Bailing out its banks: China’s hidden debt problem

28 Nov 2024
economy
Ben Charoenwong
Associate Professor of Finance, INSEAD, Singapore
China’s recent announcement of a 10 trillion RMB stimulus package addressing local government debt has attracted attention, while its parallel trillion RMB initiative to recapitalise its state banks has gone under the radar. INSEAD academic Ben Charoenwong looks at China’s hidden state bank debt issues and evaluates its recapitalisation policies.
People are seen in front of an office building of Agricultural Bank of China, in Beijing, China on 29 March 2021. (Tingshu Wang/Reuters)
People are seen in front of an office building of Agricultural Bank of China, in Beijing, China on 29 March 2021. (Tingshu Wang/Reuters)

China’s announcement of a 10 trillion RMB (US$1.4 trillion) package to address local government debt has dominated headlines. The five-year programme, which includes 6 trillion RMB to increase local government debt limits and 4 trillion RMB in special bonds, aims to slash hidden local government debt from 14.3 trillion RMB to 2.3 trillion RMB by 2028.

But the negative market reaction suggests the stimulus fell short of investors’ expectations, who have likely already anticipated this support for local government financing vehicles (LGFVs). Like putting a 1-trillion-dollar band-aid on a 13-trillion-dollar problem, outsiders may view the debt swap simply as shifting from the left pocket to the right pocket (off- to on-balance sheet). What’s getting less attention — but may be more significant — is the parallel trillion RMB initiative to recapitalise state banks.

... banks were likely systematically understating their bad loans by a factor of two to three, with aggregate bad loans of around 5 trillion RMB. 

Invisible issues: state bank debt

The recapitalisation of banks involves both helping to alleviate the local government debt, which has been discussed since at least 2019, and freeing up bank capital for additional potential funding and stimulus. The package may be more about solving hidden problems and preparing for future challenges than solving today’s most visible problems.

My research with co-author Tianyue Ruan at the National University of Singapore and Meng Miao at Renmin University studied non-performing loan transactions between 2014-2019 and found that banks were likely systematically understating their bad loans by a factor of two to three, with aggregate bad loans of around 5 trillion RMB.

Importantly, these bad loans were simply held off-balance sheet and typically went unobserved by policymakers and the public. This is more insidious than LGFVs and other off-balance sheet government debt.

While local government debt rightfully causes concern, it’s at least a known quantity since LGFVs can be linked — with some effort — to local governments. Moreover, governments typically have more levers to deal with debt burdens than banks. For example, governments may effectively default payments to suppliers, though this is a drastic measure.

In contrast, banks’ hidden bad loans are more challenging because they are generally not observable, can distort credit allocation, and mask systemic risks. Exacerbating these incentives are stringent financial regulations around non-performing loan ratios; banks under pressure to meet these requirements appear to have used these schemes to conceal non-performing loans through asset management companies, creating a shadow mountain of bad debt.

The combination of bank recapitalisation, direct household support through child allowances and consumer subsidies indicates a strategy to both strengthen bank balance sheets and stimulate domestic demand.

Chinese Finance Minister Lan Foan attends a press conference on 8 November 2024 at the Great Hall of the People in Beijing, China. (Josh Arslan/Reuters)

This matters because the current economic environment is considerably more challenging than in 2019. Property market distress, falling urban wages (down 2.5% in major cities last quarter), and high youth unemployment have created conditions where bad loans are likely proliferating faster than they’re being recognised. The trillion RMB bank recapitalisation suggests that authorities understand banks’ crucial role in trying to achieve their policy goals.

Saving state banks

The current stimulus package indicates that Chinese policymakers are taking a more sophisticated approach than mere debt relief, and hints at some level of commitment to maintaining a functioning financial system. Protecting large banks enables them to continue lending, and large banks can also be used to take over smaller banks with worse balance sheets.

The combination of bank recapitalisation, direct household support through child allowances and consumer subsidies indicates a strategy to both strengthen bank balance sheets and stimulate domestic demand. This strategy matters particularly as China prepares for potential shifts in US policy following the US election results and in anticipation of an escalating trade war.

By creating more flexibility in the banking system now, China seems to be building resilience to protect against future external shocks. Finance Minister Lan Foan’s statement about significant room for additional debt issuance is consistent with this interpretation that these initial steps could be just the beginning of a longer-term strategy to strengthen the financial system’s foundations. For now, Beijing seems able to borrow at rates close to those of the US — a sign that markets still see China as a good credit risk.

The key question is whether banks use their strengthened capital positions to support productive new lending or continue propping up zombie borrowers. 

Stimulus package: success or failure?

However, the success of this approach in the long term depends on whether there are also policies that can address the incentives that led to bad loan concealment in the first place. Our research showed that strict regulatory pressure paradoxically encouraged banks to hide rather than resolve problem loans.

And ex post bailouts, rescuing banks after a crisis, can create even more of a moral hazard by indirectly rewarding banks for taking disproportionate risks in the future. The current emphasis on “counter-cyclical measures”, suggests a welcome shift toward regulatory flexibility, but the devil will be in the implementation details.

A booth of the Industrial and Commercial Bank of China (ICBC) is seen at the China International Fair for Trade in Services (CIFTIS) in Beijing, China on 4 September 2020. (Tingshu Wang/Reuters)

Looking ahead, several indicators will reveal whether this strategy is working. First, we can look beyond the headline 5% growth target and watch for changes in bank lending patterns post-recapitalisation. The key question is whether banks use their strengthened capital positions to support productive new lending or continue propping up zombie borrowers.

Second, we can examine whether there are additional policies, either direct or indirect (such as guidelines), aimed at increasing household consumption, which is currently below 40% of GDP, to address both cyclical and structural challenges. However, success requires more than just money — it needs fundamental changes in how the financial system operates.

As China navigates these challenges, the international financial community would do well to look beyond the headline numbers about local government debt. The health of China’s banking system, with its hidden vulnerabilities, may prove more crucial for global financial stability in the years ahead.

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