Rural China banks with USD4 trillion assets facing debt test

Bond investors are weighing rising risks that smaller Chinese banks will fail against growing signs the government will do anything to avoid a financial meltdown.

A lender called Guiyang Rural Commercial Bank Co. in the southwestern province of Guizhou sparked concern that risks among smaller lenders are spreading after its rating outlook was cut last month following a jump in overdue loans to 30 percent of the total. That compares with just 3 percent at the nation’s biggest lender. Short-
term borrowing costs surged for the riskiest lenders including rural commercial banks, which hold 29 trillion yuan (USD4.2 trillion) of assets, 13.4 percent of the total amount in China’s banking system.

Yet confidence in the government’s readiness to step in and offer support to struggling borrowers is rising as authorities allow a credit-fueled recovery of manufacturing activity, helping an official factory gauge match a post-2012 high last month. While 17 onshore public bonds defaulted in the first half of the year, there have since been only seven. The combination of government support and desperation for yield helps explain why Guiyang Rural was able to sell a junior bond at 4.7 percent last month, 1.7 percentage points less than a similar offering last year.

“Investors have yet to suffer losses from any bank capital securities, which adds to their confidence,” said He Xuanlai, a Singapore-based credit analyst at Commerzbank AG. “Smaller banks have a less diversified business profile and will likely get less support from the central government compared with bigger banks. Still, the base case is the government is still not ready to let any bank fail in a disorderly way.”

That assumption has helped cut the extra yield investors demand to hold AA-rated five-year bank subordinated notes over AAA rated peers to a record low of 81 basis points, from 113 at the start of the year. There are some positive fundamentals. Rural banks are tied with the big five state-owned banks for the best Tier 1 capital ratio at 12 percent, according to an analysis by Natixis SA.

Investors must balance that against more negative signals. Because of their limited size, rural bank lending tends to be more concentrated and prone to the vicissitudes of regional economies. The average non-performing loan ratio for rural banks was 2.5 percent at the end of 2015, the worst among four types of lenders in China, according to Natixis.

Guiyang Rural reported overdue loans jumped 3.4 billion yuan in the first half to 9.18 billion yuan amid a slowing economy. China Chengxin International Credit Rating Co. cut its outlook on the AA-rating to negative. Multiple calls to various departments at the lender went unanswered.

In addition to Guiyang Rural, Bank of Liuzhou Co. has been added to a credit watch list by Golden Credit Rating International Co. Two calls to the lender went unanswered.

“It is unsustainable to have 30 percent overdue debts,” said Zhu Yu, a partner at the financial services unit of PricewaterhouseCoopers LLP. “Smaller banks are worse at controlling credit risk than bigger peers. We expect more downgrades.”

Signs of financial stress and liquidity pressure are starting to show up. Short-term paper rates for China’s riskiest banks jumped by the most on record in November and longer-term bond yields are responding. The yield on AA-rated five-year bank subordinated notes surged 55 basis points over the past month to 4.63 percent, in line with their AAA counterparts.

“Some small banks are expanding aggressively,” said Wen Bin, chief research analyst at China Minsheng Banking Corp. “But their risk management and operational capacities are limited, so investors in small banks face higher risks.” Bloomberg