BICRA Highlights

China's economic recovery is uneven.  Supportive policy stance is counterbalanced by a prolonged real estate downturn and weak consumption. Geopolitics is a longer-term risk that could cloud the country's economic growth.

Loan growth will likely slow to about 9% annually on average over 2024-2026.  The gap between loan growth and nominal GDP growth will fall as capital expenditure (capex) and economic conditions normalize in China.

Reported nonperforming loan (NPL) and special-mention loan (SML) ratios may rise moderately.  Stricter asset classification has been in effect since July 2023 and will be fully phased in by end-2025. The property market in lower-tier cities has not hit bottom, posing risks to banks that have concentrated exposure in some regions where local governments are fiscally constrained from supporting local economic development.

Our broader nonperforming assets (NPA) metric, which includes NPLs, SMLs as well as estimates of other problem loans, could fluctuate around 5.5%-5.9% over 2024-2026.

At the sector level, the overall provisioning level provides a reasonable buffer.  Credit costs could rise to maintain this buffer amid asset quality headwinds from economically vulnerable sectors, including LGFVs.

A rising proportion of low-margin loans (such as inclusive finance and restructured LGFV debt) and lending-rate cuts to support the economy continue to affect the sector's profitability metrics.

Improvements in the banking sector's information risks should be gradual in the next few years.  While disclosures may improve, big strides in information quality will take several years, especially among the weaker banks.

Economic Risk  |  7

Economic resilience: GDP growth remains on track despite challenges

We expect China's economic growth to slow moderately to 4.8% in 2024 from 5.2% in 2023.  This is slightly below the government's growth target of 5%. Deleveraging in the property and local government sectors have dampened domestic confidence and growth momentum.

But a diversified economy coupled with targeted policies should continue to support growth amid China's economic transformation. Loans to develop the green sector is about double that to property developers at end-2023, for instance.

China's real GDP growth will likely stay at 4.6% over 2025-2026 and 4.4% in 2027.  We project GDP per capita will exceed US$16,000 by 2027 from our estimate of US$13,000 in 2024. The 10-year weighted average trend growth of 4.8% is well above the average of peers.

Meanwhile, China's large sovereign wealth fund strengthens the resilience of the economy against potential growth shocks.

Global overcapacity and national security concerns cloud China's long-term growth trajectory.  These concerns likely mean weak growth for Chinese exports amid higher tariffs, and less foreign investment over the next few years. Technology sanctions and restrictions on knowledge sharing are roadblocks for China's industrial upgrade and productivity growth, which the economy needs to counterbalance an ageing and declining population.

China is developing domestic markets and homegrown technologies to overcome these pressures.  Some funds from the ultra-long special treasury bonds are set aside for a national campaign to upgrade industrial equipment and trade-in consumer goods. Meanwhile, the government continues to introduce measures that increase credit availability to support advanced manufacturing companies in strategic industries, such as science, technology, and renewable energy.

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Economic imbalances: Property and LGFV risks are manageable at the sector level

We project commercial banks' exposure to developers to fall to 5.5% of system loans in 2026 from 6.4% in 2023.  Stricter capital rules for distressed developers and modest risk appetite are curbing property development loan growth for most banks. The government has also remained steadfast in its policies to grow the economy through "new productive forces" such as industrial upgrading, rather than property investment.

We forecast property development NPLs to reach 6.4% in 2025 from our estimate of 5.0% in 2023 due to lackluster primary home sales. Despite a drop in property price, losses will be manageable because property development loans generally have loan-to-value (LTV) ratios below 70%--the maximum LTV at inception (see "China Banks Brace For Tide Of Bad Property Loans," April 14, 2024).

Losses are instead felt acutely in nonbank financing channels, which fund developers shunned by banks.  We estimate these channels account for 35%-40% of developer debt, equivalent to Chinese renminbi (RMB) 7 trillion to RMB9 trillion, versus bank lending of about RMB13 trillion (see "Global Shadow Banks Face Scrutiny As Risks Rise," March 20, 2024). This is apparent from the bankruptcy of shadow bank Zhongzhi Enterprise, to bonds reportedly amounting to about US$200 billion that defaulted or trade at distressed levels, and losses incurred by the 'Big 4' distressed asset management companies (see "China's Distressed AMCs: Government Support Will Be There," Feb. 2, 2024).

