Chinese Banks’ NPL Ratio Could Reach High Double-Digits

China today is facing many similar problems Japan did in the late 1980s and early 1990s. The ultimate non-performing loan (NPL) ratio in China in this credit cycle could be much higher than Japan’s worst of over 8%, and could end up with a significantly high double-digit figure, says a BofA Merrill Lynch Global Research report.

China is battling with imbalanced growth, government stimulus, overcapacity, an overwrought housing market, and a severely under-capitalized financial system, just as Japan did about 20 years ago.

Japan burst its asset bubble with a series of official discount rate hikes beginning in May 1989. This caused its banks’ non-performing loan (NPL) assets to pile up, seriously compromising the integrity of Japanese banks.

In 2002, the Japanese government finally acknowledged that the repercussions of those toxic assets threatened to extend to macroeconomic damage as well. The ensuing "Takenaka Plan" got banks’ bad debt off their books, and also injected public funds into under-capitalized banks.

The Chinese government raised real effective interest rates significantly in recent quarters to restrain housing price increase and debt surge that occurred since the global financial crisis.

As a result, it appears that the property market seems to be tipping over. Bad debt is likely to accumulate rapidly going forward as a result.

Despite Chinese banks’ current reported official NPL ratio of under 1%, Bank of America Merrill Lynch estimates that the ultimate NPL ratio during this credit cycle could be much higher, perhaps a significantly double-digit number.

After all, China’s NPL ratio reached close to 40% in the early 2000s before the Chinese government took bad asset off Chinese banks. In addition, Bank of America Merrill Lynch sees the factors impacting NPLs, such as exposure to property and overcapacity, are potentially worse this time.

But the Chinese government is likely to leave the issue under the carpet for some time because of political reasons.

If China does repeat the feat of Japan, the Chinese market may be entering into an asset-deflation phase. That means banks, developers and building materials should start to under-perform significantly.

Chinese banks, in particular, could face significant downside despite their poor performance in recent years.