The Real Risks Lie Beneath the Surface
China’s officially reported stock of non-performing loans is only the visible portion of the problem. The far greater risks lie in assets whose true quality has yet to be fully recognized.The first major source of concern is the enormous volume of debt issued by local government financing vehicles, or LGFVs.
In recent years, Beijing has sought to ease local government debt pressures largely by extending maturities and lowering interest rates. While this may postpone defaults, it also forces banks to hold large quantities of low-yield, illiquid assets for another decade or even two.
Instead of eliminating the problem, the policy effectively transforms those loans into long-lived “zombie assets” that continue to weigh on banks’ profitability and balance sheets.
The second source of risk is the lingering effects of China’s property market downturn. Although the worst of the real estate crisis may have passed, defaults among smaller private developers remain unresolved. Meanwhile, mortgage delinquencies and early loan repayments by households remain high, and bad loans tied to consumer lending and credit cards continue to rise. Together, these trends suggest that credit deterioration has yet to run its course.
It also remains a question whether the official 1.51 percent non-performing loan ratio accurately reflects the banking system’s true asset quality. A significant portion of potential credit risk may remain off the balance sheet or has not yet been formally recognized.
According to an estimate by Shinichi Seki, a Japanese economist and senior researcher at the Japan Research Institute, the ratio of China’s potential non-performing loans had risen to 9.3 percent by the end of 2025, up from 7.8 percent a year earlier, based on the financial statements of publicly listed corporate borrowers.
The Stock Market Is Sending a Warning
Financial markets appear to be reaching a similar conclusion.During the first half of 2026, the total market capitalization of China’s A-share market surpassed 120 trillion yuan (about $17.66 trillion) for the first time. Yet the banking sector moved in the opposite direction, losing more than 600 billion yuan (about $88.31 billion) in market value over the same period.
The selloff began almost immediately after the start of the year. Between Jan. 5 and Jan. 16, the Shenwan Banking Index fell 4.88 percent over 10 trading days, wiping out roughly 480 billion yuan (about $70.65 billion) in market capitalization.
Although the market later stabilized, bank stocks never fully recovered during the first half of the year, leaving the sector’s market capitalization well below its level at the start of 2026.
Even China’s largest banks were not immune. Agricultural Bank of China alone had lost approximately 330 billion yuan in market capitalization during the period.
Foreign Investors Are Voting With Their Feet
Another development that deserves attention is the behavior of foreign investors.Foreign investors had been reducing their exposure to China’s financial sector for three consecutive quarters.
By the end of the first quarter of 2026, Northbound Stock Connect investors held 14.936 billion shares of listed banks and 5.852 billion shares of non-bank financial companies. Both figures were the lowest in nearly five quarters. Compared with the previous quarter, holdings of bank stocks fell by nearly 7 percent, while holdings of non-bank financial stocks declined 13.24 percent.
The reasons are straightforward. As net interest margins continue to narrow, the period of easy earnings growth for Chinese banks is drawing to a close. At the same time, the long-standing strategy of expanding balance sheets to dilute bad loans is becoming increasingly difficult to sustain. Investors appear to recognize that the industry’s traditional growth model has reached its limits.
So who is buying the shares that foreign investors are selling?
Why Dividends Do Not Tell the Real Story
The true condition of China’s banking sector is being obscured in many ways. One obvious example is that the six largest state-owned banks continue to pay generous dividends as if nothing has changed. In reality, they have been relying on financial maneuvering to sustain those payouts.One key tool is the large reserve they have built up over the years to cover potential loan losses. In the first quarter, all six banks maintained provision coverage ratios above 200 percent, comfortably exceeding the regulator’s benchmark of 120 to 150 percent. When 1 yuan of bad debt is recognized, it does not have to be deducted directly from current profits. Instead, the bank can write it off using this reserve—effectively treating the reserve as a financial buffer.
The second is to offset the decline in interest income with non-interest revenue. Net interest income fell sharply in the first quarter, yet several large banks managed to keep overall earnings afloat by benefiting from the bond market rally and realizing capital gains from their proprietary investment portfolios.
Neither strategy is sustainable. The reserve cushion is gradually being depleted, and no bond bull market lasts forever. Once market conditions change, any underlying vulnerabilities could quickly come to light, making a broader banking crisis difficult to avoid.
What I find most troubling is that policymakers appear fully aware of these problems, yet continue to avoid meaningful structural reform. Instead, they suppress deposit rates, allowing banks to widen the spread at the expense of ordinary savers.
Those artificially supported profits are then used to maintain dividend yields of roughly 4 to 5 percent, benefiting major shareholders such as the Ministry of Finance, Central Huijin, insurance companies, and retail investors who have followed state-backed funds into bank stocks.
