So how bad is it?

The process of stress-testing banks could hardly be described as an exact science.

For evidence, look no further than Dexia. When the European Banking Authority (EBA) stress-tested 91 financial institutions back in July, Dexia was given the green light. More than that, in fact: as the Financial Times has pointed out, “the Franco-Belgian lender not only passed the exercise, it emerged as one of the safest banks in Europe.”

Barely three months later, Dexia was felled by the Eurozone crisis and was split up under the terms of a government bailout. This despite ranking 12th in the original stress-test (based on a forecast of a core tier one capital ratios). With hindsight, earlier stress-test results also look unconvincing. The Committee of European Bank Supervisors (a predecessor to the EBA) gave a “ringing endorsement” to the Irish banking system only four months before it collapsed, the FT says.

But that hasn’t stopped stress-testing from spreading further afield. And the latest to wade into the stress-test thicket is the International Monetary Fund, which last week published its first “formal evaluation” of the health of China’s financial system.

And the results…

The IMF report is something of a landmark, given how prickly Beijing can be about issues of sovereign authority, as well as access to information. However, the Chinese government agreed to the review when it was declared one of 25 “systemically important countries”, allowing both the IMF and the World Bank to carry out assessments of its financial system every five years.

Staff of the IMF then worked with Chinese regulators on the report, which in spite of its recent release, was actually completed on June 24. And far and away the most significant part of the exercise was an attempt to stress-test China’s 17 largest commercial banks.

The results? While noting the Chinese financial system was “robust overall” and concluding that “most of the banks appear to be resilient to isolated shocks,” the report went on to caution that, if several shocks occurred together, “the banking system could be severely impacted”.

It noted too some “near term risks”, which included bad debts from the recent lending binge. Specifically, there were worries about the bank’s aggregate exposures to dodgy local government financing vehicles (see WiC110), as well as the potential impact of falling prices in the property market (see WiC128).

The report also noted the special importance of the banks to China’s economy, identifying that the assets of the four largest banks each exceed 25% of GDP.

But on the plus side, it reports that current profits are high and that “the banking sector’s basic liquidity indicators appear healthy.”

But how do the banks fare under a “severe scenario” in which GDP growth falls to 4% (about half the current reported level)?

The IMF thought that the banks would cope – “systemwide” capital adequacy ratios would fall to about 8%. Low, but not disastrous.

Overall, the report decided that the major banks would be able to absorb “moderate potential losses”.

“This reflects improved profitability and balance sheets in recent years, which allowed banks to build up buffers,” the IMF concluded.

Some caveats, mind you…

Reading between the lines, it’s clear the assessment was a tortuously political exercise, and the IMF lays out some caveats designed to make the reader aware of some of the report’s limitations.

Although the IMF team worked with the Chinese central bank and the bank regulator, it admits that its efforts were “hindered” by the quality of information.

Specifically it says that risks were hard to assess “due to data constraints on the sectoral exposures and types of entities that banks lend to. Also, data constraints prevented an explicit analysis of off-balance sheet positions.”

Reliable information on bank exposures to local government financing vehicles was “non-existent” and the team was constrained because it didn’t have access to “confidential data”.

There are also caveats in some of the material on the real estate market. Mortgage assets may only make up 5.2% of total assets, the IMF notes, but the statistic understates the exposure of the banks to falling land values and declining apartment sales.

In fact, it estimated that aggregate exposures to real estate and local government financing vehicles were “significant” at upwards of Rmb20 trillion ($3.14 trillion), or more than 40% of total outstanding loans at the end of 2010.

Additionally, 30-45% of loans at the largest five banks are backed by collateral, the majority of which is real estate.

Herein lies the rub: “Given the importance of the real estate sector for economic growth, an economic slowdown as a result of a real estate price correction could adversely affect the banking system’s asset quality. Last but not least, local governments’ ability to support local government financing platforms via land sales and subsidies – essential for those platforms with limited cashflows to repay loans – heavily depends on the real estate market.”

It seems, then, that the IMF’s major concern is that an ongoing property market correction might hit the banking sector much harder than the official numbers currently suggest.

Liu Mingkang begs to differ…

China’s bank regulator, the CBRC, did its own stress test and its outgoing head Liu Mingkang told media that the banks could withstand a severe property correction.

In fact, Liu said that even if house prices fell 50%, bank loans would still be fully covered. That is to say the Rmb10.46 trillion of (officially documented) real estate loans could be recovered in full.

