacy in China’s banking sector were both weaker than the official figures led investors to believe.

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Guanyu said...

Tom Holland
30 December 2009

In January last year, this column warned that “Chinese banks may not be as solid as they look”.

It argued that a combination of rapidly expanding lending books, sketchy credit standards and fudged loan classifications meant that asset quality and capital adequacy in China’s banking sector were both weaker than the official figures led investors to believe.

Happily for the performance of their stock portfolios, investors ignored the warning. Instead, they drew comfort from the sector’s relative insulation from the global financial crisis and piled into the shares of Chinese banks listed in Hong Kong as a play on continued high government-supported growth on the mainland.

As the chart shows, they were well rewarded for their confidence. With 2009 almost over, profitability has held up and H shares in mainland banks have risen 44 to 93 per cent over the year.

But despite the admirable performance of Chinese bank stocks, the risks outlined a year ago have not gone away. If anything, they have grown even greater over the intervening 12 months.

The trouble is not just that mainland banks have been on a lending spree of unprecedented magnitude, although that is certainly part of the problem.

Over the 12 months to November, mainland banks extended very nearly 10 trillion yuan (HK$11.34 trillion) in new local-currency loans, almost three times as much as in the previous 12-month period.

So far, that loan growth has sent five mainland banks, including Hong Kong-listed China Merchants Bank and China Minsheng Banking Corp, scurrying to raise equity in order to maintain their capital adequacy ratios.

But it is also raising fears of a surge in non-performing loan ratios down the road. As a recent <147,1,0>report from credit agency Fitch Ratings puts it: “Credit growth of this magnitude inevitably places a strain on banks’ internal risk management, and raises concerns about a future deterioration in loan quality.”

At the moment, non-performing loan levels are declining, both in relative and in absolute terms. But as the Fitch report points out, that’s only to be expected as borrowers have taken advantage of easier access to credit this year to service older loans that they would otherwise have struggled to repay.

The dangers won’t begin to appear until credit conditions start to tighten significantly, which many analysts believe will not be until 2011.

And according to Fitch, when the problem loans do start to show up, their size could be even bigger than China’s recent loan growth figures imply. That is because over the last couple of years, Chinese banks have begun shifting loans off their balance sheets either by selling them outright to other financial institutions or by repackaging them and selling them on to their wealth management clients.

Estimating how many new loans have been disguised in this way is tricky, because reporting is minimal. But Fitch’s analysts believe as many as 16 per cent of new loans made in 2008 may have been sold on outright, with some failing to appear on the balance sheet of either the seller or the buyer.

Meanwhile, both the number and average size of loan-based wealth management products have increased sharply this year, implying that more than one trillion yuan in new loans could have been disguised in this way during 2009.

If these techniques sound much like the asset-backed securities and credit derivatives employed by developed-world banks ahead of the crisis to spread credit risks and allow them to continue lending to favoured clients, it is because the effect is much the same.

But as the crisis demonstrated, spreading risk does not diminish it. In fact, it can exacerbate the dangers by encouraging reckless lending. And as the Lehman Brothers minibond saga proved, selling credit risk to wealth management customers can come back to haunt banks with a vengeance in the event of a default.

It may be high water for the Chinese banking sector now. But the tide must turn one day. Last year’s warning holds true.