While senior Chinese leaders have warned for years of the risk accumulating in the financial system, in 2017 Beijing finally made meaningful progress toward paring it back. Most of the attention has focused on the central bank’s deft use of monetary policy to rein in interbank lending, which shrank for the first time since 2010, and to how producer price inflation helped moderate the accumulation of debt, even as the economy grew more strongly.
But drawing less attention is another trend that has been building steadily and stands as a vital part of Beijing’s efforts to ensure the long-term stability of the financial system: the disposal of bad loans. According to comments made by Guo Shuqing, the chairman of China’s banking regulator, China’s banks disposed of 979.9 billion yuan ($155 billion) worth of bad loans in the first three quarters of 2017. Assuming the trend continued for the full year, then 2017 disposals—which generally refers to a mix of write-offs and transfers to third parties like asset management corporations (AMCs)—could have amounted to more than 1.3 trillion yuan ($205 billion). Sadly, neither the China Banking Regulatory Commission nor the People’s Bank of China usually disclose aggregate disposals data, so, short of Guo noting that the disposals represented a ‘clear increase’ from 2016, we have no way of knowing how 2017 compares with previous years.
On the face of it, it seems less noteworthy than other milestones the regulators achieved last year, such as a 3.4 trillion yuan ($540 billion) reduction in the volume of outstanding wealth management products that banks had sold to other financial institutions (the total outstanding amount at the end of 2016 was 6 trillion yuan), a practice which had increasingly intertwined banks’ operations with each other, threatening to spread contagion in the face of a financial shock. Nonetheless, 1.3 trillion yuan ($205 billion) worth of loan disposals is equivalent to almost 10% of new loans that China’s banks issued last year, and without it credit would have grown significantly faster than it did. 
Moreover, it’s unfair to compare disposals with goings-on in the interbank market. Writing-off bad loans or selling them at a discount, eats into banks’ capital and profit, making it a time-consuming process that’s best spread over years. What we’re seeing, however, seems to be a willingness on the behalf of banks to deal with their asset quality issues early—that is before some economic or financial shock forces them to act on less than favorable terms—and on a relatively large scale.
Banks’ nonperforming loan (NPL) disposals have been aggressively building over the last few years. As recently as 2012, China’s banks hardly made any write-offs at all. In that year, based on calculations by MacroPolo, banks with more than 700 billion yuan ($110 billion) worth of total assets—a category that has consistently accounted for slightly more than 80% of total commercial bank assets since 2011—disposed of 32 billion yuan ($5 billion) worth of NPLs. By 2016—only four years later—disposals for the group had increased more than 16 times to 546 billion yuan ($86 billion). The incomplete data we have from 2017 bears out Guo’s observation that disposals continued apace. In the first half of the year Bank of China disposed of 38% more bad loans than it did a year earlier, and China Construction Bank disposed 31% more.
That’s helped stall the rise in commercial banks’ NPL ratio. After having risen consistently since 2012, the ratio peaked at 1.76% at the end of September 2016, before falling to 1.74% where it’s stayed ever since (in his speech, Guo gave the NPL ratio as being 1.9%, which suggests his data may have not been limited to commercial banks only). By any standard, that’s a very healthy level of bad debt. However, the banks will likely have to continue aggressively writing-off NPLs in the years ahead. Analysts generally believe that the official NPL ratio under-counts actual bad loans, although it’s an open question as to just how much. By some estimates, banks will have had to deal with 20 trillion yuan ($3.1 trillion) worth of NPLs (here and here) by the time the problem is fully resolved. Even the CBRC is aware that the official figures understate the true extent of the problem. In a statement it published on January 13 it included banks’ ‘covering up’ of NPLs as a key area of market turmoil it intends to focus on. Going into detail, the statement included a long list of deceptive practices that banks were engaged in to distort NPL levels, including the use shell companies, bridging loans, repurchase agreements that temporarily move NPLs off banks’ balance sheets, deliberately recording loans as being healthier than they are, and providing new loans to repay bad ones.
Part of the problem is that disposing of bad loans legitimately comes at a cost. With bank profits declining, that means they will had to sell more shares.
Perhaps the clearest indication that banks’ NPL disposals will intensify is that some are starting to overhaul the way they deal with bad loans in order to minimize their losses. So far, the most high-profile change has been by Ping An Bank, which toward the end of 2016 set up what it calls its ‘Special Asset Management Division,’ dedicated to disposing of NPLs.
According to speeches and interviews with Ping An Bank officials carried in the local Chinese media, responsibility for resolving NPLs originally resided with the bank’s branches. However, over the course of a three months period at the end of 2016, authority was shifted to a new division under the leadership of the bank’s head office with a mandate to resolve loans quickly and at less of a cost to the bank. By mid-2017, the division had 395 employees, up from 64 just six months earlier.
According to disclosures in the bank’s 2017 half yearly earnings report, the new division had an immediate impact. The unit managed to recover 4.4 billion yuan ($692 million) from loans the bank had classified as nonperforming—up 66.5% from a year earlier—a figure that included 1.77 billion yuan ($270 million) worth of loans that had previously been written off. Recoveries were equivalent to about 25% of the total volume of loans that the bank wrote off in the first half of 2017.
What the bank seems to be doing is that rather than transfer bad loans to asset management corporations like Cinda and Huarong, it’s building up the expertise to be able to deal with those loans itself. Notably, it only transferred 27 million yuan ($4.2 million) worth of loans to third parties in the first half of 2017, compared with more than 4 billion yuan worth of NPLs in the first half of 2016.
So far, the Bank of Suzhou has set up a division with a similar name to Ping An’s NPL department, but it’s said little about whether it will be used to accelerate bad loan disposals. And at least one other bank has been advertising to staff a department dedicated to resolving NPLs. One would expect that Ping An Bank’s success in extracting more value from its bad loans will generate impetus at other banks to do the same.
Bad loans disposals—both write-offs and transfers to third parties—are likely to be an increasingly important part of the deleveraging process. They will put pressure on banks to raise more capital, but will also clear the banks of deadwood that drags down the health of their balance sheets.
 However, it’s important to note that not all NPL disposals translates into a comparable reduction in debt. To the extent that banks transfer NPLs to asset management corporations (AMCs)—otherwise known as bad banks—and the AMCs use bank loans to purchase those NPLs, then the level of banks’ outstanding loans doesn’t change. However, the quality of the banks’ assets improves.
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