Rising Household Debt Could Weigh Down Asia's Banks

Primary Credit Analysts: Ivan Tan, Singapore (65) 6239-6335; ivan.tan@standardandpoors.com HongTaik Chung, CFA, Hong Kong 85-2-2533-3597; hongtaik.chung@standardandpoors.com Joseph M Leung, Hong Kong 852-2533-3553; joseph.leung@standardandpoors.com Secondary Contacts: Qiang Liao, PhD, Beijing (86) 10-6569-2915; qiang.liao@standardandpoors.com Deepali V Seth, Mumbai (91) 22-3342-4186; deepali.seth@standardandpoors.com Naoko Nemoto, Tokyo (81) 3-4550-8720; naoko.nemoto@standardandpoors.com Geeta Chugh, Mumbai (91) 22-3342-1910; geeta.chugh@standardandpoors.com Ritesh Maheshwari, Singapore (65) 6239-6308; ritesh.maheshwari@standardandpoors.com

Table Of Contents
Malaysia And Thailand Are Most Vulnerable To Increasing Household Debt Spiraling Property Prices In Hong Kong, Singapore, And Malaysia Heighten Economic Imbalances Financial Institutions Will Suffer In A Stress Scenario Key Household Debt Trends And Their Impact On Banks' Financial Profiles Malaysia Thailand Singapore Korea Hong Kong China

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Table Of Contents (cont.)

Rising Household Debt Is The Achilles Heel Of Some Systems Related Criteria And Research

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Rising Household Debt Could Weigh Down Asia's Banks

Banks in Asia have been operating under favorable credit conditions resulting from healthy economic growth for a few years now. Yet, a structural weakness appears to be emerging in some Asian economies: Private sector debt, particularly household leverage, has been increasing mainly from rising mortgages. Standard & Poor's Ratings Services believes rising household debt fueled by rapid loan growth and easy monetary conditions imposes risks on the credit quality of banks. Malaysia, Thailand, Singapore, and Korea have the highest household debt in Asia. In addition, high property prices in Hong Kong and China are leading to poor housing affordability there, which can undermine the credit quality of mortgages. Overview Household debt in Asia has been rising amid ample liquidity and low interest rates. High household leverage can undermine the financial profile of banks and exacerbate credit losses, especially during an economic downturn. Banks in Malaysia and Thailand are particularly vulnerable to a deterioration in the household segment, in our opinion.

The economic turmoil of the 2008 financial crisis was partly due to excessive private sector debt. Household debt in the U.S. and most of Europe soared mainly because of rapid growth in the demand and supply of home loans. Easily available mortgages were a major contributor and helped inflate property bubbles and significantly affected banks' asset quality. In the U.S., recovery prospects on foreclosures were also undermined by nonrecourse laws--which prohibit banks from pursuing anything other than property collateral--and a huge pool of homes with negative equity amid rapid price corrections. We observe parallel trends emerging in Asia, where household debt in some economies has been steadily rising since 2008 (see chart 1).

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Chart 1

Malaysia And Thailand Are Most Vulnerable To Increasing Household Debt

In our opinion, the credit profiles of banks in Malaysia and Thailand are the most vulnerable to a deterioration in the health of their respective household segments (see chart 2). Banks in both countries have significant levels of loans to households. In addition, the rapid increase in household leverage has significantly outpaced income growth in both countries. We believe the creditworthiness of the banks' household exposure is less resilient than peers for several reasons: Rapidly rising household indebtedness. Household leverage in both countries has increased sharply and is now comparable to that in Singapore and Korea. Thailand's household leverage increased to 77% of GDP in 2012, from 56% in 2008, while Malaysia's went up to 80% from 60%. We believe that credit booms can lead to banking instability particularly when liquidity is readily available and relatively cheap. With households accumulating substantial debt faster than their incomes are growing, that will lead to repayment difficulties when the credit cycle turns. Constrained income levels. The nominal GDP per capita of US$5,677 in Thailand and US$10,393 in Malaysia is low compared to other similarly rated sovereigns. Malaysia has been trying to escape the middle-income trap (where income growth in an economy stagnates after reaching middle-income status) in a protracted battle against

