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Chinese banks have yet to hit bottom

Pressure on sector likely to mount as Beijing prioritizes economic stability

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With shadow banking rampant among smaller players, the People's Bank of China recently broadened its definition of credit to include off-balance-sheet wealth management products.   © Reuters

HONG KONG "Deleveraging" has become a buzzword in China thanks to Premier Li Keqiang identifying it as one of the government's priority tasks for the first time in his state-of-the-nation address on March 5. But with stability of "overriding importance" ahead of the Communist Party's once-in-five-years congress this fall, Chinese banks will likely continue to bear the brunt of government efforts to stabilize an economy plagued by excess capacity.

"Rising debt leverage in the Chinese economy is the major factor behind our negative economic risk trend assessment for the Chinese banking sector," credit rating agency S&P Global Ratings said in a note on March 8. It pointed out that the country's official credit growth target for 2017, at 12%, again outpaces expected nominal economic expansion, at roughly 9.5%, thus presenting persistent challenges to banks' capitalization and liquidity profiles.

"In our view, the sector's internal capital accruals from retained profits cannot support projected credit growth without erosion of the banks' capital strength or raising equity capital," S&P Global said, adding that China's total credit growth will likely stand at 15-16% this year if the local government debt swap program, estimated to be worth 5 trillion to 6 trillion yuan ($720-870 billion), and the proposed budget deficit of 2.38 trillion yuan are factored in.

"We expect China's domestic savings surplus to shrink further relative to the total assets of the banking sector, leading to greater liquidity strain in the interbank market and exerting upward pressure on wholesale funding costs if the Chinese central bank won't take measures to offset the impact," the rating agency said, forecasting Chinese banks' return on average assets to drop below 0.8% in 2017 from close to 1% last year.

MISLEADING SIGNS Although the bad-debt ratio among Chinese commercial banks seems to have fallen from its peak in the third quarter of last year, many observers are skeptical that the banking sector is en route to a sustainable recovery.

According to the China Banking Regulatory Commission, commercial banks reported an average nonperforming loan ratio of 1.74%, and a ratio for special mention loans -- those overdue but yet to be considered impaired -- of 3.87% at the end of the fourth quarter. This compares to 1.76% and 4.1% for the previous quarter. In absolute terms, soured loans swelled 18.66% on the year to 1.51 trillion yuan, while special mention loans ballooned by 16.18% to 3.35 trillion yuan at the end of last year.

"[A]pparent improvement is unlikely to reflect underlying credit conditions. Official on-balance-sheet asset-quality indicators are being distorted by debt-for-equity swaps and offloading of distressed debt to asset-management companies -- which continue to grow rapidly," said credit rating agency Fitch Ratings in a March report. "Banks are finding ways to delay recognition of asset impairment."

Lai Xiaomin, chairman of Beijing-based China Huarong Asset Management, which managed over 50% of Chinese banks' distressed assets last year, was hesitant to say the country's banking sector has bottomed out. "Last year, Chinese commercial banks disposed of noticeably more impaired assets into the market compared to the past," Lai told the Nikkei Asian Review. "There are signs that falling profitability, escalating impaired asset ratios, declining return and dwindling numbers of good customers are reversing, though." Lai said he expects commercial banks' average nonperforming loan ratio to climb to 2% this year.

"As the global economic environment remains challenged, soured loans among Chinese banks will continue to mount in the next couple of years in a controlled manner," Lai said, noting that more than 2 trillion yuan worth of bad debts had accumulated over the past few years. "That is giving distressed asset managers a lot more business opportunities."

Hong Kong-listed Huarong reported a 32.84% jump in net profit to 11.12 billion yuan for the six months through June 2016. Net distressed debt assets in the period rose 21.6% to 305.82 billion yuan. "Huarong sees distressed debt management as its staple, accounting for 55-60% of the overall business. That won't change in the next five years," Lai said. He added that the company is looking to raise extra capital through bond issuances worth at least $10 billion in 2017, up from $6 billion last year. The company is also preparing to float 6.89 billion new shares on the Shanghai stock exchange.

Lai estimates that around 60 new players will enter the asset management market in the near term to help detoxify China's banking sector, given that the central government lately gave its approval for every province to set up two asset managers. Two dozen such local players have so far been established, according to Lai, who said Huarong partnered with some to better facilitate its debt-for-equity swap initiative. Of the companies included under Huarong's debt-for-equity swap program, 40% were from the steel, manufacturing, coal and other resources industries.

"I think we do need more asset management companies," said Li Lihui, former president of the Bank of China. "After all, a nonperforming loan ratio of 1.74% is rather high. Aside from bad debt, banks can also sell their special-mention loans to asset managers," Li added, hinting that such managers could become a much needed platform for asset securitization -- an important channel to help wean corporations off bank lending.

Li highlighted shadow banking as one of the various risks facing the banking sector. According to Fitch Ratings, Chinese banks' assets grew faster than total social financing and yuan loans last year, which suggests credit was being shifted into nonloan financial products such as investments in asset-management plans, trusts and wealth management products. The outstanding balance of off-balance sheet wealth management products, according to Fitch, expanded more than 30% to exceed 26 trillion yuan last year, and at least 1.7 trillion yuan would be needed to cushion such unreported risks.

"I think it's necessary to make off-balance-sheet assets transparent," said Li, who was positive on a recent measure by the People's Bank of China to broaden its credit definition to include off-balance-sheet wealth management products. He also echoed PBOC Governor Zhou Xiaochuan, who said more unified regulatory standards among different financial watchdogs are needed to rein in off-balance-sheet risks.

Shadow banking practices are apparently more pervasive among smaller banks, which generally tend to offer higher-yield products. Sustained capital outflow fueled by strong expectations of yuan depreciation is complicating the risks facing these smaller players. "If capital outflow persists, domestic liquidity conditions are likely to tighten further, with small- and mid-sized banks -- which are most reliant on wholesale funding -- feeling the greatest impact," credit rating agency Moody's Investors Service said in a note on March 13. China's current foreign reserve, rebounding from a six-year low to $3.005 trillion in February, was still a cut below its peak of nearly $4 trillion in June 2014.

"China private credit is already larger than that of the [European Union]. If we consider that China's income per capita is less than one-third of the EU, this is even more astonishing, as a country's financial deepening tends to be aligned with its income per capita," Alicia Garcia-Herrero, Natixis' chief economist for Asia-Pacific, wrote in a note on March 10. "China's private credit has clearly gone well beyond what it should." Garcia-Herrero indicated that she is concerned the country's credit binge will persist given how the government downplayed its gravity during the just-concluded session of the National People's Congress.

China's new total social financing rose 38% on the year to 1.15 trillion yuan in February. By total outstanding, the stock grew 12.8% to 160.73 trillion yuan. "PBOC's monetary tightening bias is only partially delivered so far. In our view, the credit demand of various semi-sovereign entities, such as [local government financing vehicles] and [state-owned enterprises], are still inelastic to funding costs alone," said Bank of America Merrill Lynch in a note on March 9.

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