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WSJ: Chinese Banks Are Worse Off Than You Think

July 22, 2011

I had an op-ed in today’s Wall Street Journal (July 22, 2010).  The direct link is here.  My article was written in direct response to a prominent Reuters article that appeared late last week, which is worth reading by way of background.  Anyone who wants to see the supporting reasoning behind my claim that probable loan losses could wipe out banks’ reported profits and seriously compromise their capital base should read my earlier post on this subject here.

Chinese Banks Are Worse Off Than You Think
Rosy loan-to-deposit ratios hide a serious nonperforming-loan problem

by Patrick Chovanec

Investors are worried about the health of China’s banks. They’re afraid—with good reason—that the massive, state-directed lending binge that was instrumental in pumping up China’s GDP figures the past two and a half years will end up producing an equally massive pile of bad debt. Barely a week goes by without new word of a troubled project or impending default.

Never fear, say the banks and some analysts. They point to the extraordinarily low loan-to-deposit ratios of Chinese banks, averaging around 65%, as evidence that these banks have plenty of cash to cushion themselves against any future loan losses they might suffer. Everything is under control.

This argument is misleading, and offers a false sense of comfort.

First of all, the loan-to-deposit ratio is a measure of liquidity, not of solvency. A high ratio suggests that a bank may be relying too much on volatile short-term borrowing rather than stable long-term customers to fund its lending. It risks getting caught without enough cash reserves on hand to satisfy its creditors, forcing it to sell other assets at a loss, which could eventually cause the bank to fail. Having plenty of cash reserves on the left (asset) side of a bank’s balance sheet can help prevent such a crisis. But it has nothing to do with a bank’s capacity to absorb losses from bad loans without going bankrupt.

A bank’s solvency in the face of losses depends on the loan-loss provisions it has set aside and the capital it has built up on the right (equity) side of its balance sheet. Chinese banks like to boast that they have an average “loan-loss coverage ratio”—the amount of equity set aside, divided by the amount of nonperforming loans—of 220%, up from 80% at the end of 2008. Optimists argue this shows banks have set aside more than twice the amount of equity they would need to make up for all their bad loans.

But that ratio considers only those loans a bank has formally designated as nonperforming, and banks have hardly recognized any bad loans stemming from their recent bout of lending. China’s banks are required to set aside loan-loss reserves equivalent to 2.5% of their total loan portfolios. Yet based on the lessons of previous rounds of credit expansion, it’s more likely that up to 20% or even 30% of their loan portfolios will turn bad at some point in the wake of the latest expansion.

Indeed, estimates leaked by Chinese bank regulators suggest that 23% of loans to local government-sponsored infrastructure projects are an outright loss, with another 50% at risk of cash default. If Chinese banks made appropriate provision for these losses alone, it would reverse the record earnings they have been reporting and eat into their capital base. Apply these estimates across other risky loan categories, such as real-estate development and business lending diverted to speculation in stocks or property, and their capital is in real danger of being wiped out. The loan-to-deposit ratio doesn’t matter; they can have captive deposits and lots of cash, and still be bankrupt if they threw it all away on bad loans.

In fact, all that excess liquidity Chinese banks have on their balance sheets is really part of the problem. It isn’t there because the banks are cautious lenders, but because China’s external imbalances—the inflow of money from both the current and capital accounts, accumulated as foreign-exchange reserves—keeps driving up the domestic deposit base.

Unless this constant injection of money is sterilized and kept out of circulation, with cash reserves piling up and the loan-to-deposit ratio pushed ever lower, the result is runaway lending. That is precisely what happened when banks were allowed to draw on their reserves to fund the lending boom. The high levels of liquidity in China’s banks aren’t a cushion against bad debt. They are the reason those banks loaned money so recklessly in the first place.

Even as a measure of liquidity, however, the loan-to-deposit ratio can be misleading. To bring lending back under control, China’s central bank has ratcheted up the reserve requirement ratio, the amount of cash banks must keep on deposit at the central bank, to 21.5% for larger banks. An average loan-to-deposit ratio of 65%, as of June, would seem to imply at least a 13.5% cushion of ready liquidity still in the system.

