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Chinese Banks: Improved Operating Environment, Credit Positive

Fitch Ratings revised upward the assessment for China’s bank operating environment in May 2021, to ‘bbb-’/positive from ‘bb+’/stable. Grace Wu from Fitch’s Greater China Banks team discusses how an improved operating environment has a positive impact on banks’ standalone credit profiles.

How does Fitch analyse China’s bank operating environment?

The analysis starts with a category-specific implied operating environment score, derived from two core metrics: the latest GDP per capita ($10,235 as of 1Q21 for China) and the World Bank’s Ease of Doing Business ranking (percentile rank of 83.6 for China). This gives a ‘bb’ category implied score for China, according to Fitch’s Bank Rating Criteria.

From the implied score, we apply qualitative adjustments to reflect strengths from China’s ‘A+’/Stable sovereign rating and the degree of macroeconomic stability. The assigned score of ‘bbb-’ is somewhat constrained by China’s regulatory framework as well as the level and size of system leverage, although there has been improvement in the former and we expect stabilisation in the latter.

What drove Fitch’s revision in the bank operating environment?

The upward revision captures China’s progress in curbing systemic and contagion risks in the financial system, aided by the fact that it remained economically resilient during the Covid-19 pandemic. China's higher macroeconomic stability and the sovereign's fiscal strengths also give its policymakers more flexibility to enhance the efficacy of prudential supervision.

These developments have reduced contagion risks for the banking system, but we acknowledge that structural issues remain around credit as well as financial transparency and disclosure, despite improvements in recent years. The positive outlook reflects Fitch’s expectations that progress in  ongoing regulatory developments should address these issues further, and that could lead to further upward revision if sustained.

How effective has China’s regulatory tightening been?

Since the regulatory tightening, shadow-bank assets have declined 30% from a peak in 2017 to 38% of GDP by end-2020. Outstanding off-balance-sheet wealth-management-products (WMP) have also declined to 25% of GDP, from 36%. The amount of interbank WMPs declined sharply to less than 2% by end-2020 from around 20% at end-2016.

Source: Fitch Ratings

Does China’s high system leverage pose a risk?

It is true that China’s system leverage remains high, as measured by outstanding Fitch-adjusted total social financing to GDP of around 270% at end-2020. We view it as unrealistic for an expanding economy such as China to experience a meaningful decline in leverage. It is the underlying trends in leverage that we view as more relevant, such as the shift away from shadow financing and lower leverage in key corporate sectors.

Fitch believes the authorities are increasingly aware that using banks as monetary expansion tools can create tension with their focus on stabilising system leverage. This reduces the risks of policymakers influencing banks to take on unsustainable growth.

Source: Fitch Ratings

Why is this relevant to banks’ standalone credit profiles?

The operating environment is one of the key factors Fitch considers as part of a bank’s standalone credit profile, as reflected in the Viability Ratings (VRs). Per Fitch’s criteria, a higher operating environment assessment lowers thresholds for key financial profile factors used in assessing bank VRs, thus leading to higher assessments for banks’ intrinsic profiles. Fitch upgraded the VRs on six big Chinese state banks in May 2021, as improvements in the operating environment have significantly reduced operational pressures and risks to the banks’ financial profiles.

The developments have also contributed to greater credit efficiency and a stabilising potential capital gap, which we expect to ultimately improve financial stability.

What about the rating outlook for Chinese banks?

Fitch has a stable rating outlook for Chinese banks. All rated domestic banks have Issuer Default Ratings (IDRs) underpinned by our expectations of sovereign support, reflecting their relative systemic importance.

We see further strengthening of China’s regulatory framework from the designation of domestic systemically important banks, as well as banks’ recovery and resolution planning. Subject to any clear indications that sovereign support for China’s systemically important banks will diminish under any enhanced regulatory framework, we expect the banks’ IDRs to generally remain support-driven, and be an appropriate anchor for senior debt – and potentially also for their capital securities.

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