Ever since China began to binge on debt to fuel its growth in 2009, many have wondered how long the party could go on. To the chagrin of many bearish observers, predictions of a financial crisis have not panned out. Today, China’s banking system is still standing despite a debt-to-GDP ratio of 264%. Perhaps because Beijing seems to be able to defy financial gravity, fewer people these days worry that its ballooning debt could unleash a systemic crisis. But there are many warning signs indicating that China may face a debt reckoning soon.
Weak supervision, poor risk management and corruption that likely drove the small rural banks in Henan into insolvency are systemic among the country’s nearly 4,000 small and medium-sized banks with nearly $14 trillion assets. It is highly likely that other similar banks will fail soon. By pure coincidence, when Henan authorities were cracking down on the victims of bank failure there, authorities in Shanghai had put on trial, in secret, a former billionaire who allegedly controlled a medium-sized bank in Inner Mongolia and used it to fund various illicit schemes. When the government seized the failed bank in 2019, the bailout cost several billion dollars. If a large number of small banks fail together, such an event could produce a chain reaction threatening the stability of the financial sector. Their counterparties and lenders, especially bigger banks, could suffer massive losses. Confidence in China’s shadow banking system, through which small banks attract funds with a higher interest rate, will likely evaporate.