As bad loans mount, Chinese banks brace for profit drop in 2016

Poor economy, inflexible rules to blame—credit ratings may also bear brunt.

The economic headwinds faced by Chinese lenders in 2015 are expected to continue in 2016 as bad debts brought about by a souring economy, coupled with stiff state regulations, are seen to take their toll on overall profitability, according to three top global credit ratings agencies.

“Rising credit losses and compressing interest margins are likely to substantially hit Chinese banks' profitability in 2016,” predicts Qiang Liao, credit analyst at Standard & Poor’s.

2015 data shows China’s banks endured a rough period last year. According to Grace Wu, senior director, Financial Institutions at Fitch Ratings, system-wide net income for China’s banking sector grew by a measly 2.4% in 2015, while net interest margins dropped by around 12 basis points (bps) to 2.53%.

With this, credit losses are expected to keep surging across the board this year.

Wholesale credit losses seen
“Credit distress has been spreading from a few segments that private companies dominate—such as wholesale and retail trade, export-oriented light industry, shipbuilding, and coal mining—to broad-based manufacturing industries where large firms are common,” Liao says. “We expect the sector's non-performing loan (NPL) ratio to reach 3% by the year end, up from an estimated 2.2% at end-2015 and 1.7% a year earlier,” he adds.

Thus, for 2016, credit losses—measured by the average ratio of credit provisions to average loans—are expected to leap to 150 -160 bps from only 110 -120 bps in 2015, and a mere 80 - 90 bps in 2014, Liao says.

The expected rise in credit losses comes amid a sagging economic backdrop. Liao cites China’s slipping gross domestic product (GDP) growth rate as a sign of negative things to come. “Real GDP growth moderated to 6.9% in 2015, the lowest in the past 25 years. Standard & Poor's expects it to dip further to 6.3% in 2016 and 6.1% in 2017,” Liao says. Similar declines are expected for the country’s consumer and producer price indices.

Poor policies in place?
The Chinese government has responded to these economic pressures with a series of interventions in recent years, which have so far produced mixed results in the face of numerous challenges.

“The gradual slowdown in economic growth reflects significant fiscal and monetary support, a view that could perpetuate or exacerbate imbalances in the economy, in particular high leverage in the corporate sector, thereby increasing the likelihood that contingent liabilities will crystallise on the government's balance sheet,” notes Sean Hung, Assistant Vice President-Analyst at Moody’s Investor Service.

“China's institutions are being tested by the challenges stemming from the multiple policy objectives of maintaining economic growth, implementing reform, and mitigating market volatility. Fiscal and monetary policy support to achieve the government's economic growth target of 6.5% may slow the implementation of planned reforms, including those related to state-owned enterprises,” Hung adds.

Indeed, excessive government policy—dubbed by Liao as “supply-side”—is now being blamed for additional risks threatening banks as far as NPLs are concerned.

“On top of rising credit losses and compressing interest margins, Chinese banks are facing elevated risks from changes in central government policies. We attribute a possible surge in NPLs this year mainly to elevated government policy risks on top of a further economic slowdown,” Liao says, referring to the government’s five-prong economic agenda focussing on trimming excessive industrial capacity, reducing property inventory, debt deleveraging, cost reduction for companies, and building capacity in desired products and services.

“We believe an accelerated process of removing capacity in targeted industries and the associated waning of implicit government support for distressed companies will lead to a significant rise in credit losses for banks.” Liao says.

Further, the policy also “highlights a material increase in the government's tolerance for corporate credit defaults and China's policy shift toward a trial-and-error approach to economic policymaking and execution.”

NPL provisioning rate hit
Meanwhile, the government’s minimum provisioning rate for NPLs has also come under fire as too strict, serving to hurt, and not benefit, banks by impacting their profitability.

According to Wu, early indicators suggest Chinese banks are bound to suffer from “continued subdued earnings growth amid margin compression and asset deterioration” this year following a lacklustre earnings season in 2015.

“Fitch expects these trends to continue in 2016, underscoring our negative sector outlook. Chinese bank profits are likely to decline this year unless authorities relax the minimum NPL provisioning requirement of 150%,” Wu says.

For instance, the provision coverage ratio at state and joint-stock banks had slipped to an average of 172% and 181%, respectively by end-2015. “The need to maintain this ratio above 150% will restrain earnings growth in 2016 - unless this ratio is relaxed,” Wu warns. Banks may also be discouraged from accurately disclosing their NPLs as a result of the strict rule.

The NPL provisioning requirement, originally a “back-up” cache to protect banks from future losses, is now proving to be a curse rather than a blessing as bad loans continue to pile up amid China’s sustained economic downturn.

“A combination of interest-rate cuts and worsening asset quality will continue to have an impact on profitability in 2016. The quarterly run-rate in reported NPLs decelerated in the fourth quarter of 2015, while we believe this is due partly to more substantial NPL write-offs/disposals towards the end of the year as banks struggled to meet their provisioning requirements,” Wu says.

Credit ratings threatened
In the meantime, the banking industry’s financial woes may now have the added detriment of putting a strain on the banks’ respective credit ratings.

“Major Chinese banks are continuing to strengthen their balance sheets, which may place them on a stronger footing to contend with challenges ahead. However, we believe the continued negative trend in economic risk for the sector could further weigh on the banks' credit profiles,” Liao says.

A credit divergence, according to Liao, is beginning to manifest with the country’s downward economic trend coupled with varying levels of government support for individual banks. Thus, an “overall negative outlook for the sector” is projected by Standard & Poor’s.

“The ingredients for a credit downturn in China's banking sector are coming together,” Liao warns.

Moody’s for its part, has tagged China’s banking system macro profile as “Moderate.”

“The Macro Profile for China considers the country's rapid credit induced growth in recent years, which weighs negatively on the banking system's credit conditions, but a large and stable deposit base and accommodative monetary policy support the banks' funding profiles,” Hung explains. 

“Despite the large banks’ dominant market position, competition has intensified as players adjust to financial reform and innovation, such as interest rate liberalisation and the proliferation of the shadow banking sector,” he adds.

Nevertheless, China’s Economic Strength remains “Very High” and its Susceptibility to Event Risk, “Low,” according to Moody’s.

“Chinese banks operate in an economy that has achieved strong and stable macroeconomic performance over the last two decades. Although constrained by a relatively weak institutional framework, China’s robust fiscal position and $3.2 trillion in foreign exchange reserves at end-February 2016 provide some buffers against economic and financial shocks,” Hung says.

For the 2015-2019 period, China’s GDP growth will likely average at 6.3%, “which,while slower when compared to the previous five years, will remain markedly faster than most of China's rating peers,” notes Hung.