Why Chinese Banks May Avoid Repeating Japan's Lost Decade

Primary Credit Analysts: Naoko Nemoto, Tokyo (81) 3-4550-8720; naoko.nemoto@standardandpoors.com Qiang Liao, PhD, Beijing (86) 10-6569-2915; qiang.liao@standardandpoors.com

Table Of Contents
1. Credit Growth Is Slowing Down 2. Credit Losses Are Likely To Be Absorbable 3. Preemptive Government Measures Have Reduced Risks 4. Government Support Is Likely To Be Timely Economic Growth Potential Offers Additional Support For China Why China's Banking Sector Could Still Experience Financial Distress Related Research

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Japan's last banking crisis could offer a cautionary tale for Chinese banks. The similarities are striking. China is currently grappling with soaring public sector debt, rapid credit expansion, and steep property prices at a time when the economy is slowing down (see table 1). In the early 1990s, Japan's comparable problems destabilized its banks and triggered economic stagnation for a so-called "lost decade." Are China and its banks following in these footsteps? Standard & Poor's Ratings Services believes a prolonged crisis is unlikely for Chinese banks, given distinct differences in their strengths and circumstances compared with banks in Japan. For a start, Chinese banks are financially stronger than Japanese banks were when their crisis hit. And we believe China's economy has sufficiently robust growth potential for its banks to ride out any credit crunch. But we can't rule out financial distress and severe credit losses over the next two to three years. Overview Japanese banks became overwhelmed with nonperforming loans in the 1990s, following slumping prices for land and shares. Japan's sluggish response to the crisis contributed to economic stagnation throughout the 1990s. China is also grappling with ways to constrain property speculation, in addition to high public sector debt, particularly in the "shadow banking" segment. But Chinese banks are likely to benefit from timely and preemptive government measures and the economy's robust growth potential. They also have solid capitalization and earnings.

We believe the loan quality of Chinese banks is likely to deteriorate progressively over the next two to three years. Contributing factors include the banks' high exposure to loss-making companies that are saddled with overcapacity as China's decade-long construction boom continues to cool. Tight market liquidity that the central government's measures have induced may further increase the funding costs of corporate borrowers. In addition, the government has spurred consolidation for many industries facing overcapacity.
Table 1

Comparing Key Indicators On China And Japan

Japan Per capita GDP (US$) Real GDP growth (%) Residential house price index (real): national Commercial real estate price index (real) Equity price index (year-end) Systemwide loans to real estate construction and development sector (as % of total loans) NPAs as % of total loans (year-end) NPA peak as % of total loans 24,713 1990 1.5 (1990-1999) 2.2X (1980-1990) 2.4X (1980-1990) 5.8X (1980-1990) 16.9 1990 2.4 1990 8.2 2002 China 6,910 2003 7.4* (2013-2015) 2.1X (2003-2013) 2.5X (2003-2013) +37.3% (2003-2013) 9.5 2013 1.7 2013

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Table 1

Comparing Key Indicators On China And Japan (cont.)

Corporate debt as % of GDP Household debt as % of GDP Deposit Insurance System Capital requirement 105.1 1990 58.9 1990 Established in 1971 Basel I 1992 Total 8% 102.8 2013 32.5 2013 To be established Basel III 2013 Total 9%; Common Equity Tier-1 -- 5%

*Standard & Poor's base-case estimate. Nikkei 225 index for Japan and SSE Composite Index for China. Land price index was used as a proxy. Source: Standard & Poor's BICRA reports based on national and IMF statistics.

A significant correction in the property market would also bite, given the banks' exposure to the debt-laden financing companies of local governments and highly leveraged property developers. In addition, high property prices have weakened affordability levels, and could undermine the credit quality of mortgage loans. The rapid credit expansion in China's regular and "shadow banking" systems highlights the imbalances and credit risks in the Chinese economy. We have long captured such risks in our low anchor rating of 'bbb-' for the Chinese banking system despite the banks' solid financial metrics. The rating implications of a severe deterioration in asset quality may therefore be less pronounced for Chinese banks than for Japanese banks during their crisis years. We lowered our ratings on Japan's major banks to 'BBB+' during 1993-2002, compared with an average of 'AA-' in 1992. We've identified four key differences to Japan that we believe will help China's banks absorb credit losses and reduce the risk of systemic difficulties.

1. Credit Growth Is Slowing Down

China: Private-sector leverage is already moderating
We expect indebtedness in corporate China to continue to decelerate over the next two to three years. Loan growth soared in 2009-2010 to counterbalance the fallout from the global financial crisis, exacerbating the credit risks. The pace of loan growth has slowed since 2011 because the central government has been sufficiently concerned to take steps to address the binge, such as allocating new loan quotas to the banks. The average annual increase in the ratio of China's private-sector credit to GDP has been remarkable for the past five years. But it trails the credit growth of three developed countries--the U.S., the U.K., and Spain--during 2003-2008 (see chart 1). The increase in China's credit would remain relatively moderate even if we were to add the banking sector's direct exposure to shadow banking, such as wealth management products under the banks' off-balance-sheet.

