China’s “Hidden” Bad Loans Signal Trouble Ahead

This article was originally featured on Bizmology.

Citigroup analyst and former UK policy maker Willem Buiter set off alarm bells when he recently predicted that there would be a 55% chance of a global recession within the next couple of years, which would be caused by sliding demand from the world’s #2 economy.

Most analysts found the prediction outrageous. And normally, they’d be right: On its own, China’s economy growing at an estimated 7% (at best) in 2015 — its slowest pace in 25 years — would probably be relatively harmless if the world economy were chugging along nicely.

But Buiter’s prediction is underscored by today’s gloomy global backdrop: Many developed countries’ economic growth has been sluggish since the financial crisis, while growth in emerging markets like Brazil, South Africa, and Russia has disappointed as well.

Put simply, China has been the juggernaut leading much of the world’s economic growth beyond the US in recent years. But if the latest bank data have anything to say about the health of China’s economy, the world’s shining star of growth may be becoming its biggest headache.

China’s Nonperforming Loan Problem

The state of China’s banking sector may give us a good idea of how the country’s overall economy is doing. And right now, the prognosis is not great.

As I touched on in my last post, China’s four largest banks reported that their profits grew by no more than 1.5% during the first half of 2015 — reflecting the banking sector’s worst performance in more than a decade — as they were forced to set aside more in loan loss provisions as more borrowers were unable to repay their loans.

In prior years China’s largest banks were posting annual profit growth exceeding 10% for several years. The banks enjoyed the fruits of a “lending binge” that began after 2008 as the government encouraged them to lend aggressively to local governments and state industries as a way to keep the country’s economy afloat amid the global financial crisis.

Today, with the country’s economy slowing, some of these large municipalities that borrowed from the banks have become empty “ghost cities” with unused infrastructures that have failed to deliver on promised returns — causing more loan delinquencies. As a result of this and large swathes of consumers being unable to repay, China’s bad loan debts are at their highest levels since 2010.

China’s “Hidden” Bad Loan Debts: A Symptom of a Larger Problem

Granted, even as loan loss provisions have been increasing, bullish analysts are hanging their hat on the fact that the Chinese banking sector’s bad-loan ratio, which measures nonperforming loans as a percentage of total loans, was still just 1.5% at the end of June — relatively low by global standards.

But here’s what they’re missing: Banks in China have not been federally required to show all of their bad loans. In fact, a study by Moody’s Investors Services recently found that China’s banks have not been listing some nonperforming loans that have been overdue for 90 days or more.

Further, Moody’s report found that the bad-loan ratio for these seriously delinquent loans for the 11 Chinese banks it studied rose by 77 basis points during the first half of 2015 — growing more than three times faster than the China’s widely reported bad-loan ratio, which grew by 24 basis points over the same period.

“Special-mention loans” are another type of loan debt that the industry hasn’t been showcasing but could signal another problem under the hood of China’s economy. These loans, which are ones that banks deem overdue but not yet impaired, have been in many cases rising at a faster rate than the industry’s bad-loan ratio as well.

Take Industrial and Commercial Bank of China (ICBC) — China’s and the world’s largest bank by assets — for example. The bank reported in June that its special-mention loans amounted to 420.4 billion yuan, or three times the amount of nonperforming loans it held. ICBC’s special-mention loans also accounted for 3.6% of its total loans, growing significantly from a ratio of 2.1% one year earlier.

In Conclusion

Given this research, there are three things that are clear: Nearly-bad loans, bad loans, and seriously delinquent bad loan levels are all on the rise in China’s banking sector as borrowers have been struggling to repay their loans.

As mentioned in my last post, the higher loan loss provisions that result from these bad loans will continue to eat into bank profits (and will probably lead China’s largest banks into losses for the second half of 2015). But more importantly, the rise in these three types of bad loans signals that China’s economy may be in worse shape than many think.

While we don’t know for sure if China’s banking sector will be the cause of the next global recession — much like the US’s banking sector was largely responsible for the last one — there’s a tremendous amount of uncertainty. The growth in China’s nonperforming loan assets has caused concern among analysts, but those may only be one part of a larger story of “hidden” bad loan debt waiting to be uncovered.

More articles that you may like:

The Great Fall of China’s Banking Sector May Be Underway
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Large Financial Storms Threaten Banks Worldwide

Christian Hudspeth is a company analyst for Dun & Bradstreet who researches and reports on more than 1,000 banks and financial firms for Hoover’s company database subscribers. Before joining Dun & Bradstreet, Christian was a managing editor, senior financial writer and analyst for a financial publishing company. His financial articles have been featured on MSN Money, Business Insider,, and several other well-known online publications. Before he was an editor, Christian worked in the commercial banking industry for seven years.