Amid increasing concern about risks in China’s banking sector, the latest banking data from Shanghai tells a story of resilience. The region’s non-performing loan (NPL) ration has declined for eight consecutive months to 0.79 per cent at the end of June, much lower than the 1.81 per cent ratio for China’s commercial banks as a whole. Outstanding NPLs shrank by Rmb3.6bn since the beginning of 2016.

Special-mention loans — a classification for loans that might be at risk of becoming NPLs — also decreased in Shanghai, both in volume terms and as a ratio of total loans. Thus, it’s clear that NPL figures aren’t being manipulated by hiding bad loans in the special-mention category.The good results in Shanghai come amid concerns about over-capacity, over-leverage and zombie companies in China. It seems that Shanghai is less exposed to the adverse impact of capacity reduction and de-leveraging than other provinces. This is a positive signal, as today’s Shanghai might point the way forward for the rest of China.Encouragingly, Shanghai’s turnaround is more structural than cyclical, as it has been driven by economic restructuring, the Shanghai Free Trade Zone, and the city’s efforts to build itself into a center of scientific innovation.On the supply side, the services share of gross domestic product exceeded 70 per cent for the first half of 2016 for the first time, compared to 54 per cent for China as a whole. On the demand side, fixed asset investment grew only 5.6 per cent in 2015, far below the national average of 10 per cent.Furthermore, the growth rate of private investment is higher in Shanghai than the national figure. China is transforming its economy from one driven by exports, capital-intensive industries, state-owned enterprises, and local governments to one that is driven more by market forces, consumption, services and innovative private enterprises. Shanghai leads the way. This is mirrored in bank portfolios.Yet good weather alone does not make a bountiful harvest. The bulk of Shanghai’s sound loan quality can also be attributed to the banking regulator’s forward-looking supervision of credit risk since 2011.In 2011, early warning indicators offered compelling evidence of serious over-indebtedness in Shanghai’s steel-trading industry. The regulators found fake receipts from warehouses; traders pledging their same steel holdings in the warehouses quietly as collateral to multiple lenders; traders guaranteeing each other’s loans to expand borrowing; traders investing in real estate with bank loans ostensibly intended to buy steel; and other shenanigans.For regulators, the combination of excessive lending and elevated steel prices was extremely worrying: when steel market inevitably went south along with a slowing the economy, a negative feedback loop could have sparked a financial avalanche.

The China Banking Regulatory Commision’s (CBRC) Shanghai office moved to act before the music stopped. The agency issued warning to banks on exposure to steel traders and cracked down on illegal and imprudent practices related to the steel lending spree. As a result, Shanghai banks’ exposure to steel traders has decreased from Rmb220bn in 2011 to Rmb21.4bn today. Of that reduction, Rmb150bn is due to loan repayment or restructuring, while only Rmb48.6bn in loans turned sour.