It never rains but it pours. China has battled a pandemic, a property downcycle, and a buildup of risky LGFV debt. And it now faces additional strains from more U.S. tariffs on its exports. S&P Global Ratings believes the drag on the economy will hurt the asset quality of banks.

China's GDP held up well prior to the latest tariff hits, delivering 5% real growth in 2024. This kept the commercial banking sector's nonperforming assets (NPAs) resilient at 5.1% of total loans by our estimate, better than our expectation of 5.9% and providing a lower base for our forecasts.

But our economists see tariffs slowing China's real GDP growth to an average of 4% over 2025-2027--and this was prior to the reciprocal tariffs announced by the Trump administration on April 2.

U.S. trade policy could hit export-related sectors and employment, resulting in more bad debt from MSEs and unsecured retail lending. Meanwhile, domestic macro conditions are still uncertain, dependent on the stabilization of China's property market and recovery of consumption, and the resolution of debt burdens for local government financing vehicles (LGFV).

Tariffs Add To Asset Quality Woes

China's growth deceleration could push up the commercial banking sector's NPA ratio over 2025-2027.

Table 1

We project the NPA ratio will peak in 2026 (see chart 1). This mirrors China's real GDP growth, which we forecast will trough in 2026 (see "Economic Outlook Asia-Pacific Q2 2025: U.S. Tariffs Will Squeeze, Not Choke, Growth," published on RatingsDirect on March 26, 2025).

Chart 1

Tougher asset classification rules mean that within the NPA composition, more of our estimated problem loans will show up over time as headline nonperforming loans (NPLs) or special mention loans (SMLs). The deadline for adjusting classification is end-2025 (see "China Banks Have Fewer Places To Hide Problems Under New Rules," Feb. 13, 2023).

Under our downside scenario in which the tariffs hit harder and the property sector doesn't hit its bottom, we project the China banks' NPA ratio could almost return to COVID-lockdown levels of 6.5% in 2022. If China succeeds, through stimulus measures, to meet its "around 5%" growth target in 2025 and sustain this growth through 2027, then the NPA ratio would likely be less bruising (see chart 2, and "China's Latest Budget Shows A Willingness To Take On More Debt," March 10, 2025).

Chart 2

Credit Losses To Increase Only Slowly As Provisioning Buffers Narrow

Weakening asset quality at China's commercial banks will likely push up credit losses (a gauge in provisioning). This increase will be moderated by the sector's ample provisioning buffers. The sector's regulatory NPL provision coverage was 211% in 2024, well above regulatory requirements of 130%-150%. We expect banks with the largest buffers to draw down on such reserves to prevent further erosion of profitability.

Our base case forecasts annual credit losses:

• Averaging RMB2.5 trillion (US$340 billion) over 2025-2027, up from our estimate of RMB2.1 trillion in 2024;
• Most of this increase is driven by annual loan growth of 7.0%-7.5% over this period;
• Annual credit losses could increase by 9% to RMB2.7 trillion in our downside scenario or decline by 13% to RMB2.2 trillion in our upside scenario (see chart 3).

Chart 3

The sector is likely to maintain reasonable NPA coverage at an average 54% over 2025-2027, down from 57% over 2021-2024. Hence, as a proportion of average loans, we see credit losses rising only mildly to 1.05% in 2027, from our estimate of 1.01% in 2024 (see chart 4).

Chart 4

MSEs' Asset Quality Vulnerable To Tariff Pain

Smaller companies have less financial flexibility to absorb the costs of additional tariffs or pass them on to consumers, in our view. We estimate the NPA ratio for MSE loans will increase to 9.3%-9.6% over 2025-2027, driven by companies in export-related sectors.

Tighter borrowing conditions will likely add to the sector's fallout. China's inclusive lending policies and beneficial capital rules have contained MSE loan problems over the past three years. Hence even at the recent height of the pandemic strains, in 2022, the NPA ratio didn't rise as high as it might have over the next two years (see chart 5). But inclusive lending is reaching its limits.

