Asia managers warn of threat from Chinese ‘zombie banks’

IMF urges China to bring state-owned banking sector into line with international practices

The International Monetary Fund (IMF) has urged China to bring its financial sector into line with the West, as leading Asia managers warn a looming spike in defaults could create a raft of ‘zombie banks’.

The IMF’s latest report on China’s stability said its banking system entered the global crisis from a position of strength, but has become increasingly complex, while off-balance sheet activity is rising.

“Institutional reforms will help bring the system more in line with international practices,” the IMF said, adding China needs a framework to allow orderly wind ups of distressed financial institutions.

China’s banks are state-owned, and are used by the government to support economic growth, even where this means making bad loans. The result is the government often has to stump up cash to support the banks, and of course foreign investors in these institutions also have to shoulder some of the burden.

The next wave of defaults is already on the way, with Schroders’ head of Asian equities Robin Parbrook warning of a black hole in the banking system equivalent to 25% of GDP, while Fidelity’s Anthony Bolton predicts a 20% default rate for lending through local government finance vehicles.

“The market has finally clicked what a mess the Chinese financial system is in and we feel this could be the trigger that results in a capitulation point in Asia and brings markets down to crisis lows,” Parbrook said.

He added there has been a boom in ‘shadow finance’, with over half of credit creation in China now off balance sheet.

Parbrook expects most banks in the country will end up as ‘zombie banks’, meaning they are technically insolvent but are kept alive by liquidity support from the state.

Although the 25% figure is “scary”, Parbrook said China can afford it, given its low government debt to GDP ratio and the fact losses can be spread over many years.

“We think over all segments [of the market], we will see significant bad debt problems. The situation could unravel fairly quickly over the next three to six months. In particular, the off balance sheet lending is effectively a chain that, when broken, will result in defaults all along it,” he said.

Could this raft of non-performing loans trigger a systemic crisis? First State’s head of global emerging market equities Jonathan Asante said it really hinges on whether we know the truth about China’s financial strength. 

“China’s fiscal position is difficult to understand and assess,” he said. “It depends on how much money you think the banks need. At the moment China’s fiscal position is credible, but the fiscal position in Greece was credible until three years ago. I think China’s position is better than some others but it is hard to assess because of all the state owned enterprises.” 

Parbrook said although China is facing serious problems, he does not think it will lead to a complete collapse in the growth rate or a full blown financial crisis.

Bolton echoed this sentiment, saying the Chinese government has adequate resources to deal with the losses. For him, shadow finance is more of a concern.

“In the past, the government has generally taken bad debts off the banks’ balance sheets at face value and guaranteed them. I expect something similar to happen again in two or three years’ time when the new political leadership will be able to blame its predecessors,” Bolton said.

“A newer worry for investors is the growth of the unofficial loan market in China. This market has always been there but during the tightening phase over the last 12 months or so it has grown at a very fast rate as banks restricted loans to borrowers and these borrowers have had to look elsewhere for funds.

“Although most loans are secured, the big expansion in volumes and the monetary tightening means there is the potential for loan losses which could impact some lenders, particularly in certain cities.

“I do not believe, however, that this is a major national problem that will have a big impact on the economy.”

So will the IMF’s push to get China to operate its banks more as commercial entities be enough to avert a future crisis and encourage foreign investment? Parbrook says yes.

“Broadly, we agree with the IMF’s conclusions. Banks are probably already in trouble but, if dealt with now, problems are manageable.

“A move to market interest rates and the proper pricing of credit would be a huge step towards genuine economic rebalancing, which would start to get us excited and keen to rebuild positions in the market.”

Asante is less positive, pointing to the difficulties of analysing banks’ balance sheets, because of “smoke and mirrors” accounting practices. 

He said he would find it “extremely difficult” to invest in the banks as a minority investor as long as they remain under government control.