Regional Focus

China stares down banking challenges

Published: Jul 2024

China’s financial institutions continue to face challenges in the property market, with some saying the sector is on the brink of a crisis. Others disagree and argue that China has the wherewithal to solve any problems before they have a global impact.

Piggy bank behind wooden houses

The size of China’s economy and its banks is awe-inspiring; its growth has been remarkable and, on the flip side, if things go wrong there could be terrifying implications for the wider financial system and global economy.

China’s banks continue to face problems with the property sector, with major developers running into trouble, property values crashing, and banks being saddled with loans that may not be repaid. By some estimates, loans to property developers account for 30% of the major banks’ assets. Major property companies, such as the largest real estate Country Garden have defaulted on their debt and the government has asked the banks to support dozens of major companies.

The problems also extend to the shadow banking sector, with the asset management firm Zhongzhi Enterprise Group, for example, being investigated for the billions it lent to real estate firms.

Such problems pose a problem for the rest of the world if they spill over into the global financial system. Chinese banks are still some of the largest in the world, and in 2023 held the top four spots, according to S&P Global Market Intelligence’s Global Bank Ranking. ICBC is the world’s largest bank with US$6.3trn in assets, followed by Agricultural Bank of China in second place. “Despite a downturn in the property sector, Chinese banks retained their place as the largest in the world,” says Nathan Stovall, Director of Financial Institutions Research at S&P Global Market Intelligence.

China’s banks, however, are bracing for a further tide of bad property loans. According to S&P Global Ratings analysts, the uneven economic recovery is making it difficult for banks to improve their asset quality. Meanwhile, weak home sales are hurting the developers that are surviving and triggering more debt restructuring. “The post-pandemic recovery in the asset quality of Chinese banks has hit a wall. The country’s push to promote access to financial services has helped most micro and small enterprise (MSE) loans perform following a moratorium on repayments during the pandemic. Nullifying this improvement, however, are the ongoing strains in the property sector, which have spread to surviving developers,” says Ming Tan, Primary Credit Analyst at S&P Global Ratings.

Tan says the property downcycle is poised to continue and notes that during the first two months of this year, property sales in China were down 29.3% from the previous year. “We expect excess supply and weak demand in lower-tier cities to continue. This continues to weigh on the quality of the property of property development loans, including those of surviving property developers,” Tan states. Lending to this sector will continue to weigh on the performance of Chinese banks and S&P estimates that the non-performing loan (NPL) ratio for property lending will peak higher and later at 6.4% in 2025.

Myriad problems

The banking sector faces myriad challenges and many are struggling in the Chinese market. In one sign of the difficulties, the Financial Times recently quoted Jamie Dimon, Chief Executive of US bank J.P. Morgan Chase, making private comments at a conference in Shanghai. He reportedly commented on how tough the China market is for banks, and said “Some of the investment banking business has fallen off a cliff in the last couple of years.” He did, however, add “I don’t worry about that… that will have its ups and downs.”

There are other issues that have also been reported in recent months to affect the banking sector. With the war in Ukraine continuing, there has been the suggestion the US will introduce sanctions on Chinese financial institutions in response to reports that China has been helping Russia with its war effort. In April, President Xi Jinping met US Secretary of State Antony Blinken, who urged the Chinese leader to end military support for Moscow. “I made clear that if China does not address this problem, we will,” Blinken was quoted by news outlets as saying after the meeting. This message was echoed by US Treasury Secretary Janet Yellen during a recent trip to China, where she emphasised that any country that aids Russia’s war effort in Ukraine could expose themselves to the risk of sanctions.

Imposing sanctions would have serious implications for China’s banks, which are vast international institutions that rely on connecting to the global infrastructure to serve the aims of Chinese organisations internationally. While the initial news reports may have caused alarm in some circles, a later report by Reuters cited an official source as saying that the US, although it has had preliminary discussions on the topic, does not have any plans to implement such sanctions on Chinese financial institutions.

Crisis looms?

News media have reported on other issues that are currently affecting the banking sector in China. It is, however, the problems in the property sector that continue to dominate. In January, a Hong Kong court issued a winding up order against the property giant China Evergrande Group, which had been unable to meet its debt obligations. This has been viewed as a symptom of the wider malaise in the property sector – and China’s financial institutions which had been lending to property developers. Many believe that these protracted problems in the property sector could spill over into a systemic crisis. For example, Arturo Bris, Professor of Finance at IMD Business School, writes, “The precarious state of China’s financial system raises alarm bells for global economic stability.”

Bris argues that a crisis is looming that could have major ramifications for financial markets, global supply chains and international trade. Given the disruption in China during the Covid pandemic to international trade, multinationals’ business – and the global economy – could suffer major disruption if problems in China’s banking sector are not kept under control. Bris writes that a crisis would spark panic and sell offs in the equity markets. And if banks aren’t performing well, businesses will suffer as credit conditions tighten and companies will be unable to borrow. This in turn could affect consumer confidence, reduce demand and hurt the real economy. And if China’s economy suffers, so does the worlds.

The root of these problems, argues Bris, is in the property sector, and although local provinces are injecting capital through special-purpose bonds, there are also rising consumer credit defaults, especially in real estate, which is creating further pressure on the banks. The major banks, however, are state-owned and there is an implicit understanding – comment many observers – that the Chinese government will step in if necessary. Bris argues this creates a systemic risk and the crisis could be much larger than the US subprime mortgage crisis.

