Tighter rules against shadow banking and a corporate efficiency drive combine to strengthen China’s banks.

Just over a year ago, following a fact-finding trip through China, I wrote about how we were confident that China could avoid a full-on banking crisis despite our cautious view on the negative effects of the country’s debt overhang.

One year on and we are still more optimistic. There are signs that the cleanup of the banking system is happening faster and smoother than expected, and financial risks are well under control.

Our view is supported by two key trends. First, more effective regulation has resulted in an orderly deleveraging of the financial system and stalling growth in riskier “shadow banking”. Second, strong corporate profits, coming as a result of supply-side reform and a rebalancing of the economy, has resulted in stable asset quality on bank balance sheets, culminating in China’s banks posting good third-quarter earnings reports.

Cleaning Up Finance, Making Industry More Efficient

At the start of 2017, Chinese regulators launched a clampdown on opaque shadow banking and other activities of inter-financial institutions, while promoting financial deleveraging and better transparency of complex financial transactions. The latest move has been the release of a consultation paper on guidelines for China’s asset management business, which proposes measures that will reduce duration mismatches in investment products, cap leverage and require higher capitalization, and ban products marketed with an implied minimum-return guarantee.

As a result of proposals such as these, for the first time since 2012 China’s shadow-banking sector has fallen as a share of GDP, according to analysis by Moody's. At the same time, systemwide interbank assets growth fell sharply in the year to the end of October 2017, while interbank liabilities were down by 1.1%, according to data from the People’s Bank of China (PBOC).

The regulatory clampdown has been successful thus far, and we believe this positive trend will continue, given the political resolve to see these reforms through. At the recent National Congress of the Communist Party of China, preventing financial risks ranked high on the agenda. Following that, the Financial Stability & Development Committee—the “super-regulator” set up in July this year—held its first meeting.

We believe this new body will increase coordination between regulators, and this streamlining should help to avoid policy missteps from uncoordinated regulatory actions, reduce opportunities for regulatory arbitrage, and give policymakers better control of credit risks. The recent asset management regulatory proposals, the first to target the entire RMB102 trillion asset management sector as a whole, offer evidence of that new coordination.

Figure 1: Systemwide gross interbank asset growth slowed sharply in the year to the end of October 2017

YoY Growth of Interbank Assets

Source: CEIC, PBOC, Neuberger Berman estimates.

Supporting the financial deleveraging efforts is an environment of improving corporate profits. Nonfinancial corporate profit growth in China has been strong, exceeding expectations by rising 27%, year-on-year. As a result, the debt-servicing ability of corporates has improved even as interest rates costs have been rising.

A big driver of this has been supply-side reforms that have helped the industrial sectors improve their profitability through capacity rationalization. Profits were also boosted by growth in new economy sectors such as services and technology, as well as robust household and export demand. Strong profitability was therefore broad-based. We remain optimistic on the sustainability of this profit recovery because, unlike in previous profit cycles, there has been better inventory and capex discipline.

Figure 2: Corporate debt-servicing ability has been improving

Source: CEIC, National Bureau of Statistics, Neuberger Berman estimates.

Strong Results for China’s Banks

Against this backdrop of prudent financial regulation and healthy corporate profits, third-quarter year-to-date results for Chinese banks have been strong, despite a period that saw heightened regulatory scrutiny and tighter funding.

According to CBRC data, bank profits were up 7.6% year-on-year. Moreover, the quality of those earnings has been good due to banks de-risking their balance sheets by digesting nonperforming loans, increasing their provisioning, slowing growth, and reducing exposure to shadow banking activity. NPLs stabilized at 1.74% of all outstanding loans in the third quarter of 2017, having peaked at 1.76% a year earlier.

Banks are currently in a strong position having achieved good results in a challenging regulatory and funding environment. Current sentiment and equity funding environment are supportive of further capital raising: I expect lower-tier banks in particular to raise capital.

While lower-tier banks still have to deleverage, and are still susceptible to changing economic and regulatory conditions, the banking system and regulators have proven they can execute these reforms well. If this trend continues, we can expect that the risks often associated with China’s banking system will be alleviated, resulting in a healthier environment for corporates and investors.