By Jacob L. Shapiro

China’s non-performing loans (NPLs) are inching upwards again. NPLs have been growing in the Chinese banking system since 2012, and according to the China Banking Regulatory Commission (CBRC), NPLs increased by roughly $75 billion in 2015 – double the growth in 2014. The ratio of NPLs to total loans is still relatively low – CBRC data from December 2015 put the percentage of NPLs at 1.67. (For frame of reference, our annual forecast identified Italy as a problem spot in 2016 because its NPL rate is around 17 percent.) But the increase in Chinese NPLs is accompanied by the declining profitability of Chinese banks, excessive capacity for Chinese steelmakers, coalminers and manufacturers, and a soft real estate market. China has been sweeping its NPL problem under the rug for decades now, but in the past has always been able to fall back on preternatural growth rates and booming demand for its cheap exports. This time, it will not be as easy.

Where the Problem Began

The NPL problem in China began after 1978, when Deng Xiaoping made the decision to open China’s economy to the world. As China transitioned from a traditional planned economy to a more market-oriented one (though one still with a great deal of planning), China began relying more on banks, rather than fiscal appropriations directly from the state, to fund state-owned enterprises (SOEs). In effect, what had been the fiscal burden of the government started to become the credit burden of Chinese SOEs. In the 1980s, China’s NPLs began to increase, rising from just .04 percent of all loans in 1984 to 10.31 percent by 1991.

From 1992 to 2009, NPL ratios became a key statistic for evaluating Chinese banks. As massive changes in the Chinese economy took shape, NPL ratios ballooned as high as 33.05 percent in 1998, according to official data. There were two key reasons for this spike. First, the Chinese economy began growing faster and domestic demand could not keep pace. Domestic loans in China increased by 48 percent in 1992, necessitating a government reaction that sought to control the money supply and curtail investment. Many were engaged in speculation, attempting to make quick profits by pouring money into real estate developments or unfeasible projects. Second, China’s SOEs, which had for so long been sheltered from competition, faced extreme pressure. Many of the loans that went unrepaid in the mid-1990s were bank loans taken out by SOEs to avoid bankruptcy or to pay workers’ benefits.

China set about “solving” this problem in 1999, creating four asset management companies (AMCs), one for each of China’s biggest banks. It is the job of the AMCs to dispose of NPLs. To that end, the Chinese government provided each AMC with almost $1.2 billion to purchase substandard and doubtful debt from China’s main banks at full book value, and according to a 2004 report by Financier Worldwide magazine, the AMCs succeeded in recovering 20 percent of that value on average. The CBRC was created in 2003, in part to provide regulatory oversight over the constantly changing Chinese banking system. By 2008, the average NPL rate at China’s “Big Four” banks was 2.81 percent. But one of the reasons the NPL rate was so low in 2008 was that the Agricultural Bank of China transferred almost all of its $116.9 billion in NPLs to an AMC.

Lack of Reliable Data

That the AMCs have continuously reduced the NPL burden of China’s banks is not the only misleading aspect of China’s reported NPL ratios. China’s economy may operate differently than a Western economy, but this also does not fully explain why its numbers are misleading. Parsing Chinese NPL data, like most Chinese statistics, has always involved dealing with ambiguity. For example, before 2004, China had its own unique way of classifying NPLs that differed from international banking standards. This meant that thinking of China’s NPL problem in Western terms often resulted in misunderstandings. A 2015 PricewaterhouseCoopers (PwC) report notes that in instances where most banks would qualify a loan as non-performing, a Chinese bank will not if it believes it can recoup its money, for example, by selling the borrower’s assets.

