I See China's Bad Loans Arising

02/17/2014 11:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

The bad loans at Chinese banks have risen for the ninth straight quarter, but MoneyShow's Jim Jubak thinks the level of bad loans is exactly what makes even the tiniest of slowdowns in China's economy such a big deal.

This can't be good.

Yes, Chinese stocks were up again last Thursday night with the Shanghai Composite Index adding a gain of 0.8% to finish the week up 3.5%. That's the biggest weekly advance in five months.

But bad loans at Chinese banks rose for a ninth straight quarter to the highest level since the 2008 financial crisis, the China Banking Regulatory Commission announced on February 13. Bad loans rose by 28.5 billion yuan ($4.7 billion) in the last quarter of 2013 to 592.1 billion yuan ($97.6 billion). Officially, bad loans now account for 1% of total loans, up from 0.97% in the third quarter.

Of course, nobody believes the official numbers, but even the official trend is headed in a bad direction. Last week, Standard & Poor's said that it expects loan quality to continue to decline in 2014. Some analysts are even more pessimistic. Changjiang Securities in Wuhan, for example, expects the deterioration to continue for two more years, according to Bloomberg.

And there are a lot of loans in China that could go bad. Chinese banks added 89 trillion yuan ($14.67 trillion) of assets, mostly loans, over the last five years, according to the China Banking Regulatory Commission. US commercial banks held a total of $14.6 trillion in assets at the end of the third quarter, according to the US Federal Deposit Insurance Corp.

At the moment, with Chinese markets reacting to the return of traders from the New Year holiday and surprisingly positive trade numbers, no one cares much about this potential time bomb.

But the level of bad loans is exactly what makes any slowdown—even a minor slowdown—in China's economy into such a big deal. Liabilities at nonfinancial companies hit 139% of GDP at the end of 2012 and are likely to climb to 150% of GDP by the end of 2014, according to Haitong Securities. That means any slowdown, even a drop to the 7.4% GDP growth rate for 2014 now projected by economists surveyed by Bloomberg, has the potential to set off a wave of defaults at overextended companies.

Traders are, so far, assuming that the Chinese government will bail out investors (and banks) in any default by a company or in a trust product holding company debt. That's what it did after the Asian Currency Crisis in 1997, and what it did at the end of January, when an investment trust teetered on the edge of default.

But with bad debt continuing to rise, betting that the Chinese government will bail out everyone seems risky and betting that any bailout won't roil the markets seems naïve.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund, see the fund's portfolio here.

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