Financial Risk in a Slowing Economy
T
he government work report delivered at the annual session of the National People's Congress,or parliament,called for a greater effort to ensure that the 13th Five-Year Plan (2016-2020) got off to a good start. It targeted a reduction in overcapacity in certain struggling sectors as well as reducing inventories,cutting costs for business and deleveraging - or trimming debt. Premier Li Keqiang also pointed to the importance of guarding against financial risk. Accelerating China's economic transition will inevitably put more pressure on the financial system. What is the outlook for financial risk in China? And how we should we carry out changes in financial regulation so that our financial system can promote economic growth and a transformation of the economic structure?
Zhong Wei,deputy editor-in-chief of China Forex Magazine,speaks to Ba Shusong,chief economist of the Hong Kong Stock Exchange and the China Banking Association,and He Fan,chief economist at Caixin Think Tank.
Zhong Wei: Welcome to this roundtable discussion. China's banks have long been the mainstay of the financial system. They have enjoyed an extended boom,helped by repeated replenishments of capital to support lending even as they make greater provisions for loan losses. The net result has been a fairly good return on assets and comparatively low levels at least on a percentage basis -- of non-performing loans. But with China＊s economic slowdown and a prolonged effort to promote economic restructuring,the banking sector has been facing growing pressure. In your opinion,what's the outlook for profitability for the nation's banks and how does asset quality compare to banks elsewhere? With more market-based domestic interest rates,a more flexible exchange rate for the nation's currency and policy changes such as permission for debt-to-equity swaps,how much more pressure will there be on bank profitability? And how long will this pressure last?
Ba Shusong: After the financial crisis,global commercial banks adjusted their assets and liabilities in different ways. With the introduction of loose monetary policies in the eurozone and Japan,low interest rate spreads had a more obvious impact on the operations of the banks in those markets. China's banks depend on a healthy spread between deposit and lending rates. Profits are now likely to fall under pressure from continuing declines in interest rates coupled with slower economic growth and economic restructuring. The freeing up of the renminbi's exchange rate and the gradual relaxation of restrictions on market access in the banking sector are also likely to hurt profits. As of the end of the third quarter of 2015,the G-SIBs (systemically important banks) in the United States had net profits totaling US$25.26 billion,for a year-on-year increase of 12.2%. Their return on assets was 0.8% and their return on equity was 8.5%,while their net interest margin was 1.7%. For major eurozone banks,the return on assets was 0.4% while the return on equity was 7.8% and their net interest rate margin was 1.5%. China's listed banks had an average return on assets of 1.16% and return on equity of 17.69%,relatively high by international standards. As for asset quality,the non-performing loan ratio of China's commercial banks has risen for ten straight quarters since the second quarter of 2013,reaching 1.67% by the end of 2015 for a total of 1.27 trillion yuan. As of the end of the third quarter of 2015,the ratio of non-performing loans at G-SIBs in the United States was 1.0%,down 0.2 percentage point from a year earlier. Meanwhile,the same ratio at major eurozone banks overall was 3.8%. Currently,China's banking sector is facing the dual challenge of a cyclical economic decline and an ongoing structural transformation.
We are hopeful of making further progress in deleveraging,destocking and reducing excess capacity in 2016. This will increase the non-performing loan ratio at Chinese banks though it will expose banks to other risks to a certain degree. But what requires greater attention is how to create a market mechanism to resolve non-performing assets once these other risks emerge. In debt-to-equity swaps,if calculated by book value,creditor banks may gain a short-term benefit from restructuring,thus they can improve their balance sheet as well as their profit statement. That will allow them to enhance provisions for bad debts. However,whether debt-to-equity swaps can improve the operating conditions of enterprises and turn bad assets into high-quality equity depends on those operating conditions. Recalling the process of reducing excess capacity in the period after the Asian financial crisis in 1997-1998,debt-to-equity swaps were one of the most important methods for resolving bad assets at that time. About 30 per cent of the 1.4 trillion yuan in bad assets was handled using this method in 1999,but the performance of these shares after the debt-equity swaps was very mixed.