So while China reports its NPL ratio is at 1.67 percent – well below the World Bank’s global average of 4.2 percent – there are various estimates that try to measure the actual figure. PwC, for example, estimates that the true number is somewhere between 3 percent and 5 percent. A recent report by JPMorgan Chase suggested that Chinese NPLs would peak around 7 percent – though it could rise as high as 20 percent – which would necessitate a bailout of between $600 billion and $770 billion. That may not seem like a lot for China, which boasts over $3 trillion in foreign exchange reserves. But keep in mind that China’s reserves have been declining for months now and dropped by $100 billion in January 2016. If that trend continues – and we have no reason to believe it won’t – almost a third of China’s reserves could evaporate in a year. Just because China has grown at preternatural rates for 30 years doesn’t mean it can’t run out of money like any other country.

Interactive: World Nonperforming Loans

China also now lives in a fundamentally different economic reality than it did even eight years ago. According to the South China Morning Post (SCMP), overcapacity in sectors including iron and steel, glass, cement, aluminum, solar panels and power generation equipment exceeds 30 percent. The Washington Post reported, based on data from the U.S. Geological Survey (USGS) and International Cement Review, that China used more cement from 2011 to 2013 than the United States used in the entire 20th century. Data from investment company CEIC and the USGS compiled by SCMP shows that, in 2014, China was producing 30 times as much cement as the United States and five times the amount of steel as all 28 European Union countries combined. China has a larger population than the U.S. and EU, but even so these numbers are suspect.

Bad Signs in Real Estate

One of the reasons the numbers are inflated is because China continues to pour money into construction irrespective of demand. So much of the cement, steel and other materials and products suffering from overcapacity are used in the real estate and property market in China. The research firm Gavekal estimates that 30 percent of China’s GDP comes from housing. Housing prices have only recently started to recover after a decline that began in May 2014 – they rose in October 2015 after 13 consecutive months of decline, and increased 7.7 percent year over year in December.

But this masks the fact that, while some cities like Shenzhen and Shanghai are recovering, many others, particularly smaller ones in the interior, have millions of vacant homes with no one to buy them, and ghost cities built by Chinese companies exist with no people to live in them. The state-run People’s Daily newspaper reported that, out of 50 real estate companies representing more than 30 percent of Chinese developers, 15 were operating at a loss and 23 were facing declines in profitability. Meanwhile, China’s National Bureau of Statistics reported in October 2015 that the number of unsold homes in China exceeded 14 percent. The Chinese government still has an interest in encouraging construction, and there have been positive indicators of improving home prices in recent months – but if there is a bottom to China’s real estate market, we haven’t seen it yet.

Which brings us back to NPLs. Chinese banks are themselves tied up in the property market, and the China Orient AMC estimated in 2014 that should property prices decline by more than 30 percent, Chinese banks would not be able to stay solvent. (For perspective, in the most recent dip, according to the National Bureau of Statistics, prices dropped roughly 5 percent.) But the NPL issue is also deeply intertwined with overcapacity. Without demand for houses, steel, concrete and other construction materials, Chinese companies are forced to take on additional debt to repay loans they could not pay back in the first place. And they are being lent that money either through shadow banking or from banks that have had their balance sheets scrubbed of NPLs by AMCs. At a certain point, potential investors are going to become warier because it is becoming clear to the world that a recovery in the Chinese economy is a long way off and won’t equal the export-driven growth of the previous 30 years.

Conclusion

Zhou Xiaochuan, the governor of the People’s Bank of China, said on March 12 that China had to proceed very carefully with securitization of bad Chinese debt because of lessons learned during the global financial crisis. But the deeper issue isn’t whether 2008 will be repeated – it’s whether China can afford to continue sweeping NPLs under the rug when demand for its exports continues to falter, it is hemorrhaging foreign reserves, SOEs are borrowing money just to pay off the debts they already have, and domestic unrest from workers who are losing their jobs is increasing. NPLs are not a new problem for China, and Beijing has managed much higher NPL ratios than even the worst-case scenario through creative means. But the difference now is China’s economy is not going to take off again – this is the new normal. What worked before isn’t necessarily going to work now. The NPL problem has returned, and this time with a vengeance.