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deep-rooted structural issues. Thailand suffers from large and increasing income disparities between the prosperous capital Bangkok and the poorer northern and northeastern regions. In particular, debt-to-income divergences tend to become more pronounced in the population's poorer segments. Significant exposure to riskier loans. Auto, personal, and unsecured loans accounted for a larger proportion of bank loans in Malaysia and Thailand than within our selected peer group. Under stable operating conditions, these are appealing asset classes because they offer higher yields than residential mortgages, often at only incrementally higher credit costs. Thus, these asset classes enable banks to offset margin pressure in a low interest rate environment. However, when the credit cycle turns, delinquencies tend to be worse in these categories, with losses highly correlated with the financial health of household borrowers.
Chart 2

Asset quality and credit costs across most systems in the six countries we evaluated are at or near historical lows, thanks to accommodative monetary policies and healthy economies. But differences in credit performance are not readily apparent under stable conditions. Therefore, we believe an economic downturn that leads to an increase in unemployment and interest rates will have a more pronounced effect on vulnerable systems, where high leverage relative to income will translate to greater household-related losses.

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Spiraling Property Prices In Hong Kong, Singapore, And Malaysia Heighten Economic Imbalances
Residential mortgages account for the largest component of household loans in most countries, reflecting their status among banks as intrinsic tools of client retention and cross-selling opportunities. In our opinion, property affordability has important implications for a household's borrowing needs and debt servicing burden, which ultimately affect the credit quality of mortgage loans. According to consultancy Demographia's annual international housing affordability survey for 2013, the benchmark for affordability--as measured by the median home price divided by gross annual median household income--is 3x. Rapid increases in property prices have pushed this ratio to 15.6x in Hong Kong and 12x in Singapore. Prices have gone up sharply in Malaysia as well since 2010. These factors suggest that potential asset bubbles and imbalances are building up (see table 1).
Table 1

Housing Market Indicators For Selected Asian Countries

Singapore Sovereign AAA/Stable/A-1+ foreign currency issuer credit rating Malaysia A-/Stable/A-2 Korea A+/Stable/A-1 Hong Kong AAA/Stable/A-1+ China AA-/Stable/A-1+ Thailand BBB+/Stable/A-2

Share of selected household loans/Total banking system loans Mortgages Auto loans Personal loans Credit card loans Average house price / income ratio 31% 2.5% 6.5% 2% 12x 27% 13% 5% 3% 4x 30% -10% 4% National average: 5x Seoul: 10x 15% -4% 2% 15.6x 11% 0.5% -2% National average: 8x 14%* 8.5%* 6%* 1.5%* Bangkok and its vicinity: about 5x

Shanghai: 16x Beijing: 22x

Household debt-to-annual income ratio Average loan to value Interest rate sensitivity (proportion of fixed to variable rates)

2.0x

1.4x

1.35x

1.5x

0.7x

1.2x

45% Majority fixed rate up to the third year; almost all variable rates after that.

70% Almost all variable rates.

About 50% About 85% floating rate and 15% fixed rate for mortgages.

55%** Mostly variable rates; priced against either Hong Kong Inter Bank Offered Rate or prime rate.

45%-50% Almost all variable; linked to the central bank's benchmark lending rates and subject to reset at the beginning of each calendar year.

About 80%** Majority variable rates.

*Data for commercial banks only; non-banks in Thailand account for a significant 60% of loans to households. Private property only. Includes business loans given to households. **At the point of origination. Source: Standard & Poor's calculations and estimates as of Dec. 31, 2012.

