Banks

China SpecialReport

Chinese Banks
GrowthofLeverageStillOutpacingGDPGrowth
Summary
Two years after the peak of the 2009 lending boom, credit levels in China remain elevated. Although bank lending has slowed, this moderation is being offset by a burgeoning of new credit channels both within and outside the banking system. Consequently, growth of leverage continues to outpace growth of the economy. In 2010, Fitch Ratings published reports on two key sources of credit leakage the informal securitisation of loans and the surge in undiscounted acceptances and called for a broader view when assessing credit trends in mainland China. Since then, the authorities have introduced a new measure, total societal financing (TSF), which is an important step in this direction. However, the TSF still omits a number of items, and hence does not fully capture total formal and shadow financing. Fitch has developed an adjusted TSF incorporating critical items currently omitted from the official gauge. The agencys measure shows that Chinas postcrisis credit boom often portrayed as a brief, isolated event in H109 actually lasted two solid years, and is still running quite strong. With credit still so loose, it is difficult to foresee inflation moving off the policy agenda any time soon, and any premature easing could risk a quickerthanexpected reacceleration of price increases. Fitchs adjusted TSF shows that total financing is expected to exceed CNY18trn in 2011, or 38% of GDP, CNY3.5trn above the agencys yearend estimate for the official TSF and more than double its CNY8trn estimate for new loans (Figure 1). The main components of this uncaptured financing include letters of credit (LoCs), credit from domestic trust companies, lending by other domestic non bank financial institutions (NBFIs) and loans from Hong Kong banks. All of these are on pace to reach CNY700bn1trn in 2011. By end2011, total financing/GDP could reach 185%, up 61pp from 2007. Increases of similar magnitude have been seen elsewhere in the years leading up to banking stress, underscoring the agencys cautious outlook on the sector. That Chinas economy is slowing while financing is still so abundant illustrates how dependent growth remains on loose financing (Figure 2). This is further highlighted by the continued low incremental economic return on new credit. Precrisis, a CNY1 increase in financing yielded roughly CNY0.75 in new GDP, but in 2009 this plummeted to CNY0.18. The economic return on credit is slowly rising, but still has yet to fully recover.
Figure 1 Figure 2

Analysts
Charlene Chu +8610 8517 2112 charlene.chu@fitchratings.com Chunling Wen +8610 8517 2105 chunling.wen@fitchratings.com Hiddy He +8610 8517 2135 hiddy.he@fitchratings.com Jonathan Cornish +852 2263 9901 jonathan.cornish@fitchratings.com

RelatedResearch
Applicable Criteria Global Financial Institutions Rating Criteria (August 2010) Other Research Fitch Affirms China's Ratings, Revises Local Currency Outlook to Negative (April 2011) Fitch Affirms China's State Banks, But Sees Sector Risks Rising (April 2011) China (April 2011) Chinese Banks: No Pause in Credit Growth, Still on Pace with 2009 (December 2010) The Impact of a China Slowdown on Global Credit Quality (November 2010) MacroPrudential Risk Monitor (June 2010) China: Stimulus Hangover? (October 2010) Chinese Banks: Informal Securitisation Increasingly Distorting Credit Data (July 2010)

FitchAdjusted TSF
Fitch additional credit financing TSF capital market financing TSF other credit financing TSF loans (% of GDP) 45 36 27 18 9 0 2006 2007 2008 2009 2010 2011e Q111 Source: PBOC CNY3.5trn+

Trends in Financing & GDP

Fitchadjusted TSF net new financing TSF net new financing Change in nominal GDP (CNYbn) 18,000 12,000 6,000 0 2006 Financing/ 0.76 GDP Source: PBOC 2007 0.78 2008 0.70 2009 0.18 2010 0.34 2011 0.42

www.fitchratings.com

13 July 2011

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Behindthe Official TSF
The Peoples Bank of Chinas (PBOC; the central bank) TSF consists of seven primary components: bank loans, undiscounted acceptances, triparty entrusted lending, a small portion of trust company lending, domestic corporate bond and equity fundraising, insurance company investment in real estate, and insurance policy payouts to households and corporates. Also included is a small other category, which largely consists of lending by microlenders (which are excluded from systemwide loan figures) and private equity. Below are details on the most complex items.

