Chinese banks' improved asset quality cannot hide other phantoms

Robust economic growth and, especially, higher industrial prices have pushed up Chinese corporates’ profits since 2016. This comes as an upturn after a horrible 2015. Indirectly, this has also helped banks as it has increased companies’ cash flows to repay their large debt burden. However, this improvement in asset quality cannot mask other growing concerns in China’s banking sector.

Beyond liquidity concerns, which are real but still can be managed by the PBoC’s lax monetary policy stance, there are other structural issues emerging, namely low profitability and insufficient generation of organic capital. This is not because Chinese banks are not profitable but the amount to revenue generated to keep up with the rapid speed in balance sheets. In other words, Chinese banks’ balance sheets – although decelerating – are still growing too fast. Below is a more detail account of Chinese banks’ structural problems.

Whilst the worst seems to be over in terms of profitability - as net profit growth has rebounded from a low point in 2015 - the gap between asset and profit growth is still large, pushing down banks’ return on assets (ROA) and return on equity (ROE). The insufficient profit growth stems from an increasingly meager interest income, which is still the bulk of Chinese banks’ income. This situation is particular difficult for smaller banks. The latter have long need to fight hard for liquidity and this has pushed up their funding costs and, thus, reducd their net interest rate margin.

The other factor is policy. The large scale local government debt swaps have increased banks’ investment book but have also lowered the average interest rate that banks are getting for their loans to local governments (from an average of 10% to now 4%). In other words, their lending since 2008 has ended up being safer condition but certainly less profitable.

Finally, the helping hand that Chinese banks were expecting to receive from non-interest income is increasingly limited due to the crackdown on off-balance sheet items and shadow banking. As a response, banks have switched to expanding income sources from credit cards and advisory business, but it has proven hard to substitute the previous sources of non-interest income.

As if this were not enough, Chinese banks’ cost of funding continues to increase. The lower profitability is reducing the ability of Chinese banks to generate organic capital and fueled the urgent need to seek capital elsewhere. Such demand will only increase down the road as the CBRC imposes TLAC requirements down the road.

All in all, the improvement in asset quality by sharing the risks with rest of the financial sector could be a relief for banks but it actually not enough to keep pace with the growth of assets of Chinese banks. Down the road, more stable sources of income and more organic generation of capital will be needed for Chinese banks’ to be totally out of the woods after a massive credit binge.