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Are China’s Banks Too Big To Fail?

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China’s banks are not too big to fail . . . but because they are state-owned, insured, and key to the Chinese economy and stability of the nation, the Chinese government will do everything possible to prevent their collapse.

A birds-eye view of the Chinese banking

China has the four biggest banks in the world:

  • Industrial and Commercial Bank of China (US$4 trillion) [SEHK: 1398];
  • China Construction Bank (US$3.4 trillion) [SEHK: 939];
  • Agricultural Bank of China (US$3.24 trillion) [SEHK: 1288]; and
  • Bank of China (US$2.99 trillion) [SEHK: 3988].

This year, China’s banking industry was valued at US$35 trillion. That’s about 310% bigger than China’s GDP, and 280% bigger than the European Union’s GDP. It surpassed the European Union’s US$31 trillion banking assets in 2016, and America’s US$16 trillion in banking assets in 2010.

The banking industry in China has been growing at a phenomenal rate since 2008. That year, the central government started using monetary stimulus policies to encourage the growth of its domestic industry, maintain its market actors, and support innovative industries that are expected to catapult it to the position of global leader in several industrial sectors by 2025.

Where the trouble began

As state-owned banks have loaned more and more money to state-owned enterprises (SOEs), those banks have registered a meteoric rise in non-performing loans (NPLs). The SOEs have increasingly been spending more per unit of production since 2008. In contrast, the amount of money spent from 2001 to 2008 by Chinese companies per unit production was fairly constant, and the country was able to comfortably maintain 7% GDP growth per year. Now, the central government struggles to maintain 6.5 % to 7% growth, even though it has made loans from state-owned banks to SOEs and preferred industries easily accessible at borrower-friendly terms.

Currently, President Xi Jinping and his administration are implementing banking regulations, policies, and initiatives that are intended to:

  • reduce the amount of bad loans made by banks;
  • reduce the use of questionable wealth-management products;
  • reduce investment in poorly performing overseas assets; and
  • reduce the amount of shadow banking in the provincial and regional banks.

Given the extensive reach of China’s trade, the number of developing and developed countries that are indebted to China, its socioeconomic instability, and large temperamental population, the Chinese government and the world are watching China’s banks and their financial health with great interest.

Further complicating the complex Chinese banking sector: the central government’s push for small banks weighed down with NPLs to merge with bigger banks that have better portfolios and more reserves. While this is a great short-term solution, it further concentrates banking power in an ever-decreasing number of banks.

Why investors still worry

Because most of the big banks are state-owned, managed, and/or heavily influenced by the central government, everyone should feel more secure that the banks can’t fail. However, investors’ concern comes from the rate at which Chinese banks are making loans, writing off NPLs, creating wealth-management products, and loaning money to local and regional governments to fund poorly performing or ill-thought-out local and overseas investments.

Why doesn’t the central government just tell the banks to increase the loan requirements or stop approving loan applications?

Well, Chinese companies have gotten very accustomed to having easy access to money, and having their poorly performing businesses and industries propped up by the central government. In addition, since the banks are central to the functioning of the economy, if the banks collapse, the local businesses and industries will immediately follow. Moreover, the central government has already had to step in more than once to save banks that were on the verge on collapse.

The rescued banks were taken over by the central government not for nostalgic purposes, but because if they weren’t saved, a domino effect would have driven a slew of other banks and businesses to collapse in their wake.

A potential solution

How can the central government save its poorly performing banks without causing a decline in economic growth, economic stagnation, social discord and upheaval, and economic collapse? Easy: Use its extensive financial reserves.

If China must infuse money into its banks to keep its local economy afloat and maintain minimal levels of growth – it will. As for other important measures, China has impressive capital controls in place to prevent the outflow of capital from mainland China. The central government has also eased foreign ownership and investment laws to allow more flow of foreign capital into the country.

Plus, the country is creating more investment opportunities for domestic investors to invest in local companies not listed on the mainland Chinese stock exchanges, and for foreign investors to more easily invest in Chinese equities.

In short, the Chinese government will not sit idly by and watch its economy tank. There is too much at stake for China – and the world.

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Disclosure: Alisa Hopkins doesn't own any of the stocks mentioned. Motley Fool Hong Kong is not licensed by the Hong Kong Securities and Futures Commission to carry out any regulated activities under the Securities and Futures Ordinance.