He Fan: China's economy has entered a period that we like to call a "new normal." This is certainly true as far as the banking sector is concerned. With downward pressure on the economy and a difficult restructuring period ahead,banks will face greater risks. The non-performing loan ratio increased from 1% at the end of 2013 to 1.67% as of the end of 2015,the proportion of loans classified as requiring "special attention" climbed from 2.5% in the first quarter of 2015 to 3.8% as of the end of 2015. The non-performing loan ratio remained at a low level,but this might have been underestimated and it undoubtedly will grow substantially in the future. The profitability of banks overall has declined,the return on capital has fallen from 20.8% in the first quarter of 2014 to less than 15% as of the end of 2015,while net profit growth rate of most banks dropped to single digit levels in 2015. Some banks even had negative net profit growth.
It is expected that asset quality and profitability in the banking sector will continue to face serious challenges in the future. First,during an economic downturn,enterprises will face many difficulties,demand for credit will decline and credit risks will rise. Second,there will be more pressure to address problems with so-called "zombie companies." Amid an effort to reduce excess capacity,cut back on corporate leveraging and reduce inventories,some of the debt burdens of the nation's enterprises are likely to land in the lap of the nation's banks. This will increase bad assets in the banking system. Third,during economic restructuring,the traditional business model of banks (mainly from making collateralized loans to manufacturers with good assets and stable cash flows) becomes more and more difficult. For companies in emerging sectors of the economy,especially in the service sector,risks are rising even though some companies have very strong growth prospects. Traditional banks may not be able to adapt to these changes in a short period of time. As for business structure,the demand for intermediary services from the real economy is likely to decline. This will put more pressure on bank income.
The liberalization of interest rates did not really lead to purely market-set rates. It takes time for a benchmark rate to function properly. Even more time will be required to create what has been called an interest rate corridor. Severe challenges remain for commercial banks in this regard. For example,the rapid development of third-party payment,virtual credit cards,Internet financing and other new financial tools continue to jolt the basic payment and settlement operations of the nation's banks as well as consumer finance,wealth management and other areas of the banking business. Overall the whole finance sector is showing a trend towards disintermediation,and banks are in one sense becoming a "back office" operation.
Zhong Wei: China's capital markets experienced huge ups and downs in 2015. This not only affected investor confidence,but also jolted the economy,affecting financial stability and the effort to achieve structural transformation. In the meantime,asset prices on offshore markets,including Hong Kong,have also undergone abnormal fluctuations. Looking ahead,what kind of risks can we expect for the stock market,particularly if we use a registration system for new share offers in place of regulatory approvals of each share offer,and we see continued use of financing with equity pledged as collateral? What measures are needed to limit the potential damage?
He Fan: The market turmoil of 2015 will have a significant impact on the stock market this year. Market confidence has not fully recovered,and the negative impact has not yet dissipated. Meanwhile,there may be fresh sources of risk in 2016.
Assessing the effects of a registration system is complicated. On December 27,2015,the National People's Congress authorized the State Council to arrange detailed rules for a reform that would put into effect a registration system for new stock offers. This was expected to be put in place by March 1 of this year. However,this objective was not reached as of the end of March. The 13th Five-Year Plan calls for the creation of conditions that will allow the implementation of a registration system for stock offers. The market interpreted this as a "suspension" of the registration system due to insufficiently mature conditions. We are still under pressure from an economic downturn,and there are internal as well as external economic risks. To implement a registration system at this time would mean a rapid increase in the supply of newly offered stock. That would probably undermine the market and destroy the fragile balance between supply and demand. Methods such as a halt to new offers on the emerging market board show we lack a comprehensive long-term plan for our capital markets. Stabilizing market confidence is still a key focus in the near term.
The overall scale of the use of shares as collateral for financing is limited. As long as there is no sharp fall in the market,the risks are still controllable for the banking sector. But it is worth noting that during an economic downturn and when the leverage ratio is still high,falling stock prices can easily trigger a downward spiral. Individuals and companies will need to make additional margin payments or top up their collateral. Banks may end up with those pledged shares if stock prices continue to fall.
Ba Shusong: The share registration system reform will have a tremendous impact on China's stock market. The essence of the reform is to turn over to the market the task of evaluating a company's stock. That lets the market allocate financial resources. Regulators will shift their focus from prior approval of stock offers to supervision during and after the offer,paying more attention to the quality of information that is disclosed to potential investors. The market can then determine investment behavior on its own,based on this information. This makes supervision even more important. If we lower the threshold for new share offers but fail to enhance regulatory supervision and toughen penalties for rule violations,we may have even more problems with infringements on the rights of investors. In addition,there must be a strict delisting system alongside this more convenient system for offering new shares. This is necessary to ensure the "survival of the fittest." The main boards in developed economies usually have a certain level of delistings for listed companies tha