Banks (Page 56)

TOKYO — Economists churn out mountains of reports on what China must learn from Japan’s decades of policy failure. This week, Beijing flipped the script with plans to merge hundreds of rural lenders with US$6.7 trillion of assets.

The last 12 months have been humbling for analysts predicting the Bank of Japan would end quantitative easing (QE). Oddly, many are clinging stubbornly to bets the BOJ will be hiking interest rates by April.

Hardly. One reason is the Silicon Valley Bank (SVB) risks hiding in plain sight as Japan skirts recession. Across this aging nation of 126 million people are 100-plus regional financial institutions serving less economically vibrant regions.

Reluctant to consolidate and averse to the digitalization trends disrupting the globe despite dwindling profits, these banks have fallen on hard times. As demographics gray and the corporate exodus to Tokyo accelerates, there’s less demand for loans from rural lenders. And the trauma from 20-plus years of deflation has made mid-size Japanese lenders more conservative than ever.

All too many spent the last decade investing BOJ liquidity that Tokyo hoped would increase lending activity instead into government and corporate bonds. This pivot will sound familiar to students of last year’s SVB collapse in California.

At the time, many global investors rushed to Google to learn about non-household-name US financial institutions like First Republic Bank and Signature Bank. This dynamic is alive and well in Japan, where risks facing regional banks are bursting back onto the radar screen.

Among the BOJ’s biggest worries about hiking rates is pushing scores of fragile rural lenders toward insolvency as longer-term yields skyrocket, SVB-style. And yet, Japanese Prime Minister Fumio Kishida’s team is doing less than zero to prod regional lenders to merge, diversify or embrace technological change to limit and head off risks.

China is, though. This week, Xi Jinping’s Communist Party announced its biggest-ever banking consolidation effort amid growing signs of financial stress.

Though the full contours of the plan are still trickling out, Beijing wants to merge hundreds of rural lenders into regional giants. The merging could affect about 2,100 rural banks and recalibrate financial incentives across Asia’s biggest economy.

It’s been a challenging few years for China’s banking industry as slowing growth and slumping property markets hurt balance sheets. As of the end of 2022, bad loan ratios among the banks considered part of China’s “rural cooperative system” averaged nearly 3.5%, more than twice the nation’s broader financial sector.

Since 2022, Xi’s regulators have executed mergers of rural commercial banks and cooperatives in at least seven provinces. It now appears set on supersizing the push. Between 2016 and 2022, Xi’s team has disposed of bad bank debts equivalent to roughly 13% of China’s gross domestic product (GDP).

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.

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.

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

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