The Chinese government has drafted banks into an aggressive plan to revive the economy. Planners have directed the country's "big five" banks to increase lending to micro and small enterprises (MSEs) by 40% this year. We estimate the banking system will extend Chinese renminbi (RMB) 2.9 trillion (US$420 billion) in new MSE loans in 2020, about 17% of new lending in the year. These are breathtaking numbers, and S&P Global Ratings expects the MSE program will strain the profitability of Chinese banks.

We view MSE lending as policy-led with the larger, state-controlled banks doing most of the work. The National People's Congress (NPC) in late May set a goal of creating 9 million new jobs in China in 2020, targeting an unemployment rate of 6% (see "China's New Stop-Go Cycle," published on RatingsDirect on May 25, 2020). MSEs contribute a much higher portion of economic growth compared with the credit they receive from the country's banking system. Beijing is addressing this imbalance with a series of reforms.

MSEs are defined as entities seeking credit of no more than RMB10 million (US$1.5 million).

Authorities originally wanted China's big five banks (Industrial and Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd., Bank of China Ltd., and Bank of Communications Co. Ltd.) to increase their MSE lending 20% this year. As COVID-19 hit China's economic growth, the government pushed this target to 30% in February, and then to 40% in June. The moves were aimed at alleviating MSEs' funding and liquidity strains, and at stabilizing the unemployment rate (see "China's Deflating Recovery Still Needs Stimulus," July 21, 2020.)

Chart 1

We believe such vigorous MSE support will remain at least as long as COVID-19 or other natural disasters weigh on China's economy and employment. After the effects of the pandemic subside, MSE loan growth should moderate, but stay above average.

Authorities have also directed banks to provide MSE loans with more preferential terms. These include cutting the cost of any financing guarantees, and extending moratoriums on the loan repayment. For instance, the MSEs can apply for deferring their loan repayment maturing by end-2020 to March 31, 2021, without incurring penalties.

The China Banking and Insurance Regulatory Commission (CBIRC) in July 2020 released trial rules that penalize banks that score poorly on measures tracking their support for MSEs. The penalties include suspending businesses lines, or halting the launch of new businesses.

Meanwhile, banks have woven MSE lending targets into the performance measures of their senior managers.

There are also carrots. The regulator has introduced measures to alleviate banks' MSE burden, including a loan forbearance funding program for local banks. The PBOC launched a program extending the repayment of principal and interest of MSE loans to end-March 2021, providing RMB40 billions of funds to local banks for this purpose.

Regulators have also cut lenders' reserve requirement ratio, lowered the provision coverage requirement by 20 percentage points for local banks, and sped banks' capital raising approvals.

Chart 2

Risk-Adjusted Returns May Be Negative For Small And Midsize Banks

MSE lending has thin margins. These could easily turn negative if low-cost funding evaporated, or loans soured at a faster rate than lenders expected.

We estimate the sector return on risk-weighted assets for new MSE lending to be about 44 basis points (bps), accounting for banks' practice of concessional fund transfer pricing (FTP), and for incentive programs extended to local banks' MSE loans.

Concessional FTP in this case is the bank practice of discounting the funding cost assumption applied to MSE loans, to adjust for regulators' support measures. This means that a bank's business unit has a lower profit hurdle to get an MSE loan approved internally.

We estimate the concessional FTP for the megabanks (the big five banks plus Postal Savings Bank of China Co. Ltd.) is 50 bps below their average funding cost, and 35 bps lower for small and midsize banks.

The overall returns on banks' MSE loans would likely be negative without such incentives and workarounds, compared with a system return on risk-weighted assets of 1.4% at end-2019.

This shows the importance of government incentives. MSE lending will remain largely a policy-led business, at least over the next few years.

Table 1

We estimate China's megabanks' new MSE lending has a return on risk-weighted assets of 93 bps, largely due to their low funding cost and sound risk management.

However, with lending rates on the decline, banks will find it increasingly difficult to stay profitable. Measures such as cuts to the reserve requirement ratio make such lending profitable for now, but the economics of the transactions are finely balanced (see "China's Rate Rise Puts Recovery At Risk," Aug. 18, 2020).

