China’s Nonperforming Loans – A Perennial Problem?
A discussion with students at Leiden University and Rotterdam’s School of Management
One of the greatest challenges in China’s transition from a planned to a market economy has been reforming the financial sector. The fact that banks used to be tools for financing state-owned enterprises, often based on political rather than economic rationales, has left a legacy of subsidy practices that has been hard to shake off. By the late 1990s, about 40 percent of Chinese bank loans could not be repaid (Naughton 2007: 461). These nonperforming loans, or NPL, amounted to over 420 billion Euro, which is roughly equivalent to the entire annual national income of a medium-sized European economy like Sweden. As Michael Geiger commented in 2008, “the Chinese banking system is on the edge of bankruptcy”.
Throughout the 2000s, the Chinese government has taken steps to reduce NPLs and reform China’s banking sector, and was able to reduce the ratio of bad loans to GDP from 25 percent in 2000 to only 2 percent in 2010. Nevertheless, the financial crisis and the attempts to increase lending have caused a renewed increase in this number, and the four large state-owned commercial banks today again struggle with NPLs, as both China’s state media and foreign analysts at Bloomberg have attested.
Are there structural causes for the problems in China’s financial sector, or are recent numbers simply the outcome of temporary lending practices, while the government has generally taken the right steps to reform banking? What needs to happen to assure that financial markets in China have a secure footing? In this week’s discussion, we will look at these issues and ask whether or not (and how) the problem of Chinese non-performing loans can be solved, and to what degree NPLs are hindering Chinese economic growth.
References
Geiger, Michael (2008): “Instruments of Monetary Policy in China and Their Effectiveness: 1994-2006“, UNCTAD Discussion Paper No. 187.
Naughton, Barry (2007): The Chinese Economy: Transition and Growth, Cambridge MA: The MIT Press.
World Bank (2012): China 2030 – Building a Modern, Harmonious, and Creative High-Income Society. Washington: The World Bank.
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About the Author: Florian Schneider
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Ok, to start off:
In order to battle inflation, China’s Central Bank has kept interest rates relatively high. This is causing an increase in NPLs which could steer China’s financial sector into a second economic meltdown. Thereby, the People’s Bank of China should temporarily lower its interest rates. This will increase inflation, but I argue that the risks of China’s NPLs outweigh the negative side effects of a temporary higher inflation. Also, China has to keep on reforming its financial sector.
Thank you Olaf for that interesting point of view, I partly agree however I would like to add a couple of additional points to your argumentation. In my opinion, the current problems in the Chinese banking sector do have a serious structural nature. The current culture of the largest Chinese banks resemble that of a soft-budget partner of the government and (loss-making) SOE rather than an efficient
profit-maximising bank with effective risk management and internal control processes. Without any significant changes this will result in a continuous flow of new NPL’s to under-performing SOE’s. This high NPL ratio and mismatch in incentives not only affects the efficiency of the SOE’s and banks themselves, but also the wide range of Chinese SME’s that find it harder to obtain capital. I argue that focusing more on the development of functioning capital markets can provide a solution. The central bank should provide large-scale enterprises the right incentives to acquire funding through these markets. This could be achieved by putting them on a hard budget basis and allowing the interest rates to be determined through market-mechanisms.
You make a compelling argument Jort. I agree that restructuring the capital markets in combination with a market based interest rate can attribute to a solution on the long haul. Though, in my opinion, China’s credit risks are urgent. Not only are the official projections by the Chinese government alarming, experts suggest that the actual figures are far worse. Recent publications by UBS show that the actual bad debt in the mainland banking system could be twice as high as the official figures. Thereby I propose short term lowering of the interest rate in combination with restructuring of the capital markets and the financial system.
That seems to be an adequate strategy Olaf, I concur that short-term changes in the monetary-policy are required to avoid a second economic meltdown. I would like to stress the importance of planning structural changes to avoid cyclical deficits. Short-term interest rate lowering can free up the path for these structural changes.
