The WSJ reports,"though official figures suggest that just 1% of loans are non-performing, bank balance sheets likely aren’t as healthy as they seem.
Evidence from a range of countries suggests that credit booms – as China experienced from 2009-‘13 – result in substantially higher levels of non-performing loans (NPLs). A more realistic assumption that 10%-20% of total loans might go bad implies total NPLs of RMB6-12 trillion (US$1-1.9 trillion). The higher end of the range would suggest a bad-asset problem comparable in scale to the one that followed the U.S. subprime loan crisis".
That’s risky enough — even before taking into account the rapidly expanding shadow banking sector. Shadow banking, which is more lightly regulated than conventional banking, now accounts for around 15% of total financing to China’s economy, up from less than 5% in 2005.
The existence of such a large shadow-banking sector is a warning sign about the true extent of financial-market risk. The shadow banking sector largely developed to help banks circumvent government restrictions, so asset quality there is likely lower than in the formal banking sector. Indeed, non-bank lending institutions have been key factors in other regional financial crises, notably in Thailand in 1996-97 and Korea in 2003.
What might trigger a crisis in China? The drift downward in property prices could accelerate as the economy cools, leaving substantial oversupply. Property and land are often used in China as collateral for loans, so a sharp fall in house prices would damage bank balance sheets; liquidity would dry up; and institutions with high rollover needs might struggle to find funding.
Higher interest rates also would increase debt-service payments, and banks could see their deposit bases erode as corporate deposits shrink. The growing importance of the shadow-banking system would likely exacerbate these effects.
Such a crisis would have major economic implications not only for China but — through financial and trade linkages – for the whole world. The Oxford Economics Global Economic Model estimates that, in such a scenario, Chinese gross domestic product would grow less than 2% in 2015, and world growth would drop as low as 1%.
Of course, that’s a worst-case scenario, and odds of it happening are only about 10%. With China’s overall government debt relatively low and foreign exchange reserves at an all-time high, authorities have the means to intervene on a large scale if necessary.
Still, as long as interest on deposits is capped by the government, Chinese savings will continue to be invested in riskier and higher-yielding products, adding to distortions in the financial system.
