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Bank NPL crisis in China

This is another post by Martin Miszerak (martin@miszerakassociates.pl). He is teaching at Remnin University next semester.

Long time readers have seen that I have not posted much lately. I had turned by efforts more to radio and TV. But with recent developments in the areas I cover, I plan to return with some new posts soon.

Over the course of 2019, much of the financial news out of China has centered on the condition of China’s smaller banks. The most recent resolution of Hengfeng Bank is only the latest in a procession of smaller bank rescues, including Baoshang Bank Co. Ltd and Bank of Jinzhou Co. Ltd. What we don’t know yet is whether such rescues are isolated incidents, often triggered by corruption, or symptoms of a systemic NPL crisis in China’s smaller bank sector, which is said to number over 3.000 lenders. No financial information on these failed lenders has been released, while some of them have not published annual reports for years, such as Hengfeng Bank.

Last July, Jason Bedford, a former UBS research analyst specialized in China’s banks, predicted that the 250 institutions he was covering were facing a capital shortfall of about RMB 2.4 trillion, concentrated, however, in the smaller banks. Bedford questioned the integrity of many bank accounts, claiming that loans were often disguised in their accounts as “investments” and consequently the “true” NPL ratio of the entire banking sector was much higher than the official 1.74% at the end of 2017, as published by the People’s Bank of China in the most recent Financial Stability Report. However, we may be able to gain a better insight into loan quality trends in China’s smaller banks early next year, as all mainland-only listed banks were required to transition on January 1, 2019 from IAS 39 to IFRS 9. These banks will be fully disclosing the impact of that transition on their net loans and total equity in their 2019 annual reports.

SOE accounting for subsidies

This is a guest posting by Martin Miszerak (martin@miszerakassociates.pl). He will be teaching at Remnin University next semester.

The reform of state-owned enterprises (“SOE’s”) is a never-ending saga in China. While the government professes continued commitment to SOE reform through such policy initiatives as corporatization, mergers, mixed ownership and improved governance, average financial performance of the SOE sector is not improving. On the contrary, as documented by the most recent book by Nicholas Lardy, a noted China scholar at the Peterson Institute for International Economics in Washington, average ROA of the SOE sector declined from about 5% in 2007 to only about 1,6% in 2016. The ROA returns are computed by Ministry of Finance using pre-tax profits divided by average assets and are in general a highly imperfect measure of profitability of non-financial enterprises; EBITDA margin would be much more meaningful, but no such data is available.

However, the most problematic aspect of the SOE’s ROA data is the fact that the returns are computed on the basis of revenues inclusive of subsidies. Under CAS No. 16 (Accounting Standard for Business Enterprises No. 16 – Government Grants), issued by Ministry of Finance in 2017, Chinese companies are required to credit subsidies received to the income statement, regardless of whether they are related to current operations or fixed asset investment. CAS no. 16 is essentially aligned with IFRS (IAS 20 – Accounting for government grants and disclosure of government assistance, issued with the most recent amendment in 2008). Under IAS 20, subsidies related to current operations are to be credited to the income statement, but subsidies related to fixed asset investment can be credited either to deferred income or the acquired asset, thus reducing that asset’s net value. A credit to an acquired asset is not allowed under CAS.

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