However, many of the “non-loan” assets that banks are holding are actually disguised forms of lending such as bonds held to maturity or structured equity in other financing vehicles. Such pseudo-lending has exploded this year as constraints on overt lending have tightened.

The industry-wide ratio of 65% also disguises a big imbalance between large and small banks, which is central to the interbank lending market. Most of the deposits flowing into China from current and capital account surpluses land in the large banks, while China’s smaller banks drive a disproportionate amount of the lending. The large banks have an average loan-to-deposit ratio of 63%. The ratio for small to medium-size banks is 81%, which means many of them must borrow from their larger, deposit-rich cousins to meet their regulatory reserve requirements.

Recent spikes in the interest rates at which banks are borrowing from and lending to each other—the interbank and repo rates—show just how tenuous this relationship can be, as smaller lenders push themselves to the limit, hoping the big banks can foot the bill. The volatile interbank market suggests that rank-and-file Chinese banks are dancing a lot closer to the flame of a liquidity crisis than broader measures might indicate.

People who look to low loan-to-deposit ratios as proof that all is well with Chinese banks need to think again. The statistic tells you nothing about solvency and precious little about real liquidity. If anything, it’s a symptom of the deep imbalances that lie at the heart of China’s banking system.

[As a side note, it's interesting that the large bank/small bank dynamic in China is the inverse of the relationship that long existed in the U.S. pre-liberalization, where smaller, local banks gathered deposits and lent them to the large "money center" banks that drove commercial lending.  The Chinese arrangement, in which large deposit-rich banks lend to smaller banks, would seem to imply that financial risk may be less concentrated, but that visibility and discipline may pose a greater challenge for regulators.]

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13 Comments leave one →
  1. chinese century permalink
    July 22, 2011 12:40 pm

    every decade there is another person coming out saying china will crash and burn. and every decade they are 100% wrong.
    whats makes u any different patrick? this time its different huh. lol

    i think the shift of wealth and power from west to china is really doing crazy things to patrick’s mind. get used to it buddy, china will be the biggest economy in 2018 or 2019 and put u out of ur misery.

    its impossible for china’s banking system to collapse, chinese government can always nationalise it in an instant and pump trillions of liquidity even if all the loans went bad.

    and the biggest loser in a chinese slowdown is the US because without china buying those products from western firms, the global economy would be in depression.
    by the way patrick, u should watch this video from peter schiff, he will educate u.

    to cheer u up patrick, here is a list of chinese achievements:

