Chinese banks face scrutiny over profits

Chinese banks cruised to handsome profits in the third quarter but the results have fuelled questions about whether their strength was coming at the expense of a beleaguered corporate sector.

With Chinese companies across many industries facing losses and unpaid bills, analysts warned that the banks' outperformance might not be able to last, forecasting that revenue growth would turn more sluggish and bad debts would soon begin to rise.

For the time being, though, these concerns have been held at bay. Over the past week the country's leading banks reported that their profits increased 10-20 per cent in the quarter from a year earlier, topping most expectations, and their credit quality remained very healthy.

Their hefty profits came at the same time as China slouched to 7.4 per cent annual growth, putting the economy on track for its weakest year in more than a decade.

"The divergence between banks and the real economy looks too good to be sustainable," said Stanley Li, an analyst with Mirae Asset Securities.

Two main factors explained the better-than-expected performance from China's banks.

First, investors have worried about bad debts in the wake of China's post-2008 stimulus spending spree, but once again there were no visible signs of a deterioration in asset quality.

The country's four biggest banks - Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China and Bank of China - all reported lower non-performing loan ratios than three months earlier.

Second, analysts had thought that a move to let banks compete more on deposit rates would cut into their net interest margins, which account for about two-thirds of their profits, but that effect failed to materialise. Instead, all major banks reported that their interest income was up 2-5 per cent from the second quarter.

Both these trends could soon turn against banks.

Banks' minuscule bad debt levels, which average just about 1 per cent of their overall assets, have resulted in part from loans being rolled over or shifted off their balance sheets. A slowing economy is expected to lead them to recognise more non-performing loans.

Meanwhile, interest margins will be compressed as a bigger portion of loans are repriced at lower rates following the central bank's two interest rate cuts earlier this year.

"The true [non-performing loan] ratio will continue to edge up and [net interest margins] will inevitably decline," Victor Wang, an analyst with Macquarie Securities, wrote in a research note.

However, he said there was no reason to be overly concerned. The results "tell us that we do not need to be super bearish about these moneymaking machines".

Investors took that view to heart as they piled back into Chinese bank shares in the Hong Kong market in recent weeks, triggering a more than 20 per cent rally since mid-September.

From a longer-term perspective, Chinese banks could be at a crucial turning point. They have faced intense criticism for making outsized profits thanks to their stranglehold on the country's financing channels. Acknowledging this criticism, Wen Jiabao, China's premier, said in April that "our banks make profits far too easily".

The government has put in train a series of reforms that are leading to a more vibrant corporate bond market and more interest rate liberalisation, which in time should erode the banks' dominance.