Rising Leverage in Corporate Sector Remains a Key Risk Facing China's Banks

Fitch Ratings' outlook for the Chinese banking sector in 2017 is negative, reflecting its view that weak profitability and strong credit growth will keep capitalization under pressure. High and rising leverage in the corporate sector remains a key risk facing China's banks.

China's debt-resolution timeline is being pushed back by measures to lessen the debt burden on corporate borrowers - including low interest rates, loan rollovers, debt-for-equity swaps and a loosening of prudential controls.

Leverage will continue to increase, especially at the corporate level, as long as there is reliance on credit to support GDP growth targets.

“We have revised up our estimates for growth in leverage, with Fitch-adjusted total social financing/GDP now likely to reach 258% by end-2016 and 274% by end-2017,” says Fitch.

The authorities' attempt to boost household lending may help to diversify risks. Household lending is relatively safe compared with corporate lending - given low LTV for mortgages, low household leverage and a high savings rate.

However, rapid mortgage growth is driving sharp increases in residential property prices, and has the potential to fuel a further increase in corporate leverage since corporate borrowers use real estate as collateral to secure lending.

Furthermore, policy guidance for banks to extend lending to struggling borrowers in over-capacity sectors also weighs on the banks' risk-management and governance.

Fitch expects NPL and 'special mention' loan ratios to continue rising in 2017. Bank profitability will remain lackluster and under pressure, owing to another likely cut in the benchmark one-year lending rate and further migration of deposits toward wealth management products (WMPs). WMPs now account for 17% of system deposits, and are a source of funding and liquidity risks for the banking sector.

Our forecast of flat profit growth and a double-digit increase in risk-weighted assets suggests that capitalization will remain under pressure. The amount of announced AT1 and T2 issuance is not enough to keep pace with banks' balance-sheet expansion, while equity-raising will be difficult in light of falling ROEs and questions over China's medium-term growth.

Fitch's previous research estimates that a one-off resolution of the debt problem would currently result in a capital shortfall of CNY7.4trn-13.6trn (USD1.1trn-2.1trn) - equivalent to around 11%-20% of GDP.

The capital gap could rise further if current rates of inefficient credit are sustained and no additional capital is raised.

The Viability Ratings (VRs) of Chinese banks range from 'bb' to 'b', which reflects Fitch's base case of varying-but-significant risks to capital and asset quality. These risks will linger unless there is a shift to a more stable operating environment, characterised by slower credit growth and higher loss-absorption buffers.

Fitch's stable rating outlook reflects its expectation of state support, which remains the sole rating driver for Chinese bank IDRs. More corporate debt is ultimately likely to migrate towards the sovereign balance sheet beyond the local government swap programme.

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