A recent Bloomberg report has begun to case light on the proverbial dragon in the room: credit problems in China. According to Bloomberg, the four major state owned banks of China have tripled loan write-offs from the previous year increasing from 7.65 billion rmb to 22.1 billion rmb or $3.65 billion USD. Any step in the direction of recognizing the reality of excess leverage in China is a welcome step but its importance should not be overstated. In fact, there are a number of important facts that have been overlooked.
First, buried in the Bloomberg article is the fact that while write-offs increased to 22.1 billion, these same banks increased non-performing loan numbers by 22.4 billion. In other words, their problem loans grew faster than the number they wrote off.
Second, these write-offs are comprised nearly exclusively of small business loans under 5 million rmb. In other words, the write-offs number excludes any business of any real size. This indicates that they have yet to go after the real state-owned debt dragons instead focusing on the small private firms. Until China deals with the debt at privileged state firms, the talk of managing credit problems is cheap.
Third, Chinese banks are benefiting from quiet bailouts. The Bank of Communications disposed of nearly $1 billion in non-performing loans to asset management firms (read Chinese state funded NPL vehicle). Without this sale, Bank of Communications would have had NPL growth more than double its reported rate of 17%.
China apologists have argued this surge is due to the slower growth in China, despite official 2012 growth of 7.7% and third quarter 2013 growth coming in at (wait for it) 7.8%. Furthermore, despite the argument that banks have enormous cushions and reserves to weather increases in bad loans, they certainly aren't acting like it. Market skittishness has increased as the PBOC has not injected the liquidity demanded by banks causing official repo rates to spike 150 basis points in a week to 5% despite their supposedly healthy position and ample reserves.
When China Merchants Bank conducted a secondary offering in Hong Kong in late August it priced the offering at an 18% discount to their current stock price. Let's make this as clear as possible: banks who offer an 18% discount on a secondary offering are pricing it that way because they are desperate. No strong company ever offered an 18% discount on a secondary offering. EVER.
The fundamental problem facing banks is that Chinese companies are facing enormous financial pressures. According to the Financial Times, since 2005 revenue at large Chinese firms grew at 27% annually but profits only grew at 14% or half that rate. Revenue and profits in the US and Japan grew in new perfect correlation between 7-8% over the same time. This is caused by the excessive credit creation and investment which ate into profits. What is even more notable is that Chinese companies' revenues are growing by less than GDP growth. None of this is indicative of a strong corporate sector that will be in a strong position to repay debts.
If the PBOC doesn't think banks are sound and continues to rein in credit and even the banks sell themselves at an 18% discount, there appears to remain a lot of discouraging indicators despite the investment banks in Hong Kong still hoping to secure business in China.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.