Xinhua Finance believes that the direct risks, including risks related to bond investments and loans, faced by China's banking system are still manageable, and credit risk exposure to export-driven enterprises is still limited. However, as market confidence declines, risks to banks posed by real estate development loans cannot be ignored, and retail banking will also suffer. Banking industry profits will be hindered by macro-economic policy adjustments the Chinese Government may adopt to prevent a possible economic slowdown. The ability of China's economy to continue to grow in the long run will depend on economic restructuring and transformation into an economy driven by domestic demand. Banks will play an important role in guiding the direction of capital flows. During this process, banks will
need to find new areas for profit growth, and optimize loan and revenuestructures. As China's banking regulators reconsider systemic risk
implications, they may be more cautious in deciding whether to move forward with the suggested universal banking model.
Limited direct risk exposure, but real estate loans and retail banking are likely to be affected.
1) Financial system is relatively closed, and risk exposure is manageable
Thanks to the relatively slow-paced development of China's financial system, and the fact that foreign investment by China's banking industry is subject to foreign exchange controls and regulatory approval, the banking industry's overall open foreign exchange exposure is relatively small. Only a handful of large state-owned banks, in particular the Bank of China, have been relatively heavily impacted by the Fannie Mae, Freddy Mac, and subprime mortgage securities crisis, and up until this point in time the impacts have been manageable. There has been almost no direct impact on small and medium sized banks. Total announced exposure of Chinese banks to Lehman Brothers has reached US$380 million, with ICBC topping the list. Examination of the exposure portfolio reveals that more than 50% is senior debt with high priority of repayment. It can be projected that the overall risk exposure is rather limited.
Xinhua Finance added up the total investment denominated in dollars for ICBC, BOC and CCB, including trading assets, securities available for sale, and securities held to maturity. As of June 30, 2008 the total amounted to US$109.6 billion. These dollar denominated assets are mainly highly rated government and commercial bank bonds. If one were to assume 10% are high risk securities, the total loss would be around USD 11 billion. In comparison to the total net profit of the three banks in 2007 of RMB 212.7 billion, this is a manageable sum. (Note: net profit of 14 listed banks was RMB 286.9 billion
in 2007.)
2) Relatively limited credit risk exposure to export-driven enterprises
Export-driven enterprises will be heavily affected by the impact of the global economic slowdown. Raw materials and labor costs rose significantly in the first half of 2008 and continue to remain high. In addition, weak global markets, the appreciation of the RMB, implementation of new labor laws and export tax rebate cuts have further punished export-driven SME's. Resource intensive, labor intensive and low technology SME's have occasionally closed down. Preliminary estimates by the NDRC indicate that around 67,000 SME's have gone bankrupt in the first half of 2008. However, due to the intrinsic high risk of SME's, the banking industry - especially large SOE banks - historically has not focused on loans to SME's. For this reason SME's, which contribute almost 60% of China's GDP, account for less than 20% of loans made by large financial institutions. Moreover, due to a severe imbalance between supply and demand in the market, banks have greater flexibility in selecting clients. With relatively high quality clients, the banks' risk exposure to SME's is relatively small.
3) When confidence is low, risks from real estate development loans cannot be ignored
The subprime mortgage crisis began when U.S. real estate prices began to fall. China's banking industry's exposure to real estate loans also
cannot be ignored. Chinese banks, especially some medium to small joint-stock commercial banks,, tend to provide more loans for real estate development when real estate is booming. Based on data from 14 listed banks as of June 30, 2008, real estate development loans (including construction industry loans) accounted for 12.53% of their overall loan portfolio, and personal mortgage loans accounted for 15.54%. Following the national government's implementation of controls on real estate industry funds and the housing purchase policy, the real estate market is entering a period of adjustment. Household sales volumes have recently shrunk sharply in the big cities, and a majority of cities have seen varying rates of downward trends in sales and cutting of prices. While lower prices do not necessarily lead developers to immediately hoard cash, an environment of macro-controls and slowing economy leads to consumers becoming more conservative and to a fall in investment demand. On top of this, banks become reluctant to lend to real estate developers or to extend repayment times, possibly leading to funding lines being restricted or even cut off, and giving rise to a vicious circle.
