China’s Riskiest Banks Have Run Into Trouble. Why That Matters in the U.S.

China’s long-running debt problems reached a tipping point this year, crippling numerous small lenders and raising concerns about a systemic liquidity crunch.

The lack of confidence resulted in multiple rural bank runs. Worse still, the estimated trillions of dollars of debt across the country is likely to be larger than is measurable, due to years of so-called “shadow banking”—unregulated, off-the-books lending.

Chinese economy

The causes of the ballooning debt include years of rapid, unregulated growthfollowed by a slowing Chinese economy, as well as poor corporate governance and rampant corruption at financial institutions.

In May, Inner Mongolia’s Baoshang Bank became China’s first lender to be taken over by authorities in 20 years. Months later, two other banks were bailed out. In all three cases, either financial improprieties or corruption is suspected.

Growing debt and lack of confidence in smaller lenders have caused interbank interest rates to rise and forced increased reliance on deposits for funding. This in turn has led some local banks to offer soaring interest rates in an attempt to secure commercial and interbank deposits, which could further destabilize their bottom lines.

And while China’s big state-backed lenders remain largely above the fray, new loans across the country have fallen to the lowest level in two years, according to official data. So while the backbone of China’s banking system seems relatively healthy, questions remain about the thousands of local banks scattered across the country—and whether lack of confidence in them could result in a systemic crisis.

“I think we have to be careful about calling it a banking crisis,” Michael Pettis, a professor of finance at Peking University and a senior fellow at the Carnegie-Tsinghua Center for Global Policy, told Barron’s.

“As long as China’s banking system is largely closed and the regulators credible, they can always avoid a crisis by restructuring liabilities as they come due,” he said. “That doesn’t mean there isn’t a problem: there is a huge problem in that most of the banks—and certainly all the small ones—have terrible assets and very risky liabilities. But this is a problem likely to be solved over many years (and at a much higher cost, ultimately) by gradually transferring the cost to local governments.”

One question is whether Beijing has enough power to dismantle vested interests at local government levels, and force them to liquidate their assets. After all, local governments in China have been huge beneficiaries of the unbridled growth of the boom period, and are largely responsible for the accumulation of debt.

Beijing has implemented several policies to rein in local governments, but a slowing overall economy means there will be job losses and ensuing domestic discontent—the central government’s biggest fear.

China’s economy grew at an estimated 6.1% in 2019 and is expected to dip to 6% in 2020, the Chinese Academy of Social Sciences said last week. That is a 30-year low. Pettis has previously said he believes the real growth rate is lower than 3%.

Amid this rock-and-a-hard-place policy makers find themselves in, foreign investors are keeping a close eye on China’s volatile equities markets, as well as its ever-evolving policy prescriptions.

China’s Riskiest Banks Have Run Into Trouble. Why That Matters in the U.S.
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