China Shows Japan The Way To Tackle Rural Bank Risks

The People's Bank of China, the central bank, reports that as of last June Beijing's efforts to modernize the financial system halved the number of severely weak lenders to 337. About 96% of these institutions were rural credit cooperatives and commercial banks. Some were county and village banks.

Analysts agree it's high time to accelerate the process to repair a major crack in the financial system. Yulia Wan, an analyst at Moody's Investors Service, reckons that urban and rural commercial banks and regional lenders more broadly hold 25% of mainland banking system assets – a concentration that could become a growing risk to local government finances, property and manufacturing.

Jason Bedford, a former analyst with Bridgewater Associates, told Bloomberg in December that China's $2.9 trillion trust industry also remains“deeply distressed, potentially with their capital solvency at risk.”

Bedford noted that“while some have a future, the era of high-interest rate lending to real estate developers, which has long been a mainstay for many trust companies, appears over.”

For Xi's government, acting faster is becoming a bigger political imperative since 2022, when hundreds of people protested over a multi-billion dollar local bank lending scandal in Henan province.

These banking cooperatives were created in the early 1950s, led by farmers connecting to socialist communes. In the decades that followed, they morphed into rural commercial banks. Today, they're fighting for business and relevance as smartphone apps allow customers to make payments.

Of course, consolidation – or turning rural lenders into regional behemoths – only benefits a broader economy when done competently and according to free-market conventions.

Exhibit A: a 2021 operation that created Liaoshen Bank Co to cluster roughly a dozen weak lenders. A year later, its bad-loan ratio was more than double the industry average.

Yet revitalizing a network that plays a vital role in supporting underdeveloped areas could have a powerful GDP multiplier effect, especially at a time when Xi's party has struggled to channel more credit to small and medium-sized enterprises.

In 2023, Chinese provinces injected $31 billion of fresh capital into shaky regional banks via“special-purpose bonds,” an effort that speaks to growing concern over the broader financial system . The risk, says Sherry Zhao, an analyst at Fitch Ratings, is that these special-purpose bonds“are likely to deteriorate if financing terms do not improve as the revenue model shifts.”

That has local governments“tightening their monitoring of local government financing vehicles' liquidity issues,” Zhao says.

“More have set up liquidity pools to provide emergency funding to LGFVs, especially in regions less favored by investors. We believe this is beneficial as a bridging solution but may not reduce credit risk fundamentally if the pool is funded mainly by regional financial resources,” she adds.

Another financial crack getting renewed attention is China's shadow banking system. Recently, one of its best-known conglomerates, Zhongzhi Enterprise Group, filed for bankruptcy liquidation because it was unable to service debt as real estate values plunged.

“While the firm's creditors are mostly wealthy individuals rather than financial institutions, its collapse could nevertheless hurt general market confidence,” analysts at Commerzbank wrote in a note.“It could also renew concerns over the trust industry and whether it would have broader and significant implications for the ailing real estate industry.”

All the more reason for Xi's team to build a more stable underlying financial system. The pressure is on given the insolvency proceedings enveloping China Evergrande Group , the poster child of mainland default risks.

“The wind-up of a major property developer like Evergrande could complicate the Chinese government's efforts to support the property sector and ensure the timely delivery of pre-sold homes,” says Fern Wang, a researcher at KT Capital Group.

Of course, the liquidation at the behest of a Hong Kong court could do the opposite: catalyze Beijing to get serious about ending the property crisis once and for all.

“A court-ordered liquidation of Evergrande marks the symbolic end to property's dominance of the Chinese economy,” says Diana
Choyleva
at Enodo Economics.“It ensures a cleaner break from the issues dragging on growth, as policymakers draw up plans to get the economy going again in 2024.”

That said, the“development will no doubt deepen the prevailing sense of pessimism among investors, particularly with creditors foreseeing a modest 3% recovery rate at best,” Choyleva says.

“But it is crucial to acknowledge the broader implications. With Beijing having repeatedly blocked Evergrande's proposed restructuring plans, the outcome appears to have the central government's tacit approval. Moreover, it is necessary in the broader context of rectifying the imbalances within China's property sector ,” she says.

Sign up for one of our free newsletters

• The Daily Report Start your day right with Asia Times' top stories
• AT Weekly Report A weekly roundup of Asia Times' most-read stories

One reason creating bigger regional players makes sense is to increase their financial firepower to support growth. As Fitch analysts point out in a recent report,“large state banks are likely to assume a larger role in supporting the economic recovery by channeling more funds to sectors closely aligned with the policy agenda, including the property sector.”

Fitch finds it notable that Beijing regulators have“mentioned the importance of more equal funding access between publicly and privately owned developers. Smaller regional banks, meanwhile, are likely to focus on supporting their local businesses or resolving asset risks which are already elevated.”

To be sure, it's early days for China's regional bank reforms. There's considerable heavy lifting to be done. But accelerating the effort now could cheer global investors fleeing China – and vastly reduce the odds of an SVB-like crisis.

Japan, not so much. In October, Japan's Financial Services Agency moved to stress-test
at least 20 banks for any SVB-like financial landmines. The backdrop for the probe was widespread expectations Governor Kazuo Ueda would soon exit the BOJ's 23-year-old QE experiment.

Among the wildcards: how regional banks overloaded with government bonds can withstand yields hitting 2%, 3% or higher in short order.

Japanese banks may be holding precarious amounts of government bonds. Photo: Asia Times Files / AFP

Clearly, comparisons of midsize US
and Japanese banks
aren't
ideal. As
SMBC Nikko analyst Masahiko Sato notes, the average threat to capital ratios is lower because Japan's
regional lenders
tend to prioritize bonds that can be sold, rather than holding to maturity.
Therefore, Sato does not think potential losses“are on a scale with systemic implications.”

But BOJ tapering or even a rate hike or two could change this calculus, and fast. If regional banks face profit pressures with rates at zero , the fallout from a big rate pivot by Japan's central bank could be extreme.

Given these risks and the“Japanification” chatter that irks officials in Beijing, it's wise for Xi's government to head off any SVB-like threats to China's future. If only Japan would, too.

Follow William Pesek on X at @WilliamPesek