House prices in Singapore, Hong Kong, and Malaysia have risen considerably over the past few years (see Chart 3). An increasing population and rising wealth in these countries have created demand for housing amid an apparent increase in a preference to own or upgrade one's home. Prevailing low interest rates and easy availability of affordable

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mortgage financing spur this demand. And banks are only too happy to lend because they are flush with funds from easy monetary conditions and mortgages provide a channel out for excess liquidity. The low regulatory risk weights and capital requirements associated with mortgages enable banks to pursue a volume growth strategy. What's more, the cost of credit fell substantially since 2009 because of low real interest rates, which in turn support banks' lending strategy.
Chart 3

We believe that rising property prices have attracted some speculation in the high-end segment in certain areas, even though governments in several countries have taken various measures to curb buying by speculators and foreigners (see table 2).
Table 2

Regulatory LTV Ratios For Selected Asian Countries

Singapore Maximum LTV of 80% for individuals with one outstanding housing loan, 50% for the second loan, and 40% for the third loan. Where the loan tenor exceeds 30 years or extends beyond the borrower turning 65, tighter limits of 60%, 30%, and 20% apply to the respective categories. Maximum LTV of 70% is applicable to the third house loan. Loans for the purchase of first and second homes are not subject to regulatory limits, and banks apply an LTV level based on their internal credit policies. For banks, maximum LTV of 60% to finance houses outside Seoul, 50% for houses in Seoul, and 40% for select locations in Seoul. For non-banks, maximum LTV of 70%.

Malaysia Korea

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Table 2

Regulatory LTV Ratios For Selected Asian Countries (cont.)

Hong Kong For borrowers whose income is mainly derived in Hong Kong, maximum LTV of 70% for residential properties below HK$7 million, 60% for HK$7 million-HK$10 million, 50% for HK$10 million and above; 50% for non-self-use or company-held properties, regardless of value. These LTV limits are reduced by 10% for borrowers whose income is mainly derived from outside Hong Kong without an outstanding mortgage, and by 20% with an outstanding mortgage. Maximum LTV of 70% for the first loan, 40% for the second, and no bank loan allowed for the third. No LTV limits. However, the following mortgage loans attract higher risk weights of 75% (compared to 35%): (a) mortgage loans above THB10 million with LTV of more than 80%; and (b) mortgage loans below THB10 million with LTV of more than 90% (for condominiums) and more than 95% (for other low-rise houses).

China Thailand

LTV--Loan-to-value. HK$--Hong Kong dollar. THB--Thai baht.

In our view, rising housing demand can be attributed to rising household income, low real interest rates, and availability of credit. This has led to a vicious cycle: Greater housing demand paved the way for increased household leverage, which is pushing up prices. In our base-case scenario for Singapore, Hong Kong, and Malaysia of low interest rates and unemployment, we expect mortgage delinquencies to remain low despite rising property prices. However, a borrower's primary repayment ability would be stretched in a stress scenario under which we believe the credit cost implications for banks in systems which we have identified as vulnerable, including Malaysia and Thailand, would be more severe.

Financial Institutions Will Suffer In A Stress Scenario

A severe economic downturn leading to a rise in unemployment and a significant fall in property prices would hurt financial institutions, in our opinion. The resulting dip in market sentiment might also impair banks' ability to sell foreclosed properties. These events occurring in tandem would weaken banks' asset quality and increase credit costs. Our stress-case scenario (see table 3) assumes a 30% decline in property prices, 2% hike in interest rates, 2% increase in unemployment, and a 3% reduction in GDP from our base-case 2014 GDP forecast. Under this scenario, we could consider lowering the ratings on banks in the relevant countries.
Table 3

Estimated Credit Costs From A Hypothetical Stress Scenario

(%) Singapore GDP Unemployment Credit costs (credit provision/gross loans) Malaysia GDP Unemployment Credit costs (credit provision/gross loans) Korea GDP Unemployment Credit costs (credit provision/gross loans) 2.0 3.2 0.6 2.9 3.8 0.7 4.2 3.5 0.7 1.2 5.5 ~1.75 to 2.0 5.6 3.3 0.15 4.8 3.0 0.2 5.7 3.0 0.3 2.7 5.0 ~1.5 to 1.75 1.3 2.0 0.25 4.2 2.0 0.25 3.9 2.0 0.3 0.9 4.0 ~0.75 to 1.0 2012A 2013E 2014E Hypothetical stress scenario

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Table 3

Estimated Credit Costs From A Hypothetical Stress Scenario (cont.)

