As China recovers from Covid-19, all eyes are on its banks’ bad loans. The reality is far worse than it looks.

China’s largest lenders reported quarterly earnings this month, the first since the viral outbreak shuttered large swathes of the economy. The stock of non-performing loans rose for all of them — some more than others — but total loans went up, too. As a proportion, NPLs were basically flat. Breakdowns on types of souring loans were sparse, leaving investors with few clues about the real state of things.

A closer look at their existing loan books, however, suggests there’s more pain ahead. A third of Chinese bank lending goes to personal loans without any collateral, credit cards, private companies and small or medium-size enterprises. These borrowers comprise 77% of non-performing loans. They also tend to be the weakest in a crisis, and stand to lose most in the Covid-19 aftermath.

As exports and global demand wane, private manufacturers will see their earnings washed out. Over the next 12 months, around 2.5 trillion yuan ($353.1 billion) of new non-performing loans will be generated in China’s banking system, according to CLSA Ltd. Employees and owners will feel the pain and household incomes will be hit, weakening consumer credit. Granted, companies have been getting life lines from Beijing, just enough to keep things afloat while banks get permission to forbear. But the picture will be muddy for a while.

Consumer balance sheets maybe more indicative of what’s happening. Ping An Bank Co.’s retail non-performing loans, which include mortgages, rose 59% in the quarter from a year earlier, according to Goldman Sachs Group Inc. Another troubling sign: The non-performing loan ratio for securities backed by credit card debt jumped over 4% in March, according to CLSA. Households’ debt servicing ability was already constrained, with borrowing rising faster than incomes. Writing off retail loans will be a big challenge, but rolling over millions of troubled loans will be tough, too.

Then there’s the question of what gets recognized as soured debt. Regulators have been pushing lenders to go easy on repayments and roll over loans. That means a chunk will be booked in categories like overdue, rescheduled and special mention loans before they are declared as non-performing assets. These borrowings often sit under these classifications for a long time even if they have gone bad. Using a broader definition that includes these groupings, NPLs are closer to 2.5 trillion yuan than the 1.5 trillion yuan in the financial reports of all 49 listed banks, according to Rhodium Group estimates. That was before the virus. Meanwhile, unlisted banks were already reporting NPL ratios close to 10%.

Banks will have to set aside funds for this. Rhodium Group estimates that an extra 1 trillion yuan of NPLs would require 1.5 trillion yuan of provisions. That would wipe out half the banking system’s annual profit and erode capital.

No wonder, then, banks have rushed to raise billions of capital in recent weeks through perpetual and additional tier 1 capital bonds. Meanwhile, the deterioration will start to put pressure on banks to boost earnings. That’s a dangerous place to be.

Provisions for loan losses barely increased at most big lenders in the first quarter. Under accounting rules adopted last year, such a buffer is supposed to be based on expected losses before actual ones show up. It’s unclear what these lenders are anticipating but it doesn’t look like enough. Investors should take notice. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

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