I would like to add to the discussion between Olaf and Jort that the downside of NPLs could possibly be overestimated. The original post assumes that NPLs are a substantial problem that needs to be resolved, based on the fact that these loans are not being repaid in accordance to the contract in which they are formulated. However, I think that we do not know enough about the actual long-term benefits gained by China due to the provision of these NPLs.
For example, some NPLs were extended to African countries to improve their telecommunication and network infrastructure in cooperation with Chinese firms like ZTE and Huawei. These loans can be considered as charity in the sense that they won’t be repaid, but at the same time the Chinese state has gained a considerable influence in some critical parts of the African telecommunications infrastructure. This does not only ensure future contracts for Chinese telecommunication firms in Africa, but it also provides China with significant diplomatic leverage.
Therefore the actual gains of credit provisions may be tacit, and I believe that this needs to be taken into account in the ongoing discussion. For example, it would be interesting to see how many of the increase in NPLs are extended abroad and how many were extended to SOEs.
Adding to the discussion, I would like to shift the focus towards the incentives of the bank officers responsible for making the lending decisions. As stated in the literature (Naughton, 2007), corruption did play a large role in the emergence of NPLs right from the beginning of the deregulation of the banking sector. Since corruption is clearly still an issue today and widely responsible for economic inefficiencies in the country, the degree to which it contributed to the recent rise in NPL would be interesting to investigate. After all, regulatory guidelines can only be enforced to a certain extent and much of the NPL are generated in small branches by extending loans to small businesses, distant from deliberate national policies such as the ones validly mentioned by Tom (Loans to Africa for long-term political interests).
My hypothesis would thus be that there are still insufficient measures to counteract the creation of NPL on this small scale, since pay is low and objective risk assessments are not sufficiently adopted. Corruption could therefore still be a driver in securing high risk loans which would foreseeable turn into NPL. Next to that, party officials’ promotion is still highly dependent on short-term GDP growth on any given level below the provincial one, so that the respective government entity is likely to turn a blind eye on this kind of conduct, when detected.
Therefore, grass root reforms through training, as well as pay increases for lending officers might already substantially curb this new rise of NPL.
The NPL problem does seem to be a continuing problem for the Chinese Economy. With economic growth slowing down and companies having massive excessive capacity as they are outpacing external and internal demand, this will have to be eliminated at some point. There are two question that should concern us. Will the Chinese Government inject funds in to banks again when the NPL problems becomes too big a burden for the Banks to handle? (Probably) and have the Chinese banks reformed well enough to the commercial bank standards like in the developed economies ? The NPL problem will become a serious issue again in the near future when the economic growth will slow down to a certain level.
I don’t think China’s NPLs will be a perennial problem. Many East Asian countries, like Korea, Japan and Thailand, have been burdened with monstrous NPL portfolios since the 1997 Asian financial crisis. However, they have all resolved their NPLs problems now.
Thailand ,for example, founded two state agencies to restructure its NPLs: the Thai Asset Management Corp. (TAMC) and the Corporate Debt Restructuring Advisory Committee (CDRAC). The TAMC was given extraordinary legal powers to unilaterally amend loan terms, conduct debt-for-equity swap, and foreclose on debtors’ assets, all without the debtor’s consent or court approval. Moreover, the TAMC was also given superpowers for reorganization and its workout officers were granted immunity from prosecution. The TAMC acquired primarily substandard NPLs from state-owned institutions, in addition to secured NPLs from private financial institutions. The CDRAC was established as a committee to focus on out-of-court workouts. It adopted the more traditional approach of encouraging private negotiations between creditors and debtors, with the objective of allowing enterprises to survive whenever possible (Xu, 2005).
China can learn from other Asian countries that have successful solved their NPL problems, like Thailand, to solve its NPL problem.
