China’s Banking Sector Faces Reckoning

Commentary

The ongoing banking crisis in China will test the limits of the Chinese Communist Party’s (CCP’s) ability to manage its economy and the resulting potential social unrest.

Property developer China Evergrande’s liquidation, ordered at the beginning of the year, effectively announced that the onus of the nation’s bad debts would fall on China’s banking system, which had already been grappling with prolonged defaults from the ailing real estate sector and consumer base.

The biggest challenge in dealing with China’s banking issues is that the very sector that gave rise to China’s recent GDP growth and propped up the middle class’s household wealth—real estate—is now the culprit for the current economic decline, with the banking industry experiencing turmoil, starting with smaller and regional banks.

Seeds of Crisis

Heading into this year, policymakers were already embarking on a massive consolidation effort of small lenders. Hundreds of small, mostly rural banks were merged earlier this year, creating bigger financial institutions.

During the week ending June 24, 40 Chinese banks disappeared and were absorbed into larger financial institutions. The majority of these banks were in northeastern Liaoning Province and were absorbed into Liaoning Rural Commercial Bank, an entity recently created specifically to merge failed banks.

And on July 9, another regional bank, Jiangxi Bank of China, also collapsed.

Unlike the U.S. banking sector, Chinese banks are mostly state-owned. The CCP holds majority ownership of the five biggest commercial banks in China, and provinces or affiliates of local governments own most regional banks. This structure creates a moral hazard whereby banks and borrowers take excessive risk with the implicit understanding that Beijing will bail them out.

Bailouts were carried out by specialized government “bad banks” or asset management companies (AMCs) purchasing the bad loans from bank balance sheets.

In 1999, then-Premier Zhu Rongji created four large AMCs to buy nonperforming loans from China’s four largest commercial banks. These asset managers themselves later issued new loans, and earlier this year, three of these struggling entities were merged into China’s sovereign wealth fund, China Investment Corp. The fourth was renamed China CITIC Financial Asset Management after being taken over by state-owned brokerage firm CITIC Group in 2021.

With consumer confidence sagging, depositors will likely pull money and assets from smaller institutions and transfer them into large institutions, creating even more bank failures going forward. This cycle of bailout, consolidation, and government takeover of the banking sector will likely accelerate.

Broader Economic Issues

The CCP has been buying itself time by shifting bad loans away from banks and then recognizing losses over time, with the expectation that growth, profits, and earnings will outweigh those losses in the long term.

This type of closed ecosystem could function if problems are isolated and economic growth is strong. While fewer lenders are easier for regulators to monitor, track, and manage, this cycle creates only bigger piles of bad loans at various levels of government entities.

We’re beginning to see signs that the Chinese regime’s local levels are unable to bail out these financial institutions.

Last year, Chinese provinces used $31 billion of special-purpose bonds to prop up smaller regional banks, many of which have lent significant amounts to Chinese property developers.

Due to the sustained real estate market downturn, land sales and property fees drive revenue to regional governments. However, regional governments are highly indebted and do not have the financial means to bail out regional banks.

The CCP, instead, is now looking to centralize debt issuances at the national level. Premier Li Qiang outlined in March that Beijing would issue 1 trillion yuan (about $138 billion) in long-term special bonds, the first issuance since 2020 and the fourth such sale in the past 26 years.

So far, we’ve only discussed the regulated banking sector. Over the past few years, the CCP has been sounding the alarm on debt at so-called shadow banks. These private, quasi-banking institutions—such as insurance companies, trust companies, asset managers, and other conglomerates—have also lent extensively to property developers and are capitalized by issuing high-yielding products directly to consumers.

One such financial conglomerate—Zhongzhi Enterprise Group Co. Ltd.—is currently facing liquidation.

Will Beijing bail out those companies, too? If the economy continues to grow and consumers have confidence in these institutions, the CCP can minimize its bailouts.

But economic growth isn’t happening. China is struggling with cyclical and structural economic problems, deep consumer confidence issues, and already highly indebted governments. The regime itself will struggle to honor the guarantees it has provided.

“Since April … the marginal data points are showing that the economy is once again slowing in a fairly broad-based manner,” Morgan Stanley’s Asia and China economists wrote in a July 8 note to clients.

“With the current policy trajectory, we see prolonged deflationary pressures, with adverse implications on the income growth of lower-income households, especially for the bottom 20 percent.”

They cited additional headwinds in China’s economy after a modest increase at the beginning of the year.

If China’s financial bailout system seizes, it would destabilize the entire financial industry and could lead to social instability. Consumers and investors would flock to hard assets or foreign assets.