MSE loan growth is likely to stay at 15% annually over 2025-2027, from 23%-25% annually over 2021-2023. Last year's slowdown in MSE loan growth was sharper than our previous expectation. This was due at least partly to banks' rising risk awareness that further rapid growth for such low-margin loans would erode profitability. MSE loans now exceed 15% of commercial banking sector loans.

Chart 5

Loan guarantees will reduce some of the banks' potential losses from MSE loans. The National Financing Guarantee Fund (NFGF), in collaboration with banks and local guarantee institutions at provincial or municipal levels, has established a risk-sharing mechanism for policy-supported sectors, such as inclusive and rural finance. Banks typically bear 20%-30% of losses in such arrangements. As of end-2024, the scale of NFGF's insured business was RMB1.6 trillion, of which the proportion of risk-sharing with banks was 93.5%, equivalent to 4.5% of outstanding MSE loans.

Subdued Jobs Prospects To Weigh On Consumer Credit Quality

S&P Global Ratings projects the unemployment rate will stay on the high side for China, at 5.2% over the next few years, from 5.1% in 2024. The knock-on effect on household income may strain the quality of retail loans, especially unsecured credit (consumption and credit card loans).

Pressure was already building in 2024 amid China's uneven economic recovery from the pandemic and property downturn. The average NPL ratio of consumption loans for the major listed banks increased 69 basis points (bps) to 2.39% in 2024. Over the same period, the mortgage NPL ratio rose 32 bps to 0.87%.

We believe the risk is manageable for now. Unsecured credit growth dropped by about one-third to 6.2% in 2024. Consumption loans are still a small part of the total-loan pie and banks have been reducing their exposure to credit card loans (see chart 6).

Nonetheless, China's push to stimulate domestic demand by encouraging banks to increase consumer financing and help borrowers with difficulties could test banks' risk management capabilities.

Chart 6

Property Development NPA Pressure To Ease From Elevated Level

S&P Global Ratings expects primary property sales to stabilize towards the second half of 2025, led by higher-value properties in upper-tier cities (see "Surging Secondary Sales To Stabilize China Property In 2025," Jan. 22, 2025). A recovery in primary sales is key to strengthening the balance sheets of the property developers. This will ease the stress on the quality of property development loans, in our view.

By our estimates, the NPA ratio of property development loans fell to 14% in 2024, from 18% in 2023. Measures such as China's "whitelist" mechanism helped. By ensuring access to funds for eligible projects, the whitelist limited the contagion to surviving developers that caused the NPA ratio to spike over 2022-2023. Loan growth for property development more than tripled to about 5% in 2024, above our expectation of a doubling to 3% (see chart 7).

Chart 7

Our key forecasts for this sector include:

• The NPA ratio for property loans will gradually decline over the next three years and reach 7.1% in 2027. This is under our base case, which assumes the property market stabilizes.
• Reported NPL ratio for property development loans could still rise over 2025-2026 due to stricter asset classification rules, before improving to 5.0% in 2027.
• Lending to property developers will rise at a slightly slower pace than overall loan growth.

Commercial banks' exposure to the property development sector will therefore remain broadly stable at 6.0% of total loans in 2027 compared with 6.2% in 2024, consistent with the government's stance in stabilizing the property market.

Stable bank funding to developers should help restore homebuyers' confidence in the property market, anchoring an important part of the economy amid tariff threats. We do not expect banks' exposure to grow as a proportion of total loans, given the policy goal of fostering new productive forces. In our view, less reliance on unproductive real estate investment as a growth engine will help address long-term imbalances in the economy.

