Regulatory Crackdown Contains Non-performing Loans, Gives Boost to First Half Bank Earnings

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Far-reaching efforts by regulators to bolster the health of China’s banking system will likely lead to stable earnings for the first half of 2017.

Writing for Bloomberg David Millhouse notes that lenders are finding it “hard to fight the efforts of the government” when it comes to accelerated reforms of the Chinese banking system that are intended to stymie system risk and keep a lid on non-performing loans.

“Over the past year, China has announced several policies to reduce NPL risks at the major banks, such as requiring credit committees, enabling local asset management companies, promoting debt-for-equity swaps, encouraging the growth in securitisation, and promoting new state-owned enterprise capital management holding companies,” writes Millhouse.

“Regional asset management companies are likely to play an increasingly important role in managing bad assets, possibly by stepping up purchases of NPL’s,” a move which will spare state-owned banks from bearing too much of the brunt of loan defaults.

According to Millhouse these policies are displaying some initial success, pointing to data from the China Banking Regulatory Commission which indicates that the NPL ratio at the end of the second quarter remained flat at 1.74%, while net interest margins increased to 2.05% from 2.03% in the preceding quarter.

These figures bode well for the first half earnings of Chinese banks, as do strong corporate earnings following an an impressive first-half economic performance, which will shore up asset quality.

Millhouse’s article coincides with an editorial published by the Xinhua News Agency trumpeting the early successes of a crackdown on the financial sector by Chinese regulators.

Millhouse nonetheless raises concern about the pace and scope of recent debt accumulation amongst Chinese banks, chiefly due to ongoing increases in corporate – and in particular state-owned enterprise, levels of leverage.

Debt has risen from approximately 85% in 2008 to over 150% today, in large part due to the credit-driven stimulus measures launched by the Chinese government to bolster aggregate demand in the wake of the Great Financial Crisis.

While China has embarked upon a much-vaunted deleveraging campaign to address the mountain of debt accumulated then, observers such as former Fitch Ratings analyst Charlene Chu point out that these efforts are not actually reducing the ratio of credit to GDP nor the nominal amount of credit outstanding is contracting.

They are instead dialling back the pace of credit growth relative to GDP growth, making 2017 the first year in a while that the numerator isn’t outpacing denominator two or three-fold.

The International Monetary Fund nonetheless expects total corporate and government debt in China to rise to the worrying high level of nearly 300% of GDP by 2022.

Millhouse said that a key reform needed to stave off a potential financial crisis will involve the credit allocation process at banks, in order to better channels funds towards the more efficient private sector instead of unproductive or speculative investments.

“Lending has been increasingly channeled into non-productivity-enhancing segments, specifically the property market and industrial sectors with existing overcapacity.” he writes.

“SOE’s have taken over a disproportionate percentage of bank credit for their size. This has left private enterprises either starved of capital or turning to more expensive shadow financing.”

It is also imperative for Chinese regulators to slow the pace of credit growth, as they are currently seeking to do with their putative deleveraging campaign, as well as expedite consumption with increased spending by the state on health and welfare.

“If the current pace of debt accumulation does not slow and structural reform does not accelerate, China’s financial problems will increase materially,” writes Millhouse. “For China policy, time is of the essence.”

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