BANKING: Local Govt Meddling Worsens Chinese Bad Debt Crisis

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Bottom line: Beijing and local governments need to let struggling companies fail and stop ordering banks to continue lending to them, or risk exacerbating the country’s growing bad debt crisis.

Banks ordered to lend to sinking companies

A couple of news stories last week cast a spotlight on how local governments are preventing banks from effectively managing their growing volume of bad loans, creating obstacles that could cause the problem to worsen and even spiral out of control. Neither story was actual “news”, but instead detailed practices increasingly used by local officials to support struggling state-owned companies, often to the detriment of local banks.

In one case officials ordered banks to lend to a failing local ship builder, even though the company was almost certain to default. The other case detailed how local officials had compiled lists of struggling companies for their own records, but then withheld the information from banks due to worries that disclosure might cause those companies to lose access to new loans.

Both cases reflect the cozy relationship that existed between banks and local governments in the pre-reform era, when the former were largely policy tools of the latter rather than true commercial lenders. But such relationships are increasingly dangerous in the current era of market economics, and threaten to spread the woes gripping certain bloated and poorly managed sectors in China throughout the entire financial system.

To minimize that risk, banks need to distance themselves from local government officials and learn to say “no” to requests that don’t make commercial sense. At the same time, government officials need to be more forthcoming in providing market information that can help banks make better lending decisions to avoid seeing their current bad loan problems deepen.

China’s banks are already coming under huge pressure due to ballooning bad loans, many of them made for questionable projects during Beijing’s 4 trillion yuan economic stimulus package during the global financial crisis. Non-performing loans (NPLs) for China’s banking sector exceeded a staggering 2 trillion yuan ($300 billion) at the end of May, accounting for 2.15 percent of total loans.

Many suspect the real level of NPLs may be even higher, as banks take steps to disguise loans that are likely to default but are still listed on their books as healthy. And yet despite a problem that is widely known at all levels, local governments frequently continue to call on banks in their regions to lend to struggling enterprises that are quite likely to default on any new loans.

Sinking Shipyard

A recent media report detailed one such instance with the case of Rongsheng Heavy Industries, once China’s largest shipyard, which was hit hard in a downturn plaguing the global shipping industry. (English article) The company began running into financial difficulties in 2014, but local government officials dismissed the problems and ordered local lenders, including Bank of China (HKEx: 3988; Shanghai: 601398), to continue providing money.

As the company continued to falter, the government engineered a debt-for-equity swap as a substitute for loan repayments. Shares issued under that swap plummeted after commencing trading and could easily become worthless, wiping out 17 billion yuan in debt that was owed to 22 banks and 1,000 unpaid suppliers that were forced to participate in the scheme. Rongsheng itself suspended operations earlier this year, weighed down by 22.6 billion yuan in debt.

The other case in the news last week detailed a recent practice that has seen local officials begin comping lists of financially troubled state-run companies as China’s economy slows. But those same officials refuse to provide these so-called “zombie lists” to local banks for fear that doing so would cause the banks to stop lending to the problematic companies. (English article)

As a result, banks are often unaware of the dire state of finances at some companies and continue to lending to them, even though such loans have a high likelihood of never getting repaid.

China is already suffering the effects of massive state-directed build-ups of certain industries like steel and coal mining, which have created massive overcapacity that is now weighing on the economy. Through actions like ordering banks to lend to financially troubled companies and refusing to disclose the names of those companies to lenders, local governments are laying the groundwork to spread the woes plaguing those sectors throughout the entire financial system.

That kind of scenario looks strikingly similar to what happened during the global financial crisis, which saw US subprime mortgages spread throughout the global financial system through a securitization process similar to the one used in the Rongsheng case. To prevent a similar contagion from happening in China, Beijing and local governments need to encourage and help banks to make loans based on commercial factors, rather than using them as a tool to support struggling companies.

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