Will Chinese banks withstand the credit crunch?

Institutional Investor, July 2008

It was a perfect year. Chinese banks had it all in 2007: booming local economy, improving margins, easy credit, falling bad debts, and growth in fee income at all major listed banks. 2008 is going to be nothing like as easy. But does the Chinese banking story still look good?

After all, the world looks a very different place in 2008 than 2007. The global credit crunch and US slowdown are a worry to financial enterprises worldwide; China’s own economy shows evidence of a modest slowdown; credit strength, particularly among domestic property developers and small businesses, is under scrutiny; and a crash in the domestic stock markets is likely to have a big impact on funds related business, which in recent years has provided banks with lucrative fee income.

Raphael Wu, associate director at Credit Agricole Asset Management and manager of its Asia Pacific Renaissance Fund, says he is “very confident” about the outlook for Chinese banking, regardless of the worsening global credit environment. “We are looking for about 50% overall sector earnings growth,” he says, and high teens percentage earnings growth in 2009. Macquarie Bank’s Nick Lord also estimates an average 44% earnings growth in 2008 earnings – the highest in the region – and 20% in 2009.

This bullishness seems curious given what has happened in China’s domestic stock markets this year. The Shanghai Stock Exchange’s key indices have halved since October, and banks have fallen with them. “Outlook has nothing to do with market sentiment,” says Wu. “Outlook is fundamental and fact-driven, but sentiment may not be.” He concedes that the Chinese economy, and its banking sector, would be doing better if there was no credit crunch or deteriorating US economy. “But our slowdown may already have reflected the global slowdown,” he says  – and when people in China talking about a slowdown, they mean a decline from last year’s extraordinary 11.9% GDP growth to something probably more like 10%, so hardly a recession. “Domestically there is no credit crunch, as China has been having steady loan growth since 2004 at about 14-15%.”

The round of results announced by China’s banks in April certainly show no cause for alarm yet. Bank of China’s net attributable profits of RMB21.7 billion were up 85% year on year, with 10% quarter on quarter fee growth. Despite taking another US$325 million impairment allowance for US subprime and other mortgage backed securities, the non-performing loan ratio fell to just 2.84%, from 3.17%. China Construction Bank’s first quarter net profit of RMB31.12 billion almost matched what it earned in the whole first half of 2007; net interest margins expanded from 3.18% in 2007 to 3.26% in the first quarter of 2008. ICBC’s RMB33.1 billion first quarter profit was up 77% year on year, with net fee income up 19% quarter on quarter – and this in a time when ICBC’s domestic share price fell 34% in the same quarter. And Bank of Communications’ net profits of RMB7.9 billion for the quarter more than doubled the equivalent period in 2007.

But is this as good as it gets? Macquarie’s Nick Lord says: “Investors are asking: will margins continue to expand? By how much will wealth management fee income fall? Will credit quality begin to deteriorate?” Margins in particular face challenges, as people shift assets into lower yielding products as a consequence of stock market volatility (deposit growth continues to outpace loan growth, Lord notes, and within that, there is a shift from demand to time deposits and a reduction in brokerage deposit accounts).

What about fees? The real trend of Chinese banking in recent years has been a shift from interest-based income to fee-based income. This is generally considered a much more secure and lucrative way of running a bank, and is a theme worldwide: Chinese banks have embraced it with gusto and analysts seem to think it’s here to stay. Morgan Stanley, in a June 20 report, maintained its growth estimates for 2008 fees and commissions at around 40%, despite the performance of the stock market, which one would normally expect to put a big dent in fund-related business. Morgan’s Minyan Lui holds this view because in 2007, it was non-fund related business that accounted for the bulk of fee business. China Construction Bank and Bank of Communications, two of the banks that disclose fund distribution fees in the most detail, reported that fund fees accounted for about 30% of fee business in 2007; the bulk instead came from settlements, bank cards, custody and other fees.  Morgan Stanley calculates that this non-fund business grew by an average of 60% year on year over the last three years; Bank of Communications reported 90% growth in this area in the first quarter of 2008, year on year.

Macquarie, looking at it from a different way, focuses on the outlook for wealth management fee income, and expects modest growth this year – 3% at the industry level, with lower income from fund issuance and trading, but stronger sales of banks’ own wealth management products and bancassurance.

Still, distribution of new funds has certainly been hit: 50% down year on year from January to May, according to Morgan Stanley. Average turnover in the domestic stock markets themselves was down 28% year on year. But fund custodian business has held up well, with Bank of Communications reporting a 257% year on year rise in the first quarter, although it came from a fairly low base. Bancassurance, too, is looking strong, with industry insurance premiums up 62% year on year for January to April this year. Partly, this reflects movements from funds into other products. “The shift of distribution focus could help buffer some of the decline in the fund distribution business,” says Morgan Stanley.

