Chinese banks' asset quality risks rise as leverage grows rapidly

There are two scenarios to help frame the potential scale of risk and policy solutions.

The rapid pace of growth in Chinese leverage since 2008, which has contributed to economic imbalances and decreasing credit efficiency, poses significant asset-quality risks for Chinese banks, says Fitch Ratings in a Special Report:

Credit to GDP, as measured by Fitch-adjusted total social financing, has roughly doubled over the past eight years, while credit/GDP productivity rates since 2008 indicate substantial mal-investment and further increases in problem credit. Fitch believes the Chinese authorities will continue to allow credit to drive growth and prefer to restructure debt rather than allow mass defaults, regardless of the size of problem credit in the economy.

Bad debt may be socialised and other tools employed over time - including offsetting risks through capital market issuance - to help the resolution process. The migration of debt to the sovereign balance sheet is more probable than a wholesale upfront carve-out of assets.

Chinese banks' viability ratings (VRs), which range from 'bb' to 'b', reflect substantial but varying risks to capital and asset quality. Fitch's base-case assessment of banks' intrinsic profiles considers relative loss-absorption capacity rather than subjectively adjusting reported NPL data. This is due to uncertainties relating to on-and-off balance sheet asset quality. That said, Fitch's report addresses questions about the potential size of asset quality problems facing the financial system and the process by which they will likely be addressed, with reference to implications for bank ratings.

The report also outlines two alternative scenarios beyond the base case to help frame the potential scale of risk and policy solutions. The scenarios - based around core assumptions pertaining to inefficient credit, impairment rates and loss rates - assume a one-off resolution of the debt problem over the more probable multi-year process.

Our alternative scenario assumptions yielded NPL rates of 15%-21% for the financial system, resulting in a one-off capital shortfall of CNY7.4trn-13.6trn (USD1.1trn-2.2trn) - equivalent to around 11%-20% of GDP. The aggregate capital gap for Fitch-rated commercial banks is CNY4.9trn-8.7trn, but individual gaps relative to risk-weighted assets vary across the portfolio.

Fitch has long highlighted how Chinese banks' strengths and in particular weaknesses are factored into their ratings. The pace of credit growth, the rise of shadow banking and limited transparency around certain risks have especially weighed on VRs. The size of the problem will ultimately grow, which is why we conducted the alternative scenario analysis. The scenarios are not factored into banks' ratings, and Fitch does not expect the exercise to lead directly to rating actions. Nevertheless, how the debt resolution plays out will determine bank ratings. Bank VRs may be subject to change in the event of an unexpected significant one-off fall in credit exposure, depending on its size and purpose, how the fall was achieved, and a bank's sustainable financial profile after the event.

All Issuer Default Ratings for Fitch-rated Chinese banks are support-driven, and any rating changes are tied to perceived changes in the propensity or ability of the sovereign to support the banks. Support already appears to be playing out in less explicit ways, but larger issues affecting the banks - such as idiosyncratic risks and resolution - are less inclined to face public disclosure, even though systemic issues tend to require greater disclosure to address market concerns. If support for the financial system crystallises on the sovereign's balance sheet and sufficiently alters its financial profile to warrant rating action on the sovereign, it could result in similar rating action for bank IDRs.