Monetary tightening likely to weaken Chinese banks’ profitability

Rising inflation has pushed China’s central bank to tighten monetary policy by reining in credit growth and soaking up liquidity. While maintaining a stable outlook for China’s banking sector, Standard & Poor’s Ratings Services expects that these measures and other efforts to contain credit risks could noticeably weaken the profitability of China’s banking industry and lead to greater divergence in credit quality among major players and small lenders. Qiang Liao, director of financial institutions ratings, explains why.

China’s macroeconomic policy has reversed course from a massive fiscal stimulus package in 2008 to monetary tightening in late 2010. How is that affecting credit risk and loan quality for banks in China?
The fallout of China’s macroeconomic policy U-turn is becoming increasingly visible. Since late 2010, rising inflationary pressures have prompted Chinese policymakers to progressively tighten policy to prevent a hard landing. Policymakers have cut the credit growth target, substantially increased the deposit reserve ratio and hiked interest rates (see chart 1). They have also implemented harsh administrative restrictions to cool down the property market, among other things. Such a response is a complete turnaround from the massive fiscal stimulus package and lending spree that took place in late 2008-2009.

In our view, strong loan growth during the past two years and loose underwriting standards for projects related to the government’s stimulus package have weakened the banking industry’s average loan quality, while policy easing masked the damage. Considering the cumulative effect of China’s continuing tightening measures, particularly reduced new credit availability and higher rates, we expect the sector’s cumulative nonperforming loans (NPLs) to reach 5%-10% of total loans during the next three years under a stress scenario in which lending rates rise significantly and the government’s support for project loans turns out to be negligible.

Which sectors are prone to a significant slowdown in loan growth?
It could be particularly painful for borrowers in segments facing a harsh policy-induced liquidity squeeze, including property development and local government project finance. A sharp slowdown could crowd out many highly leveraged borrowers and push up corporate delinquency rates.

Real estate-related corporate lending will probably generate a fair share of NPLs, given the sector’s high leverage and dependence on banks’ credit to fund working capital. Real estate developers have seen some of their credit lines cut and face higher funding costs, due to the central government’s determination to cool down the housing market. In addition, the government has shut out funding channels in trust funding and wealth management products. The impact is particularly significant for smaller and highly leveraged property developers.

The forced cool-down of the property market could hamper the debt-servicing capacity of local government financing vehicles. Many of them rely heavily on land sales and fiscal transfers from local governments to cover their repayments. Local government financing vehicles are also under increasing credit rationing because of the regulator’s hawkish view on the potential risks of underlying projects.

What would have a bigger impact on Chinese banks’ credit quality: a liquidity squeeze or rising interest rates?
Rising interest rates could have a more potent and far-reaching impact on the credit quality of the whole loan book than a liquidity squeeze. Policymakers have increased the one-year benchmark interest rate by 100bp during the past six months. Our sensitivity analysis shows that a 100bp hike in the average cost of borrowing, other things being equal, will lead to more than 180bp increase in the ratio of implied NPLs. A hike of an additional 150bp, coupled with a 10% squeeze in Ebitda margins, would further push up the ratio by more than 320bp.

How are various banks coping with policy tightening? Is this going to set the small banks much further apart from their bigger counterparts?
We expect potential credit losses to remain under control despite the negative effects of policy tightening. In our view, the banking sector’s low NPL base and good earnings capacity, along with the preemptive regulatory stance and a robust economy, give Chinese banks adequate room to absorb a possible spike in credit losses.

However, the effect of policy tightening on banks will be uneven across the sector. The major banks, especially the top-tier banks that Standard & Poor’s rates, should be able to manage the effects of policy tightening because of their stronger loss buffers and credit risk controls. But smaller institutions could struggle due to their asset concentration and less-favourable liquidity profiles. In addition, the earning capacity of banks varies significantly (see chart 2). Rural and policy banks are the least profitable, while many of them have proportionally heavier exposures to local government financing vehicles or specific industries. Rising credit costs could prove severe for banks with significant exposure to local government financing vehicles that fiscally weak local governments own.

Nevertheless, the possibility of risks spreading appears low because interbank funding plays a small role in Chinese banks’ funding structure. Higher deposit reserve ratios could make banks’ asset-liability management more difficult, particularly for small and foreign banks. However, most banks use customer deposits to fund their operations because banks in China have to meet the 75% loan-to-customer deposit ceiling. This funding feature essentially eliminates the risk of a system-wide bank run. It also paves the way for banks to use retained profits to revamp themselves over time or to negotiate an orderly consolidation.

Is near-term profitability for banks likely to suffer from tightened credit quotas?
The push for stronger credit buffers comes at the cost of profitability. We expect net interest margins to improve as interest rates rise and loan pricing strengthens. Nevertheless, incremental credit provisioning cost, as a percentage of gross loans, is likely to exceed the increase in net interest margins. This would lower the banking sector’s profitability during the next two to three years.

Net interest margins could continue to increase in 2011 despite an unfavourable shift in banks’ asset mix. The central bank has raised the deposit reserve ratio 12 times in a row since early 2010, to as high as 21.5% for large banks. The cumulative effect on margins is noticeable even though the impact of each hike was marginal. The tightened credit quota could have an even larger impact, because the tightening will lead to a greater share of low-yield assets on banks’ balance sheets. Nonetheless, loan pricing has increased since early 2010 and we see no signs of it retreating.

Could an increase in margin and non-interest income offset rising credit costs?
Banks’ non-interest income is likely to remain solid. Fee income has grown strongly during the past decade, having benefited substantially from ever-increasing banking activities in the corporate sector and demand for asset diversification from an increasingly wealthier household sector. Banks are likely to incur revaluation losses from their holdings of debt securities as interest rates rise. However, the effect on profitability is likely to be insignificant because the trading book is usually less than 10% of the total securities portfolio.

But rising credit costs could wipe out all the benefits of the increase in margins and non-interest income. We expect provisioning costs to rise due to tightened provisioning norms (the amount banks must set aside for loan losses) or credit deterioration. The provisioning requirement of 250bp for gross loans implies significantly less profitability for new lending business and the expected credit deterioration could mean even more provisioning.