Chinese banks have ‘a cough, not a fever’

Mounting non-performing loans from the Chinese government’s ¥4 trillion ($586 billion) post-2008 stimulus package have led to widespread fretting about the health of the Big Five state-owned Chinese banks.

Image courtesy JHH: http://commons.wikimedia.org/wiki/User:JHH755

Bank of China Shapingba branch, Chongqing

That fear has spurred selling. Shares in financial giants like China Construction Bank (CICHY, quote) and China Merchants Bank (CIHKY, quote) have dropped by some 20% over the past four months.

But experts say the worry may be overblown. The problems for Chinese banks are “like a cough, which is not a good thing, but does not pose real danger to your health,” says Xi Junyang, deputy director of the Research Center for Modern Finance at Shanghai University of Finance and Economics. “There is no fever, no need to go to the doctor.”

Non-performing loans (NPL) by Chinese banks inched up by 2.4% in the first quarter of this year compared to a year earlier, to stand at ¥438.2 billion, according to the China Banking Regulatory Commission (CBRC).

But NPL rates at all of the Big Five remained comfortably below 2%. And that total is nowhere near the ¥3.4 trillion that spurred a state rescue of the banking system in the early 1990s. Chinese banks’ quarterly profits meanwhile, jumped by 20% year-on-year to ¥326 billion systemwide.

Agricultural Bank of China (ACGBY, quote) has the highest bad-loan ratio in the Big Five at 1.44%, reflecting its heavy reliance on retail business in rural China, analysts say. “Some consider the wide customer base as an advantage, but in terms of risk management it represents a challenge,” said Cindy Li, Senior Economist at The Milken Institute.

China Merchants has the healthiest balance sheet with just 0.56% NPLS. The rates for Bank of China, (Hong Kong ticker 3988) China Construction Bank, and Bank of Communications (BCMXY, quote) are 0.98%, 1.04% and 0.81% respectively.

It is true that NPLs for Chinese banks are on the rise after declining steadily since 2004. They will go up further in the coming years, Li says, as economic growth cools and the government tightens credit to the real estate industry for fear of a bubble.

As part of their function to help China through the 2008 financial crisis and expand domestic demand, the Big Five Chinese banks also lent a worrisome ¥2.13 trillion to the so-called local government financing platform, which manages infrastructure investment projects that are not always profitable. Now that local governments are seeing red ink, the recovery of those loans becomes more questionable.

“Usually the emergence of non-performing loans lags about three to four years from the time that the loans are originated,” Li points out. Still, he expects NPLs to stay below the symbolic 2% threshold, given a relatively favorable though cooling economic background.

State-owned Chinese banks also have no trouble generating revenue thanks to healthy, so far regulated spreads, between lending and deposit rates. Interest income accounts for 80% of net operating income for the entire industry, compared to about 60% for U.S. banks like Citigroup (C, quote). Until deposit rates are liberalized, “the banks will continue to get a stable profit from the interest rate deferential,” said Li.

Serious long-range challenges remain for Chinese banks, which have to balance a dual role as government economic tools and corporations responsible to shareholders.

The Chinese government’s push to align its financial system with global standards and welcome a wider audience further complicates life for bank managers.

The system suffers from a lack of creativity, Xi says. Chinese banks rely too much on traditional operations and grow ever-more similar to each other through copying. The most crucial problem is perhaps the governance structure. “Now all the banks are state-owned, the presidents are mainly government officials named by higher government authorities and shoulder mostly responsibilities for them, not shareholders,” Xi says.

But for now, rumors of an impending crisis in Chinese banks are likely to prove exaggerated. Investors should think about buying, not running for cover.