The Real Cost of Chinese NPLs

Wed, Jan 26, 2011 - 8:42am

Once again I am starting to hear investors tell me that they have been advised by bank analysts not to worry too much about the impact of a banking crisis in China. According to this argument, China has developed a very efficient and low-cost way to address banking crises, and the proof is that China’s last banking crisis, which occurred only a decade ago, was quickly and easily resolved. I am afraid this argument makes absoutely no sense and is based on an inability to understand how the crisis was actually resolved.

Throughout modern history, and in nearly every economic system, whether we are talking about China, the US, France, Brazil or any other country, there has really only been one meaningful way to resolve banking crises. Whenever non-performing loans or contingent liabilities surge to the point where the solvency of the banking system is threatened, the regulators ensure that wealth is transferred in sufficient amounts from the household sector to borrowers or banks to replenish bank capital and bring them back to solvency. The household sector, in other words, always pays to clean up the banks.

There are many ways to make them pay. In some cases, and certainly in the US before the 1930s, banks simply defaulted and their depositors absorbed the full loss. In that case it was the actual bank depositors, mainly households, who directly bore the full cost of the losses, in the form of reduced, or sometimes no, repayment of their deposits.

Largely because this kind of system creates incentives for bank runs, regulators developed alternative systems, by which governments guaranteed deposits and otherwise bailed out the banks, and paid for the bailout by raising taxes. In that case the household sector still paid for the losses, but they did so largely in the form of taxes, and the losses were spread throughout the population.

Of course this way of bailing out the banks is politically unpopular and always leads to uncomfortable calls to punish the banks for their behavior. If the regulators are given a longer amount of time during which to clean up the banks, they can use other, less obvious and so less politically unpopular, ways to do the same thing, for example by managing interest rates. In the US and Europe it is fairly standard for the central bank to engineer a steep yield curve by forcing down short-term rates. Since banks borrow short from their depositors and lend long to their customers, the banks are effectively guaranteed a spread, at the expense of course of depositors. Over many years, the depositors end up recapitalizing the banks, usually without realizing it.

There are two additional ways used in countries, like China, with highly controlled financial systems. One is to mandate a wide spread between the lending and deposit rates. In China that spread has been an extremely high 3.0-3.5 percentage points. The other, and more effective, way is to force down the lending and deposit rates sharply in order to minimize the loan burden and to spur investment. This is exactly what China did in the past decade. These low interest rates help resolve non-performing loans by granting continual debt forgiveness to borrowers.

How so? Because if interest rates are set at a level lower than the natural rate, every year the borrower is effectively granted debt forgiveness equal to the difference between the two. By most standards, even ignoring the borrower’s credit risk, the lending rate in China during the past decade is likely to have been anywhere from 4 to 6 percentage points too low. Over five or ten years, or more, this is an awful lot of debt forgiveness.

These all sound like radically different ways of addressing insolvent banking systems, but make no mistake, they are all simply different ways of spreading the cost of bank insolvency among households.

With all the concern generated by China’s recent minimum reserve hikes and the controversy over 2011 lending quotas, it is important to remember this in the face of the widely-held but wildly incorrect belief that China was able to grow out of its last banking crisis at a relatively low cost to the economy. Why this belief? Because ten years ago, the share of non-performing loans in the Chinese banking system was estimated to range from 20 percent to 40 percent of total loans.

Within the decade, however, this once-staggering share of bad loans had shrunk dramatically to a manageable level, wihout anything resembling a Western-style banking crisis. Many analysts believe that it was combination of explicit steps to recapitalize the banks — directly by injecting capital and indirectly by purchasing bad loans at very high prices — and very rapid GDP growth, matched by even more rapid loan growth, that resolved China’s banking crisis.

In that case, these analysts say, why worry? If there were another sharp rise in non-performing loans – as many, including Beijing’s banking regulators, expect – China would easily grow out of it again using the same combination of factors, and the cost to the economy would once again be minimal.

But they would be wrong. In fact the cost of cleaning up the last banking crisis was very high, much higher than simply calculating the explicit cost of recapitalizing the banks by direct and indirect equity infusions, and so will the cost of the next one be. The combination of implicit debt forgiveness and the wide spread between the lending and deposit rate has been a very large transfer of wealth from household depositors to banks and borrowers. This transfer is, effectively, a large hidden tax on household income, and it is this transfer that cleaned up the last banking mess.

It is not at all surprising, then, that over the past decade growth in China’s gross domestic product, powered by very cheap lending rates, has substantially exceeded the growth in household income, which was held back by this large hidden tax. It is also not at all surprising that household consumption has declined over the decade as a share of gross national product from a very low 45 percent at the beginning of the decade to an astonishingly low 36 percent last year.

This is how China’s last banking crisis was resolved. It did not result in a collapse in the banking system, but it nonetheless came with a heavy cost. The banking crisis in China resulted in a collapse (and there is no other word for it) in household consumption as a share of the economy.

This is why the People’s Bank of China is so worried about another surge in non-performing loans. If the household sector is forced once again to clean up a banking mess, this will make China even more reliant for growth on the trade surplus and on investment, and that is something many in Beijing, including the PBoC, do not want to see.

Remember that there is no such thing as a painless banking crisis and anyone who suggests otherwise should not be taken very seriously. There is always a significant cost, and the cost is almost always borne one way or the other by the household sector. In China, with its already too-low household consumption, it will be very risky to force households to clean up yet another surge in non-performing loans. It would only make it more difficult than ever for China to achieve the rebalancing its economy so urgently needs.

This is an abbreviated version of the newsletter that went out Monday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis[at]yahoo[dot]com, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities (HK) will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me at that address.