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NPL reduction still a major concern
By Zhao Renfeng (China Business Weekly)
Updated: 2004-08-26 15:31

Editor's note: Experts widely agree the development of China's financial and banking sector has lagged behind the general development of the nation's economy. The government's recent steps to shore up the competitive edge of China's banks have been bold and resolute. China Business Weekly staff reporter ZHAO RENFENG recently interviewed Wei S Yen, Moody's managing-director in Asia-Pacific, regarding his views of the future landscape of the nation's banking industry.

China Business Weekly (CBW): China's recent bank reform has resulted in significant changes on the nation's banking industry. What is Moody's outlook for China's banks, particularly the Big Four banks?

Wei Yen (Yen): Moody's holds stable outlooks for China's banking industry.

Although some banks still face major challenges in improving profitability, widening financing channels and shrugging off their heavy historical legacies of bad loans, the government's firm support is likely to give the banks a shot in the arm.

We have found China's State-owned banks are resolute in their efforts to getting rid of bad loans and improving capital ratios, which will aid their future overseas listings.

CBW: China's banking reform deepened recently, when State-owned banks sped up their efforts to list overseas. What is your assessment of the banks' preparations for overseas listings? What has been their major progress so far, and what issues matter most during the critical market-oriented reform of China's State-owned banks?

Yen: We have found that China's State-owned banks have largely improved their profitability through their own efforts. Also, the government's resolveis conspicuous in helping them reduce non-performing loans (NPLs) and raise their capital ratios.

These banks have done a good job in improving their balance sheets. You may find rapid drops in their NPL ratios. The key next step, for them, is to build up healthy and sustainable business models, which can make the banks stand out in the market.

CBW: Under the current circumstances, banks are finding it hard to differentiate themselves from their competitors, due to the fixed-interest-rate policy and their limitations in product innovation. How can China's banks outperform their competitors?

Yen: Right, there are currently many policy restrictions in China's banking industry. But these policies will be loosened some day in the future. Chinese bankers need to think about what to do next, and they should start to prepare for the future right now.

There is great potential for China's banks, particularly those involved with retail businesses and intermediary businesses.

CBW: What is the role of bank finance in China's economic development? Yen: Credit-funded investments are behind much of China's rapid economic development, and, in 2003, the banks provided 85 per cent of all funds raised.

The strength of their deposit base -- spurred by foreign direct investment inflows and a rise in money supply -- is a key reason for the aggressive lending. It should be noted loan prices are controlled and, thus, do not always reflect the inherent credit risks, given that risk-management systems are still elementary.

Another detail to consider in this context is most corporate borrowers are manufacturers, and the recent rise in raw material prices has squeezed their margins. The banks do not have much flexibility in the way they can deal with non-performing loans (NPLs), but they are under pressure to reduce them.

They can't sell NPLs directly to investors because discounting NPLs is prohibited. So, the only option is to grow their loan portfolios, or in other words, to inflate the denominator used to calculate NPL ratios.

Another reason loan growth is difficult to slow down is branch managers are faced with having to perform in accordance with operating targets that are growth-oriented.

CBW: Given the difficulties in slowing loan growth, what options are open to authorities to put the brakes on excessive economic expansion?

Yen: Strong regulatory and administrative measures are really the best options, because market forces are not that powerful in China. The People's Bank of China has tightened guidelines for lending to the real estate sector since June 2003, and has introduced steps to remove liquidity from the system, such as raising the deposit reserve requirement from 6 per cent last fall to 7.5 per cent now.

The China Banking Regulatory Commission also introduced its own initiatives, including a set of new capital adequacy requirements that will slow lending, especially for the 11 shareholding banks.

CBW: How effective have these measures been? What kinds of banks bear the brunt of these measures?

Yen: Basically, the government is aiming to slow economic growth by reining in bank lending, by stimulating loans to the small and medium-sized enterprise (SME) sector, and by strengthening the supervision of poorly capitalized banks. Against this backdrop, the results have been mixed. This is due to the failure to reform other critical areas, such as the interest rate regime and the difficulties in changing bank operating targets from those based on growth to profitability.

Furthermore, local governments will continue exerting their influence on loans for particular pet projects with questionable economic benefits. A sharp slowdown in loan growth can lead to asset quality and liquidity problems for the banks -- in particular, the smaller and fast-growing shareholding and city commercial banks. These banks could be in the unenviable position of having to simultaneously handle a decline in earnings, a rise in NPLs, and tougher access to capital markets. The impact of the current restrictions will be felt most on the poorly run banks, or those which must grow their assets and earnings fast, as they position themselves to meet the challenges posed by the World Trade Organization.

To maintain earnings, against the backdrop of slowing growth, the banks must target higher-yielding assets, such as SME loans.

This could lead the banks to take on more risks, but they would also be doing so without very good mechanisms to quantify such risks, and to price their loans accordingly. Furthermore, SME loan growth is expected to be anemic, and when loans are made to the sector, they most likely will not be priced to reflect the inherent risks. The result will be an increase in asset-quality risk at the banks.

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