Friday, November 28, 2008

Yuan Watch : Betting on Red

NOVEMBER 28, 2008, 8:06 A.M. ET

For China's banks, the good times are coming to an end.

Aggressive rate cuts mean falling net interest margins are in store just as bad loans are expected to creep up.

Still largely under state-ownership, the banks will be expected to play their part in supporting the Chinese economy -- rather than pulling up the drawbridge like their foreign counterparts have been doing.

If that means earnings are pinched, few in Beijing will mind. For investors, it's a reminder that Chinese institutions aren't always the true masters of their own destiny.

The country's banks have reaped the rewards from the country's rapid economic expansion. Even now things aren't so bad. At Bank of China, the laggard among the top listed institutions, earnings rose 32% on-year through the third quarter.

Maintaining this will be tough as China continues to ease policy. This week, one-year lending and deposit rates were slashed by 108 basis points.

If Chinese government bond yields now fall as much as headline interest rates, net interest margins at the banks will fall by 26% says Citi Investment Research. Major Chinese banks invest most of their surplus cash in yuan-denominated bonds.

The spread between official lending and deposit rates, which helps the banks maintain an inbuilt profit margin, will continue to narrow. China's already cut the lending rate by more than the deposit rate in this easing cycle. The one year lending rate, at 5.58%, has much more to give than deposit rates do -- a loan rate below 4% next year now looks possible.

This comes at a critical time, when China's stimulus efforts have global implications. BNP Paribas estimates China could account for a staggering three-quarters of world economic growth next year.

Beijing wants banks to do their duty by expanding credit, which could mean lowering credit standards even as banks already face rising bad loan levels.

Whatever the cost, China's banks are unlikely to say no.

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