China’s banking sector is facing an unprecedented crisis, exacerbated by the recent collapse of Jiangxi Bank of China. In just one week, 40 banks have been absorbed into larger institutions, highlighting the severity of the problem. This crisis is largely driven by bad loans and significant exposure to the ongoing property sector recession.
Scope of the Problem
China’s banking sector comprises about 3,800 troubled institutions with assets totaling 55 trillion yuan ($7.5 trillion), accounting for 13% of the country’s total banking system. Many of these smaller banks have been mismanaged for years, accumulating vast amounts of non-performing loans. Some banks have reported that up to 40% of their loan books consist of bad loans, significantly weakening their financial stability. These banks have lent heavily to real estate developers and local governments, sectors now reeling under immense financial pressure due to the property crisis.
The Bank of Jiujiang, a mid-tier lender, recently disclosed that its profits might drop by 30% due to poorly performing loans. This rare admission underscores the gravity of the situation. While Chinese authorities have been advocating for greater transparency, the full extent of the bad debt problem is still surfacing. The four state-owned asset management companies (AMCs) created to manage these bad debts are also struggling, with one requiring a $6.6 billion bailout in 2021.
Disappearing Banks
To address the issue of small, unstable banks, the Chinese government has resorted to making them disappear by merging them into larger institutions. Of the 40 banks that vanished recently, 36 were from the Liaoning province and were consolidated into a new lender, Liaoning Rural Commercial Bank, specifically created to absorb these failing banks. Since its establishment in September, five more institutions have been formed for similar purposes, and more are expected to follow.
The Root Cause: Property Sector Recession
The root cause of this banking crisis is the deep recession in China’s property sector. Overextended real estate developers and local governments have defaulted on loans, creating a cascade of financial instability. Property prices have plummeted, and many construction projects have stalled, further straining the financial system. This downturn has significantly impacted banks that heavily invested in these sectors.
Compounding the crisis, banks have been offloading toxic loans to AMCs, creating an illusion of stability. These AMCs buy bad loans but avoid taking on the credit risks, leading to a buildup of hidden bad debts. The National Administration of Financial Regulation (NAFR), a new banking regulator, has been cracking down on these deceptive practices, issuing fines, and increasing oversight.
What’s Next?
This regulatory vanishing act is likely to accelerate. According to S&P Global, it could take a decade to resolve the issue completely. While consolidating smaller banks into fewer, larger institutions may simplify regulation, it risks creating bigger entities with even more significant problems.
The reality is that China’s economy is in an “extend and pretend” state. Years of credit-fueled growth have reached a tipping point, leading to slower economic growth and a negative impact on the global economy. As China’s growth slows, the banking sector’s problems are expected to worsen, potentially necessitating massive liquidity injections and economic stimulus measures.
Implications for the Global Economy
The collapse of Jiangxi Bank of China and the broader banking crisis have profound implications for the global economy. Investors are increasingly looking towards hard assets as a safeguard against economic instability. The potential for massive sell-offs and increased market volatility is high, as seen with the recent turmoil in global financial markets.
China’s Bond Market
China’s bond market is witnessing an influx of money, driving bond prices to new heights and yields to historic lows as investors seek refuge from the country’s faltering real estate market and unstable stock market. The yield on China’s 10-year government bond hit 2.18% on Monday, the lowest since records began in 2002. Similar trends are seen in 20-year and 30-year bonds. Lower yields usually help reduce borrowing costs, beneficial for an economy grappling with a property market crash, weak consumer spending, and low business confidence. However, this has raised concerns among Chinese policymakers about a potential bond market bubble.
The People’s Bank of China (PBOC) has issued multiple warnings about the risks of a bond bubble, likening it to the crisis faced by Silicon Valley Bank (SVB) in the United States. The PBOC has even begun borrowing bonds to sell them and control prices—a move unprecedented in its history. Governor Pan Gongsheng emphasized the need to monitor financial market stability closely, especially regarding non-bank entities holding significant long-term bonds.
China’s banking institutions are particularly exposed due to their substantial investments in long-term government bonds, which could lead to significant losses if interest rates rise suddenly. This situation is exacerbated by a “deflationary outlook” among investors, pushing them towards long-term sovereign bonds.
Policymakers are wary of a potential crisis if the bond bubble bursts, which would increase yields and harm financial institutions heavily invested in government debt. The PBOC’s intervention in the bond market aims to preemptively manage these risks and maintain stability.
Despite efforts to manage the crisis, concerns persist. A state-controlled brokerage firm reported a 61% increase in net purchases of sovereign bonds by financial institutions in the first half of the year, highlighting the scale of the issue. As the PBOC continues its interventions, the goal remains to balance economic support with preventing a financial meltdown reminiscent of SVB’s collapse.
Another Looming Financial Crisis?
The collapse of Jiangxi Bank of China marks a significant escalation in the crisis facing China’s banking sector. With thousands of troubled institutions, a vast amount of bad loans, and an ongoing property sector recession, the challenges are immense.
The Chinese government’s strategy of merging small banks into larger ones may provide temporary relief, but the underlying issues remain unresolved. As the global financial community watches closely, the implications of this crisis are far-reaching, potentially affecting economic stability worldwide.
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