NEW YORK, August 23, 2023 - Wherever you look, banks seem to be paying the price for their governments’ past policy errors. Lenders in the world’s two largest economies are in a race to see which one spirals to the bottom first.

In the US, government borrowing exploded during the pandemic, mostly in the form of short-term Treasury bills. To refinance those bills as well as the growing spending deficit, Washington will have to sell much more long-term debt — the question now is whether investors have the appetite. This has created a bond rout, pushing the 10-year sovereign yield to the highest since 2007. That, in turn, has raised renewed concerns over consumer deposit flights and the value of banks’ securities holdings. In recent weeks, ratings agencies have been downgrading US lenders, citing a “tough” climate.

Across the Pacific, Chinese banks are not sailing in safe waters either. They face the double whammy of property wobbles and fiscal woes. Lenders’ exposure to local government debt and the real estate sector accounts for close to 40% of their total assets. Meanwhile, the People’s Bank of China has been cutting interest rates to stimulate the economy and make consumers’ monthly mortgage payments more palatable. The banking sector’s net interest margin has fallen below 1.8%, a threshold that is regarded as necessary to maintain reasonable profitability.

Since the US and China like to compete on everything, here’s a hypothetical question: Where are the sick banks today? Which country has the weakest lenders that may lead to a financial meltdown?

In terms of credit risk, US banks are by far healthier, thanks in no small part to the collapse of Lehman Brothers Holdings Plc, which cleansed excessive financial engineering on Wall Street. This perhaps explains why, on average, these financial institutions still trade at around their book value, while their Hong Kong-listed Chinese counterparts are at only 0.3 times book.

But China’s political system does allow its banks to play the prisoner’s dilemma game a bit better. In recent months, big US banks have been rushing to reduce their commercial real estate exposure, selling office building loans at a discount even though most of these are still performing. This puts regional banks, which have sizable exposure, at a huge disadvantage. They might have to mark-to-market their holdings.

You would not see this in China. Banks there can just pretend and extend, and no one needs to impair anything. Here is a concrete example: In December, Zunyi Road & Bridge Engineering Construction Group, a local government financing vehicle in the impoverished Guizhou province, got a partial bailout from its bankers, swapping short-term borrowings into 15.6 billion yuan worth of low-interest, 20-year loans. For banks, national service aside, it was also self-serving, in that Zunyi Road no longer needs to be classified as non-performing.

Believe it or not, Chinese banks’ non-performing loan ratios average at only 1.6%, eerily low considering the country’s biggest real estate developers have slipped into defaults and municipal financing has gotten so bad that the central government is mulling a partial bailout again.

While investors can debate the pros and cons of each financial system, one thing is sure. Both governments are addicted to debt — and that’s affecting the health of banks’ balance sheets. Last year, US and Chinese government debt hit 120% and 112% of their gross domestic product respectively, according to estimates from the International Monetary Fund.

To maintain — or aim for — superpower status, it’s inevitable that you accrue a lot of expenses. Banks are just collateral damage.