Bad Loans

When looking for a simple indicator by which to gauge the overall asset quality of a country’s banking system, the level of non-performing loans (NPLs) is a good place to start. However, China’s non-performing loan data is widely believed to understate the actual degree of asset distress. That’s not to say the banks are blind to the risk. Even as the NPL ratio has remained stable, China’s banks have been disposing of bad loans in increasing volumes.

Despite the rapid expansion of credit over the past decade, the level of bad loans at China’s banks remains fairly healthy, relative to both developed economies and other major developing economies. However, China’s official numbers are widely believed to be suspect. Not even China’s banking regulator believes their accuracy, having railed against the various ways banks disguise their NPLs. One way banks disguise their NPLs is by recording loans that should be classified as nonperforming merely as “special mention,” a category that flags the potential for a loan to become distressed but has not yet arrived at that point. The proportion of special mention loans accelerated sharply a few years ago but has since moderated.

China’s Commercial Bank NPL Ratio Compares Favorably with Major Developed and Developing Economies
Source: World Bank.
The Rapid Increase In Special Mention Loans May Have Disguised the Extent of Distressed Debt
Source: CBRC.
Even as the NPL Ratio has Remained Low, Total Outstanding NPLs Have Ballooned
Source: Banks.

Regardless of the official level of distressed debt, China’s banks have grown increasingly active in disposing of bad loans in recent years, albeit from a very low base—so low that banks were hardly disposing of any NPLs as recently as 2012. It’s difficult to put the volume of China’s disposals into context, but we try to do that here by comparing it with US banks. Specially, we take data published by the US Federal Reserve on annual “charge-offs” (which refer to loans written off, less any funds clawed back from loans disposed of in previous periods) by the biggest US banks—which together account for about 80% of total banking assets—and compare it to bad loan disposals by a comparable set of Chinese banks. (For more information on this dataset, see here.)

Loan Disposals by China’s Biggest Banks Have Crept Above That By the Biggest US Banks
Source: Chinese banks, Federal Reserve.

Since 2015, Chinese banks have grown particularly active in disposing of NPLs, overtaking their counterparts in the US. Moreover, piecemeal evidence from 2017 suggests that the pace of bad loan disposals has accelerated further. While that has seemingly stopped the NPL ratio from rising further, less reassuring is that aggressive write-offs haven’t caused the NPL ratio to fall. No sooner than bad loans are written off, then new ones take their place.

Total Annual Bad Loan Disposals By China’s Biggest Banks
Note 1: Charge-offs refer to loans disposed of by banks, less money clawed back from loans that had been disposed of in previous periods.
Note 2: These datasets include Chinese banks with assets in excess of 700 billion yuan, accounting for about 80% of total outstanding assets in China’s banking system. The data also include US banks with assets in excess of $20 billion, accounting for about 80% of total outstanding assets in the US banking system. For further information about this dataset, please click here.
Source: Chinese banks, Federal Reserve.