China AMCs becoming more significant ouside banks in managing bad assets

But there's more beyond asset quality.

It has been noted that the shift by Chinese banks into debt investments, receivables, and interbank exposures to bypass lending restrictions, as well as the growth of the shadow banking system make it harder to assess the underlying asset quality of the banks and overall stress in the financial system.

According to a release from Fitch Ratings, China's asset management companies (AMCs) are playing an increasingly important role outside the banks in managing bad assets.

It is common for AMCs to purchase assets directly from borrowers, so bad assets are often transferred to external parties without being recognised as nonperforming loans (NPLs).

Regulatory forbearance also delays the recognition of asset impairment. These features cloud the veracity of underlying nonperforming loans (NPL) levels at banks and more broadly the transparency around the extent of debt problems in the financial system.

This renders NPL analysis less meaningful, especially as banks in China have remarkably similar NPL ratios. Banks' NPL ratios for local government and property loans are very low because riskier credit often lies off banks'balance sheets.

Here's more from Fitch Ratings:

Policy guidance on agricultural and micro lending may also lead to inappropriate pricing. The underlying problem is one of debt sustainability.

The rapid rise in leverage in China since 2008 is increasingly burdensome, with the interest cost of servicing China's debt now estimated to have reached 15% of GDP, exceeding nominal GDP growth of below 10%.

The need to strike a balance between maintaining adequate growth to support employment and ensuring banking system stability means that banks remain exposed to the risks of this unsustainable trend continuing.

Until China allows for more corporate and state owned enterprise defaults, moral hazard will prolong and exacerbate threats to the banking system beyond what reported NPLs indicate.

The longer weak entities are permitted to roll over their debt, the greater the buildup and cost of servicing that debt, and the greater the strain on the economy.

Acknowledging this concern, the People's Bank of China has cut official interest rates three times since November 2014, with the latest being a 25 bp reduction to 5.1%, effective 11 May 2015.

The authorities will need to resolve the debt at some stage through directly or indirectly absorbing the debt, disposals, and/or debt forgiveness.

Fitch therefore expects government support to play a big role in underpinning the Issuer Default Ratings for Fitch rated Chinese commercial banks, but pressure will remain on their Viability Ratings (VR) if leverage continues to rise.

While some may argue that the support the authorities often extend to troubled borrowers should be better reflected in the banks' VRs, Fitch believes such support will diminish over time, leading to a higher rate of defaults.