For other commercial banks, we estimate the overall returns are near break-even on a risk-adjusted basis with government incentives and concessional FTP. If we remove such incentives from our calculations, we estimate average returns at minus 73 bps. Many commercial banks will likely struggle to break even on their MSE lending when we consider the following:

• A regulatory initiative to increase unsecured MSE loan exposures, which could lead to higher credit costs for lenders.
• The increasingly intensive competition among megabanks for high-quality MSE clients, which could compress pricing on such loans.
• Regulators' MSE loan growth targets, along with strong competition from megabanks for high-quality MSE clients, could force the smaller banks to make high-risk loans.
• If MSE loan growth strictly matches policy targets, this may lead to growth for the sake of growth, at the expense of banks' profitability and asset quality.

Not all small banks are destined to incur losses. Some have strong local networks and local knowledge that let them profit from such loans. We understand that some local banks are having some success in incorporating offline "soft" information--such as small business owners' social behavior and relationships--into their MSE risk assessment.

Chart 3

Several privately owned banks such as WeBank have successfully used large datasets to develop credit-scoring models that closely monitor their MSE clients, dynamically refining their risk controls.

We expect the government will introduce more policies to alleviate the burden of small lenders, in particular with regard to their access to capital. We believe flexible lending rates, and the use of technology to improve the efficiency and overhead costs of small-ticket loans, may make MSE lending a more viable business.

Chart 4

MSEs Are A High-Risk Segment In China

Using simple loan growth targets to solve an MSE funding shortage may not be sustainable and could create systemic risk, in our view. Globally, MSEs are usually regarded as high risk given their small size and greater chance of failure, and their lack of high-quality collateral.

There are also risks specific to Chinese MSEs. These include a basic economic system that favors large, state-owned firms, industrial development that is skewed toward infrastructure (raising rent and staff costs for small firms), a lack of direct financing channels, and entrepreneurs' short-term tendencies.

Technology may mitigate the financial risks posed by MSEs. We note that China's leading financial technology players are reshaping how MSEs access working capital.

The effort recognizes that MSEs lack robust financial disclosure that allows lenders to assess their default risk. Fintech companies are deploying technologies to address this deficiency, such as real-time data gathering and behavioral pattern detection tools, to get a better understanding of MSEs' cash conversion cycle.

Chinese banks are investing in some of these technologies, or cooperating with fintech companies to manage the risks of MSE lending. Smaller banks are at a disadvantage on this front given their limited financial resources.

Banks' MSE exposure is particularly skewed toward China's manufacturing and retail/wholesale sectors, which are rife with credit risk (see chart 5).

Chart 5

We estimated China's wholesale and retail sectors' NPL ratio at a high 4%-5% even before COVID-19 landed, while the same ratio for the manufacturing sector was more than 4% (see "China Banks After COVID-19: Big Get Bigger, Weak Get Weaker," April 16, 2020).

Credit costs on MSE loans should not blow out over the next two years. One reason is that regulators are encouraging banks to extend or roll over MSE loans to "qualified borrowers." Qualified borrowers refer to MSEs that maintain effective collateral arrangements and promise not to lay off too many staff.   

Financial incentives to MSE borrowers will also boost MSE repayment profiles. For example, the government has alleviated the financial burden of MSE lending such as fee concessions. In addition, the government exempts qualified MSE loan interest (MSE loans priced below 1.5x the benchmark rate) from value-added tax.

Other initiatives include a shorter roll-over period for lending over one year, MSE insurance and guarantees, and some degree of loss-sharing with local governments.

Looser lending terms may help some viable MSEs stay afloat. However, such practices may also prop up defunct entities with little prospect of viability, inviting moral hazard along the way. As seen in many spheres, China is making tradeoffs to support the economy in COVID's aftermath. This particular set of trade-offs may come at the expense of banks' profits.

Appendix

Table 2

Table 3

Related Research

• China's Rate Rise Puts Recovery At Risk, Aug. 18, 2020
• China's Deflating Recovery Still Needs Stimulus, July 21, 2020
• China's New Stop-Go Cycle, May 25, 2020
• China Banks After COVID-19: Big Get Bigger, Weak Get Weaker, April 16, 2020