Is China's banking sector prepared for a meltdown?

Rising risks plague China banks amidst slowing economy.

When Yu’eBao, China’s largest online money market platform, faced increasing liquidity risks, it was able to leverage its large database and increase its assets under management to its second highest level since the fund’s launch. Tightening liquidity conditions have been pushing China’s top executives to come up with increasingly creative solutions to avert China’s growing financial instability, paving the way for the rise of the shadow banking sector.

The mainland’s economic slowdown in 2016 revealed a financial system in dire need of fundamental reforms as well as urgent re-evaluation due to the country’s growing global influence. Over the last few years, China’s economy continued to balloon at breakneck speed. The world watched in awe as the country rose to superpower status, attracting top talent from all over the world and lifting millions of its citizens from poverty. For a while, analysts believed that last year’s slowdown was just temporary, forecasting that 2017 would see a much anticipated rebound. However, recent analyses and data prove that China’s financial system is much more complex than most would care to assume.

Mainland banks, especially the smaller ones, are presently scampering to survive the loss in profitability and the increasing risks associated with corporate restructuring and a slowing economy. Across the country, companies have consistently defaulted on their loans and are expected to continue to do so, thereby resulting in the steady rise of non-performing loans (NPLs). Asset quality has also exhibited further decline in light of banks’ significant exposure to wealth management products (WMPs).

“The banks' operating environment will become more challenging in the coming 12-18 months, reflecting slower economic growth, an increase in corporate sector restructuring, and rising concerns over elevated asset prices in some areas,” according to Moody’s Investors Service.

China’s economy remains under structural downside pressure, and the government’s efforts to cut high levels of debt will definitely take a while to bear fruit. The mainland’s NPL ratio in the finance industry has been rising since 2012, and with the current slowdown in economic growth, both loan demand and quality might weaken. The Bank of China (BOC) has the most assets overseas and is extremely exposed to the interest rate changes in the United States.

According to Patricia Cheng, analyst, CLSA, how BOC and the other banks react to the changing competitive landscape will affect net interest income growth. The bank’s efforts in pushing for more fee business will also affect the results. Cheng says that the need to strengthen provision is a burden on the bottom line.

Afraid of one’s shadow

China’s shadow banking assets have doubled in size over the last five years, according to Yulia Wan, a assistant vice president and analyst at Moody's. The Chinese government imposed regulatory measures on core shadow banking activity in 2014, but 2016 saw a modest growth driven by trust loans and robust entrusted loans. Moody’s says that the uptick in core shadow banking is indicative of tighter financing conditions elsewhere, considering that due to more restrictions, there has been less access to the domestic bond market.

The People’s Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC) may be able to curb the rapid growth of WMPs through the inclusion of banks’ off-balance sheet WMP business into the PBOC’s Macro Prudential Assessment (MPA) framework, Wan says.

“The inclusion of WMPs into the loan-to-deposit ratio (LDR) would immediately bring the average ‘adjusted’ loan to deposit ratio well above the regulatory limit of 75% to around 85%. Therefore, WMPs lead to higher credit and contagion risk through over lending beyond regulatory limit to overcapacity sector, of which the loans are transferred into investment book and circulate around the financial sector,” says Alicia Garcia Herrero, chief economist, Asia Pacific, Natixis.

Furthermore, there are also indications that shadow banks are increasingly exposed to the property sector. Q316 saw a net increase of trust assets allocated to the real estate sector in absolute terms, more than the double the aggregate increase in the first two quarters.

In fact, a Moody’s report shows that mortgage loans have continued to contribute a rising share of headline bank lending to the non-financial sector in Q416. Meanwhile, corporate lending is growing at a more modest pace due to the decline in short-term loans. The 2017 outlook is quite bleak for mortgage lending growth due to the impact of tightening measures on the property market.

Cheng notes that the NPL ratio was 1.74% at the end of 2016, ending a worsening trend since 3Q12. Herrero adds that asset quality seems to have improved, however the reason is not a rebound in corporate repayment ability, but the massive debt-to-equity swaps. Herrero notes that RMB200 billion worth of debt has been swapped into equity in Q416, equivalent to 5.8% of special mention loans.

“Divergent path among Chinese banks are important and Joined-Stock Commercial Banks (JSCB) remain as a key concern. The NPL ratio of JSCBs continues to increase, with falling NPL provision coverage ratio and capital adequacy ratio, while smaller banks have shown improvement. Together with the increase in SHIBOR and their high reliance on overnight funding, the liquidity situation could only worsen,” says Herrero.

Liquidity crunch

Tighter liquidity conditions could be up ahead, as implied by several market indicators such as interbank and Certificate of Deposit (CD) rates as well as the spread between WMP yields and one year deposit rates, says Wan. Despite this trend, shadow bank borrowers are expected to be relatively inelastic to higher interest rates due to continuing financing needs in sectors such as property and overcapacity industries.

In the event of tightening liquidity conditions across the system, small and medium-sized banks have the biggest exposure to liquidity shocks. This is due to their high and growing reliance on wholesale funding which includes aggressive issuance of interbank CDs. Medium and small banks are known to be closely intertwined with China’s highly active shadow banking sector. These banks continue to invest in shadow banking products such as WMPs and the trust and asset management schemes of non-bank financial institutions.

“Looking ahead, we expect a combination of tighter liquidity conditions and stricter regulatory scrutiny on banks’ off-balance-sheet activities will curb banks’ incentives to engage in regulatory arbitrage and gradually dampen the previously fast-growing components of shadow banking such as WMPs,” adds Wan.

Chua Han Teng, senior analyst, Asia Country Risk and Financial Markets, BMI Research, says that jointly-owned Chinese banks are especially vulnerable to liquidity and asset shocks due to their significant exposure to WMPs. Chua adds that the present sell-off in the bond market will possibly result in a liquidity crunch together with investment losses, considering that WMP funds are largely invested in bonds and money market instruments.

However, Wan believes that broad liquidity conditions will remain satisfactory as a result of slowing loan growth, the central bank’s overall supportive monetary policy, and the system’s large deposit base. She adds that there is limited room for further policy easing against the backdrop of deleveraging which contains risks from capital outflows, increasing property prices, and the incremental rise of the inflation rate. Wan adds that this would eventually bear on the banks’ liquidity management, particularly for medium and small banks which are heavily involved in wholesale funding.

“We do not expect a rebound of the Chinese banking sector in 2017 neither do we expect any big crisis. The operating environment for banks would remain challenging, especially with weak macro environment and more regulatory requirements. The scale and speed of debt-to-equity swaps and local government debt swaps will be key determinants to existing loans. Going forward, we expect deterioration in asset quality underneath the headline numbers to continue due to slower GDP growth and the still weak global demand,” says Herrero.