China's financial markets-a future global force? Deutsche Bank Research Assessment of recent developments& outlook Despite much progress. Much progress has been made since the beginning of economic reforms in the early 1980s and with regard to Chinas capital market development Reforms to the tradable-non-tradable share system as well as to the issuance process have been either completed or markets are still small However, Chinas capital markets are still small, both compared to developed markets as well as to other emerging economies Especially the corporate bond market is lagging behind, thus barring companies from tapping an important form of finance. Unified regulation and supervision are necessary to promote the develop- ment of corporate bond markets. Additionally, trading platforms and clearing systems have to be unified in order to reduce exti costs for investors and encourage product innovation across segments remain unbalanced and Furthermore, the bond market segments are unbalanced and there is a lack of institutional fragmented and the investor base in the stock market lacks investors institutional investors. The high share of retail investors with frequent trading behaviour poses risks to market stability. Also, it seems that institutional investors active in China s markets prefer short-term stment gains over longer-term investments. Therefore, it is necessary both to strengthen the role of institutional investors and also to embark on a general investor education programme Additionally, the product range of investment fund companies is limited. This all makes a strong case for further concentrated efforts in terms of institutional and supervisory reforms, as well as in- creased foreign institutional investors' participation in Chinas local markets Regulators are aware of challenges The regulatory and supervisory bodies in charge seem to be aware and will continue with gradual reforms of these challenges. Goals have been formulated aiming at con- tinued improvement of China s capital markets. But one should not expect too much in the short run The reform process of Chinas capital markets will most likely continue gradually, especially facing the most recent experience in industrial countries' financial markets Looking back, this careful approach has worked well for China and is likely to provide a good basis for sustainable development in the Steffen Dyck(+49 69 910-31753, steffen dyck db. com) China Bond Market Review 2007 China Government Securities Depository Trust Clearing Co Ltd. January 2008, p. 39 19 CSRC(2008 ) China Capital Markets Development Report. China Securities egulatory Commission March 2008, p. 18 March 16. 2009
China's financial markets – a future global force? March 16, 2009 11 Despite much progress... ... markets are still small, ... ... segments remain unbalanced and there is a lack of institutional investors Regulators are aware of challenges and will continue with gradual reforms Assessment of recent developments & outlook Much progress has been made since the beginning of economic reforms in the early 1980s and with regard to China’s capital market development. Reforms to the tradable–non-tradable share system as well as to the issuance process have been either completed or are well on track. However, China’s capital markets are still small, both compared to developed markets as well as to other emerging economies. Especially the corporate bond market is lagging behind, thus barring companies from tapping an important form of finance. Unified regulation and supervision are necessary to promote the development of corporate bond markets18 . Additionally, trading platforms and clearing systems have to be unified in order to reduce extra costs for investors and encourage product innovation across segments19. Furthermore, the bond market segments are unbalanced and fragmented, and the investor base in the stock market lacks institutional investors. The high share of retail investors with frequent trading behaviour poses risks to market stability. Also, it seems that institutional investors active in China’s markets prefer short-term investment gains over longer-term investments. Therefore, it is necessary both to strengthen the role of institutional investors and also to embark on a general investor education programme. Additionally, the product range of investment fund companies is limited. This all makes a strong case for further concentrated efforts in terms of institutional and supervisory reforms, as well as increased foreign institutional investors’ participation in China’s local markets. The regulatory and supervisory bodies in charge seem to be aware of these challenges. Goals have been formulated aiming at continued improvement of China’s capital markets. But one should not expect too much in the short run. The reform process of China’s capital markets will most likely continue gradually, especially facing the most recent experience in industrial countries’ financial markets. Looking back, this careful approach has worked well for China and is likely to provide a good basis for sustainable development in the future. Steffen Dyck (+49 69 910-31753, steffen.dyck@db.com) 18 China Bond Market Review 2007. China Government Securities Depository Trust & Clearing Co. Ltd. January 2008, p. 39ff. 19 CSRC (2008). China Capital Markets Development Report. China Securities Regulatory Commission. March 2008, p. 182
