Opportunities in Chinese banks’ credit

Chinese banks’ AT1 credit is supported by a cyclical uplift and slowing NPL formation.
Chang Wei Liang07 Jun 2021
  • Chinese banks’ pace of NPL formation may have peaked
  • Banks’ capital ratios are supported by surprisingly resilient earnings
  • We explore Chinese AT1 markets for opportunities, anticipating little risks of failure to call
  • Offshore USD Chinese AT1 bonds look attractive, with wider spreads-to-call relative to CNY bonds
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China’s recovery tide lifts all credit boats

China’s rebound from its pandemic trough has been one of sharpest globally, with Q1 growth of 18.3%. Sustained growth is seen with nominal GDP in the last four quarters being 8.7% higher than the preceding four. Trade has supported the recovery, with exports up 43.8% on a year-to-date y/y basis. Domestic activity has been equally strong, with retail sales rising 32.0% in the Jan-Apr period from a year ago. In line with the broad recovery, capital inflows to China have surged. Foreign portfolio inflows hit a record of USD111bn in Q4 2020, while FDI inflows have also jumped to a multi-year high of USD93bn in Q1 this year.

Such robust growth in turn meant that industrial enterprises’ profits and local governments’ revenues have also soared. China’s growth tide has significantly lifted the credit profiles of non-financial enterprises and SOEs, across all regions of China.

Calibration in credit reduces loan risks

Much of China’s growth uplift can be attributed to a fiscal stimulus and credit expansion. China’s cumulative increase in bank loans since the outbreak of COVID19 was around 15% of GDP, close to its post-GFC credit impulse. Loans expansion was also helped by the state urging state-owned banks to continue lending at the expense of profits, and loan moratoriums/deferrals to help debtors.

The bulk of new loans was directed towards non-financial enterprises and government agencies, with increases in residential mortgages and other consumer loans being comparatively lesser.

Is the sharp jump in China’s overall indebtedness a concern, particularly for banks? Recent IMF research (see IMF Global Financial Stability Report, April 2021) has flagged a trade-off between lifting short-term growth through increased leverage, and higher downside risks to growth in the medium term. Chinese authorities are well aware of risks, and have already begun tapping the brakes on credit (see DBS Flash – China: Stimulus calibration underway, 29 Jan 2021). Various examples of policy calibration can be seen by lower special bond issuance for 2021, the “three red lines” debt limit for real estate developers, and slowing bond issuance for SOEs. In our view, China has successfully managed many mini-credit cycles since 2009, and we expect that the rise in debt stock can be digested over time given high trend growth.

Banks’ NPL trend is mostly benign

Even with a strong recovery, could legacy debt issues exacerbated by the pandemic still weigh on Chinese banks? Notably, Huarong’s USD credit spreads have surged this year on speculation of a restructuring due to legacy issues, triggering a jump in our China Financials DACS index. This development stands in stark contrast to Financials DACS indices for other Asian economies, which have been largely stable. Are there other legacy debt risks lurking in the Chinese banking system? To answer this, let’s assess how the quality of Chinese loan books has evolved post-pandemic.

One concrete guidepost on Chinese NPL expectations is from the PBoC itself, which conducted stress-tests on thirty major banks in 2020. The Bank forecasted the quantum of NPLs accumulated under three macro scenarios: 1/ a mild shock, 2/ a moderate shock, and 3/ an extreme shock. China’s 2020 growth outturn is closest to the mild shock scenario. To test if loan books are seeing worse than expected stresses, we compare these forecasts with the latest NPLs published by Chinese major banks.

Our analysis found that major banks’ actual NPL outturn for 2020 has closely matched PBoC’s forecast under the mild scenario, suggesting that there are no big surprises in credit quality. Furthermore, with China’s growth this year expected to significantly exceed the growth assumption under the mild shock scenario (DBS 2021f: 10.5%), we are highly confident that the worst pace of NPL formation has passed. PBoC’s own forecast has also shown a fair moderation for 2021, even with a more pessimistic growth path assumed.

Capital ratios buttressed by resilient earnings

On top of our expectations of more benign NPL formation, Chinese banks’ earnings have also proved resilient, with the industry’s profit rebounding to a record high of CNY 614bn in Q1 2021. Strong earnings also meant that commercial banks’ core tier 1 capital ratio has remained stable at 10.6%. For major banks, capital adequacy ratios have already recovered to pre-pandemic levels, and we expect CET1 ratios to be well supported in 2021.

Opportunities in the Chinese AT1 bond market

Given the improved outlook for Chinese banks, we explore opportunities in the bank credit market, in particular subordinated Additional Tier 1 (or AT1) bonds. With Chinese banks’ capital ratios set to be stable or rising, the likelihood of a coupon cancellation or a failure to call is correspondingly smaller.

China’s onshore Additional Tier 1 perpetual market has taken off since first approval by the Financial Stability and Development Committee (FSDC) in January 2019. Market capitalization for these bank perps now exceed CNY1trn, and is still growing steadily with new issuance. In contrast, the offshore AT1 market size is both smaller and has fewer new issues. Onshore AT1 liquidity has been supported by various PBoC measures, including the offering of a central bank bills swap (CBS) facility for bank perps, and the inclusion of highly rated (AA and above) perps as eligible collateral for the targeted medium-term lending facility (TMLF), standing lending facility (SLF) and re-lending.

Despite the size disparity, we see USD AT1 bonds offering a greater scope for gains compared to onshore CNY bonds.  Average spreads-to-call for a basket of USD AT1 bonds (comprising of large and joint-stock banks) remain wider than onshore CNY spreads-to-call for a similar group of major banks, even as the gap has narrowed since 2020. We believe the supply outlook is also more positive for the offshore AT1 market, as banks could favour issuing AT1 debt in the onshore market, which is getting more established by the day.

Looking at the dispersion of spreads-to-call for USD AT1 bonds, we find greater value amongst the mid-tier joint-stock banks than large banks, reflecting a market bias towards quality.  Given the improving banking sector outlook, we expect greater tailwinds for the credit of joint-stock banks going forward.

To read the full report, click here to Download the PDF.

Chang Wei Liang

Credit & FX Strategist

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