Bris is not the only commentator to think this. Kyle Bass, an investor and Founder of Hayman Capital Management, was quoted by Business Insider as saying, “We think that [China’s] real estate losses are US$4trn at least.” This compares to the losses from the global financial crisis that were in the region of US$700bn. Bass also said, back in December 2023, “To have a properly functioning capital market, you have to understand the banking system, and their banking system is in freefall right now.”

Differing views of China

There are differing views of the state of the Chinese banking sector, however. James Stent, author of ‘China’s Banking Transformation: The Untold Story’ comments that the analysis of Chinese banks often assumes they are similar to Western financial institutions – which they are not. Stent describes Chinese banks as hybrid institutions: they operate in the same way as Western institutions in their corporate governance, but ultimately their purpose is to serve the real economy and the goals of the Communist Party. “The Chinese banking sector operates to different dynamics and a different purpose,” Stent tells Treasury Today Asia. “The Chinese banking system does not exist in and of itself; it is designed to serve the development needs of the country and provide financial services to the people,” he adds. In this sense, as Stent also argues in his book, it makes sense to compare Chinese banks to the ‘developmental states’ of North Asia, such as South Korea and Japan, where the governments were heavily involved in the banking sector so the countries could become developed economies.

China observers are often split on how they interpret events. Peter Alexander, Managing Director of Z-Ben Advisors, compares it to a Rorschach test – the psychological test where individuals look at inkblot pictures to reveal their perceptions. Beijing recently removed thresholds on the minimum downpayment needed to buy homes. The central bank previously had a number of measures in place to let the air out of the property bubble and curb speculation. It was previously incredibly difficult to purchase a second property and the downpayment was high, at 65%. That has now been reduced to 25%. And for first-time buyers, who previously needed 30% equity before they could invest in the property market, now only need 15%.

The move to reduce these downpayment thresholds, and encourage home-buying, is described by Alexander as ‘yet another China Rorschach test’. “Whatever your current views on China will determine how you’ll internalise Beijing’s move to support the local property market,” Alexander said in a recent recording. “It is self-evident that an oversupply of property represents a material structural risk to the Chinese economy. Working through the problem will take time. The Beijing leadership and policymakers clearly understand the risk and are being quite methodical in how best to address the issue. That said, I think it is safe to put to bed the entire ‘this is China’s Lehman moment’ hyperbole,” added Alexander.

There have been numerous reports of an impending crisis, but China observers will note that this kind of reportage is nothing new; China’s banking system for years has been reported to be on the brink of a collapse that could send shockwaves around the global economy. So far, such predictions have failed to materialise.

When it comes to problems in the property sector, Stent says, “The government will prevent the property crisis from precipitating a systemic banking crisis – that would be unacceptable to the Communist Party. Property developers can be allowed to fail, but not major banks.”

Capital buffers

One measure that will improve the soundness of the banks is an additional boost to their reserves. This is a move that is in line with global regulations for banks that are ‘too big to fail’. Back in 2015, the Financial Stability Board (FSB) introduced rules for global systemically important banks (G-SIBs) so they would have more of a buffer in the event of a crisis. This was introduced after the global financial crisis when major international banks had to be bailed out by the taxpayers. Now, shareholders and creditors would have to take the hit if banks were in trouble. China’s banks were always going to be impacted by this regulation because they are some of the largest in the world. The global regulator, the FSB, gave them ten years to meet these new rules – and that deadline has now come around.

The central bank, the People’s Bank of China, has now set those rules for its G-SIBs. ICBC, BOC, CCB and ABC need to have total loss-absorbing capacity (TLAC) equivalent to 16% of risk-weighted assets, and this will rise to 18% by January 2028. Bank of Communications (BoCOM) has since become a G-SIB and has been given an additional two years to meet the deadline, according to Reuters. The rules mean that Chinese financial institutions are raising funds to bolster their balance sheets. Fitch estimates that the banks will raise ¥6.2trn by January 2028.

The South China Morning Post (SCMP) recently reported that ICBC and BOC would be raising ¥30bn each through TLAC bonds in order to meet the requirements. Vivian Xue, APAC Director of Financial Institutions at Fitch Ratings, was quoted by SCMP as saying, “We believe that the issuance of TLAC bonds will help banks establish a new loss-absorbing layer when capital instruments are insufficient to absorb losses, allowing the lenders to bail themselves out, rather than resorting to help from outside. Overall, TLAC bonds will help to enhance banks’ total loss-absorbing capacity and risk resilience.”

Meanwhile, in April, Fitch Ratings revised its outlook for Chinese banks from negative to stable and upgraded the six major state banks: ICBC, CCB, BOC, ABC, BoCOM and Postal Savings Bank of China. Fitch noted that the state-bank ratings are closely tied to its sovereign ratings for China, which reflects Fitch’s “view of a very high probability of the central government supporting the banks in a timely manner in the event of stress.”

Government safety net

There are some who argue that the necessity of additional buffers for China’s largest banks is a moot point because the major banks are state-owned, and the government would step in to rescue them if necessary. But what if a crisis spirals out of the control of the government? Could contagion take hold where the government is powerless to rein in the panic? Many don’t think so. Stent says China’s ability to handle a crisis should not be underestimated.

However, China is facing many issues concurrently. This comes at a time when Xi has numerous ambitious goals for China, including investing in the country’s defence apparatus, increasing its technological capabilities, creating a more equal society, and becoming independent of the West. “This is placing enormous financial strains on what the government and the economy can sustain,” says Stent.

What is different this time, says Stent, is that China is having to handle multiple challenges; rather than focusing and prioritising its course of action as a sequence of events, now it is having to do everything at once. “China has faced many crises and is good at solving them one by one,” says Stent. Now, however, the question is: “Can they deal with multiple crises at the same time?”

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