Concern grows over cracks in Chinese credit system

By Michael Flaherty and Samuel Shen
Thursday, October 16, 2008

HONG KONG: With signs of cracks appearing across the Chinese credit system, concerns are growing that domestic banks may be ill-equipped to handle a drop in the country's economy.

Corporate collapses and loan defaults in China over the past few weeks, together with a tightening interbank lending market, show that Chinese banks are hardly in the clear when it comes to negotiating their way through the global financial turbulence.

Some of the financial groups in the nation, including large, state-run institutions like ICBC and China Merchants Bank, have the benefit of government ownership and relatively small exposure to the subprime mortgage mess in the West.

The main concern is focused on smaller commercial banks, whose regional concentration makes it harder for them to withstand a downturn than for larger, more diverse state-run banks. There are around 8,500 rural financial institutions and 125 city commercial banks, with Bank of Shanghai, Bank of Nanjing and Bank of Hangzhou among the big-name municipal lenders.

"The main risk to China's banks is rapid slowdown in the economic growth and the crystallization of the latent credit risks," said Ryan Tsang, senior director of greater China corporate ratings at Standard & Poor's.

Should smaller banks come under serious pressure or fail, that could lead to weakening depositor confidence and a chain reaction up the banking system.

"Depositors might move a significant portion of their deposits to state-owned commercial banks and other banks that they consider as 'safe,"' Tsang said. "That would put other Chinese banks that are facing tight liquidity in an even more difficult position."

The Chinese government this month toughened its guidance on capital ratios at some banks, a move seen as a pre-emptive step to prevent Chinese banks from returning to their near-bankrupt status of roughly five years ago. That was when the government bailed out some of the largest banks, which were hobbled by nonperforming loans.

The recent collapse of Jianglong Group, a major, privately held textile company in southern China, and loan defaults by the steel maker FerroChina were grim signs for commercial lenders worried about bad loans piling up again.

Take, for example, Zhejiang Province, which focuses on exports and where around 20 percent of small and midsize companies had a loss during the first half of this year, according to GF Securities. That's not encouraging for Bank of Ningbo, a midsize lender with a bad-loan ratio of only 0.4 percent, but whose clients are mostly small, private firms concentrated in Zhejiang.

The value of loans overdue for up to 90 days jumped 53 percent to 2.29 billion yuan, or $335.4 million, in the first half of the year at Industrial Bank, a lender based in Fujian Province. Those loans are often classified as nonperforming loans. Industrial Bank is also highly exposed to the property market, with 14.29 percent of total corporate lending extended to developers - the average among peers being around 10 percent, analysts say.

"Although the bank's overall bad-loan ratio is still low, the rise in overdue loans signals increasing risks in asset quality, especially during an economic downturn," said Wang Yifeng, an analyst at TX Investment Consulting.

Interest earned on loans still accounts for upward of 70 percent of operating income at Chinese banks, making credit risk and the condition of borrowers the top focus for Fitch's analysis of Chinese banks, the ratings agency wrote in a Sept. 22 report. Fitch points to rising borrower stress, an increase in avoiding credit restrictions and tighter liquidity as chief among its concerns, noting that small export and property businesses are under particularly severe pressure.

The overall view, said Charlene Chu, a Fitch senior director, is that Chinese banks in the past five years have built up their reserves on hand to guard against losses and are in a better position than ever to withstand global market turmoil. "But this is still an emerging market," she said. "There's still a lot of risk management and internal control issues, and there are other things happening in the broader economy in terms of borrowers that point to more difficult times ahead."