Deutsche Bank Research Current Issues China's banking sector to be tested by the downturn Key recent developments Chinas banking sector has Chinas banking sector has undergone significant reform in recent undergone significant reform in years. The key banks, which include most of the state-owned banks recent years.. and the major joint-stock banks, have gone through internal reform namely through capital injections from the state or new share- holders, ownership and internal structural changes which include having foreign strategic partners, and listing on the stock market leading to improved financial Through the reform measures, the banking sector as a whole has fundamentals emerged stronger and generally enjoys improved financial funda mentals. The capital adequacy ratio(CAR)of the banking sector was 8.4%in 2007, just above the basic 8% requirement of the Basel standard. The number of banks meeting the 8% CAR has risen through the years and together these banks account for around 80% of the banking sector assets. Strong loan growth ensued as banks Since almost all key banks are better capitalised and able to offload lent aggressively and grew their the bulk of non-performing assets off their balance sheets, years of ce sheets again strong loan growth ensued as these banks lent aggressively and grew their balance sheets again. Outstanding loans grew more than 200% during 2000-08 Nominal loan and nominal GDP both grew around 165% from end-2000 to end-2007. Despite efforts to slow bank lending in recent years, the loan/GDP ratio still stood above 100%. The most recent data shows that loan growth at end-2008 China's Fl loans nominal GDP stood at almost 19% yoy, up from 16% at end-2007. This marks a reversal of credit policy, since prior to the worsening of the global 25 financial crisis the Chinese authorities had been tightening monetary policy and asked banks to Chinese economy was slowing down progressively as reflected by 6.8% yoy GDP growth in Q4 compared to 11.2% in Q4 2007, the authorities switched to aggressive monetary easing and asked 5 banks to continue lending Joint-stock banks have been the most aggressive. Their share of total banking sector assets climbed to 14% at end-2007, the second loans, yoy eop(left) largest behind the state-owned banks(53%). Joint-stock bank Bank loans/GDP, %(right) assets grew at the dizzying pace of 33% in 2007, compared to the Source:CEIC1 sector's average of 20%(state-owned banks 16%) City commercial banks have also seen strong asset growth (29% in 2007), account ing for over 6% of the banking sector's total assets Consumer lending has seen strong In terms of sector activities, consumer lending has seen strong growth with mortgage loans being the growth in recent years. The share of consumer loans in total loans is largest component estimated to have approached 20% in 2007. The largest component of consumer loans is mortgage loans, which account for more than 80%of consumer loans e Although profit growth has been Although the banking sector has in recent times reported rising profit ing, profitability remains modest growth, profitability as measured by return on assets remains modest at 0.9% in 2007. One of the factors constraining banks profitability is Chinas regulated interest rates, resulting in very tight net interest margins. Furthermore, net interest income remains the main revenue source. Fee-based income from credit cards and wealth management products has been growing but still makes up a Agricultural Bank of China, Bank of China, China Construction Bank, Industrial and Commercial Bank of China. Bank of Communications. arch16.2009
Current Issues 12 March 16, 2009 China's banking sector has undergone significant reform in recent years... ... leading to improved financial fundamentals Strong loan growth ensued as banks lent aggressively and grew their balance sheets again Consumer lending has seen strong growth with mortgage loans being the largest component Although profit growth has been rising, profitability remains modest Key recent developments China’s banking sector has undergone significant reform in recent years. The key banks, which include most of the state-owned banks1 and the major joint-stock banks, have gone through internal reform, namely through capital injections from the state or new shareholders, ownership and internal structural changes which include having foreign strategic partners, and listing on the stock market. Through the reform measures, the banking sector as a whole has emerged stronger and generally enjoys improved financial fundamentals. The capital adequacy ratio (CAR) of the banking sector was 8.4% in 2007, just