China’s financial sector takes a big step forward

Ryan Tsang of Standard & Poor’s explains why a cut in interest rates and the relaxation of lending and deposit rate controls may have far-reaching effects on China’s banking sector.

China’s financial sector takes a big step forward
China's central bank is making efforts to liberalise interest rates and reform the country’s financial sector (ImagineChina)

This month, China’s central bank announced reforms that aim to reduce lending rates and spur economic growth. Under the changes, Chinese banks can make loans at a 20% discount to benchmark lending rates, from 10% earlier, and offer interest rates to depositors of as much as 1.1 times the benchmark deposit rate.

What are the implications of these reforms?
Undoubtedly, the changes represent a giant leap in China’s efforts to liberalise interest rates and reform the country’s financial sector. One of the key long-term benefits is that China’s financial sector may end up with a more efficient system of allocating credit, as well as a more diversified loan portfolio. We believe the 10% elbow room given to banks to set their deposit interest rate is a small step in relaxing the government’s control over the previously rigid benchmark deposit-rate ceiling. The economy, too, will likely benefit as consumers and businesses take advantage of higher deposit rates and lower interest rates. That said, it will take time, perseverance, and hard work — including further development of a risk culture and expertise in managing lending to small businesses — to realise the long-term benefits.

Although these reforms will lead to some pressure on the profitability of Chinese banks over the next few years, we don’t expect these actions to have any significant influence on our bank ratings. That’s largely because our ratings on Chinese banks have already factored in falling profitability in 2012. We estimate that the interest-rate cut and the interest-rate liberalisation may hit the banking sector’s return on average assets by 10bp (equivalent to $17 billion) in 2012 and by 20bp to 25bp (equivalent to $42 billion) in 2013, if banks keep their assets and liabilities mix largely unchanged.

Despite these significant changes, we’re not predicting a drastic increase in loan growth; indeed, we’re maintaining our expectation of 12% to 14% full-year loan growth for the sector. Nevertheless, the interest-rate cut may encourage risk taking, and we expect demand for bank loans to rebound from the current weakened position. However, we believe that the Chinese government is unlikely to allow banks to expand their loan book in the same manner and pace as in 2009. That’s because the government is still dealing with the aftermath from the 2009 credit boom.

Also, we expect Chinese banks to be more selective in granting loans than in 2009. While liquidity for property developers could improve slightly, banks probably won’t materially change their attitude towards lending to these companies.

Will Chinese banks shift their behaviour?
The reforms may ease funding for smaller businesses and speed up the shift in the Chinese banking sector’s loan mix away from large companies. According to the People’s Bank of China, the country’s central bank, loans to small businesses accounted for 18.5% of the sector’s loan book at the end of 2011. As interest rates are liberalised further, the spread on loans to large corporates could narrow quickly. This will encourage banks to provide more loans to small and midsize enterprises and individuals, and therefore protect their net interest margins.

Chinese policymakers appear to favour a shift in bank loans away from large companies because they believe small business loans are vital for China’s economic transformation and job creation. The gradual move in interest liberalisation — reinforced by the lowering of risk weights on such exposures under China’s newly revised capital rules — could encourage banks to increase exposure to these classes of assets.

In an unlikely scenario that small business loans increased markedly in a very short span of time, exposures were not properly priced, and earnings were not adequately retained, the sector may face significant downside risk when those credits turn sour.

Do you expect the reforms to speed up substantially?
We view the central bank’s latest move as a symbolic restart of China’s interest-rate liberalisation process, which has been largely on hold since 2004. However, to avoid triggering any major downside risk, we believe the pace of liberalisation and the shift in the loan mix will be gradual, in an effort to keep a delicate balance between deregulating interest rates and protecting Chinese banks’ earning capacity to absorb credit losses. This issue is pertinent because China’s banks have accumulated high credit risks to segments such as local government financing platforms, property developers, and certain industries that face overcapacity, such as steel.

What influence will the revised capital requirements have on the sector?
China’s recently revised capital requirements, which extend the timeline for the minimum capital ratio implementation to align with the Basel III timetable, will likely keep banks’ capital levels within our forecast range over the next two years. Based on our risk-adjusted capital framework, we estimate the risk-adjusted capital ratios of the major banks that we rate at about 6% to 7%, indicating “moderate” capitalisation, as our criteria define the term.

The revised rules, together with the capital needed to fund growth, may push Chinese banks to shore up capital. The rated major state-owned systemic banks, which face a higher requirement, may have to retain more profits to build up their capital in the next few years. The immediate effect of the revised requirements on Chinese banks’ capital ratios would be much less severe than what it would have been under the rules proposed by the regulator’s previous consultation paper on bank capital requirements.

 

Ryan Tsang, the author of this article, is an analytical manager for financial institutions ratings at Standard & Poor’s in Asia-Pacific. Based in Hong Kong, Ryan leads a team of analysts that evaluate the credit quality of major financial institutions in Asia-Pacific.

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