    china is the largest creditor nation.
    china has the largest gross national savings ($3.2 Trillion as of 2010).
    china is the largest exporter ($1.5 trillion as of 2010).
    china has the largest Agricultural sector ($564 billion as of 2010).
    china has the largest foreign exchange reserves.
    china has the largest current account surplus.
    china is the largest holder of US government debt.
    china is the largest car consumer market.
    china is the largest car manufacturer.
    china is the largest General Motors car consumer market.
    china is the largest Volkswagen car consumer market.
    china is the largest energy consumer market.
    china is the largest primary-energy consumer market.
    china is the largest carbon dioxide emitter.
    china is the largest renewable energy producer.
    china is the largest renewable electricity producer.
    china has the largest installed windpower capacity.
    china has the largest installed solar thermal power(solar hot water) capacity.
    china has the largest installed hydropower capacity.
    china is the largest hydroelectricity producer.
    china has the largest installed hydro-electric capacity.
    china has the largest hydroelectric power station (Three Gorges Dam).
    china is the largest wind turbine manufacturer.
    china is the largest solar panel manufacturer.
    china is the largest Lithium-ion battery manufacturer.
    china is the largest Lithium-ion battery consumer market.
    china spends the most in clean energy investment ($54 billion in 2010).
    china is the largest mobile phone producer.
    china has the largest mobile phone consumer market.
    china has the largest internet market.
    china has the largest broadband market.
    china has the largest bank by market value (ICBC).
    china has the largest bank by deposits (ICBC).
    china has the largest bank by profit (ICBC).
    china has the largest bank by number of branches (Agricultural Bank).
    china is the largest raw materials consumer market.
    china is the largest meat producer.
    china is the largest cement producer.
    china is the largest cement consumer market.
    china is the largest coal producer.
    china is the largest coal consumer market.
    china is the largest gold producer.
    china is the largest gold consumer market.
    china is the largest platinum consumer market.
    china is the largest palladium consumer market.
    china is the largest copper consumer market.
    china is the largest steel producer.
    china is the largest steel consumer market.
    china is the largest stainless steel producer.
    china is the largest iron ore producer.
    china is the largest iron ore consumer market.
    china is the largest zinc producer.
    china is the largest zinc consumer market.
    china is the largest aluminium producer.
    china is the largest aluminium consumer market.
    china is the largest nickel consumer market.
    china has the largest tin reserves.
    china is the largest tin producer.
    china is the largest tin consumer market.
    china is the largest lead consumer market.
    china is the largest tungsten consumer market.
    chins is the largest vanadium consumer market.
    china is the largest antimony producer.
    china is the largest arsenic producer.
    china is the largest bismuth producer.
    china is the largest fluorite producer.
    china is the largest manganese producer.
    china is the largest fertilizer producer.
    china is the largest fertilizer consumer market.
    china is the largest cotton producer.
    china is the largest cotton consumer market.
    china is the largest silk producer.
    china is the largest silk exporter.
    china is the largest silk consumer market.
    china is the largest paper consumer market.
    china is the largest natural rubber consumer market.
    china is the largest glass producer.
    china is the largest glass consumer market.
    china is the largest pork producer.
    china is the largest pork consumer market.
    china is the largest grain consumer market.
    china is the largest rice producer.
    china is the largest rice consumer market.
    china is the largest soybean consumer market.
    china is the largest wheat producer.
    china is the largest wheat consumer.
    china is the largest tomato producer.
    china is the largest apple producer.
    china is the largest garlic producer.
    china is the largest tangerine producer.
    china is the largest peanut producer.
    china is the largest eggplant producer.
    china is the largest potato producer.
    china is the largest cabbage producer.
    china is the largest cauliflowers and broccoli producer.
    china is the largest fish producer.
    china is the largest rapeseed producer.
    china is the largest groundnuts producer.
    china is the largest tea producer.
    china is the largest tobacco producer.
    china is the largest tobacco consumer market.
    china has the largest livestock of domestic sheep.
    china has the largest livestock of domestic pigs.
    china has the largest police force.
    china is the largest trade parter of ASEAN.
    china is the largest trade parter of Brazil.
    china is the largest consumer of ASEAN exports.
    china is the largest consumer of Japan exports.
    china is the largest consumer of South Korea exports.
    china is the largest consumer of Australia exports.
    china is the largest consumer of Taiwan exports.
    china is the largest consumer of Hong Kong exports.
    china is the largest consumer of North Korea exports.
    china is the largest consumer of Mongolia exports.
    china is the largest consumer of Iran exports.
    china is the largest consumer of Yemen exports.
    china is the largest consumer of Kazakhstan exports.
    china is the largest consumer of Oman exports.
    china has the largest shopping mall (New South China Mall).
    china has the largest city square (Tiananmen Square).
    china has the longest building (Great Wall of China).
    china has the tallest statue (Spring Temple Buddha).
    china has the tallest dam (Jinping-I Hydropower Station).
    china has the longest metro system (Shanghai Metro).
    china has the largest highspeed rail network.
    china has the fastest train in the world.
    china has the largest population (1,339 million as of 2009)
    china has the largest urban population (622 million as of 2009).
    china has the largest labor force (812 million as of 2009).
    china has the largest company by market value (Petrochina).
    china has the largest insurance company by market capitalization (China Life Insurance).
    china is the largest online gaming consumer market.
    china is the largest construction consumer market.
    china was ranked number 1 in gold medals won at the 2008 olympics.
    china has the largest mobile network (China Mobile).
    china has the largest home appliance manufactuer (Haier).
    china is the largest home appliances consumer market.
    china is the largest refrigerator consumer market.
    china has the largest army.
    china has the largest golf facility (Mission Hills Golf Club).
    china is the largest power equipment consumer market.
    china is the largest metal consumer market.
    china has the largest reserves of rare earth metals
    china is the largest producer of rare earth metals.
    china is the largest emerald consumer market.
    china is the largest jade consumer market.
    china is the largest pearl consumer market.
    china has the largest microwave manufacturing company (Galanz).
    china has the largest air conditioner manufacturing company (Gree Electric Appliances Inc).
    china is the largest beer producer.
    china is the largest beer consumer market.
    china has the largest air carrier by market capitalization (Air China).
    china had the most expensive olympic games ever (2008 beijing olympics).
    china has the longest bridge (Weihe Grand Bridge).
    china has the largest arch bridge (Chaotianmen Bridge).
    china has the highest bridge (Si Du River Bridge).
    china has the largest cable-stayed bridge (Sutong Bridge).
    china has the tallest bridge (Sutong Bridge).
    china has the largest total waterways length.
    china has the largest high-speed railway network size length.
    asia-pacific is the largest aviation passenger market.
    china is the largest computer manufacturer.
    china is the largest desktop computer consumer market.
    china is the largest clothing manufacturer.
    china is the largest toy manufacturer.
    china is the largest RFID consumer market.
    china has the largest number of International trademark applications by Chinese residents in 2007 (604,952).
    china has the largest number of International trademark registrations by Chinese residents in 2007 (215,161).
    china has the largest number of International industrial design applications by Chinese residents in 2007 (253,439).
    china has the largest number of International industrial design registrations by Chinese residents in 2007 (122,288).
    china is the largest fertilizer consumer market.
    china has the fastest supercomputer (Tianhe-1A).
    china is the largest semiconductor consumer market.
    china is the largest laptop producer.
    china is the largest digital camera producer.
    china is the largest luxury watch consumer market.
    china is the largest seafood producer.
    china is the largest textile producer.
    china is the largest electronics producer.
    china is the largest gold investor
    china has the deepest diving manned submersible (Jiaolong)