above the basic 8% requirement of the Basel standard. The number of banks meeting the 8% CAR has risen through the years and together these banks account for around 80% of the banking sector assets. Since almost all key banks are better capitalised and able to offload the bulk of non-performing assets off their balance sheets, years of strong loan growth ensued as these banks lent aggressively and grew their balance sheets again. Outstanding loans grew more than 200% during 2000-08. Nominal loan and nominal GDP both grew around 165% from end-2000 to end-2007. Despite efforts to slow bank lending in recent years, the loan/GDP ratio still stood above 100%. The most recent data shows that loan growth at end-2008 stood at almost 19% yoy, up from 16% at end-2007. This marks a reversal of credit policy, since prior to the worsening of the global financial crisis the Chinese authorities had been tightening monetary policy and asked banks to restrain loan growth. However, as the Chinese economy was slowing down progressively as reflected by 6.8% yoy GDP growth in Q4 compared to 11.2% in Q4 2007, the authorities switched to aggressive monetary easing and asked banks to continue lending. Joint-stock banks have been the most aggressive. Their share of total banking sector assets climbed to 14% at end-2007, the second largest behind the state-owned banks (53%). Joint-stock bank assets grew at the dizzying pace of 33% in 2007, compared to the sector’s average of 20% (state-owned banks 16%). City commercial banks have also seen strong asset growth (29% in 2007), accounting for over 6% of the banking sector’s total assets. In terms of sector activities, consumer lending has seen strong growth in recent years. The share of consumer loans in total loans is estimated to have approached 20% in 2007. The largest component of consumer loans is mortgage loans, which account for more than 80% of consumer loans. Although the banking sector has in recent times reported rising profit growth, profitability as measured by return on assets remains modest at 0.9% in 2007. One of the factors constraining banks’ profitability is China’s regulated interest rates, resulting in very tight net interest margins. Furthermore, net interest income remains the main revenue source. Fee-based income from credit cards and wealth management products has been growing but still makes up a 1 Agricultural Bank of China, Bank of China, China Construction Bank, Industrial and Commercial Bank of China, Bank of Communications. 90 95 100 105 110 115 120 0 5 10 15 20 25 98 00 02 04 06 08F Bank loans, % yoy eop (left) Bank loans/GDP, % (right) Source: CEIC
China's financial markets-a future global force? Deutsche Bank Research small portion of banks'earnings only Non-interest income is NPLs remain high in estimated to contribute around 20% of total revenue absolute terms despite falling ratio The official NPL ratio stood at 6.2% at end-2007. down from 16.6% 16 in Q1 2004. The downward trend in NPL ratios has been driven by the transfer of impaired assets to special asset management 12 companies and strong loan growth, which lowers the ratio despite 150 have declined sian ge in absolute terms. In absolute terms NPls ignificantly since 2004, but they rose slightly again in 86420 Q4 2007 to RMB 1, 268. 4 bn(USD 185. 4 bn) Other structural changes underway 885 Other developments are underway that will change the face of China's banking sector. Among them the reform of Agricultural Bank of China(ABC) is yet to be fully carried out. The first step has begun NPL USD bn(left) with the announcement of a USD 19 bn capital injection from the NPL, of total loans(right) government. ABC reform is one of the government's top priorities. Its Soure: ceRC2retorm plan mkay ook difterent to the other ig banks as ABcks but the goal of commercial independence will be the same. oed timing of reform has been given, and it may be delayed yet again due to the current adverse global financial environment. In addition to ABC reform, mergers and consolidation of rural sector banks and co-operatives will take place to improve overall rural sector efficiency. The role of Postal Savings Bank(PSB)activities in lending against deposits will likely be expanded, playing a greater role in financial intermediation in the rural areas Reform is underway to separate the policy lending function of China Development Bank(CDB)from its commercial lending. Other policy lending banks, Agriculture Development Bank of China and China EXIM Bank, will likely follow suit Consumer banking China's loans by sector Consumer banking has been identified as having a very high %o of total loans potential in China. Household deposits have been a major source of cheap funding for banks, but households' potential as borrowers is 2006 yet to be fully explored. Consumer banking is still in an early stage 50505 deposits of almost RMB 2 trillion at end-2007, constituting vings significant source of funding for banks. The share of consumer loans was around 20%of total loans in 2007. Mortgage