By staff reporter Li Zengxin

China’s economic slowdown has exposed several problems for commercial banks, which now face their first major test since the nation’s shareholding reform began in 2003, said Shen Minggao, Caijing’s chief economist.

In the sixth edition of Caijing Macroeconomic Weekly Review, released September 22, Shen predicted commercial banks would be subject to constraints due to a narrowing loan-deposit interest rate gap, falling loan growth rate, and rising non-performing loan (NPL) ratio.

It’s the most pain China’s commercial banks have felt since a reform of the shareholding system began under fairly good economic conditions. Now, as economic growth slows, factors such as changing liquidity positions, fluctuating equity prices, loan quality downgrades and policy adjustments may bring adverse effects.

All this change has given commercial banks a full-scale test, especially in terms of incentive mechanisms, risk control maintenance and income growth styles. This testing process has five key aspects.

First, the NPL ratio is likely to bounce. The overall ratio in the banking industry may rise if most economic adjustments occur in the nation’s eastern coastal area. Data show NPL ratios for loans to small- and medium-sized enterprises have been rising in this region.

Second, the loan growth rate is falling. Commercial bank income from intermediary business has expanded steadily in recent years, but interest income is still the main income source. With a guaranteed loan-deposit interest rate differential, banks rely heavily on loan growth to generate profit. In the second half of 2008, the People’s Bank of China loosened its credit control by five percent. But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007’s.

Third, the loan-deposit interest rate gap may further shrink. On inflation concerns, a loosening of monetary policy will likely be handled in an asymmetric style. That is, loan rates will be cut while deposit rates remain unchanged, which is what the central bank did September 15.

Fourth, loans to the real estate sector and local governments will become more risky. Personal mortgages and property developer loans currently account for more than 20 percent of the lending at major banks. If house prices continue falling, however, NPLs in real estate may soar.

Fifth, administrative measures may bring side-effects. Loosening credit controls and the “double cut” decision to trim loan interest rates while lowering the required reserve ratio for banks are steps aimed at encouraging banks to lend. If the government sets loan targets for commercial banks through administrative measures, banks will lower their standards for qualified borrowers, which could lead to even more NPLs.

“The big risk for commercial banks comes from an economic slowdown,” Shen concluded, adding that bank performance prospects will depend on how well they unpeg their business from the real economy.

The sixth edition of Caijing Macroeconomic Weekly Review also contains a section called Caijing Web Site Columnist’s Opinion: Dangerous Bubble. In this section, Shen and Andy Xie, a board member for Rosetta Stone Advisors Ltd., compare and contrast the realty sectors in the United States and China.

An accompanying Weekly Summary of Macroeconomic Events includes analyses and assessments of the past week’s key domestic and international economic developments. It also includes viewpoints from top government officials and academics about China’s macroeconomic positions, which were expressed during a Caijing-hosted financial forum September 18.