This article first appeared in The Edge Malaysia Weekly, on September 28 - October 4, 2015.

There is growing concern about China’s banking sector as lenders, after years of solid growth, grapple with rising bad loans and tepid profits amid the weakening economy. This begs the question as to what extent the headwinds there will impact Malaysian banking groups with exposure to the sector.

Notably, CIMB Group Holdings Bhd and Hong Leong Bank Bhd each has an associate stake in small commercial banks there. CIMB (fundamental: 1.05; valuation: 2.25) has a 20% stake and is the single largest shareholder of Bank of Yingkou Co Ltd in Liaoning province, while Hong Leong (fundamental: 2.80; valuation: 2.70) has 20% in Bank of Chengdu Co Ltd, Sichuan.

Malayan Banking Bhd has three branches in mainland China, while CIMB has one. Public Bank Bhd has a retail and commercial banking subsidiary based in Hong Kong, Public Bank (HK) Ltd.

Just last week, in a move that rattled investors, Standard & Poor’s Ratings Services revised downwards its assessment of the economic risks facing China’s banking industry to “negative” from “stable”. It said China’s banks faced growing risks tied to bad loans and problems in the property sector.

“We view economic risks for China’s banking industry as high,” the US credit rating agency said in a Sept 21 report.

As it stands, many banks there are already seeing stagnant profit growth, even as the slowing economy increases the likelihood of borrowers having trouble repaying loans. In March this year, China announced an economic growth target of about 7% for 2015, which would be the slowest rate in 25 years.  

Even after five interest rate cuts and a few reductions in bank reserve requirements since November, economists say China may struggle to reach that target. Last year, the world’s second largest economy expanded by 7.4%.

Four of China’s biggest banks last month reported only small growth in net profit for the first half of the year, while their non-performing loan (NPL) ratios went up.

Net profit at Industrial and Commercial Bank of China Ltd (ICBC), the world’s largest bank by assets, as well as Agricultural Bank of China and China Construction Bank (CCB), grew by less than 1% for the first half compared with the same period a year ago, while Bank of China’s (BoC) grew by 1%.

The growth was sharply lower than that in the first six months of last year, when ICBC’s net profit grew by 7%, Agricultural Bank’s grew 13% and BoC’s, 11%. According to press reports out of Beijing, Chinese lenders are facing their worst year in more than a decade.

ICBC’s NPL ratio inched up to 1.4% at end-June from 1.29% at end-March, while Agricultural Bank’s moved up to 1.83% from 1.65% and BoC’s grew to 1.4% from 1.33%. CCB’s rose to 1.42% from 1.19% at end-December 2014.

While these NPL ratios are nothing out of the ordinary when compared with global standards, analysts and industry observers wonder if the ratios could actually be higher than what is reported.

“Given the economic downturn and the increasing NPL pressures, there is increasing market talk that banks are less stringent in booking NPLs. In our view, large banks continue to maintain higher NPL recognition standards, but some mid-sized banks do report lags between their overdue loans and NPLs,” says UOB Kay Hian Research in a Sept 8 report on the Chinese banking sector.

While all these point to a grim outlook for the sector, analysts are not overly concerned about the potential impact on CIMB, Hong Leong, Maybank (fundamental: 1.40; valuation: 2.25) and Public Bank (fundamental: 2.80; valuation: 1.80).

“Their exposure and earnings contributions from China is small, especially when you compare it to some of the banks’ key overseas markets like Singapore, Indonesia and Thailand. So, I don’t think it’s something to be overly concerned about,” says Kelvin Ong, a banking analyst at MIDF Research.

Nevertheless, analysts expect the banks’ profit contribution from China to come down. Hong Leong is expected to be the most impacted as it draws a higher proportion of its earnings from China than the rest.

“Bank of Chengdu accounts for about 14% to 15% of Hong Leong’s profit before tax (PBT), so the profit contribution is quite meaningful per se. Bank of Chengdu’s NPLs are on the rise and loan loss coverage levels have come off quite significantly, so it’s a bit of a concern for Hong Leong,” says another analyst.

Bank of Chengdu accounted for 14.6% of Hong Leong’s PBT in the last financial year ended June 30, 2015. The Chinese lender’s profit contribution that year grew by 8.9% to RM401.3 million.

By comparison, Bank of Yingkou accounted for less than 1% of CIMB’s bottom line in the last financial year. Contribution from the Chinese lender grew 19.4% to RM114.5 million for the year ended Dec 30, 2014, due to better interest income on the back of higher loan growth and fixed income investment.

Still, profit contribution in the final quarter that year fell by 40.7% to RM18.2 million from the third quarter.

CIMB accounts for its share of profit and draws small dividends from Bank of Yingkou, says a banking source, who adds that the Chinese business is “still doing okay” and has yet to see a rise in NPL ratio.

“In the case of Maybank and Public Bank, the impact is insignificant. Public Bank does predominantly Hong Kong business, and finds it hard to penetrate mainland China. The Chinese business contributes very little to Public Bank and Maybank’s earnings,” an analyst says.

Analyst David Chong of RHB Research says the impact from China’s slowing economy on Malaysian banks may also include slower trade finance business, apart from softer growth in contribution from associates.

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