Bankers Acceptance Bills

Figure 3

Undiscounted Acceptancesa (CNYbn)

Accep tances 1,500 1,960 2,210 2,440 3,200 4,100 5,600 5,900 Bills 1,000 1,380 1,720 1,280 1,900 2,385 1,500 1,200 Redis counted billsb 3 0 2 6 0 18 79 77 Gap 497 580 488 1,154 1,300 1,697 4,021 4,623

2004 2005 2006 2007 2008 2009 2010 Q111

a

Bankers acceptance bills refer to undiscounted acceptances, or the gap between the banking systems offbalancesheet acceptances and onbalancesheet discounted bills. When a Chinese bank discounts an acceptance, the money extended is considered a form of lending and should be recorded in its loan portfolio. However, as Fitch observed last year, Chinese banks began heavily offloading discounted bills in 2010, which has the effect of masking their true credit growth and credit exposure. As a result, the gap between acceptances and bills has soared. This gap is expected to exceed CNY5trn outstanding by endJune 2011, equivalent to more than an entire year of new bank loans before the global crisis (Figure 3).

Entrusted Loans
Entrusted loans represent triparty loans in which entities not legally permitted to extend loans (e.g., corporates) do so by entrusting the money to a bank or finance company, which then onlends the money to the designated borrower. Banks act merely as transfer agents in such transactions, and take on no direct credit risk.

Includes commercial acceptances, while TSF only includes bankers acceptances. As a result, the change in this gap differs slightly from that reported in TSF b Rediscounted by the central bank Source: PBOC

Trust Loans
Trust loans refer to credit extended through a specific type of trust product created jointly with banks and whose underlying assets consist solely of loans. Issuance of these products has plummeted amid stricter regulation. However, many market participants have incorrectly extrapolated this to mean that all trust activity has waned, when in fact issuance of other trust products remains robust (see Credit From Domestic Trust Companies below).
Figure 4

Total Societal Financing

Loans (LHS) Entrusted loans (LHS) Insurance, bonds, equity, other (LHS) Undiscounted acceptances (LHS) Trust loans (LHS) TSF (RHS) (% of GDP) 45 36 27 18 9 0 2005 Source: PBOC 2006 2007 2008 2009 2010 Q110 Q111

(CNYbn) 15,000 12,000 9,000 6,000 3,000 0

Introducingthe FitchAdjustedTSF
The creation of the TSF represents an important step forward by the Chinese authorities in broadening their conceptualisation of financing beyond lending, and provides data on several activities that previously had been unavailable at the system level. However, a number of important items remain excluded, making the TSF too narrow to be used as a solid gauge of total formal and shadow credit.

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To address these gaps, Fitch has created an adjusted TSF that incorporates data on the principal omitted items. By this measure, total financing on the mainland is expected to exceed CNY18trn in 2011 roughly CNY1.5trn greater than in 2010 (Figure 5) or more than 38% of estimated 2011 GDP. This is down from an average of 42% of GDP in 20092010, but still well above the preglobal crisis average of 22%.
Figure 5 Figure 6

FitchAdjusted TSF
Fitch additional credit financing TSF capital market financing TSF other credit financing TSF loans

Fitch Additional Credit

LoCs Credit from NBFIs (CNYbn) 3,750 3,000 2,250 Informal securitisation Hong Kong banks

(CNYbn) 20,000 15,000 10,000 5,000 0

1,500 750 0

2006 2007 2008 2009 2010 2011e Q111 Source: PBOC

2006 Source: PBOC

2007

2008

2009

2010 2011e Q111

Perhaps most strikingly, more than 55% of new financing is expected to come from outside bank lending, close to triple the level of 2006. This underscores just how rapidly offbalancesheet and nonbank financing has been expanding in China. Given the rapidity of recent growth, Fitch considers it imperative that these channels be incorporated into assessments of macroeconomic and financial sector developments. Doing this requires reliable data, which can be challenging to come by in China, particularly for new areas of activity. It is for this reason that the agency has created this framework. The Fitchadjusted TSF is a work in progress, and will evolve as new activities and/or more robust sources of data emerge. Over time, the agency hopes that China will move toward broader official reporting along the lines of sections 32, 42, and 52 of the IMFs International Financial Statistics, which include credit extended by NBFIs.