Reference:
Xu, M. (2005), Resolution of Non-Performing Loans in China, retrieved from: http://www.stern.nyu.edu/cons/groups/content/documents/webasset/uat_024327.pdf
According to professors Wang & Peiser (2011) from Harvard University the big 5 Chinese banks have dramatically reduced the total amount of their NPLs, and thus decreased the NPL ratio as a proportion of all loans on their books accordingly. In 2005 the amount was 1,072.48 billion RMB (NPL ratio of 10.49%) while in 2009 it decreased to 362.73 billion RMB (NPL ratio of 1.80%). These figures clearly indicate that NPL has been dealt with by the respective banks. Both authors argue that the quality of Chinese bank credit risk management and the rigor of regulatory oversight have become more seasoned and sophisticated. Discipline and the due diligence on loan issuance have improved over the years, partly as a result of increased operating transparency and efficiency of Chinese banks that came with the public listing
My prior argument continued:
Discipline and the due diligence on loan issuance have improved over the years, partly as a result of increased operating transparency and efficiency of Chinese banks that came with the public listing and sale of of strategic ownership stakes to Western banks and sovereign funds.
Given the trend of reforms and privatizations, I believe that credit supervision will increase and therefore the issue of NPLs will become less relevant. The figures already indicate that the amount of NPLs are decreasing and therefore it is more likely to see a continuing trend.
on a more general note : considering how much state support western banks have received in the previous years, in a free market-system which theoretically lets banks go bankrupt when they are not profitable, one can imagine China, with it’s strong political influence on the economy, finding a way to ” bury” this specific issue in the more general narrative of economics reforms that is currently being communicated outwardly.
The Chinese government has taken steps to reduce the NPL by establishing four asset management companies (AMCs) to handle the bad loans of large commercial banks. However, these AMCs mainly deal with major national banks and policy banks. With an increasing number in local and village banks, it is necessary to have more AMCs at a provincial level to reduce their growing non-performing assets. Therefore, China should consider setting up more provincial AMCs to handle the rising NPLs of the expanding local financial sector and to guard against risks related to local government’s debt.
It can be a worrying picture. The number of Chinese companies (high-profile NPL cases) in default or at least serious cash flow problems is increasing since at least a year now. The economic slowdown in China is probably not the only (sometimes not even the major) cause for their crises. Many of the struggling companies were involved in speculative activities (eg. property speculation) and massive expansion of their capacity. Many were also exposed to underground banking. These structural problems in China’s NPL cycle show that many industries have excess capacity after years of too aggressive expansion that pushed them ahead of national and international demand growth. These inefficient capacities definitely have to be eliminated. This will probably take some time, during which faster depreciation (value reduction) in the form of decreasing financial leverage by paying off debt and consolidation might be unavoidable.
At the moment, the Chinese leadership is meeting in a military owned hotel in Beijing to discuss these problems behind closed doors (until tomorrow). The reforms the public is waiting for are referred to as China’s Reform 2.0; President Xi Jinping and Premier Li Keqiang have made public statements that shall demonstrate a renewed focus on needed reforms, i.e. corruption and decreasing the power of state-owned enterprises, fighting environmental problems, encouraging domestic consumption and promoting innovation across the economy together with easing the access to funding for small- and middle-sized companies.
As this meeting takes place behind closed doors we can just assume what happens there and we will probably also not know within the next months or even years. But the NPL problem should definitely be adressed as one major topic.
If the mentioned reforms will take effect it maybe is not that much of a worrying picture after all.
