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China's Banks Face A Doubling In Real Estate NPLs

Defaults are rising among China's property developers. S&P Global Ratings estimates that roughly a third of property developers are in some form of financial trouble. This means that just as COVID-related stresses are easing, property-related pain keeps banks' nonperforming assets (NPA) elevated. The sector's woes also significantly contribute to our recent downward revision of China's GDP growth, to 4.9% in 2022 from 5.1% previously.

Authorities have fine-tuned credit-tightening requirements to provide temporary relief. This should contain spillover risk to other sectors and stabilize market confidence. Investors remain cautious, especially in offshore bond markets.

Onshore, the banks are less bearish on developers exposures because in general, they have a closer relationship with and understanding of the borrowers, and major banks usually have good understanding of the government policy direction.

While property is weighing more heavily on bank asset quality, this impact has been partially offset by COVID-related forborne loans performing better than expectation. We think credit costs should begin stabilizing next year, in part because banks are likely to write off the pain this year and release provision coverage. Our forecasts put annual credit losses at Chinese renminbi (RMB) 2 trillion on average over the four years to 2023, down from our previous estimate in August of RMB2.5 trillion. Even by end-2024, however, the NPA ratio will still be about half a percentage point higher than the pre-pandemic metric.

A Spike In Property NPLs May Not Lead To Significant Write-Offs

We estimate the ratio of nonperforming loans (NPLs) to total property loans will more than double to 5.5% by the year's end. This is up from about 2.5% in mid-2021, and 2% at end 2020. This year's second-half surge reflects substantial stress in the sector. Using a sample of 99 domestic A-share listed property developers, we infer that, about one-third of property developers could be in financial trouble (see Appendix 1).

The bulk of this stress will likely show up as special-mention loans (SML) or other problem loans that don't require high levels of provision. We reflect a portion of this in our NPA-- our broader measure of asset quality that incorporates our estimate of 90-day overdue and restructured loans. As such, the stresses at the property-development sector contribute about 20 bps to the 1.75% NPL ratio for 2021, and a more impactful 100 bps of the 5.76% NPA.

Chart 1

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Property development loans account for 8% of total loans (including corporate and retail) in the banking sector, with the smaller banks typically having a higher percentage (see Appendix 2). Concentrated just on corporate loans, property makes up more than a tenth for the top-15 banks (see chart 2).

Chart 2

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Property development loans are typically well collateralized with real estate. With our view of a moderate 3% nationwide decline in residential prices for next year, the pressure to write off loans will be limited. Having said that, weaker regions could experience larger price drops. Banks with aggressive risk appetites or high geographic concentration could be left with thinner collateral buffers, especially those with more recent vintages. We do not expect residential mortgages to be materially affected by property development loan stresses. Timely delivery of homes under construction is a priority for authorities.

We also note that, regardless of ultimate loss expectations, banks have to post sizable provisions if a loan is classified as nonperforming. As a general rule, this is about 150% of new NPLs, and could water down profitability.

Our NPA forecast includes questionable loans that are excluded from the official NPL or SML classifications for various reasons, such as project-level loans to known troubled borrowers that are performing, good collateral coverage, or loans under standstill agreements.

In our view, the recent fine-tuning of credit policies directed toward the property sector will be temporary. Key policy direction remains unchanged, including the "three red lines" and the loan concentration thresholds that limit banks' exposure to the property sector. We expect nil growth in property development loans in 2022 and modest growth over 2023 and 2024.

Table 1

Property NPLs Will Likely Max Out This Year Amid Slowing Segment Loan Growth
2020 1H 2021 2021f 2022f 2023f 2024f
Property development loans (Bil. RMB) 11,910 12,300 12,327 12,327 12,573 12,951
NPL (%) 2.00 2.55 5.49 5.40 4.89 3.85
NPL--Nonperforming loans. Bil.--Billion. RMB--Chinese renminbi. 1H--First half. f--Forecast. Source: S&P Global Ratings' estimates.

COVID-19 Asset Quality Pressures Subside; New Risks Emerge

We continue to expect heightened new NPL formation for banks, including from non-property related sectors (see "Banking Industry Country Risk Assessment: China," Aug. 9, 2021). Write-offs are likely to remain elevated to keep the reported NPL ratio stable. While new pockets of asset quality risk emerged over 2021, COVID-related forborne loans cured significantly better than we expected. As such, our NPA ratio is set to decline over the next two to three years to about 4.7% from 7.3% at end 2020.

Chart 3

image

Over this period, the provision coverage on NPLs is likely to remain above 180% (197% coverage as at third quarter-2021), and for NPAs above 65%. The decrease in this coverage takes some pressure off credit costs and is consistent with a dynamic provisioning framework. Even so, we still see bank profits as burdened due to low interest rates, deposit competition, and concessional loan rates to policy-preferred sectors. Credit divergence is again a standout, with bigger and stronger banks set to perform significantly better while weaker banks struggle further.

Some financial institutions could run into trouble over the next two to three years. We believe the government has sufficient resources and policy flexibility to support troubled commercial banks; however, such support could gradually become more selective.

Until the financial system is more resilient to bank failures, the government's strong tendency to provide direct or indirect support to systemically important banks and other financial institutions with potential to disrupt overall financial stability is likely to remain very strong. Nonetheless, the 2020 bankruptcy of private Baoshang Bank is a reminder that bank closure is not impossible in China, if the government believes the impact of the closure to the financial system is manageable.

