The Strategies for solving the problems of China’s Banking sector

As the signs of the coming global recession are becoming increasingly visible due to the intensity of the trade and monetary wars prevailing on the planet and also from geopolitical events such as the Brexit, the concern of investors is increasingly turning to China and more specifically to the banking sector which is a lever for the development of each economy.

Since last May and by the end of summer it took part a series of rescues of small banks in China, small but strong enough in size to cause a financial crisis, starting with Baoshang Bank-a small bank in the Inner Mongolia in China-and with the last (third bank in line) Hengfeng Bank Co., Ltd which eventually in order to be rescued like the previous banks indirectly nationalized when the Chinese sovereign wealth fund buy the company Xiao Jianhua which was a subsidiary of the Hengfeng Bank Co., Ltd.

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The signs that create concern

The problem was initiated by the interbank market where when things get out of control the regulators can hardly gather them. The positive side to these events was the swift response of the Chinese government to the immediate resolution of the problems. But this does not ensure that things go well in China’s banking sector.

The growth of credit in China has skyrocketed since the Chinese government began stabilising the economy from 2017 and until today without these efforts to yield the expected fruits.

Checking the credit ratio to deposits = 384/22 = 17,45 (2017) per 1000 adult residents (Source: World Bank, https://wdi.worldbank.org ), we find that China’s credit expansion has exceeded the upper ceilings and is entering in uncharted waters with regard to the risks to its financial system.

The structure elements that advocate the problems facing China’s economy can be summarized in that the actual credit expansion levels in its economy are likely to be larger than the official figures show. Just the thought that this element is likely to be true causes terror among investors.

On the other hand, China’s housing market shows signs of overheating and is constantly being fed with funds that are directed as investments in the housing market. These funds and possibly due to lack of investment opportunities are being redirected from the Stock market to the housing market where the yields may be higher and given the low risk that has the investment in property.

In recent years the efforts of the Chinese government have focused on artificially supporting the demand of the domestic market by increasing credit to consumers and businesses.

We must not miss the fact that it is common for small and medium-sized banks, such as Baoshang Bank, to be inclined to have small and small-business enterprises respectively, as customers in their credit portfolios.

This fact allows them to spread/diversify away the non-systemic risk which is always included to their investments/credits which are given in the form of a small amount of credit capital to their clients.

The constantly decreasing domestic demand due to trade wars will cause a big first wave of bankruptcies in China’s small and medium-sized enterprises, which are overborrowed due to their continued expansion in previous years.

At the same time, it is not only small and medium size businesses that operate with overborrowing in order to acquire more and more assets, but so do small banks (aggressive expansion) with aim to increase the number of their assets (i.e. their comparative advantage) in relation to their competitors.

To achieve this aggressive expansion, small banks are increasingly relying on interbank borrowing. But since the economy is shrinking (reducing GDP) small banks are increasingly exposed to high default risks because they borrow funds in the interbank market with a higher interest rate in relation to the equivalent borrowed by the major state banks.

If we add to this situation the bankruptcy of small and medium-sized overborrowed enterprises that have in their client portfolios these small banks it could be created a financial crisis that can evolve into catastrophic tsunami for the Chinese banking sector.

The fact that three small banks that would necessarily save nationalized should be an enough evidence to ring alarm for the Chinese Government.

The wrong way to solve the problem

Nationalization of problematic banks is the wrong strategy because the damage caused to banks’ balance sheets should be eliminated:

α) either by “mowing” elements in the liabilities side of banks.

β) or by state re-capitalization. The accumulated state re-capitalization (due to many banks who are in a state of high default risk-bankruptcy) would cause an increase not only of the public debt but of the widening of the fiscal deficit in the annual budget of the federal government of China.

The fact that China has a huge reserve in foreign exchange reserves with continuous state re-capitalizations of problematic banks will cause instability in its foreign exchange reserves.

The final costs incurred with any application of the first two options-strategies (a) and (b) will further burden the public debt and the annual budget deficit of the China’s federal government. It will substantially burden the Chinese taxpayer (it is unacceptable).

The correct resolution of the problem

Firstly, a thorough check should be made on the balance sheets of all banks and any other lending schemes operating in the territory of China. The problematic banks that will emerge from this audit should proceed to their re-capitalization in which will participate their shareholders. If the principal shareholder in them is the Chinese government, the funds will come from it and analogously with its shareholding percentage.

Next, one of the failing banks should then be used as a vehicle to buy it from all the other problematic banks which will have first re-capitalized. 

Subsequently, the other re-capitalized (and problematic by the audit) banks will be transferred to this bank, which is selected for redemption, all the damages that they present to their balance sheets including all the past due loans to individuals and businesses which hold in their credit portfolios.

Then there should take place a conversion-separation of this selected bank into a “good bank” and a “bad bank”. The good assets and liabilities of this “good bank” that will emerge will be shared among the other, re-capitalized first, problematic banks. On the other hand, all the damages and all the past due loans of the problematic banks will be transferred to this “bad bank”. 

Subsequently, the “bad bank” will have to restructure and re-evaluate in current values all the losses and overdue loans that it will now have in its portfolio (all losses and overdue loans of problematic Chinese banks transferred to it) so where there are overdue loans to be securitized in order to make them more appealing to the interested prospective investors-funds.

With this gigantic securitization of problematic-past due loans, these loans will be changed hands and redeemed by investors at low prices that will allow them to delete a large part of overdue and problematic loans with a profit and discharging the debtor company with full immunity from debts.

This type of flexibility is not available to banks that have granted any problematic (overdue) business loans because they cannot waive the collateral accompanying a loan, e.g. personal guarantees of businessman, not to accept loan deletions without the commitment of other assets of the debtor.

The proceeds resulting from the sale of these overdue loans and losses of the “bad bank” will be fully redirected in full to the shareholders of the re-capitalized banks and of course to the Chinese state (according to the total shareholding percentage in these banks) if it participated with its funds in the re-capitalization process of the problematic banks, so that these revenues mitigate the cost of burdening it from the re-capitalizations.

Thereafter and within a period of six years from the expiry date of the re-capitalization of the particular problematic banks, the Chinese state should proceed to sale of these re-capitalized and now established banks at much better prices in order for the shareholders and the Chinese state (as a shareholder) to be able to collect a large part of all its funds that it used for the re-capitalizations the borne by it.

In this way, the problematic part of Chinese banking system will transfer the burdens of the past and sanitized, proceeding to “cannibalism” essentially of one of the problematic banks with aim to survive the other problematic banks and to fully sanitized their existence.

By implementing this strategy does not mean that new overdue loans will not be created to these systemic or non-systemic banks from current bank loans, if the recession or sluggish growth continues in Chinese economy due to trade wars etc.

The disadvantage with this strategy is that social unrest can be created because with the securitization and sale of losses and overdue loans of the “bad bank”  will start large numbers of auctions and property foreclosures so that investors-funds can get their money back, by taking out from their loan collaterals tens of thousands of overdue borrowers/entrepreneurs.

In this case, the social protection net of the Chinese state should operate in not leaving any entrepreneur or individual without decent shelter and food while giving the opportunity to its citizen to start his life again from the beginning.