China News: Are Chinese Banks Becoming Too Big to Fail?

Majority state-owned Chinese banks, in the midst of uncertain economic times, have seen greater than expected returns in the first quarter. For the first quarter in 2013, the banks' loans increased 12%, or to 2.76 trillion Yuan, compared to last year's first quarter. This comes at a time when China is deregulating interest rates and loan defaults are increasing.

If the number of bad loans increases faster than expected, however, China's economy may falter. The shadow banking system, estimated at over $2.4 trillion, needs to be brought under regulation. Otherwise, China may have it's own credit bubble.

When the United States went through a credit crunch that saw real estate values, stock portfolios, and net worth decrease, China's economy expanded. This is due to several factors, from exports, labor, currency, and state-provided subsidies, but lending has been a key to their momentum.

In 2012, China, the second largest economy in the world, has seen its slowest GDP growth in 13 years; that was with a growth rate of 7.8%. It began to recover in the fourth quarter of last year, pointing to a possible rebound in 2013. A pivotal function of this growth rate has been lending.

When considering monetary policy, inflation is lower than expected, a sign of a slight decrease in demand. China's central bank, the People's Bank of China, has for the most part remained neutral. There is only so much that it could do to regulate the banking system and the rising levels of non-bank lending is not under PBoC's jurisdiction.

The central bank's strongest attempt at curbing consumer's new lending practices has been to increase government-sanctioned loans that could compete against the shadow lending system.

In 2012, former Premier Wen Jiabao opened up five government-sanctioned loan brokerage centers, such as in Wenzhou, in an attempt to regulate lending. This practice has failed to attract a sizable number of clients because many businesses lack collateral to leverage in case the loans fail.

Without collateral, the brokers at these loan centers charge the maximum interest allowed in China, 24%. Compared to the average bank loans that have a 6.78% interest, 97% of small to medium sized companies opt for private lending.

Wenzhou, once a booming city due to its embrace of small and medium sized private businesses, has turned into a casualty of an impending credit crunch. Prior to Jiabao's new lending program, over two dozen businesses went bankrupt and over 80 businessmen committed suicide. The city's economy was hemorrhaging money.

China's private lending problem has created a boom in lawsuits originating from disputed loans. In Wenzhou alone, there have been almost 26,000 such lawsuits totaling $7.5 billion. Since banks give such a low interest rate on typical deposit accounts, entrepreneurs decide to lend their money to small and medium sized businesses for better returns. This accounts for nearly 45% of China's GDP.

Ironically, these same entrepreneurs are largely responsible for continuing China's economic boom. There is a distinct difference between high interest rates and usury. Credit to such people provides businesses to operate, continue to produce, and hire more workers. That did not prevent Chinese law enforcement from arresting over 4,100 people, 1,400 of who were sentenced to over 5 years for illegal lending practices. Some charged as high as 70% annualized interest.

Another form of unregulated lending is originating from peer-to-peer lending websites, such as Ppdai.com. China's Banking Regulatory Commission issued a warning regarding such sites; akin to a buyer beware disclaimer. The Chinese stimulus in 2008-2009 followed by correcting for the increased credit, made such lending avenues more popular.

Beginning in January 2013, the CBoC, through Total Social Financing, has set its annual money supply goal at 13%. TSF is a broad measure of liquidity, but partially relies on bank lending. The black market lending, which has increased while bank lending decreased, is not factored into TSF, leading to a greater money supply than expected. This could eventually lead to inflation.

Overall, the positive news that came from the overall Chinese banking system could be tempered with some caution. The Bank of China failed to meet expectations; albeit it still saw its profits increase. China lacks an individual credit scoring system like in the United States, so it is difficult to assess risk. When the loans are derived from non-bank institutions, managing such risk is made even more difficult.

Currently, China is having a lending problem. In attempts to curb encroaching inflation in 2011 by regulating bank's lending practices, one problem became another. While maintaining credit for the small and medium sized businesses to expand and keep the economy on track, the shadow banking system in China grew and a faulty credit system ensued. Shadow banking needs to be brought into the light.