The risks in the Chinese banking system are mounting and are greater than headline figures suggest according to the Natixis China Banking Monitor, the first in a series of annual reports on the health of China’s banks, launched to the press at the French Chamber’s new events space on 24 November.
The Natixis China Banking Monitor offers a thorough bottom-up analysis of the health of China’s banking sector broken down into four main issues: asset quality, liquidity, profitability and solvency. It has a special focus on the evolving nature of debt-to-equity swaps and how they are changing the burden sharing of the banking sector clean up.
Chinese banks increasingly resembling investment banks
A major shift in banks’ balance sheets is underway, with assets moving from the loan book to the investment book. This can be partly explained by a general slowdown in the growth of loan demand, particularly from corporate borrowers, while households are stepping up their leverage, albeit from low levels. More important, however, is the rise of three powerful trends:
- The ongoing swapping of local government loans into bonds, which added 2.5 trillion renminbi to banks’ investment books in 2015 and over 6 trillion in 2016;
- The increasing tendency for banks to purchase investment receivables in the interbank market in the form of wealth management products in order to boost their interest income; and
- The wave of debt-to-equity swaps which started last February and has recently accelerated.
As the balance sheets of Chinese banks, particularly joint-stock commercial banks and city commercial banks, shift further towards the investment book, they look increasingly risky given the nature of the underlying.
Asset quality worse than it appears, and deteriorating
Chinese banks’ assets are deteriorating faster than indicated by non-performing loan (NPL) ratios, with “special mention” loans – those that may have potential difficulties in repaying but are not yet classified as non-performing by the banks – more than twice as large as total NPLs.
Household repayment ability remains strong, despite rapid growth in debt levels over the past five years. The weakness is among corporate borrowers, whose deteriorating earnings are likely to further add to the pressure on banks’ NPL ratios. This is particularly true of the manufacturing and trade-related sectors, which account for the largest share of both loans and NPLs of Chinese banks.
Overall, it is estimated that a one-unit decrease in corporates’ EBITDA to interest expense ratio will increase banks’ NPL ratios by 0.46 percentage points. Likewise, a one-percentage-point decrease in GDP growth would increase the banking sector’s NPL ratio by 0.43 percentage points.
Abundant liquidity but signs of stress in the interbank market
Loose monetary policy since the beginning of 2016, notably through open market operations by the People’s Bank of China, has resulted in an improving liquidity ratio among Chinese banks.
However, Chinese banks are finding it increasingly difficult to rely on cheap financing as depositors opt for higher-yielding options in the shadow banking market. This has put pressure on banks to tap the bond market for their asset liability management. In the interbank market, meanwhile, assets are increasingly short-term, while non-conventional interbank assets – such as securitized receivables from wealth management products – are now frequently used as underlyings, nearly as much as conventional assets. In addition, an increasing reliance on very short-term interbank funding is another worrisome trend in terms of maturity mismatch implications.
Shrinking profits causing banks to slash costs and wade further into shadow banking
Chinese banks’ net interest margins are being increasingly squeezed, dropping to 2.3% in the first half of 2016 from 2.7% in 2014. This is a result of interest rate liberalization, the lax monetary policy environment and the swap of local government loans into lower-yielding bonds.
In response, banks have aggressively cut costs, reducing their cost-to-income ratio to 27% in the first half of 2016 from 32% in 2014. They have also taken steps to increase fee income, which rose to 26% of total revenue in the second quarter of 2016 from 21% in 2014. This rapid growth in fee income is built on banks’ rising issuance of wealth management products in the shadow banking sector as well as their increasing bond underwriting activity.
The structural slowdown in the Chinese economy and continued lax monetary policy will ensure that interest income remains constrained. We estimate Chinese banks’ revenue to fall by 3.1% for every one-percentage-point drop in GDP, and by 0.3% for the same-sized drop in the lending rate.
Headline solvency masks growing risk of deterioration
Chinese banks’ solvency as measured by capital adequacy ratio and Tier-1 capital adequacy ratio is, for now, above regulatory limits. However, due to their weak profitability, Chinese banks have created no organic capital in 2016, which points to the need for additional capital raising in the future.
Furthermore, the rapid growth of off-balance-sheet assets on the back of a surge in issuance of wealth management products would make capital much more scarce – and certainly below the regulatory limit – if such off-balance-sheet operations were to be consolidated. We estimate that leverage, measured by assets to equity, would rise by over 15% if wealth management products and their underlying assets were to be brought on balance sheet.
Among conventional loans, rising NPLs have caused the NPL coverage ratio – a long-standing fortress for China’s regulator – to deteriorate very rapidly from almost 300% in 2013 to 176% in the second quarter of 2016, close to the regulatory level of 150%. However, if the coverage ratio were to include special-mention loans, it would drop as low as 53%.
Beyond these general trends, bank behaviour, as well as soundness, appear to differ greatly across groups of banks. Joint-stock commercial banks and city commercial banks top the ranking in terms of risky behaviour, which is already reflected in their lower solvency ratios and even in lower profitability, with increasing signs of liquidity stress.
All in all, Chinese banks’ soundness has taken a beating from the twin punches of slowing growth and rapidly-rising corporate leverage. It is not only asset quality that is deteriorating. Profitability and solvency are too. While ample liquidity stemming from very loose monetary policy is helping to dilute some of these concerns, signs of liquidity strains are surfacing within the industry, particularly for joint-stock commercial banks.
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Natixis Economic Research contacts
Alicia García Herrero
Chief Economist, Asia Pacific, Natixis
Senior Economist, Greater China