Finance

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

Uncle Xi wants you. Faced with record bad loans, China has begun engendering a solution and it involves the country's banks, among other things, taking equity in troubled companies.

China has 346 publicly traded firms considered ``zombies," with financial leverage of at least 100 percent and return on equity of less than 5 percent, according to Bloomberg Intelligence. The zombies have debts totaling 3.2 trillion yuan ($485 billion). China Banking Regulatory Commission rules give equity holdings a 400 percent risk weight in bank books, Commerzbank analyst Xuanlai He says. The weighting, which determines how much capital a bank must hold against its assets, can rise to 1,250 percent if the stake is still held after two years.

A back of the envelope calculation suggests that Chinese lenders could be about to add as much as 13 trillion yuan of risky assets to their books, just taking into account these zombie companies. That would be a 30 percent increase from the 43 trillion yuan of total risk-weighted assets China's 12 publicly traded banks reported in their latest filings. The number may be far bigger.

Rising Risk
Risk-weighted assets held by the 12 listed Chinese lenders have almost doubled in the past five years
Source: Bloomberg; company filings
* 2015 refers to data of their latest filing

It may also be smaller, given that bad loans already carry a 100 percent risk weighting under existing accounting rules. Nevertheless, that's still much less than the percentage for equity. It's probably fair to estimate that Chinese banks could require at least a further 1 trillion yuan in capital.

That's where international investors come in. Even with a liquid local market, the conversion of loans to equity will push Chinese banks to raise capital by selling stock and subordinated debt, including abroad. It won't end there. A subsequent flood of equity offerings in China and Hong Kong can be expected within two years as banks seek to sell their holdings and avoid the step-up in risk weightings.

A Lot More to Come
Chinese banks have issued $168 billion in bonds that count as capital since 2013. Much more is needed
Source: Bloomberg

Call it a market solution for China's debt problem. The upside is that it would reduce leverage in the system, even at the expense of debt and stock investors. It's also a quick answer for how to keep banks lending -- assuming they can get more capital to keep the machine running.

To meet a 2010 goal of doubling gross domestic product and per capita income by 2020, President Xi Jinping -- given the cuddly nickname of Xi Dada, or Uncle Xi, by China's state media -- said late last year that the country's annual economic growth rate should average no less than 6.5 percent in the next five years. To meet that target, Premier Li Keqiang's cabinet pledged looser monetary policy, along with an expanded fiscal deficit, or, in short, more debt across the board. Something's got to give and it looks like it will be the banks, which in turn will go around panhandling for capital.

Full Circle
After increasing following adoption of new rules, the capital adequacy ratio of Chinese banks is again dangerously close to the minimum threshold of 11.5 percent
Sources: Bloomberg, company filings
* 2015 refers to latest filing; average CAR of 12 listed banks; 11.5 percent is minimum requirement for systemically important banks, floor for other lenders is 10.5 percent

So when Uncle Xi's banks come knocking, be aware that their capital draft is only beginning. Doing business with relatives often doesn't work out well.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net