China’s banks: A sunny spell

A new mood of optimism infects investors in China’s banks

But many believe that the underlying faultlines remain

Apr 12th 2017 | SHANGHAI

GUO SHUQING, China’s new banking regulator, knows the enormity of his task. China’s banking system, he observed last month, is worth more than $33trn. So it is bigger than any other country’s, and even than Europe’s as a whole. And he is well aware of the pitfalls left by a decade of breakneck lending growth. But if Mr Guo is nervous, he is hiding it. “All problems and contradictions will be resolved,” he says.

Of course, a Chinese official can be expected to express confidence about Chinese banks. More surprising is that a small but growing number of analysts and investors seem to concur. Chinese bank shares are up by a quarter since early last year. One investment bank, Morgan Stanley, has declared that China’s lenders are “in a sweet spot”. Another, Goldman Sachs, has upgraded China to “overweight”—that is, recommending that clients buy Chinese shares—and is especially positive about the banks. Shanghai Financial News, a local newspaper, described the new mood around these giant institutions as the “return of the king”. The question is whether it will be a long, stable reign or a short-lived, turbulent one.

The clearest positive for China’s banks has been an upturn in nominal economic growth. Real GDP growth (ie, accounting for inflation) is likely to be little changed in 2017 from last year’s 6.7%. But nominal growth is nearly 10% in yuan terms, up markedly over the past 12 months. Higher prices have led to stronger corporate revenues, particularly for indebted steel-producers and coalminers. This, in turn, has made it easier for them to repay loans. Chinese banks’ official bad-debt ratio, climbing since 2012, held steady last year at about 1.7%. Many analysts still think the real level of toxic loans is many times that (some estimate the ratio is as high as 19%), but the bleeding has clearly slowed.

Meanwhile, banks have started to clean up their balance-sheets. In part, this has been through more write-offs of problem loans. Banks took losses on more than 500bn yuan ($75bn) of loans last year, a record, scrubbing them from their books and selling some to investors. With more credit going to infrastructure projects and to mortgages, which traditionally have been safe in China, loan portfolios are looking healthier. Richard Xu of Morgan Stanley reckons that high-risk credit will decline from about 6% of total credit in China today to less than 3% by 2020.

There are also signs that China’s bloated state-owned banks are getting a little more efficient as they respond to competition from fintech companies. The four biggest banks, which account for nearly two-fifths of the industry’s assets, cut employees in 2016 for the first time in six years. Banks have been rolling out mobile apps to handle payment and investment transactions that used to be conducted in person. Overall costs of listed banks rose by just 0.6% last year, even as assets grew by 12%.

All these good omens, however, may not mean China’s banks have really turned the corner. The beautification of their books has relied on financial engineering. Over the past three years the government has approved the creation of 35 asset-management companies (ie, “bad banks”). Jason Bedford of UBS, a Swiss bank, says that these companies, which buy delinquent loans from banks, often also finance themselves through bank loans.

Debt-for-equity swaps are another form of financial engineering: instead of repaying loans, indebted companies can issue shares to third parties, which acquire the loans from banks. Yet the fine print shows that their equity functions like bonds: the companies must pay dividends and buy back shares if they miss revenue targets. Moreover, the parties holding the equity are funded in part by investment products sold off-balance-sheet by banks. The upshot is that, whether stashed in bad banks or converted into equity, the debt could yet bounce back into banks’ hands.

The simple problem that underlies this complex restructuring activity is excessive lending growth. China’s total debt-to-GDP ratio has risen from less than 150% before 2008 to more than 260% today; in other economies, such increases have often presaged severe financial stress. Aware of the dangers, the Chinese government has made reducing debt a priority. It is taking baby steps towards that goal: thanks to faster nominal growth, China’s debt-to-GDP ratio will expand more slowly this year. But it will still expand. S&P Global, a rating agency, warned in March that this trajectory for Chinese banks is unsustainable.

Efforts to curb borrowing are themselves emerging as a new risk. Over the past few months the central bank has raised banks’ short-term borrowing costs. That has been a shot across the bows of overextended lenders, especially mid-tier banks. These have been most aggressive in funding themselves with loans from other banks, rather than doing the painstaking work of building up bigger deposit bases.

Already this tightening has led to volatility. In March the central bank made an emergency liquidity injection after small banks were reported to have missed interbank debt payments, suggesting that the basic gears of the financial system were starting to get gummed up.

For many in the market, the cons in Chinese banking outweigh the pros. Bank shares have rallied since last year, but investors still price them just at about 80% of the reported value of their assets (see chart). In other words, they expect more bad news to come—if not this year, then soon enough. From his seat in the regulator’s office, Mr Guo has his work cut out: not just in controlling risks, but also in persuading the wider world that it still has China’s banks pegged wrong.