Are the Days of Bumper Profit Growth for China Banks Over?

China’s big four lenders, which begin reporting earnings on Thursday, are expected to see a steep fall in profit growth in the second quarter, as the impact of a slowing economy trickles through into the country’s banking system.

Bank of China
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Bank of China

Weaker loan demand, which hampers banks’ pricing power, and rising credit costs are set to weigh on lenders’ profitability, according to analysts, who warn that the days of double-digit earnings growth are numbered.

“Chinese bank earnings are highly correlated to GDP growth…as GDP growth starts to slow, the impact on bank earnings is immediate,” Jim Antos, Hong Kong-based Banking Analyst at Mizuho Securities told CNBC.

Average earnings growth for Chinese lenders listed in Hong Kong is set to slow to 13.5 percent year-on-year in the second quarter from 17.5 percent in the first three months of the year, according to Mizuho Securities.

This marks a sharp slowdown from the 30-35 percent earnings growth enjoyed by the banks in 2010 and the first half of 2011, when the Chinese economy was growing between 9-10 percent. Growth since has slowed to 7.6 percent.

New yuan loans extended by all Chinese banks in July came to 540.1 billion yuan ($85.2 billion), the lowest level in 10 months, Reuters reported. China's big four banks - Industrial and Commercial Bank of China, China Construction Bank , Bank of China and Agricultural Bank of China - account for 30-40 percent of total bank lending.

Alongside lower loan demand, the banking system is also being faced with a rise in non-performing loans (NPLs) - another burden for lenders’ balance sheets.

In the second quarter, NPLs rose by 18.2 billion yuan, or 4.2 percent, to 456.4 billion yuan from the preceding three months, according to the China Banking Regulatory Commission. A large portion of the bad loans are arising from manufacturers, exporters, and small and medium sized enterprises (SMEs) - which are most impacted by the slowdown in foreign demand.

As a result, Mike Werner, Senior Analyst at Bernstein Research says he expects banks’ credit costs – the amount set aside as an allowance for bad loans - will increase to 0.61 percent in the April-June period, from 0.57 percent in the previous quarter.

In addition to rising provisions, May Yan, China Banks Analyst at Barclays says a slowdown in bank fee income is set to weigh on earnings.

Growth in fee income has come under pressure after China’s National Development and Reform Commission placed restrictions on the fees banks could charge to retail investors, government projects and to SMEs.

Yan forecasts fee income growth will halve to 13 percent year-on-year in the second quarter, from 26 percent in the first quarter.

Single Digit Earnings Growth?

Werner and Yan say that profitability for mainland lenders is set to decline even further in the coming months as a result of the recent interest rate cuts and liberalization, with profit growth likely to hit single-digits as early as 2013.

“As the central bank responds to slower economic growth through monetary easing (such as rate cuts), this will result in weaker earnings for the banks,” Werner said.

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The People’s Bank of China - which sets a floor on lending rates and a ceiling on deposit rates – last month said banks could lend at 70 percent of the benchmark rate, down from 80 percent, increasing competition among lenders.

Eighty percent of the operating income of China’s major state-owned commercial banks comes from net interest income, or the revenue generated from their loans, according to industry estimates, so a decline in loan earnings would heavily impact earnings.

“Banks will lower (lending) rates, and that’s going to damage their net interest margin. Net interest margins could decline up to 40-50 basis points next year,” Yan said.