Business Tianjin Magazine

China's economy has been regaining some steam in recent months after growth was hit by weak external demand and domestic tightening in the previous three quarters. As we embrace 2013, Shanghai Daily now runs a year-end series to track policy and market changes as well as their influence on different sectors for next year.

The first piece is on China's banking sector, which has achieved healthy and rapid growth but faces challenges ahead, including risks lurking in shadow banking and fierce competition escalated by China's interest rate liberation.

Chinese banks are at a crossroads, waiting for a traffic signal from the country's new leadership.

The economic landscape at this junction certainly looks more daunting for Chinese lenders. The quality of assets is coming under scrutiny.

The repercussions of the eurozone debt crisis continue to roil global trade, weakening export markets for Chinese goods and undercutting the creditworthiness of many Chinese export firms.

In the past five years, double-digit increases in house prices have been the key driver of strong loan demand in China, according to the International Monetary Fund. Government intervention to rein in property speculation has slowed that market.

The State Administration of Taxation announced earlier that China would expand its property tax pilot project beyond Shanghai and Chongqing - a clear sign of ongoing property curbs that may lead to lower valuations of bank assets.

In addition to worsening asset quality, lenders are likely to face more margin pressure as the government begins to liberalize interest rates, the IMF said.

Standard & Poor's also said it expects interest rate cuts by the People's Bank of China, the central bank, will strain banks' profits in 2013 more than they did in 2012.

Still, despite all the challenges and hurdles, the big Chinese lenders posted rather stunning results in the third quarter.

Lenders, including the locally incorporated arms of foreign banks, made a combined net income of 981 billion yuan (US$15.6 billion) in the first nine months of this year, a fifth higher than the same period in 2011, according to the China Banking Regulatory Commission.

NPL ratio low

The overall non-performing loan ratio of Chinese commercial banks stood at only 0.95 percent at the end of September - very low by global standards.

But appearances can be deceiving. The specter of shadow banking risk now looms over the industry's future.

Chinese banks have been hiding risks off their balance sheets with wealth management products that carry higher interest returns than traditional bank deposits.

The money is channeled into the unregulated shadow banking system, which, in turn, finances real estate, infrastructure and other projects that might otherwise have difficulties getting loans from banks.

The CBRC now stipulates financial instruments with capital guarantees must be shown on balance sheets, though non-guaranteed products can continue to be left out, according to Reuters.

The regulatory move came after a wealth management product sold in a Hua Xia Bank outlet in Shanghai failed to repay investors. The Beijing-based, mid-sized lender was among the most active issuers of such financial instruments.

China International Capital Co said last week that investors who purchased the Hua Xia product should bear the responsibility themselves because the contract guarantees no principal or interest returns.

The lender blamed an employee for selling the risky product, which was distributed by a third party, without authorization.

CICC, the nation's largest investment banking firm, said Hua Xia is guilty of reckless internal management but shouldn't be held responsible for the repayments.

CICC said the case has important repercussions for the banking industry. If the banking regulator forces Hua Xia to pay those investors, that will send a warning signal to all banks engaged in similar practices.

"It will have a disastrous impact on all financial institutions, not just the banks, which will further distort the pricing system of financial risks," CICC said. "In the long run, the CBRC needs to arouse public awareness of credit risk and strengthen its supervision over shadow banking."

Time to address problem

This is probably a good time for regulators to address the problem before more defaults occur.

The issuance of the risky products is picking up as the year-end push to secure deposits intensifies, Fitch Ratings said in a report last week. The value of outstanding wealth management products topped 12 trillion yuan by the end of September, and the figure is expected to reach 13 trillion yuan by year's end, up from 8.5 trillion yuan in 2011, the rating firm said.

Smaller lenders were the key driver of the rise in issuance. Their thinner liquid assets and narrower deposit bases make them less equipped to handle the risks associated with such products, according to the ratings agency.

The CBRC excludes the 13 trillion yuan of products in its official estimates of the nation's shadow banking system, according to Reuters.

Australia & New Zealand Bank estimated in a report issued last week that such products will account for about 13 percent of the aggregate assets of the banking industry this year and a third of the nation's gross domestic product.

Zhou Xiaochuan, the governor of the PBOC, said last month that the nature and scale of China's shadow banking system is nothing compared to that of developed countries.

The global shadow banking system has more than doubled in size in the past decade, becoming a US$67 trillion industry last year, according to the Financial Stability Board, the Basel-based international authority that oversees global financial risks. That figure is virtually the same as global GDP of US$70 trillion at the end of 2011, or 25 percent of the assets of the global financial system, it said.

The United States has the largest shadow banking system, with assets of US$23 trillion last year, accounting for 35 percent of the global system.

China contributed 3 percent, after the eurozone, the UK and Japan, according to the report.

Zhou may be right about the scale of the shadow banking, but neither he nor any financial regulatory body in China can be sure how much that exposes the Chinese banking system to risks.

Chinese regulators, generally renowned for their prudence, have pledged to guide the banking industry toward a more healthy development track.

"The banking industry will enhance its capacity to serve the real economy, conduct businesses by the law, improve financial services, limit risk exposure, and maintain a stable operation," the CBRC said in a report earlier this year.

The coming Central Economic Working Conference, which will set the tone for 2013's monetary and fiscal policy, is expected to give directional signals to Chinese lenders about which road they should take at this critical junction.

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