The post-pandemic recovery in the asset quality of Chinese banks has hit a wall. The country's push to promote access to financial services has helped most MSE loans perform following a moratorium on repayments during the pandemic. Nullifying this improvement, however, are the ongoing strains in the property sector, which have spread to surviving developers.

This could ultimately increase the burden on some banks because more debt restructuring of local government financing vehicles (LGFVs) in weak regions could ensue if poor land sales hurt fiscal revenues.

Table 1

S&P Global Ratings projects reported NPL and special-mention loan (SML) ratios to rise over 2024-2026, partly as banks need to comply with stricter asset classification rules by end-2025 (see "China Banks Have Fewer Places To Hide Problems Under New Rules," published on RatingsDirect on Feb. 13, 2023).

The commercial banking sector's NPA ratio, our broader gauge of problem loans, is likely to fluctuate modestly around 5.5%-5.9% amid stresses emanating from the property sector. Some of our estimated problem loans will show up as NPLs or SMLs under the tougher rules, keeping overall NPA broadly stable.

Property Woes Impede Asset Quality Recovery

China's uneven recovery could push up the commercial banking sector's NPA ratio over 2024-2026. We project the NPA ratio will rise to 5.75% in 2026 from our estimate of 5.55% in 2023. This mirrors a slowdown in China's real GDP growth to 4.6% from 5.2% over this period.

Our NPA forecasts include reported NPLs and SMLs, as well as our estimates of forborne loans and other problem assets that are classified as normal but are either 90 days overdue or, in our assessment, could face a long restructuring process.

Chart 1

Credit Costs Could Rise Slightly

By our projections, China's annual real GDP growth will fall to 4.6%-4.8% over 2024-2026, from 5.2% in 2023. This could result in higher expected credit losses. We see credit costs (a gauge of provisions) increasing to 1.28% of average loans in 2026, from our estimate of 1.16% in 2023.

We forecast annual provisions to average Chinese renminbi (RMB) 2.8 trillion (US$416 billion) over 2024-2026, up from our estimate of RMB2.2 trillion in 2023. More provisions will help the sector maintain average NPA provision coverage over this period at 2023 level of about 59%.

This translates into regulatory NPL provision coverage of about 200% over 2024-2026, down from 205% in 2023 because NPLs increase and some banks release excess provisions amid revenue pressure.

Property Development NPLs To Peak Higher, Later

China's property downcycle is poised to continue. During the first two months of 2024, nationwide property sales were down 29.3% from the previous year, according to the National Bureau of Statistics. We expect excess supply and weak demand in lower-tier cities to continue (see "China Rules Easing Gives Developers A Shot Of Liquidity," Jan. 31, 2024). This continues to weigh on the quality of property development loans, including those of surviving property developers.

The Chinese banks on average have reasonable collateral buffers on real estate loans. But the tighter asset classification rules may require banks to recognize some property development loans as NPLs or SMLs. For instance, when more than 10% of a developer's exposure at a bank defaults, its entire exposure at that bank should be classified as NPL by end-2025.

We project NPL ratios for property development will rise to 6.4% in 2025, before recovering to 5.2% in 2026. These projections are up from an estimated 4.4% at the end of 2023 based on the NPL ratio of property development loans of the major listed Chinese banks. Including SML and other problem loans, we estimate the NPA ratio for property development loans will be about 15% at end-2024.

The increase in the property development NPL ratio also stems partly from greater caution among banks toward such loans. From January 2024 onward, regulatory risk weighting for distressed developers has increased to 150% from 100%. A higher capital charge discourages banks from lending to weaker developers. Property development loans rose by a meagre 1.5% in 2023.

Given such regulatory tightening and modest risk appetite among banks, we project a moderate pick-up in lending to property developers. Commercial banks' overall exposure to the sector should decline steadily to 5.5% in 2026 from 6.4% in 2023. This reflects the government's steadfast policy to grow the economy through industrial upgrading, rather than unproductive real estate investment. We believe this will help address long-term imbalances in the economy.

Chart 2

A recovery in property sales is key to strengthening the balance sheets of the property developers. This in turn depends on the confidence among homebuyers in the ability of developers to survive this downcycle. Robust growth in second-hand housing sales in 2023 suggests underlying housing demand is there.

We assume the government's so-called white list of housing projects with bank funding will therefore gradually restore homebuyers' confidence in first-hand housing completion (see "Will China's 'White List' Boost Housing Sentiment?" March 26, 2024). This should help stabilize developers' balance sheets, leading to a turnaround in banks' property development loan quality in 2026.

More Restructuring Of LGFV Debt Possible

One prominent effect of the prolonged property downturn is weak land sales, which reduces an important source of fiscal revenue for local governments. Highly indebted city governments might be forced to cut ties with weak state-owned enterprises, leaving them to default or restructure their debt (see "What China's Shifting Priorities May Mean For Its Central SOEs," March 17, 2024).