Also Rising: NPLs For The Micro Segment

Credit stimulus will remain high for micro and small enterprises (MSEs). Since 2019, China's selected megabanks (the country's six largest) have increased financial-inclusion type MSE loans at an annual rate of 30%-40%. For the overall commercial banking sector, this should expand 25% this year, bringing the outstanding balance to 12% of bank loans. We see this as a policy-driven business with very low risk-adjusted returns.

Given the interest rates offered on these loans is already at very concessional levels, we do not expect banks to offer further interest-rate reductions absent general monetary relaxation or additional special funding from the government. In addition, we expect loan growth for inclusive-finance MSE loans to taper off to about 20% annually in the next year or two, assuming explicit targets are quietly dropped.

With slower credit stimulus, a sluggish recovery in consumption and margin squeezes facing many micro and small businesses, we believe asset quality pressures are already building up in banks' MSE loan portfolios. It is also unclear if the borrowed money was invested in such a way that can sustain long-term margins to cover repayment. Hence the policy push to increase the proportion of unsecured loans to MSEs could see even higher write-offs in future years.

We believe banks in general would write off some NPLs to keep this credit metric in check (see table 2), and to satisfy regulatory guidance that the ratio of MSE-related NPLs stays within 3% of total NPLs. While the megabanks benefit from a relatively lower-risk client base, the interest rates charged on segment loans are also significantly lower than those charged by smaller banks.

Table 2

Slower Loan Growth May Help Rein In MSEs' NPL Formation
Loans and NPLs for MSEs fitting the financial-inclusion policy 2020 1H 2021 2021f 2022f 2023f 2024f
Financial-inclusion-type MSE loans (bil. RMB) 15,267 17,750 19,067 23,547 28,715 34,691
NPL (%) 2.99 2.77 2.99 2.52 2.25 2.53
MSE--Micro and small enteprises. NPL--Nonperforming loans. Bil.--Billion. RMB--Chinese renminbi. f--Forecast. Source: S&P Global Ratings' estimates.

What To Watch: Property's Impact On Overall GDP

The property development sector has caused some jitters in the credit markets. While there is contagion within this sector, the spillover effects to general loan quality are so far limited. This is still a developing story, however, and we note that the property downturn is also weighing on economic performance.

The property market was an important consideration in our recent downward revision in China's GDP forecasts. The revision also reflects the slow recovery in consumer activity and some strain on small businesses, where we see asset quality issues building.

In our view, controlling China's housing bubble will help address long term imbalances in the economy. Nonetheless, it brings some short-term challenges and risks for financial institutions. At this stage, we believe the general banking system has the financial buffers to adequately absorb the pain. As often is the case in these times, strong banks in China should continue to report reasonable performance while smaller and weaker institutions feel the pain more keenly.

Editing: Cathy Holcombe

Digital design: Evy Cheung

Related Research

Appendix 1

We used the first-half 2021 financial reports of the top-99 listed A-share Chinese developers as a sample to proxy sector-wide asset quality of property development loans. Together these 99 companies account for about 30% of outstanding property development loans, reflecting the high degree of fragmentation of this sector.

Property developers with the following characteristics were classified as likely to be in financial trouble. Either:

  • A ratio of cash to short-term debt below 1x; and/or
  • This ratio is at or below 1.2x--and it has deteriorated by 10% or more over the past two years.

We note that the first condition is the predominant factor driving our selection of property developers assumed to be in financial trouble.

Table 3

Liquidity Stress Is Rising For A Good Portion Of Developers
Statistical summary of top 99* listed Chinese developers' ratio of cash to short term debt (x)
Statistical items 1H 2021 2020 2019 2018
Number of companies* 96 99 99 99
Number of companies in liquidity stress 29 27 34 36
Number of companies that fall under Condition 1§ 29 27 34 36
Number of companies that fall under Condition 2§ 14 17 N.A. N.A.
Ratio of cash to short term debt: Maximum 97.0 16.3 76.9 17.3
Ratio of cash to short term debt: Minimum 0.0 0.1 0.1 0.1
Ratio of cash to short term debt: Average 3.0 1.8 2.4 2.0
Ratio of cash to short term debt: Median 1.5 1.4 1.2 1.2
*Just 96 of the 99 A-share listed developers disclosed relevant data in 1H2021. §Condition 1--A ratio of cash to short-term debt below 1x. Condition 2 --This ratio is at or below 1.2x and it has deteriorated by 10% or more over the past two years. 1H--First half. N.A.--Not applicable. Source: Wind, S&P Global Ratings.

Appendix 2

Table 4

image

This report does not constitute a rating action.

Primary Credit Analyst:Harry Hu, CFA, Hong Kong + 852 2533 3571;
harry.hu@spglobal.com
Secondary Contacts:Ming Tan, CFA, Singapore + 65 6216 1095;
ming.tan@spglobal.com
Edward Chan, CFA, FRM, Hong Kong + 852 2533 3539;
edward.chan@spglobal.com
Ryan Tsang, CFA, Hong Kong + 852 2533 3532;
ryan.tsang@spglobal.com
Research Assistants:Jason Ku, Hong Kong
Cheng Zhang, HANGZHOU

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