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China’s largest banks beat expectations in 2016 earnings, what lies ahead may not be as rosy

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China's five largest banks turned in better than expected 2016 financial performance last week, but analysts warned that the worst is not over as risks of a property market shock could threaten financial stability in the world's second largest economy.

Full-year earnings released between Tuesday and Friday last week, showed that lower operating costs helped four out of the five banks to register net profit growth of between 0.4 and 1.9 percent in 2016. Bank of China was the only bank that saw net profit fall by 3.7 percent.

However, the recovery in bad loan ratios was uneven across the banks and net interest margins – a measure of lending profitability – compressed further, according to the earnings reports.

"As far as I can see, the stabilization in profitability is due mainly to the change in business taxes, which lowered operating costs and income taxes, and neatly offset the fall in net interest revenues," Matthew Phan, senior research analyst at CreditSights, told CNBC.

"But I am not convinced the worst is over. In a recovery, banks should see NPLs fall, not just stabilize… The (central bank) has tightened monetary policy and the property market is now slowing and this is an economic risk in 2017," he said.

The increase in bad debt and loan defaults are major challenges that China's banking system has been grappling with over the past years amid slowing economic growth.

Four of the country's top five banks – Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China and Bank of China – are the largest in the world by assets, according to a ranking by S&P Global Market Intelligence.

As the banks continue battling narrowing margins and China's slower growth, Moody's Investors Service pointed out in a report last Wednesday that the real estate market now poses a larger threat to the financial system.

While loans to companies in real estate and construction sectors have stayed constant at around 10 percent of total bank lending, properties pledged as collateral has risen, the report noted.

"Previously, the banking sector's exposure to the property market was relatively modest, thus limiting the potential negative impact from a real estate downturn," said Lillian Li, vice president and senior analyst at Moody's.

"But the rising share of mortgages in new bank credit, the risk from property pledged as collateral on other loans, and the increasing role of shadow banks as providers of finance to the property sector have all raised the financial system's vulnerability to a property-related shock," she said.

But Alice Guan, Greater China market specialist at Phillip Securities, said rising global interest rates and continued reforms in China will benefit the banks.

"Compared to most of the other sectors, the banking sector still has advantages of low valuation and high dividend. And with economic recovery and reform (of state-owned enterprises), the valuation of this sector is expected to improve," she told CNBC.

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