As Chinese banks creaked and groaned under the weight of increased demands to lend and large amounts of undeclared bad loans, it only became a question of time before bank bailouts began. Well, the bank bailouts in China have begun.
Despite hyperbole over unprecedented risks to the Chinese financial system from pundits, a rickety Chinese banking system and bailouts are very precedented. In the early 2000s, China faced a rising tide of bad loans that threatened to overwhelm its banking system. From roughly 2004 to 2006, China undertook a massive recapitalization of its banking system covering national- and city-state-level banks.
The recapitalization occurred through two primary channels. First, Beijing created four state-owned “bad banks” that were capitalized with state money, which then purchased bad loans from banks. These banks have a decidedly mixed record. Some of the loans ultimately were repaid as China enjoyed rapid growth from 2005 to 2020. However, large amounts of these loans haven’t been repaid and exist as zombie assets that are unlikely ever to be repaid at even heavily discounted rates. Today, these bad banks range from officially bankrupt to teetering on the edge of bankruptcy.
Second, many local governments stepped in to buy assets from banks to keep them from collapse. Here’s how the deals generally worked. The local government would buy a large amount or all of the bad debt, so the banks wouldn’t have the bad loans in their book and could continue making loans at a very long-term low or zero interest rate. The bank would then repay the loans based upon a specific hurdle or event, such as going public with a specific portion of earnings or repurchasing the bad debt in tranches.
Since large amounts of the bad loans were linked to public projects and the government needed the banks to keep making loans, there was a symbiotic need for each other. The downside was that the debt was never written down, or assets disposed of, as the government never addressed the underlying problem of bad debt. So when the bank was repaying its bad loan debt or repurchasing them, nothing had fundamentally changed about the bad debts.
China was able to tackle a significant amount of its previous bad debt by simply outgrowing its bad debt, not by actually adjusting valuations, writing down or writing off loans, or addressing banking practices. Outgrowing bad loans is uncommon on individual bad loans and incredibly rare at a macroeconomic level.
China hopes to repeat this feat as it starts addressing bad loans in the banking sector less than 20 years after the last time Beijing tried to recapitalize the banks.
Just recently, Hong Kong-listed Shengjing Bank from the northeastern province of Liaoning announced that it had sold 176 billion yuan ($24 billion) worth of bad loans to the Liaoning provincial government. However, a closer look at the transaction reveals a lot of movement and little substance.
The deal between Shengjing Bank and Liaoning is straightforward and just serves to paper over and delay dealing with the fundamental problem. No actual money is changing hands in the transaction between Shengjing Bank and Liaoning. Liaoning Asset, under the local department, is simply receiving a package of loans and investments and then issuing 15-year notes for the 176 billion yuan back to Shengjing Bank, which carries a 2.25 percent interest rate. In effect, Shengjing Bank is passing off its bad loans to the local government, hoping to get repaid in 15 years while accepting a minimal interest payment well below the official rate.
Shengjing Bank undertook this asset disposal in order to “enhance the asset quality of the bank.” However, on the surface, this is a puzzling move if we accept its published records as factual. According to Shengjing Bank’s half-year report, it had a nonperforming loan ratio of 3.17 percent, which actually declined from the 2022 level of 3.22 percent. Additionally, Shengjing Bank supposedly has bad loan provisions of 4.5 percent, meaning it has set aside 1.5 times as much as its bad loans to cover bad loans.
The amount of the loan sale also seems puzzling. The 176 billion yuan asset sale to Liaoning Asset comprises 16 percent of all Shengjing Bank’s assets, and the loan portion comprises more than 20 percent of all loans on its books. Put another way, Shengjing Bank is offloading more than five times the amount of bad loans it reports, even as it reports plenty of provisions to handle bad loans.
The problem is actually deeper and more hidden than the official financial statements make it appear. Until late 2022, Shengjing Bank’s largest shareholder and one of its largest clients was real estate developer Evergrande. In fact, in late 2022, Shengjing Bank filed a lawsuit against Evergrande for more than 32 billion yuan ($4.4 billion) in unpaid loans.
That 32 billion yuan in unpaid loans is important beyond the fact that Evergrande is unlikely to repay those loans any time soon. In its first-half financial results, Shengjing Bank listed only 3.7 billion yuan ($507 million) in loan losses and has less than 20 billion yuan ($2.7 billion) in bad loans in total. So, somehow, Shengjing Bank can’t collect more than 32 billion yuan from a client that’s in default and declaring bankruptcy, but it lists only 20 billion yuan in bad loans in its entire portfolio.
There are a few key points about the Liaoning–Shengjing Bank bailout. First, this basic structure is the historical pattern for Chinese bank bailouts. Little or no money actually changes hands, bad assets are moved to some other legal entity, and nothing is done to address the underlying asset value or banking practices. Consider this a generalized framework for future bank bailouts.
Second, even with rapid growth, large amounts of debt and assets remain from the last Chinese bank bailout nearly 20 years ago during a period in which China enjoyed historically unrivaled growth in the history of mankind. China is highly unlikely to enjoy such luck a second time, meaning more bad assets will pile up in the financial system and on government balance sheets. Even with the interest rate at a significant discount, Liaoning will struggle to repay this debt in 15 years with any type of reduction in asset value. If these are real estate and public infrastructure assets, the most likely pool of bad loans sold, then this has merely deferred the day of reckoning at a higher cost.
Third, this entire case cuts directly to why Chinese and international investors don’t believe published economic and financial data or that the government won’t stand behind major investors. Shengjing Bank’s financials clearly don’t come close to reconciling with its own financial problems, and Beijing is bailing out a bank that it desperately needs. Investors won’t believe financial and economic data but will continue to believe that the government will always come to the rescue.
As Chinese banks continue to need assistance, this is just the beginning of what’s sure to be an enormous, expensive, and lengthy process.
