Moody's: Outlook for China's banking system is negative; operating environment deteriorating

Moody's Investors Service says that the outlook for the Chinese banking system is negative, as the operating environment will become more challenging in the coming 12-18 months, reflecting slower economic growth, an increase in corporate sector restructuring, and rising concerns over elevated asset prices in some areas.

"Our baseline scenario assumes a further moderation in real GDP growth to 6.3% in 2017 from 6.7% in the first three quarters of 2016. In view of weaker demand for corporate loans and the Chinese authorities' stance to pursue corporate deleveraging, we expect credit growth to moderate as well," says Christine Kuo, a Moody's Senior Vice President.

"Accordingly, during the horizon for our outlook of 12-18 months, asset quality will remain pressured; capitalization, and funding and liquidity will be stable; and profitability will deteriorate, while the system will also be experiencing the effects of the deleveraging in the corporate sector," adds Kuo.

"At the same time, we expect government support to remain strong for the major banks, reflecting the policy imperative of maintaining public confidence and systemic stability. And, while we think that government support for smaller banks will become more selective following the implementation of the deposit insurance scheme, it will remain high for the larger regional banks," says Yulia Wan, a Moody's Assistant Vice President and Analyst.

Moody's conclusions were contained in its just-released, "Banking System Outlook - China Deteriorating Operating Environment and Asset Quality Drive Negative Outlook" co-authored by Kuo and Wan.

Moody's expectation is that the Chinese authorities will step up their efforts to tackle the country's rising level of corporate leverage over the next 12-18 months.

While this heightened policy focus to contain leverage and close non-viable companies will address a key financial system weakness, it also raises adjustment risk for the banks in the near term by increasing corporate defaults and loan restructurings.

As indicated asset quality will remain pressured. Debt restructuring for distressed borrowers will help keep the headline nonperforming loan (NPL) ratio stable, but will also result in economic losses for creditors of various classes, including the banks.

Broad liquidity conditions will remain satisfactory, reflecting slowing loan growth, the central bank's overall supportive monetary policy and the system's large deposit base. On the other hand, we see limited room for further policy easing, given the policy focus shift towards deleveraging, containing risks from capital outflows, the steep rise in property prices and gradual increase in inflation. This could pressure the banks' liquidity management, especially for mid- and small-sized banks which have become increasingly reliant on wholesale funding to support their investments in assets with longer durations.

With capitalization, the banks will maintain stable and adequate capital levels, underpinned by slowing asset growth and capital-raising. Mid and small-sized banks, which tend to grow their assets faster than large banks but have weaker internal capital generation, will face higher capital pressure and be more likely to turn to equity and capital securities issuances to sustain their capital levels.

Furthermore, profitability will be pressured as moderating economic growth, the adoption of a more conservative growth strategy by the major banks and the broad shift towards deleveraging constrain the banks' income prospects from lending. Net interest income still accounted for around 70% of total revenue in the first three quarters of 2016.

However, this pressure on profitability will be partly mitigated by continued growth in non-lending income and the banks' favorable cost structures.

In summary, Moody's assessments for the key drivers for China's banking system outlook are: Operating Environment, Deteriorating; Asset Quality and Capital, Deteriorating/Stable; Funding and Liquidity, Stable; Profitability and Efficiency, Deteriorating; and Systemic Support, Stable.

Moody's rates 22 banks in China that together accounted for 65% of total system assets as of 30 June 2016.