Whats Included and Why

Figure 7

NBFI Landscapea
2008 No. of institutions Trust 53 Insurance 120 Leasing 11 Guarantee n.a. Securities 106 Fund managers 61 Microlenders n.a. Total assets (CNYbn) Trustc 1,237 Insurance 3,342 Leasing 63 Guarantee n.a. Securities 1,191 Fund managersc 1,940 Microlenders n.a.
a

2009

2010

Figure 8 outlines the framework for the adjusted TSF, how it differs from the official TSF, and the source of data for each item. When possible, numbers are sourced from published, observable data from official entities or industry associations.

54 61 129 161 12 17 n.a. 6,030 106 108 61 62 b 606 2,614 2,041 4,060 151 n.a. 2,027 2,603 77 3,040 5,048 316 592 1,970 2,690 198

Letters of Credit
The most clearcut item excluded from the official TSF is LoCs. Although they broadly fall under the category of offbalancesheet contingent liabilities, LoCs, like acceptances, often feed into immediate economic activity. During times of tight credit restrictions in China, it is not uncommon to hear of borrowers using commoditybacked LoC transactions as a way to secure credit, even when they have no practical need for the commodities. For this reason, LoCs should be included in aggregate measures of financing. Because no systemwide data is available on LoCs, the adjusted TSF currently only includes figures on LoCs from the 22 banks that are rated by Fitch and/or publicly listed.

Credit Extended by NBFIs

NBFIs have been the fastest growing segment of the mainland financial system (Figure 7), yet little aggregate data exists on their activity apart from trust products issued by trust companies, which are discussed separately below.

Excludes asset management companies due to the absence of comprehensive data b H110 c Assets under management Source: Local regulators, Wind

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Figure 8

Comparison of the Official and FitchAdjusted TSFs

Source of financing 1. Domestic banks a. Onbalancesheet credit i. Corporate loans ii. Household loans b. Disclosed offbalancesheet items i. Transactional Letters of credit Undiscounted acceptances Entrusted loans ii. Contingent Guarantees Credit commitments c. Undisclosed offbalancesheet items i. Bank wealth management products containing informally securitised loans Trust loans Other informally securitised loans 2. Domestic nonbank financial institutions a. Trust companies i. Collectiveinvestor trust products ii. Nonbankrelated single investor trust c products b. Insurance companies c. Leasing companies d. Guarantee companies e. Asset management companies 3. Offshore banks a. Hong Kong banks claims on China b. Other countries claims on Chinaa 4. Informal lenders a. Micro lending companies b. Private lending c. Pawn shops d. Other 5. Other financing a. Domestic corporate bond issuance b. Domestic corporate equity issuanceb c. Other financing
a

FitchAdjusted TSF official source

TSF source

PBOC TSF PBOC TSF

PBOC TSF PBOC TSF

Bank financial statements PBOC TSF PBOC TSF Excluded Excluded

Excluded PBOC TSF PBOC TSF Excluded Excluded

PBOC TSF Wind; China Trustee Association

PBOC TSF Excluded

China Trustee Association Excluded PBOC PBOC PBOC PBOC TSF Depository Corporation Survey Depository Corporation Survey Depository Corporation Survey

Excluded Excluded PBOC TSF Excluded Excluded Excluded Excluded Excluded PBOC TSF Excluded Excluded Excluded PBOC TSF PBOC TSF PBOC TSF

HKMA Excluded PBOC TSF Excluded Excluded Excluded PBOC TSF PBOC TSF PBOC TSF

The majority of other countries claims occur through foreign bank subsidiary and branch operations in mainland China and Hong Kong, which are already captured in systemwide credit figures from both locales b Equity issuance and insurance payouts would not typically be included in measures of credit, but are being left in the adjusted TSF to maintain comparability with the official TSF. These items are removed when calculating credit/GDP Source: Fitch

Given this dearth of information, figures on Chinese banks claims on other financial corporations are incorporated into the adjusted TSF as a proxy for nonbank credit extension. This series is admittedly imperfect, as it only reflects the share of non bank activity that is being financed through the banking system, and therefore is likely to underestimate activity. Nevertheless, for now it is the best available indicator of current and historical trends in the NBFI sector.

