China’s smaller banks shrug off further reform

  • By Elizabeth Fry

Share prices for China’s mid-sized banks have gone gangbusters in the past two weeks as optimism that Beijing would loosen up the rules for the fast-growing smaller lenders grew. Yet, in fact, the opposite is true, according to one China expert.

Ping An Bank’s share price has rallied 16.1 per cent and Fujian province-based Industrial Bank rose 6.2 per cent over the fortnight, beating the A-share banking index which put on just 4.2 per cent.

UBS banking analysts attribute the outperformance to the market's optimistic expectations of a net interest margin turnaround among mid-sized banks as short-term rates dropped in the June quarter.

According to Jason Bedford, a few smaller lenders reported a margin squeeze in the first quarter as regulatory tightening on shadow banking led to a surge in interbank rates.

Stock prices of banks with large portions of wholesale funding generally underperformed in the first half this year, until policy-makers started to soften their crackdown on shadow banking and financial leverage recently.

“This led the market to believe margins may recover from June onwards for underperforming banks,” said Bedford. Margins, of course, get a boost when banks lend on the higher long-term rates while borrowing on the lower short-term rates.

Two-speed process

However, the analyst believes deleveraging and tightening remain firmly on Beijing’s agenda - a theme that was picked up by Bedford at a recent global investor conference along with new reform to curb excesses in the system.

“Ironically, in China the fastest-growing banks in the country are primarily located in the slowest-growing economies, namely the rust belt regions beset with overcapacity issues. We believe this is a precursor to a more determined level of state-owned company reform," he said.

“As we have stated in the past, the way we view the credit cycle in China is that it is a two-speed process. On one side, we have a rapid private-sector credit cycle that we believe is beginning to peak, and on the other we have a slow-burn state-sector credit cycle."

Therefore, Bedford expects to see more non-performing loans from these state-owned companies in the second half, an outcome that would also disproportionately impact the regional banks and the joint stock banks as they are more exposed to regional state-owned companies, as opposed to central government-owned companies.

Upside risk remains

In his opinion, new credit-tightening measures, which cap interbank borrowing at a third of a bank’s total liabilities, are not broad-based credit tightening but rather targeted specifically at the rapidly growing joint stock banks as well as many of the regional banks where annualized balance sheet growth can often be in excess of 60 per cent.

Bedford’s analysis of on/off-balance-sheet wealth management product exposures, of the banks UBS covers, suggested most joint stock banks had relatively high exposure to shadow credit compared with state-owned banks at the end of 2016. Some joint stock bank assets were 20-30 per cent shadow-related.

“Meanwhile, most banks are still under-provisioned for their shadow credit exposure," he said. "Therefore, despite asset quality stabilization, upside risk remains that provisions will increase."

At the conference, Bedford told investors that China has become too complacent in light of the People’s Party Congress at the end of the year.

“The appointment of new heads to the three regulatory bodies for insurance, banking and securities, as well as the recent slew of new regulation, all suggest a very serious commitment to financial reform," he concluded.