China's Banks Are Getting Ready For A Debt Implosion

Reuters People watch a daytime color-smoke explosive show over the Huangpu River at the Bund, in Shanghai.

Chinese banks are seeing the writing on the wall in terms of the debt they've accumulated, and they are taking measures to protect themselves.

The Bank of China is planning the biggest sale of shares ever — $6.5 billion to offshore investors,Bloomberg says.  It's all in an effort to create a capital cushion.

China's banking system has piled up the most bad loans of any time since the financial crisis, and the banks are preparing for the moment those debts collapse.

Especially in corporate and property sectors, things are looking dire.

Let's tackle the corporate sector first. Last month, Morgan Stanley released a report saying China's corporates took on 5.4 times more leverage than ever before in the first half of 2014, bringing leverage up to levels unseen since 2006.

And it hasn't stopped. Short-term lending to corporates rose to $26.8 billion in September from $11.2 billion in August. Long-term lending hit a four-month high of $45.9 billion in September, up from $39.3 billion in August.

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Societe Generale

This lending comes amid a big effort to cut costs among Chinese companies. They know a cash crunch is coming as the PBOC maintains that it will not take major measures to stimulate the economy.

Meanwhile, profit margins have been thinning for some time, and China's producer-price index has deflated 6.7% in the past 36 months.

To Societe Generale analyst Wei Yao, this just adds fuel to China's debt fire.

"China’s debt problem lies with the
corporate sector, and so PPI deflation can cause more damage to debt dynamics than CPI deflation. The cure should be capacity consolidation and debt restructuring, rather than
another stimulus package targeted to boost investment demand," she wrote in a recent note.

In terms of the property sector, that debt restructuring could be coming regardless of whether the government initiates it. Last week the industry was rocked when the $20 billion development company Agile Property Holdings canceled a $360 million share offering. Then the company's chairman, billionaire Chen Zhuolin,  disappeared.

Zhuolin has since been found and placed under house arrest. His family has pledged to support the company as it struggles with debt repayments.

But that — coupled with the March collapse of Zhejiang Xingrun Real Estate Co. under $571 million in debt — has investors spooked. Regulations around financing home purchases have been loosened a bit, but not on a large scale, and analysts think the measures that have been takenmay not be felt until early next year.

So banks have plenty of reason to worry right now, and they aren't the only ones. Chinese foreign reserves declined more than ever before in the third quarter. It's a sign that investors are seeing slowing economic data — like September's awful industrial production flashback to 2008— and moving their money elsewhere.