China's stock crash highlights underlying credit problems

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Policy-makers in China launched new efforts to stimulate business and renew investor confidence, as global markets gyrate on worries about the country's economic health.

Hours after the Shanghai composite index closed down another 7.6 per cent Tuesday – on top of an 8.5-per-cent fall Monday, the largest since 2007 – the People's Bank of China lowered interest rates by 0.25 per cent and reduced requirements for bank reserves by 0.5 per cent.

Chinese leadership has faced domestic pressure to intervene, particularly among small home investors whom state banks and media initially wooed into buying stocks. The domestic market is down some 42 per cent from its June peak.

China's market wreckage has brought into relief the underlying problems with an economy whose slowdown is reverberating in Canadian oil and gas towns, Australian iron-ore mines and Chinese banks. Many of them had made investments, expanded production or issued loans on expectations of high-speed growth that are now crumbling.

The fallout could last years, particularly as signs of distress grow in the vast Chinese accumulation of credit that propelled the most recent years of growth. At Sun Hung Kai & Co. Ltd., a Hong Kong firm that lends to Chinese consumers and small businesses, the share of "bad and doubtful debts" – non-performing loans – in the first half of 2013 and 2014 held steady at just below 10 per cent.

In 2015, it has climbed to 17.2 per cent.

Poor disclosure makes it impossible to properly survey the entire banking system; estimates suggest total bad and at-risk "special-mention" debt in China rose to 5.13 per cent this June, up well over a third from last year.

But some areas are far worse. At one small Chinese bank, the non-performing loan ratio soared to 31 per cent from 0.85 per cent in a year, according to a financial analyst who examined the firm's filings but was not authorized to speak to the media.

"Bank asset quality is far, far, far worse year on year than anything I expected," the analyst said. Though the percentage remains small, a growing number of lenders "are technically insolvent," the analyst said. "I don't think we're on the brink of a banking crisis, per se. But we're certainly at the start of a very nasty credit cycle."

The global ramifications are significant since China now has, by a large margin, the biggest national banking industry on Earth.

"How worried should we be? Well, I would say relative to a few months ago, we should definitely be more worried," said Patricia Cheng, head of China financial research at CLSA Ltd., an independent Hong Kong brokerage.

Many Chinese investors, whose savings have provided the combustible fuel for the country's stock markets, remain remarkably calm – driven in part by state media, which pinned market jitters on foreigners.

Yu Jiahu, a 33-year-old medical salesman in Beijing, began pouring his savings – about $74,000 – into stocks in 2011, because he feared Chinese housing prices had become unsustainable.

The realization that stock prices suffered the same problem hasn't been fun – on Monday, markets "kept dropping until I felt numb," Mr. Yu said. But he nonetheless holds out hope that in volatile China, what goes down can also go up.

"It can drop by over 8 per cent in a day," he said. "But it can also rise that much in a day."

To many, China's 7-per-cent GDP growth – a number foreign observers increasingly see as a fiction – is a source of assurance, even if market turmoil has been traumatizing. "Compared to other countries, I am still confident in China," said Wang Hongyi, 40. "After all, we have so many people and such a big market."

Yet signs of weakness are growing more prominent across the Chinese economy as exports fall rapidly and companies in sectors such as concrete and steel post losses.

Some of the most severe impacts of China's slowdown are also landing outside its borders, sometimes in unexpected places.

In New Zealand, for example, abattoirs are dealing with weeks-long backlogs of dairy cows being sent to slaughter because farmers can no longer afford to keep them alive.

The New Zealand national dairy herd had expanded 27 per cent since 2006, in large measure to feed China's increasing thirst for dairy. Now, some dairy farmers are slaughtering up to 15 per cent of their herds, after a 69-per-cent decrease in dairy exports to China this year helped drag down prices to a 12-1/2-year low in recent weeks.

"Any cows that are not producing to a required standard in my system – I call them freeloaders – we are culling them, because they're not economic to keep at the moment," said Chris Lewis, who milks 1,100 cattle. "There's been a hell of lot of good dairy cows gone."

With a report from Yu Mei