We are not alone in facing the challenges of a shaky banking system. Bad debts in China's banking system are back in the news along with the continued slowdown in the country's growth rate. Speculation about the extent of non-performing loans (NPL) in the Chinese banking system is now rife. Officially, NPLs stood at RMB 1.27 trillion ($204 billion) at the end of 2015; the ratio of NPLs to total gross loans in the commercial banking sector was 1.7 per cent. In addition, banks are allowed to categorise loans that are technically in default but might eventually be resolved as "special mention" (sounds familiar?) loans. According to the China Banking Regulatory Commission "special mention" loans amounted to RMB 2.9 trillion at the end of 2015. Adding these to the official figure for NPLs yields a much higher bad debt ratio of 5.6 per cent at the end of 2015.
The official NPL data give little indication of banks' exposure to the shadow financing sector, where little is known about the quality of loans or provisions made against their default. Analysts and fund managers have been trying to gauge the extent of funding needs in case the banking system has to be recapitalised. The most extreme scenario has been presented by hedge fund manager Kyle Bass, who has predicted a loss of $3.5 trillion, which exceeds the banking losses incurred in the US during the subprime crisis by more than 400 per cent. China's "hard landing" scenario is now being described not only in terms of a fall in the growth rate to below six per cent but also in terms of a jump in its NPL ratio to above 20 per cent.
Other analysts have argued against the doomsday scenario, saying that these extreme scenarios overestimate the problematic credit and don't quite capture "buffers" against NPLs, such as previously written-off NPLs, excess provisions and around $1.1 trillion in pre-provision profits of the banks. Moreover, the figures cited for balance sheets of banks in China needed to be taken with a pinch of salt. While China's banking sector had total assets of around $34 trillion at the end of 2015, only around 60 per cent, or $20.5 trillion, were credit-type assets. The remaining assets are mainly required reserves at the People's Bank of China (PBC), interbank deposits/lending and investment in treasury bonds.
Also, several incremental improvements remain underappreciated by the market, including improving credit mix (with the PBC's increased oversight over shadow credit and banks' efforts to boost risk controls on their wealth management products), lower debt burdens and relieved local government debt risks, which make Chinese banks' equity look more solid than before. We tend to agree with this view and believe that a more realistic scenario could require recapitalisation of not more than $500 billion. That Chinese regulators are working on this issue is apparent from the fact that they have resumed the process of non-performing asset securitisation, with six major commercial banks being roped in to participate in a trial programme for securitising bad loans.
The debate is also about whether China's shrinking pile of foreign exchange reserves - which the PBC has deployed in the past for recapitalisation of the banking sector - will be adequate this time around. Steady declines seen in reserve levels in recent months do concern us. For instance, since the peak in June 2014, the PBC has sold about $760 billion worth of reserves, leaving it with about $3.2 trillion as of January. According to the BIS, capital outflows were driven by unwinding of offshore renminbi deposits and Chinese companies repaying foreign currency debt.
Such outflows will continue as long as there are expectations of further depreciation in the yuan. In an effort to calm nerves, China's central bank governor has said capital outflows are normal and there is no need to worry about short-term decline in foreign exchange reserves. He has also ruled out competitive devaluation of the currency as a means to boost exports. This has intensified the war of words between officialdom and market operators, with the latter pushing for a realignment of its currency strategy.