(Bloomberg) — By any measure, Tom Hu should be in default on a $730,000 bank loan for his plastics business in China. He barely brings in enough revenue to pay expenses and can’t cover the debt costs.

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Yet rather than calling in the loan, his bank lets him defer payments — keeping him afloat, while avoiding another past-due loan on its books.

“Honestly, it feels like the economy is getting worse,” Hu said in a recent interview, noting many other business are struggling, too. “I don’t want to end up on the credit blacklist, and the banks don’t want to see their bad loans go up either.”

Stories like Hu’s are playing out across China as banks grapple with a growing pile of bad debt. It’s impossible to quantify the true extent of the problem, though most economists say the ratio of bad loans is significantly higher than the 1.5% official rate. One analyst at Absolute Strategy Research in London pegs it at about 10%, which would mean a staggering $3 trillion in loans that should be classified as past due are not. Others say it could be double that amount.

While the leniency, largely condoned by regulators in Beijing, has helped maintain financial stability over the past few years, it also means the banking system is recycling capital into unproductive companies rather than spurring real growth in healthy firms. That threatens to turn into a permanent drag for the world’s second-largest economy — a challenge for President Xi Jinping as he contends with external pressures including the global energy crisis and Donald Trump’s volatile trade policies.

“There’s no financial crisis, but there’s no free lunch in economics,” said Victor Shih, an associate professor at the University of California San Diego who’s written a book on China finance. “The price is just growth, inefficiency and low productivity.”

The apparent stability of the official bad loan rate is all the more surprising given that the economy has experienced a major property collapse and posted the slowest nominal growth outside Covid since the 1970s. In March, China lowered its 2026 growth target to between 4.5% and 5% — its least ambitious goal since 1991.

Regulators have taken note. Despite seemingly strong capital buffers and stable NPL ratios, officials have moved to bolster the nation’s six biggest banks with more than $100 billion in fresh capital.

The National Financial Regulatory Administration didn’t respond to a request for comment.

The primary culprit for the surge in bad loans is a mountain of credit extended to companies whose earnings are insufficient to cover interest payments. About 10% of listed non-financial firms have failed to cover interest payments from their earnings before interest and tax for three consecutive years, according to Absolute Strategy Research. As a result, the non-performing loan ratio is probably closer to 10% than 1.5%, according to Adam Wolfe, an emerging markets economist at the firm.

“Kicking the can down the road just prolongs the pain,” said Wolfe. He said it weighs on bank earnings and limits credit for more productive firms, “which will ultimately undermine GDP growth.”

Fed Study

A study by the Federal Reserve Bank of Dallas found that these so-called zombie firms accounted for 16% of assets at non-financial companies in China in 2024, up from just 5% in 2018. While the real estate sector has the highest rate, the manufacturing and services sectors are rising, too, the report found.

Even Chinese officials have gloomy estimates. A recent paper by the European Union Institute for Security Studies cited an anonymous interview with mid-level government officials saying that their estimates of the true NPL ratio are 15% to 20%. Shih at the University of California also pegs the rate at closer to 20%.

Assuming a 10% bad loan ratio, that would equal about 17% of China’s gross domestic product. By comparison, some analysts projected non-performing loans reached about one-third of Japan’s GDP during the early 2000s.

Hu, 48, should be squarely in that NPL category, operating a hollowed-out enterprise in the manufacturing province of Zhejiang, near Shanghai. The combination of weak domestic demand and volatile exports has forced him to slash his workforce by 90%. Since the post-pandemic reopening in late 2022, his plastics facility has teetered on the brink of insolvency, generating just enough cash to cover basic operations.

“I’m just playing it by ear, no real plans,” Hu said, asking that his lender not be named for fear of reprisals. “If the bank calls the loan, I’ve got no way to pay back the principal right now.”

China’s official NPL ratio has always been a bit of a mystery. In good times and bad, it’s rarely wavered much from 1.5%, and most economists say it greatly understates the true stress in the system. The figure captures only loans officially classified as “substandard,” “doubtful,” or “loss.”

In reality, the classification is often a subjective assessment and banks have different internal criteria. A much larger pool of troubled credit remains in the “special mention” — those that may have already become overdue but yet to be categorized as nonperforming — or “normal” categories, thanks to an aggressive use of leniency known as forbearance.

Existing rules stipulate that when repayment on a loan is overdue by more than 90 days and the borrower can’t fully repay the amount, it should be marked as nonperforming.

Economists including Wolfe estimate that about 40% of loans are either eligible or already in some sort of forbearance program, where banks are strongly discouraged from seeking repayment or recognizing losses.

The bad loan risk “could have led to a financial crisis if not for the forbearance policies and the government’s intervention,” said May Yan, head of Asia financials research at UBS Group AG. The fact that China is not in crisis speaks to the success of these measures, she said.

