Two suggestions for distressed debt investors seeking opportunities in China: look beyond the loan books, and work with local asset management companies, according to Jason Bedford, executive director of Asian financials research at UBS, who has studied China’s distressed debt sector for years.
China’s bad debt issues are increasingly regional, as illustrated in a recent report by UBS showing how some banks based in slower-growing provinces are driving the expansion of shadow banking, with shadow loan ratios much higher than those in some of the richer regions in the country.
"As the credit cycle shifts more towards the provincial level debt issue…the access point to those distressed debts are less to the big four Asset Management Companies (AMCs), but more to the regional AMCs, which have access to local distressed debts," Bedford told China Money Network.
By his reckoning, 51 local AMCs have now been established in China to handle an expected rise of bad debt at the regional and provincial level, following a decade in which local governments gobbled down massive amounts of debt.
On paper, the highest amount of bad debt occurs in the more developed, wealthier provinces of China. "If you look at the non-performing loan (NPL) trend over the last five years, what you have seen is really just a private sectors credit cycle," Bedford said. "So, the irony is that the most vibrant, dynamic economies in China are the ones that have produced far more bad debt on a relative basis than the weakest economies of the country."
This paradox stems, in part, from the fact that the more advanced provinces tend to have more active private economies. But it is increasingly due to banks in less developed provinces being more aggressive in disguising their bad debts as shadow loans. Indeed, the report shows that banks with the lowest official NPL ratios are also the ones with the largest shadow loan books.
Case in point is Bank of Tangshan, based in the industrial city of Tangshan in northeastern Hebei province, about 180 kilometers southeast to Beijing. The regional bank’s shadow bank book was 308% the size of its formal loan book in 2016, the highest ratio of any bank in China and accounted for 51% of the bank’s total assets. The bank’s NPL and special mention loan ratios, however, were 0.31% and 0.33%, respectively, the lowest among all surveyed banks, according to the report.
China’s total shadow loans, primarily in the form of trust beneficiary rights (TRBs) and directional asset management plans (DAMPs), grew 14.6% to RMB14.1 trillion in 2016, making them equivalent to about 19% of China’s GDP, according to UBS. Shadow loans are one way for local banks to "manage their NPL ratios" via credit extensions, lowering risk weightings and through inter-bank financing.
Despite an overall slowdown in the growth rate of shadow lending at the national level, some weak provinces are seeing an alarmingly rapid accumulation of shadow loans, which will eventually need to be dealt with.
For example, the ratio of shadow loans as a percentage of total loans reached 95% and 85% in Liaoning and Heilongjiang province, two heavy industrial areas in China. The ratio in more advanced provinces such as Guangdong and Jiangsu province is less than 35%, the report shows.
Fully aware of the potential risks, Beijing is taking steps to address the issue. Guo Shuqing, head of China’s Banking Regulatory Commission since February, has moved to cut or cap banks’ access to inter-bank funding, for example. The establishment of more regional AMCs is another important step.
While shadow loans pose potential contagion risks among banks, they are unlikely to present any systemic risks, Bedford believes. Economic reforms, SOE reforms and continued deleveraging can help manage the risks, in which smart investors should be able to find great investment opportunities.