China Banking Outlook 2014: A Turbulent Flight Ahead

Primary Analyst: Qiang Liao, PhD, Beijing (86) 10-6569-2915; qiang.liao@standardandpoors.com Secondary Contacts: Joseph M Leung, Hong Kong 852-2533-3553; joseph.leung@standardandpoors.com Ryan Tsang, CFA, Hong Kong (852) 2533-3532; ryan.tsang@standardandpoors.com

Table Of Contents
Asset Quality Pressure Persists Liquidity Risk Presents A Challenge For Some Banks Capital Pressure May Ease A Bit Triple-Whammy For Profitability Stand-Alone Credit Profiles Underpin Stable Outlook For Sector Related Criteria And Research

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China Banking Outlook 2014: A Turbulent Flight Ahead

After flying high and fast for the past several years, China's banking sector may be entering a danger zone. Standard & Poor's Ratings Services believes Chinese banks' loan quality and profitability will slip further in 2014 as the country's policymakers keep market liquidity tight and liberalize the financial sector. Nevertheless, we expect the credit profiles of major banks that we rate to remain adequate this year. In our view, the government's pragmatic approach to addressing shadow banking risks and fine-tuned policies toward refinancing of local government debt could mitigate downside risks of severe credit losses. Overview The Chinese banking sector's asset-quality pressures are likely to persist in 2014. We expect banks' profitability to drop but remain adequate during the year. A stabilized domestic economy and the government's pragmatic policy approaches could mitigate downside risks to our stable credit view.

Asset Quality Pressure Persists

Chinese banks' credit indicators look solid, with the reported ratio of nonperforming loans (NPLs) to total loans of commercial banks at about 1% at the end of 2013. We attribute the low official NPL ratio despite mounting credit risks mainly to solid expansion in real GDP and unabated strong credit growth. Total loans grew 13.9% to Chinese renminbi (RMB) 76.6 trillion in 2013, compared with 15.6% in 2012. But robust expansion in shadow banking (involving entities and activities outside the regular banking system) more than compensated for the slowdown in loan growth. We estimate that total credit in the economy, including both regular and shadow banking credit, grew by 18%-19% in 2013. We believe Chinese banks' loan quality will deteriorate noticeably in 2014. Banks remain heavily exposed to debt-laden local government financing platforms and manufacturers (such as steel and cement producers) saddled with overcapacity because China's decade-long construction boom is cooling. The government appears to be determined to tackle the overcapacity issue. Many companies in the targeted industries have therefore suffered from reduced access to bank credit in recent years. We believe government-engineered consolidation in these segments will reduce production capacity and could lead to a rise in NPLs for Chinese banks over the next two years. In addition, the following factors may take a toll. The corporate sector remains under pressure from China's slowing economy. The upward trend in the proportion of loss-making industrial companies persists, hitting 13.7% at the end of November 2013. That's barely improved from a year earlier and up significantly from the decade low of 9.4% at the end of 2011. Tightened market liquidity may exacerbate short-term pains for corporate bond issuers. Escalated funding costs in the bond market since June 2013 will weaken issuers' debt servicing capacity (see chart 1). Nonetheless, loans

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China Banking Outlook 2014: A Turbulent Flight Ahead

remain the mainstay of corporate financing, while any spillover effect from rising bond yields on loan pricing has been limited. Authorities' efforts to rein in the rapid growth in shadow banking could have unintended consequences for other parts of the banking system, in our opinion. Shadow banking has played a growing role in China's credit supply, particularly for financing local government projects, property development, and other risky segments. The government has been trying to contain credit supply to these unproductive segments. A drain of credit for these segments may lead to a spike in NPLs.

However, we do not expect a severe spike in NPLs in 2014. The NPL ratio is unlikely to surpass 3% by the year-end, in our view. A stabilizing domestic economy and pragmatic policy responses to deal with emerging risks should limit the rise in NPLs. Key supporting factors are: The Chinese economy has demonstrated signs of a soft landing. We project that it will grow 7.4% in real terms in 2014, versus 7.7% in 2013, which should underpin healthy cash flows for a majority of borrowers. Particularly, the export segment's credit performance is likely to get better as China's export growth recovers along with improving global economic conditions. Overall credit and liquidity supply in China remains accommodative despite policymakers' tighter grip. We expect bank loans to increase at 12%-13% in 2014, while total credit growth could be 15%-16%. Despite the government's concerns about the credit boom in recent years, it has reiterated the necessity to maintain sufficient credit supply to productive sectors.

