China's Planned Issuance of Basel III Capital Securities May Test Investor Appetite

Planned issuance of Basel III capital securities by China's largest commercial banks through to the end of 2014 could be sizeable and, as a result, may face a challenging market, says Fitch Ratings.

The large volume of issuance relative to the size of the market could test investor appetite when there are persisting uncertainties surrounding slowing profitability growth, rising non-performing loans (NPLs) and concerns about the state of the property market.

Chinese bank issues are also likely to come when European lenders are looking to return to the market with sizeable transactions following the seasonal summer lull.

"Based on market sources, we expect up to US$20 billion in Additional Tier 1 (AT1) and Tier 2 (T2) capital to be issued by the big five Chinese state lenders by the end of the year, some of which will be raised in offshore markets," says Fitch Ratings.

The issuance of capital securities by Chinese banks will provide a supportive buffer as economic conditions become more challenging.

Raising this form of capital is part of the Chinese authorities' plans to fortify balance sheets of systemically important banks amid potential asset quality risks, rising off-balance sheet exposures, tightening profit margins owing to the forthcoming liberalization of interest rates and liquidity volatility.

Further, this will also better position Chinese banks for ongoing asset growth.

The likely US$20 billion in issuance of capital securities by the big five banks is equivalent to just 2.7% of end-2013 capital and 0.2% of total assets.

While new capital securities may boost confidence in the system, the size of issuance will be small relative to existing capital and assets, and is no substitute for common equity.

Chinese banks have lower equity to asset ratios than emerging market peers, and this is before factoring in potential off-balance sheet risks emanating from the shadow banking system in China.

Some of the issuance will probably go toward refinancing legacy subordinated debt. As such, the capital raisings alone should only be modestly credit supportive.

"An additional challenge for international investors will be the uncertainties around how China will address the point of non-viability (PONV) for banks," says Fitch.

Fitch notes that previous international Basel III issuance by Chinese banks has been completed through their Hong Kong-based subsidiaries, which are regulated by the Hong Kong Monetary Authority.

In China, the China Banking Regulatory Commission (CBRC) has discretion to determine PONV for T2, but the People's Bank of China (PBOC) and State Council may also play influential roles in determining PONV, particularly when it comes to public sector capital injections.

However, for the large, systemic banks, the Chinese government will likely seek to avoid triggering PONV as this would indicate a systemic bank failure.

"While we expect all of the big five state banks to issue capital securities, as the final amount to be raised remains unknown, it is too early to determine to what extent these issues will offset pressures in the system and have a positive influence on bank standalone strength, reflected by the Viability Ratings (VRs)," says the ratings agency.

The agency says that it's main measure of capital when assessing bank capital strength, Fitch Core Capital, will not be strengthened by these issues.

"The relatively modest VRs of China's largest lenders - the five state-owned commercial banks all maintain VRs in the 'bb' range - reflect potential pressures from a combination of rapid system-wide credit risks, strains on capital, liquidity volatility and tightening margins as financial liberalization gathers pace," says Fitch.