China economy

Good times ahead for China’s banks, says Morgan Stanley

There may be light at the end of the tunnel for the mainland’s troubled lenders, as the manufacturing sector improves and interest rates start to ascend

PUBLISHED : Wednesday, 22 March, 2017, 4:59pm
UPDATED : Wednesday, 22 March, 2017, 10:35pm

The mainland’s banks might finally be emerging from the gloom.

With an industrial sector in rapid recovery, a rise in interest rates that promises better profitability, and a disposal of non-performing assets that has outpaced expectations, there may be light at the end of the tunnel for the country’s beleaguered lenders, according to Morgan Stanley.

Richard Xu, a China analyst with Morgan Stanley, said in a media briefing that reflation in the manufacturing sector means industrial firms can better absorb any negative impact from the nominal interest rate rise.

A 10 per cent rise in industrial firms’ profit means they [banks] can afford a 50 to 100 basis points rate increase
Richard Xu, analyst, Morgan Stanley

The banking sector in the past two or three years has disposed of more than 4 trillion yuan (US$580 billion) of non-performing loans, he estimated, making the remainder easier to absorb.

“We upgraded the rating on China’s banking sector last November, mainly due to the recovery of the industrial sector and the improvement in asset quality,” Xu said on Tuesday. “Further recovery in the industrial sector since then has beaten our projection.

“A 10 per cent rise in industrial firms’ profit means they [banks] can afford a 50 to 100 basis points rate increase. Recovery of banks’ net interest margin is also better than previous estimates.”

His comments came ahead of a slew of earnings reports from major Chinese banks, which have been hampered in recent years by high levels of bad debt and historically narrow margins.

Chinese banks expected to see sluggish profit growth for 2016

Lenders’ net interest margins shrank after the People’s Bank of China cut borrowing rates to stimulate economic growth. And soaring bad debts have weighed on their income as they set aside large amounts of funds to cover possible defaults.

But Morgan Stanley believes that’s all in the past. It says an upsurge in the producer price index, a gauge of factory-gate inflation, means real interest rates (the nominal rate minus inflation) are actually declining; while the nominal market rate rose by less than 30 basis points in the fourth quarter, inflation has picked up by more than 200 basis points.

The effect of the higher market rate has been further muted by the fact that the pricing of bank loans – which make up the majority of China’s credit supply – is anchored to the benchmark lending rate, not the interbank market rate.

Industrial, trade and mining firms, which are sensitive to fluctuations in producer prices, account for almost a third of China’s bank loans.

Morgan Stanley said in a February report that the country’s banking sector may be at the start of a multi-year earnings and interest-margin expansion cycle. It expected net interest margins for most Chinese banks to rebound starting in the second quarter of this year, with potentially more rapid expansion in 2018 and 2019.

The Hang Seng Mainland Banks Index has advanced 14.44 per cent from a trough in late December.

But Xu noted recovery may be uneven among banks.

“The rise in the interbank rate may be a drag on the expansion of net interest margins of some smaller banks, as their liability is more reliant on the interbank market,” he said. “They key is whether the rise in banks’ asset yields outpaces their liability costs. If liability costs rise too fast, we should look at banks’ ability to adjust their asset portfolio, raising the asset yield.”

He estimated that banks disposed of their non-performing loans at an annual rate of 2 trillion yuan in the past two or three years through write-offs, sales of bad assets and restructuring. The remaining 1 trillion yuan or so in bad assets held by state firms will be much easier to dispose of, he said.

“What’s more important is China’s resilient service sector, which is propping up the asset price and making an accommodative environment to absorb problematic credit assets. This is vastly different from the situation in mature markets – any correction in a consumer credit-driven economy leads to a plunge in asset prices, making bad assets difficult to absorb,” he said.