Hong Kong Monetary Authority

HK banks' mainland exposure may not be as risky as feared

PUBLISHED : Tuesday, 25 October, 2011, 12:00am
UPDATED : Tuesday, 25 October, 2011, 12:00am

Ratings agency Fitch warned yesterday that it could downgrade the credit standing of Hong Kong's banks because of their fast-growing exposure to the mainland.

Fitch is not the only one that's nervous. In April, the Hong Kong Monetary Authority called the city's banks sharply to heel over the speed at which they were extending new loans to mainland companies.

At the time, the HKMA noted that loans to mainland corporations ballooned by HK$440 billion in 2010, a 47 per cent rise, and warned that 'the same rapid pace of credit growth is unsustainable' in 2011.

In an attempt to check the pace of lending, the HKMA ordered Hong Kong banks to reassess their business plans and funding strategies for the remainder of the year and submit them for review.

Since then, Fitch says that loan growth to mainland companies has accelerated. In a report published yesterday, the ratings agency estimated that loans to mainland corporations grew by HK$412 billion over the first half of 2011, while exposure to mainland banks rose by HK$582 billion.

According to Fitch, at the end of June exposure to mainland banks and corporations accounted for 24 per cent of the Hong Kong banking system's total assets, more than double the share at the end of 2009 (see the first chart).

'Expanding to mainland China comes with new and unique risks,' Fitch warned yesterday.

By pushing so rapidly into an unfamiliar market, Hong Kong's banks face a range of underwriting, operational and regulatory risks together with possible liquidity difficulties which could 'trigger negative rating actions'.

Running the greatest risk of a downgrade are the Hong Kong subsidiaries of mainland parents such as Citic International Bank, which at the end of June had exposure to the mainland equal to 55 per cent of its total assets (see the second chart), and ICBC Asia.

Fitch noted 'signs of the increasing influence of Chinese bank parents on Hong Kong subsidiaries, which could negatively influence efficiency or even reverse progress in key areas including risk management'.

Warning that 'a high percentage of large exposures on the mainland would be speculative-grade in the absence of state support', the agency said it expects gradually to cut the credit ratings of Hong Kong units to the level of their parents.

Also running the risk of a possible downgrade are locally controlled institutions such as Bank of East Asia, which has expanded aggressively north, and now boasts mainland exposure equal to 46 per cent of its total assets. 'Strict discipline in risk-taking, loan-pricing and a solid funding profile will be crucial to maintain balance sheet strength,' Fitch warned.

All this will sound deeply discouraging to investors, but despite the warnings from Fitch and the HKMA, there are heartening signs that much of Hong Kong bank lending to the mainland can be considered relatively low risk.

According to the HKMA, most mainland borrowers are large state-owned firms, with implicit central or local government guarantees.

What's more, most of these companies are not borrowing from Hong Kong banks because they need the funds to finance high risk investments or even day-to-day operations, but to take advantage of a low-risk interest-rate arbitrage.

Typically a mainland company will place cash in a fixed yuan deposit at a mainland bank, where it will earn a 3.5 per cent interest rate.

In turn, the bank issues the company with a letter of credit. The company then takes this to a Hong Kong bank and lodges it as collateral against a US dollar loan, on which - earlier this year - it would pay an interest rate of 2 per cent or less.

For mainland companies settling their trade bills in yuan, this arbitrage is a no brainer, as they can easily hedge their currency exposure, collecting a nice yield pick-up in the process.

According to one estimate, this simple arbitrage accounted for almost all the increase in Hong Kong bank lending to mainland companies over the first half of 2011.

If that's right, it means the mainland exposure of Hong Kong banks may not be quite as risky as Fitch reckons.

Source: FItch