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.

Something's gotta give in China's banking system. Authorities are under pressure to reduce the required ratio of provisions for bad loans, or recapitalize banks so they can set aside more money for their soured debt. Beijing is indicating it will choose the easy way out, and just tweak the rules instead of fixing the problem. That could lead to more pain, and higher costs, later.

Pay You Later
The percentage of loans going unpaid at China's biggest banks is at the highest since the financial crisis
Source: Company filings

Four of China's big five banks -- ICBC, China Construction Bank, Bank of China and Bank of Communications -- reported earnings this week and financials from Agricultural Bank are due later Thursday. All said their nonperforming loan coverage ratios had dropped to just above the 150 percent limit set by regulators. The plunge was because of a spike in bad debt. More provisioning will be needed to bring the ratios back up to their prior levels.

Thinning Cover
The ratio between provisions and nonperforming loans at China's biggest banks dropped to the lowest since the financial crisis
Source: Company filings

Provisions are liabilities and in accounting, every addition to liabilities has to be offset by either a drop in equity or a rise in assets. Because these companies are banks, increasing assets means lending more, which they have been doing. But that then requires more capital, which requires more equity.

One way banks can add equity is by not paying dividends. Chinese banks have refused to go down that route, although they have reduced payout ratios. Shaving dividends to bolster equity, however, takes time, and considering the pace at which loans are souring, time is something lenders in China don't have a lot of.

Still Lending
Total loans at China's biggest banks continued to grow even as the share of delinquencies rose to the most since 2008
Source: Company filings

Another way to add equity is by selling more stock, diluting the central government's stake. Or Beijing could inject money directly, watering down the interests of minority investors. 

In any event, Chinese taxpayers are going to feel the pain. But Chinese banks need capital to remain healthy. Given they're some of the biggest lenders in the world by assets, that's a matter of international concern. 

Another way to sort out the problem, which officials have been hinting at, is to change the rules of the game. Most Chinese won't pay as much attention to headlines saying banks' nonperforming loan coverage ratios were reduced as they would to news the government has just handed lenders, say, 1 trillion yuan ($155 billion).

So Delinquent
Bad loans at China's biggest banks more than doubled in the past five years
Source: Company filings

But this would be just kicking the can down the road. And if big state-owned banks continue to lend at the rate they have been --  last year they increased advances 8.8 percent on average (versus an almost 40 percent increase in delinquent advances) -- the mess gets larger.

The temptation will be for a quick fix, to help the government meet its 6.5 percent average annual growth target through 2020. China should resist that course and take the tough medicine now. Sometimes, it's the shortcuts that prove the most costly.

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:
Katrina Nicholas at knicholas2@bloomberg.net