Fitch: China Operating Environment Remains Key Bank Constraint

A weak operating environment in China related to macroeconomic, regulatory and capital market factors remains one of the key constraints on bank Viability Ratings (VR), says Fitch Ratings. Issuer Default Ratings for Chinese banks are all support-driven with VRs for large state banks in the 'bb' range while mid-tier banks - whose VRs were all recently affirmed - are mostly in the 'b' category.

Positive momentum in bank VRs is unlikely until the operating environment stabilises. The current direction of structural macroeconomic rebalancing, reforms to the regulatory framework and liberalisation of capital markets is potentially positive for the sector's outlook, however there are uncertainties and risks in each of these areas.

China's ongoing economic slowdown amid restructuring away from capital investment-driven growth is a necessary step towards more sustainable long-term economic growth - Fitch forecasts China's real GDP growth to fall to 6% by 2017. A lower reliance on credit as the economy rebalances would be positive for bank stability. However, thus far, leverage as a percentage of GDP has continued to rise even though credit growth has slowed. Also, restructuring in sectors that are highly leveraged and burdened by overcapacity remains in the early stages.

Reforms to the regulatory framework are also potentially positive for the long-term sustainability of the financial system and economy, and by extension, bank VRs. However, the efficacy of the reforms may be diluted by delays in the full implementation of regulatory changes. For example, despite the removal of the loan-to-deposit (LTD) ratio cap and full interest-rate liberalisation - both significant reforms that could enhance system transparency and reduce incentives to retain risk off-balance sheet - banks remain subject to guidance in their LTD ratio and deposit pricing.

The development of equity and debt capital markets in China would increase the prospects of banks diversifying risk and reducing their high exposures to much of the credit in the financial system. This in turn would provide major benefits to bank stability. However, interventions by the authorities have at times discouraged entities from issuing equity or debt and investors from participating.

More clarity around the authorities' support for counterparties, including more explicit guidelines about which entities are considered priorities for support and when troubled borrowers would be permitted to default or restructure, is necessary to improve assessment and pricing of credit risk. By extension, this would enhance the efficiency of credit allocation and be positive for transparency and governance. Notably, the latter two factors are reflected in bank VRs.

A better understanding of banks' risks - direct and contingent - could lead to changes in how banks' intrinsic credit profiles are assessed. Fitch will also reassess Support Rating Floors to the extent that developments in regulation, corporate restructuring and the economy lead to changes in the propensity and/or ability of the government to support banks. As an example, Fitch recently revised up the Support Rating Floor and upgraded the Issuer Default Rating for Shanghai Pudong Development Bank to 'BBB-' from 'BB+'.

Greater market liberalisation and the development of fully functioning capital markets will come with risks, including increased market volatility. This may lead to higher NPLs and credit losses in the short term. However, Fitch believes that banks' long-run stability is more likely to benefit from improvements in transparency, risk management, diversification and governance.