Real estate development is characterized by high leverage, and high debt ratios. Bank credit risk management for the real estate industry primarily relies on pledged assets, without effective controls on daily financial management. As soon as real estate developers are unable to repay their debt, huge risks are transferred to the banks.
As for personal mortgage loans, since priority is given to owners living in the house, and since lending volume was restricted by soaring
real estate prices in 2007, the overall problem is not great. Hence, we consider these loans to be of little risk to the banking industry.
4) Retail banking business will slow down
The global financial turmoil and the slowing of the global economy will lead people to worry about prospects for the domestic economy. With
domestic social security still relatively deficient, citizens' consumption desires and interest in investments will be severely reduced. Domestic retail banking, which is dominated by personal mortgages, is likely to experience a sharp decline. At the same time, the relatively new private wealth management business will shrink in the aftermath of the brief boom in the stock market, as people will both harbor doubts about wealth management products and prefer to have cash on hand. In addition, we predict that regulators will be more cautious in the review and approval of new wealth management products, which will further slow the pace of development of the domestic retail banking business.
Profound indirect impact
1) Economic transformation will force banks to find new areas for profit growth
Although the current financial turmoil will have limited direct impact on China's banking industry either in terms of market risks or credit risks, Xinhua Finance believes that rebuilding of the global economy and financial order will be a long term process, and this will have a profound
impact on China's economic development. In the short term, macro-economic adjustments that the Chinese government might adopt to prevent a possible economic slowdown will have a short term impact on the banking industry's profits. From the long term point of view, in order to preserve long term economic development the government will have no choice but to speed up transformation and upgrading of the economy. This in turn will force banks to find new profit areas to enhance the quality of their growth.
2) Development of a market driven by domestic demand will lead to SME financing becoming a business focal point
Xinhua Finance believes the development of SME's will play a crucial role in terms of adjustment of the nation's economic structure, providing employment and sustainable economic development. As China's domestic demand market grows larger, SME's will be able to grow and mature through domestic market expansion, and will gradually become one of the banks' favored funding clients. As banks strengthen the use of risk pricing technology and increase risk control mechanisms, they will increase their profit generating ability and provide new areas for profit growth. With the policy decision to reduce the deposit reserve ratio, the central bank wishes to increase the availability of bank loans for SME's by increasing funding liquidity of small and medium sized banks. This is consistent with the earlier policy of increasing special project loans for SME's. However, solving the financing problems of SME's requires clear positioning of the various financial markets, establishment of a SME credit guarantee fund, and enrichment and enhancement of various additional financing channels.
3)Policy adjustments affect bank profits
The goal of the central bank's recent policy decision to cut lending rates, other than being a response to external environment challenges, is
to reduce companies' operational costs, maintain adequate liquidity, and soften the pressure of the economic slowdown. Since there is no change to deposit rates, bank profits will be squeezed with the narrowing of the spread between lending and deposit rates. Given the current negative real savings interest rate, we expect the central bank may in the future again choose asymmetric adjustment of interest rates to transfer a portion of banks' profits to other economic entities. This will negatively impact banks' profitability.
4) Universal banking is called into question
In the midst of the current financial crisis with its rapid spread of financial risk we must examine anew the universal banking model. Currently a number of Chinese financial institutions are experimenting with the development of a universal banking model. Ping'an Group, CITIC Group and Everbright Group have to some degree become financial holding companies. Although universal banking can offer one-stop services, offer efficient integration of customer resources, and promote capital flows between different markets, if it leads to a "too big to fail" situation then the system risks cannot be ignored. Universal banking can extend banking risks to other arenas such as securities, insurance, etc., and it can extend risks from other areas to the banking system, hence increasing the financial system's systemic risk. Financial holding companies also have a greater likelihood of excessive leverage risk and moral hazard risk.
Xinhua Finance feels that, given China's current regulatory capacity, financial institution maturity, and IT infrastructure, it would not be appropriate to encourage rapid development of universal banking. Steady, sound and prudent supervision is deemed to be a wise development strategy in a complex and changing international financial environment. Moreover, a universal banking environment does not leave a great deal of room for standalone investment banks and securities houses. The choice of a development path leading to universal banking is worthy of deep deliberation before a decision is made.
