Improving producer prices, industrial profits remain crucial to alleviate China’s bad loan pressures

Downside pressures on the Chinese economy, concerning the country’s bad loans are likely to be alleviated by the improvement in producer prices and industrial profits. A further rate cut by the People’s Bank of China (PBoC) is not desirable, as this will suppress net interest margins and hence banks’ profitability.

The sum of special mention and non-performing loans (NPL) rose from 3.55 percent in Q1 2014 to 5.77 percent in Q2 2016. This trend deserves serious attention. In our view, however, assessing capital adequacy of Chinese banks is more important than debating any underreporting issue of the NPL ratio (Q2: 1.75 percent).

According to ANZ’s scenario analysis, even if 75 percent of the special mention loans eventually turn non-performing this year (NPL rises to 4.8 percent immediately), the gap of loan loss reserve of RMB1.4 trillion can still be absorbed by the banks before the tax profit of around RMB2 trillion. Currently, the system can still withstand a surge of bad loans.

Moreover, the property frenzy is a serious issue. Household balance sheet and collateral will worsen if real estate price adjusts downwards sharply. Commodity prices would tumble and industrial profits would decline. It could turn out to be a global macro event. Souring bad loans will propel a bull market in onshore rates, RMB depreciation, and a surge of credit spreads, ANZ reported.