    china is the 2nd largest economy ($5.8 trillion as of 2010).
    china is the 2nd largest manufacturer ($1.48 Trillion as of 2010).
    china is the 2nd largest trading nation ($2.8 trillion as of 2010).
    china has the 2nd largest Industrial sector ($2.75 trillion as of 2010).
    china is the 2nd largest importer ($1.3 trillion as of 2010).
    china is the 2nd largest luxury goods consumer market ($10.7 billion as of 2010).
    china is the 2nd largest military spender ($90 billion in 2010).
    china has the 2nd largest sovereign wealth fund by total assets.
    china is the 2nd largest spender on R&D.
    china is the 2nd largest oil consumer market.
    china is the 2nd largest Audi car consumer market.
    china is the 2nd largest Lamborghini car consumer market.
    china is the 2nd largest Maybach car consumer market.
    china is the 2nd largest Lexus car consumer market.
    china is the 2nd largest Rolls Royce car consumer market.
    china has the 2nd largest installed renewable energy capacity (52.5 GW as of 2009).
    china is the 2nd largest destination for tourists.
    china has the 2nd largest bank by market value (China Construction Bank).
    china has the 2nd largest bank by profit (China Construction Bank).
    china has the 2nd most billionaires (128 as of 2010).
    china is the 2nd largest advertising consumer market.
    china is the 2nd largest PC consumer market.
    china is the 2nd largest global search market.
    china has the 2nd largest total expressway network length.
    china has the 2nd largest road network size.
    china has the 2nd longest total length of rapid transit systems (979 km).
    china is the 2nd largest diamond consumer market.
    china is the 2nd largest electricity producer.
    china is the 2nd largest electricity consumer market.
    china has the 2nd largest academic research papers.
    china has the 2nd largest scientific reserach papers.
    china is the 2nd largest art consumer market.
    china has the 2nd largest number of brands in the global top 500 brands (79 brands).
    china is the 2nd largest lottery consumer market.
    china is the 2nd largest grocery consumer market.
    china was the 2nd largest receiver of foreign direct investment in 2010.
    china is the 2nd largest country by land area.
    china is the 2nd largest corn consumer market.
    china is the 2nd largest energy producer.
    china is the 2nd largest energy consumer market.
    china has the 2nd largest Lithium reserves.
    china is the 2nd largest linseed(flax) producer.
    china is the 2nd largest aluminium oxide producer.
    china is the 2nd largest bauxite producer.
    china is the 2nd largest salt producer.
    china is the 2nd largest bentonite producer.
    china is the 2nd largest poultry producer.
    china is the 2nd largest poultry consumer market.
    china is the 2nd largest sugar consumer market.
    china has the 2nd largest airport terminal (Beijing Capital International Airport).
    china is the 2nd largest consumer of Malaysian exports.
    china is the 2nd largest consumer of New Zealand exports.
    china is the 2nd largest consumer of Thailand exports.
    china has the 2nd most number of supercomputers in the TOP500 fastest supercomputers list (42 supercomputers).
    china is the 2nd largest commercial aircraft consumer market.
    china is the 2nd largest flat-panel TV consumer market.
    china is the 2nd largest LCD TV consumer market.
    china is the 2nd largest smartphone consumer market.
    china is the 2nd largest Nike consumer market.
    china has the 2nd longest suspension bridge (Xihoumen Bridge).
    china is the 2nd largest Louis Vuitton consumer market.
    china is the 2nd largest sugar consumer market.
    china is the 2nd largest art consumer market.
    china is the 2nd largest advertising market.