lending makes up the largest share, around 80% of consumer lending. Other types of consumer lending such as car loans, debit and credit cards, as well as other household credit products remain relatively small Major players in consumer banking in China are the big-4 banks thanks to their large branch networks. However competition has been heating up as income from consumer banking, especially mortgage products, is seen as a generator of more steady long-term revenue, i.e. less cyclical than income from corporate banking Joint-stock banks have been putting more emphasis on increasing Source: Global Insight their market share in consumer loans Assessing consumer credit continues to be challenging. The Credit Information Centre(CIC), under the purview of the PBC, acts consumer credit bureau, and its scope of operations is still being expanded and evolving. Car loans, which make up less than 3% of Asia Banking Outlook 2008, Moody's Global Banking Special Co March 16. 2009
China's financial markets – a future global force? March 16, 2009 13 small portion of banks’ earnings only. Non-interest income is estimated to contribute around 20% of total revenue.2 The official NPL ratio stood at 6.2% at end-2007, down from 16.6% in Q1 2004. The downward trend in NPL ratios has been driven by the transfer of impaired assets to special asset management companies and strong loan growth, which lowers the ratio despite NPLs remaining large in absolute terms. In absolute terms NPLs have declined significantly since 2004, but they rose slightly again in Q4 2007 to RMB 1,268.4 bn (USD 185.4 bn). Other structural changes underway Other developments are underway that will change the face of China’s banking sector. Among them, the reform of Agricultural Bank of China (ABC) is yet to be fully carried out. The first step has begun with the announcement of a USD 19 bn capital injection from the government. ABC reform is one of the government’s top priorities. Its reform plan may look different to the other big 3 banks as ABC’s function as a key lender to the rural population cannot be weakened, but the goal of commercial independence will be the same. No timing of reform has been given, and it may be delayed yet again due to the current adverse global financial environment. In addition to ABC reform, mergers and consolidation of rural sector banks and co-operatives will take place to improve overall rural sector efficiency. The role of Postal Savings Bank (PSB) activities in lending against deposits will likely be expanded, playing a greater role in financial intermediation in the rural areas. Reform is underway to separate the policy lending function of China Development Bank (CDB) from its commercial lending. Other policy lending banks, Agriculture Development Bank of China and China EXIM Bank, will likely follow suit. Consumer banking Consumer banking has been identified as having a very high potential in China. Household deposits have been a major source of cheap funding for banks, but households’ potential as borrowers is yet to be fully explored. Consumer banking is still in an early stage of development in China. The population of 1.3 billion has savings deposits of almost RMB 2 trillion at end-2007, constituting a significant source of funding for banks. The share of consumer loans was around 20% of total loans in 2007. Mortgage lending makes up the largest share, around 80% of consumer lending. Other types of consumer lending such as car loans, debit and credit cards, as well as other household credit products remain relatively small. Major players in consumer banking in China are the big-4 banks thanks to their large branch networks. However competition has been heating up as income from consumer banking, especially mortgage products, is seen as a generator of more steady long-term revenue, i.e. less cyclical than income from corporate banking. Joint-stock banks have been putting more emphasis on increasing their market share in consumer loans. Assessing consumer credit continues to be challenging. The Credit Information Centre (CIC), under the purview of the PBC, acts as consumer credit bureau, and its scope of operations is still being expanded and evolving. Car loans, which make up less than 3% of 2 Asia Banking Outlook 2008, Moody’s Global Banking Special Comment, June 2008. 0 2 4 6 8 10 12 14 16 0 50 100 150 200 250 Jun 04 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 NPL, USD bn (left) NPL, % of total loans (right) ! " Source: CBRC # 0 5 10 15 20 25 30 35 40 Household Agriculture Real estate Mining Industrial Trade Services Others 2006 2007 Source: Global Insight % of total loans $