Hong Kong GDP Unemployment Credit costs (credit provision/gross loans) China GDP Unemployment Credit costs (credit provision/gross loans) Thailand GDP Unemployment Credit costs (credit provision/gross loans) A--Actual. E--Standard & Poor's base-case estimates. 6.5 0.7 0.7 2.8 0.9 0.85 3.6 0.8 0.95 0.6 2.8 ~2.0-2.5% 7.8 4.3 0.1 7.3 4.2 0.4 7.3 4.2 0.7 4.3 6.2 ~1.5 to 2% 1.4 3.3 0.2 3.0 3.3 0.3 4.0 3.3 0.4 1.0 5.3 ~1.0 to 1.25

However, a sharp unwinding of household balance sheets during a recession is not our baseline expectation for any country in Asia. Asset quality in the region has generally remained healthy under stable operating conditions. In our base case, we are expecting positive economic growth in the selected systems. The major banks have generally healthy financial positions by global standards, including capital and liquidity buffers, which would mitigate the potential risk from high household debt and property prices. Government support also underpins the ratings on many banks, which can rely on the country's strong fiscal position, if needed. Nevertheless, in our base case, we believe that: the record low nonperforming loan (NPL) ratios and credit costs are not sustainable over the next one to two years; interest rates are likely to rise about 25 to 50 basis points, which would increase the debt servicing burden; and loan defaults may become more pronounced after the last credit boom. In the case of China, where banks have less exposure to the household sector, our projected increase in credit losses is primarily attributable to corporate and infrastructure projects (see "China Credit Spotlight: Diverging Credit Quality Could Result In Varying Degrees Of Resilience For The Top 50 Banks," Aug. 28, 2013, on RatingsDirect).

Key Household Debt Trends And Their Impact On Banks' Financial Profiles Malaysia
Main risks in the household sector
Malaysian banks are significantly exposed to the household sector, which accounts for 55% of their loan portfolio. The country is working its way through the middle-income trap even as household leverage rapidly increased. A turn in the credit cycle could send banks' credit loss risks soaring. In addition, the pace of Malaysian property price increases has gathered momentum in recent years. House prices saw a marked acceleration from their long-term trend beginning the third quarter of 2010 (see chart 4). Home loans currently make up about 27% of Malaysian banks' loan portfolios--the single largest segment. And we believe the risk-reward equation is tilting against lenders. Banks are disbursing larger

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loans to finance more expensive properties, even as mortgage rates are falling due to competition and easy monetary conditions. We believe this is leading to a buildup of economic imbalances in Malaysia. Economic risk for banks operating in Malaysia could heighten and result in a lowering of our banking industry country risk assessment.
Chart 4

Mitigating factors
The regulator has taken pre-emptive steps to rein in household debt and ensure that banks follow prudent financing practices. It implemented tighter LTV ratios in November 2010, issued the "Responsible Lending Guidelines" in January 2012, and lowered maximum tenor of personal loans to 10 years (from 25 years) and property financing to 35 years (from 45 years) in July 2013. The government also raised the property gains tax to preempt any speculative bubble and ensure a stable and sustainable property market. We believe the government's cooling measures should help curtail price increases. In addition, the relative stability of mortgage loan growth implies that the banking system's exposure is not skewed toward speculative buying. While the growth in housing loans has been moderately higher than the overall loan growth (see chart 5), it is generally in line with the system and momentum has slowed slightly in recent years.

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Chart 5

Likely impact on banks' financial profiles

High leverage relative to income undermines household resilience in Malaysia. In particular, the leverage position of borrowers earning a monthly income of Malaysian ringgit 3,000 and below--constituting about 16% of system loans--is considerably higher than those in other income groups. Weaker financial buffers mean this group would be more vulnerable to rising unemployment and interest rates, especially in the event of a downturn. Such a scenario heightens the likelihood of losses from household loans leading to significant capital impairment, which could trigger rating downgrades on banks. In our base case, positive economic growth (4.8% in 2013) and prevailing low interest rates will continue to support household repayment ability over our outlook horizon. We anticipate that Malaysia's central bank will maintain the overnight policy rate at 3% amid weak global demand.

