Chinese defaults are back and looking messier. Creditors are losing hope, and the banks are getting worried.
After a regional state-owned enterprise with a AAA credit rating, Yongcheng Coal & Electricity, failed last week to pay 1 billion yuan ($151 million) on a short-term bond, jitters rippled through the bond and money markets. Share prices of Chinese banks also took a beating. Regulators unexpectedly didn’t intervene, putting investors on edge: Policy makers may be done with their Covid-19 sympathy and forbearance, making state bailouts no longer a fail-safe.
The shudders worsened following news from Baoshang Bank Co., which last year became the first lender seized by regulators in more than two decades. The bank said it was writing down 6.5 billion yuan of tier-2 capital bonds and will not make remaining payments of 585.6 million yuan after authorities deemed a “non-viability trigger event” had occurred. Such bonds are structured to absorb losses. Chinese banks have 2.3 trillion yuan of this kind of debt outstanding onshore.
Commentary from the central bank’s vice governor about exiting its monetary easing stance added to the anxiety. Maybe Beijing is getting tough after all, and is no longer reflexively saving the zombies. So let’s say regulators aren’t just fear-mongering and will, in fact, batten down the hatches. Are banks ready to digest the bad loans or deal with wily debtors shifting assets before they stop making payments?
Unlikely. For one thing, they’re still recovering from propping up the real economy through the coronavirus outbreak. For another, smaller lenders are in no shape to take on a stream of defaulters.
Based on the People’s Bank of China’s recent financial stability report, financial institutions were sitting on 2.84 trillion yuan of non-performing loans at the end of the third quarter, up almost 100 billion yuan since the previous three months. That’s after they disposed of 5.8 trillion yuan of dud loans over the last three years, more than the preceding eight years combined. The official bad debt ratio was close to 1.96%. The balance of loans overdue for more than 90 days was 2.59 trillion, up 4.4%. The burden on balance sheets is already high; if these debts start turning sour faster than the lenders can handle, it’s hard to say whether they’ll be able to preserve their capital buffers.
So, consider the results of the stress tests conducted by the central bank that show capital adequacy ratios would drop sharply, even under the “mild” model where the non-performing loan ratio rises to 6.73% by 2022. Under “extreme shock,” the portion of bad loans would rise to 13.36%. For small and medium lenders, the scenarios showed that hundreds could fail if the portion of bad debts doubled. The liquidity tests concluded that in the severe case, six banks would fail. They share, among other things, a higher dependence on interbank funds that pose liquidity risks.
While the banking system isn’t going belly up altogether, all this is cause for worry. What’s worse, defaulters know whether they’ll be able to pay or not, and may move their assets out of the way of creditors. As my colleague Shuli Ren wrote, even though the pace of defaults has been gradual, recovery rates are falling sharply. For banks, that means there isn’t much value left even if they go in and start clawing back collateral.
The issue isn’t so much whether China will recapitalize struggling lenders. It probably will, funded through previously announced special local government bonds that, in theory, will help for the long term. Other measures have been put in place, too.
For now, it comes down to what banks are willing to deal with. Interbank markets will get nervous. Large institutions will be reluctant to lend to smaller ones that are potentially sitting on debts of several regional state-backed firms. As cash gets tight and confidence erodes, these key funding channels could be bruised again by regulators’ sudden shifts and reduced tolerance, especially if debtors are misbehaving. Mistrust is perhaps the most dangerous of outcomes.
As analysts at Rhodium Group put it, the long-term implication is that “these SOE defaults have clearly increased the cost for local governments to maintain their credibility, especially because in many cases, defaults occurred immediately after localities' pledges of support.”
The PBOC injected liquidity Monday in a show of faith, but that doesn’t change the fact that banks are now dealing with a growing pile of known risks. They just don’t know how big. That uncertainty will be brutal.
Bloomberg
