Chinese banks’ non-performing loans have fallen from double digits percentage in the past decade to a steady low of under 2% in recent years but this does not necessarily mean risks have dissipated.

There are challenges that need to be tackled, especially after the central bank said in China’s Financial Stability report published last month there were over 580 banks that could be classified as high risk.

The policy has been to promote consumption, and loans to small business, while increasing the quota for local government special-purpose bonds for infrastructure. At its just-concluded Central Economic Work Conference, Chinese leaders indicated a growth target of around 6%, focused on upgrading consumption and stabilizing infrastructure and property investment.

Clues abound suggesting that’s too ambitious and regulators are on the case.

“I view the current policies as schizophrenic,” said Andrew Collier, managing director at Orient Capital Research. ”They are trying to have it both ways — rebalance the economy toward consumption while goosing GDP with infrastructure. Not sure who is going to win this battle. Probably the winner will be … a debt bubble.”

Analysts say the banking sector’s overall non-performing loans (NPL) ratio looks low and stable at 1.8% but does not tell the complete story. The differential performances of the various sectors are offsetting one another. A spike in defaults in one sector may be masked by the improvement in another.

“The NPL formation is mainly from private companies, personal loan products like credit cards and SMEs. The topline NPL ratio is stable because most of the portfolio has moved to less risky areas like mortgages, SOEs and infrastructure projects. This explains the stable level of NPLs,” said Hans Fan, banking analyst with CLSA.

In view of that, the steady decline in the overall non-performing loan ratio needs to be investigated further before concluding that asset quality has indeed improved.

“The key metric to watch for regarding the asset quality situation in China really is the new NPL formation rate, which is not consistently disclosed by the banks,” said Jason Tan, banking analyst with CreditSights.

HIs firm has made estimates – the Big 5 banks have seen new NPL formation rates at around 1% with the joint stock banks hovering at around 2.5% annualized as of 9M19, a tad lower than FY18.

“However, these figures, in our view, remain relatively elevated,” Tan said. “Asset quality concerns will remain a key trend to watch in 2020, particularly in the context of a complicated macroeconomic outlook.”

China’s GDP in the July-September quarter fell to 6%, the weakest growth rate since the first quarter of 1992. GDP annual growth rate in China averaged 9.39% from 1989 until 2019.

In such an environment, defaults have already picked up. International rating agency S&P Global said that aggregate defaults in China’s domestic bond market this year had exceeded 100 billion yuan (US$14.2 billion) and would overtake 2018’s record of 111 billion. Commercial banks own over 60% of the outstanding bonds.

“We see the resolution of the issue of high-risk banks in three ways – mergers, some recapitalization and in a few cases of closures,” said CLSA’s Fan. “We are unlikely to see large scale capital injection via recapitalization of the scale as we saw in the 1990s. The recent cases of Bank of Jinzhou and Evergrowing Bank” – previously called Hengfeng Bank – “are a reflection of the regulator’s intention.”

The Bank for International Settlements estimates 20-24% of 2004 GDP was pumped into China’s banking system when it conducted one of the biggest banking bailouts in history, which required massive capital injection and bad loan transfers between 1998 and 2005.

Beijing is not going to repeat this rescue act and is more likely to lean on bigger, stronger banks to absorb the high-risk lenders.