Commentary
As nonperforming and special mention loans are rising, Beijing instructs banks to securitize them, evoking reminders of the 2008 global financial crisis, which was triggered by banks bundling bad loans into securities and selling them to investors.
Nonperforming loans (NPLs)—loans that borrowers are unable to repay—experienced a notable increase last year, especially in the real estate sector, where NPLs rose from 2.8 percent at the end of 2022 to 4.99 percent at
the end of 2023. Large banks such as Industrial and Commercial Bank of China Ltd. witnessed NPLs from residential mortgages
surge by 9.6 percent. This sharp increase in distressed loans in the property sector is particularly concerning because of real estate’s substantial contribution, accounting for about 20 percent of the economy and
more than a quarter of the loans held by major banks.
Simultaneously, the aggregate nonperforming loan ratio across all industries stands
at only 1.6 percent, slightly higher than the
United States’ 1.4 percent but in line with many developed economies. However, China’s banking classification system masks the true extent of potential loan troubles. Special mention loans are deemed riskier than performing loans but not yet classified as NPLs. In other countries, some of these
special mention loans might already be categorized as NPLs because of stricter criteria. This variance in classification leads to a scenario in which China’s reported NPLs may seem lower than their actual status. The pool of special mention loans in China could signify a concealed reservoir of potential future NPLs, posing a greater risk to the banking system.
Chinese banks wrapped up the year
holding $620 billion of special mention loans. With
new transparency guidelines in place, many of these special mention loans will need to be recategorized as nonperforming, causing the NPL percentage to surge. Consequently, the aggregate nonperforming asset ratio, which includes both nonperforming loans and other assets such as repossessed real estate, is projected to reach between
5.5 percent and 5.9 percent.
The surge in NPL and special mention loans can be attributed to various factors. China’s slowing economic growth makes it harder for borrowers to make payments, while
weak home sales hinder developers’ ability to recover investments. Rising youth unemployment and delayed marriages contribute to declining home sales and consumer spending. Additionally, uncertainty from the U.S.–China trade war dampens business investment and borrowing. Compounding the problem, tighter credit conditions imposed by the central government to control debt levels further restrict loan accessibility for some borrowers.
The significant concentration of NPLs and special mention loans in the real estate sector poses an increased risk for Chinese banks. Should borrowers default and banks resort to property foreclosures, they may incur losses amid the market slowdown. With fewer loans recovered, banks have less capital available for lending. Banks may become more cautious about lending in the real estate sector, limiting funding for new development projects. This also means that Beijing cannot use real estate development to spend its way out of its current economic downturn.
To address the problem, the central government has instructed banks to
securitize nonperforming loans. Securitization essentially slices up a pool of bad loans into different risk categories (such as high-, medium-, and low-risk). These slices are packaged into financial instruments and sold to investors. NPLs can be securitized into bonds, mortgage-backed securities, asset-backed securities, collateralized debt obligations, or even derivatives. Issuance of securities backed by NPLs by Chinese banks is expected to increase
by about 40 percent this year, with lenders offloading distressed mortgages, delinquent credit card debt, and troubled consumer loans.
The benefit of securitization is that banks can recover some of the cash they loaned out. It also distributes the risk across multiple investors who buy the securities. However, it does not eliminate the bad debts or the underlying problems in the Chinese economy that led borrowers to default. Another concern with securitization is that it exacerbates the opacity issues already present in China’s banking system. Once the debts are securitized and sold, tracking and quantifying the percentage of NPLs or the actual risk banks are exposed to becomes nearly impossible, as does assessing the severity of the economy’s situation based on the percentage of individuals unable to repay their loans.
Distributing the risk may seem like a good idea, but it can result in contagion. NPL-backed securities carry high risk because of the probability of borrower defaults. This scenario mirrors the global financial crisis, when mortgage-backed securities were created from bundles of subprime mortgages—home loans granted to borrowers unable to afford them. These securities were then sold to investors who underestimated the associated risks.
The housing market bubble eventually burst, causing a decline in property prices. Consequently, there was a sharp increase in defaults on subprime mortgages, causing the value of mortgage-backed securities to plummet. By securitizing the mortgages and selling them to investors, the risk was transferred from banks to other sectors of the economy, such as pension funds, insurance companies, mutual funds, and individual investors, both large and small.
In conclusion, China’s economy is clearly slowing down. This is evident from declining consumer and home sales, as well as increasing defaults. Regardless of the Chinese Communist Party’s approach to addressing the nonperforming loan percentages on paper, the underlying causes persist, ranging from declining exports and factory activity to the aging crisis, debt bubble, and decreasing foreign direct investment. Attempting to conceal the evidence will not eradicate the underlying problems.
Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