LGFV Debt Risk Lower With Hidden Debt Swap

China's RMB10 trillion "hidden-debt" swap plan, announced in November 2024, will mitigate banks' LGFV risks (see "LGFV Brief: China's RMB10 Trillion Debt-Swap Scheme Is A Good Start," Nov. 13, 2024). Without the swap, more LGFV debt could have needed restructuring or could have defaulted. Meanwhile, efforts to stabilize the property market could bring back land sales, an important source of fiscal revenue for local governments.

We assume an NPA ratio of about 7% on outstanding loans for "weak-linked" LGFVs--i.e., those with weak ties and roles to the local government and thus less likely to receive support. These entities likely have debt of RMB32 trillion, an exposure that is unlikely to fall by much due to refinancing needs or funding for new projects. Our NPA estimate is down from our previous assumption of 10%, which corresponds to a medium stress scenario in the central bank's financial stability report in 2023, but above the 5% NPA ratio applied in a light stress scenario.

China prioritizes financial stability and will avoid policy settings that cause large-scale LGFV stress, in our view. But the problem has not gone away; LGFVs with very weak credit profiles are still on the hook for debt borrowed for commercial purposes.

Some of the weaker debt is still likely to be restructured. Lower interest rates and maturity extensions can weigh on the capital and earnings of banks. Defaults and haircuts leading to losses could also occur.

Banks, local governments, LGFVs, and original lenders will share the pain as policymakers balance the risk between creating moral hazard and triggering a public confidence event, in our view (see "Is It Working? China's LGFV Debt De-Risk Program One Year On," July 25, 2024).

Such debt restructurings are likely to be spread out over time, and concentrated in debt-laden regions in northeastern and southwestern China. The pain will likely be more acute for smaller financial institutions with loan concentration in these areas (see "LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks," Oct. 18, 2023).

Sharing The Pain

With China facing tariff threats overseas and weak economic conditions at home, smaller banks remain vulnerable and could get weaker in some regions. Consolidation of small and midsized rural banks accelerated in 2024.

The consolidation helped boost the capital and provision buffers of surviving rural banks (see table 2).

But the dissolution of weak rural banks is a reminder that bank failures are possible in China (see "Your Three Minutes In Chinese Rural Financial Institutions: A Thorough Cleanup Could Take A Decade", June 26, 2024).

Table 2

Meanwhile, China is marshalling all resources to gird the economy amid toughening macro conditions. This includes leaning on the stronger state-owned banks to support growth within their risk control abilities, such as inclusive lending to MSEs.

Chart 8

The government is also playing its part. For the first time since the 2008 global financial crisis, China is planning to inject capital into the megabanks (see "China Banking Brief: More Capital, More Flexibility," March 5, 2025).

But no pain, no gain. Funding the capital replenishment with relatively cheap sovereign bond issuance in return for relatively high dividend yields from the megabanks, China might be getting a good deal. Though only if the banks' bad debt is kept in check.

Editor: Cathy Holcombe

Digital design: Evy Cheung

Related Research

• China's Two Sessions: No Surprises In Push To Unlock Growth, March 27, 2025
• Economic Outlook Asia-Pacific Q2 2025: U.S. Tariffs Will Squeeze, Not Choke, Growth, March 26, 2025
• China's Latest Budget Shows A Willingness To Take On More Debt, March 10, 2025
• China Banking Brief: More Capital, More Flexibility, March 5, 2025
• Surging Secondary Sales To Stabilize China Property In 2025, Jan. 22, 2025
• LGFV Brief: China's RMB10 Trillion Debt-Swap Scheme Is A Good Start, Nov. 13, 2024
• Banking Industry Country Risk Assessment: China, Aug. 19, 2024
• Is It Working? China's LGFV Debt De-Risk Program One Year On, July 25, 2024
• Your Three Minutes In Chinese Rural Financial Institutions: A Thorough Cleanup Could Take A Decade, June 26, 2024
• Will China's 'White List' Boost Housing Sentiment?, March 26, 2024
• LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks, Oct. 18, 2023
• China Banks Have Fewer Places To Hide Problems Under New Rules, Feb. 13, 2023