Chinese Banks: Not Facing A Crisis But Still Unbuyable

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The BIS has warned about a banking crisis in China within three years.

CHina is unlikely to have a classical bank crisis with collapsing funding markets and asset blow ups.

Chinese banks are likely to remain uninvestible anyway.

The warning given by the Bank for International Settlements (BIS) that there is an increasing risk of a banking crisis within the next three years has raised once again the question of China's debt burden. Rather than making a generic point about debt build up, the BIS is reacting to dynamic data series that measure the pace of credit growth in relation to its long term trend, a measurement which it defines as the "Credit to GDP gap". thanks to recent rapid credit growth in China, the Credit-to-GDP-gap has reached a level where, as the BIS states, this indicator has foreshadowed banking crises in other markets.

The market has long approached Chinese banks with a sense of near revulsion, given that the stated non-performing loan ratios ceased to make any sense a number of years ago. The reserves of my own belief that China could control its credit problem without a painful reckoning in the economy were used up in 2012. Back then, an important market debate was whether China could reign in credit growth following the stimulus of 2010 to around 1x its nominal GDP growth rate. I think we got the answer in 2012 when China did indeed slow down bank lending growth but also experienced an explosion in wealth management products that served as a form of trust financing much like lending . The big picture, in other words, had not changed: savings were, one way or another, funding high levels of fixed asset investment within the GDP mix.

Concerns like this are why China's banks have been range bound since 2010. The chart of for the Hong Kong line of one of the higher quality "Big Four" banks, ICBC.

However, with due respect to the BIS, I would put a very low probability on China experiencing a banking crisis due to rapid credit growth of the kind we are familiar with from history in other markets. This is based on the funding position of China's banking system, which remains liquid, with loan/deposit ratios of 65-80% and almost entirely domestically funded. This means there is not going to be a sudden stop to the liquidity position of at least the major Chinese banks, which also means the interbank market will remain supported. Classically, a stretched liquidity position becomes a problem when interbank lenders pull the plug on borrowers because they are worried their asset quality is so poor it might affect their solvency. It is often this halt in funding markets that triggers a run among retail depositors when they hear a bank has been cut off in the funding markets. Again, it seems unrealistic to imagine the interbank market in China seizing up for this reason as it would certainly threaten the ability to provide credit to the economy. If this happened bad loans would build very rapidly given that inter-company working capital chains are already extended. Rather, national service would win out again and interbank credit would flow, while the PBOC in any case has the capacity to support interbank flows.

As Michael Pettis, of Peking University, had made clear though, this is entirely different to saying that China does not have a debt problem. China has a huge debt problem: the evidence is the falling rate of GDP growth opposite the ever expanding credit/GDP ratio. The costs of resolving it increase the longer it is put off, but it is not yet obvious how China will - even in my view if it can - address its bad debt problem.

Bloomberg drew attention to a UBS report from August this year that suggested uneven efforts to raise capital and sell bad debts are underway. To my mind, the key sentence in the article was the qualification by a UBS analyst that banks that unlisted banks to have raised significant capital were also showing continued rapid asset growth, which to my mind means they may not be being cleaned up in a meaningful sense at all. There is some parallel between this reversion to bad practice by some banks and recent anecdotal reports of coal plants that had previously been closed due to overcapacity reopening following improvements in coal end prices. In an economy with very low credit penetration it is possible to "clean up and keep going" with fresh lending having a positive multiplier effect on economic growth. In China this has not been the case for a number of years.

China certainly seems to have the fiscal space to take any number of officially backed paths to stripping bad assets out of the banking system, but the real issue is whether China can maintain economic growth at a politically acceptable rate while significantly lowering the credit dependency of its economy going forward.

I would look to short Chinese banks after their recent positive run and own Indian Private Sector banks on the other side. I would close the short if a convincing reform program were undertaken in China to address bad loans and supply side overcapacity issues and perhaps also if the government were to orchestrate a bull market as occurred in 1H 2015.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.