The Covid-19 fallout has seen “whatever it takes” moments for policymakers in many countries, where unconventional monetary and fiscal tools are being deployed to boost liquidity or bail out troubled firms. But policymakers in China have an additional page in their playbook: calling up banks into ‘national service’.
The Chinese financial sector must forgo a total of 1.5 trillion renminbi ($214 billion) in revenue this year, as lenders are required to extend cheaper loans to small enterprises and tolerate later payments from them, Premier Li Keqiang said at a State Council meeting in June. While details have yet to emerge on how to measure forsaken revenues, the unprecedented price tag reflects the government’s resolve to bail out small firms at the expense of banks.
Like global peers, Chinese lenders have been facing an overall decline in net interest margins, with lending rates trending lower even without the new bailout duty. Investors in the sector, in the short term at least, may feel they are at the raw end of the deal.
Playing the long game
But despite near term headwinds, we think the long-term damage from national service will be limited, as the Chinese economy gradually recovers and the government is expected to reward banks for their sacrifice. For instance, the central bank may cut the reserve requirement ratios for commercial lenders that have done well in bailing out small firms. Lowering the RRRs would help free up their capital for potential revenue growth. Loans to small firms currently account for less than 10 per cent of China’s overall banking assets, limiting the scope for potential bad debt growth.
Chinese traders often refer to the relationship between the central bank and commercial lenders as one of mother and children. The People’s Bank of China is widely dubbed yangma, or “mom PBOC”. The implication is that while there are candies for the children when times are good, they also must step up when the family is in difficulty.
Lessons from the GFC
An epic version of this national service came in late 2008, when China counted on banks for a stimulus package worth 4 trillion renminbi (around $570 billion at today’s exchange rates) to cushion the impact of the global financial crisis. Around 40 per cent of the funding was directed towards infrastructure projects like railroads, highways and airports across the country. The lending machine ran at full steam with many state-owned banks expanding their loan book by 30-50 per cent in 2009. Among the main borrowers were local government investment vehicles and companies from smokestack industries like steelmakers and cement producers.
While the post-GFC lending spree helped drive a V-shaped economic rebound, the problem of bad loans haunted Chinese banks for years afterward. Many companies and government vehicles that received quick money for hasty or economically questionable projects later found themselves mired in debt.
In 2015-16, a slowing economy prompted policymakers to encourage another lending boom, with an aim to boost household spending. Mortgages and personal loans jumped as a result, and the ratio of household debt to GDP climbed 5 percentage points in a matter of months - to about 50 per cent in early 2016. The lending binge helped support economic growth, but it also created headaches for the government by fueling a property bubble.
More targeted this time around
Will history repeat itself? We think the national service of 2020 will come in a more targeted and controlled fashion, as Chinese policymakers have learned lessons from previous rounds of easing. Banking regulators are expected to maintain a high degree of control over industry risks, while lenders shall be allowed to limit their unprofitable support for small firms.
Over the last few months, some large Chinese banks have boosted new loans for small enterprises by about 40 per cent from a year ago, based on our checks with banking executives. New loans are being extended to the borrower group at an average interest rate of about 5 per cent, down from 6-7 per cent last year, while the bad loan ratio for small firms could exceed 5 per cent at many midsize banks, based on our estimates. That implies a certain level of losses could arise from the current round of national service. Bad debt concerns are partially reflected in the depressed valuations of Chinese banking stocks, many of which trade at an unusually low 0.4-0.6 times book value in Hong Kong.
Still, nationwide bank loans for small firms stood at a modest level of about 1.2 trillion renminbi, or less than a tenth of total loans outstanding. It’s unlikely that the current lending spree will be extended to larger enterprises. In fact, banks are turning their backs on some medium-sized companies on the verge of default.
Getting more selective
Banks appear more cautious and disciplined than they were in previous rounds of national service, partly due to unprecedented challenges posed by the coronavirus. They are managing to differentiate between companies with short-term stress caused by Covid-19 fallout from those that have lost competitiveness in the long run. Lenders like Ping An Bank and China Merchants Bank have recently tightened credit card loans.
The largest state-owned banks are more likely to shoulder the bulk of the bailout duty, while joint-stock banks, which feature more non-state ownership, may enjoy a degree of flexibility over how much national service to perform. Investors may focus on lenders whose management is more profit driven than politically motivated.
In an era of unlimited central bank support around the world, China’s bailout of small firms actually looks somewhat constrained. Chinese banks had less than 5 per cent of their loans on moratorium as of April, compared to about 30 per cent in India, more than 10 per cent in Singapore and a high single-digit ratio in Australia, according to estimates by Aletheia Capital. On a cautious note, central bank governor Yi Gang said in June that policymakers should consider when to end Covid-induced easing to minimise moral hazard.
We expect China’s overall bad debt ratio to stay at manageable levels, especially if the Covid threat recedes next year as vaccines go into public use. However, if the virus continues disrupting economic activities for two to three years, a substantial part of the current new loans for small firms will risk turning sour. In that case, bailing out small firms at the expense of banks’ balance sheets would only add to longer term economic inefficiency. That’s not our base case. Instead, we think that in a less bearish Covid scenario, the national service performed by banks today should help lower the tail risks to China’s economy, with its weakest links being shored up.