We've discussed before here at The Money Game what we like to call The China Weak Spot, ie. the massive off-balance sheet lending game happening between Chinese banks and trust companies.
They've colluded to exploit a loophole in Chinese regulations, allowing them to create more loans than the government wants created.
This weak spot is to us an even greater potential risk than the nation's property market, though it's intertwined with the nation's property market risk as well, given that a property crash could expose a mass of bad loans within China's financial system, many perhaps off-balance sheet.
Well, the Chinese government has now announced that it wants off-balance sheet loans to be brought onto banks' balance sheets. This could mean that Chinese banks will need to raise substantial amounts of capital, since a significant proportion of off-balance sheet lending could be comprised of bad loans.
So watch $339 billion of Chinese loans appear out of thin air:
The move may increase pressure for capital-raising at Chinese banks, which Fitch Ratings last month said had more than 2.3 trillion yuan ($339 billion) of off-balance sheet assets. It also underscores concerns about the health of the banking industry after a person with knowledge of the matter said regulators last month ordered lenders to conduct stress tests to gauge the impact of home prices falling as much as 60 percent.
The regulator’s order “will plug the loophole that more and more banks now employ to get around government lending curbs,” said Liao Qiang, a Beijing-based analyst at Standard & Poor’s. Bringing loans back on to the balance sheet will restrict banks’ ability to expand lending while “their capital requirement will increase,” Liao said.
Larger banks will be required to maintain the mandated capital adequacy ratio of 11.5 percent after taking the off- balance-sheet loans back onto their books, the people with knowledge of the matter said. Smaller Chinese lenders are required to meet a 10 percent ratio.
One has to give the government credit for trying to push this problem into the open, rather than trying to ignore it and sweep it under the rug. Thing is, as banks are forced to come clean with the true state of their balance sheets, we could see some very ugly financial situations emerge.
The move will also act as a headwind for Chinese growth, given that banks may find their lending suddenly restricted by far lower capital adequacy ratios than previously reported. (Given that they are forced to maintain minimum rations, as described in the excerpt above.)
Disclosure: No positions