How Will Capital Shortages Affect Chinese Banks?

by Prassenjit Lahiri

The IMF has done its checks and has drawn the conclusion that things don’t look good for many Chinese banks where capital adequacy is concerned. The findings point to capital shortfalls of up to 2.5% of GDP. It’s alarming to say the least. The irony of the whole situation is that this follows closely on the heels of a credit boom in China. But then again, it’s not that surprising considering what happened in the US in the 2007-2010 credit crisis. It was a similar scenario. Apparently, no one bothered to send China the memo about what not to do to avoid an economic crisis. No matter how you view it, if things don’t change, and fast, Chinese banks may face huge problems.

What does capital shortage mean for Chinese banks? Well, for one thing, it means that the economy is at great financial risk. If it were a case of just a few banks in this situation, it wouldn’t be a huge concern. But considering that approximately 82% of the banks examined by the IMF were found to be under-capitalized, it’s a wake-up call that needs to be heeded, and sooner rather than later. The banks have exposed the Chinese to great economic risk; and credit risk in particular. Will the banks be able to remain going concerns if they don’t have sufficient assets to cover the growing value of liabilities that they continue to take on? It’s a rhetorical question but it needs to be answered.

Mind you, not everyone agrees that this situation is a crisis waiting to happen. Some believe that the Chinese economy continues to be strong and that the IMF is making a mountain out of a mole hill. The Chinese President is adamant that the Central government has everything under control. But the truth is that there has been a surge in the issuing of credit in China in the last decade or so and added to that, the government has basically guaranteed these loans.

I tend to agree with the IMF’s recommendation that Chinese banks should aim to double asset base from a mere 0.5% to 1% during the course of the next 12 months. While the Chinese banks are operating within the Basel Committee guidelines, any slowing of economic growth could trigger a financial crisis. The IMF believes that China needs to strengthen the asset base of small and medium sized banks, which account for the majority of banks in China. For now, China’s 4 largest banks appear to be adequately capitalized. But every chain is only as strong as its weakest link, right? The undercapitalized banks are that weak link and if nothing is done, the chain is going to snap.

There also needs to be an end to implicit guarantees that the government will step in to cover debt that the banks can’t cover. This is only creating greater vulnerability and increasing default risk within the banking sector. Remove the guarantees and the madness must stop.

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