China's rural bank problem

China's rural banks are a source of potential instability worrying leaders at this year's "two sessions" legislative conclave...and possibly a canary in the coal mine of a financial meltdown. 

Beijing Shangbao reported last week that finding an "orderly solution for risks in medium and small financial organizations is of the utmost importance in current financial work." Premier Li Qiang's government work report identified resolution of risks related to small and medium financial institutions alongside real estate and local government debt as keys to maintaining economic and social stability. Among small and medium financial institutions, rural banks have the most prominent problems.

China Banking and Insurance News reported that rural banks had nonperforming loans totaling 754.6 billion yuan at the end of 2022 and a nonperforming loan rate of 3.22%--more than double the rate for larger Chinese banks. Some rural banks have already refused to pay depositors, leading to protests. Authorities already undertook a huge consolidation of rural banks earlier this year. 

Two groups of rural banking institutions were set up in reforms 2 decades ago meant to clean up an earlier financial mess and to address the lack of lending for rural small businesses and farmers. A sprawling system of "rural credit cooperatives"--largely insolvent in the early 2000s--received injections of state capital and were merged into provincial or regional "rural commercial banks" and "rural cooperative banks." A network of village and town banks were set up by urban banks and foreign banks.

The fundamental problems of a small, fragmented rural customer base with few liquid assets persisted, and the countryside is riddled with debt.  Financial experts say rural Chinese banks would be unviable without subsidies. Many are plagued by mismanagement and economic slowdown in rural regions; the pandemic tipped many into crisis. With paper-thin margins, rural banks were tempted to offer high-yield financial products outside their rural mandate. Some went bust; some managers fled the country with bank funds in their suitcases.

There are likely a lot more problems lurking in rural China's finances. A hot topic at last year's "two sessions" was a report revealing that Chinese villages were in debt to the tune of 900 billion yuan (about $125 billion). Based on a 2019 Ministry of Agriculture survey, news outlet Yicai called the debts "heavy baggage" for village collectives and a potential "stumbling block to rural revitalization." Another outlet confirmed that its investigations found debts were common in villages all over the country, in both rich and poor areas. A Sichuan Daily article 4 months ago reported that a survey of 48 villages showed persistent problems with village debt despite a 12-year campaign by provincial authorities to resolve the debts. A local official in Shandong Province wrote that "village debt is a microcosm of rural social conflicts and problems." Debts arise from failed village-operated pig farms and other business ventures, road-building projects, covid control, poverty alleviation projects, and decades-old obligations for unpaid taxes.

The Agricultural Development Bank of China (ADBC)--a government-run rural policy bank--likely has a higher nonperforming loan rate than it claims. ADBC has participated in 3 rounds of the China banking regulator's pilot program that moves bad loans to take them off the books. ADBC was created 30 years ago to finance procurement and storage of grain, oilseed and cotton and has broadened its portfolio to include rural development and industrial parks. ADBC's soaring loan balance seems worrying. The ADBC loan book reached 8.79 trillion yuan ($1.23 trillion) in 2023, up 1 trillion yuan each of the last two years and triple the balance 9 years ago. ADBC lending has grown much faster than the agricultural sector. The ADBC loan balance is now 93% of the annual value of agricultural GDP, up from 46% in 2013 and 33% in 2004.

Source: annual reports of Agricultural Development Bank.

In 2022 ADBC lent 407.8 billion yuan to finance procurement of grain, cotton and oilseed purchases and 94.6 billion yuan to finance 23 million metric tons of imports. ADBC said it financed 64 percent of China's grain purchases in 2022. Interest on ADBC's loans is largely paid by government subsidies for holding reserves, but recent loans are probably underwater due to falling grain and oilseed prices. The value of grain purchased at high prices in 2022 has shrunk with grain prices falling, so it will be impossible to repay the principle on the loans by selling the grain. Income from giant grain logistics projects, poverty alleviation and construction of apartment buildings to resettle displaced rural people is unlikely to be sufficient to repay the interest or principle.