Capital & Strategic Issues,China,Markets Exchanges,rating,riskmanagement,Transaction Banking,

Capital & Strategic Issues,China,Markets Exchanges,rating,riskmanagement,Transaction Banking,

Fitch Ratings expects upcoming earnings announcements for Chinese banks to provide further evidence of rising system leverage and profitability pressures from narrowing interest margins and weakening asset quality. We view continued rapid credit growth, and the increasing complexity and interconnectedness of the financial system, as a rising and significant medium-term threat to China's financial stability.

Chinese banks are due to release 2016 earnings reports this month. The People's Bank of China's (PBOC) quarterly report has already pointed to a slowdown in the commercial banking sector's net profit growth last year, as well as a lower return on assets and equity. Bank earnings reports are likely to confirm these negative trends. They are also likely to show that reported NPL ratios remained relatively stable, but banks are heavily managing NPLs via debt resolution initiatives.

Fitch expects net interest margins to remain under pressure in 2017. The average loan borrowing rate dropped 20bp in December from a year earlier, as a rising proportion of new loans were priced below the PBOC's benchmark rate during 2016 - often an indicator that more lending is going to SOEs at favourable rates. Meanwhile, the rise in reverse repo rates is pushing up funding costs, especially for rapidly-growing mid-tier banks that are more reliant on central bank facilities - an indicator of tight funding in this sector.

The official commercial banking sector NPL ratio was just 1.74% at the end of 2016, and "special-mention" loans fell for the first time since 2014. However, Fitch does not believe this apparent improvement reflects underlying credit conditions, as on-balance sheet asset quality indicators have benefitted from recently-established debt-for-equity swaps and the offloading of distressed debt to asset management companies - which continue to grow rapidly. Some of these transactions might not be commercially driven, might not involve a true transfer of risk or may simply shift that risk to other parts of the financial system, without any write-down. Banks also have an incentive to delay recognition of asset impairment to keep provision coverage ratios above the 150% regulatory minimum.

Pressure on asset quality in large part reflects a build-up in system leverage, which Fitch expects to continue in 2017. Bank credit also continues to become more complex and the financial system increasingly interconnected, making it harder to assess underlying risks. Bank assets grew by 15.8% yoy in 2016, which was faster than total social financing (TSF) and renminbi loans, as credit continued to shift into non-loan financial products, such as investments in asset management plans, trusts and wealth management products (WMPs). This was despite regulatory measures introduced over the last year to curb the use of these products, which carry lower risk-weight relative to loans and allow banks to bypass lending restrictions.

The PBOC will broaden its credit definition in 1Q17 to include off-balance-sheet WMPs, having acknowledged that their underlying use of funds is not materially different from on-balance-sheet credit and that their growth runs counter to deleveraging efforts. Fitch has for some time highlighted risks associated with the increased use of WMPs, which we believe makes lenders vulnerable to asset-quality shocks and strains on funding and liquidity. The outstanding balance of off-balance-sheet WMPs grew by more than 30% yoy to over CNY26trn at end-2016.

Entrusted lending is also adding to financial-sector risks. There are indications that some SOEs are using their easier access to bank credit to on-lend to riskier borrowers, including those operating in sectors facing overcapacity. Excessive entrusted lending has potential to undermine an SOE's financial profile, and banks cannot easily track the ultimate use of loan proceeds. Entrusted loans accounted for 8.5% of outstanding TSF in January, up from 8.0% a year earlier and around 3.0% in the early 2000s.

Re-disseminated by The Asian Banker