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Chart 1

Japan: Leverage accelerated for a decade

Loans from unregulated entities in Japan rapidly expanded during the 1980s, underscoring high leverage in the private sector. The ratio of loans channeled through nonbank sectors compared with total loans for depositary institutions peaked at 34% in 1990. A decade earlier, the ratio stood at 19%. In addition, the ratio of total household and corporate debt to GDP gathered pace throughout 1980-1990 (see chart 2).

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Chart 2

2. Credit Losses Are Likely To Be Absorbable

China: Earnings and capitalization are solid
We expect the pre-provisioning profitability of China's banking sector to remain high and compare favorably with that of its global peers over the next three years. In 2012, the average return on assets (ROA) of China's five largest banks was 1.3%, higher than those of most other Asian countries. However, banks' net interest margins could become even more strained amid financial disintermediation and further liberalization of deposit rates. China's major banks have sufficient core capital on a global basis. The common equity tier-1 ratios of all the banks that we rate are between 9% and 11%, exceeding the regulatory requirement of 7.5% (8.5% for a systemic bank) that will be implemented under Basel III by 2019. Sizable countercyclical loan-loss reserves further support the loan-loss buffers of Chinese banks. The reserves stood at 3x the sector's reported nonperforming loans at end-2013.

Japan: Capitalization and earnings were weak when the crisis hit
Conversely, in 1990, Japanese banks had to absorb large credit costs with weak capitalization and earnings. And that led to significant shortfalls in capital. The average ROA of all the banks in the 1990s was 0.2% and the average tier-1 ratio was 4.5%. Consequently, banks attempted to improve their financial profiles by reducing costs, expanding fee

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income, and consolidating to generate economies of scales. Nevertheless, financial institutions began to recover as the domestic economy improved and the Japanese government injected capital.

3. Preemptive Government Measures Have Reduced Risks

China: The central government is taking a tough stance
We believe China's central government and regulators will remain preemptive in reining in credit growth and excessive investments. Recently, policymakers tightened market liquidity to stem the growth of shadow banking and the rapid expansion of interbank transactions. (See "Tight Interbank Liquidity Tests China's Delicate Dance Between Bank Discipline And Stability," published on RatingsDirect on June 24, 2013.) Other steps include the implementation of the global Basel III capital framework in January 2013. China's minimum common equity leverage ratio is 4.0%, which is higher than the global standard of 3.5%. In the property sector, regulators have demanded high down payments to deter speculation. The maximum loan-to-value ratio is 70% for first-time buyers and 40% for second-time buyers. Already, such measures have cooled demand.

Japan: Regulators took no effective measures to avert the crisis

Japan's financial regulators failed to take any preemptive and effective measures to curb excessive credit growth during the bubble period that started in the 1980s. Instead, the Bank of Japan provided administrative guidance, such as target loan growth, which took the form of a moral obligation. Shadow banking rapidly expanded in late 1980s because underwriting standards and regulations for nonbanks were less restrictive than those for banks. For instance, banks had to report to regulators the concentration of real estate-related loans among their total loans. A nonperforming-loan problem in Japan's banking system first surfaced when the former Nippon Credit Bank requested lenders to reduce the interest rates on the loans that they had extended to its nonbank affiliates in 1994. Many banks had to incur large costs to save their nonbank affiliates in order to contain reputation risks, although most of the nonbanks were not consolidated entities.

4. Government Support Is Likely To Be Timely

China: The government can and will act quickly if needed
In our opinion, the Chinese government has a high likelihood of providing timely support to financial institutions if needed. In China, state ownership is prevalent in the banking sector, and banks play critical roles in economic policies. The government has a record of providing extraordinary support to troubled financial institutions, including massive capital injections to the big five state-owned banks.

Japan: The government's response was sluggish

When Japan's banks faced capital shortages and struggled with credit crunches in the late 1990s, the government was unable to take prompt and decisive action. Injections of public funds into banks were, in some cases, inadequate to

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enhance their capital in terms of quantity and quality. The government's insufficient financial flexibility was due to a massive fiscal deficit and frequent changes in the political administration. In addition, the public was strongly opposed to providing bailouts for the banking industry, which many perceived to have fueled the bubble. The central bank's loose monetary policy persisted until May 1989. Thereafter, the central bank raised its key policy rate to 6% from 2.5% over a 15-month period. In the grips of the crisis, the Ministry of Finance introduced quantitative restrictions on banks' real-estate loans in 1990 and introduced a 0.3% tax on property holdings in 1992 to curb large property purchases for speculative purposes. Such an abrupt turnaround had overkill effects on the real estate industry and financial institutions. It led to liquidity shortages and a sharp plunge in property prices.