Deutsche Bank Research Current Issues consumer lending, have seen a relatively high rate of defaults China credit cards implying that risk assessment and management need to be see ex ive growth but stilll in improved 1.60 Credit card business is also among the subsectors identified 1.400 having a bright potential At end-2007, there were around 90 million credit cards (6.8%of the population or 15. 2% of the urban popul ation). The number of debit cards is much larger at around 1. 4 billion cards presumably due to multiple card holding, reflecting that 600 Chinese customers are still cautious on spending on personal credit. Credit card business makes up less than 3% of consumer lending 200 80000 Foreign banks have also joined in the competition, capitalising on the internationally recognised brand names. Many of the foreign a Number of issues, million(left) banks issue co-brand cards with their local partners to combine the Transaction amount, RMB tr(right) international brand with local relationships Source: CEIC As more banks are intent on gaining market share, competitive pressures have kept fee charges low. Banks are also trying to win over customers via the quality of services. Big local banks enjoy the advantage of having existing relationships with large local companies, which open doors to offering their employees card products. Foreign banks on the other hand have focused more on Mortgages make up around wealthy customers in the big cities. The lucrative segment for card 80% of consumers loans products appears to be young professionals who are less averse to Mortgages/consumer loans, funding their spending on consumer credit. Given the low penetration rate of credit cards, the size of the pie for card business 84 is yet to reach its full 82 Mortgage lending has the potential to become the new staple for Chinese banks. The default rate for mortgage lending has thus far 76 been lower than other consumer loans, similar to the experience of banking sectors in other countries. Furthermore, government measures have constantly favoured first-time home buyers and buyers of smaller housing, which counterbalance the measures to guard against speculative buyers. This coupled with underlying long- Sources: Moody s, PBC term demand, as supported by urbanisation and population trends indicating that another 350 million will become city-dwellers in China by the year 2030, suggests that long-term growth prospects for gage lending in China remain price correction China had highest HNWI population among BRICs Wealth management has enjoyed strong growth in China. The in2007 number of high net worth individuals(HNWi) in China is estimated to be the highest in non-Japan Asia at more than 400,000. Similar to credit cards, wealth management is another area where large local banks and foreign banks are keenly competing for market shares 15 Foreign banks have, at least up to the period before the global financial crisis in 2008, enjoyed advantages over local banks due to their international network and established brand names. The unfolding global financial crisis could erode this advantage and the regulatory authorities are likely to adopt a cautious approach on new China India Brazil Russia product developments aHNWI population, 000(left) Challenges HNWI population, yoy(right) Source: Merry! Lynch World Wealth Report 2008 ate key concern facing China's domestic banks is the impact of the economic slowdown on their earnings and profitability Global Insight Report: China(Banking)2008 4 For details see "Chinese financial markets in the global context-much growth little integration" on pp. 17-22 in this report. By 2030 China s cities have to be equipped for at least 350 million new inhabitants, DB Research Talking Point, August 29, 2008 arch16.2009
Current Issues 14 March 16, 2009 consumer lending, have seen a relatively high rate of defaults3 , implying that risk assessment and management need to be improved. Credit card business is also among the subsectors identified as having a bright potential. At end-2007, there were around 90 million credit cards (6.8% of the population or 15.2% of the urban population). The number of debit cards is much larger at around 1.4 billion cards presumably due to multiple card holding, reflecting that Chinese customers are still cautious on spending on personal credit. Credit card business makes up less than 3% of consumer lending. Foreign banks have also joined in the competition, capitalising on the internationally recognised brand names. Many of the foreign banks issue co-brand cards with their local partners to combine the international brand with local relationships4 . As more banks are intent on gaining market share, competitive pressures have kept fee charges low. Banks are also trying to win over customers via the quality of services. Big local banks enjoy the advantage of having existing relationships with large local companies, which open doors to offering their employees card products. Foreign banks on the other hand have focused more on wealthy customers in the big cities. The lucrative segment for card products appears to be young professionals who are less averse to funding their spending on consumer credit. Given the low penetration rate of credit cards, the size of the pie for card business is yet to reach its full potential. Mortgage lending has the potential to become the new staple for Chinese banks. The default rate