Chinese banks may need to trade lower profitability for economic stability

As China feels the chill from weak economic data, the People’s Bank of China (PBoC) has switched gear from a neutral to a more accommodative monetary policy stance. Beyond lowering the reserve requirement ratio (RRR) by 50 bps to unleash liquidity in early December 2021, China has just cut the 1-year loan prime rate (LPR) by 5 bps. In this note, we analyze the implications of the recent policy moves for China’s banking sector.

The relaxation of monetary policies is a piece of good news in providing ample liquidity and reducing credit risk for both corporates and banks. This reinforces the government’s call to step up both cross-cycle and counter-cyclical macroeconomic policies in the Central Economic Work Conference. In terms of credit transmission, the growth of total social financing has bottomed out with renewed growth in bond and equity financing, but loan growth has continued to decelerate. Given the important role of banks’ lending for Chinese firms, reviving credit growth is key for defying pressure in economic growth. That said, banks may benefit from faster loan growth and asset expansion.

At the same token, the reduction in LPR should be positive for economic growth, but the consequences are different for banks. The cut in LPR comes without any change in the medium-term lending facility (MLF) rate. This means banks’ funding costs from the central bank remain the same while lending rates are bound to decline, narrowing the net interest margin (NIM). The 5-bps cut may be small in magnitude, but the move is indicative for the direction of lending rates. In fact, banks are already confronted with policies geared towards asking banks to contribute more on maintaining economic stability. The best example is probably the “interest concession”, meaning banks are encouraged to reduce lending rates, fees and commissions. Indeed, NIM for Chinese banks has declined from 2.2% in 2019 to 2.07% in 2021, indicating weaker profitability. Despite a sharp rebound from the pandemic, two-year average profit growth for Chinese banks has fallen from 6.8% YoY in 2019 to 1.6% YoY in Q3 2021, meaning the speed is still way slower than previous levels.

It should be noted, though, the 5-year LPR has remained unchanged. This shows there is no U-turn in sight for the strict policies on real estate, but some marginal relaxations may slowly emerge to contain credit risks, such as granting extra quotas for mortgages, relaxing rules for bond issuance for the property sector, and more recently, encouraging the financial support for acquisitions and consolidations among real estate developers. Even though the Chinese government may not want to treat real estate as a major driver, macroprudential easing will need to continue if smoothening economic growth is the goal.

All in all, China’s monetary policy stance is becoming more accommodative for the sake of economic stability, but it is not yet clear how much of the responsibilities will need to be shouldered by banks. Given the central role in credit transmission, Chinese banks may be end up bearing a further reduction in their NIM and profitability. Still, if the dark cloud over economic growth – and especially the shock stemming from the real estate sector – is cleared, banks might still be better off after all from other aspects, such as asset quality.