Economic Growth Potential Offers Additional Support For China

Standard & Poor's estimates that China will maintain high GDP growth of about 7% for at least until 2016. That compares favorably with most countries, and would be much stronger than Japan's in the 1990s. Such growth should support the government and help the industrial sectors to resolve the problems relating to excess capacity over time. And that in turn should limit the systemic risk for Chinese banks.

Why China's Banking Sector Could Still Experience Financial Distress

In our view, the health of Chinese banks is still susceptible to certain stress-inducing events. These include a steep drop in real estate prices, a sharp hike in interest rates, and a severe economic downturn that would increase unemployment. China's low-income families are more vulnerable to an economic downturn than those in Japan. China's nominal GDP per capita was US$6,910 in 2013, compared with Japan's US$24,713 as of 1990. In addition, China's social safety nets, such as unemployment insurance, aren't fully developed.

Shadow banking is still a pain point

Distorted growth in China's shadow banking system could lead to an unintended build-up of credit risks. China's policymakers have not viewed these activities as entirely undesirable as they meet financing needs that China's heavily regulated lending system could not. On the other hand, the regulators are concerned with the rapid growth of non-bank activities. In particular, some products are mispriced based on the implicit government guarantee, which could lead to excessive investment in non-viable projects. Although the expansion of credit other than bank loans has slightly slowed (see chart 3), it is not certain that the regulators will be able to rein the growth of shadow banking activities without causing any unintended consequences on economic growth and financial stability.

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Chart 3

In our base-line scenario for China, we expect credit losses from shadow banking activities, excluding the wealth management products that banks originated, to be shared among various stakeholders, such as nonbanks, individual financiers, investors, and public entities. We don't expect banks to bail out distressed trust products. But if they did, we would review our assessment of our Banking Industry Country Risk Assessment on China and the stand-alone credit profile of individual banks. That would reflect the banks' larger credit exposure to shadow banking, which we currently estimate at about RMB6 trillion-RMB7 trillion (US$1 trillion-US$1.2 trillion) by end-2013. Even if banks choose not to bail out distressed products, they aren't insulated from contagion risk or collateral damage stemming from credit failures in the shadow banking system. Massive defaults of shadow banking credits could trigger the failure of smaller banks with weaker financial profiles than major banks. That, in turn, could undermine depositor confidence and cause a liquidity crunch in the interbank market. In our opinion, certain parts of the shadow banking sector, notably trust companies, will continue to be the weak link in China's financial system. In Japan, we note the banking sector absorbed most of the credit losses of nonbank sectors by providing financial

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support to its nonbank affiliates or taking losses as creditors. One of the factors behind the nonperforming-loan problems in Japan was insufficient credit risk management. In response, banks introduced more sophisticated internal rating systems, which enabled them to address borrowers' deteriorating performances at an earlier stage. The banks also reduced their concentration risk, which was high because of their reliance on the real-estate sector or a small number of large borrowers. The Financial Supervisory Agency was set up as an independent supervisory agency. Its aim was to depart from traditional forbearance policy, and enhance information disclosure and loan assessments. The Japanese government has also reformed the Deposit Insurance Law several times. The government has developed an institutional and administrative framework to provide timely support to banks under a systemic crisis. China appears to have taken note from Japan's past troubles. The Chinese government and industry regulators are steering the banks away from the cliff edge. Such caution and preemptive measures suggest to us that a lost decade isn't around the corner. How Japan's Banking Crisis Evolved In the early 1990s, nonperforming loans overwhelmed banks as the economy buckled. That followed plunging prices for land and stock prices, after a prolonged period of rapid growth. The benchmark Nikkei Stock Index surged 5.8x and commercial land prices jumped 2.4x during 1980-1990. Japan's economy stalled to average GDP growth of 1.5% in the 1990s, down from 4.3% in the 1980s (see charts 4 and 5). Industrial corporate entities needed to reduce excessive debt and shed overcapacity, creating problems for the economy. In addition, the labor force started to decline in the early 1990s, and further undermined GDP growth, which was already weak. Japanese banks incurred total credit losses of about 99 trillion (US$950 billion) from fiscal 1992 (ended March 31, 1993) through fiscal 2007 (ended fiscal March 31, 2008). This is equivalent to 105% of their total core operating profits and 285% of their total capital during the same period. The government spent 47 trillion, excluding liquidity facilities, to help banks tackle their nonperforming-loan problem. This is equivalent to 9% of the average GDP for the same period.

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Chart 4

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Chart 5

Related Research
Banking Industry Country Risk Assessment: China, Jan. 9, 2014 Banking Industry Country Risk Assessment: Japan, Aug. 22, 2013 Why Shadow Banking Is Yet To Destabilize China's Financial System, March 27, 2013 Japan's Lost Decade Offers Lessons For Current Global Turmoil, Dec. 7, 2008

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