Standard & Poors (S&P) has released its China Banking Outlook for 2014, which warns of a “turbulent flight ahead”:
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.
However, S&P does not anticipate a severe rise in non-performing loans (NPLs), which it expects will hit 3% by years end (from around 1% currently), supported by a stabilising domestic economy and pragmatic policy responses.
S&P also notes growing liquidity challenges for some banks:
…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.
It also expects Chinese bank profitability to fall:
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.
Nevertheless, S&P ascribes a stable outlook for the 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 factors in strong credit growth and high financial volatility.
A more alarmist take on China’s financial system is provided by perma-bear, Ambrose Evans Pritchard, who warns of a deflationary vice as China deflates its bubble:
What is clear is that we are dealing with a credit expansion of unprecedented scale, equal in size to the US and Japanese banking systems combined. The outcome may matter more for the world than anything that the US Federal Reserve does over coming months under Janet Yellen, well signalled in any case…
The effects of [a hard landing in China] on large parts of Latin America, Africa, the Middle East, and core Eurasia would hit before offsetting benefits accrued to consumers in the West. Such commodity shocks are “asymmetric” at first. Southern Europe would fall over the edge into deflation, pushing Italy, Portugal, and Spain deeper into a debt compound trap…
Whether this unfolds depends entirely on how the world responds. One can hardly be sanguine. Raghuram Rajan, India’s rock star central bank chief, says global co-ordination has “broken down”. Turkey, Brazil, and South Africa, among others, are tightening into economic downturns to defend their currencies. Others are distracted by their own political struggles at home…
So we keep our fingers crossed as we glimpse the first foam of a deflationary Ch’ient’ang’kian coming our way from China. The world’s central banks have no margin for error.
I’ll believe it when I see it.
