A Non-Performing-Loan (NPL) anywhere outside of China is a pretty uninteresting class of asset. There is no precise universal definition, but an NPL is an asset held by a bank or financial institution that does not generate the expected return.
Ordinarily, a bank is expected either to «write-off» an NPL or make a provision against it on the balance sheet to reflect diminished expectations over its installment loans ID eventual payment. Auditing a bank’s asset book ensures this is done, thus warranting the bank’s solvency.
Given the overall level of transparency in China the figures are difficult to estimate. The official rate, according to the China Banking Regulatory Commission (CBRC) stood at 1.4 trillion yuan, or 1.75% of the total loan book at the end of Q1-2016.
This figure is not exceptionally large by international standards, but it has been rising steadily since 2013, and there have always been bearish voices that suggest the official figure is a significant underestimate. Alongside NPLs, for example, there is another category of «Special Mention Loans» totalling 3.2 trillion yuan. Then the market estimates of the true position reaches as high as 15-19% of the loan book (from CLSA) which is very high, if true, but SocGen goes higher and estimates the overall exposure to loss within the banking sector amounts to as much as 12% of 2015 GDP.
Nevertheless, due to the nature of China’s banking system no one is expecting the sort of bank runs that might result from similar estimates in the West. Banks in China are just one reservoir of bad debts waiting to be purged by the next state led initiative, and NPLs are merely one category of debt.
On the other side of the ledger, it is an outstanding loan on which the debtor has not kept up with the scheduled payments
In this respect China’s NPL to Equity initiative (announced in March) is one of several schemes designed to clear debts without obliging banks to take the kind of asset write down implied by bundling and selling the impaired assets.
The IMF recently published some «technical notes» on this initiative, noting that «NPL to Equity» schemes can play a role in resolving problems of excessive debt, subject to certain provisions. Then only a few days ago, the IMF repeated its assessment that the NPL problem was «manageable, but must not be allowed to get out of hand.»
Not so in China, where NPLs have gone from being a minor question of bank operation, to a lead indicator over the health of the entire economy
The overall idea has been referred to as «stealth nationalisation» as it would put shareholdings of equal value to the NPLs on the books of the state owned banks, but according to the IMF, offloading these assets is the only materially significant way of reducing the bank’s exposure to the underlying conditions of asset impairment. If, for example, the loans are not performing, this is likely because the corporate entity is unprofitable, and a shareholding in an unprofitable entity might not be worth the nominal value, let alone a notional market value.
All of which indicates that China’s plans, if they do eventually conform to IMF guidelines, will inevitably involve writing off at least a proportion of the overall amount, as the realised value from any sale will be lower than the book value of the asset. The last time China did this, the ratio was less than 20% recovery. This therefore reinforces the suspicion that the real intention is to simply shuffle the debt load around, rather than deal with it directly.
Andrew Collier, of Orient Capital Research in Hong Kong, views the problem as like a game of «hot potato,» taking place within China’s interlocking matrix of central and local government agencies.
«This is Beijing gradually putting bad debt on the central bank balance sheets through the state owned banks,» he says. But he also makes clear that it is the «inevitable outcome of the explosion in lending that has caused a huge rise in bad debt among local governments and corporates.»
The problem is the NPL to Equity programme presents something of a «Catch 22» for the banks. On the one hand, transferring NPLs into Equity may only delay an inevitable effort to address overcapacity within the Chinese economy, but by the same token, addressing the huge overcapacity will inevitably produce more NPLs. So the overall effect of the NPL to Equity programme may simply be to provide a conduit for the flushing of considerable amounts of distressed debt through state banks to end up spread between the portfolios of various state organs. In other words, not so much a «stealth nationalisation», as a state bailout by another name.
When viewed against the background of the steady rise in NPLs and corporate debt, the stand out issue is how China deals with its massive industrial overcapacity, which will inevitably see more corporate closures, not less. The NPL to Equity programme may be innovative, and «play a role» in resolving problems of excessive debt, but the fundamental question is how it assists in resolving the overcapacity issue.
If the effect is to provide channels through the distributed central and regional authorities capable of keeping the banks solvent while closing down large amounts of unprofitable productive capacity, then the NPL to Equity programme may serve a crucial purpose in the years ahead.
But if instead the NPL to Equity programme is used to forestall such closures by facilitating further borrowing on less indebted — though now part or increasingly state owned — entities, then the game of hot potato will continue.
On the specific NPL to Equity programme Collier is sanguine; «it is a bad but necessary idea,» he says. «The migration of debt indirectly onto the state will force the state eventually to acknowledge this debt.» And this is a good thing «only because Beijing is unwilling to [directly] reform the corporate sector, so has to resort to centralizing the debt.»