July 22, 2013 / 4:17 AM / 7 years ago

China's rate reform adds to concerns for bank investors

SHANGHAI (Reuters) - Beijing’s move to scrap the floor on lending rates is not yet a game-changer for Chinese banks, but it may have just started the countdown to an eventual industry overhaul which will deprive the banks of virtually risk-free profits.

A businessman looks at his mobile phone as he walks in the financial area of Pudong in Shanghai May 30, 2013. REUTERS/Carlos Barria

China bank stocks mostly fell on Monday, the first trading session following the rate reform announced late on Friday. An index of banks listed in Shanghai .SSEBKI was down 1.7 percent in late morning trading, compared with a decline of 0.4 percent for the broader Shanghai Composite Index .SSEC.SS.

Any liberalization is seen as positive for China’s financial sector and the world’s second-largest economy. But many Chinese investors fear the nation’s banks, which for years have made easy profits from state-mandated spreads between borrowing and lending rates, will struggle to benefit from more competition.

Reflecting such skepticism, the Shanghai-listed banks trade at a median price-to-earnings ratio of 4.98 based on projected twelve-month earnings and a median price-to-book of 0.97, Thomson Reuters data shows.

Some economists believe nimble banks can reap some benefits after the People’s Bank of China (PBOC) announced on Friday that banks could lend at any rate they wanted, enabling them to lure more business by offering lower rates.

However, with few loans extended at or near the previous lending limits, the latest change is seen as having little practical impact.

It could, though, be a prelude to much bigger reform - removing the cap on deposit rates, currently set at 3 percent for one-year deposits - which would dismantle the system that enables lenders to effectively make guaranteed profit margins.

“China has removed almost all controls on lending rates, and rates in the money market and capital market are also effectively free. The next and more important step is, of course, the ceiling on deposit rates,” said Wang Tao, head of China research at UBS in Beijing.

That may take some time. The central bank has made it clear it considered lifting the deposit cap as the “most risky” step and promised to proceed with caution and only after implementing various safeguards, including a deposit insurance scheme.

Bank of America Merrill Lynch economist Lu Ting said that as an interim step - just like Japan in late 1970s - China could allow banks to issue floating-rate negotiable certificates of deposits, which could also be traded in the secondary market.

In the meantime, the latest move might help boost confidence in the sector’s overall competitiveness and efficiency on the assumption that more reform would follow. Barclays analysts said that it could be positive for bank stocks in the near term.

The ability to offer lower rates would also allow banks to provide an attractive alternative to short-term bond issues, Bank of America Merrill Lynch said in a research note.

How retail Chinese investors will react is an open question, however. Investors have been wary of Chinese financial firms, which many believe are saddled with underperforming loans dating back to China’s stimulus-driven spending spree in the aftermath of the 2008-2009 global financial crisis.

And economists say the latest initiative could give some big, influential state-owned companies leverage to secure lower borrowing costs at the banks’ expense.

That could put some pressure on China’s biggest banks, such as Industrial and Commercial Bank of China Ltd (601398.SS), China Construction Bank Corp (601939.SS), Bank of China Ltd (601988.SS) and Agricultural Bank of China Ltd (601288.SS).

For smaller banks, which rely more on short-term interbank funding, the immediate concern is that their costs will rise even before the final leg of the rate liberalisation kicks in.

Last month, the central bank engineered a cash crunch in the interbank market out of concerns that credit was being funneled into speculative real estate investments and poorly conceived local government investment projects.

Though interbank rates have since retreated from peaks near 30 percent, dealers expect cash to stay tight in coming months.

Additional reporting by Nishant Kumar in Hong Kong: Editing by Tomasz Janowski, Mark Bendeich and Neil Fullick

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