Thailand
Main risks in the household sector
Thailand's household leverage has increased sharply in recent years and is now comparable to that of Singapore and Malaysia. It increased to 77% of GDP in 2012 from 55% in 2007, leaving households more vulnerable to rising interest

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rates, unemployment, and economic slowdown. Competition among financial institutions to lend to households has become particularly aggressive. Commercial banks account for about 42% of household loans, followed by specialized financial institutions (30%), saving cooperatives (15%), and credit card, leasing, and personal companies (10%). In our view, underwriting standards of Thai banks appear to be much weaker compared with that of Asian peers, particularly in terms of LTV ratios. Banks have average LTV ratios of 80% at origination, with a maximum LTV ratio of more than 100%. Underwriting standards of other non-bank competitors, especially specialized financial institutions, are even more relaxed. Thailand's auto segment is also sizable with intense competition. Within this segment, the search for higher yields is pushing banks to lend to the riskier used-car category. For a few banks, the proportion of used-car loans in the overall auto loan book has been rising. Some other banks have already turned cautious and are withdrawing from this market. Overall, credit growth has been high, and we believe this is leading to a buildup of economic imbalances in Thailand. Economic risk for banks operating in Thailand could heighten and lead to a lowering of our banking industry country risk assessment on Thailand.

Mitigating factors
While the growth in consumer loans has been aggressive in recent years, wage increases are partially mitigating that risk. Still, debt accumulation has been much faster than the rise in wages. Accordingly, the ratio of household debt to average annual income increased to 1.22x in 2012, from 0.97x in 2009. We expect the growth in the personal consumption segment to moderate in the second half of 2013 and in 2014. That partially reflects the phasing out of the government stimulus policy of tax rebates for first-time car buyers, which led to a sharp rise in auto loans in 2012. Moreover, reported household leverage of 77% may partially overstate the risk because Thailand's central bank uses a broad definition for loans to households, including loans and investments in household debtors. Accordingly, household loans may include business loans given to households as well. For example, loans for personal consumption given by commercial banks form about 80% of their total loans to households, suggesting that 20% of such loans may be given for business purposes. The increase in real estate prices in Thailand has been low, except in a few pockets. While, the prices of condominium apartments have increased sharply, particularly in Bangkok, the banking sector's loans to this segment are currently limited. Moreover, anecdotal evidence suggests that banks have recently tightened underwriting standards in the consumer segment and that their rejection rates have increased.

Likely impact on banks' financial profiles

The rapid growth in consumer loans, particularly for cars and condominiums, is a risk, in our view. Consumer loans grew about 19.5% year-on-year in the first half of 2013. The competition in this segment is intense, and is weighing on banks' margins. High growth amid rising competition could contribute to deteriorating loan performance. Already, it has started to translate into higher NPLs and delinquencies in the auto loan segment, especially in the used-car category because of sharp price declines. The delinquent car loans rose 80 basis points to 6.8% in first-half 2013, compared with a stable delinquency ratio of 2.2% for the entire loan book. Similarly, the NPL ratio increased by 30 basis points to 1.7% for car loans, while the ratio for the overall loan book declined by 10 basis points. On the other hand, banks' exposure to the condominium segment, although rising, is currently limited. We expect NPLs and credit

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costs in this segment to increase gradually in the next 12-24 months as the economy slows down, but in our base case, we expect this increase to be manageable.

Singapore
Main risks in the household sector
Mortgages form the single largest loan exposure for Singapore banks, and an overheated property sector could send banks' credit loss risks soaring. Strong buying in the private residential segment, supported by low interest rates on home loans, has sent prices spiraling upward. Consequently, housing affordability in Singapore has worsened in recent years. We estimate that the affordability ratio is about 12x in 2012, significantly above the benchmark of 3x. In Singapore, government-built housing represents almost 90% of the market. Therefore, using median household income may overestimate private home affordability. If we use the top 80th decile household income to calculate affordability, the ratio is about 7x, suggesting that private property remains expensive even for the higher income segments.

