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Asia-PacificJuly 4 2018

China's largest lenders shrug off regulatory and trade obstacles

How are Chinese banks reacting to sustained regulatory tightening and potential new risks such as household debt growth and the Sino-US trade dispute? Stefania Palma reports.
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China Agri

In a banking sector where regulators are tightening their grip on shadow banking and illicit activity to deflate China’s debt bubble, the divergence between the country’s strongest and weakest banks is widening.

This is good news for China’s large lenders, including the big four banks: Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), China Construction Bank (CCB) and Bank of China. But the smaller banks, whose business is often linked to the city or region they are based in, could run into trouble as their asset quality and capitalisation levels tend to be weaker and their reliance on wholesale deposits tends to be higher.

What is more, China’s overall banking sector could face new risks both at home, with accelerating household debt, and beyond its borders, with a potential escalation of the Sino-US trade dispute.

Big banks, strong banks

China’s largest banks have flourished in the face of tightening regulation, a trend that accelerated in 2017 as institutions tackled the country’s total debt-to-gross domestic product (GDP) ratio, which had ballooned to 257%. Chinese regulators have focused on stifling the shadow banking sector, whose contribution to China’s overall leverage remains unclear.

Chinese authorities have cracked down on shadow banking before, but have tended to loosen up regulation as soon as it dented economic growth. This latest tightening, however, has stood out for its rapid escalation as much as for its lifespan. “[The authorities] have been so much more aggressive than anyone expected, yet it has not hurt growth at all. Credit intensity to GDP will continue to go down and [China’s GDP will] still be able to grow well above 6%,” says David Mann, global chief economist at Standard Chartered.

A spokesperson at Shanghai Pudong Development Bank (SPDB) adds that tight regulation helps reduce potential risks while increasing the sustainability of the banking sector. Among other things, “strong oversight helps reduce the banking industry’s leverage and default rates; lessens the impact of mismatching in the maturity of assets and liabilities; eliminates regulatory arbitrage… [and] standardises the regulatory development of [the] interbank business”, says the spokesperson.

The regulatory crackdown has not hurt China’s top six banks (ICBC, ABC, CCB, Bank of China, Bank of Communications and Postal Savings Bank of China), whose average year-on-year net profit grew 4% in 2017, according to rating agency Standard & Poor’s. There had been almost no growth in the previous two years.

A trade war is not very attractive. If there is an impact on the Chinese economy, Chinese banks cannot ignore that

Jin Yu

Pushing up interbank rates was one way in which the People’s Bank of China (PBOC), the central bank, tackled shadow banking. China’s smaller banks, which are heavily reliant on interbank lending as well as wholesale rather than deposit funding, were hit the hardest. But as net lenders in the interbank market, the top six benefited from this regulatory change. These lenders also started moving away from interbank business altogether, which tends to offer relatively low margins. Net interest margins (NIM) for five out of China’s six top banks grew year on year in 2017.

Bank of Communications, which has a weaker deposit base and therefore has to rely more on the interbank market, is the only top six lender whose NIM dropped in that time period, by 31 basis points.

Improving asset quality

On the asset side, the question of Chinese non-performing loans (NPLs) remains problematic, especially for smaller lenders. But China’s top banks have been cleaning up their books. The NPL ratios for the top six all dropped year on year in 2017, according to S&P.   

To tackle the NPL problem further, Chinese regulators have been granting new licences to set up asset management companies at the provincial level, in addition to the four large existing companies (Cinda, Huarong, Great Wall and Orient).

The authorities also launched pilot programmes in 2016, allowing banks to securitise NPLs. As of the second quarter of 2018, the volume of NPL securitisation totalled Rmb28.75bn ($4.5bn), according to S&P. What is more, the number of banks eligible to securitise NPLs tripled from 2016 to 2017.

New draft guidelines that target asset management products, published jointly by the PBOC, the China Banking Regulatory Commission, the China Securities Regulatory Commission, the China Insurance Regulatory Commission and the State Administration of Foreign Exchange, could help strengthen China’s banking sector further. These products are often deemed risky as it is hard to identify the underlying assets they are exposed to.