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China Banking Outlook 2014: A Turbulent Flight Ahead The government has been responsive to recent interbank liquidity stresses. Property sector and local government financing platforms continue to present severe risks for the banking sector. But we expect the government to stay vigilant and quench any credit or liquidity crunch in these segments. Notably, it has recently taken further measures to mitigate refinancing risks of local government platforms. The government has made it easier for banks to write off NPLs. The banking sector has accumulated sizable countercyclical loss reserves over the years (3x NPLs) to deal with a potential increase in NPLs.

Liquidity Risk Presents A Challenge For Some Banks

The funding and liquidity ratios of Chinese banks remain sound, in our opinion. However, it has become increasingly difficult for banks to keep their loans-to-deposits ratios within the very conservative regulatory ceiling of 75% when financial disintermediation is becoming common. Many Chinese banks have dealt with the problem by resorting to off-balance-sheet lending or accounting tricks (e.g. booking credit exposures as nonloan assets such as debt investment). Nonetheless, the sector's aggregate loans-to-deposits ratio still increased to 71.6% at the end of 2013, from 71.3% a year earlier. We expect the sector's aggregate loans-to-deposits ratio to move closer to the regulatory ceiling of 75% in 2014. This, coupled with China's heavy reserve requirements of 20.5%, could challenge banks' asset and liquidity management. China's interbank liquidity stress in late June 2013 and toward the end of the year reflects these forces. In our opinion, the situation does not pose a fundamental threat to the banks' liquidity profile. This is because of the system's strong deposit base and the economy's dependence on the banking system to channel funds. While depositors have been progressively shifting their funds away from deposits and to higher-yield wealth management products, these funds still mostly circulate within the banking system. However, rapidly growing interbank exposures could be a game-changer for smaller banks. In our view, contagion risks stemming from the banks' expanding interbank businesses are growing. Some national banks and a growing number of small regional banks have aggressively stepped up interbank lending and borrowing to maximize profits. This has not only stretched their own capitalization and liquidity management but has also exposed a large number of smaller banks to significant counterparty risks. We expect a noticeable repercussion for a wider segment of the banking sector if severe credit losses and ensuing depositor runs hit the banks at the center of interbank financing. We expect the formal deposit insurance scheme that Chinese policymakers plan to launch this year to weaken some banks' funding profiles. While the scheme aims to forestall depositor panic at distressed banks, its psychological impact on Chinese depositors is untested, especially those of medium-sized banks. Such banks have on average tighter liquidity management and rely more on corporate and wealthy individual depositors than their local peers. Such depositors may be more sensitive to a likely cap on insured deposits under the proposed deposit insurance scheme.

Capital Pressure May Ease A Bit

Major Chinese banks have been in compliance with the Basel III capital requirement since its rollout in 2013. But based on our risk-adjusted capital framework, the risk-adjusted capital ratios of the seven largest commercial banks we

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China Banking Outlook 2014: A Turbulent Flight Ahead

rate will stay at 6%-7% over the next couple of years, indicating "moderate" capitalization, in our view. We anticipate that Chinese banks will need to constantly replenish capital because of their strong credit growth, both on- and off-balance sheet. With profit increases slowing, Chinese banks' retained profits may barely support credit growth of 15% a year without weakening their capitalization. However, a possible slowdown in credit growth and acceleration in asset securitization may offer banks some relief this year. Major Chinese banks are exploring Basel III-compliant subordinated bonds and other hybrid capital instruments to shore up their capital base. The capital structure of these banks is heavily biased toward common equity and retained profits, leaving significant room for regulatory capital enhancement through issuances of hybrid instruments. However, we do not expect these measures to meaningfully strengthen the banks' capitalization this year, given the untested market appetite for such instruments.

Triple-Whammy For Profitability

Rising credit costs (ratio of provisioning for bad loans to total loans), compressing interest margins, and slowing growth in noninterest income are likely to hit bank earnings in 2014. We expect the sector's return on average assets to fall to 0.8%-1% during the year, from 1.1%-1.2% in 2013. Chinese banks' strong profits in the past few years have come at a cost because they've built up massive latent credit risks. As NPLs start to pile up, we believe the banks' credit-provision cost could jump to 0.80%-1% in 2014, from 0.60%-0.80% in 2013. The contraction in Chinese banks' interest margins may appear modest because these banks' wealth management business tempered the impact of deregulation of interest rates and tighter market liquidity on their financial statements. We believe the average funding cost would be 20 bps-30 bps higher if we treat the banks' off-balance-sheet wealth management products as term deposits. The sector's outstanding wealth management products grew by 40% in 2013 to more than RMB10 trillion, equivalent to about 9.4% of total deposits, with the estimated average yield of 4.5%-5% in 2013. Tempered growth in noninterest income could be the third hit to Chinese banks' financial performance in 2014. We expect fee income linked to off-balance-sheet credits to grow slower than before as a result of a falloff in credit growth. Revaluation losses from bond investments look unavoidable because we expect China's interbank rates to stay relatively high amid a significantly reduced liquidity buffer, given the current deposit reserve requirement.