Credit From Domestic Trust Companies

Trust companies are the most rapidly growing component of Chinas nonbank financial sector. In the late 1990s, the trust sector experienced a widespread meltdown that led to numerous defaults on trust companies foreign debt issuance. The sector subsequently underwent substantial restructuring, but remained largely inactive until 2007, when trust companies began jointly working with banks to informally securitise loans into investment products. Trust company activities can be broadly separated into two categories (Figure 9): collectiveinvestor trust products (CTPs) that are issued by and liabilities of the trust companies themselves (item 2.a. in Figure 8; see Figure 10 for recent trends);
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and singleinvestor trust products, the majority of which are sold to banks, which then onsell the product to investors as a bank wealthmanagement product (item 1.c.i. in Figure 8). Products sold on as bank wealth management products are generally considered liabilities of banks, as they would be reputationally on the hook for investor losses on any products sold by them. Trust products not sold on by banks are considered liabilities of the trust companies themselves.
Figure 9

Trust Products
Trust Products

Single Investor Trust Products

Collective Investor Trust Products

Figure 10

Amount of Trust Products Outstanding

CTPs loan only (CNYbn) 800 600 400 200 0 2007 2008 2009 2010 Q111 Source: Wind, Fitch, China Trustee Assoc. CTPs other

Trust Loans

Other Informally Securitised Loans

Liabilities of Trust Cos.

Other Single Investor Products

The official TSF excludes all collective Liabilities of Banks Products created in cooperation with banks and investor trust products, and includes whose underlying assets consist solely of loans figures on only one of the three subsets Source: Fitch of singleinvestor trust products. The Fitchadjusted TSF includes data on collectiveinvestor trust products, as well as two of the three types of singleinvestor trust products.

Informally Securitised Loans

In 2010, loans that were transferred off bank balance sheets and informally securitised into trust and wealth management products were the largest component of uncaptured credit (item 1.c.i. in Figure 8). Oversight of this activity intensified in H210, and regulators now require that these loans be reincorporated onto Chinese banks balance sheets by end2011. Fitchs understanding is that no explicit guidance has yet been given as to where the loans must be recorded on the balance sheet; in most cases, they remain outside the loan portfolio and excluded from credit figures. For this reason, they have been added to the adjusted TSF. Fitch has received numerous inquiries about the precise magnitude of informally securitised loans, and about how data from regulators compares with numbers the agency published in its 2010 reports. Early this year, the CBRC announced that CNY1.6trn in informally securitised loans was sitting off bank balance sheets at end 2010, and should be reincorporated onbalancesheet by end2011. This figure refers only to loans, whereas Fitchs data on creditbacked wealth management products (CWMPs) includes both loans and discounted bills and hence is considerably higher. Figure 11 illustrates how popular discounted bill products have become, though it is worth noting that the nominal size of products is usually smaller than other CWMPs. Currently, banks are not required to bring back on balancesheet any discounted bills in such products.
2009 2010 Q111

Figure 11

No. Discounted Bill & Loan CWMPs Outstanding

CWMPs loan only Discounted bill (No. products) 6,000 4,000 2,000 0 2007 2008 CWMPs mixed

Source: Wind, Fitch

Given that the full balance of missing discounted bills is already included in the TSF, only loans that have been informally securitised have been added to the adjusted TSF. (For more information about informal securitisation in China, see Related Research links on page 1.)

Credit from Hong Kong banks

An often overlooked but increasingly important financing channel for mainland entities is credit extended offshore by Hong Kong banks. From H109 to Q111, Hong Kong banks claims on the mainland more than quadrupled from CNY463bn to CNY2,003bn outstanding. Of this CNY1,540bn increase, approximately CNY1,100bn was related to economic activity, while the remainder reflected monies placed on deposit at the central clearing bank. 1 Nonclearing bankrelated claims on the

Hong Kong authorities currently do not disclose data on the amount of renminbi deposits held at Bank of China Hong Kong, the sole approved clearing bank for renminbi. As a result, Fitch

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mainland are on pace to rise another CNY1trn+ in 2011, well in excess of an entire month of new loans extended domestically by Chinese banks (Figure 12). The majority of this credit is extended in foreign currency to Chinese corporates, which use the money to pay for external obligations, often traderelated. These companies are typically customers of large mainland banks, who frequently provide letters of credit or guarantees for the transactions. In this way, Hong Kong banks ultimate exposure is to the Chinese bank guaranteeing the borrower. For this reason, 74% of the territorys nonclearing bankrelated claims on China are booked as claims on mainland banks and recorded in Hong Kong banks interbank portfolios rather than their loan portfolios.
Figure 12

