Chinese banks may see earnings growth slow in the second half as uncertainty affected the country's economic outlook and tightened policy hammered some fast-growing sectors.

The six largest Chinese commercial banks in terms of assets reported a total net profit of 602.4 billion yuan in the six months ended June 30, marking a 13.06% year-over-year increase, according to data from the China Banking and Insurance Regulatory Commission. However, that is still below the pre-pandemic level of 605.7 billion yuan for the same period in 2019.

"The second-quarter earnings [were] above our forecast, but in the second half of 2021, we [will] see increasing pressure due to recent headwinds on China's economy," said Tang Shengbo, Nomura's head of Hong Kong and China financial research. The Japanese investment bank downgraded its annual GDP growth forecast for China to 8.2% in August from the previous projection of 8.9%.

Recent economic indicators suggest China's factory activity and household consumption are slowing amid a new wave of lockdowns following the resurgence of COVID-19 cases. Regulatory clampdowns on the financial, technology and real estate sectors, as well as ongoing tensions between Beijing and Washington, are fueling concerns over the prospects of Chinese banks' loan growth and asset quality improvement, which were the key drivers of the lenders' earnings in the first half.

Despite a strong first half, some banks have set aside more loan-loss provisions to insure against future losses.

For example, Industrial & Commercial Bank of China Ltd., or ICBC, reserved 590.95 billion yuan as provisions for the first half, up from 531.16 billion yuan a year earlier, despite reporting its first quarter-over-quarter decline in its nonperforming loan ratio since China reported its first case of COVID-19 in late 2019. The bank's coverage ratio, a metric that reflects the size of cash reserves versus bad loans, increased to 191.97% as of June 30 from 180.68% at the end of 2020.

"Coverage ratios should continue to rise. The [earnings] growth rate, [however] should slow down in the second half on the back of a slower economy and a higher base effect," said Michael Chang, a Hong Kong-based China financial analyst at CGS-CIMB Securities.

Strong start

China's four largest banks reported strong growth in the second quarter, with the lenders all posting year-over-year increases in net income attributable to owners of more than 20% for the period, according to data from S&P Global Market Intelligence. Agricultural Bank of China Ltd., for example, reported the strongest rebound among the four banks at 26.4% year over year.

The strong loan growth and improved asset quality amid the recovery propelled banks' earnings in the first half. Chinese lenders loaned out 12.76 trillion yuan in the first half, up 667.7 billion yuan compared to the same period the prior year, according to the People's Bank of China.

"Strong first half year-over-year growth [was] mainly supported by stabilizing net interest margin and improving asset quality [amid a] recovering macro environment. We expect net profits of major banks [in the first half] to account for 55% to 60% of our full-year forecast," said Johannes Au, a Hong Kong-based analyst with ABCI Securities.

Similar to lenders around the globe, Chinese banks' net interest margins, a metric that reflects the difference between the interest paid and received by lenders, have been squeezed in the past quarters amid low-interest rates as the government has lowered funding costs to support businesses that faced disruptions amid the pandemic.

The decrease, however, has slowed down for the four banks in the second quarter and remained almost flat quarter-over-quarter, with Bank of China Ltd. reporting the biggest decline of 5 basis points in the second quarter.

In addition, asset quality for the large commercial banks has improved in the first half. Apart from ICBC, the NPL ratios for Bank of China and Agricultural Bank of China decreased. China Construction Bank Corp.'s second-quarter NPL ratio was not available on Capital IQ Pro.

However, analysts said banks are still facing some default risks in the second half amid China's tightened regulations across sectors including real estate and technology. The country has implemented a series of new rules to curb its red hot real estate market in the past years, including tightening approval on mortgages and loans to developers.

Chen Shujin, a Hong Kong-based analyst at Jefferies, said the tightening control on the real estate sector will have a long-term effect on banks. Though the recent crackdown on education companies and game developers has not yet spilled over to banks, Chen said it could cause a ripple effect in the future.

"The crackdown could lead to a higher unemployment rate in the second half and next year, which may lead to default of personal loans and late payment on credit cards," Chen said.

Chen added that net interest margins will still remain at a low level in the second half, albeit not significantly lower, as China will likely keep interest rates low to stimulate economic growth.

Fee income

As interest income is under pressure amid the low-interest environment, banks have been relying more on fee income, such as the sale of wealth management products and stock brokerage fees, to boost its profit.

Ji Zhihong, executive vice president of China Construction Bank, said the company's wealth management income increased 6.8% in the first half to a record 9.1 billion yuan.

"Our wealth management subsidiary, since its opening two years ago, has seen fast growth of asset size with stronger capability [and] strong profitability. Our bank has listed wealth management as [one of] our major strategies, [and] we will continue to pull in the good resources of wealth managing products so we can make sure that our products complement each other," Ji said in an earnings conference on Aug. 30.

However, Jefferies' Chen said fee income is unlikely to be a game changer for the lenders, citing low contribution as a reason.

Fee income currently accounts for less than 20% of the largest four Chinese banks' operating income, and all of them saw a decreased contribution from fee income in the second quarter.

About 16.3% of ICBC's operating income came from net fees and commissions in the second quarter, the highest among the four banks. However, that's still lower than 17.81% for the second quarter of 2020, according to data compiled by Market Intelligence.

As of Sept. 8, US$1 was equivalent to 6.46 Chinese yuan.