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Chinese banks' profit en route to contraction

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 strange to see that several Chinese banks havereported near identical net profit growth — close to zero percent — in theirrecently announced 2015 results. This led me to believe that banks may havebeen in discussions with one another to be in concert on their reportedfigures. There may have been an imperative from Beijing for banks not to reportdramatically lower figures at this stage.

Gone are the days of heady growth for Chinese banks, whichis no surprise, given the ramp-up of bad loans, worsening credit growth andpressure on net interest margins. As I look at a few of the banks' reportedfigures, the key conclusion is that this is the first stop before profit growthis negative.

Bank ofCommunications Co. Ltd., which posted a 1% gain in net profit for 2015, is interestingin its tempered growth of nonperforming loans. The comparative is what banks inHong Kong have been reporting for their own NPLs in China, as well as the NPLsof many other Chinese banks. The difference is big, which raises questions.

Bank of Communications said in its 2015 that it took variousmeasures to reduce NPLs by 34.5 billion yuan, of which 9.8 billion yuan wascollected in cash. This is an interesting statement in itself. Given that thelender's NPLs totaled 56.21 billion yuan at the end of 2015, it suggests to methat this figure would have been quite a bit higher had it not been for theseso-called various measures.

Some of these measures will surely include restructuring ofNPLs, which often takes the form of extending the loan term and lowering thecontract interest rate. It will be interesting to see if Bank ofCommunications' loan yields continue to narrow and become disproportionate tobenchmark interest rates.

Ping An BankCo. Ltd. has reported a doubling of impairment costs each yearsince 2013. Its impairment figures are now among the highest in China, with itsprovision costs making up 2.63% of its average amortized loans in 2015,according to SNL Financial data. This is a far cry from the 0.76% that Bank ofCommunications reported for the same period, further making me wonder if thebank is somehow flattering its NPL position.

Ping An Bank took net write-offs of 21.20 billion yuan in2015, which is a high figure and well over its year-end NPLs of 17.65 billion.So even here, I feel that the credit metrics are worse than they appear on thesurface. The bank's NPLs would be meaningfully higher had it not taken thiswrite-off, which is a reduction to total NPLs.

Details in the asset-quality breakdown for , which a 0.74% year-over-yearrise in net profit in 2015, is revealing when trying to consider how creditmetrics are deteriorating below the surface. Banks have three categories ofNPLs, with the sub-standard category being the most benign, followed by thedoubtful category and then the worst, called loss.

Bank of China's loss NPLs were fairly static from 2011through to 2013, according to SNL Financial data. However, by 2014, the rise inNPLs was substantial at 58%. In 2015, the bank's loss NPLs grew 43% to 30.6billion yuan. Over the same period, its doubtful NPLs, which had been fairly stablefrom 2011 to 2014, suddenly spiked in 2015, growing 68%.

These types of NPLs — loss and doubtful — should requiremore balance sheet provisions and should over time have worse loss-given-defaultratios. There appears to be a clear migration of other loans into these morepoor risk NPL buckets for Bank of China and yet its NPL coverage is not keepingpace. The lender's NPL coverage ratio declined to 153.30% in 2015 from 187.60%in 2014 and from 229.35% in 2013. If the composition of NPLs was not worseningso dramatically, a lower level of NPL coverage may be more understandable.

Across Asia-Pacific banking cycles, there tends to be two tothree years of elevated impairment costs when NPLs are at their worst. It israrely, if ever, a single-year event. At the same time, there tends to be anincubation year, where impairment costs tend to springboard higher thannormalized levels, but not to dizzying heights. I believe this is where China'sbanks currently sit.

The implications are that in 2017, Chinese banks will facegreater impact from the underlying weak economy, with yet higher bad loans andmore associated impairment costs. When assessing the country's banks, wheremuch of their risk resides in loan-like assets, rather than customer loans asclassified on the balance sheet, we must also be aware not to focus exclusivelyon credit impairments. Other impairments will ratchet upward, and for some ofthe smaller joint stock and city banks, these can end up overshadowingtraditional credit costs.

In either case, this worst lies ahead for China's banks andthe barely positive profit growth now will likely turn to sharply negativegrowth in 2017 and 2018.

As of March 30, US$1was equivalent to 6.47 Chinese yuan.