Chinese banks' accounting methods hide substantial risks
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A recent article published in the Wall Street Journal highlights an emergent debt crisis within China’s banking system that some have described as a ticking time bomb. Clear-eyed observers have been sounding the alarm for years that the level of debt within China’s financial system has been rising at alarming rates.

To date, China’s debt-to-GDP ratio hovers around 250% of GDP. To put this into perspective, the financial crisis that plunged Japan into its “lost decade” was sparked when its debt-to-GDP ratio hit 180%. China is in a league of its own regarding this key economic measure.  

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Observers who have been critical of China’s rapidly escalating debt have wondered how China’s banking system has managed to avoid the prospects of insolvency given the tremendous buildup of debt within the system. How is it that we’ve not witnessed the collapse of one or more Chinese banks?

The Wall Street Journal substantiates what many have suspected all along; Chinese banks are using accounting sleight of hand. They have been reclassifying what are, essentially, loans into another balance sheet line item described as an “investment receivable.”

When a bank classifies a loan as “investment receivables,” it does not have to backstop the loan with capital reserves, as normal lending practice would require. This classification enables banks to get around capital reserve requirements and expand their loan book at a volume forbidden in most regulatory environments. 

The estimated amount of “investment receivables” has been valued at around two trillion U.S. dollars. If this figure is correct, the total outstanding amount of loans on Chinese banks' balance sheets is being seriously underreported, calling into question the safety and soundness of China’s banking system.

The implications of such a massive buildup of debt threatens the stability of China’s economy, leading to a potential financial crisis with broad-reaching implications. 

Given this set of circumstances, it seems the day of reckoning is drawing near. So what’s going to be the catalyst that sets in motion a banking crisis in China?

To answer this, we need to understand where all the debt went and who the borrowers are. A majority of the debt issued was directed to special investment vehicles (SIVs).

City and municipal governments, as well as real estate developers, made great use of such SIVs, borrowing and applying funds toward infrastructure and real estate development.  

The tipping point will come when the municipalities and real estate firms fall short on their revenue projections and are forced to miss payments on their outstanding loans. Given the many articles written about China’s overbuilding, excess real estate and infrastructure, the day when one or more Chinese banks run into liquidity problems as a result of growing non-performing loans lies in the foreseeable future. 

Following this tipping point, one of two possible scenarios will play out. The process will be drawn out and gradual, with growing non-performing loans on bank balance sheets requiring amendments and extensions on existing loans. Or, banks will come under pressure, given the undercapitalization of such loans, and be forced to call the loans.

Either way, a full-scale banking crisis would be inevitable, requiring central bank intervention. 

Given the state of China’s economy and its ongoing growth deceleration, the likelihood of a financial crisis has just increased by a few notches. Thus far, China’s policymakers have managed to avoid a widely speculated “hard landing.” New insights into the safety and soundness of its banking system bring into sharper focus the possibility of turbulence ahead.

 

Arthur Dong is a Professor of Strategy and Economics at Georgetown University’s McDonough School of Business.


 

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