In other words, rather than cracking down on deadbeat borrowers, China’s banks are encouraged to cut them some slack. Regulators have for years urged the big banks to keep their reported bad loan ratio under 2%, according to people familiar with the guidance.

With the forbearance policy — a legacy of Covid support programs that’s been extended to property developers and other firms — Beijing is signaling its desire to maintain financial stability. It wants to avoid a rash of bank failures that would follow a surge in reported bad credits and company defaults.

A leniency policy for small businesses that was introduced during the pandemic was extended in 2024 to encourage banks to roll over loans for companies enduring temporary difficulties. This policy is effective until late next year, and applies to 9.4 trillion yuan ($1.38 trillion) worth of loans, according to officials.

As a result, banks routinely roll over maturing loans, extend repayment periods, or allow interest to be capitalized to avoid triggering NPL recognition. Local governments also exert pressure on lenders to maintain stability by avoiding cuts to risk classifications on loans tied to sensitive sectors. Those include property developers, local government debt and small businesses in weaker regions, according to a dozen bankers interviewed by Bloomberg News.

The leniency also extends to underwater mortgages, in which loans are worth more than the home itself. Several state-owned banks have approached cash-strapped borrowers and offered them payment holidays on their mortgages for as long as two years, according to people familiar with the matter. Some lenders are working with customers to find buyers for their homes, instead of forcing defaults and foreclosing on the properties, the people said.

For Shih, it’s a clear case of moral hazard, where entities take on excessive risk knowing there are no real consequences.

“The banks are not lending on the basis of commercial viability of the debtors’ profile,” he said. “Banks are lending because the government has told them to lend, and that will just generate a lot of bad assets.”

Some banks have collectively concealed more than 800 billion yuan of non-performing assets over the five years through 2024, according to Bloomberg’s calculations based on reports published by the National Audit Office.

“The authorities recognize that there cannot be one massive wave of recognition of bad debt, or a lot of banks in the country, particularly smaller ones, are going to need a bailout,” said Charlene Chu, senior analyst at Autonomous Research.

It’s hard to pinpoint which banks are most prone to deferring loan payments, though it tends to be more common in weaker rural banks, analysts said. Shares of financial giants such as Industrial & Commercial Bank of China Ltd. and Agricultural Bank of China Ltd. haven’t suffered from the deteriorating credit quality. Investors in these stocks tend to buy them for the 5% dividend yield and relatively cheap valuations, confident that Beijing will always provide a backstop in times of stress. ICBC shares have jumped 12% already this year in Hong Kong.

To counter the weak loan books and shore up the banks’ balance sheets, the government is injecting money into the lenders. China will issue a total of 300 billion yuan worth of special sovereign bonds this year to recapitalize banks, adding to a 500 billion yuan lifeline last year.

All this leniency comes at a cost. Financial resources are trapped in unprofitable and even inactive firms, hindering banks’ ability to promote growth in healthy businesses. Overall loan growth is slowing significantly after fixed-asset investment experienced an unprecedented contraction last year.

Chinese banks extended the smallest amount of new loans since 2018 last year. A further deterioration of loan growth could mean that banks are no longer able to offset the detrimental impact of the central bank’s rate cuts on their profitability, Chu said.

The wave of bad debt also has implications for China’s macroeconomic policies.

It aggravates concerns over the banking sector’s health, which has become a significant constraint on the central bank’s rate decisions in recent years. With banks’ net interest margins already at record lows, policymakers worry that further cuts could squeeze their ability to generate profits.

In 2025, the People’s Bank of China delivered the least amount of interest rate reductions in four years, disappointing economists who expected monetary easing to play a bigger role in bolstering domestic demand.

Still, there are signs the banks are taking steps to improve credit quality.

High-risk financial assets, which include NPLs at commercial banks and risky debt at opaque platforms such as shadow banks, fell to 4.9% of total financial assets at the end of 2025 from a peak of 30% in 2017. That figure is expected to fall further to around 3% by 2027, said Richard Xu, head of China financials research at Morgan Stanley.

Large Write-off

Chinese banks are also accelerating write-offs and transfers of bad assets. Lenders have disposed of more than 3 trillion yuan of non-performing assets a year since 2020, with the total rising to roughly 3.8 trillion yuan in 2024, the highest on record.

Banks have stepped up transfers of NPL portfolios to asset management companies, which typically hoover up bad assets in China. Still, these firms entrust collection back to the originating banks in many cases, according to people familiar with the matter. The funds used to purchase bad loans largely come from the banks, meaning the risks aren’t fully removed from the financial system.

Despite these efforts, the mounting debt woes speak to the gradual decline of China’s economy, according to a recent report by the Rhodium Group. The think tank’s partner Logan Wright said the best way to describe it isn’t crisis or collapse, but more of a “prolonged decay.”

“The financial system lends rising proportions of a smaller volume of new credit to unproductive local government and state-owned enterprises simply to prevent them from collapsing,” he said.

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