Small is ugly

IF THE recent actions of China’s regulators are anything to judge by, its lenders need help. Over the past ten days alone, the central bank has pumped extra cash into the financial system, cut interest rates and lowered the portion of deposits banks must hold in reserve; the government has scrapped a ceiling on their loan-to-deposit ratios. The combined effect is to free more cash for banks to lend—a boost for banks seeking to improve the return on their assets as well as a prop for the sputtering economy and plunging stockmarket. The official data, though, suggest China’s lenders are still in rude health: bad loans make up just 1.4% of their balance-sheets. That is a touch above the level of the past few years, but still more than two-thirds lower than before the global financial crisis.

How to explain the discrepancy? One possible answer is that bad loans are a lagging indicator. It is only after the economy has struggled for a while that borrowers begin to suffer. Looked at this way, China is trying to anticipate problems, keeping its banks in good nick by sustaining economic growth of nearly 7% year-on-year. Another, more worrying possibility is that bad loans are worse than official data indicate. Many in the market have long suspected this: bank shares are priced as though bad loans constitute 5-10% of their books.

That has consistently looked too pessimistic for China’s biggest banks, which are managed conservatively and largely focus on the country’s highest-quality borrowers. But there is mounting evidence that when it comes to smaller banks, especially those yet to list on the stockmarket, bad loans are piling up. That is important, because unlisted lenders account for just over a third of the Chinese banking sector, making them as big as Japan’s entire banking industry (see chart).

Although non-performing loans have edged up only slowly, the increase in special-mention loans (a category that includes those overdue but not yet classified as impaired) has been much bigger. At the end of the first quarter, they accounted for 3.5% of banks’ balance-sheets, up one percentage point from a year earlier, according to the banking regulator. Special-mention loans are about 2% at most of China’s big, listed banks, suggesting that they must be much higher at their smaller, unlisted peers. Many of these overdue-but-not-impaired loans are simply bad debts which banks have not yet admitted to.

Another troubling omen is China’s roaring trade in dud loans. Some 15 years ago, the government created asset-management companies (often referred to as “bad banks”) to take on the non-performing loans of its lenders. After the initial transfer, the bad banks had little to buy. But last year, they began gobbling up troubled loans again. Cinda, the biggest of the bad banks, bought nearly 150 billion yuan ($24 billion) of distressed assets last year, two-thirds more than in 2013. Without the disposals, these assets would have nudged up the banks’ bad-loan ratio by a few tenths of a percentage point.

Although such numbers are still not very alarming, a bleaker picture emerges from a close reading of the balance-sheets of unlisted lenders. Jason Bedford and Stephen Andrews of UBS, a bank, reviewed last year’s results for 138 banks, of which only 20 are listed. They found that “shadow loans”—loans recorded as investments—have grown to as much as 8.7 trillion yuan, or 5% of the industry’s assets. These are heavily concentrated on the balance-sheets of smaller, unlisted banks (see chart). Banks need not specify whether their shadow loans have gone bad or not.

A handful of banks do spell things out and, for a few, the figures are frightening. Bank of Changsha’s impairments on its shadow loans are 12 times higher than on its conventional loan book. Leshan City Commercial Bank’s impaired shadow loans are 80 times higher, in effect putting its bad-loan ratio at a jaw-dropping 20% (the bank says this reflects investments at risk, not in default). These may be extreme cases but, given scant disclosures from other unlisted banks, it is impossible to be sure. They may be deliberately disguising bad debts as shadow loans. At a minimum, all this points to a need for recapitalisation. Small banks can make big waves.