Contagion risk to the banking system from these channels is limited, in our view. Lending to nonbank financial institutions accounted for less than 1% of system loans at end-June 2024, according to central bank data.

We estimate commercial banks' exposure to LGFVs in 12 high-risk regions at 2%-4% of system loans.  Restructuring of LGFV debt will likely be selective and gradual. And local governments, LGFVs and original lenders will share the pain of restructuring with banks to avoid moral hazard, in our view (see "Is It Working? China's LGFV Debt De-Risk Program One Year On" July 25, 2024).

We believe the central government is also committed to stability and will provide a broadly supportive funding environment that avoids large-scale LGFV stress. In a downside scenario, we estimate Chinese commercial banks to see their net interest margin hit by 25 basis points (bps) on average, if all LGFV loans were to restructure simultaneously. The hit shrinks to five bps if wholesale restructuring occurs only in the 12 high-risk regions.

That said, small banks could face disproportionately high risks given their constrained credit profile.  Local banks in high-risk regions may have limited capacity to restructure LGFV debt, for instance. Some of these banks may fail, or merge with other institutions with the government's help to prevent them from threatening regional stability (see "Your Three Minutes In Chinese Rural Financial Institutions: A Thorough Cleanup Could Take a Decade," June 26, 2024).

We believe the risks small banks face are adequately reflected by our anchor of 'bb+' and the hypothetical stand-alone credit profile (SACP) of 'b-' for an average Chinese rural bank (see box on the SACP construct by bank type below).

China's economic transformation could lead to more stable debt growth and property price.  Policymakers are making a structural shift away from unproductive, debt-fueled economic growth. System loan growth has decelerated to 8.3% year on year as of end-June 2024, from 10.6% in 2023. We expect credit expansion to gradually converge with nominal GDP growth, barring shocks.

Meanwhile, property price speculation is largely removed from the system, as apparent from mortgage prepayments that led outstanding home loans to fall 2% in 2023. More social housing will help keep a lid on average home prices. A sustained period of stable home prices and debt growth would be credit positive for the banking sector.

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Credit risk in the economy: China's private sector leverage is significantly higher than peers'

The increase in private sector debt-to-GDP ratio is likely to slow over 2024-2026.  We forecast this ratio to rise moderately to 235% by end-2026, from 232% at end-2024, as China reduces its reliance on credit-funded infrastructure investment as a growth engine. There is also less need for the central bank to provide countercyclical credit support so long as GDP growth remains broadly stable. In estimating private sector leverage, we adjust for both shadow lending and quasi-public sector borrowing.

China's private sector debt-to-GDP ratio overstates credit risks faced by banks, in our view.  With low inflation at home, China has been cutting interest rates. Domestic borrowing cost is therefore lower than other developing economies with similar income per capita. Net of deposits, China's private sector debt-to-GDP ratio also compares favorably to that of peers. Lower net debt has contributed to manageable actual losses--less than 50% of our estimated normalized losses for most mega and joint-stock banks on average in the past 10 years.

The Chinese banking sector's loan composition is more diverse than the peer average.  This reflects China's large and diversified economy. Households (including personal business and microfinance loans) accounted for about 34% of domestic loans, and low-risk residential mortgages about 16% at the end of 2023. Banks' exposure to property developers was about 6% of sector loans, while other high-risk segments such as commodities was insignificant. Meanwhile, overseas loans were 2% of total system loans. Single-name risk on group basis is generally limited because regulators cap such exposure at 10% of a bank's equity.

We consider China's lending and underwriting standards to be moderately conservative.  Commercial banks continue to focus on sufficient collateral protection, even when lending to projects under the government's white-list scheme (see "Will China's 'White List' Boost Housing Sentiment?" March 25, 2024).

We estimate the average indexed LTV for residential mortgage lending will rise slightly to 60%-65% over 2024-2026, following the relaxed downpayment rules in May 2024 and softening property prices in China (see "Your Three Minutes In China Bank Mortgages: Risks To Rise In Lower-Tier Cities," May 27, 2024).

