Trouble ahead

The US$1.4 trillion in loans issued by China’s banks in 2009 may have helped to keep the country’s economic engine running, but not without consequences. On the surface, those consequences may not appear to be severe.

Certainly, compared with the battering taken by their counterparts overseas, China’s lenders have shown relatively healthy earnings and indications of asset quality. A Citi report in mid-December indicated a positive view on the sector thanks in part to growth momentum and good earnings visibility.

Big lenders

However, concern is mounting about the scale of the lending. "We have actually become more concerned than we were before the crisis," said Charlene Chu, senior director at Fitch Ratings in Beijing. "This is a considerable amount of money to enter an emerging market in a short amount of time, and we think it inevitably places pressure on Chinese banks’ risk management."

Chu believes the length of time Chinese banks take to recognize loans as non-performing, poor disclosure of off-balance-sheet transactions, and banks’ lack of experience going through a full economic cycle since being commercialized could all pose significant risks in the medium term.

Leo Wah, vice president and senior analyst at Moody’s in Hong Kong, agrees that there are medium-term risks. "More often than not, when banks are expanding their balance sheets rapidly, there are problems ahead," he said.

A central problem is the difficulty in calculating banks’ exposure to bad debts. The lag in recognizing non-performing loans is only one issue; Wah says that corporations and financial institutions are "very creative" in finding ways to give the appearance of low exposure to bad loans.

In 2009, some banks leapt at the opportunity to reduce their non-performing loan ratios by rapidly increasing the total number of loans. Others mask their exposure through practices such as temporarily selling loans to trust companies, which then securitize them for clients. These loans are removed from banks’ books, further obscuring the institutions’ exposures.

"Banks argue that the reason they’re not disclosing [these loans] is because they’ve transferred the full credit risk and are therefore no longer exposed," said Chu. "But it’s not clear to us that the full credit risk has been transferred."

In a December report, Chu said such unreported loans are "distorting credit growth figures at an institutional and systemic level and represent a growing pool of hidden credit risk."

Slow burners

Such risks are unlikely to rear their heads in the next year. The time lag for bad debt to surface may hide some of the effects, and a positive outlook for the Chinese economy in the next year could mean reasonably strong performance for the banking sector overall. Wah also says that Beijing has the financial muscle to even go as far as instituting a second stimulus program should the global economy take a turn for the worse – though it will have to do so while balancing the economy and keeping inflation in check.

While temporarily hidden, however, the medium-term risks are no less real. Fitch’s Chu warned that those risks may lead to downgraded ratings for banks in 2010.

"The individual ratings of some Chinese banks could be revised downward … particularly if we see credit and capital diverging even more than they have [in 2009]," Chu said.