HONG KONG -- Chinese banks' turnaround in profitability is faltering as the country's largest lenders get sucked into further support for ailing parts of the economy and struggling state-owned companies, despite a broad recovery from the coronavirus pandemic.
This year was expected to mark the start of a multiyear recovery at China's commercial banks, after their combined net profit fell 2.7% in 2020, the first decline in a decade.
But while profits are rising again, they are doing so more slowly than predicted. In the first quarter, commercial banks' net profit grew 1.5% year on year, well below the 5% analysts' consensus.
At the four largest banks -- Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China (ABC) and Bank of China (BOC) -- profits rose by less than 3% year-on-year, also missing analysts' expectations.
The change in fortune has stalled a rally in bank stocks. The mainland bank index has fallen 7% from its peak in February as investors fear that Chinese lenders will again lag their global peers.
Banks' continuing provisions for bad debts are one reason for the nasty surprise for investors. They remain at levels set at the heights of the coronavirus pandemic.
Another dampener of profitability is the expectation that the lenders deliver "national services" for Beijing -- subsidizing small businesses by cutting fees and interest rates, extending loan holidays and boosting the proportion of lending.
"We see China banks tending to be less pro-cyclical than their global peers," Citigroup analyst Judy Zhang said, referring to an upswing in global bank profits as loan losses from the pandemic were not as bad as originally feared.
Chinese banks will record lower margins "despite the economic recovery," as regulators still want lower borrowing costs for the real economy, while "relatively high provisions" this year and next will result in "muted" earnings growth for most banks, she said.
Shareholders are also nervous about the fallout for banks from a possible restructuring of China Huarong Asset Management, the nation's largest bad debt manager. Its offshore bonds slumped to junk levels, and Fitch Ratings and Moody's Investors Service cut their ratings last month after the company missed earnings disclosure deadlines, sparking fears of a debt restructuring.
ICBC's Singapore branch gave Huarong a loan to help it repay a 600 million Singapore dollar (US$452 million) bond that matured on April 27, Bloomberg reported. ICBC did not respond to an email seeking comment. Two people familiar with the matter also said Chinese authorities have asked banks to extend loans to Huarong to allow it to meet debt redemptions.
How Beijing handles Huarong is shaping up to be a test for its resolution of mounting debt at other state-backed companies.
But banks may lose either way. Bailouts would mean banks getting roped into supporting such companies; defaults would also hurt banks, which are both the primary lenders to such companies as well as the main owners of their onshore bonds.
"The Huarong incident further highlighted that if the government does not step in, banks may suffer asset quality risks on state-owned enterprise defaults," said JPMorgan Chase & Co.'s Hong Kong-based analysts led by Katherine Lei. "If the government does intervene, banks may be asked to finance the bailout."
Lei halved the earnings growth forecast for state-run banks to 4% for 2021. She also reduced the rating on ICBC to the equivalent of sell, from hold, while dropping China Construction Bank and Agricultural Bank of China to hold.
Valuations of "China banks are likely capped at their current trading ranges due to a lack of catalysts for profit," said Lawrence Chen, an analyst at CCB International Securities, a unit of China Construction Bank. He has cut his profit expectations for the sector by 3 percentage points to annual growth of 5% in 2021. Chen estimates a 9% rebound next year.
China's largest banks have been guided by the government to grow loans to small and medium enterprises by at least 30% this year. The target comes on the back of a 50% rise last year, when the pandemic disrupted businesses and shut shops down for months.
The government will also allow small enterprises to defer principal and interest repayments, and guide banks to lower loan rates for COVID-hit industries, according to a report unveiled in March at the annual meeting of parliament.
More lending to riskier companies at lower interest rates would hit bank profits and lead to concerns about asset quality.
Rob Mumford, a Hong Kong-based investment manager at GAM Investments, said he was avoiding the large banks as an investment. "Potential interest rate cuts are negative for the banks," he said.
Lending growth peaked late last year and is slowing down as Beijing imposes limits on mortgage lending, which makes up almost a third of all outstanding loans. Outstanding yuan loans climbed 12.6% in March, the slowest pace in over a year, according to regulatory data.
Interest margins and other drivers of bank profits are also under pressure. Margins have been squeezed by mortgage repricing and interest rate reductions to small businesses just as the central bank begins to reduce liquidity -- pushing banks to seek more expensive funding to meet the lending needs.
With Chinese bond defaults rising and banks racing to eliminate or recognize so-called "shadow banking" exposure by year-end, analysts also expect lenders to continue charging more provisions this year.
Not so long ago Chinese bank stocks were drawing in investors, lured by the promise of an economic rebound after China managed to control the virus. Bank stocks were also cheap, trading at around half the value of their net assets.
The CSI 300 Banks Index, which tracks the biggest lenders traded in Shanghai and Shenzhen, had surged a third by mid-February from the lows in late May and was one of the bright spots in the Chinese stock market. The rally has now reversed course.