But banks lend mainly to first-time homebuyers, which we believe account for 90% of mortgage loans and tend to perform in line with household income than property prices. The mortgage NPL ratio has remained low at less than 1% generally during the ongoing property downturn.

The payment culture in China is a weakness, in our view.  Corporate China has an underdeveloped payment culture due to the continued dominance of state ownership and legacy effects of the country's planned economy. This problem has received the attention of the Chinese government in recent years. In a plenary meeting in July 2024, authorities flagged plans to improve the legal framework to help clear overdue payments owed to private firms.

The rule of law is still less than adequate in China.  Concerns of triggering systemic risks led officials to guide against open defaults in the bond market (see "China's Bond Market Reforms Key To Growing With Less Debt," June 11, 2024). Protracted delays and uncertainties over recovery emerge when it comes to claims over defaults by state-owned enterprises (SOEs).

Liquidations also remain rare as creditors prefer out-of-court resolutions, partly due to the latter's higher cash recovery rates. We believe there is growing recognition that court actions may be preferable to out-of-court negotiations that drag on for years. Court actions also raise transparency and make outcomes more predictable.

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Industry Risk  |  5

Institutional framework: Weak governance and transparency will take time to improve

We see China's banking industry institutional framework risk to be high.  The sector broadly follows and abides by regulations. But smaller banks have weaker governance and financial buffers and may lean toward the letter and not the spirit of the rules.

Regulators have focused their supervisory efforts on these banks in recent years. For instance, the share of regulatory fines imposed on rural institutions (including credit cooperatives and village banks) almost doubled to 38% in the first half of 2024, from 22% in 2021.

China's regulatory record is average among peers, in our view.  Final Basel 3 rules were effective from January 1, 2024. Banks holding about 80% of sector assets are supervised according to international standards. Simpler supervisory rules apply to smaller banks to reduce compliance cost.

Such differentiation in rules does not mean less regulatory oversight. The regulator has established early warning and prompt corrective mechanisms to identify and deal with at-risk banks, many of which are rural institutions. Consolidation of small and mid-sized rural banks has accelerated in 2024, absorbed by new institutions set up by the local governments or larger banks.

Gaps between central and local authorities could present challenges arising from rapid market development and product innovation. A new super regulator was established in May 2023 to centralize control and eliminate these gaps.

We believe supervisory resources are adequate, with about six regulatory staff per institution (or 30 staff including those from the central bank) in China. Various credit bubbles, such as risks posed by some wealth management products, were deflated in an orderly manner over the years. Regulators are also vigilant against emerging risks. They have progressively strengthened climate-risk stress tests on the banking sector, for instance.

A record of governance above regulatory standards could lead to a more favorable assessment.  Authorities have continued their multiyear campaign against misconduct, including high-profile convictions of senior bank and regulatory officials. Regulatory fines imposed on banks have increased 46% in 2023.

The government has institutionalized these actions, which should prompt banks to further enhance their governance. The toll on affected individuals is significant, even if the fines are typically small relative to the profits of the banks in question.

Stricter asset classification rules should improve transparency.  The rules will see more problem assets (including investments) on- and off-balance sheet officially reported. Banks must comply with these rules by end-2025. Still, exceptions are allowed within these rules for stressed borrowers who could create systemic instability. Small, weak banks could also need more time to comply.

Competitive dynamics: Prevalent state ownership influences economic decisions

We consider the competitive dynamics embedded in the Chinese banking system to be high risk.  Prevalent state ownership in the banking sector distorts lending and investment decisions toward policy-supported sectors. It undermines risk pricing because national priorities may outweigh profitability considerations.

Examples include lowering lending rates to inherently riskier small companies that have less collateral, and increasing credit availability to strategic industries that are potentially risky or could cause overcapacity issues that challenge banks' asset quality.

Sector profitability has been on a gradual decline over the years as a result. This was made worse by China's rate-cut cycle and portfolio derisking by banks amid lackluster economic growth and weak income confidence.

A move to fundamentals-driven pricing could take time.  Regulatory guidance on lending typically requires banks to consider their ability to manage risks at the same time. This can be observed from the slow uptick in lending to developers despite policy loosening and very selective cases of loan restructuring for LGFVs.

