Matthews Asia: Beginning Of The End – To China Bank Woes

The rise and development of China’s financial system has been different from most other emerging economies. One unique aspect has been the rapid accumulation of bank deposits over the last 10 years. Another more controversial aspect has been the corresponding on-lending of these deposits to a wide variety of borrowers—some less creditworthy than others. Some people suggest that the increase in bank loans has been excessive.

Why have bank loans risen so quickly? After the Global Financial Crisis, Chinese banks were asked to take on what was largely state lending that should have been done by the government directly. These loans have been sitting on bank balance sheets ever since. In 2015, the government recognized the need to take many of these questionable loans off bank balance sheets and convert loans into local government bonds—effectively improving the mix of bank assets and transferring the loans to the government, where the risk should have been all along.

What also makes the system unique is the conservative loan-to-deposit ratio, which is a result of a conservative reserve requirement ratio (RRR) set by China’s central bank. The 17.5% RRR for the large banks ensures that banks are not able to lend this amount into the system, a cash pile that represents over 30% of GDP uncirculated. This is a conservative stance to say the least. Despite such a move, the banking system in China was asked during the period of rapid industrialization to take on some of the funding requirements of the government directly.

With these aspects in mind, I have summarized a few of our key observations over the past 12 months.

1. The government itself appears to have no problem servicing this debt in aggregate. Fiscal reform is in the pipeline and will address the allocation of funding between local and central governments, which should make it easier for local governments to service this debt once it’s been cleared from banks.
2. In addition, the first half results of listed commercial banks showed a deliberate recognition of debt (outside of that previously mentioned) that was lent into sectors that are finding it hard to repay. This is ongoing. The results showed that deliberate clean-up is taking place, but it is hard to quantify where it ends at this stage. The problem is now being recognized.
3. Major commercial banks have been writing off nonperforming loans more aggressively. The conclusion here is that profit and loss statements are being hit hard with credit costs, hence flat earnings growth. But if we are nearing the end of the clean-up, then most banks have ample reserves. If it gets worse, then capital may become an issue, although not immediately and not unless the pace of write-offs becomes more aggressive.
4. The other operating trends in Chinese banks are showing good signs. Despite a falling interest rate environment, net interest margins (NIMs) are only declining somewhat. Credit penetration into the small- and medium-sized enterprises and retail sector is helping this stability. The NIM structural change is because the banks are now permitted to price deposits and loans as they see fit, a huge change. They are also not being forced to lend into government-directed lending programs, which was an error of the financial crisis.
5. Another issue has been the rapid build-up of credit in the system since the financial crisis that began in 2007. To put this in perspective, between 2007 and 2015 private credit to GDP was estimated to have risen from 120% to 200%. The macroeconomic argument that never goes away is that the credit creation in the system has been too aggressive and capital has been misallocated. I agree with this point, and the bank results are proving this. I do, however, disagree with the extent to which people argue this point. I don’t think the misallocation was anything close to catastrophic, and the government finances appear to support that. Most of this excess was government-related. And the government debt load, including for local governments, is very low by global standards.

Ultimately, it appears that China banks are undergoing a state of clean-up. The world, in my opinion, is far too bearish on the resultant outcome. But profit growth could yet be muted for some time. As always, it’s the magnitude of the issue that counts, not the over-investment argument itself.

Andrew Mattock, CFA
Portfolio Manager
Matthews Asia

Beginning Of The End – To China Bank Woes by Andrew Mattock, CFA – Matthews Asia