    china has the 3rd largest total household wealth ($16.5 trillion as of 2010).
    china is the 3rd largest consumer market ($2.3 trillion as of 2010).
    china has the 3rd largest Service sector ($2.56 trillion as of 2010).
    china has the 3rd most number of global 500 companies in Fortune Magazine (46 companies).
    china is the 3rd country to independently send humans into space.
    china is the 3rd country to independently carry out a spacewalk.
    china is the 3rd most visited country by international tourist arrivals.
    china is the 3rd largest Ethanol producer.
    china is the 3rd largest Ethanol consumer market.
    china is the 3rd largest wood consumer market.
    china is the 3rd largest cosmetic consumer market.
    china is the 3rd largest paper consumer market.
    china has the 3rd largest railway network size.
    china is the 3rd largest titanium consumer market.
    china is the 3rd largest BMW car consumer market.
    china is the 3rd largest Porsche car consumer market.
    china is the 3rd largest Bentley car consumer market.
    china has the 3rd largest stock market by daily average turnover (trading value).
    china has the 3rd most world heritage sites (40 total sites).
    china has the 3rd largest tidal power station (Jiangxia Tidal Power Station).
    china is the 3rd largest Lithium producer.
    china has the 3rd largest Lithium reserve base.
    china is the 3rd largest sugarcane producer.
    china is the 3rd largest dry bean producer.
    china is the 3rd largest wool producer.
    china is the 3rd largest hop producer.
    china is the 3rd largest green bean producer.
    china has the 3rd largest coal reserves.
    china has the 3rd busiest airport by passenger traffic (Beijing Capital International Airport).
    china is the 3rd largest consumer of Indonesia exports.
    china is the 3rd largest consumer of Philippine exports.
    china is the 3rd largest sugar producer.
    china is the 3rd largest silver producer.
    china has the 3rd largest number of International patents in force by Chinese residents in 2010 (828,054).
    china is the 3rd largest tourism market.
    china has the 3rd largest PC manufacturer (Lenovo).

    china has the 4th largest number of millionaires (477,400 as of 2009).
    china has the 4th largest installed biomass capacity.
    china is the 4th largest Mercedes-Benz car consumer market.
    china is the 4th largest Jaguar car consumer market.
    china has the 4th largest movie consumer market ($1.5 billion as of 2010).
    china is the 4th largest copper producer.
    china has the 4th largest total pipeline length.
    china has the 4th largest contract chip maker (SMIC).

    china has the 5th largest gold reserves (1,054 tonnes as of 2010).
    china has the 5th largest stock market by market capitalization.
    china is the 5th largest fast food consumer market.
    china has the 5th largest International patent applications in 2010 (12,339).
    china has the 5th most international tourism receipts (earner).
    china has the 5th largest number of International patents granted to Chinese residents in 2010 (48,814).

