Last April, China had an idea about how to boost the country’s dying credit impulse.
As we’ve been at pains to explain for more than a year, China is attempting to do the impossible. They need to deleverage and re-leverage all at the same time. Efforts to rein in the mammoth shadow banking system after years of expansion put pressure on an economy that was already decelerating and by the end of 2014, Beijing was struggling to figure out how to keep credit flowing without embedding more risk into the system.
One idea was to supercharge the country’s nascent ABS market which was barely producing $50 billion in supply per year (for context, consider that the US auto loan-backed ABS market alone saw $125 billion in issuance last year).
As Reuters noted at the time, the idea was simple: “By making it easier for banks to repackage and resell receivables - such as loan repayments on mortgages, car loans and credit cards - the government hopes to free up banks' balance sheets so they can lend more to the real economy.”
In other words, offload the credit risk to investors who are searching for yield and once your book is unencumbered, make more loans, then package and sell them to investors, and around you go. It’s the “virtuous” originate-to-sell model and it works great - until it doesn’t.
In any event, despite comments from the likes of ANZ’s Zhao Hao who said “there is a huge demand from banks alone to securitise assets," the plan didn’t work.
Why? Because China's NPLs were rising at a rapid clip as the economy continued to deteriorate. Banks didn't want to lend more and risk further imperiling their balance sheet and even if they did, demand for credit was hardly robust in an economy struggling with an acute overcapacity problem. "With the evidence mounting that the country is experiencing an economic slowdown, Chinese banks don’t want to lend, so they don’t need to sell ABS to free up more room for lending,” Ji Weijie, senior associate at Beijing-based China Securities Co. said in June. “Plus with rising bad loans, banks are reluctant to move good assets off their balance sheets."
Right. Fortunately, China now has a solution for that rather vexing problem. Beijing will simply allow banks to securitize their NPLs.
"China will allow domestic banks to issue up to 50 billion yuan ($7.7 billion) of asset-backed securities based on their non-performing loans, the first quota for such sales since 2008," Bloomberg reports, citing the ubiquitous people familiar with the matter. "The quota, which will initially be allocated mainly to China’s largest banks, will allow lenders to remove non-performing loans from their balance sheets at a time when asset quality is deteriorating and the economy is slowing, the people said, asking not to be named as the plan isn’t public."
If this goes as planned it could allow banks to remove as much as CNY150 billion in bad loans from their books. While that may sound "relatively significant" to quote Sanford C. Bernstein's Zhou Min, it's probably not significant at all if you look at it in the context of the size of China's banking system and the likely real NPL ratio which is probably much closer to 10% than it is to the headline prints.
Of course China will also need to find buyers for this paper and with the likes of Kyle Bass shouting from the rooftops about credit risk, it's difficult to see how Chinese banks are going to get anyone excited about buying their non-performing assets especially in an evironment where the situation is expected to deteriorate continually going forward.
Also, it's not at all clear that even if China's banks do find buyers, they will use the balance sheet slack to lend to the real economy. Yes, China created an unbelievable $500 billion in debt last month, but TSF data is notoriously difficult to interpret (i.e. it would probably be a mistake to take that figure and attribute it solely to either banks' willingness to lend or the real economy's enthusiam to borrow). More importantly, this may be just another effort to manage the numbers. That is, if you engineer an epic TSF boom and then allow banks to dispose of their NPLs via ABS issuance, that's just another way to fudge the NPL data. The souring debt hasn't gone away. It's just someone else's responsibility.
Meanwhile, China's shadow banking system continues to find new ways to obscure risk. As we wrote earlier this month, mid-tier Chinese banks are using DAMPs to make new loans that they can carry on their books as "investments" and "receivables" against which they do not hold much in the way of reserves. For instance, at Industrial Bank, the size of the "investment receivables" book doubled during 2015 and now sits at a massive $267 billion or, as Reuters noted at the time, more than its entire loan book and equivalent to "the total assets in the Philippine banking system."
Of course these are all just channel loans. It's the same basic story: banks are finding innovative ways to lend outside of their official loan books and by carrying a non-trivial percentage of their credit risk as something that doesn't count towards NPLs, they are obscuring risk. And on a massive scale.
"Banks are increasingly turning to so-called directional asset-management plans issued by brokerages and the subsidiaries of mutual-fund providers to channel lending," Bloomberg wrote on Wednesday, adding that "the amount of money placed in such products jumped 70 percent last year to 18.8 trillion yuan ($2.9 trillion), outpacing the 17 percent growth for trust assets."
"These new shadow channels work like trusts. The structure typically involves a bank investing proceeds from its wealth-management products in a directional plan that will then lend to a borrower chosen by the bank," Bloomberg continues. "This allows banks to extend credit while circumventing restrictions on certain borrowers -- such as local government financing vehicles -- as well as capital requirements on regular loans."
As we said three weeks ago, this isn't exactly the same as ABS issuance. That is, the bank retains the credit risk here. The brokers are just the middlemen. “If you talk to a bank, they’ll say it’s somebody else’s credit risk,” Macquarie 's Matthew Smith told Bloomberg. “But the ultimate credit risk doesn’t disappear. The brokers for sure are not taking this on in exchange for a few basis points, so ultimately the banks are still holding onto this credit risk. If it all goes bad, the brokers don’t have the balance sheet to support it, and somebody else has to come in and take it over."
Or, as we put it: "...but that's just semantics. You can call them "assets" or "investments" or "receivables" or whatever the hell else, but at the end of the day, these are loans. And the bank shoulders the entirety of the credit risk."
But again, because of these are carried on banks' books, you won't see them show up in the NPL column - even if they go bad.
The takeaway from all of this is that trying to pin down credit risk at Chinese banks is an endless game of "Whack-a-Mole". Beijing is constantly working to allow banks to shift and reclassify "assets" and/or transfer credit risk either to some entity where it can't be tracked or at least to areas of the balance sheet where it effectively disappears. As Moody's Stephen Schwartz puts it "every time they clamp down on one area, the financing pops up in another."