for mortgage lending has thus far been lower than other consumer loans, similar to the experience of banking sectors in other countries. Furthermore, government measures have constantly favoured first-time home buyers and buyers of smaller housing, which counterbalance the measures to guard against speculative buyers. This coupled with underlying longterm demand, as supported by urbanisation and population trends indicating that another 350 million will become city-dwellers in China by the year 20305 , suggests that long-term growth prospects for mortgage lending in China remain intact despite a looming property price correction. Wealth management has enjoyed strong growth in China. The number of high net worth individuals (HNWI) in China is estimated to be the highest in non-Japan Asia at more than 400,000. Similar to credit cards, wealth management is another area where large local banks and foreign banks are keenly competing for market shares. Foreign banks have, at least up to the period before the global financial crisis in 2008, enjoyed advantages over local banks due to their international network and established brand names. The unfolding global financial crisis could erode this advantage and the regulatory authorities are likely to adopt a cautious approach on new product developments. Challenges An immediate key concern facing China’s domestic banks is the impact of the economic slowdown on their earnings and profitability. 3 Global Insight Report: China (Banking) 2008. 4 For details see “Chinese financial markets in the global context – much growth, little integration” on pp. 17-22 in this report. 5 By 2030 China’s cities have to be equipped for at least 350 million new inhabitants, DB Research Talking Point, August 29, 2008. 0 20 40 60 80 100 120 140 0 200 400 600 800 1,000 1,200 1,400 1,600 97 99 01 03 05 07 Number of issues, million (left) Transaction amount, RMB tr (right) %!& Source: CEIC ' 70 72 74 76 78 80 82 84 86 00 01 02 03 04 05 06 07 ( ! )*+ " Mortgages/consumer loans, % Sources: Moody's, PBC , 0 5 10 15 20 25 0 100 200 300 400 500 China India Brazil Russia HNWI population, '000 (left) HNWI population, % yoy (right) - . !! /0 #**1 Source: Merryl Lynch World Wealth Report 2008 2
China's financial markets-a future global force? Deutsche Bank Research Borrowers are facing increasing Borrowers are facing increasing stress from several factors including stress slowing orders for exporters, rising labour costs and RMB appreciation( for exporters), the last two pressuring profit margins. In the past, Chinese companies have compensated for these margin China's listed banks Tier 1 pressures with a rise in sales volume, benefiting from strong CAR LLR coverage ratio demand globally. Now that is changing. The rise in borrowers financial stress does not bode well for banks interest income from loans is estimated to account for more than 70% of china s banks operating income. As the economic cycle enters a downturn, 120 delinquencies can be expected to rise H1 2008 data already shows that the amount of loans recorded as overdue from one day to one year increased at several key banks The ability of banks to withstand the potential decline in asset qual during the downturn varies. Larger banks appear better able to bsorb the deterioration in asset quality. In H1 2008, listed banks I Tier 1 CAR (left) average loan-loss reserve coverage ratio was 135%, improving LLR coverage ratio(right) markedly from 82% in 2005. The Tier 1 CAR of listed banks stood at Source: 9. 1% compared to 6.5%in 2005. Their pre-provision profit/average assets improved to 2. 4%from 1.5%in 2005. However, smaller Exposure to the real estate sector is Bank exposure to the real estate sector is an area of concern. There an area of concern are no official data on the banking sectors exposure to the real estate sector, but data from various reliable independent sources suggests that real estate loans(loans to developers and con- struction companies)make up around 12% of total loans. When taking into account mortgage loans, the banking sector's property- related loans are more than 20% of the total, a substantial exposure There are unofficial reports that the real estate sector in some key cities is already slumping, for example in Shenzhen where prices dropped 30% yoy. The real estate loan portfolio is therefore vulner- able to a deterioration in asset quality. As past experience in other countries suggests, a drop in property prices dampens sales volumes, leading to tight cash flows for real estate developers and construction companies Banks tend to focus their lending on The corporate sector commands the largest share of bank loans state-owned enterprises. estimated at around 80% of the total within the corporate sector, banks tend to focus their lending activities on state-owned enter prises ( SOEs)and large private companies, which often have government support. This is reflective of the past practice of state- directed lending, relationship-based credit decisions, and the general lack of