China’s Worsening Debts

A veil has just been lifted that for years hid the true financial health of China’s four biggest state-owned banks. The veil may not have been lifted very high, but an alarming picture is already taking shape.

The performance of this group of banks is critical to China’s future because they account for most new lending. Furthermore, they still dominate the country’s financial sector. Together, they had assets of more than RMB 10,000bn ($1,200bn) at the end of last year, equivalent to 115 per cent of China’s gross domestic product.

The Bank of China, one of the four, recently disclosed its level of non-performing loans based on new, more forward-looking criteria that correspond more closely to international standards. Applying the new criteria, non-performing loans in 1999 accounted for 39 per cent of the bank’s loan portfolio—2.6 times more than the ratio reported the year before using the old criteria. More important, there is evidence that new non-performing loans continue to emerge at a prodigious rate.

The poor performance of these banks is no secret. The People’s Bank of China, for example, the country’s central bank, has long acknowledged their low profits, large accumulations of non-performing loans and minimal capital adequacy. But the precise state of affairs was never clear until now. Many of the banks’ non-performing loans have been transferred to state-owned asset management companies set up to improve the banks’ balance sheets. According to Dai Xianglong, the central bank governor, the scheme has reduced the banks’ combined non-performing loans from 35 per cent of the total loan portfolio at the end of 1999 to 25 per cent by the end of 2000.

Yet these figures seem to be calculated using the old criteria. And even if one accepts them, a comparison with the actual value of non-performing loans transferred to the asset management companies suggest that an additional RMB 400bn emerged in new bad loans during 2000. That is equivalent to more than 4 per cent of GDP. Given such a big increase, it doubtful that the absorption of bad loans by the asset management companies will be a one-off exercise, as Chinese authorities have claimed.

Increasingly the question is: how will the state be able to bear the fiscal cost of restoring the banks to financial health and prevent households from suffering massive losses on their deposits? The government issued RMB 270bn in bonds to bolster bank capital in 1998. It is also the implicit guarantor of RMB 1,400bn in bonds issued by the four asset management companies in 1999 and 2000. In addition, the big four banks still have almost RMB 2,000bn in non-performing loans on their balance sheets. Using international standards, that figure could be as high as RMB 5,000bn. In total, this amounts to 40-75 per cent of last year’s GDP.

Compounding the government’s growing fiscal problem is the modest performance so far of its asset management companies.

By the end of last year, they had disposed of RMB 90bn in bad loans—about 6 per cent of the non-performing assets taken over from the banks. The cash recovery on these sales was only RMB 8.3bn. That is far below the interest due on the bonds issued by the asset management companies to banks, which is in excess of RMB 30bn a year.

Worse, the asset management companies appear to have financed most of their interest and other obligations by borrowing from the central bank.

China’s Ministry of Finance never tires of pointing out that its budget deficit and government debt outstanding are low by international standards: 3 per cent and 15 per cent of GDP, respectively, in 2000. Yet these figures are misleading for four reasons. First, the true deficit is closer to 7 per cent if borrowing by the asset management companies is included. Second, government debt outstanding is understated because it excludes bonds issued by the state-owned asset management companies as well as bonds of the state-owned policy banks created in the mid-1990s. These amount to an additional 25 percentage points of GDP. Third, the official debt figure makes no allowance for implicit government debt, which includes not only the need for a substantial additional injection of funds into the banks but also China’s huge implicit pension debt. Last, China’s budgetary revenues are very modest—less than 15 per cent of output. As a result, in 1999 and 2000 the central government financed more than half its own expenditures by net bond issuance.

China’s Ministry of Finance never tires of pointing out that its budget deficit and government debt outstanding are low by international standards: 3 per cent and 15 per cent of GDP, respectively, in 2000. Yet these figures are misleading for four reasons. First, the true deficit is closer to 7 per cent if borrowing by the asset management companies is included. Second, government debt outstanding is understated because it excludes bonds issued by the state-owned asset management companies as well as bonds of the state-owned policy banks created in the mid-1990s. These amount to an additional 25 percentage points of GDP. Third, the official debt figure makes no allowance for implicit government debt, which includes not only the need for a substantial additional injection of funds into the banks but also China’s huge implicit pension debt. Last, China’s budgetary revenues are very modest—less than 15 per cent of output. As a result, in 1999 and 2000 the central government financed more than half its own expenditures by net bond issuance.

China needs both to accelerate the restructuring of its loss-making state-owned manufacturing companies—the underlying cause of most of the non-performing loans in the banking system—and to develop a fully commercial credit culture in its state-owned banks. If it fails, it will find itself in a full-blown fiscal crisis.