Chinese banks' creditworthiness to deteriorate over the next 12-18 months: Moody's

Five factors contribute to the negative outlook.

According to Moody's analyst Frank Wu, "The operating environment is deteriorating and our baseline scenario now assumes a further moderation in GDP growth to 6.3% in 2016 from 6.8% in 2015. Overall system leverage -- as measured by total credit to nominal GDP -- will likely reach 209% in 2015 and rise further in 2016, from 193% at end-2014, and adding to repayment risks."

Moody's analysis is based on five drivers: Operating Environment -- deteriorating; Asset Quality and Capital -- deteriorating / stable; Funding and Liquidity -- stable; Profitability and Efficiency -- deteriorating; and Systemic Support -- stable. 

Problem loan and delinquency formation rates are increasing, reflecting the effect of slower economic growth. There is also some evidence that problem loan recognition has become less stringent as an increasing number of loans overdue for more than 90 days are not classified as problems loans.

Moody's believes that the uptrend in problem loans and delinquencies will continue to be most evident in sectors experiencing overcapacity and/or cyclical downturns. These sectors include wholesale and retail, and manufacturing. 

Capitalization levels will remain broadly stable with the larger banks better positioned because of their relatively subdued credit growth and lower credit costs. By contrast, small- and medium-sized banks, with their faster asset growth and weaker asset profiles, will face greater capital pressure.

Funding and Liquidity will remain ample and a strength for Chinese banks, helped by the authorities' policy of monetary easing, despite the increased risk of further capital outflows as a result of changing exchange-rate conditions. Chinese banks remain largely deposit funded and hold adequate liquid assets to cover their market funding.

Profitability is set to deteriorate as narrowing net interest margins -- the result of recent policy rate cuts and interest rate liberalization -- and rising credit costs will erode banks' net earnings.

On the other hand, government support remains high. China is unlikely to adopt an operational resolution regime over the outlook horizon.

Moody's expects support to remain strong for major banks, reflecting the policy imperative of maintaining public confidence and systemic stability. However, support for smaller banks will become more selective following the implementation of the deposit insurance scheme.