Mitigating factors
Singapore's government has shown a readiness to take measures to rein in rising home prices. On Jan. 11, 2013, the government announced its seventh round of cooling measures since 2009, and its most comprehensive to date. Key changes include higher additional buyer's stamp duty of up to 18%, lower LTV of 50%, and cash down payment of 25%. The bulk of these measures apply to loans for second homes, while Singaporean first-time buyers and buyers of government-built flats are relatively unaffected. On June 28, 2013, the regulator introduced a total debt servicing ratio framework under which a borrower's total loan repayments, including all property related loans and non-property related loans such as student loans, credit cards, auto etc., cannot exceed 60% of the individual's income. This framework will require banks to consider borrowers' other outstanding debt obligations when granting property loans. In our view, these measures address the over-exuberance in residential property investments and instill greater financial prudence in buyers of government flats. We expect the government to continue to implement more measures until it meets its price stabilization objectives.

Likely impact on banks' financial profiles

We believe that accumulated household savings should counterbalance increased leverage. On an aggregate basis, household assets exceed household debt by about 7x, with cash and deposits alone being greater than the total household debt. However, this does not apply to all households, and those that are overextended would be more vulnerable. Loan defaults may become more pronounced as interest rates increase and diminish the ability of customers to repay. We believe that mortgage NPLs and credit costs for Singapore banks will increase slightly in the next 18-24 months, under our base-case scenario of 4.2% economic growth in 2013.

Korea
Main risks in the household sector
We believe that heavy household indebtedness could pose a threat to Korea's banking system, particularly if real estate prices plummet or interest rates surge. In our view, household debt quality has been weakening gradually. Household

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debt continued to rise in 2012, although the pace of increase has slowed in the past couple of years. The ratio of household debt to disposable income also rose to about 136% at the end of 2012, from about 131% at the end of 2010 and about 110% at the end of 2005. This suggests that households' debt-servicing capabilities have steadily weakened. We expect relatively high risks at non-bank deposit-taking institutions, which account for about 20% of the system's total loans and 30% of deposits. Loans from these institutions have grown quickly in the past several years with loose underwriting standards. We also note that about 30% of Korean mortgages are bullet payment-type loans, which could be difficult to roll-over if real estate prices decline sharply.

Mitigating factors
Although the Korean banking system faces risks related to high household leverage, low LTV ratios of about 50% on average for residential mortgage loans partly mitigate these risks. Residential mortgages constitute about 30% of the banking system's total loans. Also, household delinquency ratios still remain at about 1% despite rising gradually in 2013, and credit card delinquency ratios rose only slightly to about 2.03% in the first half of 2013 from 1.96% a year ago. In the past two years, the regulator introduced various measures to ease household indebtedness, including imposing debt service-to-income ratios of between 40%-60% in the Seoul area and more stringent underwriting standards for nonbank lenders. Non-bank loan growth slowed to 4.8% in 2012, from the annual 13.6% from 2008 to 2011. The regulator also plans to increase the proportion of fixed-rate mortgages to 30% of the total by 2016 (from about 17% by the end of June 2013 and about 8% in 2011), and to replace bullet-type principal repayment mortgages with installment loans. We believe these measures should ease the repayment burden on households.

Likely impact on banks' financial profiles

In our base-case scenario, we expect credit costs from households to remain manageable--despite rising gradually--in the coming few years amid modest economic recovery. We also expect the low LTV ratio to provide some additional buffer to absorb possible losses from a potentially sharp decline in real estate prices. Nevertheless, we believe Korean households remain vulnerable to certain events, such as a steep drop in real estate prices and a hike in interest rates. Also, we see higher risks in the non-bank sector given its loose underwriting standards and customers that have weak credit quality.

Hong Kong
Main risks in the household sector
Residential property prices have increased rapidly. The residential property price index rose to 244.8 in July 2013, which is 42% above the historical peak in May 1997. Between December 2008 and December 2012, residential property prices increased 21.4% on average, faster than nominal GDP growth of 4.6% and GDP per capita growth of 3.8%. The delinquency rate could increase from the current low levels if the local economy turns down, leading to increased unemployment and bankruptcies. In addition, rising interest rates could strain borrowers' repayment capacity. The Hong Kong Monetary Authority introduced a minimum risk weight of 15% for all residential mortgages granted after Feb. 22, 2013. We believe this could prompt banks to review their strategy and raise interest rates on loans to price in the higher risk charges and capital use.