I anticipate that the high NPL ratio will remain a problem in the next years. Although Daniel points out that the total amount of NPL of China’s biggest banks have dramatically decreased and the control of NPLs have improved in recent years, my main concern for the continuing accumulation of NPL is the government intervention. Attempts have been made to commercialize the major state banks, but it is highly doubtful if these banks are now truly financially independent. The banking reforms in the mid-1990s are considered to have improved the Chinese financial system, but without the bailout of bad debts and the injection of 270 billion yuan into the major banks the NPLs would never have decreased so fast. Besides, with the targeted economic growth rate of 7 or 8 percent, the central government will continue to encourage banks to extend credit beyond the commercially prudent level. If the Chinese banks retain their soft-budget constraint, the NPLs will pile up again and the government is likely to pay of bad debts again. Therefore I argue that in order to reduce the NPL ratio the major state banks have to be commercialized to a further extent, which will reduce reliance on the government as a saver in case of high debts. However, this seems to be unlikely to happen.
I do believe China´s NPLs are a substantial problem that needs to be addressed. Even though, the government backed asset management companies have done outstanding jobs in decreasing the ratio of these NPLs they remain to exist. The underlying reasons like funding of inefficient SOEs and corruption, as mentioned by Johannes, for the occurrence of NPLs from my point of view clearly show that the financial system in China is still underdeveloped. Now that China´s economic growth is slowing down, naturally, more loan defaults will occur. China should definitely focus on the development of its financial system. I believe the financial reform plan released by the government in 2012 for the next 5 years is already a good incentive. The plans focus is on marketization of exchange and interest rates and also encourages the use of private capital, as mentioned by Jort. This would increase efficiency, which is essential for the development of the system. Also, I believe emphasis should be put on increasing transparency of its financial transactions to attract investors and overcome problems of corruption.
The Chinese economic growth is mainly based on exports rather than domestic consumption. In addition, the Chinese government considers it important that large state-owned enterprises make investments. Companies can invest to obtain a loan by the Chinese banks for example. These investments are important, because this may increase the export which in turn benefits the Chinese economic growth. The problem is that not all loans are repaid to the Chinese banks, the so-called non-performing loans (NPL). As Annie already mentioned, it is very important that the problem of the NPL will be solved for the Chinese economy. The loans, including NPL, are necessary for economic growth because they increase the quality of exports through investments. On the other hand, by providing more loans to companies increases the risk of the Chinese banks that they may not receive the money. In short, I think that the NPL is a major problem and has a great influence on Chinese economic growth.
I think that this is a structural problem which can be solved by the Chinese government and Chinese banks. The overseas shipments decreased by 3.1 compared to previous year by the impact of the financial crisis in many countries (Bloomberg, 2013). The Chinese economy is growing less quickly than previously, but still growing. When the financial crisis is resolved the exports will improve, because China is dependent on many other countries like the West. The companies can pay the loans back to the Chinese banks if the export rises again and reduced the problem of NPL. In addition, I think that the Chinese government and the Chinese bank can solve the problem by improve two cases. Firstly, the Chinese government should ensure that China less dependent on exports and domestic consumption needs to increase. This could be achieved by upgrading the Chinese currency, which increases the purchasing power of the country. Secondly, the Chinese banks should have stricter requirements when providing a loan, which reduces the risk on non-repayment of a loan.
Bloomberg. 2013. http://www.bloomberg.com/news/2013-07-10/china-exports-unexpectedly-drop-with-imports-in-drag-on-economy.html
It is clear that using the banking system to fund loss making SOE’s undermines the efficiency and profitability of the banking system. In order to solve the problems, the SOE’s need to be reformed in a way that they finance their business through the capital markets. This will lead to a reform of the banks and finally to an effective capital market. Some preconditions for the establishment of an effective capital market are 1) there must be an adequate information structure in order for investors to allocate funds effectively 2) the rights of creditors should be strengthened by means of an effective legal system which will enforce bankruptcy laws 3) the managerial incentive structures should be adapted, because the performance of the firm is dependent on the effort and quality of its management 4) corporate governance structure needs reforming, part of this is setting up a property rights infrastructure. I believe these are some proposals for how the NPL problem can be solved.
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what is npl affected in chinese banking system
I’m afraid I’m not sure what you mean. Are you asking how non-performing loans affect China’s banking system? The short answer would arguably be: badly.