Hong Kong Banks' China Claims Rising Quickly

HK banks' claims on China HK banks' propertyrelated loans (% of equity) 140 120 100 80 60 40 20 0 2004 2005 2006 2007 2008 2009 2010 Q111 Excludes CNY deposits held at the clearing bank Source: HKMA, Fitch

Figure 13

Breakdown of HK Claims
Claims on nonbanks (% of total loans) Claims on banks (% of interbank assets) (%) 20 15

This means that the interbank 10 portfolios of Hong Kong banks are 5 increasingly exposed to underlying 0 corporate credit risk on the mainland, 2004 2005 2006 2007 2008 2009 2010 Q111 and may be less liquid than they Excludes CNY deposits held at the clearing bank appear on the surface. At endQ111, Source: HKMA, Fitch nonclearing bankrelated claims on Chinese banks accounted for 17% of Hong Kong banks total interbank assets (inclusive of acceptances), up from 5% in H109 (Figure 13). In the past, Chinarelated claims constituted only a small fraction of Hong Kong banks overall growth, constituting just 2.7% of total net new assets from 2005 to 2008. However, from end2009 to Q111, this share surged to 29%, meaning that Chinarelated business today accounts for a 10 times greater share of Hong Kong banks balance sheet expansion than a few years ago. 2 To put this in clearer perspective, from end2009 to Q111, propertyrelated lending of Hong Kong banks rose HKD317bn, less than half the HKD767bn rise in claims on China. If this pace of growth continues, Hong Kongs banking sector landscape could be dramatically altered over the coming years.

Whats Excluded
Two types of credit are excluded from the adjusted TSF: contingent offbalance sheet items of banks (item 1.b.ii. in Figure 8), and most credit extended by informal lenders (items 4.bd. in Figure 8). In the case of the former, guarantees are omitted as the underlying credit is usually already captured in other line items, while commitments are excluded because as yet no money has been extended and no economic activity has been generated.

estimates this series by taking total renminbi deposits in the Hong Kong banking system and subtracting monies invested in nonsovereign renminbidenominated bonds Similar trends related to China have also begun to appear in Macau banks, though to a much lesser extent than in Hong Kong

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Informal lending, particularly interenterprise credit, has accelerated in 2011, but so far no comprehensive, reliable sources of data exist except for that on micro lending companies, which is already included in the TSF under the other category.

LeverageIsHigherthanMeetstheEye
A key reason for Fitchs concern about the mediumterm outlook for the Chinese banking system has been the large and rapid buildup of leverage since the global crisis. Based on Fitchs adjusted stock of credit3, the ratio of total financing/GDP in China rose from 124% at end2007 to 174% at end2010, and is on pace to rise by another 11pp to 185% in 2011. Such a rapid runup in leverage relative to GDP is a sign that the incremental economic return on credit has declined, meaning that borrowers ability to repay is not keeping pace with the additional leverage being incurred. Over the medium term, this points to a potentially significant rise in loan delinquencies and pressure on Chinese banks earnings and capital. Admittedly, the recent divergence between credit and GDP in China is not as blatant as some past extreme cases, e.g., the 310pp rise in credit/GDP in Iceland from 130% to 440% during 2003 to 2008. Nevertheless, increases of similar magnitude to that recently experienced in China have been witnessed in other countries in the years leading up to episodes of financial stress (Figure 14), underscoring Fitchs cautious mediumterm outlook for the Chinese banking sector.
Figure 14

PreStress Period Credit/GDP

(%) 220 200 180 160 140 120 100 US 200207, IFS 52d Peaktrough: Max 2year: +41pp +22pp t6 t5 t4 t3 t2 t1

UK 200207, IFS 32d +50pp +20pp

Japan 198590, IFS 52d +45pp +26pp

Korea 199498, IFS 32d, 42d, 42dg +47pp +36pp

China 200611e, Fitchadjusted credit +61pp +48pp

Source: IMF International Financial Statistics, CEIC, Fitch

Both the official and Fitchadjusted TSF are measures of the flow of new financing in the Chinese economy. In this regard, certain items are included in these figures that would not typically be included in measures of the stock of domestic credit. In calculating credit/GDP, Fitch subtracts corporate equity raising and insurance policy payouts from the adjusted stock of credit. Lending from Hong Kong banks remains included, since the majority is being extended by the Hong Kong arms of Chinese banks and would be included if reported on a consolidated basis

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Chinese Banks July 2011