Why the Chinese Banking Sector is Built on Quicksand

It’s 2008 all over again, only in China instead of the U.S. You see, the housing bubble was built on dreams. Young couples, families, singles, everyone wanted to buy a nice house, and they believed the could. They believed that they could afford it, they could pay their mortgages and everything would be fine. And why not? Most people are intrinsically optimistic. And the banks played along and said, ‘sure, we’ll finance that.’ And they’re the experts, so if they’re willing to dish out the cash, they must also believe that the loans would be paid off. Right? Wrong. As we learned the hard way, the incentives of the people signing off on those loans were extremely distorted, so they benefited from handing out bad loans like candy on Halloween. And we see how that turned out.

Cut to Beijing, circa 2017, and you have a not so different scenario playing out. It’s not so much about real estate, although there are some bubbles going on in the larger cities, and it’s a result of intentional wrongdoing on the part of the bankers. When they gave out these loans they had every hope that they would be repaid as planned. But once payments didn’t come in, that’s when the fun and games started. Rather than writing off bad debt to a bankrupt company, the bank would kick the can forward. So if a client couldn’t make a payment on a loan due (in whole or in part) in 2017, the bank would simply make the loan due in 2018, or 2019, or 2025. And refinancing is fine in many situations, but when it’s used as a tool to make the bank’s balance sheet look nicer when the underlying debt is one they know they’ll never collect on (i.e. the company went bust and there’s nothing left to collect), you’re on rocky footing.

Eventually, all of these bad debts will add up, and if they add up to large enough numbers, the solvency of the banks will come into question. And that will not be a pretty picture for anyone. One positive note is that Beijing is floating on enough cash to bail out the banks. Let’s just hope they do so wisely.