Regulating asset management

The new regulation addresses all asset management products across the Chinese market, “effectively reducing the scope of regulatory arbitrage”, says David Yin, a senior analyst at Moody’s. The draft guidelines tackle the maturity mismatch between the tenor of the asset management product and underlying assets; they eliminate the implicit guarantee that financial institutions offer these products’ buyers, and ask banks to allocate sufficient capital and set enough provisions against asset management products.

The new guidelines are particularly promising in that they could benefit weaker small and mid-sized banks. “These banks originate and manage large amounts of asset management products, and they also have large investments in asset management products originated by other financial institutions,” says a Moody’s report. The guidelines were published in November 2017 and will be enforced by the end of June 2019.

In April 2018, the PBOC announced additional measures to support China’s smaller lenders. The central bank cut the required reserve ratio for most commercial and foreign banks by one percentage point to improve banks’ liquidity and trigger more lending for small businesses. In June, a further half a percentage point cut for some banks was announced.

As the market switches to direct financing, commercial banks will lose corporate business such as commercial loans

Gu Shu

“According to the PBOC, although the lower ratio will release Rmb1300bn of liquidity into the banking system, the net effect is about Rmb400bn because Rmb900bn is earmarked for [bank’s outstanding medium-term lending facilities, or MLF] repayments [to the central bank],” says a Moody’s report. But since China’s smaller banks tend not to be big MLF borrowers, most of the Rmb400bn could benefit them.

Household debt rise

But despite Chinese authorities’ increased scrutiny of the banking sector and support for smaller banks, new potential risks are taking shape, such as the rapid growth of household debt. “Household debt became the single largest component of new credit in China’s banking system for the first time in 2017, accounting for more than half of new loans and 37% of domestic balance sheet growth,” said a report from Fitch. The rating agency estimates that Chinese household debt accounted for 50% of GDP and 82% of disposable income at the end of 2017, having jumped considerably from 20% and 31%, respectively, at the end of 2008. If the current rate of growth continues, China’s household debt-to-disposable income ratio could reach almost 100% by 2020, says Fitch, reaching levels similar to the US (at 105%) and Japan (at 99%).

But according to Bank of Shanghai chairman Jin Yu, the problem is not the speed of the increase in household debt, so much as the context in which this debt is rising. “In Bank of Shanghai the average amount of every consumer loan is about Rmb5000 to Rmb6000. In China the individual credit system is also improving. If we provide finance to people that have real consumer demand, at these small amounts, the risk can be controlled,” says Mr Jin.

Bank of Shanghai is also adamant about consumer lending not being used for investments in the real estate and stock markets. “For Bank of Shanghai, this is high-risk business and it is not our direction for business development,” says Mr Jin.

Mortgage loans dominate household debt on Chinese banks’ books, accounting for 59% of the total. But banks in China’s largest cities – Beijing and Shanghai – do not fear their exposure to mortgages.

“In a conference [in March], a PBOC speaker said that mortgages are the most high-quality assets,” says Xu Li, president at Shanghai Rural Commercial Bank (SRCB). “As a result of the governmental regulation, the rapid increase of house prices in Shanghai housing price is effectively curbed. However, the mortgage loan business of commercial banks needs to gradually accommodate [this rise].”

Mortgages account for 30% of ICBC’s total loan portfolio. But bank president Gu Shu is unworried considering both PBOC and China’s commercial banks have adopted measures addressing mortgage loan growth. “That can ensure that personal loans will not pose systemic risks to the banking industry,” says Mr Gu.

Retail move

The jump in household debt has gone hand in hand with Chinese lenders’ shift to retail following growing concerns about domestic corporates’ debt servicing capacity.

“Facilitating [growth in] the real economy is at the core of finance, and is finance’s duty and purpose. Deviating from this vital orientation would destabilise the development of the banking industry,” says an SPDB spokesperson.

