How a 'hard landing' could hurt Chinese banks

Fears rise over credit quality deterioration.

According to Bernstein Research, the greatest risk to the Chinese banks is a hard landing scenario in China. 

Should real GDP growth slow to the 3-4% range, the analyst would suspect that a number of the businesses operating in the country would default under the scenario resulting in a substantial deterioration of credit quality in the banking system.

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As a result, we would expect to see a rise in NPLs and credit costs that would negatively impact the banks' profitability.

We are forecasting a decline in China's economic growth rates in the coming years as real GDP growth slows from the 9-10% annual level reported in China over the past 5 years (excluding 2008) to 7-8% growth as the central government focuses more on the quality of growth, and not just the quantity.

The slowdown in economic growth, coupled with the massive credit expansion at the banks in 2009 will lead to 2.5-3.5% NPLs in our models by the end of 2015. Any further decline in GDP growth would result  in higher NPLs and weaker earnings.

Another major risk to investors in the Chinese banks would be a change in the government or regulatory policy governing the operations of the banks.

The Chinese banking system is still a heavily regulated industry as it is still in its early stages of development.

As a result, the operating environment is heavily influenced by the regulators and the central government.

While changes to the regulatory environment in recent years (the increase in minimum capital adequacy ratios, provisioning levels and stricter requirements on sales of wealth management products) have all been a negative for the ROEs of the Chinese banks, they have succeeded in making the banking system more stable and improved its resilience to economic weakness.