Chinese media were quick to question that outlook. CBN, for example, seemed to consider it borderline Panglossian. For a start, the top bankers that it interviewed thought that the official figure on the amount of real estate loans was too low. That’s because bankers and their clients have been using an array of “stealth tactics” to grow property loans in the face of recent official prohibitions. CBN quoted one senior banking source as making a “conservative” estimate that property-related loans were double the official figure i.e. around Rmb20 trillion.

It also cited information from an executive from a Shanghai steel-trading firm. Notionally, he says, the company’s borrowing would be classified as industrial in nature, but he readily admitted to using the loans for land and housing speculation.

Nor was CBN as sanguine as Liu about the impact of a 50% decline in house prices, quoting a veteran property developer who said he’d soon go bankrupt (and have to flee) if prices dropped by anything like as much. There was just one silver lining to this doomsday scenario as far as the developer was concerned: “Then again, the banks must die earlier than me.”

For example, he doubted whether the banks would be able to cover their losses on mortgaged properties in such a situation. “Facing a market downturn, even if you reduce the prices, you cannot sell them,” he warned. National Business Daily said something similar happened during an earlier property bust in Hainan – the repossessed units couldn’t be sold and eventually had to be treated as non-performing assets.

CBN also drew attention to the effect of a 50% fall on the wider economy. Falls in home prices are expected to hurt 42 other industries, with property construction accounting for 13% of GDP last year. “All sectors will collectively suffer bad loans,” a banker warned the newspaper.

And property is now a problem?

As WiC noted a fortnight ago, there is growing evidence that the volume of property transactions is slowing. Most attention has focused on frothier real estate markets like Shanghai, Beijing and Shenzhen. But as South Weekend points out, Hefei also offers another revealing – if anecdotal – insight. House prices remain modest in the city (in Anhui province) but Hefei has caused a media stir due to real estate developers fleeing, leaving their unpaid debts behind.

The newspaper says four developers have fled so far, in a sign that China’s own credit crunch is starting to bite hard.

Mix in the financial logjam now beginning to spill out of the Eurozone, and there may be further grounds for pessimism.

At least that seems to be the view of China’s vice-premier Wang Qishan, who also appears to have adopted a less rosy assessment than retiring regulator Liu.

Wang told state media at the weekend that he feared that the global economic downturn would last “a long time” and might result in the uncovering of “some structural problems” with China’s financial system.

Parsing this down, it seems Wang is also worried that further slowdown will see a spike in bad loans.

The IMF’s recommendations?

As mentioned, the IMF isn’t saying China has a banking crisis.

But it does have a raft of suggestions for how Beijing might avert one in future.

One way to protect the banks and diversify financial risk is to promote corporate bond issuance. Xinhua says that the government agrees and that new measures were announced last Friday to standardise issuance. Firms listed on the ChiNext stock exchange will soon be able to raise funds via bonds too.

The IMF also calls for more information about off-balance sheet exposure. That means better “data collection” to facilitate a “good understanding of financial institutions’ balance sheets and linkages”.

Again, the government seems to agree. But while it works on getting better data, it has opted for an administrative fix. Last week 21CN Business Herald reported that banks have been told to stop selling one of their favourite off-balance sheet vehicles: wealth management products (although the provision so far only applies to those with a duration of less than a month).

But the most far-reaching recommendation in the report involves interest rates. Unless these are determined by the market, the IMF warns, China’s economic growth always risks looking unbalanced. “Interest rates should be the primary instrument to govern credit expansion rather than administrative limits on bank lending,” it notes.

Behind all of this, as the report recognises, is that the government keeps a tight grip on the domestic financial sector in order to “pursue broader policy goals”.

Indeed, in one of the most critical comments in the entire report, the IMF stresses that there can be no proper bank regulation till some of that grip is relaxed.

Although the CBRC has a clear mandate to ensure stability and soundness, the IMF notes that its operational autonomy “is often undermined by the use of the commercial banking system for development purposes.”

Whether Beijing heeds the advice remains to be seen. It would obviously involve a major mindset shift for country that still steers its economy with five year-plans.

And as to the IMF’s mostly benign verdict on the health of the banks, Jim Chanos begs to differ. In an interview with Bloomberg TV, the bearish hedge fund manager said they were anything but stable. “They’re built on quicksand,” he commented.

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