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Flood of problem loans to stretch China’s bad banks

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When Goldman Sachs economists wanted to bring their global clients up to speed on the risks in China's credit boom, they spoke to Charlene Chu, the Fitch Ratings analyst known for her bearish views.

Ms Chu has studied China's shadow finance sector to come up with one of the highest estimates of the country's debt pile at more than 200 percent of gross domestic product. She also warns that the banking sector is far more exposed to many of the shadow loans than most people realize.

The latest official figures show non-performing loans (NPLs) at Chinese banks grew by Rmb 13 billion ($2 billion) in the second quarter to Rmb 540 billion, increasing for a seventh straight quarter.

(Read more: China Banks May Need 'Tape' to Hold Together)

More than a decade ago, Beijing set up four state-funded asset management companies (AMCs) to take over the bad debts of the four biggest state-owned banks. After a rocky start, the bad banks have become adept at working out problem loans in only the past couple of years, according to bankers.

Profit figures are hard to come by for these privately held companies, but Trevor Kalcic, analyst at CIMB, reckons their combined return on equity has increased from 8.9 percent in 2009 to 15.5 percent last year. He also calculates that the four saw total pre-tax profits grow by 29 percent last year.

"The AMCs are now already playing an important and largely unrecognized role in solving the country's bad debt problem," Mr Kalcic says. "This is probably one of the key reasons why the system-wide NPL balance has remained relatively low in spite of the large increase in system leverage in recent years."

Now, two of those AMCs, Cinda and Huarong, are raising fresh private capital in order to play a much bigger role in the next round of bad debts that are expected to emerge from the huge expansion in lending that has taken place in China since 2008.

This will not only come from the commercial banks but also from wealth management and trust products and from the balance sheets of ordinary companies which are owed money by other businesses unable to pay it back.

(Read more: Chinese Bank Stocks Dumped on Tighter Regulations)

Cinda and Huarong were set up to take on the bad debts of China Construction Bank and Industrial and Commercial Bank of China, respectively.

This role in buying a broader set of non-performing loans and receivables from across the financial sector is what many bankers and analysts see as the market-based future of how China will deal with bad debts.

China at present lacks significant players to ensure the next round of working out non-performing loans will be market-driven. But "when Cinda and Huarong are privatized and become more professional, they are expected to become a force in the NPL markets", says one senior Hong Kong-based banker not involved with Cinda or Huarong's capital raisings.

(Read more: Goldman Slashes Target for China Stocks)

Mr Kalcic says the government is preparing these businesses to play a bigger role in working out some of the problem assets in the financial system. After the capital raisings, and further increases in leverage, the four AMCs combined could take up to Rmb 1.2 trillion of non-performing loans or assets out of the financial system, which equals 1.85 percent of total bank loans outstanding.

"We believe the four AMCs combined have a significant capacity to assume bad debts from the banking system as well as poor credit from the broader economy," he says.

More on the Financial Times:

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China moves towards market remedy for bad loans

In 1998, when these AMCs were formed, the first Rmb 1.4 trillion batch of bad loans were bought at face value, or 100 cents on the dollar, which was great for the big four banks, but less good for the bad banks. They recovered only about 20 cents on the dollar.

However, in the late 1990s, that Rmb 1.4 trillion accounted for about 15 percent of bank loans, according to CLSA. Ms Chu calculates that the Chinese banking system's assets grew by $14 trillion between 2008 and 2013 – equivalent to adding the entire US banking system to its banks' balance sheets.

This illustrates why China needs more than merely a government bailout to tackle bad loans this time and that it will probably take a lot more than four privatized AMCs.

(Read more: Is China Right to Brush Aside a Credit Squeeze)

"There is tremendous confidence in the ability and the willingness of the Chinese Communist party to bail everyone out," Ms Chu said in Goldman's flagship economics and strategy publication last week. "But as the system gets bigger and bigger, there are more questions about how feasible that is."

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