China economy

Supply-side reforms expected to stoke bad debt levels of city banks

Industrial production cuts could push up their NPLs by an additional 600 billion yuan, says OUB

PUBLISHED : Tuesday, 12 July, 2016, 4:31pm
UPDATED : Tuesday, 12 July, 2016, 10:01pm

Chinese banks are under the most-severe pressure from bad loans in a decade, with the country’s ongoing supply-side structural reforms expected to accelerate their exposures to soured debt.

In particular, city commercial lenders — which are so often intertwined with local governments and have lax corporate governance — are likely to see the highest earnings volatility, according to analysts.

The Chinese government recently unveiled a barrage of measures under its supply-side reform programme, a policy initiative aiming to match supply with demand in the economy by lowering taxes and cutting overcapacity.

The measures include suspending new investments, shutting down capacity, and reducing production in crowded sectors, such as coal and steel.

However, “as much of the capital expenditure in those sectors was funded by bank borrowing, the cuts in production are expected to push up banks’ non-performing loan (NPL) ratios, ” said Edmond Law and Jasmine Duan, analysts for UOB Kay Hian, in a research note.

UOB now expects the production cuts to push up the banks’ NPLs by an additional 600 billion yuan, assuming 20 per cent of loans to those sectors with overcapacity, will become NPLs.

Chinese banks are facing the most severe bad-loan pressure since 2004, when China cleaned up bad debt at state-owned banks and restructured them for IPOs
Yu Xuejun, chairman of the supervisory board for major state-owned financial institutions under the China Banking Regulatory Commission

China’s top banking regulator also sounded the alarm bell recently on soaring sour loans.

“Chinese banks are facing the most severe bad-loan pressure since 2004, when China cleaned up bad debt at state-owned banks and restructured them for IPOs, ” said Yu Xuejun, chairman of the supervisory board for major state-owned financial institutions under the China Banking Regulatory Commission, in a public speech last week.

According to Yu, NPLs in China’s banking sector had “far exceeded” 2 trillion yuan by the end of May, with the NPL ratio jumping to 2.15 per cent of total bank lending, up 0.16 of a percentage point from the start of the year.

Separately, government statistics from the top banking regulator showed the NPL ratio of city commercial banks rose to 1.46 per cent by the end of the first quarter, compared with 1.4 per cent by the end of 2015. The NPLs of the city banks had increased to 134.1 billion yuan, up 12.8 billion yuan from the end of 2015.

“The pressure is not going away in the near term,” he added.

“It takes time for the economy to shift away from the old-fashioned way of propping up the economy via rapid credit expansion.

But there is still a long way to go in cutting overcapacity and reducing leverage. Therefore, the banking sector could face increased risks from non-performing loans.”

Among the banks, unlisted city commercial lenders are probably the most exposed, given their regular ties with local governments and problematic corporate governance, said UOB Kay Hian.

“It is not uncommon for local governments to request smaller banks to support the development of their local industries, which may include real estate, steel and other overcapacity sectors,” Law said.

Large shareholders, too, are often given easier access to funding by city commercial lenders.

In the southwestern province of Guangxi, for instance, city lenders granted around 30 per cent of their loans to “related parties” of their large shareholders in 2015, according to a recent report by the 21st Century Business Herald.

As the asset quality of those loans deteriorated, “special-mention” loans — overdue debt that could potentially go bad — surged 163 per cent in 2015 at the Guangxi-based Bank of Liu Zhou, for instance.

“As such, we expect these city commercial banks may see the highest earnings volatility under the supply side reform, ” analysts from UOB Kay Hian said.

Bank of Dalian, another city lender, based in northeastern Liaoning province, saw its net profit slump a combined 94 per cent in 2014 and 2015, with its NPL ratio climbing to 3.89 per cent at the end of 2015, way above the industry average of 1.67 per cent.

Analysts attribute the bank’s soaring bad debt levels mainly to the economic downturn and over-supply in certain industries.

Other city banks considered on their “caution list” include Bank of Chengdu, Bank of Hankou, Bank of Zhongyuan, Bank of Jiangxi, and Bank of Chang’an.

Further up the banking industry pecking order, large state-owned banks are relatively better positioned than their small and mid-sized peers, as they have lower investment receivable exposures in crowded sectors, experts say.

“While not all investment receivables are loan-related, we understand some of these larger lenders do have exposure to over-capacity sectors,” Law said.

“As it is difficult to identify underlying assets of investment receivables, investors are likely to prefer banks with lower exposure to these securities.”

For the large banks, investment receivables account for only around 4 per cent of total assets, compared with 10 to 15 per cent for mid-sized institutions.

Nonetheless, analysts warn that all banks are likely to see higher NPLs and lower earnings due to the expected reform-led capacity cuts, and suggest investors remain cautious on the sector.