Markets

China's Government Can Afford Its Bad Loans. Can Its People?

By Constantine von Hoffman

Updated on: September 21, 2011 / 6:13 PM EDT / MoneyWatch

The International Monetary Fund estimates China's domestic loans equaled 173 percent of GDP at the end of June. So why isn't China (or the IMF) worried? Maybe because Beijing can afford them -- at least in a monetary sense.

China's facing two real estate crises, one in the public sector and one in the private:

The private sector one will be familiar to anyone who hasn't been in a coma in the last decade: Banks have been making loans in an over-heated market, pushing property values to an unsustainable level (up 60 percent since 2006). If prices deflate in a hurry, banks turn into zombies and a lot of people lose everything.
The public sector one is unique to China. Local governments have gone on a development binge, borrowing an estimated $1.7 trillion. Stephen Green, head of research for Standard Chartered Greater China, estimates up to 80 percent of local government loans won't be able to make debt service payments this year. Recent reports from one province in northeastern China show that 85 percent of local government-backed borrowers missed payments in 2010.

This would be more worrying if China's government wasn't flush with taxes collected from its booming economy (estimated GDP growth for this year: 9.5 percent) and $3.2 trillion in foreign exchange reserves. Plus, as authorities are quick to point out, China's banks are well capitalized.

Whether that's true depends on how much you trust Chinese bank regulators and which numbers you look at. (Try not to snicker.) As Tom Orlick points out:

Tier 1 capital ratios -- a measure that compares risk-weighted assets to banks' own capital to assess their resilience to losses -- are above 9 percent for all of [China's] big four banks. That suggests they are well placed to weather the storm.

But, as he also says, not all capital is created equal. You get a very different picture if you compare total equity to total assets instead of looking at the Tier 1 ratios. At Industrial and Commercial Bank of China, the nation's largest bank, the ratio of total equity to total assets is 5.77 percent. That's close to half of Bank of America's (BAC) ratio. Beijing is not blind to this and is taking steps to make the banks stronger. It set new capital requirements of 21.5 percent of all deposits (including previously exempt margin accounts).

So China's official financial institutions are in good-not-great condition to handle all the bad debts (and compared to Europe's banks they are in a great-bordering-on-amazing condition). While the government can cover losses in those official banks, China has a huge informal banking system and that is likely to take a beating. How big a beating may determine the nation's long-term stability. And how the world's markets respond to China's banks going semi-bust will determine whether there's enough demand to keep up the GDP growth.

Related: