China: Bank Bailout Rumor

Last week, Reuters reported China is contemplating a bailout of its local government’s bad debts, possibly starting as soon as this month and concluding by year end. As of this writing, the Reuters report is unverified (and China’s Ministry of Finance has denied the assertion), but media chatter has increased on the subject.

According to the report, local governments have roughly 10 trillion yuan (~$1.5 trillion) in debt, and the government expects roughly 20% to go bad (~$300 billion). The report suggests China is reviewing a number of options, including:

• Transferring some debt to state-owned banks (and having them write off bad loans)
• Transferring some debt to the central government
• Creating a “bad bank” to buy bad debts
• Any combination of the above

The report further suggests that, following the bailout, local governments will be allowed to issue bonds (similar to municipal bonds) rather than rely on loans from the state-owned banks. (China’s market for municipal-like bonds is basically non-existent as of now.)

We’ve long taken China’s loan statistics (including bad loan data) with many grains of salt, but this report is difficult to verify to say the least. Even so, a recapitalization wouldn’t be a huge surprise—China has recapitalized banks after numerous periods of economic stress since 1998.

Historical Chinese Bank Recapitalizations:

• 1998: China recapitalized its four largest state-owned banks by issuing $33 billion in bonds.
• 1999: China created four state-owned asset managers, funded them with $48 billion and allowed them to issue $121 billion in state-guaranteed bonds. These asset managers then bought $170 billion of bad loans from the four largest banks at face value.
• 2003: China recapitalized its four largest banks with $80 billion.
• 2008: State investment arm injected $19 billion into the fifth largest state-owned bank (Agricultural Bank of China, Ag Bank).
• 2009: The government again recapitalized Ag Bank with an additional $30 billion.
• 2010: The government recapitalized the state-owned banks with an estimated $56 billion (including the $22 billion IPO of Ag Bank).

Note: Excluding 2010, the figures cited above do not include IPOs.

Ultimately, this is one reason Chinese financial system reform is needed, or China will eventually experience great difficulty once their infrastructure productivity wanes. But that point likely isn’t in 2011, and with over $3 trillion in foreign currency reserves, China easily has the needed funds to execute a bailout right now, if desired.