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Mitigating factors
The LTV ratio is low, averaging 55% at origination in 2012. This could help banks absorb a potential drop in property prices. A robust credit data sharing system, which includes both positive and negative data, supports underwriting standards. We believe the household sector is resilient to credit cycles, as the low historical delinquency rate of residential mortgages in Hong Kong reflects. When property prices in Hong Kong fell 66% between May 1997 and July 2003, the three-month delinquency rate remained below 1.5%. We think that household leverage remains manageable, with household debt estimated to be 1.5x household income. The government has a track record of supporting stability and maintaining confidence in the financial system. In 2009, it rolled out a series of counter-cyclical prudential measures to rein in rising property prices. These included lowering the LTV ratio, imposing a special stamp duty, and limiting mortgage tenor to 30 years. The government has the option to roll-back these measures, if needed, to lower the volatility in the property market.

Likely impact on banks' financial profiles

We expect the credit quality of households in Hong Kong to remain resilient even if property prices fall. Low LTV ratios, moderate household leverage, and a slow recovery of the domestic economy as reflected by our base case GDP growth forecast should support household creditworthiness. However, a potential economic slowdown in China could weigh on economic growth in Hong Kong as well as the credit quality of the overall banking system in Hong Kong. In our base-case, the NPL ratio and loan loss provision charge could increase gradually in 2013-2014, but should remain below the peak during 2008-2009, when NPLs hit 1.51% and credit costs reached 0.5%.

China
Main risks in the household sector
Weak housing affordability is the main risk in China's household sector, in our opinion. Affordability in China appears poor, with nationwide average home prices at 8x of average disposable household income in 2012. While the national ratio has been quite stable over the past decade, housing affordability in major cities, such as Beijing and Shanghai, has deteriorated substantially after years of a rapid run-up in property prices. Rising interest rates could also impair housing affordability because floating-rate loans based on the central bank's benchmark lending rates have dominated China's housing loan market. A rapid increase in benchmark lending rates could exacerbate the borrowers' debt service capacity.

Mitigating factors
The credit performance of Chinese banks' residential mortgage loan book has been consistently solid, with the NPL ratio at 0.29% at the end of 2012, and always below 2% historically. In our view, the co-existence of weak housing affordability and strong track record of credit performance in this segment is a reflection of structural factors. These factors include robust household income growth, high household savings propensity, conservative down-payment requirements, and regulated mortgage loan rates. In particular, high down payment requirements and rapid income growth have been key mitigating factors for risks stemming from weak housing affordability. The government has taken harsh measures to cool down property demand

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and contain risks, including imposing a maximum LTV ratio of 70% for first-time home buyers and 40% for second-time buyers. Further, household income has been growing for several years and we expect this trend to continue, given China's still robust economy.

Likely impact on banks' financial profiles

The credit performance of housing loans in China is likely to remain strong over the next two years, even though some slippage in housing loan quality might occur as the economy slows. A possible correction in the property market could expose the housing loan portfolio to rising defaults, especially for highly leveraged and speculative borrowers. However, high down payment at origination and lenders' rights to full-recourse mitigate this risk. We estimate the average LTV ratio for the current portfolio to be 45%-50%. These factors provide banks with a significant buffer to absorb potential credit losses and also relieve borrowers' interest servicing burden. Unless property prices decline substantially, interest rates go up significantly, and the job market becomes distressed, we do not expect the credit performance of Chinese banks' housing loans to deteriorate materially.

Rising Household Debt Is The Achilles Heel Of Some Systems

Increasing household debt is a weak link in highly leveraged and low income systems. While stable economic growth and credit conditions should enable banks in most Asian countries to maintain their financial profiles, a downturn could leave the vulnerable systems exposed.

Related Criteria And Research

Gravity Tugs At Asia-Pacific Sovereign Ratings As Global Risks Persist And Domestic Challenges Grow, Oct. 1, 2013 S&P To Publish Economic And Industry Risk Trends For Banks, March 12, 2013 Banks: Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

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