confidence in counterparty credit outside the realm of as a result emerging SMEs have not the public-sector entities. As a result, the emerging small and had their financing needs served medium-sized enterprises(SMEs)have not had their financing sufficiently needs served sufficiently Many SMEs have been relying on retained earnings and informal lending for funding needs. The Peoples Bank of China has become increasingly concerned that the SME sector is under-served. On the flipside, accounting standards at many SMEs are not on par with those at SOEs and large private companies, making it difficult, if at all possible, for banks to assess their true financial position, projection of future cash flow and ultimately their creditworthiness. In this regard, two areas need to be addressed simultaneously SMEs have to improve their accounting standards if they want to access bank financing. Banks also have to develop expertise in SME credit assessment For China to develop success- Chinese Banks: Signs of Strain Emerging, Despite Strong H1 08, Fitch Ratings, September 22, 2008
China's financial markets – a future global force? March 16, 2009 15 Borrowers are facing increasing stress Exposure to the real estate sector is an area of concern Banks tend to focus their lending on state-owned enterprises... ... as a result emerging SMEs have not had their financing needs served sufficiently Borrowers are facing increasing stress from several factors including slowing orders for exporters, rising labour costs and RMB appreciation (for exporters), the last two pressuring profit margins. In the past, Chinese companies have compensated for these margin pressures with a rise in sales volume, benefiting from strong demand globally. Now that is changing. The rise in borrowers’ financial stress does not bode well for banks. Interest income from loans is estimated to account for more than 70% of China’s banks operating income. As the economic cycle enters a downturn, delinquencies can be expected to rise. H1 2008 data already shows that the amount of loans recorded as overdue from one day to one year increased at several key banks. The ability of banks to withstand the potential decline in asset quality during the downturn varies. Larger banks appear better able to absorb the deterioration in asset quality. In H1 2008, listed banks’ average loan-loss reserve coverage ratio was 135%, improving markedly from 82% in 2005. The Tier 1 CAR of listed banks stood at 9.1% compared to 6.5% in 2005. Their pre-provision profit/average assets improved to 2.4% from 1.5% in 20056 . However, smaller banks are generally not as strong. Bank exposure to the real estate sector is an area of concern. There are no official data on the banking sector’s exposure to the real estate sector, but data from various reliable independent sources suggests that real estate loans (loans to developers and construction companies) make up around 12% of total loans. When taking into account mortgage loans, the banking sector’s propertyrelated loans are more than 20% of the total, a substantial exposure. There are unofficial reports that the real estate sector in some key cities is already slumping, for example in Shenzhen where prices dropped 30% yoy. The real estate loan portfolio is therefore vulnerable to a deterioration in asset quality. As past experience in other countries suggests, a drop in property prices dampens sales volumes, leading to tight cash flows for real estate developers and construction companies. The corporate sector commands the largest share of bank loans, estimated at around 80% of the total. Within the corporate sector, banks tend to focus their lending activities on state-owned enterprises (SOEs) and large private companies, which often have government support. This is reflective of the past practice of statedirected lending, relationship-based credit decisions, and the general lack of confidence in counterparty credit outside the realm of the public-sector entities. As a result, the emerging small and medium-sized enterprises (SMEs) have not had their financing needs served sufficiently. Many SMEs have been relying on retained earnings and informal lending for funding needs. The People’s Bank of China has become increasingly concerned that the SME sector is under-served. On the flipside, accounting standards at many SMEs are not on par with those at SOEs and large private companies, making it difficult, if at all possible, for banks to assess their true financial position, projection of future cash flow and ultimately their creditworthiness. In this regard, two areas need to be addressed simultaneously. SMEs have to improve their accounting standards if they want to access bank financing. Banks also have to develop expertise in SME credit assessment. For China to develop success- 6 Chinese Banks: Signs of Strain Emerging, Despite Strong H1 08, Fitch Ratings, September 22, 2008. 0 20 40 60 80 100 120 140 160 0 2 4 6 8 10 2005 H1 2008 Tier 1 CAR (left) LLR coverage ratio (right) 3 40 0 & % Source: Fitch 1