In Bank of Shanghai’s case, consumer lending remains very attractive thanks to higher profitability and relatively “controllable” risk, says Mr Jin. In 2017, Bank of Shanghai set up a joint venture with Ctrip, a leading Chinese travel service provider. The venture, called Shanghai Shangcheng Consumer Finance, tapped into China’s consumer lending potential.

SRCB has also renewed its retail focus as regulators are discouraging lenders from growing investment banking and the financial markets business too rapidly. Today, retail accounts for 30% of SRCB’s total income. But the bank wants to push that to 50% in the next three years, according to Mr Xu. “This year we will invest more money in retail business, internet banking and in mobile banking systems’ upgrade,” he sys.

Even ICBC, the largest bank worldwide by Tier 1 capital, will continue devoting more resources to retail. “Retail banking is always going to be one of our major focuses,” says Mr Gu, who adds that Chinese banks are responding to a shift in the domestic economic model away from exports and investment and towards consumption. “The contribution of consumption to GDP will be growing. The middle class is [also] growing so there will be an expanding market for personal financial needs,” he says.

ICBC is also keen to focus on retail, in light of firms diversifying their lending away from bank loans and into bond or equity markets. “As the market switches to direct financing, commercial banks will lose corporate business such as commercial loans. That is [one of the] reasons why we will focus on our retail business,” says Mr Gu.

The Trump effect

Aside from household debt, another potential risk to the Chinese banking sector comes from beyond the country’s borders. Volatility in Sino-US trade relations has intensified in 2018, with a string of tariff threats and retaliations from both sides. In early April, US president Donald Trump announced the US would impose 25% tariffs on about $50bn in Chinese imports on the back of Beijing’s alleged theft of US intellectual property. China responded by listing about 100 US products it would target with its own tariff rise, at which point Mr Trump announced he asked his staff to look into a tariff increase for an additional $100bn in Chinese imports.

As The Banker went to press, no tariff had been implemented. But how do Chinese banks see this escalation in the Sino-US dispute?

Bank of Shanghai’s Mr Jin says a trade war would not affect the lender’s cross-border business as this mainly focuses on specific projects, such as mergers and acquisitions. But still, “a trade war is not very attractive”, he says. “If there is an impact on the Chinese economy, Chinese banks cannot ignore that.” He adds that he will keep a close eye on any industry or company that might be exposed to a potential trade war.

SRCB’s Mr Xu is generally optimistic about the outcome of the Sino-US trade dispute. “I don’t think there will be a trade war. This is not mutually beneficial for both sides,” he says. Citing Chinese president Xi Jinping’s announcement in early 2018 that China would open up financial and automobile sectors further to foreign investors, Mr Xu adds: “I think this sends signals to [the] outside [world] to say China will be more open.”

Meanwhile, ICBC’s Mr Gu is “not seriously worried” about the trade conflict. Though the bank will pay attention to corporates focusing on exports or trade, Mr Gu says: “I don’t think there will be a very significant impact even in the worst-case scenario, because trade suppliers account for a small percentage of China’s GDP.”

Mr Gu also argues that China’s trade surplus with the US is a result of the two countries’ economic structures rather than manipulation from Beijing, as often stated by the White House. “One of the major reasons why we have a surplus with the US is that the US does not export what China wants to buy, for example hi-tech products. [In addition] American people don’t save a lot, they consume a lot. We export of a lot of consumer goods,” he says.

What is more, Mr Gu thinks the total volume of Chinese exports to the US might be overstated. “Many of the parts of [one product] are imported from our neighbouring countries, assembled in China and then exported to the US. But when the US does the calculations, the whole value [of the product] will be calculated into the number of [Chinese] exports,” says Mr Gu.

The Chinese banking sector is going through a transition, in which tighter regulation tries to stifle irregularities in the industry. But while smaller banks remain at risk, the top lenders in the country are coming out strong. The largest are not even worried about rising household debt at home, or the risk of a trade war with the US.

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