Chinese banking system under fire!

Yvan Berthoux - 27 November 2019

China has the world’s largest financial system as assets reached US$40 trillion in 2019, twice the size of the US. Elevated economic uncertainty combined with growing counterparty concerns have significantly raised Chinese repo rates, forcing small and medium-sized banks to rely entirely on wholesale deposits for funding, making bank failures more probable. As opposed to the ‘Big Four’ (ICBC, China Construction, Agri Bank of China, Bank of China), small and medium-sized Chinese banks rely much more on wholesale funding (figure 1, left frame), and rising interbank rates will directly impact their net interest margin, which is the difference between the interest a bank gains on its assets (loans and investments) and the interest it pays out on its liabilities (mainly deposits).

Bad debts and rising non-performing loans have interacted with poor governance in small and medium Chinese banks to create a series of bailouts and nationalizations earlier this year (e.g. Heng Feng Bank, Bank of Jinzhou). Alternative measures of the growth of the Chinese economy, such as the ‘adjusted Industrial Production’ introduced by the Chinese Academy of Social Sciences (obtained by multiplying the current industrial production by 0.7), suggest a steeper deceleration is underway. Figure 1 (right frame) shows that the growth rates of real GDP and adjusted IP correlated strongly between 1992 and 2012 but have diverged subsequently. The adjusted IP measure is currently pricing in an annual real growth rate ranging between 3.5% and 4%. This week was also marked by a collapse in China industrial profits, which plunged by 9.9% YoY in September, the biggest drop on record. As for Europe, the rise in policy uncertainty in China has been weighing on the country’s fundamentals, which could result in higher bankruptcies in the coming 6 to 12 months. Figure 2 (left frame) shows the exponential rise in the EPU index since 2010.

Even though the core equity tier (CET) 1 ratios averaged 12 per cent in the first half of 2019 for the top big four banks, small and rural banks are still undercapitalized relative to the ‘world’s standard’ with CET1 ratios below 8 per cent on average. UBS recently calculated that Chinese banks need to raise a total of US$340bn to raise core CET1 ratios to the 12.5 per cent norm. As a result, the PBoC recently warned in its annual Financial Stability Report that 13.5 per cent of China’s 4,379 financial institutions are considered ‘very risky’ (figure 2, right frame). With such a massive financial system, it is important to spell out that 13.5 per cent of US$40 trillion corresponds to US$5.4 trillion, which is a significant number, especially if the official 6-percent growth rate is overstated.

As a result of the global economic slowdown, China decided to relax its credit conditions this year and the annual growth of the Total Social Financing (TSF) reversed from -14 per cent in December 2018 to 14.3 per cent in October 2019. However, if we look at the change relative to the country’s GDP, China’s TSF rebounded from 21.6 per cent in Dec18 to 24.2 per cent in Oct19, which is significantly less than the pickups we saw in 2012 and 2016-17 (figure 3, left frame). The weakness in global trade is hindering the progress of the Chinese economy, which is also experiencing a ‘scarcity’ of US Dollars as its current account balance has now collapsed to zero. This is a difficult situation for the Chinese Communist Party, which appears still to be committed to a strong currency to recapitalize its banks and finance The Belt and Road Initiative.

Figure 1: 

Data Source: Eikon Reuters, PBoC

Figure 2:

Source: Baker et al. (2016), Bloomberg

Figure 3:

Data Source: Eikon Reuters


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