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Chinese banks may be facing tougher economic challenges than GDP data shows

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Chinese banks may be facing tougher economic challenges than GDP data shows

Daniel Tabbush hascovered banks in Asia for 20 years, most recently as head of Asian bankresearch at CLSA. The following does not constitute investment advice, and theviews and opinions expressed are those of the author and do not necessarilyrepresent the views of S&P Global Market Intelligence.

It is questionable whether China's economy is as robust asits official GDP figures suggest, considering the pace of bad loan formation,with companies' ability to pay back debt deteriorating. If you look beyondgrowth data, though, there are ways to paint a clearer picture of the Chineseeconomy and stress in it — and ultimately, of what banks there are up against.

China's GDPincreased 6.7% in the second quarter from a year earlier. The latest headlinenumber points to a continued slowdown in China's economy, but it still is ahigh rate in the global context.

For anyone doubting China's GDP numbers, there are otherindicators to look at. Trade figures, for one, are more easily audited andtraceable, hence more trustworthy, than GDP data. And China's figures in thatarea are not looking good, with exports down 4.8% year over year in June andimports down 8.5%.

Also, data from China's largest power producer offers arealistic window into the strength or weakness of the country's economy, giventhat power consumption is often used as a gauge of industry demand. HuanengPower International Inc. said July 16 that total power generation by powerplants in China fell 10.43% year over year in the second quarter. In addition,electricity sales declined 30% or more in five provinces in the first half.These declines are signs of economic weakness.

True, lending by Chinese banks is still growing strongly,but I do not believe that new credit demand is a result of healthy economicgrowth.

Sure, credit demand can be a function of economicperformance. But when an economy is worsening and companies are in morefinancial distress, there is another factor than can cause a sharp increase in loans— loan-commitment drawdowns that show up on bank balance sheets as actual loans.

New loans in China increased 556 billion yuan in April, 986billion yuan in May and 1.38 trillion yuan in June. This sharp acceleration canbe a cause for concern, if companies are indeed drawing down on committedfacilities, just as their financial positions worsen. That assumption isworrisome because those new loans would be more likely to become nonperforming.

One way to see if that is the case is to look at the financialhealth of businesses in China. A good measure of that is interest coverage, ora company's EBIT as a multiple of interest expenses.Based on S&P Capital IQ data, 48% of a sample of 2,000 Chinese companies hasinterest coverage ratios of less than 2. Such vulnerability means a lot of newcredit could be drawdowns on loan commitments.

Another possible contributor to credit expansion is banklending to help existing borrowers service their outstanding debt. In theory,such practices should hurt interest margins, exacerbating the impact ofmonetary easing, because rates on loans for that purpose are lower.

Most banks in China saw a substantial decline in averageloan yields in the first quarter from year-ago levels, according to S&PCapital IQ data.

What all this means is that things are not looking up forChinese banks. They will likely have far worse income in the coming years thanin the past, with some reporting losses. Times maybe much tougher for the sector than the government's GDP numbers indicate.

As of July 19, US$1was equivalent to 6.70 Chinese yuan.