Under Article 16 of China's proposed Financial Stability Law, local governments are required to let financial institutions operate independently. If carried out effectively, this could gradually create more market-driven pricing in local banks' daily operations.

China's banks have an adequate risk appetite, in our view.  Outstanding credit-card loans contracted 1% in 2023. Joint-stock banks have reduced their loan growth to support capitalization amid pressure on profitability. We believe Chinese banks' compensation structure is linked to multiple performance indicators and de-emphasizes short-term profitability to encourage a balanced approach toward risk. The government's "common prosperity" drive has also resulted in cuts to pay and perks in the sector.

The banking industry is stable given regulatory attention on emerging risks.  Tougher regulations and government policies have reined in the disorderly expansion of conglomerates, fintech companies, and the property sector. Complex and risky products have been curbed since the introduction of stricter asset management rules in 2018. Internet-based lenders now face capital requirements like banks, leveling the playing field. And anti-monopoly rules in May 2024 limit the market share of nonbank payment institutions.

Adoption of central bank digital currency (CBDC) is growing fast off a low base.  The e-CNY (digital renminbi) in circulation was RMB16.5 billion, equivalent to 0.15% of total currency in circulation in 2023. It is now available in 26 cities and accepted by at least 10 million merchants in the mainland. Foreigners can now use the e-CNY wallet app after it received a major update in September 2023.

The CBDC trial was also expanded overseas. Hong Kong residents can set up e-CNY wallets through local banks without needing a mainland bank account. Project mBridge--a wholesale cross-border multi-CBDC payment platform that involves central banks from China, Hong Kong, Thailand, the United Arab Emirates and Saudi Arabia--has reached the minimum viable product stage in June 2024.

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Systemwide funding: Stable deposit base, low external debt and large bond market are strengths

We consider systemic funding risk to be very low in China.  The reported commercial banking sector loan-to-deposit ratio was 78.7% at end-2023. And our core customer loan-to-deposit ratio, which takes a 50% haircut on corporate deposits, was about 118%. This is strong among peers, considering China's very low external debt, and its broad and deep domestic bond market. China has the world's second largest bond market and was added to several major global bond indices in the past few years.

Systemwide funding is a strength of the Chinese banking system, compared with many other banking jurisdictions. We see limited scope for any diminution of systemwide funding metrics or characteristics, which could weaken our risk assessment.

Depositor confidence appears high in China.  Corporates and households hold more time deposits than demand. This is partly due to the government's record of providing liquidity during periods of market turmoil, and the central bank's strong capacity to support banks. A significant portion of corporate deposits comes from SOEs, which we see as a stable source of government related funding for banks. Meanwhile, China's capital controls limit individuals to convert up to the equivalent of US$50,000 in renminbi into foreign currencies each year.

The central bank has taken lessons from the deposit runs at Silicon Valley Bank and Credit Suisse, by strengthening confidence in the deposit insurance mechanism. The regulator reportedly mobilized more than RMB10 billion using deposit insurance and local government funds to repay customers hit by the fraud at some Henan village banks in 2022 up to the coverage limit of RMB500,000.

The banking sector in China has very low external debt.  Geopolitical concerns and the threat of secondary sanctions may continue to constrain some foreign investors' demand for Chinese securities. We believe the likelihood of sanctions happening is very low given the global contagion risk such actions--and the retaliatory actions they could trigger--may entail. But the consequences are high if severe sanctions result in defaults by financial institutions.

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Peer BICRA Scores

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Government Support: Highly Supportive

We classify the Chinese government as highly supportive of private sector systemically important commercial banks. The government tends to view the banking industry as a lever to maintain its influence over the economy. The largest banks in China, which collectively dominate the Chinese banking system, are government-related entities.

We believe the government views maintaining stability in the financial system as a precondition for the country's economic development. The importance of banks--which account for more than 60% of system credit and major investors in government papers--means the government is unlikely to allow a major institution to fail.

By global standards, we view the Chinese government as tending to intervene in the banking sector. The Chinese government has a long record of providing different types of extraordinary support to troubled financial institutions in the past few decades, from the megabanks in late 1990s and 2000s to Bank of Jinzhou Co. Ltd. and Evergrowing Bank Co. Ltd. in more recent years.

