Rapid loan growth puts Chinese banks at risk

Loan growth among Chinese banks hit more than Rmb7.76 trillion ($1.13 trillion) in the first half of 2009, a record high. As a result, asset quality is likely to slip further in 2009, but should remain highly manageable. It could deteriorate sharply in the next two to three years, however, if the economic slowdown is protracted in China.

Chinese banks seem to be lending so aggressively despite the economic slowdown for three key reasons. First, the strong growth suggests that the banks' corporate governance is still relatively weak and that the government continues to exert strong influence over banking practices as a dominant shareholder. Second, the banks appear willing to extend additional funding to borrowers facing cash-flow difficulties on the premise that such difficulties are short-term in nature and should correct themselves when China's growth recovers. And third, they may be looking to compensate for the negative effects on earnings from the squeeze in net interest margins.

We expect the quality of new loans to be on average inferior to the banks' loan book a year ago. That's because the banks are either expanding into an enlarged but inferior client base or making incremental loans to existing clients with deteriorated financial metrics. Some new borrowers had no or limited access to bank credit in the past because they didn't meet previous underwriting standards. But banks are likely to have eased their underwriting standards for projects related to the government's stimulus package, as the government relaxed the capital leverage requirement for many types of projects. Loan quality should, however, be adequate for infrastructure projects that the central government or affluent provincial governments have backed; but these loans perhaps represent only a fraction of total new lending.

While further slippage in bad loans in 2009 and 2010 is likely in our view, it should be at a manageable pace. This is due to the very supportive liquidity environment for corporations as a result of strong loan growth, the limited exposure of major banks to severely hit small businesses in the export sector, and signs of economic recovery, particularly at home. A jump in the non-performing loan ratio is still very likely, as the dilutive effect gradually wanes and banks eventually stop renewing loans.

Barring a protracted slowdown in the Chinese economy, we anticipate the system will on average be able absorb incremental credit costs, given still healthy official interest spreads and banks' improving capacity to generate fee-based income. For banks that are aggressively increasing their exposure in concentrated segments or regions, we expect potential credit losses to significantly weigh down their already below-average earnings profile. This is likely to lead to further divergence in credit profiles across the sector.

The aggressive loan growth in the first six months of this year could significantly stretch Chinese banks' newly developed risk management systems and undermine their underdeveloped risk culture. Inflationary pressure may be the single-largest macroeconomic risk that the banks face. Historically in China, inflation often followed when loan growth ran above 20% (it was about 30% year-over-year at the end of June 2009). We'll have to wait to see if this time will be an exception as the global economic slowdown continues to weigh on overall pricing levels. If the inflation pressure becomes so acute that the government resorts to a policy u-turn and increases lending restrictions, the heightened policy risks could exacerbate the difficulties for borrowers and banks.

The government's role and commitment to reforms

The government remains highly influential with regard to lending policy at the banks, in our view. It has encouraged banks to make loans to prevent the economy from making a hard landing. But some government agencies, particularly the China Banking Regulatory Commission, have continually warned against excessive lending. Recently, the government seems to be fine-tuning its policy to favour a greater check on bank loan growth. The central government appears to have a delicate balancing act. It's trying to use bank credit as a lever to maintain economic growth while preserving the banking system's fundamental strengths. This reflects an inherent conflict between the government's different roles as the country's policymaker, banking regulator and major shareholder.

There are still strong incentives for the government to press ahead with banking reforms. The aggressive response to the government's call for greater lending indicates that the banks do not yet have a sound risk culture and effective corporate governance in place. Given the experience in some markets, Chinese policymakers are likely to take a cautious approach to deregulating relatively risky activities and products. They're also likely to slow down some reforms, such as those regarding compensation schemes. Some recent initiatives, such as those related to the development of the debt market and renminbi convertibility, indicate the government's intention to proceed with market-oriented banking reforms.

Ratings impact on Chinese banks

We believe the major rated banks have sufficient financial strength to weather the economic slowdown. Although we see growing pressure from credit risks, policy risks and other risks for the banking sector, these are still within our expectation. We have long factored the significant volatility in Chinese banks' financial metrics into the ratings on banks. If we are convinced that any bank has been performing better than we originally expected due to its own structural strengths, we would acknowledge these strengths against the context of a less-supportive operating environment.

The authors of this article, Qiang Liao and Ryan Tsang, are senior analysts in the financial institutions ratings team at Standard & Poor's Ratings Services.