Last week, I explored the issue of mainland banks' exposure to local government financial vehicles (LGFV) in two articles.

In this last "episode" of the series, I would like to focus more on the possible impact of local government debt on the nation's commercial banks.

According to audited financial reports, the provision coverage of the mainland's listed banks reached 776 billion yuan at the end of 2010, implying a provision coverage ratio of 201 percent. In 2010, the pre-provision profit was around 1.1 trillion yuan. With the assumption that the pre-provision profit remains at the same level in each year that follows, the sum of the pre-provision profits for the next three years will amount to 3.3 trillion yuan.

If we further assume a 70 percent actual loss rate for non-performing loans (NPLs), it is implied that the banks' capital will not come under threat if the total NPL does not exceed 4.7 trillion in the next three years. And if the NPL ratio does not surpass the 9.86 percent mark three years after that.

Furthermore, we conducted a sensitivity test between the NPL ratio change and banks' net profit changes under certain assumptions. In the worst case scenario, under which the LGFV NPL ratio rises to 30 percent, the overall NPL ratio will climb from the current 1.16 percent to 3.9 percent in 2013, while the sector's net profit in 2013 will decline by 55 percent from that in 2010.

Among individual banking stocks, those with higher LGFV loan ratios and sensitivity to provisions will take a larger blow. What's noteworthy is that companies may have different criteria in classifying LGFV loans. Currently, I am short of means to distinguish each type of LGFV loan concretely.

Therefore, the following estimates are based on the same LGFV NPL ratio of 30 percent. To evaluate the actual risk, we need to know the locations, levels and investment projects of the LGFV loans made by the banks. Currently, I believe county-level LGFVs in the central-western region are the highest. As a result, both Agricultural Bank of China and Minsheng Bank face higher risks.

Separately, the People's Bank of China (PBoC) announced another interest rate hike in the base rates of financial institutions' yuan deposits and loans earlier this month. The base rates of financial institutions' time deposits and loans of various terms were all raised by 0.25 percentage point, whereas the demand deposit rate remains unchanged.

Compared to the previous interest rate hikes, the latest move did not raise the demand deposit rate or the longer-term deposit rates by greater increments. Consequently, among the five interest rate hikes taken since 2010, this one is the most beneficial to the banks' net interest margin (NIM).

However, as the latest hike was implemented mid-year, the contribution to NIM and profit will only occur in the second half. Under my estimate, the latest hike will help expand the listed banks' 2011 NIM by 3.3 basis points (bps) on average and their 2011 net profit by 2.2 percent on average. The benefits of the current hike will be more significant to the listed banks' 2012 results. The NIM is expected to increase by more than 6bps on average in 2012.

Given the favorable rate hike, the banking sector may rebound near-term. However, rising concerns over asset quality will continue to limit the room for a rebound amid persisting inflationary pressure and slower economic growth.

The author is executive director of BOCI Research Ltd. The opinions expressed here are entirely his own. Nothing in this article constitutes an investment recommendation.

(HK Edition 07/26/2011 page2)