    • February 12, 2012 10:26 pm

      Im not quite sure what you want us to think of your long list, I do not think it is particularily shocking or amazing that China is the biggest actor in x,y,z. China is one of the world’s biggest countries so that’s the way things “should be” It doesn’t take much to be the biggest when you are the biggest.

      Also, I’m amazed by the fact that you could be bothered to compile such a long list yet does not put down the effort to spell the three letter word “you”.

    • Noe Wei permalink
      November 23, 2012 2:50 pm

      Insecure much?

  2. July 22, 2011 4:13 pm

    Great post, and superb context for this Caixin article* on banks pushing short term high yield wealth management products to finance big ticket real estate and local government projects.

    * http://english.caing.com/2011-07-21/100282196.html

  3. July 22, 2011 8:54 pm

    Yes here in the US we’ve had recklessly politicized longterm lending pretty much confined to the housing sector with Fannie Mae and Freddie Mac. The poor Chinese are afflicted with an economy in which Fannie Maes and Freddie Macs are all over the economy, setting up not just housing and real estate bubbles but bubbles in railroads, mining, electric power, tollroads…..you name it they have government/politically driven mischiefmakers at work unconstrained by the risk side of the risk/reward balance needed for a viable market economy.

  4. Rahul permalink
    July 25, 2011 5:06 am

    Patrick,

    Could you comment on news reports circulating recently about the extent of underground banking in china. There have been news reports that underground banks may have extended credit in excess of $ 1 Trillion. Also, that underground banks are operating hand-in-glove with regulated banks with clients referred to the former from the latter. One of the myth’s that has abounded is that the chinese are prodiguous savers and that banks require a 30 % down payment for property purchase so the banks are protected. Could it be that this 30 % down payment is not actual savings but borrowing from underground banks? If this was true, it would make the chinese system as vulnerable to a shock as the US housing market with the layering of risk and hidden debt in the household as well as the banking sectors. We are seeing news reports of credit stress in the underground system with spiking of interest rates and clients being turned away. Do you see this as a problem?

    • alvaro permalink
      September 3, 2012 5:30 pm

      Chinese people traditionally ask their relatives/friends to cover this downpayment. It is not an actual loan but at the end people has to pay it back to their friends.

  5. Hua Qiao permalink
    July 25, 2011 9:36 am

    Mainlanders love statistics. Reserve to NPL, loan to deposit ratios. Nice and comfy in statistics but when it comes to seeing risk or deconstructing what these statistics mean, well, don’t feel too comfortable.
    Who was it that blew the cover off local government investment platforms? Not the CBRC. It was Victor Shih, a professor outside the system. Who was it that shined the bright light on bank’s peddling walth management products carrying an implied bank guarantee? Not the CBRC. It was Fitch’s rating agency. Again outside the system.
    Basel was tailor made for Chinese banks. It puts everything into risk based captial formulas. The problem is that no one challenges the integrity of the models and especially, in China, the input data is massaged to get the answer that the user seeks.
    LIe, damn lies, statistics and models.

  6. David S permalink
    July 26, 2011 2:18 am

    Where are you getting all this info? I’d like to read the source material myself.

  7. Brian permalink
    July 28, 2011 7:29 am

    Great article! :)

  8. November 8, 2011 5:23 pm

    Thank you, great article.

  9. January 19, 2012 12:03 am

    In recent time the Chinese have been purchasing and buying back Jade
    at prices heretofore not seen. Good quality Jade now sells for twice the price of gold. There are many cultural reasons for Chinese to purchase Jade but Jade offers wealthy Chinese a portable store of value
    unlike most investments. To me, this is confirmation of an underground
    economy in China looking for a way preserve Chinese culture by investing
    is solid assets that are portable that are not make of PAPER. Most Americans do not understand the place Jade has in the Chinese culture, thankfully I have been collecting Jade for many years and look forward
    to the shift in the balance of trade.

    George Vietze

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