Chinese banks are slowly admitting they have a few bad loans stuffed in their balance sheets. Investors should brace for more.
Two of the country’s big four state-owned lenders have now reported full-year 2014 earnings, and both showed rising costs from soured loans. Net profit, which for some time has grown in double digits, rose last year by just 8% for both Bank of China and Agricultural Bank of China, known as AgBank. Their figures show that a profit pothole formed at the end of the year, with implied fourth-quarter net profit rising just 5% for Bank of China and 4% for AgBank.
More worryingly, nonperforming loans for the year rose 37% at Bank of China and 42% at AgBank. Midsize lender China Citic Bank, which reported earlier this month, saw nonperforming loans rise 43%.
Bank of China’s relative outperformance may be due to its bigger overseas exposure. At 27% of total assets, its international book is bigger than any competitor. Its overall nonperforming loan ratio came to 1.18%, below average for the sector, but the domestic NPL ratio was 1.47%.
These numbers would look even worse if lenders weren’t actively disposing of nonperforming loans by selling them to the asset-management companies set up in the 1990s to bail out the banks. An AgBank executive told reporters Tuesday the firm sold more than 26 billion yuan ($4.2 billion) worth of nonperforming loans to these companies last year, at 37 cents on the dollar.
An industry-wide nonperforming loan ratio of 1.29% at the end of last year, up from 1% a year earlier, may not sound so bad. But few investors believe the figures.
So it could be seen as welcome news that the banks are recognizing problem loans and disposing of hopeless assets. The problem is that no one knows how bad things will get.
In all likelihood, China is only at the early stages of a negative credit cycle. Economic growth is still slowing, and conditions in the property market are worsening. AgBank told analysts it thinks nonperforming loans are likely to peak in the second half of this year or in 2016, according to Barclays.
Resilient net interest margins, which rose in 2014 for both Bank of China and AgBank, are unlikely to be maintained. Interest rate cuts, and the gradual loosening of deposit rates, will squeeze margins going forward. This could reduce overall bank earnings by up to 3.9% this year and 10.5% in 2016, according to Barclays. The situation would intensify if People’s Bank of China Gov. Zhou Xiaochuan is right that deposit rates could be fully liberalized by the end of this year.
Bulls argue that Chinese bank stocks are cheap, hovering around book value. But that has been the case for years. With the outlook darkening on interest rates and loan quality, there’s no relief in sight.