Credit risk: the big unknown in an autarkic financial system

A fascinating analysis by Beijing University economics professor Christopher Balding notes that Chinese banks report nearly 4 times as much interest income from their outstanding loans as Chinese companies report in liabilities attributed to financial (i.e. interest) costs on their balance sheets. According to Professor Balding, this is a shocking indicator of the yawning gap between the official ratio of bad debt in the Chinese economy vice the actual figure.

China's nonperforming loan (NPL) problem has long been a big one: back on the eve of China's accession to the WTO in 2000-2001, the state banking system was widely recognized as insolvent, with NPLs believed to run at 25 to 40 percent of the total. The sheer size of the problem relative to national GDP at the time gave plenty of fodder to doomsayers like Gordon Chang to predict the inevitable collapse of the communist system within a decade.

Fifteen years later, with an economy ten times bigger, this fundamental problem lingers. Officially, the big four state banks - Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), and China Construction Bank (CCB) - have an NPL ratio of just 1 percent; Chinese financial markets price in a figure of 10 percent. In all likelihood, it is higher still, given that Chinese financial exchanges are still restrictive and closed compared with their Western counterparts.

By now it should be apparent to everyone that so long as China's remains a closed and autarkic financial ecosystem, it simply doesn't have to play by the same rules as the recognized global norms. Hence it can pretty much cheat on a massive scale - as far as global conventions are concerned - when it comes to accounting for loan repayments (which would appear inflated on banks' income statements) or the actual writing off or restructuring of bad debt.

However, given the disproportionate contribution of financial services to China's overall GDP growth lately, it is now more important than ever to get the best possible grip on the PRC's financial health metrics, and if there are such massive discrepancies as this one noted by Professor Balding, it's important to somehow reconcile it.

The comment board for the aforementioned Financial Times piece zeroed in on the most obvious explanation: capitalization of interest payments. I added the latest post:

My thoughts:

1) Industrial and manufacturing firms have a strong tendency to capitalize interest on their major plant investments, just as real estate firms do so for construction. The post-crisis stimulus of 2009 saw overall investment approach 50 percent of GDP, meaning massive interest capitalizations across huge swathes of the economy over the last 6 years, read: massive under-reporting of financial expenses attributed to interest payments.

2) The Big 4 state banks' actual loans outstanding is probably significantly higher than reported, so the 7.8 percent interest income ratio is overstated. With a likely bad loan (NPL) ratio of 10 to 20 percent, that figure comes down to 6-6.5 percent. With aggressive revenue recognition of many "good" loans that are structured for lax repayment by the predominantly state-owned enterprise (SOE) borrowers, this figure can go down even further, maybe to about 5 percent.

3) Smaller (i.e. midsize) private firms aren't as likely to get sweetheart loans from the Big 4, so we need the interest income ratio for the banking sector as a whole, including breakdowns of the non-Big 4 state banks, municipal banks, private banks, etc.

4) The big cloud hanging over all this is shadow finance, which peaked around 2012-2013 but still plays a significant role in firms' debt structures which may or may not be reflected in their balance sheets.