Stand-Alone Credit Profiles Underpin Stable Outlook For Sector

Our outlook on the Chinese banking sector remains stable. In our view, banks' business position, capitalization, risk position, and funding and liquidity should support their stand-alone credit profiles, particularly for most of the major banks that we rate. The sector's credit and financial performances could slip in 2014. However, our analysis of China's Banking Industry Country Risk Assessment (BICRA) and individual banks' capitalization and risk position already

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China Banking Outlook 2014: A Turbulent Flight Ahead

factors in strong credit growth and high financial volatility. We see limited upside to our current sector view. Downside risks may come from significant economic underperformance or unexpected government policies. Such policy risks include an excessive push for consolidation of industries afflicted by overcapacity. This could lead to substantial rises in the banks' credit losses, despite China's still comparatively strong economic growth. A significant shortfall in government support to distressed local government platforms could also trigger a credit crunch in the economy. That said, provided that our sovereign rating on China remains unchanged, the ratings on major Chinese banks may stay largely stable even if we lower our BICRA of China by one notch. This is because Chinese banks' "moderate" capital assessment may then become a neutral rating factor, according to our criteria, and offset the downward pressure owing to a lower anchor rating.
Table 1

Key Indicators Of Selected China Banks

Gross NPAs/customer loans + other real estate owned (%) Net NPAs/customer loans + other real estate owned (%)

Name of the Bank

Issuer rating

SACP

Return on average assets (%)

Tier 1 capital ratio (%)

Total loans/customer deposits (%) 2012A 59.22

2013H1 2012A 2013H1 Agricultural Bank of China Ltd. Bank of China Ltd. A/Stable/A-1 bbb1.34 1.16 1.26

2012A 2013H1 1.35 -3.17

2012A 2013H1 2012A 2013H1 -3.14 9.11 9.67 60.47

A/Stable/A-1

bbb bbb-

1.24 1.27

1.14 1.18

0.95 1

0.97 0.93

-1.31 -1.23

-1.31 -1.4

9.28 11.2

10.54 11.24

76.92 80.98

78.72 79.05

Bank of A-/Stable/A-2 Communications Co. Ltd. Bank of Nanjing Co. Ltd. China Construction Bank Corp. BBB-/Stable/A-3 A/Stable/A-1

bbbbbb-

1.28 1.66

1.28 1.47

0.96 0.99

0.9 1.02

-1.69 -1.68

-1.79 -1.72

10.64 10.66

12.13 11.32

56.41 66.63

63.09 66.23

China Merchants BBB+/Stable/A-2 bbb Bank Co. Ltd. Industrial and Commercial Bank of China Ltd. Shanghai Pudong Development Bank Co. Ltd. A/Stable/A-1 bbb

1.46 1.53

1.46 1.44

0.69 0.89

0.61 0.87

-1.51 -1.65

-1.59 -1.68

8.12 10.48

8.49 10.62

75.61 65.05

75.59 64.53

BBB+/Stable/A-2 bbb-

1.17

1.17

1.06

0.79

-1.3

-1.56

8.48

8.97

70.91

72.83

SACP--Stand-alone credit profile. NPAs--Nonperforming assets. A--Full year. H1--First half.

Table 2

Banking Industry Country Risk Assessment

Country Government support China Highly supportive BICRA group Anchor rating Group 5 bbb-

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Table 2

Banking Industry Country Risk Assessment (cont.)

Economic risk factors and descriptors Economic risk Economic resilience Economic imbalances 6 Intermediate risk High risk Industry risk factors and descriptors Industry risk 5

Institutional framework High risk Competitive dynamics Systemwide funding High risk Very low risk

Credit risk in the economy High risk

Related Criteria And Research

Related Criteria
Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related Research
A Key Test Case Looms For China's Shadow Banking System, Jan. 24, 2014 How Risky Is The Spike In China's Public Debt?, Jan. 23, 2014 Banking Industry Country Risk Assessment: China, Jan. 9, 2014 2014 Asia-Pacific Financial Institutions Outlook: Rising Private-Sector Leverage May Overshadow Banks' Performance Amid Softer Economic Prospects, Dec. 10, 2013

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