Worst-Case Scenario No Sweat for Chinese Banks: PineBridge

(Bloomberg) -- It's no secret that economists spend much of their time reading between the lines of China's official statistics. Data can be misleading, or incomplete.

So set China's staggeringly low official non-performing loan ratio of 1.8 percent to one side, for a moment, and imagine a far more pessimistic view of the nation's financials; one in which 15.5 percent of the assets of its largest banks turn sour. That presupposes that all of the commercial lending that the International Monetary Fund's April stability report identified as "potentially at risk" goes bad. 

That's still no sweat for the world's biggest lenders, says PineBridge Investments' Arthur Lau: banks in China can withstand the shock, and subordinated bank debt is still a buy, according to Lau, co-head of emerging-market fixed income at the company, who was speaking at a briefing in Hong Kong on Tuesday in which he called the nation's financial stability "very robust".

The view is based on a stress analysis that assumes all 15.5 percent of the  at-risk assets of China's "big five" banks — Bank of China Ltd., the Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of Communications Co. — are impaired due to bad loans. "We have found that they can absorb the shock over the next two or three years without hurting their capital and liquidity ratios, given the top five banks' strong profitability," he said.


The backdrop against which he's speaking seems dire, on the face of it: according to the IMF, China may have 8.2 trillion yuan ($1.3 trillion) of loans extended to borrowers who don't have sufficient income to cover interest payments. The organization put potential losses for China's banks from bad loans at as much as 7 percent of gross domestic product, and the outstanding amount of sour debt has been rising steadily, reaching its highest levels in 11 years at the end of September. 

Corporate debt is growing faster than in Japan's bubble period, Goldman Sachs Group Inc. analysts said last month, urging China to be “more proactive” in recognizing and disposing of bad loans.

The key question, for whether those risks become systemic, is "whether China's banking sector can refinance some of the distressed loans,'' Liao Qiang, analyst for China banks at S&P said during a webcast Thursday. And that, Lau says, is a question of profitability. 

"Based on top five banks, annual pre-provision profit is around 1.5 trillion yuan," said Lau. "This is almost twice the reported stock of NPLs, which is around 700 billion yuan. Existing provision coverage is already more than 100 percent. That means the current stock of NPLs is already being provided and covered."

"Even if you assume the actual NPLs are 10x more than the reported NPLs and the recovery ratio is just 50 percent, it takes only two years of pre-provision profit of the top five banks to deal with the NPLs issue. That is, it won't even touch its equity/capital position," added Lau. "It is just that they may have much lower net profit after the NPL charge off."

The increasing odds of a Federal Reserve rate hike may also help improve margins of Asian banks with "minimal exposure to external shocks," according to Bloomberg Intelligence.

China's big banks have stepped up efforts to dispose of bad loans by writing them off, selling the credit to asset-management companies or packaging them up as securities. The government's new debt-to-equity swap program also seeks to cut corporate leverage and reduce soured credits.

According to PineBridge, overall total capital adequacy ratio has been stable for the last few years, with that of big five banks in 2015 improving compared to the previous year. 

Sources: CBRC, CEIC, SNL, Deutsche Bank

Lau doesn't expect systematic risks to spill out in the Chinese banking system even if the debt bubble blows up. 

"While there are hurdles to overcome in terms of writing down the bad debts, my opinion is that buying Chinese banks' subordinated-debt is probably better than equities," he said.

On a volatility-adjusted basis, Asia's fixed-income market has largely been resilient despite global headwinds. In the first 10 months of the year regional investment-grade dollar credit performed better than many global asset classes, he said, including the S&P 500.

Within Asia, dollar-denominated investment-grade bonds yielded 5.5 percent on average in the run-up to the U.S. presidential election, about 100 basis points higher than the Hang Seng Index, he said. It has been relatively stable after Donald Trump's surprise victory, with spreads of Asian credit, especially those of sovereign players, showing less volatility than global emerging markets ex-Asia.

Source: Barclays, JPM, PineBridge Investments

 

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