In April 2020’s Global Financial Stability Report, the IMF praises China for its financial stability throughout the COVID-19 pandemic and ascribes its stability to “still limited external financial linkages, a strong role of government-owned financial institutions and firms, and early proactive efforts by the authorities that helped stabilize market conditions and sentiment.” Indeed, China’s commercial banks remained healthy and posted a net profit growth rate of 5 percent in the first quarter of 2020 on a year-to-year basis. However, there are various signs that the banking sector is under serious challenges. It is thus important to recognize these challenges and take measures to secure the banking sector’s stability and profitability.
Asset Quality
The first challenge pertains to the negative impacts on the banks’ asset quality due to the pandemic. While the large state-owned commercial banks are in a good shape, smaller banks are seeing eroding asset quality and heightened credit risks, according to China’s Banking and Insurance Regulatory Committee. This is due to three main reasons. First, one-third of bank lending went to manufacturing, wholesale and retail, and transportation, storage, and postal services, and these sectors are significantly distressed by the pandemic.
Second, over 75 percent of banks’ revenues come from interest income. As the central bank cut prime lending rates in February to stimulate the economy, it reduced the net interest margin (NIM) of the banks. Although it is generally believed that the central bank won’t further slash lending rates, it is still a possibility should the economic recovery not proceed as expected. For example, CIMB International Securities expected a 5 to 10 basis point contraction of NIM this year.
Third, and most relevant for small- and medium-sized banks, is the fact that these banks account for a much larger share of the loans to small- and medium-sized enterprises (SMEs). While large commercial banks take up over 60 percent of the banking sector assets, they only account for around 30 percent of SME loans, whereas joint stock banks, urban commercial banks, and rural commercial banks comprise 70 percent of such loans. In particular, rural commercial banks account for 37.6 percent of SME loans. The quality of SME loans is quickly worsening as SME borrowers are hard hit during the pandemic. The industry-wide nonperforming loan (NPL) ratio for banks has climbed from 1.86 percent in the last quarter of 2019 to 2.04 percent in the first quarter of 2020. While the level of NPL is still low, the increase of 9.6 percent in just one quarter is significant and concerning. Worse, the NPL ratio of 134 city commercial banks reached 2.49 percent by the end of March, while that of thousands of rural commercial banks reached 4.9 percent. With less capital reserves and riskier loans, these smaller banks are much more vulnerable as their NPL ratio rises.
Financial Opening and Reform
While the first challenge is relatively short term, the second challenge, due to China’s financial opening and reform, would affect commercial banks over the medium and long term. The Chinese government has committed to further opening the Chinese financial sector. The so-called 11 Measures, passed in July 2019, allow majority foreign ownership in securities, fund management, futures, life insurance and currency brokerage. Foreign players are allowed to participate in pension fund management, credit rating agencies, and domestic bond underwriting. Limits to ownership or participation in other areas have also been raised, including foreign-invested insurance companies, insurance asset management, wealth management, and pension fund management.
Additionally, the government has decided that China needs to develop further its capital markets. In January 2020, regulators called for more household savings be diverted to capital markets through “wealth management, insurance, trust and other products.” Currently, 42.9 percent of household financial assets are held in bank deposits and 13.4 percent in wealth management products (WMPs). Only 8.1 percent, 3.2 percent, and less than 1 percent are in securities, funds, and bonds, respectively. Given households’ portfolio preferences, Chinese banks have enjoyed plentiful of deposits at low costs, but this could change as the capital markets further develop and attract household wealth away from bank deposits. And financial services provided by the capital markets and foreign financial institutions would intensify competition and further reduce NIM and non-interest incomes for banks.
Shadow Banking
The third and final challenge comes from the shadow banking system. The “deleveraging campaign” started in 2017 has significantly curtailed the shadow banking system, whose assets shrank by 11.5 trillion Chinese RMB ($1.6 trillion) in the past three years. But the pandemic and economic slowdown may prompt regulators to rebalance the priority between reining in credit expansion and stimulating the economy. The Institute of International Finance (IFF) estimated that China’s debt-to-GDP ratio reached 317 percent in Q1 2020, up from 300 percent in Q4 2019, the largest quarterly increase on record, which suggests that the government has eased the credit constraint. According to Moody’s, shadow banking assets grew by 100 billion RMB to reach 59.1 trillion RMB in the first quarter of 2020.
With the shadow banking growth, risks heighten. A few salient examples help illustrate the problem: about 43 percent of total WMPs have a maturity of three months or less, which indicates a high refinancing risk. For trusts, the amount of trust assets classified as prone to default or repayment risks exceeded 643 billion RMB. Various small loan and internet-finance companies have stopped raising funds and halted or deferred interest and principal payments. The loan balance of peer lending industry fell by 17 percent in the first quarter of 2020 from the end of 2019.
Further, the fintech industry is gradually morphing into the shadow banking system. Alipay and WeChat Pay control about 90 percent of China’s digital payments market, which not only costs banks $23 billion in card transaction fee revenues, or 5-8 percent of bank revenues, but more importantly, transaction data now bypass the banks. Losing the contact point data of their customers, banks are at a great disadvantage in serving their clients. In addition, Ant Finance now offers a wide spectrum of financial services, such as money market investment (Yu’e Bao), insurance service (ZhongAn), credit rating (Sesame Credit), personal credit line (Ant Micro Loan), and lending (MYbank). All these could pose disintermediation challenges for banks, and compete for some of the important sources of bank revenues.
Indeed, financial opening, capital market development, and fintech growth would also provide opportunities for China’s banks to learn, compete, and improve over the long run. But the challenges they pose should also be reckoned and managed with caution to ensure banking sector stability. From a policy level, while small- and medium-sized banks should continue to extend credit and support SMEs, large commercial banks are better positioned to withstand risks and should play a bigger role. Moreover, aside from prudently expansionary monetary policy, fiscal measures should be more forcefully carried out in order to bolster demand and improve business profits. At the regulatory level, regulators need to minimize regulatory arbitrage that tilts the playing field in favor of shadow institutions at the expense of traditional banks. At the bank level, banks must continue to invest in financial technologies, in particular, artificial intelligence, blockchain, cloud computing, and data analytics.
Finally, financial opening means that Chinese banks should accelerate their pace of “going global.” Chinese banks’ overseas lending grew by 11 percent from 2016 to 2019; they earned three times more investment-banking fees than all Asian rivals combined (except for Japan). Going forward, banks should take advantage of the Belt and Road Initiative and other similar projects, where policy banks are investing in basic infrastructure like ports and roads, while commercial banks could pick up lending to “bankable” projects such as shopping centers and properties.
Yan Liang is Professor of Economics at Willamette University.