Perhaps the real worry is credit quality. Many people fear that the bad old days of Chinese bad loans have only gone away for two reasons: because all the bad debts were taken off the big banks to be disposed of by custom-built agencies, rather than being resolved by the banks themselves; and because the economy has been booming. Under this scenario, any downturn in China’s economic performance could reveal a host of loans that are only robust in a rising tide. In a harsher environment, there could be another bad loan crisis waiting to happen. Alongside this, of course, there are the credit quality issues created by the US slowdown, as well as by domestic inflation, changes in labour law, rising commodity costs, and policy.

“We expect the NPL formation rate to gradually pick up,” says Wu. “After all, we have already had quite a number of years of improving asset quality with little or even negative net new NPL formation rates. As the economy goes through cycles, inevitably,” the picture may change.

Banks are certainly aware of the challenge. “The recent subprime mortgage crisis has brought lots of implications to Chinese banks, including CCB,” says a spokesman for China Construction Bank. CCB, like others, has put a lot of effort into developing risk management systems, and reformed its approach in 2006 to establish a vertical risk management structure with a dedicated team of professionals and a chief risk officer. Consequently its NPL ratio was just 2.22% in the first quarter of 2008, down by 0.38 percentage points from the end of 2007; other major banks boast similarly impressive numbers.

Domestically, concerns about credit quality tend to focus on property developers, export-related industries, and small to medium enterprises. “These segments warrant closer monitoring throughout the year,” says Lord.

To start with property developers, the system exposure to this part of the market is less than 10% of book, according to Macquarie. Small to mid-size developers are facing cashflow constraints as banks have become more selective in who they lend to, focusing on larger names instead; they are getting financing, but through costlier methods. That said, the land banks that secure bank lending remain valuable. “We believe sector consolidation will occur first where larger, more cashed-up players acquire projects off small struggling players,” Lord says. The key risk, he says, is if there is a sharp downturn in the property market.

SMEs, too, account for less than 10% of bank lending exposure, despite the fact that there are some 40 million of them in China, according to Macquarie. Since small businesses basically have to take whatever terms are offered to them, banks are quite powerful in these lending relationships, with most SME lending featuring collateral or a credit guarantee.

Wu says: “A gradual pick up [in NPLs] may be absorbed by banks. Banks have strong buffers: a good capital base and high NPL coverage.”

There are, though, plenty of areas of potential growth in Chinese banking. “With the deepening reform of China’s economic system, customer demand for financial services is increasing both in scope and intensity,” says CCB. “During this process a lot of new growing points for profit are appearing in the banking business, such as consumption financing, asset management, financing for small companies, and investment banking.” The whole of consumer spending and saving behaviour is changing as wealth grows among ordinary citizens, and at the same time, entrepreneurship drives the growth of small businesses.

From time to time, unpredictable one-off events can hit the sector, and an example of this was the Sichuan earthquake this year. In May, the China Banking Regulatory Commission ordered banks to write off retail loans to businesses with collateral damaged by the earthquake, and to borrowers who, through lack of insurance, could not recover their financial losses. While nobody in China doubts the humanitarian merit of this approach, “banks’ operating independence is clearly reduced,” says Dorris Chen, analyst at BNP Paribas Equities in Shanghai. She calculates that direct credit losses to banks will be limited to 1 to 2% of 2008 earnings. Besides, she also expects some compensation in a surge of loans to rebuild Sichuan. “Direct economic losses caused by property damage, and indirect losses caused by business interruption, are expected to reach RMB500 billion in aggregate,” she says. “We assume a total of RMB200 billion of bank credit will be used for this purpose.” She calculates an extra 1.82% of earnings in 2008 – almost exactly the same as the credit loss.

The currency is also an important consideration. Macquarie forecasts a 10% appreciation in the renminbi in the 2008 financial year, and 18% in 2009, and believes this is positive for banks. A trickier issue is what happens when, as inevitably one day it will, greater convertibility is permitted with the Chinese currency. But that is perhaps a debate for another day. Wu says “It’s hard to gauge the impact of greater convertibility. I think in the next couple of years the progress on this will be limited.”

But whatever the risks ahead, there are certain to be as many opportunities; in an emerging market of such a scale, nothing stays the same for long. “Customer needs are changing all the time,” says CCB. “And dependent on whether the customers are high-end or ordinary, on their locations, on their age, profession, or whether they are large enterprises or small companies, there are differences in how those needs are changing. A commercial bank can only provide its customers with the best services if it is customer focused and has a full knowledge of their needs.” Knowing your customer has never been more important.