Improving producer prices and industrial profits are crucial to alleviate bad-loan pressures. A further rate cut by the People’s Bank of China is not desirable, as this will suppress net interest margins and hence banks’ profitability.
The property frenzy is also a serious issue. Household balance sheets and collateral will worsen if real estate prices adjust downwards sharply.
Commodity prices would tumble and industrial profits would decline. It could turn out to be a global macro event. Souring bad loans will propel a bull market in onshore rates, RMB depreciation, and a surge of credit spreads.
The bottom line is Chinese banks will need to deal with more bad loans given the rising trend of special mention and overdue loans. Credit risks are increasing and defaults will be more frequent.
That said, bad loans represent only one side of the balance sheet. To assess the stability of the banking sector, we need to assess banks’ ability to write off and capacity to raise capital.
CAPITAL ADEQUACY MATTERS MORE
Bad loans are a backward-looking indicator. A forward looking approach adopted by regulators is to assess capital adequacy ratios (CAR) and risk-weighted assets (RWA).
Consider that China adopted Basel III in 2012 and its six largest banks have already adopted an advance approach in calculating capital adequacy.
As of the second quarter of 2016, core Tier 1 CAR (CET1) was 10.69 per cent and Tier 1 CAR was 11.1 per cent (computed as common equity to risk-weighted assets, or RWAs).
When loss reserves and subordinated debts are included, CAR grows to 13.1 per cent. By Basel III, banks need to maintain a Tier of 6 per cent, comprising a minimal CET1 at 4.5 per cent plus an additional Tier 1 of 1.5 per cent. Given a difference of 5.1 per cent, the CARs of Chinese banks maintain a good margin above Basel requirements.
While the size of potential loan loss is higher than the total loss provision at the moment, the risk of a significant threat to the Chinese banking system is still low. If no more than 33 per cent of special mention loans turn sour, the current level of reserves can cover the actual loan losses.
If we assume that 75 per cent of the special mention loans eventually turn into NPLs, banks will need to fill a gap of RMB1.4 trillion.
As the net profits before tax of the banking industry are projected to be about RMB2trn in 2016, the overall system can still meet losses without the need for extra capital injection.