China's banking goliath: from growth engine to economic drag

China’s banking system has long been utilised as a quasi-government tool to channel China’s huge household savings towards the government’s objectives. This has been instrumental to the country’s economic miracle, yet the support it provides is diminishing as banks face rapidly falling profitability and stretched balance sheets. This will have important consequences for the Chinese economy.Thirty years ago, China lacked a functional financial sector. By 1998, banks were saddled with 50% non-performing loans, prompting a massive recapitalisation. The rebuilt system, centred around four giant, state-owned banks, amassed deposits from a thrifty population who could not move their money abroad due to capital controls.During the 2008 financial crisis, China unleashed a major fiscal stimulus mainly financed by banks. Their assets grew 30% annually in 2009 and 2010 with loans being poured into roads, factories and property, boosting growth and catapulting China to become the world's second-largest economy. Banks intermediated excess household savings, still trapped by capital controls, to support favoured sectors like electric vehicles and solar panels, and helped finance a real estate and infrastructure boom – not all of which was productive. This overuse of banks’ balance sheets pushed China's banking sector to become the world's largest, with assets of approximately $60 trillion compared to an $18 trillion economy. That ratio alone signals over-leveraging, confirmed by overall debt having surpassed 300% of GDP.After this period of overuse, we are now seeing ‘underuse’ as Chinese banks cope with a lack of demand for credit – a consequence of the collapse of the real estate sector and, more generally, the rapid deceleration in fixed-asset investment. Only local governments are eager to borrow, though this strains the banking sector further as local-government creditworthiness has worsened substantially.The real estate collapse helps to understand what is happening to Chinese banks. Property, once a pillar of growth, now drags it down. Even the largest real estate developers either default (on $300 billion of debt, in the case of Evergrande) and leave unfinished projects and devalued assets on bank books, or see their investments collapse. Local governments, reliant on land sales for revenue, created financing vehicles to skirt borrowing limits. Banks being the creditors, this hurts them as well.At the same time, banks need to act as backstops to mitigate the economic and social consequences of their own solvency issues. This encourages them to limit the number of defaults, thus piling up so-called ‘zombie’ assets that are neither productive nor worth what bank balance sheets show. This has led to Chinese banks’ assets being far more stretched than they look on the surface. Official non-performing loans stand at 1.7% of total loans, but another 2.2% of poorly provisioned loans need to be considered, as well as ‘special mention loans’ that are currently paid but highly likely to become non-performing in the future.Compounding this, banks' profitability is eroding as interest rates inevitably come down in China from growth deceleration and deflation. Net interest margins – the spread between lending and deposit rates – have narrowed to historic lows of around 1.7%, squeezed by the People's Bank of China's guidance rates, administrative controls and the increasingly lower interest rates needed to continue to stimulate the economy. Return on assets hovers below 1%, far less than global peers.Politically, reform is elusive. State control is still emphasised, prioritising stability and ‘global champions’ over efficiency. No real privatisation in the financial sector is anticipated. Liberalisation efforts, such as interest rate deregulation, have been cosmetic: banks remain ‘administered’, not regulated. This suits Beijing's goal of commandeering savings for industrial policy but has negative consequences for households who then suffer from a very low return on their savings.Without addressing bad debts, inefficient capital allocation or boosting consumption to feed the system, stagnation looms. Beijing's reluctance to let losses surface risks a Japan-style ‘lost decade’, where zombie firms sap economic vitality.Europe and the world should take note of the unique characteristics of China’s banking system that feed China’s industrial model, resulting in overcapacity that pushes Chinese producers towards lower and lower prices. China’s ‘involution’ problem – the fight for market share without consideration for profits – would not be possible without Chinese banks’ state-backed assistance to companies. China's model may look strong, but the unintended consequences are catching up.This is a reprint. This article has been published as part of Bruegel Zhonghua Mundus Newsletters.Original link: /newsletter/chinas-banking-goliath-growth-engine-economic-drag