Don't be fooled by Chinese banks' reported improvement in asset quality

Profitability has been further reduced, as well as solvency ratios to a lesser extent.

The China Banking Regulatory Commission has released main regulatory indicators in 2016. Reported asset quality seems to have improved, at least when measured by the ratio of stressed loans to total loans. Non-performing loans (NPL) increase but the proportion is diluted by loan growth, according to Natixis.

Here's more from Natixis:

The major change comes from the reduction in special mention loans (SML). However, the reason behind is not a rebound in corporate repayment ability, but the massive bank cleanup scheme, i.e. the debt-to- quity (D/E) swaps. The improvement is so far only half the size of the D/E swaps that have been carried out in Q4.

We estimate that 203 RMB billion worth of debt has been swapped into equity in Q4 2016 from available disclosure. This is equivalent to 5.8% of SML. Most of the swaps have been in old industries, such as coal and steel, which are highly indebted with repayment issues.

This move is positive in improving bank’s asset quality at the cost that risk is shifted to rest of the financial system. We expect the cleanup with a similar scale to continue in Q1 2017. As shown in a previous note, the total scale of the D/E swaps will range between 1.5 to 3.1 RMB trillion.

Worsening profitability and solvency
The measures have shifted the risk away from banks into the rest of the financial sector but the risk has not disappeared. Furthermore, the general financial health of Chinese banks has not really improved. Profitability has been further reduced, as well as solvency ratios to a lesser extent.

First, profitability continues to worsen as banks could not halt the fall in ROA and ROE. Second, in terms of solvency, NPL coverage ratio has improved slightly. However, this does not change the fact that the provision covers only half of the total stressed loans. Banks are still capable of meeting regulatory requirements, but key capital ratios have declined, i.e. no organic capital is created.