The intervention extends to important financial institutions besides banks. In 2021, the government organized the recapitalization of China CITIC Financial Asset Management Co. Ltd. (formerly known as China Huarong Asset Management Co. Ltd.) and coordinated state-owned banks to maintain its funding.

Regulatory developments in China such as those related to systemically important banks and "living wills" align the supervisory framework with global practices. China's implementation of Basel recommendations such as rules for total loss-absorbing capacity instruments and a resolution framework could help speed up banking sector reform and consolidation.

Chinese government's support to commercial banks could gradually become more selective if the Chinese financial system becomes more resilient in absorbing shocks from bank failures. The bankruptcy of Baoshang Bank Co. Ltd. in 2020, bankruptcy proceedings at two rural banks in the Liaoning province in 2022, and the dissolution of rural banks amid consolidations in 2024 are reminders that bank failures are possible in China.

We therefore anticipate the potential for continuing credit differentiation between large, systemically important institutions (where we expect government support will be forthcoming and remain strong) and small, non-systemically important banks (where government support will decline).

The Chinese government is likely to retain the flexibility to provide preemptive support, even when a resolution framework is in place. Local governments have issued nearly RMB500 billion of special-purpose bonds since 2020 to recapitalize banks in their regions. This suggests financial stability remains the Chinese government's topmost priority, even with respect to smaller local regions.

We believe the government has sufficient resources and policy flexibility to support troubled banks. Liquidity mechanisms are in place, such as the central bank's standing lending facility. Under the proposed Financial Stability Law, the central bank has responsibility as the lender of last resort to provide liquidity to the Financial Stability Guarantee Fund via its relending facility during the resolution of a financial institution.

China has one of the world's largest sovereign funds, including the State Administration of Foreign Exchange, China Investment Corp., and National Social Security Fund. The monetary authority holds foreign exchange reserves of US$3 trillion. The government also has strong influence over major financial institutions and SOEs, which it can mobilize to deliver support via a reasonably developed institutional and administrative framework.

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Appendix

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Related Criteria

• Banking Industry Country Risk Assessment Methodology And Assumptions, Dec. 9, 2021
• Financial Institutions Rating Methodology, Dec. 9, 2021
• Sovereign Rating Methodology, Dec. 18, 2017

Related Research

• Banking Industry Country Risk Assessment Update: July 2024, Aug. 1, 2024
• Is It Working? China's LGFV Debt De-Risk Program One Year On, July 25, 2024
• Global Banks Country-By-Country Midyear Outlook 2024, July 17, 2024
• Global Banks: Our Credit Loss Forecasts, July 11, 2024
• China's Local Governments: Capacity To Support SOEs Will Be Tighter For Longer, July 8, 2024
• China Ratings Affirmed At 'A+/A-1'; Outlook Stable, June 27, 2024
• Your Three Minutes In Chinese Rural Financial Institutions: A Thorough Cleanup Could Take a Decade, June 26, 2024
• Your Three Minutes In China LGFV Bonds: Weaker Entities Go Long, June 26, 2024
• Economic Outlook Asia-Pacific Q3 2024: Exporters And EMs Are Outperforming, June 23, 2024
• China's Bond Market Reforms Key To Growing With Less Debt, June 11, 2024
• Your Three Minutes In China Bank Mortgages: Risks To Rise In Lower-Tier Cities, May 27, 2024
• China's Latest Property Policies Could Be A Temporary Confidence Booster, May 21, 2024
• China's TLAC Debuts: The Road Ahead, May 17, 2024
• China Property Watch: Searching For A Bottom, May 6, 2024
• China Banks Brace For Tide Of Bad Property Loans, April 14, 2024
• Will China's 'White List' Boost Housing Sentiment?, March 25, 2024
• Global Shadow Banks Face Scrutiny As Risks Rise, March 20, 2024
• China's Distressed AMCs: Government Support Will Be There, Feb. 2, 2024
• Chinese Bank Funding: Rebuilding Buffer Amid Fragile Confidence, Nov. 23, 2023