China’s economy isn’t just slowing down, it might also be contracting. While China’s published rates for annual growth are still positive, the nation’s economic growth was negative from the fourth quarter of 2013 to the first quarter of 2014.

That is a result of excessive government spending on unproductive sectors of the economy. It appears that the People’s Bank of China (PBoC) has been more aggressive in its quantitative easing (QE) that the Federal Reserve has, but much of that money has gone into unproductive credit expansion. China’s banking assets have grown to over 100% of its GDP in the last three years. If the U.S. had engaged in similar policies, it too would have achieved more than 7% GDP growth.

China's five largest banks- the Agricultural Bank of China (ABC), the Bank of China (BOC), the Bank of Communications, the China Construction Bank (CCB) and the Industrial and Commercial Bank of China (ICBC)- had a total of 374 billion yuan (60 billion U.S. dollars) in outstanding NPLs at the end of 2013, nearly 47 billion yuan more than at the end of 2012; an average NPL ratio of 1.03 percent. Smaller banks- China CITIC Bank and China Everbright Bank, for example — are in an even worse fix. Their outstanding NPLs shot up 63 percent and 33 percent, respectively. Commercial banks’ outstanding NPLs stood at over 590 billion yuan by the end of last year, a 99 billion yuan increase.

China’s banking assets now total approximately $25 trillion, or almost three times the size of its $9 trillion economy. Much of that lending is construction-related and the marginal return on those loans must be very small. For example, the EBT (earnings before tax) margins of steel makers crashed to 0.9 percent in 2013, down from 5.7 percent in 2007, according to Peterson’s Institute in Washington. It goes without saying that banks will inevitably be hurt by rising NPLs as outdated capacities are phased out after huge bank loans have been put in. Deflation is also threatening China and the PBoC may have to engineer a devaluation of the remnibi as a way to stimulate exports and avert deflation.

One common strategy Chinese banks have used so far involves extending or otherwise modifying loans as they come due. But that strategy is raising alarms among analysts and bank investors and could add to banks' increasing piles of bad loans and may restrict their ability to lend to bolster the softening economy. Another method is to remove non-performing loans from their books entirely by selling them to one of the big four state-owned asset management companies. Bad loans are being sold to these companies, but not in big quantities. Banks are reluctant to sell such loans to the asset management companies if it will lead to their taking a loss, so they price them near book value. At this level, the asset management companies can't make much profit, so few deals get done.

If non-performing loans go from 1% to somewhere between 10%-20% with loss severities of 100% for the worst loans, then China would use its $4 trillion of foreign exchange reserves to stabilize its banking system. China’s leaders are fully aware of the dangers its economy faces, and they hope to slow growth in a measured fashion, including through the restructuring of its banking system. The government might be able to do that and in that case, the GDP growth is just going to slow down a lot more than people expect. 


Shambo Dey

May 27, 2014