(Bloomberg) -- China’s regional lenders are facing growing risks in the nation’s $4.3 trillion sovereign debt market after an unprecedented bond rally this year prompted a slew of warnings from the central bank.
The lenders, some with over 50% of their assets in bonds, are bracing for potential sales by the People’s Bank of China, which is seeking to control risks and cool the market. The banks are divided over whether to keep chasing the rally or trim their positions, according to interviews with more than a dozen bankers who requested anonymity discussing a private matter.
Regional banks have been the most aggressive buyers of Chinese bonds over the past year to make up for profits lost on their bread-and-butter lending businesses as competition intensifies amid weaker loan demand.
That’s put them in the crosshairs of regulators seeking to limit risks at these financial institutions, especially after the collapse of Silicon Valley Bank, which had piled into US Treasuries before rates rose. The PBOC’s local branches have dispatched teams to some lenders to check on their bond holdings and transactions, said the people, asking not to be identified.
Jason Bedford, a former analyst who predicted troubles at China’s regional banks in 2019, said they’re buying government bonds “like there’s no tomorrow.”
“As they push more of their balance sheet into sovereign debt, downward pressure on yields is going to continue,” the former analyst with Bridgewater Associates and UBS Group AG said, noting the banks’ outsized role in determining yields. “That is difficult for any central bank to control.”
Chinese bonds have been among the best performers in the world this year as the central bank lowers interest rates to revive growth in an economy battered by a housing slump and weak consumer demand. The Bloomberg China Aggregate Total Return Index has risen 4.6% this year, compared with a 1.06% gain in a similar US gauge.
The rally is proving attractive for regional lenders, raising concerns from regulators that they’re exposing themselves to excessive risk if the market turns. The bond surge has pushed yields lower, meaning banks are buying new bonds with lower interest rates, eroding profit margins.
“Yields on China rates still have a ways to go down,” Bedford said. “So you’ll have a short-term sugar high from the mark to market gains, but as you go to buy new rates instruments you’ll get ever lower yields, which will squeeze that interest margin.”
Bond Holdings
Bond holdings at listed city and rural commercial banks, mostly sovereign debt and quasi-government bonds, accounted for about 27% of the group’s total assets at the end of 2023, according to data compiled by PricewaterhouseCoopers LLP. That ratio likely moved higher in the first half, PwC said. That compared with bond exposure of 25% and 22% at big banks and joint-stock lenders, respectively.
Dongguan Rural Commercial Bank Co. had almost 38% of its assets in bonds as of December, the highest among listed regional banks, followed by Bank of Hangzhou Co. and Qilu Bank Co. at 35% and 34% respectively, public filings show.
The holdings could be even higher at China’s vast and opaque network of more than 1,600 rural commercial lenders, with just 13 of them publicly listed. Recent surveys by the PBOC found exposure at some smaller lenders topped 50% of total assets, people familiar with the matter said.
The PBOC didn’t immediately reply to a fax seeking a comment.
The central bank has hinted it may sell the securities to influence yields, and ordered some rural lenders to shorten duration of their bond holdings.
Mired in a property slump and beset by deflation, China’s economy needs a low interest-rate environment to stimulate growth. But rates can’t be so low that it hurts bank profits, leads to a debt-buying binge or weakens the yuan at a time of US dollar supremacy.
While the PBOC has so far refrained from direct intervention, the overhang has put more pressure on regional banks relying on investments to meet profit targets, people familiar said. Some had trimmed their debt holdings since April following guidance from authorities, while others rushed to buy more before the central bank steps in.
Inevitable Trend
Yields on the benchmark 10-year government bonds dropped some 40 basis points this year to a record low of 2.14%, testing the PBOC’s tolerance of the rally.
James Chang, financial services leader of PwC China, expects the central bank’s possible operations to be more aimed at shaping the slope of the yield curve and preventing an inversion, rather than sending a signal of tightening.
“There’s no reason to push up market rates” given the state of the economy, said Chang from Shenzhen. “Regional lenders will continue to pile into financial investments for returns and that’s an inevitable trend that’ll likely last for another two to three years.”
While rural commercial banks have maintained higher margins than big state-owned banks and joint-stock lenders, their bad loans ratio hit 3.34% as of March, more than double that of bigger peers, official data showed.
Rate Risks
Now interest rate risk is adding to challenges, prompting regulatory warnings to prevent a severe mismatch of their assets and liabilities, according to Fitch Ratings Inc.
“Should there be any big swing in bond prices, it’ll deal a blow to profitability of the regional banks in this overcrowded trade,” said Vivian Xue, director of Asia-Pacific Financial Institutions at Fitch. “Smaller banks’ fragility will increase.”
--With assistance from Helen Sun and Heng Xie.
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