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China, US hit Hong Kong banks with double whammy

Bank of East Asia says its non-performing loan ratio for mainland China reached 2.65 per cent in the first half of this year. Photo: Bloomberg

Hong Kong banks are caught in a jam between the world's two biggest economies.

On the one hand, lenders in the city have never been more exposed to the Chinese mainland's slowing economy. As a matter of survival, local banks have lent aggressively across the border, but cracks are forming on the credit profiles of many of those borrowers.

The pain is not hard to see. Bank of East Asia, for example, notched a 2.65 per cent non-performing loan ratio for the Chinese mainland in the first half of the year, the lender disclosed this month.

On the other hand, the Federal Reserve in the United States is expected to gradually raise interest rates, a move that, due to Hong Kong's peg to the US dollar, will invariably increase the cost of credit from what have been historic lows for close to a decade.

Many of the troubled loans that borrowers have refinanced until now will go bad. As the excess credit recedes, pressure will mount on an overvalued property market where prices have climbed more than 170 per cent since early 2009.

"In fact, Hong Kong is caught in a pincer movement between a prospective US monetary policy tightening and the continued slowdown and travails of the mainland economy with which Hong Kong's economic cycle is increasingly more correlated," said Mole Hau, an Asia economist at BNP Paribas, in a note to investors.

"Downward pressures on domestic costs and asset prices, including property values, will build, adding to more popular discontent against the peg."

At home, the ultra-low interest rates have caused Hong Kong's domestic loan-gross domestic product ratio to soar.

This measure of credit growth against the economy showed that outstanding loans had reached 209 per cent of GDP growth at the end of March, according to Moody's Investors Service, a record high and up from 203 per cent in the third quarter of last year.

One of the main reasons that loans have increased so fast compared to flagging GDP growth, and non-performing loans have stayed at a negligible level, was because credit has been so cheap that many borrowers refinance instead of defaulting on loans.

The non-performing loan ratio, which hovered at a low 0.46 per cent at the end of March, will rise with interest rates.

How fast that rise in bad debt plays out is a question for the Fed. The first increase in the rate is still expected by some next month but growing gloom across international markets, including in China and the US, has more than a few economists betting that the Fed will baulk next month, potentially giving emerging markets a moment to catch their breath.

By the middle of next year, the Fed rate could be 1 per cent higher than the current 0.25 per cent.

"The headwinds for Hong Kong, even if we factor into a very gradual tightening cycle, are still underestimated," UBS economist Silvia Liu said in a report.

Hong Kong's low economic growth rate was out of step with that of the US.

At the peak of a credit cycle, even a small increase in interest rates would lead to a meaningful rise in the debt service burden, Liu said, pointing out that Hong Kong's private non-financial sector debt, the kind that easily goes bad as rates rise, was far higher than it was during the Asian financial crisis: 190 per cent of GDP today compared to just 125 per cent in 1997.

Comparison with that crisis year that shook the city is bold, but Liu said that some of the similarities were uncanny.

The Fed has stated that increases in its benchmark rate should not lead to instability abroad.

Still, Bank for International Settlements senior economist Feng Zhu, speaking at an academic event in Hong Kong this month, summed up the rise in the Fed rate and the subsequent effect on emerging markets as "the problem is, eventually [a return to normal rates] may cause some problems".

Those are just the problems on Hong Kong's local loan books. Cross-border lending to mainland Chinese companies has in a few short years become the biggest driver of growth for Hong Kong banks, as well as the primary concern for the sector in general.

Lending to mainland China has hit about 190 per cent of Hong Kong's GDP and 23 per cent of total assets in the banking sector, according to data from BNP.

The banks have said the business was a natural development of Hong Kong's robust financial industry but rating agencies and the International Monetary Fund have warned that China's economic downturn could spell serious trouble for some debtors.

China's GDP was expected to grow at 6.9 per cent this year and the non-performing loan ratio at mainland commercial banks could hit 2 per cent by the end of the year, against 1 per cent at the start of last year.

It was the combination of Hong Kong's onshore and offshore challenges that has darkened its prospects for the next few years.

"All of these factors lead to a negative outlook on Hong Kong's banking system and that is not going to go away anytime soon," said Sonny Hsu, a senior analyst at Moody's.

Moody's has maintained that outlook since June 2013.

Gloomy indeed, but industry watchers have not sounded the alarm for a crisis just yet.

For one, Hong Kong banks have strong balance sheets. At the start of the year, the banking system's average tier-1 capital ratio was 13.9 per cent and total capital adequacy ratio was 16.8 per cent, according to Moody's, placing most of the banks in good positions to weather asset deterioration in mainland China and at home.

Back in 1997, the foundations of international regulations on capital were still in their infancy.

Most analysts recognise the potential for pressure to build as US interest rates rise, but the extent is expected to be limited.

"Hong Kong loans will see an increase in [non-performing loans] but we think they will remain at a fairly low level. The main concern will be in retail loans," said Edmond Law, a bank analyst at UOB Kay Hian.

The double whammy from the US and the Chinese mainland has already started to reduce the appetite for risk at Hong Kong banks. From the perspective of Hsu, shrinking balance sheets at the lenders are a positive outcome from the current situation after a period of rampant expansion.

"Investors may not like this but it's a positive sign for the bank's credit quality," he said.

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