Chinese banks may face spike in credit losses as Beijing cools economy, warns S&P

STANDARD & Poor’s has warned Beijing’s anti-inflation efforts are likely to squeeze profits at China’s banks, highlighting growing concern about the impact of tighter monetary policy on lenders that have poured out credit in recent years to help drive growth in the world’s second-biggest economy.

“Inflation and a possible economic slowdown stemming from tightening measures could lead to a spike in credit losses over the next two to three years,” the ratings company said in a report.

“Chinese banks’ profitability could slip in the remainder of 2011 and drop further in the next two years.”

The efforts are likely to take a toll on the profitability and credit quality of even the country’s biggest lenders. But S&P and other analysts said China’s smaller banks may be particularly hard hit by Beijing’s efforts to cool China’s economy.

The S&P report comes amid broader worries that China’s economy — the biggest engine of global growth in recent years — could slow significantly this year. Part of the concern is that banks could throttle back on credit too quickly.

“Over tightening could lead China into an unwanted policy-induced slowdown. This is the main risk,” said Paul Schulte, head of financial strategy and banks research at the Hong Kong unit of China Construction Bank Corp.

Separately, the Organisation for Economic Co-operation and Development revised its forecast for China’s gross domestic product growth this year down to 9.0 per cent, from a projection of 9.7 per cent made in November. China’s GDP grew 10.3 per cent in 2010.

Although about two-thirds of the banking system’s assets are concentrated in a handful of commercial and joint-stock banks, in total China has more than 3500 banking institutions, many of which provide vital financing to local areas.

Most of the smaller banks lack the risk-management skills of their larger counterparts, and have traditionally been more susceptible to pressure from local authorities to make loans for political reasons.

Rural banks have lent a greater portion of their loan-book to firms backed by local governments than the major banks. While such companies kept China’s economy ticking during the global financial crisis by funding a massive infrastructure expansion, the poor quality of their finances have set alarm bells ringing in Beijing, with S&P forecasting 30 per cent of such loans could turn sour.

“The pain will be uneven across the sector,” the S&P report said. “The major banks, especially the top-tier banks that we rate, should be able to manage the effects of policy tightening because of their stronger loss buffers and credit risk controls.”

The S&P report said that tightening measures could drive the overall level of nonperforming loans at China’s banks to 5 per cent to 10 per cent of total loans in the next three years, echoing an estimate made last year. That would be a sharp increase from an average 1.14 per cent ratio at the end of 2010.

Regulators have expressed particular concern about the state of smaller banks. In written remarks prepared for a recent gathering of China’s city commercial banks — which account for about 8 per cent of bank assets in China — China Banking Regulatory Commission chairman Liu Mingkang said the banks’ risk management needs to be improved.

“The foundations for the development of city commercial banks are still not strong enough, and management still has some shortcomings,” Mr Liu said.

Curbing inflation has been the top economic priority for China’s authorities in recent months, prompting four interest rate hikes since October and a series of increases in the share of deposits they must hold at the central bank.

The government requires all banks in China to cap the value of their outstanding loans at 75 per cent of deposits. With the reserve requirement ratio now at more than 20 per cent, some banks are struggling to come up with new funds to lend out — particularly smaller banks.

Banks have been in a frantic scramble for deposits in recent months in an effort to ensure they can continue lending. Banks can’t differentiate themselves by offering higher interest rates –Beijing sets a ceiling on deposit rates. But they can offer enhanced services, such as picking up deposits from high-end customers.

Smaller banks instead may find themselves more dependent on borrowing from the interbank market, where benchmark seven-day repurchase agreement rate has almost doubled to about 5.4 per cent in the past two months.

Bank of Beijing Co, of which Dutch financial group ING Groep owns about 16 per cent, said in April that “if the company fails to effectively and immediately replenish its capital base, its capital adequacy ratio can’t satisfy the normal need of business development”.

Larger lenders have the advantage of bigger networks to draw upon, and often the financial resources to attract large deposits at lower cost. Savings accounts now pay interest of only 0.5 per cent a year.

“In an environment where there’s pressure from high inflation and monetary tightening, the scale of the big four banks and their political status will put them in a better position to negotiate for fewer (funding) resources,” said Luo Yi, an analyst at China Merchants Securities.

Still, even big banks’ first-quarter earnings this year suggested Beijing’s moves to cool the economy are having an impact. Profits continued to grow strongly, but at a slower pace than last year.

Industrial & Commercial Bank of China, China’s largest bank by assets, posted a 29 per cent rise in net profit compared with a year earlier, below the 32 per cent rise in the fourth quarter. Bank of China’s net profit growth slowed to 28 per cent from 34 per cent over the same period.

Last month, DBS Vickers trimmed its profit forecast for China Construction Bank by 3 per cent-7 per cent for both 2011 and 2012 to factor in higher operating and credit cost assumptions.

Citigroup in March cut its earnings forecast for small-sized Chongqing Rural Commercial Bank’s results for 2011 and 2012 by 11 per cent and 13 per cent, respectively.

Banks have traditionally drawn the bulk of their profits from lending, with the fixed gap between the central bank-mandated lending and deposit rates giving banks a comfortable profit margin in every yuan they lend out. Beijing is now trying to wean banks off their loan dependence, encouraging banks to earn more of their income from providing services that generate fees.

“But rising credit costs could wipe out all the benefits of the increase in margins and noninterest income,” the S&P report said.

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