China’s Property Market: The Risks for Banks
By Hayden Briscoe (pictured) and Hua Cheng of AllianceBernstein (NYSE:AB)
Despite worries about a collapse in China’s property market, we think the financial system will navigate the coming credit cycle if banks can buy time to resolve loan problems—and receive government support if needed.
Below is our 13F roundup for some high profile hedge funds for the three months to the end of March 2021 (Q1). Q1 2021 hedge fund letters, conferences and more The statements only include equity positions as 13Fs do not include cash and debt holdings. They also only include US equity holdings. Funds may hold Read More
As we’ve noted, fundamentals in the property market remain strong. But what about the risks from the standpoint of banking and finance? Among China’s financial institutions, banks lend the most to the property sector: by 2013, they had provided RMB9 trillion (US$1.46 trillion), compared with RMB5.4 trillion from the shadow-banking sector. For property developers, though, banks aren’t the main source of liquidity. Nearly 70% of their liquidity comes from nonbank sources, 39% from their own cash and 28% from customer deposits, so they don’t rely too much on bank funding.
We think that this is a crucial point about the Chinese property market that many investors might miss: it’s not really overleveraged, even though it might face some supply/demand headwinds.
From the banks’ perspective, the risks from their exposure to the property sector alone seem manageable. Loans to the property and construction sector as a percentage of total loans outstanding have been capped at between 11% and 12% for the last six years, and residential mortgages have been capped at around 14%. Given that there hasn’t been a significant upturn in nonperforming loans (NPLs) for properties despite two downturns in prices (Display 1), banks seem unlikely to reduce their exposure to the property sector.
While the credit exposure to property alone doesn’t appear alarming, exposure to the property and related sectors—through local government financing vehicles (LGFVs) and shadow banks, for example—could be substantial.
If a property market crash were to occur, we think that banks would prove to be resilient if allowed to manage their NPLs over a number of years. Their NPL coverage ratio (280% at the end of 2013) is high, and they’re very profitable. This profitability is helped by the fact that interest rates haven’t been fully liberalized, so banks can keep their deposit rates artificially low. Due to this virtually guaranteed margin, which accounts for 70% of banks’ revenues, their pre-provision operating profit margin (on-balance-sheet resources used to absorb credit losses other than loan loss provisions) is 60%—one of the highest in the world.
Our research suggests that banks’ NPL ratios could increase by 8% or 9% in a single year without exacting a toll on their equity bases. If banks were allowed to resolve NPLs over a number of years, they could possibly absorb even more.
Outside the banking system, the main risk is in shadow banking. This sector is more exposed to the lower-quality property and LGFV credits than traditional banks are, in terms of incremental funding. If tighter regulation or credit defaults cause dramatic shrinkage of the shadow-banking sector, it could trigger a liquidity problem that would lead to more defaults, including by property companies and LGFVs. Since much of the shadow-banking sector is directly or indirectly financed by banks, risk in the shadow-banking system could spread to traditional banks.
This risk should still be manageable, in our view. If shadow-banking exposures were consolidated into banks’ balance sheets, we would expect banks’ loan-to-deposit ratios to increase from the reported 69% to 78% (Display 2). One reason for the shadow banks’ rapid growth has been that traditional banks use them as a form of regulatory arbitrage to work around the 75% cap on their loan-to-deposit ratios—one of the lowest caps in the world.
The government (rightly, in our view) is paring back the shadow-banking sector, and a quick solution to the instability this poses might be to raise or remove the cap so banks could provide liquidity directly where needed, taking some of the heat out of the shadow system. This is only a suggestion, but it’s yet another illustration that policy risk, rather than fundamentals, is the real issue with China’s property and banking sectors.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Hayden Briscoe is Director of Asia-Pacific Fixed Income and Hua Cheng is a Research Analyst for Corporate Credit, both at AllianceBernstein.
This article previously appeared in the Financial Times.