In our forecast for the commercial banking sector, we assume an NPA ratio of about 10% on our estimated stock of weak-linked LGFV debt of about RMB32 trillion. This NPA level corresponds to a level-two shock in the central bank's stress test on hidden local government debt--higher than the 5% NPA ratio in a level-one shock that we assumed last year.

We anticipate more restructuring of LGFV debt to occur rather than outright default. We consider such debt as NPA. The stricter asset classification rules could, however, make an exception to allow such debt to be considered as performing.

The central government is committed to stability and will provide a broadly supportive funding environment that avoids large-scale LGFV stress, in our view. LGFV restructuring will likely be selective over time to avoid moral hazard too. We see restructuring concentrated in debt-laden regions such as Gansu, Guizhou, and Tianjin.

Lower interest rates and maturity extensions for such debt would weigh on the capital and earnings of banks. The pain will likely be more acute for smaller financial institutions with loan concentration in these areas (see "LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks," Oct. 18, 2023).

MSEs' Asset Quality Broadly Stable

We estimate the NPL ratio of MSE loans will remain at 3.1%-3.2% over 2024-2026. More inclusive lending policies and beneficial capital rules support the loan performance of MSEs, which are an important source of employment in China.

Loans to MSEs in China should continue to grow at an elevated rate of about 18% a year over 2024-2026. We anticipate a gradual slowdown from 23% in 2023 because the proportion of MSE loans will start to exceed 15% of commercial banking sector loans in 2024. MSE loans are low in margin and banks need to preserve profitability amid pressure on revenues and provisions.

Meanwhile, the performance of MSE forborne loans has been decent since the pandemic moratorium ended in mid-2023. China's real GDP growth rebounded to 5.2% in 2023 from 3.0% in 2022 after COVID restrictions were lifted. Together with the country's inclusive finance policies, most Chinese banks will absorb the existing pandemic-related MSE forborne loans into their books by end-2025, in our view.

Chart 3

Asset Quality Cost Spreads Across Provisions, Coverage And Margins

Write-offs and provisioning for the Chinese commercial banking sector could increase slightly due to China's uneven growth. We project credit costs to average 1.2% of average loans over 2024-2026 and write-offs to average 0.9%.

Chart 4

Most banks will be hesitant to reduce credit costs to boost profitability amid asset quality headwinds from property development and LGFV loans, in our view. They do, however, have the buffer to do so. The average NPL provision coverage ratio at end-2023 ranged from 134% for rural banks to 248% for the megabanks, well above regulatory minimum of 120%-150%.

In addition, we see some of the burden of weak loans manifesting through lower net interest margins rather than higher credit costs. For instance, restructured LGFV debt results in lower modified interest rates, and potentially lower provisioning requirements if it is exempted from being downgraded to NPL.

The Weak May Get Weaker

China's policymakers have been resolute in seeking new growth engines while instilling financial discipline in local governments and the property sector (see "Policy Implications Of China's 2024 Two Sessions," March 17, 2024). We believe their efforts could reduce long-term economic imbalances.

Short-term obstacles to the banking sector during this transition include a prolonged property downcycle. Smaller banks could be vulnerable in the process, especially those in city and rural areas because they must endure local economic conditions. Rural banks on average had the highest NPL ratio, lowest profitability, and weakest capital and provision coverage buffers at end-2023.

Table 2

More financial institutions could fall into trouble over the next two to three years. The bankruptcies of two rural banks in Liaoning province 2022 is a sign that government support is becoming more selective. That said, any reduction in support to poorly managed financial institutions could be gradual, given the system has many weak small banks.

The government's strong tendency to provide direct or indirect support is likely to remain for financial institutions with potential to disrupt financial stability, even with respect to smaller regions. About RMB500 billion of special-purpose bonds have been issued since 2020 to recapitalize some local banks.

We believe the government has sufficient resources and policy flexibility to support troubled banks. It has set up a financial stability fund, with the central bank providing liquidity support to backstop the fund if needed. The monetary authority holds foreign exchange reserves of US$3 trillion.

The government also has strong influence over major financial institutions and state-owned enterprises, which it can mobilize to deliver support via a reasonably developed institutional and administrative framework. The government's objective is to ensure market confidence while at the same time allowing for weaker banks to exit via bankruptcy or be absorbed by their peers.

For China's banks, the prerequisites for asset quality are clear. In the case of property, it means solid projects with good cash flow or adequate underlying collateral. That might help mitigate credit risk. Now the hard part: restoring the confidence of the average homebuyer as China seeks new growth engines for its economy.

Editor: Lex Hall

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