Chinese banks' earnings outlook will hinge on their ability to grow their loan books, with help from loosening monetary policy, as the economic prospects of the world's second-largest economy weaken.

The People's Bank of China on April 15 cut the reserves that banks are required to hold with the central bank by 25 basis points, with effect from April 25. For some smaller lenders, the reserve requirement ratio was cut by 50 basis points. Analysts expect further loosening of monetary policy, including lowering of the benchmark loan prime rates, along with economic stimulus, as a wave of COVID-19 infections in key cities triggers some of the strictest lockdown measures in two years.

"The resilience of some Chinese banks could be tested the longer the duration of the COVID restrictions," according to S&P Global Ratings' credit analyst Ming Tan.

China has reported more than 400,000 COVID-19 cases since March, including 300,000 in Shanghai alone, forcing the financial hub to impose several restrictions to curb the spread of the virus. More cities in the country face lockdowns as the infection spreads, threatening to drag economic activity lower. GDP grew 4.8% year over year in the first quarter, the government reported April 18, compared with the full-year aim of a 5.5% expansion set at its biggest annual political meeting in March.

Margin squeeze

Any reduction in interest rates will likely further squeeze banks' net interest margins, especially for rural lenders. In the first quarter, NIMs were "squeezed by the weakening loan repricing power and uptrending cost of deposits," said Dai Zhifeng, banking analyst at Shandong-based Zhongtai Securities Co.

Chinese banks' aggregate interest income may have grown 4.9% year over year in the January-to-March quarter, helped by 7.7% loan growth, with rural lenders leading the pack with a 10.5% increase, according to Dai's estimates. That would have partly offset an expected contraction in aggregate NIMs.

While the cuts in the required rate of return will help bring down funding costs for banks, J.P. Morgan analysts believe stronger policy support is needed, especially with the urban unemployment rate climbing to 5.8% in March from the previous month's reading of 5.5%.

Cutting in the loan prime rate "is a more effective way to support the real economy," Chaoping Zhu, Shanghai-based global market strategist at JPM Asset Management said, "since it could help relieve the burden of existing debt for businesses which are losing income."

China has cut its one-year loan prime rate, or LPR, twice in the past four months, and the five-year LPR, a benchmark for home mortgage rates, was cut in January for the first time since April 2020, fueling concerns over banks' interest margins. Still, the lenders' net interest income, which made up 80% of their revenues in 2021 according to Bank of China Research Institute, may stay resilient as the potential loan growth would offset narrowing margins.

Challenges ahead

Banks may report high-single-digit income growth in their first-quarter results due in the coming weeks, Jefferies' analysts wrote in an April 18 note. Still, retail banks "face more challenges ahead, as personal loan growth and asset quality are both likely to worsen due to weak consumption and higher unemployment," Jefferies said.

"Policies on property and local [government] financing vehicles are likely to loosen in order to boost credit growth and lower default risk," it added.

Chinese banks extended 3.13 trillion yuan in new loans in March, according to the central bank's April 11 release, compared with 1.23 trillion yuan in February, usually a weak month. Total social financing, a broad measure of funds provided to the real economy, jumped to 4.65 trillion yuan from 1.19 trillion yuan in February, the data showed.