China's banking sector deepens reforms

Based in Inner Mongolia, Baoshang Bank (BSB), which is rated AA+, had not published financial reports since the third quarter of 2017;² it faced accusations that its largest shareholder had misappropriated bank funds. According to the People’s Bank of China (PBoC) and the China Banking and Insurance Regulatory Commission (CBIRC), the administrative takeover was intended to safeguard against systemic risks, protect the legitimate rights and interests of depositors and other clients, and ensure that the business operations of BSB were not suspended.³ BSB was also an active participant in the interbank market: The bank had outstanding interbank liabilities (certificates of deposit) of RMB$60 billion when it was taken over. While small depositors will likely remain protected, larger creditors could potentially face losses.⁴

Looking at the bigger picture, we view this action as the government’s attempt to deepen reform in the financial sector, particularly for smaller, lower-tier banks. With approximately 4600 banks⁵ in China, ranging from the large state-owned and joint-stock commercial entities, to rural and city commercial banks, the move marks a deepening of the regulatory oversight on the lower-tier firms.

We noticed that some of the lower tier banks in China have similar disclosure issues to that of BSB. In fact, roughly one week after the takeover, the auditors of the Bank of Jinzhou (which had not published its 2018 annual results) resigned after they determined a portion of the bank’s loans to clients were not used for the stated purpose. Overall, 15 other Chinese banks have delayed or failed to disclose their financial reporting this year: 12 of which are rural commercial banks; the remaining three are city commercial banks.⁶

We think this event symbolizes important changes in the financial sector. Previously, investors believed that the government would backstop potential losses in the interbank market. This led to an increase in moral hazard. Although the final outcome of negotiations between creditors and regulators has not yet emerged, we believe investors should be aware that the implicit guarantee assumed by many for financial institutions likely may not apply in the future.

Taking a broader look at the banking system, we see improvements in asset quality. Problem loans represented 4.8% of total lending at the end of March 2019, the lowest figure in five years; general reserves and capital levels in the system also stood at multi-year highs during the same period.⁷

However, the improvements are mainly being seen among the large state-owned and joint-stock commercial banks, while city commercial and rural commercial banks face ongoing difficulties due to deteriorating asset quality, inadequate capitalization, and an over-reliance on wholesale funding. We expect that this credit-differentiation trend within the banking sector will continue and investors could consider moving up in quality and focus on the large state-owned and selected joint-stock commercial banks.

That said, we do not anticipate a systemic shock or crisis among Chinese banks, even if there are more BSB-type incidents. The banking system will continue to de-risk; furthermore, financial regulators will ensure that any credit events in the banking sector will be well contained.

As the Chinese economy experiences challenges, we anticipate an uptick in defaults. Indeed, there has already been a rise in defaults among privately-owned enterprises in China as the onshore default rate rose to 4.6% in 2018 from 0.7% in 2017; the default rate has remained elevated in the first five months of 2019 at 2.1%.⁸

Moving forward, Chinese government policy should play an influential role in credit markets. The PBOC’s current accommodative monetary stance should be generally supportive of debt refinancing efforts. However, we believe that not all sectors will benefit equally. In particular, we see an increasing risk of defaults in the high-yield China industrial space, as many first-time issuers are scheduled to repay their offshore bonds over the next two years. We think that refinancing will be a challenge as investors have remained skeptical on some of these credits due to poor disclosure and weak corporate governance.

Active fiscal policy should also support key segments of the market. For example, we think that state-owned enterprises (SOEs) that are closely linked to government policies or have systematic importance should be one main beneficiary, as the government rolls out plans to support local enterprises with infrastructure and related government spending. Indeed, we have seen an uptick in onshore issuance by SOEs with lower funding rates as liquidity conditions have improved. Onshore default rates of SOEs have also stayed low as a majority of defaults this year are from privately owned enterprises. Nevertheless, we still hold a cautious view on lower quality SOEs with weak standalone credit profiles and limited strategic importance, some of which have experienced near-defaults or coupon payment delays in recent months.

As a key contributor to the Chinese economy, the China property sector is also likely to benefit as the government looks to stabilize growth amid the escalation of U.S.-China trade tension. In recent months, we have seen policy easing in selective cities on home purchase restrictions and lower mortgage rates, which led to a recovery in developers’ contracted sales.⁹ Refinancing risks for China developers have been reduced as many have pre-funded their maturing debt through new bond issuances in the first four months of this year.

Finally, we will be closely watching a new wave of funding needs for China’s local government financing vehicles (LGFVs) in the offshore U.S. dollar bond market, as offshore debt maturities will be elevated in the next three years with annual maturities of over US$10 billion.¹⁰ We believe this transition will be a true test of LGFV refinancing ability. Markets, to a certain extent, still expect that a majority of these bonds will be refinanced, as there has not been any recent default of offshore LGFV bonds. If that doesn’t happen, investors may revisit some of their assumptions regarding implicit guarantees of government debt.

Overall, we believe it’s in China’s best interest to allow some companies to default on the condition that it wouldn’t have a systemic effect, and is executed through a managed approach. Again, security selection is vital—with markets so tough, we should see increasing divergence. During good times, all companies trade well, but it’s only when the market turns that you will see which firms are the ones with strong fundamentals.

1 The People’s Bank of China, as of May 24, 2019. 2 Dagong Global Credit Rating Co., Ltd., October 31, 2017; Reuters, May 30, 2019. 3 The People’s Bank of China, as of May 26, 2019. 4 The People’s Bank of China announced on May 24, 2019, that it will backstop corporate deposits and interbank liabilities below RMB$50 million, while liabilities exceeding RMB$50 million would be negotiated with creditors. 5 China Banking and Insurance Regulatory Commission, as of December 2018. 6 Securities Times, May 27, 2019. 7 CBIRC, May 10, 2019. Problem loans are defined as special-mention loans and non-performing loans. 8 Bloomberg, May 8, 2018; Goldman Sachs, May 39, 2019. 9 “New home prices rise in almost all Chinese cities as lower mortgage rates, lighter restrictions spur demand,” South China Morning Post, May 16, 2019. 10 Citibank, January 2019.