China is delicately prodding lenders to clean up their balance sheets as economic growth stalls. We examine this in detail elsewhere in this edition of Fidelity Answers - but it is a scenario that will sound familiar to anyone who followed Japan’s financial system a quarter of a century ago. Back in the early 1990s, after the collapse of the country’s asset bubble, eternally optimistic Japanese authorities, ever hopeful of an economic recovery, delayed restructuring and recapitalising the banking system. That procrastination worsened the pain when Japan’s turnaround didn’t arrive. The result of this inefficient allocation of capital was economic stagnation as business sentiment, consumption and asset prices all withered, and the country became mired in the long deflationary spiral of its ‘Lost Decade’. What lessons can China learn from its neighbour?

Successive market crashes from early 1990 left Japanese companies highly leveraged and over-staffed with excess capacity. Banks had lent funds to them - which were rapidly turning into non-performing loans (NPLs). The collateral securing the loans was often real estate which had aso seen its value plunge. The situation became a serious threat to the banking sector. 

Does China face a similar crisis today? Certainly, the proportion of corporate debt in the economy has exceeded Japan’s peak and despite recent deleveraging efforts, China's debt levels are still high. Furthermore, many of the NPLs are related to real estate. 

There are, however, several differences between China today and Japan in the 1990s. First, China’s largest lenders are all effectively owned by the central government and their biggest borrowers are also state-owned enterprises, giving authorities more direct control over the financial system. Furthermore, while Japan slid into recession in 1993, China’s economy is currently growing at over 6 per cent, meaning today’s Chinese borrowers have a more supportive environment to grow profits and repay debts. And China’s inflation is still positive - unlike in Japan in the 1990s, when deflation increased the value of debt burdens. 

Nevertheless, a delay in addressing some of the bad loan problems at China’s smaller and mid-sized banks, as well as in the shadow banking sector, could allow problems to deepen if the economy doesn’t pick up, as Japan’s example shows. 

Japan’s case study: No grasp of the scale

Some estimates put the total amount of Japanese loans that were eventually written off at more than 100 trillion yen ($940 billion at the current exchange rate) - equivalent to about 20 per cent of the country’s gross domestic product at the time. When the bubble burst, neither the Japanese financial industry nor the authorities could fully fathom the scale of the problem or its potential risks, because NPL disclosure - or even a comprehensive definition of NPL - did not yet exist.

Chinese regulators, by contrast, seem to have a better grasp of the country's NPL problem than their Japanese counterparts two decades ago. Last year, the China Banking and Insurance Regulatory Commission gave commercial banks until the end of 2018 to classify loans more than 90 days overdue as non-performing, and this year it has developed new rules on how banks should classify assets based on risks. As of June 2019, China’s commercial banks had about 2.24 trillion renminbi ($313 billion) in non-performing loans on their balance sheets, implying an NPL ratio of 1.81 per cent, with another 3.63 trillion renminbi of Special Mention loans that are showing signs of stress. 

Although the Japanese banking industry publicly recognised bad loans were a problem as early as 1992, disposal proceeded at an uneven pace for several years. Both politicians and the financial industry itself were initially averse to the use of public funds, so a lack of capital resources slowed write-offs. Moreover, many lenders covered up past bad loans by issuing new ones, in the hope that struggling companies might turn around as the economy recovered. 

By 1995, several regional financial institutions had failed due to NPL problems, sometimes combined with a lack of governance and falling asset prices. In August 1995, the mid-sized regional Hyogo Bank became the first Japanese commercial bank to fail since the second World War. It had 3.75 trillion yen in total assets, about 40 per cent of which were invested in real estate-related problem loans. Authorities resolved these failures with no losses to creditors, leading some observers to raise concerns about a moral hazard.

‘Japan premium’ underscored credit fears

As NPL resolution dragged on, overseas lenders became increasingly concerned about Japanese financial institutions’ creditworthiness and were reluctant to lend them dollars in the interbank call market. In 1995 they began to charge a so-called ‘Japan premium’. 

The Japanese financial system finally reached an inflection point in late 1997, against the backdrop of the Asian currency crisis which took a toll on the broader economy. The default of a mid-sized securities firm in the interbank markets triggered a series of defaults by major financial institutions including Hokkaido Takushoku Bank, Yamaichi Securities, Nippon Credit Bank and Long-term Credit Bank of Japan. 

To address the credit crisis, the Japanese government pumped in two massive injections of public funds: the first, in March 1998, put 1.8 trillion yen into 21 banks; the second a year later injected 7.5 trillion yen into 15 large lenders. This helped Japan avoid any large-scale bank runs, and by the turn of the century, authorities had begun pushing banks to increase the pace of writing off NPLs. The financial industry did not emerge from turmoil until 2003, when authorities gave major banks a two-year deadline to halve their bad-loan ratios.

By comparison, the United States acted more immediately and decisively when it faced its own credit crisis a decade later. The Emergency Economic Stabilization Act of 2008 created the $700 billion Troubled Asset Relief Program to purchase banks’ distressed assets and buy $105 billion of preferred stock in the eight biggest banks. 

Baoshang Bank’s managed failure

In China, the economic slowdown has hit rural areas harder than urban ones, prompting regional banks to invest in high-risk assets as local borrowers have become scarce. A recent milestone could herald more reform steps: in May the government stepped in to take over a lender in Inner Mongolia. It marked the country’s first bank failure in nearly 20 years.

As it made the move, the People’s Bank of China (PBoC) citied ‘serious’ credit risks at Baoshang Bank’s operations and put it under the administration of China Construction Bank, one of the largest state-owned lenders. The PBoC guaranteed 100 per cent of all retail deposits, though it said that corporate and interbank deposits over 50 million renminbi (around $7 million) would receive markdowns on their asset value. 

Subsequently, a few other regional financial institutions received capital support from state and local governments and state-owned enterprises to avoid failures, and the steps so far have prevented financial panic. Still, in contrast with Japan’s visibility in its initially cautious approach, China’s case-by-case support measures raise concerns over a lack of transparency in its bank resolution processes. 

As China faces the challenges of financial reform, it will consider its own unique circumstances and will no doubt examine the mistakes of other nations and recognize similarities when they exist. Studying Japan’s cautionary tale of prolonging action for years while hoping for an economic turnaround could help China avoid wider damage to its domestic economy as well as to its credibility in the eyes of global investors.