MNI: China Bad Bank Calls Grow As Debt Overhang Saps Growth

Calls are growing for the creation of dedicated bad banks to absorb nonperforming loans by China’s local government and property developers, prominent scholars and policy advisors told MNI, though some stressed that moral hazard should be avoided to minimise the risk that the problems could recur.

China’s bank-dominated system means monetary easing through lower rates or reserve requirements only adds “debt on top of debt” at times when the economy is already over-leveraged, said Gong Gang, dean of the School of Economics at Yunnan University of Finance and Economics, calling on the PBOC to create a state-owned entity or special-purpose vehicle to acquire distressed assets from real-estate developers and local government financing vehicles that have not formally entered bankruptcy, but are already in de-facto default or shut out of bank lending.

Funding this by issuing base money to resolve bad debts could ease the burden without triggering inflation, he said, so long as growth in the overall money supply remains aligned with nominal GDP. (See MNI INTERVIEW 2: China Fiscal Stimulus Key To Deflation Fight)

Policymakers have been toying with the idea of an SPV to purchase housing, financed by CNY500 billion in Ministry of Finance special treasury bond issuance alongside CNY5 trillion in PBOC targeted funding, since 2021, a policy advisor noted. 

Implementation would depend on real-estate market stress, the advisor said, adding that if local governments could no longer provide support, the central government would need to step in given that property is the primary collateral for bank lending.

In the 2000s, the stripping of non-performing assets from China’s “Big Four” state-owned banks was a key step in their restructuring and listing, as well as in resolving financial risks. This process was mainly carried out through three large-scale rounds of NPL disposals, mainly to four specially-established asset management companies. At the end of 2002, average non-performing loan ratios had reached as high as 25% at the Big Four banks, while their capital adequacy ratios averaged only 4.25%, far below international regulatory requirements and leaving them technically insolvent. 

Current PBOC Governor Pan Gongsheng was deeply involved in the restructuring, recapitalisation and listing of the state-owned banks in the 2000s, serving in senior roles in Industrial and Commercial Bank of China and Agricultural Bank of China.

DEBT RISK 

China’s current mild deflation is rooted in excessive borrowing and overcapacity, pulling GDP growth below potential, Gong said. Debt swap schemes of the sort already seen only delay a crisis which could be even more damaging, he warned. (See MNI: China's GDP Faces H2 Growth Challenges)

Real-estate oversupply is a major concern, with unsold commercial housing stock in Beijing and Shanghai reaching about 25 million square metres each. Gong suggested the PBOC could exchange base money for banks’ non-performing property assets and repurpose them as affordable rental housing. High prices in cities lock out migrant workers, discourage consumption, and cap domestic demand, he said.

POLICY CONCERNS

Sun Lijian, director of the Financial Research Center at Fudan University, said SPVs could prove more effective than traditional tools during downturns by revitalising non-performing assets and easing debt burdens. 

However, Sun, also an advisor to the PBOC and the Shanghai government, noted that this requires mature financial markets, sound regulation and effective isolation of risks. Without these, SPVs might only worsen the bad debt problem, as happened in Japan, he said.

Many exposed financial risks are essentially moral hazards, Sun continued, noting how nonperforming loan ratios are rising again despite the purchase of CNY2.14 trillion in bad debt from the Big Four between 1999 and 2005.

While Sun did not rule out SPVs, he stressed they would require broad policy consensus that banks can no longer generate liquidity on their own and that property and local government debt risks could spark liquidity crises in smaller financial institutions. For now, he said, conditions are not yet that severe.

Shifting all local government debt onto the central balance sheet could lead to a sharp deterioration of central fiscal conditions, as was seen in Japan, undermining China’s sovereign credit rating, potentially triggering capital outflows and prompting exchange rate distortions, he warned.