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Chinese banks in good shape to pass economic test

The unfolding global recession ought to resolve one of the great known unknowns about China. How will its supposedly strong banks fare when the going gets tough?

Skeptics have long identified the financial system as a weak link. Despite a bailout that started a decade ago costing perhaps $500 billion, China's banks would be exposed by a downturn as unreconstructed state-run behemoths stuffed with dodgy loans.

So runs the theory. If true, the consequences for China's economy, and hence for the rest of the world, will be grim.

With economic gloom descending, the banks obviously face harsher times. So do America's and Europe's. But the view of some people paid to worry about these things is that the banks are in fact in a solid position to ride out the storm.

“There still will be damage, but we are probably the best placed in the world to survive the crisis with the least damage,” said Simon Gleave, the financial services partner in the Beijing office of KPMG, an auditing, tax and advisory company.

The capital cushion of banks is fairly strong; the bulk of their loans is to state-linked firms that can count on official support; and banks, far from under-reporting non-performing loans (NPLs), tend to be conservative in their accounting, Gleave said.

“The judgment of the quality of loans is currently very good in China,” he said.

Most importantly, banks enjoy a fat interest margin because deposit and lending rates are set by the central bank, not by the market. This has been generating massive profits for the banks and provides a plump cushion should loan quality deteriorate.

“They could probably absorb up to 20% NPLs with that cushion in place,” Gleave said. “I don't think it's a massive problem here because of the interest rate regime.”

Chinese officials, though, have been sounding the alarm.

Jiang Dingzhi, a vice-chairman of the China Banking Regulatory Commission, said on November 15 that NPLs were showing signs of trending higher and singled out the property sector.

“The risk of defaults on home mortgage loans is accelerating,” he said.

But was Jiang crying wolf? At 5.5% of all loans at the end of September, NPLs still look high. But the ratio, down from 6.2% at the start of 2008, would be much lower if the state had completed a bailout of Agricultural Bank of China.

To be sure, the housing market is losing altitude after a giddy climb. China International Capital Corp, Credit Suisse, Nomura and Standard Chartered all expect property prices to fall 20% or so in the next year or two.

However, with a borrower required to put down at least 20% of the price of the house they are buying, only one% of home mortgages is non-performing. And in contrast to the West, banks in China come under serious pressure to reschedule loans before resorting to repossession, Gleave said.

“It is fair to say that banks can withstand a fall in house prices of as much as 30%,” Yan Qingming, the banking commission's head in Shanghai, told the 21st Century Business Herald on November 5. Stress tests had shown that banks would find it “unbearable” only if prices plunged even more than that, he said.

Lending to developers is more problematic. Many are suffering acute cash flow strains and their stock prices are in free fall.

But banks have been scaling back lending to developers, which now account for just 7% or so of all bank loans. Mortgages make up a further 12% of the loan book.

Charlene Chu with Fitch Ratings in Beijing estimates banks' on-balance-sheet exposure to property at 25-30% of all loans. In the United States the figure is about 50%.

Chu says banks' total exposure, once lending through special purpose vehicles and off-balance-sheet entrusted loans is included, is significantly higher and is a potential worry.

But she said the real estate and construction sectors stand to benefit from this month's massive 4 trillion yuan stimulus package aimed at building roads, railways and affordable housing.

“It's not clear to me that we're going to see a really significant impact on Chinese bank balance sheets from property market issues in the near term,” she said.

None of this is to say China can sound the all clear.

China has shored up its defenses, but it does not control how long the credit crunch will last.

“This is not a US subprime crisis; it's a global deleveraging crisis. So everyone is going to have their financial sector tested,” said Dominique Dwor-Frecaut with Royal Bank of Scotland in Singapore.

The risk is of a deep downturn in the export and property sectors, with knock-on effects in ancillary sectors, that is then amplified by a collapse of confidence within China if America and Europe fail to halt the bleeding in their banks.

The words “financial crisis” are now muttered in backwaters across China where peasants have never heard of Wall Street.

That is why Premier Wen Jiabao has made several visits to China's manufacturing heartlands, urging businessmen not to lose their nerve. Boosting confidence was a “powerful weapon” to deal with the turmoil, Xinhua on Sunday quoted Wen as saying.

Another concern is that, while Chinese banks now operate more along commercial lines, tougher reforms to their credit culture, risk management and governance are still in the early stages, Chu at Fitch said.

A severe economic shock could also expose weaknesses in the data underlying banks' expected loss models, Chu said in a report. Her conclusion? Increased vigilance is warranted.

As Yi Gang, a deputy central bank governor, told a conference this month: “China's banking system has never weathered the test of an economic cycle, and now the test has started.” (Reuters)