Convergence and Reversion: China's Banking System at 70

Abstract

During its 70‐year existence, China's modern banking system has typically been ill used by its government. Nevertheless, after the collapse of the Soviet Union, the Chinese government made effective use of ten years and a lot of capital to restructure its banks. And on the eve of the global financial crisis in 2008, China's principal banks had cleaned up their bad loans and received or raised large amounts of equity, in part by listing their shares internationally. In so doing, such banks may well have positioned themselves to face the crisis with the strongest balance sheets in the world.But since then, in the wake of the global financial crisis, China's banks have used securitization models—originating for the most part in the U.S.—to create products similar to the mortgage‐backed securities that nearly brought down the global banking system. The collapse of such securities in 2008 compelled China to undertake a massive stimulus program driven by bank lending. This stimulus has lasted nearly a decade, with a second recent and massive injection prompted by the COVID‐19 pandemic. The net effect of such stimulus is that China's total bank assets are now over 3.5 times national GDP—as compared to 1.0 in the U.S.—and more than twice the total level of U.S. banking assets in an economy just two‐thirds the size.But even with such an increase, reported non‐performing assets have remained at remarkably low levels—though the report itself has been received with near universal skepticism. Fueling this skepticism, the scale and balance sheet quality of these banks do not compute when one takes a closer look at the banks' main borrowers: largely local government entities with limited revenue bases. In China, local governments do not enjoy taxing authority and their budgets consistently exceed their revenue, with the funding gaps filled by ever more bank loans. As a consequence, most local governments are effectively bankrupt.How, then, given the financial condition of their borrowers, do Chinese banks continue to report superlative earnings and clean balance sheets? The author discusses in detail the two main methods banks have used to meet their accounting requirements while obscuring asset quality: (1) converting bank loans into bonds issued by the same borrowers; and (2) the creation of massive amounts of wealth management products (or WMPs), which are retail deposits backed not just by Treasuries and other liquid securities (as in the U.S.), but in significant part by illiquid assets that create troublingly large maturity mismatches. After pointing out the similarity of such WMPs to the mortgage‐backed securities used by American banks a decade ago, the author emphasizes the irony that, having used American banks as models for restructuring, China's government has forced its banks to continue to follow in their path to what at some point is highly likely to be a painful reckoning.